Lecture 2 The Law of Demand. ■ Our objectives: ► Explain individual choices among unlimited wants in the face of limited resources ► Develop a theory that satisfies the universal criteria for theories ► Apply the theory to what we observe around us. The Law of Demand. - PowerPoint PPT Presentation
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Lecture 2 Lecture 2 The Law of Demand The Law of Demand ■ ■ Our objectives: Our objectives: ► ► Explain individual choices among unlimited Explain individual choices among unlimited wants in the face of limited resources wants in the face of limited resources ► ► Develop a theory that satisfies the universal Develop a theory that satisfies the universal criteria for theories criteria for theories ► ► Apply the theory to what we observe around us Apply the theory to what we observe around us
Transcript
Lecture 2Lecture 2
The Law of DemandThe Law of Demand
■ ■ Our objectives:Our objectives:
► ► Explain individual choices among unlimited wants in Explain individual choices among unlimited wants in the face of limited resourcesthe face of limited resources
► ► Develop a theory that satisfies the universal criteria for Develop a theory that satisfies the universal criteria for theories theories
► ► Apply the theory to what we observe around usApply the theory to what we observe around us
The Law of DemandThe Law of Demand
■■ Holding all other relevant factors constant, the Holding all other relevant factors constant, the lower the price of a good, the greater will be lower the price of a good, the greater will be the quantity demanded.the quantity demanded.
► ► Like all scientific propositions, it is a Like all scientific propositions, it is a ceteris paribus ceteris paribus (“other things equal’) statement(“other things equal’) statement
► ► It is symmetric: a higher price leads to a smaller It is symmetric: a higher price leads to a smaller quantity demandedquantity demanded
► ► NoteNote thethe terminologyterminology::-changes in the price of the good lead to changes in -changes in the price of the good lead to changes in ““quantity demandedquantity demanded” ---- they ” ---- they DO NOTDO NOT lead to lead to changes in changes in demanddemand
Why focus on the Law of Why focus on the Law of Demand?Demand?
► ► This is the most powerful proposition in This is the most powerful proposition in economics.economics.
► ► Sprinkler design in arid and wet climatesSprinkler design in arid and wet climates
► ► Building heights in cities compared to small townsBuilding heights in cities compared to small towns
► ► The seasonal pattern of fruit and vegetable pricesThe seasonal pattern of fruit and vegetable prices
► ► Why people sit in inferior seats to watch games or performancesWhy people sit in inferior seats to watch games or performances
► ► The shape of waterfront propertiesThe shape of waterfront properties
► ► Electricity prices and automatic switchesElectricity prices and automatic switches
► ► Etc., etc., etc.Etc., etc., etc.
FoundationsFoundations
■ ■ The principle of Diminishing Marginal ValueThe principle of Diminishing Marginal Value► ► As the rate of consumption rises, the As the rate of consumption rises, the marginalmarginal use use
value of the next unit declinesvalue of the next unit declines
■ ■ Decision RuleDecision Rule► ► Chose a rate of consumption so that marginal use Chose a rate of consumption so that marginal use
value of the last unit equals price:value of the last unit equals price:
MV=PMV=P
■ ■ When combined, these yield the When combined, these yield the Law of DemandLaw of Demand
Adding the Decision Rule MV=PAdding the Decision Rule MV=P
yields a Demand Curve (Dyields a Demand Curve (D))
Demand
PRICE
UNITS/TIME PERIOD
The Demand FunctionThe Demand Function
Summarizes the relationship between quantity Summarizes the relationship between quantity consumed and the factors determining that quantityconsumed and the factors determining that quantity
■ ■ PricePrice of the good in question—determines the location of the good in question—determines the location alongalong the demand curve the demand curve
■ ■ Other factorsOther factors — determine the — determine the placementplacement of the demand of the demand curve:curve:
► ► Prices of related goodsPrices of related goods► ► Income of the buyerIncome of the buyer► ► Tastes (preferences) of the buyerTastes (preferences) of the buyer► ► Expectations held by the buyer, regarding the futureExpectations held by the buyer, regarding the future► ► Other matters, particular to each good, including Other matters, particular to each good, including
quality, etc.quality, etc.
The Role of TastesThe Role of TastesDe gustibus non est De gustibus non est disputandumdisputandum
■ ■ They are unmeasurable, and so we ignore They are unmeasurable, and so we ignore themthem
■ ■ Look to marketing and psychology for Look to marketing and psychology for guidance here, for you’ll not get any from guidance here, for you’ll not get any from economists!economists!
■ ■ For us, tastes are the unexplained portion of For us, tastes are the unexplained portion of consumptionconsumption
ExpectationsExpectations
■ ■ Difficult to measure under most Difficult to measure under most circumstancescircumstances
■ ■ When measurable, include in the When measurable, include in the analysisanalysis
■ ■ Like tastes, these can be used to Like tastes, these can be used to “explain” anything “explain” anything ► ► Don’t fall into this trapDon’t fall into this trap
The Demand FunctionThe Demand Function
■ ■ The rate of consumption of a good is a function The rate of consumption of a good is a function of:of:
► ► The “own” price of the goodThe “own” price of the good --------------------------------------------------------------------------► ► The The ceteris paribusceteris paribus conditions: conditions:- Prices of related goods- Prices of related goods- Income- Income- Other, idiosyncratic factors (the “X-vector”)- Other, idiosyncratic factors (the “X-vector”)
Demand for DVD Demand for DVD RentalsRentalsPrice $Price $ Monthly consumption at different income Monthly consumption at different income
■ ■ Substitutes:Substitutes:► ► Intuitively, goods used in place of each otherIntuitively, goods used in place of each other► ► Different brands of gasoline; Different brands of gasoline;
theater v. movie rentals; theater v. movie rentals; DVDs v. concert ticketsDVDs v. concert tickets
■ ■ Complements:Complements:► ► Intuitively, goods used togetherIntuitively, goods used together► ► Computer hardware and software; Computer hardware and software;
tennis balls and rackets; tennis balls and rackets; airplane travel and hotel roomsairplane travel and hotel rooms
Changes in the Price of Related Changes in the Price of Related GoodsGoodsThese effects These effects definedefine the relationship “substitute” the relationship “substitute”
■ ■ X and Y are substitutes if and only if:X and Y are substitutes if and only if:
► A change in price of X changes demand for Y in same direction
- Px up implies Dy up (Dy shifts to the right)
- Px down implies Dy down (Dy shifts to the left)
► Effect of Py on Dx is also in same direction
More on the Prices of Related GoodsMore on the Prices of Related GoodsThese effects These effects definedefine the relationship the relationship “complement”“complement”
■ ■ V and W are complements if:V and W are complements if:
► ► A change in A change in price of Vprice of V changes changes demand for Wdemand for W in in opposite directionopposite direction
- Pv up implies Dw down (Dw shifts to left)- Pv up implies Dw down (Dw shifts to left)
- Pv down implies Dw (Dw shifts to right)- Pv down implies Dw (Dw shifts to right)
► ► Effect of Pw on Dw is also in Effect of Pw on Dw is also in oppositeopposite direction direction
Changes in IncomeChanges in Income
■ ■ Normal Goods:Normal Goods:► Change in income changes demand in same direction
- Higher income causes increase in demand- Lower income causes decrease in demand
► ”Superior” good is a variant: change in demand due to income change is quite large
■ Inferior goods:► Change in income changes demand in opposite
direction- Higher income causes decrease in demand- Lower income causes increase in demand
Increase in DemandIncrease in Demand
■ ■Caused by:Caused by:
-Higher price of substitute -Higher price of substitute
-Lower price of -Lower price of complementcomplement
-Increase in income if -Increase in income if superiorsuperior
-Decrease in income if -Decrease in income if inferiorinferior
Price
D lower
D higher
Decreases in DemandDecreases in Demand
Caused by:Caused by:
-Lower price of -Lower price of substitutesubstitute
-Higher price of -Higher price of complementcomplement
-Decrease in income -Decrease in income if superiorif superior
-Increase in income -Increase in income if inferiorif inferior
D highD low
PRICE
Quantity
TerminologyTerminologyThis is important to avoid confusionThis is important to avoid confusion
■ ■ Changes in Changes in quantity demanded:quantity demanded:► Caused by changes in Caused by changes in own priceown price of good of good► Refer to movement along a given demand curve
■ Changes in demand:► Caused by changes in ceteris paribus conditions
- Prices of other goods- Income- Other factors
► Refer to a shift of the entire demand curve■ Be precise and you’ll be richer. . . .
What else would you want to know?What else would you want to know?
The Demand curve plots the relationship The Demand curve plots the relationship between price and quantity demanded – between price and quantity demanded – nothing else – everything else is nothing else – everything else is ceteris ceteris paribus.paribus.
What else would you want to know if you What else would you want to know if you wanted to understand that market better?wanted to understand that market better?
Name likely relevant factors:Name likely relevant factors:
Deriving a Real Demand Deriving a Real Demand CurveCurve
Define your market:Define your market:Boulder, Colorado, over time; Boulder, Colorado, over time;
consumption of water by people consumption of water by people
served by city water; price per served by city water; price per
Questions on Law of Questions on Law of DemandDemand
True – FalseTrue – False1.1. Your mother gives you a coat that cost her $100 Your mother gives you a coat that cost her $100
and that she likes, but you hate. You have and that she likes, but you hate. You have received a gift worth $100.received a gift worth $100.
2.2. In thinking about demand by consumers, we In thinking about demand by consumers, we usually assume that income varies among usually assume that income varies among consumers but that prices do not.consumers but that prices do not.
3.3. If the price of mailing a letter rises by 10 cents, If the price of mailing a letter rises by 10 cents, from 30 cents to 40 cents; and the price of from 30 cents to 40 cents; and the price of sending a letter by special delivery increases 10 sending a letter by special delivery increases 10 cents, from $3.20 to $3.30, consumers will cents, from $3.20 to $3.30, consumers will purchase the same purchase the same proportionsproportions of both kinds of of both kinds of delivery services.delivery services.
Which Goods Are Which Goods Are Complements, Complements,
Which Are Substitutes?Which Are Substitutes?
1.1. Plate glass and bricks.Plate glass and bricks.
2.2. Steel and bricks.Steel and bricks.
3.3. Wine and beer.Wine and beer.
4.4. Domestic shirts and imported Domestic shirts and imported shirts.shirts.
5.5. Oil from Iran and coal from China.Oil from Iran and coal from China.
6.6. Paper and pencils.Paper and pencils.
Needs and WantsNeeds and Wants
When you truly need something, When you truly need something, such as a new television, your such as a new television, your demand curve is a vertical line. That demand curve is a vertical line. That is, you do not care what price you is, you do not care what price you have to pay because you really need have to pay because you really need it? What about the need to eat it? What about the need to eat dinner? The need to obtain an MBA? dinner? The need to obtain an MBA? The need to have an operation The need to have an operation because you have cancer?because you have cancer?
Demand ApplicationDemand Application
In the past 20 years in the U.S., the In the past 20 years in the U.S., the price of attending college has price of attending college has risen more than the price of most risen more than the price of most other goods and services. Despite other goods and services. Despite the price rise, more people are the price rise, more people are going to college than before. going to college than before. Does this contradict the law of Does this contradict the law of demand?demand?
Demand ApplicationDemand Application The sale of heroin in the U.S. is a The sale of heroin in the U.S. is a
serious crime. Does that mean serious crime. Does that mean that no heroin is sold? that no heroin is sold?
Since heroin is illegal, does that Since heroin is illegal, does that mean that the price is higher than mean that the price is higher than it would be if it were legal?it would be if it were legal?
Demand analysisDemand analysis
Which of the following would cause an Which of the following would cause an increase in the demand for hairpieces increase in the demand for hairpieces (wigs) or hair replacement treatment?(wigs) or hair replacement treatment?
1.1. A rise in income.A rise in income.
2.2. A rise in the divorce rate.A rise in the divorce rate.
3.3. A rise in the demand by many other A rise in the demand by many other people.people.
4.4. A fall in the price of wigs.A fall in the price of wigs.
Clever sales pitchClever sales pitch
A British mobile-phone company A British mobile-phone company promised new subscribers in promised new subscribers in November and December that all November and December that all calls on Christmas Day, calls on Christmas Day, December 25, would be free. December 25, would be free. What would you expect happened What would you expect happened to the volume of calls that day?to the volume of calls that day?
Question on Question on complementary complementary
effectseffects GE research showed that about GE research showed that about
1980 the average size of the 1980 the average size of the American family was declining and American family was declining and so was the average square footage so was the average square footage of houses.of houses.
How would you think this impacted How would you think this impacted the demand for appliances or the the demand for appliances or the nature of the appliances?nature of the appliances?
Looking AheadLooking Ahead
Some countries are going to Some countries are going to experience falling populations and experience falling populations and aging populations in the next several aging populations in the next several decades. Japan will be one of the decades. Japan will be one of the hardest hit, and Italy, Spain, Greece hardest hit, and Italy, Spain, Greece and Germany.and Germany.
All else held equal, what major All else held equal, what major changes in demand for various goods changes in demand for various goods and services are likely to occur?and services are likely to occur?
