The Demand Side of the The Demand Side of the Market Market - - PDF document

The Demand Side of the The Demand Side of the Market Market

Econ Dept, UMR Presents

N Utility Theory N Consumer Surplus N Elasticity

Starring Starring

Featuring Featuring

N NThe MU/P Rule

The MU/P Rule

N NThe Meaning of Value

The Meaning of Value

N NFour Elasticities:

Four Elasticities:

O OPrice Elasticity of Demand

Price Elasticity of Demand

O OIncome Elasticity

Income Elasticity

O OCross Price Elasticity

Cross Price Elasticity

O OPrice Elasticity of Supply

Price Elasticity of Supply

N NThe Elasticity

The Elasticity-

• TR Relationship

TR Relationship

In Three Parts In Three Parts

Consumer Choice Theory Consumer Choice Theory Consumer Surplus Consumer Surplus Elasticity Elasticity

• A. Price Elasticity of Demand
• A. Price Elasticity of Demand
• B. Other Important Elasticities
• B. Other Important Elasticities

Elasticity Elasticity Measures of Response Measures of Response

Part 3

This Slide Show Discusses This Slide Show Discusses Income Elasticity; Cross Price Income Elasticity; Cross Price Elasticity of Demand; And Elasticity of Demand; And Price Elasticity of Supply Price Elasticity of Supply

N N Price elasticity of demand is discussed

Price elasticity of demand is discussed in slide show III.A. in slide show III.A.

Review: A Generic Definition Review: A Generic Definition

• f Elasticity
• f Elasticity

N N Y = f(x)

Y = f(x)

N N Elasticity,

Elasticity, , , ,

, = %

= %∆ ∆y/ y/% %∆ ∆x, where x, where ∆ ∆ is read is read “ “change in change in” ”

N N %

%∆ ∆Y = ( Y = (∆ ∆y/y)*100; y/y)*100; % %∆ ∆X = ( X = (∆ ∆x/x)*100 x/x)*100

N N (

(∆ ∆Y/y)/( Y/y)/(∆ ∆x/x), or x/x), or

N N [(

[(∆ ∆Y/ Y/∆ ∆x)/(x/y)] x)/(x/y)]

N N In words, elasticity gives us the estimated

In words, elasticity gives us the estimated percentage change in one variable, y, in percentage change in one variable, y, in response to a percentage change in another response to a percentage change in another variable, x, variable, x, c.p. c.p.

Review: G Review: Generic Interpretation

eneric Interpretation

• f Elasticity
• f Elasticity

N N ,

,

= % = %∆ ∆Y/ Y/% %∆ ∆x = 2 x = 2

O O This means if x were to change by 1 percent

This means if x were to change by 1 percent we would expect y to change by 2 percent we would expect y to change by 2 percent in the in the same same direction, direction, c.P c.P

N N ,

,

= % = %∆ ∆Y/ Y/% %∆ ∆x = x = -

• 2

2

O O This means if x were to change by 1 percent

This means if x were to change by 1 percent we would expect y to change by 2 percent we would expect y to change by 2 percent in the in the opposite

• pposite direction,

direction, c.p. c.p.

Other Important Elasticities Other Important Elasticities

INCOME ELASTICITY CROSS-PRICE ELASTICITY PRICE ELASTICITY OF SUPPLY % change DX % change in consumer income % change DX % change in the price of another good, Z

= =

% change Qs % change in price

= , I = =

, X,Z

= , S

Elasticity Formulas Elasticity Formulas

N N Income elasticity

Income elasticity

N N Cross price elasticity of demand

Cross price elasticity of demand

N N Price elasticity of supply

Price elasticity of supply

%∆ in QS ∆QS ∆ P P Q , S = %∆ in P = %∆ in D ∆D ∆ I I D , I = %∆ in I = %∆ in D1 ∆D1 ∆ P2 P2 D1 , D1,P2 = %∆ in P2 =

Income Elasticity of Demand Income Elasticity of Demand

N N An estimate of the rate at which the

An estimate of the rate at which the demand for a good changes as demand for a good changes as consumer incomes change by a given consumer incomes change by a given percent percent

Income Elasticity of Demand Income Elasticity of Demand

N N Income elasticity of demand

Income elasticity of demand ( (,

, I

I)

) -

• measures the responsiveness of demand

measures the responsiveness of demand to changes in income to changes in income

O O

% %∆ ∆ In D In D % %∆ ∆ in income in income

N N Note that the sign IS important!

Note that the sign IS important!

, I =

Normal Goods Normal Goods

N N Typically, if our income rises, we buy

Typically, if our income rises, we buy more and visa versa. These types of more and visa versa. These types of goods are called goods are called normal goods normal goods

N N

> 0 normal good > 0 normal good

, I

Inferior Goods Inferior Goods

N N There are some good we buy less of as

There are some good we buy less of as

• ur income grows and more of as our
• ur income grows and more of as our

income falls income falls

N N For instance, in college you probably

For instance, in college you probably eat a lot of hamburger. But when you eat a lot of hamburger. But when you get a well get a well-

• paying job (as all UMR grads

paying job (as all UMR grads do) you will probably buy more steak do) you will probably buy more steak and less burger and less burger

N N If a good’s income elasticity is < 0 it is

If a good’s income elasticity is < 0 it is an inferior good an inferior good

Calculating Income Elasticity Calculating Income Elasticity

N N D

DX

X = 100

= 100 -

• 2p

2px

x + 0.5inc

+ 0.5inc

N N ∆

∆D DX

X/

/∆ι ∆ιnc = 0.5 thus X is a nc = 0.5 thus X is a “ “normal normal” ” good good

N N Evaluate

Evaluate ,

, I

I at any given income and

at any given income and quantity, e.G., quantity, e.G.,

N N D = 200 million units; Inc = $600 million

D = 200 million units; Inc = $600 million

N N ,

, I

I = 0.5(600/200) = 1.5

= 0.5(600/200) = 1.5

Cross Price Elasticity of Demand Cross Price Elasticity of Demand

N N Another type of elasticity is the

Another type of elasticity is the cross cross price elasticity price elasticity. This gets at how . This gets at how changes in price of one good can effect changes in price of one good can effect the demand of another the demand of another

N N Cross price elasticity of demand

Cross price elasticity of demand ( ) ( ) measures the responsiveness of measures the responsiveness of quantity demanded of good one when quantity demanded of good one when the price of good two changes the price of good two changes

N N This elasticity is very important in

This elasticity is very important in antitrust cases antitrust cases

, 1, 2

Cross Price Elasticity of Cross Price Elasticity of Demand Demand

N N The % change in the demand for one

The % change in the demand for one good divided by the % change in the good divided by the % change in the price of another good. price of another good.

N N Substitutes

Substitutes -

• as price of A rises so does the

as price of A rises so does the demand for B. demand for B.

N N Complements

Complements -

• as price of A rises the

as price of A rises the demand for B decreases. demand for B decreases.

N N Unrelated

Unrelated -

• as the price of A rises there is

as the price of A rises there is no change in the demand for B. no change in the demand for B.

Cross Price Elasticity of Cross Price Elasticity of Demand Demand

N N

% % ∆ In D of good 1 In D of good 1 % % ∆ ∆ in P of good 2 in P of good 2

N N Note that the sign DOES matter for this

Note that the sign DOES matter for this elasticity also! elasticity also!

O O If

If , , 1,2

1,2 >

> 0 goods one and two are 0 goods one and two are substitutes substitutes

O O If

If , , 1,2

1,2 <

< 0 goods one and two are 0 goods one and two are complements complements

, 1,2 =

Substitute Goods Substitute Goods

N N Consider coke and Pepsi. If the price of

Consider coke and Pepsi. If the price of coke goes up, what would you expect to coke goes up, what would you expect to happen to the demand for Pepsi happen to the demand for Pepsi

O O It will rise, since people will buy less coke

It will rise, since people will buy less coke and more Pepsi. Thus the demand for and more Pepsi. Thus the demand for Pepsi will rise Pepsi will rise

N N So the bottom of the elasticity fraction is

So the bottom of the elasticity fraction is positive and the top of the elasticity positive and the top of the elasticity fraction is positive, fraction is positive, ,

, 1,2

1,2 >

> 0

Complement Goods Complement Goods

N N Consider washing machines and dryers.

Consider washing machines and dryers. If the price of washing machines goes If the price of washing machines goes up, what would you expect to happen up, what would you expect to happen to the demand for dryers to the demand for dryers

O O It will fall, since people will buy less

It will fall, since people will buy less washers at the new price, they will need washers at the new price, they will need less dryers less dryers

N N So the bottom of the elasticity fraction is

So the bottom of the elasticity fraction is positive and top of the elasticity fraction positive and top of the elasticity fraction is negative, is negative, ,

, 1,2

1,2 <

< 0

Calculating Cross Price Elasticity Calculating Cross Price Elasticity

N N D

DX

X = 100

= 100 -

• 2p

2px

x + 0.5inc

+ 0.5inc -

• 8000P

8000PW

W + 4000P

+ 4000PZ

Z

N N ∆

∆D DX

X/

/∆ ∆P PW

W =

= -

• 8000 thus X and W are

8000 thus X and W are complements complements

N N ∆

∆D DX

X/

/∆ ∆P PZ

Z = 4000 thus X and Z are

= 4000 thus X and Z are substitutes substitutes

N N Evaluate

Evaluate ,

, XW

XW or

• r ,

, XZ

XZ at any given price of

at any given price of W or Z and quantity, e.G., W or Z and quantity, e.G.,

N N D = 20 million units; P

D = 20 million units; PW

W = $100; P

= $100; PZ

Z = $50

= $50

O O ,

, XW

XW =

= -

• 8000(100/20m) =

8000(100/20m) = -

• 0.04

0.04

O O ,

, XZ

XZ = 4000(50/20m) = 0.01

= 4000(50/20m) = 0.01

Demand Elasticities for Alcoholic Demand Elasticities for Alcoholic Beverages Beverages

Beer Wine Spirits

, WB = 0.16 , BW = 0.31 , B = 0.23 , W = 0.40 , Sp = 0.25 , SpB = 0.07 , BSp = 0.15 , WSp = 0.10 , SpY = 0.09 , WI = 5.03 , BI = -0.09 , SpI = 1.21 I: Income; B: Beer; W: Wine; Sp: Spirits; , B(W)(Sp): Price elasticity of beer (wine, spirits); , XZ: Cross Price Elasticity of X with respect to Z, that is the % change in the demand for X divided by the % change in the price of Z; , XI: Income Elasticity

• f X.

Source: Goa, et.al., Applied Economics, Jan. 1995

Notes on Estimated Demand Notes on Estimated Demand Elasticities for Alcoholic Beverages Elasticities for Alcoholic Beverages

Beer Wine Spirits

, WB = 0.16 , BW = 0.31 , B = 0.23 , W = 0.40 , Sp = 0.25 , SpB = 0.07 , BSp = 0.15 , WSp = 0.10 , SpY = 0.09 , WI = 5.03 , BI = -0.09 , SpI = 1.21 >Notice Beer, Wine, and Spirits are substitutes as defined by economists >Which two are closest substitutes? Appears beer for wine >Which is more sensitive to changes in income? Looks like Wine >Notice Beer is an “inferior” good

Elasticity of Supply Elasticity of Supply

N N This one is the same as price elasticity

This one is the same as price elasticity

• f demand, except we substitute the
• f demand, except we substitute the

word supply for demand and drop the word supply for demand and drop the negative sign in the definition negative sign in the definition

N N Elasticity of supply

Elasticity of supply, , ,

, S

S , , measures the

measures the responsiveness of quantity supplied to responsiveness of quantity supplied to changes in price of the good changes in price of the good

Elasticity of Supply Elasticity of Supply

N N

% %∆ ∆ In Q In Qs

s

% %∆ ∆ in P in P

N N The tendency of supply tells us this

The tendency of supply tells us this number is generally positive number is generally positive

, S =

Calculating Price Elasticity of Calculating Price Elasticity of Supply Supply

N N S

SX

X =

= -

• 100 + 2p

100 + 2px

x

N N ∆

∆ S SX

X/

/∆ ∆P PX

X = 2.0

= 2.0

N N Evaluate

Evaluate ,

, S

S at any given price and

at any given price and quantity, e.G., quantity, e.G.,

N N S = 200 units; P

S = 200 units; PX

X = $60

= $60

N N ,

, S

S = 2(60/200) = 0.6

= 2(60/200) = 0.6

Estimates of Labor Supply Estimates of Labor Supply Elasticity Elasticity

N N ,

, S

S of annual hours for males is estimated at

• f annual hours for males is estimated at
• 0.1 (a 10% increase in wages is predicted to

0.1 (a 10% increase in wages is predicted to reduce annual hours of males by 1%) reduce annual hours of males by 1%)

N N ,

, S

S of annual hours for women is 0.2

• f annual hours for women is 0.2

N N ,

, Sf Wh

Sf Wh, %

, %) )female hours/% female hours/%) )husband husband’ ’s wage, s wage, estimated at 0.17 estimated at 0.17

N N ,

, Sflfpr Wh

Sflfpr Wh, %

, %) )female labor force participation female labor force participation rate/% rate/%) )husband husband’ ’s wage, estimated at 0.53 s wage, estimated at 0.53

Determinants of Elasticity of Determinants of Elasticity of Supply Supply

N N If supply is getting more (or less)

If supply is getting more (or less) elastic, we are saying that the sellers can elastic, we are saying that the sellers can change supply in larger (or smaller) change supply in larger (or smaller) quantities when price changes quantities when price changes

N N Generally,

Generally, anything anything that can effect a that can effect a seller seller’ ’s ability to change production s ability to change production will effect the elasticity of supply will effect the elasticity of supply

Determinants of Elasticity of Determinants of Elasticity of Supply Supply

N N The time period: the longer the period

The time period: the longer the period the more elastic supply the more elastic supply

N N Availability of alternatives: the more

Availability of alternatives: the more alternatives, or an improvement in the alternatives, or an improvement in the attractiveness of alternatives, the more attractiveness of alternatives, the more elastic supply elastic supply

The End