Behind the Demand Curve: Consumer choice Microeconomics

Explaining the law of demand  Substitution Effect of a change in the price of a good is …  the change in the quantity of that good demanded as the  consumer substitutes the good cheaper good for the more expensive good  Need pictures

Substitution effect Eli has $6 so spend on snacks. Jellybeans cost $1/package and Gummy Worms cost $2/package. What is the max amount of packages Eli can buy given he has to buy at least one jellybean and at least 1 gummy worms? 4 jelly beans and 1 gummy worms What is the opportunity cost of one gummy worms? 1 gummy worm is 2 jellybeans

Substitution effect  The price of gummy worms falls to $1/package. Jelly beams remains the same.  What is the opportunity cost of one gummy worms?  One jelly beans  So, gummy worms are now less expensive, and Eli will substitute some gummy worms for jelly beans.  The substitution effect of a lower price creates an increase in quantity demanded.

Explaining the law of demand  Income effect of a change in the price of a good is …  the change in the quantity of that good demanded that results  From a change in the consumer’s purchasing power Need pictures

Income effect Eli has $6 so spend on snacks. Jellybeans cost $1/package and Gummy Worms cost $2/package. How many packages of jellybeans could Eli buy if he spends all his income on jellybean? Gummy worms? 6 packages jellybeans 3 packages gummy worms Gummy worms are now $1 each. How many packages of gummy worms can he buy? 6 packages

Income effect  Eli’s income is the same. His purchasing power has increased. He now has the opportunity to buy more gummy worms.  Substitution effect + income effect =  lower price creates an increase in quantity demanded.

Exercises  Do CYU # 1 and TTT 1 an 2 on the handout

Defining and Measuring Elasticity  Price Elasticity of Demand is the ratio … Ed = %Q D (effect) / %P (cause) Elastic = consumer relatively responsive to P Inelastic = consumer unresponsiveP

Calculating Price Elasticity of Demand (Ed) The price of digital cameras increase by 1% and quantity demanded falls by 2%. What is the Ed? Ed = -2%/1% = -2; absolute value of -2 = 2. % Q d was twice as large as the %in P Sensitive = Elastic

Calculating Price Elasticity of Demand (Ed) The price of milk increases by 10% and quantity demanded falls by 5%. Ed = -5%/10% = -1/2; absolute value = ½ or.5 % Q d was half as large as the %in P Insensitive = Inelastic

Calculating Ed Computing a % ∆ Between Two Numbers % ∆ P= (New Price – Old Price/ Old Price) *100 % ∆ Qd= (New Quantity – Old Quantity/ Old Quantity) *100 The price of a doughnut rises from $1.00 to $1.15 and Homer reduces his weekly doughnut consumption from 20 to 19.

Calculating Ed The price of a doughnut rises from $1.00 to $1.15 and Homer reduces his weekly doughnut consumption from 20 to 19. %∆P = 100(New Price – Old Price/Old Price) = 100*(1.15 – 1)/1 = 15% increase %∆Qd = 100(New Quantity – Old Quantity/Old Quantity) = 100(19-20)/20 = 5% decrease Homer’s Price Ed for doughnuts = %∆Qd/ %∆P = 5%/15% = 1/3 Is Homer’s Ed elastic or inelastic? Inelastic (fraction)

Calculating Ed Using the Mid Point Method The price of a college tuition increases from $20,000 to $24,000 per year. The college discovers that the entering class of first-year students declined form 500 to 450. %∆P = 100(New Price – Old Price)/Average Price) = 100*(24,000 – 20,000)/22,000 = 9.5 increase %∆Qd = 100(New Quantity – Old Quantity)/Average Quantity) = (450 – 500)/475 = -10.5% decrease Price Ed for college tuition = %∆Qd/ %∆P = 9.5%/10.5% =.90 Is the price of college tuition elastic or inelastic? Inelastic (fraction)

Price Elasticity of Demand  Price Elasticity of Demand is the consumer response (Qd) to a price change.  Ed = % change Qd/ % change P  Ed < 1 = demand inelastic  Ed = 1 = demand Unit elastic  Ed > 1 = demand elastic

CHAPTER 5 ELASTICITY AND ITS APPLICATION Q1Q1 P1P1 D “Perfectly inelastic demand” (one extreme case) Consumers have NO response to higher or lower prices. P Q P2P2 P falls by 10% Q changes by 0% Consumers’ price sensitivity: 0 D curve: Elasticity: 0 vertical

CHAPTER 5 ELASTICITY AND ITS APPLICATION D “Perfectly elastic demand” (the other extreme) Consumers immediately reduce consumption to zero. P Q P1P1 Q1Q1 P changes by 0% Q changes by any % Q2Q2 P 2 = Consumers’ price sensitivity: D curve: Elasticity: infinity horizontal extreme

Elastic v. Inelastic  E lastic  I nelastic

Elastic v. Inelastic  D curve closer to vertical (steeper) WILL BE less elastic than a D curve closer to horizontal (flatter)

CHAPTER 5 ELASTICITY AND ITS APPLICATION D Unit Elastic Demand P Q Q1Q1 P1P1 Q2Q2 P2P2 Q rises by 10% 10% = 1 Price elasticity of demand = % change in Q % change in P = P falls by 10% Consumers’ price sensitivity: Elasticity: intermediate 1 D curve: intermediate slope

CHAPTER 5 ELASTICITY AND ITS APPLICATION D “Inelastic demand” P Q Q1Q1 P1P1 Q2Q2 P2P2 Q rises less than 10% < 10% 10% < 1 Price elasticity of demand = % change in Q % change in P = P falls by 10% Consumers’ price sensitivity: D curve: Elasticity: relatively steep relatively low < 1

CHAPTER 5 ELASTICITY AND ITS APPLICATION D “Elastic demand” P Q Q1Q1 P1P1 Q2Q2 P2P2 Q rises more than 10% > 10% 10% > 1 Price elasticity of demand = % change in Q % change in P = P falls by 10% Consumers’ price sensitivity: D curve: Elasticity: relatively flat relatively high > 1

Total Revenue  Total Revenue (TR) = Price (P) * Quantity Demanded (Qd)  P  competes with Qd  on TR  Who wins?  Depends!!

Price Effect  Price effect happens after a price increase when …  Units sold sells at a higher P  Revenue rises  P  and TR 

Quantity Effect  Quantity effect happens after a price increase when …  Fewer units are sold –m lower Qd  Revenue is lower  P  and TR 

P and Qd Effect Examples  P rises 1% and Qd decreases 5%  Elastic or inelastic?  Which effect is stronger?  TR fall or rise?

P and Qd Effect Examples  P rises 10% and Qd decreases 5%  Elastic or inelastic?  Which effect is stronger?  TR fall or rise?

P and Qd Effect Examples  P rises 10% and Qd decreases 10%  Elastic or inelastic?  Which effect is stronger?  TR fall or rise?

Elasticity Along the Demand Curve PQdTRPe of D $070$

CHAPTER 5 ELASTICITY AND ITS APPLICATION The Determinants of Price Elasticity: A Summary ElasticInelastic LuxuryNecessity Available SubstituteUnavailable Substitute Ample Time AvailableLittle Time Available Large Portion of Income Small Portion of Income

CHAPTER 5 ELASTICITY AND ITS APPLICATION EXAMPLE 1: Rice Krispies vs. Sunscreen  The prices of both of these goods rise by 20%. For which good does Q d drop the most? Why?  Rice Krispies has lots of close substitutes (e.g., Cap’n Crunch, Count Chocula), so buyers can easily switch if the price rises.  Sunscreen has no close substitutes, so consumers would probably not buy much less if its price rises.  Lesson: Price elasticity is higher when close substitutes are available.

CHAPTER 5 ELASTICITY AND ITS APPLICATION EXAMPLE 2: “Blue Jeans” vs. “Clothing”  The prices of both goods rise by 20%. For which good does Q d drop the most? Why?  For a narrowly defined good such as blue jeans, there are many substitutes (khakis, shorts, Speedos).  There are fewer substitutes available for broadly defined goods. (Can you think of a substitute for clothing, other than living in a nudist colony?)  Lesson: Price elasticity is higher for narrowly defined goods than broadly defined ones.

CHAPTER 5 ELASTICITY AND ITS APPLICATION EXAMPLE 3: Insulin vs. Caribbean Cruises  The prices of both of these goods rise by 20%. For which good does Q d drop the most? Why?  To millions of diabetics, insulin is a necessity. A rise in its price would cause little or no decrease in demand.  A cruise is a luxury. If the price rises, some people will forego it.  Lesson: Price elasticity is higher for luxuries than for necessities.

CHAPTER 5 ELASTICITY AND ITS APPLICATION EXAMPLE 4: Gasoline in the Short Run vs. Gasoline in the Long Run  The price of gasoline rises 20%. Does Q d drop more in the short run or the long run? Why?  There’s not much people can do in the short run, other than ride the bus or carpool.  In the long run, people can buy smaller cars or live closer to where they work.  Lesson: Price elasticity is higher in the long run than the short run.

CHAPTER 5 ELASTICITY AND ITS APPLICATION Elasticity of a Linear Demand Curve The slope of a linear demand curve is constant, but its elasticity is not. P Q $ $ % 40% = 5.0 E =E = 67% = 1.0 E =E = 40% 200% = 0.2 E =E =

Other Elasticities  Suppose the price of gasoline were to increase. Who would be interested?  Large trucks and SUVs, FEDEX, any business which relies on trucks to transport its goods  Cross-Price Elasticity is used to measure this response.

CHAPTER 5 ELASTICITY AND ITS APPLICATION Other Elasticities  Cross-Price Elasticity of Demand measures the response of demand for one good to changes in the price of another good. Cross-price elast. of demand = % change in Q d for good 1 % change in P of good 2  Substitute - cross-price elasticity > 0  E.g., an increase in price of beef causes an increase in demand for chicken.  Complements - cross-price elasticity < 0  E.g., an increase in price of computers causes decrease in demand for software.

Other Elasticities  Suppose the economy is suffering a recession and personal incomes are lower. Who would be interested?  Airlines and the hotel industries  Income Elasticity is used to measure this response.

CHAPTER 5 ELASTICITY AND ITS APPLICATION Other Elasticities  Income Elasticity of Demand (Ei) measures the response of Q d to a change in consumer income. Income elasticity of demand = Percent change in Q d Percent change in income  What is a normal good? Inferior good?  Normal goods – Ei > 0  Example: Consumer income rises by 4% and the quantity of fresh vegetables purchased increases by 1%.  Inferior goods - Ei < 0  Consumer income falls by 5% and consumers increase SPAM consumption by 4%

Other Elasticities  The Law of Supply says …  P increases, Qs increases  Economists want to measure HOW MUCH Q will increase in response to this higher P.  Price Elasticity of Supply is used to measure this response.

CHAPTER 5 ELASTICITY AND ITS APPLICATION Price Elasticity of Supply  Price elasticity of supply measures how much Q s responds to a change in P. Price elasticity of supply = Percentage change in Q s Percentage change in P Es < 1 = demand inelastic Es = 1 = demand Unit elastic Es > 1 = demand elastic

Price Elasticity of Supply Factors  Availability of Inputs  More elastic = inputs get into and out of production quickly  Time Period  ‘Market period’ is short = Es is inelastic  ‘Short-run supply’ more elastic than Market Period and less elastic than Long-run Supply.  ‘Long-run supply’ is most elastic = longer time period to adjust