Outline Six - Market Demand:  Aggregating Individual Demand Curves

Horizontal Summation:

Graph:

Price Elasticity of Demand Revisited

Price Elasticity of Demand =

Remember the polar cases:  Perfectly elastic and perfectly inelastic

Elasticity along a demand curve:

Elasticity and Total Revenue

 When operating along the elastic portion of a demand curve, a drop in price will increase total revenue (the % increase in demand will more than offset the % drop in price).  Marginal revenue is positive.

When operating along the unitary portion of a demand curve, a drop in price will not change total revenue (the % increase in demand will just offset the % drop in price).  Marginal revenue is zero.

When operating along the inelastic portion of a demand curve, a drop in price will decrease total revenue (the % increase in demand will not make up for the % drop in price).  Marginal revenue is negative.

Graphs:  Demand and Total Revenue

Determinants of Price Elasticity of Demand (let’s add a new one now that we have looked at the substitution and income effects):

1.       Substitutes

2.       Budget share

3.       Time

4.       NOW – Direction of income effect:

    Normal good - the income effect argues in favor of buying more with a price drop and vice versa - Drop price, real income goes up, buy more.

    Inferior good - the income effect argues in favor of buying less with a price drop and vice versa - Drop price, real income goes up, buy less.

So - an inferior good will be more inelastic than a normal good with a change in price (ceteris paribus).

 Note:  Short-run is less than a year.  Long-run is more than a year.

Source:  http://www.mackinac.org/article.aspx?ID=1247

The Dependence of Market Demand on Income

The quantity of a good demanded by any person depends not only on its price but also on the person’s income (as we have seen).  Since the market demand curve is the horizontal sum of individual demand curves, it too will be influenced by consumer incomes.

In some cases the effect of income on market demand can be accounted for completely if we know only the average income level in the market – and this is usually assumed to be the case.  This would be the case if all consumers in the market were alike in terms of preference and all had the same incomes.

Realistically, however, this is not the case.  The level of average income in a market will sometimes create different market demands depending on how income is distributed among persons.  Why?

Example (Food):

Demand in other markets is relatively insensitive to variations in the distribution of income.  In particular, the distribution of income is not likely to matter much in markets in which individual demands tend to move roughly in proportion to changes in income (the increases offset the decreases).

If this is the case – then we can talk about:

Income Elasticity of Demand -  Market Demand:

Food, typically has an income elasticity less than one (sometimes called a necessity).

Expensive jewelry or foreign travel typically have an income elasticity greater than one (sometimes called luxuries).

Application:  Forecasting Economic Trends?

Economists have estimated the following income elasticities:

Given that GDP (an indirect measure of income) has increased on average about 2% since the industrial revolution – what would you predict about the good/services above?  Why might the forecasts be wrong?

Cross-Price Elasticities of Demand

Substitutes:

Complements:

What would you predict – would the cross price elasticity of demand be positive or negative for the following pairs of goods?  A)  apples and oranges, B) airline tickets and automobile tires, C) computer hardware and software, D) pens and paper, E) pens and pencils?

Economists have estimated the following cross-price elasticities.  Note that the same cross-price elasticity does not come about with the same two goods  - it depends upon how it is calculated.  Does this make sense?