Transcript price elasticity of demand - McGraw Hill Higher Education

Chapter 4:
Consumer Demand
McGraw-Hill/Irwin
Copyright © 2009 by The McGraw-Hill Companies, Inc. All Rights Reserved.
Patterns of Consumption
o About 70% of a household’s budget is
spent on housing, transportation, food,
and health expenditures.
o “Essential” items have changed from
years ago.
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Determinants of Demand
o What determines what we buy?
o The Sociopsychiatric Explanation
o The Economic Explanation
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The Sociopsychiatric Explanation
o The desire for goods and services arises
from our needs for social acceptance,
security, and ego gratification.
o “Keeping up with the Joneses”
o Self preservation
o Expressions of affluence
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LO-1
The Economic Explanation
o Prices and income are just as relevant to
consumption decisions as more basic
desires and preferences.
o Demand – The ability and willingness to
buy specific quantities of a good at
alternative prices in a given time period,
ceteris paribus.
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LO-1
Determinants of Market Demand
o Tastes - desire for this and other goods:
o If a study says ice cream is good for you, the
demand for ice cream would increase.
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Determinants of Market Demand
o Income (of the consumer):
o If you won the lottery you might buy more ice
cream.
o The demand for ice cream would increase,
shifting the demand curve to the right.
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Determinants of Market Demand
o Expectations (for income, prices, tastes)
o If you knew you were going to get rich soon
you might deplete savings to buy more ice
cream now.
o This would increase the demand for ice
cream.
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Determinants of Market Demand
o Other goods (their availability and price):
o If the price of chocolate candy bars
increased, you might buy ice cream instead
of a candy bar.
o This would increase the demand for ice
cream.
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Determinants of Market Demand
o The number of consumers in the market:
o If the number of buyers in the ice cream
market increased, the demand for ice cream
would also increase.
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Market Demand
o The total quantities of a good or service
people are willing and able to buy at
alternative prices in a given time period.
o Market demand is the sum of all individual
demands.
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Utility Theory
o Economists assume that the more
pleasure a product gives, the higher price
buyers are willing to pay.
o Students who like butter are willing to pay
more for buttered popcorn than nonbuttered popcorn because it offers more
total utility.
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Total Utility
o Utility is the pleasure or satisfaction
obtained from a good or service.
o Total utility is the amount of satisfaction
obtained from entire consumption of a
product.
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Marginal Utility
o 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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Law of Diminishing Marginal Utility
o The marginal utility of a good declines as
more of it is consumed in a given time
period.
o A student who enjoys popcorn can eat all
he/she wants for free:
o The first box consumed is very rewarding.
o The second box is good.
o The third box is decent, etc.
o After eating the sixth box, he/she gets sick.
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Law of Diminishing Marginal Utility
o Did the sixth box increase his/her
satisfaction?
o No, it had a negative marginal utility.
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Law of Diminishing Marginal Utility
o As long as the marginal utility is positive,
the consumer receives additional
satisfaction and total utility increases.
o Additional quantities of a good yield
increasingly smaller increments of
satisfaction.
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Utility Theory
o An absolute measure of utility is not
possible because the perception of
satisfaction differs among individuals.
o Diminishing marginal utility is a common
experience.
o It is a sufficient basis for economic
predictions of consumer behavior.
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Utility Theory
o Why do we waste water even though it is
vital to human life?
o We consume so much water that additional
water offers little (if any) marginal utility.
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Price and Quantity
o Many forces determine how much we are
willing to buy.
o Economists focus on the relationship
between price and quantity rather than
trying to explain all the forces at once.
o This is the ceteris paribus (all other things
being equal) assumption.
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LO-1
Factors of Demand
o The concepts of marginal utility and
ceteris paribus explain the downward
slope of the demand curve.
o 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
o Therefore, according to the law of
demand, the quantity of a good
demanded in a given time period
increases as its price falls, ceteris paribus.
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The Demand Curve
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Price Elasticity
o The response of consumers to a change
in price is measured by the price elasticity
of demand.
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Price Elasticity
o 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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LO-2
Price Elasticity
o The price of popcorn goes up 20% and
the quantity demanded goes down 10%.
o The price elasticity of demand is:
percentage change in
quantity demanded
–10%
(E) =
=
= – 0.5
percentage change
20%
in price
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Elastic versus Inelastic Demand
o Demand can be elastic, inelastic, or
unitary elastic.
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Elastic Demand
o Demand is elastic if the absolute value of
E is greater than 1.
o Consumer response is large relative to the
change in price.
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Inelastic Demand
o Demand is inelastic if the absolute value
of E is less than 1.
o Consumers are not very responsive to
price changes.
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Unitary Elastic Demand
o Demand is unitary elastic if the absolute
value of E equals 1.
o The percentage change in quantity
demanded is equal to the percentage
change in price.
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Elasticity Estimates
o Products that have an elastic demand are
airline travel, fresh fish, and new cars.
o Products that have an inelastic demand
are cigarettes, gasoline, and coffee.
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Price Elasticity and Total Revenue
o Price elasticity explains why producers
cannot charge the highest possible price.
o Higher prices may actually lower total
sales revenue.
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Price Elasticity and Total Revenue
o Total revenue - the price of a product
multiplied by the quantity sold in a given
time period.
Total revenue = price x quantity sold
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Elasticity and Total Revenue Graph
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Elasticity and Total Revenue
o A price cut decreases total revenue if
demand is price inelastic.
• A price cut increases total revenue if
demand is price elastic.
• A price cut does not change total revenue
if demand is unitary elastic.
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Determinants of Price Elasticity
o Differences in price elasticity are
explained by several factors:
o Necessities versus Luxuries
o Availability of Substitutes
o Price Relative to Income
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Necessities versus Luxuries
o Some goods are so critical to our
everyday life that we regard them as
necessities.
o Demand for necessities is relatively
inelastic.
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Necessities versus Luxuries
o 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.
o Demand for luxury goods is relatively
elastic.
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Availability of Substitutes
o The greater the availability of substitutes,
the higher the price elasticity of demand.
o The smaller the availability of substitutes,
the lower the price elasticity of demand.
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Price Relative to Income
o If the price of a product is very high
relative to the consumer’s income, the
demand will tend to be elastic.
o If the price of a product is very low relative
to the consumer’s income, the demand
will tend to be inelastic.
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Substitute Goods and
Complementary Goods
o Substitute Goods:
o The demand for a substitute good increases
when the price of the product goes up.
o Complementary Goods:
o The demand for a complementary good
decreases when the price of the product goes
up.
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Changes in Income
o Income is a determinant of demand.
o We illustrate income changes with shifts
of the demand curve.
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Caveat Emptor: The Role of Advertising
o Advertising campaigns are often designed
to exploit our senses and lack of
knowledge.
o Caveat emptor means “let the buyer
beware.”
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Are Wants Created?
o Advertising is not the only reason
consumption has increased.
o Personality and social interaction
dynamics have changed how much we
consume.
o A successful advertising campaign is one
that shifts the demand curve to the right.
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LO-5
Consumer
Demand
End of Chapter 4
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