1 Law of Demand  Law of Demand  People do less of what they want to do as the cost of doing it rises  Recall the Cost-Benefit Principle  Pursue an action if and only if its benefits are at least as great as its costs  Recall the Reservation Price  The highest price we’d be willing to pay

2 Total Expenditure  Total Expenditure equals  The number of units sold multiplied by the price of the good  Total Expenditure = Total Revenue  The dollar amount that consumers spend on a product is equal to the dollar amount that sellers receive

3 The Law of Demand and Total Expenditure  “Will consumers spend more on my product if I sell more units at a lower price or fewer units at a higher price?”  Depends upon price elasticity of demand  When price rises, total expenditure may  increase, decrease, or stay the same  This is due to the Law of Demand  As price rises, quantity demanded falls  As price falls, quantity demanded rises

4 Fig. 5.7 The Demand Curve for Movie Tickets

5 Fig. 5.8 The Demand Curve for Movie Tickets

6 Fig Total Expenditure as a Function of Price

7 Price Elasticity of Demand  In order to predict what will happen to total expenditures,  We must know how much quantity will change when the price changes  Price elasticity of demand is  the percentage change in the quantity demanded that results from a one-percent change in its price

8 Price Elasticity of Demand

9 Price Elasticity  Elastic – quantity changes by a lot when price changes even a little  price elasticity is greater than one  Inelastic – quantity changes by a little when price changes even a lot  price elasticity is less than one  Unit elastic – quantity change = price change  price elasticity equals one  When calculating price elasticity of demand, you will always get a negative- WHY?  For convenience we will take the absolute value

10 Fig Elastic and Inelastic Demand

11 Price Elasticity and Expenditures  For an elastic product  Quantity demanded is highly responsive  Percentage change in quantity dominates  An increase in price will reduce total expenditure  A decrease in price will increase total expenditure  For an inelastic product  Quantity demanded is not responsive  Percentage change in price dominates  An increase in price will increase total expenditure  A decrease in price will decrease total expenditure

12 Determinants of Elasticity  Substitution possibilities  Price elasticity of demand will be relatively high if it is easy to substitute between products – Why?  Budget share  The larger the share of the budget the good uses tends to have higher price elasticities of demand – Why?  Time  Because substitution takes time, price elasticity will be higher in the long run than in the short run

13 Examples  What are some goods that will have very elastic demand?  What are some goods that will have very inelastic demand?

14 Calculating Price Elasticity  Proportion by which quantity demanded changes divided by the proportion by which price changes

15 Fig Graphical Interpretation of Price Elasticity of Demand

16 Other Elasticities of Demand  Income Elasticity of Demand  The amount by which the quantity demanded changes in response to a one- percent change in income  Positive for normal goods  Negative for inferior goods

17 Other Elasticities of Demand  Cross Price Elasticity of Demand  The amount by which the quantity demanded of one good changes in response to a one-percent change in the price of another good  Positive for substitutes  Negative for complements

18 Perfect Elasticity  Perfectly Elastic demand  Price elasticity of demand is infinite  Even the slightest change in price leads consumers to find substitutes  Perfectly Inelastic demand  Price elasticity of demand is zero  Consumers do not switch to substitutes even when price increases dramatically  Do goods like these exist?

19 Fig Perfectly Elastic and Perfectly Inelastic Demand Curves

20 Price Elasticity of Supply  The percentage change in the quantity supplied that will occur in response to a one-percent change in its price

21 Determinants of Supply Elasticity  The more easily additional units of inputs can be acquired, the higher the price elasticity (more elastic)  Flexibility of Inputs  Mobility of Inputs  Ability to Produce Substitute Inputs  Time  Unique and Essential Inputs

22 Perfect Elasticity  Perfectly Inelastic  Elasticity of supply is zero  Whether the price is high or low, the same amount is available  Perfectly Elastic  Elasticity of supply is infinite  When additional units can be produced using the same combination of inputs purchased at the same prices

23 Fig A Perfectly Inelastic Supply Curve

24 Fig A Perfectly Elastic Supply Curve

25 Elasticity of Supply  What determines whether the supply of a particular good will be elastic or inelastic?  Availability of resources used to produce the good – how quickly and easily can producers respond to a price change?  Eg of good with inelastic supply?  Eg of good with elastic supply?

26 Naturalist Questions  Why do you pay $5 for a beer in the airport when you can buy the same beer for less than $1 outside the airport?  Why do you get a discounted airfare when you stay over a Saturday night?  Why are there so many personalized license plates in Virginia vs. NC?