Price elasticity of demand.

Price elasticity of demand measures how sensitive

consumers are to price changes, and is computed as e_D = % change in Q / % change
in P. Why do we care about this number? Well, if youre a monopolist and your
consumers have a low e_D, you might want to raise the price, because you can raise
the price relatively a lot without losing a lot of customers - I think youll see that later in
the course.
Lets carry out this computation: % change in Q is the same thing as change in Q / Q
(evaluated at some point), % change in P is the same thing as change in P / P, so we
have:
e_D = dQ / Q / dP/P. We can rewrite this in one of two final forms as dQ/dP times P / Q,
or if youre into calculus, you can write it (perhaps more accurately) as partial Q / partial
P times P/Q. In this problem, for example, you might see that theres something notable
about dQ; but you can certainly compute this for any give P and Q, in any scenario.
Review: Law of demand: If the price of a good goes up, less of it is demanded. How
much less depends on the ability to substitute away from it, and on the income effect more on that later.
Normal, Inferior, Giffen, Necessity, Luxury goods: Some of these have been covered in
your class, but all of them are worth thinking about. Normal goods, which make up I
think most goods, for example cars, medicine, expensive meat, and movie tickets, are
goods that you buy more of as your income increases. Inferior goods, like spam, are
goods that you buy less of as your income increases.
A question on my final at the university of Chicago was are any goods always inferior
goods? And the answer is, I think, no; If things that are always inferior goods we could
call them bads, and they are usually negative versions of good. I guess sickness is
always an inferior good - but thats actually a little philosophical. Lets move on - Goods
are inferior or normal for different values of income. Spam is practically a luxury to
someone who would otherwise eat dirt, dirt is a luxury to someone who has literally
nothing to eat, but to many Yale students spam is an inferior good - when I earn money,
at least, I spend it on pizza instead of spam. So this is something to think about: Luxury
is a product of your position in life.

Nonetheless we can talk about broader categories of goods, usually, as inferior or

normal. For an average or typical american, at least, restaurant meals are normal
goods; spam and kmart clothing are inferior goods.
An important distinction between kinds of goods that is often made in discussion of tax
policy is necessities and luxuries, and we usually like taxing the rich, or imposing
luxury taxes. This is a whole lectures worth of material, but Ill try to cover the gist of it:
goods that make up a larger fraction of poor peoples income are necessities, while
goods that make up a larger fraction of rich peoples incomes are luxuries. Truly
impoverished people are too poor to own picasso paintings, so they spend 0% of their
yearly income on picasso; the 1%, meanwhile, might have truly expensive tastes and
spend 10% of their yearly income buying fine art. In contrast, impoverished people
might spend 10% of their income on an iPhone plan which has become in many parts of
the country a necessary part of being employed. The super rich, even if they buy a
golden iPhone and very expensive phone plan, are unlikely to spend even 1% of their
total income on iPhone plans. Why do we care about this distinction? Well, its probably
not good tax policy to tax iPhone plans, because that would be a regressive tax - it
would (proportionally) hurt the poor more than the rich. We might prefer to tax picasso
paintings, and reallocate money from the rich to the poor. Well, you might.
Notice that both necessities and luxuries are normal goods; the rich person has the
same needs as the poor person. The person making a billion dollars a year spends a
smaller fraction of her income on iPhones, but she still may buy a gold-plated case
where the poor person is scraping by without a case at all! Increased income still leads
to increased spending on phones - phones are a normal good.
Giffen goods, which are mostly theoretical, are both extremely necessary and extremely
inferior goods. Its hard to talk about them in the abstract, so let me give you the only
example that has been observed or analyzed (in a 2008 study): rice for poor people.
First, necessity: Suppose that every person absolutely has to consume 1000 calories
per day, or they will starve to death; but maybe the reward for consuming more than
1000 calories is not very high; and suppose that our model poor person has exactly $12
available to them to purchase food. If rice is $1/100 calories, and chicken is $2/100
calories, our impoverished fellow will buy 800 calories of rice and 200 calories of
chicken (the implication is that he highly prefers chicken to rice, and will buy as much as
possible; rice is completely inferior to chicken). But if the price of rice goes up to
$1.20/100 calories, that person will be forced to eat only rice - 1000 calories of it, more

than before! It looks like rice breaks the law of demand for this person - but its clear that
this behavior is the result of severe constraints, which well call necessity, and a lack of
available substitutes; the substitution effect is low, and the income effect (its an inferior
good) is very high.
You should be careful, in general, before labeling something a Giffen good. They dont
really exist, or at least are very rare - make sure that the quantity demanded really goes
up with an increase in price.
Some keywords that might show up on a test or problem set are income effect consuming less of something because you have less money (purchasing power), either
because income has gone down or prices have gone up; and substitution effect consuming more or less of something (switching to and away from close substitutes)
because of reduced purchasing power. In the rice case, the substitution effect away from
luxury chicken (a result of being inferior) towards rice (food is a necessity, so theres
essentially no income effect) outweighs the income effect of overall being able to buy
less food.
On the other hand, my favorite example of a good with a weird demand curve has zero
income effect and zero substitution effect: insulin. At any price, the same quantity of
insulin is demanded by each person and the market. Some individuals are so reliant on
drugs that they will pay any price for them; their demand curves are horizontal, and their
price elasticity of demand is zero. We might expect to see this especially in drugs with
no close substitute, like medicines.
Theres a second kind of good that violates the law of demand - Veblen goods, or
conspicuous consumption. Somehow those arent the same thing, though, and you
should try not to confuse them.
How about substitutes and complements?
Two goods are substitutes if individuals are close to indifferent between consumption of
one or the other. For example, coffee and tea are substitutes. When you go to Blue
State, you look at the menu and decide whether to buy coffee or tea. If theyre both $2,
you might decide to get a cup of coffee; I would get a cup of tea, because I really like
their oolong. What happens when prices change? Suppose the price of coffee shoots up
to $10. You might look at the menu and say, huh, its not really worth that much! And

buy a cup of tea. So when the price of coffee goes up [and so quantity demanded goes
down], quantity demanded of tea goes up, too. On the other hand, if the price of tea
were to go up to $10, say because a huge part of the tea supply had been dumbed into
boston harbor, and coffee prices remained at $2, I might buy coffee instead of tea. So
the characterization of substitutes is that when the price of one goes up, demand for the
other goes up. Of course, when the price of one goes down, demand for the other goes
down as people substitute demand away from the second towards the first.
Complements are the opposite of substitutes. When the price of good 1 goes up, the
demand for good 2 goes down, etcetera. For example, Tea and Paper cups are perfect
complements; right now, when you go to blue state and buy, say, 4 cups of tea for $2.00
each, you receive 4 free paper cups. If the price of tea were to go up, you might buy less
tea and so also fewer paper cups; or if the government charged a tax on paper cups to
cut down on waste, say $1 / paper cup, you would be forced to buy less tea.
This related to problem 3: what does an indifference curve look like for perfect
complements and perfect substitutes?
Perfect complements, which must be consumed in some fixed ratio a:b, have utility
functions of the form U = min(ax, by); for example, the utility of 6 cups of tea and 4
paper cups is the same as the utility of 4 cups of tea and 5 paper cups is the same as
the utility of 4 cups of tea and 4 paper cups (do you see why?). Other examples of
perfect complements are things like left and right shoes, or glasses frames and lenses
(the ratio is 1:2).
Perfect substitutes, on the other hand, have utility functions of the form U = Ax + By.
What are perfect substitutes? They are things like blue and black pens, where a
consumer is truly indifferent to consumption of one or the other. If the price of just one
good goes up, then, the consumer wont be any worse off. How does that work? Well,
lets look at our indifference curves: they are lines, and our budget constraints are also
lines. We cant solve for equilibrium in the usual way, looking for tangents - instead we
are forced into a corner solut
ion. For example, if X is black pens and Y is blue pens, the consumer would receive
one unit of utility out of either kind of pen, so U = X + Y. If black pens cost $1 and blue
pens cost $2, the consumer would buy all black pens: see how the budget constraint
intersects the indifference curves at the corner. And if black pens cost $2 and blue pens
cost $1, the opposite would happen. On the other hand, if black and blue pens each

cost $1, we would see that the indifference curve and the budget constraint overlap - a
consumer would be equally happy with any combination of the goods.
You might notice that this idealized version of perfect substitutes has constant
marginal utility. This helps explain the corner solution behavior - a consumer will
choose to consume the good which provides the most utility per dollar, and has no
preference for balanced consumption, or a mix of the goods.
Finally, we should talk about aggregating demand. Theres really nothing to it; If q_1,
q_2. are the individuals consumer demand functions, say in terms of P, then the sum
of q_1 + q_2 + .. is the market demand. For example, if there are 100 people with
demand functions q_i = 1-P, then the market demand is Q^M = 100-100P. On the other
hand, if there are 50 people with demand function q_i = 1-P, and 50 people with demand
function q_i = 2-2P, then the market demand is Q^M = 150 - 150P. The aggregate
demand curve is a scaled version of the individuals demand curve, and of course if
there are many individuals with different demands it is a scaled version of the average
demand - the steep slope of these curves should be unsurprising if you think about what
it means to take many peoples desires for things into account. A small change in the
price of a McDonald cheeseburger results in a huge change (in absolute quantity) in
demand, although the percentage change is the same at the individual and aggregate
level.