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Demand Curve

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The demand curve is flatter (more horizontal) the closer the substitutes for the product and the less diminishing marginal utility is at work for the buyers. •The dependent variable in demand analysis is the quantity (the number of units) sold. The independent variables are price, income of buyers, the price of substitutes, and the price of complements. •An increase in income shifts the demand curve to the right for normal good. It goes to the left for an inferior good. •An increase in the price of a substitute product shifts the demand curve to the right. Consider an increase in the price of bagels; bagel buyers shift along their demand curve to buy less bagels and substitute toward bread, shifting the demand curve for bread to the right at every price.

•An increase in the price of a complement shifts the demand curve to the left. When the price of jam rises, jam purchasers substitute along their demand curve, buying less jam and also less bread. This causes the demand curve for bread to shift to the left. •There is a positive relationship between the price and the quantity supplied along the supply curve. •The supply curve is positively sloped because of increasing costs as output increases •The supply curve shifts left (up) when the price of inputs rise or when productivity or technology declines (less output at same price). •The supply curve shifts right (down) when the price of inputs fall or when productivity or technology improves •The shortage is the quantity gap between the demand curve and the supply curve at the shortage price. •A surplus occurs if the price is maintained higher than at E. •Demand is more price elastic in recessions

•The price elasticity of demand equals the percentage change in quantity of units sold divided by the percentage change in price. •It measure how quantity or unit purchases by customers respond to changes in price • e = – (% change in Q)/(% change in P)

•firm demand equals the overall market elasticity divided by the firm’s proportional market share. If the elasticity of demand for movies is 3.6 and you have a movie chain in Austin with a proportional share of city movie theaters equal to .4 (ie, 40%), then the elasticity of demand for your movie chain is 3.6/(.4) which equals 9. •Rival products to your firm’s products are substitutes. The cross price elasticity of demand measures the % change in your firm’s quantity sold with respect to the % change in the rival’s (substitute) price. •If the cross elasticity = 4, then a 5% drop in the price of the rival product will cut your firm’s quantity (volume) sold by 20% (4 times -5% = -20%). The formula is • (% change in your Q) = (cross elasticity of demand) * (% change in the price of the substitute product). •Assume that the price elasticity of demand for your firm’s product (say bread) = 3 and The cross elasticity of demand for your bread with respect to your competitor’s bagels = 2. How would you respond to a 10% drop in the price of the rival firm’s bagel prices?

•You know from the above that the 10% rival price drop generates a change in your Q = (2) *( -10%) = -20%. If you want to experience no decrease in your Q, then drop your price by (% change in your Q caused by the rival price drop) / (your price elasticity of demand) = (-20%)/3 = -6.3%. Thus, your 20% Q decrease from the rival price change is almost completely offset by your 6.3% price drop. •Recall the 10% rival price drop generates a change in your Q = (1) *( -10%) = -10%. If you match the rival’s price drop, then the effect on your quantity sold is (% change in the rival’s price change [=% change in your price]) * (-your price elasticity of demand) = (-10%) * 3 = +30%. •No change in total revenue means that the % increase in quantity (the numerator in the elasticity formula) just equals the % decrease in price (the denominator in the elasticity formula). Thus e = 1. •Implication is that price drops lead to no change in total revenue at M where e = 1. •Income is maximized if activities are allowed to expand so long as the marginal benefits exceed the marginal costs. Economists argue that pollution be allowed to expand until the marginal benefit of another unit of pollution just equals the costs. •In general, people continue to use a common resource so long as the average value received from it exceeds the marginal cost of using

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