How do we explain why demand sensitivities are so commonly held? What influences our reactions to price changes?
EXHIBIT 1 Demand Response to Price Change
1 1 2 3 4 5
2 3 4 5
QUANTITY DEMAND CURVE FOR PENICILLIN D
PANEL a
PRICE ($)
1 1 2 3 4 5
2 3 4 5
QUANTITY DEMAND CURVE FOR COCA-COLA
D
PANEL c
PRICE ($)
1 2 3 4 5
6 0
0 0
8 10 12 QUANTITY
DEMAND CURVE FOR SPARK PLUGS
D
PANEL b
PRICE ($)
Panelsa, b, andcdepict three different responses to a $3 to $2 price cut. In panela, the response is zero for a price cut in penicillin. In panelb, price matters. The $3 to $2 cut in spark plugs generates an increase in quantity demanded from 8 to 10. The demand response to the same price cut in panelcis considerably greater. Quantity demanded of Coca-Cola increases from 1 to 3 cartons.
84 PART 2 Find more at http://www.downloadslide.comINTRODUCTION TO MICROECONOMICS
Low-Priced Goods
If most people won’t even bother to pick up a penny from a sidewalk, why would we expect them to be at all concerned about price changes on nickel-and- dime items? The fact is, we don’t. That’s why, in our chewing gum example, a price increase from 5 to 10 cents was anything but earthshaking. Even though it represents a 100 percent increase, the nickel increase goes virtually unnoticed.
Do you suppose a 100 percent price increase on a 25-cent comb would deter many from making the purchase? Would a 10-cent increase on a 10-cent parking meter turn people to public transportation? Because these prices are relatively low, they represent only a tiny fraction of our income. Any price change, therefore, even a 100 percent increase, on these low-priced goods has so little impact on our total spending that the quantities demanded of them tend to be almost independent of their prices.
Income Levels
What may be little money to some people may be a lot of money to others. We must be careful, then, about making quick assertions concerning demand sensi- tivities unless we know something about individual income levels. Rich people generally are less concerned about price changes than poor people. While a $75 to
$200 price change on a graphite tennis racket might deter a university student
EXHIBIT 2 Market Demand for Coca-Cola and Spark Plugs
0 2 1
2 3
4 6 8 10 12 14 16 QUANTITY (10,000s)
DEMAND CURVE FOR COCA-COLA
D
PANEL a
PRICE ($)
0 1 2 3
18 20 22 24 26 28 30 QUANTITY (10,000s)
DEMAND CURVE FOR SPARK PLUGS
D
PANEL b
PRICE ($)
At a price of $3, the quantity of Coca-Cola demanded, shown in panela, is 50,000 cartons, including Misty’s demand for one carton. When price is cut to $2, Misty and all other buyers increase their willingness to buy Coke. Quantity demanded increases to 150,000 cartons.
The market for spark plugs is shown in panelb. Note the difference in the slopes of the demand curves in panelsa andb. Buyers increase quantity demanded of spark plugs when price is cut from $3 to $2, but by a smaller percentage than in panela.
Why does it have little effect on our quantity demanded for parking space when parking meter prices increase 100 percent?
whose income is $4,000 from making the purchase, the university’s chancellor, earning $175,000, would make the purchase effortlessly.
What can we conclude? First, poor people are typically more sensitive to price changes than rich people, and second, as people’s incomes increase, their demand sensitivities to these price changes become less intense.
Substitute Goods
Our sensitivity to price changes depends as well upon the alternatives available.
After an eventful night, Rolaids may provide some relief. But so might Tums, Bromo-Seltzer, and Pepto-Bismol. Because they are all effective antacids, Rolaids has to be careful about raising its price. Why? Many who prefer Rolaids would switch to another brand if Rolaids raised its price.
If Coca-Cola and Pepsi-Cola areclose substitutes, and if Rolaids and Tums are close as well, what can we say about potatoes grown on two different potato farms in Idaho? An Idaho potato is an Idaho potato, yes? They are perfect substitutes.
Can you imagine buying the more expensive potato when a cheaper, identical potato is available?
Because Idaho potato farmers produce perfect substitutes, they have no leverage over their prices. Were one of them, say, Steve Coombs, foolish enough to insist on charging a higher price than his competitors—even if the price increase were only a fraction of a penny—the quantity demanded of Steve’s higher-priced potatoes would fall to zero. After all, why would anyone buy a single potato from him when a cheaper, perfect substitute is available?
It makes sense, doesn’t it, to suppose that our demand sensitivity to price changes depends upon the availability and closeness of substitute goods.
Basic Goods
How many slices of bread could you eat at a sitting? You know without even trying that it wouldn’t take much to reach your limit. Even at bargain prices, the quantity demanded by bread lovers could not really increase significantly.
What about price increases? Bread is a basic food in our diet. Were price to increase, even substantially, the quantity demanded would fall, but not by much.
We demand bread for much the same reason that people in Southeast Asia demand rice. It is an important staple in our diet. What about our demand for milk and eggs? They, too, are staples in our diet. Would you expect the demand curve for these basic food goods to look most like the curve in panel a, b, or c of Exhibit 1?
Food items are not the only goods that represent basic needs in our society.
Medicine, obviously, is another. We assumed, in our penicillin example, that the quantity demanded is totally insensitive to changes in price. Many other nonfood goods also have demand curves that look like Exhibit 1, panel a. There are con- siderably more whose demand curves take on the character shown in panel b.
What about your textbooks? Or your demand for electricity?
Do you suppose businesspeople would be more careful about the number of trips they make when the price of airline travel increases? Their demand for air travel is dictated by the sheer necessity of business. Flights are basic items needed to transact business. More might be made when prices fall, fewer when they increase, but probably not by much in either case.
Coke and Pepsi are close substitutes, and the demand for each is relatively elastic. What strategies do Coca-Cola (http://www.coca-cola.
com/) and Pepsi (http://
www.pepsi.com/) use to make the demand for their products less elastic?
Why are daytime telephone rates typically higher than evening rates?
86 PART 2 Find more at http://www.downloadslide.comINTRODUCTION TO MICROECONOMICS
Linked Goods
Some goods are coupled, like mac and cheese. Their linked relationship often determines our demand sensitivities to their price changes, particularly when one good in the link is much more expensive than the other. For example, what do you suppose would happen to the quantity of shoelaces demanded if the price of shoelaces increased? Think about it. People can’t go about their business with unlaced shoes! It would be silly to stop wearing a $75 pair of shoes because the price of shoelaces jumped from $1.25 to $1.50.
Perhaps a substantial price cut might prompt a few people to change their laces more often or perhaps a price increase might prompt some to tie a knot or two before buying another pair. But most people do not change their shoelace- buying behavior because of price changes.
Imagine an owner of a $250,000 Bentley Continental leaving his car in the garage and taking a bus to work because gasoline prices increased from $2.50 to
$3.00 per gallon. Unlikely, isn’t it? Or suppose you made that planned trip to Hawaii and decided not to rent a beach umbrella because the hotel just raised its price $5 per day. Unlikely, as well, isn’t it?
Time to Adjust
Time matters. How we react to price changes depends, to some extent, on how much time we have to adjust our demands to price changes. Consider our demand for energy.
How did people initially respond to the many-fold increases in oil prices during the 1970s? Paralysis! Prices rose from $2 per barrel in 1973 to $12 per barrel in 1974.
What could we Americans have done? We were completely locked into our dependence on oil. We found it exceedingly difficult to make any demand adjustment even when oil prices soared to $34 a barrel in 1980.
But weeventually switched to smaller cars, lower speed limits, more efficient home insulation, and tolerance of a wider range of living room temperatures.
The long-run response surprised oil producers as well as us! We discovered that, given time to adjust, we became rather demand sensitive to oil price changes.