Transcript price elasticity of demand - McGraw Hill Higher Education

Chapter 4
Consumer Demand
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Determinants of
Demand
• What determines what we buy?
– The Sociopsychiatric Explanation.
– The Economic Explanation.
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Sociopsychiatric
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.
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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.
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Determinants of Demand
• Market demand for a specific product is
determined by:
– Tastes.
– Income.
– Expectations.
– Other goods.
– The number of consumers in the market.
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Total Utility
• 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.
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Marginal Utility
• Marginal utility is the change in total
utility obtained by consuming one
additional (marginal) unit of a good or
service.
change in total utility
Marginal utility =
change in quantity
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Figure 4.3
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Law of Diminishing
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 free.
– The first box consumed is very rewarding.
– The third box is decent, etc.
– After eating the sixth box, she gets sick.
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Law of Diminishing
Marginal Utility
• 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.
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Law of Demand
• 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.
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Law of Demand
• 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.
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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.
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Figure 4.4
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Price Elasticity
• The price elasticity of demand is the
percentage change in quantity demanded
divided by the percentage change in price.
percentage change in
quantity demanded
Price elasticity (E) =
percentage change
in price
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Price Elasticity
• The price of popcorn goes up 20% and the
quantity demanded goes down 10%.
• The price elasticity of demand is:
percentage change in
quantity demanded
(E) =
percentage change
in price
–10%
=
= – 0.5
20%
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Elastic Demand
• 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.
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Inelastic Demand
• 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.
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Unitary Elastic
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.
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Table 4.1
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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.
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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).
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Figure 4.5
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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
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Necessities versus
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.
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Necessities versus
Luxuries
• 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.
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Availability of
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.
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Price Relative
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.
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Price Relative
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.
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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.
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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.
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Changes in Income
• 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.
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