CHAPTERS 4-6SUPPLY & DEMAND

Unit III Review

4.1 Understanding Demand

Demand: the desire to own something and the ability to pay for it.

The law of demand: consumers buy more of a good when its price decreases and less when its price increases. The result of two patterns of behavior that overlap. Substitution effect: When consumers react to an

increase in a good’s price by consuming less of that good and more of other goods.

Income effect: the change in consumption resulting from a change in real income.

4.1 Understanding Demand

The Income Effect Rising prices make us feel poorer because you can no

longer buy the same combination of goods you once did.

Effect is seen when you buy fewer units of a good without increasing your purchases of other goods.

Economists measure consumption in the amount of a good that is bought, not the amount of money spent to buy it.

With rising prices, you are spending more on a good, but you are consuming less of it.

Income effect also operates when prices decline.

4.1 Understanding Demand

Demand Schedule: A table that lists the quantity of a good a person will buy at each different price.

Market demand schedule: a table that lists the quantity of a good all consumers in a market will buy at each different price.

4.1 Understanding Demand

Demand curve: a graphic representation of a demand schedule Vertical axis is always labeled with the prices and the

horizontal axis is always labeled with the quantity demanded.

Only shows the relationship between price and quantity demanded- all other factors are held constant.

The curve slopes downward to the right to show that as the price decreases, the quantity demanded increases.

4.2 Shifts of the Demand Curve

Ceteris paribus: all other things held constantA demand curve is only accurate as long as it is

only price that is changing.A movement along the demand curve due to a

change in price is a change in quantity demanded.

When a factor other than price changes the quantity demanded, it shifts the entire curve, referred to as a change in demand.

Shift right = increase in demand; shift left = decrease in demand

4.2 Shifts of the Demand Curve

Income Normal good: a good that consumers demand more

of when their income increases. Inferior good: a good that consumers demand less of

when their income increases.Consumer Expectations

Our expectation of the future can affect our demand for certain goods today.

If you expect higher prices in the future, your immediate demand will increase.

If you expect lower prices in the future, your immediate demand will decrease.

4.2 Shifts of the Demand Curve

Related Goods Complements: two goods that are bought and used

together. If the price of a good increases, the demand for it and its complement(s) will fall and vice versa.

Substitutes: goods used in place of each other. If the price of a good increases, the demand for its substitute(s) will increase and vice versa.

Preferences Advertising, social trends, celebrities, tv and movies,

publicityMarket Size (Population)

An increase in market size will lead to an increase in demand for most goods and vice versa.

4.3 Elasticity of Demand

Elasticity of demand: a measure of how consumers react to a change in price.

Inelastic: describes demand that is not very sensitive to a change in price.

Elastic: describes demand that is very sensitive to a change in price.

Calculating elasticity Percentage change in demand of good/percentage

change in price of demand Percentage change = ([original number – new

number]/original number) x 100

4.3 Elasticity of Demand

Price Range Demand for a good can be highly elastic at one price

and inelastic at a different price.Values of Elasticity

If the elasticity of demand for a good at a certain price is less than 1, demand is inelastic.

If the elasticity is greater than 1, demand is elastic. Unitary elastic: describes demand whose elasticity is

exactly equal to 1. When elasticity of demand is unitary, the percentage

change in quantity demanded is exactly equal to the percentage change in price.

4.3 Elasticity of Demand

Factors Affecting Elasticity Availability of substitutes: lack of substitutes can make

demand inelastic and a variety of substitutes can make demand elastic.

Relative importance: if you spend a large portion of your budget on a good, a price increase will make your demand elastic. If it is a small percentage of your budget, your demand is probably inelastic.

Necessities vs. luxuries: people will always buy necessities, even when price increases (inelastic). Luxuries are elastic as they are easy to reduce the quantity demanded.

Change over time: consumers cannot respond quickly to price changes, making their demand inelastic in the short term. Over time, they find substitutes and their demand becomes elastic.

4.3 Elasticity of Demand

Total revenue: the total amount of money a firm receives by selling goods or services. Price x quantity sold When a good has an elastic demand, raising the price

will decrease the quantity sold by a larger percentage, which can reduce a firm’s total revenue.

When demand is inelastic, higher prices make up for lower sales, increasing a firm’s total revenue.

A firm makes pricing decisions based on the elasticity of its good(s).