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Law of Demand. Law of Demand People do less of what they want to do as the cost of doing it rises Recall the Cost-Benefit Principle Pursue an action if and only if its benefits are at least as great as its costs Recall the Reservation Price The highest price we’d be willing to pay.
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Law of Demand • Law of Demand • People do less of what they want to do as the cost of doing it rises • Recall the Cost-Benefit Principle • Pursue an action if and only if its benefits are at least as great as its costs • Recall the Reservation Price • The highest price we’d be willing to pay
Total Expenditure • Total Expenditure equals • The number of units sold multiplied by the price of the good • Total Expenditure = Total Revenue • The dollar amount that consumers spend on a product is equal to the dollar amount that sellers receive
The Law of Demand and Total Expenditure • “Will consumers spend more on my product if I sell more units at a lower price or fewer units at a higher price?” • Depends upon price elasticity of demand • When price rises, total expenditure may • increase, decrease, or stay the same • This is due to the Law of Demand • As price rises, quantity demanded falls • As price falls, quantity demanded rises
Price Elasticity of Demand • In order to predict what will happen to total expenditures, • We must know how much quantity will change when the price changes • Price elasticity of demand is • the percentage change in the quantity demanded that results from a one-percent change in its price
Price Elasticity • Elastic – quantity changes by a lot when price changes even a little • price elasticity is greater than one • Inelastic – quantity changes by a little when price changes even a lot • price elasticity is less than one • Unit elastic – quantity change = price change • price elasticity equals one • When calculating price elasticity of demand, you will always get a negative- WHY? • For convenience we will take the absolute value
Price Elasticity and Expenditures • For an elastic product • Quantity demanded is highly responsive • Percentage change in quantity dominates • An increase in price will reduce total expenditure • A decrease in price will increase total expenditure • For an inelastic product • Quantity demanded is not responsive • Percentage change in price dominates • An increase in price will increase total expenditure • A decrease in price will decrease total expenditure
Determinants of Elasticity • Substitution possibilities • Price elasticity of demand will be relatively high if it is easy to substitute between products – Why? • Budget share • The larger the share of the budget the good uses tends to have higher price elasticities of demand – Why? • Time • Because substitution takes time, price elasticity will be higher in the long run than in the short run
Examples • What are some goods that will have very elastic demand? • What are some goods that will have very inelastic demand?
Calculating Price Elasticity • Proportion by which quantity demanded changes divided by the proportion by which price changes
Fig. 5.12 Graphical Interpretation of Price Elasticity of Demand
Other Elasticities of Demand • Income Elasticity of Demand • The amount by which the quantity demanded changes in response to a one-percent change in income • Positive for normal goods • Negative for inferior goods
Other Elasticities of Demand • Cross Price Elasticity of Demand • The amount by which the quantity demanded of one good changes in response to a one-percent change in the price of another good • Positive for substitutes • Negative for complements
Perfect Elasticity • Perfectly Elastic demand • Price elasticity of demand is infinite • Even the slightest change in price leads consumers to find substitutes • Perfectly Inelastic demand • Price elasticity of demand is zero • Consumers do not switch to substitutes even when price increases dramatically • Do goods like these exist?
Fig. 5.14Perfectly Elastic and Perfectly Inelastic Demand Curves
Price Elasticity of Supply • The percentage change in the quantity supplied that will occur in response to a one-percent change in its price
Determinants of Supply Elasticity • The more easily additional units of inputs can be acquired, the higher the price elasticity (more elastic) • Flexibility of Inputs • Mobility of Inputs • Ability to Produce Substitute Inputs • Time • Unique and Essential Inputs
Perfect Elasticity • Perfectly Inelastic • Elasticity of supply is zero • Whether the price is high or low, the same amount is available • Perfectly Elastic • Elasticity of supply is infinite • When additional units can be produced using the same combination of inputs purchased at the same prices
Elasticity of Supply • What determines whether the supply of a particular good will be elastic or inelastic? • Availability of resources used to produce the good – how quickly and easily can producers respond to a price change? • Eg of good with inelastic supply? • Eg of good with elastic supply?
Naturalist Questions • Why do you pay $5 for a beer in the airport when you can buy the same beer for less than $1 outside the airport? • Why do you get a discounted airfare when you stay over a Saturday night? • Why are there so many personalized license plates in Virginia vs. NC?
