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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