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CHAPTER 4: DEMAND [2] CHAPTER 4: DEMAND [2]


2
Luxury goods and necessary goods
In general, Engel curves do not have to be straight lines. That is,
the relationship between income and consumption needs not be
linear.
If the demand for a good goes up by a greater proportion than
income, we say that it is a luxury good, and if it goes up by a
lesser proportion than income we say that it is a necessary
good.
Of course, both luxury goods and necessary goods are
normal goods.
On the other hand, we have the case of inferior good if
the demand goes down as income increases.
3
Own price effect VS. Cross price effect
Suppose that we decrease the price of good X
P
X
Y
X
As p
X
decreases, the
demand quantity for
good X increases.
In this case, we say good
X is an ordinary good.
As p
X
decreases, the
demanded quantity for
good Y decreases.
In this particular case,
good Y is a substitute
of good X.
4
Income and Substitution effects of own price
change
When the price of good X changes, the change in the
consumption of good X can be broken to two effects:
The substitution effect and the income effect.
The substitution effect is that component of the total effect
of a price change that results from the associated change
in the relative attractiveness of other goods.
The income effect is that component that results from the
associated change in real purchasing power.
To decompose the total effect we begin by asking: How
much income would the consumer need to reach his
original indifference curve?
If the consumer were given a total income of that amount, it
would undo the injury caused by the loss of purchasing
power.
5
Income and Substitution effects of own price
change
In the following example the price of shelter increases from
$6 per sq yd/wk to $24.
As a result shelter consumption decreased from 10 sq
yd/wk to 2.
How do we brake the change?
6
The Substitution and Income
Effects of a Price Change
To get the substitution
effect slide the new budget
B
1
outward Parallel to itself
until it becomes tangent to
the original indifference
curve I
0
.
The movement from A to C
reflects The substitution
effect.
The movement from C to D
reflects the income effect. It
is the reduction in shelter
that results from the loss in
purchasing power.
7
The Substitution and Income
Effects of inferior good
By contrast to the case of a normal good, the income effect in
an inferior good acts to offset the substitution effect
8
Income change: A brief review
Income changes have the effect of shifting the budget line in
a parallel fashion.
From the apparatus of indifference curves, we derive the income
expansion path, describing how the optimal consumption bundle
changes as we change the income.
If we focus onl y on good X,
then we derive the Engel
curve for the good,
describing how the optimal
consumption of good X
changes as we change the
income.
For income changes, we can
have two possible cases:
(1) the normal good case
(2) the inferior good case
9
Own price change: A brief review
Own-price changes have the effect of pivoting the budget line.
From the apparatus of indifference curves, we derive the price
offer curve, describing how the optimal consumption bundle
changes as we change the price of the good in question.
If we focus onl y on the good
whose price has changed, then
we derive the demand curve for
that good, describing how the
optimal consumption of the
good changes as we change its
price.
For own-price changes, we can
have two possible cases:
(1) the ordinary good case
(2) the Giffen good case
10
Cross price change: A brief review
good X is a
substitute
for good Y
p
Y
x
good X is a
complement
to good Y
p
Y
x
11
MARKET DEMAND MARKET DEMAND
12
Here we see how to add up individual
choices to get total market demand.
Once we have derived the market demand curve,
we will examine some of its properties, such as the
relationship between demand and revenue.
Introduction
We have seen in earlier chapters how to model individual
consumer choice.
13
From indi vidual to market demand
Let us use X
1
(p
X
, p
Y
, M
i
) to represent consumer i's demand
function for good X, and Y
i
(p
X
, p
Y
, M
i
) consumer i's demand
function for good Y.
Suppose that there are n consumers.
Then the market demand for good X, also called the
aggregate demand for good X, is the sum of these individual
demands over all consumers:
) , , ( ) ,......, , , (
1
1 i Y X
n
i
i n Y X
M p p X M M p p X

=
=
The analogous equation holds for good Y:
) , , ( ) ,......, , , (
1
1 i Y X
n
i
i n Y X
M p p Y M M p p Y

=
=
14
) , , ( ) ,......, , , (
1
1 i Y X
n
i
i n Y X
M p p X M M p p X

=
=
Since each individual's demand for each good
depends on prices and his money income:
The aggregate demand will generally depend on prices and
the distribution of incomes (M
1
, M
2
, ., M
n
).
But, to know the distribution of incomes, we need a lot of data.
So, it is sometimes convenient to think of the aggregate
demand as the demand of some " representative " representative
consumer" consumer" who has an income that is just the sum of all
individual incomes.
15
The representative consumer
It is convenient to ignore income distribution issues and
think of the aggregate demand as the demand of some
" representative consumer" who has an income that is just
the sum of all individual incomes.
The aggregate demand function will change from:
to:


=
=

=
n
i
i
i Y X
n
i
i Y X
M M where
M p p x M p p X
1
1
1 1
), , , ( ) , , (
Under this
representative
consumer
assumption, the
aggregate demand
in the economy is
just like the
demand of some
individual who
faces prices (p
X
,p
Y
)
and has income M.
That is, the distribution of income does
not matter! Only the sum matters.
) , , ( ) , , (
1
i Y X
n
i
i Y X
M p p X M p p X

=
=
16

= =
=
n
i
i i Y X
n
i
i Y X
M M where M p p X M p p X
1 1
), , , ( ) , , (
If we hold constant the aggregate income M and p
2
:
) , ( M p p X
Y X
p
X
X
aggregate demand
curve for good 1
) , ( M p p X
Y X
Note that the demand
curve is drawn holding
all other prices and
incomes fixed.
If income and other
prices change, the
aggregate demand
curve will shift.
17
p
X
X
aggregate demand
curve for good X
) , ( M p p X
Y X
For example, if goods X and Y are substitutes, then
we know that increasing p
Y
will tend to increase the
demand for good X whatever its price.
This means that
increasing the price of
good Y will tend to shift
the aggregate demand
curve for good X outward.
On the other hand, if
goods X and Y are
complements, increasing
the price of good Y will
shift the aggregate
demand curve for good X
inward.
good X and
good Y are
substitutes
18
p
X
X
aggregate demand
curve for good X
) , ( M p p X
Y X
If good X is a normal
good, there will be an
inward shift in the
demand curve.
Now, suppose that there is a reduction in the income.
On the other hand, if
good X is an inferior
good, the demand curve
will shift out.
good X is a
normal good
19
The inverse demand function
We can look at the aggregate demand curve as giving us
quantity as a function of price: direct demand function, q(p).
This function measures what the quantity demanded would
have to be if the price is at the level p.
Al ternativel y, we can look at the aggregate demand curve as
giving us price as a function of quantity: inverse demand
function, p(q).
This function measures what the market price for the good
would have to be for q units of it to be demanded.
20
Elasticity
q q p po m = ( , ) It is often of useful to have a
measure of how " responsive"
demand is to a change in own
price.
p
q
aggregate demand for the
good in question
The first idea that springs to mind is to use the inverse of the
slope of a demand curve as a measure of responsiveness.
After all, the definition of
the slope of a demand
curve is the change in
price divided by change in
quantity demanded:
p
q
q
p
curve demand of slope

=
p
q
curve demand
of slope the of inverse

=
So, the inverse of the slope of a
demand curve looks like a measure
of demand responsiveness.
21
Well, it is a measure of responsiveness - but it suffers
one major drawback: It depends on the units in which
we measure price and quantity.
For example, if we measure demand in gallons rather
than in quarts, the slope becomes four times bigger, and
hence, one over slope becomes four times smaller.
It is convenient to consider a unit-free measure of
demand responsiveness.
Economists have chosen to use a measure known as
elasticity elasticity.
q
p
curve demand of slope

=
p
q
curve demand
of slope the of inverse

=
22
Own price elasticity of demand
The own-price elasticity of demand, , is defined to be
the percentage change in quantity demanded divided by
the percentage change in own price.

A 10 percent increase in
price is the same percentage
increase whether the price is
measured in American
dollars or English pounds.
Thus, measuring
increases in percentage
terms keeps the
definition of elasticity
unit-free.
q
p
p
q
p
p
q
q
p
p
q
q
p in
q in

100
100
%
%

23
=
%
%


in q
in p
% in q associated with 1% in p
=
30%
5%


in q
in p
6% in q associated with 1% in p
curve demand the of slope the q
p
q
p
p
q
Note
1
*
:
=

=
The own-price elasticity can be expressed as
the ratio of own price to quantity multiplied by
the inverse of the slope of the demand curve.
24
= =
%
%

in q
in p
q
q
p
p
p
q
q
p
The sign of the elasticity of demand is
generally negative, since demand
curves invariabl y have a negative slope.
- 2 or - 3
It is tedious to keep referring to a price elasticity of minus
something-or-other, so it is common in verbal discussion to refer
to price elasticities of 2 or 3, rather than -2 or -3.
To avoid confusion, we will keep
the signs straight in the
discussion by referring to the
absolute value of elasticity.
2 3 or
25
A 1%increase in the price of the good will cause
a 0.5%reduction in the demand quantity.

= - 0.5
= 05 .
Good X

= - 1.5
= 15 .
A 1% increase in the price of th good will cause
a 1.5% reduction in the demand quantity.
Good Y
Which of the two goods is more own-price elastic?
Good Y is more own-price elastic. The absolute value
of its own price elasticity is larger than that of good X.
26
OWN-PRICE: Elastic VS. Inelastic
A 1%increase in the price of the good will cause
a 0.5%reduction in the demand quantity.

= - 0.5
= 05 .
This good is own-price inelastic.

= - 1.5
= 15 .
A 1% increase in the price of the good will cause
a 1.5% reduction in the demand quantity.
This good is own-price elastic.

= - 1.0
= 10 .
A 1% increase in the price of the good will cause
a 1% reduction in the demand quantity.
The elasticity is unitary.
27
If a good has an own-price elasticity of demand greater than
1 in absolute value we say that it has an elastic demand.
If a good has an own-price elasticity of demand less than 1
in absolute value we say that it has an inelastic demand.
If a good has an own-price elasticity of demand of exactly 1
in absolute value we say that it has unit elastic demand.
The own-price elasticity of demand for an ordinary good is
a negative number because the demand curve is
downwardl y sloped.
However, the own-price elasticity of demand for a Giffen
good is a positive number because, in this case, the
demand curve is upwardly sloped.
28
elastic
inelastic
unitary
0
- infinity
+ infinity
-1
own-price elasticity
ordinary good
Giffen good
q
p
ordinary good
q
p
Giffen good
29
= =
p
q
q
p
p
q the slope of the demand curve

*
1
p
q
p
q
slope = - 0
slope = - infinity
elasticity = - infinity elasticity = - 0
Perfectl y Elastic Perfectl y Inelastic
The flatter the demand curve is, the more own-price
elastic is the demand.
30
p
q
p
q
flatter
steeper
That is, the flatter the demand curve is, the more
room there is for the quantity to adjustment.
The flatter the demand curve is, the more own-price
elastic is the demand.
31
Elasticity and close substitutes
Take our example of red pens and blue pens. Suppose that
everyone regards them as perfect substitutes. Then, red pens
and blue pens must sell for the same price.
Now think what would happen to the demand for red pens if
their price should rise, and the price of blue pens stays
constant.
Clearly the demand for red pens would drop to zero.
In other words, the demand for red pens is very elastic.
This is because it has a perfect substitute.
The own-price elasticity of demand for a good depends to
a large extent on how many close substitutes it has.
p
q
32
So what?
If a good has many close substitutes, we would expect that its
demand curve would be very responsive to its price changes.
That is, its demand would be very own-price elastic.
On the other hand, if there are few close substitutes for a good,
its demand curve would be very unresponsive to its price
changes.
That is, its demand would be very own-price inelastic.
33
Example: Own price elasticity of a LINEAR
DEMAND CURVE
Consider the linear demand curve: q = a - b p
p
q
1/slope = - b
If q = 0:
?
0 = a - b p
p = a / b
a/b
If p = 0:
? q = a
a
34
p
q
=

b
p
a bp
When p = 0, the own-price
elasticity of demand is zero.
= 0
When q = 0, p = a/b and the
own-price elasticity of demand
is (negative) infinity.
=
At what value of price is the
price elasticity of demand
equal to -1?
a/b
a
q = a - bp
bp a
p
b
q
p
b
p
q
q
p

= =

=
b
slope p
q
= =

1
= 0 =
??? 1 =
35
p
q
=

b
p
a bp
= 0
=
a/b
a
1 =

p b a
p
b
Well, let's set the elasticity to -1:
Solve the above for p:
b
a
p
2
=
= 0 =
??? 1 =
Substitute the solution for p to
the demand equation to find
the associated q:
2
a
q =
a
b 2
a
2
= 1
36
p
q
= 0
=
a/b
a
a
b 2
a
2
= 1
Except in special cases,
the magnitude of price
elasticity changes as one
moves along the demand
curve.
In other words, the magnitude
of price elasticity changes as
price changes.
= ( ) p
37
Evaluating own price elasticity at a sample point
Since the elasticity coefficient may vary along a demand
curve, It is not technically correct to say that the demand
for a commodity is own-price elastic or inelastic.
That is, demand may be own-price elastic or
inelastic only within some range of the data.
In making empirical computations, a common procedure
is to evaluate own-price elasticity of demand at the mean
of the data.
q
p
p
q
*

=
where are the price
and quantity demanded, evaluated
at the mean of the data.
q and p
38
250 , 20 , 4
, 5 , 3 , 2 Q
: are variables the of means sample The
beef
= = =
= = =
SPPD M P
P P
chicken
pork beef
Write down the formula for own-price elasticity of demand for beef.
Compute the own-price elasticity of demand for beef (evaluating
at the sample means). Is the demand elastic or inelastic? Is
beef an ordinary good or a Giffen good?
Suppose that the price of beef is projected to decrease by 2% next
month, what would be the percentage change in Q
beef
(demand)?
social and
demographic
variables
SPPD M P P P
chicken pork beef
01 . 0 04 . 0 01 . 0 03 . 0 5 . 0 01 . 0 Q
: products beef for equation demand following the Consider
beef
+ + + + =
income
39
PUT YOUR ANSWERS HERE
75 . 0
2
3
5 . 0
,
=
=

=
beef
beef
beef
beef
P Q
Q
P
P
Q
beef beef

5 . 0 =

beef
beef
P
Q
The coefficient associated with
P
beef
in the demand equation.
A 1% increase in P
beef
will be accompanied by a 0.75%
decrease in Q
beef
(demand).
The demand is inelastic, and beef is an ordinary good.
If P
beef
is to drop by 2%, Q
beef
will increase by 1.5%.
[(-2%) * (-0.75) = 1.5%]
40
Own price elasticity and industry revenue
Revenue is the price of a good times the
quantity sold of that good: R = p q
You are the only seller in the market and are thinking about
raising the price. What would happen to your revenue?
p q R
? or
It depends on how responsive the demand is to the price change.
If the demand drops a lot
due to the price increase,
revenue will fall.
If the demand drops only a little
due to the price increase,
revenue will increase.
This suggests that the direction of change in revenue has
something to do with the own-price elasticity of demand.
41
Change in industry revenue
R = p q
Let the price change to:
p p +
Let the quantity change to:
q q +
We have a new revenue of:
R p p q q
p q q p p q p q
new
= + +
= + + +
( ) ( )

Subtracting R from R
new
we have:
R q p p q p q = + +
42
R q p p q p q = + +
For small values of and , the last term can safel y
be neglected.
p q
a small number times
another small number
Thus, the expression for the change in revenue
can be approximated by:
q p p q R +
That is, the change in revenue is roughl y equal to the
original quantity times the change in price plus the original
price times the change in quantity.
43
R = p q
R q p p q p q = + +
q p p q R +
price
quantity
The original price and
quantity are p and q,
respectivel y.
p
q
Thus, the original
revenue is pq.
original
revenue, pq
When the price
increases, we add a
rectangular area on the
top of the box, which
is:
q p
p p +
q p
44
price
quantity
p
q
p p +
To reflect the
quantity
reduction, we
need to subtract
an area on the
side of the box,
which is: p q
q q +
original
revenue, pq
p q
The leftover part,
p q
is the little square
in the corner of
the box.
p q
This leftover part will be
very small relative to
the other magnitudes.
R q p p q p q = + +
q p p q R +
q p
45
So, there are two main effects on the revenue when one
increases the price:
Positive Effect: q p
p q Negative Effect:
Why is this second effect negative? q < 0
When will the net result of these two effects be positive? That
is, when will an increase in the price be followed by an increase
in the revenue?
Two effects on revenues
q p p q R +
46
R q p p q = +
??? 0 when will is, That > + q p p q
Divide the expression by
p
q p
q
p
+ >

0
q
q
p
q
q
p
+ >

0
p
q
q
p

> 1 > 1
< 1
0
- infinity
+ infinity
-1
inelastic
47
The revenue will increase as the price is increased if the
own-price elasticity of demand is less than 1 is absolute
value. That is, if the demand is own-price inelastic.
Inelastic:
p q
R
The revenue will decrease as the price is increased if
the own-price elasticity of demand is greater than 1 is
absolute value. That is, if the demand is own-price
elastic.
Elastic:
p q
R
If the price elasticity is unitary, what would happen to
the revenue when price increases?
48
Demand is Own
Price Inelastic:
p q
Demand is Own
Price Elastic:
p q
Quantity is not responsive to the price change.
inelastic
demand
Quantity is responsive to the price change.
elastic
demand
NOW, THE OTHER SIDE OF THE MIRROR:
IS THE PRICE RESPONSIVE TO A CHANGE IN
QUANTITY? [PRICE FLEXIBILITY]
Price is responsive to the quantity change. flexible
price
Price is not responsive to the quantity change.
inflexible
price
49
Marginal revenue and own price elasticity
Marginal Revenue is the additional
revenue to an additional unit of output.
M R
R
q

We saw earlier that the change in revenue is given by:


R p q q p = +
M R
p q q p
q
p q
p
q
p
q p
p q

+
= + = +

1
50
M R p
q p
p q
+

What is the second


term inside the
brackets?
Nope, it's not elasticity. It is the reciprocal of elasticity.
q p
p q
p q
q p

= =
1 1

M R p +

1
1

MR p +

1
1
05 .
To avoid confusion due
to the fact that own-price
elasticity is a negative
number, we rewrites the
expression as:
M R p

1
1

MR p

1
1
05 .
51
If the demand is inelastic, then marginal
revenue is negative. So, revenue
decreases as you increase output.
p p R M 3
25 . 0
1
1 =


price is flexible
If the demand is unitary, then marginal
revenue is zero. So, revenue does not
change as you increase output.
0
0 . 1
1
1 =

p R M
price flexibility is unitary
If the demand is elastic, then marginal
revenue is positive. So, revenue
increases as you increase output.
M R p

1
1

p p R M 5 . 0
0 . 2
1
1 =


price is not flexible
52
Both sides of the mirror
If the demand is inelastic,
revenue decreases as you
increase output.
If the demand is inelastic,
revenue increases as you
increase price.
If the demand is unitary,
revenue does not change as
you increase output.
If the demand is unitary,
revenue does not change
as you increase price.
If the demand is elastic,
revenue increases as you
increase output.
If the demand is elastic,
revenue decreases as you
increase price.
53
Income elasticity
The income elasticity of demand is used to describe how the
quantity demanded responds to a change in income:
income elasticity of demand =
% change in quantity demanded
% change in income

m
in q
in income
q
q
m
m
q
q
m
m
= =
%
%

100
100

m
in q
in m
m
q
q
m
=
%
%

54

m
in q
in m
m
q
q
m
=
%
%

A normal good is one for which an increase


in income leads to an increase in demand.
0 >

m
q
The income elasticity of demand is positive.
Further, we say the good is a luxury good if its
income elasticity of demand is greater than 1.
An inferior good is one for which an increase in
income leads to a decrease in demand.
0 <

m
q
The income elasticity of demand is negative.
55
Inferior good
normal good
0
- infinity
+ infinity
1
luxury good
Income Elasticity
q
p
income increase
inferior good
q
p
income increase
normal good / luxury good
56
EVALUATING INCOME ELASTICITY AT A SAMPLE
POINT
In making empirical computations, a common procedure
is to evaluate income elasticity of demand at the mean of
the data.
q
m
m
q
m
*

=
where are the
income and quantity demanded,
evaluated at the mean of the
data.
q and m
57
250 , 20 , 4
, 5 , 3 , 2 Q
: are variables the of means sample The
beef
= = =
= = =
SPPD M P
P P
chicken
pork beef
Write down the formula for income elasticity of demand for beef.
Compute the income elasticity of demand for beef (evaluating at
the sample means). Is beef a normal good or an inferior good?
Suppose that income is projected to decrease by 2% next
month, what would be the percentage change in Q
beef
(demand)?
SPPD M P P P
chicken pork beef
01 . 0 04 . 0 01 . 0 03 . 0 5 . 0 01 . 0 Q
: products beef for equation demand following the Consider
beef
+ + + + =
income
social and
demographic
variables
58
PUT YOUR ANSWERS HERE
4 . 0
2
20
04 . 0
,
=
=

=
beef
beef
P Q
Q
M
M
Q
beef beef
04 . 0 =

M
Q
beef
The coefficient associated with
M in the demand equation.
A 1% increase in M will be accompanied by a 0.4% increase
in Q
beef
(demand)
Beef is a normal good.
If M is to drop by 2%, Q
beef
will decrease by 0.8%.
[(-2%) * (0.4) = -0.8%]
59
LET'S GENERALIZE OUR NOTATIONS

q p
inq
in p
p
q
q
p
=
%
%

Elasticity of demand (q) with respect to price (p)

q m
in q
in m
m
q
q
m
=
%
%

Elasticity of demand (q) with respect to income (m)


60

m
in q
in m
m
q
q
m
=
%
%

P
Q
P
Q
Q
P
P
Q
Cross price elasticity of with
respect to
Q
P
61
Two goods are substitutes if their cross-price
elasticity is positive.
Two goods are complements if their cross-price
elasticity is negative.
Two goods are independent if their cross-price
elasticity is zero.

m
in q
in m
m
q
q
m
=
%
%

P
Q
P
Q
Q
P
P
Q
62
complements
substitutes
0
- infinity
+ infinity
1
Cross-Price Elasticity
Independent goods
1
q
1
p
p
2
increase
goods 1 and 2 are complements
1
q
1
p
p
2
increase
goods 1 and 2 are substitutes
63
Evaluating cross price elasticity at a sample point
In making empirical computations, a common procedure
is to evaluate cross-price elasticity of demand at the mean
of the data.
Consider the cross-price elasticity of demand for good 1
with respect to a change in the price of good 2:
1
2
2
1
*
2 1
q
p
p
q
p q

=
where are the price
of good 2 and quantity of good 1,
evaluated at the mean of the
data.
1 2
q and p
64
250 , 20 , 4
, 5 , 3 , 2 Q
: are variables the of means sample The
beef
= = =
= = =
SPPD M P
P P
chicken
pork beef
Write down the formula for the cross-price elasticity of demand
for beef with respect to pork price.
Compute the cross-price elasticity (evaluating at the sample
means). Are beef and pork substitutes or complements?
Suppose the price of pork is projected to decrease by 2% next
month, what would be the percentage change in Q
beef
(demand)?
SPPD M P P P
chicken pork beef
01 . 0 04 . 0 01 . 0 03 . 0 5 . 0 01 . 0 Q
: products beef for equation demand following the Consider
beef
+ + + + =
income
social and
demographic
variables
65
PUT YOUR ANSWERS HERE
075 . 0
2
5
03 . 0
,
=
=

=
beef
pork
pork
beef
P Q
Q
P
P
Q
beef beef

03 . 0 =

pork
beef
p
Q
The coefficient associated with
P
pork
in the demand equation.
A 1% increase in P
pork
will be accompanied by a 0.075%
increase in Q
beef
(demand).
Beef and pork are substitutes.
If P
pork
is to drop by 2%, Q
beef
will decrease by 0.15%.
[(-2%) * (0.075) = -0.15%]