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“The Economic
Way of Thinking”
11th Edition
© 2006 Prentice Hall Business Publishing
Chapter 3
Substitutes
Everywhere:
The Concept
of Demand
The Economic Way of Thinking, 11/e
Heyne/Boettke/Prychitko
Chapter 3 Outline
• Introduction
• On the Notion of “Needs”
• Marginal Values
• Everyday Choices – Marginal Choices
• The Demand Curve
• The Law of Demand
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Chapter 3 Outline
• Demand and Quantity Demanded
• Demand Itself Can Change
• Everything Depends Upon Everything Else
• Misperceptions Caused by Inflation
• Time Is on Our Side
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Chapter 3 Outline
• Price Elasticity of Demand
• Thinking About Elasticity
• Elasticity and Total Receipts
• The Myth of Vertical Demand
• All Scarce Goods Must Be Rationed – Somehow
• Is Money All That Matters? Money Costs, Other
Costs and Economic Calculation
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Introduction
• Most goods are scarce.
– Sacrifice is necessary
• There are substitutes for everything
• Intelligent choice entails trade-offs.
• Market price signals encourage buyers to
economize
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On the Notion of “Needs”
• What is the relationship between “trade-offs”
and “needs”?
• Consider these four statements…
– The average person needs eight glasses of water per
day to maintain good health.
– All citizens should be able to obtain the medical care
they need regardless of their ability to pay.
– A diabetic needs insulin.
– You need to read your economics textbook.
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On the Notion of Needs
• Higher prices (sacrifices) lead people to seek
substitutes.
• The fact that goods and services are scarce
entails trade-offs, i.e., the sacrifice of other
goods and services we value.
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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 beliefs
versus marginal cost.
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Everyday Choices and Marginal Choices
• The Economic Way of Thinking…
– Rejects the all-or-nothing approach
– Favors attention to
• Marginal benefits
• Marginal costs
– More of A and less of B versus more of B and less of A
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The Demand Curve
In a world of scarcity, individuals incur trade-offs.
Thus, economists developed the idea of
demand.
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The Demand Curve
Making it Graphic
• Graphs can be used to illustrate relationships.
• Demand Curves
– Illustrate the relationship between price and quantity
demanded.
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The Demand Curve
Consumption Table
Price per Gallon
Gallons per Day
$.07
.04
.02
.01
.005
25
40
80
160
320
Demand Schedule is a tabular representation of graphical data:
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The Demand Curve
• Vertical Axis – possible prices that might be
charged.
• Horizontal Axis – quantity purchased at those
prices.
• Economists call that a Demand Curve.
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The Demand Curve
$.07
PRICE PER GALLON
.06
.05
.04
.03
.02
.01
.00
0
40
80
120
160
200
240 280
320
360
400
GALLONS OF WATER PER DAY
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The Demand Curve
• A demand curve illustrates the amount of a good
that consumers plan to purchase at any given
price.
• Read a demand curve by taking a price and
finding corresponding quantity.
• That is the Quantity Demanded
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The Law of Demand
“Law of Demand”
A negative relationship exists between the amount of
anything that people want to purchase and the price
they must pay.
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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.
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Demand and Quantity Demanded
Change in Quantity demanded:
P
Change in demand::
P
D2
D
D1
Q
Q
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Demand and Quantity Demanded
• 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 or less
at each price.
– The demand curve shifts.
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Demand Itself Can Change
Price per Gallon
Original Gallons/Day
$.07
40
15
.04
60
25
.02
140
55
.01
240
100
.005
400
200
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The Economic Way of Thinking, 11/e
New Gallons/Day
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Demand Itself Can Change
$.07
PRICE PER GALLON
.06
.05
.04
.03
.02
.01
.00
0
40
80
120
160
200
240 280
320
360
400
GALLONS OF WATER PER DAY
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Everything Depends Upon Everything
Else
• Influences that can cause a change in demand
for a good:
–
–
–
–
# of customers
Change in customer tastes
Change in income
Change in price of a substitute
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Everything Depends Upon Everything
Else
• Influences that can cause a change in demand
for a good:
– Change in the price of a complementary good
– Change in the expected price of a good
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Misperceptions Caused by Inflation
• Inflation is an increase in the average money
price of goods.
• If the money price of all goods (including labor)
increases, then no good (except money) will
have changed in real price.
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Time Is On Our Side
• Changes in the quantity demanded take 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 takes time for producers to devise, produce, and
publicize substitutes.
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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.
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Price Elasticity of Demand
• ….is the percentage change in the quantity
demanded divided by the percentage change in
price.
• Elasticity is influenced by:
– Time
– Availability of substitutes
– Proportion of one’s budget spent on a good
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Price Elasticity of Demand
% change in Q
Price elasticity of demand =
% change in P
.5
E P   2.5
.2
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Price Elasticity of Demand
• Example
– Price increases by 20%
– Quantity demanded decreases by 50%
• Consumers are relatively responsive - Elastic
• Example
– Price decreases by 20%
– Quantity demanded increases by 15%
• Consumers are relatively unresponsive - Inelastic
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Price Elasticity of Demand
• Elastic Demand
– Price elasticity > 1
• Inelastic Demand
– Price elasticity < 1
• Unit Elastic
– Price elasticity = 1
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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 prices if demand were inelastic?
• Question
– Would a firm want to raise prices if demand were elastic?
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Thinking About Elasticity
P
D
Inelastic Demand
Q
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Thinking About Elasticity
P
Elastic Demand
D
Q
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Thinking About Elasticity
• Question
– Can food stores charge any price they want since
they sell food?
• Question
– Would it be wise to impose a tax on table salt?
• Question
– Would the demand for Morton’s salt be more elastic
or inelastic than the demand for salt?
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Thinking About Elasticity
• 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.
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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
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Elasticity and Total Receipts
• “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.
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Elasticity and Total Receipts
P
Elastic demand
between C and E
since OBCG < OAEF.
B
C
E
A
O
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D
G
F
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Elasticity and Total Receipts
P
Inelastic demand
between A and B.
B
A
D
Q
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Elasticity and Total Receipts
P
Demand for wheat
The price when
1/4 of crop is burned.
The market price
when entire crop is sold
Q
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The Myth of Vertical Demand
P
P1
D
P2
Q
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The Myth of Vertical Demand
• 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.
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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 sacrifice.
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All Scarce Goods Must Be Rationed
Somehow
• Scarce goods must be rationed.
• Rationing can be done by willingness to pay
prices.
• Other ways to ration:
–
–
–
–
–
“Fist come, first served”
Lottery
Equal shares for all
“Might makes right”
Merit
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All Scarce Goods Must Be Rationed
Somehow
• When the price of a good rises, users find it in
their own interest to economize.
• They will choose ways to economize that entail
the smallest sacrifice.
• Individuals are in the best position to pick and
choose among the ways to economize.
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Is Money All That Matters?
Money Costs, Other Costs, and Economic
Calculation
• As the opportunity cost of an action increases,
the chooser will tend to undertake less of that
action.
• As the opportunity cost of an action decreases,
the user will tend to undertake more of that
action.
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Is Money All That Matters?
Money Costs, Other Costs, and Economic
Calculation
• People compare the expected additional benefit
against the expected additional cost.
• In a commercial market economy, money is a
common denominator (i.e. a yardstick).
• Money allows individuals to calculate relative
costs and benefits.
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Once Over Lightly
• Trade-offs
• Needs
• Law of Demand
• Demand Curve
• Quantity Demanded
• Dependence
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Once Over Lightly
• Inflation
• Time
• Price Elasticity of Demand
• Elasticity and Receipts
• Rationed Goods
• Money Costs
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End of Chapter 3
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