Chapter 4 – Product Market Demand

1. Chapter 4 – Product Market Demand • This chapter examines the major causes of the Demand for a specific good – its own price, the prices of related goods, tastes, and consumer income. • Also we distinguish between the qualitative (direction of change) versus the quantitative (elasticity) effects of a ceteris paribus change in each of these causes.

2. Price and Quantity Demanded: Direction of Change • Recall – the good’s own price (P) is a cause of quantity demanded of that good (Q). • Qualitative Effect:P  QD. • Qualitative Effect – measures direction of change.

3. Underlying Reason: Inverse Relationship • Consumer maximizes utility subject to their budget constraint when MU1/P1 = MU2/P2 = … • If P1, then consumer should rebalance by MU1 to make the ratio equal across goods again. • Given diminishing Marginal Utility, this is done by having Q1.

4. Own Price Elasticity of Demand • Own Price Elasticity of Demand () – measures the magnitude of responsiveness of quantity demanded of a good to changes in its own price. In other words, the Quantitative Effect of a change in price on the quantity demanded of that good.

5. Own Price Elasticity of Demand (): A Formula  = |Percentage Change in QD| |Percentage Change in P| . Always has positive sign. Ratio of percentage changes instead of slope, makes it a unit-free measure.

6. Price Inelastic Goods • Price Inelastic Goodshave < 1. These goods are unresponsive to changes in their own price. Example – suppose that if the Price of Milk increases by 10%, Quantity Demanded of Milk goes down by 3%. Then, for Milk,  = |-3%|/|10%| = 0.3.

7. Price Elastic Goods and Unitary Price Elasticity • Price Elastic Goodshave > 1. These goods are responsive to changes in their own price. Example – suppose that if the Price of Cars increase by 10%, Quantity Demanded of Cars goes down by 18%. Then, for Cars,  = |-18%|/|10%| = 1.8. • Unitary Price Elasticity:  = 1.

8. What Features Make Goods Price Inelastic or Elastic? • Necessity versus Luxury • Number and Quality of Available Substitutes • Time Frame • Price Relative to Wealth or Income

9. Own Price Elasticity: The Demand Curve • Price Inelastic goods are described with steep demand curves. The vertical demand curve is the extreme case of  = 0. • Price Elastic goods are described with flat demand curves. The horizontal demand curve is the extreme case of  = .

10. Own Price Elasticity and Equilibrium • Consider an equilibrium, where Demand equals Supply. • Supply shifts (rightward or leftward) change the equilibrium, accomplished by moving along the existing demand curve. • Therefore the new equilibrium quantity can be compared to the original one by means of own price elasticity.

11. Own Price Inelasticity and Total Revenue of Firms • Total Revenue(TR) = (Price of Good)x(Quantity Sold), or TR = PxQ. • This relationship implies that, in percentage change terms: (% Change in TR) = (% Change in P) + (% Change in Q).

12. Own Price Elasticity and Increasing the Price • Consider our two goods: milk ( = 0.3), and cars ( = 1.8). Suppose that supply shifts so that the price of each increases by 10%. • % Change in TR of Milk = 10% + -3% = 7%. • % Change in TR of Cars = 10% + -18% = -8%.

13. Own Price Elasticity and Decreasing the Price • Consider again our two goods: milk ( = 0.3), and cars ( = 1.8). Suppose supply shifts so that the price of each decreases by 10%. • % Change in TR of Milk = -10% + 3% = -7%. • % Change in TR of Cars = -10% + 18% = 8%.

14. Application: What Goods Should Have a Sales Tax? • Sales tax – tax on supply. • Firms try to pass it on to consumers. • Consider the contrast between a sales tax on a price inelastic good versus a sales tax on a price elastic good. • What is the government’s goal – collect tax revenue or significantly reduce the quantity traded?

15. Another Cause of Demand – Prices of Related Goods • Consider, for example, the Demand for Coffee. • Affected by prices of related goods in two different ways. -- PDONUTS  QCOFFEE (Complements) -- PTEA  QCOFFEE  (Substitutes)

16. Cross Price Elasticity • Cross Price Elasticity (1x2)– measures the responsiveness of demand to changes in the prices of complements or substitutes. 1x2 = Percentage Change in Q2 Percentage Change in P1 .

17. Interpreting Cross Price Elasticity • 1x2 = Percentage Change in Q2 Percentage Change in P1 . • Sign of 1x2 describes whether the related good is a complement (negative) or substitute (positive). • Absolute Value of 1x2 describes the magnitude of response. |1x2| < 1 describes an inelastic response, while |1x2| > 1 describes an elastic response.

18. Cross Price Elasticity: A Numerical Example • Suppose that, for coffee: DONUTSxCOFFEE = -0.4 Negative sign  Donuts are a complement. Absolute value < 1  Inelastic, or unresponsive. TEAxCOFFEE = 1.5 Positive sign  Tea is a substitute. Absolute value > 1  Elastic, or responsive.

19. Cross Price Elasticity and Dependence of Markets • Consider the markets (i.e. Demand and Supply) for Gasoline, Cars, and Ethanol. • Gasoline and Cars are Complements (PGAS  QCARS). • Gasoline and Ethanol are Substitutes (PGAS  QETHANOL).

20. Cross Price Elasticity and Dependence of Markets • Suppose the government decides to put a substantial sales tax on gasoline (or another supply disruption). • Decreases supply of gasoline, described by shifting supply curve for gas leftward P*GAS, Q*GAS.

21. Cross Price Elasticity and Dependence of Markets • The move also has effects in the markets for cars and ethanol. • Decreases demand for cars, described by shifting the demand curve for cars leftward P*CARS , Q*CARS. • Increases demand for ethanol, described by shifting the demand curve for ethanol rightward P*ETHANOL, Q*ETHANOL. • Cross Price Elasticity – describes size of shifts for cars and electricity.

22. Another Cause of Demand – Consumer Income • The Demand for most goods is affected by changes in the consumer’s income (I). -- I  Q (Normal Goods) -- I  Q(Inferior Goods)

23. Income Elasticity • Income Elasticity (I)– measures the responsiveness of demand to changes in consumer income. I = Percentage Change in QD Percentage Change in I .

24. Interpreting Income Elasticity • I = Percentage Change in QD Percentage Change in I . • Sign of I describes whether the good is a normal good (positive) or inferior good (negative). • Absolute Value of I describes the magnitude of response. |I| < 1 describes an inelastic response, while |I| > 1 describes an elastic response.

25. Income Elasticity: A Numerical Example • Suppose that: For Tuna Helper, I = -1.4. Negative sign  inferior good. Absolute value > 1  Elastic, or responsive. For Apples, I = 0.5. Positive sign  normal good. Absolute value < 1  Inelastic, or unresponsive.

26. Income Changes: Graphical Description • Since income is “another cause” of demand, changes in income are described as shifts of the demand curve. • Since it shifts the Demand curve, changes in consumer income affect P* and Q* as well.

27. Income Changes: Graphical Description • For normal goods(I > 0),I  QD. • Therefore, one describes an increase in income as a rightward shift in the demand curve. • For inferior goods(I < 0),I  QD . • Therefore, one describes an increase in income as a leftward shift in the demand curve. • Absolute value of income elasticity describes size of shift.

28. Individual Versus Market Demand • The Market Demand for any good is obtained by summing up the individual demands for all the consumers for this good. • Example – consider the demand for apples. • Suppose the demanders consist of two people, me and you.

29. Demand for Apples Price ($)Me + You = Market 0.20 25 8 33 0.25 23 7 30 0.30 21 6 27 0.35 19 5 24 0.40 17 4 21 0.45 15 3 18

30. Causes: Market Demand For a Good • Price of Good • Price of Related Goods (Substitutes or Complements) • Consumer Income (Normal or Inferior Good) • Tastes • Number of buyers in the market (Market Demand only)

31. Demographics and Market Demand for Goods • Changing population needs and preferences lead to changes in the number of participants. • Example – aging of baby boomers. • Decreases in market demand (shifts leftward) for fast food, adult soccer leagues, starter homes. • Increases in market demand (shifts rightward) for fresh fruits, walking sneakers, retirement condos.