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PREVIEW
Tonight we consider two final components of standard demand analysis; (a)
Converting individual demand curves into a market demand curve and (b) elasticities.
Specifically, we proceed as follows
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D. Types of Demand Curves
1. Linear Demand
2. Constant Demand Elasticty
Lecture________________________________________________
VIII. Chapter 8 Market Demand and Elasticitity. We have considered in some detail
price and quantity effects for a particular consumer. Suppose now we consider the effects
of aggregating across consumers. We also devote some attention to the elasticity
measures very widely used in empirical work
Market demand is simply the sum of individual demands for good X. Thus
Observations:
- If each individuals demand curve for good X (holding PY,I1 and I2 fixed)
is downsloping, market demand for good X will be downsloping as well.
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Graphically, market demand is simply the horizontal summation of individual
demands (e.g., a
P P P
P1
X1 X2 X1 + X2
Individual 1 Individual 2 Market
Factors that shift individual demands would generally shift market demand in a
similar manner.
- A change in the price of a related good can affect all individual demands
uniformly.
- Income effects, however, are a bit more complicated, since incomes can
change differently for different individuals. The way the income changes
can affect demand. (This is often overlooked)
Example:
Consider two consumers with the following simple linear demand curves for
Oranges
X1 = 10 - 2PX + .1I1 + .5PY
X2 = 17 - PX + .05I1 + .5PY
Where
PX = Price of oranges
Ii = Individual is income (in thousands of dollars)
PY = Price of Grapefruit (a gross substitute for Oranges)
(Notice that we can sum across PX and PY, assuming the law of one price. On the other
hand, we cannot sum across individual incomes.)
To graph DX, we nee values for the variables other than own price. Let I1 = 40, I2 = 20 and
PY = 4. Then
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= 27 + 9 - 3PX
= 36 - 3 PX
If the price of grapefruit were to rise to $6, then demand would shift out to
On the other hand, setting PY = 4 again, impose a redistributive income tax that takes 10
from 1 and transferrs it to 2. The following results:
2. The n consumer case This simple analysis with two consumers extends readily to the
case of n consumers. Given a representative consumer j with demand for good i
B. Elasticity
1. Motivation and a general definition As we have seen, economists are
often interested in the way that one variable A affects another variable B. Economists, for
example, are often interested in the way that changes in various prices affect the quantity
demanded of a good. An important problem with such comparisons is that the variables
are not measured in readily comparable terms (for example, steak is measured in pounds,
the price is in dollars. Oranges may be sold by the dozen, and price changes may be on
the order of dimes.
One coherent way to address these different units of measure is to denominate all
these changes in percentage terms. This of elasticity
Notice from the definition that elasticity is a(n inverse) slope coefficient,
weighted by a location. We know, for example, that apple consumption will decrease with
an increase in the price of apples. However, the location allows us to speak more
meaningfully of the magnitude of the response.
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2. Price Elasticity of Demand Perhaps the most important elasticity
measure is own price elasticity, or the responsiveness of changes in a price on the
quantity of that good consumed.
a. Definition
Barring a Giffen Good relationship, own price elasticity measures are always negative
numbers (since Q/P<0). However, economists often divide goods by the magnitude of
the quantity response. If |eQ,P|<-1, then consumers are said to be insensitive, or inelastic
consumers of a good. On the other hand, if |eQ,P|>-1 then consumers are said to be
sensitive.
b. Price Elasticity and Total Expenditures. A common way to
explain these notions of sensitivity and insensitivity is in terms of the effects of a
price change on total expenditures. Recall, that total expenditures equal PQ. Write Q as
a function of P (for example Q = 10 P ; to raise quantity one must lower price). Then
take the partial derivate w.r.t. P.
PQ(P) = Q + Q(P)
P P
Notice that TR will move with price if demand is inelastic ( |eQ,P|<1) and TR will move
inversely with price if demand if elastic (|eQ,P|>1).
Graphically, this can easily be seen by considering price changes at different points along
a linear demand curve.
P P P
Price box
P
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Qty Box
Qty Box> Price Box Qty Box = Price Box Qty Box < Price Box
Elastic Segment Unitary Elastic Segment Inelastic Segment
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In the leftmost panel, observe that when price changes, the effects on total revenue can be
divided into a price box and a quantity box. In the case of a price reduction, for
example, the price box is the revenues lost from units that would have sold at the higher
price (Dimension PQ). The quantity box denotes the extra revenues realized from lower
the price (Dimension QP). The left panel illustrates a situation where TR moves
inversely with the price change. This is an elastic segment of the demand curve (recall |
eQ,P| = |(Quantity box)/ (Price Box)| = |QP /QP| >1). People are price sensitive in the
sense that total revenue increases when price falls.
The right most panel illustrates an inelastic segment (|eQ,P| = |(Quantity box)/
(Price Box)| = |QP /QP| <1), Here consumers are price insensitive, in the sense that
TR falls with a price reduction or, equivalently, TR increases with a price increase.
More revenues are gained from consumers staying in the market and paying the higher
price than are lost from consumers leaving the market.
The middle panel illustrates a unitary elastic segment, where the price box just
equals the quantity box (and eQ,P| = |(Quantity box)/ (Price Box)| = |QP /QP| =1). Here
the price and quantity boxes indicate that price and quantity effects are exactly offsetting.
Unlike own price elasticity, income elasticity can be positive or negative. The sign and
the magnitude of income elasticity is important.
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Example: Elasticities are easily understood in terms of a linear demand function.
For example, consider the market demand function
Then eQ,P = -2(5)/6 = -1.67, the firm is on the elastic portion its
demand curve
eQ,I = .1(40)/6 = 0.67, the product is a normal, noncyclical
good.
eQ,P = .5(4)/6 = 0.33, good Y is a substitute.
X = dX(PX, PY, I)
and
Y = dY(PX, PY, I).
Further, assume these demand functions are homogeneous of degree zero in prices
and income. Differentiating the budget constraint w.r.t. I,
PX(X/I) + PY(Y/I) = 1
sxeX,I + sYeY,I = 1
Thus, the share weighted sum of the income elasticities for all good equals 1.
(e.g., if income increases 10%, expenditures must increase 10%). Thus, for every
luxury good (with income elasticity greater than 1) there must be offsetting goods witn
income elasticities less than 1.
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2. Slutsky Equation in Elasticities Recall in chapter 5 the Slutsky equation
X = X | - X X
PX PX |U = constant I
X PX = X PX | - X[ X I ] PX
PX X PX X |U = constant IX I
Where
eSXP denotes the compensated price elasticity of demand
and
sx denotes the share of income spent on X.
Notice that the above (bolded expression provides an additional reason to use
uncompensated demand: When sx is small uncompensated and compensated elasticities
are very similar.
When m=0, then the Eulers theorem states that the sum of the quantity weighted
first derivatives equals zero.
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By Eulers Theorem+
This is another way to state the homogeniety of degree zero property of demand
functions. An equal percentage change in all prices and incomes will leave the quantity
demanded of X unchanged.
U(X,Y) = XY where + = 1.
X = I/PX Y = I/PY
eX,Py = 0
eY,Py = -1
eY,I = 1
eY,Px = 0
sX = PXX/I = PXI/PXI =
sY = PYY/I =
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The constancy of income shares provides another way of shown the unitary
elasticity of demand.
-1 + 0 + -1 = 0
-1 = eSXP - (1)
Thus
eSXP = -(1 - )= -
In words, the compensated price elasticity of demand for one good is the income
share for the other good. This is special case of the more general result that
Q = a + bP + cI + dP
Q = a + bP
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eX,Px = (X/PX) PX /X = bP/Q
Obviously as P rises Q falls, and demand becomes more elastic.
Q = 36 3P.
Price elasticity of demand is
Notice demand is unit elastic when P = 6. For P>6 demand is elastic. For P<6
demand is inelastic. Because elasticity varies with price on a linear demand curve, one
must be very careful to specify the point at which elasticity is being measured. In
empirical work with linear demand curves, it is conventional to report the arc price
elasticity, that is, the average elasticity over the average price prevailing for a period.
2. Constant Elasticity Demand If one want to assume that elasticities are constant
use an exponential function.
Q = aPbIcPd
Where a>0, b<0, c>0 (a normal good) and d<>0, as for the linear good. Notice
that one can easily linearize such a function by taking natural logarithms (ln)
Notice that one can estimate the parameters of such a function with ordinary least
squares. Notice also that
eQ,I = c ; eQ,P = d
Therefore, from a linear regression, one can read elasticities without having to
make any mathematical computations. For example, if one estimated
We know that
eQ,P = -1.5 ; eQ,I = .5
and eQ,P = 1
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