Demand and Price Determination
Transcript of Demand and Price Determination
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Demand and Price Determination
There are several names used to describe the
US Economy
Free Enterprise
Free Market
Capitalistic
Private Enterprise
Price Directed
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The American Economy There are three components in the American
economic system that make it unique, and that allowthe price directed nature to drive the economy.
1. Price System2. Private Property
3. Competition
These features are called the Pillars of Private
Enterprise.
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Price Directed Economy
In a market economy, price serves two
important functions
1. Price motivates production.
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Price Directed Economy
In a market economy, price serves twoimportant functions
1. Price motivates production.2. Price rations goods
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In order to establish price, a market depends
upon the interaction between sellers
(producers) and buyers (consumers).
The market forces that influence the actions
of these two groups are known as Supply and
Demand.
We will be concentrating upon Demand, since
most of us are more familiar with acting as
consumers.
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Demand
Demandis defined as the overall willingness ofconsumers to purchase (or consume) a given quantity
of a given good(or service) at a given price, a givenplace and a given time.
We will generally assume that place and time are
constant (even though we know they are not).
This definition means that demand includes all goods, atany price. A change in price has no effect upon
demand, since demand includes all possible prices.
Demand can be affected by a change in any factor otherthan price.
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Quantity Demanded is defined as
the actual amount that will
be bought (or consumed) oncethe price is specified.
This means that quantity demanded is tied toa price, and any change in price will result in a
change in quantity demanded.
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The Law of Demand
The Law of Demand states that as price rises, quantity
demanded will fall. As price falls, quantity demandedwill rise.
The law reflects the inverse relationship between price and quantity
demanded.There are three proofs of the Law of Demand:
1. The Law of Diminishing Marginal Utility At some
point during consecutive consumption of likeobjects, the utility received from consumption of an
additional unit will be less than the utility received
from consumption of the previous unit.
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2. The Income Effect Since income is relatively
fixed, as prices rise, one can no longer afford to buythe same amount of a good, so quantity demanded
falls. Inversely, as price falls, one can buy more with
the same income, so quantity demanded rises.
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3. The Substitution Effect As prices rise, we
tend to substitute less expensive alternatives,
thus quantity demanded (for the original good)
goes down.
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Exceptions to the Law of Demand
1. Speculative Purchases
-Goods bought with the intent to resell.
Increasing price can prove to buyers that the
product is a good investment, and inspire
them to buy more.
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Exceptions to the Law of Demand
2. Immature Markets
-As a market develops, shortages can cause
prices to rise while demand is still increasing.
If there is enough time, the market will catch
up, producing more items to satisfy that
demand. Before the market catches up,
people will continue to buy more even thoughprices are rising.
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Exceptions to the Law of Demand
3. Luxury Goods
- Some items are bought not because of what
they are, but rather because of the message
they send. In those cases, an increasing price
can make the item more attractive, and
quantity demanded will rise even though the
price is increasing. These items are also knownas Veblen Goods.
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Demand Curves
We can create values for a graph by creating a Demand
Schedule, a chart that shows different prices, and the
Quantities Demanded that correspond to each price.
Demand Schedule
Price Qd
$1....300
$2.200
$3.100
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Demand Curves
We can use the Demand Schedule to
emphasize the difference between changes inDemand and changes in Quantity Demanded.
Demand Schedule
Price Qd$1....300
$2.200
$3.100
Since Demand represents the
overall willingness to buy, itencompasses all three prices.
As the price changes, note
that you simply move to a new
Quantity Demanded, whileoverall Demandis unchanged.
Now we can take the values from the Demand Schedule,
and apply them to the xy graph.
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Demand Curves
We can now take the data points provided by the price and
quantity demanded that corresponds to that price, and plotthose points onto an XY graph.
The Y values will be price, the X values will be quantity,
resulting in a graph that looks like this
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Demand CurvesA normal Demand Curve will always take a downward slope.
0
0.5
1
1.5
2
2.5
3
3.5
0 100 200 300 400
Price
Quantity
D
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Change in Quantity Demanded
0
0.5
1
1.5
2
2.5
3
3.5
0 100 200 300 400
Price
Quantity
D
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8 Determinants of Demand
1. in Seasons
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8 Determinants of Demand
1. in Seasons
2. in Consumer Preference
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8 Determinants of Demand
1. in Seasons
2. in Consumer Preference
3. in Perceived Utility
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8 Determinants of Demand
1. in Seasons
2. in Consumer Preference
3. in Perceived Utility
4. in Income (Normal/Inferior)
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8 Determinants of Demand
1. in Seasons
2. in Consumer Preference
3. in Perceived Utility
4. in Income (Normal/Inferior)
5. in Price of Substitutes
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8 Determinants of Demand
1. in Seasons
2. in Consumer Preference
3. in Perceived Utility
4. in Income (Normal/Inferior)
5. in Price of Substitutes
6. in Price of Complements
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8 Determinants of Demand
1. in Seasons
2. in Consumer Preference
3. in Perceived Utility
4. in Income (Normal/Inferior)
5. in Price of Substitutes
6. in Price of Complements
7. in Consumer Expectations
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8 Determinants of Demand
1. in Seasons
2. in Consumer Preference
3. in Perceived Utility
4. in Income (Normal/Inferior)5. in Price of Substitutes
6. in Price of Complements
7. in Consumer Expectations
8. in Market Size
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Price Elasticity of Demand
A measure of the responsiveness of quantitydemanded to changes in price.
We know that price will cause quantity demanded to
change, and we know that quantity demanded willchange in the opposite direction from price. What wedont know is how much quantity demanded will
change.
There are other types of elasticity, but we will only beconcerned with price elasticity at this point.
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Price Elasticity of Demand
A measure of the responsiveness of quantitydemanded to changes in price.
Three Possible States of Elasticity1. Inelastic - % P>% Qd
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Price Elasticity of Demand
A measure of the responsiveness of quantitydemanded to changes in price.
Three Possible States of Elasticity1. Inelastic - % P>% Qd
2. Unitary Elasticity (or Unit Elastic) - % P=% Qd
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Price Elasticity of Demand
A measure of the responsiveness of quantitydemanded to changes in price.
Three Possible States of Elasticity1. Inelastic - % P>% Qd
2. Unitary Elasticity (or Unit Elastic) - % P=% Qd
3. Elastic (or Highly Elastic) - % P
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Price Elasticity of Demand
Testing for Inelasticity
Three Qualifications for Inelasticity
If a good has any of these qualities, it will be an inelastic good. If it
has none of these, then it will be elastic (or highly elastic).
1. It is a necessity.
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Price Elasticity of Demand
Testing for Inelasticity
Three Qualifications for Inelasticity
If a good has any of these qualities, it will be an inelastic good. If it
has none of these, then it will be elastic (or highly elastic).
1. It is a necessity.
2. There is no close substitute.
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Price Elasticity of Demand
Testing for Inelasticity
Three Qualifications for Inelasticity
If a good has any of these qualities, it will be an inelastic good. If it
has none of these, then it will be elastic (or highly elastic).
1. It is a necessity.2. There is no close substitute.
3. It is so inexpensive that it occupies an
insignificant portion of the budget.
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Price Elasticity of Demand Point Test Calculate the percentage change in price and in quantity demanded
and compare to the formula.
Demand Schedule
Price Qd
$1....300
$2.150
$3.100
1. Inelastic - % P>% Qd2. Unitary Elasticity (or Unit Elastic) - % P=% Qd
3. Elastic (or Highly Elastic) - % P
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Price Elasticity of Demand Point Test Calculate the percentage change in price and in quantity demanded
and compare to the formula.
Demand Schedule
Price Qd
$1....300
$2.150
$3.100
Demand Schedule
Price Qd
$1....300
$2.200
$3.150
1. Inelastic - % P>% Qd2. Unitary Elasticity (or Unit Elastic) - % P=% Qd
3. Elastic (or Highly Elastic) - % P
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Price Elasticity of Demand Point Test Calculate the percentage change in price and in quantity demanded
and compare to the formula.
Demand Schedule
Price Qd
$1....300
$2.150
$3.100
Demand Schedule
Price Qd
$1....300
$2.200
$3.150
1. Inelastic - % P>% Qd2. Unitary Elasticity (or Unit Elastic) - % P=% Qd
3. Elastic (or Highly Elastic) - % P
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Price Elasticity of Demand
Total Revenue Test Multiply Price x Quantity Demanded to
calculate Total Revenue.
Demand Schedule
Price Qd TR$1....300 = 300
$2..200 = 400
$3..150 = 450
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Price Elasticity of Demand
Total Revenue Test Multiply Price x Quantity Demanded to
calculate Total Revenue. If TR rises as price rises, then the good is inelastic.
Demand Schedule
Price Qd TR$1....300 = 300
$2..200 = 400
$3..150 = 450
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Price Elasticity of Demand
Total Revenue Test Multiply Price x Quantity Demanded to
calculate Total Revenue. If TR declines as price rises, then the good is elastic.
Demand Schedule
Price Qd TR$1....300 = 300
$2..100 = 200
$3....50 = 150
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Price Elasticity of Demand
Total Revenue Test Multiply Price x Quantity Demanded to
calculate Total Revenue. If TR remains constant as price rises, then the good is unit elastic.
Demand Schedule
Price Qd TR$1.....300 = 300
$2..150 = 300
$3..100 = 300
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Price Elasticity of Demand
Total Revenue Test Multiply Price x Quantity Demanded to
calculate Total Revenue. ????
Demand Schedule
Price Qd TR$1....300 = 300
$2..125 = 250
$3..100 = 300
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Price Elasticity of Demand
Proving Elasticity or Inelasticity
The Coefficient of Elasticity
i l i i f d
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Price Elasticity of Demand
If the % change in quantity demanded is a larger number
than the % change in price, then the coefficient will be
greater than 1.
By definition, this identifies an Elastic Good, so any time
the coefficient is a positive number greater than one, the
good must be Elastic.
The greater the value above 1, the greater the degree of
elasticity.
P i El i i f D d
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Price Elasticity of Demand
If the % change in quantity demanded is a smaller
number than the % change in price, then the coefficient
will be less than 1.
By definition, this identifies an Inelastic Good, so any
time the coefficient is a value less than 1, the good must
be inelastic.
The greater the value below 1, the greater the degree of
inelasticity.
P i El i i f D d
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Price Elasticity of Demand
If the % change in quantity demanded is an equal
number to the % change in price, then the coefficient
will be exactly 1.
By definition, this identifies a Unit Elastic Good, so any
time the coefficient is exactly one, the good must be unit
elastic.
A coefficient value of 1 is unusual, but not impossible.
It is no more or less likely an occurrence than any other
single point in the range.
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Demand Curve for an Elastic Good
Price
Quantity
>45
D
f l
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Demand Curve for an Inelastic Good
Price
Quantity
>45
D
d f l d
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Demand Curve for a Unit Elastic Good
Price
Quantity
= 45
D
Perfectly Inelastic
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Perfectly Inelastic
and
Perfectly ElasticThere are two theoretically possible states of elasticity, that result in
either an % change in quantity demanded or a 0% change in quantity
demanded.
0
0.5
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2
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3
3.5
0 100 200 300
Price
Quantity
0
0.5
1
1.5
2
2.5
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0 100 200 300 400
Price
Quantity
= 0 degrees
=90
degrees
D
Ch i El ti it
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Change in Elasticity
0
0.5
1
1.5
2
2.5
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0 100 200 300 400
Price
Quantity