Lecture Essentials of Economics: Chapter 4 - Bradley R. Schiller, Cynthia Hill

Chapter 4 Consumer demand, after reading this chapter, you should be able to: Explain why demand curves slope downward, describe what the price elasticity of demand measures, depict the relationship of price elasticity, price, and total revenue, recite the factors that influence the degree of price elasticity.

Consumer Demand

• What determines what we buy?

– The Sociopsychiatric Explanation.

– The Economic Explanation.

Determinants of 

Demand

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.

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

• 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

• Marginal utility is the change in total

utility obtained by consuming one

additional (marginal) unit of a good or

service

Figure 4.3

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

• 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

Law of Diminishing 

Marginal Utility

• 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

• 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

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.

Law of Demand 

Figure 4.4

• The price elasticity of demand is the

percentage change in quantity

demanded divided by the percentage

change in price

Price Elasticity 

• The price of popcorn goes up 20% and the quantity demanded goes down

10%

• The price elasticity of demand is:

(E) =

percentage change in quantity demanded percentage change = –10%

20% = – 0.5

Price Elasticity 

• 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

• 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

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.

Table 4.1

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

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)

Figure 4.5

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

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.

• 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.

Necessities versus 

Luxuries

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

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.

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.

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.

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.

• 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