Download Chapter 4 Learning Objectives If It Doesn`t Have Utility, You Won`t

Learning Objectives
Chapter 4
Consumer Decision
Making and
Consumer Reaction
to Price Changes
• Distinguish between total and marginal
utility.
• Distinguish between elastic and inelastic
demand.
• Define the price elasticity of demand and
state the formula for measuring it.
• List and describe three determinants of the
price elasticity of demand.
• Explain the relationship between price
elasticity of demand and consumer
expenditures.
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If It Doesn’t Have Utility, You
Won’t Buy It
Measuring Utility
• Everything for which you have a
demand must generate satisfaction.
• Another way of describing satisfaction is
utility, defined as want -satisfying
power.
• The concept of utility is purely
subjective.
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• In order to understand utility better, we
arbitrarily define units
of utility as utils.
• A util is an abstract concept that is
defined as a representative unit by
which utility is measured.
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Of Total and Additional Utility
(cont.)
Of Total and Additional Utility
• By definition, everything that you
consume gives you some amount of
satisfaction, or utility. If you watch ten
movies a month, you get a certain
amount of total utility from that activity
over the month.
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Figuring Out Marginal Utility
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Diminishing Marginal Utility
• Marginal utility is the change in total
utility as you increase your consumption
rate.
• Assume your total utility from
consuming two units of a given item is
16 utils, and your total utility from
consuming three units is 19 utils. Then,
the marginal utility of consuming the
third unit is 19 minus 16, or 3 utils.
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• But what about the additional utility you
receive when you see another movie?
• We call this additional utility marginal
utility, for which the word marginal
means additional or incremental.
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• According to the law of diminishing
marginal utility, after you consume a
good or service, the marginal utility you
receive for yet more of that same good
or service will start falling.
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2
Measuring Consumer
Responsiveness
The Price Elasticity of Demand
• If the price of salt goes down 50
percent, how much more salt would you
purchase in a year? Probably not very
much.
• In contrast, if you normally buy fast
food dinners, and the price of fast food
were to drop by 50 percent, you would
probably increase the number of
fast-food dinners you buy quite a bit.
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Elasticity Calculations
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Elasticity Calculations (cont.)
• We measure the price elasticity of
demand by comparing the percentage
change in price with the percentage
change in quantity demanded.
Price elasticity of demand =
• The official term for consumer
responsiveness to price changes is
price elasticity of demand.
• If consumers react a lot to a given
percentage change in price, we say
they have an elastic demand. If they
do not react very much, we say they
have an inelastic demand.
Percentage change in Qd
Percentage change in price
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• For example, a price elasticity of
demand for oil of –1 means that a 1
percent increase in the price of oil would
lead to a 1 percent decrease in the
quantity demanded of oil.
• Because of the law of demand, price
elasticity of demand will always be
negative.
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How We Actually Calculate
Elasticity
Using Average Formulas
• To calculate the price elasticity of demand,
we have to compute percentage changes in
quantity demanded and in relative price.
• However, there is an arithmetic problem
when we calculate percentage changes
with respect to the starting point. The
percentage change from 2 to 3—50 %—
is not the same as the percentage change
from 3 to 2—33.3 %.
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Price elasticity of demand =
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change in Q change in P
?
( Q1 + Q 2 ) 2
( P1 + P2 ) 2
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Factors that Determine the Price
Elasticity of Demand
Price Elasticity Ranges
• Whenever the price elasticity of demand is
numerically greater than one, we say that it is
an elastic demand.
• If the price elasticity of demand is numerically
less than one, we say that we are dealing
with an inelastic demand.
• When demand is neither elastic nor inelastic,
it is said to be unit-elastic demand.
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• A way out of this dilemma is to use
average values.
• For relatively small changes in price, the
formula for computing the price
elasticity of demand then becomes
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1. The Existence of Substitutes: The
more substitutes that exist for a good,
the more responsive consumers will
be to a change in its price.
2. The Percentage of a Person’s Total
Budget Devoted to the Purchase of
that Good: The larger the percentage
of your budget devoted to an item, the
more price elastic will its demand be.
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Factors that Determine the Price
Elasticity of Demand (cont.)
Figure 4-3: Short-Run and Long-Run
Price Elasticity of Demand
3. The Time Allowed for Adjustment:
The longer the time allowed for
adjustment to a price change, the
more that consumers will react.
The longer any price change persists,
the greater the elasticity of demand,
other things held constant.
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Table 4-1: Selected Estimated Short and
Long Run Price Elasticities of Demand
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Price Elasticity of Demand and
Consumer Expenditures
• Suppose that you are in charge of the pricing
decision for a cellular telephone service
company. How would you know when it is
best to raise or not to raise prices?
• The answer depends in part on the effect of
your pricing decision on consumer
expenditures —which become your total
revenues or receipts —on your services.
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Price Elasticity of Demand and
Consumer Expenditures (cont.)
• It is commonly thought that the way to
increase total revenues is to increase
price per unit.
• Is this always the case? Or is it
possible that a price increase could lead
to a decrease in consumer
expenditures?
• The answers to these questions depend
on the price elasticity of demand.
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Price Elasticity of Demand and
Consumer Expenditures (cont.)
• When the firm faces a demand that is
elastic, if it raises its price, total
consumer expenditures will fall.
• When facing a unit-elastic demand, any
small changes in price do not change
consumer expenditures.
Price Elasticity of Demand and
Consumer Expenditures (cont.)
• When the firm is facing a demand that is
inelastic, if it raises its price, consumer
expenditures will go up; if it lowers its
price, consumer expenditures will fall.
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Key Terms and Concepts
•
•
•
•
•
elastic demand
elasticity
inelastic demand
marginal utility
price elasticity of
demand
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• principle of
diminishing marginal
utility
• unit-elastic demand
• utility
• utils
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