Demand and Price Determination

There are several names used to describe the US Economy Free Enterprise Free Market Capitalistic Private Enterprise Price Directed

The American Economy

There are three components in the American economic system that make it unique, and that allow the price directed nature to drive the economy.

1. Price System 2. Private Property 3. Competition

These features are called the Pillars of Private Enterprise.

Price Directed Economy

In a market economy, price serves two important functions

1. Price motivates production.

Price Directed Economy

In a market economy, price serves two important functions

1. Price motivates production. 2. Price rations goods

 In order to establish price, a market depends upon the interaction between sellers (producers) and buyers (consumers). The market forces that influence the actions of these two groups are known as Supply and Demand. We will be concentrating upon Demand, since most of us are more familiar with acting as consumers.

Demand Demand is defined as the overall willingness of consumers to purchase (or consume) a given quantity of a given good (or service) at a given price, a given place and a given time.
We will generally assume that place and time are constant (even though we know they are not). This definition means that demand includes all goods, at any price. A change in price has no effect upon demand, since demand includes all possible prices. Demand can be affected by a change in any factor other than price.

Quantity Demanded is defined as the actual amount that will be bought (or consumed) once the price is specified.
This means that quantity demanded is tied to a price, and any change in price will result in a change in quantity demanded.

The Law of Demand The Law of Demand states that as price rises, quantity demanded will fall. As price falls, quantity demanded will rise.
The law reflects the inverse relationship between price and quantity demanded.

There are three proofs of the Law of Demand:

1. The Law of Diminishing Marginal Utility At some point during consecutive consumption of like objects, the utility received from consumption of an additional unit will be less than the utility received from consumption of the previous unit.

2. The Income Effect Since income is relatively fixed, as prices rise, one can no longer afford to buy the same amount of a good, so quantity demanded falls. Inversely, as price falls, one can buy more with the same income, so quantity demanded rises.

3. The Substitution Effect As prices rise, we tend to substitute less expensive alternatives, thus quantity demanded (for the original good) goes down.

Exceptions to the Law of Demand

1. Speculative Purchases -Goods bought with the intent to resell. Increasing price can prove to buyers that the product is a good investment, and inspire them to buy more.

Exceptions to the Law of Demand

2. Immature Markets -As a market develops, shortages can cause prices to rise while demand is still increasing. If there is enough time, the market will catch up, producing more items to satisfy that demand. Before the market catches up, people will continue to buy more even though prices are rising.

Exceptions to the Law of Demand

3. Luxury Goods - Some items are bought not because of what they are, but rather because of the message they send. In those cases, an increasing price can make the item more attractive, and quantity demanded will rise even though the price is increasing. These items are also known as Veblen Goods.

Demand Curves
We can create values for a graph by creating a Demand Schedule, a chart that shows different prices, and the Quantities Demanded that correspond to each price.

Demand Schedule Price Qd $1....300 $2.200 $3.100

Demand Curves
We can use the Demand Schedule to emphasize the difference between changes in Demand and changes in Quantity Demanded.
Demand Schedule Price Qd $1....300 $2.200 $3.100 Since Demand represents the overall willingness to buy, it encompasses all three prices. As the price changes, note that you simply move to a new Quantity Demanded, while overall Demand is unchanged.

Now we can take the values from the Demand Schedule, and apply them to the xy graph.

Demand Curves
We can now take the data points provided by the price and quantity demanded that corresponds to that price, and plot those points onto an XY graph. The Y values will be price, the X values will be quantity, resulting in a graph that looks like this

Demand Curves
A normal Demand Curve will always take a downward slope.
3.5

3
2.5 Price 2 1.5 1 0.5 0 0 100 200 Quantity 300 400

Change in Quantity Demanded

3.5

3
2.5

Price

2 1.5 1 0.5 0 0 100 200 Quantity 300 400

8 Determinants of Demand 1. in Seasons

8 Determinants of Demand 1. in Seasons 2. in Consumer Preference

8 Determinants of Demand 1. in Seasons 2. in Consumer Preference 3. in Perceived Utility

8 Determinants of Demand 1. 2. 3. 4. in Seasons in Consumer Preference in Perceived Utility in Income (Normal/Inferior)

8 Determinants of Demand 1. 2. 3. 4. 5. in Seasons in Consumer Preference in Perceived Utility in Income (Normal/Inferior) in Price of Substitutes

8 Determinants of Demand 1. 2. 3. 4. 5. 6. in Seasons in Consumer Preference in Perceived Utility in Income (Normal/Inferior) in Price of Substitutes in Price of Complements

8 Determinants of Demand 1. 2. 3. 4. 5. 6. 7. in Seasons in Consumer Preference in Perceived Utility in Income (Normal/Inferior) in Price of Substitutes in Price of Complements in Consumer Expectations

8 Determinants of Demand
1. 2. 3. 4. 5. 6. 7. 8. in Seasons in Consumer Preference in Perceived Utility in Income (Normal/Inferior) in Price of Substitutes in Price of Complements in Consumer Expectations in Market Size

Price Elasticity of Demand

A measure of the responsiveness of quantity demanded to changes in price.
We know that price will cause quantity demanded to change, and we know that quantity demanded will change in the opposite direction from price. What we dont know is how much quantity demanded will change. There are other types of elasticity, but we will only be concerned with price elasticity at this point.

Price Elasticity of Demand

A measure of the responsiveness of quantity demanded to changes in price. Three Possible States of Elasticity 1. Inelastic - % P>% Qd

Price Elasticity of Demand

A measure of the responsiveness of quantity demanded to changes in price. Three Possible States of Elasticity 1. Inelastic - % P>% Qd 2. Unitary Elasticity (or Unit Elastic) - % P=% Qd

Price Elasticity of Demand

A measure of the responsiveness of quantity demanded to changes in price. Three Possible States of Elasticity 1. Inelastic - % P>% Qd 2. Unitary Elasticity (or Unit Elastic) - % P=% Qd 3. Elastic (or Highly Elastic) - % P<% Qd

Price Elasticity of Demand

Testing for Inelasticity Three Qualifications for Inelasticity
If a good has any of these qualities, it will be an inelastic good. If it has none of these, then it will be elastic (or highly elastic).

1. It is a necessity.

Price Elasticity of Demand

Testing for Inelasticity Three Qualifications for Inelasticity
If a good has any of these qualities, it will be an inelastic good. If it has none of these, then it will be elastic (or highly elastic).

1. It is a necessity.

2. There is no close substitute.

Price Elasticity of Demand

Testing for Inelasticity Three Qualifications for Inelasticity
If a good has any of these qualities, it will be an inelastic good. If it has none of these, then it will be elastic (or highly elastic).

1. It is a necessity. 2. There is no close substitute.

3. It is so inexpensive that it occupies an insignificant portion of the budget.

 Point Test Calculate the percentage change in price and in quantity demanded and compare to the formula.
1. Inelastic - % P>% Qd 2. Unitary Elasticity (or Unit Elastic) - % P=% Qd 3. Elastic (or Highly Elastic) - % P<% Qd

Price Elasticity of Demand

Demand Schedule Price Qd $1....300 $2.150 $3.100

 Point Test Calculate the percentage change in price and in quantity demanded and compare to the formula.
1. Inelastic - % P>% Qd 2. Unitary Elasticity (or Unit Elastic) - % P=% Qd 3. Elastic (or Highly Elastic) - % P<% Qd

Price Elasticity of Demand

Demand Schedule Price Qd $1....300 $2.150 $3.100

Demand Schedule Price Qd $1....300 $2.200 $3.150

 Point Test Calculate the percentage change in price and in quantity demanded and compare to the formula.
1. Inelastic - % P>% Qd 2. Unitary Elasticity (or Unit Elastic) - % P=% Qd 3. Elastic (or Highly Elastic) - % P<% Qd

Price Elasticity of Demand

Demand Schedule Price Qd $1....300 $2.150 $3.100

Demand Schedule Price Qd $1....300 $2.200 $3.150

Demand Schedule Price Qd $1....300 $2.100 $3...50

Price Elasticity of Demand

Total Revenue Test Multiply Price x Quantity Demanded to calculate Total Revenue.

Demand Schedule Price Qd $1....300 = $2..200 = $3..150 =

TR 300 400 450

Price Elasticity of Demand

Total Revenue Test Multiply Price x Quantity Demanded to calculate Total Revenue. If TR rises as price rises, then the good is inelastic.

Demand Schedule Price Qd $1....300 = $2..200 = $3..150 =

TR 300 400 450

Price Elasticity of Demand

Total Revenue Test Multiply Price x Quantity Demanded to calculate Total Revenue. If TR declines as price rises, then the good is elastic.

Demand Schedule Price Qd $1....300 = $2..100 = $3....50 =

TR 300 200 150

Price Elasticity of Demand

Total Revenue Test Multiply Price x Quantity Demanded to calculate Total Revenue. If TR remains constant as price rises, then the good is unit elastic.

Demand Schedule Price Qd TR $1.....300 = 300 $2..150 = 300 $3..100 = 300

Price Elasticity of Demand

Total Revenue Test Multiply Price x Quantity Demanded to calculate Total Revenue. ????

Demand Schedule Price Qd TR $1....300 = 300 $2..125 = 250 $3..100 = 300

Price Elasticity of Demand

Proving Elasticity or Inelasticity
The Coefficient of Elasticity

Price Elasticity of Demand

If the % change in quantity demanded is a larger number than the % change in price, then the coefficient will be greater than 1. By definition, this identifies an Elastic Good, so any time the coefficient is a positive number greater than one, the good must be Elastic. The greater the value above 1, the greater the degree of elasticity.

Price Elasticity of Demand

If the % change in quantity demanded is a smaller number than the % change in price, then the coefficient will be less than 1. By definition, this identifies an Inelastic Good, so any time the coefficient is a value less than 1, the good must be inelastic. The greater the value below 1, the greater the degree of inelasticity.

Price Elasticity of Demand

If the % change in quantity demanded is an equal number to the % change in price, then the coefficient will be exactly 1. By definition, this identifies a Unit Elastic Good, so any time the coefficient is exactly one, the good must be unit elastic. A coefficient value of 1 is unusual, but not impossible. It is no more or less likely an occurrence than any other single point in the range.

Demand Curve for an Elastic Good

>45
Price

Quantity

Demand Curve for an Inelastic Good

>45
Price

D
Quantity

Demand Curve for a Unit Elastic Good

= 45
Price

Quantity

Perfectly Inelastic and Perfectly Elastic

There are two theoretically possible states of elasticity, that result in either an % change in quantity demanded or a 0% change in quantity demanded.
3.5 3 2.5 3.5

=90 degrees Price

3 2.5 2 1.5 1

Price

2 1.5 1 0.5 0 0 100

= 0 degrees

D
200 300

0.5 0 0 100 200 300 400

Quantity

Quantity

Change in Elasticity
3.5 3 2.5

Price

2 1.5 1 0.5 0 0 100 200 Quantity 300 400