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Principles of Microeconomics, 1st Canadian Edition

Robert H. Frank, Cornell University
Ben S. Bernanke, Princeton University
Lars Osberg, Dalhousie University
Melvin Cross, Dalhousie University
Brian MacLean, Laurentian University

Demand: The Benefit Side of the Market

Cyberlecture

This chapter introduces you to the concept of utility, and the way in which economists use utility to explain consumer choice. You will also learn about demand elasticity, and how consumer choice affects total expenditure on goods and services.

What is the Law of Demand?
The Law of Demand states that people do less of what they want to do as the cost of doing it rises. In other words, there is an inverse relationship between price, or overall cost, and quantity.

The cost of doing something can take many forms:

money price
time spent waiting in line
combinations of money prices and time prices

What is utility?
Utility is the satisfaction or benefit people derive from consuming goods and services. Utility is measured in utils, a conceptual construct that allows for relative measures.
Economists assume that people try to maximize their total utility, that is the utility they derive from all their consumption activities.

total utility usually rises with additional consumption
when a person consumes too much, total utility declines with added consumption

Cyberlecture ch5 2 (2.0K)

Lamar's Total Utility from Ice Cream Consumption
Cone quantity (cones/hour)	Total utility (utils/hour)
0	0
1	100
2	150
3	175
4	187
5	184

Marginal utility is the change in total utility that occurs when a person consumes one more unit of a good or service.

marginal utility may increase with the first few units consumed
- each unit brings greater satisfaction
marginal utility eventually declines as additional satisfaction decreases

The Law of Diminishing Marginal Utility states that as consumption of a good increases beyond some point, the additional utility gained from an additional unit of the good tends to decline.

Lamar's Total and Marginal Utility
from Ice Cream Consumption
Cone quantity
(cones/hour) Total utility
(utils/hour) Marginal utility
(utils/cone)
0 0
100
1 100
50*
2 150
25
3 175
12
4 187
-3
5 184
* Marginal
utility = change in utility
change in consumption
= 150 utils – 100 utils
2 cones – 1 cone
= 50 utils/cone

If the cost of a good is zero, a person will maximize total utility by consuming the good until the marginal utility (benefit) is zero. The cost-benefit rule governs our consumption decisions.

Some towns go to great lengths to increase the marginal utility tourists will derive from visiting them. Why would a town wish to increase tourist marginal utility? So tourists will spend more money in businesses in the town. Visit http://www.bigthings.ca to view some of the monuments small towns have developed and read the editorial written by website owner David Yanciw. See what happened to his marginal utility!

How much should a person consume if cost is greater than zero?
When cost is greater than zero, a person must have an income in order to consume. The person's income is called her budget constraint — it is usually fixed, and thus puts a maximum limit on how much can be consumed.

consumers maximize their total utility subject to their budget constraints

The Rational Spending Rule states that spending should be allocated across goods so that the marginal utility per dollar is the same for each good.

MUc
Pc = MUs
Ps
if marginal utility per dollar of Good C > marginal utility per dollar of Good S, the consumer enjoys Good C more and should consume more of it
consuming more Good C reduces the marginal utility of Good C
the two marginal utilities per dollar grow closer to equality

What happens when income and prices change?
When a person's income increases, she is able to purchase more goods and services.

if the good is a normal good, she will purchase more of it
if the good is an inferior good, she will purchase less of it

Practice Activity 1
Try answering some questions about maximizing utility subject to a budget constraint.

When the price of a good that a person is buying changes, the ratio of marginal utility to price of that good changes too. It may increase or decrease, depending on the price change.

if the price increases, the marginal utility per dollar decreases
- the person will probably consume less, relative to other goods she consumes
if the price decreases, the marginal utility per dollar increases
- the person will probably consume more, relative to the other goods she consumes

Economic Naturalist
So why am I ignored when I walk into the store?

What is the market demand curve?
When many individuals demand goods and services, together they create a collective or market demand. The market demand curve is the horizontal addition of all the individual demand curves.

The market demand curve can be portrayed in three ways:

in the form of a demand schedule, or table
Price ($/can) Quantity
(1000s of
cans/month)
0 12
1 10
2 8
3 6
4 4
5 2
6 0
in the form of a graphical portrayal of the demand schedule
in the form of a demand equation

P = b – mQ

where Pº price
whereQº quantity demanded
wherebº the vertical intercept on the graph
where –mº slope of the demand curve ºDP ÷ DQ

How is total expenditure calculated?
Total expenditure is always price x quantity.

a higher price does not always mean a larger total expenditure
a lower price does not always mean a lower total expenditure

In the figure below the higher price leads to increased total expenditure.

the larger black striped area represents expenditure when price is $4
the smaller gray area is spending when price is $2

However, using the same demand curve, a similar increase in price can cause a decrease in total spending.

the larger gray rectangle represents a decrease in total expenditure
the smaller gray rectangle represents an increase in total expenditure

A price increase will result in an increase in total expenditure if the percentage increase in price exceeds the percentage decrease in quantity demanded.

What is price elasticity of demand?
The price elasticity of demand measures the percentage change in quantity demanded when price decreases, or increases, by one percent.

e = %DQ^d ÷ %DP
price elasticity of demand is always negative
inverse relationship between price and quantity demanded along a demand curve
take the absolute value of price elasticity of demand, and express in positive numbers

Price elasticity of demand is:

inelastic if its value < 1
unit elastic if its value = 1
elastic if its value > 1

Cyberlecture ch5 11 (1.0K)

A straight-line demand curve is elastic at the top of its curve. It becomes less elastic as price falls until it reaches unit elasticity at its mid-point. Below the mid-point, the straight-line demand curve is inelastic.

Cyberlecture ch5 9 (3.0K)

Price elasticity of demand has an effect on total expenditure. Depending on the price elasticity of a good, an increase in price may increase expenditure, decrease expenditure or leave total expenditure unchanged.

e > I Price increase causes
reduction in total expenditure Price reduction causes
increase in total expenditure
e = I Price increase causes no
change in total expenditure Price reduction causes no
change in total expenditure
e < I Price increase causes
increase in total expenditure Price reduction causes
reduction in total expenditure

What determines price elasticity of demand?
There are three primary determinants of price elasticity of demand.

Substitutes: The more substitutes there are for a product, the more elastic will be its demand.
- it is easier to substitute out of this product if its price rises
Budget Share: The larger the proportion of a person's income the purchase of a good requires, the more elastic will be its demand.
- it is relatively less affordable when its price rises, thus discouraging consumption
Time: The longer the time period under consideration, the more elastic will be the demand for a good.
- there will be time for consumers to find or develop substitutes for a product whose price has increased

Practice Activity 2
Try answering some questions about determinants of price elasticity of demand.

How is price elasticity of demand calculated?
Price elasticity of demand is the percentage change in quantity demanded divided by a percentage change in price. The formula, based on a demand curve, looks like this:

Price elasticity = e = (DQ/Q)
(DP/P)
where Pº price
where Qº quantity demanded
where DPº the change in the price
where DQº the change in the quantity

The variables in the formula can be maneuvered so that the slope of the demand curve (DP ÷ DQ) can be used in the calculation. The point elasticity of demand, which measures elasticity at a given point on the demand curve, can be rewritten:

e_A = æ P
Q ö æ 1
slope ö
è ø è ø

Arc elasticity of demand measures the price elasticity of demand over an interval of price change. This measure gives an average elasticity over the segment of the demand curve, whether the change in price is an increase or a decrease.

arc e  =       DQ
  (Q1 + Q2)/2
    DP
(P1 + P2)/2   =       DQ
  Q1 + Q2
    DP
P1 + P2   =   æ
è P1 + P2
Q1 + Q2 ö
ø æ
è    1
slope ö
ø
where P₁º initial price
whereP₂º new price
whereQ₁º initial quantity demanded
whereQ₂º new quantity demanded
whereDPºP₂ – P₁
whereDQºQ₂ – Q₁

Visit http://www.econtools.com/jevons/java/elastic/Elasticity.html and use the interactive price elasticity of demand model to explore the relationship between a linear demand curve and total revenue. You will find instructions for using the model at the bottom of the webpage.

What are perfectly elastic, perfectly inelastic and unit elastic demand curves?

A perfectly elastic demand curve looks horizontal. Its slope is infinite.
A perfectly inelastic demand curve looks vertical. Its slope is zero.
A unit elastic demand curve has a price elasticity of demand equal to one at all points. It is not a straight-line demand curve.

What is income elasticity of demand?
Income elasticity of demand measures the percentage change in quantity demanded when consumer incomes change by one percent:

Income elasticity = percentage change in quantity demanded
percentage change in income = (DQ/Q)
(DI/I)
where I = initial income
whereDIº change in income

If income elasticity of demand is positive, the good is a normal good - quantity demanded increased when income increased, and vice versa. If income elasticity of demand is negative, the good is an inferior good - quantity demanded decreased when income increased, and vice versa.

What is cross-price elasticity of demand?
Cross-price elasticity of demand measures the percentage change in quantity demanded of one good when the price of another good changes by one percent:

Cross-price elasticity = percentage change in quantity of good X
percentage change in price of good Y
= (DQx/Qx)
(DPy/Py)
where Q_Xº quantity of Good X
whereP_Yº price of Good Y

If cross-price elasticity of demand is positive, the two goods are substitutes - when the price of Good Y increases, consumers substitute into Good X. If cross-price elasticity of demand is negative, the two goods are complements - when the price of Good Y increases, the cost of buying both Good X and Good Y increases, so consumers purchase less of both.

Understanding Questions
Do I understand this chapter? As a check to your understanding of the material in this chapter, you should be able to answer our questions.

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