chapter 7 consumer choice and elasticity

2 © 2015 Pearson Education, Inc.

Chapter Outline and Learning Objectives

7.1 Utility and Consumer Decision Making 7.2 Where Demand Curves Come From 7.3 Social Influences on Decision Making 7.4 Behavioral Economics: Do People

Make Their Choices Rationally? 7.5 The Price Elasticity of Demand and Its

Measurement 7.6 The Determinants of the Price

Elasticity of Demand 7.7 The Relationship between the Price

Elasticity of Demand and Total Revenue

CHAPTER

7 CHAPTER

Consumer Choice and Elasticity


Consumer Decision Making

In our study of consumers so far, we have looked at what they do, but not why they do what they do. Economics is all about the choices that people make; a better understanding of those choices furthers our understanding of economic behavior. At the same time, we need to know the limits of our understanding. This chapter will examine what we know, and what we can’t explain, about how consumers behave.

LEARNING OBJECTIVE


Utility and Consumer Decision Making

7.1

Define utility and explain how consumers choose goods and services to maximize their utility.


Rationality and Its Implications

As a starting point, economists assume that consumers are rational: making choices intended to make themselves as well-off as possible. We examine these choices when consumers make their decisions about how much of various items to buy, given their scarce resources (income). Facing this budget constraint, how do people choose? Budget constraint: The limited amount of income available to consumers to spend on goods and services.


Measuring Happiness

Economists refer to the enjoyment or satisfaction that people obtain from consuming goods and services as utility. Utility cannot be directly measured. but for now, suppose that it could. What would we see? •  As people consumed more of an item (say, pizza) their total utility

would change: •  The amount by which it would change when consuming an

extra unit of a good or service is called the marginal utility. •  Generally expect to see the first items consumed produce the most

marginal utility, so that subsequent items gave diminishing marginal utility.

Law of diminishing marginal utility: The principle that consumers experience diminishing additional satisfaction as they consume more of a good or service during a given period of time.


Pizza on Super Bowl Sunday

The table shows the total utility you might derive from eating pizza on Super Bowl Sunday. The numbers, in utils, represent happiness: higher is better. A graph of this utility is initially rising quickly, then more slowly, and eventually, it turns downward (as you get sick of pizza).

Total and marginal utility from eating pizza on Super Bowl Sunday

Figure 7.1a


Pizza on Super Bowl Sunday—continued

The increase in utility from one slice to the next is the marginal utility of a slice of pizza. We can calculate marginal utility for every slice of pizza… … then graph the results. The graph of marginal utility is decreasing, showing the Law of Diminishing Marginal Utility directly.

Total and marginal utility from eating pizza on Super Bowl Sunday

Figure 7.1 a&b


Allocating Your Resources

Given unlimited resources, a consumer would consume every good and service up until the maximum total utility. But resources are scarce; consumers have a budget constraint. The concept of utility can help us figure out how much of each item to purchase. Each item purchased gives some (possibly negative) marginal utility; by dividing by the price of the item, we obtain the marginal utility per dollar spent; that is, the rate at which that item allows the consumer to transform money into utility.


Utility from Pizza and Coke

Suppose you can now obtain utility by eating pizza and drinking Coke.

The table gives the total and marginal utility derived from each activity.

Total utility and marginal utility from eating pizza and drinking Coke

Table 7.1

Number of Slices of Pizza

Total Utility from Eating

Pizza

Marginal Utility from

the Last Slice

Number of Cups of Coke

Total Utility from

Drinking Coke

Marginal Utility from

the Last Cup

0 0 — 0 0 —

1 20 20 1 20 20

2 36 16 2 35 15

3 46 10 3 45 10

4 52 6 4 50 5

5 54 2 5 53 3

6 51 −3 6 52 −1


Marginal Utility from Pizza and Coke

Suppose that pizza costs $2 per slice, and Coke $1 per cup.

Marginal utility of pizza per dollar is just marginal utility of pizza divided by the price, $2.

Similarly for Coke: divide by $1.

Converting marginal utility to marginal utility per dollar

Table 7.2

(1) Slices

of Pizza

(2) Marginal

Utility (MUPizza)

(4) Cups

of Coke

(5) Marginal

Utility (MUCoke)

1 20 10 1 20 20 2 16 8 2 15 15 3 10 5 3 10 10 4 6 3 4 5 5 5 2 1 5 3 3 6 −3 −1.5 6 −1 −1


Rule of Equal Marginal Utility per Dollar Spent

Suppose the marginal utility per dollar obtained from pizza was greater than that obtained from Coke.

Then you should eat more pizza, and drink less Coke.

This implies the rule of equal marginal utility per dollar spent: consumers should seek to equalize the “bang for the buck”.

Some combinations satisfying this rule are given below.

Equalizing marginal utility per dollar spent

Table 7.3

Combinations of Pizza and Coke with Equal

Marginal Utilities per Dollar

Marginal Utility Per Dollar

(MU/P) Total

Spending Total Utility

1 slice of pizza and 3 cups of Coke 10 $2 + $3 = $5 20 + 45 = 65

3 slices of pizza and 4 cups of Coke 5 $6 + $4 = $10 46 + 50 = 96



Optimizing Your Consumption of Pizza and Coke

The actual combination to purchase would depend on your budget constraint:

•  With $5 to spend, you would purchase 1 slice of pizza and 3 cups of Coke.

•  With $10 to spend, you would purchase 3 slices of pizza and 4 cups of Coke.

In each case, you seek to exhaust your budget, since spending additional money gives more utility.

Equalizing marginal utility per dollar spent

Table 7.3

Combinations of Pizza and Coke with Equal

Marginal Utilities per Dollar

Marginal Utility Per Dollar

(MU/P) Total

Spending Total Utility

1 slice of pizza and 3 cups of Coke 10 $2 + $3 = $5 20 + 45 = 65




Conditions for Maximizing Utility

This gives us two conditions for maximizing utility: 1.  Satisfy the Rule of Equal Marginal Utility per Dollar Spent:

=

Pizza

Pizza

PMU

Coke

Coke

PMU

2.  Exhaust your budget:

Spending on pizza + Spending on Coke = Amount available


What If We “Disobey” the Rule?

It should be clear that failing to spend all your money will result in less utility—each item you buy increases our utility. But what if you buy a combination which doesn’t satisfy the Rule of Equal Marginal Utility per Dollar? For example, you could buy 4 slices of pizza and 2 cups of Coke for $10. From Table 7.1, this would give you 52 + 35 = 87 utils, less than the 96 utils that you get from 3 slices and 4 cups. Marginal utility per dollar from 4th slice: 3 utils per dollar Marginal utility per dollar from 2nd cup: 15 utils per dollar Since you get so much more marginal utility per dollar from Coke, you ought to drink more Coke—and indeed, that would increase utility.


According to the law of diminishing marginal utility, as the consumption of a particular good increases,

a.  Total utility increases by more and more. b.  Marginal utility increases. c.  Total utility decreases. d.  Marginal utility decreases.


When total utility is maximized, which of the following is true concerning marginal utility?

a.  Marginal utility is equal to total utility. b.  Marginal utility equals zero. c.  Marginal utility is also maximized. d.  Marginal utility is minimized.


The budget constraint illustrates:

a.  the limited amount of income available to consumers to spend on goods and services.

b.  the amount of income that yields equal marginal utility per dollar spent.

c.  the amount of income that must be spent on goods and services in order to maximize utility from consumption.

d.  the amount of money necessary to purchase a given combination of goods.


How can the inequality below be resolved?

a.  By consuming more pizza. b.  By consuming more coke. c.  By consuming more of both goods. d.  By consuming less of both goods.


How do the income and substitution effects work when the price of an inferior good decreases?

a.  Both the income effect and the substitution effect cause an increase in the quantity demanded of the good.

b.  Both the income effect and the substitution effect cause a decrease in the quantity demanded of the good.

c.  The income effect causes an increase in the quantity demanded and the substitution effect causes a decrease in the quantity demanded.

d.  The income effect causes a decrease in the quantity demanded and the substitution effect causes an increase in the quantity demanded.

LEARNING OBJECTIVE


Where Demand Curves Come From

7.2

Use the concept of utility to explain the law of demand.


What If Prices Change?

If the price of pizza changes from $2 to $1.50, then the rule of equal marginal utility per dollar spent will no longer be satisfied. You must adjust your purchasing decision. We can think of this adjustment in two ways: 1.  You can afford more than before; this is like having a higher

income. 2.  Pizza has become cheaper relative to Coke.

We refer to the effect from 1. as the income effect, and the effect from 2. as the substitution effect.


1. Income Effect

The income effect of a price change refers to the change in the quantity demanded of a good that results from the effect of the change in price on consumer purchasing power, holding all other factors constant. We know that some goods are normal (goods that we consume more of as our income rises) and some are inferior (goods that we consume less of as our income rises). If pizza is a normal good, the income effect of its price decreasing will cause you to consume more pizza. If pizza is an inferior good, the income effect of its price decreasing will cause you to consume less pizza.


2. Substitution Effect

The substitution effect of a price change refers to the change in the quantity demanded of a good that results from a change in price making the good more or less expensive relative to other goods, holding constant the effect of the price change on consumer purchasing power. To isolate the substitution effect, we can think of your income decreasing so you can just afford your previous combination. If you had $10 before, you bought 3 slices of pizza (3 x $2.00) and 4 cups of Coke (4 x $1.00). If pizza cost $1.50, $8.50 would allow you to purchase the same combination of items: 3 x $1.50 + 4 x $1.00.


2. Substitution Effect—continued

But this would no longer maximize utility, since the Rule of Equal Marginal Utility per Dollar Spent is not satisfied:

█■𝑴𝑼↓𝑷𝒊𝒛𝒛𝒂 /𝑶𝒍𝒅 𝑷𝒓𝒊𝒄𝒆↓𝑷𝒊𝒛𝒛𝒂  &=&𝑴𝑼↓𝑪𝒐𝒌𝒆 /𝑶𝒍𝒅 𝑷𝒓𝒊𝒄𝒆↓𝑪𝒐𝒌𝒆  @𝟏𝟎/𝟐 &=&𝟓/𝟏 @𝟏𝟎/𝟏.𝟓𝟎 &>&𝟓/𝟏  

𝑴𝑼↓𝑷𝒊𝒛𝒛𝒂 /𝑵𝒆𝒘 𝑷𝒓𝒊𝒄𝒆↓𝑷𝒊𝒛𝒛𝒂  > 𝑴𝑼↓𝑪𝒐𝒌𝒆 /𝑶𝒍𝒅 𝑷𝒓𝒊𝒄𝒆↓𝑪𝒐𝒌𝒆  

To restore equality, consumption of pizza should rise (decreasing the marginal utility of pizza), and/or consumption of Coke should fall (increasing the marginal utility of pizza) Consuming more pizza and less Coke is the substitution effect.


Deriving the Consumer’s Demand Curve for Pizza

We can use our two observations of consumer behavior (with pizza prices of $2.00 and $1.50) to trace out the demand curve for pizza:

Deriving the demand curve for pizza

Figure 7.2


Deriving the Market Demand Curve for Pizza

Each individual has a demand curve for pizza. By adding the individual demand at each price, we obtain the market demand for pizza. Deriving the market demand

curve from individual demand curves

Figure 7.3


Making the

Connection Could a Demand Curve Slope Upward?

For a demand curve to be upward sloping, the good would have to be an inferior good making up a very large portion of consumers’ budgets with a greater income effect than substitution effect. A 2006 economic experiment revealed that for poor regions in China, decreases in the price of rice led to some very poor people consuming less rice. A good with an upward-sloping demand curve is known as a Giffen good.

LEARNING OBJECTIVE


Social Influences on Decision Making

7.3

Explain how social influences can affect consumption choices.


Why Would Social Influences Matter for Consumption?

In most standard economic models, people are assumed to make choices independently of others. Such models sometimes incorrectly predict consumer behavior, by ignoring the social aspects of decision-making. “The utility from drugs, crime, going bowling… depends on whether friends and neighbors take drugs, commit crime, go bowling…”

Gary Becker and Kevin Murphy in Social Economics: Market Behavior in a Social Environment


Examples of Social Influences on Demand

Celebrity endorsements Firms use celebrity endorsements regularly. They work. Consumers might believe: •  “The celebrity knows more about the product than I do”; or •  “By buying this product, I will become more like the celebrity.” Network externalities Network externalities are situations in which the usefulness of a product increases with the number of consumers who use it. Examples: Facebook; Blu-ray discs; AT&T cell phone service Network externalities might result in market failure, if enough people become locked into inferior products. Example: QWERTY keyboards are designed to be slower to use than alternatives, but almost all keyboards are QWERTY now.


Examples of Social Influences on Demand—cont.

Fairness People like to be treated fairly, and prefer to treat each other fairly even if it is bad for them financially Example: People tend to tip their servers, even if they never plan to go back to the restaurant. Businesses learn from this, and attempt to appear fair even when it will cost them profits. Example: The NFL sells tickets to the Super Bowl at $850-$1,250 (2013 prices); but these tickets get resold for much more. Surveys reveal that NFL fans would consider it unfair if the NFL raised ticket prices; instead, fans believe the current system of randomly distributing tickets to applicants is fairer. The NFL forgoes potential profit to avoid alienating fans.


Testing Fairness in the Laboratory

Ultimatum game Pairs are given $100. Person A proposes a split of the money, say $75 for him, and $25 for person B. If B accepts, each get the money. If B rejects, neither gets any. “Optimal” play: B should accept any split, hence A should offer B very little. Actual play: Non-even splits are often rejected, and people anticipate this, tending to offer 50/50 splits. Dictator game Same game, except B cannot reject. “Optimal” play: give B nothing! Actual play: 50/50 splits are still common!


Testing Fairness in the Laboratory—conclusions

The results from these laboratory games suggest that people strongly value fairness. However it may be the perception of fairness that people value: •  Subjects might be concerned about the experimenter or other

subjects thinking they were selfish, if they kept a large proportion for themselves.

•  When subjects are asked to perform tasks to earn the money, they are more likely to keep as much as they believe they earned.

Conclusion: Care needs to be taken in interpreting artificial laboratory experiments.


Business Implications of Fairness

Occasionally, businesses appear to fail to maximize profits by selling at too low a price. •  Many sports tickets resell at a higher price than they are sold for •  The same is often true for concert tickets

What is happening? Consumers seem to be willing to accept higher prices when they are caused by increased costs, but unwilling to accept them when they are caused by increased demand. •  Businesses may make more long-term profits by forsaking short-

term profits in order to appear fair.


Making the

Connection What’s Up with “Fuel Surcharges”?

As oil prices rose in 2008, many firms introduced “fuel surcharges” to make their cost-related price increases appear fair to consumers.

In 2011, demand for air travel was starting to rise. This would suggest prices would also rise.

But decreases in the price of oil allowed supply to expand.

The unnecessary “fuel surcharges” remained, as companies would not want to explain why prices didn’t fall when the “fuel surcharges” were removed.


What happens when network externalities are present?

a.  The usefulness of telecommunications equipment rises.

b.  The usefulness of networks diminishes with the number of consumers who enter them.

c.  The usefulness of a product increases with the number of consumers who use it.

d.  The usefulness of a product decreases as the number of products rises.

LEARNING OBJECTIVE


Behavioral Economics: Do People Make Their Choices Rationally?

7.4

Describe the behavioral economics approach to understanding decision making.


Behavioral Economics

In recent years, some economists have started studying situations in which people make choices that do not appear to be economically rational. This field of study is known as behavioral economics. Three common mistakes made by consumers are: 1.  Taking into account monetary costs but ignoring nonmonetary

opportunity costs 2.  Failing to ignore sunk costs 3.  Being unrealistic about their own future behavior


1. Ignoring Nonmonetary Opportunity Costs

People often treat monetary and non-monetary costs differently, even though they are both opportunity costs. Example: People who won the NFL lottery for Super Bowl tickets were asked the following two questions: 1.  If you had not won the lottery, would you have been willing to pay

$3,000 for the ticket? 2.  If, after winning the lottery, someone had offered you $3,000 for

your ticket, would you have sold it? Traditional economists believe that if you answer “no” to the first question, you should answer “yes” to the second; both questions rely on whether you value the ticket at $3,000 or more.


Super Bowl Ticket Question Results

People did not answer those questions similarly; far from it: •  94% said they would not have bought the ticket for $3,000; but •  92% said they would not sell the ticket for $3,000 either!

Behavioral economists refer to this difference to the endowment effect: the tendency of people to be unwilling to sell a good they already own even if they are offered a price that is greater than the price they would be willing to pay to buy the good if they didn’t already own it. In simpler terms, people don’t like losing what they have; they consider losing an object to hurt them more than gaining a similar object would help them.


2. Failing to Ignore Sunk Costs

A sunk cost is a cost that has already been paid and cannot be recovered. Once you have paid money and can’t get it back, you should ignore that money in any future decisions you make. But people often allow past costs to influence future decisions. Example: NFL teams persist with first-round-pick quarterbacks much longer than later-round picks with similar performance, because they have “paid” more for the first-rounder. Admitting mistakes and moving on is crucial, but people often find that difficult to do.


Making the

Connection A Blogger Who Understands Sunk Costs

In 2000, Arnold Kim began blogging about Apple products. By 2008, Kim’s site had become very successfully, and he was earning more than $100,000 per year from paid advertising. Sounds good, right? The “problem” was, Kim was a medical doctor who had invested over $200,000 in his education. What should Kim do? He believed he would ultimately make more as a blogger than as a doctor but committing to blogging full-time would mean “wasting” his education. Kim realized his education costs were sunk—unrecoverable regardless of what career choice he made. So he went with what he wanted to do: blogging full time. •  Could you have made the same choice?


3. Being Unrealistic about Future Behavior

People often make decisions that are inconsistent with their long-run intentions. Example: In 2010, 69% of smokers reported wanting to quit, and 52% actually attempted to quit. But despite their intentions, few actually quit; they found it hard to control their future behavior. Have you ever intended to quit a bad behavior or start a new good behavior, and failed? You likely believed that you would be able to carry through with your intentions.


Is Our Theory Useless?

Our theory of utility maximization suggests we should compare the marginal utility per dollar spent on every item we buy. But when you go grocery shopping, buying dozens of items, would you really do this? Likely, no. Does this invalidate our theory? Traditional economists often answer “no”, because: 1.  Unrealistic assumptions are necessary to simplify complex

decision-making problems, in order to focus on the most important factors.

2.  Models are best judged by the success of their predictions, rather than the accuracy of their assumptions.

Indeed, models like our standard one are quite successful in predicting many types of consumer behavior.


The Behavioral Economics of Shopping

Behavioral economists say that it does matter that consumers do not usually make “optimal” consumption choices. •  They believe modeling how people actually make decisions is

important. Some important “irrational” consumption behaviors include: Rules of Thumb •  Making general rules that often, but not always, produce optimal

results •  This can save on decision-making time Anchoring •  “Irrelevant” information can often influence behavior. •  Example: posting “limit 10 items per customer” will often induce

people to buy 10 items, even they would have bought fewer without the sign


Making the

Connection J.C. Penney Meets Behavioral Economics

When Ron Johnson became CEO of J.C. Penney, he instituted a new pricing strategy of “everyday low prices”, instead of artificially high “regular” prices, and normal “sale” prices. It turns out that consumers buy much more when told an item is on sale, even if the sale price is the same as the “everyday low price.” •  This is an example of “anchoring”;

the “regular” price acts as an anchor, making people believe they are getting a good deal.

Johnson thought people were smart enough to see through this common department store ploy. But he was wrong, and he paid for his mistake with his job when he was fired after only 17 months.


What is the study of situations in which people act in ways that are not economically rational called?

a.  Normative economics. b.  Rational economics. c.  Behavioral economics. d.  The economics of fairness.


According to the endowment effect, people are unwilling to sell a good they already own in which of the following cases? a.  Even if they are offered a price greater than the price

they would pay if they did not already own the good. b.  If they are offered a price lower than the price they

would have to pay to replace the good. c.  If they can’t replace the good. d.  If the good was a gift.

LEARNING OBJECTIVE


The Price Elasticity of Demand and Its Measurement

7.5

Define price elasticity of demand and understand how to measure it.


Do People Respond to Changes in the Price of Gasoline?

Some argue that people don’t vary the quantity of gasoline they buy as the price changes. •  Do you think this is correct? From May 2010 to May 2011, the price of gasoline rose by about a third ($2.79 per gallon to $3.89 per gallon). •  Gasoline consumption fell by about 5%.

People do respond to incentives, changing their behavior as prices, incomes, and prices of related goods change. This remaining sections of this chapter explore these behavioral changes.


Measuring Responsiveness to Price Changes

Although we saw consumers did change the amount of gasoline they bought, they didn’t appear to change it by very much. How can we come up with a sensible way to measure how much quantity changes when price changes? One idea is to look at the slope of the demand curve. •  But this won’t work, since the value of the slope depends on the

units used to measure on the axes.


Price Elasticity of Demand

A better way to measure responsiveness of quantity demanded is to think in terms of percentage changes. •  This avoids the problem with units of measurement.

pricein change Percentage

demandedquantity in change Percentagedemand of elasticity Price =

Although the slope and price elasticity of demand are related, they are not the same thing. Since price and quantity change in opposite directions on the demand curve, the price elasticity of demand is a negative number. •  However we often refer to “more negative” elasticities as being

“larger” or “higher”.


Price Elasticity of Demand Terminology

A “large” value for the price elasticity of demand means that quantity demanded changes a lot in response to a price change. Formally, we say demand is price elastic if its price elasticity of demand is larger (in absolute value) than 1. •  So a 10% increase in price would result in a greater than 10%

decrease in quantity demanded. Demand is price inelastic if its price elasticity of demand is smaller (in absolute value) than 1. •  That is, close to zero, indicating that quantity demanded changes

little in response to a price change.

Demand is unit price elastic if the price elasticity of demand is exactly equal to (negative) 1.


Elastic and Inelastic Demand

Along D1, cutting the price from $4.00 to $3.70 increases the number of gallons sold from 1,000 per day to 1,200 per day, so demand is elastic between point A and point B. Along D2, cutting the price from $4.00 to $3.70 increases the number of gallons sold from 1,000 per day only to 1,050 per day, so demand is inelastic between point A and point C.

Elastic and inelastic demand

Figure 7.5


Percentage Changes and the Midpoint Formula

Percentage changes have the unfortunate characteristic that the percentage change from A to B is not the negative of the percentage change from B to A. Example: On the previous slide, from point A to point B, quantity increased from 1,000 to 1,200, an increase of 20%. However from B to A, quantity decreases by 16.7%. This would mean the elasticity from A to B was different from the elasticity from B to A, an undesirable characteristic. To avoid this, we calculate percentage changes using the midpoint formula:

⎟⎠

⎞⎜⎝

⎛ +−

=

2

)(ChangePercentageBABA


The Midpoint Formula

The midpoint formula avoids the confusion of whether we are going from A to B or from B to A: we use the average of A and B in the denominator instead of choosing one of them. Price elasticity of demand becomes:

⎟⎠

⎞⎜⎝

⎛ +−

÷

⎟⎠

⎞⎜⎝

⎛ +−

=

2

)(

2

)(demand of elasticity Price21

12

21

12

PPPP

QQQQ

The first term is the percentage change in quantity, using the midpoint formula. The second term is the percentage change in price, using the midpoint formula.


Calculating Price Elasticity of Demand—part 1

At your gas station, you cut the price from $3.50 to $3.30 per gallon. Gasoline sales went up from 2,000 to 2,500 gallons per day. To calculate this price elasticity, we first need the average quantity and price:

250,22

2,5002,000quantity Average =+

=

40.3$2

$3.30$3.50price Average =+

=



Now calculate the percentage change in quantity and price:

%2.22

1002,2502,0002,500

demandedquantityinchangePercentage

=

×−

=

%9.5

100$3.40$3.50$3.30

priceinchangePercentage

−=

×−

=

Then price elasticity of demand is the ratio of these two:

8.35.9%.2%22

demand ofelasticity Price

−=−

=

This is greater in absolute value than –1, so we say that demand in this range is price elastic.



What if quantity had only increased to 2,100? Percentage change in price remains the same (-5.9%). Percentage change in quantity is now:

%9.4

1002,0502,0002,100

demandedquantityinchangePercentage

=

×−

=

So price elasticity of demand is now…

8.05.9%

4.9%demand ofelasticity Price

−=−

=

This is smaller (in absolute value) than -1, so demand is inelastic.


Observations about Elasticity

While slope and elasticity are not the same, they are related: •  If two demand curves go through the same point, the one with the

higher slope also has the higher (more negative) elasticity.

A vertical demand curve means that quantity demanded does not change as price changes. •  So elasticity is zero. •  A vertical demand curve is perfectly inelastic.

A horizontal demand curve means quantity demanded is infinitely responsive to price changes. •  Elasticity is infinite. •  A horizontal demand curve is perfectly elastic.


Summary of Price Elasticity of Demand—part 1

Summary of the price elasticity of demand

Table 6.1

If demand is… then the absolute value of price elasticity is…




Table 6.1



Do People Respond to Changes in the Price of Gasoline?

We can now use our knowledge to answer this question in economic terms. •  Gasoline demand is inelastic: the quantity demanded does not

change much as the price of gasoline changes. •  It is not perfectly inelastic: it is somewhat responsive to price. Which panel shows this?


Elasticity is a measure that shows:

a.  how producers respond to consumers’ needs. b.  how one economic variable responds to changes

in another economic variable. c.  How the slope of supply and demand curves is

defined. d.  how supply and demand respond to changes in

market conditions.


Which demand curve is more elastic?

a.  The steeper demand curve. b.  The flatter demand curve. c.  Both curves appear to be elastic. d.  Neither curve appears to be elastic.


If demand is perfectly elastic, then what is the impact of an increase in price?

a.  A decrease in quantity demanded to zero. b.  No change in quantity demanded. c.  A proportional change in quantity demanded that is

exactly equal to the proportional change in price. d.  A very small change in quantity demanded.

LEARNING OBJECTIVE


The Determinants of the Price Elasticity of Demand

7.6

Understand the determinants of the price elasticity of demand.


What Determines the Price Elasticity of Demand?

Why do some goods have a high price elasticity of demand, while others have a low price elasticity of demand? There are several characteristics of the good, of the market, etc. that determine this. 1.  The availability of close substitutes If a product has more substitutes available, it will have more elastic demand. Example: There are few substitutes for gasoline, so its price elasticity of demand is low. Example: There are many substitutes for Nikes (Reeboks, Adidas, etc.), so their price elasticity of demand is high.


More Determinants of the Price Elasticity of Demand

2.  The passage of time Over time, people can adjust their buying habits more easily. Elasticity is higher in the long run than the short run. Example: If the price of gasoline rises, it takes a while for people to adjust their gasoline consumption. How might they do that? •  Buying a more fuel-efficient car •  Moving closer to work

3.  Whether the good is a luxury or a necessity People are more flexible with luxuries than necessities, so price elasticity of demand is higher for luxuries. Example: Many people consider milk and bread necessities; they will buy them every week almost regardless of the price. And if the price goes down, they won’t drastically increase their consumption of bread or milk.


Yet More Determinants of the Price Elasticity of Demand

4.  The definition of the market The more narrowly defined the market, the more substitutes are available, and hence the more elastic the demand. Example: You might believe there is no good substitute for jeans, so your demand for jeans is very inelastic. But if you consider different brands of jeans, you might be more sensitive to the price of a particular brand.

5.  The share of a good in a consumer’s budget If a good is a small portion of your budget, you will likely not be very sensitive to its price. Example: You might buy table salt once a year or less; changes in its price will not affect very much how much you buy. Example: Changes in the price of housing do affect where people choose to live.


Some Real-World Price Elasticities of Demand

Estimated real-world price elasticities of demand

Table 7.5

Product Estimated Elasticity Product

Estimated Elasticity

Books (Barnes & Noble) –4.00 Bread –0.40 Books (Amazon) –0.60 Water (residential use) –0.38 DVDs (Amazon) –3.10 Chicken –0.37

Post Raisin Bran –2.50 Cocaine –0.28

Automobiles –1.95 Cigarettes –0.25

Tide (liquid detergent) –3.92 Beer –0.29

Coca-Cola –1.22 Catholic school attendance –0.19

Grapes –1.18 Residential natural gas –0.09

Restaurant meals –0.67 Gasoline –0.06

Health insurance (low-income households) –0.65 Milk –0.04

Sugar –0.04


Making the

Connection Price Elasticity of Demand for Breakfast Cereal

What is the price elasticity of demand for breakfast cereal? The answer depends on whether you mean: •  A particular brand of a particular breakfast cereal •  A particular category of breakfast cereal •  Breakfast cereal in general

The further down the list we go, the more broadly the market is defined, and hence the fewer close substitutes are available. •  So we would expect the price elasticity of demand to become

smaller as we move down the list. •  And so it does:

Cereal Price elasticity of demand

Post Raisin Bran –2.5 All family breakfast cereals –1.8 All types of breakfast cereal –0.9


Which of the following is the most important determinant of price elasticity of demand?

a.  The availability of substitutes. b.  The passage of time. c.  Share of the good in the consumer’s budget d.  The definition of the market.


If a good takes only a small fraction of a consumer’s budget, then this good tends to have:

a.  a more elastic demand. b.  a less elastic demand. c.  a unit-elastic demand curve. d.  a perfectly elastic demand curve.

LEARNING OBJECTIVE


The Relationship between Price Elasticity of Demand and Total Revenue

7.7

Understand the relationship between the price elasticity of demand and total revenue.


Elasticity and the Pricing Decision

If you are a business owner, you need to decide how to price your product. •  “How many customers will I gain if I cut my price?” •  “What will happen to my total revenue if I cut my price?” Total revenue: The total amount of funds received by a seller of a good or service, calculated by multiplying the price per unit by the number of units sold. Knowing the price elasticity of demand for your product can help to answer these questions.


Effect of Cutting Price with Different Elasticities

Suppose demand for your product is relatively price inelastic. •  Customers are not very sensitive to the price of your product. •  As you decrease the price, you expect to gain few additional

customers. •  The few additional customers do not compensate for the lost

revenue, so overall revenue goes down.

Suppose demand for your product is relatively price elastic. •  Customers are very sensitive to the price of your product. •  As you decrease the price, you expect to gain many additional

customers. •  The many additional customers more than compensate for the lost

revenue, so overall revenue goes up.


Cutting Price when Demand Is Inelastic

Revenue before price cut (at A): 1,000 x $4.00 = $4,000 Revenue after price cut (at B): 1,050 x $3.70 = $3,885 The decrease in price does not generate enough extra customers (area E) to offset revenue loss (area C).

The relationship between price elasticity and total revenue

Figure 7.6a


Cutting Price when Demand Is Elastic

Revenue before price cut (at A): 1,000 x $4.00 = $4,000 Revenue after price cut (at B): 1,200 x $3.70 = $4,440 The decrease in price generates enough extra customers (area E) to more than offset revenue loss (area C).

The relationship between price elasticity and total revenue

Figure 7.6b


Why Are Elasticity and Total Revenue Related?

The formula for price elasticity of demand is:

pricein change Percentagedemandedquantity in change Percentagedemand of elasticity Price =

So if this is greater than 1 (in absolute terms) then quantity demanded goes up by a higher percentage than price, raising the revenue. A special case occurs when price elasticity of demand is -1: the percentage change in quantity demanded equals the percentage change in price, so revenue does not change.


Total Revenue along a Linear Demand Curve

Suppose we have a linear demand curve. What happens to total revenue as price increases? •  Initially, total revenue rises,

suggesting demand is inelastic. •  But then total revenue starts to

fall, suggesting demand is elastic!

Elasticity is not constant along a linear demand curve

Figure 7.7


Total Revenue along a Linear Demand Curve—cont.

The data from the table are plotted in the graphs. As price decreases from $8, revenue rises—hence demand is elastic. As price continues to fall, revenue eventually flattens out—demand is unit elastic. Then as price falls even further, revenue begins to fall—demand is inelastic.

Elasticity is not constant along a linear demand curve

Figure 7.7


Price Elasticity of Demand and Revenue

The relationship between price elasticity and revenue

Table 7.6

If demand is… then... because... elastic an increase in price

reduces revenue the decrease in quantity demanded is proportionally greater than the increase in price.

elastic a decrease in price increases revenue

the increase in quantity demanded is proportionally greater than the decrease in price.

inelastic an increase in price increases revenue

the decrease in quantity demanded is proportionally smaller than the increase in price.

inelastic a decrease in price reduces revenue

the increase in quantity demanded is proportionally smaller than the decrease in price.

unit elastic an increase in price does not affect revenue

the decrease in quantity demanded is proportionally the same as than the increase in price.

unit elastic a decrease in price does not affect revenue

the increase in quantity demanded is proportionally the same as than the decrease in price.


Estimating Price Elasticity of Demand

We can see that knowing the price elasticity of demand would be very useful for a firm. But how can a firm know this information?

•  For a well-established product, economists can use historical data to estimate the demand curve.

•  To calculate the price elasticity of demand for a new product, firms often rely on market experiments.

With market experiments, firms try different prices and observe the change in quantity demanded that results.


Common Misconceptions to Avoid

Economists do not assume people maximize utility, but they commonly assume people behave as if they maximized utility. To maximize utility, do not seek to equalize the utility gained from each unit of a good but instead from each dollar spent on each good. Take care interpreting economic experiments; the lessons sometimes don’t carry over to the “real world”. While price elasticity of demand is strictly negative, we often refer to it as a positive number. Don’t think because of this that quantity demanded and price move in the same direction.


Refer to the figure below. In which of the graphs does a price decrease lead to an increase in total revenue?

a.  In the graph on the left. b.  In the graph on the right. c.  In both graphs. d.  In neither graph.


When demand is price-elastic, what is the relationship between price and total revenue?

a.  They move together. b.  They move in opposite directions. c.  They move in unpredictable directions. d.  They are not related at all.

chapter 7 consumer choice and elasticity

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