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How to Study for Chapter 3 The Law of Demand Chapter 3 introduces the law of demand and the principle of elasticity. 1. Begin by looking over the Ob ectives listed below. !his will tell you the main points you should be looking for as you read the chapter. ". #ew words or definitions are highlighted in italics in the te$t. Other key points are highlighted in bold type. 3. %ou have a graph in this chapter. Be sure to go over every point so that you can see how they are derived. Be sure that you can explain in your own words why the curve has the shape that it does &and how this shape relates to elasticity'. (. %ou will be given an )n Class *ssignment and a +omework assignment to illustrate the two main concepts of this chapter. ,hen you have finished the te$t and the assignments- go back to the Ob ectives. .ee if you can answer the /uestions without looking back at the te$t. )f not- go back and re0read that part of the te$t. ,hen you are ready- try the practice /ui1 for Chapter ( at the end of the te$t. Objectives for Chapter 3 The Law of Demand

*t the end of Chapter 3- you will be able to define the followin terms2 3emand 4aw of 3emand 3emand .chedule 3emand Curve &and draw the curve' 5rice 6lasticity of 3emand 7elatively )nelastic 3emand 7elatively 6lastic 3emand 8nit 6lastic 3emand 5erfectly )nelastic 3emand 5erfectly 6lastic 3emand !otal 7evenue *t the end of Chapter 3- you will also be able to answer the following2 &1' 6$plain what will happen to total revenue if the price rises and demand is relatively inelastic- &"' relatively elastic- or &3' unit elastic &"' #ame the factors that determine whether the demand for a given product will Be relatively elastic or relatively inelastic.

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Chapter 3

The Law Of Demand

&4atest revision *ugust "99('

*s already noted- markets are places &physical or otherwise' where buyers come to buy and sellers come to sell. )n this chapter- we shall focus on the /uantity of a given product that buyers wish to buy 000 called the demand. ,hat factors e$plain the /uantity demanded of a given product by buyers: One of the key factors is certainly the price of the product. !hink of buying soft drinks. %ou go into the market. * si$0pack sells for ;1.<<. %ou buy a given number 000 say two si$0packs. #e$t week- there is a sale 000 the price is ;9.<< a si$0pack. %ou stock up and buy five si$0packs= !he following week- the price has risen to ;".<< per si$0pack. !his is ust too e$pensive 000 you don>t buy any= !he result is familiar to anyone who shops for anything regularly. ,e can generali1e it with the following statement2 as the price of the product rises (falls), the quantity demanded of that product falls (rises). !he statement is typically referred to as the law of demand. ,hile one can perhaps think of an e$ception &if the price of a life saving drug that has no substitute rises- what would happen to your /uantity demanded:'- they are so few that we can assume safely that the statement is true in all cases. !he following demand schedule for new homes illustrates the law of demand2 !rice 1 " 3 ( A @ B ? < 19 11 "uantity Demanded !er #onth 9 1999 "999 3999 (999 A999 @999 B999 ?999 <999 19999 11999

;3(9-999 ;3"9-999 ;399-999 ;"?9-999 ;"@9-999 ;"(9-999 ;""9-999 ;"99-999 ;1?9-999 ;1@9-999 ;1(9-999 ;1"9-999

#ote that- in this e$ample- at any price above ;3"9-999- no one will buy any homes. !hen- as the price falls- people buy more homes in the month. ,e can then picture this in the graph on the ne$t page. !he graph allows us to analy1e more clearly because we can see visually what is occurring. #otice the downward$slopin line. *s the price of homes falls- people buy more homes.
Test %our &nderstandin Corm in a group. *ssume that you are planning to attend 5alomar College ne$t semester. )ndividuallydetermine how many units you would take if the fee per unit is as given. !hen- add up the total number of units for all members of the group.

3 C66 567 8#)! ; 9 ; A ;1A ;"@ ;A9 ;199 ;A99 ;1-999 %O8 EEEEE EEEEE EEEEE EEEEE EEEEE EEEEE EEEEE EEEEE D7O85 !O!*4 EEEEEEEEEE EEEEEEEEEE EEEEEEEEEE EEEEEEEEEE EEEEEEEEEE EEEEEEEEEE EEEEEEEEEE EEEEEEEEEE

Demand Curve
$350,000 1 $300,000 2 3 $250,000 4 5 6 Price of Homes $200,000 7 8 $150,000 9 10 11 $100,000

$50,000

$0 1 2 3 4 5 6 Number of Homes 7 8 9 10 11

!he law of demand tells us some information that is useful. )f we- as a company- charge a higher price- people will buy less of our product. But this information is not enough. ,e want to know precisely what will happen to the /uantity demanded of our product if we raise the price by a given amount. )n particular- we want to know what is called the price elasticity of demand. *s a formula- this is2 !ercenta e Chan e in "uantity Demanded !ercenta e Chan e in !rice In words, this is the percentage change in the quantity demanded of a given product that results because of a given percentage change in the price of that product. )t measures how much buyers respond to the change in the price. &#otice that we use Fpercentage changeF instead of Fchange in amountF. !his allows us to compare different products. 5eople will respond much differently to a ten0cent increase in the price of a candy bar than to a ten0cent increase in the price of an automobile. .o we measure the change in percentage terms to allow comparison.' ,hen we calculate our formula- we get a number. &!he number is actually negative- but we will ignore the minus sign.' If the number is more than zero but less than one, we say that demand is relatively inelastic' !his means that buyers reduce their buying- but very little- as the price of the product rises. If the number is more than one, we say that demand is relatively elastic. !his means that buyers not only reduce their buying- but they reduce it considerably- as the price rises. If the number exactly equals one, we say that demand is unit elastic. F8nitF means one. If the number exactly equals zero, we say that demand is perfectly inelastic. !his means that buyers do not change their /uantity demanded at all if the price rises. 5erfectly inelastic demand would be a violation of the law of demand. ,e will not encounter any e$amples of perfectly inelastic demand. Finally, if the number is infinitely large, we say that the demand is perfectly elastic. ,e will encounter several e$amples of this. )t means that the market is infinitely largeG the seller can sell as much as he or she wants at the price that e$ists in the market. (f the number is) *etween + and , .reater than , 0, 0+ (nfinitely Lar e Demand is) -elatively (nelastic -elatively /lastic &nit /lastic !erfectly (nelastic !erfectly /lastic

7emember that the demand curve was drawn as a downward0sloping line. Below are two demand curves for two different products- H and %. Both are downward0sloping lines. Cor which of the two is the demand relatively inelastic:

5rice

5rice

;11

;11

;19 9

.*
3emand

;19 Iuantity 9 39 &%'

*
3emand

<A199 &H'

199

Iuantity

!he answer is H. )n both cases- the price starts at ;19 and the /uantity demanded is 199 &5oint *'. )n both cases- the price rises to ;11. Cor H the /uantity demanded only falls to <A while for % the /uantity demanded falls to 39 &5oint B'. !he demand for H is more inelastic than the demand for %. Or we can say it differently2 the demand for % is more elastic than the demand for H. ,e can generali1e2 the more inelastic (elastic) is the demand for the product, the steeper (flatter) is the demand curve. Below are two graphs. ,hich represents perfectly inelastic demand and which represents perfectly elastic demand: 5rice 3emand 5rice EEEEEEEEEEEEEEEEEEEEE 3emand

EEEEEEEEEEEEEEEEEEEEEEEE 9 &H' Iuantity

EEEEEEEEEEEEEEEEEEEEEEEEEEEE 9 &%' Iuantity

!he answer is that 1 2the vertical line3 represents perfectly inelastic demand. !he /uantity demanded stays the same regardless of the price. % 2the hori4ontal line3 represents perfectly elastic demand. *t the given price- the company can sell all it desires. !he dividing line between relatively inelastic demand and relatively elastic demand occurs when the number is e/ual to one &unit elastic demand'. !here is a reason for this. !he reason has to do with total revenue. otal revenue is the amount of money received from selling the product. It is the product of price times quantity. &)n the first graph- if the price is ;19 and the /uantity demanded is 199- the total revenue is ;1-999.' )f the price rises- what will happen to the

total revenue: !he answer depends on the price elasticity of demand. )f the demand is relatively inelastic- the number is less than one. Cor this to occur- the percentage change in the price must be greater than the percentage change in the /uantity demanded &review the formula'. .ince the price is rising and the /uantity demanded is falling- the fact that the percentage change in the price is greater than the percentage change in the /uantity demanded means that total revenue must be risin . 8sing the numbers above- if the price rises to ;11- the /uantity demanded falls to <A- and the total revenue rises to ;1-9(A &;11 $ <A'. On the other hand- if the demand is relatively elastic- the number must be greater than one. !his means that the percentage change in the /uantity demanded must be greater than the percentage change in the price &again- review the formula'. .ince the /uantity demanded is falling and the price is risingthe fact that the percentage change in the /uantity demanded is greater than the percentage change in the price means that the total revenue must fall. 8sing the numbers above- if the price rises to ;11- /uantity demanded falls to 39. !otal revenue falls to ;339 &;11 $ 39'. Cinally- assume that the demand is unit elastic. .ince the number e/uals one- the percentage change in /uantity demanded must be the same as the percentage change in the price. !he result is that- if the price rises- the total revenue stays the same' &)f the price rises to ;11- /uantity demanded falls to about <1. !otal revenue stays ;1-999.' In summary, if the price rises (falls), and demand is! relatively inelastic, total revenue rises (falls). relatively elastic, total revenue falls (rises). unit elastic, total revenue stays the same. !his point is commonly misunderstood by businesses. Businesses tend to assume that the demand for their products is relatively inelastic. &Often- they assume that the demand for their products is perfectly inelastic.' !hey believe that- if they raise the price- they will take in more revenues. !his is often not the case. *s one e$ample- until the early 1<?9s- the airlines &*merican *irlines- 3elta *irlines- 8nited *irlines- and so forth' were regulated by an agency of the government- the Civil *eronautics Board &C*B'. * purpose of the regulations was to keep airlines prices high. )n the late 1<B9s- there was a proposal to eliminate the regulations. !he large airlines believed &correctly' that the end of the regulations would means lower airline prices. !hey also believed that this would mean lower airline revenues &that is- the assumed that the demand for airline travel was relatively inelastic'. 3espite opposition from the large airline companies- the proposal was accepted and the regulations were eliminated. *s e$pected- the airline prices fell. But- total revenues rose considerably. !his means that the demand for airline travel was actually relatively elastic. !he airline companies had fought to prevent something that turned out to be very good for them. *nother e$ample involves the .an 3iego baseball team in the early 1<<9s. !he team was consistently bad and consistently operated at a loss. *ttendance was low. !he team owners had several options. !hey could have tried to have a better team &which- of course- they finally did'. +owever- they could not afford the best players. !hey could have tried to market the product by having promotions- better hot dogs- and so forth. !hey did this but- with such a bad team- it had only a small effect on attendance. Or they could have tried to lower costs by getting rid of the most e$pensive players. Cinally- they could have raised their prices. !hey chose these last two alternatives. !hey never considered another alternative2 lower the price to fill up the empty seats. 4ike airline travel- the demand for baseball is very elastic. 4owering the prices might

have increased attendance considerably. !he team put a tarp around the upper deck- admitting that they could not sell these tickets. But at ;A or less- someone might buy them. ;A would be better than 1ero and total revenues would be larger. !he possibility of lowering prices to increase total revenues seems to have never entered the minds of team owners. )n late 1<<(- they sold the team at a loss. * similar e$ample occurred for Jills College- a small women>s liberal arts college in Oakland. Caced with a low enrollment and low revenues- the college considered a ma or change 000 admitting men. 5rotests were e$tensive- ultimately leading to the resignation of the college 5resident. !he college then decided that enrollment must grow to 1999 or men would be allowed in as students. .omehow the college trustees have never considered the possibility that enrollment is low because the fees are so high. 4owering the fees they charge might actually increase total revenues- allowing the college to survive as the only women>s college in the ,est.
Test %our 5nowled e *nswer the following /uestions without referring back. 1. !o calculate the price elasticity of demand- you divide the EEEEEEEEEEEEE by the EEEEEEEEE. ". )f the elasticity number is between 1ero and one- we say the demand is EEEEEEEEEEEEEEEEEE. 3. )f the elasticity number is more than one- we say the demand is EEEEEEEEEEEEEEEEEE. (. )f the elasticity number is one- we say the demand is EEEEEEEEEEEEEEEEEE. A. )f the elasticity number is 1ero- we say the demand is EEEEEEEEEEEEEEEEEE. @. )f the demand for * is more inelastic than the demand for B- the graph of the demand for * would be drawn EEEEEEEEEEE &flatter or steeper:' B. )f the demand for * is perfectly elastic- the graph of the demand for * would be drawn EEEEEEEEEEEE.

!hese e$amples illustrate that it is important to know if the demand for your product is relatively inelastic or relatively elastic. One can do detailed statistical studies. But these are e$pensive to do and may not be totally accurate. +owever- if one knows that factors that determine whether demand for a particular good is relatively inelastic or relatively elastic- one can make a good guess as to what the true number is likely to be. There are three such factors. Cirst- consider the demand for electricity: )s this demand likely to be relatively elastic or relatively inelastic &i.e.- if the price of electricity rises by 19K- will the /uantity demanded fall very little or fall greatly': #ow consider the demand for baseball tickets. )s this demand likely to be relatively elastic or relatively inelastic: Jost likely you said that the demand for electricity is relatively inelastic and the demand for baseball tickets is relatively elastic. &)f you did not say this- go back and review the definitions.' ,hat accounts for the difference: !he answer is substitutes available 000 how many substitutes are there and how close are they as substitutes: )f the price of electricity rises- what will buyers do: !hey can reduce their buying by turning off the lights- closing the refrigerator door- insulating their homes- and so forth. But the options are limited. !here are simply not good substitutes for electricity. 5eople will reduce their buying very little- making the demand relatively inelastic. )f the price of baseball tickets rises- what will buyers do: !hey can reduce their buying greatly because there are many substitutes for baseball tickets 000 movies- beach- parks- camping- television- and so forth. !herefore- the demand for baseball tickets is relatively elastic. Consider the demand for telephone services. )s this demand relatively elastic or inelastic: Jany would probably say inelastic- but this is not so. !he answer is confusing because of the

unusual way we pay for local telephone service &a fi$ed fee with no additional charge within a given geographic area'. *ssume that we pay- instead- for the telephone through message units. !his means that we pay more the longer we talk and the farther away is the other party &as we do for long distance'. #ow- is the demand is relatively elastic or inelastic: &)f the telephone rates rise- will you talk for a little less time or for much less time:' Jost people will reduce their time on the telephone considerably- making the demand relatively elastic. )f we have to pay for each call- we will simply not make them. Or we will keep them to only a few minutes. The point is that the substitute involved does not have to be a different product' (t mi ht be 6do nothin 6' )n this case- Fnot calling is a good substitute for using the telephone. "fter substitutes, a second factor affecting the price elasticity of demand is time. By this we mean the time to develop substitutes. .uppose that- in the last hour- the price of gasoline rose to ;A per gallon. %our tank is almost empty. ,hat will you do today: !he answer is that you will probably fill your tank- pay the higher price- and complain loudly= But as time goes on- you will find ways to substitute. %ou will change your driving habits. %ou will arrange car0pooling. %ou may even buy a bicycle for shorter trips. Diven a long enough time- you will buy a new car that gets much better gasoline mileage. " third of the factors affecting the price elasticity of demand is the price of the product in relation to one#s income. Jore loosely- we are asking how expensive is the product. 5eople will respond more to an increase in the price of an e$pensive product than an ine$pensive one. *ssume that the price of a can of 5epsi Cola in the machine rises by ?K. !his would be a nickel. Cor most people- a nickel is not much money. )f you want the Cola- you will ust pay the higher price. Iuantity demanded will fall slightly. #ow assume that the price of an automobile rises by the same ?K. On an average car- this would be about ;"-999. Cor most people- this is e$pensive. 5eople are more likely to considerably reduce their buying of cars. Because of this last point- we need to re0e$amine the shape of the demand curves. 6arlier- it was said that- if demand were relatively inelastic- the demand curve would be steeper and- if demand were relatively elastic- the demand curve would be flatter. +owever- because of the third factor affecting elasticity- the elasticity of demand changes as we move along the demand curve. "t low prices, the demand is li$ely to be relatively inelastic because the product is not expensive. "s the price rises, the demand will become more and more elastic. 5rice . 6lastic .ection

. )nelastic .ection 3emand EEEEEEEEEEEEEEEEEEEEEEEEEEEEEEE 9 Iuantity

<

Consider cigarettes. )s the demand relatively elastic or inelastic: Jost would answer Frelatively inelastic on the basis that people are FhookedF and cannot /uit easily. Cigarettes currently sell for about ;( a pack. )magine what would occur if the price rose to ;A. to ;19. to ;"9. *s the price of cigarettes become very e$pensive- we suspect that people would find a way to /uit- or at least cut down. hus, as the price rises, the demand has become relatively more elastic. &Iuestion2 why would the demand for cigarettes be more elastic for people age 13 than for people age (9:' Let us summari4e' he demand for a given product will be relatively more elastic (buyers will respond more if the price rises) if! (%) there are many good substitutes for the product, including doing without (&) there is a longer time under consideration (') the price of the product is relatively high is relation to buyers# incomes. The reverse would cause the demand to be relatively more inelastic'
Test %our &nderstandin 1. 6arlier it was argued that the demand for airline travel was relatively elastic. 6$plain why this would be so using the three factors discussed in this section. ". !he case of Jills College was described earlier. ,ould the demand for this type of college be relative elastic or inelastic: 8se the three factors to e$plain why. 3. )n the middle 1<<9s- Dovernor ,ilson wanted to raise the fees at community colleges to ;39 per unit to increase revenues. )s the demand for community college courses relatively elastic or relatively inelastic: 8se the three factors to e$plain why. (. !he 5ost Office raised the price of a first class stamp from 3" cents to 33 cents. )n this rangeis the demand to send a first class letter relatively elastic or relatively inelastic: ,hy: A. )n each case- state whether you believe the demand for the product is relatively elastic or relatively inelastic: !hen- provide reasons for your conclusion. a. .ervices of a doctor to fi$ a broken arm b. .ervices of a doctor for plastic surgery &changing one>s appearance' c. * new 4e$us ;A9-999 automobile d. 8se of cigarettes e. Buying gasoline

!ractice "ui4 for Chapter 7


1. !he law of demand states that2 a. as the /uantity demanded rises- the price falls b. as the price rises- the /uantity demanded falls !he demand curve normally slopes a. down to the right b. up to the right c. as income rises- the demand for the product rises d. as supply rises- the demand rises d. vertically

". 3.

c. hori1ontally

!he price elasticity of demand is the2 a. percentage change in /uantity demanded divided by the percentage change in price b. percentage change in price divided by the percentage change in /uantity demanded c. dollar change in /uantity demanded divided by the dollar change in price d. percentage change in /uantity demanded divided by the percentage change in /uantity supplied )f the price elasticity of demand e/uals 9.A- the demand for the product is2 a. relatively inelastic c. perfectly inelastic b. relatively elastic d. unit elastic

(.

19 A. Community Colleges desired to increase revenues. !hey decided to raise fees paid by students with Bachelors degrees to ;A9 because they believed this would result in greater revenues. !herefore- the Community Colleges must have believed that the demand for Community College courses by people with Bachelors degrees is2 a. relatively inelastic b. unit elastic c. relatively elastic d. perfectly elastic @. !he demand for a product would be more inelastic2 a. the longer is the time under consideration b. the greater is the number of substitutes available to buyers c. the less e$pensive is the product in relation to incomes d. all of the above B. !he following is a demand curve for a product. *t which point along this demand curve is the demand for the product likely to be most elastic: &+int2 the elasticity is related to how e$pensive the product is' 5rice C B .* 3emand EEEEEEEEEEEEEEEEEEEEEEEEEEEEEEEEE 9 Iuantity 3emanded ?. )f the demand for a product is unit elastic and the price rises- the total revenue will a. rise b. fall c. stay the same <. Cor which of the following products would the demand be most elastic: a. hamburger b. beef c. meat d. food

19. )n drawing the demand curve- if the demand for the product is more inelastic- you would draw the line2 a. flatter b. steeper *nswers 1. B ". * 3. * (. * A. * @. C B. C ?. C <. * 19. B