3 3 Consumer Choice, Market Demand, and Elasticity.
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Transcript of 3 3 Consumer Choice, Market Demand, and Elasticity.
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3
Consumer Choice, Market Demand, and Elasticity
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● Scarcity and Demand
● Utility: A Tool to Analyze Purchase Decisions
● Consumer Choice as a Trade-off: Opportunity Cost
● From Individual Demand Curves to Market Demand Curves
● Exceptions to the Law of Demand
● Scarcity and Demand
● Utility: A Tool to Analyze Purchase Decisions
● Consumer Choice as a Trade-off: Opportunity Cost
● From Individual Demand Curves to Market Demand Curves
● Exceptions to the Law of Demand
OutlineOutline
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● Price Elasticity of Demand
● Its Effect on Total Revenue
● What Determines Demand Elasticity?
● Elasticity as a General Concept
● Price Elasticity of Demand
● Its Effect on Total Revenue
● What Determines Demand Elasticity?
● Elasticity as a General Concept
OutlineOutline
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Scarcity and DemandScarcity and Demand
● Income is limited → consumers face constraints on their choices
● Wealthy and poor individuals have limited incomes relative to their desires.
● Every decision has an opportunity cost. ♦ ↑purchases of clothing → ↓purchases of restaurant
meals
● Income is limited → consumers face constraints on their choices
● Wealthy and poor individuals have limited incomes relative to their desires.
● Every decision has an opportunity cost. ♦ ↑purchases of clothing → ↓purchases of restaurant
meals
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Utility: A Tool to Analyze Purchase DecisionsUtility: A Tool to Analyze Purchase Decisions
● How do consumers make choices?♦ Theory of consumer choice = each consumer spends
his or her income in a way that yields the greatest satisfaction or utility.
♦ Cannot measure utility (or satisfaction) directly.
How should we measure your utility of a movie theater ticket?
● How do consumers make choices?♦ Theory of consumer choice = each consumer spends
his or her income in a way that yields the greatest satisfaction or utility.
♦ Cannot measure utility (or satisfaction) directly.
How should we measure your utility of a movie theater ticket?
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● Total utility = largest sum of money that a consumer will voluntarily give up for a good ♦ E.g., I will buy 7 pints of Chunky Monkey only if it costs
$21.50 or less. So the TU (or benefit) that I receive from 7 pints is $21.50.
● Marginal utility = addition to TU that an individual receives by consuming 1 more unit of the good ♦ E.g., if I consumed 6 pints of Chunky Monkey, MU measures
how much add. satisfaction I get by consuming 7 pints instead.
● Total utility = largest sum of money that a consumer will voluntarily give up for a good ♦ E.g., I will buy 7 pints of Chunky Monkey only if it costs
$21.50 or less. So the TU (or benefit) that I receive from 7 pints is $21.50.
● Marginal utility = addition to TU that an individual receives by consuming 1 more unit of the good ♦ E.g., if I consumed 6 pints of Chunky Monkey, MU measures
how much add. satisfaction I get by consuming 7 pints instead.
Total vs. Marginal UtilityTotal vs. Marginal Utility
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TABLE 1. Leah’s Total and Marginal Utility from Chunky Monkey
TABLE 1. Leah’s Total and Marginal Utility from Chunky Monkey
Quantity(per month)
Total Utility(dollars)
Marginal Utility(dollars)
Label forgraph
0 0.00 ------ ------
1 6.00 6.00 A
2 11.00 5.00 B
3 15.00 4.00 C
4 18.00 3.00 D
5 20.00 2.00 E
6 21.00 1.00 F
7 21.50 0.50 G
8 21.50 0.00 H
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Total vs. Marginal UtilityTotal vs. Marginal Utility
● TU: 1 pint is worth no more than $6.00 to me and 2 pints are worth no more than $11.00 to me, etc.
● MU: 1st pint is worth $6 to me and 2nd pint is worth $5.00 to me, while the 3rd is worth $4.00, etc.
● TU: 1 pint is worth no more than $6.00 to me and 2 pints are worth no more than $11.00 to me, etc.
● MU: 1st pint is worth $6 to me and 2nd pint is worth $5.00 to me, while the 3rd is worth $4.00, etc.
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FIGURE 1. Leah’s Marginal Utility Curve for Chunky Monkey
FIGURE 1. Leah’s Marginal Utility Curve for Chunky Monkey
Number of pints per Month
8
Mar
gin
al U
tilit
y (P
rice
) p
er p
int
6
5
4
$3
2
1
0 7
H
F
E
D
C
B
A
6 5 4 3 2 1
$7
G
Price
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● Law of diminishing MU = the more of a good a consumer has, the less MU an additional unit contributes to overall satisfaction.
● Additional units of a good are worth less and less to a consumer in money terms.♦ E.g., each add. pint is worth less to me. 1st pint eat by myself;
2nd share with my husband; 3rd share with my friend; 4th share with my dog, Dante; 5th share with my mother-in-law. Thus, each successive pint has a lower priority.
Can you think of any exceptions to the law of diminishing marginal utility?
● Law of diminishing MU = the more of a good a consumer has, the less MU an additional unit contributes to overall satisfaction.
● Additional units of a good are worth less and less to a consumer in money terms.♦ E.g., each add. pint is worth less to me. 1st pint eat by myself;
2nd share with my husband; 3rd share with my friend; 4th share with my dog, Dante; 5th share with my mother-in-law. Thus, each successive pint has a lower priority.
Can you think of any exceptions to the law of diminishing marginal utility?
“Law” of Diminishing MU“Law” of Diminishing MU
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Total vs. Marginal UtilityTotal vs. Marginal Utility
● Graph of MU has (-) slope → ↓MU as ↑Qd.
● ↑TU as long as MU is (+). ♦ E.g., when a commodity is very scarce (diamonds),
economists expect it to have high MU even though it provides very little TU.
Can you think of a good that has a very low MU but a very high TU?
● Graph of MU has (-) slope → ↓MU as ↑Qd.
● ↑TU as long as MU is (+). ♦ E.g., when a commodity is very scarce (diamonds),
economists expect it to have high MU even though it provides very little TU.
Can you think of a good that has a very low MU but a very high TU?
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Using MU: The Optimal Purchase RuleUsing MU: The Optimal Purchase Rule
How many pints of Chunky Monkey should I purchase?● Goal: max. total benefit from pints while min. their cost.
As long as MU is (+), ↑TU by consuming more pints. But each add. pint costs money.
● Net TU = TU – total expenditure; where TE = P*Qd.● Max. net TU by watching net MU; net MU = MU – P.
♦ E.g., If P = $3.00/pint and I buy 3 pints, then net MU = $1.00; so I can ↑net TU by purchasing more.
How many pints of Chunky Monkey should I purchase?● Goal: max. total benefit from pints while min. their cost.
As long as MU is (+), ↑TU by consuming more pints. But each add. pint costs money.
● Net TU = TU – total expenditure; where TE = P*Qd.● Max. net TU by watching net MU; net MU = MU – P.
♦ E.g., If P = $3.00/pint and I buy 3 pints, then net MU = $1.00; so I can ↑net TU by purchasing more.
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Using MU: The Optimal Purchase RuleUsing MU: The Optimal Purchase Rule
● Two rules govern the optimal purchase rule:1. if net MU is (+) (or MU > P) → consumer buys too
little of the good to max. net TU2. if net MU is (-) (or MU < P) → consumer buys too
much of the good to max. net TU
● Combining these 2 rules → net TU is maximized when net MU = 0 (or MU = P).
MU = P is the optimal purchase rule
● Two rules govern the optimal purchase rule:1. if net MU is (+) (or MU > P) → consumer buys too
little of the good to max. net TU2. if net MU is (-) (or MU < P) → consumer buys too
much of the good to max. net TU
● Combining these 2 rules → net TU is maximized when net MU = 0 (or MU = P).
MU = P is the optimal purchase rule
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● Demand curve = MU curve♦ Law of diminishing MU (-) slope of D curves P Qd MU
■ E.g., P = $3 → Qd = 4 pints. But if the ↑P to $5 → Qd = 2 pints. If ↓P to $2 → Qd = 5 pints. As ↑P, use the good for higher valued uses –to share with my friend or husband. As ↓P, use the good for lower valued uses –to share with my dog or mother-in-law.
● Demand curve = MU curve♦ Law of diminishing MU (-) slope of D curves P Qd MU
■ E.g., P = $3 → Qd = 4 pints. But if the ↑P to $5 → Qd = 2 pints. If ↓P to $2 → Qd = 5 pints. As ↑P, use the good for higher valued uses –to share with my friend or husband. As ↓P, use the good for lower valued uses –to share with my dog or mother-in-law.
From MU to Demand CurvesFrom MU to Demand Curves
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Consumer Choice as a Trade-Off: Opportunity CostConsumer Choice as a Trade-Off: Opportunity Cost
● Recall the importance of opportunity cost● Decision to purchase something decision to forgo
something else♦ Real cost of 4 pints purchased for $3.00 each is not the $12
given up. It is the 4 movie rentals that are given up. I have given up $12 worth of other goods to buy 4 pints of Chunky Monkey.
● Recall the importance of opportunity cost● Decision to purchase something decision to forgo
something else♦ Real cost of 4 pints purchased for $3.00 each is not the $12
given up. It is the 4 movie rentals that are given up. I have given up $12 worth of other goods to buy 4 pints of Chunky Monkey.
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Consumer Surplus Consumer Surplus
● CS = net TU = TU - TE
● Economists assume that firms max profit and consumers max CS.
● Consumer must experience some gain from a voluntary transaction; otherwise the consumer would refuse to purchase the good.
● CS = net TU = TU - TE
● Economists assume that firms max profit and consumers max CS.
● Consumer must experience some gain from a voluntary transaction; otherwise the consumer would refuse to purchase the good.
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TABLE 2. Calculating CSTABLE 2. Calculating CS
Quantity(pints per mo.)
Marginal Utility Price Net MU (per unit surplus)
1 $ 6.00 $ 3.00 $ 3.00
2 5.00 3.00 2.00
3 4.00 3.00 1.00
4 3.00 3.00 0.00
5 2.00 3.00 -1.00
Two ways of calculating CS:
(1) CS = TU – TE or (2) CS = ∑(MU – P)
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FIGURE 2. Graph of CSFIGURE 2. Graph of CSM
arg
inal
Uti
lity
and
Pri
ce p
er p
int
$0
6
5
4
3
2
1 $.50
$1
$2
0
Number of pints purchased
8 7 6 5 4 3 2 1
7
$6
$3
A
B
C
$5
$4
$3D
E
F
GH
$2$1
P$0
MU
CS per unit MU (or D) curve
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Graph of Consumer SurplusGraph of Consumer Surplus
● CS = area under D curve and above P. ♦ Leah was willing to pay $18 for the 4 pints (i.e., the
TU of 4 pints), but only paid $12 (i.e., $3*4) so her total CS = $6.
● TU = area under entire D curve
● TE = rectangular area that reflects P*Qd
● CS = area under D curve and above P. ♦ Leah was willing to pay $18 for the 4 pints (i.e., the
TU of 4 pints), but only paid $12 (i.e., $3*4) so her total CS = $6.
● TU = area under entire D curve
● TE = rectangular area that reflects P*Qd
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● Market D curve = horizontal sum of individual D curves
● Steps to move from individual D to market D:1. Pick any relevant P.
2. Find Qd at that P for each person.
3. Add the Qd at that P to get Qd in the market.
Repeat these steps for all possible prices.
● Market D curve = horizontal sum of individual D curves
● Steps to move from individual D to market D:1. Pick any relevant P.
2. Find Qd at that P for each person.
3. Add the Qd at that P to get Qd in the market.
Repeat these steps for all possible prices.
From Individual to Market D CurvesFrom Individual to Market D Curves
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FIGURE 3. Total Market D vs. Individual Consumer D
FIGURE 3. Total Market D vs. Individual Consumer D
Pri
ce
Pri
ce
4 3
(c)
Quantity Demanded 7 0
M
M Market demand
(b)
Quantity Demanded 3 0
Z
Z Joe’s demand
(a)
Quantity Demanded
Pri
ce
$3
4 0
M M J J L L
K
D
D
Leah’s demand
$7
1 1
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From Individual to Market D CurvesFrom Individual to Market D Curves
● The “Law” of Demand♦ (-) slope for market D curves
■ Individual D curves have (-) slopes because of the law of diminishing MU
■ Lower P draws new customers into the market
● E.g., Fig. 3, only Joe will buy Chunky Monkey at P = $7. Yet, at P < $7, Leah will also purchase ice cream. As ↓P, Joe will buy more and Leah will enter the market, insuring that ↑Qd as ↓P.
● The “Law” of Demand♦ (-) slope for market D curves
■ Individual D curves have (-) slopes because of the law of diminishing MU
■ Lower P draws new customers into the market
● E.g., Fig. 3, only Joe will buy Chunky Monkey at P = $7. Yet, at P < $7, Leah will also purchase ice cream. As ↓P, Joe will buy more and Leah will enter the market, insuring that ↑Qd as ↓P.
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From Individual to Market D CurvesFrom Individual to Market D Curves
● Exceptions to the “Law” of Demand♦ Goods whose quality is judged by price –if a ↓P
signals poor quality → ↓Qd ■ E.g., Bayer aspirin vs. generic brand aspirin
♦ Goods with snob appeal –some people buy expensive goods to advertise their wealth
■ E.g., Rolls Royce
● Exceptions to the “Law” of Demand♦ Goods whose quality is judged by price –if a ↓P
signals poor quality → ↓Qd ■ E.g., Bayer aspirin vs. generic brand aspirin
♦ Goods with snob appeal –some people buy expensive goods to advertise their wealth
■ E.g., Rolls Royce
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● Elasticity = measure of the responsiveness of one variable to changes in another variable
● Price elasticity of demand = (%∆Qd) ∕ (%∆P)
● Elasticity = measure of the responsiveness of one variable to changes in another variable
● Price elasticity of demand = (%∆Qd) ∕ (%∆P)
Elasticity: Measure of ResponsivenessElasticity: Measure of Responsiveness
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Elasticity: Measure of ResponsivenessElasticity: Measure of Responsiveness
● Governments, courts, and businesses need to understand the relationship between Qd and P
● If consumers respond sharply to ∆P → D is elastic
● If consumers are unresponsive to ∆P → D is inelastic
● Governments, courts, and businesses need to understand the relationship between Qd and P
● If consumers respond sharply to ∆P → D is elastic
● If consumers are unresponsive to ∆P → D is inelastic
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FIGURE 4(a). Perfectly Inelastic Demand
FIGURE 4(a). Perfectly Inelastic Demand
Qd is 90 no matter the P.
%∆Qd = 0
Consumer purchases do not respond to ∆P.
E.g., goods with very low prices that are used with something else –salt or shoelaces. Or an essential medicine.
P D
QD0
90
Elasticity = 0
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FIGURE 4(b). Perfectly Elastic Demand
FIGURE 4(b). Perfectly Elastic Demand
Slight ↑P → ↓Qd to 0.
%∆Qd = infinitely large
Consumer are completely responsive to ∆P.
E.g., Demand for a firm that produces an undifferentiated product.
Elasticity =
D
QD
P
$5
0
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FIGURE 4(c). Straight-line DemandFIGURE 4(c). Straight-line Demand
Slope remains constant but ε is changing.
ε (a-b) = (2/3) (2/5) = 1.67
ε (c-d) = (2/6) (2/2) = 0.33
Moving down the D curve ε is getting smaller because average Q is rising while average P is falling.
D
P
a
b
c
d
6
4
3
1
2 4 5 7 QD
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FIGURE 4(d). Unit-elastic DemandFIGURE 4(d). Unit-elastic Demand
Slope is changing but ε is constant and equal to 1.
ε (e-f) = (7/10.5) (10/15) = 1.0
Note: if ε = 1 → D is “unit elastic”
if ε > 1 → D is “elastic”
if ε < 1 → D is “inelastic”
D
P
QD
20
10
7 14
e
f
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Elasticity of Demand and Total Revenue Elasticity of Demand and Total Revenue
● Firms want to know whether an ↑P will raise or lower their sales revenues.
♦ If D is elastic: ↑P → ↓TR♦ If D is unit elastic: ↑P → TR constant♦ If D is inelastic: ↑P → ↑TR
■Recall: TR = TE = P x Qd
● Firms want to know whether an ↑P will raise or lower their sales revenues.
♦ If D is elastic: ↑P → ↓TR♦ If D is unit elastic: ↑P → TR constant♦ If D is inelastic: ↑P → ↑TR
■Recall: TR = TE = P x Qd
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Elasticity of Demand and Total RevenueElasticity of Demand and Total Revenue
● Further examples:♦ If P↓ by 10% and ↑Qd by 10% → D is unit elastic and
TR are constant.♦ If P↓ by 10% and ↑Qd by 15% → D is elastic and
↑TR. ♦ If P↓ by 10% and ↑Qd by 5% → D is inelastic and
↓TR.
● Further examples:♦ If P↓ by 10% and ↑Qd by 10% → D is unit elastic and
TR are constant.♦ If P↓ by 10% and ↑Qd by 15% → D is elastic and
↑TR. ♦ If P↓ by 10% and ↑Qd by 5% → D is inelastic and
↓TR.
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FIGURE 5. An Elastic Demand CurveFIGURE 5. An Elastic Demand Curve
5
12
Quantity Demanded
Pri
ce
$6
1
2
3
4
4 0
U
W
D
D
R
T
S
V
Pt. S: TR = $24 = area of 0RST
Pt. V: TR = $60 = area of 0WVU
D is elastic as ↓P → ↑TR.
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TABLE 3. Estimates of Price Elasticities
TABLE 3. Estimates of Price Elasticities
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What Determines Demand Elasticity?What Determines Demand Elasticity?
1. Nature of the good: ♦ Necessities have very inelastic demands, while
luxuries have elastic demands.♦ E.g., ε potatoes = 0.3 and the ε restaurant meals =
1.6.
What do these numbers mean?● 10%↑ in P of potatoes → ↓sales of potatoes by 3%. And 10%↑
in P of restaurant meals → ↓restaurant dining by 16%.
1. Comes from the elasticity formula: %P * ε = %Qd
1. Nature of the good: ♦ Necessities have very inelastic demands, while
luxuries have elastic demands.♦ E.g., ε potatoes = 0.3 and the ε restaurant meals =
1.6.
What do these numbers mean?● 10%↑ in P of potatoes → ↓sales of potatoes by 3%. And 10%↑
in P of restaurant meals → ↓restaurant dining by 16%.
1. Comes from the elasticity formula: %P * ε = %Qd
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What Determines Demand Elasticity?What Determines Demand Elasticity?
2. Availability of a close substitute:♦ If consumers can buy a good substitute for a
product whose ↑P, they will readily switch.■ E.g., D for gas is inelastic because you can’t run a car
without it. But D for Chevron gas is elastic because Mobile or Shell gas work just as well.
2. Availability of a close substitute:♦ If consumers can buy a good substitute for a
product whose ↑P, they will readily switch.■ E.g., D for gas is inelastic because you can’t run a car
without it. But D for Chevron gas is elastic because Mobile or Shell gas work just as well.
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What Determines Demand Elasticity?What Determines Demand Elasticity?
3. Fraction of Income Absorbed:♦ Very inexpensive items have an inelastic demand.
Who will use more salt if the price falls?♦ Very expensive items have elastic demands.
Families will buy fewer homes if housing prices increase.
3. Fraction of Income Absorbed:♦ Very inexpensive items have an inelastic demand.
Who will use more salt if the price falls?♦ Very expensive items have elastic demands.
Families will buy fewer homes if housing prices increase.
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What Determines Demand Elasticity?What Determines Demand Elasticity?
4. Passage of Time:● D for products is more elastic in LR than SR because
consumers have more time to adjust their purchases.♦ E.g., suppose recent ↑P gas continues. In SR, consumers
may take fewer summer road trips to ↓Qd gas. But in LR, consumers can buy more fuel efficient cars to further ↓Qd gas.
4. Passage of Time:● D for products is more elastic in LR than SR because
consumers have more time to adjust their purchases.♦ E.g., suppose recent ↑P gas continues. In SR, consumers
may take fewer summer road trips to ↓Qd gas. But in LR, consumers can buy more fuel efficient cars to further ↓Qd gas.
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Elasticity as a General ConceptElasticity as a General Concept
● Elasticity can be used to measure the responsiveness of anything to anything else.
● Income Elasticity:♦ Income elasticity of D = % Qd % Y
● Price Elasticity of Supply:♦ Price elasticity of S = % Qs % P
● Elasticity can be used to measure the responsiveness of anything to anything else.
● Income Elasticity:♦ Income elasticity of D = % Qd % Y
● Price Elasticity of Supply:♦ Price elasticity of S = % Qs % P
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Cross Elasticity of DemandCross Elasticity of Demand
● Cross εd is used to determine whether two goods are compliments or substitutes. It is calculated as:
εcross = (%∆Qd good X) (%∆P good Y)
● Cross εd is used to determine whether two goods are compliments or substitutes. It is calculated as:
εcross = (%∆Qd good X) (%∆P good Y)
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Cross Elasticity of DemandCross Elasticity of Demand
● Two goods are compliments if an ↑Qd for one
good → ↑Qd of the other good. ♦ E.g, ketchup and french fries or coffee and cream.
■ If ↓P of coffee → ↑purchases of coffee and cream. Cross elasticity for compliments is (-). As ↓P of coffee falls → ↑Qd of cream.
● Two goods are compliments if an ↑Qd for one
good → ↑Qd of the other good. ♦ E.g, ketchup and french fries or coffee and cream.
■ If ↓P of coffee → ↑purchases of coffee and cream. Cross elasticity for compliments is (-). As ↓P of coffee falls → ↑Qd of cream.
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Cross Elasticity of DemandCross Elasticity of Demand
● Two goods are substitutes if an ↑Qd for one good → ↓Qd of the other good. ♦ E.g., ice cream and frozen yogurt or cans of salmon
and cans of tuna.■ If ↑P of ice cream → ↓purchases of ice cream and
↑purchases of frozen yogurt. Cross elasticity for substitutes is (+). As ↑P of ice cream → ↑Qd of frozen yogurt.
● Two goods are substitutes if an ↑Qd for one good → ↓Qd of the other good. ♦ E.g., ice cream and frozen yogurt or cans of salmon
and cans of tuna.■ If ↑P of ice cream → ↓purchases of ice cream and
↑purchases of frozen yogurt. Cross elasticity for substitutes is (+). As ↑P of ice cream → ↑Qd of frozen yogurt.
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Cross Elasticity of DemandCross Elasticity of Demand
● Cross elasticity is often used in “anti-trust” lawsuits. If firms face strong competition, it is difficult to overcharge customers. A very high and (+) cross elasticity indicates effective competition in a market.
● Cross elasticity is often used in “anti-trust” lawsuits. If firms face strong competition, it is difficult to overcharge customers. A very high and (+) cross elasticity indicates effective competition in a market.