6.

Demand Characteristics
Elasticities, Market Demand
Individual Market Demand Functions
Economy has n consumers i = 1,n
Consumer is ordinary demand function for commodity j:
All consumers price-takers market demand function for commodity j:

all consumers are identical then (M = nm) :

market demand curve horizontal sum of individual consumers demand curves
Example:
2 consumers i = AB

Why Use an elasticity measure?

Application:
o Only seller of good (maybe only designer of custom website for local business community)
Monopoly
o if you sell at lower price sell more units
o want to know:
will price cut increase revenue per period (increase in # of websites sold get greater
increase in revenue than is lost by cutting price)
decrease revenue (price cut reduces revenue more that quantity change increases it)
Application:
o Union negotiator
o Succeed in wining general wage increase union members will get higher incomes, others
laid of
o Want to know:
Will increase income to those still employed exceed loss of income to those losing
their jobs?
Application:
o Govt trade policy-maker
o Want to impose import quota on some imported good to protect domestic produces from
low-price foreign comp
o Want to know:
By how much must the with-quota domestic price of imports increase in order to allow
domestic produces to survive (w/e increase prices to buyers)
Interested in Sensitivity
How sensitive is quantity to a change in price?
Elasticity: ratio of changes
Economic Application of Elasticity
Use elasticities to measure sensitivity of:
o QD of commodity i with respect to $ of commodity i (own-price elasticity of demand)
o Demand for commodity i with respect to $ of commodity j (cross-price elasticity of demand)
o Demand for commodity i with respect to income (income elasticity of demand)
o
o
o

QS of commodity i with respect to commodity i (own-price elasticity of supply)

QS of commodity i with respect to wage rate (elasticity of S with r to $ of labour)
.

Price

Elasticity of Demand
demand price elastic when QD is very responsive to a change in products own price
demand inelastic when DQ is very unresponsive to changes in its price
price elasticity of D is related to slope of demand curve not exactly the same

Own-Price Elasticity of Demand

why not use Demand curves slope to measure sensitivity of QD to a change in commoditys own
price?

which case if QD x1* more sensitive to changes in p1?

Same in both cases
Value of sensitivity then depends upon the units of measurement used for QD & scale of
measurements on axis
o

Using Absolute Changes to Indicate Elasticity

Example:
2 goods, price for each reduced by $10
QD for good X rises 10 units
QD for good Y rises by 10,000 units
Which is more sensitive to price changes?
o How significant is price change of $10?
Original $10 big change (dvds)
Original $500 not that much of diference (laptops)
o How significant is quantity change of 10/10,000 units
Original D is 15 big change (houses)
Orginal D 10,000,000 not that much (timmies cofee)
Measure that Incorporates Significance
Taking account how much a change matters ratio
o Percent change in QD to associated percent change in price
General form for elasticity:
Elasticities
measures sensitivity of 1 variable with respect to another
elasticity of X with respect to Y
Property of Elasticity Measures
independent of units of measure ($, quantity)
change in quantity measured in same units as base quantity units cancel
change in price measured in same units as base price so units cancel
o end up with pure number
Example:
can compare price elasticity of SUVs with price elasticity of gasoline

can compare when both money units and quantity units difer
ex. demand for milk in France (litres, euros) compared to milk in Cali (quarts, $)

complication:
o what to use as base price and quantity
computing percent changes (use starting values as bases)
used when computing growth rates
example:

we dont want 2 elasticity values for the same interval of the demand curve
o especially if one is price elastic (abs value of price elastic > 1)
while other in inelastic (abs value of price elastic <1)
prefer measure that indicates unique elasticity over interval irrespective to price
increasing/decreasing
solution:
o for arc elasticity large movements in price &
quantity)
o use mid-point (averages of values

Price Elasticity of Demand along Straight Line Demand Curves

along straight-line demand price-elasticity is always changing
as price falls & quantity rises abs value of price elasticity of demand gets smaller
Example:
slope of linear demand curve = constant
associated price elasticity of demand is not constant

Absolute Value of Price Elasticity falls as we move down a linear demand curve

elastic > 1
unit = 1
inelastic < 1

Elasticity Formula

first part
(green)
o related to slope of demand curve
o reciprocal of slope what is drawn (run/rise)
if demand curve is straight line constant
second part (red)
o ratio of price to quantity
o falls as we move from left to right
price falls, quantity rises, ratio of price to quantity falls
entire elasticity value falls as we move left to right (b/c of second term)

Price Elasticity and Total Revenue

total revenue received by the sole seller of a product, or of ALL sellers together
monopoly case:
o (single seller) all spending on the product MUST be revenue to the sole
seller
relation between revenue and elasticity common application deals with relation
between (controllable) price and total revenue to single seller
Elasticity and Total Expenditure
along demand curve total spending on good = product price and QD
Total Expenditure = Price x Quantity

if demand elastic fall in price = increased total expenditure

o Q rises a lot, P falls a bit growth in Q larger then fall in P
If demand is inelastic fall in price = decrease total expenditure
o Q rises a bit, P falls a lot growth in Q is smaller than fall in P
If demand is unit elastic fall in price = no efect in expenditure
o Growth in P is as much as decline in Q

D elastic total expenditure increases when price falls

D inelastic total expenditure decreases when price falls
D unit elastic total expenditure is at max

Marginal Revenue
The change in total revenue associated with a change in quantity
Demand, Inverse Demand (Willingness to Pay)
Demand Q = f(P)

o Plot
Demand function
o Tells seller how many units can be sold at a specified price
Causation running in the opposite direction
o Height of demand curve (at some Q = Qo) shows max price at which
Qo will be demanded (sold)
addition of 2 linear inverse functions kink in market demand curve

quantity

Example:
Linear demand tells us how many units are demanded at P
Invert to plot (make it = to P)
P is the mac price a single seller can charge and still sell the specified Q
If seller sets price highet than this P QD will be les than the specfied Q
Increase QD, Reduce Price
MR to a single seller (monopoly) from an increase in Q sold = (lower) price of new units sold MINUS
(price reduction on previously sold units) x (# of prev sold units)
MR = P Spoilage
Since MR = P (something)
o MR < P (for single price, profit-maximizing monopoly)

As price lowered QS increases

o Revenue rises, MR = positive
o Increase in QS @ lower price dominates the
Reducing price on a small number of units
originally sold
o As number of units sold increase loss in
revenue from further price cuts (spoilage) gets
bigger
o QS increases as P reduced
At a point loss in revenue from reducing P is just
ofset by increase in revenue from selling more
o Change in total revenue (MR) = 0

price reduction

At greater quantities, lower prices loss in revenue from price cuts EXCEEDS gain in revenue from
selling more
o Total revenue falls (MR = negative)

Marginal Revenue & Own-Price Elasticity of Demand

What does positive/negative MR imply?
To derive rules of diferentiation

Power Function Rule

C = multiplicative constant
a = exponent (real #, +ive,-ve)
derivative of f(x) w.r.t. x
Special case exponent = 0
derivative = 0
Product Rule
Price Elasticity of Demand

start with TR (p x q)
max price P(Q) = function of Q from inverse demand
TR(Q) = Q x P(Q) product of 2 functions Q
o Product rule for diferentiation

MR (Q) = positive if term in last bracket > 0

MR(Q) = negative if term in last bracket > 0

MR(Q) = zero if term square brackets = 0

Summary
Own-price inelastic demand

o Price rise rise in sellers revenue

Own-price unit elastic demand
o Price rise no change in sellers revenue
Own-price elastic demand
o Price rise fall in sellers revenue
Linear demand function
Inverse demand (willingness to pay)
TR = P x Q
o Upside down bowl
o Positive values for all Q between edges of bowl @ edges, TR = 0
o

2 values of Q where TR = 0
find it by solving for Q when P(Q) = 0

MR =
o
o
MR =
o

slope of TR
Rate of change of TR as Q increased
Change in TR/associated change in Q
derivative of TR w.r.t. Q
MR function

MR, Average Revenue

AR: TR/Q
o Ratio of LEVELS (not changes)
If monopoly seller cannot price-discriminate if all units sold at same price
o Average revenue = P
o Height of the inverse demand function at any Q
Have inverse demand P(Q) quadratic TR(Q) & MR(Q)

o
o

MR(Q) = 0
Get TR(Q) max
TR

AR & MR

TR & AR & MR

Income Elasticity of Demand

> 0 normal good

o
o

0<

< 1 necessity
> 1 luxury

< 0 inferior good

goods increase in income leads to increase in QD (income elasticity = positive)
o normal goods (necessities & luxury)
goods decreases when income rises (income elasticity = negative)
o inferior goods

the more necessary an item is lower its income elasticity

income elasticities vary with level of consumers income
Ex. regular ground beef
= luxury if consumer cant aford meat often (low income)
= necessity when ground beef is afordable (higher income)
= inferior when income increases enough to allow purchases of other meat (subs
away)
o good cant be inferior at all levels of income

Cross-Price Elasticity of Demand

measures the response of demand for one good to changes in the price of another good

substitutes Cross-price > 0

ex. increase in price of beef increase in demand for chicken
complements cross-price < 0
ex. decrease in price of computers increase in demand for software

Arc and Point Elasticities

an average own-price elasticity of demand for commodity i over an interval of values for Pi
o arc-elasticity
usually computed by mid-point formula
elasticity computed for single value Pi
o point elasticity
Arc Own-Price Elasticity

Point Own-Price Elasticity

Examples