Download The Effect of Extra Border Patrols on the Market for Illicit Drugs

Chapter 5
Demand: The Benefit Side of the
Market
Outline
• State the Law of Demand (LoD) and relate
the LoD to the Benefit-Cost Principle
• Apply the Benefit-Cost Principle to
important decisions facing consumers
• Measuring responsiveness by elasticity
• Examine how price elasticity of demand
determines the relationship between the
amount spent on a good and its price
Law of Demand (Lod)
• In markets, price rations goods and
services among competing users
• The demand curve is a relationship
between the quantity demanded and all
costs, monetary and non-monetary
• Law of Demand
– People do less of what they want to do as
the cost of doing it rises
Law of Demand and the BenefitCost Principle
• Reservation Price is the highest price that
we would be willing to pay for the marginal
unit.
• Demand curve gives one’s reservation price
for the marginal unit at each quantity. That
is also the the marginal benefit of that unit
• Pursue an action if and only if its added
benefits are at least as great as its added
costs
Major Decisions for Individuals
• Allocation of time between work and
leisure
• Allocation of income between consumption
now and future consumption (saving)
• Allocation of current expenditure between
different goods.
Needs vs. Wants
• Once we have achieved bare subsistence
levels of consumption, economists speak
only in terms of wants
• Helps us focus on the correct solutions to
problems
Utility
• People purchase goods for the satisfaction that
they derive from their consumption
• Utility represents the satisfaction people derive
from consumption activities
• Utility Maximization refers to people trying and
allocate their incomes to maximize their
satisfaction
• Normally, the more we consume, the more utility
we have
Lamar’s Total Utility from Ice
Cream Consumption
Marginal Utility
• The additional utility gained from
consuming an additional unit of the good
• The Law of Diminishing Marginal Utility
– As consumption of a good increases beyond
some point, the additional utility gained from
an additional unit of the good tends to decline
Allocating Expenditure between
Two Goods
• Consumer has a fixed amount of funds to spend on
two goods. How should the funds be allocated
between the two goods so as to maximize utility?
• The Benefit-Cost Principle says to equate the
marginal benefits for the two goods or activities.
(Remember, if they are not equal you can increase
utility by shifting spending away from the one
with the lower marginal benefit to the one with the
higher marginal benefit.)
Optimal Combination
• The marginal benefit for a good is the marginal
utility per dollar of expenditure on that good
which is the marginal utility of the good divided
by the price.
• Allocate the funds so that the added utility from
spending an additional dollar on one good is the
same as that from spending the dollar on the other
good. Gives the rational spending rule.
Rational Spending Rule
Spending should be allocated across goods so that
the marginal utility per dollar is the same for each good
MUC
MU S

PC
PS
the marginal utility per dollar =
MU
P
The ratio of marginal utility to price must be
the same for each good the consumer buys
The Demand Curve
• Suppose the consumer has chosen the best
combination. How would the combination change
if the price of one good in ( say, cones) increased?
• Then, the marginal benefit from sundaes would be
greater than the marginal benefit from cones.
Balance is restored by reducing the consumption
of cones and increasing the consumption of
sundaes. We get a negative relationship between
quantity demanded of cones and price or the LoD!
Role of Substitution
• When the price of a good or service goes up
– Rational consumers seek out less expensive
substitutes
• When prices return to their original levels
– People often return to the original good
Real vs. Nominal
• Nominal Price
– The absolute price in dollar terms
• Real Price
– The dollar price relative to the average dollar
price of all other goods and services
Equation for a Straight Line
Demand Curve
–
–
–
–
P is for the price of the good
Q is for the quantity demanded
b is the vertical intercept
m represents the slope
P  b  mQ
The Market Demand Curve for
Canned Tuna
Total Expenditure
• Total Expenditure equals
– The number of units sold multiplied by the
price of the good
• Total Expenditure = Total Revenue
– The dollar amount that consumers spend on a
product is equal to the dollar amount that sellers
receive
How does the Amount Spent on a Good
change when its Price Increases?
• From LoD we know that quantity demanded
decreases. But expenditure is quantity times
price and it can increase, decrease, or stay
the same!
• You pay more for the units that you buy,
which increases expenditure, but you buy
fewer units, which decreases expenditure.
• What can be said?
Key Relationship
• %Change in expenditure =
%change in price + % change in
quantity
• We need to know the percentage in quantity
that results from the percent change in
price, ceteris paribus?
Price Elasticity of Demand
• In order to predict what will happen to total
expenditures,
– We must know how much quantity will change
when the price changes
• Price elasticity of demand is
– the percentage change in the quantity demanded
that results from a one-percent change in its
price
Calculating Price Elasticity
• We need the ratio of the % change in
quantity to the % change in price or
• Eta = (%change in Q)/(% change in p)
D stands for
•
= 100(DQ/Q)/100(DP/P)
change in
•
= (DQ/DP)x(P/Q)
•
= (1/slope)x(P/Q)
Elasticity and the Demand Curve
Calculating Price Elasticity of
Demand
A Easy Way to Calculate Elasticity
•
•
•
•
•
•
•
Slope = - 20/5 or - (20-8)/3
Price = 8
Quantity = 3
Elasticity =(P/Q)(-1/slope)=(8/3)(-3/(20-8))
= - 8/(20-8) = - 2/3
Note elasticity = P/(max P – P)
Can be read from graph!
What Happens to the Amount
Spent on a Good when its Price
Increases?
• It all depends on the direct price elasticity
of demand !
• Key relationship:
• %Change in expenditure = %change in
price + % change in quantity
Terminology
• If the %change in quantity exceeds the
percentage change in price we say that
demand is elastic.
• If the %change in quantity is less than the
percentage change in price, we say that
demand is inelastic.
• If they are equal, we say demand is of
unitary elasticity.
Price Elasticity
• Elastic
– price elasticity is numerically greater than one
• Inelastic
– price elasticity is numerically less than one
• Unit elastic
– price elasticity equals one
• When calculating price elasticity of demand, you
will always get a negative
– For convenience we will take the absolute value
Price Elasticity and Expenditures
• For an elastic product
–
–
–
–
Quantity demanded is highly responsive
Percentage change in quantity dominates
An increase in price will reduce total expenditure
A decrease in price will increase total expenditure
• For an inelastic product
–
–
–
–
Quantity demanded is not responsive
Percentage change in price dominates
An increase in price will increase total expenditure
A decrease in price will decrease total expenditure
Determinants of Price Elasticity
• Substitution possibilities
– Price elasticity of demand will be relatively high if it is
easy to substitute between products
• Budget share
– The larger the share of the budget tend to have higher
price elasticities of demand
• Time
– Because substitution takes time, price elasticity will be
higher in the long run than in the short run
Other Elasticities of Demand
• Income Elasticity of Demand
– The amount by which the quantity demanded
changes in response to a one-percent change in
income
• Cross Price Elasticity of Demand
– The amount by which the quantity demanded of
one good changes in response to a one-percent
change in the price of another good
Perfect Elasticity
• Perfectly Elastic demand
– Price elasticity of demand is infinite
– Even the slightest change in price leads
consumers to find substitutes
• Perfectly Inelastic demand
– Price elasticity of demand is zero
– Consumers do not switch to substitutes even
when price increases dramatically
Perfectly Elastic and Perfectly
Inelastic Demand Curves
The Effect of Extra Border Patrols on
the Market for Illicit Drugs