Chapter 7

MARKET DEMAND AND

ELASTICITY
Copyright 2002 by South-Western, a division of Thomson Learning. All rights reserved.
MICROECONOMIC THEORY
BASIC PRINCIPLES AND EXTENSIONS
EIGHTH EDITION
WALTER NICHOLSON
Market Demand Curves
Assume that there are only two goods
(X and Y) and two individuals (1 and 2)
The first persons demand for X is
X
1
= d
X
1
(P
X
,P
Y
,I
1
)
The second persons demand for X is
X
2
= d
X
2
(P
X
,P
Y
,I
2
)

Market Demand Curves
Features of these demand curves:
Both individuals are assumed to face the
same prices
Each buyer is assumed to be a price taker
must accept the prices prevailing in the market
Each persons demand depends on his or
her own income
Market Demand Curves
The total demand for X is the sum of the
amounts demanded by the two buyers
The demand function will depend on P
X
,
P
Y
, I
1
, and I
2
total X = X
1
+ X
2

total X = d
X
1
(P
X
,P
Y
,I
1
) + d
X
2
(P
X
,P
Y
,I
2
)
total X = D
X
(P
X
,P
Y
,I
1
,I
2
)
Market Demand Curves
To construct the market demand curve,
P
X
is allowed to vary while P
Y
, I
1
, and I
2

are held constant
If each individuals demand for X is
downward sloping, the market demand
curve will also be downward sloping
Market Demand Curves
X X X
P
X

P
X
P
X

d
X
1

d
X
2

X
1
*
X
2
*
P
X
*
To derive the market demand curve, we sum the
quantities demanded at every price
Individual 1s
demand curve
Individual 2s
demand curve
Market demand
curve
X*
D
X

X
1
* + X
2
* = X*
Shifts in the Market
Demand Curve
The market demand summarizes the
ceteris paribus relationship between X
and P
X

Changes in P
X
result in movements along the
curve (change in quantity demanded)
Changes in other determinants of the
demand for X cause the demand curve to
shift to a new position (change in demand)
Shifts in Market Demand
Suppose that individual 1s demand for
oranges is given by
X
1
= 10 2P
X
+ 0.1I
1
+ 0.5P
Y

and individual 2s demand is
X
2
= 17 P
X
+ 0.05I
2
+ 0.5P
Y

The market demand curve is
X = X
1
+ X
2
= 27 3P
X
+ 0.1I
1
+ 0.05I
2
+ P
Y


Shifts in Market Demand
To graph the demand curve, we must
assume values for P
Y
, I
1
, and I
2


If P
Y
= 4, I
1
= 40, and I
2
= 20, the market
demand curve becomes
X = 27 3P
X
+ 4 + 1 + 4 = 36 3P
X




Shifts in Market Demand
If P
Y
rises to 6, the market demand curve
shifts outward to
X = 27 3P
X
+ 4 + 1 + 6 = 38 3P
X

Note that X and Y are substitutes
If I
1
fell to 30 while I
2
rose to 30, the
market demand would shift inward to
X = 27 3P
X
+ 3 + 1.5 + 4 = 35.5 3P
X

Note that X is a normal good for both buyers



Generalizations
Suppose that there are n goods (X
i
, i = 1,n)
with prices P
i
, i = 1,n.
Assume that there are m individuals in the
economy
The j ths demand for the i th good will
depend on all prices and on I
j

X
ij
= d
ij
(P
1
,,P
n
, I
j
)
Generalizations
The market demand function for X
i
is the
sum of each individuals demand for that
good
) ,..., , ,..., (
m n
m
j
i ij i
P P D X X I I
1 1
1

=
= =
The market demand function depends on
the prices of all goods and the incomes
and preferences of all buyers
Elasticity
Suppose that a particular variable (B)
depends on another variable (A)
B = f(A)
We define the elasticity of B with respect
to A as
B
A
A
B
A A
B B
A
B
e
A B

c
c
=
A
A
= =
/
/
in change %
in change %
,
The elasticity shows how B responds (ceteris
paribus) to a 1 percent change in A
Price Elasticity of Demand
The most important elasticity is the price
elasticity of demand
measures the change in quantity demanded
caused by a change in the price of the good
Q
P
P
Q
P P
Q Q
P
Q
e
P Q

c
c
=
A
A
= =
/
/
in change %
in change %
,
e
Q,P
will generally be negative
except in cases of Giffens paradox
Distinguishing Values of e
Q,P

Value of e
Q,P
at a Point
Classification of
Elasticity at This Point
e
Q,P
< -1 Elastic
e
Q,P
= -1 Unit Elastic
e
Q,P
> -1 Inelastic
Price Elasticity and Total
Expenditure
Total expenditure on any good is equal to
total expenditure = PQ
Using elasticity, we can determine how
total expenditure changes when the price
of a good changes
Price Elasticity and Total
Expenditure
Differentiating total expenditure with
respect to P yields

P
Q
P Q
P
PQ
c
c
+ =
c
c
Dividing both sides by Q, we get

P Q
e
Q
P
P
Q
Q
P PQ
,
/
+ =
c
c
+ =
c c
1 1
Price Elasticity and Total
Expenditure
Note that the sign of cPQ/cP depends on
whether e
Q,P
is greater or less than -1
If e
Q,P
> -1, demand is inelastic and price and
total expenditures move in the same direction
If e
Q,P
< -1, demand is elastic and price and
total expenditures move in opposite directions
P Q
e
Q
P
P
Q
Q
P PQ
,
/
+ =
c
c
+ =
c c
1 1
Price Elasticity and Total
Expenditure
Responses of PQ
Demand Price Increase Price Decrease
Elastic Falls Rises
Unit Elastic No Change No Change
Inelastic Rises Falls
Income Elasticity of Demand
The income elasticity of demand (e
Q,I
)
measures the relationship between
income changes and quantity changes
Q
Q Q
e
Q
I
I I
I

c
c
= =
in change %
in change %
,
Normal goods e
Q,I
> 0
Luxury goods e
Q,I
> 1
Inferior goods e
Q,I
< 0


Cross-Price Elasticity of
Demand
The cross-price elasticity of demand (e
Q,P
)
measures the relationship between
changes in the price of one good and and
quantity changes in another
Q
P'
P'
Q
P'
Q
e
P Q

c
c
= =
in change %
in change %
' ,
Gross substitutes e
Q,P
> 0
Gross complements e
Q,P
< 0


Relationships Among
Elasticities
Suppose that there are only two goods
(X and Y) so that the budget constraint
is given by
P
X
X + P
Y
Y = I
The individuals demand functions are
X = d
X
(P
X
,P
Y
,I)
Y = d
Y
(P
X
,P
Y
,I)

Relationships Among
Elasticities
Differentiation of the budget constraint
with respect to I yields

1 =
c
c
+
c
c
I I
Y
P
X
P
Y X

Multiplying each item by 1

1 =
c
c

+
c
c

Y
Y Y P
X
X X P
Y X
I
I I
I
I I

Relationships Among
Elasticities
Since (P
X
X)/I is the proportion of income
spent on X and (P
Y
Y)/I is the proportion
of income spent on Y,
s
X
e
X,I
+ s
Y
e
Y,I
= 1
For every good that has an income
elasticity of demand less than 1, there
must be goods that have income
elasticities greater than 1
Slutsky Equation in Elasticities
The Slutsky equation shows how an
individuals demand for a good responds
to a change in price
I c
c

c
c
=
c
c
=
X
X
P
X
P
X
U
X X
constant
Multiplying by P
X
/X yields
X
X
X P
X
P
P
X
X
P
P
X
X
U
X
X
X
X
1

constant

c
c

c
c
=
c
c
=
I
Slutsky Equation in Elasticities
Multiplying the final term by I/I yields
X
X X P
X
P
P
X
X
P
P
X
X
U
X
X
X
X
I
I I

constant

c
c

c
c
=
c
c
=
Slutsky Equation in Elasticities
A substitution elasticity shows how the
compensated demand for X responds to
proportional compensated price changes
it is the price elasticity of demand for
movement along the compensated demand
curve
constant
,

=

c
c
=
U
X
X
S
P X
X
P
P
X
e
X
Slutsky Equation in Elasticities
Thus, the Slutsky relationship can be
shown in elasticity form
I , , ,

X X
S
P X P X
e s e e
X X
=
It shows how the price elasticity of
demand can be disaggregated into
substitution and income components
Note that the relative size of the income
component depends on the proportion of total
expenditures devoted to the good (s
X
)
Homogeneity
Remember that demand functions are
homogeneous of degree zero in all
prices and income
Eulers theorem for homogenous
functions shows that
0 =
c
c
+
c
c
+
c
c
I
I

X
X
P
P
X
P
P
X
Y
Y X
Homogeneity
Dividing by X, we get
0 =
c
c
+
c
c
+
c
c
X
X
X
P
P
X
X
P
P
X
Y
Y X
I
I

X
Using our definitions, this means that
0 = + +
I , , , X P X P X
e e e
Y X
An equal percentage change in all
prices and income will leave the
quantity of X demanded unchanged
Cobb-Douglas Elasticities
The Cobb-Douglas utility function is
U(X,Y) = X
o
Y
|

The demand functions for X and Y are
X
P
X
I o
=
Y
P
Y
I |
=
The elasticities can be calculated
1
1
2
=
|
|
.
|

\
|
o

o
=
o
=
c
c
=
,
X
X
X
X
X
X
P X
P
P X
P
P X
P
P
X
e
X
I
I I
Cobb-Douglas Elasticities
Similar calculations show
1 =
I , X
e 0 =
Y
P X
e
,
1 =
,
Y
P Y
e 1 =
I , Y
e 1 =
Y
P Y
e
,
Note that
o = =
I
X P
s
X
X
| = =
I
Y P
s
Y
Y
Cobb-Douglas Elasticities
Homogeneity can be shown for these
elasticities
The elasticity version of the Slutsky
equation can also be used
0 1 0 1 = + + = + +
I , , , X P X P X
e e e
Y X
I , , ,

X X
S
P X P X
e s e e
X X
=
(1)
,
o =
S
P X
X
e 1
| = o = ) - (1
,
S
P X
X
e
Cobb-Douglas Elasticities
The price elasticity of demand for this
compensated demand function is equal
to (minus) the expenditure share of the
other good
More generally
o = ) - (1
, X
S
P X
s e
X
where o is the elasticity of substitution
Linear Demand
Q = a + bP + cI + dP
where:
Q = quantity demanded
P = price of the good
I = income
P = price of other goods
a, b, c, d = various demand parameters
Linear Demand
Q = a + bP + cI + dP
Assume that:
cQ/cP = b s 0 (no Giffens paradox)
cQ/cI = c > 0 (the good is a normal good)
cQ/cP = d 0 (depending on whether the
other good is a gross substitute or gross
complement)
Linear Demand
If I and P are held constant at I* and
P*, the demand function can be written
Q = a + bP
where a = a + cI* + dP*
Note that this implies a linear demand
curve
Changes in I or P will alter a and shift the
demand curve
Linear Demand
Along a linear demand curve, the slope
(cQ/cP) is constant
the price elasticity of demand will not be
constant along the demand curve
Q
P
b
Q
P
P
Q
e
P Q

,
=
c
c
=
As price rises and quantity falls, the
elasticity will become a larger negative
number (b < 0)
Linear Demand
Q
P
-a/b
a
e
Q,P
< -1
e
Q,P
= -1
e
Q,P
> -1
Demand becomes more
elastic at higher prices
Constant Elasticity Functions
If one wanted elasticities that were
constant over a range of prices, this
demand function can be used
Q = aP
b
I
c
P
d

where a > 0, b s 0, c > 0, and d 0.
For particular values of I and P,
Q = aP
b
where a = aI
c
P
d

Constant Elasticity Functions
This equation can also be written as
ln Q = ln a + b ln P
Applying the definition of elasticity,

b
P a
P P ba
Q
P
P
Q
e
b
b
P Q
=

=
c
c
=

'
'

,
1
The price elasticity of demand is equal
to the exponent on P

Important Points to Note:
The market demand curve is negatively
sloped on the assumption that most
individuals will buy more of a good when the
price falls
it is assumed that Giffens paradox does not
occur
Effects of movements along the demand
curve are measured by the price elasticity of
demand (e
Q,P
)
% change in quantity from a 1% change in price
Important Points to Note:
Changes in total expenditures on a good
caused by changes in price can be
predicted from the price elasticity of demand
if demand is inelastic (0 > e
Q,P
> -1) , price and
total expenditures move in the same direction
if demand is elastic (e
Q,P
< -1) , price and total
expenditures move in opposite directions
Important Points to Note:
If other factors that enter the demand
function (prices of other goods, income,
preferences) change, the market demand
curve will shift
the income elasticity (e
Q,I
) measures the effect
of changes in income on quantity demanded
the cross-price elasticity (e
Q,P
) measures the
effect of changes in another goods price on
quantity demanded
Important Points to Note:
There are a number of relationships among
the various demand elasticities
the Slutsky equation shows the relationship
between uncompensated and compensated
price elasticities
homogeneity is reflected in the fact that the sum
of the elasticities of demand for all of the
arguments in the demand function is zero