BASIC OF ECONOMICS

1. UNIT 2 BASIC OF ECONOMICS

2. CHAPTER 4 DEMAND

3. Chapter 4 Section 1 Understanding Demand

4. Understanding Demand DEMAND is the desire to own something and the ability to pay for it.

5. The Law of Demand • The law of demand states that when a good’s price is lower, consumers will buy more of it. When the price is higher, consumers will buy less of it. • The law of demand is the result of not one pattern of behavior, but of two separate patterns that overlap. • The substitution effect and the income effect

6. The Law of Demand Substitution effect Income effect The change in consumption resulting from change in real income • When consumers react to an increase in a good’s price by consuming less of that good and more of other goods.

7. Substitution Effect Example Example This can also work the other way as well. If the price of pizza drops, it becomes more inexpensive compared to other foods, such as hamburgers or tacos. As a result, consumers become more and more likely to buy pizza over a hamburger or a taco. • When the price of pizza rises, pizza becomes more expensive compared to other foods, such as hamburgers or tacos. • As a result, consumers become more and more likely to buy a hamburger or a taco.

8. Income Effect Example Economist One important fact to remember is that they measure consumption in the amount of good that is bought, not the amount of money spent on it. Although you are spending more on pizza, you are consuming fewer slices, so your consumption has gone down. • Rising prices make us feel poorer. • As a result, you can no longer afford to buy the same combination of goods and you must cut back on some of your purchases. • If you buy fewer slices of pizza without increasing your purchases of other foods, that is income effect.

9. Income Effect Continued: Remember, too, that the income effect also operates when the price is lowered. If the price of pizza falls, all of a sudden you feel wealthier. If as a result you buy more pizza, that’s the income effect. • Although people spend more of their money on pizza, when the price goes up, the quantity demanded goes down. • In this sense, the income effect leads to the law of demand.

10. The Law of Demand Price As prices go up… Demand Quantity demanded goes down Demand Quantity demanded goes up. PRICE As prices go down…

11. Building the Law of Demand

12. Why Do Price and Quantity Demanded Move in Opposite Directions? • This is because of the law of diminishing marginal utility • This states that as a person consumes additional units of a good, the utility or satisfaction, gained from each additional unit of the good will eventually decrease. • For example, that first taste of water after a long workout taste better than the 10th drink. • How does this apply to demand? • The more utility you receive from a good, the higher the price you are willing to pay for it….the less utility, lower the price you are willing to pay

13. Understanding Demand • To have demand for a good, you must be willing to buy it at the specified price. • This means you want the good and you can afford to buy it. • A demand schedule is a table that lists the quantity that a person will purchase at each price in a market

14. Market Demand Schedules • When you add up the demand schedules of every buyer in the market, you can create a market demand schedule. • This shows the quantity at each price by all consumers in the market

15. Demand Schedules

16. The Demand Graph Demand Curve A graphic representation of a demand schedule

17. The Demand Graph Slices of pizza per day

18. Reading a Demand Curve • The graph shows only the relationship between the price of this good and the price Ashley will pay • The demand curve on the graph slopes downward to the right. • You will notice that as the price decreases, the quantity demanded increases

19. Limits on a Demand Curve The market demand curve is only accurate for one very specific set of market conditions. If a nearby factory would close, so that fewer people were in your area at lunchtime, the pizzeria would see less pizza even if the price stayed the same.

20. 4.1 Questions • In your own words, what is the law of demand? • What does the law of diminishing marginal utility have to do with demand? • What is your personal demand price for the following items? • Championship game for your favorite sports team • A new Star Wars movie • Starbucks coffee in the morning before school • The Taylor Swift concert in Tampa in August • A pair of shoes

21. Chapter 4 Section 2 Shifts in the Demand Curve

22. Introduction • Why does the demand curve shift? • Shifts in the demand curve are caused by more than just price increases and decreases. • Several factors can lead to a change in demand, rather than simply changing the quantity demanded. • Income • Buyer Preference (Consumer Taste and Expectations) • Prices of Related Goods • Number of Buyers • Consumer Expectations of Future Prices • Advertising

23. Changes in Demand • A demand schedule takes into account only changes in price. It does not consider the effects of news reports of any one of the thousands of other factors that change from day to day that could affect the demand for a particular good. • A demand curve is accurate only as long as there are no changes other than price that could affect the consumer’s decision.

24. Changes in Demand, cont. • A demand curve is accurate only as long as the ceteris paribus assumption—that all other things are held constant—is true. • When we drop the ceteris paribus rule and allow other factors to change, we no longer move along the demand curve. Instead, the entire demand curve shifts. • A shift in the demand curve means that at every price, consumers buy a different quantity than before; this shift of the entire demand curve is what economists refer to as a change in demand.

25. Graphing Changes in Demand • When factors other than price cause demand to fall, the demand curve shifts to the left. An increase in demand appears as a shift to the right. • If the price of a book rose by one dollar, how would you show the change on one of these graphs?

26. Income • Several factors can lead to a change in demand, rather than simply changing the quantity demanded. • Income • Most items that we purchase are normal goods, which consumers demand more of when their income increases. • A rise in income would cause the demand curve to shift to the right, indicating an increase in demand. A fall in income would cause the demand curve to shift left, indicating a decrease in demand. • normal good: a good that consumers demand more of when their income increases • inferior good: a good that consumers demand less of when their income increases

27. Buyer Preference (Consumer Taste & Expectations) • The things that people used to like are no longer the things they buy • Example • Records-Tapes-CD’s-MP3-Streaming • Also, your expectation about the product or services can change demand. • Example • Taylor Swift concert is going to be amazing= $$$$ for tickets • NFL Preseason game where the starters are not playing= empty stadiums

28. Prices of Related Goods • The demand curve for one good can also shift in response to a change in demand for another good. • There are two types of related goods that interact this way: • Complements are two goods that are bought and used together. • Substitutes are goods that are used in place of one another.

29. Number of Buyers • Changes in the size of the population will also affect the demand for most products. • Population trends can have a particularly strong effect on certain goods.

30. Consumer Expectations of Future Prices • The current demand for a good is positively related to its expected future price. • If you expect the price to rise, your current demand will rise, which means you will buy the good sooner. • If you expect the price to drop your current demand will fall, and you will wait for the lower price.

31. Advertising • Advertising is a factor that shifts the demand curve because it plays an important role in many trends. • Companies spend money on advertising because they hope that it will increase the demand for the goods they sell.

32. Change in Demand vs. Change in Quantity Demanded

33. 4.2 Questions • Decide whether each of these events would cause a change in demand or only a change in the quantity demanded of the good in parentheses, and explain why. • (a) A computer manufacturer lowers its prices. (computers) • (b) A volleyball maker convinces high schools to fund varsity volleyball teams. (volleyballs) • (c) A freeze ruins the orange crop, and orange juice prices rise. (apple juice) • What is the shift to the right of the curve called? What is the shift to the left of the curve called? • What is an example of something you consider an inferior good? • What is one product that is typically considered to have a substitute for it, but for you personally, there is no substitute. Explain.

34. Chapter 4 Section 3 Elasticity of Demand

35. Key Terms • elasticity of demand: a measure of how consumers respond to price changes • inelastic: describes demand that is not very sensitive to price changes • elastic: describes demand that is very sensitive to a change in price • unitary elastic: describes demand whose elasticity is exactly equal to 1

36. Introduction • What factors affect elasticity of demand? • Economists have developed a way to calculate how strongly consumers will react to a change in price. • Original price and how much you want a particular good are both factors that will determine your demand for a particular product. • Example • You buy a donut every morning before school. Each day the price of the donut goes up five cents. At what point do you stop buying a donut? Or…Each day the price of the donut goes down five cents. At what point do you buy two donuts or three donuts.

37. Consumer Response • Elasticity of demand (the relationship between the percentage change in quantity demanded and the percentage change in price) is the way that consumers respond to price changes; it measures how drastically buyers will cut back or increase their demand for a good when the price rises or falls. • Your demand for a good that you will keep buying despite a price change is inelastic. • The percent change in quantity demanded is less than the percent change in price (less than 1) • If you buy much less of a good after a small price increase, your demand for that good is elastic. • The percentage change in quantity demanded is greater than the percentage change in price (greater than 1) • If your demand for a good changes at the same percent as the price your demand for that good is unit elastic. • Percentage change in quantity demanded is the same as the percentage change in price (1)

38. Calculating Elasticity of Demand • In order to calculate elasticity of demand, take the percentage change in the quantity of the good demanded and divide this number by the percentage change in the price of the good. The result is the elasticity of demand for the good. • The law of demand implies that the result will always be negative. This is because increases in the price of a good will always decrease the quantity demanded, and a decrease in the price of a good will always increase the quantity demanded.

40. Measuring Elasticity • If the elasticity of demand for a good at a certain price is less than 1, the demand is inelastic. If the elasticity is greater than 1, demand is elastic. If elasticity is exactly equal to 1, demand is unitary elastic. According to the cartoon, grazing sheep are this homeowner’s solution to the high price of gasoline.

41. What Determines Elasticity of Demand? • Elasticity of Demand comes from one or more of these factors: • The availability of substitutes • Need vs. Luxury • Importance • Percentage of Income Spent of the good/service • Time

42. Factors Affecting Elasticity • Availability of Substitutes • If there are a few substitutes for a good, then even when its price rises greatly, you might still buy it. • If the lack of substitutes can make demand inelastic, a wide choice of substitute goods can make demand elastic.

43. Factors Affecting Elasticity • Necessities v. Luxuries • Whether a person considers a good to be a necessity or a luxury has a great impact on a person’s elasticity of demand for that good.

44. Factors Affecting Elasticity • Importance • How much do you need or want the item? Is the item essential to your existence, popularity, or essential to who you are as a person?

45. Factors Affecting Elasticity • Percentage of Income Spent on item • Small part of budget versus larger portion of budget • If an item is a small part of your budget, and price doubles you are more likely to continue to purchase the item • If an item is a large part of your budget, and the price doubles, you are more likely to stop or buy less of the item.

46. Factors Affecting Elasticity • Time • Consumers do not always react quickly to a price increase, because it takes time to find substitutes. Because they cannot respond quickly to price changes, their demand is inelastic in the short term. • Demand sometimes becomes more elastic over time as people eventually find substitutes.

47. Total Revenue • Elasticity is important to the study of economics because elasticity helps us measure how consumers respond to price changes for different products. • The elasticity of demand determines how a change in price will affect a firm’s total revenue or income.

48. Total Revenue and Elastic Demand • The law of demand states that an increase in price will decrease the quantity demanded. • When a good has elastic demand, raising the price of each unit sold by 20% will decrease the quantity sold by a larger percentage. The quantity sold will drop enough to reduce the firm’s total revenue. • The same process can also work in reverse. If the price is reduced by a certain percentage, the quantities demanded could rise by an even greater percentage. In this case, total revenues would increase.

49. Total Revenue and Inelastic Demand • If demand is inelastic, consumers’ demand is not very responsive to price changes. If prices increase, the quantity demanded will decrease, but by less than the percentage of the price increase. This will result in higher total revenues.

50. Elasticity and Revenue • Elasticity of demand determines the effect of a price change on total revenues. • Why will revenue fall if a firm raises the price of a good whose demand is elastic? • What happens to total revenue when price decreases, but demand is inelastic?