Download Price Elasticity of Demand and Consumer Expenditures (cont.)

Chapter 4
Consumer Decision
Making and
Consumer Reaction
to Price Changes
Learning Objectives
• 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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4-2
If It Doesn’t Have Utility, You Won’t
Buy It
• 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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4-3
Measuring Utility
• 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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4-4
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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4-5
Of Total and Additional Utility
(cont.)
• 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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4-6
Figuring Out 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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4-7
Diminishing Marginal Utility
• 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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4-8
Measuring Consumer
Responsiveness
• 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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4-9
The 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.
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4-10
Elasticity Calculations
• We measure the price elasticity of
demand by comparing the percentage
change in price with the percentage
change in quantity demanded.
Percentage change in Qd
Price elasticity of demand =
Percentage change in price
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4-11
Elasticity Calculations (cont.)
• 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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4-12
How We Actually Calculate
Elasticity
• 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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4-13
Using Average Formulas
• 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
change in Q change in P
Price elasticity of demand =

(Q1 + Q2 ) 2
(P1 + P2 ) 2
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4-14
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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4-15
Factors that Determine the Price
Elasticity of Demand
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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4-16
Factors that Determine the Price
Elasticity of Demand (cont.)
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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4-17
Figure 4-3: Short-Run and Long-Run
Price Elasticity of Demand
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4-18
Table 4-1: Selected Estimated Short and
Long Run Price Elasticities of Demand
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4-19
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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4-20
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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4-21
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.
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4-22
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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4-23
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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