chapter 6 price: supply and demand together · price: supply and demand together 04 ... a good...

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C H A P T E R 4Demand

C H A P T E R 5Supply

C H A P T E R 6Price: Supply and Demand Together

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“Start with the idea

that you can't repeal

the laws of economics.

Even if they are

inconvenient.”—Larry Summers

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04 (086-109) EMC Chap 04 11/17/05 4:36 PM Page 87

Why It Matters

Certain people and institutions play impor-tant roles in your life. For example, yourparents, teachers, and friends are impor-

tant. Government is an institution that also plays animportant part in your life. It determines such things aswhen you can get a driver’s license, the amount of taxesyou must pay, and when you will be able to vote.

Markets also have a major impact on your life. A mar-ket is any place where people come together to buyand sell goods or services. Markets determine whatprices you pay for computers, cars, television sets,books, and clothes. Markets also determine what peo-

ple earn as teachers, truckdrivers, television and moviestars, baseball players, andnurses. How much moneyyou earn in the future willdepend on markets.

If you are interested in theprices you pay for the goodsand services you buy, or inwhy some people earnhigher salaries than others,then you will be interested inlearning how markets work.The first step is to learn aboutdemand, the subject of thischapter.

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Shopping for a more pow-erful computer and the lat-est software program canbe fun. Whether or notthese shoppers decide tomake a purchase willdepend on their willing-ness and ability to buy,conditions you will learnmore about in this chapter.

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The following events occurred one dayin June.

9:03 A.M. Sam is a student at a technical college in NewYork City. He is currently working on one of the computers in theschool library. He’s not doing any research right now; instead,he’s online checking the prices of various stocks. He recentlyinherited some money and is thinking of investing it in the stockmarket. He checks the share price of various stocks: GeorgiaPacific, General Motors, Microsoft, and Dell. He is thinkingabout buying 100 shares of Dell, current price $39.35. He isabout to place his order online with his online broker, whenhe has second thoughts. A friend of his told him that theprice of tech stocks, including Dell, would probably begoing down this week. Maybe, Sam thinks, I should waituntil later to buy this stock.• What does the (expected) future price of a share ofstock have to do with buying stock today?

10:41 A.M. A U.S. senator is in his officetalking with his staff. He is concerned about teenagesmoking in America. He wonders whether he, as aU.S. senator, can do anything to reduce the amountof teenage smoking. One member of his staff saysthat the federal government should increase the taxon a pack of cigarettes. “That way,” he says, “a lot ofthese kids will stop smoking.” “How so?” asks thesenator. “The tax will push up the overall price ofcigarettes,” the staffer says, “and that will lead toteens buying fewer cigarettes.” Another stafferenters the conversation. “I am not so sure manyteens will stop smoking,” she says. “If they arereally hooked on cigarettes, I think they may keepon buying just as many cigarettes, even at thehigher price.”• Will higher taxes on cigarettes cut down onthe number of packs of cigarettes teens pur-chase? Will higher taxes cut down on the amountof money teens spend on cigarettes?

11:35 P.M. Evan is sitting up in bed reading amagazine. He turns the page of the magazine and looksat an ad about a hotel in Dallas. Under the name of the

hotel are the words “The greatest hotel in the world.”Evan reads the magazine for a few more minutes, then

turns out the light in his bedroom, and goes to sleep.• What is the purpose of the Dallas hotel calling itself

“the greatest hotel in the world”?

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90

What Is Demand? A market is any place where people come

together to buy and sell goods or services.Economists often say a market has two sides:a buying side and a selling side. In econom-ics, the buying side is referred to as demand,and the selling side is referred to as supply. Inthis chapter, you will learn about demand; inthe next chapter, you will learn about supply.

The word demand has a specific meaningin economics. It refers to the willingness andability of buyers to purchase different quan-tities of a good at different prices during aspecific time period. Willingness to purchasea good refers to a person’s want or desire forthe good. Having the ability to purchase agood means having the money to pay for thegood. Both willingness and ability to pur-chase must be present for demand to exist. Itis important for you to remember that ifeither one of these conditions is absent,there is no demand.

Cruz doesn’t have the$34,000 needed to buy a particular car. If shedid have the money, though, she says thatshe certainly would buy the car. Notice that

E X A M P L E :

Chapter 4 Demand

Cruz has the willingness (she wants the car),but not the ability (not enough money) tobuy the car. Under these circumstances(willingness, but not ability, to buy), Cruzdoes not have a demand for the car. �

Molly is shopping for a newcell phone. The one she likes is $129, whichis within her price range. She was worriedthat she wouldn’t have enough money, butshe has set aside just enough for the newphone. Because Molly has the willingnessand the ability to buy the cell phone,demand does exist. �

What Does the Law ofDemand “Say”?

Suppose the average price of a compactdisc rises from $10 to $15. Will customerswant to buy more or fewer compact discs atthe higher price? Most people would say thatcustomers would buy fewer CDs.

Now suppose the average price of a com-pact disc falls from $10 to $5. Will cus-tomers want to buy more or fewer compactdiscs at the lower price? Most people wouldsay more.

E X A M P L E :

UnderstandingDemand

Focus Questions � What is demand?� What is the difference between demand

and quantity demanded?� Why do price and quantity demanded move

in opposite directions?� What is the law of diminishing marginal

utility?� What is the difference between a demand

schedule and a demand curve?

Key Terms marketdemandlaw of demandquantity demandedlaw of diminishing marginal utilitydemand scheduledemand curve

marketAny place where peoplecome together to buyand sell goods orservices.

demandThe willingness and abil-ity of buyers to purchasedifferent quantities of agood at different pricesduring a specific timeperiod.

law of demandA law stating that asthe price of a goodincreases, the quantitydemanded of the gooddecreases, and that asthe price of a gooddecreases, the quantitydemanded of the goodincreases.

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If you answered the questions the waymost people would, you instinctively under-stand the law of demand. This law says thatas the price of a good increases, the quantitydemanded of the good decreases. The law ofdemand also says that as the price of a gooddecreases, the quantity demanded of the goodincreases. In other words, price and quantitydemanded move in opposite directions. Thisrelationship (you have probably heard itreferred to as an inverse relationship in yourmath classes) can be shown in symbols:

Law of DemandIf P ↑ then Qd ↓If P↓ then Qd ↑

(where P � price and Qd � quantity demanded)

If you were reading closely, you probablynoticed two words that sound alike: demandand quantity demanded. Don’t make themistake of thinking they mean the samething. Demand, as you learned earlier, refersto both the willingness and ability of buyersto purchase a good or service. For example,if an economist said that Karen had ademand for popcorn, you would know thatKaren has both the willingness and ability topurchase popcorn.

Quantity demanded is a new and dif-ferent concept. It refers to the number ofunits of a good purchased at a specificprice. For example, suppose the price ofpopcorn is $5 a bag, and Karen buys twobags. In this case two bags of popcorn is thequantity demanded of popcorn at $5 a bag.As you work your way through this chapter,you will see why it is important to know thedifference between demand and quantitydemanded.

Why Do Price and QuantityDemanded Move inOpposite Directions?

The law of demand says that as price rises,quantity demanded falls, and that as pricefalls, quantity demanded rises. Why?According to economists, it is because of thelaw of diminishing marginal utility, whichstates that as a person consumes additionalunits of a good, eventually the utility or sat-

isfaction gained from eachadditional unit of the gooddecreases. For example, youmay receive more utility(satisfaction) from eatingyour first hamburger atlunch than your secondand, if you continue, more utility from yoursecond hamburger than your third.

What does this have to do with the law ofdemand? Economists state that the moreutility you receive from a unit of a good, thehigher price you are willing to pay for it; andthe less utility you receive from a unit of agood, the lower price you are willing to payfor it. According to the law of diminishingmarginal utility, individuals eventuallyobtain less utility from additional units of agood (such as hamburgers), so it follows thatthey will buy larger quantities of a good onlyat lower prices. And this is what the law ofdemand states.

91Section 1 Understanding Demand

“The main reason economists

believe so strongly in the law

of demand is that it is so

plausible, even to

noneconomists.”

— David R. Henderson

� Harry Potter and the Order of the Phoenix was in great demand hoursafter its release in Russia in early 2004. Do these people have bothwillingness and ability to purchase?

quantity demandedThe number of units ofa good purchased at aspecific price.

law of diminishingmarginal utilityA law stating that as aperson consumes addi-tional units of a good,eventually the utilitygained from each addi-tional unit of the gooddecreases.

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The Law of Demand inNumbers and Pictures

The law of demand can be representedboth in numbers and pictures. Look atExhibit 4-1(a), which has a “Price” columnand a “Quantity demanded” column. Noticethat as the prices fall (from $4 to $3 to $2 to$1), the quantity demanded rises (from 1 to2 to 3 to 4). Do you see that price and quan-

tity demanded are moving in opposite direc-tions? The economic term for this type ofnumerical chart showing the law of demandis demand schedule.

Now let’s see how you would illustratethe law of demand in picture form. Thesimple way is to plot the numbers from ademand schedule in a graph. Look atExhibit 4-1(b), which shows how the com-binations of price and quantity demanded

92 Chapter 4 Demand

The Walt DisneyCompany operates two

major theme parks in theUnited States: Disneyland inAnaheim, California, and WaltDisney World in Orlando,Florida. Each year millionsof people visit each park.

Regardless of which parkyou visit, the price you pay foryour ticket will depend on howmany days you want to spend at thepark. For example, Disneyland’s Website lists prices for one- to five-daytickets. On the day we checked, thevarious ticket prices were as follows:

• One-day ticket, $63• Two-day ticket, $85• Three-day ticket, $109• Four-day ticket, $129• Five-day ticket, $139

Notice that the price of a one-day ticket ($63), when doubled, is

$126. Disneyland does not chargevisitors double its one-day ticketprice for visiting two days; it charges$85. Similarly, triple the price of a

one-day ticket would be $189, butDisneyland charges $109 for athree-day ticket.

Disneyland seems to be tellingvisitors that if they want to visit thetheme park for one day, they haveto pay $63, but a second day willcost only $22 more, not $63 more.Notice that the price Disneylandcharges to stay a fifth day is only$10 more than staying four days.Do you wonder how muchDisneyland would charge to stay,say, a tenth day? By the tenth day,

it might be that you would onlyhave to pay 25 cents more.

Why does Disneyland chargeless for the second day than the first

day? It’s because of the lawof diminishing marginal util-ity, which states that as a per-son consumes additionalunits of a good, eventuallythe utility (satisfaction orhappiness) from each addi-tional unit of the gooddecreases. Disneyland can’tcharge as high a price whenutility is low as when it ishigh. If you have never beento Disneyland, or haven’tbeen for five years, your first

day is likely to be quite enjoyable. Ifyou’ve already spent, say, two daysat Disneyland, your third consecu-tive day isn’t likely to give you asmuch utility as your first.

Can you think of agood or service that is

priced the way visits to Disneylandare priced (for two units of the goodor service, you pay less than doublewhat you pay for one unit)?

THINKABOUT IT

???Are the Prices

at DisneylandGoofy?

demand scheduleThe numerical represen-tation of the law ofdemand.

04 (086-109) EMC Chap 04 11/17/05 4:36 PM Page 92

in Exhibit 4-1(a) are plotted. The first com-bination (a price of $4 and a quantitydemanded of 1) is labeled as point A. Thesecond price and quantity demanded com-bination ($3 and a quantity demanded of 2)is labeled B. The same process continues forpoints C and D. If we connect all fourpoints, from A to D, we have a line thatslopes downward from left to right. Thisline, called a demand curve, is the graphicrepresentation of the law of demand.

You might be wondering why we use theword curve when, as you can see in Exhibit 4-1(b), we ended up drawing a straight lineto represent demand. The answer has to dowith the standard practice in economics,which is to call the graphic representation ofthe relationship between price and quantitydemanded a demand curve, whether it is acurve or a straight line.

93Section 1 Understanding Demand

Individual Demand Curvesand Market Demand Curves

An individual demand curve and a mar-ket demand curve are different. An individ-ual demand curve is what it sounds like: thedemand curve that represents an individ-ual’s demand. For example, Harry’s demandcurve represents Harry’s (and only Harry’s)demand for, say, DVDs. A market demandcurve is simply the sum of all the differentindividual demand curves added together.

EX H I B IT 4-1 Demand Schedule and Demand Curve

$4321

Price(in dollars)

1234

Quantity demanded(in units)

(a)

(b)

$4

$3

$2

$1

0 1 2 3 4

Pric

e (i

n do

llars

)

Quantity demanded(in units)

B

A

C

D

Demandcurve

� (a) A demand schedule for a good. Notice that as price decreases,quantity demanded increases. (b) Plotting the four combinations of priceand quantity demanded from part (a) and connecting the points gives usa demand curve. Price, on the vertical axis, represents price per unit of agood. Quantity demanded, on the horizontal axis, always applies to aspecific time period (a week, a month, a year, and so on).

demand curveThe graphical represen-tation of the law ofdemand.

QUESTION: I’ve seen a car, a radio, and adiamond ring in the real world, but I’venever seen a demand curve in real life. (Ihave seen one in this textbook, though.)Do demand curves exist in the realworld?

ANSWER: If you go outside and look upinto the sky, you’re not going to see ademand curve. If you look under yourbed or in the school auditorium, youwon’t see a demand curve, which doesn’tmean that demand curves don’t exist inthe real world. (You also can’t see a viruswith the naked eye, but that doesn’tmean viruses don’t exist.)

The data (numbers) that make up ademand curve—combinations of priceand quantity demanded—do exist inthe real world. When people (in the realworld) buy more of a good (such as a canof soda or a new pair of jeans) at a lowerprice than at a higher price, they areexpressing the law of demand, which isgraphically portrayed as a demand curve(in a textbook). So what do you think?Do demand curves exist in the realworld?

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Suppose that the wholeworld has only three buyers of DVDs:Harry, Sally, and Elizabeth. At a price of $10per DVD, quantity demanded is 2 for Harry,1 for Sally, and 3 for Elizabeth. As a result,the market demand curve would include apoint representing a price of $10 per DVDand a market quantity demanded of 6DVDs (2 � 1 � 3).

To see this graphically, look at Exhibit 4-2.In panels (a) through (c) you see the indi-

E X A M P L E :

94 Chapter 4 Demand

vidual demand curves for Harry, Sally, andElizabeth, respectively. (To keep things sim-ple, we identify only one point on thedemand curve for each person.) Now look atpanel (d). Here you can see the marketdemand curve (for all buyers—Harry, Sallyand Elizabeth—of DVDs). Notice that thepoint we identify on the market demandcurve simply represents the quantitydemanded of all three buyers together if theprice of a DVD is $10. �

Defining Terms1. Define:

a. demandb. quantity demanded c. marketd. demand schedulee. demand curvef. law of demand

2. Use the terms demandand quantity demandedcorrectly in a sentenceabout concert tickets.

Reviewing Facts and Concepts 3. State the law of demand.

4. Give an example of ademand schedule.

Critical Thinking5. Yesterday the price of a

good was $10, and thequantity demanded was100 units. Today theprice of the good is $12,and the quantitydemanded is 87 units.Did quantity demandedfall because the priceincreased, or did theprice rise because quan-tity demanded fell?

6. What does the law ofdiminishing marginalutility have to do withthe law of demand?

Applying EconomicConcepts7. Assume that the law of

demand applies to crimi-nal activity. What mightcommunity leaders do toreduce the number ofcrimes committed in thecommunity?

EX H I B IT 4-2 From Individual Demand Curves to Market Demand Curve

(a)

$10

0 2

Pric

e of

DVD

s

Harry’sdemandcurve

(b)

$10

0 1

Sally’sdemandcurve

(d)

0 6

Marketdemandcurve

$10

(c)Quantity demanded of DVDs

$10

0 3

Elizabeth’sdemand

curve

DHarry DSally DElizabeth DAll buyers

+ + =

� In parts (a) through (c) you see the individual demand curve for Harry, Sally, and Elizabeth.The market demand curve, shown in part (d), is simply the sum of the individual demand curves.Stated differently, we know that at a price of $10 per DVD, the quantity demanded of DVDs is 2 forHarry, 1 for Sally, and 3 for Elizabeth. It follows that all three buyers together would like to buy 6DVDs at a price of $10 per DVD. This point is identified on the market demand curve in part (d).

04 (086-109) EMC Chap 04 11/17/05 4:36 PM 4

When Demand Changes,the Curve Shifts

Demand can go up, and it can go down.For example, the demand for orange juicecan rise or fall. The demand for CDs can riseor fall. Every time the demand changes for agood, any good, the demand curve for thatgood shifts. By shift we mean that it moves; itmoves either to the right or to the left.

For example, if the demand for orangejuice increases, the demand curve for orangejuice shifts to the right. If the demand fororange juice decreases, the demand curvefor orange juice shifts to the left.

Demand increases → Demand curve shifts rightwardDemand decreases → Demand curve shifts leftward

We can understand shifts in demandcurves better with the aid of Exhibit 4-3.Look at the curve labeled D1 in Exhibit 4-3.Suppose this demand curve represents theoriginal and current demand for orangejuice. Notice that the quantity demandedat a price of $1 is 400 quarts of orangejuice. Now suppose that the demand fororange juice increases. For whatever reason,

95Section 2 The Demand Curve Shifts

The Demand Curve Shifts

Focus Questions� What does it mean when a demand curve

shifts to the right?� What does it mean when a demand curve

shifts to the left?� What is a normal good? An inferior good?

A neutral good?� What factors can change demand?� What factor can change quantity demanded?

Key Termsnormal goodinferior goodneutral goodsubstitutecomplement

people want to buy more orange juice. Thisincrease in demand is shown by thedemand curve D1 shifting to the right andbecoming D2.

� Moving from D1 (original demand curve) to D2 represents a rightwardshift in the demand curve. Demand has increased. Moving from D1 to D3

represents a leftward shift in the demand curve. Demand has decreased.

EX H I B IT 4-3 Shifts in a Demand Curve

$1

0 300 600100 500400200

Pric

e (d

olla

rs p

er q

uart

)

Quantity demanded of orange juice (quarts)

Originaldemand curve

D3

D1

D2

C A B

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What does it mean for a demand curve toshift to the right? The answer is easy if youagain look at Exhibit 4-3, focusing on thehorizontal axis and the numbers on it, alongthe bottom of the graph. What is the quan-tity demanded on curve D2 at the price of$1? The answer is 600 quarts of orange juice.In other words, an increase in demand (or ashift righward in the demand curve) is thesame thing as saying, “Buyers want to buymore of a good at each and every price.” Inour example, buyers want to buy morequarts of orange juice at $1.

How would we graphically represent adecrease in demand? In Exhibit 4-3, againlet’s suppose that D1 is our original andcurrent demand curve. A decrease indemand would then be represented as ashift leftward in the demand curve fromD1 to D3. A decrease in demand means thatbuyers want to buy less of the good at eachand every price. Specifically, if we look atthe price $1, we see that buyers oncewanted to buy 400 quarts of orange juice at$1 a quart, but now they want to buy only200 quarts at $1 a quart.

QUESTION: Is saying that demandhas increased for a good the same assaying that buyers are buying moreof the good?

ANSWER: Yes, but with one importantqualification. Buyers are buying more ofthe good at the same price at whichthey earlier bought less. For example,suppose that on Monday buyers bought100 units of a good at $3 per unit. Thenon Tuesday they bought 150 units of thesame good at $3 per unit. An economistwould say that demand for the goodincreased between Monday and Tuesdaybecause the buyers bought more at thesame price. If the good’s price changed,the economist would describe the situa-tion differently. The economist wouldsay that the quantity demandedchanged, rather than any change indemand.

What Factors Cause DemandCurves to Shift?

Demand curves do not shift to the right orleft without cause. They shift because ofchanges in demand, which can result fromchanges in several factors.These factors includeincome, buyer preferences, prices of relatedgoods, number of buyers, and future price.

IncomeAs their income changes, people may buy

more or less of a particular good. You mightthink that if income goes up, demand will goup, and if income goes down, demand willgo down. This relationship is not necessarilythe case, however. Much of what happensdepends on what goods are involved.

If a person’s income and demand changein the same direction (both go up, or both godown), then the good is called a normalgood. For example, if Robert’s income risesand he buys more CDs, then CDs are a nor-mal good for Robert. If, however, income anddemand go in different directions (one goesup, while the other goes down), the good iscalled an inferior good. If a person buys thesame amount of the good when incomechanges, the good is called a neutral good.

On the average, eachmonth Simon bought and consumed fivehot dogs, one steak, and one tube of tooth-paste when he was a college student earning$100 a week. Now that he has graduatedfrom college, and is earning $700 a week, hebuys two hot dogs, three steaks, and onetube of toothpaste a month. During thistime, prices have been stable, meaning nochanges in prices. So, for Simon, hot dogsare an inferior good (he buys less as hisincome rises), steak is a normal good (hebuys more as his income rises), and tooth-paste is a neutral good (he buys the sameamount as his income rises). �

If you’re wondering if a good can be anormal good for one person and an inferiorgood for another person, the answer is yes.People, not economists, decide whether agood is normal or inferior for them. If Bob’sincome goes up and he buys fewer potatochips, then potato chips are an inferior good

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96 Chapter 4 Demand

normal goodA good for which thedemand rises as incomerises and falls as incomefalls.

inferior goodA good for which thedemand falls as incomerises and rises as incomefalls.

neutral goodA good for which thedemand remainsunchanged as incomerises or falls.

04 (086-109) EMC Chap 04 11/17/05 4:36 PM Page 96

for Bob. If Georgia’s income goes up and shebuyers more potato chips, then potato chipsare a normal good for Georgia.

Preferences

People’s preferences affect how much of agood they buy. A change in preferences infavor of a good shifts the demand curve tothe right. A change in preferences away froma good shifts the demand curve to the left.

People begin to favor (pre-fer) small, gas-efficient cars more than theydid in the past. As a result, the demand curvefor small, gas-efficient cars shifts rightward.At the same time, people may begin to favorseveral new brands of computers and stopbuying Dell computers, which had been themost popular computer for several years. Asa result, the demand curve for Dell comput-ers shifts leftward. �

Prices of Related Goods

Demand for goods is affected by the pricesof related goods. The two types of relatedgoods are substitutes and complements.

When two goods are substitutes, thedemand for one good moves in the samedirection as the price of the other good. Inother words, if the price for a good, saypeanuts, goes up, the demand for that good’ssubstitutes, say pretzels, will also go up. Formany people coffee is a substitute for tea.Thus, if the price of coffee increases, thedemand for tea increases as people substitutetea for the higher-priced coffee.

Jessica is in the supermar-ket looking at the soft drinks. She usuallybuys a six-pack of Coke a week. She noticesthat the price of Coke has risen from what itwas last week. So, instead of buying a six-pack of Coke, she buys a six-pack of Pepsi.For Jessica, Coke and Pepsi are substitutes,which means that as the price of Coke goesup, so does Jessica’s demand for Pepsi. �

Two goods are complements if they areconsumed together. For example, tennisrackets and tennis balls are used together toplay tennis. With complementary goods, thedemand for one moves in the opposite direc-tion as the price of the other. As the price of

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tennis rackets rises, for example, the demandfor tennis balls falls. Other examples ofcomplements (or complementary goods)include cars and tires, lightbulbs and lamps,and golf clubs and golf balls.

Number of Buyers

The demand for a good in a particularmarket area is related to the number of buy-ers in the area. The more buyers, the higherthe demand; the fewer buyers, the lower thedemand. The number of buyers may increasebecause of a higher birthrate, increasedimmigration, or the migration of peoplefrom one region of the country to another.Factors such as a higher death rate or themigration of people can also cause the num-ber of buyers to decrease.

Future Price

Buyers who expect the price of a goodto be higher in the future may buy thegood now, thus increasing the currentdemand for the good. Buyers who expectthe price of a good to be lower in thefuture may wait until the future to buy thegood, thus decreasing the current demandfor the good.

Suppose Brandon is willing and able tobuy a house (demand exists), but he thinksthe price of houses on average will be lowernext month. As a result, Brandon is likely tohold off on making a purchase, which hasthe effect of decreasing current demand.


� If SouthwestAirlines expectsthe price of fuel torise, and decidesto buy fuel nowinstead of later,what will happento the currentdemand for fuel?

substituteA similar good. Withsubstitutes, the price ofone and the demand forthe other move in thesame direction.

complementA good that is consumedjointly with anothergood. With comple-ments, the price of oneand the demand for theother move in oppositedirections.

04 (086-109) EMC Chap 04 11/17/05 4:36 PM Page 97

What Factor Causes aChange in QuantityDemanded?

We identified the factors (income, prefer-ences, etc.) that can cause demand to change,but what factor can cause a change in quan-tity demanded? Only one: price. For exam-ple, the only thing that can cause customersto change their quantity demanded of

orange juice is a change in the price oforange juice; the only thing that can cause achange in the quantity demanded of pencilsis a change in the price of pencils.

As we stated earlier, a change in demandis represented as a shift in the demand curve.The curve moves either right or left. SeeExhibit 4-4(a). So how do we represent achange in quantity demanded? When quan-tity demanded changes, the curve doesn’t

98 Chapter 4 Demand

In the early 1980s, the Pepsi com-pany started asking people to take

the “taste test.” The taste test con-sisted of two small paper cups with afew teaspoons of Coke in one cupand a few teaspoons of Pepsi in theother. Members of the public didn’tknow which cup contained Pepsi andwhich cup contained Coke. It isimportant to note here that Pepsi isa slightly sweeter cola than Coke.

Members of the public wereasked to drink the contents of bothcups and then state which cola theypreferred. Pepsi won the “taste test”more often than Coke. This newsscared Coca-Cola, which, at the time,was holding on to a small lead insales over Pepsi. Coca-Cola decidedto undertake its own taste test. Duringits taste test, it experimented with thetaste of Coke. One option consisted ofsweetening the taste of Coke to luremore teenagers to its brand.

In its own taste tests, Coca-Colalearned that its new, sweeter Coke

was beating Pepsi. In other words,Coca-Cola thought it had found theway to gain market share in the softdrink market. So, it undertook toreplace its old, original Coke withwhat was called “New Coke.”

On April 23, 1985, Coca-Colalaunched New Coke. It was a disaster.Coke consumers across the countryturned their backs on New Coke. Oneperson said replacing the old Cokewith New Coke was like “spitting onthe flag.” Another said, “At first I wasnumb. Then I was shocked. Then Istarted to yell and scream and runup and down.”

Coca-Cola experienced a backlashfrom consumers. What had gonewrong? The company hadn’t realizeda fundamental problem with thesetaste tests. As it turns out, asking peo-ple to decide between a few tea-spoons of different sodas is quitedifferent from asking them to decidebetween entire bottles of soda. Often,when only a small amount of a colais consumed, people choose thesweeter of the two colas. But whenpeople have to drink larger amounts,they often find that the sweetnessthey liked in a teaspoon becomes“too sweet” before they finish the

hundreds of teaspoons contained inan entire bottle.

Coca-Cola obviously thoughtthat its taste tests indicated a strongdemand for New Coke. That interpre-tation was wrong. What the tastetests actually showed was a strongdemand for a few teaspoons of NewCoke, not a demand for a six-pack ofNew Coke, especially when it meanttaking old Coke off the market. Coca-Cola made a mistake in thinking thatbuyers had a demand for New Cokewhen they didn’t. On July 11, 1985,Coca-Cola brought old Coke back asClassic Coke. And over time it didaway with New Coke.

What might Coca-Colahave done during its

taste test to reduce the chances ofmaking such a costly mistake?

THINKABOUT IT

New Coke, Classic Coke,

or Pepsi???????????????????

04 (086-109) EMC Chap 04 11/17/05 4:36 PM Page 98

move right or left. Instead, the only move-ment is to a different point along a givendemand curve, which stays in the same placeon the graph. See Exhibit 4-4(b).

Ian notices that the price ofbananas has fallen; as a result, he goes frombuying three bananas a week to buying fivebananas a week. An economist would say

E X A M P L E :

that Ian’s quantity demanded of bananas hasincreased (from three to five) as a result ofthe price of bananas falling. �

The price of a book was $10in July and Jeff bought three. The pricewas $10 in August and Jeff bought four.Economists would say that Jeff ’s demand forbooks increased between July and August. �

E X A M P L E :


Defining Terms 1. Define:

a. normal goodb. inferior goodc. substituted. neutral goode. complement

Reviewing Facts and Concepts 2. Explain what it means if

demand increases.3. Jerry, a comedian, started

out doing stand-up com-edy and went on to per-form on a popular hit

television series. As hewent from stand-upcomedian to TV star, hisincome increased sub-stantially. During thistime, he bought morecars (specifically,Porsches) to add to hiscollection. For Jerry, whatkind of good arePorsches?

Critical Thinking4. Identify a good that is a

substitute for one goodand a complement for

another. (Hint: A Coca-Cola may be a substitutefor a Pepsi and a comple-ment for a hamburger.)

Applying EconomicConcepts 5. In recent years the price

of a computer has fallen.What effect is this pricechange likely to have onthe demand for software?Explain your answer.

6. Graph the following:a. an increase in demandb. a decrease in demand

EX H I B IT 4-4 A Change in Demand Versus aChange in Quantity Demanded

0Quantity demanded

D1

D2

0

Pric

e

Pric

e

Quantity demanded

D2

(b)(a)

B

A

D1

� (a) A change in demand refers to a shift in the demand curve. A change in demand can bebrought about by a change in a number of factors (income, preferences, prices of related goods,number of buyers, future price). (b) A change in quantity demanded refers to a movement along agiven demand curve, which is brought about only by a change in the price of the good.

04 (086-109) EMC Chap 04 11/17/05 4:36 PM Page 99

You just learned that buyers’expectations about future

prices can affect current demand. Ifcomputer buyers think computerprices will be higher next year, theymight buy their computers now (atthe lower price) instead of next year(at the higher price) Buyers whothink computer prices will be lowernext year, might hold off buying thisyear, thinking they will get a lowerprice next year.

The Tulip ExampleSimilar thinking has been affect-

ing prices and demand for hundredsof years. In the 1600s in Holland, forexample, a tulip craze became sofrenzied that some people sold their

businesses and family jewels just tobuy a few tulip bulbs. Why wouldpeople behave in this way? Theanswer has to do with what thesepeople thought the future price oftulips would be. They believed that ifthey bought tulips today at a rela-tively lower price, they could sell thetulips at a higher price in the future.

Too Good to Be True?

100 Chapter 4 Demand

� Stock traders such as these partici-pated in the buying surge of Internetstocks in the late 1990s.

Don’t Forget Beanie BabiesNow think back to 1998. In that

year, many people in the UnitedStates were buying Beanie Babies (asmall stuffed animal). They believedthat Beanie Babies would become

And What About RealEstate Prices?

Well, Beanie Babies, tulips, andmany Internet stocks all crashed inprice. Beanie Babies that once soldfor $100 were selling for $5; tulipsthat sold for hundreds of thousandsof dollars ended up selling for (theequivalent of) a few pennies; andInternet stock prices in some caseswent from $400 a share to a fewcents a share.

Do you think real estate pricesmight be similar to these examples?During the period from 2001 to2005 in many places around thecountry, all you heard was howhome prices were destined—yes,destined—to just keep on rising. Itwas as if some law—let’s call it thelaw of antigravity—kept pulling pricesup, much like the real law of gravitypulls things down. In southernCalifornia, especially coastal southernCalifornia, it was not uncommon tohear people say, “There is no way

collectors’ items, and that the futureprice of Beanie Babies would behigher than the current price. Theythought that if they bought BeanieBabies in 1998, they could turnaround and sell those Beanie Babiesat a higher price in 1999, or 2000,or in some later year.

Then Came theInternet Bubble

One more example: Internetstocks in the late 1990s. Everyoneseemed to be saying that the priceswere going to be higher next week ornext month and so you ought to buythe stocks as soon as possible. Eventhough many experts said the stockswere overpriced, people kept buying,thinking that the prices would con-tinue to climb. Many people bor-rowed money to buy the stocks.

04 (086-109) EMC Chap 04 11/17/05 4:37 PM Page 100

101Chapter 4 Demand

that houses near the coast are goingto go down in price. After all, there’sonly so much coast to go around.” Atthe time, many people were buyinghouses not to live in, but to specu-late on. In other words, they boughta house in 2003 because they were“certain” they could sell the house in2004 for a higher price.

Many of these people did justthat. Of course, many of the peoplewho bought Beanie Babies, tulips,and Internet stocks did the samething: they bought low and sold high.Not everybody was so fortunate. Inall three crazes—Beanie Babies,tulips, and Internet stocks—somepeople bought at high prices andended up selling at low prices.

Will it be the same with houses?It very well could be. It’s happenedbefore, and no economic law says itwon’t happen again.

One Last PointConsider George. George

watches as the price of houses sky-rockets. He also notices that houseprices are rising much more rapidlythan house rents. Based on thediscrepancy between the rate ofchange in house rents and the rate

of change in house prices, he is quitesure that sometime in the futurehouse prices will decline (perhapsvery quickly).

What George doesn’t know iswhen house prices will start todecline. Will the price decline beginnext week, next month, next year, orfive years from now? It is muchharder to predict the timing of anevent than it is to predict the event.(The doctor can tell the pregantwoman that she is going to have ababy, but be unsure of the day andtime. The weather forecaster is fairlysure that it will rain in the next 24hours, but he’s not sure if the rain willstart at 7:08 a.m. or at 9:32 a.m.)

My Personal Economics Action Plan

Here are some points you may want to consider and some

guidelines you might want to put into practice:

❑✔1. When someone says that “price has nowhere to go but

up,” you might want to recall what happened to the

price of Beanie Babies, tulips, and Internet stocks. Many

things that sound too good to be true are just that.

Before making a major financial decision, I will talk to some

experts and do some research to make sure that my deci-

sion is based on facts, not “hype.”

❑✔2. Don’t jump to the conclusion that just because you can

predict that an event will occur, you can predict when

the event will occur. Remember that no one, not even

the leading experts in a particular field, can know with

certainty when an economic event will occur.

� Can economists predict whenreal estate prices will rise or fall?

04 (086-109) EMC Chap 04 11/17/05 4:37 PM Page 101

What Is Elasticity ofDemand?

Suppose Jimmy loves chewing gum, somuch so that he buys as many as four or fivepacks a week. One day he notices that theprice of his favorite gum has gone up a quar-ter. Jimmy will probably now buy less chew-ing gum. But how much less?

This question about Jimmy’s gum buyingis the kind of question that you will learnhow to answer as you study our next eco-nomic concept, elasticity of demand.Elasticity of demand deals with the relation-ship between price and quantity demanded.It is a way of measuring the impact that aprice change has on the number of units of agood people buy. In some cases a small pricechange causes a major change in the numberof units of a good people buy. In other cases,a small price change causes little change inhow many units of a good people buy.

Elastic Demand Economists have created a way to meas-

ure these relationships between price and


Elasticity ofDemand

Focus Questions � What is elasticity of demand?� How do we compute elasticity of demand?� What does it mean to say that the demand

for a good is elastic? Inelastic? Unit elastic?� What factors can change the elasticity of

demand?� Does an increase in price for a good neces-

sarily bring about a higher total revenue?

Key Termselasticity of demandelastic demandinelastic demandunit-elastic demand

quantity demanded. They compare the per-centage change in quantity demanded of agood to the percentage change in the price ofthat good. In mathematical terms, here iswhat elasticity of demand looks like:

In the equation, the numerator is percent-age change in quantity demanded, and thedenominator is percentage change in price.Elastic demand exists when the quantitydemanded (the numerator) changes by agreater percentage than price (the denomi-nator). For example, suppose the quantitydemanded of lightbulbs falls by 15 percentas the price of lightbulbs increases by 10percent. An economist would say thatbecause the numerator (15%) is greater thanthe denominator (10%), the demand forlightbulbs is elastic. Another way that aneconomist might say it is that elasticity ofdemand is greater than 1, because if youdivide 15 percent by 10 percent, you get 1.5,which is greater than 1.

elasticity of demandThe relationshipbetween the percentagechange in quantitydemanded and the per-centage change in price.

elastic demandThe type of demand thatexists when the percent-age change in quantitydemanded is greaterthan the percentagechange in price.

Elasticity ofdemand

�

Percentage change in quantity demanded

Percentage change in price

04 (086-109) EMC Chap 04 11/17/05 4:37 PM Page 102

falls by 2 percent. In this situation, we wouldsay that the demand for education at thisparticular university is inelastic. Why?Because the percentage change in quantitydemanded (2%) is less than the percentagechange in price (10%). �

What Determines Elasticityof Demand?

The demand for some goods (coffee,gasoline at the local gas station, physicians’services) is inelastic, while the demand forother goods (oysters, restaurant meals, andcars) is elastic. Why is the demand for somegoods inelastic, while the demand for othergoods is elastic? Four factors affect the elas-ticity of demand: (1) the number of substi-tutes available, (2) whether something is aluxury or a necessity, (3) the percentage ofincome spent on the good, and (4) time.

Number of Substitutes Let’s look at two goods: heart medicine

and soft drinks. Heart medicine has relativelyfew substitutes; many people must have it tostay well. Even if the price of heart medicinewent up by 50, 100, or 150 percent, the quan-tity that people demanded probably wouldnot fall by much. Is the demand for heartmedicine more likely to be elastic or inelas-tic? The answer is inelastic. Do you see thereasoning here? The fewer substitutes for agood, the less likely the quantity demandedwill change much if the price rises.

Inelastic DemandInelastic demand exists when the quan-

tity demanded changes by a smaller percent-age than price—that is, when the numeratorchanges by less than the denominator.Suppose the quantity demanded of salt fallsby 5 percent as the price of salt rises by 10percent. In this case the numerator (5%) isless than the denominator (10%), so thedemand for salt is inelastic. An economistcould say that elasticity of demand is lessthan 1 (if you divide 5% by 10% you get 0.5,which is less than 1).

Unit-Elastic DemandFinally, unit-elastic demand exists when

the quantity demanded changes by the samepercentage as price—that is, when thenumerator changes by the same percentageas the denominator. For example, supposethe quantity demanded of picture framesdecreases by 10 percent as the price of pic-ture frames rises by 10 percent. The numer-ator (10%) is equal to the denominator(10%), so the demand for picture frames isunit elastic. According to an economist, elas-ticity of demand would be equal to 1 (10%divided by 10% equals 1).

When elasticity of demand is greater than1, we say that demand is elastic. When it isless than 1, we say that demand is inelastic.And finally, when it is equal to 1, we say thatdemand is unit-elastic. See Exhibit 4-5.

Elastic or Inelastic?So, you’re probably wondering what prod-

ucts are elastic and which ones are inelastic?One economics study identified oysters,restaurant meals, and automobiles as goodswith elastic demand. For these goods, pricechanges have a strong impact on how muchcustomers will buy. In the same study, coffee,gasoline (for your car), physicians’ services,and legal services were identified as goodswith inelastic demand. For these products achange in price had less impact on howmuch customers will buy.

A university raises itstuition by 10 percent. As a result, the num-ber of students applying to the university

E X A M P L E :

103Section 3 Elasticity of Demand

EX H I B IT 4-5 Elasticity of Demand

Elastic

Unit-elastic

Quantity demanded changes by a larger percentage than price. For example, if price rises by 10 percent, quantity demanded falls by, say, 15 percent.

If demand is . . . That means . . .

Quantity demanded changes by a smaller percentage than price. For example, if price rises by 10 percent, quantity demanded falls by, say, 5 percent.

Quantity demanded changes by the same percentage as price. For example, if price rises by 10 percent, quantity demanded falls by 10 percent.

Inelastic

inelastic demandThe type of demand thatexists when the percent-age change in quantitydemanded is less thanthe percentage changein price.

unit-elastic demandThe type of demand thatexists when the percent-age change in quantitydemanded is the sameas the percentagechange in price.

04 (086-109) EMC Chap 04 11/17/05 4:37 PM Page 103

In contrast, a particular soft drink (saySprite) has many substitutes (Fresca, Moun-tain Dew, etc.). Therefore, if the price ofSprite rises, we would expect the quanitydemanded to fall greatly, because people havemany other soft drinks they can choose. Is thedemand for a particular soft drink more likelyto be elastic or inelastic? The answer is elastic,because the more substitutes there are for agood, the more likely people will buy a lotfewer of the item if the price rises.

Luxuries Versus NecessitiesLuxury goods (luxuries) are goods that

people feel they do not need to survive. Forexample, a $70,000 car would be a luxurygood for most people. Necessary goods(necessities), in contrast, are goods that peo-ple feel they need to survive. Heart medicinemay be a necessity for some people. Food isa necessity for everyone.

Generally speaking, if the price of a neces-sity, such as food, increases, people cannotcut back much on the quantity demanded.(They need a certain amount of food tolive.) However, if the price of a luxury goodincreases, people are more able to cut backon the quantity demanded. Between the twotypes of goods, luxuries and necessities, thedemand for luxuries tends to be elastic; thedemand for necessities is more likely to beinelastic.

Percentage of Income Spent on the Good

Claire has a monthly income of $2,000. Ofthis amount, she spends $10 on magazinesand $400 on dinners at restaurants. In per-centage terms, she spends one-half of 1 per-cent of her monthly income on magazinesand 20 percent of her monthly income ondinners at restaurants. Suppose the price ofmagazines and the price of dinners at restau-rants both double. What will Claire be morelikely to cut back on, the number of maga-zines she buys or the number of dinners atrestaurants?

She will probably reduce the number ofdinners at restaurants, don’t you think?Claire will feel this price change morestrongly because it affects a larger percentageof her income. She may shrug off a doublingin the price of magazines, on which shespends only one-half of 1 percent of herincome, but she is less likely to shrug off adoubling in the price of dinners at restau-rants, on which she spends 20 percent.

In short, buyers are more responsive toprice changes for goods on which they spenda larger percentage of their income. In thesecases, the demand is likely to be elastic.Whereas, the demand for goods on whichconsumers spend a small percentage of theirincome is more likely to be inelastic.

Time As time passes, buyers have greater

opportunities to change quantity demandedin response to a price change. If the price ofelectricity went up today and you knewabout it, you probably would not changeyour consumption of electricity much today.By three months from today, though, youwould probably have changed it more. Astime passes, you have more chances tochange your consumption by finding substi-tutes (natural gas), changing your lifestyle(buying more blankets and turning downthe thermostat at night), and similar actions.The less time you have to respond to a pricechange in a good, the more likely it is thatyour demand for that good is going to beinelastic.


Demand for OilIn recent years, China’s demandfor oil has been rising. Two rea-sons: First, about 2.5 million cars

are added to China’s roads everyyear. Second, the industrial demand

for oil has been rising because China’seconomy has been rapidly growing.

As China’s demand for oil rises, what willhappen to the world demand for oil?

Although you won’t study the topic of price until a laterchapter, what do you think China’s rising demand foroil will do to the price for gasoline you pay at the pump?

ECONOMICTHINKING

04 (086-109) EMC Chap 04 11/17/05 4:37 PM Page 104

An Important RelationshipBetween Elasticity and TotalRevenue

Demand is elastic for one good andinelastic for another good. Does it matter?As you just read, it can matter to you as anindividual, and it definitely matters to thesellers of goods. In particular, it matters to aseller’s total revenue (money sellers receivefor selling their goods). To see how elasticityof demand relates to a business’s total rev-enue, let’s consider four cases in detail. Thecases look at both elastic and inelastic goodsand what happens to each when the pricerises, and when the price falls.

• Case 1: Elastic Demand and a PriceIncreaseJavier currently sells 100 basketballs aweek at a price of $20 each. His totalrevenue (price × quanity) per week is$2,000. Suppose Javier raises the price ofhis basketballs to $22 each, a 10 percentincrease in price. As a result, the quantitydemanded falls from 100 to 75, a 25percent reduction. The demand iselastic because the change in quantitydemanded (25%) is greater than thechange in price (10%). What happenedto Javier’s total revenue at the new priceand quantity demanded? It is $1,650:the new price ($22) multiplied by thenumber of basketballs sold (75).

Notice that if demand is elastic, aprice increase will lead to a decline intotal revenue. Even though he raised theprice, Javier’s total revenue went down,from $2,000 to $1,650. An importantlesson here is that an increase in pricedoes not always bring about an increasein total revenue.

Elastic demand � Price increase �Total revenue decrease

• Case 2: Elastic Demand and a PriceDecrease In case 2, as in case 1, demand is elastic.This time, however, Javier lowers theprice of his basketballs from $20 to $18, a

10 percent reduction in price. We knowthat if price falls, quantity demanded willrise. Also, if demand is elastic, the per-centage change in quantity demanded isgreater than the percentage change inprice. Suppose quantity demanded risesfrom 100 to 130, a 30 percent increase.Total revenue at the new, lower price($18) and higher quantity demanded(130) is $2,340. Thus, if demand is elasticand price is decreased, total revenue willincrease.

Elastic demand � Price decrease �Total revenue increase

• Case 3: Inelastic Demand and a PriceIncreaseNow let’s assume that the demand forbasketballs is inelastic, rather than elas-tic, as it was in cases 1 and 2. SupposeJavier raises the price of his basketballsto $22 each, a 10 percent increase inprice. If demand is inelastic, the per-centage change in quantity demandedmust fall by less than the percentagerise in price. Suppose the quantitydemanded falls from 100 to 95, a 5 per-cent reduction.

Javier’s total revenue at the new priceand quantity demanded is $2,090, which


The Bureau of Labor Statistics(BLS) is an agency within theU.S. Department of Labor.

The agency collects data on pricesin the economy. To see whether consumer prices are rising,falling, or remaining constant, go to the BLS Web site atwww.emcp.net/prices. Once there, click on “Inflation &Consumer Spending.” Next, scroll down the page until yousee “Consumer Price Index (CPI).” The CPI is a measure ofthe prices of the goods and services purchased by consumers.Have prices risen, fallen, or remained constant in the lastmonth reported? If prices have risen or fallen, by what per-centage have they risen or fallen?

04 (086-109) EMC Chap 04 11/17/05 4:37 PM Page 105

is the new price ($22) multiplied by thenumber of basketballs sold (95). Noticethat if demand is inelastic, a priceincrease will lead to an increase in totalrevenue. Javier’s total revenue went from

$2,000 to $2,090 when he increased theprice of basketballs from $20 to $22.

Inelastic demand � Price increase �Total revenue increase


Rock stars need to know morethan how to write and play

music. They also need to knowabout elasticity of demand. In fact,a large part of their earnings willdepend on whether they knowabout elasticity of demand.

Suppose you are a rock star.You write songs, record them, andspend 150 days each year on theroad performing. Let’s say thattonight you will be performing inChicago. The auditorium there seats

30,000 people. Do you earn moreincome if all 30,000 seats are soldor if only 20,000 seats are sold?

This question seems a little silly.It seems obvious that you would bebetter off if you sold more ticketsthan fewer tickets. Certainly 30,000would be better than 20,000,wouldn’t it?

“You can’t always get

what you want

But if you try sometimes

You just might find

You’ll get what you need”

—The Rolling Stones

The obvious answer here is notnecessarily correct. The answerreally depends on an understandingof elasticity of demand. Let’s saythat to sell all 30,000 seats, the

price per ticket has to be$30. At this ticket price,total revenue, which is thenumber of tickets soldtimes the price per ticket,is $900,000.

If the demand foryour Chicago performanceis inelastic, a higher ticketprice will actually raisetotal revenue. (Remem-ber: Inelastic demand +Price increase = Increasein total revenue.) Supposeyou raise the ticket price

to $50. At this higher price you willnot sell as many tickets as you soldwhen the price was $30 per ticket.Let’s say you sell only 20,000 tick-ets. You have not “sold out” theauditorium, but it doesn’t matter. Ata price of $50 per ticket and 20,000seats sold, total revenue is $1 mil-lion—or $100,000 more than it waswhen you sold out the auditorium.*

Is a sold-out auditorium, then,better than an auditorium that is notsold out? Usually you would thinkso, but an understanding of elastic-ity of demand informs us that it maybe better to sell fewer tickets at ahigher price than to sell more ticketsat a lower price. Who would havethought it?

1. You may notbecome a rock star,

but you may run your own businesssomeday. Explain why it will beimportant for you to understandelasticity of demand.

2. What basic economic conceptthat you learned in Chapter 1 isexpressed by the Rolling Stones’lyrics on this page?

*This description assumes that only one ticketprice, $30 or $50, can be charged. If more thanone ticket price can be charged, then someseats may be sold for $30, some for $40,some for $50, and so on.

THINKABOUT IT

?Who’s Rockin’ with“Elasticity of Demand”?

04 (086-109) EMC Chap 04 11/17/05 4:37 PM Page 106

• Case 4: Inelastic Demand and a PriceDecrease Demand is again inelastic, but Javier nowlowers the price of his basketballs from$20 to $18, a 10 percent reduction inprice. We know that if demand is inelas-tic, the percentage change in quantitydemanded is less than the percentagechange in price. Suppose quantitydemanded rises from 100 to 105, a 5 per-cent increase. Total revenue at the new,lower price ($18) and higher quantitydemanded (105) is $1,890. Thus, ifdemand is inelastic and price decreases,total revenue will decrease.

Inelastic demand � Price decrease �Total revenue decrease

See Exhibit 4-6 for a summary of the fourtypes of relationships between elasticity andrevenue.

QUESTION: Most people seem to thinkthat if a seller raises the price, the seller’stotal revenue will automatically rise. Butit isn’t always true, is it?

ANSWER: No, it isn’t always true. Ifdemand is inelastic (case 3), then ahigher price will lead to a higher totalrevenue, but if demand is elastic (case1), a higher price will lead to a lowertotal revenue.


Defining Terms 1. Define:

a. elasticity of demandb. unit-elastic demandc. inelastic demandd. elastic demand

Reviewing Facts and Concepts 2. Does an increase in price

necessarily bring about ahigher total revenue?

3. The price of a good risesfrom $4 to$4.50, and as aresult, total revenue falls

from $400 to $350. Isthe demand for the goodelastic, inelastic, or unit-elastic?

4. Good A has 10 substi-tutes, and good B has 20substitutes. The demandis more likely to be elasticfor which good? Explainyour answer.

Critical Thinking 5. How is the law of demand

(a) similar to and (b) dif-

ferent from elasticity ofdemand?

Applying EconomicConcepts6. A hotel chain advertises

its hotels as “The BestHotels You Can FindAnywhere.” Does this adhave anything to do withelasticity of demand? Ifso, what?

EX H I B IT 4-6 Relationship of Elasticity of Demand to Total Revenue

Elasticdemand

If

If

ThenPrice

PriceThen

Total revenue

Total revenue

Inelasticdemand

If

If

Price

Price

Then

Then

Total revenue

Total revenue

� If demand is elastic, price and total revenue move in opposite direc-tions: as price goes up, total revenue goes down, and as price goesdown, total revenue goes up. If demand is inelastic, price and total rev-enue move in the same direction: as price goes up, total revenue goesup, and as price goes down, total revenue goes down.

04 (086-109) EMC Chap 04 11/17/05 4:37 PM Page 107


Economics Vocabulary

To reinforce your knowledge of the key terms inthis chapter, fill in the following blanks on a sepa-rate piece of paper with the appropriate word orphrase.

1. A(n) ______ is any place where people cometogether to buy and sell goods or services.

2. If, as income rises, demand for a good falls, thenthat good is a(n) ______ good.

3. According to the law of demand, as the price ofa good rises, the ______ of the good falls.

4. According to the ______, price and quantitydemanded are inversely related.

5. According to the ______, as a person consumesadditional units of a good, eventually the utilitygained from each additional unit of the gooddecreases.

6. Demand is ______ if the percentage change inquantity demanded is less than the percentagechange in price.

7. A downward-sloping demand curve is thegraphic representation of the ______.

8. For a(n) ______ good, the demand increases asincome rises and falls as income falls.

9. If, as the price of good X rises, the demand for Yincreases, then X and Y are ______.

10. When demand is ______, the percentagechange in quantity demanded is the same as thepercentage change in price.

Understanding the Main Ideas

Write answers to the following questions to reviewthe main ideas in this chapter.

1. Margarine and butter are substitutes. What hap-pens to the demand for margarine as the priceof butter rises?

2. Explain what happens to the demand curvefor apples as a consequence of each of thefollowing.a. More people begin to prefer apples to

oranges.b. The price of peaches rises (peaches are a

substitute for apples).c. People’s income rises (apples are a normal

good).

Chapter Summary

Be sure you know and remember the followingkey points from the chapter sections.

Section 1� Demand is the willingness and ability of buy-

ers to purchase different quantities of a good atdifferent prices during a specific time period.

� A market is any place where people cometogether to buy and sell goods and services.There are two sides to a market—demand andsupply.

� The law of demand says that price and quan-tity demanded move in opposite directions.

� A demand curve graphically represents the lawof demand.

Section 2� An increase in demand for a good causes the

demand curve to shift to the right.� A decrease in demand causes a leftward shift in

the demand curve.� A change in demand may be caused by changes

in income, people’s preferences, price ofrelated goods, number of buyers, and futureprice expectations.

� A change in price is what causes quantitydemanded to change.

Section 3� Elasticity of demand deals with the relationship

between price and quantity demanded.� Demand is elastic when quantity demanded

changes by a greater percentage than price.� Demand is inelastic when quantity demanded

changes by a smaller percentage than price.� Elasticity of demand is affected by available

substitutes, whether the good is a luxury ornecessity, percentage of income spent on thegood, and time.

04 (086-109) EMC Chap 04 11/17/05 4:37 PM Page 108

109Chapter 4 Demand

3. “Sellers always prefer higher to lower prices.” Doyou agree or disagree? Explain your answer.

4. In each of the following, identify whether thedemand is elastic, inelastic, or unit-elastic.a. The price of apples rises 10 percent as the

quantity demanded of apples falls 20percent.

b. The price of cars falls 5 percent as the quan-tity demanded of cars rises 10 percent.

c. The price of computers falls 10 percent asthe quantity demanded of computers rises10 percent.

5. State whether total revenue rises or falls in eachof the following situations.a. Demand is elastic and price increases.b. Demand is inelastic and price decreases.c. Demand is elastic and price decreases.d. Demand is inelastic and price increases.

Doing the Math

Do the calculations necessary to solve the followingproblems.

1. If the percentage change in price is 12 percentand the percentage change in quantitydemanded is 7 percent, what is the elasticity ofdemand equal to?

2. The price falls from $10 to $9.50, and the quan-tity demanded rises from 100 units to 110 units.What does total revenue equal at the lower price?

Working with Graphs

and Charts

Use Exhibit 4-7 to answer questions 1 through 3.(P � Price and Qd � Quantity demanded)

1. What does Exhibit 4-7(a) represent?2. What does Exhibit 4-7(b) represent?3. What does Exhibit 4-7(c) represent?

4. In Exhibit 4-8, a downward-pointing arrow (↓)means a decrease, an upward-pointing arrow(↑) means an increase, and a bar (—) over avariable means the variable remains constant(unchanged). Fill in the blanks for parts (a)through (c).

Solving Economic Problems

Use your thinking skills and the information youlearned in this chapter to find a solution to the fol-lowing problem.

1. Application. Income in the economy isexpected to grow over the next few years. Youare thinking about buying stock in a company.Is it better to buy stock in a company that pro-duces a normal, inferior, or neutral good?Explain your answer.

Go to www.emcp.net/economics and choose Economics:New Ways of Thinking, Chapter 4, if you need more help inpreparing for the chapter test.

EX H I B IT 4-7

0 Qd

(a)

D1

D2

(b)

P

(c)

D

B

A

D2

D1

EX H I B IT 4-8

P = Price TR = Total revenue

(a)

(b)

(c)

Demand is . P TR

Demand is . P TR

Demand is . P TR

04 (086-109) EMC Chap 04 11/17/05 4:37 PM Page 109

chapter 6 price: supply and demand together · price: supply and demand together 04 ... a good...

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