R14 SS4 Intro to Demand

What does a high cross-price elasticity of demand suggest?

A high value indicates that the products are very close substitutes (i.e., if the price of one rises by only a small amount, demand for the other will rise significantly). For substitutes, the numerator and denominator of the cross-elasticity formula head in the same direction. cross-price elasticity of demand for substitutes is positive.

What effects are in play when a normal good price decreases?

Both the substitution effect and income effect. A decrease in price tends to cause consumers to buy more of this good in place of other goods. The increase in real income resulting from the decline in this good's price causes people to buy even more of this good. Thus, for normal goods, substitution and income effects reinforce each other

Income Elasticity of Demand Equation

% change in quantity demanded / % change in income

If demand is relatively elastic, a 5% decrease in price will result in

an increase in quantity demanded of more than 5%. Therefore, total expenditure (or revenue) will increase.

Law of demand

as the price of a product increases (decreases), consumers will be willing and able to purchase less (more) of it (i.e., price and quantity demanded are inversely related)

Total expenditure (and revenue) equals

price times quantity purchased (sold)

Substitution Effect

A good becomes relatively cheaper compared to other goods, so more of the good gets substituted for other goods in the consumer's consumption basket. For example, when the price of beef falls, it becomes relatively cheaper compared to chicken. As a result, the typical consumer will purchase a little more beef and a little less chicken than before.

If own-price elasticity of demand is greater than 1

Demand is relatively elastic

If own-price elasticity of demand lies between 0 and 1

Demand is relatively inelastic

own price elasticity of demand equation

ED = % change in quantity demanded / % change in price ED = change in quantity demanded / change in price x Price divided by quantity demanded

On the demand curve, the area above the unit-elastic demand midpoint is

Elastic demand

Normal Good

If Income elasticity is positive, it's a normal good.

Proportion of Income Spent on the Good

If small proportion of consumer income is spent on the good, like toothpaste, consumption will not significantly drop if prices increase. Demand is relatively inelastic If consumption of the good takes up a large portion of income, like a car, may be forced to reduce quantity demanded quite a bit when price increases. Demand is elastic.

Total Revenue and Price Elasticity

If the demand curve facing a producer is relatively elastic, an increase in price will decrease total revenue. If the demand curve facing a producer is relatively inelastic, an increase in price will increase total revenue. If the demand curve facing a producer is unit elastic, an increase in price will not change total revenue.

If no effect on demand from income,

Income elasticity of demand = 0

Income Elasticity of Demand

Income elasticity of demand measures the responsiveness of demand for a particular good to a change in income, holding all other things constant.

On the demand curve, the area below the unit-elastic demand midpoint is

Inelastic Demand

Own-Price Elasticity of Demand

Sensitivity of quantity demanded to change in price.

If the percentage increase in price is lower than the percentage decrease in quantity demanded,

Total revenue will decline

Availability of Close Substitutes

If consumer can easily switch from good, response to price increase is high, thus demand is relatively elastic Generally, demand curve faced by individual producers is more elastic than industry. Think Nike versus all shoes.

The income effect of a price change depends on

whether the good is normal or inferior. For a normal good, the income effect reinforces the substitution effect, both leading to a negatively sloped demand curve. For an inferior good, the income effect and the substitution effect work in opposite directions.

Demand Equation

"the quantity demanded of Good X (QDX) depends on the price of Good X (PX), consumers' incomes (I), and the price of Good Y (PY), etc."

Cross-Price Elasticity of Demand Equation

% change in quantity of A demanded / % change in price of B Also found by multiplying Change in quantity demanded of A / Change in price of B by Price of B divided by quantity demanded of A

ceteris paribus

all other things being equal

Explain changing elasticity along the curve

At lower prices with high quantities, the ratio of price to quantity is low, so demand is relatively inelastic At high prices and lower quantities, ratio of price to quantity is high, so elasticity of demand is higher and relatively elastic

What are Demand Elasticity Predictors?

Availability of Close Substitutes Proportion of Income Spent on the Good Time Elapsed since Price Change The Extent to Which the Good Is Viewed as Necessary or Optional

Complements

For complements, the numerator and denominator of the cross-elasticity formula head in opposite directions. The cross elasticity of demand for complements is negative. Note that two products are classified as complements if the cross-price elasticity of demand is negative, regardless of whether they are typically consumed as a pair.

What goods have upward sloping demand curves?

Giffen and Veblen goods

When price elasticity is greater than one (relatively elastic), the numerator

MUST be greater than the denominator. If the denominator changes by 5%, the numerator HAS to change by more than 5%. The effect of a decrease in prices will be outweighed by the effect of the increase in quantity demanded and total expenditure will rise.

When income changes, the demand curve...

Shifts right for normal goods and left for inferior goods

Giffen Goods

Special case where inferior good's negative income effect of a decrease in price of good is so strong it outweighs the positive substitution effect. Thus, quantity demanded falls when there is a decrease in price. All Giffen goods are inferior, but not all inferior goods are Giffen goods.

Reasons law of demand holds

Substitution and income effect

Income Effect

The consumer's real income increases (in terms of the quantity of goods and services that can be purchased with the same dollar income), which leads to an increase in quantity of the good purchased. For example, if the price of beef were to fall, the typical consumer would purchase more beef (and other goods, as well) because of the increase in her real income.

Time Elapsed since Price Change

The longer the time that has elapsed since the price change, the more elastic demand will be. Think of gas. Gas goes up, we can't immediately stop driving to work. With time we may move closer to work or ride a bike. Long run demand is elastic Durable goods behave differently. If price of refrigerators fall, may get a bump, but if prices stay low for awhile, will not increase buying of refrigerators over lifetime

The Extent to Which the Good Is Viewed as Necessary or Optional

The more the good is seen as being necessary (or non-discretionary), the less elastic its demand is likely to be. The more the good is seen as being optional (or discretionary), the more elastic its demand is likely to be. Example, demand for milk (a non-discretionary item) is less elastic than demand for opera tickets (a discretionary item).

Substitution and income effect on Inferior goods

The substitution effect of a change in price will be the same as for a normal good (i.e., a decrease in price of the good will cause the consumer to buy more of the good). However, the income effect will be the opposite of what it is for a normal good. For an inferior good, the increase in real income resulting from a decline in the good's price will cause the consumer to buy less of this good. Overall, the income effect mitigates the substitution effect of a price change

On the demand curve, the midpoint equals

Unit-Elastic Demand

Veblen Goods

When price tag determines desirability. Status items like jewelry include the utility of status for the consumer into the price. Veblen goods are not inferior goods. Increase in income doesn't lead to decrease in demand

What does an income elasticity of demand of .5 mean?

means that whenever income increases by 1%, the quantity demanded at each price would rise by 0.5%.

Cross-Price Elasticity of Demand

measures the responsiveness of demand for a particular good to a change in price of another good, holding all other things constant.

If demand is relatively inelastic (elasticity less than 1), a 5% decrease in price will result in

an increase in quantity demanded of less than 5%. Therefore, total expenditure will decrease.

Other factors that influence demand

ability and willingness of consumers to purchase a good include income levels, tastes, and preferences, and prices and availability of substitutes and complements.

Income effect on inferior goods

an increase in income causes consumers to buy less of those goods.

Income effect on Normal Goods

an increase in income causes consumers to buy more of those goods.

Demand

defined as the willingness and ability of consumers to purchase a given amount of a good or a service at a particular price

If income elasticity is greater than 1

demand is income elastic, and the product is classified as a normal good. As income rises, the percentage increase in demand exceeds the percentage change in income. As income increases, a consumer spends a higher proportion of her income on the product.

If income elasticity lies between zero and 1

demand is income inelastic, but the product is still classified as a normal good. As income rises, the percentage increase in demand is less than the percentage increase in income. As income increases, a consumer spends a lower proportion of her income on the product.

Own-price elasticity infinite

demand is said to be perfectly elastic

Own-price elasticity 0

demand is said to be perfectly inelastic

If own-price elasticity of demand equals 1

demand is said to be unit elastic

Demand Curve

drawn up based on the inverse demand function (which makes price the subject), not the demand function (which makes quantity demanded the subject). The slope of the demand curve is therefore not the coefficient on own-price (PG) in the demand function; instead it equals the coefficient on quantity demanded (QDG) in the inverse-demand function. Note that the slope of the demand curve is also the reciprocal of the coefficient on own-price (PG) in the demand function

Total Expenditure (revenue) test

gauges price elasticity by looking at the direction of the change in total revenue in response to a change in price: If the price cut increases total revenue, demand is relatively elastic. If the price cut decreases total revenue, demand is relatively inelastic. If the price cut does not change total revenue, demand is unit elastic.

The substitution effect of a change in price will always go

in the direction opposite to that of the price change. If the price increases, less will be consumed, and if the price decreases, more will be consumed.

If demand is unit elastic, a 5% decrease in price will result in an

increase in quantity demanded of exactly 5%. Therefore, total expenditure will not change.

If a producer is charging in an inelastic region of the demand curve, they can

increase total revenue by increasing prices since a lower quantity is being sold (and produced), total costs would also fall, which implies a certain boost in profitability. Therefore, no producer would knowingly set a price that falls in the inelastic region of the demand curve.

Inferior is really

just a term that is used to refer to a good that some people tend to buy less of if they have an increase in income. Does not necessarily mean low quality Some goods can be normal for one group and inferior to another. Fast food and low-income versus high-income groups

Absolute value of cross-elasticity

tells us how closely consumption of the two products is tied together and how closely they serve as complements for each other. A high absolute number indicates very close complements. If the price of one rises, consumers will significantly reduce their demand for the other.

If income elasticity is less than zero (negative)

the product is classified as an inferior good. As income rises, there is a negative change in demand. The amount spent on the good decreases as income rises.

When will price cuts increase total revenue?

total revenue will only increase if the percentage increase in demand (sales) is greater than the percentage decrease in prices.

Substitute

two products are classified as substitutes if the cross-price elasticity of demand is positive, regardless of whether they would actually be considered similar.