Study Notes on Demand and Elasticity

Chapter 3: Demand and Elasticity

Learning Objectives

Law of Demand and Cost-Benefit Principle
- Relate the law of demand to the Cost-Benefit Principle.
Consumer Decision Making
- Apply the law of demand to show how it relates to substitution and income effects.
Demand Curves
- Discuss the relationship between individual and market demand curves.
Price Elasticity of Demand
- Define price elasticity of demand and explain the factors determining elastic or inelastic demand.
Calculating Elasticity
- Calculate price elasticity of demand using information from a demand curve.
Price Changes and Revenue
- Describe how price changes affect total revenue and expenditure based on elasticity.
Cross-Price and Income Elasticity
- Explain cross-price elasticity of demand and income elasticity of demand.

Free Ice Cream – Or Is It?

The cost of a good includes more than just its monetary cost:
- Waiting in line.
- Purchasing a permit.
- Participating in a lottery.
The concept of "free" goods illustrates how non-monetary costs such as time can act as the actual price of a good.
Demand curves encompass the relationship of quantity demanded to all associated costs, not limited to monetary expenses.

Law of Demand

Law of Demand: As the cost of something increases, individuals tend to decrease their consumption of that good.

Cost-Benefit Principle

Principle: Engage in actions when marginal benefits outweigh or equal marginal costs.
The effect of an increase in market price approaches individual reservation prices.
- If the market price exceeds the reservation price, the individual will cease to purchase more.
- Costs encompass both explicit and implicit factors, including:
  - Money
  - Time
  - Reputation

Origins of Demand

Reservation Price: Each individual's demand is influenced by:
- Personal tastes and preferences
- Biological needs (e.g., food, shelter)
- Cultural influences
- Peer behaviors
- Individual differences
  - Perceived quality
  - Expected benefits
- Tastes may evolve over time, integrating new goods into personal priorities.

Needs Versus Wants

Needs: Essentials required for subsistence (e.g., food, shelter, clothing).
Wants: Preferences that arise post-subsistence and are conditioned by price fluctuations.
- E.g., water pricing in California influences behavior.
- Regulations can complicate needs; price mechanisms can respond more swiftly and effectively to demand.

California Water Shortages

Issue: High population with low annual rainfall signifies potential water shortages.
- Comparison: New Mexico has lower rainfall per capita yet fewer shortages.
- California maintains low water prices, discouraging efficient water use.
  - Cheap water incentivizes rice and almond production, leading to inefficient water allocation.

Applying the Law of Demand: Substitution Effects

Substitution: The ability to replace one good with another influences consumer choices:
- Opting for new cars vs. used cars
- Selecting carpooling over bus transport
- Choosing between dining options (e.g., French vs. Chinese) or home cooking
- Making decisions to go out or stay home (e.g., movie vs. HBO Max)
- Utilizing heating versus wearing warmer clothing.

Example: Housing in Manhattan vs. Seattle

Observation finds differing housing sizes among affluent individuals in Seattle and Manhattan.
- Fact: Homes in Seattle are double the size of those in Manhattan.
- Analysis points to higher housing prices in Manhattan due to:
  - Expensive land
  - Elevated construction costs
- Consequently, New Yorkers purchase less housing, allocating resources to alternatives like vacation homes, travel, dining, and theater.

Nominal and Real Prices

Nominal Price: The actual price of a good as indicated in store currency.
Real Price: Adjusted nominal price against the average price of all other goods, accounting for inflation.

Example: Cylinder Count in Cars

Observation: Trends shift from 4-cylinder cars in the 1970s to 6- and 8-cylinder cars in the 1990s.
Gas Prices (Historical):
- 1973: $0.38
- 1974: $0.52
- 1979: $1.19
- 1999: $1.40
Conclusion: Through real price analysis, the inflated gas price in 1973 was higher relative to 1999 values.
- Lower real gas prices in 1999 fueled demand for larger vehicles, which reversed in 2004 due to rising gas prices.

Income Differences Matter

Income levels significantly influence demand patterns:
- Free Goods: Higher taker rates in lower income regions versus higher income demographics.
- Individuals in lower income areas confront longer waiting times linked to the low opportunity cost of their time, contrasted with higher-income counterparts who favor efficiency and shorter wait times through increased spending on service.

Individual and Market Demand Curves

Market Demand: The aggregation of individual demand curves horizontally.
- At every price point, compute total units demanded from individual contributions to establish market demand.

Identical Individual Demand Curves

Condition: When individuals demand the same quantity at each price point, market demand is computed by multiplying individual demand by the number of buyers.

Drug Enforcement and Theft Hypothesis

Hypothesis: Drug users resort to theft to finance substance purchases.
Increased drug enforcement may decrease theft rates, contingent on overall drug expenditure falling post-enforcement:
- Enforced regulations impact drug supply, resulting in higher prices.
- Reduced quantity demanded aligns with diminished theft, assuming a decline in total drug spending occurs.

Price Elasticity of Demand

Definition: Price elasticity of demand measures the responsiveness of quantity demanded based on price changes, defined as the percentage change in quantity demanded resulting from a 1% change in price.
Example: A 1% decrease in the price of beef induces a 2% increase in quantity demanded, rendering the price elasticity of demand at -2.

Calculate Price Elasticity

Elasticity Notation: Represented with the lowercase Greek letter epsilon (ε).
Demand elasticity typically appears as negative (-), reflecting the inverse correlation between price changes and quantity demanded; however, the absolute value is used for analysis, disregarding negativity in application.

Elastic Demand

When price elasticity exceeds 1, demand is classified as elastic:
- Percentage change in quantity exceeds the percentage change in price.
- Implies strong responsiveness to price fluctuations.

Inelastic Demand

When price elasticity is less than 1, demand is classified as inelastic:
- Percentage change in quantity is lower than the percentage change in price, indicating minor responsiveness to price shifts.

Unit Elastic Demand

When price elasticity equals 1, demand is deemed unit elastic:
- Price changes correlate exactly with equivalent percentage changes in quantity demanded.

Example: Demand for Pizza

Initial Price: $1.00
New Price: $0.97
% Change in Price: 3%
Original Quantity: 400
New Quantity: 404
Percentage Change in Quantity: 1%
Result: Demand identified as inelastic.

Determinants of Price Elasticity of Demand

Substitution Possibilities: Wider availability of substitutes leads to more elastic demand.
- Example: Salt vs. Morton’s salt.
Budget Share: Higher expenditure shares lead to greater elasticity:
- Example: Cars vs. salt.
Time: Longer adjustment periods yield increased elasticity:
- Example: Air conditioning vs. gasoline.

Examples of Elasticities

Green Peas: 2.8
Restaurant Meals: 1.6
Beer: 1.2
Coffee: 0.3

Taxes and Teen Smoking

Hypothesis: Teen demand for cigarettes is primarily inelastic due to peer influence and lack of financial means.
Analysis indicates that increased cigarette taxes elevate prices, thereby causing a decrease in consumption; some teens may quit, encouraging peers to do the same.
Result: Higher taxes are likely to reduce overall youth smoking rates.

Unintended Effects of the Yacht Tax

Hypothesis: A proposed luxury tax on yachts exceeding $100,000 was expected to generate $31 million in revenue.
Outcome Analysis:
- The demand for yachts exhibited high price elasticity. Actual tax revenue was only $16.6 million.
- Consumers opted to buy yachts internationally to evade tax, leading to job losses in the U.S. boating industry (approx. 7,600 jobs).
- Resulted in tax repeal after 2 years.

Price Elasticity Notation

Let ΔQ represent the change in quantity.
Percentage Change in Quantity: denoted as \ rac{ΔQ}{Q}
Let ΔP signify change in price.
Percentage Change in Price: denoted as \ rac{ΔP}{P}

Price Elasticity: Graphical View 1

The graph's horizontal axis indicates quantity ranging from 0 to Q + ΔQ, while the vertical axis indicates price from 0 to P.
The demand curve slopes downward through the points (Q, P) and intersects at a lower price following the increase in quantity.

Price Elasticity: Graphical View 2

At point A, observed values for price and quantity reflect variable elasticity as illustrated by the intersecting demand curves.

Price Elasticity and Slope

When demand curves intersect, the absolute value of the elasticity (ε) remains constant across both curves, but individual slopes vary:
- The steeper curve is less elastic than the flatter curve at the intersection point.

Price Elasticity on a Straight-Line Demand Curve

Elasticity varies at each point along a straight-line demand curve, despite uniform slope characteristics.
- Price elasticity decreases as prices diminish and quantity demanded increases.

Price Elasticity Pattern

Systemic elasticity variations occur as price diminishes along a demand curve:
- At elevated prices (high P) and reduced quantities (low Q), elasticity (ε) becomes larger (elastic demand).
- At the midpoint of the curve, elasticity is unitary (ε = 1).
- At diminished prices (low P) and increased quantities (high Q), elasticity lessens (inelastic demand).

Two Special Cases

Perfectly Elastic Demand: Exhibits infinite price elasticity (horizontal demand curve).
Perfectly Inelastic Demand: Exhibits zero price elasticity (vertical demand curve).

Elasticity and Total Expenditure

Changes in total expenditure (total revenue) in correlation with price alterations hinge primarily on elasticity.
- Terminology: Total expenditure = Total revenue = Price (P) × Quantity (Q).
- Graphing Concept: Total expenditure illustrates a rectangle area determined by the height (P) and width (Q) of the demand curve.

Price Elasticity and Total Expenditure 1

Consider a price rise of movie tickets from $2 to $4 (inelastic demand region).
- Total revenue escalates as pricing increases.

Price Elasticity and Total Expenditure 2

Take a ticket price increase from $8 to $10 (elastic demand segment).
- Total revenue diminishes with pricing increase as more consumers exit the market.

The Effect of a Price Change on Total Expenditure

Graph Data Overview: Illustrates changes in price levels ($12 to $0) correlating with varying quantities (0 to 6,000), determining shifts in expenditure.

Elasticity, Price Change, and Expenditure

Outcomes:
- When demand is elastic (E > 1), a price increase leads to reduced total expenditure; a price reduction leads to increased total expenditure.
- When demand is inelastic (E < 1), a price increase leads to elevated total expenditure; a price decrease results in reduced overall spending.

Cross-Price Elasticity of Demand

Defines the reaction in quantity demanded of good A corresponding to a 1% price change of good B.
- Complementary Goods: Exhibit negative cross-price elasticity (increase in price of one reduces demand for the other).
- Substitutable Goods: Demonstrate positive cross-price elasticity (increase in price of one increases demand for the other).

Income Elasticity of Demand

Measures the percentage change in quantity demanded corresponding to a 1% income change.
- Normal Goods: Exhibit positive income elasticity (demand rises with income).
- Inferior Goods: Reflect negative income elasticity (demand declines as income ascends).

References

All charts and graphs referenced in the document are illustrative and approximate in data presentation, focusing on the effective communication of demand-related principles and elasticity.