Transcript Introduction - National Tsing Hua University

Chapter 4
Market Demand
And Elasticity
© 2006 Thomson Learning/South-Western
Market Demand Curves
2

Market demand: total quantity of good or
service demanded by all potential buyers.

Market demand curve shows relationship
between the total quantity demanded of a
single good or service and its price,
holding all other factors constant.
Constructing the Market Demand Curve


We construct a market demand curve (D)
by horizontally summing the all individual
consumers’ demand for the good or
service.
Fig. 4-1: Assume market consists of only
two buyers

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
Area AEB the consumer surplus area in Figure 3-11.

P*
X
0
X*
1
(a) Individual 1
5
0
X*
2
(b) Individual 2
FIGURE 4-1: Constructing Market Demand
Curve from Individual Demand Curves
PX
PX
PX
P*
X
D
0
X*
1
(a) Individual 1
6
0
X*
2
(b) Individual 2
0
X*
X
(c) Market Demand
Construction of Market Demand Curve
7

The total QX demanded at market P*X is sum of
two amounts:
X* = X*1 + X*2 .

Point X*, P*X provides one point on market
demand curve.

Other points on D curve similarly plotted based
on all QX demanded at other PX.
Shifts in Market Demand Curve: Income
8

An increase in income for each consumer
would shift their individual demand curves
out so that the market demand curve
would also shift out from the origin.

Shown in Figure 4-2
FIGURE 4-2: Increases in Each Individual’s
Income: Market Demand Curve Shifts Outward
PX
PX
PX
D’
D
P*
X
0
X* X**
1 1
(a) Individual 1
9
0
X* X**
2 2
(b) Individual 2
0
X*
X**
X
(c) Market Demand
Shifts in Market Demand Curve: Income

Some events result in ambiguous demand
curve outcomes:


10
If one consumer’s demand curve shifts out
while another’s shifts in, the net effect
depends on the size of the relative shifts.
Income increases for pizza lovers would
increase market demand for pizza, so long
as pizza is normal good.
Shifts in Market Demand Curve: Income

If only people who don’t like pizza enjoyed
income increases, the market demand
curve for pizza would not change.

Changes in prices of related goods-substitutes or complements--will also shift
individual and market demand curves.
11
Shifts in Market Demand Curve: Related Goods

If goods X and Y are substitutes, an
increase in PY will increase DX. Similarly,
a decrease in PY will decrease DX.

If goods X and Y are complements, an
increase in PY will decrease DX. A
decrease in PY will increase DX.
12
Elasticity

Elasticity: measures percentage change
in one variable brought about by a 1
percent change in some other variable.

Because it’s measured in percentages,
units cancel out-- elasticity is a unit-less
measure of responsiveness.
13
Price Elasticity of Demand

Price elasticity of demand: percentage
change in quantity of a good demanded in
response to a 1 percent change in its price
Priceelasticityof demand  eQ ,P
14
Percentagechangein Q

Percentagechangein P
Price Elasticity of Demand



15
Price elasticity of demand records how QX
changes (in percentage terms) given a
percentage change in PX.
On 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
decrease in quantity demanded.
TABLE 4.1: Terminology for the
Ranges of eQ,P
Value of eQ,P at a Point
on Demand Curve
eQ,P < -1
16
Terminology for Curve
at This Point
Elastic
eQ,P
= -1
Unit elastic
eQ,P
> -1
Inelastic
Price Elasticity: Substitutes Effect


17
Goods that have many close substitutes
are strongly affected by price changes, so
their market demand curve is likely to be
relatively elastic (flat).
Goods with few close substitutes will likely
be relatively inelastic (demand curve will
be more steep).
Price Elasticity and the
Substitution Effect


18
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

For some items, substitutes can be quickly
developed--such as brands of breakfast
cereal. Other goods, such as heating fuel,
are much less subject to being copied.

We must thus make the distinction
between short-term and long-term price
elasticities of demand.
19
Price Elasticity and Total
Expenditures


Total expenditures on a good are found by
multiplying the good’s price (PX) times the
quantity purchased (QX).
When demand is price elastic, price
increases will cause total expenditures to
fall.

20
Given percentage increase in price more than
counterbalanced by decrease in quantity
demanded.
Price Elasticity and Total Expenditures

Suppose price elasticity of demand = -2.



21
Initially people buy 1 million automobiles at
$10,000 each-- total expenditure of $10
billion.
10% price increase to $11,000 would cause
20 percent decline in cars purchased to
800,000 vehicles.
Total expenditures after price increase would
be only $8.8 billion
TABLE 4.2: Relationship between Price
Changes and Changes in Total Expenditure
22
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
FIGURE 4-3: Relationship between Price
Elasticity and Total Revenue
Price
PX
P1
P1
P0
P0
D
D
0
Q1 Q0
(a) Inelastic Demand
23
Quantity
per period
0
Q1
Quantity
Q0 per period
(b) Elastic Demand
Demand Curves and Price Elasticity

Relationship between particular demand curve
and price elasticity it exhibits can be
complicated.

For some curves, elasticity remains constant
everywhere (unit elastic); for others, it differs at
every point along curve.

More accurate to describe elasticity at current
price—specifies point on curve.
24
Linear Demand Curves and Price Elasticity

Price elasticity of demand changes
continuously along linear demand curves.



25
Demand elastic at prices above midpoint
price.
Demand unit elastic at midpoint price.
Demand inelastic at prices below midpoint
price.
Numerical Example: Elasticity along Linear
Demand Curve

Assume a straight-line demand curve for
Walkman cassette tape players is
Q = 100 - 2P
where Q is the quantity of players demanded
per week and P is their price.

26
Figure 4-4 shows this demand curve;
Table 4-3 shows several price-quantity
combinations.
FIGURE 4-4: Elasticity Varies along a
Linear Demand Curve
Price
(dollars)
50
40
30
25
Demand
20
10
0
27
20
4050 60
80
100
Quantity of CD
players per week
TABLE 4-3: Price, Quantity, and Total
Expenditures on Walkmans for Demand
Function Q = 100 - 2P
Price (P)
$50
40
30
25
20
10
0
28
Quantity (Q)
0
20
40
50
60
80
100
Total Expenditures (P  Q)
$0
800
1,200
1,250
1,200
800
0
Elasticity of a Straight Line
Demand Curve

More generally, for linear demand curve of
form Q = a - bP,
eQ ,P
eQ ,P
29
Q
Q P
Q



 P P Q
P
P
 b  .
Q
A Unitary Elastic Curve
Suppose demand for tape players took form
1,200
Q
P
• Figure 4.5 shows graph of this equation--a
hyperbola.
• P·Q = $1,200 regardless of price so demand is
unit elastic (-1) everywhere on the curve.
30
General Formula:
Elasticity of Hyperbola Demand Curves

If demand curve takes the following form,
price elasticity of demand equals b
everywhere along curve:
Q  aP (b  0)
b
31
FIGURE 4-5: Unitary Elastic Demand Curve
Price
(dollars)
60
50
40
30
20
20
32
24
30
40
60
Quantity of
CD players
per week
Income Elasticity of Demand


Income elasticity of demand:
percentage change in quantity demanded
of a good in response to 1 percent change
in income.
The formula is given by (I represents
income):
eQ, I
33
Percentagechangein Q

.
Percentagechangein I
Income Elasticity of Demand



34
Normal goods: eQ,I positive--income
increases lead to increased purchases of
good.
Inferior goods: eQ,I negative
eQ,I > 1, purchase of good increases more
on percentage basis than income--good is
called luxury good.
Cross-Price Elasticity of Demand

Cross-price elasticity of demand:
measures percentage change in quantity
demanded of one good in response to a 1
percent change in price of another good.
Letting P’ be the price of another good,
eQ ,P
35
Percentagechangein Q

.
Percentagechangein P'
Cross-Price Elasticity of Demand


36
If goods are substitutes, increase in
price of one good will cause buyers to
purchase more of substitute: Cross-price
elasticity positive.
If goods are complements, increase in
price of one good will cause buyers to buy
less of that good as well as less of the
complementary good: Cross-price
elasticity negative.
Problems Estimating Demand Curves

First problem: how to derive estimate
holding all other factors constant (the
ceteris paribus assumption).

As discussed in Appendix to Chapter 1,
ceteris paribus problem often solved using
multiple regression analysis.
37
Problems Estimating Demand Curves


38
Second problem: what is observed in the
data. Data points represent quantity and
price outcomes simultaneously
determined by both demand and supply
curves.
Econometric problem here is to “identify”
the demand curve from equilibrium points
that generated curve.
Some Elasticity Estimates


Table 4-4 gathers estimated income and
price elasticities of demand.
Note:


39
All estimated price elasticities are less than
zero--as predicted by negatively sloped
demand curve.
Most price elasticity estimates indicate that
goods are price inelastic.
TABLE 4-4: Representative Price and
Income Elasticities of Demand
Food
Medical services
Rental housing
Owner-occupied
housing
Electricity
Automobiles
Beer
Wine
Marijuana
Cigarettes
Abortions
Transatlantic air travel
Imports
Money
40
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 Cross-price Elasticity
Estimates

Table 4-5 shows cross-price elasticity
estimates

All goods appear to be substitutes and
have positive cross-price elasticities.
41
TABLE 4-5: Representative
Cross-Price Elasticities of Demand
Demand for
42
Elasticity Estimate
Butter
Margarine
1.53
Electricity
Natural gas
0.50
Coffee
Tea
0.15