1 REVIEW

If you demand something, then you

o Want it,
o Can afford it, and
o Have made a definite plan to buy it.

Examples: Can-Am, Pink Unicorn, etc.

Wants are the unlimited desires or wishes people have for goods and
services.

Demand reflects a decision about which wants to satisfy.

Definition: The quantity demanded of a good or service is the amount that
consumers plan to buy during a particular time period, at a particular price.

Determinants of Quantity Demanded of a Good (say, some general good X)

Price of Good X for example, PX then QX (or PX then QX ).

The relationship between price and quantity for most goods is negative.
Given data on this relationship, we can proceed to map the demand curve for
good X.
Market demand is defined only when all variables other than the price of the
good in question (PX) are held constant. A demand schedule shows how
quantity demanded and price are relatedforming a demand curve.
Determinants of Quantity Demanded of a Good

For the given data PX QX

2 6
PX 3 5
4 4
6 5 3
6 2
5

QX
2 3 4 5 6
Determinants of Quantity Demanded of a Good
Any change in any other variables serves to change the location of Market
Demand (i.e. they cause shifts in the demand curve).

These shift variables could be:

The Price of Other Goods (i.e. good Y) for example,
baseball and gloves
PY then QX (complementary goods)
PY then QX (substitute goods) coffee and red ball

The relationship between the price of Y and quantity of X depends on the

relationship between the uses of the two goods.
Determinants of Quantity Demanded of a Good
Changes in Income (M) for example,
If when M then QX (we have an inferior good)
If when M then QX (we have a normal good)
More on this later
Other Shift Variables:
Consumer Tastes / Preferences
Income Distribution
Credit Availability demand at the beginning, eg motagage

Government Policies
Future Expectations in the Market eg, buy a car this yr is expensive next yr will be lower,maybe wait for next yr

and others
Demand Review:

The LAW OF DEMAND states that other things remaining the same, the higher
the price of a good, the smaller is the quantity demanded (or the lower the
price of a good, the larger is the quantity demanded).

The LAW OF DEMAND results from the combined influences of the

substitution effect and the income effect.

Substitution effectwhen the relative price (opportunity cost) of a good or

service rises, people seek substitutes for it, so the quantity demanded
decreases (not a proper definitionmore later in the course).
Income effectwhen the price of a good or service rises relative to income,
people cannot afford all the things they previously bought, so the quantity
demanded decreases (not a proper definitionmore later in the course).
Demand Review:

Distinction between Market Demand (D) and Quantity Demanded (Q):

P P

Q Q

Market Demand (D) is a curve Quantity demanded (Q) is a

representing the complete distance along the horizontal
relationship between price and axis.
quantity demanded, normally a
downward-sloping curve in price-
quantity space.
Demand Review:

Movement Along a Demand Curve

P P
-

-- +

D D
+

Q Q
As P then Q As P then Q

Movement along Demand occurs when only the price of the good in question changes,
ceteris paribus*.
In our example, all other variables that affect Q are assumed to remain constant, and thus the
position of the demand curve does not change.

* Ceteris paribus is a term used in economics to indicate all other factors held constant.
Demand Review: shift to right
means buy more
at the original
price
Shifts in the Demand Curve
Assume something occurs to shift the demand
P curve to the right. For example, income (M)
goes up and the good is a normal good.
A shift in Demand
occurs when
P1 something other than
the price of the good
in question changes.
P0 In this case, as
income increases the
D1
consumer will
respond by increasing
D0 the quantity
demanded at any
price level (when the
Q1 Q0 Q1 | Q0 | Q good is a normal
good).
Demand Review:

Other Examples of Demand Shifts (for example, Wheat)

Pw Pw
M and wheat is
buy less goods
an inferior good.

DI
D
DI D
Qw Qw
Pcorn
Corn is a substitute for wheat. As corn becomes
Pw more expensive consumers switch to the now
cheaper wheat.

Pmilk - Milk is a complement of wheat. As milk becomes

D more expensive so does the consumption of wheat with milk.
DI Consumers switch to any now cheaper substitutes of wheat
Qw and milk.
Demand Review:

Notice that these shifts in demand are not induced by a change in the price of
wheat, but by changes in other variables that affect the quantity demanded of
wheat.

Math Review: Simple Derivatives

The derivative of a function y = f(x) is defined to be

df(x) = lim f(x + x) f(x)

dx x0 x

In words, the derivative is the limit of the rate of change of y with respect to x
as the change in x approaches 0. The derivative gives us the most precise
meaning to the phrase the rate of change of y with respect to x for small
changes in x.
Math Review: Simple Derivatives

We can denote the derivative of f(x) with respect to x by f|(x).

So, df(x) = dy = f|(x)(all the same, just different notations)

dx dx

Lets do a few examples,

The general equation of a line is y = a + bX. Using the general formula for the
derivative

df(x) = lim f(x + x) f(x) and subbing in y = f(x)

dx x0 x

df(x) = lim a + b(x + x) (a + bx) = b x = bsimply the slope of the line!

dx x0 x x
Math Review: Simple Derivatives

For nonlinear functions, like y = x2 we use the same process. Using the general
formula for the derivative

df(x) = lim f(x + x) f(x) and subbing in y = f(x)

dx x0 x

df(x) = lim (x + x)2 x2 = x2 +2xx + (x)2 x2 = 2x + x = 2x (as x 0)

dx x0 x x

For more complex nonlinear functions, like y = zx2 we use the same process. Using
the general formula for the derivative

df(x) = lim f(x + x) f(x) and subbing in y = f(x)

dx x0 x

df(x) = lim z(x + x)2 zx2 = zx2 +2zxx + z(x)2 zx2 = 2zx + zx = 2zx (as x 0)
dx x0 x x
Math Review: Simple Derivatives

Some examples will illustrate these general results.

Linear function

Suppose y = 17 3x. Then dy/dx = 3.

Generally, if y = a + bx then dy/dx = b.

Nonlinear function

Suppose y = 6x2. Then dy/dx = 12x. Suppose y = 5x3. Then dy/dx = 15x2.
Suppose y = 4x4. Then dy/dx = 16x3. Suppose y = 3x5. Then dy/dx = 15x4.

Generally, if y = cxn. Then dy/dx = cnxn-1.

Math Review: Simple Derivatives
Some examples will illustrate these general results.

Multi-variable Nonlinear function

Suppose U = 2x2y2. Then dU/dx = 4xy2.

Suppose U = x1/2 y1/2. Then dU/dx = 0.5x-1/2 y1/2 or dU/dx = y1/2
2 x1/2

Generally, if U = cxnym. Then dU/dx = cnxn-1ym.

Elasticity of Demand:

Definition:
ed = % in Qw
% in Pw

the percentage change in quantity demanded as a result of a percentage

change in the price of the same good.
This is the own price elasticity of demand.
Note that when we have downward sloping demand curves this price
elasticity is negative since there is an inverse relationship between price and
quantity demanded.
always negative

*Normally, we think of ed in terms of absolute value (i.e. we ignore the negative sign when we say it
aloudbut it is important to remember that it is always negative whenever we do calculations).
 Elasticity of Demand:
We can write ed as ed = Q/Q = Q . P
P/P P Q (called point elasticity)
QD=alph-beta *P

Note that ed = Q . P Q (slope of the demand curve)

P Q P

The elasticity depends on the position of the point where we are evaluating it,
as well as, on the slope of the demand curve.

The point elasticity formula is used to measure elasticity at a particular point

on the demand curve.

The price elasticity of demand varies along the demand curve.

Elasticity of Demand:

If you remember, in ECON 101 you were asked to use the arc elasticity
formula

ed = Q = Q . (P1 + P2)
(Q1 + Q2)/2 P (Q1 + Q2)
P
(P1 + P2)/2

This expression is a linear approximation of the demand elasticity and it

becomes more and more inaccurate as the distance between Q1 and Q2
becomes larger.
Elasticity of Demand:

What this ARC elasticity formula is really measuring is the midpoint elasticity
of a line connecting point A and point B! This is why we prefer the POINT
elasticity formulait is much more accurate.
P
ed = Q/Q = Q . P
P/P P Q

P1 A measures the elasticity at the

point of interest.

B
P2
D

Q1 Q2 Q
Elasticity of Demand:

The following demand curves are both special cases where one of the
variables (P or Q) are constant.
P P

Q Q

Perfectly Inelastic Demand Perfectly Elastic Demand

ed = % in Q = 0 =0 ed = % in Q = % in Q = -
% in P % in P % in P 0

no matter what the price is quantity always change

Elasticity of Demand:

For demand elasticities in between these two extremes, we know that the
main determinant of the degree of price elasticity of demand is the
availability of substitutes.
Pgas
Pcola
-

+
-
+
D
D
Qcola Qgas

Demand Elastic (flatter) Demand Inelastic (steeper)

There are many close substitutes for cola. There are very few close substitutes for gasoline.
Elasticity of Demand:

In terms of numerical values for the price elasticity of demand, we can

summarize as follows:
P P P

D
D
D
Q Q Q

Inelastic Unit Elastic Elastic

ed = 1 1 < ed <
0 < ed < 1
few close substitutes many close substitutes

necessities luxuries

short run long run

Lecture #1: Homework Questions

1. Suppose that you are given a utility function defined as U(X, Y) = 2X1/2Y1/2.
What is U/ X? What is U/ Y?

2. Suppose that you are given a utility function defined as U(X, Y) = X3/5Y5/7.
What is U/ X? What is U/ Y?

3. Suppose that you are given a function defined as Y = F(A) = A3 + 4A2 7A + 3.

What is F/ A?

4. Suppose that we know that a general demand curve is defined as: QD = P.

a) What is the elasticity of demand at the point where = 400, = 3, and P = 25? Is this elastic or
inelastic?
b) What is the elasticity of demand at the point where = 400, = 3, and P = 75? Is this elastic or
inelastic?

5. Suppose that you are given a profit function defined as = F(X) = PX 21X 45.
What is / X?