Law of Demand

Law of Demand
People do less of what they want to do as the cost of doing it rises

Recall the Cost-Benefit Principle

Pursue an action if and only if its benefits are at least as great as its costs

Recall the Reservation Price

The highest price wed be willing to pay
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Total Expenditure
Total Expenditure equals
The number of units sold multiplied by the price of the good

Total Expenditure = Total Revenue

The dollar amount that consumers spend on a product is equal to the dollar amount that sellers receive

The Law of Demand and Total Expenditure

Will consumers spend more on my product if I sell more units at a lower price or fewer units at a higher price?
Depends upon price elasticity of demand

When price rises, total expenditure may

increase, decrease, or stay the same

This is due to the Law of Demand

As price rises, quantity demanded falls As price falls, quantity demanded rises

Fig. 5.7 The Demand Curve for Movie Tickets

Fig. 5.8 The Demand Curve for Movie Tickets

Fig. 5.10 Total Expenditure as a Function of Price

Price Elasticity of Demand

In order to predict what will happen to total expenditures,
We must know how much quantity will change when the price changes

Price elasticity of demand is

the percentage change in the quantity demanded that results from a one-percent change in its price
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Price Elasticity of Demand

P
D

% Q %P

Price Elasticity
Elastic quantity changes by a lot when price changes even a little
price elasticity is greater than one

Inelastic quantity changes by a little when price changes even a lot

price elasticity is less than one

Unit elastic quantity change = price change

price elasticity equals one

When calculating price elasticity of demand, you will always get a negative- WHY?
For convenience we will take the absolute value
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Fig. 5.11 Elastic and Inelastic Demand

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Price Elasticity and Expenditures

For an elastic product
Quantity demanded is highly responsive Percentage change in quantity dominates An increase in price will reduce total expenditure A decrease in price will increase total expenditure

For an inelastic product

Quantity demanded is not responsive Percentage change in price dominates An increase in price will increase total expenditure A decrease in price will decrease total expenditure
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Determinants of Elasticity
Substitution possibilities
Price elasticity of demand will be relatively high if it is easy to substitute between products Why?

Budget share
The larger the share of the budget the good uses tends to have higher price elasticities of demand Why?

Time
Because substitution takes time, price elasticity will be higher in the long run than in the short run
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Examples
What are some goods that will have very elastic demand?

What are some goods that will have very inelastic demand?

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Calculating Price Elasticity

Proportion by which quantity demanded changes divided by the proportion by which price changes

%Q %P

Q Q P

P Q 1 slope

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Fig. 5.12 Graphical Interpretation of Price Elasticity of Demand

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Other Elasticities of Demand

Income Elasticity of Demand
The amount by which the quantity demanded changes in response to a onepercent change in income Positive for normal goods Negative for inferior goods

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Other Elasticities of Demand

Cross Price Elasticity of Demand
The amount by which the quantity demanded of one good changes in response to a one-percent change in the price of another good Positive for substitutes Negative for complements

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Perfect Elasticity
Perfectly Elastic demand
Price elasticity of demand is infinite Even the slightest change in price leads consumers to find substitutes

Perfectly Inelastic demand

Price elasticity of demand is zero Consumers do not switch to substitutes even when price increases dramatically

Do goods like these exist?

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Fig. 5.14 Perfectly Elastic and Perfectly Inelastic Demand Curves

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Price Elasticity of Supply

The percentage change in the quantity supplied that will occur in response to a one-percent change in its price

S P

% Q %P

Q Q P P

P Q 1 slope

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Determinants of Supply Elasticity

The more easily additional units of inputs can be acquired, the higher the price elasticity (more elastic) Flexibility of Inputs Mobility of Inputs Ability to Produce Substitute Inputs Time Unique and Essential Inputs
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Perfect Elasticity
Perfectly Inelastic
Elasticity of supply is zero Whether the price is high or low, the same amount is available

Perfectly Elastic
Elasticity of supply is infinite When additional units can be produced using the same combination of inputs purchased at the same prices
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Fig. 6.10 A Perfectly Inelastic Supply Curve

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Fig. 6.11 A Perfectly Elastic Supply Curve

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Elasticity of Supply
What determines whether the supply of a particular good will be elastic or inelastic?
Availability of resources used to produce the good how quickly and easily can producers respond to a price change?

Eg of good with inelastic supply? Eg of good with elastic supply?

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Naturalist Questions
Why do you pay $5 for a beer in the airport when you can buy the same beer for less than $1 outside the airport? Why do you get a discounted airfare when you stay over a Saturday night? Why are there so many personalized license plates in Virginia vs. NC?
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