Behind the Demand Curve:
Consumer choice
Microeconomics
Explaining the law of demand
 Substitution Effect of a change in the price of a good is
…
the change in the quantity of that good demanded
as the
consumer substitutes the good cheaper good for the
more expensive good
Need pictures
Substitution effect
Eli has $6 so spend on snacks. Jellybeans cost $1/package and
Gummy Worms cost $2/package.
What is the max amount of packages Eli can buy given he has to buy
at least one jellybean and at least 1 gummy worms?
4 jelly beans and 1 gummy worms
What is the opportunity cost of one gummy worms?
1 gummy worm is 2 jellybeans
Substitution effect
 The price of gummy worms falls to $1/package. Jelly beams remains the
same.
 What is the opportunity cost of one gummy worms?
 One jelly beans
 So, gummy worms are now less expensive, and Eli will substitute some
gummy worms for jelly beans.
The substitution effect of a lower price creates
an increase in quantity demanded.
Explaining the law of demand
 Income effect of a change in the price of a good is …
the change in the quantity of that good demanded
that results
From a change in the consumer’s purchasing power
Need pictures
Income effect
Eli has $6 so spend on snacks. Jellybeans cost $1/package and
Gummy Worms cost $2/package.
How many packages of jellybeans could Eli buy if he spends all his
income on jellybean? Gummy worms?
6 packages jellybeans
3 packages gummy worms
Gummy worms are now $1 each. How many packages of gummy
worms can he buy?
6 packages
Income effect
income
purchasing power has increased. He
 Eli’s
is the same. His
now has the opportunity to buy more gummy worms.
Substitution effect + income effect =
 lower price creates an increase in quantity demanded.
Exercises
Do CYU # 1 and TTT 1 an 2 on the handout
Defining and Measuring Elasticity
 Price Elasticity of Demand is the ratio …
Ed = %
QD (effect) / %
P (cause)
Elastic = consumer relatively responsive to
Inelastic = consumer unresponsive
P
P
Calculating Price Elasticity of Demand
(Ed)
The price of digital cameras increase by 1% and quantity demanded
falls by 2%. What is the Ed?
Ed = -2%/1% = -2; absolute value of -2 = 2.
%
Qd was twice as large as the %
Sensitive = Elastic
in P
Calculating Price Elasticity of Demand
(Ed)
The price of milk increases by 10% and quantity demanded falls by 5%.
Ed = -5%/10% = -1/2; absolute value = ½ or .5
%
Qd was half as large as the %
Insensitive = Inelastic
in P
Calculating Ed
Computing a % ∆ Between Two Numbers
% ∆ P= (New Price – Old Price/ Old Price) *100
% ∆ Qd= (New Quantity – Old Quantity/ Old Quantity) *100
The price of a doughnut rises from $1.00 to $1.15 and Homer reduces his weekly doughnut
consumption from 20 to 19.
Calculating Ed
The price of a doughnut rises from $1.00 to $1.15 and Homer reduces his weekly doughnut
consumption from 20 to 19.
%∆P = 100(New Price – Old Price/Old Price) = 100*(1.15 – 1)/1 = 15% increase
%∆Qd = 100(New Quantity – Old Quantity/Old Quantity) = 100(19-20)/20 = 5% decrease
Homer’s Price Ed for doughnuts = %∆Qd/ %∆P = 5%/15% = 1/3
Is Homer’s Ed elastic or inelastic?
Inelastic (fraction)
Calculating Ed Using the Mid Point Method
The price of a college tuition increases from $20,000 to $24,000 per year. The college discovers that
the entering class of first-year students declined form 500 to 450.
%∆P = 100(New Price – Old Price)/Average Price) =
100*(24,000 – 20,000)/22,000 = 9.5 increase
%∆Qd = 100(New Quantity – Old Quantity)/Average Quantity) =
(450 – 500)/475 = -10.5% decrease
Price Ed for college tuition = %∆Qd/ %∆P = 9.5%/10.5% = .90
Is the price of college tuition elastic or inelastic?
Inelastic (fraction)
Price Elasticity of Demand
Price Elasticity of Demand is the consumer
response (Qd) to a price change.
Ed = % change Qd/ % change P
Ed < 1 = demand inelastic
Ed = 1 = demand Unit elastic
Ed > 1 = demand elastic
“Perfectly inelastic demand” (one extreme case)
Consumers have NO response to higher or lower prices.
D curve:
P
vertical
P1
Consumers’
price sensitivity: 0
Elasticity: 0
D
P2
P falls by
10%
Q1
Q changes
by 0%
Q
CHAPTER 5
ELASTICITY AND
ITS APPLICATION
“Perfectly elastic demand” (the other extreme)
Consumers immediately reduce consumption to zero.
P
D curve: horizontal
Consumers’
price sensitivity: extreme
Elasticity: infinity
D
P2 = P1
P changes by
0%
Q1
Q2
Q changes
by any %
Q
CHAPTER 5
ELASTICITY AND
ITS APPLICATION
Elastic v. Inelastic
E
I nelastic
lastic
Elastic v. Inelastic
D curve closer to vertical (steeper) WILL BE
less elastic than a D curve closer to horizontal (flatter)
Unit Elastic Demand
Price elasticity
of demand
=
% change in Q
% change in P
Elasticity: 1
P falls by
10%
=
10%
=1
P
D curve: intermediate slope
Consumers’
price sensitivity: intermediate
10%
P1
P2
D
Q1
Q2
Q
Q rises by 10%
CHAPTER 5
ELASTICITY AND
ITS APPLICATION
“Inelastic demand”
Price elasticity
of demand
D curve:
=
% change in Q
% change in P
=
< 10%
<1
10%
P
relatively steep
Consumers’
price sensitivity: relatively low
P1
P2
D
Elasticity: < 1
P falls by
10%
Q1 Q2
Q rises less than
10%
Q
CHAPTER 5
ELASTICITY AND
ITS APPLICATION
“Elastic demand”
Price elasticity
of demand
=
% change in Q
% change in P
10%
>1
P
D curve: relatively flat
Consumers’
price sensitivity: relatively high
Elasticity: > 1
=
> 10%
P falls by
10%
P1
P2
D
Q1
Q
Q2
Q rises more than
10%
CHAPTER 5
ELASTICITY AND
ITS APPLICATION
Total Revenue
 Total Revenue (TR) = Price (P) * Quantity Demanded (Qd)
 P competes with Qd  on TR
 Who wins?
 Depends!!
Price Effect
Price effect happens after a price increase
when …
Units sold sells at a higher P
Revenue rises
P and TR 
Quantity Effect
Quantity effect happens after a price increase
when …
Fewer units are sold –m lower Qd
Revenue is lower
P and TR 
P and Qd Effect Examples
P rises 1% and Qd decreases 5%
Elastic or inelastic?
Which effect is stronger?
TR fall or rise?
P and Qd Effect Examples
P rises 10% and Qd decreases 5%
Elastic or inelastic?
Which effect is stronger?
TR fall or rise?
P and Qd Effect Examples
P rises 10% and Qd decreases 10%
Elastic or inelastic?
Which effect is stronger?
TR fall or rise?
Elasticity Along the Demand Curve
P
Qd
TR
$0
70
$0
1
60
60
2
50
100
3
40
120
4
30
120
5
20
100
6
10
60
7
0
0
Pe of D
The Determinants of Price Elasticity:
A Summary
Elastic
Inelastic
Luxury
Necessity
Available Substitute
Unavailable Substitute
Ample Time Available Little Time Available
Large Portion of
Income
Small Portion of
Income
CHAPTER 5
ELASTICITY AND
ITS APPLICATION
EXAMPLE 1:
Rice Krispies vs. Sunscreen
 The prices of both of these goods rise by 20%.
For which good does Qd drop the most? Why?
 Rice Krispies has lots of close substitutes
(e.g., Cap’n Crunch, Count Chocula),
so buyers can easily switch if the price rises.
 Sunscreen has no close substitutes,
so consumers would probably not
buy much less if its price rises.
 Lesson: Price elasticity is higher when close substitutes are
available.
CHAPTER 5
ELASTICITY AND
ITS APPLICATION
EXAMPLE 2:
“Blue Jeans” vs. “Clothing”
 The prices of both goods rise by 20%.
For which good does Qd drop the most? Why?
 For a narrowly defined good such as
blue jeans, there are many substitutes
(khakis, shorts, Speedos).
 There are fewer substitutes available for broadly defined goods.
(Can you think of a substitute for clothing,
other than living in a nudist colony?)
 Lesson: Price elasticity is higher for narrowly defined goods
than broadly defined ones.
CHAPTER 5
ELASTICITY AND
ITS APPLICATION
EXAMPLE 3:
Insulin vs. Caribbean Cruises
 The prices of both of these goods rise by 20%.
For which good does Qd drop the most? Why?
 To millions of diabetics, insulin is a necessity.
A rise in its price would cause little or no decrease in demand.
 A cruise is a luxury. If the price rises,
some people will forego it.
 Lesson: Price elasticity is higher for luxuries than for necessities.
CHAPTER 5
ELASTICITY AND
ITS APPLICATION
EXAMPLE 4:
Gasoline in the Short Run vs. Gasoline in the Long Run
 The price of gasoline rises 20%. Does Qd drop more in the short
run or the long run? Why?
 There’s not much people can do in the
short run, other than ride the bus or carpool.
 In the long run, people can buy smaller cars
or live closer to where they work.
 Lesson: Price elasticity is higher in the
long run than the short run.
CHAPTER 5
ELASTICITY AND
ITS APPLICATION
Elasticity of a Linear Demand Curve
P
$30
200%
E =
= 5.0
40%
20
67%
67%
E =
40%
E =
= 0.2
200%
10
$0
= 1.0
0
20
40
60
The slope
of a linear
demand
curve is
constant,
but its
elasticity
is not.
Q
CHAPTER 5
ELASTICITY AND
ITS APPLICATION
Other Elasticities
 Suppose the price of gasoline were to increase. Who
would be interested?
 Large trucks and SUVs, FEDEX, any business which relies
on trucks to transport its goods
 Cross-Price Elasticity is used to measure this response.
Other Elasticities
 Cross-Price Elasticity of Demand measures the response of demand
for one good to changes in the price of another good.
Cross-price elast.
of demand
=
% change in Qd for good 1
% change in P of good 2
 Substitute - cross-price elasticity > 0
 E.g., an increase in price of beef causes an increase in
demand for chicken.
 Complements - cross-price elasticity < 0
 E.g., an increase in price of computers causes decrease in
demand for software.
CHAPTER 5
ELASTICITY AND
ITS APPLICATION
Other Elasticities
 Suppose the economy is suffering a recession and
personal incomes are lower. Who would be interested?
 Airlines and the hotel industries
 Income Elasticity is used to measure this response.
Other Elasticities
 Income Elasticity of Demand (Ei)measures the response of Qd
to a change in consumer income.
d
Percent
change
in
Q
Income elasticity of
=
demand
Percent change in income
 What is a normal good? Inferior good?
 Normal goods – Ei > 0
 Example: Consumer income rises by 4% and the quantity of
fresh vegetables purchased increases by 1%.
 Inferior goods - Ei < 0
 Consumer income falls by 5% and consumers increase SPAM
consumption by 4%
CHAPTER 5
ELASTICITY AND
ITS APPLICATION
Other Elasticities
 The Law of Supply says …
 P increases, Qs increases
 Economists want to measure HOW MUCH Q will increase in
response to this higher P.
 Price Elasticity of Supply is used to measure this response.
Price Elasticity of Supply
 Price elasticity of supply measures how much Qs responds to a
change in P.
Price elasticity of
supply
=
Percentage change in Qs
Percentage change in P
Es < 1 = demand inelastic
Es = 1 = demand Unit elastic
Es > 1 = demand elastic
CHAPTER 5
ELASTICITY AND
ITS APPLICATION
Price Elasticity of Supply Factors
 Availability of Inputs
 More elastic = inputs get into and out of production quickly
 Time Period
 ‘Market period’ is short = Es is inelastic
 ‘Short-run supply’ more elastic than Market Period and less
elastic than Long-run Supply.
 ‘Long-run supply’ is most elastic = longer time period to adjust