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Chapter 4
Section 1: Understanding Demand
• What is the law of demand?
• How do the substitution effect and income effect
influence decisions?
• What is a demand schedule?
• What is a demand curve?
In the US, most goods are allocated through a
• MARKET SYSTEM
– Interactions of buyers and sellers
– Determines prices
– Determines what and how much will be produced
• Demand is the desire to own something and the ability
to pay for it.
What Is the Law of Demand?
The law of demand states that consumers buy more
of a good when its price decreases and less
when its price increases.
• The law of demand is the result of two separate
behavior patterns that overlap, the substitution effect
and the income effect.
• These two effects describe different ways that a
consumer can change his or her spending patterns for
other goods.
• Together they explain why an increase in price
decreases the quantity purchased and they can change
a consumer’s buying habits.
• Which one would you buy?
• Which one would
sell the most?
The Substitution Effect
The Substitution Effect
• The substitution effect occurs
when consumers react to an
increase in a good’s price by
consuming less of that good
and more of other goods.
• The opposite can occur if a
good’s price drops. If the price
of the good becomes cheaper
compared to alternatives,
consumers will substitute the
cheaper good for the higher
priced good, causing demand to
rise
The Income Effect
The Income Effect
• Rising prices make us feel
poorer because your money just
won’t buy as much as it used to
buy. In other words, you feel like
you have less money than you
had before
• Remember, economists
measure consumption in the
amount of a good that is
bought, not the amount of
money spent to buy it.
• The income effect happens
when a person changes his or
her consumption of goods and
services as a result of a change
in real income.
• The law of demand explains how the price of any item
affects the quantity demanded of that item.
• To have demand for a good, you must be willing and
able to buy it a the specified price. Basically, you want
it and you can afford it.
The Demand Schedule
• A demand schedule is a table
that lists the quantity of a
good a person will buy at each
different price in a market.
• A market demand schedule is
a table that lists the quantity
of a good all consumers in a
market will buy at each
different price.
Demand Schedules
Individual Demand Schedule
Price of a
slice of pizza
Quantity demanded
per day
$.50
$1.00
$1.50
$2.00
$2.50
$3.00
5
4
3
2
1
0
Market Demand Schedule
Price of a
slice of pizza
$.50
$1.00
$1.50
$2.00
$2.50
$3.00
Quantity demanded
per day
300
250
200
150
100
50
•Compare the two: At higher prices the quantity demanded is lower. The only
difference between the two schedules is that the market schedule lists larger
quantities demanded.
The Demand Curve
• When reading a demand curve,
assume all outside factors, such
as income, are held constant.
• NOTE: shows only the
relationship between the price
of this good and the quantity
purchased
–Price of other goods, income
and quality are held constant
–This curve shows market
demand, individual demand is
the same except the numbers
are smaller on the horizontal
axis.
Market Demand Curve
Price per slice (in dollars)
• A demand curve is a graphical
representation of a demand
schedule.
3.00
2.50
2.00
1.50
1.00
Demand
.50
0
0
50
100 150 200 250 300 350
Slices of pizza per day
Limits of a Demand Curve
• Market demand curve can be used to PREDICT how people will
change their buying habits when the price of a good rises or falls.
• It is only accurate for a very specific set of market conditions.
• Shifts can occur because of changes in factors other than price.
Section 1 Assessment
1. The law of demand states that
(a) consumers will buy more when a price increases.
(b) price will not influence demand.
(c) consumers will buy less when a price decreases.
(d) consumers will buy more when a price decreases.
2. If the price of a good rises and income stays the same, what is the effect on
demand?
(a) the prices of other goods drop
(b) fewer goods are bought
(c) more goods are bought
(d) demand stays the same
Section 1 Assessment
1. The law of demand states that
(a) consumers will buy more when a price increases.
(b) price will not influence demand.
(c) consumers will buy less when a price decreases.
(d) consumers will buy more when a price decreases.
2. If the price of a good rises and income stays the same, what is the effect on
demand?
(a) the prices of other goods drop
(b) fewer goods are bought
(c) more goods are bought
(d) demand stays the same
Section 2: Shifts of the Demand Curve
• What is the difference between a change in quantity
demanded and a shift in the demand curve?
• What factors can cause shifts in the demand curve?
• How does the change in the price of one good affect
the demand for a related good?
Shifts in Demand
• Ceteris paribus is a Latin phrase economists use
meaning “all other things held constant.”
• A demand curve is accurate only as long as there are
no changes other than price that could affect the
consumer’s decision – as long as the ceteris paribus
assumption is true.
• When the ceteris paribus assumption is dropped, and
other factors are allowed to change, movement no
longer occurs along the demand curve. Rather, the
entire demand curve shifts.
• This means that at every price, consumers buy a
different quantity than before – referred to as a change
in demand.
What Causes a Shift in Demand?
• Several factors can lead to a change in demand:
1. Income
Changes in consumers incomes affect demand. A normal good is a good
that consumers demand more of when their incomes increase. An inferior
good is a good that consumers demand less of when their income
increases.
2. Consumer Expectations
Whether or not we expect a good to increase or decrease in price in the
future greatly affects our demand for that good today.
3. Population
Changes in the size of the population also affects the demand for most
products. Ex – increase in demand for food, housing, many other goods
4. Consumer Tastes and Advertising
Advertising plays an important role in many trends and therefore
influences demand.
Prices of Related Goods
The demand curve for one good can be affected by a
change in the demand for another good.
•
Complements are two goods that
are bought and used together.
Example: skis and ski boots
•
Substitutes are goods used in
place of one another. Example:
skis and snowboards
•
Skis are useless without ski
boots. IF the price of ski boots
rise, the demand for skis boots
will drop and therefore the
demand for skis will fall at all
prices
•
Consider the effect on the
demand for skis when the price
for snowboards (a substitute for
skis) rises. A rise in prices of
snowboards will cause people to
buy fewer of them and therefore
look to buy more pairs of skis at
every price.
Section 2 Assessment
1. Which of the following does not cause a shift of an entire demand curve?
(a) a change in price
(b) a change in income
(c) a change in consumer expectations
(d) a change in the size of the population
2. Which of the following statements is accurate?
(a) When two goods are complementary, increased demand for one will cause
decreased demand for the other.
(b) When two goods are complementary, increased demand for one will cause
increased demand for the other.
(c) If two goods are substitutes, increased demand for one will cause increased
demand for the other.
(d) A drop in the price of one good will cause increased demand for its substitute.
Section 2 Assessment
1. Which of the following does not cause a shift of an entire demand curve?
(a) a change in price
(b) a change in income
(c) a change in consumer expectations
(d) a change in the size of the population
2. Which of the following statements is accurate?
(a) When two goods are complementary, increased demand for one will cause
decreased demand for the other.
(b) When two goods are complementary, increased demand for one will cause
increased demand for the other.
(c) If two goods are substitutes, increased demand for one will cause increased
demand for the other.
(d) A drop in the price of one good will cause increased demand for its substitute.
Section 3: Elasticity of Demand
• What is elasticity of demand?
• How can a demand schedule and demand curve be
used to determine elasticity of demand?
• What factors affect elasticity?
• How do firms use elasticity and revenue to make
decisions?
What Is Elasticity of Demand?
Elasticity of demand
• is a measure of how consumers react to a change in price.
• dictates how drastically buyers will cut back or increase their
demand for a good when the price rises or falls.
• Demand for a good that
consumers will continue to
buy despite a price increase
is inelastic, or relatively
unresponsive to price change.
• Demand for a good that is
very sensitive to changes in
price is elastic, or very
responsive to price change.
Calculating Elasticity
• There is a formula. To compute elasticity of demand
take the percentage change in the demand of a good
and divide this number by the percentage change in the
price of the good
• The law of demand implies that the result will always be
negative because an increase in the price of a good will
always decrease the quantity demanded, and a
decrease in the price of a good will always increase the
quantity demanded
Calculating Elasticity
Elasticity of Demand
Elasticity is determined using the following formula:
Elasticity =
Percentage change in quantity demanded
Percentage change in price
To find the percentage change in quantity demanded or price, use the following formula:
subtract the new number from the original number, and divide the result by the original
number. Ignore any negative signs, and multiply by 100 to convert this number to a
percentage:
Percentage change =
Original number – New number
Original number
x 100
Price Range
• Elasticity varies at every price level.
• Demand for the same product can be highly elastic at
one price and inelastic at a different price.
•Cost of glossy magazine
increases 50% from .20
to .30 is inelastic because
the price s still very low
and almost as many
people will buy it as they
did before
•Cost of glossy magazine
increases 50% from 4.00
to 6.00 is much more
elastic because many
readers will refuse to pay
2.00 more for the
magazine
•In terms of percentages, the magazine’s price is the same
as when it rose from 20 to 30 cents – a 50% increase.
Elastic Demand
Elastic Demand
If demand is elastic, a small change in price
leads to a relatively large change in the quantity
demanded. Follow this demand curve from left to
right.
$7
$6
Price
$5
The price decreases from $4 to $3, a decrease
of 25 percent.
$4
$3
Demand
$2
The quantity demanded increases from 10
to 20. This is an increase of 100 percent.
$4 – $3
x 100 = 25
$4
10 – 20
x 100 = 100
10
$1
0
5
10
15
20
Quantity
25
30
Elasticity of demand is equal to 4.0.
Elasticity is greater than 1, so demand is
elastic. In this example, a small decrease
in price caused a large increase in the
quantity demanded.
100%
25%
= 4.0
Inelastic Demand
Inelastic Demand
If demand is inelastic, consumers are not very
responsive to changes in price. A decrease in
price will lead to only a small change in quantity
demanded, or perhaps no change at all. Follow
this demand curve from left to right as the price
decreases sharply from $6 to $2.
$7
$6
Price
$5
$4
The price decreases from $6 to $2, a decrease
of about 67 percent.
$3
Demand
The quantity demanded increases from 10
to 15, an increase of 50 percent.
$2
$6 – $2
x 100 = 67
$6
10 – 15
x 100 = 50
10
$1
0
5
10
15
20
Quantity
25
30
Elasticity of demand is about 0.75. The
elasticity is less than 1, so demand for this
good is inelastic. The increase in quantity
demanded is small compared to the
decrease in price.
50%
67%
= 0.75
Factors Affecting Elasticity
• Ask yourself “What is essential to me? What goods
must I have, even if the price rises greatly?”
• Several different factors can affect the elasticity of
demand for a certain good.
1. Availability of Substitutes
2. Relative Importance
3. Necessities versus Luxuries
4. Change over Time
Availability of Substitutes
– If there are few substitutes for a good, then demand will not
likely decrease as price increases. The opposite is also
usually true.
– Ex: concert tix to your fave band – how much does price really
matter?
– Moderate change in price will not change your mind so
demand is inelastic
– Life-saving medicine? Only possible substitution is an
unproven treatment…people will buy as much needed
medicine as they can afford, even when price goes up
– Lack of substitutes can make demand inelastic
– Wide choice of substitutes can make demand elastic
– Demand for brand name goods is elastic when dozens of
good substitutes are available if price of preferred brand goes
up.
Relative Importance
– Another factor determining elasticity of demand is
how much of your budget you spend on the good.
– If you already spend a lot on a good a price
increase will force you to make some tough
choices
• Either cut back drastically on other goods in
your budget or
• reduce consumption of that good by a
significant amount to keep budget under control
Necessities versus Luxuries
– Whether a person considers a good to be a necessity or a
luxury has a great impact on the good’s elasticity of demand
for that person.
– Necessity – a good people will always buy, even when the price
increases (ex: milk) demand is inelastic
– Luxuries aren’t necessary and can have substitutes. (ex: steak)
– Quantity of luxuries demanded is easy to reduce therefore
demand is elastic
Change over Time
– Demand sometimes becomes more elastic over time because
people can eventually find substitutes.
– When prices change, consumers often need time to change
their habits
– It takes time to find substitutes.
– Demand would be inelastic in the short-term but would
become more elastic over time as substitutes are found.
Elasticity and Revenue
• Elasticity helps us measure how consumers respond to
price changes for different products.
• The elasticity of demand determines how a change in
prices will affect a firm’s total revenue or income.
Computing Firm’s Total Revenue
• A company’s total revenue is the total amount of money the
company receives from selling its goods or services.
• Determined by two factors:
– Price of the goods
– Quantity sold
Total Revenue and Elastic Demand
• Law of Demand=increase in price will decrease quantity demanded
• If prices rise too sharply, demand will drop and total revenue can
drop.
• Reverse is true – reduce prices, quantity demanded could rise and
therefore total revenues could rise
• Firms need to be aware of the elasticity of demand for the good or
service they are providing.
• Elastic demand comes from one or more factors:
– Availability of substitute goods
– Limited budget that does not allow price changes
– Perception of the good as a luxury item
• If these conditions are present, then demand for a good is elastic
and a firn may find that a price increase reduces its total revenue
Total Revenue and Inelastic Demand
• If demand is inelastic, consumers’ demand is not very responsive
to price changes.
• If prices go up by 25%, quantity demanded will fall but by less
than 25% so the firm will have greater total revenues.
• Higher price makes up for firm’s lower sales so the firm makes
more money.
• However, decrease in price will lead to an increase in quantity
demanded if demand is inelastic but it will not rise as much in
percentage terms and firms total revenue will decrease.
Elasticity and Pricing Policies
• Firm needs to know if demand for its product is elastic or
inelastic at a given price
• Helps the firm make pricing decisions that lead to greatest
revenue
• If elastic at current price then an increase will reduce total
revenue
• If inelastic at current price then an increase will increase total
revenue
Section 3 Assessment
1. What does elasticity of demand measure?
(a) an increase in the quantity available
(b) a decrease in the quantity demanded
(c) how much buyers will cut back or increase their demand when prices rise or
fall
(d) the amount of time consumers need to change their demand for a good
2. What effect does the availability of many substitute goods have on the elasticity of
demand for a good?
(a) demand is elastic
(b) demand is inelastic
(c) demand is unitary elastic
(d) the availability of substitutes does not have an effect
Section 3 Assessment
1. What does elasticity of demand measure?
(a) an increase in the quantity available
(b) a decrease in the quantity demanded
(c) how much buyers will cut back or increase their demand when prices rise or
fall
(d) the amount of time consumers need to change their demand for a good
2. What effect does the availability of many substitute goods have on the elasticity of
demand for a good?
(a) demand is elastic
(b) demand is inelastic
(c) demand is unitary elastic
(d) the availability of substitutes does not have an effect