Transcript Market Demand and Elasticity

Chapter 4
Market
Demand and
Elasticity
© 2004 Thomson Learning/South-Western
Market Demand Curves

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2
The market demand is the total quantity of a
good or service demanded by all potential
buyers.
The market demand curve is the relationship
between the total quantity demanded of a good
or service and its price, holding all other factors
constant.
Construction of the Market Demand
Curve


The market demand curve is constructed by
horizontally summing the demands of the
individual consumers
Assume the market consists of only two buyers
as shown in Figure 4.1
–
3
At any given price, such as P*X, individual 1
demands X*1 and individual 2 demands X*2.
FIGURE 4.1: Constructing a Market Demand
Curve from Individual Demand Curves
PX
P*
X
0
X*
1
(a) Individual 1
4
FIGURE 4.1: Constructing a Market Demand
Curve from Individual Demand Curves
PX
PX
P*
X
0
X*
1
(a) Individual 1
5
0
X*
2
(b) Individual 2
Construction of the Market Demand
Curve
–

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6
The total quantity demanded at the market at P*X is
the sum of the two amounts:
X* = X*1 + X*2 .
The point X*, P*X is one point on the market
demand curve.
The other points on the curve are similarly
plotted.
FIGURE 4.1: Constructing a Market Demand
Curve from Individual Demand Curves
PX
PX
PX
P*
X
D
0
X*
1
(a) Individual 1
7
0
X*
2
(b) Individual 2
0
X*
X
(c) Market Demand
Shifts in the Market Demand Curve

8
To discover how some event might shift a
market demand curve, we must first find out
how this event causes individual demand
curves to shift and then compare the horizontal
sum of these new demand curves with the old
demand curve.
Shifts in the Market Demand Curve

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9
For example consider the two buyer case
where both consumers regard X as a normal
good.
An increase in income for each consumer
would shift their individual demand curves out
so that the market demand curve, would also
shift out
This situation is shown in Figure 4.2
FIGURE 4.2: Increases in Each individual’s Income
Cause the Market Demand Curve to Shift Outward
PX
PX
PX
D
P*
X
0
X*
1
(a) Individual 1
10
0
X*
2
(b) Individual 2
0
X*
X
(c) Market Demand
FIGURE 4.2: Increases in Each individual’s Income
Cause the Market Demand Curve to Shift Outward
PX
PX
PX
D’
D
P*
X
0
X* X**
1 1
(a) Individual 1
11
0
X* X**
2 2
(b) Individual 2
0
X*
X**
X
(c) Market Demand
Shifts in the Market Demand Curve

However, some events result in ambiguous
outcomes.
–
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12
If one consumer’s demand curve shifts out while
another’s shifts in, the net effect depends on the
size of the relative shifts.
An increase in income for pizza lovers would
increase the market demand for pizza so long
as it is a normal good.
Shifts in the Market Demand Curve
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
13
On the other hand, if the increase in income
was for people who don’t like pizza, there
would be no significant effect on the market
demand curve for pizza.
Changes in the prices of related goods,
substitutes or complements, will also shift the
individual and market demand curves.
Shifts in the Market Demand Curve
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14
If goods X and Y are substitutes, an increase in
the price of Y will increase the demand for X.
Similarly, a decrease in the price of Y will
decrease the demand for X.
If goods X and Y are complements, an
increase in the price of Y will decrease the
demand for X. A decrease in the price of Y will
increase the demand for X.
APPLICATION 4.1: Consumption
and Income Taxes
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15
People’s ability to purchased goods and
services is dependent upon their after tax
income.
In the 1950’s Milton Friedman argued that
people’s consumption decisions are based
mostly on their long-term (permanent) income.
APPLICATION 4.1: Consumption
and Income Taxes

One implication of the permanent-income
hypothesis is that temporary tax changes will
have little effect on the demand for
consumption goods
–
16
This prediction is supported by the small impact on
consumption by both the temporary tax surcharge
during the Nixon administration and the Ford
administration’s temporary income tax rebate
APPLICATION 4.1: Why the 2001 Tax Cut
Was a Dud
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17
In May 2001, Congress passed one of the
largest cuts in personal income taxes in history.
Our discussion of demand theory showed that
changes in personal incomes shift demand
curves outward.
However, Milton Friedman viewed that
spending decisions are based on a person’s
“permanent” income.
APPLICATION 4.1: Why the 2001 Tax Cut
Was a Dud
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18
This insight suggests that the 2001 tax cut had
little impact for two reasons.
First, The $300 checks were too small to
stimulate spending on any major goods, so they
were largely saved.
Second, Most of the tax cuts do not begin until
2006, and the largest cuts are reserved until
2009-10.
A Word on Notation and Terms
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19
When looking at only one market, Q is used for
the quantity of the good demanded, and P is
used for its price.
When drawing the demand curve, all non-price
factors are assumed to not change.
Movements along the curve are changes in
quantity demanded, while shifts are changes in
demand.
Elasticity
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20
Goods are often measured in different units
(steak is measured in pounds while oranges
are measured in dozens).
It can be difficult to make simple comparisons
between goods when trying to determine which
is more responsive to changes in price.
Elasticity

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21
Elasticity is a measure of the percentage
change in one variable brought about by a 1
percent change in some other variable.
Since it is measured in percentages, the units
cancel out so that it is a unit-less measure of
responsiveness.
Price Elasticity of Demand

The price elasticity of demand is the
percentage change in the quantity demanded
of a good in response to a 1 percent change in
its price
Priceelasticityof demand  eQ ,P
22
Percentagechangein Q

Percentagechangein P
Price Elasticity of Demand

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23
The price elasticity records how Q changes in
percentage terms in response to a percentage
change in P.
Since, on a typical demand curve, P and Q
move oppositely, eQ,P will be negative.
For example, if eQ,P = -2, a 1 percent increase
in price leads to a 2 percent decline in
quantity.
Values of the Price Elasticity of
Demand
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24
When eQ,P < -1, a price increase causes more
than a proportional quantity decrease and the
curve is called elastic.
When eQ,P = -1, a price increase causes a
proportional quantity decrease, and the curve
is called unit elastic.
When eQ,P > -1, a price increase causes less
than a proportional quantity decrease, and
the curve is called inelastic.
TABLE 4.1: Terminology for the
Ranges of eQ,P
Value of eQ,P at a Point
on Demand Curve
eQ,P < -1
25
Terminology for Curve
at This Point
Elastic
eQ,P
= -1
Unit elastic
eQ,P
> -1
Inelastic
Price Elasticity and the Shape of
the Demand Curve

We often classify market demand curves by
their elasticities
–
–
26
For example, the market demand curve for
medical services is inelastic (nearly vertical) since
there is little quantity response to changes in
price.
Alternatively, the market demand curve for a single
type of candy bar is very responsive to price
change (nearly flat) and is very elastic.
Price Elasticity and the
Substitution Effect
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27
Goods which have many close substitutes are
subject to large substitution effects from a price
change so their market demand curve is likely
to be relatively elastic.
Goods with few close substitutes, on the other
hand, will likely be relatively inelastic.
Price Elasticity and the
Substitution Effect
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28
There is also an income effect that will
determine how responsive quantity demanded
is to changes in price.
However, since changes in the prices of most
goods have a small effect on individuals’ real
incomes, the income effect will likely not have
as large an impact on elasticity as the
substitution effect.
Price Elasticity and Time
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29
Some items can be quickly substituted for,
such as a brand of breakfast cereal, others,
such as heating fuel, may take several years.
Thus, in some situations, it is important to
make the distinction between the short-term
and long-term elasticities of demand.
APPLICATION 4.2: Brand Loyalty
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30
Substitution due to price changes will likely
take a longer time if individual’s develop
spending habits.
Such brand loyalties are rational since they
reduce decision making costs.
Over the long term, however, price differences
may cause buyers to try other brands.
APPLICATION 4.2: Brand Loyalty
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31
It took several years, but by the 1970s the
price differences between U.S. and Japanese
cars eventually convinced Americans to buy
the Japanese cars.
Brand name Licensing, such as Coca-Cola
sweatshirts and Mickey Mouse watches,
makes products that were previously nearly
perfect substitutes, now much less so.
Price Elasticity and Total
Expenditures


Total expenditures on a good are found by
multiplying the good’s price (P) times the
quantity purchased (Q).
When demand is elastic, price increases will
cause total expenditures to fall.
–
32
The given percentage increase in price is more than
counterbalanced by the decrease in quantity
demanded.
Price Elasticity and Total
Expenditures

For example suppose price elasticity = -2.
–
–
–
33
Suppose people buy 1 million automobiles at $1000
each for a total expenditure of $10 billion.
A price increase to $11,000 (10 percent) would
cause a 20 percent decline in quantity to 800,000
vehicles.
Total expenditures after the price increase would
now be only $8.8 billion
Price Elasticity and Total
Expenditures


Of course, when demand is elastic and prices
fall, total expenditures increase.
With unit elasticity, total expenditures remain
the same with a price change.
–
34
The movement in one direction by the price is fully
offset by the movement in the other direction with
the quantity demanded.
Price Elasticity and Total
Expenditures


When demand is inelastic, a price increase will
cause total expenditures to increase too.
Suppose the price elasticity of wheat = -0.5.
–
35
Suppose people bought 100 million bushels at $3
per bushel so total expenditures equal $300 million.
Price Elasticity and Total
Expenditures
–


36
A 20 percent price increase to $3.60 means quantity
falls by 10 percent to 90 million with total
expenditures now equal to $324 billion.
Alternatively, if the demand is inelastic and
prices fall, total revenue will also fall.
Table 4.2 summarizes the relationship between
price elasticity and total expenditures.
TABLE 4.2: Relationship between Price
Changes and Changes in Total Expenditure
37
If Demand Is
Elastic
In Response to an
Increase in Price,
Expenditures will
Fall
In Response to a
Decrease in Price,
Expenditures will
Rise
Unit elastic
Not change
Not change
Inelastic
Rise
Fall
APPLICATION 4.3: Volatile Farm Prices
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38
The demand for many basic agricultural
products (wheat, corn, etc.) is relatively
inelastic.
Even modest changes in supply, brought about
by weather patterns, can have large effects on
crop prices.
The Paradox of Agriculture


Good weather tends to produce bountiful
crops, but very low crop prices.
Bad weather can result in very high crop
prices.
–
39
Relatively small supply disruptions in the U.S. grain
best during the early 1970s resulted in farm
incomes rising more than 40 percent over a two
year period.
Boom and Bust in the Late 1990s

Since the New Deal in the 1930s, the volatility
of farm prices has been moderated through
federal price-support programs.
–
–
40
Acreage restrictions constrained increased planting
The federal government purchased crops outright
Boom and Bust in the Late 1990s
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
These programs moderated severe farm price
swings.
With the passage of the Federal Agricultural
Improvement and Reform Act in 1996, federal
governmental intervention into agricultural
markets was reduced.
–
41
In 1997, farm prices were unusually high, but this
was followed by very low prices in 1998.
Demand Curves and Price Elasticity
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42
The relationship between a particular demand
curve and the price elasticity it exhibits can be
complicated.
For some curves, the elasticity remains
constant everywhere, but for others it is
different at every point.
A more accurate way to describe it would be to
say the elasticity is for current prices.
Linear Demand Curves and Price
Elasticity

The price elasticity of demand is always
changing along a straight line demand curve.
–
–
–
43
Demand is elastic at prices above the midpoint
price.
Demand is unit elastic at the midpoint price.
Demand is inelastic at prices below the midpoint
price.
Numerical Example of Elasticity on
a Straight Line Demand Curve

Assume a straight-line demand curve for
Walkman cassette tape players is
Q = 100 - 2P
–

44
where Q is the quantity of players demanded per
week and P is their price.
This demand curve is illustrated in Figure 4.3
and Table 4.3 shows several price-quantity
combinations.
FIGURE 4.3: Elasticity Varies along a
Linear Demand Curve
Price
(dollars)
50
40
30
25
Demand
20
10
0
45
20
4050 60
80
100
Quantity of tape
players per week
TABLE 4.3: Price, Quantity, and Total
Expenditures on Walkmans for the Demand
Function Q = 100 - 2P
Price (P)
$50
40
30
25
20
10
0
46
Quantity (Q)
0
20
40
50
60
80
100
Total Expenditures (P  Q)
$0
800
1,200
1,250
1,200
800
0
Numerical Example of Elasticity on
a Straight Line Demand Curve
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47
For prices of $50 or more, nothing is bought so
total expenditures are $0.
As prices fall between $50 and $25, the
midpoint, total expenditures increase.
At the midpoint, total expenditures reach a
maximum.
As prices fall below $25, total expenditures
also fall.
Elasticity of a Straight Line Demand
Curve

More generally, for a linear demand curve of
the form Q = a - bP,
eQ ,P
eQ ,P
48
Q
Q P
Q



 P P Q
P
P
 b  .
Q
A Unitary Elastic Curve

Suppose the demand for tape players took the
form
1,200
Q
P
• The graph of this equation, shown in Figure 4.4,
is a hyperbola.
• P·Q = $1,200 regardless of price so demand is
unit elastic (-1) everywhere on the curve.
49
General Formula for the Elasticity
of a Hyperbola

If the demand curve takes the following form,
the price elasticity of demand is equal to b
everywhere on the curve.
Q  aP (b  0)
b
50
FIGURE 4.4: A Unitary Elastic
Demand Curve
Price
(dollars)
60
50
40
30
20
20
51
24
30
40
60
Quantity of
tape players
per week
Income Elasticity of Demand


The income elasticity of demand equals the
percentage change in the quantity demanded
of a good in response to a 1 percent change in
income.
The formula is given by (where I represents
income):
eQ, I
52
Percentagechangein Q

.
Percentagechangein I
Income Elasticity of Demand

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53
For normal goods, eQ,I is positive because
increases in income lead to increases in
purchases of the good.
For inferior goods eQ,I is negative.
If eQ,I > 1, the purchase of the good increases
more rapidly than income so the good might be
called a luxury good.
APPLICATION 4.4: An Experiment in
Health Insurance

Most developed countries have some form of
national health insurance.
–
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54
In the U.S. Medicare covers the elderly and
Medicaid is available for many of the poor.
Recently a number of comprehensive
government health plans have been proposed.
The Moral Hazard Problem

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55
A “moral hazard” problem occurs because
insurance misleadingly lowers the out-ofpocket expenses to patients, greatly increasing
their demand for medical services.
An important question, in considering
implementing national health insurance is how
large an increase is likely to develop?
The Rand Experiment

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56
The Rand Corporation conducted a
government-funded large-scale experiment in
four cities.
People were assigned to different insurance
plans that varied in the generosity of coverage
they offered.
Table 1 shows the results from the experiment.
The Rand Experiment

A rough estimate of the elasticity of demand
can be obtained by averaging the percentage
changes across the various plans in Table 1
% changein Q  12
e 

 0.18
% changein P  66
57
Table 1: Results of the Rand Health
Insurance Experiment
Coinsurance Percent change Average total
rate
in price
spending
0.95
540.00
0.50
-47%
573.00
0.25
-50
617.00
0.00
-100
750.00
Average
-66
58
Percent change
in quantity
6.10%
7.7
21.6
12
Low Elasticities for Hospital and
Doctors’ Visits
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59
Using the estimate of -0.22 found in Table 4.4,
and based on other studies suggests only a
small increase in hospital and doctor visits
would result from the lower prices provided by
insurance.
Alternatively, researchers have found greater
elasticities (around -0.5) for dental care and
outpatient mental health care.
Cross-Price Elasticity of Demand

The cross-price elasticity of demand
measures the percentage change in the
quantity demanded of a good in response to a
1 percent change in the price of another good.
Letting P’ be the price of another good,
eQ ,P
60
Percentagechangein Q

.
Percentagechangein P'
Cross-Price Elasticity of Demand


61
If the goods are substitutes, an increase in the
price of one will cause buyers to purchase
more of the substitute, so the elasticity will be
positive.
If the goods are complements, an increase in
the price of one will cause buyers to buy less
of that good and also less of the good they
use with it, so the elasticity will be negative
Empirical Studies of Demand:
Estimating Demand Curves
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62
Estimating a demand curve for a product is one
of the more difficult but important problems in
econometrics.
Empirical studies are useful because they a
provide a more precise estimate of the amount
of change in quantity demanded that results
due to a price change.
Problems Estimating Demand
Curves


63
The first problem is how to derive an estimate
holding all other factors (the ceteris paribus
assumption) constant.
This problem is often solved, as discussed in
the Appendix to Chapter 1, by the use of
multiple regression analysis.
Problems Estimating Demand
Curves


64
The second problem deals with what is
observed in the data. The data points
represent quantity and price outcomes that are
simultaneously determined by both the
demand and the supply curves.
The econometric problem is to “identify” from
these equilibrium points the demand curve that
generated them.
Some Elasticity Estimates


Table 4.4 gathers a number of estimated
income and price elasticities of demand.
Some things to note
–
–
65
All of the estimated price elasticities are less than
zero as predicted by a negatively sloped demand
curve.
Most of the price elasticity estimates are inelastic.
TABLE 4.4: Representative Price and
Income Elasticities of Demand
66
Food
Medical services
Rental housing
Owner-occupied
housing
Electricity
Automobiles
Beer
Wine
Marijuana
Cigarettes
Abortions
Transatlantic air travel
Imports
Money
Price Elasticity
Income Elasticity
-0.21
-0.22
-0.18
+0.28
+0.22
+1.00
-1.20
-1.14
-1.20
-0.26
-0.88
-1.50
-0.35
-0.81
-1.30
-0.58
-0.40
+1.20
+0.61
+3.00
+0.38
+0.97
0.00
+0.50
+0.79
+1.40
+2.73
+1.00
Some Elasticity Estimates
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67
The income elasticities of automobiles and
transatlantic travel exceed 1 (luxuries).
The high income elasticities are balanced by
goods such as food and medical care which
are less than 1 (necessities).
There is no evidence of Giffen’s paradox in the
table.
Some Cross-price Elasticity
Estimates


68
Table 4.5 shows a few cross-price elasticity
estimates
All of the goods appear to be substitutes and
have positive cross-price elasticities.
TABLE 4.5: Representative Cross-Price
Elasticities of Demand
69
Demand for
Effect of Price of Elasticity Estimate
Butter
Margarine
1.53
Electricity
Natural gas
0.50
Coffee
Tea
0.15
Application 4.5: Alcohol Taxes as Drunk
Driving Policy



70
Each year more than 40,000 Americans die in
automobile accidents.
It is generally believed that alcohol
consumption is a major contributing factor in at
least half of those accidents.
Most empirical studies of alcohol consumption
show that it is sensitive to price.
Application 4.5: Alcohol Taxes as Drunk
Driving Policy

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
71
The figures in Table 4.4 suggest that these
elasticities range from approximately –0.3 for
beer to perhaps as large as –0.9 for wine.
Most teenage alcohol consumption is beer.
The lower price elasticity of demand for beer
poses a problem for those who would use
alcohol taxes as a deterrent to drunk driving.