Lecture Principles of economics (Brief edition, 2e): Chapter 4 - Robert H. Frank, Ben S. Bernanke

Chapter 4 - Demand and elasticity. We begin in chapter 4 by exploring the concept of elasticity, which describes the sensitivity of demand and supply to variations in prices, incomes, and other economic factors.

Chapter 4: Demand and Elasticity

1 Relate the law of demand to the Cost-Benefit

Principle

2 Discuss the relationship between the individual

demand curve and the market demand curve

3 Define and calculate consumer surplus

4 Define price elasticity of demand and explain its

determinants

5 Calculate price elasticity of demand using information

from the demand curve

6 Describe the relationship between price elasticity of

demand and total expenditure

• Cost-Benefit Principle at work

– Do something if the marginal benefits are at least as great as the marginal costs

• An increase in the market price approaches our reservation price

– If market price exceeds the reservation price, buy no more

– Costs include ALL costs – money, time, reputation

• Consider implicit and explicit costs

Law of Demand

Law of Demand People do less of what they want to do

Origins of Demand

• Reservation price

– Individual tastes and preferences differ

 Biological needs ■ Cultural influences

 Peer behavior ■ Individual differences

 Perceived quality ■ Expected benefits

– Tastes may change over time

• Macaroni and cheese

• Spinach

• New goods get incorporated into priorities

Needs versus Wants

• Some goods are required for subsistence

– These are needs

• Beyond subsistence, behavior is driven by wants

– Kidneys or hamburger

– Oatmeal or toaster pastries

• Wants depend on price

– Water in California

• Regulations or price mechanism

– Regulations are cumbersome and expensive

Substitution at Work

• Substitution has powerful effects on our choices

– New car or used one

– Car pool or bus

– French restaurant, Chinese restaurant, cook at

home

– Soccer game or TV or read a book

– Go to movies or join Netflix or get cable TV

– Turn on the heat or put on a hoodie

Nominal and Real Prices

• Nominal price: the absolute price of a good in

terms of dollars

– The price you see on a good in a store

• Real price: the nominal price of a good relative

to the average dollar price of all other goods

– Real prices are adjusted for inflation

Income Differences Matter

• Income is one of the determinants of demand

– "Free goods" have more takers in lower income

neighborhoods than in higher income areas

• The wait to get the free good is the price

– Waiting times in lower income areas will be longer

» Lower opportunity cost of the residents' time

– Stores in higher income areas have lower waiting

times to pay for purchases

• The higher value of time causes these people to be willing to pay for more store staff

Individual and Market Demand

Curves

• The market demand is the horizontal sum of

individual demand curves

– At each possible price, add up the number of units demanded by individuals to get the market demand

Identical Individual Demand

Curves

• In the special case where all buyers demand

exactly the same quantity at each price

– Multiply the individual quantity demanded by the

number of buyers to get the market demand

Market Individual

Consumer Surplus on a Graph

• Consumer surplus is the

difference between the

buyer's reservation price and

the market price

• When a product is sold in

whole units, the demand

curve is a stair-step function

• Many goods are indivisible:

movie tickets and TVs

– If the market supplied only

one unit, the maximum price

Vanilla Ice Cream

Consumer Surplus on a Graph

• Market price is $6 for all

sales

• Total consumer surplus

• The first sale generates $5

of consumer surplus

– Reservation price of $11

minus the price of $6

• Selling the second unit has

$4 of consumer surplus,

and so on

• Total consumer surplus

is the area under the

12 Vanilla Ice Cream

Price Elasticity of Demand

• Price elasticity of demand is defined as the

percentage change in quantity demanded from a 1% change in price

– Measure of responsiveness of quantity demanded

to changes in price

• Example:

– Price of beef decreases 1%

– Quantity of beef demanded

increases 2%

P

Calculate Price Elasticity

• Symbol for elasticity is ε

– Lower case Greek letter epsilon

• For small percentage changes in price

ε = Percentage change in quantity demanded

Percentage change in price

 Price elasticity of demand is always negative

 Ignore the sign

Elastic Demand

If price elasticity is greater than 1, demand is elastic

– Percentage change in quantity is greater than percentage change in price

– Demand is responsive to price

Inelastic Demand

• If price elasticity is less than 1, demand is inelastic

– Percentage change in quantity is less than percentage

change in price

– Quantity demanded is not very responsive to price

Unit Elastic Demand

• If price elasticity is 1, demand is unit elastic

– Price and quantity change by the same percentage

Price Elasticity Notation

• ΔQ is the change in quantity

– ΔQ / Q is percentage change in quantity

• ΔP is change in price

– ΔP / P is percentage change in price

ΔQ / Q

Price Elasticity: Graphical View

Price Elasticity and Slope

• When two demand curves cross

• P / Q is same for both curves

• (1 / slope) is smaller for the steeper curve

– At the common

point demand

is less price elastic

for the steeper

e More Elastic Less Elastic

Price Elasticity on a

Straight-Line Demand Curve

• Price elasticity is different at each point

– Slope is the same for the demand curve

– P/Q decreases as price goes down and quantity

goes up

Q

1 slope

x

Price Elasticity Pattern

• Price elasticity changes systematically as price goes down

• At high P and low Q, P / Q is large

• Demand is elastic

• At the midpoint,

demand is unit elastic

• At low P and high Q,

Two Special Cases

• Zero price elasticity of demand

Price

D

Price

D

Elasticity and Total Expenditure

• When price increases, total expenditure can

increase, decrease or remain the same

– The change in expenditure depends on elasticity

• Terminology: total expenditure = total revenue

– Calculate as P x Q

• Graphing idea: total

expenditure is the area

of a rectangle with height P

and width Q

– Example: P = 2 and

Price

D 2

Expenditure = 8

Price Elasticity and Total

Expenditure

• Movie ticket price increases from $2 to $4

– A and B are both below the midpoint of the curve

• Inelastic portion of the demand curve

– Total revenue increases when price increases

Price Elasticity and Total

Expenditure

• Movie ticket price increases from $8 to $10

– Prices are both above the midpoint of the curve

• Elastic portion of the demand curve

– Total revenue decreases

Cross-Price Elasticity of Demand

• Substitutes and complements affect demand

• Cross-price elasticity of demand is defined as the

percentage change in quantity demanded of good A from a

1 percent change in the price of good B

• Sign of cross-price elasticity shows relationship between the goods

– Complements have negative cross-price elasticity

– Substitutes have positive cross-price elasticity

Income Elasticity of Demand

• Income elasticity of demand is defined as the

percentage change in quantity demanded from a 1

percent change in income

• Income elasticity of demand can be positive or negative