PRICE E LASTICITY OF DEMAND
• The change in price as a percentage of the average • Responsiveness of the quantity demanded of a good
price—the average of the initial and new price to a change in its price
• (25/87.5) x 100%=28.6 % Percentage change in the quantity demanded
• The change in the quantity demanded as a •
percentage of the average quantity Percentage change in the price
demanded—the average of the initial and Price: $75 to $100
new quantity Percentage change in price?
25%? (25/100) or 33.3%? (25/75)
Depends on the denominator
Mid-point formula
EXAMPLE : C ALCULATING P RICE E LASTICITY OF DEMAND
• Initially, the price of a pizza is $20.50 and the The price of a pizza falls to $19.50 and the quantity
quantity demanded is 9 pizzas an hour demanded increases to 11 pizzas an hour
The price falls by $1 and the quantity demanded increases
by 2 pizzas an hour
• The average price is $20, and the average quantity • The percentage change in quantity demanded is
demanded is 10 pizzas an hour DQ/Qave x 100%
• (2/10) x 100% = 20%
• The percentage change in price is DP/Pave x 100%
• ($1/$20) x 100% = 5%
• The price elasticity of demand is A Few Things About Price Elasticity of Demand
• 20% / 5% = 4
Why average price and quantity?
Same elasticity value regardless of whether the
price rises or falls
Positive or negative value?
Negative
Price and quantity move in opposite directions
Magnitude, or absolute value
How responsive the quantity change has been to
a price change
Perfectly inelastic demand Perfectly elastic demand
The quantity demanded doesn’t change when the • The change in quantity demanded is infinitely large
price changes when the price changes
Inelastic and Elastic Demand Elasticity along a linear demand curve
• Inelastic demand Calculate the price elasticity of demand
• The price elasticity of demand is less than 1 Prices falls from 25 to 15
• The percentage change in the quantity Prices falls from 15 to 10
demanded is smaller than the percentage Prices falls from 10 to 0
change in price
• Elastic demand
• The price elasticity of demand is greater than
1
• The percentage change in the quantity
demanded is greater than the percentage
change in price
ELASTICITY AND SLOPE ALONG A LINEAR DEMAND CURVE
• Price falls from $25 to $15 • Price falls from $15 to $10
• Quantity increases from 0 to 20 • Quantity increases from 20 to 30
• The price elasticity of demand is (20/10)/(10/20)=4 • The price elasticity of demand is (10/25)/(5/12.5)=1
• Price falls from $10 to $0 • Elasticity is not the same as slope
• Quantity increases from 30 to 50 • Points on a linear line have the same slope but
• The price elasticity of demand is (20/40)/(10/5)=1/4 different elasticities
DISCUSSION QUESTION: (TOTAL REVENUE AND PRICE)
• The total revenue from the sale of a good or
service equals the price of the good multiplied by
the quantity sold
• Will a rise in price always increase total revenue?
• When the
price rises
from 19.5 to
20.5, does
total revenue
increase?
• No!
• Revenue
before=214.5
• Revenue
after=184.5
• %DQ / %DP =
20% / 5% = 4
Implication of inelastic and elastic demand: Total Revenue Example
• Will a rise in price always increase total revenue? (No!) • Which video streaming platforms are most
• Depends on the elasticity of demand popular among Singapore consumers?
• If demand is elastic • Netflix!
• Price increases, total revenue decreases • Over one in three (36%) consumers
• If demand is inelastic are subscribers in 2023
• Price increases, total revenue increases • Demand is elastic or inelastic?
• In 2011, Netflix increases its prices
Discussion Question: Factors that influence the Elasticity of Demand for various packages, and this led to a
significant decrease in the
subscriptions
• In 2023, PED is 0.13 (inelastic)
• Why?
• Change in consumer preference
(Covid)/Netflix unique content
CONSUMPTION P OSSIBILITIES
• Where does the demand curve come
from?
• Consumer choices
• Where does the supply curve come from?
• Producer choices
Basic Assumptions
• Consumers face budget constraints
• Consumers are rational (maximize
satisfaction)
• Consumers are fully informed
• There is no saving or borrowing, only
buying
Consumer Theory Road Map • The things that you can afford to buy
• Consumption Possibilities • Limited by income and the prices
• Budget line
Example: Sweaters and Jeans
• Prices and income
• Income=300
• Preference: Describe what consumers like?
• Price of Sweaters=$25
• Consumer Choice
• Price of Jeans=$50
• How do consumers choose what to buy and how much to
What are the combinations of sweaters and jeans
buy?
you can afford to buy?
• Best affordable choice
• 12 sweaters
• 6 jeans
• 4 sweaters and 4 jeans
Budget line=limits of consumption possibilities Discussion Question: Budget line
Negative
Income=300, Price of
slope?
Sweaters=$25, Price of
Equation?
Jeans=$50
12 0 Jeans y=12-2x
Sweaters
What does
8 Sweaters 2 Jeans the slope
represent?
4 Sweaters 4 Jeans Price of
Jeans/Price
0 Sweaters 6 Jeans
of Sweaters
Discussion Question: Budget line UTILITY
Income=300 Price of Taste and preferences: Like and dislike
Sweaters=$25 Price of
Jeans=$50 • How do consumers rank two products?
• The price of a sweater • A consumer prefers good A to good B
doubles • If the consumer is more
• Or your income falls to $150 satisfied with A than with B
a month • A consumer prefers good B to good A
• Or both the price of a • A consumer is indifferent between A
sweater and a pair of jeans and B
double • If the consumer is equally
satisfied with A or B
Utility Total utility Marginal Utility
• Benefit or satisfaction from The change in total utility
consuming a good or service that results from a unit-
is called utility increase in the quantity of
• Total Utility the good consumed
• Total benefit a person
gets from the Increasing or diminishing
consumption of marginal utility?
goods
• Generally, more consumption Negative Marginal Utility?
results in more total utility
From total utility to marginal utility How to represent preference in graph?
• Indifference Curve
• For simplicity, our consumption basket only has
sweaters and jeans
845
Basket A: 6 sweaters and 3 pairs of jeans
Basket B: 4 sweaters and 5 pairs of jeans
How to represent preference in graph? Indifference Curve
• Indifferent between
• A: 6 sweaters + 3 pairs of jeans
• B: 4 sweaters + 5 pairs of jeans
A Common Assumption: More is Better
• Consumers like both goods
E.g., 2 sweaters + 3 pairs of jeans 1 sweater + 3 pairs of jeans
E.g., 2 sweaters + 3 pairs of jeans 2 sweaters + 2 pairs of jeans
E.g., 2 sweaters + 3 pairs of jeans 1 sweater + 1 pair of jeans
What can we gain from this assumption?
Indifference Curves are Downward Sloping Which baskets are preferred/less preferred to A?
Higher indifference curve, higher satisfaction Preference Map
Special Preferences Example of Perfect Substitutes: iPhones
• Perfect substitutes
• Indifference curves are linear
• Perfect complements
• Indifference curves are L-shaped
Example of Perfect Substitutes
• “White iPhones and black iPhones are equivalent”
• 1 white iPhone always brings the same level of satisfaction
as 1 black iPhone
• To the consumer, white iPhone and black iPhone are
perfect substitutes
Example of Perfect Complements Example of Perfect Complements: Shoes
• “For every right shoe, I need exactly one left shoe”
• 2 right shoes and 1 left shoe brings the same level of
satisfaction as 1 right shoe and 1 left shoe
• To the consumer, right shoes and left shoes are perfect
complements
Discussion Question: Shin-chan’s indifference curve?
• Shin-chan hates “green pepper” but likes “hamburger”
• The satisfaction from 2 hamburgers exactly offsets the
dissatisfaction from 1 green pepper
• Draw one indifference curve for Shin-chan starting from
the origin
CONSUMER CHOICE
Finding the best affordable basket from the Graph Conditions for best affordable basket
• On the budget line
• On the highest attainable indifference curve
Utility-Maximizing Choice: Total Utility
• Consumption possibility that maximizes total utility
• The direct way to find the utility-maximizing choice
1. Find the just-affordable combinations
2. Find the total utility for each just-affordable
combination
3. The utility-maximizing combination is the
consumer’s choice
Find Just-Affordable Combinations Discussion Question: Find the Total Utility for Each
• Income=300, Price of Sweaters=$25, Price of Jeans=$50 Just-Affordable Combination (page 39 for total utility)
• Combinations of sweater and jeans you can afford to buy?
A more natural way: Choosing at the Margin Equal Marginal Utility per Dollar
• The marginal utility per dollar MUs MU J
• The marginal utility from a good divided by its price • >¿ , buy more sweaters and less
Ps PJ
jeans
MUs MU J
• <¿ , buy more jeans and less
Ps PJ
sweaters
MUs MU J
• =¿
Ps PJ
Why does the demand curve have a negative slope?
Discussion Question: Where is the point on the demand Summary
curve for jeans? • Changes in prices and income change the best
affordable choices
Wrap it up Part 1
• Assuming that Grove decides to increase the price of
its Kopi from $1 to $3, and that results in a 20%
decrease in demand, Calculate the price elasticity of
demand for Kopi.
20%/100% = 0.2
• What would the demand curve look like if the
increase in price, does not cause a change in
demand?
Wrap it up Part 2
• “For every right shoe, I need exactly one left shoe”
• Income=$1800
• The price of left shoe=$300, the price of right
shoe=$600
• What is the best affordable choice?
Discussion Question: Best affordable choice for perfect
complements
• What would the demand curve look like if the
increase in price, results in an infinite decrease in
demand?
KEY IDEAS FOR LECTURE 3
• The price elasticity of demand is a measure of the responsiveness of the
quantity demanded of a good to a change in its price
• The buyer’s problem has three parts: what you like, prices, and your
budget
• An optimizing buyer makes decisions at the margin
• An individual’s demand curve reflects an ability and willingness to pay for
a good or service