3 3 Consumer Choice, Market Demand, and Elasticity

Copyright© 2006 South-Western/Thomson Learning. All rights reserved. ●Scarcity and Demand ●Utility: A Tool to Analyze Purchase Decisions ●Consumer Choice as a Trade-off: Opportunity Cost ●From Individual Demand Curves to Market Demand Curves ●Exceptions to the Law of Demand ●Scarcity and Demand ●Utility: A Tool to Analyze Purchase Decisions ●Consumer Choice as a Trade-off: Opportunity Cost ●From Individual Demand Curves to Market Demand Curves ●Exceptions to the Law of Demand Outline

Copyright© 2006 South-Western/Thomson Learning. All rights reserved. ●Price Elasticity of Demand ●Its Effect on Total Revenue ●What Determines Demand Elasticity? ●Elasticity as a General Concept ●Price Elasticity of Demand ●Its Effect on Total Revenue ●What Determines Demand Elasticity? ●Elasticity as a General Concept Outline

Copyright© 2006 South-Western/Thomson Learning. All rights reserved. Scarcity and Demand ●Income is limited → consumers face constraints on their choices ●Wealthy and poor individuals have limited incomes relative to their desires. ●Every decision has an opportunity cost. ♦↑purchases of clothing → ↓purchases of restaurant meals ●Income is limited → consumers face constraints on their choices ●Wealthy and poor individuals have limited incomes relative to their desires. ●Every decision has an opportunity cost. ♦↑purchases of clothing → ↓purchases of restaurant meals

Copyright© 2006 South-Western/Thomson Learning. All rights reserved. Utility: A Tool to Analyze Purchase Decisions ●How do consumers make choices? ♦Theory of consumer choice = each consumer spends his or her income in a way that yields the greatest satisfaction or utility. ♦Cannot measure utility (or satisfaction) directly. How should we measure your utility of a movie theater ticket? ●How do consumers make choices? ♦Theory of consumer choice = each consumer spends his or her income in a way that yields the greatest satisfaction or utility. ♦Cannot measure utility (or satisfaction) directly. How should we measure your utility of a movie theater ticket?

Copyright© 2006 South-Western/Thomson Learning. All rights reserved. ●Total utility = largest sum of money that a consumer will voluntarily give up for a good ♦E.g., I will buy 7 pints of Chunky Monkey only if it costs $21.50 or less. So the TU (or benefit) that I receive from 7 pints is $ ●Marginal utility = addition to TU that an individual receives by consuming 1 more unit of the good ♦E.g., if I consumed 6 pints of Chunky Monkey, MU measures how much add. satisfaction I get by consuming 7 pints instead. ●Total utility = largest sum of money that a consumer will voluntarily give up for a good ♦E.g., I will buy 7 pints of Chunky Monkey only if it costs $21.50 or less. So the TU (or benefit) that I receive from 7 pints is $ ●Marginal utility = addition to TU that an individual receives by consuming 1 more unit of the good ♦E.g., if I consumed 6 pints of Chunky Monkey, MU measures how much add. satisfaction I get by consuming 7 pints instead. Total vs. Marginal Utility

TABLE 1. Leah’s Total and Marginal Utility from Chunky Monkey Quantity (per month) Total Utility (dollars) Marginal Utility (dollars) Label for graph A B C D E F G H

Copyright© 2006 South-Western/Thomson Learning. All rights reserved. Total vs. Marginal Utility ●TU: 1 pint is worth no more than $6.00 to me and 2 pints are worth no more than $11.00 to me, etc. ●MU: 1 st pint is worth $6 to me and 2 nd pint is worth $5.00 to me, while the 3 rd is worth $4.00, etc. ●TU: 1 pint is worth no more than $6.00 to me and 2 pints are worth no more than $11.00 to me, etc. ●MU: 1 st pint is worth $6 to me and 2 nd pint is worth $5.00 to me, while the 3 rd is worth $4.00, etc.

FIGURE 1. Leah’s Marginal Utility Curve for Chunky Monkey Number of pints per Month 8 Marginal Utility (Price) per pint $ H F E D C B A $7 G Price

Copyright© 2006 South-Western/Thomson Learning. All rights reserved. ●Law of diminishing MU = the more of a good a consumer has, the less MU an additional unit contributes to overall satisfaction. ●Additional units of a good are worth less and less to a consumer in money terms. ♦E.g., each add. pint is worth less to me. 1 st pint eat by myself; 2 nd share with my husband; 3 rd share with my friend; 4 th share with my dog, Dante; 5 th share with my mother-in-law. Thus, each successive pint has a lower priority. Can you think of any exceptions to the law of diminishing marginal utility? ●Law of diminishing MU = the more of a good a consumer has, the less MU an additional unit contributes to overall satisfaction. ●Additional units of a good are worth less and less to a consumer in money terms. ♦E.g., each add. pint is worth less to me. 1 st pint eat by myself; 2 nd share with my husband; 3 rd share with my friend; 4 th share with my dog, Dante; 5 th share with my mother-in-law. Thus, each successive pint has a lower priority. Can you think of any exceptions to the law of diminishing marginal utility? “Law” of Diminishing MU

Copyright© 2006 South-Western/Thomson Learning. All rights reserved. Total vs. Marginal Utility ●Graph of MU has (-) slope → ↓MU as ↑Qd. ●↑TU as long as MU is (+). ♦E.g., when a commodity is very scarce (diamonds), economists expect it to have high MU even though it provides very little TU. Can you think of a good that has a very low MU but a very high TU? ●Graph of MU has (-) slope → ↓MU as ↑Qd. ●↑TU as long as MU is (+). ♦E.g., when a commodity is very scarce (diamonds), economists expect it to have high MU even though it provides very little TU. Can you think of a good that has a very low MU but a very high TU?

Copyright© 2006 South-Western/Thomson Learning. All rights reserved. Using MU: The Optimal Purchase Rule How many pints of Chunky Monkey should I purchase? ●Goal: max. total benefit from pints while min. their cost. As long as MU is (+), ↑TU by consuming more pints. But each add. pint costs money. ●Net TU = TU – total expenditure; where TE = P*Qd. ●Max. net TU by watching net MU; net MU = MU – P. ♦E.g., If P = $3.00/pint and I buy 3 pints, then net MU = $1.00; so I can ↑net TU by purchasing more. How many pints of Chunky Monkey should I purchase? ●Goal: max. total benefit from pints while min. their cost. As long as MU is (+), ↑TU by consuming more pints. But each add. pint costs money. ●Net TU = TU – total expenditure; where TE = P*Qd. ●Max. net TU by watching net MU; net MU = MU – P. ♦E.g., If P = $3.00/pint and I buy 3 pints, then net MU = $1.00; so I can ↑net TU by purchasing more.

Copyright© 2006 South-Western/Thomson Learning. All rights reserved. Using MU: The Optimal Purchase Rule ●Two rules govern the optimal purchase rule: 1.if net MU is (+) (or MU > P) → consumer buys too little of the good to max. net TU 2.if net MU is (-) (or MU < P) → consumer buys too much of the good to max. net TU ●Combining these 2 rules → net TU is maximized when net MU = 0 (or MU = P). MU = P is the optimal purchase rule ●Two rules govern the optimal purchase rule: 1.if net MU is (+) (or MU > P) → consumer buys too little of the good to max. net TU 2.if net MU is (-) (or MU < P) → consumer buys too much of the good to max. net TU ●Combining these 2 rules → net TU is maximized when net MU = 0 (or MU = P). MU = P is the optimal purchase rule

Copyright© 2006 South-Western/Thomson Learning. All rights reserved. ●Demand curve = MU curve ♦Law of diminishing MU  (-) slope of D curves ♦  P   Qd   MU ■E.g., P = $3 → Qd = 4 pints. But if the ↑P to $5 → Qd = 2 pints. If ↓P to $2 → Qd = 5 pints. As ↑P, use the good for higher valued uses –to share with my friend or husband. As ↓P, use the good for lower valued uses –to share with my dog or mother-in-law. ●Demand curve = MU curve ♦Law of diminishing MU  (-) slope of D curves ♦  P   Qd   MU ■E.g., P = $3 → Qd = 4 pints. But if the ↑P to $5 → Qd = 2 pints. If ↓P to $2 → Qd = 5 pints. As ↑P, use the good for higher valued uses –to share with my friend or husband. As ↓P, use the good for lower valued uses –to share with my dog or mother-in-law. From MU to Demand Curves

Copyright© 2006 South-Western/Thomson Learning. All rights reserved. Consumer Choice as a Trade- Off: Opportunity Cost ●Recall the importance of opportunity cost ●Decision to purchase something  decision to forgo something else ♦Real cost of 4 pints purchased for $3.00 each is not the $12 given up. It is the 4 movie rentals that are given up. I have given up $12 worth of other goods to buy 4 pints of Chunky Monkey. ●Recall the importance of opportunity cost ●Decision to purchase something  decision to forgo something else ♦Real cost of 4 pints purchased for $3.00 each is not the $12 given up. It is the 4 movie rentals that are given up. I have given up $12 worth of other goods to buy 4 pints of Chunky Monkey.

Copyright© 2006 South-Western/Thomson Learning. All rights reserved. Consumer Surplus ●CS = net TU = TU - TE ●Economists assume that firms max profit and consumers max CS. ●Consumer must experience some gain from a voluntary transaction; otherwise the consumer would refuse to purchase the good. ●CS = net TU = TU - TE ●Economists assume that firms max profit and consumers max CS. ●Consumer must experience some gain from a voluntary transaction; otherwise the consumer would refuse to purchase the good.

TABLE 2. Calculating CS Quantity (pints per mo.) Marginal UtilityPriceNet MU (per unit surplus) 1$ 6.00$ Two ways of calculating CS: (1) CS = TU – TE or (2) CS = ∑(MU – P)

FIGURE 2. Graph of CS Marginal Utility and Price per pint $ $.50 $1 $2 0 Number of pints purchased $6 $3 A B C $5 $4 $3 D E F G H $2 $1 P $0 MU CS per unit MU (or D) curve

Copyright© 2006 South-Western/Thomson Learning. All rights reserved. Graph of Consumer Surplus ●CS = area under D curve and above P. ♦Leah was willing to pay $18 for the 4 pints (i.e., the TU of 4 pints), but only paid $12 (i.e., $3*4) so her total CS = $6. ●TU = area under entire D curve ●TE = rectangular area that reflects P*Qd ●CS = area under D curve and above P. ♦Leah was willing to pay $18 for the 4 pints (i.e., the TU of 4 pints), but only paid $12 (i.e., $3*4) so her total CS = $6. ●TU = area under entire D curve ●TE = rectangular area that reflects P*Qd

Copyright© 2006 South-Western/Thomson Learning. All rights reserved. ●Market D curve = horizontal sum of individual D curves ●Steps to move from individual D to market D: 1.Pick any relevant P. 2.Find Qd at that P for each person. 3.Add the Qd at that P to get Qd in the market. Repeat these steps for all possible prices. ●Market D curve = horizontal sum of individual D curves ●Steps to move from individual D to market D: 1.Pick any relevant P. 2.Find Qd at that P for each person. 3.Add the Qd at that P to get Qd in the market. Repeat these steps for all possible prices. From Individual to Market D Curves

FIGURE 3. Total Market D vs. Individual Consumer D Price 43 (c) Quantity Demanded 70 M M Market demand (b) Quantity Demanded 30 Z Z Joe’s demand (a) Quantity Demanded Price $3 40 MMJJLL K D D Leah’s demand $7 1 1

Copyright© 2006 South-Western/Thomson Learning. All rights reserved. From Individual to Market D Curves ●The “Law” of Demand ♦(-) slope for market D curves ■Individual D curves have (-) slopes because of the law of diminishing MU ■Lower P draws new customers into the market ●E.g., Fig. 3, only Joe will buy Chunky Monkey at P = $7. Yet, at P < $7, Leah will also purchase ice cream. As ↓P, Joe will buy more and Leah will enter the market, insuring that ↑Qd as ↓P. ●The “Law” of Demand ♦(-) slope for market D curves ■Individual D curves have (-) slopes because of the law of diminishing MU ■Lower P draws new customers into the market ●E.g., Fig. 3, only Joe will buy Chunky Monkey at P = $7. Yet, at P < $7, Leah will also purchase ice cream. As ↓P, Joe will buy more and Leah will enter the market, insuring that ↑Qd as ↓P.

Copyright© 2006 South-Western/Thomson Learning. All rights reserved. From Individual to Market D Curves ●Exceptions to the “Law” of Demand ♦Goods whose quality is judged by price –if a ↓P signals poor quality → ↓Qd ■E.g., Bayer aspirin vs. generic brand aspirin ♦Goods with snob appeal –some people buy expensive goods to advertise their wealth ■E.g., Rolls Royce ●Exceptions to the “Law” of Demand ♦Goods whose quality is judged by price –if a ↓P signals poor quality → ↓Qd ■E.g., Bayer aspirin vs. generic brand aspirin ♦Goods with snob appeal –some people buy expensive goods to advertise their wealth ■E.g., Rolls Royce

Copyright© 2006 South-Western/Thomson Learning. All rights reserved. ●Elasticity = measure of the responsiveness of one variable to changes in another variable ●Price elasticity of demand = (%∆Qd) ∕ (%∆P) ●Elasticity = measure of the responsiveness of one variable to changes in another variable ●Price elasticity of demand = (%∆Qd) ∕ (%∆P) Elasticity: Measure of Responsiveness

Copyright© 2006 South-Western/Thomson Learning. All rights reserved. Elasticity: Measure of Responsiveness ●Governments, courts, and businesses need to understand the relationship between Qd and P ●If consumers respond sharply to ∆P → D is elastic ●If consumers are unresponsive to ∆P → D is inelastic ●Governments, courts, and businesses need to understand the relationship between Qd and P ●If consumers respond sharply to ∆P → D is elastic ●If consumers are unresponsive to ∆P → D is inelastic

FIGURE 4(a). Perfectly Inelastic Demand Qd is 90 no matter the P. %∆Qd = 0 Consumer purchases do not respond to ∆P. E.g., goods with very low prices that are used with something else –salt or shoelaces. Or an essential medicine.

FIGURE 4(b). Perfectly Elastic Demand Slight ↑P → ↓Qd to 0. %∆Qd = infinitely large Consumer are completely responsive to ∆P. E.g., Demand for a firm that produces an undifferentiated product.

FIGURE 4(c). Straight-line Demand Slope remains constant but ε is changing. ε (a-b) = (2/3)  (2/5) = 1.67 ε (c-d) = (2/6)  (2/2) = 0.33 Moving down the D curve ε is getting smaller because average Q is rising while average P is falling.

FIGURE 4(d). Unit-elastic Demand Slope is changing but ε is constant and equal to 1. ε (e-f) = (7/10.5)  (10/15) = 1.0 Note: if ε = 1 → D is “unit elastic” if ε > 1 → D is “elastic” if ε < 1 → D is “inelastic”

Copyright© 2006 South-Western/Thomson Learning. All rights reserved. Elasticity of Demand and Total Revenue ●Firms want to know whether an ↑P will raise or lower their sales revenues. ♦If D is elastic: ↑P → ↓TR ♦If D is unit elastic: ↑P → TR constant ♦If D is inelastic: ↑P → ↑TR ■Recall: TR = TE = P x Qd ●Firms want to know whether an ↑P will raise or lower their sales revenues. ♦If D is elastic: ↑P → ↓TR ♦If D is unit elastic: ↑P → TR constant ♦If D is inelastic: ↑P → ↑TR ■Recall: TR = TE = P x Qd

Copyright© 2006 South-Western/Thomson Learning. All rights reserved. Elasticity of Demand and Total Revenue ●Further examples: ♦If P↓ by 10% and ↑Qd by 10% → D is unit elastic and TR are constant. ♦If P↓ by 10% and ↑Qd by 15% → D is elastic and ↑TR. ♦If P↓ by 10% and ↑Qd by 5% → D is inelastic and ↓TR. ●Further examples: ♦If P↓ by 10% and ↑Qd by 10% → D is unit elastic and TR are constant. ♦If P↓ by 10% and ↑Qd by 15% → D is elastic and ↑TR. ♦If P↓ by 10% and ↑Qd by 5% → D is inelastic and ↓TR.

FIGURE 5. An Elastic Demand Curve 5 12 Quantity Demanded Price $ U W D D R T S V Pt. S: TR = $24 = area of 0RST Pt. V: TR = $60 = area of 0WVU D is elastic as ↓P → ↑TR.

TABLE 3. Estimates of Price Elasticities

Copyright© 2006 South-Western/Thomson Learning. All rights reserved. What Determines Demand Elasticity? 1.Nature of the good: ♦Necessities have very inelastic demands, while luxuries have elastic demands. ♦E.g., ε potatoes = 0.3 and the ε restaurant meals = 1.6. What do these numbers mean? ●10%↑ in P of potatoes → ↓sales of potatoes by 3%. And 10%↑ in P of restaurant meals → ↓restaurant dining by 16%. ♦Comes from the elasticity formula: %  P * ε = %  Qd 1.Nature of the good: ♦Necessities have very inelastic demands, while luxuries have elastic demands. ♦E.g., ε potatoes = 0.3 and the ε restaurant meals = 1.6. What do these numbers mean? ●10%↑ in P of potatoes → ↓sales of potatoes by 3%. And 10%↑ in P of restaurant meals → ↓restaurant dining by 16%. ♦Comes from the elasticity formula: %  P * ε = %  Qd

Copyright© 2006 South-Western/Thomson Learning. All rights reserved. What Determines Demand Elasticity? 2.Availability of a close substitute: ♦If consumers can buy a good substitute for a product whose ↑P, they will readily switch. ■E.g., D for gas is inelastic because you can’t run a car without it. But D for Chevron gas is elastic because Mobile or Shell gas work just as well. 2.Availability of a close substitute: ♦If consumers can buy a good substitute for a product whose ↑P, they will readily switch. ■E.g., D for gas is inelastic because you can’t run a car without it. But D for Chevron gas is elastic because Mobile or Shell gas work just as well.

Copyright© 2006 South-Western/Thomson Learning. All rights reserved. What Determines Demand Elasticity? 3.Fraction of Income Absorbed: ♦Very inexpensive items have an inelastic demand. Who will use more salt if the price falls? ♦Very expensive items have elastic demands. Families will buy fewer homes if housing prices increase. 3.Fraction of Income Absorbed: ♦Very inexpensive items have an inelastic demand. Who will use more salt if the price falls? ♦Very expensive items have elastic demands. Families will buy fewer homes if housing prices increase.

Copyright© 2006 South-Western/Thomson Learning. All rights reserved. What Determines Demand Elasticity? 4.Passage of Time: ●D for products is more elastic in LR than SR because consumers have more time to adjust their purchases. ♦E.g., suppose recent ↑P gas continues. In SR, consumers may take fewer summer road trips to ↓Qd gas. But in LR, consumers can buy more fuel efficient cars to further ↓Qd gas. 4.Passage of Time: ●D for products is more elastic in LR than SR because consumers have more time to adjust their purchases. ♦E.g., suppose recent ↑P gas continues. In SR, consumers may take fewer summer road trips to ↓Qd gas. But in LR, consumers can buy more fuel efficient cars to further ↓Qd gas.

Copyright© 2006 South-Western/Thomson Learning. All rights reserved. Elasticity as a General Concept ●Elasticity can be used to measure the responsiveness of anything to anything else. ●Income Elasticity: ♦Income elasticity of D = %  Qd  %  Y ●Price Elasticity of Supply: ♦Price elasticity of S = %  Qs  %  P ●Elasticity can be used to measure the responsiveness of anything to anything else. ●Income Elasticity: ♦Income elasticity of D = %  Qd  %  Y ●Price Elasticity of Supply: ♦Price elasticity of S = %  Qs  %  P

Copyright© 2006 South-Western/Thomson Learning. All rights reserved. Cross Elasticity of Demand ●Cross ε d is used to determine whether two goods are compliments or substitutes. It is calculated as: ε cross = (%∆Qd good X)  (%∆P good Y) ●Cross ε d is used to determine whether two goods are compliments or substitutes. It is calculated as: ε cross = (%∆Qd good X)  (%∆P good Y)

Copyright© 2006 South-Western/Thomson Learning. All rights reserved. Cross Elasticity of Demand ●Two goods are compliments if an ↑Qd for one good → ↑Qd of the other good. ♦E.g, ketchup and french fries or coffee and cream. ■If ↓P of coffee → ↑purchases of coffee and cream. Cross elasticity for compliments is (-). As ↓P of coffee falls → ↑Qd of cream. ●Two goods are compliments if an ↑Qd for one good → ↑Qd of the other good. ♦E.g, ketchup and french fries or coffee and cream. ■If ↓P of coffee → ↑purchases of coffee and cream. Cross elasticity for compliments is (-). As ↓P of coffee falls → ↑Qd of cream.

Copyright© 2006 South-Western/Thomson Learning. All rights reserved. Cross Elasticity of Demand ●Two goods are substitutes if an ↑Qd for one good → ↓Qd of the other good. ♦E.g., ice cream and frozen yogurt or cans of salmon and cans of tuna. ■If ↑P of ice cream → ↓purchases of ice cream and ↑purchases of frozen yogurt. Cross elasticity for substitutes is (+). As ↑P of ice cream → ↑Qd of frozen yogurt. ●Two goods are substitutes if an ↑Qd for one good → ↓Qd of the other good. ♦E.g., ice cream and frozen yogurt or cans of salmon and cans of tuna. ■If ↑P of ice cream → ↓purchases of ice cream and ↑purchases of frozen yogurt. Cross elasticity for substitutes is (+). As ↑P of ice cream → ↑Qd of frozen yogurt.

Copyright© 2006 South-Western/Thomson Learning. All rights reserved. Cross Elasticity of Demand ●Cross elasticity is often used in “anti-trust” lawsuits. If firms face strong competition, it is difficult to overcharge customers. A very high and (+) cross elasticity indicates effective competition in a market.