Transcript Market Demand and Elasticity - AUEB e

INTERMEDIATE
MICROECONOMICS
AND ITS APPLICATION
Chapter 4
Market Demand and Elasticity
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Market Demand Curves
• 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.
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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
– At any given price, such as P*X, individual 1
demands X*1 and individual 2 demands X*2.
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FIGURE 4.1: Constructing a Market Demand
Curve from Individual Demand Curves
PX
P*
X
0
X*
1
(a) Individual 1
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FIGURE 4.1: Constructing a Market Demand
Curve from Individual Demand Curves
PX
PX
P*
X
0
X*
1
(a) Individual 1
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0
X*
2
(b) Individual 2
Construction of the Market
Demand Curve
– 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.
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FIGURE 4.1: Constructing a Market Demand
Curve from Individual Demand Curves
PX
PX
PX
P*
X
D
0
X*
1
(a) Individual 1
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0
X*
2
(b) Individual 2
0
X*
(c) Market Demand
X
Shifts in the Market Demand
Curve
• 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.
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Shifts in the Market Demand
Curve
• 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
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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
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0
X*
2
(b) Individual 2
0
X*
(c) Market Demand
X
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
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0
X* X**
2 2
(b) Individual 2
0
X*
X**
(c) Market Demand
X
Shifts in the Market Demand
Curve
• However, some events result in ambiguous
outcomes.
– 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.
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Shifts in the Market Demand
Curve
• 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.
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Shifts in the Market Demand
Curve
• 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.
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APPLICATION 4.1:
Consumption and Income Taxes
• 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.
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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
– 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
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APPLICATION 4.1:
Consumption and Income Taxes
• Permanent changes in taxes, however,
should have an impact on consumption.
– The tax cuts during the early years of the
Reagan administration did not have a
significant impact on consumption until later
when consumers decided they were permanent.
– Alternatively Bush’s tax increase, breaking his
“read my lips” pledge not to raise taxes, had an
immediate negative impact on consumption.
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A Word on Notation and Terms
• 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 nonprice factors are assumed to not change.
• Movements along the curve are changes in
quantity demanded, while shifts are changes
in demand.
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Elasticity
• 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.
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Elasticity
• 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.
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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
Price elasticity of demand  eQ ,P
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Percentage change in Q

Percentage change in P
Price Elasticity of Demand
• 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 in 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.
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Values of the Price Elasticity of Demand
• 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.
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TABLE 4.1: Terminology for the
Ranges of eQ,P
Value of eQ,P at a Point
on Demand Curve
eQ,P < -1
Terminology for Curve
at This Point
Elastic
eQ,P
= -1
Unit elastic
eQ,P
> -1
Inelastic
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Price Elasticity and the Shape of
the Demand Curve
• We often classify market demand curves by
their elasticities
– 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.
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Price Elasticity and the
Substitution Effect
• 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.
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Price Elasticity and the
Substitution Effect
• 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.
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Price Elasticity and Time
• 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.
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APPLICATION 4.2: Brand
Loyalty
• 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.
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APPLICATION 4.2: Brand
Loyalty
• 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.
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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.
– The given percentage increase in price is more
than counterbalanced by the decrease in
quantity demanded.
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Price Elasticity and Total
Expenditures
• For example suppose price elasticity = -2.
– 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
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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.
– The movement in one direction by the price is
fully offset by the movement in the other
direction with the quantity demanded.
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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.
– Suppose people bought 100 million bushels at $3
per bushel so total expenditures equal $300
million.
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Price Elasticity and Total
Expenditures
– 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.
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TABLE 4.2: Relationship between Price
Changes and Changes in Total Expenditure
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
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APPLICATION 4.3: Volatile
Farm Prices
• 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.
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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.
– 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.
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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.
– Acreage restrictions constrained increased
planting
– The federal government purchased crops
outright
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Boom and Bust in the Late 1990s
• 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.
– In 1997, farm prices were unusually high, but
this was followed by very low prices in 1998.
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Demand Curves and Price
Elasticity
• 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.
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Linear Demand Curves and Price
Elasticity
• The price elasticity of demand is always
changing along a straight line demand
curve.
– 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.
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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
– 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 pricequantity combinations.
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FIGURE 4.3: Elasticity Varies
along a Linear Demand Curve
Price
(dollars)
50
40
30
25
Demand
20
10
0
20
4050 60
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80
100 Quantity of Walkmans
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
Quantity (Q)
0
20
40
50
60
80
100
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Total Expenditures (P  Q)
$0
800
1,200
1,250
1,200
800
0
Numerical Example of Elasticity
on a Straight Line Demand Curve
• 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.
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Elasticity of a Straight Line
Demand Curve
• More generally, for a linear demand curve
of the form Q = a - bP,
eQ ,P
eQ ,P
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Q
Q P
Q



P P Q
P
P
 b  .
Q
A Unitary Elastic Curve
• Suppose the demand for Walkman 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.
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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
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FIGURE 4.4: A Unitary Elastic
Demand Curve
Price
(dollars)
60
50
40
30
20
20
24
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30
40
60
Quantity of
Walkmans
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 ,P
Percentage change in Q

.
Percentage change in I
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Income Elasticity of Demand
• 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.
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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
Percentage change in Q

.
Percentage change in P'
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Cross-Price Elasticity of Demand
• 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
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Empirical Studies of Demand:
Estimating Demand Curves
• 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.
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Problems Estimating Demand
Curves
• 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.
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Problems Estimating Demand
Curves
• 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.
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Some Elasticity Estimates
• Table 4.4 gathers a number of estimated
income and price elasticities of demand.
• Some things to note
– 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.
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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
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Price Elasticity
Income Elasticity
-0.21
-0.22
-0.18
-1.20
-1.14
-1.20
-0.26
-0.88
-1.50
-0.35
-0.81
-1.30
-0.58
-0.40
+0.28
+0.22
+1.00
+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
• 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.
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Some Cross-price Elasticity
Estimates
• Table 4.5 shows a few cross-price elasticity
estimates
• All of the goods appear to be substitutes and
have positive cross-price elasticities.
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TABLE 4.5: Representative CrossPrice Elasticities of Demand
Demand for
Effect of Price of Elasticity Estimate
Butter
Margarine
1.53
Electricity
Natural gas
0.50
Coffee
Tea
0.15
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APPLICATION 4.4: The Economics
and Politics of Health Insurance
• Most developed countries have some form
of national health insurance.
– In the U.S. Medicare covers the elderly and
Midicaid is available for many of the poor.
• Recently a number of comprehensive
government health plans have been
proposed.
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The Moral Hazard Problem
• 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?
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Low Elasticities for Hospital and
Doctors’ Visits
• 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.
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The Politics of Elatically
Demanded Services
• Political pressure to include psychiatric and
other services greatly increased the price of
the 1994 Clinton Health Care Plan and
contributed to the defeat of the bill.
• Recent proposals to have Health Maintenance Organizations provide services at
zero out-of-pocket costs threaten to reverse
cost savings the HMOs have achieved.
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