Docstoc

The Demand for Goods

Document Sample
The Demand for Goods Powered By Docstoc
					  Chapter-5


The Demand for Goods
In This Chapter….

5.1. Why is demand curve downward
     slopping?
5.2. How to measure behavioral responses of
     consumers to changes in determinants of
     demand (Elasticity)?
5.3. The Effect of Elasticity on the Revenue of
     the Producer (Seller).
5.3. How Consumers Allocate their Income
     Among Competing Ends?
5.1. What Explains the Consumer
Behavior?
o   What determines what we buy? How
    we buy?

o   What leads us to buy some goods
    while rejecting others?

o   Why do we buy more at lower prices
    and less at higher prices?
5.1.What Explains the
Consumer Behavior?

o   Two Explanations

    n   The Sociopsychiatric Explanation
    n   The Economic Explanation
5.1.What Explains the
Consumer Behavior?
o   The Sociopsychiatric Explanation

    n   In Freud’s view, higher levels of
        consumption satisfy our basic drives for
        security, sex, and ego gratification.

    n   According to sociologists, consuming more
        is an expression of identity that provokes
        recognition or social acceptance.
Affluent Teenagers
5.1. What Explains the Consumer
Behavior?
o   The Economic Explanation

    n   In explaining consumer behavior,
        economists focus on the demand for
        goods and services.

    n   Demand is the willingness and ability to
        buy specific quantities of a good at
        alternative prices in a given time period,
        ceteris paribus.
The Economic Explanation

o    An individual’s demand for a product
     is determined by:

    – Tastes—desire for this and other goods.
    – Income—of the consumer.
    – Expectations—for income, prices, tastes.
    – Other goods—their availability and prices.
The Economic Explanation

o   Economists use the Demand Curve to Explain
    the consumer behavior… how consumer
    tastes affect consumption decisions.
    n   Law of demand: Ceteris paribus, individuals buy
        less quantities, when prices are higher and more
        quantities when prices are lower.


o   They do so because they have a goal of
    getting maximum Possible Satisfaction
    (Pleasure) from their limited resources.
o   Utility
The Economic Explanation
o   Utility is the pleasure or satisfaction
    obtained from a good or service. Utility
    Theory

    n   Measuring Utility (Satisfaction)
          n   Cardinal Units (absolute numbers
              indicating levels): Utils

          n   Ordinal Unity (Rankings, Orders of
              preferences)
The Economic Explanation

o   Total Utility is the amount of satisfaction
    obtained from entire consumption of a
    product.

    n   The more we consume of a product the more
        utility (satisfaction) we obtain. I.e., More is
        Preferred to Less!

    n   Thus the more pleasure (utility) a product
        gives us, the higher the price we’re willing to
        pay for it.
The Economic Explanation

o   However, more is not always
    and necessarily better.

Two Distinct Levels of Satisfaction:
  o Total Utility

  o Marginal (additional) Utility
The Economic Explanation

o   Total Utility :
    n   the amount of satisfaction obtained from the
        entire consumption of a product.
o   Marginal utility:
    n   the change in total utility obtained by
        consuming one additional (marginal) unit of
        a good or service.
The Economic Explanation

o   There is a natural limit to how much more...


                                       TOTAL UTILITY



                                                          Total utility
               Total Utility




                                                     ty
                                                  tili
                                                lu
                                                ta
                                              to
                                          g
                                        sin
                                       Ri




                               0   1      2     3    4     5    6
                                       Quantity of Popcorn
                                       (boxes per show)
The Economic Explanation
o   Although we prefer more to less, more is not
    always and necessary better …

    n   Human Behavior:
        o   When we have more and more of some thing we
            start to value it less and less. We do so…

        o   The additional satisfaction we get from consuming
            one more unit of the same product is lower than the
            level of satisfaction we obtain from consuming earlier
            units of the product.

        o   Declining Marginal Utility
            The Economic Explanation

                        TOTAL UTILITY                                               MARGINAL UTILITY


                                                                                                          Negative
                                             Total utility                                                marginal




                                                             Marginal Utility
Total Utility




                                                                                    Dim                   utility
                                        ty


                                                                                         inis
                                    tili



                                                                                              hin
                                lu




                                                                                                 gm
                                ta




                                                                                                    arg
                               to




                                                                                                        ina
                                                                                                              l ut
                           g
                          sin




                                                                                                                     ility
                        Ri




                0   1      2    3      4      5    6                            0   1     2     3   4     5      6
                        Quantity of Popcorn                                             Quantity of Popcorn
                         (boxes per show)                                                (boxes per show)
Diminishing Marginal Utility

o   According to the law of diminishing
    marginal utility, the marginal utility
    of a good declines as more of it is
    consumed in a given time period.

o   As long as marginal utility is positive,
    total utility must be increasing.
Diminishing Marginal Utility

o   According to the law of diminishing
    utility, each successive unit of a good
    consumed yields less additional
    utility.

o   Eventually, additional quantities of a
    good yield increasingly smaller
    increments of satisfaction.
    n   Downward slopping Demand Curve
The Economic Explanation

Implication…

   o   Our consumption decision is guided by
       not by how much total satisfaction we
       get, but by how much additional
       satisfaction we get when consuming
       one more unit of a product
The Economic Explanation
    Demand Curve: Price and Quantity relationship (Why is it
    downward slopping?)

o   Tastes, through marginal utility, tells us how much we
    desire particular goods.

o   Price tell us how much of a good we will buy.

o   The more marginal utility a product delivers, the more a
    consumer is willing to pay, ceteris paribus.

o   As the marginal utility of a good diminishes, so does our
    willingness to pay.
5.2. Gagging Responses to Changes
in the Determinants of Demand
5.2. Gagging Responses to Changes
in the Determinants of Demand
o   According to the law of demand, the
    quantity of a good demanded in a
    given time period increases as its
    price falls, ceteris paribus.

o   (Own Price, Income, Price of other
    Products,….)
5.2. Gagging Responses to Changes
in the Determinants of Demand


o   Elasticity
    n   A measure of the responsiveness (the
        sensitivity) of consumers (buyers) –in
        terms of the quantities they buy, to
        changes in the determinants of demand
        (Own Price, Income of the Consumer,
        Price of Other Goods, etc)
5.2. Gagging Responses to Changes
in the Determinants of Demand


o   Elasticity
    n   Price Elasticity of Demand
    n   Income Elasticity of Demand
    n   Cross Price Elasticity of Demand
Price Elasticity (E)


o   The price elasticity of demand is
    the percentage change in quantity
    demanded divided by the percentage
    change in price.

    n   Is a measure of the response of
        consumers to a changes in own price of
        a product.
Individual’s Demand Schedule
and Curve
                        $0.55
                              A
                         0.50       The willingness to pay
                               B    diminishes along with
                         0.45
                                 C marginal utility




               PRICE (per ounce)
                         0.40
                                  D
                         0.35
                                     E
                         0.30
                                        F
                         0.25
                                             G
                         0.20
                                                H
                         0.15
                                                      I
                         0.10
                                                          J
                         0.05

                                   0 4 8 12 16 20 24 28 32
                                   Quantity Demanded (Ounces per show)
Computing Price Elasticity (E)
Computing Price Elasticity

o   To ensure consistency,…
    n    average quantity and average price
        (before and after) is used in the calculation
        of Elasticity.
Computing Price Elasticity
Note on the Sign of Price Elasticity
(E) of Demand
o   The price elasticity of demand (E) is
    always negative because quantity
    demanded decreases when prices
    increase.

o   However, as we often use its absolute
    value, the price elasticity of demand is
    reported as a positive number (greater
    than zero).
In Class Hands-on-Problem

                       $0.55         Compute Elasticity for
                             A       A movement from
                        0.50
                              B      •   C to D
                        0.45         •   G to H
                                C




              PRICE (per ounce)
                        0.40         •   J to I
                                  D
                        0.35
                                    E
                        0.30
                                       F
                        0.25
                                          G
                        0.20
                                                H
                        0.15
                                                  I
                        0.10
                                                        J
                        0.05

                                  0 4 8 12 16 20 24 28 32
                                  Quantity Demanded (Ounces per show)
Possible Values of Elasticity: |E|

o   E can take any value between from 0 to
    infinity

o   Five Broad categories

    n   0<E<1; E=1; 1<E<Positive Infinity
    n   Two extreme Values (E=0 ; E=Positive
        Infinity)
Elastic, Inelastic, Unitary Elastic
Demand
o   If E is larger than 1, demand is elastic.
    n   Consumer response is large relative to the change
        in price.
    n   Relatively Flat Demand Curve

o   If E equals 1, demand is unitary elastic.

o   If E is less than 1, demand is inelastic.
    n   Consumers aren’t very responsive to price
        changes.
    n   Relatively Steeper Demand Curve
Elasticity Estimates
    Extremes of Elasticity
o    Two extreme Values (E=0; E=Positive
     Infinity)
o    E=0: Perfectly inelastic.
     n   Quantity demanded will not change regardless of
         the price change.
     n   A Vertical demand curve

o    E=Infinity: Perfectly elastic
     n   Any price increase would cause demand to fall to
         zero.
     n   A Horizontal demand curve.
        Extremes of Elasticity

             Perfectly elastic (E = ¥)                Perfectly inelastic (E = 0)


        p2                                       p2
Price




                                         Price
        p1                                       p1




        0              q1                        0               q1
                     Quantity                                  Quantity
Determinants of Elasticity

o   The price elasticity of demand is
    influenced by all of the determinants
    of demand.

o   Four factors are particularly worth
    noting:
    n   Necessities vs. Luxuries.
    n   Availability of Substitutes.
    n   Relative Price (to income).
    n   Time.
Necessities vs. Luxuries

o   Necessities are goods that are critical
    to our day-to-day life.
    n   Demand for necessities is relatively
        inelastic
• Luxuries are goods we would like to
  have but are not likely to buy unless
  our income jumps or the price declines
  sharply.
    n   Demand for luxury goods is relatively
        elastic.
Availability of Substitutes

o   If a good has relatively many
    substitutes, consumers are highly
    sensitive to changes in the price of
    the good.

    n   Thus the greater the availability of
        substitutes, the higher is the price
        elasticity of demand…relatively elastic
Relative Price (to income)
o   Consumers are more sensitive to changes
    in prices of goods that account for a
    relatively larger share of their budget (at
    higher price level) than those that account
    for relatively smaller share of their budget
    (lower price)

    n   The higher the price of a good relative to a
        consumer’s income, the higher the elasticity of
        demand.

    n   The price elasticity of demand declines as price
        moves down the demand curve.
Time

o   Consumers are better able to change
    their buying habits over the long-run
    (thus more sensitive to changes in
    prices) than in the short-run (Less
    sensitive).

    n   Thus in the long-run price elasticity of
        demand is higher than the short-run
        elasticity.
       Elasticities and the Other
       Determinants of Demand
o   Price Elasticity of Demand

o   Income Elasticity of Demand
o   Cross Price Elasticity of Demand
Shifts vs. Movements

o   Recall:
    n   When the price changes, the outcome is a
        movement along the same demand curve.


    n   When any one of the underlying determinants of
        demand (other than own price of the good)
        changes, the entire demand curve shifts.

        o   Income and prices of other goods are
            among such factors
Income Elasticity

o   An increase (decrease) in consumer
    income will cause a rightward
    (leftward) shift in demand.

o   I.e., consumers will purchase more at
    any price than they did prior to the
    increase in income.
Income Elasticity
Price of Popcorn (dollars per ounce)




                                              Shift

                                                 F              N
                                       0.25



                                                                            D2 (after income rise)

                                                                        D1 (before income rise)

                                         0     12             16
                                              Quantity of Popcorn (ounces per show)
    Income Elasticity

o   Income elasticity of demand is the
    measure of the percentage change in
    quantity demanded by the consumer
    resulting from a percent change in
    income of the consumer.
Computing Income Elasticity

o   As with price elasticity, income
    elasticity is computed using average
    values for the changes in quantity
    and income.
Normal vs. Inferior Goods

o   A normal good has an income elasticity
    of demand greater than zero.
    n   A normal good is a good for which
        demand rises when income rises.
o   An inferior good has an income
    elasticity of demand less than zero.
    n   An inferior good is a good for which
        demand decreases when income rises.
Cross-Price Elasticity

o   A change in the price of one good
    affects the demand for another.

    n   The decision to buy a good also depends
        on the prices of substitutes and
        complements of that good.
Cross-Price Elasticity

o   Substitute goods are goods that substitute
    for each other.
    n   When the price of good X rises, the demand for
        good Y increases, ceteris paribus.


o   Complementary goods are goods
    frequently consumed in combination.
    n   When the price of good X rises, the demand for
        complementary good Y falls, ceteris paribus.
Substitutes and Complements
 (cents per ounce)
  Price of Popcorn




                                    R        F
                     0.25
                                                                 D3
                                                            D1
                                                       D2

                       0           8       12
                            Quantity of Popcorn (ounces per show)
Calculating Cross-Price
Elasticity
o   Cross price elasticity is the
    percentage change in the quantity
    demanded of X divided by percentage
    change in price of Y.
Sign of Cross-Price Elasticity

o   When the cross-price elasticity of
    demand has a negative sign the two
    goods are complementary goods.

o   When the cross-price elasticity of
    demand has a positive sign the two
    goods are substitute goods.
Elasticity and Revenue
 (Elasticity and Pricing Decision)
    5.3. Elasticity and Pricing
    Decision
o   Strong relationship between price
    elasticity and total revenue.

    n   Total revenue is The price of a product
        multiplied by the quantity sold in a given
        time period.

    n   Total revenue = Price X Quantity sold
    n              TR= P X Q
5.3. Elasticity and Pricing
Decision
             TR = P x Q
o   Given the law of demand ( Price and
    Quantity are inversely related), what
    happens to the total revenue of the
    seller when there is:
o   A Price Hike?
o   A Price Decline (Sales Discount)?
5.3. Elasticity and Pricing
Decision
o   A price hike increases total revenue
    of a seller only if demand is inelastic
    (E < 1).
    n   if demand is elastic (E > 1), a hike in
        price reduces total revenue of the seller.


    n   if demand is unitary elastic (E = 1), hike
        in price does not change total revenue of
        the seller
    5.3. Elasticity and Pricing
    Decision
o   A decline in price (Sales Discount) on the
    other hand increases total revenue of a seller
    if the demand is elastic (E > 1).

o   If the demand is inelastic (E<1) sales discount
    doesn’t increase the total revenue of the
    producer

o   Implication?
Implication?
 n    Most of the time, we get discounts for
      luxury goods than necessities; and on goods
      that account for relatively larger share of
      our budget (those that have higher prices)

 2.   The impact of a price change on total
      revenue of the seller depends on the price
      elasticity of demand.

 3.   Price elasticity changes along a demand
      curve.
Price Elasticity and Total
Revenue
Price Elasticity and Total
Revenue
                                                             At Lower prices E < 1
                    $0.55           At higher prices E > 1
                     0.50
                                B
                     0.45
PRICE (per ounce)




                                    C
                     0.40
                     0.35
                     0.30
                     0.25
                     0.20
                     0.15
                     0.10
                     0.05
                       0    2    4 6 8 10 12 14 16 18 20 22 24 26 28 30 32
                                QUANTITY DEMANDED (ounces per show)
                                  The demand curve
                  $8
                   7                     Elastic E > 1
                   6
PRICE



                   5                                      Unit elastic E = 1
                   4
                   3
                   2
                   1                       Inelastic E < 1
                   0   10   20   30   40 50 60 70 80 90 100 110
                                      Total revenue
                                                      E=1
TOTAL REVENUE




                $225
                 200
                 175
                 150
                 125                        Elastic      Inelastic E
                 100                         E>1         <1
                  75
                  50
                  25
                   0   10   20   30   40 50    60     70 80     90 100 110
 How consumers Decide
to Allocate their Income
(Choosing Among Products)
5.4. Choosing Among Products

o   Goal: Utility Maximization
o   Consumers should choose the optimal
    consumption combination.

    n   the mix of consumer purchases that
        maximizes the utility attainable from
        available income (budget).
5.4. Choosing Among Products

o   The purchase of any one single good
    also means giving up the opportunity
    to buy more of other goods.

o       Recall Opportunity costs –
    n   The alternatively most desired goods or
        services that are forgone in order to
        obtain something else.
5.4. Choosing Among Products

o   Economist assume that consumers
    have Rational Behavior.

    n   Rational behavior requires one to
        compare the anticipated utility of each
        expenditure with its cost.

    n   Thus to maximize utility, the consumer
        should choose that good which delivers
        the most marginal utility per dollar.
Example…
Utility Maximizing Rule

o   If a person could get more utility per
    dollar by buying good X, then she
    should continue to buy good X.
Utility Maximizing Rule

o   If a person could get more utility per
    dollar by buying good Y, then she
    should continue to buy good Y.
Utility Maximizing Rule

o   Continue this process until the ratios
    are equal – only then will utility be
    maximized.
 Example…
The consumer has $10; Px=$1 and Py=$2. To get Max Utility
How much of each good should the consumer purchase?
The Outcome: Optimal
o   Economic theory predicts that the
    final choices of consumers -- the
    equilibrium outcome -- will be
    optimal.

o   There is no better combination that
    gives more utility for the money
    (budget), given the prices
The Outcome: Optimal




 o   Why advertising then?
The Outcome: Optimal

o   Some advertising is intended to
    provide information about new or
    existing products.

o   A great deal more of advertising is
    designed to exploit our senses and
    lack of knowledge.
    n   Advertising can’t be blamed for our
        foolish consumption
The Outcome: Optimal



o   A successful advertising campaign is
    one that shifts the demand curve to
    the right.
Impact of Advertising on the
Demand Curve


                                                              Demand curve
  Price (dollars per unit)




                                                              after advertising
                             P
                                 Demand curve
                                 before advertising



                             0             Q1               Q2
                                     Quantity Demanded (units per time period)

				
DOCUMENT INFO
Shared By:
Categories:
Tags:
Stats:
views:0
posted:7/27/2013
language:English
pages:76