© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin The Demand for Goods Chapter 5

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Introduction n This chapter answers the following questions: l How do we decide how much of any good to buy? l How does a change in the price of a good affect the quantity we purchase or the amount of money we spend on it? l Why do we buy certain goods but not others?

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Determinants of Demand n What leads us to buy some goods while rejecting others?

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin The Sociopsychiatric Explanation n In Freud’s view, we strive for higher levels of consumption to satisfy basic drives for security, sex, and ego gratification.

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin The Sociopsychiatric Explanation n According to some sociologists, people consume more as expressions of identity that provoke recognition or social acceptance.

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin The Sociopsychiatric Explanation n Not all consumption is motivated by ego or status concerns. n There are always basic needs (food, clothes, shelter) that are a necessity.

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Affluent Teenagers Stereo Television Telephone Computer Video Game System In-line skates Auto Pager/beeper Cell phone Stocks, bonds Digital camera DVD player Percent of Teens Owning Products % 10% 71% 63% 61% 52% 56% 39% 35% 25% 17%

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin The Economic Explanation n Sociopsychiatric theories tell us why we desire certain goods -- not what goods will actually be purchased. n Prices and income are just as relevant to consumption decisions as are more basic desires and preferences.

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin The Economic Explanation n In explaining consumer behavior, economists focus on the demand for goods and services. n Demand is the willingness and ability to buy specific quantities of a good at alternative prices in a given time period, ceteris paribus.

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin The Economic Explanation n An individual’s demand for a product is determined by: l Tastes —desire for this and other goods. l Income —of the consumer. l Expectations —for income, prices, tastes. l Other goods —their availability and prices.

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin The Demand Curve n Economists are interested in how consumer tastes affect consumption decisions.

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Utility Theory n Utility is the pleasure or satisfaction obtained from a good or service. n The more pleasure a product gives us, the higher the price we’re willing to pay for it.

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Total vs. Marginal Utility n Total utility is the amount of satisfaction obtained from entire consumption of a product.

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Total vs. Marginal Utility n Marginal utility is the change in total utility obtained by consuming one additional (marginal) unit of a good or service.

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Total vs. Marginal Utility Total Utility Quantity of Popcorn (boxes per show) Total utility Rising total utility TOTAL UTILITY Marginal Utility Quantity of Popcorn (boxes per show) Diminishing marginal utility 56 Negative marginal utility MARGINAL UTILITY

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Diminishing Marginal Utility n According to the law of diminishing marginal utility, the marginal utility of a good declines as more of it is consumed in a given time period. n As long as marginal utility is positive, total utility must be increasing.

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Diminishing Marginal Utility n According to the law of diminishing utility, each successive unit of a good consumed yields less additional utility. n Eventually, additional quantities of a good yield increasingly smaller increments of satisfaction.

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Diminishing Marginal Utility Total Utility Quantity of Popcorn (boxes per show) Total utility Rising total utility TOTAL UTILITY Marginal Utility Quantity of Popcorn (boxes per show) Diminishing marginal utility 56 Negative marginal utility MARGINAL UTILITY

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Price and Quantity n Tastes, through marginal utility, tells us how much we desire particular goods. n Price tell us how much of a good we will buy.

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Price and Quantity n We make the ceteris paribus assumption when we look at the relationship between the price of the good and the amount we’re willing to buy. l Ceteris paribus - The assumption of nothing else changing.

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Price and Quantity n The more marginal utility a product delivers, the more a consumer is willing to pay, ceteris paribus.

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Price and Quantity n This is due to diminishing marginal utility – people are willing to buy additional quantities of a good only if its price falls. n As the marginal utility of a good diminishes, so does our willingness to pay.

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Price and Quantity n With given income, tastes, expectations, and prices of other goods and services, people are willing to buy additional quantities of a good only if its price falls.

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Price and Quantity n According to the law of demand, the quantity of a good demanded in a given time period increases as its price falls, ceteris paribus.

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Price and Quantity n The demand curve is a curve describing the quantities of a good a consumer is willing and able to buy t alternative prices in a given time period, ceteris paribus. n The law of demand is illustrated by a downward-sloping demand curve.

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Price and Quantity n A demand curve describes the quantities of a good a consumer is willing and able to buy at alternative prices in a given period, ceteris paribus.

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Individual’s Demand Schedule and Curve Quantity Demanded (Ounces per show) PRICE (per ounce) A B C D E F G H I J $0.55 The willingness to pay diminishes along with marginal utility

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Price Elasticity n The response of consumers to a change in price is measured by the price elasticity of demand.

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Price Elasticity n The price elasticity of demand is the percentage change in quantity demanded divided by the percentage change in price.

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Price Elasticity n The law of demand implies that the absolute value of the price elasticity of demand will always be greater than zero.

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Price Elasticity n Technically, price elasticity of demand (E) is always negative because quantity demanded decreases when prices increase.

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Computing Price Elasticity n To ensure consistency, average quantity and average price (before and after) is used in the calculation.

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Computing Price Elasticity

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Elastic vs. Inelastic Demand n If E is larger than 1, demand is elastic. l Consumer response is large relative to the change in price. n If E is less than 1, demand is called inelastic. l Consumers aren’t very responsive to price changes. n If E equals 1, demand is unitary elastic.

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Elasticity Estimates

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Elasticity Extremes n A horizontal demand curve means that demand is perfectly elastic. l Any price increase would cause demand to fall to zero. n A vertical demand curve means that demand is completely inelastic. l Quantity demanded will not change regardless of the price change.

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Elasticity Extremes p1p1 p2p2 q1q1 0 Quantity Price Completely elastic (E =  ) p1p1 p2p2 q1q1 0 Quantity Price Completely inelastic (E = 0)

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Determinants of Elasticity n The price elasticity of demand is influenced by all of the determinants of demand.

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Determinants of Elasticity n Four factors are particularly worth noting: l Necessities vs. luxuries. l Availability of substitutes. l Relative price. l Time.

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Necessities vs. Luxuries n Demand for necessities is relatively inelastic n Necessities are goods that are critical to our everyday life,

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Necessities vs. Luxuries n Demand for luxury goods is relatively elastic. n Luxuries are goods we would like to have but are not likely to buy unless our income jumps or the price declines sharply.

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Availability of Substitutes n The greater the availability of substitutes, the higher the price elasticity of demand.

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Relative Price n The higher the price in relation to a consumer’s income, the higher the elasticity of demand.

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Relative Price n The price elasticity of demand declines as price moves down the demand curve.

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Time n The long-run price elasticity of demand is higher than the short-run elasticity. n Consumers are better able to change their buying habits over the long-run that in the short-run.

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Price Elasticity and Total Revenue n Higher prices don’t always mean higher total revenue.

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Price Elasticity and Total Revenue n There is a relationship between price elasticity and total revenue. Total revenue – The price of a product multiplied by the quantity sold in a given time period: p x q. Total revenue = Price X Quantity sold

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Price Elasticity and Total Revenue n A price hike increases total revenue only if demand in inelastic (E < 1). n A price hike reduces total revenue if demand is elastic (E > 1). n A price hike does not change total revenue if demand is unitary elastic (E = 1).

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Price Elasticity and Total Revenue

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Price Elasticity and Total Revenue $ QUANTITY DEMANDED (ounces per show) PRICE (per ounce) B C Higher prices will reduce total revenue if E < 1

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Changing Value of E n Price elasticity changes along a demand curve. n The impact of a price change on total revenue depends on the (changing) price elasticity of demand.

$ PRICE Elastic E > 1 Unit elastic E = 1 Inelastic E < 1 The demand curve $ Elastic E > 1 Inelastic E < TOTAL REVENUE Total revenue E = 1

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Other Elasticities n Other factors affect consumption behavior.

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Shifts vs. Movements n When the price changes, the outcome is a movement along the unchanged demand curve. n When the underlying determinants of demand change, the entire demand curve shifts.

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Shifts vs. Movements n A shift in demand is a change in the quantity demanded at any (every) given price.

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Income Elasticity n An increase in consumer income will cause a rightward shift in demand. n Consumers will now purchase more at any price than they did prior to the increase in income.

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Income Elasticity Quantity of Popcorn (ounces per show) Price of Popcorn (dollars per ounce) Shift D 2 (after income rise) D 1 (before income rise) NF

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Income Elasticity n Income elasticity of demand is the percentage change in quantity demanded divided by percentage change in income.

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Computing Income Elasticity n As with price elasticity, income elasticity is computed using average values for the changes in quantity and income.

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Normal vs. Inferior Goods n A normal good has an income elasticity of demand greater than zero. n A normal good is a good for which demand rises when income rises.

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Normal vs. Inferior Goods n An inferior good has an income elasticity of demand less than zero. n An inferior good is a good for which demand decreases when income rises.

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Cross-Price Elasticity n A change in the price of one good affects the demand for another. n The decision to buy a good depends on the prices of substitutes and complements of that good.

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Cross-Price Elasticity n Substitute goods are goods that substitute for each other. n When the price of good X rises, the demand for good Y increases, ceteris paribus.

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Cross-Price Elasticity n Complementary goods are goods frequently consumed in combination. n When the price of good X rises, the demand for complementary good Y falls, ceteris paribus.

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Substitutes and Complements RF D3D3 D1D1 D2D Quantity of Popcorn (ounces per show) Price of Popcorn (cents per ounce)

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Calculating Cross-Price Elasticity n Cross price elasticity is the percentage change in the quantity demanded of X divided by percentage change in price of Y.

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Calculating Cross-Price Elasticity n When the cross-price elasticity of demand has a negative sign the two goods are complementary goods. n When the cross-price elasticity of demand has a positive sign the two goods are substitute goods.

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Choosing Among Products n The purchase of any one single good means giving up the opportunity to buy more of other goods. l Opportunity costs – The most desired goods or services that are forgone in order to obtain something else.

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Marginal Utility vs. Price n Rational behavior requires one to compare the anticipated utility of each expenditure with its cost.

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Marginal Utility vs. Price n To maximize utility, the consumer should choose that good which delivers the most marginal utility per dollar.

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Utility Maximization n Optimal consumption is the mix of consumer purchases that maximizes the utility attainable from available income. n To maximize total utility, consumers choose the optimal consumption combination.

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Utility Maximization

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Utility Maximizing Rule n The basic approach to utility maximization is to purchase that good next which delivers the most marginal utility per dollar.

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Utility Maximizing Rule n If a person could get more utility per dollar by buying good X, then she should continue to buy good X.

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Utility Maximizing Rule n If a person could get more utility per dollar by buying good Y, then she should continue to buy good Y.

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Utility Maximizing Rule n The process continues until the ratios are equal. n Only then will utility be maximized.

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Equilibrium Outcomes n Economic theory predicts that the final choices of consumers -- the equilibrium outcome -- will be optimal.

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Caveat Emptor n Some advertising is intended to provide information about new or existing products. n A great deal more of advertising is designed to exploit our senses and lack of knowledge.

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Are Wants Created? n Advertising can’t be blamed for our foolish consumption n A successful advertising campaign is one that shifts the demand curve to the right.

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Impact of Advertising on the Demand Curve Quantity Demanded (units per time period) 0 Price (dollars per unit) Demand curve after advertising Demand curve before advertising

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin The Demand for Goods End of Chapter 5