Download Product Market Demand

Chapter 4 –
Product Market Demand
This chapter examines the major
causes of the Demand for a specific
good – its own price, the prices of
related goods, tastes, and consumer
income.
Also we distinguish between the
qualitative (direction of change) versus
the quantitative (elasticity) effects of a
ceteris paribus change in each of these
causes.
Price and Quantity Demanded:
Direction of Change
Recall – the good’s own price (P)
is a cause of quantity demanded of
that good (Q).
Qualitative Effect: P  QD.
Qualitative Effect – measures
direction of change.
Underlying Reason:
Inverse Relationship
Consumer maximizes utility subject to
their budget constraint when
MU1/P1 = MU2/P2 = …
If P1, then consumer should rebalance
by MU1 to make the ratio equal across
goods again.
Given diminishing Marginal Utility, this
is done by having Q1.
Own Price
Elasticity of Demand
Own Price Elasticity of Demand ()
– measures the magnitude of
responsiveness of quantity
demanded of a good to changes in
its own price. In other words, the
Quantitative Effect of a change in
price on the quantity demanded of
that good.
Own Price Elasticity of
Demand (): A Formula
 = |Percentage Change in QD|
|Percentage Change in P| .
Always has positive sign.
Ratio of percentage changes instead of
slope, makes it a unit-free measure.
Price Inelastic Goods
Price Inelastic Goods have  < 1. These
goods are unresponsive to changes in
their own price.
Example – suppose that if the Price of
Milk increases by 10%, Quantity
Demanded of Milk goes down by 3%.
Then, for Milk,  = |-3%|/|10%| = 0.3.
Price Elastic Goods
and Unitary Price Elasticity
Price Elastic Goods have  > 1. These
goods are responsive to changes in
their own price.
Example – suppose that if the Price of
Cars increase by 10%, Quantity
Demanded of Cars goes down by 18%.
Then, for Cars,  = |-18%|/|10%| = 1.8.
Unitary Price Elasticity:  = 1.
What Features Make Goods
Price Inelastic or Elastic?
Necessity versus Luxury
Number and Quality of
Available Substitutes
Time Frame
Price Relative to Wealth or Income
Own Price Elasticity:
The Demand Curve
Price Inelastic goods are
described with steep demand
curves. The vertical demand curve
is the extreme case of  = 0.
Price Elastic goods are described
with flat demand curves. The
horizontal demand curve is the
extreme case of  = .
Own Price Elasticity and
Equilibrium
Consider an equilibrium, where
Demand equals Supply.
Supply shifts (rightward or leftward)
change the equilibrium, accomplished
by moving along the existing demand
curve.
Therefore the new equilibrium quantity
can be compared to the original one by
means of own price elasticity.
Own Price Inelasticity and
Total Revenue of Firms
Total Revenue (TR) =
(Price of Good)x(Quantity Sold),
or TR = PxQ.
This relationship implies that, in
percentage change terms:
(% Change in TR)
= (% Change in P) + (% Change in Q).
Own Price Elasticity and
Increasing the Price
Consider our two goods: milk ( = 0.3),
and cars ( = 1.8). Suppose that supply
shifts so that the price of each
increases by 10%.
% Change in TR of Milk
= 10% + -3% = 7%.
% Change in TR of Cars
= 10% + -18% = -8%.
Own Price Elasticity and
Decreasing the Price
Consider again our two goods: milk
( = 0.3), and cars ( = 1.8). Suppose
supply shifts so that the price of each
decreases by 10%.
% Change in TR of Milk
= -10% + 3% = -7%.
% Change in TR of Cars
= -10% + 18% = 8%.
Application: What Goods
Should Have a Sales Tax?
Sales tax – tax on supply.
Firms try to pass it on to consumers.
Consider the contrast between a sales
tax on a price inelastic good versus a
sales tax on a price elastic good.
What is the government’s goal – collect
tax revenue or significantly reduce the
quantity traded?
Another Cause of Demand –
Prices of Related Goods
Consider, for example, the
Demand for Coffee.
Affected by prices of related goods in
two different ways.
-- PDONUTS  QCOFFEE
(Complements)
-- PTEA  QCOFFEE 
(Substitutes)
Cross Price Elasticity
Cross Price Elasticity (1x2) –
measures the responsiveness of
demand to changes in the prices
of complements or substitutes.
1x2 = Percentage Change in Q2
Percentage Change in P1 .
Interpreting
Cross Price Elasticity
1x2 = Percentage Change in Q2
Percentage Change in P1 .
Sign of 1x2 describes whether the
related good is a complement
(negative) or substitute (positive).
Absolute Value of 1x2 describes the
magnitude of response. |1x2| < 1
describes an inelastic response, while
|1x2| > 1 describes an elastic response.
Cross Price Elasticity:
A Numerical Example
Suppose that, for coffee:
DONUTSxCOFFEE = -0.4
Negative sign  Donuts are a
complement. Absolute value < 1
 Inelastic, or unresponsive.
TEAxCOFFEE = 1.5
Positive sign  Tea is a
substitute. Absolute value > 1
 Elastic, or responsive.
Cross Price Elasticity and
Dependence of Markets
Consider the markets (i.e. Demand
and Supply) for Gasoline, Cars,
and Ethanol.
Gasoline and Cars are
Complements (PGAS  QCARS ).
Gasoline and Ethanol are
Substitutes (PGAS  QETHANOL ).
Cross Price Elasticity and
Dependence of Markets
Suppose the government decides
to put a substantial sales tax on
gasoline (or another supply
disruption).
Decreases supply of gasoline,
described by shifting supply curve
for gas leftward  P*GAS, Q*GAS.
Cross Price Elasticity and
Dependence of Markets
The move also has effects in the markets for
cars and ethanol.
Decreases demand for cars, described by
shifting the demand curve for cars leftward
 P*CARS , Q*CARS.
Increases demand for ethanol, described by
shifting the demand curve for ethanol
rightward
 P*ETHANOL,
Q*ETHANOL .
Cross Price Elasticity – describes size of
shifts for cars and electricity.
Another Cause of Demand –
Consumer Income
The Demand for most goods is
affected by changes in the
consumer’s income (I).
-- I  Q (Normal Goods)
-- I  Q (Inferior Goods)
Income Elasticity
Income Elasticity (I) – measures
the responsiveness of demand to
changes in consumer income.
I =
Percentage Change in QD
Percentage Change in I .
Interpreting
Income Elasticity
I =
Percentage Change in QD
Percentage Change in I .
Sign of I describes whether the good is a
normal good (positive) or inferior good
(negative).
Absolute Value of I describes the magnitude
of response. |I| < 1 describes an inelastic
response, while |I| > 1 describes an elastic
response.
Income Elasticity:
A Numerical Example
Suppose that:
For Tuna Helper, I = -1.4.
Negative sign  inferior good.
Absolute value > 1
 Elastic, or responsive.
For Apples, I = 0.5.
Positive sign  normal good.
Absolute value < 1
 Inelastic, or unresponsive.
Income Changes:
Graphical Description
Since income is “another cause”
of demand, changes in income are
described as shifts of the demand
curve.
Since it shifts the Demand curve,
changes in consumer income
affect P* and Q* as well.
Income Changes:
Graphical Description
For normal goods (I > 0), I  QD.
Therefore, one describes an increase
in income as a rightward shift in the
demand curve.
For inferior goods (I < 0), I  QD .
Therefore, one describes an increase
in income as a leftward shift in the
demand curve.
Absolute value of income elasticity
describes size of shift.
Individual Versus
Market Demand
The Market Demand for any good is
obtained by summing up the individual
demands for all the consumers for this
good.
Example – consider the demand for
apples.
Suppose the demanders consist of two
people, me and you.
Demand for Apples
Price ($)
0.20
0.25
0.30
0.35
0.40
0.45
Me + You
25
8
23
7
21
6
19
5
17
4
15
3
= Market
33
30
27
24
21
18
Causes:
Market Demand For a Good
Price of Good
Price of Related Goods
(Substitutes or Complements)
Consumer Income
(Normal or Inferior Good)
Tastes
Number of buyers in the market
(Market Demand only)
Demographics and
Market Demand for Goods
Changing population needs and
preferences lead to changes in the
number of participants.
Example – aging of baby boomers.
Decreases in market demand (shifts
leftward) for fast food, adult soccer
leagues, starter homes.
Increases in market demand (shifts
rightward) for fresh fruits, walking
sneakers, retirement condos.