Transcript Consumer Choice, Market Demand, and Elasticity

3
Consumer Choice, Market
Demand, and Elasticity
Outline
● Scarcity and Demand
● Utility: A Tool to Analyze Purchase Decisions
● Consumer Choice as a Trade-off: Opportunity
Cost
● From Individual Demand Curves to Market
Demand Curves
● Exceptions to the Law of Demand
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Outline
● Price Elasticity of Demand
● Its Effect on Total Revenue
● What Determines Demand Elasticity?
● Elasticity as a General Concept
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Scarcity and Demand
● Income is limited → consumers face constraints
on their choices
● Wealthy and poor individuals have limited
incomes relative to their desires.
● Every decision has an opportunity cost.
♦ ↑purchases of clothing → ↓purchases of restaurant
meals
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Utility: A Tool to Analyze
Purchase Decisions
● How do consumers make choices?
♦ Theory of consumer choice = each consumer spends
his or her income in a way that yields the greatest
satisfaction or utility.
♦ Cannot measure utility (or satisfaction) directly.
How should we measure your utility of a movie theater
ticket?
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Total vs. Marginal Utility
● Total utility = largest sum of money that a consumer will
voluntarily give up for a good
♦ E.g., I will buy 7 pints of Chunky Monkey only if it costs
$21.50 or less. So the TU (or benefit) that I receive from 7
pints is $21.50.
● Marginal utility = addition to TU that an individual
receives by consuming 1 more unit of the good
♦ E.g., if I consumed 6 pints of Chunky Monkey, MU measures
how much add. satisfaction I get by consuming 7 pints instead.
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TABLE 1. Leah’s Total and Marginal
Utility from Chunky Monkey
Quantity
(per month)
Total Utility
(dollars)
Marginal Utility
(dollars)
Label for
graph
0
0.00
------
------
1
6.00
6.00
A
2
11.00
5.00
B
3
15.00
4.00
C
4
18.00
3.00
D
5
20.00
2.00
E
6
21.00
1.00
F
7
21.50
0.50
G
8
21.50
0.00
H
Total vs. Marginal Utility
● TU: 1 pint is worth no more than $6.00 to me and 2 pints
are worth no more than $11.00 to me, etc.
● MU: 1st pint is worth $6 to me and 2nd pint is worth
$5.00 to me, while the 3rd is worth $4.00, etc.
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Marginal Utility (Price) per pint
FIGURE 1. Leah’s Marginal Utility
Curve for Chunky Monkey
$7
6
5
4
$3
2
1
0
A
B
C
D
Price
E
F
G
H
1 2 3 4 5 6 7 8
Number of pints per Month
“Law” of Diminishing MU
● Law of diminishing MU = the more of a good a
consumer has, the less MU an additional unit contributes
to overall satisfaction.
● Additional units of a good are worth less and less to a
consumer in money terms.
♦ E.g., each add. pint is worth less to me. 1st pint eat by myself;
2nd share with my husband; 3rd share with my friend; 4th share
with my dog, Dante; 5th share with my mother-in-law. Thus,
each successive pint has a lower priority.
Can you think of any exceptions to the law of diminishing
marginal utility?
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Total vs. Marginal Utility
● Graph of MU has (-) slope → ↓MU as ↑Qd.
● ↑TU as long as MU is (+).
♦ E.g., when a commodity is very scarce (diamonds),
economists expect it to have high MU even though it
provides very little TU.
Can you think of a good that has a very low MU but
a very high TU?
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Using MU: The Optimal
Purchase Rule
How many pints of Chunky Monkey should I purchase?
● Goal: max. total benefit from pints while min. their cost.
As long as MU is (+), ↑TU by consuming more pints.
But each add. pint costs money.
● Net TU = TU – total expenditure; where TE = P*Qd.
● Max. net TU by watching net MU; net MU = MU – P.
♦ E.g., If P = $3.00/pint and I buy 3 pints, then net MU = $1.00;
so I can ↑net TU by purchasing more.
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Using MU: The Optimal
Purchase Rule
● Two rules govern the optimal purchase rule:
1. if net MU is (+) (or MU > P) → consumer buys too
little of the good to max. net TU
2. if net MU is (-) (or MU < P) → consumer buys too
much of the good to max. net TU
● Combining these 2 rules → net TU is maximized when
net MU = 0 (or MU = P).
MU = P is the optimal purchase rule
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From MU to Demand Curves
● Demand curve = MU curve
♦ Law of diminishing MU  (-) slope of D curves
♦ P  Qd  MU
■ E.g., P = $3 → Qd = 4 pints. But if the ↑P to $5 → Qd = 2
pints. If ↓P to $2 → Qd = 5 pints. As ↑P, use the good for
higher valued uses –to share with my friend or husband. As
↓P, use the good for lower valued uses –to share with my
dog or mother-in-law.
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Consumer Choice as a TradeOff: Opportunity Cost
● Recall the importance of opportunity cost
● Decision to purchase something  decision to forgo
something else
♦ Real cost of 4 pints purchased for $3.00 each is not the $12
given up. It is the 4 movie rentals that are given up. I have
given up $12 worth of other goods to buy 4 pints of Chunky
Monkey.
Copyright© 2006 South-Western/Thomson Learning. All rights reserved.
Consumer Surplus
● CS = net TU = TU - TE
● Economists assume that firms max profit and
consumers max CS.
● Consumer must experience some gain from a
voluntary transaction; otherwise the consumer
would refuse to purchase the good.
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TABLE 2. Calculating CS
Quantity
(pints per mo.)
Marginal Utility
Price
Net MU
(per unit surplus)
1
$ 6.00
$ 3.00
$ 3.00
2
5.00
3.00
2.00
3
4.00
3.00
1.00
4
3.00
3.00
0.00
5
2.00
3.00
-1.00
Two ways of calculating CS:
(1) CS = TU – TE or (2) CS = ∑(MU – P)
Marginal Utility and Price per pint
FIGURE 2. Graph of CS
MU
7
6
$6
A
$5
5
MU (or D) curve
CS per unit
B
$3
$4
$2
4
C
$1
$3
3
D
P
$2
$0
2
E
0
F
$.50
$1
1
1
2
3
4
5
6
Number of pints purchased
G
$0
7
H
8
Graph of Consumer Surplus
● CS = area under D curve and above P.
♦ Leah was willing to pay $18 for the 4 pints (i.e., the
TU of 4 pints), but only paid $12 (i.e., $3*4) so her
total CS = $6.
● TU = area under entire D curve
● TE = rectangular area that reflects P*Qd
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From Individual to Market D
Curves
● Market D curve = horizontal sum of individual
D curves
● Steps to move from individual D to market D:
1. Pick any relevant P.
2. Find Qd at that P for each person.
3. Add the Qd at that P to get Qd in the market.
Repeat these steps for all possible prices.
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FIGURE 3. Total Market D vs.
Individual Consumer D
$7
$3
Joe’s
demand
L
L
M
Market demand
Price
Z
Price
Price
D
Leah’s
demand
J
J
K
M
M
4
D
0
4
Quantity Demanded
(a)
3
Z
0 1
3
Quantity Demanded
(b)
M
0 1
7
Quantity Demanded
(c)
From Individual to Market D
Curves
● The “Law” of Demand
♦ (-) slope for market D curves
■ Individual D curves have (-) slopes because of the law of
diminishing MU
■ Lower P draws new customers into the market
● E.g., Fig. 3, only Joe will buy Chunky Monkey at P =
$7. Yet, at P < $7, Leah will also purchase ice cream.
As ↓P, Joe will buy more and Leah will enter the
market, insuring that ↑Qd as ↓P.
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From Individual to Market D
Curves
● Exceptions to the “Law” of Demand
♦ Goods whose quality is judged by price –if a ↓P
signals poor quality → ↓Qd
■ E.g., Bayer aspirin vs. generic brand aspirin
♦ Goods with snob appeal –some people buy expensive
goods to advertise their wealth
■ E.g., Rolls Royce
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Elasticity: Measure of
Responsiveness
● Elasticity = measure of the responsiveness of
one variable to changes in another variable
● Price elasticity of demand = (%∆Qd) ∕ (%∆P)
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Elasticity: Measure of
Responsiveness
● Governments, courts, and businesses need to
understand the relationship between Qd and P
● If consumers respond sharply to ∆P → D is
elastic
● If consumers are unresponsive to ∆P → D is
inelastic
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FIGURE 4(a). Perfectly Inelastic
Demand
Qd is 90 no matter the P.
Elasticity = 0
P
%∆Qd = 0
D
Consumer purchases do not
respond to ∆P.
E.g., goods with very low
prices that are used with
something else –salt or
shoelaces. Or an essential
medicine.
0
90
QD
FIGURE 4(b). Perfectly Elastic
Demand
P
Slight ↑P → ↓Qd to 0.
Elasticity = 
$5
%∆Qd = infinitely large
D
Consumer are completely
responsive to ∆P.
E.g., Demand for a firm that
produces an
undifferentiated product.
0
QD
FIGURE 4(c). Straight-line Demand
Slope remains constant but
ε is changing.
P
ε (a-b) = (2/3)  (2/5) = 1.67
6
ε (c-d) = (2/6)  (2/2) = 0.33
a
b
4
3
c
Moving down the D curve ε
is getting smaller because
average Q is rising while
average P is falling.
d
1
2
4
5
7
D
QD
FIGURE 4(d). Unit-elastic Demand
Slope is changing but ε is constant
and equal to 1.
P
ε (e-f) = (7/10.5)  (10/15) = 1.0
Note: if ε = 1 → D is “unit elastic”
20
if ε > 1 → D is “elastic”
e
if ε < 1 → D is “inelastic”
10
f
D
7
14
QD
Elasticity of Demand and Total
Revenue
● Firms want to know whether an ↑P will raise or
lower their sales revenues.
♦ If D is elastic: ↑P → ↓TR
♦ If D is unit elastic: ↑P → TR constant
♦ If D is inelastic: ↑P → ↑TR
■Recall: TR = TE = P x Qd
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Elasticity of Demand and Total
Revenue
● Further examples:
♦ If P↓ by 10% and ↑Qd by 10% → D is unit elastic and
TR are constant.
♦ If P↓ by 10% and ↑Qd by 15% → D is elastic and
↑TR.
♦ If P↓ by 10% and ↑Qd by 5% → D is inelastic and
↓TR.
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FIGURE 5. An Elastic Demand Curve
$6
Price
5
D
R
Pt. S: TR = $24
= area of 0RST
S
W
V
4
D is elastic as
↓P → ↑TR.
3
2
1
T
0
Pt. V: TR = $60
D = area of 0WVU
4
U
12
Quantity Demanded
TABLE 3. Estimates of Price
Elasticities
What Determines Demand
Elasticity?
1. Nature of the good:
♦ Necessities have very inelastic demands, while
luxuries have elastic demands.
♦ E.g., ε potatoes = 0.3 and the ε restaurant meals =
1.6.
What do these numbers mean?
●
10%↑ in P of potatoes → ↓sales of potatoes by 3%. And 10%↑
in P of restaurant meals → ↓restaurant dining by 16%.
♦ Comes from the elasticity formula: %P * ε = %Qd
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What Determines Demand
Elasticity?
2. Availability of a close substitute:
♦
If consumers can buy a good substitute for a
product whose ↑P, they will readily switch.
■
E.g., D for gas is inelastic because you can’t run a car
without it. But D for Chevron gas is elastic because
Mobile or Shell gas work just as well.
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What Determines Demand
Elasticity?
3. Fraction of Income Absorbed:
♦
♦
Very inexpensive items have an inelastic demand.
Who will use more salt if the price falls?
Very expensive items have elastic demands.
Families will buy fewer homes if housing prices
increase.
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What Determines Demand
Elasticity?
4. Passage of Time:
●
D for products is more elastic in LR than SR because
consumers have more time to adjust their purchases.
♦
E.g., suppose recent ↑P gas continues. In SR, consumers
may take fewer summer road trips to ↓Qd gas. But in LR,
consumers can buy more fuel efficient cars to further ↓Qd
gas.
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Elasticity as a General
Concept
● Elasticity can be used to measure the
responsiveness of anything to anything else.
● Income Elasticity:
♦ Income elasticity of D = %  Qd  % Y
● Price Elasticity of Supply:
♦ Price elasticity of S = %  Qs  %  P
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Cross Elasticity of Demand
● Cross εd is used to determine whether two goods
are compliments or substitutes. It is calculated
as:
εcross = (%∆Qd good X)  (%∆P good Y)
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Cross Elasticity of Demand
● Two goods are compliments if an ↑Qd for one
good → ↑Qd of the other good.
♦ E.g, ketchup and french fries or coffee and cream.
■ If ↓P of coffee → ↑purchases of coffee and cream. Cross
elasticity for compliments is (-). As ↓P of coffee falls →
↑Qd of cream.
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Cross Elasticity of Demand
● Two goods are substitutes if an ↑Qd for one good
→ ↓Qd of the other good.
♦ E.g., ice cream and frozen yogurt or cans of salmon
and cans of tuna.
■ If ↑P of ice cream → ↓purchases of ice cream and
↑purchases of frozen yogurt. Cross elasticity for substitutes
is (+). As ↑P of ice cream → ↑Qd of frozen yogurt.
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Cross Elasticity of Demand
● Cross elasticity is often used in “anti-trust”
lawsuits. If firms face strong competition, it is
difficult to overcharge customers. A very high
and (+) cross elasticity indicates effective
competition in a market.
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