The Demand Side of the The Demand Side of the Market Market - PDF document

Econ Dept, UMR Presents The Demand Side of the The Demand Side of the Market Market

Starring Starring N Utility Theory N Consumer Surplus N Elasticity

Featuring Featuring N The MU/P Rule The MU/P Rule N The Meaning of Value N The Meaning of Value N Four Elasticities: N Four Elasticities: N Price Elasticity of Demand O Price Elasticity of Demand O Income Elasticity O Income Elasticity O Cross Price Elasticity O Cross Price Elasticity O Price Elasticity of Supply O Price Elasticity of Supply O N The Elasticity The Elasticity- -TR Relationship TR Relationship N

In Three Parts In Three Parts Consumer Choice Theory Consumer Choice Theory Consumer Surplus Consumer Surplus Elasticity Elasticity A. Price Elasticity of Demand A. Price Elasticity of Demand B. Other Important Elasticities B. Other Important Elasticities

Part 3 Elasticity Elasticity Measures of Response Measures of Response

This Slide Show Discusses This Slide Show Discusses Income Elasticity; Cross Price Income Elasticity; Cross Price Elasticity of Demand; And Elasticity of Demand; And Price Elasticity of Supply Price Elasticity of Supply N Price elasticity of demand is discussed Price elasticity of demand is discussed N in slide show III.A. in slide show III.A.

Review: A Generic Definition Review: A Generic Definition of Elasticity of Elasticity N Y = f(x) Y = f(x) N , , , = % ∆ y/ ∆ x, where ∆ is read = % ∆ % ∆ x, where ∆ N Elasticity, Elasticity, , y/% is read N “change in change in” ” “ ∆ Y = ( ∆ y/y)*100; ∆ X = ( ∆ x/x)*100 % ∆ Y = ( ∆ % ∆ X = ( ∆ N % y/y)*100; % x/x)*100 N ∆ Y/y)/( ∆ x/x), or ( ∆ Y/y)/( ∆ N ( x/x), or N [( ∆ ∆ Y/ Y/ ∆ ∆ x)/(x/y)] N [( x)/(x/y)] N N In words, elasticity gives us the estimated In words, elasticity gives us the estimated N percentage change in one variable, y, in percentage change in one variable, y, in response to a percentage change in another response to a percentage change in another variable, x, c.p. variable, x, c.p.

Review: G eneric Interpretation Review: G eneric Interpretation of Elasticity of Elasticity ∆ Y/ ∆ x = 2 = % ∆ % ∆ Y/% x = 2 = % N , N , O This means if x were to change by 1 percent This means if x were to change by 1 percent O we would expect y to change by 2 percent we would expect y to change by 2 percent in the same same direction, direction, c.P c.P in the ∆ Y/ ∆ x = = % ∆ % ∆ Y/% x = - - 2 2 = % N , N , O This means if x were to change by 1 percent This means if x were to change by 1 percent O we would expect y to change by 2 percent we would expect y to change by 2 percent in the opposite in the opposite direction, direction, c.p. c.p.

Other Important Elasticities Other Important Elasticities % change D X INCOME = , I = ELASTICITY % change in consumer income % change D X CROSS-PRICE = = , X,Z ELASTICITY % change in the price of another good, Z PRICE ELASTICITY % change Q s = , S = OF SUPPLY % change in price

Elasticity Formulas Elasticity Formulas N Income elasticity Income elasticity N % ∆ in D ∆ D I = , I = ∆ I % ∆ in I D N Cross price elasticity of demand Cross price elasticity of demand N % ∆ in D 1 ∆ D 1 P 2 , D1,P2 = % ∆ in P 2 = ∆ P 2 D 1 N Price elasticity of supply Price elasticity of supply N % ∆ in Q S ∆ Q S P = , S = % ∆ in P ∆ P Q

Income Elasticity of Demand Income Elasticity of Demand N An estimate of the rate at which the An estimate of the rate at which the N demand for a good changes as demand for a good changes as consumer incomes change by a given consumer incomes change by a given percent percent

Income Elasticity of Demand Income Elasticity of Demand N Income elasticity of demand Income elasticity of demand ( ( , ) - - I ) , I N measures the responsiveness of demand measures the responsiveness of demand to changes in income to changes in income ∆ In D % ∆ % In D O O , I = % ∆ ∆ in income % in income N Note that the sign IS important! Note that the sign IS important! N

Normal Goods Normal Goods N Typically, if our income rises, we buy Typically, if our income rises, we buy N more and visa versa. These types of more and visa versa. These types of goods are called normal goods normal goods goods are called > 0 normal good > 0 normal good N N , I

Inferior Goods Inferior Goods N There are some good we buy less of as There are some good we buy less of as N our income grows and more of as our our income grows and more of as our income falls income falls N For instance, in college you probably For instance, in college you probably N eat a lot of hamburger. But when you eat a lot of hamburger. But when you get a well- -paying job (as all UMR grads paying job (as all UMR grads get a well do) you will probably buy more steak do) you will probably buy more steak and less burger and less burger N If a good’s income elasticity is < 0 it is If a good’s income elasticity is < 0 it is N an inferior good an inferior good

Calculating Income Elasticity Calculating Income Elasticity N D D X = 100 - - 2p 2p x + 0.5inc X = 100 x + 0.5inc N N ∆ ∆ D ∆ι nc = 0.5 thus X is a / ∆ι D X nc = 0.5 thus X is a “ normal ” X / “ normal ” N good good N Evaluate Evaluate , at any given income and I at any given income and , I N quantity, e.G., quantity, e.G., N D = 200 million units; Inc = $600 million D = 200 million units; Inc = $600 million N = 0.5(600/200) = 1.5 I = 0.5(600/200) = 1.5 N , , I N

Cross Price Elasticity of Demand Cross Price Elasticity of Demand N Another type of elasticity is the Another type of elasticity is the cross cross N price elasticity. This gets at how price elasticity . This gets at how changes in price of one good can effect changes in price of one good can effect the demand of another the demand of another N Cross price elasticity of demand Cross price elasticity of demand ( ) ( ) N , 1, 2 measures the responsiveness of measures the responsiveness of quantity demanded of good one when quantity demanded of good one when the price of good two changes the price of good two changes N This elasticity is very important in This elasticity is very important in N antitrust cases antitrust cases

Cross Price Elasticity of Cross Price Elasticity of Demand Demand N The % change in the demand for one The % change in the demand for one N good divided by the % change in the good divided by the % change in the price of another good. price of another good. N Substitutes Substitutes - - as price of A rises so does the as price of A rises so does the N demand for B. demand for B. N Complements Complements - - as price of A rises the as price of A rises the N demand for B decreases. demand for B decreases. N Unrelated Unrelated - - as the price of A rises there is as the price of A rises there is N no change in the demand for B. no change in the demand for B.

Cross Price Elasticity of Cross Price Elasticity of Demand Demand % ∆ In D of good 1 In D of good 1 % N N , 1,2 = ∆ in P of good 2 % ∆ in P of good 2 % N Note that the sign DOES matter for this Note that the sign DOES matter for this N elasticity also! elasticity also! > 0 goods one and two are 0 goods one and two are 1,2 > O If If , , 1,2 O substitutes substitutes < 0 goods one and two are 0 goods one and two are 1,2 < O If If , , 1,2 O complements complements

Substitute Goods Substitute Goods N Consider coke and Pepsi. If the price of Consider coke and Pepsi. If the price of N coke goes up, what would you expect to coke goes up, what would you expect to happen to the demand for Pepsi happen to the demand for Pepsi O It will rise, since people will buy less coke It will rise, since people will buy less coke O and more Pepsi. Thus the demand for and more Pepsi. Thus the demand for Pepsi will rise Pepsi will rise N So the bottom of the elasticity fraction is So the bottom of the elasticity fraction is N positive and the top of the elasticity positive and the top of the elasticity > 0 0 1,2 > fraction is positive, , fraction is positive, , 1,2

Complement Goods Complement Goods N Consider washing machines and dryers. Consider washing machines and dryers. N If the price of washing machines goes If the price of washing machines goes up, what would you expect to happen up, what would you expect to happen to the demand for dryers to the demand for dryers O It will fall, since people will buy less It will fall, since people will buy less O washers at the new price, they will need washers at the new price, they will need less dryers less dryers N So the bottom of the elasticity fraction is So the bottom of the elasticity fraction is N positive and top of the elasticity fraction positive and top of the elasticity fraction < 0 0 1,2 < is negative, , is negative, , 1,2