Demand: The Benefit Side of the Market

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Chapter 5

• Demand The Benefit Side of the Market

2
Outline

• State the Law of Demand (LoD) and relate the LoD
  to the Benefit-Cost Principle
• Apply the Benefit-Cost Principle to important
  decisions facing consumers
• Measuring responsiveness by elasticity
• Examine how price elasticity of demand determines
  the relationship between the amount spent on a
  good and its price

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Law of Demand (Lod)

• In markets, price rations goods and services
  among competing users
• The demand curve is a relationship between the
  quantity demanded and all costs, monetary and
  non-monetary
• Law of Demand
• People do less of what they want to do as the
  cost of doing it rises

4
Law of Demand and the Benefit-Cost Principle

• Reservation Price is the highest price that we
  would be willing to pay for the marginal unit.
• Demand curve gives ones reservation price for
  the marginal unit at each quantity. That is also
  the the marginal benefit of that unit
• Pursue an action if and only if its added
  benefits are at least as great as its added costs

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Major Decisions for Individuals

• Allocation of time between work and leisure
• Allocation of income between consumption now and
  future consumption (saving)
• Allocation of current expenditure between
  different goods.

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Needs vs. Wants

• Once we have achieved bare subsistence levels of
  consumption, economists speak only in terms of
  wants
• Helps us focus on the correct solutions to
  problems

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Utility

• People purchase goods for the satisfaction that
  they derive from their consumption
• Utility represents the satisfaction people derive
  from consumption activities
• Utility Maximization refers to people trying and
  allocate their incomes to maximize their
  satisfaction
• Normally, the more we consume, the more utility
  we have

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Lamars Total Utility from Ice Cream Consumption
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Marginal Utility

• The additional utility gained from consuming an
  additional unit of the good
• The Law of Diminishing Marginal Utility
• As consumption of a good increases beyond some
  point, the additional utility gained from an
  additional unit of the good tends to decline

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Allocating Expenditure between Two Goods

• Consumer has a fixed amount of funds to spend on
  two goods. How should the funds be allocated
  between the two goods so as to maximize utility?
• The Benefit-Cost Principle says to equate the
  marginal benefits for the two goods or
  activities. (Remember, if they are not equal you
  can increase utility by shifting spending away
  from the one with the lower marginal benefit to
  the one with the higher marginal benefit.)

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Optimal Combination

• The marginal benefit for a good is the marginal
  utility per dollar of expenditure on that good
  which is the marginal utility of the good divided
  by the price.
• Allocate the funds so that the added utility from
  spending an additional dollar on one good is the
  same as that from spending the dollar on the
  other good. Gives the rational spending rule.

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Rational Spending Rule

• Spending should be allocated across goods so that
  the marginal utility per dollar is the same for
  each good

• the marginal utility per dollar

• The ratio of marginal utility to price must be
  the same for each good the consumer buys

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The Demand Curve

• Suppose the consumer has chosen the best
  combination. How would the combination change if
  the price of one good in ( say, cones)
  increased?
• Then, the marginal benefit from sundaes would be
  greater than the marginal benefit from cones.
  Balance is restored by reducing the consumption
  of cones and increasing the consumption of
  sundaes. We get a negative relationship between
  quantity demanded of cones and price or the LoD!

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Role of Substitution

• When the price of a good or service goes up
• Rational consumers seek out less expensive
  substitutes
• When prices return to their original levels
• People often return to the original good

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Real vs. Nominal

• Nominal Price
• The absolute price in dollar terms
• Real Price
• The dollar price relative to the average dollar
  price of all other goods and services

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Equation for a Straight Line Demand Curve

• P is for the price of the good
• Q is for the quantity demanded
• b is the vertical intercept
• m represents the slope

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The Market Demand Curve for Canned Tuna
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Total Expenditure

• Total Expenditure equals
• The number of units sold multiplied by the price
  of the good
• Total Expenditure Total Revenue
• The dollar amount that consumers spend on a
  product is equal to the dollar amount that
  sellers receive

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How does the Amount Spent on a Good change when
its Price Increases?

• From LoD we know that quantity demanded
  decreases. But expenditure is quantity times
  price and it can increase, decrease, or stay the
  same!
• You pay more for the units that you buy, which
  increases expenditure, but you buy fewer units,
  which decreases expenditure.
• What can be said?

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Key Relationship

• Change in expenditure change in price
  change in quantity
• We need to know the percentage in quantity that
  results from the percent change in price, ceteris
  paribus?

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Price Elasticity of Demand

• In order to predict what will happen to total
  expenditures,
• We must know how much quantity will change when
  the price changes
• Price elasticity of demand is
• the percentage change in the quantity demanded
  that results from a one-percent change in its
  price

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Calculating Price Elasticity

• We need the ratio of the change in quantity to
  the change in price or
• Eta (change in Q)/( change in p)
• 100(DQ/Q)/100(DP/P)
• (DQ/DP)x(P/Q)
• (1/slope)x(P/Q)

D stands for change in
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Elasticity and the Demand Curve
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Calculating Price Elasticity of Demand
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A Easy Way to Calculate Elasticity

• Slope - 20/5 or - (20-8)/3
• Price 8
• Quantity 3
• Elasticity (P/Q)(-1/slope)(8/3)(-3/(20-8))
• - 8/(20-8) - 2/3
• Note elasticity P/(max P P)
• Can be read from graph!

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What Happens to the Amount Spent on a Good when
its Price Increases?

• It all depends on the direct price elasticity of
  demand !
• Key relationship
• Change in expenditure change in price
  change in quantity

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Terminology

• If the change in quantity exceeds the percentage
  change in price we say that demand is elastic.
• If the change in quantity is less than the
  percentage change in price, we say that demand is
  inelastic.
• If they are equal, we say demand is of unitary
  elasticity.

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Price Elasticity

• Elastic
• price elasticity is numerically greater than one
• Inelastic
• price elasticity is numerically less than one
• Unit elastic
• price elasticity equals one
• When calculating price elasticity of demand, you
  will always get a negative
• For convenience we will take the absolute value

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Price Elasticity and Expenditures

• For an elastic product
• Quantity demanded is highly responsive
• Percentage change in quantity dominates
• An increase in price will reduce total
  expenditure
• A decrease in price will increase total
  expenditure
• For an inelastic product
• Quantity demanded is not responsive
• Percentage change in price dominates
• An increase in price will increase total
  expenditure
• A decrease in price will decrease total
  expenditure

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Determinants of Price Elasticity

• Substitution possibilities
• Price elasticity of demand will be relatively
  high if it is easy to substitute between products
• Budget share
• The larger the share of the budget tend to have
  higher price elasticities of demand
• Time
• Because substitution takes time, price elasticity
  will be higher in the long run than in the short
  run

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Other Elasticities of Demand

• Income Elasticity of Demand
• The amount by which the quantity demanded changes
  in response to a one-percent change in income
• Cross Price Elasticity of Demand
• The amount by which the quantity demanded of one
  good changes in response to a one-percent change
  in the price of another good

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Perfect Elasticity

• Perfectly Elastic demand
• Price elasticity of demand is infinite
• Even the slightest change in price leads
  consumers to find substitutes
• Perfectly Inelastic demand
• Price elasticity of demand is zero
• Consumers do not switch to substitutes even when
  price increases dramatically

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Perfectly Elastic and Perfectly Inelastic Demand
Curves
34
The Effect of Extra Border Patrols on the Market
for Illicit Drugs