Demand and Price Determination

7/29/2019 Demand and Price Determination

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Demand and Price Determination

There are several names used to describe the

US Economy

Free Enterprise

Free Market

Capitalistic

Private Enterprise

Price Directed


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The American Economy There are three components in the American

economic system that make it unique, and that allowthe price directed nature to drive the economy.

1. Price System2. Private Property

3. Competition

These features are called the Pillars of Private

Enterprise.


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Price Directed Economy

In a market economy, price serves two

important functions

1. Price motivates production.


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Price Directed Economy

In a market economy, price serves twoimportant functions

1. Price motivates production.2. Price rations goods


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In order to establish price, a market depends

upon the interaction between sellers

(producers) and buyers (consumers).

The market forces that influence the actions

of these two groups are known as Supply and

Demand.

We will be concentrating upon Demand, since

most of us are more familiar with acting as

consumers.


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Demand

Demandis defined as the overall willingness ofconsumers to purchase (or consume) a given quantity

of a given good(or service) at a given price, a givenplace and a given time.

We will generally assume that place and time are

constant (even though we know they are not).

This definition means that demand includes all goods, atany price. A change in price has no effect upon

demand, since demand includes all possible prices.

Demand can be affected by a change in any factor otherthan price.


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Quantity Demanded is defined as

the actual amount that will

be bought (or consumed) oncethe price is specified.

This means that quantity demanded is tied toa price, and any change in price will result in a

change in quantity demanded.


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The Law of Demand

The Law of Demand states that as price rises, quantity

demanded will fall. As price falls, quantity demandedwill rise.

The law reflects the inverse relationship between price and quantity

demanded.There are three proofs of the Law of Demand:

1. The Law of Diminishing Marginal Utility At some

point during consecutive consumption of likeobjects, the utility received from consumption of an

additional unit will be less than the utility received

from consumption of the previous unit.


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2. The Income Effect Since income is relatively

fixed, as prices rise, one can no longer afford to buythe same amount of a good, so quantity demanded

falls. Inversely, as price falls, one can buy more with

the same income, so quantity demanded rises.


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3. The Substitution Effect As prices rise, we

tend to substitute less expensive alternatives,

thus quantity demanded (for the original good)

goes down.


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Exceptions to the Law of Demand

1. Speculative Purchases

-Goods bought with the intent to resell.

Increasing price can prove to buyers that the

product is a good investment, and inspire

them to buy more.


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2. Immature Markets

-As a market develops, shortages can cause

prices to rise while demand is still increasing.

If there is enough time, the market will catch

up, producing more items to satisfy that

demand. Before the market catches up,

people will continue to buy more even thoughprices are rising.


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3. Luxury Goods

- Some items are bought not because of what

they are, but rather because of the message

they send. In those cases, an increasing price

can make the item more attractive, and

quantity demanded will rise even though the

price is increasing. These items are also knownas Veblen Goods.


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Demand Curves

We can create values for a graph by creating a Demand

Schedule, a chart that shows different prices, and the

Quantities Demanded that correspond to each price.

Demand Schedule

Price Qd

$1....300

$2.200

$3.100


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Demand Curves

We can use the Demand Schedule to

emphasize the difference between changes inDemand and changes in Quantity Demanded.

Demand Schedule

Price Qd$1....300

$2.200

$3.100

Since Demand represents the

overall willingness to buy, itencompasses all three prices.

As the price changes, note

that you simply move to a new

Quantity Demanded, whileoverall Demandis unchanged.

Now we can take the values from the Demand Schedule,

and apply them to the xy graph.


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Demand Curves

We can now take the data points provided by the price and

quantity demanded that corresponds to that price, and plotthose points onto an XY graph.

The Y values will be price, the X values will be quantity,

resulting in a graph that looks like this


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Demand CurvesA normal Demand Curve will always take a downward slope.

0

0.5

1

1.5

2

2.5

3

3.5

0 100 200 300 400

Price

Quantity

D


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Change in Quantity Demanded

0

0.5

1

1.5

2

2.5

3

3.5

0 100 200 300 400

Price

Quantity

D


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8 Determinants of Demand

1. in Seasons


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1. in Seasons

2. in Consumer Preference


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1. in Seasons


3. in Perceived Utility


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1. in Seasons



4. in Income (Normal/Inferior)


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1. in Seasons




5. in Price of Substitutes


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1. in Seasons





6. in Price of Complements


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1. in Seasons






7. in Consumer Expectations


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1. in Seasons



4. in Income (Normal/Inferior)5. in Price of Substitutes


7. in Consumer Expectations

8. in Market Size


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Price Elasticity of Demand

A measure of the responsiveness of quantitydemanded to changes in price.

We know that price will cause quantity demanded to

change, and we know that quantity demanded willchange in the opposite direction from price. What wedont know is how much quantity demanded will

change.

There are other types of elasticity, but we will only beconcerned with price elasticity at this point.


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Three Possible States of Elasticity1. Inelastic - % P>% Qd


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2. Unitary Elasticity (or Unit Elastic) - % P=% Qd


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2. Unitary Elasticity (or Unit Elastic) - % P=% Qd

3. Elastic (or Highly Elastic) - % P


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Testing for Inelasticity

Three Qualifications for Inelasticity

If a good has any of these qualities, it will be an inelastic good. If it

has none of these, then it will be elastic (or highly elastic).

1. It is a necessity.


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1. It is a necessity.

2. There is no close substitute.


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1. It is a necessity.2. There is no close substitute.

3. It is so inexpensive that it occupies an

insignificant portion of the budget.


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Price Elasticity of Demand Point Test Calculate the percentage change in price and in quantity demanded

and compare to the formula.

Demand Schedule

Price Qd

$1....300

$2.150

$3.100

1. Inelastic - % P>% Qd2. Unitary Elasticity (or Unit Elastic) - % P=% Qd



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Demand Schedule

Price Qd

$1....300

$2.150

$3.100

Demand Schedule

Price Qd

$1....300

$2.200

$3.150




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Demand Schedule

Price Qd

$1....300

$2.150

$3.100

Demand Schedule

Price Qd

$1....300

$2.200

$3.150




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Total Revenue Test Multiply Price x Quantity Demanded to

calculate Total Revenue.

Demand Schedule

Price Qd TR$1....300 = 300

$2..200 = 400

$3..150 = 450


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calculate Total Revenue. If TR rises as price rises, then the good is inelastic.

Demand Schedule

Price Qd TR$1....300 = 300

$2..200 = 400

$3..150 = 450


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calculate Total Revenue. If TR declines as price rises, then the good is elastic.

Demand Schedule

Price Qd TR$1....300 = 300

$2..100 = 200

$3....50 = 150


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calculate Total Revenue. If TR remains constant as price rises, then the good is unit elastic.

Demand Schedule

Price Qd TR$1.....300 = 300

$2..150 = 300

$3..100 = 300


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calculate Total Revenue. ????

Demand Schedule

Price Qd TR$1....300 = 300

$2..125 = 250

$3..100 = 300


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Proving Elasticity or Inelasticity

The Coefficient of Elasticity

i l i i f d


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If the % change in quantity demanded is a larger number

than the % change in price, then the coefficient will be

greater than 1.

By definition, this identifies an Elastic Good, so any time

the coefficient is a positive number greater than one, the

good must be Elastic.

The greater the value above 1, the greater the degree of

elasticity.

P i El i i f D d


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If the % change in quantity demanded is a smaller

number than the % change in price, then the coefficient

will be less than 1.

By definition, this identifies an Inelastic Good, so any

time the coefficient is a value less than 1, the good must

be inelastic.

The greater the value below 1, the greater the degree of

inelasticity.

P i El i i f D d


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If the % change in quantity demanded is an equal

number to the % change in price, then the coefficient

will be exactly 1.

By definition, this identifies a Unit Elastic Good, so any

time the coefficient is exactly one, the good must be unit

elastic.

A coefficient value of 1 is unusual, but not impossible.

It is no more or less likely an occurrence than any other

single point in the range.


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Demand Curve for an Elastic Good

Price

Quantity

>45

D

f l


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Demand Curve for an Inelastic Good

Price

Quantity

>45

D

d f l d


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Demand Curve for a Unit Elastic Good

Price

Quantity

= 45

D

Perfectly Inelastic


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Perfectly Inelastic

and

Perfectly ElasticThere are two theoretically possible states of elasticity, that result in

either an % change in quantity demanded or a 0% change in quantity

demanded.

0

0.5

1

1.5

2

2.5

3

3.5

0 100 200 300

Price

Quantity

0

0.5

1

1.5

2

2.5

3

3.5

0 100 200 300 400

Price

Quantity

= 0 degrees

=90

degrees

D

Ch i El ti it


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Change in Elasticity

0

0.5

1

1.5

2

2.5

3

3.5

0 100 200 300 400

Price

Quantity

Demand and Price Determination

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