4.0 Product Market Demand Under Perfect Competition

4.1 Introduction

This graph includes functional form of the relationships Q D = D (p | shift variables) Q s = S (p | shift variables)

4.2.1 We’ll examine why the product demand line slopes down What determines the responsiveness of Q 1 D to p 1 What shift variables move D and how

Product demand slopes down and to the right It is an inverse relationship between p and Q You can use the decision rule to prove mathematically why this must be so

4.2.5 Own price elasticity of demand- How responsive the quantity demanded is to a change in the good’s own price Elastic = responsive or sensitive Inelastic = not as responsive or sensitive

4.2.6 Comparing elastic and inelastic demand curves

If prices go up equally,

Since the quantity demanded of Good 1 fell by more than the Quantity demanded of Good 2 We say Good 1 is the more elastic of the two

4.2.7 – Elasticity is important for both private and public policies Private example – McDonalds changing prices Public example – public transportation price changes

The two extreme cases Which would you prefer if you were selling a product?

Firms hope for as inelastic demand as possible

What determines how elastic or inelastic a good’s demand will be?

A) Necessity or luxury Necessities tend to be more inelastic you tend to pay any price Ex. Lifesaving health procedure increases in price - Qd roughly the same Movies increase price - Qd drops by more

B) Number and quality of substitutes fewer substitutes - more inelastic Ex. If it is a unique item - increase in price has not much effect on Qd

C) Time horizon involved more time - more options can be found very short time horizon - more inelastic longer time period more elastic

D) Size of price relative to one’s income smaller the price, more likely to be inelastic Ex. Bubble gum goes from 1 penny to 2 pennies 100% increase no big deal on Qd Car goes from $10,000 to $20, % increase - really big deal

4.2.13

Absolute value eliminates a negative

There are three major categories of elasticity

Elastic demand

Inelastic demand

Special case - Unitary Elasticity

Special case - Perfect Inelasticity No matter how much price changes, quantity demanded does not change “Pay any price”

4.2.14

Elasticity yields some incredibly valuable information to firms

Total Expenditure = Total Revenue = Price X Quantity TE = TR = P X Q For a firm,

Snowplow business P Q D

P Q D Pizza Business

4.2.15

Firms hope for as inelastic as a demand curve as possible

Advertising serves to promote the ideas that: there are no substitutes (more inelastic) and goods are a necessity (also more inelastic)

In a perfectly competitive world, we assume that individual firms are not able to distinguish their products nor keep competitors away Individual suppliers will face a perfectly elastic demand line

Public policy case Want to reduce drug crime – Cutting supply on on inelastic demand curve – Price goes up by much more than quantity demanded drops- might create more crime in the short run Market is dynamic, however Longer run – might keep those from starting a more expensive proposition

Taxes and Markets

In the inelastic case on the left, The tax is paid almost entirely by the consumer The price goes up by almost the full amount of the tax In the elastic case on the right, the tax burden goes primarily to the supplier

Tax incidence- Who really pays the tax Goal – tax consumer – tax inelastic goods Goal – tax supplier – tax elastic goods

Taxes are imposed for different reasons Goal – discourage consumption – tax elastic demand Goal – raise revenue – tax inelastic goods

4.3.1 We know that Q 1 D = D (p 1 | shift variables) Now we will identify the shift varaibles

Q 1 D = D (p 1 | p r, I, T) where P r stands for the price of related goods I stands for income T stands for tastes

4.3.2

All of the following have an effect on the position of the D curve (which will result in a shift in the curve)

Tastes and Preferences Examples: A band becomes popular Clothes become in fashion

These will result in an increase in the demand these changes in tastes will shift the demand curve for that good to the right

D D' P Q An increase in demand

Tastes work the other way, too

D D' P Q A decrease in demand

4.3.3 Price of related goods also shifts demand Ex. Increase in price of burgers affects the quantity demanded of fries and quantity demanded of drinks This is called a cross price effect

Goods consumed together Are called complements

Cross price elasticity of demand

If P 1  and Qd 2  the goods have a negative cross-price elasticity and are Complements Ex. Burgers and fries

If P 1  and Qd 2  the goods have a positive cross-price elasticity and are Substitutes Ex. Coke and Pepsi

The sign of the cross price elasticity Determines the nature of the relationship (sub./comp.) The size of the cross price elasticity Determines how strong this cross price effect is

4.3.6 Cross price elasticity is zero A change in the price of one good has no effect on the quantity demanded for another good

In theory There is no such thing as unrelated markets, so The cross price elasticity is actually very close to zero, but can be treated as zero Markets are like a spider web A change in one affects others everywhere – There is a complex web of connections

4.3.7 Private firms consider not only own price elasticity, but also cross price elasticities Ex. McDonalds – raising burger prices might lower amount of drinks and fries sold

4.3.8 Public policies also have to consider effects of cross price elasticity Ex. Drunk driving example

4.3.9 Policy – whether public or private – is rarely simple Complex problems sometimes require complex solutions

Changes in the price of related goods shift demand lines Increase in price of hamburgers causes, ceteris paribus, Decrease in demand for French fries Increase in demand for pizza

Another thing that shifts demand lines is income If a good’s demand curve increases when income rises the good has a positive income elasticity and is called a normal good however, some goods have a decrease in their demand when income rises- negative income elasticity / inferior goods

Income elasticity of demand

Goods are not inherently normal or inferior It depends on the individuals’ preferences

Individual vs. Market Demand to determine the market demand, we simply add the D curves for each individual household each household’s tastes and preferences differ

Additionally, the exit or entry of households have an effect on market demand curve Consider baby boomers and their effects on: diapers ’s schools ’s Geritol or Viagra ’s Nursing homes ’s

Conclusion on product demand We started with a utility maximization rule given scarcity then developed a downward sloping demand curve Then we discussed what it represents, its responsiveness, and what shifts it (tastes, income, price of related goods) Lastly, we looked at how individual demand curves are summed into a market demand curve