Demand Curve Basics Unit 6 Consumers and Demand

Demand Curve Basics Unit 6: Consumers and Demand

I. Demand demand – the amount of a good that people are willing and able to purchase at every possible price • economists differentiate between demand quantity demanded – the amount of a good that people are willing and able to purchase at a specific price Example: white wine • either way it is expressed, it is a relationship between two variables, price (P) and quantity (Q): – price is the independent variable – quantity is the dependent variable

II. Law of Demand law of demand – the quantity demanded of a good increases as price falls and decreases as price rises • there is an inverse relationship between price and quantity: Price↓, Quantity↑ Price↑, Quantity↓ • for the law of demand to be true, the following assumptions are made: 1. 2. 3. 4. good must be well defined must be willingness and ability to purchase particular time period must be specified only price can change, everything else must be held constant

III. Demand Schedule demand schedule – a table, chart, or list of the prices and corresponding quantities demanded for a good Your Demand Schedule for Pizza Combination Price per Slice Quantity Demanded per Day (# of Slices) A $3 1 B $2 2 C $1 3

IV. Demand Curve •

Your Demand Curve for Pizza 5 Price per Slice 4 3 A B 2 1 C Your Demand 0 0 1 2 3 Quantity Demanded per Day (# of Slices) 4 5

V. Individual Demand vs. Market Demand market demand – the sum of every consumer’s demand Market Demand Schedule for Pizza My Quantity Demanded per Day (# of Slices) Market Quantity Demanded per Day (# of Slices) Combination Price per Slice Your Quantity Demanded per Day (# of Slices) A $3 1 . 5 1. 5 B $2 2 1 3 C $1 3 1. 5 4. 5 • note that each individual can have a different demand for the same good

Market Demand Curve for Pizza 5 Price per Slice 4 3 Your Demand My Demand 2 Market Demand 1 0 0 1 2 3 Quantity Demanded per Day (# of Slices) 4 5

VI. Changes in Quantity Demanded vs. Changes in Demand • if price is the only variable that changes, then we say there is a change in the quantity demanded and there will be movement along the demand curve • as price falls from $2 to $1, then the quantity demanded increases from 2 to 3 and there is movement down the demand curve (B ↘ C) • as price rises from $2 to $3, then the quantity demanded decreases from 2 to 1 and there is movement up the demand curve (A ↖ B)

Movement along the Demand Curve 5 Price per Slice 4 3 A B 2 1 0 Your Demand C 0 1 2 3 Quantity Demanded per Day (# of Slices) 4 5

• if price remains constant, but other variables that affect demand change, then we say there is a change in demand there will be a shift of the demand curve • there will be a change in the quantity demanded at every possible price • as income rises, then the quantity demanded increases at every possible price and the demand curve shifts rightward (Original Demand → Demand with Higher Income) • as income falls, then the quantity demanded decreases at every possible price and the demand curve shifts leftward (Demand with Lower Income ← Original

Shifts of the Demand Curve 5 Price per Slice 4 3 Original Demand with Higher Income 2 Demand with Lower Income 1 0 0 1 2 3 Quantity Demanded per Day (# of Slices) 4 5

VII. Determinants of Demand • other factors that affect demand besides price are known as determinants of demand: 1. income • relationship between income and demand depends on type of good: – direct relationship between income and demand for normal goods (NG): Income ↑, Demand. NG ↑, Shift → Income ↓, Demand. NG ↓, Shift ← Example: – inverse relationship between income and demand for inferior goods (IG): Income ↑, Demand. IG ↓, Shift ← Income ↓, Demand. IG ↑, Shift → Example:

2. tastes • demand obviously depends on tastes for that and other goods 3. prices of related goods • relationship between price of related goods and demand depends on type of goods: – direct relationship between price of substitute goods (SG) and demand for original good (OG): Price. SG ↑, Demand. OG ↑, Shift → Price. SG ↓, Demand. OG ↓, Shift ← Example: – inverse relationship between price of complimentary goods (CG) and demand for original good (OG): Price. CG ↑, Demand. OG ↓, Shift ← Price. CG ↓, Demand. OG ↑, Shift → Example:

4. expectations • expectations about future events, such as price of good and income affect demand today 5. number of buyers • direct relationship between number of buyers and market demand for a good Number of Buyers ↑, Market Demand ↑ Number of Buyers ↓, Market Demand ↓

The Downward (Negative) Slope of the Demand Curve Unit 6: Consumers and Demand

I. Goal of Consumers • goal of consumers in an economy is to maximize utility – satisfaction • theoretically measured in units called utils

II. Marginal vs. Total Utility •

III. Man vs. Food Utility Gl s 9 as s 1 Gl 1 as s Gl 13 as s 1 5 as s 7 Gl as s 5 Gl as Gl Gl as s 1 50 45 40 35 30 25 20 15 10 5 0 -5 -10 -15 -20 -25 -30 -35 -40 -45 -50 s 3 Total Utility Utils 10 9 8 7 6 5 4 3 2 1 0 -1 -2 -3 -4 -5 -6 -7 -8 -9 -10 Gl as s Gl 1 as s Gl 3 as s Gl 5 as s Gl 7 as Gl s 9 as s Gl 11 as s Gl 13 as s 1 5 Utils Marginal Utility

IV. Law of Diminishing Marginal Utility law of diminishing marginal utility – the marginal utility of a product declines as more of it is consumed in a given time period • law holds true for most products

V. Relationship between Marginal and Total Utility • as long as marginal utility is positive, your total utility will increase • as long as you are getting utility from consuming each incremental unit of a good, total utility will increase…but at a decreasing rate, because you will be getting less and less utility per unit as you consume more and more units • eventually you will reach a point where it literally hurts you to consume another unit and you will experience negative marginal utility • this will cause your total utility to begin to decrease…it will take away from the utility you have already experienced • consumers want to consume at maximum total utility

VI. Marginal Utility and Shape of Demand Curve Your Demand Curve for Pizza Price per Slice 5 4 3 2 1 0 A B C Y. . . 0 1 2 3 4 5 Quantity Demanded per Day (# of Slices) • Consume 1 st Slice: – TU = $3 – MU = $3 • Consume 2 nd Slice: – TU = $4 – MU = $1 – We will “demand” to only pay $2/slice if you want us to consume both slices (the average of both marginal utilities) • Consume 3 rd Slice – TU = $3 – MU = -$1 – We will demand to only pay $1/slice if you want us to consume all 3 slices (the average of all 3 marginal utilities)

• law of diminishing marginal utility partially explains the downward slope of demand curve • we demand to pay a lower average price the more units of a good we consume

Price Elasticity of Demand Unit 6: Consumers and Demand

I. Background WE KNOW: • P↓ Q↑ and P↑ Q↓ WE WANT TO KNOW: • How much will quantity change given price changes, and how will this affect total revenue Total Revenue = Price X Quantity TR = P X Q IF: • Quantity changes in proportion to price, there will be no effect on total revenue BUT: • This rarely happens because of the concept of price elasticity

II. Price Elasticity of Demand Formula

III. Price Elasticity of Demand Example • The price of pizza drops from $15 to $10 and the quantity demanded rises from 1 to 2. What is the price elasticity of pizza?

Q: What do these numbers mean? A: Quantity demanded (numerator) rises 67% given a 40% drop in price (denominator) OR Quantity demanded rises 1. 68 times (or 168%) faster than price drops

+ and –’s • in the numerator and denominator, all the + and – tell us is whether the quantity and price is rising (+) or falling (-) • in the final value for E, all the + and – tell us, is relationship between the two variables • with price elasticity, the E will always be – because of the inverse relationship between price and quantity • you can leave the negative off the final answer, since it’s a rate of change, not an absolute number

IV. Types of Elasticities of Demand E > 1: Elastic Good • Sensitive to price changes • 10% drop in price yields a 20% rise in quantity demanded E < 1: Inelastic Good • Insensitive to price changes • 10% drop in price yields a 5% rise in quantity demanded E = 1: Unitary Elastic Good • Proportional to price changes • 10% drop in price yields a 10% rise in quantity demanded

V. Effects of Price Elasticity on Total Revenue Elastic Goods (E>1): P↓ TR↑ P↑ TR↓ Inelastic Goods (E<1): P↓ TR↓ P↑ TR↑ Unitary Elastic Goods (E=1): P↓ TR→ P↑ TR→

Factors that Affect Price Elasticity and Other Elasticities Unit 6: Consumers and Demand

I. Determinants of Price Elasticity of Demand 1. Availability and Closeness of Substitute Products • If substitute products are available, then demand for the original product tends to be price elastic • Example: Lincoln MKZ – 10% price increase yields a 20% decrease in the quantity demanded • If substitute products are not available, then demand for the original product tends to be price inelastic • Example: Prescription Drugs – 10% price increase yields a 0% drop in the quantity demanded

2. Proportion of Income • If the product costs a large proportion of income, then demand tends to be elastic • Example: Houses – 10% price increase in homes yields a 20% decrease in the quantity demanded • If the product costs a small proportion of income, then demand tends to be inelastic • Example: Bicycle - 10% price increase yields a 5% decrease in the quantity demanded

3. Luxuries vs. Necessities • If a product is a luxury, then demand tends to be elastic • Example: Lobster – 10% price increase yields a 20% decrease in the quantity demanded • If a product is a necessity, then demand tends to be inelastic • Example: Insulin – 10% price increase yields a 0% decrease in the quantity demanded

4. Short-run vs. Long-run • In the short-run, demand tends to be inelastic • In the long-run, demand tends to be elastic • Example: gasoline prices increase – Demand will not decrease in the short-run because consumers cannot immediately buy a more fuel-efficient car – Demand may decrease in the long-run because consumers will have had time to purchase a more fuelefficient car

5. Definition of the Market • narrowly defined markets or goods tend to be more elastic, because close substitutes are available • ex. market for heinz mustard tends to elastic • broadly defined markets or goods tend to be more inelastic, because close substitutes are not available • ex. market for food tends to be inelastic

II. Other Elasticities of Demand • elasticities of demand can be calculated not only for price, but for any variable that affects demand • the dependent variable (%ΔQ) will always be the numerator, and the independent variable will always be the denominator • some common ones:

2. Cross-price Elasticity of Demand (CPE) – measure how much demand changes for an original good given changes in prices of related goods – whether CPE is + or - depends on type of goods: • CPE tends to be + for substitute goods (direct relationship between QOG and PSG ) • CPE tends to be – for complimentary goods (inverse relationship between QOG and PCG)