CHAPTER 4, SECTION 1

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2 DAILY LECTURE CHAPTER 4, SECTION 1 Understanding Demand What Is Demand? Demand is the willingness and ability of buyers to purchase different quantities of a good, at different prices, during a specific time period. Both willingness and ability must be present; if either is missing, there is no demand. Quantity demanded is different from demand. Quantity demanded is the number of units of a good purchased at a specific price. Quantity demanded is always a number. The Law of Demand The law of demand tells us what happens to the quantity demanded when the price changes. (See Transparency 4-1.) Basically, it says that when the price goes up, the quantity demanded goes down and when the price goes down, the quantity demanded goes up. Do you notice anything about the relationship between price and quantity demanded? They move in opposite directions. Why is the law of demand important, and what does it mean to you? It shows that you, and other consumers, are willing to purchase fewer goods as the price goes up. And it shows that you are willing to purchase more goods as the price goes down. 64

3 The Law of Diminishing Marginal Utility Why does the law of demand work the way it does? Economists say it is because of the law of diminishing marginal utility. This is an interesting idea that sounds more difficult to understand than it is. Let s break the term down. (See Transparency 4-2.) Diminishing simply means declining or decreasing. Whatever we are talking about, if it is diminishing, it s going down. Marginal is the economist s word for additional. If we are at a certain point, and then we add more, the more is marginal. Utility means that something has value or use to us, that the something gives us satisfaction. So, the law of diminishing marginal utility says that as a person consumes additional units of a good, eventually, the utility gained from each additional unit of the good decreases. The Law of Demand in Numbers and Pictures We can actually show how the law of demand works by listing prices and quantities demanded in a table, and by plotting those numbers in a graph. In economics, such a table is called a schedule and such a graph is called a curve. (See Transparency 4-3.) Since we re looking at demand here, the table is a demand schedule and the graph is a demand curve. The demand curve is the line that connects the plotted points on the graph. In this example, the curve is actually a straight line. CHAPTER 4, SECTION 1 65

4 Do you see how the table works? At a price of $3, what is the quantity demanded? (Answer: Two.) What is the quantity demanded at $1? (Answer: Four.) Now look at the graph. At a price of $3, what is the quantity demanded? Find $3 on the vertical axis, and follow the dotted black line over to where it meets the solid red line, which is the demand curve. The place where the two lines intersect is point B. Follow the dotted black line from point B down to the horizontal axis. What is the quantity demanded? (Answer: Two, just as it was in the demand schedule.) Now find the quantity demanded at a price of $1. (Answer: Four.) Individual and Market Demand Curves One final point: We can look at individual or market demand curves; these are different. An individual demand curve represents one person s demand for a good. A market demand curve is the sum of all the individual demand curves for a good. CHAPTER 4, SECTION 1 66

5 DAILY LECTURE CHAPTER 4, SECTION 2 The Demand Curve Shifts When Demand Changes, the Curve Shifts Demand can change. It can go up, or it can go down. Economists show changes in demand on graphs the demand curves that we learned about in the last lesson. When demand goes up, the demand curve shifts to the right. When demand goes down, the demand curve shifts to the left. (See Transparency 4-4.) In the graph you see here, the demand curve in the middle, the one labeled D 1, is the starting point. On this curve, what is the quantity demanded at a price of $1? (Answer: Four hundred quarts of orange juice.) Suppose that the demand for orange juice increases to 600 quarts. People still want to pay $1 per quart, but now they want to buy more at that price. What happens to the demand curve? (Answer: It shifts to the right and becomes D 2.) When demand goes up, the demand curve shifts to the right. Now suppose that the demand for orange juice decreases to 200 quarts. What happens to the demand curve? (Answer: It shifts to the left and becomes D 3.) When demand goes down, the demand curve shifts to the left. 67

6 Notice that in all these examples, the price stays the same. When the quantity demanded goes up, at the same price, the curve shifts to the right. When the quantity demanded goes down, at the same price, the curve shifts to the left. What Factors Cause Demand Curves to Shift? Five factors cause demand curves to shift: Income. As a person s income changes, he or she may buy more or less of a certain good. If a person s income and demand change in the same direction, the good is a normal good. If income and demand go in opposite directions, the good is an inferior good. If demand does not change even though income does, the good is a neutral good. Preferences. Changes in preferences cause changes in demand. Prices of related goods. When two goods are substitutes, the demand for one moves in the same direction as the price of the other. When two goods are complements, the demand for one moves in the opposite direction of the price of the other. Complements are goods used together. Number of buyers. A change in the number of buyers, either an increase or a decrease, can change demand. Future price. Buyers expectations of future prices can cause them to buy now or wait to buy. Both actions affect current demand. CHAPTER 4, SECTION 2 68

7 The only factor that affects quantity demanded is price. Remember: Demand and quantity demanded are not the same thing. CHAPTER 4, SECTION 2 69

8 DAILY LECTURE CHAPTER 4, SECTION 3 Elasticity of Demand What Is Elasticity of Demand? Elasticity is another term in economics that sounds more difficult to understand than it really is. It measures how a price change affects the quantity of a particular good that people want to buy. Demand for a good can be elastic, inelastic, or unit-elastic. Elastic means that a price change has a significant impact on the quantity demanded. Inelastic means that there is a minor change in quantity demanded when the price changes. And unit-elastic means that the impact of a price change is neutral that is, neither major nor minor. (See Transparency 4-5.) How do we find out which type of demand is at work? In all cases, the type of demand has to do with the relationship between the percentage change in quantity demanded and the percentage change in price. When we divide the percentage change in quantity demanded by the percentage change in price, we get a number that is greater than 1, less than 1, or exactly 1. If the answer to our division problem is greater than 1, the demand is elastic; if the answer is less than 1, the demand is inelastic; if the answer is exactly 1, the demand is unit-elastic. 70

9 Let s look at some examples to see how we determine elasticity of demand. (See Transparency 4-6.) Suppose the quantity demanded goes down by 15 percent and the price goes up by 10 percent. We divide 15 percent by 10 percent and get 1.5. Is this number greater than or less than 1? It s greater than 1, so the demand is elastic. Now let s say that the quantity demanded goes down by 5 percent and the price goes up by 10 percent. We divide 5 percent by 10 percent and get 0.5. The answer is five-tenths, or one-half, so it s less than 1, which means the demand is inelastic. Finally, let s say that the quantity demanded goes down by 10 percent and the price goes up by 10 percent. We divide 10 percent by 10 percent and get 1. One is obviously equal to 1, so the demand is unit-elastic. To summarize: If the answer is greater than 1, the demand is elastic, which means that a relatively small price change has a big impact on the quantity demanded. If the answer is less than 1, the demand is inelastic, which means that the price change has little impact on the quantity demanded. And finally, if the answer is exactly 1, the changes in price and quantity demanded are the same, and therefore the impact is neutral. CHAPTER 4, SECTION 3 71

10 What Determines Elasticity of Demand? Four factors affect the elasticity of demand: Number of substitutes. When there are few substitutes for a good, the quantity demanded is unlikely to change much if the prices rises. Therefore, the demand for the good is likely to be inelastic. When there are many substitutes for a good, the opposite is true: the demand tends to be elastic. Luxuries versus necessities. Demand for necessities tends to be inelastic because people need those goods even if price rises. Demand for luxuries tends to be elastic because people will often do without thoses goods if price rises. Percentage of income spent on the good. If a good requires a large percentage of a person s income, demand for it tends to be elastic. Demand for goods that require a small percentage of a person s income tends to be inelastic. Time. When consumers have little time to respond to a price change, demand is usually inelastic. When they have more time to respond, demand is usually elastic. Relationship Between Elasticity and Revenue Elastic demand and an increase in price lead to a decrease in total revenue. Elastic demand and a decrease in price lead to an increase in total revenue. Inelastic demand and an increase in price lead to an increase in total revenue. Inelastic demand and a decrease in price lead to a decrease in total revenue. CHAPTER 4, SECTION 3 72