Econ ch04

Chapter 4 Section Main Menu

Understanding Demand

• What is the law of demand?

• How do the substitution effect and income effect influence decisions?

• What is a demand schedule?

• What is a demand curve?


Law of Demand

• Demand – the desire to own something and ability to pay for it

• Law of Demand

– Price goes down = demand goes up

– Price goes up = demand goes down

– Price of a good strongly influences the decision to buy it

– Example

• How many pieces of pizza would you buy at $1?

• Same piece at $2, $3, and so on


Law of Demand

• Two separate patterns overlap b/c of Law of Demand

– Substitution Effect and Income Effect

• They describe 2 different ways that a consumer can change their spending patterns


Substitution Effect

• When the price of the pizza rises, more people will start buying other products

– Drops the demand for pizza

– Change in spending is known as the substitution effect

• Eating pizza on Mondays and Fridays now turns into pizza on only Mondays and something else on Fridays

– Reacting to the price change of one good and substituting it for another


The Income Effect

• Price of the goods you buy go up, you start to make cut backs on the purchases you make

– Cut back on buying pizza, clothes, etc.

• Buying fewer products w/o increasing your purchases of other goods is the Income Effect

• Economists measure consumption in the amount of a good that is bought, not the price on the good

– Spending more on pizza but you are consuming less

• People spend more money on pizza, the demand still goes down


Understanding Demand

• To have demand for a good you must be willing and able to pay for it at a specified price

– Might want a new car, but you can’t afford it so you do not demand it

• Demand Schedule

– Table that lists the quantity of a good that a person will purchase at each price in a market


Market Demand Schedules

• Adding up the demand schedules for every buyer in the market, this is creating a Market Demand Schedule

– Shows the quantities demanded at each price by all consumers in the market

– Businesses use these to predict the total sale of a product at different prices

• This schedule shows the Law of Demand in play


Demand Schedules

Individual Demand Schedule

Price of a slice of pizza

Quantity demanded per day

Market Demand Schedule

Price of a slice of pizza

Quantity demanded per day

$.50

$1.00

$1.50

$2.00

$2.50

$3.00

5

4

3

2

1

0

$.50

$1.00

$1.50

$2.00

$2.50

$3.00

300

250

200

150

100

50

The Demand Schedules


Market Demand Curve

3.00

2.50

2.00

1.50

1.00

.50

0

0 50 100 150 200 250 300 350Slices of pizza per day

Pri

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ars)

Demand

The Demand Curve

• A demand curve is a graphical representation of a demand schedule.

• Reading a demand curve

–Only price and quantity are taken into account

–Slopes downward and right

–Prices rise, quantity drops

–Prices decrease, quantity raises


Limits of a Demand Curve

• Only accurate for one very specific set of market conditions

• Does not take any other factors into account

– Pizza place near a factory that has layoffs will lose business b/c those workers will stop coming in


Shifts of the Demand Curve

• What is the difference between a change in quantity demanded and a shift in the demand curve?

• What factors can cause shifts in the demand curve?

• How does the change in the price of one good affect the demand for a related good?


Changes in Demand

• Demand curves are accurate as long as there are no other changes other than price that affects decisions

• Ceteris Paribus

– “all other things held constant”

– This was used on the Demand Curve w/ pizza

– Does not take into account any other factors (only price and quantity)

• When price changes we move along the curve

– Change in quantity demanded

– Up or down the curve


Changes in Demand

• Get rid of the ceteris paribus rule then we no longer move along the curve

– The entire curve shifts left or right

• A shift in the demand curve means that at every price, consumers buy a diff. amount than before

– Called Change in Demand


Causes for Shifts - Income

• Normal Goods – goods that consumers demand more of when their income increases

– This would move the curve to the right to show more demand at each price

• Increase in Demand

• Decrease in Demand – if the curve shifts to the left

– Inferior Goods – an increase in income causes us to buy less of these

• Buy name brand stuff once your income rises instead of store brand


Causes - Consumer Expectations

• Expectations of a higher price will affect your immediate demand of the product

– Example

• Go into Best Buy to buy a laptop and the sales person tells you the price will go up in a week

• Your demand for the product raises and you would probably purchase it then b/c you expect a higher price

• Your immediate demand will drop if the laptop would be on sale next week


Causes - Population

• Rise in population obviously raises the demand for food, shelter, etc.

• After WWII

– Record number of men and women married and had children (“baby boom”) from mid 1940s – 1964

– Initial demand grew w/ baby products, then it thousands of schools were needed and built (universities also expanded later)

– Now that they are retiring, the demands among senior citizens will rise


Causes – Consumer Tastes and Advertising

• Trends change over periods of time (clothes, music, etc.)

• Advertising and publicity play an important role

– Companies spend large amounts of money on advertising to try and raise the demand for their products


Prices of Related Goods

• Demand curve for one good can be affected by a change in the demand for another good

– Complements

• Two goods that are bought and used together

• Buy new skis, need ski boots

• If the price of skis go up, the demand for both products go down

– Substitutes

• Goods used in place of another

• Price of skis goes up, some people will switch to snowboarding


Elasticity of Demand

• What is elasticity of demand?

• How can a demand schedule and demand curve be used to determine elasticity of demand?

• What factors affect elasticity?

• How do firms use elasticity and revenue to make decisions?



• Elasticity of Demand - Dictates how drastically buyers will cut back or increase their demand for a good when price rises or falls

• Inelastic – demand for a good that you will keep buying no matter the rise in price

– Not too responsive to price change

• Elastic – buy much less of a good when the price increases

– Very responsive to price change


Price Range

• Demand for a good can be highly elastic at one price and inelastic at another

– Example:

• Price of a bottle of Coke goes from $1.00 to $1.50– Raises 50%, most people will keep buying

almost the same amount– Inelastic

• If the price went from $2.00 to $3.00– Still 50% rise, however the demand will go

down more than the first example– Highly elastic


Values of Elasticity

• If the elasticity of demand for a good at a certain price is LESS than 1 it is INELASTIC

• Elasticity is GREATER than 1 it is ELASTIC

• Elasticity = 1, it is called Unitary Elastic

– % change in quantity demanded is exactly equal to the % change in the price

– Example: Demand for a magazine at $2 is unitary

• Price rises to $3 (50% rise)

• The newsstand will sell exactly half as many copies as before


Values of Elasticity

• Pizza Example from before

– Demand schedule showed that when the price rose from $1 to $1.50, her demand fell from 4 to 3 slices

– Change in price was 50% and the quantity decreased by 25%

– Dividing 25% by 50% you get .5

– Less than 1 so it is inelastic



Elasticity is determined using the following formula:

Elasticity =Percentage change in quantity demanded

Percentage change in price

Percentage change =Original number – New number

Original numberx 100

To find the percentage change in quantity demanded or price, use the following formula: subtract the new number from the original number, and divide the result by the original number. Ignore any negative signs, and multiply by 100 to convert this number to a percentage:

Calculating Elasticity


If demand is elastic, a small change in price leads to a relatively large change in the quantity demanded. Follow this demand curve from left to right.

Pri

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Quantity

$7

$6

$5

$4

$3

$2

$1

Elastic Demand

05 10 15 20 25 30

Demand

The price decreases from $4 to $3, a decrease of 25 percent.

$4 – $3

$4x 100 = 25

The quantity demanded increases from 10 to 20. This is an increase of 100 percent.

10 – 20

10x 100 = 100

Elasticity of demand is equal to 4.0. Elasticity is greater than 1, so demand is elastic. In this example, a small decrease in price caused a large increase in the quantity demanded.

100%

25%= 4.0

Elastic Demand


Pri

ce

Quantity

$7

$6

$5

$4

$3

$2

$1

Inelastic Demand

05 10 15 20 25 30

Demand

If demand is inelastic, consumers are not very responsive to changes in price. A decrease in price will lead to only a small change in quantity demanded, or perhaps no change at all. Follow this demand curve from left to right as the price decreases sharply from $6 to $2.

The price decreases from $6 to $2, a decrease of about 67 percent.

$6 – $2

$6x 100 = 67

The quantity demanded increases from 10 to 15, an increase of 50 percent.

10 – 15

10x 100 = 50

Elasticity of demand is about 0.75. The elasticity is less than 1, so demand for this good is inelastic. The increase in quantity demanded is small compared to the decrease in price.

50%

67%= 0.75

Inelastic Demand


Factors Effecting Elasticity

• Availability of Substitutions

– No good substitutions for a product means when the price rises for one, you will probably still buy it

• Want to see your favorite band in concert, probably buy the tickets b/c there is no good sub (inelastic)

– Lots of substitutes make some products elastic

• Foods at grocery store, just switch brands based on price


Factors continued

• Relative Importance

– If you buy a lot of one good and price goes up, you must make tough decisions

• Reduce consumption of that good or cut back drastically on other goods in order to keep budget in control

• Higher the jump, more adjustments

• Spend half of budget on clothes, price goes up, large cut backs = elastic demand


Factors continued

• Necessities vs. Luxuries

– Necessities – food, water, gas, clothes, etc.

• Things we buy no matter the price (inelastic)

– Some people feel that Starbucks is a luxury

• Price goes down more people will buy it

• Price its at now and especially if it rises, people will buy cheaper coffee

• Elastic

• Everyone has different idea of what necessities and luxuries are


Change Over Time

• Consumers shopping habits do not change quickly when prices increase

– Takes time to find substitutes

– Inelastic in the short term, but becomes elastic over time

• Example

– Person buys an SUV that takes a lot of gas to run

– Work is far away and so is the grocery store

– Factors can’t be changed very easily


Change Over Time

• Gasoline Example continued

– 1970s – gas prices rose, but at first people kept buying gas

– Over time the prices stayed high so people bought more fuel efficient cars or car pooled

– Demand for gas went down

– Inelastic in short term, became elastic over time


Computing a Firm’s Total Revenue

• Total Revenue – the total amount of money a firm receives by selling goods/services

– Need to know the price of goods and the amount sold

– Pizzeria sells 125 slices/day at $2 a slice

– Total revenue is $250/day


Total Revenue and Elastic Demand

• When a good has an elastic demand (price of each good raises 20% and the quantity sold drops by 50%)

– Quantity sold drops enough to reduce the total revenue

• Pizzeria Example

– $2.50/slice will sell 100 slices/day making total revenue $250

– Increase the price to $3/slice and you only sell 50 slices/day

• Total revenue is now only $150


Total Revenue and Elastic Demand

• Elastic Demand comes from one or more of these factors

– 1. Availability of substitute goods

– 2. a limited budget that does not allow price changes

– 3. the perception of the good as a luxury item

• If these are present, then the firm may find a price increase reduces total revenue


Total Revenue and Inelastic Demand

• Firm raises its price by 25% and the amount sold falls by less than 25%

– Firm has greater total revenues

– Higher price makes up for the firm’s lower sales

• A decrease in price will lead to an increase in quantity demanded (if demand is inelastic)

– Demand will not rise much (in %) as price fell

– Firms total revenue will decrease


Elasticity and Revenue

• Elastic Demand

– Price is lowered = total revenue rises

– Price raised = total revenue falls

• Inelastic Demand

– Price lowered = total revenue falls

– Price raised – total revenue rises

Econ ch04

Business

Transcript of Econ ch04