ECON 308

Week 3

September 14, 2012

Chapter 4

Review

• Markets are the interaction of buyers and sellers.

• Focus on buyers and sellers separately.

• Ceteris paribus: look at one thing at a time; All other things held equal.

$ P x

$ 10 $ 9 $ 8 $ 7 $ 6 $ 5 $ 4 $ 3 $ 2 $ 1

1 2 3 4 5 6 7 8 9 10

Demand x

Demand shows the amounts purchased at alternative prices (horizontal distances at each price)

Qtyx /T

Dx

Dx

Demand for X

Supply Curve$Price

$10

8

6

4

2

2 4 6 8 10 12 14 16 Qty x/ T

$Price

$ 4

3

2.50

2.00

1.50

1.00

.50

.25

100 200 300 400 500 600 700 800 900 1000 1100 Q x/ T

Demand

Supply

Surplus at this $ Price

$Price

$ 4

3

2.50

2.00

1.50

1.00

.50

.25

100 200 300 400 500 600 700 800 900 1000 1100 Q x/ T

Demand

Supply

Shortage at this $ Price

$Price

4

3

2.50

2.00

1.50

PePe 1.00

.50

.25

100 200 300 400 500 600 700 800 900 1000 1100 Q x/ T QeQe

Demand Supply

Market EquilibriumMarket Equilibrium

Qty D = Qty S

$ P x

$ 10 $ 9 $ 8 $ 7 $ 6 $ 5 $ 4 $ 3 $ 2 $ 1

1 2 3 4 5 6 7 8 9 10 11 12 Qtyx /T

SupplyDo

Do

Sx

Effects of Increase in Demand on Price and Quantity

Increases Price and Quantity

Pe

Qe

D1

D1

$ P x

$ 10 $ 9 $ 8 $ 7 $ 6 $ 5 $ 4 $ 3 $ 2 $ 1

1 2 3 4 5 6 7 8 9 10 11 12 Qtyx /T

Demand

DxS0

Effects of an Increase in Supply on Price and Quantity

Price decreases and Quantity increases

Pe

Qe

S0

S1

S1

$ P x

$ 10 $ 9 $ 8 $ 7 $ 6 $ 5 $ 4 $ 3 $ 2 $ 1

1 2 3 4 5 6 7 8 9 10 11 12 Qtyx /T

SupplyDemand

Dx

Pe

Qe

Total Revenue = P X Q

$6x5 = $30

A B

PxPx

Qx/T Qx/T

P0

Q0

P0

Q0

Slope of Supply Shows responsiveness of quantity to a change

in Price

P1

Q1

P1

Q1

Slope Shows Responsiveness of Quantity to a Change in Price

A B

Px Px

Qx/T Qx/T

P0 P0

Dx

Dx

Q0Q1 Q0

P1P1

Q1

Elasticity: a Measure of responsiveness of Quantity to a Change in Price

• Ed = % Δ Qd/ % Δ price

• Es = % Qs / % price

Measures of Elasticity

• Demand is ElasticElastic : %Δ Qd > %Δ P;

ie |Ed| >1. A decrease in Price an increase in Total Revenue.

• Demand is Unitary ElasticUnitary Elastic: %ΔQd = %ΔP;

ie |Ed| = 1. A Change in price no change in Total Revenue.

• Demand is InelasticInelastic: %ΔQd < %ΔP;i.e. |Ed| < 1. An increase in Price an increase in Total Revenue.

Elasticity, Price Change & Total Revenue

$Px $PxElastic

Inelastic

Q1Qty/T

P0

P1

Q0

P1

P0

Q0Q1

Increased Demand with elastic Supply$ P x

$ 10 $ 9 $ 8 $ 7 $ 6 $ 5 $ 4 $ 3 $ 2 $ 1

1 2 3 4 5 6 7 8 9 10 11 12 Qtyx /T

Sx

Dx

Dx

Sx

Pe

Qe

Dx`

Qe`

Pe`

$ P x

$ 10 $ 9 $ 8 $ 7 $ 6 $ 5 $ 4 $ 3 $ 2 $ 1

1 2 3 4 5 6 7 8 9 10 11 12 Qtyx /T

SxDx

Dx

Sx

Pe

Qe

Dx’

Qe’

Pe’

Increased Demand , Inelastic Supply

Decrease in Supply, Elastic Demand$ P x

$ 10 $ 9 $ 8 $ 7 $ 6 $ 5 $ 4 $ 3 $ 2 $ 1

1 2 3 4 5 6 7 8 9 10 11 12 Qtyx /T

SxDx

Dx

Sx’

Pe

QeQe`

Pe`

$ P x

$ 10 $ 9 $ 8 $ 7 $ 6 $ 5 $ 4 $ 3 $ 2 $ 1

1 2 3 4 5 6 7 8 9 10 11 12 Qtyx /T

SxDx

Dx

Sx’

Pe

QeQe’

Pe’

Decrease in Supply, Inelastic Demand

Determinants of Price Elasticity of Demand

• Number & Closeness of Substitutes.

• Information about price change and availability of substitutes.

• Percentage of Income Spent on good.

• Period of time: Second Law of DemandSecond Law of Demand: Demand is more elastic over a longer period of time.

Other Elasticity's

A Measure of responsiveness of Quantity to a Change in some other factor

Income Elasticity: Measure of responsiveness of Quantity to a Change in Income

• EdI = % Δ Qd/ % Δ income

• EdI = 100 * ΔQ/Q = I * ΔQ

100 * ΔI/I Q * ΔI

• Normal Goods: Positive

• Clothing: .95: 10% income → 9.5%

• Stereo: 27.2: 10% income → 27.2%

• Increase may be Quantity or Quality

• Inferior Goods: Negative

Cross Price Elasticity: Measure of responsiveness of Quantity to a Change Price of other good

• Exy = % Δ Qx/ % Δ Py

• EdI = 100 * ΔQx/Qx = Py * ΔQx

100 * ΔPy/Py Qx * ΔPy

• Substitutes: Positive

• Complements: Negative

Uses of Cross Price Elasticity

• Magnitude of cross price elasticity reflects closeness of substitutes or complements

• Able to identify your closest competitors

• Courts use cross-price to measure monopoly power

Network Effects

• Bandwagon: Demand for a good increases as the number of users of the good increases– fax machines– High Definition DVD versus Blu-Ray

Snob: Demand for a good decreases as the number of users of the good increases

4-25

Product Attributes

• Managers must understand consumer demand

• What product attributes are important to consumers?– price– product design– packaging– promotion

4-26

Product Life Cycle

Time

Indu

stry

qu

antit

y of

out

put

Introduction

Product life cycle

Maturity DeclineGrowth

T

Q

4-27

Demand Estimation

• Three general techniques– interviews

• surveys, focus groups, questionnaires

– price experimentation• track changes in sales when prices change

– statistical analysis• must account for omitted variables and other issues

4-28

Omitted Variables Problem 

2006 2007 2008

Income (I) $3,000 $4,000 $3,500

Advertising (A) 2 3 2.5

Price (P) 10 10 10

Sales (S) 236 284 260

True demand S=120-2P+8A+0.04I

Estimated demand S=140+48A

4-29

Estimating DemandThe Identification Problem

Pric

e (in

dol

lars

)

Quantity

Estimated demand

$

Q

S1

S2

S3

D1

D2

D3

Q1 Q2 Q3

P1

P2

P3

Three differentequilibriums are notmapping out the demand curve

4-30

Transaction Costs of Exchange

• Information Costs– Search Costs– Quality Identification Cost

• Negotiating Costs: Cost of agreeing on what and how much will be exchanged

• Transportation Costs: Cost of moving goods between parties

31