Lecture 2(a) Lecture 2(a) Basics of Basics of DemandDemand

Why Study DemandWhy Study Demand Obvious Reason: To help with forecasting Obvious Reason: To help with forecasting

revenuesrevenues What will happen to sales tax revenues collected What will happen to sales tax revenues collected

from the sale of cigarettes if the price goes up as from the sale of cigarettes if the price goes up as a consequence of the Federal Government’s a consequence of the Federal Government’s lawsuit?lawsuit?

Less Obvious Reason: To help understand Less Obvious Reason: To help understand pricing strategiespricing strategies

Why do some firms make it difficult to buy Why do some firms make it difficult to buy “unbundled”--e.g., MS wants to sell Office or “unbundled”--e.g., MS wants to sell Office or Explorer as a package?Explorer as a package?

What Is Involved in What Is Involved in Building a Complete Building a Complete Theoryof Demand?Theoryof Demand?

A complete theory is based on and begins A complete theory is based on and begins with a theory of individual demandwith a theory of individual demand

And then considers how individual behavior And then considers how individual behavior aggregate to market behavior.aggregate to market behavior.

The Theory of Individual Demand The Theory of Individual Demand is Organized by Conducting the is Organized by Conducting the Following Thought Experiment: Following Thought Experiment: What Determines How Much of What Determines How Much of

_____ Do You Want to Buy?_____ Do You Want to Buy? TasteTaste Price of the GoodPrice of the Good IncomeIncome Price of Other StuffPrice of Other Stuff

TasteTaste

While may be the most important factor, but it is While may be the most important factor, but it is also the factor that is most difficult to model and also the factor that is most difficult to model and forecast.forecast.

Therefore, the conventional approach in Therefore, the conventional approach in microeconomics is to simply accept the microeconomics is to simply accept the consumers tastes as given (often pretentiously consumers tastes as given (often pretentiously invoking the Latin expression invoking the Latin expression non degustibus non degustibus disputandem—disputandem—which I think means, “there is no which I think means, “there is no arguing about tastes” and which I have no idea arguing about tastes” and which I have no idea how to spell.) how to spell.)

Interestingly, though, a small but brave group of Interestingly, though, a small but brave group of economists have tried to formulate an economic economists have tried to formulate an economic theory of taste formation. In this class, though, theory of taste formation. In this class, though, we’ll mostly accept the consumer as he or she is.we’ll mostly accept the consumer as he or she is.

The Relationship Between The Relationship Between Price and QuantityPrice and Quantity

When price goes up, it seems very When price goes up, it seems very unlikely that a consumer will choose unlikely that a consumer will choose to buy more (although can you think to buy more (although can you think of exceptions?) and there are good of exceptions?) and there are good reasons to think that higher prices reasons to think that higher prices will cause consumption to fall .will cause consumption to fall . ((Note: this prediction assumes thatNote: this prediction assumes that

onlyonly price changes.) price changes.)

This Seems Obvious, but It This Seems Obvious, but It is Worth Thinking About is Worth Thinking About Exactly Why People Buy Exactly Why People Buy Less When Prices Go UpLess When Prices Go Up

Most consumers are likely to be faced Most consumers are likely to be faced with with income constraintsincome constraints and so as the and so as the price of something goes up, they have price of something goes up, they have less to spend on some goods. This is less to spend on some goods. This is easy to understand, but we’ll give a easy to understand, but we’ll give a simple example in class. simple example in class.

Most consumers have preferences Most consumers have preferences over most goods that are consistent over most goods that are consistent with with diminishing marginal utility.diminishing marginal utility.

The relationship between prices of The relationship between prices of other goods and demandother goods and demand

(How Would My Demand for X (How Would My Demand for X Change if the Price of Y Went Up?)Change if the Price of Y Went Up?) Suppose X is a ticket to the opera in Verona, Italy and Y Suppose X is a ticket to the opera in Verona, Italy and Y

is an airplane ticket to italy.is an airplane ticket to italy. Suppose X is a ticket to the opera in Verona and Y is a Suppose X is a ticket to the opera in Verona and Y is a

ticket to the first round of the Italian Idol audition.ticket to the first round of the Italian Idol audition. Obviously the relationship depends on the type of goodsObviously the relationship depends on the type of goods

X is a X is a SubstituteSubstitute for Y, if an increase in the for Y, if an increase in the price of Y leads to an increase in the demand for price of Y leads to an increase in the demand for XX

X is a X is a ComplementComplement for Y, if an increase in the for Y, if an increase in the price of Y leads to an decrease in the demand price of Y leads to an decrease in the demand for Xfor X

The relationship between The relationship between income and demandincome and demand

If I were Bill Gates, how would my life If I were Bill Gates, how would my life be different?be different? I’d buy more rides on private jets than I I’d buy more rides on private jets than I

do now.do now. But I’d buy fewer coach tickets than now.But I’d buy fewer coach tickets than now.

The relationship between income and The relationship between income and demand is ambiguous. Thus, we have demand is ambiguous. Thus, we have the following definitionsthe following definitions Normal goodNormal good: Any good such that as income : Any good such that as income

goes up, demand goes up (e.g., Mercedes).goes up, demand goes up (e.g., Mercedes). Inferior goodInferior good: Income goes up, demand goes : Income goes up, demand goes

down (e.g., 1993 Mercury)down (e.g., 1993 Mercury)

Another way to make the same Another way to make the same pointspoints

What matters to most consumers is What matters to most consumers is relative values, relative values, such as the price of such as the price of one good relative to the price of one good relative to the price of another good and relative to the another good and relative to the income of the consumer income of the consumer

Some Helpful Jargon About Some Helpful Jargon About DemandDemand

Suppose we thought that the relationship between price and the Suppose we thought that the relationship between price and the quantity demanded of a particular good could be represented by the quantity demanded of a particular good could be represented by the following linear relationship (where P represents the price and Q following linear relationship (where P represents the price and Q the quantity demanded). the quantity demanded).

Q=2(50-P)Q=2(50-P) This expression could be rearranged asThis expression could be rearranged as

P=50-.5QP=50-.5Q These expressions are, of course, really just two different ways of These expressions are, of course, really just two different ways of

saying the same thing, but to help distinguish them we will refer to saying the same thing, but to help distinguish them we will refer to the first expression (Q on the left hand side by itself) as the the first expression (Q on the left hand side by itself) as the demand demand functionfunction and the second expression as the and the second expression as the inverse demand inverse demand functions.functions.

When we draw a graph of such relationships it is conventional to put When we draw a graph of such relationships it is conventional to put the price on the vertical axis and quantity on the horizontal axis. the price on the vertical axis and quantity on the horizontal axis.

Some economists (and most textbooks) make a fetish out of the Some economists (and most textbooks) make a fetish out of the distinction between a shift in the entire curve (usually caused by a distinction between a shift in the entire curve (usually caused by a change in one of the many factors that influence demand and change in one of the many factors that influence demand and referred to as a “change in demand”) and movement along the referred to as a “change in demand”) and movement along the demand curve (caused by a change in price and referred to as “a demand curve (caused by a change in price and referred to as “a change in quantity demanded”.)change in quantity demanded”.)

IssuesIssues

Market demand vs individual demand.Market demand vs individual demand. At on level, this is just arithmetic. For example, if each of 60 At on level, this is just arithmetic. For example, if each of 60

students demand 3 beers at a price of $3, market demand will be students demand 3 beers at a price of $3, market demand will be 180.180.

But can you think of some goods where, an individual’s demand But can you think of some goods where, an individual’s demand may be influenced by the number of others demanding the good?may be influenced by the number of others demanding the good?

Market demand vs firm demand.Market demand vs firm demand. This is something we’ll think a lot more about when we get to the This is something we’ll think a lot more about when we get to the

part of the course on competitive markets, but for now think part of the course on competitive markets, but for now think about why this distinction should matter. Also, think about why about why this distinction should matter. Also, think about why the market demand is probably less sensitive to price than an the market demand is probably less sensitive to price than an individual firm’s demand.individual firm’s demand.

What exactly do we mean by a good? That is, a good can be What exactly do we mean by a good? That is, a good can be distinguished by (among other things).distinguished by (among other things).

Geography (beer at the ball park versus beer at home)Geography (beer at the ball park versus beer at home) Quality (diet beer versus heavy beer) Quality (diet beer versus heavy beer)

Since demand measures a Since demand measures a flowflow (that is, the amount (that is, the amount demanded over some period of time), what is the relevant demanded over some period of time), what is the relevant time. time.

From Demand to Revenue

It is obviously possible to derive total revenue from demand simply by multiplying Q by P.

TR=P*Q. Since this is economics, we of course

want marginal revenue Words: MR is the change in TR when Q

changes For discreet changes: MR=Change in

TR/Change in Q (approximate) Calculus: MR = d TR/ dQ (precise)

Example: Demand for Airline Seats

Quantity Price TR MR

500 800$ 400,000$

600 700$ 420,000$ 200

700 600$ 420,000$ 0

800 500$ 400,000$ -200

900 400$ 360,000$ -400

This example is consistent with demand This example is consistent with demand being given by being given by

Q= 1300- P or P=1300-QQ= 1300- P or P=1300-Q ThusThus

Total Revenue = PQ= (1300-Q)Q = 1300 Q – Total Revenue = PQ= (1300-Q)Q = 1300 Q – Q2Q2

andand

Marginal Revenue = dTR/dQ = 1300 – 2QMarginal Revenue = dTR/dQ = 1300 – 2Q (Remember the numbers for MR derived in (Remember the numbers for MR derived in

the table are only an approximation).the table are only an approximation).

Puzzle: Why Does TR Puzzle: Why Does TR Increase and Then Increase and Then

Decrease?Decrease? Good NewsGood News: When price falls from to $500 from : When price falls from to $500 from

$600, you get 100 new passengers. Each of $600, you get 100 new passengers. Each of these contributes an extra $500 in revenues.these contributes an extra $500 in revenues.

Bad NewsBad News: In order to get the new customers, : In order to get the new customers, you had to cut the price of tickets by $100 (from you had to cut the price of tickets by $100 (from $600 to $500) for 700 passengers who would $600 to $500) for 700 passengers who would have been willing to fly without the price have been willing to fly without the price reduction.reduction.

Summary: MR=(Revenue from “new” sales at Summary: MR=(Revenue from “new” sales at the “new” price-revenue lost from sales to “old” the “new” price-revenue lost from sales to “old” customers at “old” price)/(number of “new” customers at “old” price)/(number of “new” customers.customers.

Obvious (but useful) insight MR will be bigger, Obvious (but useful) insight MR will be bigger, the more new customers are attracted by the the more new customers are attracted by the reduced pricereduced price

Measuring the Responsiveness Measuring the Responsiveness of Demand to Price: Elasticity of Demand to Price: Elasticity

of Demandof Demand Consider how much vital information is Consider how much vital information is

presented by the following formulapresented by the following formula

Elasticity =(% change in Quantity Elasticity =(% change in Quantity Demanded)/(%Change in Price)Demanded)/(%Change in Price)

If, for example, you were contemplating If, for example, you were contemplating a 10% price cut, and you know the a 10% price cut, and you know the value for demand elasticity, you would value for demand elasticity, you would immediately be able to predict how immediately be able to predict how much sales would increase.much sales would increase.

Formulas for Demand Elasticity Formulas for Demand Elasticity and Some Observationsand Some Observations

Since demand elasticity is expressed in terms of Since demand elasticity is expressed in terms of percentage changes (BTW, see if you can figure out percentage changes (BTW, see if you can figure out why it is important to work with percentages instead why it is important to work with percentages instead of absolute changes), one way to write the formula isof absolute changes), one way to write the formula is

((ΔΔQ/Q)/(Q/Q)/(ΔΔP/P) = (P/P) = (ΔΔQ/Q/ΔΔP)(P/Q) P)(P/Q) When measuring discreet changes in any variable, the When measuring discreet changes in any variable, the

calculation of “% change” may depend on the context calculation of “% change” may depend on the context of the problem. (Quick, tell me the % difference of the problem. (Quick, tell me the % difference between a price of $5 and $4.)between a price of $5 and $4.)

In order to eliminate any confusion, it is often useful In order to eliminate any confusion, it is often useful to explicitly rely on calculus to express elasticity. If to explicitly rely on calculus to express elasticity. If we can write the demand function as x=D(p), then we can write the demand function as x=D(p), then elasticity is elasticity is

D’(p)p/xD’(p)p/x

More Fun Facts About More Fun Facts About ElasticityElasticity

The value of elasticity will change depending on The value of elasticity will change depending on where you are taking the measurement. That is, where you are taking the measurement. That is, for different values of p and x, the value of for different values of p and x, the value of elasticity may be different (I say “may” because elasticity may be different (I say “may” because there are such things as “constant elasticity” there are such things as “constant elasticity” demand curves.)demand curves.)

Elasticity is actually a negative number (since Elasticity is actually a negative number (since dp/dx is always negative). It is a common, but not dp/dx is always negative). It is a common, but not universal, convention to report it as an absolute universal, convention to report it as an absolute value. But if that convention is not honored then value. But if that convention is not honored then “elastic” demand would describe a situation “elastic” demand would describe a situation where elasticity < -1where elasticity < -1

Relationship between MR Relationship between MR and Elasticityand Elasticity

If absolute value of elasticity>1 (defined as “elastic”), then If absolute value of elasticity>1 (defined as “elastic”), then MR>0. This means that when p goes down and q goes up, MR>0. This means that when p goes down and q goes up, TR goes up.TR goes up.

If absolute value of elasticity<1 (defined as “inelastic”), If absolute value of elasticity<1 (defined as “inelastic”), then MR<0 (I.e., when p goes down and q goes up, TR then MR<0 (I.e., when p goes down and q goes up, TR goes down).goes down).

If absolute value of elasticity=1 (defined as “unit If absolute value of elasticity=1 (defined as “unit elasticity”), then MR=0 (I.e., when p goes down and q goes elasticity”), then MR=0 (I.e., when p goes down and q goes up, TR remains constant).up, TR remains constant).

We can see from our example that this is true and a bit of We can see from our example that this is true and a bit of clever algebra done with the exact (that is, calculus) clever algebra done with the exact (that is, calculus) definition of MR will also confirm that it is true. But if you definition of MR will also confirm that it is true. But if you really understand the intuitive definition of elasticity, it is really understand the intuitive definition of elasticity, it is really almost common sense.really almost common sense.

In fact, there is an extremely useful formula that captures In fact, there is an extremely useful formula that captures this entire relationship. Letting v(x) stand for elasticitythis entire relationship. Letting v(x) stand for elasticity

Quantity Price TR MR % ΔQ % ΔP Elasticity

500 $800 $ 400,000

600 $700 $ 420,000 200 18% 13% 1.36

700 $600 $ 420,000 0 15% 15% 1.00

800 $500 $ 400,000 -200 13% 18% 0.73

900 $400 $ 360,000 -400 12% 22% 0.53

Elasticity > 1 means TR goes

up

Elasticity < 1 means TR goes

down