Individual demand

Rational behaviour on the individuals part

Elasticity
Elastic: quantity demanded responds a great deal (is sensitive) to a price change Inelastic: quantity demanded responds little (is insensitive) to a price change. Measure: (absolute value of) the percentage change in quantity demanded for a onepercent change in price: - (DQ/Q0)/(DP/P0) > 1, elastic
3

Additional topics on demand

implies: quantity demanded rises as the own-price (P ) of a good falls as the total budget or income (Y ) rises QD = f (P, Y , PF) ,+,+ QD = a bP + cY +dPF
1 2

Elasticity
Price D1 D2 DQ > DQ DQ / Q0 > DQ /Q 0 DQ / Q DQ _____ 0 > ____ /Q 0 -DP /P0 - DP /P0 From the same price and quantity on the same scale, a steeper curve is less elastic.
DQ DQ

Elasticity and revenue

Price D1 D2 Revenue decreases as price falls on the inelastic curve. Revenue increases as price falls on the elastic curve.

Elasticity of individual demand: factors involved

Goods with more substitutes are more elastic, e.g., beef has more substitutes than rice; demand for the former is more elastic. Goods that take up a smaller share of the budget are more inelastic, e.g., shoelaces vs. a new dress. Goods that complement others that are elastic in demand will also be elastic. Time: demand is always more elastic in the long run (allows more substitutes to be found).
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P
0

P
0

DP

P1

P1

Q0 Q1

Q2

Quantity
4

Q0 Q1

Q2

Quantity
5

N.B. DP is negative in this example/

Price elasticity of market demand: other factors

Price level: demand will be more elastic at higher prices than at lower ones.
reducing high prices draws in new buyers, e.g., middle-classes and the poor; at already-low prices, even the poor will be satiated. Another reason that luxuries are more price-elastic than necessities.

Application: who pays a tax?

Producers are better able to pass on a tax to consumers if the demand is price-inelastic. Hence, a tax on rice (with few substitutes) will hurt consumers more than a tax on beef (which has more).

Elasticity can vary along the same demand curve

Price D1 Revenue increases as price falls on the elastic part of the curve Revenue falls as price falls on the inelastic part of the curve.

P
0

P1 P2

Income distribution: demand for the same good will be less price-elastic if income is more equally distributed.
At any price, more people would already be buying the good
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Q0
8

Q1

Q2

Quantity
9

Elasticity of individual demand: midpoint method

Problem with the simple method of computing elasticity:
- (DQ/Q0)/(DP/P0) = - (Q1 - Q0)/Q0)/((P1 - P0)/P0) Formula can give a different value depending on whether one is measuring a price increase or a price decrease, because the percentage increase in price or quantity depends on the base, or starting point: Q0 and P0.
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Elasticity of individual demand: why the midpoint method

price
From A to B, elasticity is: - (40 - 30)/30)(2 - 4)/4 = - (1/3)/(-1/2) = 2/3.

Elasticity of individual demand: midpoint method

Solution: make the base equal to the average of the initial and terminal values. So instead of using Q0 and P0 in:
- (DQ/Q0)/(DP/P0) = - (Q1 - Q0)/Q0)/((P1 - P0)/P0) replace Q0 by: (Q1 + Q0)/2 and P0 by: (P1 + P0)/2, hence the formula: - [(Q1 - Q0)/(Q1 + Q0)/2 ]/[(P1 - P0)/(P1 + P0)/2]
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A 4
From B to A, elasticity is: - (30 - 40)/40)((4 -2)/2) = - (-1/4)/(1) = 1/4.

30

40

quantity

= - [(Q1 - Q0)/(P1 - P0)]/[(P1 + P0)/(Q1 + Q0)]

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Elasticity of individual demand: why the midpoint method

price
From A to B, elasticity is: - (40 - 30)/(40+30)/2 (2 - 4)/(4 +2)/2 = - (10/35)/(-2/3) = 3/7. From B to A, elasticity is: - (30 - 40)/(40+30)/2 (4 -2)/(4 + 2)/2 B = - (-10/35)/(2/3) = 3/7.

Application: who pays a tax?

Price
Consumers with inelastic demands are penalised more by a tax.

Summary points regarding a tax

1. The deadweight loss from a tax increases with the height of the tax. 2. The revenue actually collected from a tax does not always increase with the height of the tax. Income = Y 3. The burden of the tax borne by buyers (resp. sellers) is reduced as the elasticity of demand (resp. supply for the good increases.

A 4

S+T S D2 D1
Quantity

30

40

quantity
13 14

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Income and demand: Engels Law

One of the rare unconditional regularities in microeconomics. Share of food in a households total spending falls as the household income increases. poorer families spend a greater proportion of their income on food than wealthy families do. inferior (Engel) good (DQ /Q0)/(DY /Y0) < 1
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The Engel relation

Spending on Food = PX A higher income implies a smaller budget proportion spent on food (slope flatter than slope .)

The Engel relation

(alternative depiction)
Budget share = PX /Y 1.0

Slope equals proportion of income spent on food

spending on food

Y1
Total income

Y2

Income = Y

Y1
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Income = Y
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Food spending by income deciles

(budget share by mean decile income in thousand pesos)
0.8 0.7 0.6 0.5 0.4 0.3 0.2 0.1 0 0 100 200 300 400 500 600
Agriculture Share, %

Share of agriculture in GDP versus income per capita for 32 selected countries
(percent, current US$, 2000)
70 60 50 40 30 20 10 0 0 1000 2000 3000 4000 5000 6000

Food share

Welfare and international trade

Philippines

Mean decile income

19

Grossa national income per capita , current US$

20

21

Equilibrium in autarky
Price

Small country assumption

Domestic demand and supply determine price and quantity

Small country assumption

If the world price is above the autarkic domestic price, then the country becomes an exporter of the good. The higher price encourages producers to more. Local consumers buy less. The difference is exported to the rest of the world.
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P0

D Q0
Quantity
22

Suppose the country cannot affect the world price, I.e., has not bargaining power. Then it can buy or sell as large a quantity as it desires without raising or lowering the world price of the good in question. (E.g. compare the effect of Philippine and US petroleum demand on world prices of oil.) The world price becomes the prevailing price.

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Small country: exporter

Price
Exports

Small country assumption

If the world price is below the autarkic domestic price, then the country becomes an importer of the good. The lower price encourages producers to produce less than before. But local consumers buy more. What the consumers cannot buy from local producers is imported.
25 26

Small country: importer

Price

PW P0

P0 PW
Imports

D QC Q0 QP
Quantity

D QC
Quantity
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QP

Q0

Winners and losers from trade

Who wins and who gains depends on whether the world price is above or below the autarkic price. (a) If the world price is higher, then consumers lose and producers gain. (b) Conversely consumers gain and producers lose when the world price is lower than the autarkic price.
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Social gains and losses

Price
Exports

Social gains and losses

Price

S
Consumers lose B Producers gain B+D Hence a net social gain equal to D A

S
Producers lose B. Consumers gain B + C. B D Imports

PW P0

A
B C

P0
PW

Hence a net social gain equal to C.

D QC Q0 QP
Quantity
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D QC
Quantity
30

QP

Q0

Social gains and losses

Whether society as a whole gains from trade depends on whether the net gains and losses of consumers and producers are positive. That means whoever gains can in principle compensate the losers, I.e., the compensation principle. Moving from autarky to trade, one finds that the gains of the winners are always enough to compensate the losers. (Problem in real life is whether they actually do.)*31

Trade policy
Protection measures aim to prevent or restrict the entry of imports. Major instruments of protection include: Import controls or import quotas: restrictions on the quantities or values of allowable imports
allow no more than X metric tonnes of rice allow no more than V million pesos worth of imports

Trade policy
Quotas are equivalent to tariffs in their welfare effects. Under both, consumers get hurt; producers benefit; But under a quota, the revenue goes to the quota holders; under a tariff the revenue goes to government. (If government auctions off the right to import, then the revenue is fully or partly recaptured by government.) There is always a deadweight loss from either: consumers can buy less than they want; producers incur more costs to produce more than they should. 33

Tariffs: taxes on imports

specific (per unit), e.g., P + T ad valorem (according to the value), e.g., P(1 + t), where t is the tariff rate.
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Trade policy
Other differences: if world prices go up, the domestic price remains the same under a quota; but it rises under a tariff. If there are demand and supply shifts, domestic price changes under a quota; but it remains the same under a tariff. The quota regime is more prone to corruption, since it gives government discretion to select who gets to import. (Historically the main reason for the bad reputation of the quota system in the Philippines.)
Price

A protective tariff
S
Consumers lose B + C +D+E. Producers gain B. Government gains D. A A

A quota
Price

Consumers lose B + C +D+E. Producers gain B. Quota holders gain D.

PW + T PW
F

Hence a net social loss of C + E.

PD PW
F

D Quota

Hence a net social loss of C + E.

Imports

D
Quantity
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D QC
Quantity
36

QP

QC

QP

34