Consumer Theory - Part 2 Flashcards
If there are 10 billion packs of cigarettes sold in a year, how much revenue would a new tax of $0.25 per pack generate?
A. Less than $2.5 billion?
B. $2.5 billion?
C. More than $2.5 billion?
Why?
A. Less than $2.5 Billion
Why?
* There is a behavioral response to the tax imposed.
What is the Price Elasticity of Demand?
A measure of the responsiveness of quantity demanded to changes in price:
ϵd = (% change in quantity demanded) / (% change in price) <= 0
Interpretation: “A one-percent increase in the price leads to an ϵd percent decrease in quantity demanded.”
Or the more precise definition:
ϵd = ( ∂Qd / ∂P )( P / Qd ) ≤ 0
As the demand curve is always ___________ sloping, price elasticity is always ______________ .
downward, negative
- If −1 < ϵd ≤ 0 , demand is inelastic… less sensitive to changes in price
- If ϵd < −1 , demand is elastic… more sensitive to changes in price
If −1 < ϵd ≤ 0 , demand is ____________ and therefore ____________ sensitive to change in price
inelastic, less
If ϵd < −1 , demand is ______________ and therefore _____________ sensitive to changes in price
elastic, more
All else equal, flatter demand curves
imply…
… a more elastic demand
Where ϵd is less negative, the same
price increase would lead to smaller
decreases in the quantity demanded.
Consumer Theory Part 2, Slide 5
Perfectly elastic demand
Quantity demanded falls to zero when
the price increases and approaches
infinity when the price decreases
Represented graphically by a horizontal demand curve
ϵd −> ∞
Consumer Theory Part 2, Slide 6
Perfectly inelastic demand
Quantity demanded does not change
when the price changes.
Represented graphically by a vertical demand curve
ϵd = 0
Consumer Theory Part 2, Slide 7
What influences the responsiveness of an individual’s choice of quantity demanded to a change in price?
- The availability of close substitutes
- More alternatives -> higher price sensitivity
- The fraction of income spent on the good
- More spending relative to income -> higher price sensitivity
- Having more time to respond
- More time to adjust -> higher price sensitivity
Good/Service Elasticity of Demand Elastic or Inelastic?
Business travel -0.10
Medical care -0.17
Coffee -0.25
Tobacco -0.45
Movies -0.90
Private school -1.10
Restaurant meals -1.60
Leisure travel -2.40
Fresh vegetables -3.70
Honda cars -4.00
Business travel -0.10 Inelastic
Medical care -0.17 Inelastic
Coffee -0.25 Inelastic
Tobacco -0.45 Inelastic
Movies -0.90 Inelastic
Private school -1.10 Elastic
Restaurant meals -1.60 Elastic
Leisure travel -2.40 Elastic
Fresh vegetables -3.70 Elastic
Honda cars -4.00 Elastic
For a linear demand curve, as quantity demanded increases, ϵd ___________________ .
Increases toward zero.
ϵd = ( ∂Qd / ∂P )( P / Qd ) ≤ 0
A linear demand curve is ___________ elastic at higher prices.
A linear demand curve is ___________ elastic at lower prices.
A linear demand curve is more elastic at higher prices.
A linear demand curve is less elastic at lower prices.
Elastic Region
Increase price -> decrease revenue
The decrease in quantity demanded
(revenue lost) outweighs the increase
in price (revenue gained)
Consumer Theory Part 2, Slide 11
Inelastic Region
Increase price -> increase revenue
The increase in price (revenue gained)
outweighs the decrease in quantity
demanded (revenue lost)
Consumer Theory Part 2, Slide 12
In general, firms will/should not produce in the _____________ portion of the demand curve.
Inelastic
When in the inelastic portion, Increasing price increases revenue and lowers costs, which leads to increases profits. win win to increase price until you are no longer in the inelastic region.
Consumer Theory Part 2, Slide 12
What determines a consumers demand for a product?
- Our income or wealth
- The price of other goods
- The legality of consuming the good
- The cost of maintaining the good
- Our health
- Our finite existence
- etc
An increase in demand…
At every price, the individual is now
willing and able to purchase more
units than before
The equilibrium quantity increases
The equilibrium price increases
This is graphically represented by a shift in the entire demand curve to the right. There is no movement up or down the demand curve.
Consumer Theory Part 2, Slide 16
A decrease in demand…
At every price, the individual is now
willing and able to purchase fewer
units than before
The equilibrium quantity decreases
The equilibrium price decreases
This is graphically represented by a shift in the entire demand curve to the left. There is not movement up or down the demand curve.
Consumer Theory Part 2, Slide 17
Income and the price of other goods have ambiguous effects on demand
What happens when income changes?
What happens when the price of another good changes
It depends… on whether the good is normal or inferior
It depends… on whether the goods are substitutes or complements
Normal goods
A good for which demand increases as income increases, all else equal
- Organic food
- Fine dining
- Air travel
- Political donations
- Consumer electronics
- Children?
Graphically represented by the demand curve shifting right. Income increases -> Demand increases
Consumer Theory Part 2, Slide 19-20
Inferior goods
A good for which demand decreases as income increases, all else equal.
Examples
* Ramen noodles
* Fast food
* Canned vegetables
* Second-hand furniture
* Public transportation
* Payday loans
Graphically represented by the demand curve shifting left. Income increases -> demand decreases
Consumer Theory Part 2, Slide 21-22
Substitutes
Two goods for which the demand of one good increases as the price of the other good increases, all else equal
Examples
* Ubers and traditional taxis
* Levi jeans and Wrangler jeans
* iPad and Microsoft Surface
* F150 and F150 Lightening
* Traditional MBAs and Executive MBAs
* Pepsi and Coke
* Small coffees and large coffees
Complements
Two goods for which the demand of one good decreases as the price of the other good increases, all else
equal.
Examples
* Peanut butter and jam
* Flexible work and school
* Gasoline and F150 pickup trucks
* Paper and pencils
* Wine and cheese
* Coffee and milk
