The Demand Side of the The Demand Side of the Market Market - - PowerPoint PPT Presentation

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

Econ Dept, UMR Presents

Utility Theory Consumer Surplus Elasticity

Starring Starring

Featuring Featuring

• The MU/P Rule

The MU/P Rule

• The Meaning of Value

The Meaning of Value

• Four Elasticities:

Four Elasticities:

• Price Elasticity of Demand

Price Elasticity of Demand

• Income Elasticity

Income Elasticity

• Cross Price Elasticity

Cross Price Elasticity

• Price Elasticity of Supply

Price Elasticity of Supply

• The 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

Consumers and producers move along their demand and supply curves when the price of the good changes QUESTION: HOW CAN WE PREDICT THE MAGNITUDE OF THESE REACTIONS? Demand and supply curves shift when factors

• ther than price change in the marketplace

QUESTION: HOW CAN WE PREDICT THE MAGNITUDE OF THESE REACTIONS?

ANSWER: ELASTICITIES!!

A Generic Definition of A Generic Definition of Elasticity Elasticity

• Y = f(x)

Y = f(x)

• Elasticity,

Elasticity, ,

, ,

, = %

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

• %

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

• (

(∆ ∆Y/y)/( Y/y)/(∆ ∆x/x), or x/x), or

• [(

[(∆ ∆Y/ Y/∆ ∆x)/(x/y)] x)/(x/y)]

• 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

G Generic Interpretation of Elasticity

eneric Interpretation of Elasticity

• ,

,

= % = %∆ ∆Y/ Y/% %∆ ∆x = 2 x = 2

• 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.

• ,

,

= % = %∆ ∆Y/ Y/% %∆ ∆x = x = -

• 2

2

• 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.

Rewriting the Formula for Elasticity Rewriting the Formula for Elasticity

• ,

,

= % = %∆ ∆Y/ Y/% %∆ ∆x x

• Percentage change,

Percentage change, %

%∆ ∆y = ( y = (∆ ∆ y/y)*100 y/y)*100

• E.G., Percentage change from 50 to 100 is change

E.G., Percentage change from 50 to 100 is change (= +50), divided by the base (=100) times 100 = (= +50), divided by the base (=100) times 100 = (50/100)* 100 = 50% (50/100)* 100 = 50%

• Since the numerator and denominator have 100,

Since the numerator and denominator have 100, they cancel, and they cancel, and

• ,

,

= % = %∆ ∆Y/ Y/% %∆ ∆x = ( x = (∆ ∆y/y)*( y/y)*(∆ ∆x/x) or x/x) or

• ,

,

= = ( (∆ ∆Y/ Y/∆ ∆x)*(x/y) x)*(x/y)

• It

It’ ’s this last formula that is most convenient s this last formula that is most convenient to use as we see later to use as we see later

• Price elasticity of demand

Price elasticity of demand

• Cross price elasticity of demand

Cross price elasticity of demand

• Income elasticity

Income elasticity

• Price elasticity of supply

Price elasticity of supply

D1 D

Some Important Elasticities Some Important Elasticities

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

This Slide Show Discusses This Slide Show Discusses Price Elasticity of Demand Price Elasticity of Demand

• Other Elasticities are discussed in slide

Other Elasticities are discussed in slide show III.B. show III.B.

Price Elasticity of Demand Price Elasticity of Demand Measures How Responsive Measures How Responsive Consumers Are to Changes Consumers Are to Changes in the Price of a Product in the Price of a Product

Demand Demand

• We know, from the law of demand, that

We know, from the law of demand, that price and quantity demanded are price and quantity demanded are inversely related inversely related

• Now, we are going to get more specific

Now, we are going to get more specific in defining that relationship in defining that relationship

• We want to know just

We want to know just how much how much will will quantity demanded change when price quantity demanded change when price changes? That is what changes? That is what elasticity of elasticity of demand demand measures measures

• Price elasticity of demand

Price elasticity of demand ( (,

, D

D)

) measures the responsiveness of Q measures the responsiveness of QD

D of a

• f a

good to a change good to a change in its P in its P

• %

%∆ ∆ In Q In QD

D

% %∆ ∆ in P in P

• Note that

Note that ∆

∆ means “change”

means “change”

• Also note that the law of demand

Also note that the law of demand implies implies ∆ ∆Q QD

D ∆

∆P is negative. Our P is negative. Our definition of definition of ,

, D

D includes a negative

includes a negative sign, so sign, so ,

, D

D will always be a positive

will always be a positive number (I know its confusing but …) number (I know its confusing but …)

Price Elasticity of Demand Price Elasticity of Demand

, D = -

Ambiguity of the Sign of Ambiguity of the Sign of ,

, D

D

• Some economists define

Some economists define ,

, D

D with

with a a negative sign, that negative sign, that’ ’s what we do s what we do

• Some economists leave the negative sign

Some economists leave the negative sign

• ut of the formula and then talk about
• ut of the formula and then talk about

about the absolute value of about the absolute value of ,

, D

D

• Some economists are just sloppy and talk

Some economists are just sloppy and talk

• f negative
• f negative ,

, D

D sometimes and positive

sometimes and positive sometimes sometimes

• Regardless the interpretation is the same:

Regardless the interpretation is the same:

• If

If = 2 or = 2 or -

• 2 the meaning is clear, a 10%

2 the meaning is clear, a 10% change in price is expected to change change in price is expected to change quantity demanded quantity demanded in the opposite direction in the opposite direction by 20% by 20%

, D

Calculating Elasticity of Calculating Elasticity of Demand Demand

P Q/t

5 6 2 6 16 14 4 1 D Consider the following Demand Curve: QD = 16 - 2P 12

Calculating Elasticity Calculating Elasticity

P Q/t

5 6 2 6 4 1 D A …and let’s say we want to find the Elasticity of Demand at point A Notice the slope of the demand curve, ) P/) Q, = -1/2

• We know

We know

• %

%∆ ∆ Can be calculated as the change divided Can be calculated as the change divided by starting point by starting point

• In this case,

In this case, ∆ ∆Q QD

D/

/)

) P

P is

is -

• 2 (the inverse of the

2 (the inverse of the slope of the demand curve) slope of the demand curve)

• P/Q is 6/4 (we use the initial P and Q as our

P/Q is 6/4 (we use the initial P and Q as our base base

• ,

, D

D =

= -

• (

(-

• 2

2)(

)(6/4

6/4)

) = 3

= 3

Calculating Elasticity Calculating Elasticity

%∆ in QD ∆Q ∆ P P Q , D = - %∆ in P = -

Calculating Elasticity Calculating Elasticity

P Q/t

5 6 2 12 4 1 D A Now, let’s find the Elasticity of Demand at point C C

• Again,

Again,

• ∆

∆Q

QD

D/

/∆

∆P P is still

is still -

• 2 (the inverse of the slope of

2 (the inverse of the slope of the demand curve) the demand curve)

• P/Q is 2/12 (again use the initial P and Q as

P/Q is 2/12 (again use the initial P and Q as the base the base

• ,

, D

D =

= -

• (

(-

• 2)(2/12

2)(2/12)

) = 1/3

= 1/3

Calculating Elasticity Calculating Elasticity

%∆ in QD ∆Q ∆ P P Q , D = - %∆ in P = -

Calculating Elasticity Calculating Elasticity

• Note that is different at different places

Note that is different at different places along the curve along the curve

• Specifically, it gets smaller as you move

Specifically, it gets smaller as you move down the curve down the curve

• Note that elasticity and slope are NOT the

Note that elasticity and slope are NOT the same thing same thing

, D

Calculating Elasticity Using Calculating Elasticity Using the Demand Equation the Demand Equation

• Q

QD

D = 16

= 16 -

• 2p

2p

• The parameter attached to price is

The parameter attached to price is ∆ ∆Q

QD

D/

/∆

∆P, here = P, here = -

• 2

2

• The negative sign in the price elasticity

The negative sign in the price elasticity formula makes formula makes -

• 2 equal to 2

2 equal to 2

• Select any price and find

Select any price and find ,

, D

D

• For example at P = 7, Q

For example at P = 7, QD

D = 2

= 2

• ,

, D

D = 2(7/2) = 7

= 2(7/2) = 7

How Do We Interpret Price How Do We Interpret Price Elasticity of Demand? Elasticity of Demand?

• The number we get from computing the

The number we get from computing the elasticity is a percentage elasticity is a percentage -

• there are no

there are no units units

• We can read it as the percentage change

We can read it as the percentage change in quantity for a 1% change in price in quantity for a 1% change in price

How Do We Interpret Price How Do We Interpret Price Elasticity of Demand? Elasticity of Demand?

• Thus, if = 2, that means that at that

Thus, if = 2, that means that at that point on the demand curve, a 1% point on the demand curve, a 1% change in price will cause a 2% change change in price will cause a 2% change in quantity demanded in the opposite in quantity demanded in the opposite

• direction. Or if we extrapolate, a 2%
• direction. Or if we extrapolate, a 2%

increase in price will cause a 4% increase in price will cause a 4% decrease in quantity demanded, decrease in quantity demanded, c.p. c.p.

, D

Extreme Cases of Extreme Cases of

• Perfectly inelastic

Perfectly inelastic

• =

= -

• %

%∆ ∆ In Q In QD

D

% %∆ ∆ in P in P

• =

= -

• %

%∆ ∆ in P in P

• = 0

= 0

• No matter how much price changes,

No matter how much price changes, consumers purchase the same amount of the consumers purchase the same amount of the good good

• No example exists according to the law of

No example exists according to the law of demand, but things like insulin have an demand, but things like insulin have an elasticity that is pretty large elasticity that is pretty large

, D , D , D

, D

Perfectly Inelastic, Perfectly Inelastic, ,

, D

D =

= 0

P Q/t

Perfectly Inelastic

Extremes Cases of Extremes Cases of

• Perfectly elastic

Perfectly elastic

• =

= -

• %

%∆ ∆ In Q In QD

D

% %∆ ∆ in P in P

• =

= -

• %

%∆ ∆ In Q In QD

D

∞ ∞ % %∆ ∆ in P 0 in P 0

• =

= ∞ ∞

• No matter how little the price changes, consumer

No matter how little the price changes, consumer purchases drop to zero, or expand to infinity purchases drop to zero, or expand to infinity

• As with perfectly inelastic demand no example

As with perfectly inelastic demand no example exists according to the law of demand, but we exists according to the law of demand, but we have use for the concept of perfectly elastic when have use for the concept of perfectly elastic when we look at the behavior of firms we look at the behavior of firms , D , D , D

, D

Perfectly Elastic, Perfectly Elastic, ,

, D

D =

= ∞ ∞

P Q/t

Perfectly Elastic

Empirical Estimates of Empirical Estimates of ,

, D

D

• 0 <

0 < ,

, d

d <

< ∞ ∞

• If 0 <

If 0 < ,

, D

D < 1 we say demand is price inelastic

< 1 we say demand is price inelastic

• Any % change in P leads to a smaller % change in

Any % change in P leads to a smaller % change in Q QD

• If

If ,

, D

D = 1 we say demand is unitary elastic

= 1 we say demand is unitary elastic

• Any % change in P leads to the same % change in

Any % change in P leads to the same % change in Q QD

• If 1<

If 1< ,

, D

D <

< ∞ ∞ we say demand is price elastic we say demand is price elastic

• Any % change in P leads to a larger % change in

Any % change in P leads to a larger % change in Q QD

The Following Categories Help to The Following Categories Help to Describe Consumer Responsiveness: Describe Consumer Responsiveness:

• If the elasticity coefficient is

If the elasticity coefficient is less than 1 less than 1 demand is demand is inelastic

• inelastic. Consumers are

. Consumers are relatively unresponsive to price changes. relatively unresponsive to price changes.

• If the elasticity coefficient is

If the elasticity coefficient is greater than greater than 1 1 demand is demand is elastic

• elastic. Consumers are

. Consumers are relatively responsive to price changes. relatively responsive to price changes.

• If the elasticity coefficient is

If the elasticity coefficient is equal to 1 equal to 1, , demand is demand is unitary elastic unitary elastic. .

Generalizing About Elasticity Generalizing About Elasticity

• Notice that the vertical D curve has an

Notice that the vertical D curve has an elasticity of zero and the flat D curve has elasticity of zero and the flat D curve has an elasticity of infinity an elasticity of infinity

• As the demand curve goes from vertical

As the demand curve goes from vertical to horizontal the elasticity goes from 0 to to horizontal the elasticity goes from 0 to infinity infinity

• Unfortunately, we can’t say the flatter

Unfortunately, we can’t say the flatter the demand curve, the greater the the demand curve, the greater the elasticity elasticity

Linear Demand Curves Have Linear Demand Curves Have Elastic, Unitary, and Inelastic Elastic, Unitary, and Inelastic Regions Regions

P

D

Q/t

ELASTIC UNITARY ELASTIC INELASTIC

Midpoint 10 5 7 14 , D = ∞ , D > 1 , D = 1 , D < 1 , D = 0

Why Would a Business Firm Why Would a Business Firm Need to Calculate Them, Need to Calculate Them, and How Would the Firm and How Would the Firm Use the Information? Use the Information?

Now that you can calculate the price elasticity of demand, what would you use it for?

There Is an Important Relationship There Is an Important Relationship Between Between Price Elasticity of Demand Price Elasticity of Demand and and Total Revenues Total Revenues: :

• When demand is

When demand is inelastic inelastic, price and , price and total revenues are total revenues are directly directly related. related. Price increases generate higher Price increases generate higher revenues. revenues.

• When demand is

When demand is elastic elastic, price and total , price and total revenues are revenues are indirectly indirectly related. Price

• related. Price

increases generate lower revenues. increases generate lower revenues.

Total Revenue Total Revenue

• Total revenue = P*Q

Total revenue = P*Q

• The firm is interested in how TR (total

The firm is interested in how TR (total revenue) changes as p and q change revenue) changes as p and q change

Total Revenue Calculation Total Revenue Calculation -

• Example

Example

• Price $1 Q

Price $1 QD

D = 100

= 100

• TR = $100

TR = $100

• Price $5 Q

Price $5 QD

D = 90

= 90

• TR = $450

TR = $450

• Price $5 Q

Price $5 QD

D = 10

= 10

• TR = $ 50

TR = $ 50

• Price $5 Q

Price $5 QD

D = 20

= 20

• TR = $100

TR = $100

Total Revenue and Elasticity Total Revenue and Elasticity

• Let’s say demand is inelastic. Then if

Let’s say demand is inelastic. Then if the firm raises prices 10%, the sales will the firm raises prices 10%, the sales will drop by less than 10%: drop by less than 10%: (% (%∆ ∆Q QD

D <

< % %∆ ∆P) P)

• In other words, the gain in revenue

In other words, the gain in revenue from higher prices is greater than the from higher prices is greater than the loss in revenue from lost loss in revenue from lost sales.Therefore, total revenue will rise sales.Therefore, total revenue will rise

Total Revenue and Elasticity Total Revenue and Elasticity

• If they lowered prices, though, the loss

If they lowered prices, though, the loss

• f revenue from higher prices would be
• f revenue from higher prices would be

greater than the gain from increased greater than the gain from increased sales, so total revenue will fall sales, so total revenue will fall

Total Revenue and Elasticity Total Revenue and Elasticity

• Let’s say demand is elastic. Then if the

Let’s say demand is elastic. Then if the firm raises prices 10%, the sales will firm raises prices 10%, the sales will drop by more than 10% drop by more than 10% (% (%∆ ∆Q QD

D >

> % %∆ ∆P) P) in other words, the gain in revenue in other words, the gain in revenue from higher prices is less than the loss from higher prices is less than the loss in revenue from lost sales.Therefore, in revenue from lost sales.Therefore, total revenue will fall total revenue will fall

Total Revenue and Elasticity Total Revenue and Elasticity

• If they lowered prices, though, the loss

If they lowered prices, though, the loss

• f revenue from higher prices would be
• f revenue from higher prices would be

less than the gain in revenue from less than the gain in revenue from increased sales, so total revenue will increased sales, so total revenue will rise rise

Total Revenue and Demand Total Revenue and Demand

• So we can look at what happens to total

So we can look at what happens to total revenue as we move down a demand revenue as we move down a demand curve curve

• As we move down a demand curve we

As we move down a demand curve we know that we start off elastic and as we know that we start off elastic and as we lower price we get less and less elastic lower price we get less and less elastic (but total revenue rises, since it is (but total revenue rises, since it is elastic) until we hit the point that we elastic) until we hit the point that we are inelastic and then as we continue to are inelastic and then as we continue to lower price, total revenue falls lower price, total revenue falls

Total Revenue and Demand Total Revenue and Demand

Total Revenue Demand $ $ Q/t Q/t Elasticity = 1 Elastic Inelastic

Total Revenue Test Total Revenue Test

• If P and total revenue move together

If P and total revenue move together

• Demand is inelastic

Demand is inelastic

• If P and TR move in opposite directions

If P and TR move in opposite directions

• Demand is elastic

Demand is elastic

• If changes in P doesn’t change TR

If changes in P doesn’t change TR

• Demand is unitary elastic

Demand is unitary elastic

TR and Farm Revenue TR and Farm Revenue

• In 1988, wheat farmers experienced the worst

In 1988, wheat farmers experienced the worst drought since the 1930s drought since the 1930s

• Estimates of the price elasticity of demand for

Estimates of the price elasticity of demand for wheat range from 0.3 to 0.7 wheat range from 0.3 to 0.7

• Due to the poor harvest, supply decreased by

Due to the poor harvest, supply decreased by 14% 14%

• What happened to wheat price?

What happened to wheat price?

• $2.57 in 1987 and $3.72 in 1988, a 45% increase

$2.57 in 1987 and $3.72 in 1988, a 45% increase

• The implied

The implied , , D

D = 14/45 = 0.31

= 14/45 = 0.31

• What happened to total revenue?

What happened to total revenue?

• It increased (of course for farmers whose crops were

It increased (of course for farmers whose crops were wiped out, their TR fell) wiped out, their TR fell)

Now... Now...What Factors Help What Factors Help to Determine Price to Determine Price Elasticity of Demand Elasticity of Demand? ?

Notice that this gives the firm information that it can use to establish pricing policy.

Determinants Of Price Determinants Of Price Elasticity Of Demand Elasticity Of Demand

• Availability of substitutes

Availability of substitutes --

• - demand

demand is more elastic when there are more is more elastic when there are more substitutes for the product. substitutes for the product.

• Importance of the item in the budget

Importance of the item in the budget --

• demand is more elastic when the item

demand is more elastic when the item is a more significant portion of the is a more significant portion of the consumer’s budget. consumer’s budget.

• Time frame

Time frame --

• - demand becomes more

demand becomes more elastic over time. elastic over time.

Determinants of Determinants of ,

, D

D

• Availability of substitutes

Availability of substitutes

• As there are more substitutes, demand is

As there are more substitutes, demand is more elastic (and vice versa) more elastic (and vice versa)

• Example:

Example:

• Insulin has no substitutes if diabetic and

Insulin has no substitutes if diabetic and demand is very inelastic demand is very inelastic

• Kroger brand cola has many substitutes

Kroger brand cola has many substitutes and hence, demand is very elastic and hence, demand is very elastic

Determinants of Determinants of ,

, D

D

• Amount of consumers budget

Amount of consumers budget

• The less expensive a good is as a fraction of

The less expensive a good is as a fraction of

• ur total budget, the more inelastic the
• ur total budget, the more inelastic the

demand for the good is (and vice versa) demand for the good is (and vice versa)

• Example:

Example:

• Price of cars go up 10% (from $20,000 to

Price of cars go up 10% (from $20,000 to $22,000) $22,000)

• Price of soda goes up 10% (from $0.50 to

Price of soda goes up 10% (from $0.50 to $0.55) $0.55)

• Demand is more effected by the price of

Demand is more effected by the price of cars increasing cars increasing

Determinants of Determinants of ,

, D

D

• Time

Time

• The longer the time frame is, the more

The longer the time frame is, the more elastic the demand for a good (and vice elastic the demand for a good (and vice versa) versa)

• Example

Example -

• price of gasoline increases

price of gasoline increases

• Immediately: can’t do much, still need to

Immediately: can’t do much, still need to get to work, school, etc get to work, school, etc

• Short

Short-

• run: find a car pool, ride bike, etc

run: find a car pool, ride bike, etc

• Long

Long-

• run: next car you buy uses less gas

run: next car you buy uses less gas

Some Estimates of Some Estimates of ,

, D

D :

: Short

Short and Long Run and Long Run*

*

Short Run Long Run

Cigarettes Water Physicians’ services Gasoline Automobiles Chevrolets Electricity, h’hold Air Travel

• 0.6

0.2 0.1 0.1 0.35 0.4 0.5 to 1.5 1.5 4.0 1.9 2.4

• * The long run is a period so full adjustment occurs. Elasticity

estimates are reported by Browning, et.al., Microeconomic Theory,5th ed., 1996

The End

Check out other elasticities in III.b.