Download o Tastes—desire for this and other goods. o Income—of the

INTRODUCTION

This chapter answers the following questions:



THE DEMAND
FOR
GOODS

Chapter 5
How do we decide how much of any good to buy?
How does a change in the price of a good affect the
quantity we purchase or the amount of money we
spend on it?
Why do we buy certain goods but not others?
What leads us to buy some goods while rejecting
others?
2
THE SOCIOPSYCHIATRIC EXPLANATION
AFFLUENT TEENAGERS
In Freud’s view, we strive for higher levels of
consumption to satisfy basic drives for security,
sex, and ego gratification.
 According to some sociologists, people consume
more as expressions of identity that provoke
recognition or social acceptance.
 Not all consumption is motivated by ego or status
concerns.
 There are always basic needs (food, clothes,
shelter) that are a necessity.

Stereo
Television
Telephone
Video Game System
Computer
39%
In-line skates
Auto
35%
Cell phone
25%
17%
Pager/beeper
17%
Stocks, bonds
15%
Digital camera
DVD player 10%
0
3
THE ECONOMIC EXPLANATION
Sociopsychiatric theories tell us why we desire
certain goods -- not what goods will actually be
purchased.
 Prices and income are just as relevant to
consumption decisions as are more basic desires
and preferences.
 In explaining consumer behavior, economists
focus on the demand for goods and services.
 Demand is the willingness and ability to buy
specific quantities of a good at alternative prices
in a given time period, ceteris paribus.
10
20
71%
63%
61%
56%
52%
30 40 50 60 70 80
Percent of Teens Owning Products
90
100
4
THE ECONOMIC EXPLANATION


An individual’s demand for a product is
determined by:
G
G
G
G
5

Tastes—desire for this and other goods.
Income—of the consumer.
Expectations—for income, prices, tastes.
Other goods—their availability and prices.
Economists are interested in how consumer
tastes affect consumption decisions.
6
UTILITY THEORY
TOTAL VS. MARGINAL UTILITY
Utility is the pleasure or satisfaction obtained
from a good or service.
 The more pleasure a product gives us, the higher
the price we’re willing to pay for it.
 Total utility is the amount of satisfaction
obtained from entire consumption of a product.


Marginal utility is the change in total utility
obtained by consuming one additional (marginal)
unit of a good or service.
7
TOTAL VS. MARGINAL UTILITY
TOTAL UTILITY
1
2
3
4
5
Quantity of Popcorn
(boxes per show)
6
0
1
2
3
4
5
According to the law of diminishing marginal
utility, the marginal utility of a good declines as
more of it is consumed in a given time period.
 As long as marginal utility is positive, total
utility must be increasing.

Negative
marginal
utility
Marginal Utility
Total Utility
0
DIMINISHING MARGINAL UTILITY
MARGINAL UTILITY
Total utility
8
6
Quantity of Popcorn
(boxes per show)
9
DIMINISHING MARGINAL UTILITY
According to the law of diminishing utility, each
successive unit of a good consumed yields less
additional utility.
TOTAL UTILITY
Eventually, additional quantities of a good
yield increasingly smaller increments of
satisfaction.
Total utility
0
1
2
3
4
5
Quantity of Popcorn
(boxes per show)
11
MARGINAL UTILITY
6
Negative
marginal
utility
Marginal Utility
I
DIMINISHING MARGINAL UTILITY
Total Utility

10
0
1
2
3
4
5
6
Quantity of Popcorn
(boxes per show)
12
PRICE AND QUANTITY
PRICE AND QUANTITY
Tastes, through marginal utility, tells us how
much we desire particular goods.
 Price tell us how much of a good we will buy.
The more marginal utility a product delivers, the
more a consumer is willing to pay, ceteris
paribus.
 This is due to diminishing marginal utility –
people are willing to buy additional quantities of
a good only if its price falls.
 As the marginal utility of a good diminishes, so
does our willingness to pay.


We make the ceteris paribus assumption when
we look at the relationship between the price of
the good and the amount we’re willing to buy.
 Ceteris paribus - The assumption of nothing
else changing.

13
14
INDIVIDUAL’S DEMAND SCHEDULE AND
CURVE
PRICE AND QUANTITY
According to the law of demand, the quantity of
a good demanded in a given time period increases
as its price falls, ceteris paribus.
 The demand curve is a curve describing the
quantities of a good a consumer is willing and
able to buy at alternative prices in a given time
period, ceteris paribus.
 The law of demand is illustrated by a downwardsloping demand curve.

PRICE (per ounce)
$0.55
A
0.50
The willingness to pay
B
diminishes along with
0.45
C marginal utility
0.40
D
0.35
E
0.30
F
0.25
G
0.20
H
0.15
I
0.10
J
0.05
0 4 8 12 16 20 24 28 32
16
Quantity Demanded (Ounces per show)
15
PRICE ELASTICITY
PRICE ELASTICITY
The response of consumers to a change in price is
measured by the price elasticity of demand.
 The price elasticity of demand is the
percentage change in quantity demanded divided
by the percentage change in price.
Technically, price elasticity of demand (E) is
always negative because quantity demanded
decreases when prices increase.
 To ensure consistency, average quantity and
average price (before and after) is used in the
calculation.


17
18
COMPUTING PRICE ELASTICITY
ELASTIC VS. INELASTIC DEMAND

If E is larger than 1, demand is elastic.

Consumer response is large relative to the change in
price.

If E is less than 1, demand is called inelastic.

If E equals 1, demand is unitary elastic.

Consumers aren’t very responsive to price changes.
19
ELASTICITY ESTIMATES
20
ELASTICITY EXTREMES

A horizontal demand curve means that demand
is perfectly elastic.


Any price increase would cause demand to fall to
zero.
A vertical demand curve means that demand is
completely inelastic.

Quantity demanded will not change regardless of the
price change.
21
ELASTICITY EXTREMES
22
DETERMINANTS OF ELASTICITY
The price elasticity of demand is influenced by all
of the determinants of demand.
 Four factors are particularly worth noting:

Completely elastic (E = )
Completely inelastic (E = 0)
p2
Price
Price
p2
p1
G
G
G
p1
G
0
q1
Quantity
0
q1
Quantity
23
Necessities vs. luxuries.
Availability of substitutes.
Relative price.
Time.
24
NECESSITIES




VS.
AVAILABILITY OF SUBSTITUTES
RELATIVE PRICE
LUXURIES
AND
Demand for necessities is relatively inelastic
Necessities are goods that are critical to our
everyday life
The greater the availability of substitutes, the
higher the price elasticity of demand.
 The higher the price in relation to a consumer’s
income, the higher the elasticity of demand.
 The price elasticity of demand declines as price
moves down the demand curve.

Demand for luxury goods is relatively elastic.
Luxuries are goods we would like to have but
are not likely to buy unless our income jumps or
the price declines sharply.
25
TIME
26
PRICE ELASTICITY AND TOTAL REVENUE
The long-run price elasticity of demand is higher
than the short-run elasticity.
 Consumers are better able to change their buying
habits over the long-run that in the short-run.
Higher prices don’t always mean higher total
revenue.
 There is a relationship between price elasticity
and total revenue.



Total revenue – The price of a product multiplied by
the quantity sold in a given time period: p x q.
Total revenue = Price X Quantity
sold
27
PRICE ELASTICITY AND TOTAL REVENUE
28
PRICE ELASTICITY AND TOTAL REVENUE
A price hike increases total revenue only if
demand in inelastic (E < 1).
 A price hike reduces total revenue if demand is
elastic (E > 1).
 A price hike does not change total revenue if
demand is unitary elastic (E = 1).

29
30
CHANGING VALUE OF E
PRICE ELASTICITY AND TOTAL REVENUE
PRICE (per ounce)

$0.55
0.50
0.45
0.40
0.35
0.30
0.25
0.20
0.15
0.10
0.05
0

B
C
2
Higher prices will reduce
total revenue if E < 1
Price elasticity changes along a demand curve.
The impact of a price change on total revenue
depends on the (changing) price elasticity of
demand.
4 6 8 10 12 14 16 18 20 22 24 26 28 30 32
QUANTITY DEMANDED (ounces per show)
31
32
PRICE
The demand curve
$8
7
6
5
4
3
2
1
0
OTHER ELASTICITIES
Elastic E > 1
Unit elastic E = 1

Other factors affect consumption behavior.

Inelastic E < 1
10 20 30 40 50 60 70 80 90 100 110

When the price changes, the outcome is a movement
along the unchanged demand curve.
When the underlying determinants of demand
change, the entire demand curve shifts.
TOTAL REVENUE
Total revenue
$225
200
175
150
125
100
75
50
25
0
E=1
Elastic
E>1
Inelastic
E<1
33
10 20 30 40 50
34
60 70 80 90 100 110
SHIFTS VS. MOVEMENTS
INCOME ELASTICITY
A shift in demand is a change in the quantity
demanded at any (every) given price.
 An increase in consumer income will cause a
rightward shift in demand.
 Consumers will now purchase more at any price
than they did prior to the increase in income.
Price of Popcorn (dollars per ounce)

Shift
0.25
N
D2 (after income rise)
D1 (before income rise)
0
35
F
12
16
Quantity of Popcorn (ounces per show)
36
INCOME ELASTICITY

COMPUTING INCOME ELASTICITY
Income elasticity of demand is the percentage
change in quantity demanded divided by
percentage change in income.

As with price elasticity, income elasticity is
computed using average values for the changes in
quantity and income.
37
NORMAL VS. INFERIOR GOODS
38
NORMAL VS. INFERIOR GOODS
A normal good has an income elasticity of
demand greater than zero.
 A normal good is a good for which demand rises
when income rises.


I
An inferior good has an income elasticity of
demand less than zero.
An inferior good is a good for which
demand decreases when income rises.
39
CROSS-PRICE ELASTICITY
40
CROSS-PRICE ELASTICITY
A change in the price of one good affects the
demand for another.
 The decision to buy a good depends on the prices
of substitutes and complements of that good.
 Substitute goods are goods that substitute for
each other.
 When the price of good X rises, the demand for
good Y increases, ceteris paribus.


I
41
Complementary goods are goods frequently
consumed in combination.
When the price of good X rises, the
demand for complementary good Y falls,
ceteris paribus.
42
SUBSTITUTES AND COMPLEMENTS
CALCULATING CROSS-PRICE ELASTICITY
Price of Popcorn
(cents per ounce)

0.25
R
Cross price elasticity is the percentage change
in the quantity demanded of X divided by
percentage change in price of Y.
F
D3
D1
D2
0
8
12
Quantity of Popcorn (ounces per show)
43
CALCULATING CROSS-PRICE ELASTICITY

44
CHOOSING AMONG PRODUCTS
When the cross-price elasticity of demand has a
negative sign the two goods are complementary
goods.

The purchase of any one single good means
giving up the opportunity to buy more of other
goods.

I
When the cross-price elasticity of demand
has a positive sign the two goods are
substitute goods.

Opportunity costs – The most desired goods or
services that are forgone in order to obtain something
else.
Rational behavior requires one to compare the
anticipated utility of each expenditure with its
cost.
45
MARGINAL UTILITY VS. PRICE
46
UTILITY MAXIMIZATION
To maximize utility, the consumer should choose
that good which delivers the most marginal
utility per dollar.
 Optimal consumption is the mix of consumer
purchases that maximizes the utility attainable
from available income.
 To maximize total utility, consumers choose the
optimal consumption combination.

47
48
UTILITY MAXIMIZING RULE

UTILITY MAXIMIZING RULE
The basic approach to utility maximization is to
purchase that good next which delivers the most
marginal utility per dollar.

If a person could get more utility per dollar by
buying good X, then she should continue to buy
good X.
49
UTILITY MAXIMIZING RULE

50
UTILITY MAXIMIZING RULE
If a person could get more utility per dollar by
buying good Y, then she should continue to buy
good Y.


The process continues until the ratios are equal.
Only then will utility be maximized.
51
EQUILIBRIUM OUTCOMES
52
ARE WANTS CREATED?
Economic theory predicts that the final choices of
consumers -- the equilibrium outcome -- will be
optimal.
 Some advertising is intended to provide
information about new or existing products.
 A great deal more of advertising is designed to
exploit our senses and lack of knowledge.
Advertising can’t be blamed for our foolish
consumption
 A successful advertising campaign is one that
shifts the demand curve to the right.


53
54
Price (dollars per unit)
IMPACT OF ADVERTISING ON THE DEMAND
CURVE
Demand curve
after advertising
Demand curve
before advertising
THE DEMAND
End of Chapter 5
0
Quantity Demanded (units per time period)
55
FOR
GOODS