Chapter 4 Consumer Decision Making and Consumer Reaction to Price Changes Learning Objectives Distinguish between total and marginal utility. Distinguish between elastic and inelastic demand. Define the price elasticity of demand and state the formula for measuring it. List and describe three determinants of the price elasticity of demand. Explain the relationship between price elasticity of demand and consumer expenditures. Copyright 2005 Pearson Addison-Wesley. All rights reserved. 4-2 If It Doesn t Have Utility, You Won t Buy It Everything for which you have a demand must generate satisfaction. Another way of describing satisfaction is utility, defined as want -satisfying power. The concept of utility is purely subjective. Measuring Utility In order to understand utility better, we arbitrarily define units of utility as utils. A util is an abstract concept that is defined as a representative unit by which utility is measured. Copyright 2005 Pearson Addison-Wesley. All rights reserved. 4-3 Copyright 2005 Pearson Addison-Wesley. All rights reserved. 4-4 1
Of Total and Additional Utility By definition, everything that you consume gives you some amount of satisfaction, or utility. If you watch ten movies a month, you get a certain amount of total utility from that activity over the month. Of Total and Additional Utility (cont.) But what about the additional utility you receive when you see another movie? We call this additional utility marginal utility, for which the word marginal means additional or incremental. Copyright 2005 Pearson Addison-Wesley. All rights reserved. 4-5 Copyright 2005 Pearson Addison-Wesley. All rights reserved. 4-6 Figuring Out Marginal Utility Diminishing Marginal Utility Marginal utility is the change in total utility as you increase your consumption rate. Assume your total utility from consuming two units of a given item is 16 utils, and your total utility from consuming three units is 19 utils. Then, the marginal utility of consuming the third unit is 19 minus 16, or 3 utils. According to the law of diminishing marginal utility, after you consume a good or service, the marginal utility you receive for yet more of that same good or service will start falling. Copyright 2005 Pearson Addison-Wesley. All rights reserved. 4-7 Copyright 2005 Pearson Addison-Wesley. All rights reserved. 4-8 2
Measuring Consumer Responsiveness If the price of salt goes down 50 percent, how much more salt would you purchase in a year? Probably not very much. In contrast, if you normally buy fast food dinners, and the price of fast food were to drop by 50 percent, you would probably increase the number of fast-food dinners you buy quite a bit. The Price Elasticity of Demand The official term for consumer responsiveness to price changes is price elasticity of demand. If consumers react a lot to a given percentage change in price, we say they have an elastic demand. If they do not react very much, we say they have an inelastic demand. Copyright 2005 Pearson Addison-Wesley. All rights reserved. 4-9 Copyright 2005 Pearson Addison-Wesley. All rights reserved. 4-10 Elasticity Calculations Elasticity Calculations (cont.) We measure the price elasticity of demand by comparing the percentage change in price with the percentage change in quantity demanded. Percentage change in Q d Price elasticity of demand = Percentage change in price For example, a price elasticity of demand for oil of 1 means that a 1 percent increase in the price of oil would lead to a 1 percent decrease in the quantity demanded of oil. Because of the law of demand, price elasticity of demand will always be negative. Copyright 2005 Pearson Addison-Wesley. All rights reserved. 4-11 Copyright 2005 Pearson Addison-Wesley. All rights reserved. 4-12 3
How We Actually Calculate Elasticity To calculate the price elasticity of demand, we have to compute percentage changes in quantity demanded and in relative price. However, there is an arithmetic problem when we calculate percentage changes with respect to the starting point. The percentage change from 2 to 3 50 % is not the same as the percentage change from 3 to 2 33.3 %. Using Average Formulas A way out of this dilemma is to use average values. For relatively small changes in price, the formula for computing the price elasticity of demand then becomes change in Q change in P Price elasticity of demand =? ( Q + Q )2 ( P + P )2 1 2 1 2 Copyright 2005 Pearson Addison-Wesley. All rights reserved. 4-13 Copyright 2005 Pearson Addison-Wesley. All rights reserved. 4-14 Price Elasticity Ranges Whenever the price elasticity of demand is numerically greater than one, we say that it is an elastic demand. If the price elasticity of demand is numerically less than one, we say that we are dealing with an inelastic demand. When demand is neither elastic nor inelastic, it is said to be unit-elastic demand. Factors that Determine the Price Elasticity of Demand 1. The Existence of Substitutes: The more substitutes that exist for a good, the more responsive consumers will be to a change in its price. 2. The Percentage of a Person s Total Budget Devoted to the Purchase of that Good: The larger the percentage of your budget devoted to an item, the more price elastic will its demand be. Copyright 2005 Pearson Addison-Wesley. All rights reserved. 4-15 Copyright 2005 Pearson Addison-Wesley. All rights reserved. 4-16 4
Factors that Determine the Price Elasticity of Demand (cont.) Figure 4-3: Short-Run and Long-Run Price Elasticity of Demand 3. The Time Allowed for Adjustment: The longer the time allowed for adjustment to a price change, the more that consumers will react. The longer any price change persists, the greater the elasticity of demand, other things held constant. Copyright 2005 Pearson Addison-Wesley. All rights reserved. 4-17 Copyright 2005 Pearson Addison-Wesley. All rights reserved. 4-18 Table 4-1: Selected Estimated Short and Long Run Price Elasticities of Demand Price Elasticity of Demand and Consumer Expenditures Suppose that you are in charge of the pricing decision for a cellular telephone service company. How would you know when it is best to raise or not to raise prices? The answer depends in part on the effect of your pricing decision on consumer expenditures which become your total revenues or receipts on your services. Copyright 2005 Pearson Addison-Wesley. All rights reserved. 4-19 Copyright 2005 Pearson Addison-Wesley. All rights reserved. 4-20 5
Price Elasticity of Demand and Consumer Expenditures (cont.) It is commonly thought that the way to increase total revenues is to increase price per unit. Is this always the case? Or is it possible that a price increase could lead to a decrease in consumer expenditures? The answers to these questions depend on the price elasticity of demand. Copyright 2005 Pearson Addison-Wesley. All rights reserved. 4-21 Price Elasticity of Demand and Consumer Expenditures (cont.) When the firm faces a demand that is elastic, if it raises its price, total consumer expenditures will fall. When facing a unit-elastic demand, any small changes in price do not change consumer expenditures. Copyright 2005 Pearson Addison-Wesley. All rights reserved. 4-22 Price Elasticity of Demand and Consumer Expenditures (cont.) Key Terms and Concepts When the firm is facing a demand that is inelastic, if it raises its price, consumer expenditures will go up; if it lowers its price, consumer expenditures will fall. elastic demand elasticity inelastic demand marginal utility price elasticity of demand principle of diminishing marginal utility unit-elastic demand utility utils Copyright 2005 Pearson Addison-Wesley. All rights reserved. 4-23 Copyright 2005 Pearson Addison-Wesley. All rights reserved. 4-24 6