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Chapter 4 Consumer Demand Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Determinants of Demand • What determines what we buy? – The Sociopsychiatric Explanation. – The Economic Explanation. 4-2 Sociopsychiatric Explanation • The desire for goods and services arises from our needs for social acceptance (or envy), security, and ego gratification. – “Keeping up with the Joneses.” – Self-preservation. – Expressions of affluence. 4-3 The Economic Explanation • Prices and income are just as relevant to consumption decisions as more basic desires and preferences. • The willingness and ability to pay are critical. 4-4 Determinants of Demand • Market demand for a specific product is determined by: – Tastes. – Income. – Expectations. – Other goods. – The number of consumers in the market. 4-5 Total Utility • Utility is the pleasure or satisfaction obtained from a good or service. • Total utility is the amount of satisfaction obtained from entire consumption of a product. 4-6 Marginal Utility • Marginal utility is the change in total utility obtained by consuming one additional (marginal) unit of a good or service. change in total utility Marginal utility = change in quantity 4-7 Figure 4.3 4-8 Law of Diminishing Marginal Utility • The marginal utility of a good declines as more of it is consumed in a given time period. • Suppose a student who enjoys popcorn can eat all he/she wants for free. – The first box consumed is very rewarding. – The third box is decent, etc. – After eating the sixth box, she gets sick. 4-9 Law of Diminishing Marginal Utility • As long as the marginal utility is positive, the consumer receives additional satisfaction and total utility increases. • Additional quantities of a good yield increasingly smaller increments of satisfaction. 4-10 Law of Demand • The concepts of marginal utility and ceteris paribus explain the downward slope of the demand curve. • With given income, tastes, expectations, and prices of other goods and services, people are willing to buy additional quantities of a good only if its price falls. 4-11 Law of Demand • The higher the marginal utility, the more you are willing to pay. • Diminishing marginal utility explains why price must decrease in order for you to continue to buy a good or service. 4-12 Law of Demand • According to the law of demand, the quantity of a good demanded in a given time period increases as its price falls, ceteris paribus, and vice versa. 4-13 Figure 4.4 4-14 Price Elasticity • The price elasticity of demand is the percentage change in quantity demanded divided by the percentage change in price. percentage change in quantity demanded Price elasticity (E) = percentage change in price 4-15 Price Elasticity • The price of popcorn goes up 20% and the quantity demanded goes down 10%. • The price elasticity of demand is: percentage change in quantity demanded (E) = percentage change in price –10% = = – 0.5 20% 4-16 Elastic Demand • Demand is elastic if the absolute value of E is greater than 1. • Consumer response is large relative to the change in price. – A 20% price rise generates a 30% decrease in quantity demanded. 4-17 Inelastic Demand • Demand is inelastic if the absolute value of E is less than 1. • Consumers are not very responsive to price changes. – A 20% price rise generates only a 10% decrease in quantity demanded. 4-18 Unitary Elastic Demand • Demand is unitary elastic if the absolute value of E equals 1. • The percentage change in quantity demanded is equal to the percentage change in price. – A 20% price rise generates a 20% decrease in quantity demanded. 4-19 Table 4.1 4-20 Price Elasticity and Total Revenue • Price elasticity explains why producers cannot charge the highest possible price. • Although one would think otherwise, higher prices may actually reduce total sales revenue. 4-21 Elasticity and Total Revenue • A price cut decreases total revenue if demand is price inelastic (E < 1). • A price cut increases total revenue if demand is price elastic (E > 1). • A price cut does not change total revenue if demand is unitary elastic (E = 1). 4-22 Figure 4.5 4-23 Determinants of Price Elasticity • Differences in price elasticity are explained by several factors: – Whether the Good Is a Necessity or Luxury – The Availability of Substitutes – The Price Relative to Income 4-24 Necessities versus Luxuries • Some goods are so critical to our everyday life that we regard them as necessities. – We must buy even if the price goes up. • Demand for necessities is relatively inelastic. 4-25 Necessities versus Luxuries • A luxury good is something we’d like to have but aren’t likely to buy unless our income jumps or the price declines sharply. – We will simply wait for a sale. • Demand for luxury goods is relatively elastic. 4-26 Availability of Substitutes • If substitute goods are readily available, we can switch to the substitute. Demand for goods easily substituted for will be relatively elastic. • If substitute goods are not readily available, we must stay with this good. Demand for goods with few substitutes will be relatively inelastic. 4-27 Price Relative to Income • If the price of a product is very high relative to the consumer’s income, the demand will tend to be elastic. – We will put off the purchase until there is a sale. 4-28 Price Relative to Income • If the price of a product is very low relative to the consumer’s income, the demand will tend to be inelastic. – We do not pay much attention to any price change. 4-29 Substitute and Complementary Goods • Substitute Goods: The demand for a good increases when the price of a substitute for the good goes up. – We will switch from Starbucks to Dunkin’ Donuts. 4-30 Substitute and Complementary Goods • Complementary Goods: The demand for a good decreases when the price of a complement to the good goes up. – As gas prices rise, people trade in SUVs for hybrids. 4-31 Changes in Income • Income is a determinant of demand. – If our income rises, we can, and do, want to buy more products at any price. • We illustrate income changes with shifts of the demand curve. 4-32