Chapter 4 Section 1 Understanding Demand

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 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 • 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 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 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 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 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 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 The price decreases from $4 to $3, a decrease of 25 percent. Price $5 $4 $3 Demand $2 $4 – $3 The quantity demanded increases from 10 to 20. This is an increase of 100 percent. 10 – 20 x 100 = 25 $4 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 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 The price decreases from $6 to $2, a decrease of about 67 percent. $6 – $2 The quantity demanded increases from 10 to 15, an increase of 50 percent. $4 10 – 15 $3 Demand $2 x 100 = 67 $6 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