Eco 6351 Economics for Managers Chapter 4. CONSUMER DEMAND Prof. Vera Adamchik

In Chapter 3 we learned the Law of Demand (p. 59 in the textbook). The Law of Demand: The quantity of a good demanded in a given time period increases as its price falls, ceteris paribus. In other words, cutting the price of a good increases the quantity demanded, and raising the price reduces the quantity demanded.

Learning objectives In Chapter 4 we will take a closer look at consumer demand. In this chapter, you will learn: 1. how the economic model of consumer behavior leads to the Law of Demand (that is, the downward-sloping demand curves) – UTILITY THEORY; 2. how responsive the quantity demanded of a good is to changes in its price – PRICE ELASTICITY OF DEMAND.

1. UTILITY THEORY

Example Lisa has a monthly income of $30 Soda costs $3 per six-pack Movies cost $6 each Every month Lisa can afford 10 six- packs or 5 movies or some combinations of soda and movies What is the best choice for Lisa?

Preferences Preferences tell us about consumers’ likes and dislikes Two approaches to describing preferences: –Marginal utility theory –Indifference curve theory

Preferences Utility is the enjoyment, pleasure or satisfaction that a person gets from the consumption of a good or service. The units of measurement of utility are called “utils.” Utils are arbitrary - like the units of measurement of temperature. For example, 90 F in Houston and 70 F in New York City or 32 C in Houston and 21 C in New York City both tell the same story – it is hotter in Houston.

Movies Soda Quantity Total Quantity Total per month Utility per month Utility

Total Utility This figure is a graph of Lisa’s total utility from the first 5 movies per month Notice that Lisa’s total utility increases as she sees more movies But the increments in utility get smaller

Marginal Utility Marginal Utility: the additional utility derived from the last unit of a good consumed. Calculation of marginal utility: The change in total utility resulting from consuming one more unit of a good.

This figure shows the connection between total utility and marginal utility

The Law of Diminishing Marginal Utility The Law of Diminishing Marginal Utility is the fundamental assumption of the marginal utility theory. The Law states that the marginal utility derived from each additional unit of a good declines as more of it is consumed in a given time period.

Utility Theory and the Law of Demand As the marginal utility of each additional unit of a good diminishes, so does people’s willingness to pay. In other words, people are willing to buy additional quantities of a good only if its price falls, ceteris paribus. The inverse relationship between the quantity demanded of a good and its price is referred to as the Law of Demand.

Example (conclusion) What is the best choice for Lisa? If Lisa had an unlimited budget, her decision would be easy: to buy as much of everything as she wants. Given that she has a limited budget, what will she do?

Example (conclusion) Economists assume that consumers act so as to make themselves as well off as possible. Therefore, Lisa should choose among those combinations of soda and movies that she can afford, the one combination that makes her as well as possible (that is, gives Lisa the highest possible level of enjoyment, pleasure or satisfaction).

Example (conclusion) ChoicesMoviesSodaTotal Utility A =291 B =310 C =313 D =302 E =267 F =175

Example (conclusion) The combination of 2 movies and 6 packs of soda per month will give Lisa the highest possible level of enjoyment, ceteris paribus.

2. PRICE ELASTICITY OF DEMAND

2.1. Price Elasticity of Demand: Concept and Measurement

As firms analyze the demand for their products, a key factor they focus on is how responsive consumer demand is to a change in price. The Law of Demand: when the price of a product falls, the quantity demanded of the product increases, ceteris paribus. The Law of Demand tells firms only that the demand curves for their products slope downward.

The Law of Demand is useful, but firms often need to know the numbers behind the Law of Demand. That is, firms need to know exactly how much more will be demanded at a lower price (or how much less will be demanded at a higher price). To answer these questions, we need to quantify the Law of Demand, exploring the responsiveness of consumers to changes in price.

The price elasticity of demand is a measure of the responsiveness of the quantity demanded to changes in price. It is equal to the absolute value of the percentage change in the quantity demanded of a product divided by the percentage change in the product’s price:

is always negative due to the Law of Demand. A price increase (a positive change in price) leads to a quantity decrease (a negative change in quantity), and vice versa. So economists usually ignore the minus sign and report the absolute value of the price elasticity of demand.

Example A 10% fall in the price of bagels results in a 20% increase in the quantity of bagels demanded. It means that a 1% change in price will result in a 2% change in quantity demanded.

Very often we need to calculate the percentage change in quantity demanded and the percentage change in price. Percent changes are best measured using the midpoint method, in which the percent change in each variable is calculated using the average of starting and final values. We use the midpoint formula to ensure that we have only one value of the price elasticity of demand between the same two points on the same demand curve.

The midpoint formula

Example Calculate the price elasticity for the two demand curves (D1 and D2) on the segments between points A and B (for D1) and A and C (for D2). These segments correspond to the same price change of $10 (either a price increase from $20 to $30 or a price decrease from $30 to $20).

Calculating the Price Elasticity of Demand

Example For D1 between A and B: It means that a 1% change in price will result in a 1.4% change in quantity demanded.

Example For D2 between A and C: It means that a 1% change in price will result in a 0.6% change in quantity demanded.

Elastic and inelastic demand Perfectly elastic demand: Ed=infinity Elastic demand: Ed > 1 Unit-elastic demand: Ed = 1 Inelastic demand: Ed < 1 Perfectly inelastic demand: Ed = 0

Elastic demand Demand is elastic when the percentage change in quantity demanded is greater than the percentage change in price, so the price elasticity is greater than 1 in absolute value. Inelastic demand Demand is inelastic when the percentage change in quantity demanded is less than the percentage change in price, so the price elasticity is less than 1 in absolute value. Elastic Demand and Inelastic Demand Unit-elastic demand Demand is unit-elastic when the percentage change in quantity demanded is equal to the percentage change in price, so the price elasticity is equal to 1 in absolute value.

Summary of the Price Elasticities of Demand Out of the two demand curves, the flatter curve is relatively more elastic, and the steeper curve is relatively more inelastic

Two Polar Cases: Perfectly Elastic and Perfectly Inelastic Demand Perfectly inelastic demand The case where the quantity demanded is completely unresponsive to price, and the price elasticity of demand equals zero. Perfectly elastic demand The case where the quantity demanded is infinitely responsive to price, and the price elasticity of demand equals infinity.

Summary of the Price Elasticities of Demand (continued)

Elasticity along a linear demand curve At a high price and small quantity, elasticity is large

Elasticity along a linear demand curve At a low price and large quantity, elasticity is small

Elasticity along a linear demand curve At the mid- point price and quantity, elasticity is 1

2.2. The Determinants of the Price Elasticity of Demand

The Determinants of the Price Elasticity of Demand Availability of Close Substitutes Passage of Time Luxuries versus Necessities Definition of the Market Share of a Good in a Consumer’s Budget The key determinants of the price elasticity of demand are as follows:

Availability of Close Substitutes In general, if a product has more substitutes available, it will have more elastic demand. If a product has fewer substitutes available, it will have less elastic demand.

Passage of Time The more time that passes, the more elastic the demand for a product becomes.

Luxuries versus Necessities The demand curve for a luxury is more elastic than the demand curve for a necessity.

Definition of the Market The more narrowly we define a market, the more elastic demand will be.

Share of the Good in the Consumer’s Budget In general, the demand for a good will be less elastic the smaller the share of the good in the average consumer’s budget.

Ed for Selected Products Salt Food (wealthy countries) Physician visits Cofee Gasoline (short run) Eggs Cigarettes Food (poor countries)

Ed for Selected Products Shoes and footwear Gasoline (long run) Housing Fruit juice Automobiles Foreign travel Motorboats Restaurant meals Air travel Movies Specific brands of coffee

2.3. The Relationship between Price Elasticity of Demand and Total Revenue

A firm is interested in price elasticity because it allows the firm to calculate how changes in price will affect its total revenue (TR=Price*Quantity sold).

Disagree. Price and Revenue Don’t Always Move in the Same Direction Do you agree or disagree with the following statement: “The only way to increase the revenue from selling a product is to increase the product’s price.”

The Relationship between Price Elasticity and Revenue IF DEMAND IS...THEN... BECAUSE... elastic an increase in price reduces revenue the decrease in quantity demanded is proportionally greater than the increase in price. elastic a decrease in price increases revenue the increase in quantity demanded is proportionally greater than the decrease in price. inelastic an increase in price increases revenue the decrease in quantity demanded is proportionally smaller than the increase in price. inelastic a decrease in price reduces revenue the increase in quantity demanded is proportionally smaller than the decrease in price. unit-elastic an increase in price does not affect revenue the decrease in quantity demanded is proportionally the same as the increase in price. unit-elastic a decrease in price does not affect revenue the increase in quantity demanded is proportionally the same as the decrease in price.

Elasticity and Revenue with a Linear Demand Curve Figure 6-3 Elasticity Is Not Constant Along a Linear Demand Curve

Total Revenue TR=P*Q Then, %  TR ≈ %  P + %  Q

Example If demand is unit elastic, a decrease in price results in an equal percentage increase in the quantity demanded and total revenue and total expenditure remain constant: %  TR = %  P + %  Q = -1%+1% = 0.

Example If demand is elastic, a decrease in price results in an larger percentage increase in the quantity demanded and total revenue and total expenditure increase. For example, if Ed = 3: %  TR = %  P + %  Q = -1%+3% = +2%.

If demand is inelastic, a decrease in price results in an smaller percentage increase in the quantity demanded and total revenue and total expenditure decrease. For example, if Ed = 0.7: %  TR = %  P + %  Q = -1%+0.7% = -0.3%. Example

Estimating Price Elasticity of Demand To calculate the price elasticity of demand for new products, firms often rely on market experiments. With market experiments, firms try different prices and observe the change in quantity demanded that results.

Total Revenue Test If a price cut increases TR, demand is elastic. If a price cut decreases TR, demand is inelastic. If a price cut leaves TR unchanged, demand is unit elastic.

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