4.0 Product Market Demand Under Perfect Competition

4.1 Introduction

Figure 4.1.1 - Product Picture Market for Good #1

p1

Q1

D1

S1

Q1D =D1(p1| shift var)

Q1S=S1(p1| shift var)

This graph includes functional form of the relationships

QD = D (p | shift variables)

Qs = S (p | shift variables)

4.2.1

We’ll examine why the product demand line slopes down

What determines the responsiveness of Q1 D to

p1

What shift variables move D and how

4.2.2- 4.2.4

Product demand slopes down and to the right

It is an inverse relationship between p and Q

You can use the decision rule to prove mathematically why this must be so

4.2.5

Own price elasticity of demand-

How responsive the quantity demanded is to a change in the good’s own price

Elastic = responsive or sensitive

Inelastic = not as responsive or sensitive

4.2.6 Comparing elastic and inelastic demand curves

Good # 1 Good # 2

Figure 4.2.1 - Own Price Elasticities of Demand - Different Attitudes

p

Q

p

Q

DD

If prices go up equally,Good # 1 Good # 2

Figure 4.2.2 - Own Price Elasticities of Demand - Comparing Responses

P

Q

P

Q

DD

P

P' P'

P

Q' Q' QQ

Since the quantity demanded of

Good 1 fell by more than the

Quantity demanded of Good 2

We say Good 1 is the more elastic of the two

4.2.7 – 4.2.9

Elasticity is important for both private and public policies

Private example – McDonalds changing prices

Public example – public transportation price changes

4.2.10 The two extreme cases

Which would you prefer if you were selling a product?

p

Figure 4.2.3 - Perfectly Elastic Demand

Q

D

p

Figure 4.2.4 - Perfectly Inelastic Demand

Q

D

Firms hope for as inelastic demand as possible

4.2.11- 4.2.12

What determines how elastic or inelastic a good’s demand will be?

A) Necessity or luxury

Necessities tend to be more

inelastic

you tend to pay any price

Ex. Lifesaving health procedure increases in price - Qd roughly the same

Movies increase price - Qd drops by more

B) Number and quality of substitutes

fewer substitutes -

more inelastic

Ex. If it is a unique item -

increase in price has not much effect on Qd

C) Time horizon involved

more time - more options can be found

very short time horizon -

more inelastic

longer time period more elastic

D) Size of price relative to one’s income

smaller the price, more likely to be

inelastic

Ex. Bubble gum goes from 1 penny to 2 pennies

100% increase

no big deal on Qd

Car goes from $10,000 to $20,000

100% increase - really big deal

4.2.13

iceChangeOwn

angeQuantityCh

Pr%

%

Absolute value eliminates a negative

There are three major categories of elasticity

Elastic demand

1PQD %%

Inelastic demand

1PQD %%

Special case - Unitary Elasticity

PQD %%

1

Special case - Perfect Inelasticity

No matter how much price changes, quantity demanded does not change

“Pay any price”

0

4.2.14

Elasticity yields some incredibly valuable information to firms

Total Expenditure = Total Revenue = Price X Quantity

TE = TR = P X Q

For a firm,

Snowplow businessP

Q

D

10

100

20

90

P

Q

D

10

100

20

5

Pizza Business

4.2.15

Firms hope for as inelastic as a demand curve as possible

Advertising serves to promote the ideas that:

there are no substitutes (more inelastic)

and goods are a necessity (also more inelastic)

In a perfectly competitive world,

we assume that individual firms are not able to distinguish their products

nor keep competitors away

Individual suppliers will face a perfectly elastic demand line

4.2.16 Public policy case

Want to reduce drug crime – Cutting supply on on inelastic demand curve –Price goes up by much more than quantity

demanded drops-might create more crime in the short runMarket is dynamic, howeverLonger run – might keep those from starting a

more expensive proposition

4.2.17 Taxes and Markets

Figure 4.2.5- Elasticity and Tax Incidence

Tax

p

D

p1

p0

S'

S

QQ0Q1

(p1 - Tax)

Tax

p

D

p1

p0

S'

S

QQ0

Q1

(p1 - Tax)

Tax

Tax

In the inelastic case on the left,

The tax is paid almost entirely by the consumer

The price goes up by almost the full amount of the tax

In the elastic case on the right, the tax burden goes primarily to the supplier

Tax incidence-

Who really pays the tax

Goal – tax consumer – tax inelastic goods

Goal – tax supplier – tax elastic goods

Taxes are imposed for different reasons

Goal – discourage consumption – tax elastic demand

Goal – raise revenue – tax inelastic goods

4.3.1

We know that

Q1D = D (p1 | shift variables)

Now we will identify the shift varaibles

Q1D = D (p1 | pr, I, T)

where

Pr stands for the price of related goods

I stands for income

T stands for tastes

4.3.2

All of the following have an effect on the position of the D curve

(which will result in a shift in the curve)

Tastes and Preferences

Examples:

A band becomes popular

Clothes become in fashion

These will result in an increase in the demand

these changes in tastes will shift the demand curve for that good to the right

D D'

P

Q

An increase in demand

Tastes work the other way, too

DD'

P

Q

A decrease in demand

4.3.3

Price of related goods also shifts demand

Ex. Increase in price of burgers affects the quantity demanded of fries and quantity demanded of drinks

This is called a cross price effect

Goods consumed together

Are called complements

ffffhbg hbg QDQp

Cross price elasticity of demand

geofGood1%PriceChan

d2hangeofGoo%QuantityC21 x

If P1 and Qd2

the goods have a negative cross-price elasticity

and are

Complements

Ex. Burgers and fries

If P1 and Qd2

the goods have a positive cross-price elasticity

and are

Substitutes

Ex. Coke and Pepsi

The sign of the cross price elasticity

Determines the nature of the relationship (sub./comp.)

The size of the cross price elasticity

Determines how strong this cross price effect is

4.3.6

Cross price elasticity is zero

A change in the price of one good has no effect on the quantity demanded for another good

021 x

In theory

There is no such thing as unrelated markets, so

The cross price elasticity is actually very close to zero, but can be treated as zero

Markets are like a spider web

A change in one affects others everywhere –

There is a complex web of connections

4.3.7

Private firms consider not only own price elasticity,

but also cross price elasticities

Ex. McDonalds – raising burger prices might lower amount of drinks and fries sold

4.3.8

Public policies also have to consider effects of cross price elasticity

Ex. Drunk driving example

4.3.9

Policy – whether public or private –

is rarely simple

Complex problems sometimes require complex solutions

4.3.10

Changes in the price of related goods shift demand lines

Increase in price of hamburgers causes, ceteris paribus,

Decrease in demand for French fries

Increase in demand for pizza

Figure 4.3.2 - Connecting Markets by Cross Price Effects

p

p1

p0

S1

S0

QQ0Q1

Hamburger

p0

p

p1

S

QQ0Q1

French Fries

D1

p

D0

p1

p0

S

QQ1Q0

Pizza

D1D0D

4.3.12Another thing that shifts demand lines is

income If a good’s demand curve increases when income

risesthe good has a positive income elasticityand is called a normal goodhowever, some goods have a decrease in their

demand when income rises-negative income elasticity / inferior goods

4.3.13 Income elasticity of demand

geIncomeChan

hangeQuantitiyCI

%

%

4.3.14

Goods are not inherently normal or inferior

It depends on the individuals’ preferences

4.3.15

Individual vs. Market Demand

to determine the market demand,

we simply add the D curves for each individual household

each household’s tastes and preferences differ

Figure 4.3.3 - From Individual to Market Demand

Q1 3 542 60

p

D1

2

3

4

5

Q1 3 542 60

p

D1

2

3

4

5

Q1 3 542 60

p

D1

2

3

4

5#1 #3#2

Q

1

2

3

4

5

6

1 3 7542 86 9 10 11 12 13 140 15

D

p

Additionally,

the exit or entry of households have an effect on market demand curve

Consider baby boomers and their effects on:

diapers - 1950’s

schools - 1960’s

Geritol or Viagra - 1990’s

Nursing homes - 2010’s

4.3.17 Conclusion on product demandWe started with a utility maximization rule given

scarcitythen developed a downward sloping demand curveThen we discussed what it represents, its

responsiveness,and what shifts it (tastes, income, price of related

goods) Lastly, we looked at how individual demand curves

are summed into a market demand curve