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Lecture 2 The Law of Demand

Lecture 2 The Law of Demand. ■ Our objectives: ► Explain individual choices among unlimited wants in the face of limited resources ► Develop a theory that satisfies the universal criteria for theories ► Apply the theory to what we observe around us. The Law of Demand.

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Lecture 2 The Law of Demand

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  1. Lecture 2The Law of Demand ■ Our objectives: ► Explain individual choices among unlimited wants in the face of limited resources ► Develop a theory that satisfies the universal criteria for theories ► Apply the theory to what we observe around us

  2. The Law of Demand ■Holding all other relevant factors constant, the lower the price of a good, the greater will be the quantity demanded. ► Like all scientific propositions, it is a ceteris paribus (“other things equal’) statement ► It is symmetric: a higher price leads to a smaller quantity demanded ► Notetheterminology: -changes in the price of the good lead to changes in “quantity demanded” ---- they DO NOT lead to changes in demand

  3. Why focus on the Law of Demand? ► This is the most powerful proposition in economics. ► Sprinkler design in arid and wet climates ► Building heights in cities compared to small towns ► The seasonal pattern of fruit and vegetable prices ► Why people sit in inferior seats to watch games or performances ► The shape of waterfront properties ► Electricity prices and automatic switches ► Etc., etc., etc.

  4. Foundations ■ The principle of Diminishing Marginal Value ► As the rate of consumption rises, the marginal use value of the next unit declines ■ Decision Rule ► Chose a rate of consumption so that marginal use value of the last unit equals price: MV=P ■ When combined, these yield the Law of Demand

  5. Diminishing Marginal Value Rate of ConsumptionMarginal Value 1 2.00 2 1.75 3 1.10 4 0.50 5 0.25

  6. Diminishing Marginal Value MV MV1 MV2 MV Units/time period Q1 Q2

  7. Adding the Decision Rule MV=Pyields a Demand Curve (D) PRICE P1 Demand P2 UNITS/TIME PERIOD Q1 Q2

  8. The Demand Function Summarizes the relationship between quantity consumed and the factors determining that quantity ■ Price of the good in question—determines the location along the demand curve ■ Other factors — determine the placement of the demand curve: ► Prices of related goods ► Income of the buyer ► Tastes (preferences) of the buyer ► Expectations held by the buyer, regarding the future ► Other matters, particular to each good, including quality, etc.

  9. The Role of TastesDe gustibus non est disputandum ■ They are unmeasurable, and so we ignore them ■ Look to marketing and psychology for guidance here, for you’ll not get any from economists! ■ For us, tastes are the unexplained portion of consumption

  10. Expectations ■ Difficult to measure under most circumstances ■ When measurable, include in the analysis ■ Like tastes, these can be used to “explain” anything ► Don’t fall into this trap

  11. The Demand Function ■ The rate of consumption of a good is a function of: ► The “own” price of the good ------------------------------------- ► The ceteris paribus conditions: - Prices of related goods - Income - Other, idiosyncratic factors (the “X-vector”)

  12. Demand for DVD Rentals Price $Monthly consumption at different income levels $1000/mo $2000/mo $3000/mo 6 1 2 5 5 2 4 7 3 4 8 11 2 5 10 13 1 6 12 15

  13. Demand for DVD Rentals PRICE Changes in Demand 5 4 3 2 1 D3 D2 D1 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 QUANTITY

  14. Related Goods ■ Substitutes: ► Intuitively, goods used in place of each other ► Different brands of gasoline; theater v. movie rentals; DVDs v. concert tickets ■ Complements: ► Intuitively, goods used together ► Computer hardware and software; tennis balls and rackets; airplane travel and hotel rooms

  15. Changes in the Price of Related GoodsThese effects define the relationship “substitute” ■ X and Y are substitutes if and only if: ► A change in price of X changes demand for Y in same direction - Px up implies Dy up (Dy shifts to the right) - Px down implies Dy down (Dy shifts to the left) ► Effect of Py on Dx is also in same direction

  16. More on the Prices of Related GoodsThese effects define the relationship “complement” ■ V and W are complements if: ► A change in price of V changes demand for W in opposite direction - Pv up implies Dw down (Dw shifts to left) - Pv down implies Dw (Dw shifts to right) ► Effect of Pw on Dw is also in opposite direction

  17. Changes in Income ■ Normal Goods: ► Change in income changes demand in same direction - Higher income causes increase in demand - Lower income causes decrease in demand ► ”Superior” good is a variant: change in demand due to income change is quite large ■ Inferior goods: ► Change in income changes demand in opposite direction - Higher income causes decrease in demand - Lower income causes increase in demand

  18. Increase in Demand ■Caused by: -Higher price of substitute -Lower price of complement -Increase in income if superior -Decrease in income if inferior Price 5 4 3 2 1 D higher D lower Q 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15

  19. Decreases in Demand Caused by: -Lower price of substitute -Higher price of complement -Decrease in income if superior -Increase in income if inferior PRICE 5 4 3 2 1 D high D low Quantity 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15

  20. TerminologyThis is important to avoid confusion ■ Changes in quantity demanded: ► Caused by changes in own price of good ► Refer to movement along a given demand curve ■ Changes in demand: ► Caused by changes in ceteris paribus conditions - Prices of other goods - Income - Other factors ► Refer to a shift of the entire demand curve ■ Be precise and you’ll be richer. . . .

  21. What else would you want to know? The Demand curve plots the relationship between price and quantity demanded – nothing else – everything else is ceteris paribus. What else would you want to know if you wanted to understand that market better? Name likely relevant factors:

  22. Deriving a Real Demand Curve Define your market: Boulder, Colorado, over time; consumption of water by people served by city water; price per 1,000 gallons; billions gallons/yr. consumed by demanders. Year Price Quantity 1968 $0.28 29 1972 $0.36 19 1977 $0.50 13 1982 $0.74 9 Price .74 .50 D .36 .28 0 9 13 19 29 Quantity

  23. Questions on Law of Demand True – False • Your mother gives you a coat that cost her $100 and that she likes, but you hate. You have received a gift worth $100. • In thinking about demand by consumers, we usually assume that income varies among consumers but that prices do not. • If the price of mailing a letter rises by 10 cents, from 30 cents to 40 cents; and the price of sending a letter by special delivery increases 10 cents, from $3.20 to $3.30, consumers will purchase the same proportions of both kinds of delivery services.

  24. Which Goods Are Complements, Which Are Substitutes? • Plate glass and bricks. • Steel and bricks. • Wine and beer. • Domestic shirts and imported shirts. • Oil from Iran and coal from China. • Paper and pencils.

  25. Needs and Wants • When you truly need something, such as a new television, your demand curve is a vertical line. That is, you do not care what price you have to pay because you really need it? What about the need to eat dinner? The need to obtain an MBA? The need to have an operation because you have cancer?

  26. Demand Application In the past 20 years in the U.S., the price of attending college has risen more than the price of most other goods and services. Despite the price rise, more people are going to college than before. Does this contradict the law of demand?

  27. Demand Application • The sale of heroin in the U.S. is a serious crime. Does that mean that no heroin is sold? • Since heroin is illegal, does that mean that the price is higher than it would be if it were legal?

  28. Demand analysis • Which of the following would cause an increase in the demand for hairpieces (wigs) or hair replacement treatment? • A rise in income. • A rise in the divorce rate. • A rise in the demand by many other people. • A fall in the price of wigs.

  29. Clever sales pitch • A British mobile-phone company promised new subscribers in November and December that all calls on Christmas Day, December 25, would be free. What would you expect happened to the volume of calls that day?

  30. Question on complementary effects • GE research showed that about 1980 the average size of the American family was declining and so was the average square footage of houses. How would you think this impacted the demand for appliances or the nature of the appliances?

  31. Looking Ahead • Some countries are going to experience falling populations and aging populations in the next several decades. Japan will be one of the hardest hit, and Italy, Spain, Greece and Germany. All else held equal, what major changes in demand for various goods and services are likely to occur?

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