PRICE ELASTICITY OF D EMAND

• The change in price as a percentage of the average price—the • Responsiveness of the quantity demanded of a good to a
average of the initial and new price change in its price
• (25/87.5) x 100%=28.6 % Percentage change in the quantity demanded
•
Percentage change in the price
• The change in the quantity demanded as a
percentage of the average quantity demanded—the • Price: $75 to $100
average of the initial and new quantity • Percentage change in price?
• 25%? (25/100) or 33.3%? (25/75)
• Depends on the denominator
• Mid-point formula

EXAMPLE: C ALCULATING P RICE ELASTICITY OF DEMAND

• Initially, the price of a pizza is $20.50 and the quantity The price of a pizza falls to $19.50 and the quantity demanded increases
demanded is 9 pizzas an hour to 11 pizzas an hour

The price falls by $1 and the quantity demanded increases by 2 pizzas an

hour

• The average price is $20, and the average quantity demanded is • The percentage change in quantity demanded is DQ/Qave x
10 pizzas an hour 100%
• (2/10) x 100% = 20%
• The percentage change in price is DP/Pave x 100%
• ($1/$20) x 100% = 5%

• The price elasticity of demand is A Few Things About Price Elasticity of Demand
• 20% / 5% = 4
 Why average price and quantity?
 Same elasticity value regardless of whether the price rises
or falls
 Positive or negative value?
 Negative
 Price and quantity move in opposite directions
 Magnitude, or absolute value
 How responsive the quantity change has been to a price
change
Perfectly inelastic demand Perfectly elastic demand
 The quantity demanded doesn’t change when the price • The change in quantity demanded is infinitely large when the
changes price changes

Inelastic and Elastic Demand Elasticity along a linear demand curve

• Inelastic demand  Calculate the price elasticity of demand
• The price elasticity of demand is less than 1  Prices falls from 25 to 15
• The percentage change in the quantity demanded is  Prices falls from 15 to 10
smaller than the percentage change in price  Prices falls from 10 to 0
• Elastic demand
• The price elasticity of demand is greater than 1
• The percentage change in the quantity demanded is
greater than the percentage change in price

ELASTICITY AND SLOPE ALONG A LINEAR DEMAND CURVE

• Price falls from $25 to $15 • Price falls from $15 to $10
• Quantity increases from 0 to 20 • Quantity increases from 20 to 30
• The price elasticity of demand is (20/10)/(10/20)=4 • The price elasticity of demand is (10/25)/(5/12.5)=1

• Price falls from $10 to $0 • Elasticity is not the same as slope

• Quantity increases from 30 to 50 • Points on a linear line have the same slope but different
• The price elasticity of demand is (20/40)/(10/5)=1/4 elasticities
DISCUSSION QUESTION: (TOTAL REVENUE AND PRICE)
• The total revenue from the sale of a good or service equals
the price of the good multiplied by the quantity sold
• Will a rise in price always increase total revenue?
• When the price
rises from 19.5
to 20.5, does
total revenue
increase?
• No!
• Revenue
before=214.5
• Revenue
after=184.5
• %DQ / %DP =
20% / 5% = 4
Implication of inelastic and elastic demand: Total Revenue Example
• Will a rise in price always increase total revenue? (No!) • Which video streaming platforms are most popular
• Depends on the elasticity of demand among Singapore consumers?
• If demand is elastic • Netflix!
• Price increases, total revenue decreases • Over one in three (36%) consumers are
• If demand is inelastic subscribers in 2023
• Price increases, total revenue increases • Demand is elastic or inelastic?
• In 2011, Netflix increases its prices for
Discussion Question: Factors that influence the Elasticity of Demand various packages, and this led to a
significant decrease in the subscriptions
• In 2023, PED is 0.13 (inelastic)
• Why?
• Change in consumer preference
(Covid)/Netflix unique content
CONSUMPTION POSSIBILITIES
• Where does the demand curve come from?
• Consumer choices
• Where does the supply curve come from?
• Producer choices
Basic Assumptions
• Consumers face budget constraints
• Consumers are rational (maximize satisfaction)
• Consumers are fully informed
• There is no saving or borrowing, only buying
Consumer Theory Road Map • The things that you can afford to buy
• Consumption Possibilities • Limited by income and the prices
• Budget line
Example: Sweaters and Jeans
• Prices and income
• Income=300
• Preference: Describe what consumers like?
• Price of Sweaters=$25
• Consumer Choice
• Price of Jeans=$50
• How do consumers choose what to buy and how much to buy?
What are the combinations of sweaters and jeans you can
• Best affordable choice
afford to buy?
• 12 sweaters
• 6 jeans
• 4 sweaters and 4 jeans
Budget line=limits of consumption possibilities Discussion Question: Budget line
Negative
Income=300, Price of
slope?
Sweaters=$25, Price of
Equation?
Jeans=$50

12 Sweaters 0 Jeans y=12-2x

8 Sweaters 2 Jeans What does the

slope
4 Sweaters 4 Jeans represent?
0 Sweaters 6 Jeans Price of
Jeans/Price of
Sweaters

Discussion Question: Budget line UTILITY

Income=300 Price of Sweaters=$25 Taste and preferences: Like and dislike
Price of Jeans=$50
• The price of a sweater doubles • How do consumers rank two products?
• Or your income falls to $150 a • A consumer prefers good A to good B
month • If the consumer is more satisfied
• Or both the price of a sweater and with A than with B
a pair of jeans double • A consumer prefers good B to good A
• A consumer is indifferent between A and B
• If the consumer is equally satisfied
with A or B
Utility Total utility Marginal Utility
• Benefit or satisfaction from The change in total utility that
consuming a good or service is results from a unit-increase in the
called utility quantity of the good consumed
• Total Utility
• Total benefit a person Increasing or diminishing marginal
gets from the utility?
consumption of goods
• Generally, more consumption Negative Marginal Utility?
results in more total utility
From total utility to marginal utility How to represent preference in graph?
• Indifference Curve
• For simplicity, our consumption basket only has
sweaters and jeans

845
Basket A: 6 sweaters and 3 pairs of jeans
Basket B: 4 sweaters and 5 pairs of jeans
How to represent preference in graph? Indifference Curve
• Indifferent between
• A: 6 sweaters + 3 pairs of jeans
• B: 4 sweaters + 5 pairs of jeans
A Common Assumption: More is Better
• Consumers like both goods
E.g., 2 sweaters + 3 pairs of jeans → 1 sweater + 3 pairs of jeans
E.g., 2 sweaters + 3 pairs of jeans → 2 sweaters + 2 pairs of jeans
E.g., 2 sweaters + 3 pairs of jeans → 1 sweater + 1 pair of jeans
What can we gain from this assumption?
Indifference Curves are Downward Sloping Which baskets are preferred/less preferred to A?

Higher indifference curve, higher satisfaction Preference Map

Special Preferences Example of Perfect Substitutes: iPhones

• Perfect substitutes
• Indifference curves are linear
• Perfect complements
• Indifference curves are L-shaped
Example of Perfect Substitutes
• “White iPhones and black iPhones are equivalent”
• 1 white iPhone always brings the same level of satisfaction as 1 black
iPhone
• To the consumer, white iPhone and black iPhone are perfect
substitutes

Example of Perfect Complements Example of Perfect Complements: Shoes

• “For every right shoe, I need exactly one left shoe”
• 2 right shoes and 1 left shoe brings the same level of satisfaction as 1
right shoe and 1 left shoe
• To the consumer, right shoes and left shoes are perfect complements
Discussion Question: Shin-chan’s indifference curve?
• Shin-chan hates “green pepper” but likes “hamburger”
• The satisfaction from 2 hamburgers exactly offsets the dissatisfaction
from 1 green pepper
• Draw one indifference curve for Shin-chan starting from the origin

CONSUMER CHOICE
Finding the best affordable basket from the Graph Conditions for best affordable basket
• On the budget line
• On the highest attainable indifference curve

Utility-Maximizing Choice: Total Utility

• Consumption possibility that maximizes total utility
• The direct way to find the utility-maximizing choice

1. Find the just-affordable combinations

2. Find the total utility for each just-affordable combination
3. The utility-maximizing combination is the consumer’s
choice
Find Just-Affordable Combinations Discussion Question: Find the Total Utility for Each Just-
• Income=300, Price of Sweaters=$25, Price of Jeans=$50 Affordable Combination (page 39 for total utility)
• Combinations of sweater and jeans you can afford to buy?

A more natural way: Choosing at the Margin Equal Marginal Utility per Dollar
• The marginal utility per dollar MUs MU𝐽
• > , buy more sweaters and less jeans
Ps P𝐽
• The marginal utility from a good divided by its price MUs MU𝐽
• < , buy more jeans and less sweaters
Ps P𝐽
MUs MU𝐽
• =
Ps P𝐽

Why does the demand curve have a negative slope?

Discussion Question: Where is the point on the demand curve for Summary
jeans? • Changes in prices and income change the best affordable
choices
Wrap it up Part 1

• Assuming that Grove decides to increase the price of its Kopi

from $1 to $3, and that results in a 20% decrease in demand,
Calculate the price elasticity of demand for Kopi.
20%/100% = 0.2
• What would the demand curve look like if the increase in price,
does not cause a change in demand?

Wrap it up Part 2
• “For every right shoe, I need exactly one left shoe”
• Income=$1800
• The price of left shoe=$300, the price of right shoe=$600
• What is the best affordable choice?
Discussion Question: Best affordable choice for perfect complements
• What would the demand curve look like if the increase in price,
results in an infinite decrease in demand?

KEY IDEAS FOR LECTURE 3

• The price elasticity of demand is a measure of the responsiveness of the quantity
demanded of a good to a change in its price
• The buyer’s problem has three parts: what you like, prices, and your budget
• An optimizing buyer makes decisions at the margin
• An individual’s demand curve reflects an ability and willingness to pay for a good or
service