Lecture #1

Review: Market Demand

If you demand something, then you
1. Want it,
2. Can afford it, and
3. Have made a definite plan to buy it.
Wants are the unlimited desires or wishes people have for goods and services. Demand reflects a
decision about which wants to satisfy.

Definition: The quantity demanded of a good or service is the amount that consumers plan to
buy during a particular time period, at a particular price.

Determinants of Quantity Demanded of a Good (say, good X)

Price of Good X for example, PX then QX (or PX then QX ). The relationship between
price and quantity for most goods is negative. Given data on this relationship, we can proceed to
map the demand curve for good X.

Review: Market Demand

For the given data

PX
2
3
4
5
6

PX
6

QX
6
5
4
3
2

5
Market demand is defined only when all
variables other than the price of the good
in question (PX) are held constant.

4
3
2

QX

Review: Market Demand

Any change in those other variables serves to change the location of Market Demand (i.e. they
cause shifts in the demand curve).
These shift variables could be:
The Price of Other Goods (i.e. good Y) for example,
PY then QX (complementary goods)
PY then QX (substitute goods)
The relationship between the price of Y and quantity of X depends on the relationship between
the uses of the two goods.
Changes in Income (M) for example,
If when M then QX (we have an inferior good)

If when M then QX (we have a normal good)

More on this later
Consumer Tastes / Preferences

Income Distribution

Credit Availability

Government Policies

Future Expectations in the Market

and others

Review: Market Demand

The LAW OF DEMAND: states that other things remaining the same, the higher the
price of a good, the smaller is the quantity demanded (or the lower the price of a
good, the larger is the quantity demanded).
The LAW OF DEMAND results from the combined influences of the substitution effect
and the income effect.

Substitution effectwhen the relative price (opportunity cost) of a good or service

rises, people seek substitutes for it, so the quantity demanded decreases (not a
proper definitionmore later in the course).

Income effectwhen the price of a good or service rises relative to income, people
cannot afford all the things they previously bought, so the quantity demanded
decreases (not a proper definitionmore later in the course).

Distinction between Market Demand (D) and Quantity Demanded (Q)

P

D
Q

Market Demand (D) is a curve

representing the complete
relationship between price and
quantity demanded, normally a
downward-sloping curve in pricequantity space.

Quantity demanded (Q) is a

distance along the horizontal
axis.

Movement Along a Demand Curve

P

--

+
+

Q
As P then Q

Q
As P then Q

Movement along Demand occurs when only the price of the good in question
changes, ceteris paribus*.
In our example, all other variables that affect Q are assumed to remain constant,
and thus the position of the demand curve does not change.
* Ceteris paribus is a term used in economics to indicate all other factors held constant.

Shifts in the Demand Curve

Assume something occurs to shift the demand curve

to the right. For example, income (M) goes up and
the good is a normal good.

P1

A shift in Demand occurs when something other

than the price of the good in question changes. In
this case, as income increases the consumer will
respond by increasing the quantity demanded at any
price level (when the good is a normal good).

P0
D1
D0

Q1

Q0

Q1 |

Q0 |

Other Examples of Demand Shifts (for example, Wheat)

Pw

Pw
M and wheat is
an inferior good.

DI

D
D

DI

Qw

Pcorn

Qw

Corn is a substitute for wheat. As corn

becomes more expensive consumers
switch to the now cheaper wheat.

Pw

Pmilk - Milk is a complement of wheat.

D
DI
Qw

As milk
becomes more expensive so does the consumption of
wheat with milk. Consumers switch to any now cheaper
substitutes of wheat and milk.

Notice that these shifts in demand are not induced by a change in the price of
wheat, but by changes in other variables that affect the quantity demanded of
wheat.
Math Review: Simple Derivatives

The derivative of a function y = f(x) is defined to be

df(x) = lim f(x + x) f(x)
dx
x0
x
In words, the derivative is the limit of the rate of change of y with respect to x as the
change in x approaches 0. The derivative gives us the most precise meaning to the
phrase the rate of change of y with respect to x for small changes in x.
We can denote the derivative of f(x) with respect to x by f|(x).
So, df(x) = dy = f|(x)(all the same, just different notations)
dx dx

Lets do a few examples,

The general equation of a line is y = a + bX. Using the general formula for the
derivative
df(x) = lim f(x + x) f(x)
dx
x0
x

and subbing in y = f(x)

df(x) = lim a + b(x + x) (a + bx) = b x = bsimply the slope of the line!

dx
x0
x
x
For nonlinear functions, like y = x2 we use the same process. Using the general
formula for the derivative
df(x) = lim f(x + x) f(x)
dx
x0
x

and subbing in y = f(x)

df(x) = lim (x + x)2 x2 = x2 +2xx + (x)2 x2 = 2x + x = 2x (as x 0)

dx
x0
x
x

For more complex nonlinear functions, like y = zx2 we use the same process. Using
the general formula for the derivative
df(x) = lim f(x + x) f(x)
dx
x0
x

and subbing in y = f(x)

df(x) = lim z(x + x)2 zx2 = zx2 +2zxx + z(x)2 zx2 = 2zx + zx = 2zx (as x 0)
dx
x0
x
x

Some examples will illustrate these general results.

Linear function
Suppose y = 17 3x. Then dy/dx = 3. Generally, if y = a + bx then dy/dx = b.
Nonlinear function
Suppose y = 6x2. Then dy/dx = 12x.
Suppose y = 5x3. Then dy/dx = 15x2.
Suppose y = 4x4. Then dy/dx = 16x3. Suppose y = 3x5. Then dy/dx = 15x4.
Generally, if y = cxn. Then dy/dx = cnxn-1.

Some examples will illustrate these general results.

Multi-variable Nonlinear function
Suppose U = 2x2y2. Then dU/dx = 4xy2.
Suppose U = x1/2 y1/2. Then dU/dx = 0.5x-1/2 y1/2 or dU/dx = y1/2
2 x1/2
Generally, if U = cxnym. Then dU/dx = cnxn-1ym.
Price Elasticity of Demand (ed)
Definition:
ed = % in qw
% in pw
the percentage change in quantity demanded as a result of a percentage change in the
price of the same good.
This is the own price elasticity of demand. Note that when we have downward sloping
demand curves this price elasticity is negative since there is an inverse relationship
between price and quantity demanded. Normally, we think of ed in terms of absolute
value (i.e. we ignore the negative sign when we say it aloudbut it is important to
remember that it is always negative whenever we do calculations).

We can write ed as

Note that

ed = Q/Q = Q . P
P/P
P Q

ed = Q . P Q
P Q
P

(called point elasticity)

(slope of the demand curve)

The elasticity depends on the position of the point where we are evaluating it, as well as,
on the slope of the demand curve. The point formula is used to measure elasticity at a
particular point on the Demand curve. However, the price elasticity of demand varies
along the demand curve.
If you remember, in ECON 101 you were asked to use the arc elasticity formula

ed =

Q
(Q1 + Q2)/2
P
(P1 + P2)/2

Q . (P1 + P2)
P (Q1 + Q2)

This expression is a linear approximation of the demand elasticity and it becomes

more and more inaccurate as the distance between Q1 and Q2 becomes larger.

P1

What this ARC elasticity formula is really

measuring is the midpoint elasticity of a line
connecting point A and point B! This is why we
prefer the POINT elasticity formulait is
accurate.

P2

D
Q1

ed = Q/Q = Q . P
P/P
P Q

Q2

measures the elasticity at the point of interest.

The following Demand curves are both special cases where one of the variables (P or
Q) are constant.
P

D
D
Q

Perfectly Inelastic Demand

Perfectly Elastic Demand

ed = % in Q =
0
=0
% in P % in P

ed = % in Q = % in Q =
% in P
0

For demand elasticities in between these two extremes, we know that the main
determinant of the degree of price elasticity of demand is the availability of
substitutes.
Pgas

Pcola

+
D
D

Qcola

Qgas

Demand Elastic (flatter)

Demand Inelastic (steeper)

There are many close substitutes for cola.

There are very few close substitutes for gasoline.

In terms of numerical values for the price elasticity of demand, we can summarize as follows:

D
D

Inelastic

0 < ed < 1

D
Q

Q
Unit Elastic
ed = 1

Q
Elastic

1 < ed <

few close substitutes

many close substitutes

necessities

luxuries

short run

long run

Price Elasticity Along a Straight-Line Demand Curve

Along a straight-line demand curve, ed, is calculated as the ratio of two segments
separated by the point of interest.

F
F
F
H

ed = FH / FV > 1

ed = FH / FV = 1

ed = FH / FV < 1

At F, demand is
elastic.

At F, demand is unit
elastic.

At F, demand is
inelastic.

So, the ranges of ed along a straight-line demand curve are:

Recall, the ratio ed = FH / FV
If F is the point V, then ed =

(Demand is perfectly elastic at V)

If F is the point H, then ed = 0

(Demand is perfectly inelastic at H)

If F is the point M, then ed = 1

H
Q

(Demand is unit elastic at the

midpoint of a straight-line demand
curve)

If F falls between V and M then ed > 1 and demand is elastic at the point of interest,
F.
If F falls between M and H then ed < 1 and demand is inelastic at the point of
interest, F.

Why is demand more elastic at higher prices than at lower prices?

P
12

At a price like P1 = 8, a $2 increase in price

(to P1 = 10) results in a 50% drop in quantity
demanded. We can see that Q falls from 4
units to 2 units. At such high prices, the
consumer finds that more and more
substitutes are affordable.

10

-2
+2

8
6

-2
+2

2
0

H
8 10 12 Q

However, at a price like P2 = 2, a $2 increase

in price (to P2 = 4) results in only a 20%
reduction in quantity demanded. We can see
that Q drops from 10 units to 8 units. At
lower prices there are fewer affordable
substitutes.

What are the 2 price elasticities in this example (i.e. at point A and point B)?
At point A:

ed = AH / AV

ed = 10 / 2

ed = 5

At point B:

ed = BH / BV

ed = 4 / 8

ed =

Shifts in Demand and Price Elasticity

A parallel shift in demand to the right (raises / lowers) the price elasticity at any given
price level.
P

V
V

P1

+ B

Clearly, AH / AV > BH / BV
This means that on the new demand curve the same price increase causes a smaller (percentage)
decrease in the quantity demanded. Said differently, the price elasticity at any given price has fallen.
We should remember that the price elasticity depends upon the slope of the demand curve and
ALSO upon P and Q.