Demand & Utility

What is Utility?
Satisfaction, happiness, benefit
Cardinal Utility vs. Ordinal Utility
Cardinal Utility: Assigning numerical
values to the amount of satisfaction
Ordinal Utility: Not assigning numerical
values to the amount of satisfaction but
indicating the order of preferences, that is,
what is preferred to what
Util
A unit of measure of utility
Total Utility
The amount of satisfaction obtained by
consuming specified amounts of a product
per period of time.
Example: TU(X) = U(X) = 16 X X
2
where X is the amount a good that is
consumed in a given period of time.

5 units of the product per period of time
yields 55 utils of satisfaction
Marginal Utility
The change in total utility (ATU) resulting from
a one unit change in consumption (AX).
MU = ATU/ AX
Diminishing Marginal Utility
Each additional unit of a product contributes
less extra utility than the previous unit.
When the changes in consumption are
infinitesimally small, marginal utility is the
derivative of total utility.
MU = dTU/dX
Calculating MU from a TU Function
Example: TU(X) = 16 X X
2
MU = dTU/dX = 16-2X
In general, the derivative of a total function
is the marginal function.
The marginal function is the slope of the
total function.
X
X
Total
Utility
Marginal
Utility
TU
MU
X
1
X
2
X
1
X
2
Graphs of Total Utility
& Marginal Utility
X
2
is where total utility reaches
its maximum.
MU is zero.
This is the saturation point or
satiation point.
After that point, TU falls and
MU is negative.
X
1
is where marginal utility
reaches its maximum.
This is where we encounter
diminishing marginal utility.
The slope of TU has reached its
maximum; TU has an inflection
point here.
Example: If TU = 15 X + 7X
2
(1/3) X
3
,
find (a) the MU function,
(b) the point of diminishing marginal utility,
& (c) the satiation point.
a. MU = dTU/dX = 15 +14X X
2
b. Diminishing MU is where MU has a maximum, or the
derivative of MU is zero.
0 = dMU/dx = 14 2X
X = 7
c. Satiation is where TU reaches a maximum or its
derivative (which is MU) is zero.
How do we determine where MU = 15 +14X X
2
= 0 ?
Apply Quadratic Formula to X
2
+ 14 X + 15 = 0 .
a 2
ac 4 b b
X
2

=
) (
) )( ( ) (
1 2
15 1 4 14 14
2

=
2
16 14

=
15
2
30
X or 1
2
2
X either So =

= =

=
2
256 14

=
Since a negative amount of a product makes no sense,
X must equal 15.
If the previous example were about eating
free cookies at a party, youd eat 15 of them.
That is where you become satiated.
After 15 cookies, you begin to feel a bit bloated.
When you have more than one product,
the marginal utility is a partial derivative.
Calculating partial derivatives is no more difficult than calculating
other derivatives.
You just treat all variables as constants, except the one with
which you are taking the derivative.
We denote the partial derivative of Z with respect to X as cZ/cX
instead of dZ/dX.
Example: Z = X
2
+3XY + 5Y
3
To take the partial derivative with respect to X, pretend Y is a
constant (like 4). Then,
cZ/cX = 2X + 3Y .
Similarly, to take the partial derivative with respect to Y,
pretend X is a constant (like 4). So,
cZ/cY = 3X + 15Y
2
.
The Connection between
Demand and Utility
Instead of thinking in terms of utils, lets
think in terms of dollars.
Suppose the purchase of one unit of a
good gives you $10 worth of
satisfaction.
In other words, the marginal utility of
that first unit of the good is $10.
Then you would be willing to pay up to
$10 for it.
If a second unit of the good contributes $8
more of satisfaction, the marginal utility of
your second unit is $8 and you would be
willing to pay up to $8 for it.
If a third unit of the good contributes $6
more of satisfaction, the marginal utility of
your third unit is $6 and you would be
willing to pay up to $6 for it.
Remember that the demand curve tells
you what people are willing to pay for
various amounts of a good or,
equivalently, how many units of a good
they are willing to purchase at various
prices.
So, since we just found that the
marginal utility tells us what we are
willing to pay for a good, the marginal
utility provides us with information that
we can use to determine our demand
curve.
In our example, we had the following:
Number of units
purchased (Q)
Price you are
willing to pay (P)
Marginal
Utility
0 - -
1 10 10
2 8 8
3 6 6
If we graph that information,
we get our demand curve.
Number of units
purchased (Q)
Price you are
willing to pay (P)
Marginal
Utility
0 - -
1 10 10
2 8 8
3 6 6
price
quantity
1
0

8

6


1 2 3
Demand
Notice that by adding our MU values we can determine
our total utility at different consumption levels.
Number of units
purchased (Q)
Price you are
willing to pay (P)
Marginal
Utility
Total
Utility
0 - - 0
1 10 10 10
2 8 8 18
3 6 6 24
Indifference Curve
A set of combinations of goods that are
viewed as equally satisfactory by the
consumer.
Indifference Map
A collection of indifference curves
Assumptions
1. The consumer can rank all bundles of
commodities.
2. If bundle A is preferred to bundle B and
B is preferred to C, then A is preferred to
C. (This property is called transitivity.)
3. More is better.
Characteristics of indifference curves
Indifference curves slope down from left to right.
Consider 2 points A & B on the
same indifference curve.
At point B, you have more food
than at point A.
If the amount of clothing you had
at point B was the same as or
more than at point A (like at
point C), you would not be
indifferent between A and B
(since more is better).
So A & B could not be on the
same indifference curve, which
goes against our initial statement
that they are.
So you must have less clothing
at B, which means than B lies
below A and the indifference
curve slopes downward.
clothing
food
A
B
C
Indifference curves to the northeast are preferred.
Point E is preferred to
point A because it has
more food & more
clothing.
Since you are indifferent
between A & all points
on IC
1
, E must be
preferred to all points on
IC
1
.
Since you are indifferent
between E and all
points on IC
2
, all points
on IC
2
must be
preferred to all points on
IC
1
.
IC
2
food
A
E
clothing
IC
1
Indifference curves can not intersect.
Suppose indifference curves could intersect.
Let the intersection of IC
1
& IC
2
be D.
Then you must be indifferent between D &
any other point A on IC
1
.
Similarly, you must be indifferent between D
& any other point B on IC
2
.
food
A
D
clothing
IC
1
B IC
2
By transitivity, you must be
indifferent between A & B.
But A & B are not on the same
indifference curve, which they
should be if you are indifferent
between them.
Then, our initial supposition that
indifference curves could
intersect must be wrong.
Indifference curves are convex
[the slopes of ICs fall as we move from left to right, or
we have a diminishing marginal rate of substitution (MRS)]
When we have lots of
clothing & not much food
(as near A & B), we are
willing to give up a lot of
clothing to get a little
more food.
When we have lots of
food & not much clothing
(as near C & D), we are
willing to give up very
little clothing to get a
little more food.
food
A
C
clothing
B
D
Odd special cases that are not
consistent with the characteristics
listed previously.
Perfect Complements
You need exactly 4 tires
with 1 car body
(ignoring the spare tire).
Having more than 4 tires
with 1 car body doesnt
increase utility.
Also having more than 1
car body with only 4
tires doesnt increase
utility either.
tires
Car bodies 1 2
8


4
IC
1
IC
2
Perfect Substitutes
Consider two packs of paper;
the mini-pack has 100 sheets &
the jumbo pack has 500 sheets.
No matter how many mini-packs
or jumbo packs you have, you
are always willing to trade 5
mini-packs for 1 jumbo pack.
Since the rate at which youre
willing to trade is the slope of
the IC, and that rate is constant,
your ICs have a constant slope.
That means they are straight
lines.
Mini-packs
Jumbo
packs
1 2
10


5
IC
1
IC
2
Goods versus Bads
As you get more of a
bad, you need more
of a good to
compensate you, to
keep you feeling
equally happy.
So IC of a good & a
bad slopes upward.
production
pollution
IC
1
IC
2
Neutral Good
Your utility is unaffected
by consumption of a
neutral good.
Neutral good
Desired
good
IC
1
IC
2
IC
3

Addict
The more substance 1
the addict has the more
he/she is willing to give
up of substance 2 to get
a little more of 1 (& vice
versa).
So the ICs are concave
instead of convex.
Substance 1
Substance 2
The slope of the indifference curve is
the rate at which you are willing to
trade off one good to get another good.
It is called the marginal rate of substitution
or MRS.
What is the MRS or slope of the IC?
Suppose points A & B are on the same
indifference curve & therefore have the
same utility level.
Lets break up the move from A to B
into 2 parts.
AD: ATU = AC (MU
C
)
DB: ATU = AF (MU
F
)
AB:
0 = ATU = AC (MU
C
) + AF (MU
F
)
AC (MU
C
) = AF (MU
F
)
AC/AF = MU
F
/ MU
C
IC
1
Food F
A
D
Clothing C
B
IC
2
So along an indifference curve, the slope or MRS is the
negative of the ratio of the marginal utilities (with the MU of
the good on the horizontal axis in the numerator).
MRS = MU
X
/ MU
Y
For example,
Suppose IC
1
is the 90-util indifference
curve & IC
2
is the 96-util indifference
curve.
Point A is 7 units of food & 6 of
clothing.
B is 9 units of food & 5 of clothing.
Since an additional unit of clothing
gives you 6 more utils of satisfaction,
the MU of clothing must be 6.
Since an additional 2 units of food
also give you 6 more utils of
satisfaction, the MU of food must be
3.
So, MRS = MU
F
/ MU
C
=

-3/6 = -0.5 .
Youd give up 2 units of food to get
1 units of clothing.
IC
1
=90

Food F
A
D
Clothing C
B
IC
2
= 96

6

5
7 9
Budget Constraint or Budget Line
This equation tells you what you can buy.
For example, suppose you have $24, & there are
two goods.
The price of the first good is $3 per unit & the price
of the second good is $4 per unit.
So, if you buy X units of the first good for $3 each,
you spend 3X on that good.
Similarly, if you buy Y units of the second good, you
spend 4Y on that good.
Your total spending is 3X+4Y.
If you spend all 24 dollars that you have, 3X+4Y=24.
That equation is your budget constraint.
Example: Budget constraint for $24 of income,
and $3 & $4 for the prices of the two goods.
X
Y
(0,6)
(8,0)
0
If you spent all $24 on the 1
st
good,
you could buy 8 units.
If you spent all $24 on the 2
nd
good,
you could buy 6 units.
So we have the intercepts of the
budget constraint.
The slope of the line connecting these
two points is
AY/AX = 6/8 = 3/4 = 0.75 .
Lets generalize. Keep in mind that income was $24
and the prices of the goods were $3 & $4. The equation of
the budget constraint in our example was 3X + 4Y = 24.
X
Y
(0,6)
(8,0)
0
So the budget constraint is p
1
X + p
2
Y = I
Solving for Y in terms of X, p
2
Y = I p
1
X,
or Y = I /p
2
(p
1
/p
2
)X
So from our slope-intercept form, we see that
the intercept is I /p
2
, and the slope is p
1
/p
2
.
The intercept is income divided by the price of
the good on the vertical axis.
The slope is the negative of the ratio of
the prices, with the price of the good
on the horizontal axis in the
numerator.
We have the intercept is I /p
2
,
& the slope is p
1
/p
2
.
What if income increased?
The slope would stay the same & the budget constraint
would shift out parallel to the original one.
Suppose in our example with income of 24 & prices of
3 & 4, income increased to 36.
Our new y-intercept will be 36/4 =9
& the new X-intercept will be 36/3=12.
X
Y
(0,6)
(8,0)
0
(0,9)
(12,0)
Suppose the price of the good on the X-axis increased.
If we bought only the good whose price
increased, we could afford less of it.
If we bought only the other good, our
purchases would be unchanged.
So the budget constraint would pivot inward
about the Y-intercept.
X
Y
(0,6)
(8,0)
0
(6,0)
For example, if the price increased
from $3 to $4, our $24 would only
buy 6 units.
Similarly, if the price of the good on the Y-axis
increased, the budget constraint would pivot
in about the X-intercept.
X
Y
(0,6)
(8,0)
0
(0,4)
Suppose the price of the 2
nd
good
increased from $4 to $6. If you bought
only that good, with your $24, your $24
would only buy 4 units of it.
Lets combine our indifference curves &
budget constraint to determine our utility
maximizing point.
Point A doesnt maximize
our utility & it doesnt
spend all our income.
(Its below the budget
constraint.)
X
Y
0
IC
1
IC
2
IC
3
A
Points B & C spend all our
income but they dont maximize
our utility. We can reach a
higher indifference curve.
X
Y
0
IC
1
IC
2
IC
3
B
C
Point D is unattainable. We
cant reach it with our budget.
X
Y
0
IC
1
IC
2
IC
3
D
Point E is our utility-maximizing point.
We cant do any better than at E.
Notice that our utility is maximized at
the point of tangency between the
budget constraint & the indifference
curve.
X
Y
0
IC
1
IC
2
IC
3
E
Recall from Principles of Microeconomics, to maximize
your utility, you should purchase goods so that the
marginal utility per dollar is the same for all goods.
If there were just two goods, that means that MU
1
/P
1
= MU
2
/P
2
Multiplying both sides by P
1
/MU
2
, we have MU
1
/MU
2
= P
1
/P
2
.
The expression on the right is the negative of the slope of the
budget constraint.
The expression on the left is the negative of the slope of the
indifference curve.
So the slope of the indifference curve must be equal to the slope
of the budget constraint.
If at a particular point, two functions have the same slope, they
are tangent to each other.
That means your utility-maximizing consumption levels are where
your indifference curve is tangent to the budget constraint.
This is the same conclusion we reached using our graph.
Example: If TU = 10X + 24Y 0.5 X
2
0.5 Y
2
, the
prices of the two goods are 2 and 6, and we have
$44, how much should you consume of each good?

Taking the derivatives of TU we have
MU
1
= 10 X and MU
2
= 24 Y
Since MU
1
/MU
2
= P
1
/P
2
, we have
(10 X) / (24 Y) = 2 / 6 ,
or 60 6 X = 48 2Y ,
or 6X 2Y = 12 .
This an equation with two unknowns.
Our budget constraint provides us with a 2
nd
equation.
Combining the two equations, we can solve for X & Y.
The budget constraint is 2X + 6Y = 44 .
So our two equations are
6X 2Y = 12 and 2X + 6Y = 44
Multiplying the second equation by 3 yields
6X + 18Y = 132 .
Now we have 6X + 18Y = 132
6X 2Y = 12
--------------------
So, 20Y = 120
and Y = 6 .
Plugging 6 in for Y in the 1
st
equation yields 6X 12 = 12,
or 6X = 24.
So, X = 4 .
Lets see if all this works.
We had $44, the prices were 2 & 6, and
MU
1
= 10 X & MU
2
= 24 Y. We bought 4 units
of the 1st good & 6 of the 2
nd
good.
First, did we spend exactly what we had?
We spent (2)(4) + (6)(6) = 8 + 36 = 44 Good.
Is the marginal utility per dollar the same for both
goods?
For the 1
st
good: MU
1
/P
1
= (10 X)/2 = (10-4)/2 = 3
For the 2
nd
good: MU
2
/P
2
= (24 Y)/6 = (24-6)/6 = 3
So theyre equal and things look fine.
What happens to consumption when income
rises?
For normal goods, consumption increases.
For inferior goods, consumption decreases.
What does this look like on our graph?
Two Normal Goods
As income increases, the
budget constraint shifts out
& we are able to reach
higher & higher ICs.
The points of tangency are
at higher & higher levels of
consumption of both goods.
X
Y
IC
1
IC
2
IC
3
C
B
A
Y
3
Y
2
Y
1
X
1
X
2
X
3
Income-Consumption Curve
The curve that traces out
these points is called the
income-consumption curve.
For two normal goods, the
curve slopes upward.
It may be convex (as drawn
here), concave, or linear.
X
Y
IC
1
IC
2
IC
3
C
B
A
Y
3
Y
2
Y
1
X
1
X
2
X
3
One Normal Good & One Inferior Good
Suppose the good on the
horizontal axis is normal &
the one on the vertical
axis is inferior.
Then X will rise & Y will fall
as income increases.
X
Y
IC
1
IC
2
IC
3
C
B
A
X
1
X
2
X
3
Y
1
Y
2
Y
3
Income-Consumption Curve
The result is a downward sloping
income-consumption curve.
X
Y
IC
1
IC
2
IC
3
C
B
A
X
1
X
2
X
3
Y
1
Y
2
Y
3
Engel Curve
The Engel Curve shows
the quantity of a good
purchased at each
income level.
The graph has income
on the vertical axis and
the quantity of the good
on the horizontal.
It slopes up for normal
goods & down for
inferior goods.
X
Income
C
B
A
X
1
X
2
X
3
I
3
I
2
I
1
We can also look at consumption levels of two
goods when the price of one of them changes.
Suppose there is an increase in the price
of the 1
st
good (the good on the X-axis).
The budget constraint pivots inward.
Here we see X drop & Y increase.
In this case, our 2 goods are
substitutes.
X
Y
X
3
X
2
X
1
Y
3
Y
2
Y
1
If we connect the points, we have the
price consumption curve.
It shows the utility-maximizing
points when the price of a
good changes.
X
Y
X
3
X
2
X
1
Y
3
Y
2
Y
1
If we look at the price of a good & the amount
of it consumed, we have the demand curve
for our particular individual.
As the price decreases the
quantity demanded increases
& vice versa.
X
P
X
1
X
2
X
3
P
1
P
2
P
3
We can separate the effect of a change in the price of
a good on its consumption level into two parts:
the income effect & the substitution effect.
Suppose the price of the
first good increases.
The budget constraint was
originally the blue line and
we were at A consuming
quantities X
A
& Y
A
.
After the price change, the
budget constraint is the red
line, and were at B
consuming X
B
& Y
B
.
X
Y
A
B Y
B
Y
A
X
B
X
A
We first want to capture the effect of the price change
without the effect of the change in income.
X
Y
H
A
B
Y
H
Y
B
Y
A
X
B
X
H
X
A
We draw a line parallel to the new budget
constraint and tangent to the old indifference
curve.
This will reflect the new relative prices, but since
we are tangent to the old indifference curve we
are just as well off as initially.
Under those circumstances we would be at point
H (for hypothetical).
Since the 1st good is now relatively more
expensive compared to the 2nd, we will
substitute, increasing Y & decreasing X.
The movement from A to H is the
substitution effect.
X
Y
H
A
B
Y
H
Y
B
Y
A
X
B
X
H
X
A
As a result of the increase in the relative
price of the 1
st
good, we reduce our
consumption of it and consume more of
the other good.
Now we move from H to B
X X
Y
H
A
B
Y
H
Y
B
Y
A
X
B
X
H
X
A
Our purchasing power has been reduced by
the price change. That results in the income
effect.
In our graph, we now hold the relative prices
constant at the new level, but income has
fallen. Our budget constraint has shifted
inward.
If both goods are normal, as a result of the
change in income, we reduce our consumption
of both goods, and X & Y fall.
This is the income effect of the price change.
Total Effect of Price Increase
X
Y
H
A
B
Y
H
Y
B
Y
A
X
B
X
H
X
A
The total effect is to move from A to B.
X has fallen.
Both the substitution & income effects led to a
drop in X.
Y has increased in this case.
The substitution effect increased consumption
of the 2
nd
good, but the income effect reduced
it by less than the substitution effect increased
it.
Lets do a price decrease.
X
Y
H
B
A
Y
B
Y
A
Y
H
X
A
X
H
X
B
The budget constraint moves from the blue line
to the red line.
We draw a line parallel to the new budget
constraint and tangent to the old indifference
curve.
H is the tangency of the hypothetical budget
constraint with the old indifference curve.
The substitution effect is the movement from A
to H.
We substitute increasing X & decreasing Y.
The movement from H to B is the income effect.
X
Y
H
B
A
Y
B
Y
A
Y
H
As a result of the higher income (greater
purchasing power), we consume more of both
goods, if they are normal goods.
X
A
X
H
X
B
Total Effect
X
Y
H
B
A
Y
B
Y
A
Y
H
The total effect is to move from A to B.
X has increased.
Both the substitution & income effects led to an
increase in X.
Y has also increased in this case.
The substitution effect decreased consumption
of the 2
nd
good, but the income effect
increased it by more than the substitution
effect decreased it.
X
A
X
H
X
B
Income and Substitution Effects, in words
The income effect is the result of the change in purchasing
power.
If the price of a normal good increases, you feel poorer,
and the income effect is to consume less.
If the price of a normal good decreases, you feel richer, and
the income effect is to consume more.
The substitution effect is the result of a change in relative
prices.
If the price of a good increases, the substitution effect is to
consume less of it & more of the other goods that are
now relatively cheaper.
If the price decreases, the substitution effect is to consume
more of it & less of the goods that are now relatively
more expensive.
What if the price changed of an inferior good?
The substitution effect would be the same
but the income effect would be the opposite.
Price increase for an inferior good
Income effect:
Your purchasing power has decreased. You feel poorer.
So you consume more of the inferior good.
Substitution effect:
The good is now relatively more expensive than other goods,
so you consume less of it and more of other goods.
Notice the IE & SE are in opposite directions in this case.
If the SE is larger than the IE, you will consume less of the
good.
If the IE is larger than the SE, you will consume more of the
good.
An inferior good for which the IE is larger
than the SE is called a Giffen good.
It is a good for which consumption rises
when the price increases, and consumption
falls when the price decreases.

Price decrease for an inferior good
Income effect:
Your purchasing power has increased. You feel richer. So
you consume less of the inferior good.
Substitution effect:
The good is now relatively more cheaper than other goods,
so you consume more of it and less of other goods.
Again the IE & SE are in opposite directions in this case.
If the SE is larger than the IE, you will consume more of the
good.
If the IE is larger than the SE, you will consume less of the
good.
We previously looked at the demand curve
for individuals.
How do we get the market demand curve
from the demand curve for individuals?
We just horizontally sum up the individual
demand curves.
Market Demand Curve: 3-person example
Person A Person B Person C Market
P
P
Q
Q
2

1
2

1
2 4
P
P
Q Q
2

1
2

1
4 9 1 3 1 2
At a price of $1, person A will buy 4 units of a good, B will buy 2
units, & C will buy 3 units. So at a price of $1, the quantity
demanded by the entire 3-person market is 9 units.
Market Demand Curve: 3-person example
Person A Person B Person C Market
P
P
Q
Q
2

1
2

1
2 4
P
P
Q Q
2

1
2

1
4 9 1 3 1 2
At a price of $2, person A will buy 2 units of a good, B will buy 1
units, & C will buy 1 units. So at a price of $2, the quantity
demanded by the entire 3-person market is 4 units.
Market Demand Curve: 3-person example
Person A Person B Person C Market
P
P
Q
Q
2

1
2

1
2 4
P
P
Q Q
2

1
2

1
4 9 1 3 1 2
Continuing the process, we get the market demand curve.
The Demand for a product can be
expressed as a function of
1. its price
(changes in which lead to movements along the
demand curve), and
2. other determinants such as income, prices of related
goods, & expectations (changes in which lead to shifts
of the demand curve).
So we have Q
DX
= g(P
X
, P
subst
, P
comp
, Inc., Expect.)
A particular demand curve Q
DX
= g(P
X
) shows the
relation between the quantity demanded of a product
and its price when we hold all the factors constant.
This is also sometimes written as P= f(Q).
TR = PQ
Total Revenue
Average Revenue
total revenue per unit of output
AR = TR / Q
= (PQ) / Q
= P
AR & P are the same function of Q.
Marginal Revenue
The additional revenue associated with
an additional unit of output
MR = dTR / dQ
Example: Horizontal Demand Curve
(price is a constant function)
P
Q
10
D

Q
P
TR
slope = MR = 10
= AR =MR
P = f(Q) = 10
AR = P = 10
TR = PQ = 10 Q
MR = dTR / dQ = 10
So D, AR, & MR are the same
horizontal function.
TR is an upward sloping line with
a constant slope.
Implications for revenue:
Every time you sell another unit
of output, revenue increases by
the price, which is constant.
Example:
linear, downward-sloping Demand curve
P
Q
8
D = AR
Q
P
TR
MR
P = f(Q) = 8 3Q
AR = P = 8 3Q
TR = PQ = (8 3Q) Q
= 8Q 3Q
2
MR = dTR / dQ = 8 6Q
D & MR have the same vertical
intercept. MR is twice as steep
as D. (The slope of MR is -6;
the slope of D is -3)
Implications for revenue:
Revenue increases more &
more slowly & then decreases
more & more quickly.
Example:
quadratic, downward-sloping Demand curve
P
Q
20
D = AR
Q
P
TR
MR
P = f(Q) = 20 Q
2
AR = P = 20 Q
2
TR = PQ = (20 Q
2
) Q
= 20Q Q
3
MR = dTR / dQ = 20 3Q
2
MR is a quadratic; TR is a cubic.
Elasticity
Responsiveness or sensitivity of one
variable to a change in another variable
(% change in X)
= ------------------------
(% change in Y)
Price Elasticity of Demand
(% change in quantity demanded)
= ------------------------------------------------
(% change in price)
Two methods of calculating elasticity
Arc elasticity: measures responsiveness
between 2 points
Point elasticity: measures responsiveness
at a single point for an infinitesimally small
change
Arc Elasticity
Q/(avg Q) [Q
2
Q
1
] / [(Q
1
+Q
2
)/2]
--------------- = --------------------------------
P/(avg P) [P
2
P
1
] / [(P
1
+P
2
)/2]

Arc Elasticity Example
Calculate the price elasticity of demand if in response to a increase in
price from 9 to 11 dollars, the quantity demanded decreases from
60 to 40 units.
P: 911 Q: 6040
Q/(avg Q) [Q
2
Q
1
] / [(Q
1
+Q
2
)/2]
= --------------- = --------------------------------
P/(avg P) [P
2
P
1
] / [(P
1
+P
2
)/2]
[40 60] / [(60+40)/2] -20 / 50 -0.4
= ------------------------------ = ------------ = ------- = -2.0
[11 9] / [(9+11)/2] 2 / 10 0.2
The negative sign indicates that price & quantity move in opposite
directions.
The negative sign is sometimes dropped with the understanding that
price & quantity are still moving in opposite directions.
Point Elasticity
dQ / Q dQ P
= ---------- = ----- ----
dP / P dP Q
Point Elasticity Example
If the demand function is Q = 245 3.5 P, find the
price elasticity of demand when the price is 10.
When P = 10, Q = 245 3.5(10) = 210
The derivative dQ / dP = = 3.5
dQ / Q dQ P 10
= ---------- = ----- --- = - 3.5 ------ = - 0.167
dP / P dP Q 210
Categories of
Price Elasticity of Demand
Demand is elastic if || > 1
Demand is inelastic if || < 1
Demand is unit elastic if || = 1
What is the relationship between elasticity &
the slope of the demand curve?
dQ / Q dQ P 1 P
= ---------- = ----- ---- = -------- ----
dP / P dP Q dP/dQ Q
= (1/slope) (P/Q)
So, if 2 demand curves pass through the same point
(& therefore have the same values of P & Q at
that point), the flatter curve (curve with the smaller
slope) has the greater elasticity at that point.
Example
At point E, D
1
has greater elasticity than D
2
.

P
Q
E
D
2
D
1
Elasticity on a Linear Demand Curve
At the midpoint, || = 1 (unit elasticity)
Above the midpoint, || > 1 (elastic)
Below the midpoint, || < 1 (inelastic)
P
Q
Lets show in an example that || = 1
at the midpoint of a linear demand curve.
P
Q
D
MR
|| = 1
24
6 3
demand curve: P = 24 4Q
When Q = 0, P = 24. So thats our vertical intercept.
When P = 0, Q = 6. Thats our horizontal intercept.
The midpoint then is (3,12).
The slope is dP/dQ = 4 .
We found earlier that = (1/slope) (P/Q)
So = (1/-4) (12/3)
= (1/-4) (4)
= -1
12
Relationship between Elasticity
& Total Revenue
Price increase:
|| > 1: P | Q + TR+
|| < 1: P | Q + TR |
|| = 1: P | Q + TR unchanged
Relationship between Elasticity
& Total Revenue
Price decrease:
|| > 1: P + Q | TR |
|| < 1: P + Q | TR +
|| = 1: P + Q | TR unchanged
The most profitable place to be is in the
elastic portion of the demand curve.
In the inelastic portion of the demand curve,
marginal revenue is negative (additional
units of output lower total revenue).
While this is true in general, we can
demonstrate it in the linear demand case.
Recall that for a linear demand curve,
marginal revenue is twice as steep as the demand curve.
Q
TR
So MR reaches the horizontal axis
when the demand curve is only halfway
there.
From the graph, we can see that above
the midpoint where || > 1, MR > 0
& TR is increasing.
So when MR = 0 at the midpoint, || = 1.
Below the midpoint, where || < 1 ,
MR < 0 & TR is decreasing.
P
Q
D
P
MR
|| > 1
|| = 1
|| < 1
Special Elasticity Cases
|| =
Infinite Elasticity
Perfectly Elastic
P
Q
D
|| = 0
Zero Elasticity
Perfectly Inelastic
P
Q
D
|| = 1
Unit Elasticity
P
Q
D
P = k / Q
where k is a constant
Facts about Price Elasticity of Demand
1. The more substitutes there are for a product,
the more elastic the demand.
2. An individual firms product has a more elastic
demand than the entire industrys product.
3. The longer the time period, the greater the
elasticity of demand, because the greater the
adjustments that are possible.
4. Products (like salt) that are a small part of the
budget have low elasticities of demand.
Some examples of
estimated price elasticities of demand
Commodity Price Elasticity of Demand
wheat 0.08
cotton 0.12
potatoes 0.31
beef 0.92
haddock 2.20
movies 3.70
Notice that the demands for wheat & cotton are not very responsive to price
changes, whereas the demands for haddock and movies are very responsive.
So far the only elasticity that we have
discussed is price elasticity of demand.
There are other types of elasticities.
Each type can be computed as
arc elasticity or point elasticity.
Income Elasticity of Demand
(% change in quantity demanded)

I
= ------------------------------------------------
(% change in income)
Categories of Income Elasticity of Demand
Normal Goods:

I
> 1 income elastic

I
= 1 unit income elastic
0 <
I
< 1 income inelastic
Luxury items have high income elasticities of demand,
while necessities have low income elasticities of demand.
Inferior Goods:

I
< 0
Some examples of
estimated income elasticities of demand
Commodity Income Elasticity of Demand
flour -0.36
margarine -0.20
milk 0.07
butter 0.42
books 1.44
restaurant
consumption
1.48
Note that flour & margarine are inferior goods, milk is not very responsive
to income changes, & books & restaurant consumption are income elastic.
Cross Elasticity of Demand
(% change in quantity demanded of Y)

YX
= ---------------------------------------------------
(% change in price of X)
Categories of Cross Elasticity of Demand
Substitutes:
YX
> 0
The price of X & the quantity demanded of Y
move in the same direction. When the price of X
increases, you consume less of X and more of the
goods that you can use in place of X.
Complements:
YX
< 0
The price of X & the quantity demanded of Y
move in opposite directions. When the price of X
increases, you consume less of X and less of the
goods that you use with X.
Some examples of
estimated cross elasticities of demand
Commodity
Cross Elasticity with
respect to price of
Cross elasticity
Pork Beef +0.14
Beef Pork +0.28
Butter Margarine +0.67
Margarine Butter +0.81
Notice that the cross elasticity of demand for Y with respect to
the price of X is not necessarily equal to the cross elasticity of
demand for X with respect to the price of Y.
Price Elasticity of Supply
(% change in quantity supplied)

S
= ------------------------------------------------
(% change in price)
Categories of
Price Elasticity of Supply
Supply is elastic if
S
> 1
Supply is inelastic if
S
< 1
Supply is unit elastic if
S
= 1