Chapter 5

Market Demand
& Elasticity

© 2004 Thomson Learning/South-Western

 Market Demand Curve

The market demand is the total quantity of a good or

service demanded by all potential buyers.

The market demand curve is the relationship

between the total quantity demanded of a good or
service and its price, holding all other factors constant.

2
 Construction of the Market Demand
Curve

The market demand curve is constructed by

horizontally summing the demands of the individual
consumers

Assume the market consists of only two buyers as

shown in Figure 4.1
– At any given price, such as P*X, individual 1 demands X*1
and individual 2 demands X*2.

3
 FIGURE 4.1: Constructing a Market Demand
Curve from Individual Demand Curves

PX PX PX

P*
X

0 X* 0 X* 0 X* X
1 2

(a) Individual 1 (b) Individual 2 (c) Market Demand

4
 Shifts in the Market Demand Curve

To discover how some event might shift a market

demand curve, we must first find out how this event
causes individual demand curves to shift and then
compare the horizontal sum of these new demand
curves with the old demand curve.

5
 FIGURE 4.2: Increases in Each individual’s Income Cause
the Market Demand Curve to Shift Outward

PX PX PX D’
D

P*
X

0 X* X** 0 X* X** 0 X* X** X

1 1 2 2

(a) Individual 1 (b) Individual 2 (c) Market Demand

6
 Shifts in the Market Demand Curve

However, some events result in ambiguous outcomes.

– If one consumer’s demand curve shifts out while
another’s shifts in, the net effect depends on the size of
the relative shifts.

An increase in income for pizza lovers would increase

the market demand for pizza so long as it is a normal
good.

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 Shifts in the Market Demand Curve

If goods X and Y are substitutes, an increase in the

price of Y will increase the demand for X. Similarly,
a decrease in the price of Y will decrease the demand
for X.

If goods X and Y are complements, an increase in the

price of Y will decrease the demand for X. A decrease
in the price of Y will increase the demand for X.

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 APPLICATION 4.1: Consumption and
Income Taxes

 People’s ability to purchased goods and services is

dependent upon their after tax income.

 In the 1950’s Milton Friedman argued that people’s

consumption decisions are based mostly on their
long-term (permanent) income.

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 APPLICATION 4.1: Consumption and
Income Taxes

 One implication of the permanent-income

hypothesis is that temporary tax changes will have
little effect on the demand for consumption goods
– This prediction is supported by the small impact on
consumption by both the temporary tax surcharge during
the Nixon administration and the Ford administration’s
temporary income tax rebate

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 Bandwagon Effect

The bandwagon effect is a psychological phenomenon

in which people do something primarily because other
people are doing it, regardless of their own beliefs,
which they may ignore or override.
For example, people might buy a new electronic item because of its
popularity, regardless of whether they need it, can afford it or even really
want it.
The desire or demand for wearing jeans by girls is influenced by the number
of other girls who have chosen to wear them.

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 Example of Bandwagon Effect

12
 Snob Effect

The snob effect is a phenomenon described in

microeconomics as a situation where the demand for a
certain good by individuals of a higher income level is
inversely related to its demand by those of a lower
income level. as a result of snob effect, the quantity
demanded of the good falls as more people are
believed to own it.

13
 Example of Snob Effect

14
 Veblen Effect

Veblen goods are types of luxury goods for which the

quantity demanded increases as the price increases, an
apparent contradiction of the law of demand, resulting
in an upward-sloping demand curve.

15
 Example of Veblen Effect

16
 A Word on Notation and Terms

 When looking at only one market, Q is used for the

quantity of the good demanded, and P is used for its
price.
 When drawing the demand curve, all non-price
factors are assumed to not change.
 Movements along the curve are changes in quantity
demanded, while shifts are changes in demand.

17
 Elasticity

Goods are often measured in different units (steak is

measured in pounds while oranges are measured in
dozens).

It can be difficult to make simple comparisons

between goods when trying to determine which is
more responsive to changes in price.

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 Elasticity

 Elasticity is a measure of the percentage change in

one variable brought about by a 1 percent change in
some other variable.

 Since it is measured in percentages, the units cancel

out so that it is a unit-less measure of
responsiveness.

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 Price Elasticity of Demand

The price elasticity of demand is the percentage change

in the quantity demanded of a good in response to a 1
percent change in its price
– Consumers’ responsiveness to a change in price
– Percentage change in quantity demanded divided by percentage
change in price

Percentage change in Q
Price elasticity of demand  eQ , P 
Percentage change in P

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 Example

If the price of Good X drops from

$1.10 $1.10 to $0.90, the quantity
demanded increases from 95,000 to
0.90 105,000.
Price per taco

0 95 105 Thousands per day

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 Categories of Elasticity

 If %∆q < %∆p

– ED between 0 and 1
– Inelastic D
 If %∆q > %∆p
– ED greater than 1
– Elastic D
 If %∆q = %∆p
– ED = 1
– Unit elastic D

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 Types of Elasticity
 Perfectly Elastic Demand
 Perfectly Inelastic Demand
 Relative Elastic Demand
 Relatively Inelastic Demand
 Unit Elastic Demand

24
 Perfectly Elastic Demand

When a small change in price of a product causes a major change in its

demand, it is said to be perfectly elastic demand. In perfectly elastic
demand, a small rise in price results in fall in demand to zero, while a small
fall in price causes increase in demand to infinity.

25
 Perfectly Inelastic Demand

A perfectly inelastic demand is one when there is no change

produced in the demand of a product with change in its price.

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 Relative Elastic Demand

The demand is relatively elastic when the proportionate change in the demand for a
commodity is greater than the proportionate change in its price. Mathematically,
relatively elastic demand is known as more than unit elastic demand (ep>1). For
example, if the price of a product increases by 20% and the demand of the product
decreases by 25%, then the demand would be relatively elastic.

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 Relatively Inelastic Demand

Relatively inelastic demand is one when the percentage change produced in demand
is less than the percentage change in the price of a product. For example, if the price
of a product increases by 30% and the demand for the product decreases only by
10%, then the demand would be called relatively inelastic. The numerical value of
relatively elastic demand ranges between zero to one (ep<1).

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 Unit Elastic Demand

When the proportionate change in demand produces the same change in the
price of the product, the demand is referred as unitary elastic demand. The
numerical value for unitary elastic demand is equal to one (ep=1)

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 TABLE 4.1: Terminology for the
Ranges of eQ,P

Value of eQ,P at a Point Terminology for Curve

on Demand Curve at This Point
eQ,P < -1 Elastic

eQ,P = -1 Unit elastic

eQ,P > -1 Inelastic

30
 Price Elasticity and the Shape of the
Demand Curve

 We often classify market demand curves by their

elasticities
– For example, the market demand curve for medical
services is inelastic (nearly vertical) since there is little
quantity response to changes in price.

– Alternatively, the market demand curve for a single

type of candy bar is very responsive to price change
(nearly flat) and is very elastic.

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 Formula of Price Elasticity of Demand

2 B

E
1

G
.50

0 2 6 10 Q

32
 Point Elasticity of Demand
ARC elasticity of Demand

2 B

E
1

G
.50

0 2 6 10 Q
33
 Price Elasticity Graphically
P
A
2 B

K E
1

G
Dx
.50
J H
0 2 6 10 12 Q

34
 Exercise

1. Measure graphically the price elasticity of demand curve

Dx in the left panel of Figure Above.
a) At point B
b) At point G
2. Prove that = ∞ & = 0 at point A & H sequentially on Dx
Curve in the same figure above.

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 Demand Curve Rectangular Hyperbole
P
4

2 B

1 E

.5 G D

L J H N
36 0 3 6 12 24 Q
 Price Elasticity and the
Substitution Effect

 Goods which have many close substitutes are

subject to large substitution effects from a price
change so their market demand curve is likely to be
relatively elastic.
 Goods with few close substitutes, on the other hand,
will likely be relatively inelastic.

37
 APPLICATION 4.2: Brand Loyalty

 Substitution due to price changes will likely

take a longer time if individual’s develop
spending habits.
 Such brand loyalties are rational since they
reduce decision making costs.
 Over the long term, however, price differences
may cause buyers to try other brands.

38
 Price Elasticity and Total
Expenditures

 Total expenditures on a good are found by

multiplying the good’s price (P) times the quantity
purchased (Q).
 When demand is elastic, price increases will cause
total expenditures to fall.
– The given percentage increase in price is more than
counterbalanced by the decrease in quantity demanded.

39
 Price Elasticity and Total
Expenditures

 Of course, when demand is elastic and prices

fall, total expenditures increase.
 With unit elasticity, total expenditures remain
the same with a price change.
– The movement in one direction by the price is fully
offset by the movement in the other direction with
the quantity demanded.

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 TABLE 4.2: Relationship between Price
Changes and Changes in Total Expenditure

In Response to an In Response to a
Increase in Price, Decrease in Price,
If Demand Is Expenditures will Expenditures will
Elastic Fall Rise

Unit elastic Not change Not change

Inelastic Rise Fall

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 APPLICATION 4.3: Volatile Farm Prices

 The demand for many basic agricultural

products (wheat, corn, etc.) is relatively
inelastic.
 Even modest changes in supply, brought about
by weather patterns, can have large effects on
crop prices.

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 Demand Curves and Price Elasticity

 The relationship between a particular demand

curve and the price elasticity it exhibits can be
complicated.
 For some curves, the elasticity remains
constant everywhere, but for others it is
different at every point.
 A more accurate way to describe it would be to
say the elasticity is for current prices.

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 Linear Demand Curves and Price
Elasticity

 The price elasticity of demand is always

changing along a straight line demand curve.
– Demand is elastic at prices above the midpoint
price.
– Demand is unit elastic at the midpoint price.
– Demand is inelastic at prices below the midpoint
price.

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 FIGURE 4.3: Elasticity Varies along a
Linear Demand Curve
Price
(dollars)
50

40

30
25 Demand
20

10

0 20 40 50 60 80 100 Quantity of tape

45 players per week
 TABLE 4.3: Price, Quantity, and Total
Expenditures on Walkmans for the Demand
Function Q = 100 - 2P

Price (P) Quantity (Q) Total Expenditures (P  Q)

$50 0 $0
40 20 800
30 40 1,200
25 50 1,250
20 60 1,200
10 80 800
0 100 0

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 Elasticity of a Straight Line Demand
Curve

 More generally, for a linear demand curve of

the form Q = a - bP,
Q
Q Q P
eQ ,P   
P P Q
P
P
eQ ,P  b  .
Q
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 A Unitary Elastic Curve

 Suppose the demand for tape players took the

form
1,200
Q
P
• The graph of this equation, shown in Figure 4.4,
is a hyperbola.
• P·Q = $1,200 regardless of price so demand is
unit elastic (-1) everywhere on the curve.
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 General Formula for the Elasticity
of a Hyperbola

 If the demand curve takes the following form,

the price elasticity of demand is equal to b
everywhere on the curve.

Q  aP (b  0)
b

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 FIGURE 4.4: A Unitary Elastic
Demand Curve

Price
(dollars)

60
50
40
30
20

20 24 30 40 60 Quantity of
tape players
per week

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 Income Elasticity of Demand
 The income elasticity of demand equals the
percentage change in the quantity demanded of
a good in response to a 1 percent change in
income.
 The formula is given by (where I represents
income):
Percentage change in Q
eQ , I  .
Percentage change in I

51
 Income Elasticity of Demand

 For normal goods, eQ,I is positive because

increases in income lead to increases in
purchases of the good.
 For inferior goods eQ,I is negative.
 If eQ,I > 1, the purchase of the good increases
more rapidly than income so the good might be
called a luxury good.

52
 APPLICATION 4.4: An Experiment in
Health Insurance

 Most developed countries have some form of

national health insurance.
– In the U.S. Medicare covers the elderly and
Medicaid is available for many of the poor.
 Recently a number of comprehensive
government health plans have been proposed.

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 The Moral Hazard Problem

 A “moral hazard” problem occurs because

insurance misleadingly lowers the out-of-
pocket expenses to patients, greatly increasing
their demand for medical services.
 An important question, in considering
implementing national health insurance is how
large an increase is likely to develop?

54
 The Rand Experiment

 A rough estimate of the elasticity of demand

can be obtained by averaging the percentage
changes across the various plans in Table 1

% change in Q  12
e    0.18
% change in P  66

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 Low Elasticities for Hospital and
Doctors’ Visits

 Using the estimate of -0.22 found in Table 4.4,

and based on other studies suggests only a
small increase in hospital and doctor visits
would result from the lower prices provided by
insurance.
 Alternatively, researchers have found greater
elasticities (around -0.5) for dental care and
outpatient mental health care.

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 Cross-Price Elasticity of Demand

 The cross-price elasticity of demand

measures the percentage change in the
quantity demanded of a good in response to a
1 percent change in the price of another good.
Letting P’ be the price of another good,

Percentage change in Q
eQ ,P  .
Percentage change in P'
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 Cross-Price Elasticity of Demand

 If the goods are substitutes, an increase in the

price of one will cause buyers to purchase
more of the substitute, so the elasticity will be
positive.
 If the goods are complements, an increase in
the price of one will cause buyers to buy less
of that good and also less of the good they
use with it, so the elasticity will be negative

58
 Empirical Studies of Demand:
Estimating Demand Curves

 Estimating a demand curve for a product is one

of the more difficult but important problems in
econometrics.
 Empirical studies are useful because they a
provide a more precise estimate of the amount
of change in quantity demanded that results
due to a price change.

59
 Problems Estimating Demand
Curves

 The first problem is how to derive an estimate

holding all other factors (the ceteris paribus
assumption) constant.
 This problem is often solved, as discussed in
the Appendix to Chapter 1, by the use of
multiple regression analysis.

60
 Problems Estimating Demand
Curves

 The second problem deals with what is

observed in the data. The data points
represent quantity and price outcomes that are
simultaneously determined by both the
demand and the supply curves.
 The econometric problem is to “identify” from
these equilibrium points the demand curve that
generated them.

61
 Some Elasticity Estimates

 Table 4.4 gathers a number of estimated

income and price elasticities of demand.
 Some things to note
– All of the estimated price elasticities are less than
zero as predicted by a negatively sloped demand
curve.
– Most of the price elasticity estimates are inelastic.

62
 TABLE 4.4: Representative Price and
Income Elasticities of Demand
Price Elasticity Income Elasticity
Food -0.21 +0.28
Medical services -0.22 +0.22
Rental housing -0.18 +1.00
Owner-occupied
housing -1.20 +1.20
Electricity -1.14 +0.61
Automobiles -1.20 +3.00
Beer -0.26 +0.38
Wine -0.88 +0.97
Marijuana -1.50 0.00
Cigarettes -0.35 +0.50
Abortions -0.81 +0.79
Transatlantic air travel -1.30 +1.40
Imports -0.58 +2.73
Money -0.40 +1.00
63
 Some Elasticity Estimates

 The income elasticities of automobiles and

transatlantic travel exceed 1 (luxuries).
 The high income elasticities are balanced by
goods such as food and medical care which
are less than 1 (necessities).
 There is no evidence of Giffen’s paradox in the
table.

64
 Some Cross-price Elasticity
Estimates

 Table 4.5 shows a few cross-price elasticity

estimates
 All of the goods appear to be substitutes and
have positive cross-price elasticities.

65
 TABLE 4.5: Representative Cross-Price
Elasticities of Demand

Demand for Effect of Price of Elasticity Estimate

Butter Margarine 1.53

Electricity Natural gas 0.50

Coffee Tea 0.15

66
 Application 4.5: Alcohol Taxes as
Drunk Driving Policy

 Each year more than 40,000 Americans die in

automobile accidents.
 It is generally believed that alcohol
consumption is a major contributing factor in at
least half of those accidents.
 Most empirical studies of alcohol consumption
show that it is sensitive to price.

67
 Application 4.5: Alcohol Taxes as
Drunk Driving Policy

 The figures in Table 4.4 suggest that these

elasticities range from approximately –0.3 for
beer to perhaps as large as –0.9 for wine.
 Most teenage alcohol consumption is beer.
 The lower price elasticity of demand for beer
poses a problem for those who would use
alcohol taxes as a deterrent to drunk driving.

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