Market Demand and Elasticity Chapter 4 Market Demand and Elasticity

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.

Construction of the Market Demand Curve The market demand curve is constructed by horizontally summing the demands of the individual consumers

FIGURE 4.1: Constructing a Market Demand Curve from Individual Demand Curves At any given price, such as P*X, individual 1 demands X*1 and individual 2 demands X*2. PX PX PX P* X D X* X* X* X 1 2 (a) Individual 1 (b) Individual 2 (c) Market Demand The total quantity demanded at the market at P*X is the sum of the two amounts: X* = X*1 + X*2 .

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

FIGURE 4.2: Increases in Each individual’s Income Cause the Market Demand Curve to Shift Outward (b) Individual 2 (a) Individual 1 (c) Market Demand PX D’ PX PX D P* X X* X** X* X** X* X** X 1 1 2 2 An increase in income for each consumer would shift their individual demand curves out so that the market demand curve, would also shift out.

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. 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.

Substitutes and Complements Changes in the prices of related goods, substitutes or complements, will also shift the individual and market demand curves. 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.

APPLICATION 4.1: The 2001 Tax Cut People’s ability to purchase 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. One-time increase in income will not stimulate spending Major tax cuts announced in 2001 to counter recession Every taxpayer received $300 in 2001, but these checks were mostly saved

APPLICATION 4.1: Consumption and Income Taxes Timing of tax cuts Most cuts deferred until 2009-2010 Present value: small in 2001, spending does not increase Credibility: hard to believe the government will live up to its promises to cut taxes eight years later Complexity of income tax “Sunset” provisions: return to 2001 levels after 2011 AMT (alternative minimum tax) rate increases Many tax reductions in the form of specific credits e.g. tuition fees, energy conservation etc

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

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.

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.

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

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,P will be negative. For example, if eQ,P = -2, a 1 percent increase in price leads to a 2 percent decline in quantity.

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.

TABLE 4.1: Terminology for the Ranges of eQ,P

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.

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.

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. Price elasticity is mostly affected by the substitution effect

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. Substitution effects are stronger in the long-run compared to the short-tun.

APPLICATION 4.2: Brand Loyalty Reduce opportunity costs of constant re-evaluation Makes consumer insensitive to (small) price differentials Is more likely to change in the long-run Automobiles Loyalty to US cars prior to 1980s After 1980s developing loyalty to Japanese cars US automakers increase size of US cars to compete Estimates: $1600 (in 1991) price reduction on US cars would make customers loyal to Japanese cars switch

APPLICATION 4.2: Brand Loyalty Licensing of Brand Names Makes products less substitutable with goods of similar price-quality ratio Coca-Cola blue jeans Mickey-Mouse handbags etc Overcoming Brand Loyalty Consumers face “switching costs” when they try a new loyalty Producers Offer temporary price discounts Engage in heavy advertizing Shum (2004): Advertizing is less costly for the same effect compared to temporary price reductions

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.

Price Elasticity and Total Expenditures Suppose price elasticity = -2. Suppose people buy 1 million automobiles at $10000 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

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.

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. A 20 percent price increase to $3.60 means quantity falls by 10 percent to 90 million with total expenditures now equal to $324 million.

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

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.

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 belt during the early 1970s resulted in farm incomes rising more than 40 percent over a two year period. When good weather returned, prices quickly fell back Bad weather is often actually good news for the farmers!

Volatile Prices and Government Programs 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 Subsidies to keep farmland fallow The federal government purchased crops outright Federal Agricultural Improvement and Reform Act (FAIR) Reduced government intervention Factors mitigating the FAIR act Bad weather: Katrina etc Elections in 2002

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 that elasticity is NOT the slope, in general varying along the demand curve.

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.

Numerical Example of Elasticity on a Straight Line Demand Curve Assume a straight-line demand curve is Q = 100 - 2P

FIGURE 4.3: Elasticity Varies along a Linear Demand Curve Price For prices of $50 or more, nothing is bought so total expenditures are $0. (dollars) 50 As prices fall between $50 and $25, the midpoint, total expenditures increase. 40 At the midpoint, total expenditures reach a maximum. 30 25 As prices fall below $25, total expenditures also fall. 20 10 20 40 50 60 80 100 Quantity

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

A Unitary Elastic Curve Suppose the demand for tape players took the form P·Q = $1,200 regardless of price so demand is unit elastic (-1) everywhere on the curve.

FIGURE 4.5: A Unitary Elastic Demand Curve Price (dollars) 60 50 40 30 20 20 24 30 40 60 Quantity of tape players per week

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.

Income Elasticity of Demand The income elasticity of demand equals the percentage change in the quantity demanded of a good in response to a 1 percent change in income. The formula is given by (where I represents income):

Income Elasticity of Demand For normal goods, eQ,I is positive because increases in income lead to increases in purchases of the good. For inferior goods eQ,I is negative. If eQ,I > 1, the purchase of the good increases more rapidly than income so the good might be called a luxury good.

APPLICATION 4.4: An Experiment in Health Insurance U.S. has several medical insurance policies Medicare: insurance for the aged Medicaid: insurance for the poor Common problem for any medical insurance scheme Moral hazard Insurance coverage increases demand for health services Korea: can’t go to the university hospital before visiting a small one

Rand Corporation Experiment How large are the effects of moral hazard going to be? Medicare introduced in 1965 Increase in demand by the elderly immediate Rand Corporation experiment Coinsurance rate varied from zero to almost 100% Experiment conducted in four cities

Table 1: Results of the Rand Health Insurance Experiment

The Rand Experiment A rough estimate of the elasticity of demand can be obtained by averaging the percentage changes across the various plans in Table 1 The average extent of moral hazard effects has been found to be small Dental care and mental health care are different since demand for these services has been found to be elastic

Cross-Price Elasticity of Demand The cross-price elasticity of demand measures the percentage change in the quantity demanded of a good in response to a 1 percent change in the price of another good. Letting P’ be the price of another good,

Cross-Price Elasticity of Demand If the goods are substitutes, an increase in the price of one will cause buyers to purchase more of the substitute, so the elasticity will be positive. If the goods are complements, an increase in the price of one will cause buyers to buy less of that good and also less of the good they use with it, so the elasticity will be negative.

Empirical Studies of Demand: Estimating Demand Curves Estimating a demand curve for a product is one of the more difficult but important problems in econometrics. Empirical studies are useful because they provide a more precise estimate of the amount of change in quantity demanded that results due to a price change.

Problems Estimating Demand Curves The first problem is how to derive an estimate holding all other factors (the ceteris paribus assumption) constant. This problem is often solved, as discussed in the Appendix to Chapter 1, by the use of multiple regression analysis.

Problems Estimating Demand Curves The second problem deals with what is observed in the data. The data points represent quantity and price outcomes that are simultaneously determined by both the demand and the supply curves. The econometric problem is to “identify” from these equilibrium points the demand curve that generated them. Do the observed combinations of prices and quantities belong to the same, or to several different demand curves?

TABLE 4.4: Some Elasticity Estimates

Some Elasticity Estimates The income elasticities of automobiles and transatlantic travel exceed 1 (luxuries). The high income elasticities are balanced by goods such as food and medical care which are less than 1 (necessities). There is no evidence of Giffen’s paradox in the table.

Some Cross-price Elasticity Estimates All of the goods appear to be substitutes and have positive cross-price elasticities. Demand for Effect of Price of Elasticity Estimate

Application 4.5: Alcohol Taxes as Drunk Driving Policy Each year more than 40,000 Americans die in automobile accidents. It is generally believed that alcohol consumption is a major contributing factor in at least half of those accidents. Most empirical studies of alcohol consumption show that it is sensitive to price. Government policies Increasing legal driving age Adopting stricter drunk-driving laws

Application 4.5: Alcohol Taxes as Drunk Driving Policy How is teen alcohol consumption related to alcohol taxes? Price elasticity of beer is less than half that of wine Most teen alcohol consumption is beer More alcohol taxes will have little effect on teens Why is price elasticity of demand for beer so low? Group drinking: marginal cost of one more drink is zero once the keg is there Preferences: most beer consumers drink more than habitually However, binge drinking may be a habit that takes time to form In the longer run, elasticity of beer demand may be higher than the short-run estimates imply