Chapter 4

Market
Demand and
Elasticity

© 2004 Thomson Learning/South-Western

 Market Demand Curves

 The market demand is the total quantity of a

good or service demanded by all potential
buyers.
 The market demand curve is the relationship
between the total quantity demanded of a good
or service and its price, holding all other factors
constant.

2
 Construction of the Market Demand
Curve

 The market demand curve is constructed by

horizontally summing the demands of the
individual consumers
 Assume the market consists of only two buyers
as shown in Figure 4.1
– At any given price, such as P*X, individual 1
demands X*1 and individual 2 demands X*2.

3
 FIGURE 4.1: Constructing a Market Demand
Curve from Individual Demand Curves

PX

P*
X

0 X*
1

(a) Individual 1

4
 FIGURE 4.1: Constructing a Market Demand
Curve from Individual Demand Curves

PX PX

P*
X

0 X* 0 X*
1 2

(a) Individual 1 (b) Individual 2

5
 Construction of the Market Demand
Curve

– The total quantity demanded at the market at P*X is

the sum of the two amounts:
X* = X*1 + X*2 .
 The point X*, P*X is one point on the market
demand curve.
 The other points on the curve are similarly
plotted.

6
 FIGURE 4.1: Constructing a Market Demand
Curve from Individual Demand Curves

PX PX PX

P*
X

0 X* 0 X* 0 X* X
1 2

(a) Individual 1 (b) Individual 2 (c) Market Demand

7
 Shifts in the Market Demand Curve

 To discover how some event might shift a

market demand curve, we must first find out
how this event causes individual demand
curves to shift and then compare the horizontal
sum of these new demand curves with the old
demand curve.

8
 Shifts in the Market Demand Curve

 For example consider the two buyer case

where both consumers regard X as a normal
good.
 An increase in income for each consumer
would shift their individual demand curves out
so that the market demand curve, would also
shift out
 This situation is shown in Figure 4.2

9
 FIGURE 4.2: Increases in Each individual’s Income
Cause the Market Demand Curve to Shift Outward

PX PX PX
D

P*
X

0 X* 0 X* 0 X* X
1 2

(a) Individual 1 (b) Individual 2 (c) Market Demand

10
 FIGURE 4.2: Increases in Each individual’s Income
Cause the Market Demand Curve to Shift Outward

PX PX PX D’
D

P*
X

0 X* X** 0 X* X** 0 X* X** X

1 1 2 2

(a) Individual 1 (b) Individual 2 (c) Market Demand

11
 Shifts in the Market Demand Curve

 However, some events result in ambiguous

outcomes.
– If one consumer’s demand curve shifts out while
another’s shifts in, the net effect depends on the
size of the relative shifts.
 An increase in income for pizza lovers would
increase the market demand for pizza so long
as it is a normal good.

12
 Shifts in the Market Demand Curve

 On the other hand, if the increase in income

was for people who don’t like pizza, there
would be no significant effect on the market
demand curve for pizza.
 Changes in the prices of related goods,
substitutes or complements, will also shift the
individual and market demand curves.

13
 Shifts in the Market Demand Curve

 If goods X and Y are substitutes, an increase in

the price of Y will increase the demand for X.
Similarly, a decrease in the price of Y will
decrease the demand for X.
 If goods X and Y are complements, an
increase in the price of Y will decrease the
demand for X. A decrease in the price of Y will
increase the demand for X.

14
 APPLICATION 4.1: Consumption
and Income Taxes

 People’s ability to purchased goods and

services is dependent upon their after tax
income.
 In the 1950’s Milton Friedman argued that
people’s consumption decisions are based
mostly on their long-term (permanent) income.

15
 APPLICATION 4.1: Consumption
and Income Taxes

 One implication of the permanent-income

hypothesis is that temporary tax changes will
have little effect on the demand for
consumption goods
– This prediction is supported by the small impact on
consumption by both the temporary tax surcharge
during the Nixon administration and the Ford
administration’s temporary income tax rebate

16
 APPLICATION 4.1: Why the 2001 Tax
Cut Was a Dud

 In May 2001, Congress passed one of the

largest cuts in personal income taxes in history.
 Our discussion of demand theory showed that
changes in personal incomes shift demand
curves outward.
 However, Milton Friedman viewed that
spending decisions are based on a person’s
“permanent” income.

17
 APPLICATION 4.1: Why the 2001 Tax
Cut Was a Dud

 This insight suggests that the 2001 tax cut had

little impact for two reasons.
 First, The $300 checks were too small to
stimulate spending on any major goods, so they
were largely saved.
 Second, Most of the tax cuts do not begin until
2006, and the largest cuts are reserved until
2009-10.

18
 A Word on Notation and Terms

 When looking at only one market, Q is used for

the quantity of the good demanded, and P is
used for its price.
 When drawing the demand curve, all non-price
factors are assumed to not change.
 Movements along the curve are changes in
quantity demanded, while shifts are changes in
demand.

19
 Elasticity

 Goods are often measured in different units

(steak is measured in pounds while oranges
are measured in dozens).
 It can be difficult to make simple comparisons
between goods when trying to determine which
is more responsive to changes in price.

20
 Elasticity

 Elasticity is a measure of the percentage

change in one variable brought about by a 1
percent change in some other variable.
 Since it is measured in percentages, the units
cancel out so that it is a unit-less measure of
responsiveness.

21
 Price Elasticity of Demand

 The price elasticity of demand is the

percentage change in the quantity demanded
of a good in response to a 1 percent change in
its price
Percentage change in Q
Price elasticity of demand  eQ ,P 
Percentage change in P

22
 Price Elasticity of Demand

 The price elasticity records how Q changes in

percentage terms in response to a percentage
change in P.
 Since, on a typical demand curve, P and Q
move oppositely, eQ,P will be negative.
 For example, if eQ,P = -2, a 1 percent increase
in price leads to a 2 percent decline in
quantity.

23
 Values of the Price Elasticity of
Demand
 When eQ,P < -1, a price increase causes more
than a proportional quantity decrease and the
curve is called elastic.
 When eQ,P = -1, a price increase causes a
proportional quantity decrease, and the curve
is called unit elastic.
 When eQ,P > -1, a price increase causes less
than a proportional quantity decrease, and
the curve is called inelastic.
24
 TABLE 4.1: Terminology for the
Ranges of eQ,P

Value of eQ,P at a Point Terminology for Curve

on Demand Curve at This Point
eQ,P < -1 Elastic

eQ,P = -1 Unit elastic

eQ,P > -1 Inelastic

25
 Price Elasticity and the Shape of
the Demand Curve

 We often classify market demand curves by

their elasticities
– For example, the market demand curve for
medical services is inelastic (nearly vertical) since
there is little quantity response to changes in price.
– Alternatively, the market demand curve for a
single type of candy bar is very responsive to price
change (nearly flat) and is very elastic.

26
 Price Elasticity and the
Substitution Effect

 Goods which have many close substitutes are

subject to large substitution effects from a price
change so their market demand curve is likely
to be relatively elastic.
 Goods with few close substitutes, on the other
hand, will likely be relatively inelastic.

27
 Price Elasticity and the
Substitution Effect

 There is also an income effect that will

determine how responsive quantity demanded
is to changes in price.
 However, since changes in the prices of most
goods have a small effect on individuals’ real
incomes, the income effect will likely not have
as large an impact on elasticity as the
substitution effect.

28
 Price Elasticity and Time

 Some items can be quickly substituted for,

such as a brand of breakfast cereal, others,
such as heating fuel, may take several years.
 Thus, in some situations, it is important to
make the distinction between the short-term
and long-term elasticities of demand.

29
 APPLICATION 4.2: Brand Loyalty

 Substitution due to price changes will likely

take a longer time if individual’s develop
spending habits.
 Such brand loyalties are rational since they
reduce decision making costs.
 Over the long term, however, price differences
may cause buyers to try other brands.

30
 APPLICATION 4.2: Brand Loyalty

 It took several years, but by the 1970s the

price differences between U.S. and Japanese
cars eventually convinced Americans to buy
the Japanese cars.
 Brand name Licensing, such as Coca-Cola
sweatshirts and Mickey Mouse watches,
makes products that were previously nearly
perfect substitutes, now much less so.

31
 Price Elasticity and Total
Expenditures

 Total expenditures on a good are found by

multiplying the good’s price (P) times the
quantity purchased (Q).
 When demand is elastic, price increases will
cause total expenditures to fall.
– The given percentage increase in price is more than
counterbalanced by the decrease in quantity
demanded.

32
 Price Elasticity and Total
Expenditures

 For example suppose price elasticity = -2.

– Suppose people buy 1 million automobiles at $1000
each for a total expenditure of $10 billion.
– A price increase to $11,000 (10 percent) would
cause a 20 percent decline in quantity to 800,000
vehicles.
– Total expenditures after the price increase would
now be only $8.8 billion

33
 Price Elasticity and Total
Expenditures

 Of course, when demand is elastic and prices

fall, total expenditures increase.
 With unit elasticity, total expenditures remain
the same with a price change.
– The movement in one direction by the price is fully
offset by the movement in the other direction with
the quantity demanded.

34
 Price Elasticity and Total
Expenditures

 When demand is inelastic, a price increase will

cause total expenditures to increase too.
 Suppose the price elasticity of wheat = -0.5.
– Suppose people bought 100 million bushels at $3
per bushel so total expenditures equal $300 million.

35
 Price Elasticity and Total
Expenditures
– A 20 percent price increase to $3.60 means quantity
falls by 10 percent to 90 million with total
expenditures now equal to $324 billion.
 Alternatively, if the demand is inelastic and
prices fall, total revenue will also fall.
 Table 4.2 summarizes the relationship between
price elasticity and total expenditures.

36
 TABLE 4.2: Relationship between Price
Changes and Changes in Total Expenditure

In Response to an In Response to a
Increase in Price, Decrease in Price,
If Demand Is Expenditures will Expenditures will
Elastic Fall Rise

Unit elastic Not change Not change

Inelastic Rise Fall

37
 APPLICATION 4.3: Volatile Farm Prices

 The demand for many basic agricultural

products (wheat, corn, etc.) is relatively
inelastic.
 Even modest changes in supply, brought about
by weather patterns, can have large effects on
crop prices.

38
 The Paradox of Agriculture

 Good weather tends to produce bountiful

crops, but very low crop prices.
 Bad weather can result in very high crop
prices.
– Relatively small supply disruptions in the U.S. grain
best during the early 1970s resulted in farm
incomes rising more than 40 percent over a two
year period.

39
 Boom and Bust in the Late 1990s

 Since the New Deal in the 1930s, the volatility

of farm prices has been moderated through
federal price-support programs.
– Acreage restrictions constrained increased planting
– The federal government purchased crops outright

40
 Boom and Bust in the Late 1990s

 These programs moderated severe farm price

swings.
 With the passage of the Federal Agricultural
Improvement and Reform Act in 1996, federal
governmental intervention into agricultural
markets was reduced.
– In 1997, farm prices were unusually high, but this
was followed by very low prices in 1998.

41
 Demand Curves and Price Elasticity

 The relationship between a particular demand

curve and the price elasticity it exhibits can be
complicated.
 For some curves, the elasticity remains
constant everywhere, but for others it is
different at every point.
 A more accurate way to describe it would be to
say the elasticity is for current prices.

42
 Linear Demand Curves and Price
Elasticity

 The price elasticity of demand is always

changing along a straight line demand curve.
– Demand is elastic at prices above the midpoint
price.
– Demand is unit elastic at the midpoint price.
– Demand is inelastic at prices below the midpoint
price.

43
 Numerical Example of Elasticity on
a Straight Line Demand Curve

 Assume a straight-line demand curve for

Walkman cassette tape players is
Q = 100 - 2P
– where Q is the quantity of players demanded per
week and P is their price.
 This demand curve is illustrated in Figure 4.3
and Table 4.3 shows several price-quantity
combinations.

44
 FIGURE 4.3: Elasticity Varies along a
Linear Demand Curve
Price
(dollars)
50

40

30
25 Demand
20

10

0 20 40 50 60 80 100 Quantity of tape

45 players per week
 TABLE 4.3: Price, Quantity, and Total
Expenditures on Walkmans for the Demand
Function Q = 100 - 2P

Price (P) Quantity (Q) Total Expenditures (P  Q)

$50 0 $0
40 20 800
30 40 1,200
25 50 1,250
20 60 1,200
10 80 800
0 100 0

46
 Numerical Example of Elasticity on
a Straight Line Demand Curve
 For prices of $50 or more, nothing is bought so
total expenditures are $0.
 As prices fall between $50 and $25, the
midpoint, total expenditures increase.
 At the midpoint, total expenditures reach a
maximum.
 As prices fall below $25, total expenditures
also fall.

47
 Elasticity of a Straight Line Demand
Curve

 More generally, for a linear demand curve of

the form Q = a - bP,
Q
Q Q P
eQ ,P   
P P Q
P
P
eQ ,P  b  .
Q
48
 A Unitary Elastic Curve

 Suppose the demand for tape players took the

form
1,200
Q
P
• The graph of this equation, shown in Figure 4.4,
is a hyperbola.
• P·Q = $1,200 regardless of price so demand is
unit elastic (-1) everywhere on the curve.
49
 General Formula for the Elasticity
of a Hyperbola

 If the demand curve takes the following form,

the price elasticity of demand is equal to b
everywhere on the curve.

Q  aP (b  0)
b

50
 FIGURE 4.4: A Unitary Elastic
Demand Curve

Price
(dollars)

60
50
40
30
20

20 24 30 40 60 Quantity of
tape players
per week

51
 Income Elasticity of Demand
 The income elasticity of demand equals the
percentage change in the quantity demanded of
a good in response to a 1 percent change in
income.
 The formula is given by (where I represents
income):
Percentage change in Q
eQ , I  .
Percentage change in I

52
 Income Elasticity of Demand

 For normal goods, eQ,I is positive because

increases in income lead to increases in
purchases of the good.
 For inferior goods eQ,I is negative.
 If eQ,I > 1, the purchase of the good increases
more rapidly than income so the good might be
called a luxury good.

53
 APPLICATION 4.4: An Experiment in
Health Insurance

 Most developed countries have some form of

national health insurance.
– In the U.S. Medicare covers the elderly and
Medicaid is available for many of the poor.
 Recently a number of comprehensive
government health plans have been proposed.

54
 The Moral Hazard Problem

 A “moral hazard” problem occurs because

insurance misleadingly lowers the out-of-
pocket expenses to patients, greatly increasing
their demand for medical services.
 An important question, in considering
implementing national health insurance is how
large an increase is likely to develop?

55
 The Rand Experiment

 The Rand Corporation conducted a

government-funded large-scale experiment in
four cities.
 People were assigned to different insurance
plans that varied in the generosity of coverage
they offered.
 Table 1 shows the results from the experiment.

56
 The Rand Experiment

 A rough estimate of the elasticity of demand

can be obtained by averaging the percentage
changes across the various plans in Table 1

% change in Q  12
e    0.18
% change in P  66

57
 Table 1: Results of the Rand Health
Insurance Experiment

Coinsurance Percent change Average total Percent change

rate in price spending in quantity
0.95 540.00
0.50 -47% 573.00 6.10%
0.25 -50 617.00 7.7
0.00 -100 750.00 21.6
Average -66 12

58
 Low Elasticities for Hospital and
Doctors’ Visits

 Using the estimate of -0.22 found in Table 4.4,

and based on other studies suggests only a
small increase in hospital and doctor visits
would result from the lower prices provided by
insurance.
 Alternatively, researchers have found greater
elasticities (around -0.5) for dental care and
outpatient mental health care.

59
 Cross-Price Elasticity of Demand

 The cross-price elasticity of demand

measures the percentage change in the
quantity demanded of a good in response to a
1 percent change in the price of another good.
Letting P’ be the price of another good,

Percentage change in Q
eQ ,P  .
Percentage change in P'
60
 Cross-Price Elasticity of Demand

 If the goods are substitutes, an increase in the

price of one will cause buyers to purchase
more of the substitute, so the elasticity will be
positive.
 If the goods are complements, an increase in
the price of one will cause buyers to buy less
of that good and also less of the good they
use with it, so the elasticity will be negative

61
 Empirical Studies of Demand:
Estimating Demand Curves

 Estimating a demand curve for a product is one

of the more difficult but important problems in
econometrics.
 Empirical studies are useful because they a
provide a more precise estimate of the amount
of change in quantity demanded that results
due to a price change.

62
 Problems Estimating Demand
Curves

 The first problem is how to derive an estimate

holding all other factors (the ceteris paribus
assumption) constant.
 This problem is often solved, as discussed in
the Appendix to Chapter 1, by the use of
multiple regression analysis.

63
 Problems Estimating Demand
Curves

 The second problem deals with what is

observed in the data. The data points
represent quantity and price outcomes that are
simultaneously determined by both the
demand and the supply curves.
 The econometric problem is to “identify” from
these equilibrium points the demand curve that
generated them.

64
 Some Elasticity Estimates

 Table 4.4 gathers a number of estimated

income and price elasticities of demand.
 Some things to note
– All of the estimated price elasticities are less than
zero as predicted by a negatively sloped demand
curve.
– Most of the price elasticity estimates are inelastic.

65
 TABLE 4.4: Representative Price and
Income Elasticities of Demand
Price Elasticity Income Elasticity
Food -0.21 +0.28
Medical services -0.22 +0.22
Rental housing -0.18 +1.00
Owner-occupied
housing -1.20 +1.20
Electricity -1.14 +0.61
Automobiles -1.20 +3.00
Beer -0.26 +0.38
Wine -0.88 +0.97
Marijuana -1.50 0.00
Cigarettes -0.35 +0.50
Abortions -0.81 +0.79
Transatlantic air travel -1.30 +1.40
Imports -0.58 +2.73
Money -0.40 +1.00
66
 Some Elasticity Estimates

 The income elasticities of automobiles and

transatlantic travel exceed 1 (luxuries).
 The high income elasticities are balanced by
goods such as food and medical care which
are less than 1 (necessities).
 There is no evidence of Giffen’s paradox in the
table.

67
 Some Cross-price Elasticity
Estimates

 Table 4.5 shows a few cross-price elasticity

estimates
 All of the goods appear to be substitutes and
have positive cross-price elasticities.

68
 TABLE 4.5: Representative Cross-Price
Elasticities of Demand

Demand for Effect of Price of Elasticity Estimate

Butter Margarine 1.53

Electricity Natural gas 0.50

Coffee Tea 0.15

69
 Application 4.5: Alcohol Taxes as
Drunk Driving Policy

 Each year more than 40,000 Americans die in

automobile accidents.
 It is generally believed that alcohol
consumption is a major contributing factor in at
least half of those accidents.
 Most empirical studies of alcohol consumption
show that it is sensitive to price.

70
 Application 4.5: Alcohol Taxes as
Drunk Driving Policy

 The figures in Table 4.4 suggest that these

elasticities range from approximately –0.3 for
beer to perhaps as large as –0.9 for wine.
 Most teenage alcohol consumption is beer.
 The lower price elasticity of demand for beer
poses a problem for those who would use
alcohol taxes as a deterrent to drunk driving.

71