Chapter 4 Product Market Demand

1
Chapter 4 Product Market
Demand

• This chapter examines the major causes of the
  Demand for a specific good its own price, the
  prices of related goods, tastes, and consumer
  income.
• Also we distinguish between the qualitative
  (direction of change) versus the quantitative
  (elasticity) effects of a ceteris paribus change
  in each of these causes.

2
Price and Quantity Demanded Direction of Change

• Recall the goods own price (P) is a cause of
  quantity demanded of that good (Q).
• Qualitative Effect P? ? QD?.
• Qualitative Effect measures direction of
  change.

3
Underlying Reason Inverse Relationship

• Consumer maximizes utility subject to their
  budget constraint when MU1/P1 MU2/P2
• If P1?, then consumer should rebalance by MU1? to
  make the ratio equal across goods again.
• Given diminishing Marginal Utility, this is done
  by having Q1?.

4
Own Price Elasticity of Demand

• Own Price Elasticity of Demand (?) measures the
  magnitude of responsiveness of quantity demanded
  of a good to changes in its own price. In other
  words, the Quantitative Effect of a change in
  price on the quantity demanded of that good.

5
Own Price Elasticity of Demand (?) A Formula

• ? Percentage Change in QD
• Percentage Change in P .
• Always has positive sign.
• Ratio of percentage changes instead of slope,
  makes it a unit-free measure.

6
Price Inelastic Goods

• Price Inelastic Goods have ? lt 1. These goods
  are unresponsive to changes in their own price.
• Example suppose that if the Price of Milk
  increases by 10, Quantity Demanded of Milk goes
  down by 3.
• Then, for Milk, ? -3/10 0.3.

7
Price Elastic Goods
and Unitary Price Elasticity

• Price Elastic Goods have ? gt 1. These goods are
  responsive to changes in their own price.
• Example suppose that if the Price of Cars
  increase by 10, Quantity Demanded of Cars goes
  down by 18.
• Then, for Cars, ? -18/10 1.8.
• Unitary Price Elasticity ? 1.

8
What Features Make Goods Price
Inelastic or Elastic?

• Necessity versus Luxury
• Number and Quality of Available
  Substitutes
• Time Frame
• Price Relative to Wealth or Income

9
Own Price Elasticity The Demand Curve

• Price Inelastic goods are described with steep
  demand curves. The vertical demand curve is the
  extreme case of ? 0.
• Price Elastic goods are described with flat
  demand curves. The horizontal demand curve is
  the extreme case of ? ?.

10
Own Price Elasticity and Equilibrium

• Consider an equilibrium, where Demand equals
  Supply.
• Supply shifts (rightward or leftward) change the
  equilibrium, accomplished by moving along the
  existing demand curve.
• Therefore the new equilibrium quantity can be
  compared to the original one by means of own
  price elasticity.

11
Own Price Inelasticity and Total Revenue of Firms

• Total Revenue (TR)
• (Price of Good)x(Quantity Sold),
• 
  or TR PxQ.
• This relationship implies that, in percentage
  change terms
• ( Change in TR)
• ( Change in P) ( Change in Q).

12
Own Price Elasticity and Increasing the Price

• Consider our two goods milk (? 0.3), and cars
  (? 1.8). Suppose that supply shifts so that
  the price of each increases by 10.
• Change in TR of Milk
• 10 -3 7.
• Change in TR of Cars
• 10 -18
  -8.

13
Own Price Elasticity and Decreasing the Price

• Consider again our two goods milk (? 0.3),
  and cars (? 1.8). Suppose supply shifts so
  that the price of each decreases by 10.
• Change in TR of Milk
• -10 3
  -7.
• Change in TR of Cars
• -10 18
  8.

14
Application What Goods Should Have a Sales Tax?

• Sales tax tax on supply.
• Firms try to pass it on to consumers.
• Consider the contrast between a sales tax on a
  price inelastic good versus a sales tax on a
  price elastic good.
• What is the governments goal collect tax
  revenue or significantly reduce the quantity
  traded?

15
Another Cause of Demand Prices of Related Goods

• Consider, for example, the Demand
  for Coffee.
• Affected by prices of related goods in two
  different ways.
• -- PDONUTS? ? QCOFFEE?
• (Complements)
• -- PTEA? ? QCOFFEE ?
• (Substitutes)

16
Cross Price Elasticity

• Cross Price Elasticity (?1x2) measures the
  responsiveness of demand to changes in the prices
  of complements or substitutes.
• ?1x2 Percentage Change in Q2
• Percentage Change in P1 .

17
Interpreting Cross Price
Elasticity

• ?1x2 Percentage Change in Q2
• Percentage Change in P1 .
• Sign of ?1x2 describes whether the related good
  is a complement (negative) or substitute
  (positive).
• Absolute Value of ?1x2 describes the magnitude of
  response. ?1x2 lt 1 describes an inelastic
  response, while ?1x2 gt 1 describes an elastic
  response.

18
Cross Price Elasticity A Numerical
Example

• Suppose that, for coffee
• ?DONUTSxCOFFEE -0.4
• Negative sign ? Donuts are a
• complement. Absolute value lt 1
• ? Inelastic, or unresponsive.
• ?TEAxCOFFEE 1.5
• Positive sign ? Tea is a
• substitute. Absolute value gt 1
• ? Elastic, or responsive.

19
Cross Price Elasticity and Dependence of Markets

• Consider the markets (i.e. Demand and Supply) for
  Gasoline, Cars, and Ethanol.
• Gasoline and Cars are Complements (PGAS? ? QCARS?
  ).
• Gasoline and Ethanol are Substitutes (PGAS? ?
  QETHANOL? ).

20
Cross Price Elasticity and Dependence of Markets

• Suppose the government decides to put a
  substantial sales tax on gasoline (or another
  supply disruption).
• Decreases supply of gasoline, described by
  shifting supply curve for gas leftward ? PGAS?,
  QGAS?.

21
Cross Price Elasticity and Dependence of Markets

• The move also has effects in the markets for cars
  and ethanol.
• Decreases demand for cars, described by shifting
  the demand curve for cars leftward ? PCARS ?,
  QCARS?.
• Increases demand for ethanol, described by
  shifting the demand curve for ethanol rightward
  ? PETHANOL?,
  QETHANOL? .
• Cross Price Elasticity describes size of shifts
  for cars and electricity.

22
Another Cause of Demand Consumer Income

• The Demand for most goods is affected by changes
  in the consumers income (I).
• -- I? ? Q? (Normal Goods)
• -- I? ? Q? (Inferior Goods)

23
Income Elasticity

• Income Elasticity (?I) measures the
  responsiveness of demand to changes in consumer
  income.
• ?I Percentage Change in QD
• Percentage Change in I .

24
Interpreting Income
Elasticity

• ?I Percentage Change in QD
• Percentage Change in I .
• Sign of ?I describes whether the good is a normal
  good (positive) or inferior good (negative).
• Absolute Value of ?I describes the magnitude of
  response. ?I lt 1 describes an inelastic
  response, while ?I gt 1 describes an elastic
  response.

25
Income Elasticity A Numerical
Example

• Suppose that
• For Tuna Helper, ?I -1.4.
• Negative sign ? inferior good.
  
• Absolute value gt 1
  ? Elastic, or responsive.
• For Apples, ?I 0.5.
• Positive sign ? normal good.
• Absolute value lt 1
• ? Inelastic, or unresponsive.

26
Income Changes Graphical Description

• Since income is another cause of demand,
  changes in income are described as shifts of the
  demand curve.
• Since it shifts the Demand curve, changes in
  consumer income affect P and Q as well.

27
Income Changes Graphical Description

• For normal goods (?I gt 0), I? ? QD?.
• Therefore, one describes an increase in income as
  a rightward shift in the demand curve.
• For inferior goods (?I lt 0), I? ? QD ?.
• Therefore, one describes an increase in income as
  a leftward shift in the demand curve.
• Absolute value of income elasticity describes
  size of shift.

28
Individual Versus Market Demand

• The Market Demand for any good is obtained by
  summing up the individual demands for all the
  consumers for this good.
• Example consider the demand for apples.
• Suppose the demanders consist of two people, me
  and you.

29
Demand for Apples

• Price () Me You Market
• 0.20 25 8 33
• 0.25 23 7 30
• 0.30 21 6 27
• 0.35 19 5 24
• 0.40 17 4 21
• 0.45 15 3 18

30
Causes Market
Demand For a Good

• Price of Good
• Price of Related Goods
  (Substitutes or Complements)
• Consumer Income
  (Normal or Inferior Good)
• Tastes
• Number of buyers in the market (Market Demand
  only)

31
Demographics and Market Demand for Goods

• Changing population needs and preferences lead to
  changes in the number of participants.
• Example aging of baby boomers.
• Decreases in market demand (shifts leftward) for
  fast food, adult soccer leagues, starter homes.
• Increases in market demand (shifts rightward) for
  fresh fruits, walking sneakers, retirement
  condos.