“The Economic Way of Thinking” 11 th Edition

1. “The Economic Way of Thinking”11th Edition Chapter 3 Substitutes Everywhere: The Concept of Demand

2. Chapter 3 Outline • Introduction • On the Notion of “Needs” • Marginal Values • Everyday Choices – Marginal Choices • The Demand Curve • The Law of Demand

3. Chapter 3 Outline • Demand and Quantity Demanded • Demand Itself Can Change • Everything Depends Upon Everything Else • Misperceptions Caused by Inflation • Time Is on Our Side

4. Chapter 3 Outline • Price Elasticity of Demand • Thinking About Elasticity • Elasticity and Total Receipts • The Myth of Vertical Demand • All Scarce Goods Must Be Rationed – Somehow • Is Money All That Matters? Money Costs, Other Costs and Economic Calculation

5. Introduction • Most goods are scarce. • Sacrifice is necessary • There are substitutes for everything • Intelligent choice entails trade-offs. • Market price signals encourage buyers to economize

6. On the Notion of “Needs” • What is the relationship between “trade-offs” and “needs”? • Consider these four statements… • The average person needs eight glasses of water per day to maintain good health. • All citizens should be able to obtain the medical care they need regardless of their ability to pay. • A diabetic needs insulin. • You need to read your economics textbook.

7. On the Notion of Needs • Higher prices (sacrifices) lead people to seek substitutes. • The fact that goods and services are scarce entails trade-offs, i.e., the sacrifice of other goods and services we value.

8. Marginal Values • Questions • Which is more valuable, water or diamonds? • Which is more valuable, a glass of water or a glass of diamonds? • Answers • The values that matter are marginal values • Marginal means “additional,”so in economics we make decisions based on expected marginal beliefs versus marginal cost.

9. Everyday Choices and Marginal Choices • The Economic Way of Thinking… • Rejects the all-or-nothing approach • Favors attention to • Marginal benefits • Marginal costs • More of A and less of B versus more of B and less of A

10. The Demand Curve In a world of scarcity, individuals incur trade-offs. Thus, economists developed the idea of demand.

11. The Demand CurveMaking it Graphic • Graphs can be used to illustrate relationships. • Demand Curves • Illustrate the relationship between price and quantity demanded.

12. The Demand CurveConsumption Table Price per Gallon Gallons per Day $.07 25 .04 40 .02 80 .01 160 .005 320 Demand Schedule is a tabular representation of graphical data:

13. The Demand Curve • Vertical Axis – possible prices that might be charged. • Horizontal Axis – quantity purchased at those prices. • Economists call that a Demand Curve.

14. The Demand Curve $.07 .06 .05 .04 PRICE PER GALLON .03 .02 .01 .00 0 40 80 120 160 200 240 280 320 360 400 GALLONS OF WATER PER DAY

15. The Demand Curve • A demand curve illustrates the amount of a good that consumers plan to purchase at any given price. • Read a demand curve by taking a price and finding corresponding quantity. • That is the Quantity Demanded

16. The Law of Demand “Law of Demand” A negative relationship exists between the amount of anything that people want to purchase and the price they must pay.

17. Demand and Quantity Demanded • “A change in demand” is not the same thing as a “change in quantity demanded.” • Demand is a relationship between two specific variables. • It is a schedule or a curve.

18. P P D2 D D1 Q Q Demand and Quantity Demanded Change in Quantity demanded: Change in demand::

19. Demand and Quantity Demanded • A change in quantity demanded is a movement from one point on a curve to another point on the same curve. • A change in demand results from some other factor that makes households buy more or less at each price. • The demand curve shifts.

20. Demand Itself Can Change Price per Gallon Original Gallons/Day New Gallons/Day $.07 40 15 .04 60 25 .02 140 55 .01 240 100 .005 400 200

21. Demand Itself Can Change $.07 .06 .05 .04 PRICE PER GALLON .03 .02 .01 .00 0 40 80 120 160 200 240 280 320 360 400 GALLONS OF WATER PER DAY

22. Everything Depends Upon Everything Else • Influences that can cause a change in demand for a good: • # of customers • Change in customer tastes • Change in income • Change in price of a substitute

23. Everything Depends Upon Everything Else • Influences that can cause a change in demand for a good: • Change in the price of a complementary good • Change in the expected price of a good

24. Misperceptions Caused by Inflation • Inflation is an increase in the average money price of goods. • If the money price of all goods (including labor) increases, then no good (except money) will have changed in real price.

25. Time Is On Our Side • Changes in the quantity demanded take time. • These changes will be greater for any price change the longer the time period allowed for adjustment. • It takes time for customers to find and begin to use substitutes. • It takes time for producers to devise, produce, and publicize substitutes.

26. Price Elasticity of Demand • Price elasticity of demand measures consumer responsiveness to price changes. • Inelastic Demand • If quantity demanded changes very little as a result of a large change in price. • Elastic Demand • If quantity demanded changes substantially as a result of a small change in price.

27. Price Elasticity of Demand • ….is the percentage change in the quantity demanded divided by the percentage change in price. • Elasticity is influenced by: • Time • Availability of substitutes • Proportion of one’s budget spent on a good

28. Price Elasticity of Demand

29. Price Elasticity of Demand • Example • Price increases by 20% • Quantity demanded decreases by 50% • Consumers are relatively responsive - Elastic • Example • Price decreases by 20% • Quantity demanded increases by 15% • Consumers are relatively unresponsive - Inelastic

30. Price Elasticity of Demand • Elastic Demand • Price elasticity > 1 • Inelastic Demand • Price elasticity < 1 • Unit Elastic • Price elasticity = 1

31. Thinking About Elasticity • “People aren’t going to buy much more no matter how far we cut the price.” • “This is a competitive business. We would lose half our customers if we raised our prices by as little as 2 percent.” • Question • Would a firm want to lower prices if demand were inelastic? • Question • Would a firm want to raise prices if demand were elastic?

32. P D Inelastic Demand Q Thinking About Elasticity

33. P Elastic Demand D Q Thinking About Elasticity

34. Thinking About Elasticity • Question • Can food stores charge any price they want since they sell food? • Question • Would it be wise to impose a tax on table salt? • Question • Would the demand for Morton’s salt be more elastic or inelastic than the demand for salt?

35. Thinking About Elasticity • A product’s elasticity depends upon… • The proportion of one’s budget spent on an item. The more a product takes of your budget, the more elastic. • The more substitutes a product has, the more elastic. • Necessities are less elastic than luxuries. • All products become more elastic with time.

36. Elasticity and Total Receipts • “The university’s total receipts from tuition would actually increase if tuition rates were cut by 20 percent.” • The 20 percent cut in prices must cause quantity demanded to increase by more than 20 percent. • Elastic demand

37. Elasticity and Total Receipts • “It’s odd but true. Wheat farmers would gross more money if they all got together and burned one-quarter of this year’s crop.” • Elastic Demand • Prices and total receipts move in opposite directions. • Inelastic Demand • Prices and total receipts move in the same direction.

38. P Elastic demand between C and E since OBCG < OAEF. C B E A D Q G F Elasticity and Total Receipts O

39. P Inelastic demand between A and B. B A D Q Elasticity and Total Receipts

40. Demand for wheat The price when 1/4 of crop is burned. The market price when entire crop is sold Elasticity and Total Receipts P Q

41. P1 D P2 The Myth of Vertical Demand P Q

42. The Myth of Vertical Demand • Question • Does a perfectly inelastic demand curve exist? • Will consumers buy the same quantity at all prices? • There is no such thing as a completely inelastic demand curve over the entire possible range of prices. • If the price of insulin falls, diabetics would be more likely to purchase a larger quantity, implying that the demand curve for insulin is downward sloping.

43. All Scarce Goods Must Be Rationed Somehow • Market prices and willingness to pay are our primary criteria for rationing goods and services. • If a good is scarce, sacrifices must be made to obtain it. • When prices of products and services rise, people respond by economizing in their use. • People naturally find ways to economize that entail the least sacrifice.

44. All Scarce Goods Must Be Rationed Somehow • Scarce goods must be rationed. • Rationing can be done by willingness to pay prices. • Other ways to ration: • “Fist come, first served” • Lottery • Equal shares for all • “Might makes right” • Merit

45. All Scarce Goods Must Be Rationed Somehow • When the price of a good rises, users find it in their own interest to economize. • They will choose ways to economize that entail the smallest sacrifice. • Individuals are in the best position to pick and choose among the ways to economize.

46. Is Money All That Matters?Money Costs, Other Costs, and Economic Calculation • As the opportunity cost of an action increases, the chooser will tend to undertake less of that action. • As the opportunity cost of an action decreases, the user will tend to undertake more of that action.

47. Is Money All That Matters?Money Costs, Other Costs, and Economic Calculation • People compare the expected additional benefit against the expected additional cost. • In a commercial market economy, money is a common denominator (i.e. a yardstick). • Money allows individuals to calculate relative costs and benefits.

48. Once Over Lightly • Trade-offs • Needs • Law of Demand • Demand Curve • Quantity Demanded • Dependence

49. Once Over Lightly • Inflation • Time • Price Elasticity of Demand • Elasticity and Receipts • Rationed Goods • Money Costs

50. End of Chapter 3