Chapter 5 Demand: The Benefit Side of the Market.

Chapter 5

Demand: The Benefit Side of the Market

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

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

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 one’s 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

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.

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

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

Lamar’s Total Utility from Ice Cream Consumption

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

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.)

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.

Rational Spending Rule

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

MU

P

MU

PC

C

S

S

the marginal utility per dollar =MU

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

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!

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

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

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

P b mQ

The Market Demand Curve for Canned Tuna

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

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?

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?

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

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

Elasticity and the Demand Curve

Calculating Price Elasticity of Demand

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!

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

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.

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

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

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

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

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

Perfectly Elastic and Perfectly Inelastic Demand Curves

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