© 2006 Prentice Hall Business Publishing The Economic Way of Thinking, 11/e Heyne/Boettke/Prychitko Chapter 3 Substitutes Everywhere: The Concept of Demand “The Economic Way of Thinking” 11 th Edition

© 2006 Prentice Hall Business Publishing The Economic Way of Thinking, 11/e Heyne/Boettke/Prychitko 2 of 49 Chapter 3 Outline Introduction On the Notion of “Needs” Marginal Values Everyday Choices – Marginal Choices The Demand Curve The Law of Demand

© 2006 Prentice Hall Business Publishing The Economic Way of Thinking, 11/e Heyne/Boettke/Prychitko 3 of 49 Chapter 3 Outline Demand and Quantity Demanded Demand Itself Can Change Everything Depends Upon Everything Else Misperceptions Caused by Inflation Time Is on Our Side

© 2006 Prentice Hall Business Publishing The Economic Way of Thinking, 11/e Heyne/Boettke/Prychitko 4 of 49 Chapter 3 Outline Price Elasticity of Demand Thinking About Elasticity Elasticity and Total Receipts The Myth of Vertical Demand All Scarce Goods Must Be Rationed – Somehow Is Money All That Matters? Money Costs, Other Costs and Economic Calculation

© 2006 Prentice Hall Business Publishing The Economic Way of Thinking, 11/e Heyne/Boettke/Prychitko 5 of 49 Introduction Most goods are scarce. –Sacrifice is necessary There are substitutes for everything Intelligent choice entails trade-offs. Market price signals encourage buyers to economize

© 2006 Prentice Hall Business Publishing The Economic Way of Thinking, 11/e Heyne/Boettke/Prychitko 6 of 49 On the Notion of “Needs” What is the relationship between “trade-offs” and “needs”? Consider these four statements… –The average person needs eight glasses of water per day to maintain good health. –All citizens should be able to obtain the medical care they need regardless of their ability to pay. –A diabetic needs insulin. –You need to read your economics textbook.

© 2006 Prentice Hall Business Publishing The Economic Way of Thinking, 11/e Heyne/Boettke/Prychitko 7 of 49 On the Notion of Needs Higher prices (sacrifices) lead people to seek substitutes. The fact that goods and services are scarce entails trade-offs, i.e., the sacrifice of other goods and services we value.

© 2006 Prentice Hall Business Publishing The Economic Way of Thinking, 11/e Heyne/Boettke/Prychitko 8 of 49 Marginal Values Questions –Which is more valuable, water or diamonds? –Which is more valuable, a glass of water or a glass of diamonds? Answers –The values that matter are marginal values –Marginal means “additional,” so in economics we make decisions based on expected marginal beliefs versus marginal cost.

© 2006 Prentice Hall Business Publishing The Economic Way of Thinking, 11/e Heyne/Boettke/Prychitko 9 of 49 Everyday Choices and Marginal Choices The Economic Way of Thinking… –Rejects the all-or-nothing approach –Favors attention to Marginal benefits Marginal costs –More of A and less of B versus more of B and less of A

© 2006 Prentice Hall Business Publishing The Economic Way of Thinking, 11/e Heyne/Boettke/Prychitko 10 of 49 The Demand Curve In a world of scarcity, individuals incur trade-offs. Thus, economists developed the idea of demand.

© 2006 Prentice Hall Business Publishing The Economic Way of Thinking, 11/e Heyne/Boettke/Prychitko 11 of 49 The Demand Curve Making it Graphic Graphs can be used to illustrate relationships. Demand Curves –Illustrate the relationship between price and quantity demanded.

© 2006 Prentice Hall Business Publishing The Economic Way of Thinking, 11/e Heyne/Boettke/Prychitko 12 of 49 The Demand Curve Consumption Table $ Demand Schedule is a tabular representation of graphical data: Price per Gallon Gallons per Day

© 2006 Prentice Hall Business Publishing The Economic Way of Thinking, 11/e Heyne/Boettke/Prychitko 13 of 49 The Demand Curve Vertical Axis – possible prices that might be charged. Horizontal Axis – quantity purchased at those prices. Economists call that a Demand Curve.

© 2006 Prentice Hall Business Publishing The Economic Way of Thinking, 11/e Heyne/Boettke/Prychitko 14 of 49 The Demand Curve GALLONS OF WATER PER DAY $.07 PRICE PER GALLON.01

© 2006 Prentice Hall Business Publishing The Economic Way of Thinking, 11/e Heyne/Boettke/Prychitko 15 of 49 The Demand Curve A demand curve illustrates the amount of a good that consumers plan to purchase at any given price. Read a demand curve by taking a price and finding corresponding quantity. That is the Quantity Demanded

© 2006 Prentice Hall Business Publishing The Economic Way of Thinking, 11/e Heyne/Boettke/Prychitko 16 of 49 The Law of Demand “Law of Demand” A negative relationship exists between the amount of anything that people want to purchase and the price they must pay.

© 2006 Prentice Hall Business Publishing The Economic Way of Thinking, 11/e Heyne/Boettke/Prychitko 17 of 49 Demand and Quantity Demanded “A change in demand” is not the same thing as a “change in quantity demanded.” Demand is a relationship between two specific variables. –It is a schedule or a curve.

© 2006 Prentice Hall Business Publishing The Economic Way of Thinking, 11/e Heyne/Boettke/Prychitko 18 of 49 Demand and Quantity Demanded Change in Quantity demanded: D Q P Change in demand:: D1 Q P D2

© 2006 Prentice Hall Business Publishing The Economic Way of Thinking, 11/e Heyne/Boettke/Prychitko 19 of 49 Demand and Quantity Demanded A change in quantity demanded is a movement from one point on a curve to another point on the same curve. A change in demand results from some other factor that makes households buy more or less at each price. –The demand curve shifts.

© 2006 Prentice Hall Business Publishing The Economic Way of Thinking, 11/e Heyne/Boettke/Prychitko 20 of 49 Demand Itself Can Change Price per Gallon Original Gallons/Day New Gallons/Day $

© 2006 Prentice Hall Business Publishing The Economic Way of Thinking, 11/e Heyne/Boettke/Prychitko 21 of 49 Demand Itself Can Change GALLONS OF WATER PER DAY $.07 PRICE PER GALLON.01

© 2006 Prentice Hall Business Publishing The Economic Way of Thinking, 11/e Heyne/Boettke/Prychitko 22 of 49 Everything Depends Upon Everything Else Influences that can cause a change in demand for a good: –# of customers –Change in customer tastes –Change in income –Change in price of a substitute

© 2006 Prentice Hall Business Publishing The Economic Way of Thinking, 11/e Heyne/Boettke/Prychitko 23 of 49 Everything Depends Upon Everything Else Influences that can cause a change in demand for a good: –Change in the price of a complementary good –Change in the expected price of a good

© 2006 Prentice Hall Business Publishing The Economic Way of Thinking, 11/e Heyne/Boettke/Prychitko 24 of 49 Misperceptions Caused by Inflation Inflation is an increase in the average money price of goods. If the money price of all goods (including labor) increases, then no good (except money) will have changed in real price.

© 2006 Prentice Hall Business Publishing The Economic Way of Thinking, 11/e Heyne/Boettke/Prychitko 25 of 49 Time Is On Our Side Changes in the quantity demanded take time. These changes will be greater for any price change the longer the time period allowed for adjustment. –It takes time for customers to find and begin to use substitutes. –It takes time for producers to devise, produce, and publicize substitutes.

© 2006 Prentice Hall Business Publishing The Economic Way of Thinking, 11/e Heyne/Boettke/Prychitko 26 of 49 Price Elasticity of Demand Price elasticity of demand measures consumer responsiveness to price changes. Inelastic Demand –If quantity demanded changes very little as a result of a large change in price. Elastic Demand –If quantity demanded changes substantially as a result of a small change in price.

© 2006 Prentice Hall Business Publishing The Economic Way of Thinking, 11/e Heyne/Boettke/Prychitko 27 of 49 Price Elasticity of Demand ….is the percentage change in the quantity demanded divided by the percentage change in price. Elasticity is influenced by: –Time –Availability of substitutes –Proportion of one’s budget spent on a good

© 2006 Prentice Hall Business Publishing The Economic Way of Thinking, 11/e Heyne/Boettke/Prychitko 28 of 49 Price Elasticity of Demand

© 2006 Prentice Hall Business Publishing The Economic Way of Thinking, 11/e Heyne/Boettke/Prychitko 29 of 49 Price Elasticity of Demand Example –Price increases by 20% –Quantity demanded decreases by 50% Consumers are relatively responsive - Elastic Example –Price decreases by 20% –Quantity demanded increases by 15% Consumers are relatively unresponsive - Inelastic

© 2006 Prentice Hall Business Publishing The Economic Way of Thinking, 11/e Heyne/Boettke/Prychitko 30 of 49 Price Elasticity of Demand Elastic Demand –Price elasticity > 1 Inelastic Demand –Price elasticity < 1 Unit Elastic –Price elasticity = 1

© 2006 Prentice Hall Business Publishing The Economic Way of Thinking, 11/e Heyne/Boettke/Prychitko 31 of 49 Thinking About Elasticity “People aren’t going to buy much more no matter how far we cut the price.” “This is a competitive business. We would lose half our customers if we raised our prices by as little as 2 percent.” Question –Would a firm want to lower prices if demand were inelastic? Question –Would a firm want to raise prices if demand were elastic?

© 2006 Prentice Hall Business Publishing The Economic Way of Thinking, 11/e Heyne/Boettke/Prychitko 32 of 49 Thinking About Elasticity D Inelastic Demand P Q

© 2006 Prentice Hall Business Publishing The Economic Way of Thinking, 11/e Heyne/Boettke/Prychitko 33 of 49 Thinking About Elasticity D Elastic Demand P Q

© 2006 Prentice Hall Business Publishing The Economic Way of Thinking, 11/e Heyne/Boettke/Prychitko 34 of 49 Thinking About Elasticity Question –Can food stores charge any price they want since they sell food? Question –Would it be wise to impose a tax on table salt? Question –Would the demand for Morton’s salt be more elastic or inelastic than the demand for salt?

© 2006 Prentice Hall Business Publishing The Economic Way of Thinking, 11/e Heyne/Boettke/Prychitko 35 of 49 Thinking About Elasticity A product’s elasticity depends upon… –The proportion of one’s budget spent on an item. The more a product takes of your budget, the more elastic. –The more substitutes a product has, the more elastic. –Necessities are less elastic than luxuries. –All products become more elastic with time.

© 2006 Prentice Hall Business Publishing The Economic Way of Thinking, 11/e Heyne/Boettke/Prychitko 36 of 49 Elasticity and Total Receipts “The university’s total receipts from tuition would actually increase if tuition rates were cut by 20 percent.” The 20 percent cut in prices must cause quantity demanded to increase by more than 20 percent. –Elastic demand

© 2006 Prentice Hall Business Publishing The Economic Way of Thinking, 11/e Heyne/Boettke/Prychitko 37 of 49 Elasticity and Total Receipts “It’s odd but true. Wheat farmers would gross more money if they all got together and burned one-quarter of this year’s crop.” Elastic Demand –Prices and total receipts move in opposite directions. Inelastic Demand –Prices and total receipts move in the same direction.

© 2006 Prentice Hall Business Publishing The Economic Way of Thinking, 11/e Heyne/Boettke/Prychitko 38 of 49 Elasticity and Total Receipts P Q D Elastic demand between C and E since OBCG < OAEF. B C G A E F O

© 2006 Prentice Hall Business Publishing The Economic Way of Thinking, 11/e Heyne/Boettke/Prychitko 39 of 49 Elasticity and Total Receipts P Q D A Inelastic demand between A and B. B

© 2006 Prentice Hall Business Publishing The Economic Way of Thinking, 11/e Heyne/Boettke/Prychitko 40 of 49 Elasticity and Total Receipts P Q Demand for wheat The market price when entire crop is sold The price when 1/4 of crop is burned.

© 2006 Prentice Hall Business Publishing The Economic Way of Thinking, 11/e Heyne/Boettke/Prychitko 41 of 49 The Myth of Vertical Demand P Q D P1P1 P2P2

© 2006 Prentice Hall Business Publishing The Economic Way of Thinking, 11/e Heyne/Boettke/Prychitko 42 of 49 The Myth of Vertical Demand Question –Does a perfectly inelastic demand curve exist? Will consumers buy the same quantity at all prices? –There is no such thing as a completely inelastic demand curve over the entire possible range of prices. –If the price of insulin falls, diabetics would be more likely to purchase a larger quantity, implying that the demand curve for insulin is downward sloping.

© 2006 Prentice Hall Business Publishing The Economic Way of Thinking, 11/e Heyne/Boettke/Prychitko 43 of 49 All Scarce Goods Must Be Rationed Somehow Market prices and willingness to pay are our primary criteria for rationing goods and services. If a good is scarce, sacrifices must be made to obtain it. When prices of products and services rise, people respond by economizing in their use. –People naturally find ways to economize that entail the least sacrifice.

© 2006 Prentice Hall Business Publishing The Economic Way of Thinking, 11/e Heyne/Boettke/Prychitko 44 of 49 All Scarce Goods Must Be Rationed Somehow Scarce goods must be rationed. Rationing can be done by willingness to pay prices. Other ways to ration: –“Fist come, first served” –Lottery –Equal shares for all –“Might makes right” –Merit

© 2006 Prentice Hall Business Publishing The Economic Way of Thinking, 11/e Heyne/Boettke/Prychitko 45 of 49 All Scarce Goods Must Be Rationed Somehow When the price of a good rises, users find it in their own interest to economize. They will choose ways to economize that entail the smallest sacrifice. Individuals are in the best position to pick and choose among the ways to economize.

© 2006 Prentice Hall Business Publishing The Economic Way of Thinking, 11/e Heyne/Boettke/Prychitko 46 of 49 Is Money All That Matters? Money Costs, Other Costs, and Economic Calculation As the opportunity cost of an action increases, the chooser will tend to undertake less of that action. As the opportunity cost of an action decreases, the user will tend to undertake more of that action.

© 2006 Prentice Hall Business Publishing The Economic Way of Thinking, 11/e Heyne/Boettke/Prychitko 47 of 49 Is Money All That Matters? Money Costs, Other Costs, and Economic Calculation People compare the expected additional benefit against the expected additional cost. In a commercial market economy, money is a common denominator (i.e. a yardstick). Money allows individuals to calculate relative costs and benefits.

© 2006 Prentice Hall Business Publishing The Economic Way of Thinking, 11/e Heyne/Boettke/Prychitko 48 of 49 Once Over Lightly Trade-offs Needs Law of Demand Demand Curve Quantity Demanded Dependence

© 2006 Prentice Hall Business Publishing The Economic Way of Thinking, 11/e Heyne/Boettke/Prychitko 49 of 49 Once Over Lightly Inflation Time Price Elasticity of Demand Elasticity and Receipts Rationed Goods Money Costs

© 2006 Prentice Hall Business Publishing The Economic Way of Thinking, 11/e Heyne/Boettke/Prychitko 50 of 49 End of Chapter 3