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Chapter 4

Chapter 4. Market Demand and Elasticity. © 2004 Thomson Learning/South-Western. Market Demand Curves. The market demand is the total quantity of a good or service demanded by all potential buyers.

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Chapter 4

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  1. Chapter 4 Market Demand and Elasticity © 2004 Thomson Learning/South-Western

  2. Market Demand Curves • The market demand is the total quantity of a good or service demanded by all potential buyers. • The market demand curve is the relationship between the total quantity demanded of a good or service and its price, holding all other factors constant.

  3. Construction of the Market Demand Curve • The market demand curve is constructed by horizontally summing the demands of the individual consumers • Assume the market consists of only two buyers as shown in Figure 4.1 • At any given price, such as P*X, individual 1 demands X*1 and individual 2 demands X*2.

  4. FIGURE 4.1: Constructing a Market Demand Curve from Individual Demand Curves PX P* X 0 X* 1 (a) Individual 1

  5. FIGURE 4.1: Constructing a Market Demand Curve from Individual Demand Curves PX PX P* X 0 X* 0 X* 1 2 (a) Individual 1 (b) Individual 2

  6. Construction of the Market Demand Curve • The total quantity demanded at the market at P*X is the sum of the two amounts: X* = X*1 + X*2 . • The point X*, P*X is one point on the market demand curve. • The other points on the curve are similarly plotted.

  7. FIGURE 4.1: Constructing a Market Demand Curve from Individual Demand Curves PX PX PX P* X D 0 X* 0 X* 0 X* X 1 2 (a) Individual 1 (b) Individual 2 (c) Market Demand

  8. Shifts in the Market Demand Curve • To discover how some event might shift a market demand curve, we must first find out how this event causes individual demand curves to shift and then compare the horizontal sum of these new demand curves with the old demand curve.

  9. Shifts in the Market Demand Curve • For example consider the two buyer case where both consumers regard X as a normal good. • An increase in income for each consumer would shift their individual demand curves out so that the market demand curve, would also shift out • This situation is shown in Figure 4.2

  10. FIGURE 4.2: Increases in Each individual’s Income Cause the Market Demand Curve to Shift Outward PX PX PX D P* X 0 X* 0 X* 0 X* X 1 2 (a) Individual 1 (b) Individual 2 (c) Market Demand

  11. FIGURE 4.2: Increases in Each individual’s Income Cause the Market Demand Curve to Shift Outward PX D’ PX PX D P* X 0 X* X** 0 X* X** 0 X* X** X 1 1 2 2 (a) Individual 1 (b) Individual 2 (c) Market Demand

  12. Shifts in the Market Demand Curve • However, some events result in ambiguous outcomes. • If one consumer’s demand curve shifts out while another’s shifts in, the net effect depends on the size of the relative shifts. • An increase in income for pizza lovers would increase the market demand for pizza so long as it is a normal good.

  13. Shifts in the Market Demand Curve • On the other hand, if the increase in income was for people who don’t like pizza, there would be no significant effect on the market demand curve for pizza. • Changes in the prices of related goods, substitutes or complements, will also shift the individual and market demand curves.

  14. Shifts in the Market Demand Curve • If goods X and Y are substitutes, an increase in the price of Y will increase the demand for X. Similarly, a decrease in the price of Y will decrease the demand for X. • If goods X and Y are complements, an increase in the price of Y will decrease the demand for X. A decrease in the price of Y will increase the demand for X.

  15. APPLICATION 4.1: Consumption and Income Taxes • People’s ability to purchased goods and services is dependent upon their after tax income. • In the 1950’s Milton Friedman argued that people’s consumption decisions are based mostly on their long-term (permanent) income.

  16. APPLICATION 4.1: Consumption and Income Taxes • One implication of the permanent-income hypothesis is that temporary tax changes will have little effect on the demand for consumption goods • This prediction is supported by the small impact on consumption by both the temporary tax surcharge during the Nixon administration and the Ford administration’s temporary income tax rebate

  17. APPLICATION 4.1: Why the 2001 Tax Cut Was a Dud • In May 2001, Congress passed one of the largest cuts in personal income taxes in history. • Our discussion of demand theory showed that changes in personal incomes shift demand curves outward. • However, Milton Friedman viewed that spending decisions are based on a person’s “permanent” income.

  18. APPLICATION 4.1: Why the 2001 Tax Cut Was a Dud • This insight suggests that the 2001 tax cut had little impact for two reasons. • First, The $300 checks were too small to stimulate spending on any major goods, so they were largely saved. • Second, Most of the tax cuts do not begin until 2006, and the largest cuts are reserved until 2009-10.

  19. A Word on Notation and Terms • When looking at only one market, Q is used for the quantity of the good demanded, and P is used for its price. • When drawing the demand curve, all non-price factors are assumed to not change. • Movements along the curve are changes in quantity demanded, while shifts are changes in demand.

  20. Elasticity • Goods are often measured in different units (steak is measured in pounds while oranges are measured in dozens). • It can be difficult to make simple comparisons between goods when trying to determine which is more responsive to changes in price.

  21. Elasticity • Elasticity is a measure of the percentage change in one variable brought about by a 1 percent change in some other variable. • Since it is measured in percentages, the units cancel out so that it is a unit-less measure of responsiveness.

  22. Price Elasticity of Demand • The price elasticity of demand is the percentage change in the quantity demanded of a good in response to a 1 percent change in its price

  23. Price Elasticity of Demand • The price elasticity records how Q changes in percentage terms in response to a percentage change in P. • Since, on a typical demand curve, P and Q move oppositely, eQ,Pwill be negative. • For example, if eQ,P= -2, a 1 percent increase in price leads to a 2 percent decline in quantity.

  24. Values of the Price Elasticity of Demand • When eQ,P< -1, a price increase causes more than a proportional quantity decrease and the curve is called elastic. • When eQ,P = -1, a price increase causes a proportional quantity decrease, and the curve is called unit elastic. • When eQ,P > -1, a price increase causes less than a proportional quantity decrease, and the curve is called inelastic.

  25. TABLE 4.1: Terminology for the Ranges of eQ,P

  26. Price Elasticity and the Shape of the Demand Curve • We often classify market demand curves by their elasticities • For example, the market demand curve for medical services is inelastic (nearly vertical) since there is little quantity response to changes in price. • Alternatively, the market demand curve for a single type of candy bar is very responsive to price change (nearly flat) and is very elastic.

  27. Price Elasticity and the Substitution Effect • Goods which have many close substitutes are subject to large substitution effects from a price change so their market demand curve is likely to be relatively elastic. • Goods with few close substitutes, on the other hand, will likely be relatively inelastic.

  28. Price Elasticity and the Substitution Effect • There is also an income effect that will determine how responsive quantity demanded is to changes in price. • However, since changes in the prices of most goods have a small effect on individuals’ real incomes, the income effect will likely not have as large an impact on elasticity as the substitution effect.

  29. Price Elasticity and Time • Some items can be quickly substituted for, such as a brand of breakfast cereal, others, such as heating fuel, may take several years. • Thus, in some situations, it is important to make the distinction between the short-term and long-term elasticities of demand.

  30. APPLICATION 4.2: Brand Loyalty • Substitution due to price changes will likely take a longer time if individual’s develop spending habits. • Such brand loyalties are rational since they reduce decision making costs. • Over the long term, however, price differences may cause buyers to try other brands.

  31. APPLICATION 4.2: Brand Loyalty • It took several years, but by the 1970s the price differences between U.S. and Japanese cars eventually convinced Americans to buy the Japanese cars. • Brand name Licensing, such as Coca-Cola sweatshirts and Mickey Mouse watches, makes products that were previously nearly perfect substitutes, now much less so.

  32. Price Elasticity and Total Expenditures • Total expenditures on a good are found by multiplying the good’s price (P) times the quantity purchased (Q). • When demand is elastic, price increases will cause total expenditures to fall. • The given percentage increase in price is more than counterbalanced by the decrease in quantity demanded.

  33. Price Elasticity and Total Expenditures • For example suppose price elasticity = -2. • Suppose people buy 1 million automobiles at $1000 each for a total expenditure of $10 billion. • A price increase to $11,000 (10 percent) would cause a 20 percent decline in quantity to 800,000 vehicles. • Total expenditures after the price increase would now be only $8.8 billion

  34. Price Elasticity and Total Expenditures • Of course, when demand is elastic and prices fall, total expenditures increase. • With unit elasticity, total expenditures remain the same with a price change. • The movement in one direction by the price is fully offset by the movement in the other direction with the quantity demanded.

  35. Price Elasticity and Total Expenditures • When demand is inelastic, a price increase will cause total expenditures to increase too. • Suppose the price elasticity of wheat = -0.5. • Suppose people bought 100 million bushels at $3 per bushel so total expenditures equal $300 million.

  36. Price Elasticity and Total Expenditures • A 20 percent price increase to $3.60 means quantity falls by 10 percent to 90 million with total expenditures now equal to $324 billion. • Alternatively, if the demand is inelastic and prices fall, total revenue will also fall. • Table 4.2 summarizes the relationship between price elasticity and total expenditures.

  37. TABLE 4.2: Relationship between Price Changes and Changes in Total Expenditure

  38. APPLICATION 4.3: Volatile Farm Prices • The demand for many basic agricultural products (wheat, corn, etc.) is relatively inelastic. • Even modest changes in supply, brought about by weather patterns, can have large effects on crop prices.

  39. The Paradox of Agriculture • Good weather tends to produce bountiful crops, but very low crop prices. • Bad weather can result in very high crop prices. • Relatively small supply disruptions in the U.S. grain best during the early 1970s resulted in farm incomes rising more than 40 percent over a two year period.

  40. Boom and Bust in the Late 1990s • Since the New Deal in the 1930s, the volatility of farm prices has been moderated through federal price-support programs. • Acreage restrictions constrained increased planting • The federal government purchased crops outright

  41. Boom and Bust in the Late 1990s • These programs moderated severe farm price swings. • With the passage of the Federal Agricultural Improvement and Reform Act in 1996, federal governmental intervention into agricultural markets was reduced. • In 1997, farm prices were unusually high, but this was followed by very low prices in 1998.

  42. Demand Curves and Price Elasticity • The relationship between a particular demand curve and the price elasticity it exhibits can be complicated. • For some curves, the elasticity remains constant everywhere, but for others it is different at every point. • A more accurate way to describe it would be to say the elasticity is for current prices.

  43. Linear Demand Curves and Price Elasticity • The price elasticity of demand is always changing along a straight line demand curve. • Demand is elastic at prices above the midpoint price. • Demand is unit elastic at the midpoint price. • Demand is inelastic at prices below the midpoint price.

  44. Numerical Example of Elasticity on a Straight Line Demand Curve • Assume a straight-line demand curve for Walkman cassette tape players is Q = 100 - 2P • where Q is the quantity of players demanded per week and P is their price. • This demand curve is illustrated in Figure 4.3 and Table 4.3 shows several price-quantity combinations.

  45. FIGURE 4.3: Elasticity Varies along a Linear Demand Curve Price (dollars) 50 40 30 25 Demand 20 10 0 20 40 50 60 80 100 Quantity of tape players per week

  46. TABLE 4.3: Price, Quantity, and Total Expenditures on Walkmans for the Demand Function Q = 100 - 2P

  47. Numerical Example of Elasticity on a Straight Line Demand Curve • For prices of $50 or more, nothing is bought so total expenditures are $0. • As prices fall between $50 and $25, the midpoint, total expenditures increase. • At the midpoint, total expenditures reach a maximum. • As prices fall below $25, total expenditures also fall.

  48. Elasticity of a Straight Line Demand Curve • More generally, for a linear demand curve of the form Q = a - bP,

  49. A Unitary Elastic Curve • Suppose the demand for tape players took the form • The graph of this equation, shown in Figure 4.4, is a hyperbola. • P·Q = $1,200 regardless of price so demand is unit elastic (-1) everywhere on the curve.

  50. General Formula for the Elasticity of a Hyperbola • If the demand curve takes the following form, the price elasticity of demand is equal to b everywhere on the curve.

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