1. The Economic Way of Thinking 10e ©Prentice Hall 2003 1 “The Economic Way of Thinking” 10 th Edition by Paul Heyne, Peter Boettke, and David Prychitko “Substitutes Everywhere: The Concept of Demand PowerPoint Slides prepared by Assistant Professor Paul Harris Camden County College

2. The Economic Way of Thinking 10e ©Prentice Hall 2003 2 Chapter Outline I.Introduction II.On the Notion Of “Needs” III.The Concept of Demand IV.Marginal Values V.Decisions at the Margin VI.Making it Graphic

3. The Economic Way of Thinking 10e ©Prentice Hall 2003 3 Chapter Outline VII.Demand and Quantity Demanded VIII.The Difference It Makes IX.Law of Demand: A Summary X.Misperceptions caused by Inflation XI.Time is on Our Side XII.Price Elasticity of Demand XIII.Thinking about Elasticity Chapter Outline

4. The Economic Way of Thinking 10e ©Prentice Hall 2003 4 Chapter Outline XIV.Elasticity and Total Receipts XV.The Myth of Vertical Demand XVI. All Scarce Goods Must be Rationed Somehow XVII. Money Cost and Other Cost XVIII. Once Over Lightly Chapter Outline

5. The Economic Way of Thinking 10e ©Prentice Hall 2003 5 Introduction Most goods are scarce.Most goods are scarce. –Sacrifice is necessary. There are substitutes for everything.There are substitutes for everything. Intelligent choice entails trade-offs.Intelligent choice entails trade-offs. Market price signals encourage buyer to economizeMarket price signals encourage buyer to economize Most goods are scarce.Most goods are scarce. –Sacrifice is necessary. There are substitutes for everything.There are substitutes for everything. Intelligent choice entails trade-offs.Intelligent choice entails trade-offs. Market price signals encourage buyer to economizeMarket price signals encourage buyer to economize

6. The Economic Way of Thinking 10e ©Prentice Hall 2003 6 What is wrong with the following statements?What is wrong with the following statements? 1) Fire safety requires that there be two exits from each apartment unit. 2) We need a new car. What is wrong with the following statements?What is wrong with the following statements? 1) Fire safety requires that there be two exits from each apartment unit. 2) We need a new car. Introduction

7. The Economic Way of Thinking 10e ©Prentice Hall 2003 7 On the Notion of “Needs” What is the relationship between “tradeoffs” and “needs”?What is the relationship between “tradeoffs” and “needs”? Consider these four statements………Consider these four statements……… 1.The average person needs eight glasses of water per day to maintain good health. 2.All citizens should be able to obtain the medical care they need regardless of their ability to pay. 3.A diabetic needs insulin. 4.You need to read your economics textbook. All of these statements have necessity in common. All of these statements have necessity in common.

8. The Economic Way of Thinking 10e ©Prentice Hall 2003 8 Higher prices (sacrifices) lead people to seek substitutes. The fact that goods and services are scarce entails tradeoffs, i.e., the sacrifice of other goods and services that we value. Higher prices (sacrifices) lead people to seek substitutes. The fact that goods and services are scarce entails tradeoffs, i.e., the sacrifice of other goods and services that we value. On the Notion of “Needs”

9. The Economic Way of Thinking 10e ©Prentice Hall 2003 9 The Concept of Demand Demand Relates amounts people want to obtain to the sacrifices they must make When a want can only be satisfied at some cost we accept less. Demand Relates amounts people want to obtain to the sacrifices they must make When a want can only be satisfied at some cost we accept less.

10. The Economic Way of Thinking 10e ©Prentice Hall 2003 10 “Law of Demand” A negative relationship exists between the amount of anything that people want to purchase and the price they must pay. The Concept of Demand

11. The Economic Way of Thinking 10e ©Prentice Hall 2003 11 Question: Are there any exceptions to the Law of Demand? “Let’s stock up before the price goes even higher.” Answer: Alleged exceptions are based on misinterpretation of the evidence. Expectations of future price increases encourages people to buy more now, so that they can buy less later at the higher price. The Concept of Demand

12. The Economic Way of Thinking 10e ©Prentice Hall 2003 12 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 benefits, versus marginal cost.

13. The Economic Way of Thinking 10e ©Prentice Hall 2003 13 Decisions at the Margin Decisions are not made in terms of “all or nothing.”Decisions are not made in terms of “all or nothing.” The “Economic Way of Thinking”….The “Economic Way of Thinking”…. –Measures the change in one alternative, versus the change in another, compared to the original state of affairs. –Marginal decision making is true for people who economize on any scarce food, including a basic “necessity” such as water.

14. The Economic Way of Thinking 10e ©Prentice Hall 2003 14 Making It Graphic Graphs can be used to illustrate relationships. Demand Curves Illustrate the relationship between price and quantity demanded Graphs can be used to illustrate relationships. Demand Curves Illustrate the relationship between price and quantity demanded

15. The Economic Way of Thinking 10e ©Prentice Hall 2003 15 Price per Gallon Gallons per Day $.0725.0440.0280.01160.005320 Making It Graphic Demand Schedule is a tabular representation of graphical data:

16. The Economic Way of Thinking 10e ©Prentice Hall 2003 16 GALLONS OF WATER PER DAY 04080120200280320360400160240.00.02.03.04.05.06 $.07 PRICE PER GALLON.01 Making It Graphic

17. The Economic Way of Thinking 10e ©Prentice Hall 2003 17 Economic theory assumes: Households compare price with its “utility.” Consumption decreases when marginal benefit is less than the price. Total usefulness is the area under the curve. Making It Graphic

18. The Economic Way of Thinking 10e ©Prentice Hall 2003 18 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. D Q P D1 Q P D2 Change in Quantity demanded: Change in demand::

19. The Economic Way of Thinking 10e ©Prentice Hall 2003 19 PriceQuantity Demanded 50 cents125,000 40160,000 30175,000 Demand and Quantity Demanded

20. The Economic Way of Thinking 10e ©Prentice Hall 2003 20 A change in quantity demanded is a movement from one point on a curve to another point on the same curve.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 at each price.A change in demand results from some other factor that makes households buy more at each price. –The demand curve shifts. Demand and Quantity Demanded

21. The Economic Way of Thinking 10e ©Prentice Hall 2003 21 Price per GallonOriginal Gallons/DayNew Gallons/Day $.072540.044060.0280140.01160240.005320400 Demand and Quantity Demanded

22. The Economic Way of Thinking 10e ©Prentice Hall 2003 22 GALLONS OF WATER PER DAY 04080120200280320360400160240.00.02.03.04.05.06 $.07 PRICE PER GALLON.01 Demand and Quantity Demanded

23. The Economic Way of Thinking 10e ©Prentice Hall 2003 23 $.072515.044025.028055.01160100.005320200 Price Per Gallon Demand and Quantity Demanded Original Gallons/ Day New Gallons/ Day

24. The Economic Way of Thinking 10e ©Prentice Hall 2003 24 GALLONS OF WATER PER DAY 04080120200280320360400160240.00.02.03.04.05.06 $.07 PRICE PER GALLON.01 Demand and Quantity Demanded

25. The Economic Way of Thinking 10e ©Prentice Hall 2003 25 The Difference It Makes An editorial in The Wall Street Journal incorrectly stated,An editorial in The Wall Street Journal incorrectly stated, –“The coffee market is behaving the way the basic textbooks say a market behaves: Prices go up, demand falls, and prices come down.” Price and quantity demanded move in opposite directions.Price and quantity demanded move in opposite directions.

26. The Economic Way of Thinking 10e ©Prentice Hall 2003 26 Demand for a good is a function of: Biological realities Social relationships Psychological factors Economic variables IncomeSubstitutes Demand for a good is a function of: Biological realities Social relationships Psychological factors Economic variables IncomeSubstitutes The Difference It Makes

27. The Economic Way of Thinking 10e ©Prentice Hall 2003 27 P Q D1D1 D2D2 A fall in the demand The Difference It Makes

28. The Economic Way of Thinking 10e ©Prentice Hall 2003 28 D P Q P1P1 Q1Q1 P2P2 Price goes up, quantity demanded goes down, period! Q2Q2 The Difference It Makes

29. The Economic Way of Thinking 10e ©Prentice Hall 2003 29 Demand for bicycles: effect of a lower price P Q The Difference It Makes

30. The Economic Way of Thinking 10e ©Prentice Hall 2003 30 P Q Demand for bicycles: effect of environmental concern The Difference It Makes

31. The Economic Way of Thinking 10e ©Prentice Hall 2003 31 The Law of Demand A Summary Other things constant, if the price of a good changes, the quantity demanded changes.Other things constant, if the price of a good changes, the quantity demanded changes. A higher price decreases quantity demanded.A higher price decreases quantity demanded. A lower price increases quantity demanded.A lower price increases quantity demanded. A change in price causes movement along a stable demand curve. When something other than price changes, the whole demand curve changes (shifts) either to the right (increase), or to the left (decrease).When something other than price changes, the whole demand curve changes (shifts) either to the right (increase), or to the left (decrease).

32. The Economic Way of Thinking 10e ©Prentice Hall 2003 32 The Law of Demand A Summary The non-price determinants of demand that encourage consumers to buy more or less are……… Changes in consumer taste and preferences. Changes in incomes. Changes in the price of other goods and services. Changes in expectations. Demand can increase or decrease because of these factors.

33. The Economic Way of Thinking 10e ©Prentice Hall 2003 33 Time Is On Our Side Changes in the quantity demanded takes 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 also takes time for producers to devise, produce, and publicize substitutes.

34. The Economic Way of Thinking 10e ©Prentice Hall 2003 34 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.

35. The Economic Way of Thinking 10e ©Prentice Hall 2003 35 Price Elasticity of Demand

36. The Economic Way of Thinking 10e ©Prentice Hall 2003 36 Example Price increases by 20% Quantity demanded decreases by 50% Consumers are relatively responsive ElasticExample Price decreases by 20% Quantity demanded increases by 15% Consumers are relatively unresponsive Inelastic Price Elasticity of Demand

37. The Economic Way of Thinking 10e ©Prentice Hall 2003 37 Elastic Demand Price elasticity > 1 Inelastic Demand Price elasticity < 1 Unit Elastic Price elasticity = 1 Price Elasticity of Demand

38. The Economic Way of Thinking 10e ©Prentice Hall 2003 38 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 price if demand were inelastic? Question Would a firm want to raise price if demand were elastic? The answer is no to both questions.

39. The Economic Way of Thinking 10e ©Prentice Hall 2003 39 D Inelastic Demand P Q Thinking About Elasticity

40. The Economic Way of Thinking 10e ©Prentice Hall 2003 40 D Elastic Demand P Q Thinking About Elasticity

41. The Economic Way of Thinking 10e ©Prentice Hall 2003 41 QuestionQuestion –Can food stores charge any price they want since they sell food? QuestionQuestion –Would it be wise to impose a tax on table salt? QuestionQuestion –Would the demand for Morton’s salt be more elastic or inelastic than the demand for salt? Thinking About Elasticity

42. The Economic Way of Thinking 10e ©Prentice Hall 2003 42 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. Thinking About Elasticity

43. The Economic Way of Thinking 10e ©Prentice Hall 2003 43 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

44. The Economic Way of Thinking 10e ©Prentice Hall 2003 44 “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. Elasticity and Total Receipts

45. The Economic Way of Thinking 10e ©Prentice Hall 2003 45 P Q D Elastic demand between C and E since OBCG < OAEF. B C G A E F O Elasticity and Total Receipts

46. The Economic Way of Thinking 10e ©Prentice Hall 2003 46 P Q D A Inelastic demand between A and B. B Elasticity and Total Receipts

47. The Economic Way of Thinking 10e ©Prentice Hall 2003 47 P Q Demand for wheat The market price when entire crop is sold The price when 1/4 of crop is burned. Elasticity and Total Receipts

48. The Economic Way of Thinking 10e ©Prentice Hall 2003 48 The Myth of Vertical Demand P Q D P1P1 P2P2

49. The Economic Way of Thinking 10e ©Prentice Hall 2003 49  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. The Myth of Vertical Demand

50. The Economic Way of Thinking 10e ©Prentice Hall 2003 50 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 sacrifices.

51. The Economic Way of Thinking 10e ©Prentice Hall 2003 51 Scarce goods must be rationed. Rationing can be done by willingness to pay prices. Other ways to ration: “First come, first served” Lottery Equal shares for all “Might makes right” Merit All Scarce Goods must be Rationed Somehow

52. The Economic Way of Thinking 10e ©Prentice Hall 2003 52 Money Costs and Other Costs People respond to changes in cost: ExplicitImplicit Money is a common denominator, a yardstick, and a measure of value. Changes in money prices are a useful device for coordinating people’s behavior.

53. The Economic Way of Thinking 10e ©Prentice Hall 2003 53 Once Over Lightly TradeoffsScarcitySubstitutesMarginalismNeeds The Law of Demand Demand Schedule Changes in Demand Non-Price Determinants of Demand RationingElasticity

54. End of Chapter 3 Next Chapter 4 Opportunity Cost and the Supply of Goods