Transcript 4.0 Product Market Demand Under Perfect Competition

4.0 Product Market Demand
Under Perfect Competition
4.1 Introduction
p1
S1
Q1S=S1(p1| shift var)
D1
Q1D =D1(p1| shift var)
Q1
Figure 4.1.1 - Product Picture Market for Good #1
This graph includes functional form of the
relationships
D
Q = D (p | shift variables)
s
Q = S (p | shift variables)
4.2.1
We’ll examine why the product demand line
slopes down
D
What determines the responsiveness of Q1
to p1
What shift variables move D and how
4.2.2- 4.2.4
Product demand slopes down and to the right
It is an inverse relationship between p and Q
You can use the decision rule to prove
mathematically why this must be so
4.2.5
Own price elasticity of demandHow responsive the quantity demanded is to a
change in the good’s own price
Elastic = responsive or sensitive
Inelastic = not as responsive or sensitive
4.2.6 Comparing elastic and
inelastic demand curves
Good # 1
Good # 2
p
p
D
D
Q
Figure 4.2.1 - Own Price Elasticities of Demand - Different Attitudes
Q
If prices go up equally,
Good # 1
Good # 2
P
P
P'
P'
P
P
D
Q'
Q
D
Q
Q'
Q
Figure 4.2.2 - Own Price Elasticities of Demand - Comparing Responses
Q
Since the quantity demanded of
Good 1 fell by more than the
Quantity demanded of Good 2
We say Good 1 is the more elastic of the two
4.2.7 – 4.2.9
Elasticity is important for both private and
public policies
Private example – McDonalds changing
prices
Public example – public transportation price
changes
4.2.10 The two extreme cases
Which would you prefer if you were selling a
product?
p
D
Q
Figure 4.2.3 - Perfectly Elastic Demand
p
D
Q
Figure 4.2.4 - Perfectly Inelastic Demand
Firms hope for as inelastic
demand as possible
4.2.11- 4.2.12
What determines how elastic or inelastic a
good’s demand will be?
A) Necessity or luxury
Necessities tend to be more
inelastic
you tend to pay any price
Ex. Lifesaving health procedure increases in
price - Qd roughly the same
Movies increase price - Qd drops by more
B) Number and quality of
substitutes
fewer substitutes more inelastic
Ex. If it is a unique item increase in price has not much effect on Qd
C) Time horizon involved
more time - more options can be found
very short time horizon more inelastic
longer time period more elastic
D) Size of price relative to one’s
income
smaller the price, more likely to be
inelastic
Ex. Bubble gum goes from 1 penny to 2 pennies
100% increase
no big deal on Qd
Car goes from $10,000 to $20,000
100% increase - really big deal
4.2.13
%QuantityChange

%Own Pr iceChange
Absolute value eliminates a
negative
There are three major categories
of elasticity
Elastic demand
 1
%QD  %P
Inelastic demand
 1
%QD  %P
Special case - Unitary Elasticity
 1
%QD  %P
Special case - Perfect Inelasticity
No matter how much price changes, quantity
demanded does not change
“Pay any price”
 0
4.2.14
Elasticity yields some incredibly
valuable information to firms
For a firm,
Total Expenditure = Total Revenue = Price X
Quantity
TE = TR = P X Q
Snowplow business
P
20
10
D
90 100
Q
Pizza
Business
P
20
10
D
5
100
Q
4.2.15
Firms hope for as inelastic as a
demand curve as possible
Advertising serves to promote the
ideas that:
there are no substitutes (more inelastic)
and goods are a necessity (also more inelastic)
In a perfectly competitive world,
we assume that individual firms are not able
to distinguish their products
nor keep competitors away
Individual suppliers will face a perfectly
elastic demand line
4.2.16 Public policy case
Want to reduce drug crime –
Cutting supply on on inelastic demand curve –
Price goes up by much more than quantity
demanded dropsmight create more crime in the short run
Market is dynamic, however
Longer run – might keep those from starting a
more expensive proposition
4.2.17 Taxes and Markets
p
p
S'
S'
Tax
S
p1
Tax
Tax
S
p0
Tax
(p1 - Tax)
D
(p1 - Tax)
D
Q 1 Q0
p1
p0
Q
Q1
Figure 4.2.5- Elasticity and Tax Incidence
Q0
Q
In the inelastic case on the left,
The tax is paid almost entirely by the
consumer
The price goes up by almost the full amount
of the tax
In the elastic case on the right, the tax burden
goes primarily to the supplier
Tax incidenceWho really pays the tax
Goal – tax consumer – tax inelastic goods
Goal – tax supplier – tax elastic goods
Taxes are imposed for different
reasons
Goal – discourage consumption – tax elastic
demand
Goal – raise revenue – tax inelastic goods
4.3.1
We know that
D
Q1 = D (p1 | shift variables)
Now we will identify the shift varaibles
D
Q1 = D (p1 | pr, I, T)
where
Pr stands for the price of related goods
I stands for income
T stands for tastes
4.3.2
All of the following have an
effect on the position of the D
curve
(which will result in a shift in the curve)
Tastes and Preferences
Examples:
A band becomes popular
Clothes become in fashion
These will result in an increase in
the demand
these changes in tastes will shift the demand
curve for that good to the right
An increase in demand
P
D
D'
Q
Tastes work the other way, too
A decrease in demand
P
D'
D
Q
4.3.3
Price of related goods also shifts demand
Ex. Increase in price of burgers affects the
quantity demanded of fries and quantity
demanded of drinks
This is called a cross price effect
Goods consumed together
Are called complements
 phbg  Qhbg  Dff  Qff
Cross price elasticity of demand
%QuantityC hangeofGoo d2
 1x 2 
%PriceChan geofGood1
If P1  and Qd2 
the goods have a negative cross-price
elasticity
and are
Complements
Ex. Burgers and fries
If P1  and Qd2 
the goods have a positive cross-price elasticity
and are
Substitutes
Ex. Coke and Pepsi
The sign of the cross price
elasticity
Determines the nature of the relationship
(sub./comp.)
The size of the cross price elasticity
Determines how strong this cross price effect
is
4.3.6
 0
1x 2
Cross price elasticity is zero
A change in the price of one good has no
effect on the quantity demanded for
another good
In theory
There is no such thing as unrelated markets,
so
The cross price elasticity is actually very close
to zero, but can be treated as zero
Markets are like a spider web
A change in one affects others everywhere –
There is a complex web of connections
4.3.7
Private firms consider not only own
price elasticity,
but also cross price elasticities
Ex. McDonalds – raising burger prices
might lower amount of drinks and fries
sold
4.3.8
Public policies also have to consider
effects of cross price elasticity
Ex. Drunk driving example
4.3.9
Policy – whether public or private –
is rarely simple
Complex problems sometimes require
complex solutions
4.3.10
Changes in the price of related goods
shift demand lines
Increase in price of hamburgers causes,
ceteris paribus,
Decrease in demand for French fries
Increase in demand for pizza
Hamburger
French Fries
p
S1
Pizza
p
p
S
S
S0
p1
p1
p0
p0
p1
p0
D
Q1 Q0
Q
D1
Q1 Q0
D0
D0
Q
Figure 4.3.2 - Connecting Markets by Cross Price Effects
Q0 Q1
D1
Q
4.3.12
Another thing that shifts demand lines is
income
If a good’s demand curve increases when income
rises
the good has a positive income elasticity
and is called a normal good
however, some goods have a decrease in their
demand when income risesnegative income elasticity / inferior goods
4.3.13 Income elasticity of
demand
%QuantitiyChange
I 
% IncomeChange
4.3.14
Goods are not inherently normal or inferior
It depends on the individuals’ preferences
4.3.15
Individual vs. Market Demand
to determine the market demand,
we simply add the D curves for each
individual household
each household’s tastes and preferences differ
p 5
p 5
#1
p 5
#2
4
4
4
3
3
3
2
2
2
1
1
D
1
2
p
3
4
5
D
1
D
Q
0
#3
Q
6
0
2
1
3
4
5
Q
0
6
1
2
14
15
3
4
6
5
4
3
2
1
D
0
1
2
3
4
5
6
7
8
9
10
11
12
Figure 4.3.3 - From Individual to Market Demand
13
Q
5
6
Additionally,
the exit or entry of households have an effect
on market demand curve
Consider baby boomers and their effects on:
diapers - 1950’s
schools - 1960’s
Geritol or Viagra - 1990’s
Nursing homes - 2010’s
4.3.17 Conclusion on product
demand
We started with a utility maximization rule given
scarcity
then developed a downward sloping demand curve
Then we discussed what it represents, its
responsiveness,
and what shifts it (tastes, income, price of related
goods)
Lastly, we looked at how individual demand curves
are summed into a market demand curve