CHAPTER 8 Consumer Choice and Demand in Traditional and Network Markets

CHAPTER 8

Consumer Choice and Demand in
Traditional and Network Markets
It is not the province of economics to determine the value of life in “hedonic units” or
any other units, but to work out, on the basis of the general principles of conduct and the
fundamental facts of social situation, the laws which determine prices of commodities
and the direction of the social economic process. It is therefore not quantities, not even
intensities, of satisfaction with which we are concerned. . . .or any other absolute
magnitude whatever, but the purely relative judgment of comparative significance of
alternatives open to choice.
Frank Knight

P

eople adjust to changes in some economic conditions with a reasonable degree of
predictability. When department stores announce lower prices, customers will pour
through the doors. The lower the prices go, the larger the crowd will be. When the
price of gasoline goes up, drivers will make fewer and shorter trips. If the price stays up,
drivers will buy smaller, more economical cars. Even the Defense Department will
reduce its planned purchases when prices rise.
Behavior that is not measured in dollars and cents is also predictable in some
respects. Students who stray from the sidewalks to dirt paths on sunny days stick to
concrete when the weather is damp. Professors who raise their course requirements and
grading standards find their classes are shrinking in size. Small children shy away from
doing things for which they have recently been punished. When lines for movie tickets
become long, some people go elsewhere for entertainment.
On an intuitive level you find these examples reasonable. Going one step beyond
intuition, the economist would say that such responses are the predictable consequences
of rational behavior. That is, people who desire to maximize their utility can be expected
to respond in these ways. Their responses are governed by the law of demand, a concept

we first introduced in Chapter 3 and now take up in greater detail.

Predicting Consumer Demand
The assumptions about rational behavior described early in the book provide a good
general basis for explaining behavior. People will do those things whose expected
benefits exceed their expected costs. They will avoid doing things for which the opposite
is true. By themselves, however, such assumptions do not allow us to predict future


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Chapter 8 Consumer Choice and Demand in
Traditional and Network Markets

behavior. The law of demand, which is a logical consequence of the assumption of
rational behavior, does allow us to make predictions.
The alert reader may sense an inconsistency in logic. Rational behavior is based on
the existence of choice, but a true choice must be free—it cannot be predetermined or
predicted. If we can predict a person’s behavior, can that individual be free to choose?
Choice is not completely free, nor is complete freedom required by the concept of
rationality. As discussed earlier, the individual’s choices are constrained by time and by
physical and social factors that restrict his or her opportunities. There are limits to a
person’s range of choice. Freedom exists within those limits.
Our ability to predict is also limited. We cannot specify with precision every choice
the individual will make. For instance, we cannot say anything about what Judy
Schwartz wants or how much she wants the things she does. Before we can employ the
law of demand, we must be told what she wants. Even given that knowledge, we can
only indicate the general direction of her behavior. Theory does not allow us to
determine how fast or how much her behavior will change.
To see how consumer behavior can be predicted, we will derive the law of demand

from the behavior of an individual consumer.
Rational Consumption: The Concept of Marginal Utility
The essence of the economist’s notion of rational behavior can be summed up this way:
more goods and services are preferable to less (assuming that the goods and services are
desired). This statement implies that the individual will use his entire income, in
consumption or in saving or in some combination of the two, to maximize his
satisfaction. It also implies that the individual will use some method of comparing the
value of various goods.
Generally speaking, the value the individual places on any one unit of a good
depends on the number of units already consumed. For example, you may be planning to
consume two hot dogs and two Cokes for your next meal. Although you may pay the
same price for each unit of both goods, there is no reason to assume that you will place
the same value on each. The value of the second hot dog—its marginal utility—will
depend on the fact that you have already eaten one. The formula for marginal utility is
MU =

change in total utility
change in quantity consumed

Achieving Consumer Equilibrium
Marginal utility determines the variety of a quantity of goods and services you consume.
The rule is simple. If the two goods, Cokes and hot dogs, both have the same price, you
will allocate your income so that the marginal utility of the last unit of each will be equal.
Mathematically, the formula can be stated as
MU c = MU h


3

Chapter 8 Consumer Choice and Demand in

Traditional and Network Markets

Where MU c equals the marginal utility of a Coke and MU h equals the marginal utility of a
hot dog.
If you are rational, and if the price of a Coke is the same as the price of a hot
dog, the last Coke you drink will give you the same amount of enjoyment as the
last hot dog you eat. When the marginal utilities of goods purchased by the
consumer are equal, the resulting state is called consumer equilibrium.
Consumer equilibrium is a state of stability in consumer purchasing patterns in
which the individual has maximized his or her utility. Unless conditions—income,
taste, or prices—change, the consumer’s buying patterns will tend to remain the
same.
An example will illustrate how equilibrium is reached. Suppose for the sake of
simplicity that you can buy only two goods, Cokes and hot dogs. Suppose further that
one of each cost the same price, $1, and you are going to spend your whole income.
(How much your total income is and how many units of Coke or hot dogs you will
purchase is unimportant. We simply assume that you purchase some combination of
those two goods.) We will also assume that utility (joy, satisfaction) can be measured. As
you remember from an earlier chapter, a unit of satisfaction is called a util. Finally,
suppose that the marginal utility of the last Coke you consume is equal to 20 utils, and the
marginal utility of the hot dog is 10 utils. Obviously you have not maximized your
utility, for the marginal utility of your last Coke is greater than (>) the marginal utility of
your last hot dog:
MU c > MU h
You could have purchased one less hot dog and used the dollar saved the to buy an
additional Coke. In doing so, you would have given up 10 utils of satisfaction (the
marginal utility of the last hot dog purchased), but you would have acquired an additional
20 utils from the new Coke. On balance, your total utility would have risen by 10 utils
(20 – 10). If you are rational, you will continue to adjust your purchases of Coke and hot
dogs until their marginal utilities are equal.

Even if you would prefer to spend your first dollar on a hot dog, after eating
several you might wish to spend your next dollar on a Coke. Purchases can be
adjusted until they reach equilibrium because as more of a good is purchased, its
relative marginal utility decreases—a phenomenon known as the law of
diminishing marginal utility. According to the law of diminishing marginal
utility, as more of a good is consumed, its marginal utility or value relative to the
marginal value of the good or goods given up eventually diminishes. Thus, if
MU h > MU c, and MU h falls relative to MU c as more hot dogs and fewer Cokes are
consumed, sooner or later the result will be MU h = MU c.
Adjusting for Differences in Price and Unit Size
Cokes and hot dogs are not usually sold at exactly the same price. To that extent, our
analysis has been unrealistic. If we drop the assumption of equal prices, the formula for
maximization of utility becomes:


Chapter 8 Consumer Choice and Demand in
Traditional and Network Markets

MU c = MU h
Pc
Ph
Where MU c equals the marginal utility of a Coke, MU h the marginal utility of a hot dog,
Pc the price of a Coke, a Ph the price of a hot dog. This is the same formula we used
before, but because the price of the goods was the same in that example, the
denominators canceled out. When prices differ, the denominator must be retained. The
consumer must allocate his or her money so that the last penny spent on each commodity
yields the same amount of satisfaction.
Suppose a Coke costs $0.50 and the price of a hot dog is $1. If you buy hot dogs
and Cokes for lunch and the marginal utility of the last Coke and hot dog you consume
are the same, say 15 utils, you will not be maximizing your satisfaction. In relation to

price, you will value your Coke more than your hot dog. That is, MU c/Pc (or 15
utils/$0.50) exceeds MU h /Ph (or 15 utils/$1). You can improve your welfare by eating
fewer hot dogs and drinking more Cokes. By giving up a hot dog, you can save a dollar,
which you can use to buy two Cokes. You will lose 15 utils by giving up the hot dog,
something you would probably prefer not to do. You will regain that loss with the next
Coke purchased, however, and the one after that will permit you to go beyond your
previous level of satisfaction.
Therefore, if you are rational, you will adjust your purchases until the utility-price
ratios of the two goods are equal. As you consume more Coke, the relative value of each
additional Coke will diminish. If you reach a point where the next Coke gives you 10
utils and the next hot dog yields 20 utils, you will no longer be able to increase your
satisfaction by readjusting your purchases. By giving up the next hot dog, you save $1
and lose 20 utils of satisfaction. Now the most you can accomplish by using that $1 to
buy two Coke instead is to recoup your loss of 20 utils. In fact, the value of the second
new Coke may be less than 10 utils, so you may actually lose by giving up the hot dog.
So far we have been talking in terms of buying whole units of Cokes and hot dogs,
but the same principles apply to other kinds of choices as well. Marginal utility is
involved when a consumer chooses a 12-ounce rather than a 16-ounce can of Coke, or a
regular-size hot dog rather than a foot-long hot dog. The concept could also be applied to
the decision whether to add cole slaw and chili to the hot dog. The pivotal question the
consumer faces in all these situations is whether the marginal utility of the additional
quantity consumed is greater or less than the marginal utility of other goods that can be
purchased for the same price.
Most consumers do not think in terms of utils when they are buying their lunch, but
in a casual way, they do weigh the alternatives. Suppose you walk into a snack bar. If
your income is unlimited, you have no problem. If you can only spend $3 for lunch,
however, your first reaction may be to look at the menu and weigh the marginal values of
the various things you can eat. If you have twenty cents to spare, do you not find
yourself mentally asking whether the difference between a large Coke and a small one is
worth more to you than lettuce and tomato on your hamburger? (If not, why do you

choose a small Coke instead of a large one?) You are probably so accustomed to making
decisions of this sort that you are almost unaware of the act of weighing the marginal
values of the alternatives.

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Chapter 8 Consumer Choice and Demand in
Traditional and Network Markets

Consumers do not usually make choices with conscious precision. Nor can they
achieve a perfect equilibrium—the prices, unit sizes, and values of the various products
available may not permit it. They are trying to come as close to equality as possible, The
economist’s assumption is that the individual will move toward equality, not that he will
always achieve it.
Changes in Price and the Law of Demand
Suppose your marginal utility for Coke and hot dogs is as shown in the table below.

Unit Consumed

Marginal Utility of
Cokes (at $0.50)

Marginal Utility of
Hot Dogs (at $1)

First

10 utils

30 utils

Second

9 utils

15 utils

Third

3 utils

12 utils

If a Coke is priced at $0.50 and a hot dog at $1, $3 will buy you two hot dogs and two
Cokes—the best you can do with $3 at those prices. Now suppose the price of Coke rises
to $0.75 and the price of hot dogs falls to $0.75. With a budget of $3 you can still buy
two hot dogs and two Cokes, but you will no longer be maximizing your utility. Instead
you will be inclined to reduce your consumption of Coke and increase your consumption
of hot dogs.
At the old prices, the original combination (two Cokes and two hot dogs) gave you
a total utility of only 64 utils (45 from hot dogs and 19 from Coke). If you cut back to
one Coke and three hot dogs now, your total utility will rise to 67 utils (57 from hot dogs
and 10 from Coke). Your new utility-maximizing combination—the one that best
satisfies your preferences—will therefore be one Coke and three hot dogs. No other
combination of Coke and hot dogs will give you greater satisfaction. (Try to find one.)
To sum up, if the price of hot dogs goes down relative to the price of Coke, the
rational person will buy more hot dogs. If the price of Coke rises relative to the price of

hot dogs, the rational person will buy less Coke. This principle will hold true for any
good or service and is commonly known as the law of demand. The law of demand
states the assumed inverse relationship between product price and quantity demanded,
everything else held constant. If the relative price of a good falls, the individual will buy
more of the good. If the relative price rises, the individual will buy less.
Figure 8.1 shows the demand curve for Coke—that is, the quantity of Coke
purchased at different prices. The inverse relationship between price and quantity is
reflected in the curve’s downward slope. If the price falls from $1 to $0.75, the quantity
the consumer will buy increases from two Cokes to three. The opposite will occur if the
price goes up.
Thus the assumption of rational behavior, coupled with the consumer’s willingness
and ability to substitute less costly goods when prices go up, leads to the law of demand.


Chapter 8 Consumer Choice and Demand in
Traditional and Network Markets

We cannot say how many Cokes and hot dogs a particular person will buy to maximize
his or her satisfaction. That depends on the individual’s income and preferences, which
depend in turn on other factors (how much he likes hot dogs, whether he is on a diet, and
how much he worries about the nutritional deficiencies of such a lunch). We can predict
the general response, whether positive or negative, to a change in prices.

FIGURE 8.1 The Law of Demand
Price varies inversely with the quantity consumed,
producing a downward-sloping curve like this one.
If the price of Coke falls from $1 to $0.75, the
consumer will buy three Cokes instead of two.

Price is whatever a person must give up in exchange for a unit of goods or services

purchased, obtained, or consumed. It is a rate of exchange and is typically expressed in
dollars per unit. Note that price is not necessarily the same as cost. In an exchange
between two people—a buyer and a seller—the price at which a good sells can be above
or below the cost of producing the good. What the buyer gives up to obtain the good
does not have to match what the seller-producer gives up in order to provide the good.
Nor is price always stated in dollars and cents. Some people have a desire to watch
sunsets—a want characterized by the same downward-sloping demand curve as the one
for Coke. The price of the sunset experience is not money. Instead it may be the lost
opportunity to do something else, or the added cost and trouble of finding a home that
will offer a view of the sunset. (In that case, price and cost are the same because the
buyer and the producer are one and the same.) The law of demand will apply
nevertheless. The individual will spend some optimum number of minutes per day
watching the sunset and will vary that number of minutes inversely with the price of
watching.
From Individual Demand to Market Demand
Thus far we have discussed demand solely in terms of the individual’s behavior. The
concept is most useful, however, when applied to whole markets or segments of the
population. Market demand is the summation of the quantities demanded by all
consumers of a good or service at each and every price during some specified time
period. To obtain the market demand for a product, we need to find some way of adding
up the wants of the individuals who collectively make up the market.

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Chapter 8 Consumer Choice and Demand in
Traditional and Network Markets

The market demand can be shown graphically as the horizontal summation of the
quantity of a product each individual will buy at each price. Assume that the market for

Coke is composed of two individuals, Anna and Betty, who differ in their demand for
Coke, as shown in Figure 8.2. The demand of Anna is DA and the demand of Betty is DB.
Then to determine the number of Cokes both of them will demand at any price, we
simply add together the quantities each will purchase, at each price (see Table 8.1). At a
price of $11, neither person is willing to buy any Coke; consequently, the market demand
must begin below $11. At $9, Anna is still unwilling to buy any Coke, but Betty will buy
two units. The market quantity demanded is therefore two. If the price falls to $5, Anna
wants two Cokes and Betty, given her greater demand, wants much more, six. The two
quantities combined equal eight. If we continue to drop the price and add the quantities
bought at each new price, we will obtain a series of market quantities demanded. When
plotted on a graph they will yield curve DA+B , the market demand for Coke (see Figure
8.2).
___________________________________
FIGURE 8.2 Market Demand Curve
The market demand curve for Coke, DA+B, is
obtained by summing the quantities that individuals
A and B are willing to buy at each and every price
(shown by the individual demand curves DA and
DB).

This is, of course, an extremely simple example, since only two individuals are
involved. The market demand curves for much larger groups of people, however, are
derived in essentially the same way. The demands of Fred, Marsha, Roberta, and others
would be added to those of Anna and Betty. As more people demand more Coke, the
market demand curve flattens out and extends further to the right.
Elasticity: Consumers’ Responsiveness to Price Changes
In the media and in general conversation, we often hear claims that a price change will
have no effect on purchases. Someone may predict that an increase in the price of
prescription drugs will not affect people’s use of them. The same remark is heard in
connection with many other goods and services, from gasoline and public parks to

medical services and salt. What people usually mean by such statements is that a price

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Chapter 8 Consumer Choice and Demand in
Traditional and Network Markets

change will have only a slight effect on consumption. The law of demand states only that
a price change will have an inverse effect on the quantity of a good purchased. It does
not specify how much of an effect the price change will have.

TABLE 8.1 Market Demand for Coke

Price
of Coke
(1)
$11
10
9
8
7
6
5
4
3
2
1

Quantity
Demanded by
Anna (DA )
(2)
0
0
0
0.5
1.0
1.5
2.0
2.5
3.0
3.5
4.0

Quantity
Demanded by
Betty (DB )
(3)
0
1
2
3
4
5
6
7
8

9
10

Quantity Demanded
by both Anna and Betty
(DA+B )
(4)
0
1.0
2.0
3.5
5.0
6.5
8.0
9.5
11.0
12.5
14.0

Note: The market demand curve, DA+B, in Figure 8.2 is obtained by plotting the quantities in column (4)
against their respective prices in column (1).

In other words, we have established only that the market demand curve for a
good will slope downward. The actual demand curve for a product may be relatively flat,
like curve D1 in Figure 8.3, or relatively steep, like curve D2 . Notice that at a price of P1 ,
the quantity of the good or service consumed is the same in both markets. If the price is
raised to P2 , however, the response is substantially greater in market D1 than in D2 . In
D1 , consumers will reduce their purchases all the way to Q1 . In D2 , consumption will
drop only to Q2 .
Economists refer to this relative responsiveness of demand curves as the price

elasticity of demand. Price elasticity of demand is the responsiveness of consumers, in
terms of the quantity purchased, to a change in price, everything else held constant.
Demand is relatively elastic or inelastic, depending on the degree responsiveness to price
change. Elastic demand is a relatively sensitive consumer response to price changes. If
the price goes up or down, consumers will respond with a strong decrease or increase in
the quantity demanded. Demand curve D1 in Figure 8.3 may be characterized as
relatively elastic. Inelastic demand is a relatively insensitive consumer response to price
changes. If the price goes up or down, consumers will respond with only a slight
decrease or increase in the quantity demanded. Demand curve D2 in Figure 8.3 is
relatively inelastic.
The elasticity of demand is a useful concept, but our definition is imprecise.
What do we mean by “relatively sensitive” or “relatively insensitive”? Under what


Chapter 8 Consumer Choice and Demand in
Traditional and Network Markets

circumstances is consumer response sensitive or insensitive? There are two ways to add
precision to our definition. One is to calculate the effect of a change in price on total
consumer expenditures (which must equal producer revenues). The other is to develop
mathematically values for various levels of elasticity. We will deal with each in turn.

FIGURE 8.3 Elastic and Inelastic Demand
Demand curves differ in their relative elasticity.
Curve D1 is more elastic than curve D2 , in the sense
that consumers on curve D1 are more responsive to
a price change than are consumers on curve D2 .

Analyzing Total Consumer Expenditures
An increase in the price of a particular product can cause consumers to buy less.

Whether total consumer expenditures rise, fall, or stay the same, however, depends on the
extent of the consumer response. Many people assume that businesses will charge the
highest price possible to maximize profits. Although they sometimes do, high prices are
not always the best policy. For example, if a firm sells fifty units of a product for $1, its
total revenue (consumers’ total expenditures) for the product will be $50 (50 x $1). If it
raises the price to $1.50 and consumers cut back to forty units, its total revenue could
rise to $60 (40 x $1.50). If consumers are highly sensitive to price changes for this
particular good, however, the fifty-cent increase may lower the quantity sold to thirty
units. In that case total consumer expenditures would fall to $45 ($1.50 x 30).1

1

To prove this result, let’s look at marginal revenue MR, or the change in total revenue in response to a
change in quantity Q. Taking the derivative of P(Q) • Q with respect to Q, we obtain

MR =

d[ P(Q ) • Q ]
dP
= P (Q ) +
•Q
dQ
dQ

Factoring price out of the right-hand side of this equation gives us

 dP Q 
MR = P 1 +
• 
 dQ P 

which, because E =

 dQ 
−
 , is the same as
 dP 

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Chapter 8 Consumer Choice and Demand in
Traditional and Network Markets

The opposite can also happen. If a firm establishes a price of $1.50 and then
lowers it to $1, the quantity sold may rise, but the change in total consumer expenditures
will depend on the degree of consumer response. In other words, consumer
responsiveness determines whether a firm should raise or lower its price. (We will return
to this point later.)
We can define a simple rule of thumb for using total consumer expenditures to
analyze the elasticity of demand. Demand is elastic:
•

if total consumer expenditures rise when the price falls, or

•

if total consumer expenditures fall when the price rises.

Demand is inelastic:
• if total consumer expenditures rise when the price rises, or
• if total consumer expenditures fall when the price falls.
Determining Elasticity Coefficients
Although we have refined our definition of elasticity, it still does not allow us to
distinguish degrees of elasticity or inelasticity. Elasticity coefficients do just that. The
elasticity coefficient of demand (Ed) is the ratio of the percentage change in the quantity
demanded to the percentage change in price. Expressed as a formula,
Ed =

percentage change in quantity
percentage change in price

The elasticity coefficient will generally be different a different points on the
demand curve. Consider the linear demand curve in Figure 8.4. At every point on the
curve, a price reduction of $1 causes quantity demanded by rise by ten units, but a $1
decrease in price at the top of the curve is a much smaller percentage change than a $1
decrease at the bottom of the curve. Similarly, an increase of ten units in the quantity
demanded is a much larger percentage change when the quantity is low than when it is
high. Therefore the elasticity coefficient falls as consumers move down their demand
curve. Generally, a straight-line demand curve has an inelastic range at the bottom, a
unitary elastic point in the center, and an elastic range at the top.2

> 0 if E > 1
 1
MR = P 1 −  = 0 if E = 1
 E
< 0 if E < 1
From this it follows immediately that an increase in Q (a decrease in P) increases total revenue if E > 1, has
no effect on total revenue if E = 1, and reduces total revenue if E < 1.

2
To prove this, we recognize that the equation for a linear domain curve can be expressed mathematically
as

P = A − BQ

where P represents price, Q is quantity demanded, and A and B are positive constants. The total revenue
associated with this demand curve is given by


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Chapter 8 Consumer Choice and Demand in
Traditional and Network Markets

___________________________________
FIGURE 8.4 Changes in the Elasticity Coefficient
The elasticity coefficient decreases as a firm moves
down the demand curve. The upper half of a linear
demand curve is elastic, meaning that the elasticity
coefficient is greater than one. The lower half is
inelastic, meaning that the elasticity coefficient is
less than one. This means that the middle of the
linear demand curve has an elasticity coefficient
equal to one.

There are two formulas for elasticity, one for use at specific points on the curve
and one for measuring average elasticity between two points, called arc elasticity. The
formula for point elasticity, which is used for very small changes in price, is:
Ed =

change in quantity demanded
initial quantity demanded

÷

change in price
initial price

or
Q1 - Q2
Ed =
Q1

÷

P1 - P2
P1

The formula for arc elasticity is:

PQ = AQ − BQ 2
The marginal revenue is obtained by taking the derivative of total revenue with respect to Q or

MR = A − 2BQ

From footnote 1, we know that when marginal revenue is equal to 0, elasticity is equal to 1. From Equation
(2) here, this implies that E = 1 when

A − 2 BQ = 0

or when

Q=

1 A
•
2 B

From Equation (1) we know that when the demand curve intersects the Q axis, P = 0 and

Q=

A
B

Thus, with a linear demand curve, E = 1 when Q is one-half the distance between Q = 0 and the Q that
drives price down to 0. The reader is invited to prove that E > 1 when Q < ẵ ã A/B, and that E < 1 when Q
> ẵ ã A/B.


12

Chapter 8 Consumer Choice and Demand in
Traditional and Network Markets

Q1 -- Q2
P1 – P2
Ed = ½ (Q1 + Q2 ) ÷ ½ (P1 -- P2 )
Where the subscripts 1 and 2 represent two distinct points, or prices, on the demand

curve. Note that although the calculated elasticity is always negative, economists, by
convention, speak of it as a positive number. Economists, in effect, use the absolute
value of elasticity.
The change can be illustrated by computing the arc elasticity between two
sets of points, ab and cd. Arc elasticity between points a and because:

10 – 20
10 9
10
1
95
Ed = ẵ (10 + 20) ữ ẵ (10 + 9) = - 15 ÷ 9.5 = - 15 = -6.33
or 6.33 in absolute value.
Arc elasticity between points c and d:
90 – 100
2–1
Ed = ½ (90 + 100) ÷ ½ (2 + 1)

10
1
= -95 ÷ 1.5 = - 0.16 or 0.16 in absolute value.

Elasticity coefficients can tell us much at a glance. When the percentage
change in quantity is greater than the percentage change in price, an elasticity
coefficient that is greater than 1.0 results. In these cases, demand is said to be elastic.
When the percentage change in quantity is less than the percentage change in price,
the elasticity coefficient will be less than 1.0. Demand is said to be inelastic. When
the percentage change in the price is equal to the percentage change in quantity, the
elasticity coefficient is 1.0, and demand is unitary elastic.3 In short:
Elastic demand:

Ed > 1

Inelastic demand:

Ed < 1

Unitary elastic demand:

Ed = 1

Elasticity coefficients enable economists to make accurate comparisons. A
demand with an elasticity coefficient of 1.75 is more elastic than one with an elasticity
coefficient of 1.55. A demand with a coefficient of 0.25 is more inelastic than one with a
coefficient of 0.78.
Although elasticity coefficients are useful for some purposes, their accuracy
depends on data that are often less than precise. In the real world, there is constant
change in the nonprice variables that influence how much of any product consumers
want. It is extremely difficult for economists to separate the effects of a change in price
3

Remember that all elasticity coefficients are negative and are preceded by a minus sign. (The demand
curve has a negative slope.) economists generally omit the minus sign, as we have seen.


Chapter 8 Consumer Choice and Demand in
Traditional and Network Markets

from all the other forces operating in the marketplace. Small differences in elasticity
coefficients may reflect the imperfections of statistical analysis rather than true

differences in consumer responsiveness to price.
Elasticity, Not the Same as Slope
Students often confuse the concept of elasticity of demand with the slope of the demand
curve. A comparison of their mathematical formulas, however, shows they are quite
different.

slope =

elasticity =

rise
run =

change in price
change in quantity

percentage change in quantity
percentage change in price

The confusion is understandable. The slope of a demand curve does say something
about consumer’s responsiveness: it shows how much the quantity consumed goes up
when the price goes down by a given amount. Slope is an unreliable indicator of
consumer responsiveness, however, because it varies with the units of measurement for
price and quantity. For example, suppose that when the price rises from $10 to $20,
quantity demanded decreases from 100 to 60. The slope is –1/4.

slope =

-10 -1
40 = 4

If a price is measured in pennies instead of dollars, however, the slope comes out to –25.

slope =

-1000
-25
40 = 1

No matter how the price is measured, the arc elasticity of demand remains –0.75.
Furthermore, two parallel demand curves of identical slope will not have the same
elasticity coefficients. For example, consider the two curves in Figure 8.5. When the
price falls from $5 to $4, the quantity demanded rises by the same amount for each curve:
ten units. Yet the percentage change in quantity is substantially lower for D2 than for D1 .
(A rise from seventy to eighty is not nearly as dramatic in percentage terms as a rise from
twenty-five to thirty-five.) Thus the elasticity coefficient is lower for demand curve D2 .
Be careful not to judge the elasticity of demand by looking at a curve’s slope.

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Chapter 8 Consumer Choice and Demand in
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Applications of the Concept of Elasticity
Elasticity of demand is particularly important to producers. Together with the cost of
production, it determines the prices firms can charge for their products. We have seen
that an increase or decrease in price can cause total consumer expenditures to rise, fall, or
remain the same, depending on the elasticity of demand. Thus if a firm lowers its price
and incurs greater production costs (because it is producing and selling more units), it

may still increase its profits. As long as the demand curve is elastic, revenues can (but
will not necessarily) go up more than costs. Over the last three decades, the American
Telephone and Telegraph Company has frequently lowered its prices on long-distance
calls. To justify those decisions, AT&T had to reason that demand was sufficiently
elastic to produce revenues that would more than cover the cost of servicing the extra
calls. During the 1950s a 1960s, many electric power companies requested rate
reductions for the same reason.
Producers of concerts and dances estimate the elasticity of demand when they
establish the price of admission. If admission costs $10, tickets may be left unsold. At a
lower price, say $7, attendance and profits may be higher. Even if costs rise (for extra
workers and more programs), revenues can still rise more.
___________________________________
FIGURE 8.5 Two Parallel Curves Do Not Have
the Same Elasticity
Even two parallel demand curves of the same slope
do not have the same elasticity. Although a given
change in price—for example, a $1 change—will
produce the same unit change in quantity
demanded, the percentage change will differ.
Here, a drop in price from $5 to $4 produces a tenunit gain in quantity demanded on both curves
D1 and D2 . A ten-unit increase in sales represents a
lower percentage change at an initial sales level of
seventy (curve D2 ).
The difference in the elasticity of the two curves
can be illustrated by computing the arc elasticity
between two sets of points, ab on curve D1 and cd
on curve D2 . Arc elasticity between points a and b:
25 - 35
5 - 4
Ed = ẵ(25 + 35) ữ ẵ(5 + 4) =

1.50
Arc elasticity between points c and d:
70 - 80
5 - 4
Ed = ẵ(70 + 80) ữ ẵ(5 + 4) = 0.60

Government too must consider elasticity of demand, for the consumer’s demand
for taxable items is not inexhaustible. If a government raises excise taxes on cars or
jewelry too much, it may end up with lower tax revenues. The higher tax, added to the
final price of the product, may cause a negative consumer response. It is no accident that

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Chapter 8 Consumer Choice and Demand in
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the heaviest excise taxes are usually imposed on goods for which the demand tends to be
inelastic, such as cigarettes and liquor.
The same reasoning applies to property taxes. Many large cities have tended to
underestimate the elasticity of demand for living space. Indeed, a major reason for the
recent migration from city to suburbs in many metropolitan areas has been the desire of
residents to escape rising tax rates. By moving just outside a city’s boundaries, people
can retain many of the benefits a city provides without actually paying for them. This
movement of city dwellers to the suburbs lowers the demand for property within the city,
undermining property values and destroying the city’s tax base. Thus, if governments
wish to maintain their tax revenues, they have to pay attention to the elasticity of demand
for living in their jurisdictions.
Determinants of the Price Elasticity of Demand
So far our analysis of elasticity has presumed that consumers are able to respond to a

price change. However, consumers’ ability to respond can be affected by various factors,
such as the number of substitutes and the amount of time consumers have to respond to a
change in price by shifting to other products or producers.
Substitutes
Substitutes allow consumers to respond to a price increase by switching to another good.
If the price of orange juice goes up, you are not required to go on buying it. You can
substitute a variety of other drinks, including water, wine, and soda.
The elasticity of demand for any good depends very much on what substitutes are
available. The existence of a large number and variety of substitutes means that demand
is likely to be elastic. That is, if people can switch easily to another product that will
yield approximately the same value, many will do so when faced with a price increase.
The similarity of substitutes—how well they can satisfy the same basic want—also
affects elasticity. The closer a substitute is to a product, the more elastic demand for the
product will be. If there are no close substitutes, demand will tend to be inelastic. What
we call necessities are often things that lack close substitutes.
Few goods have no substitutes at all. Because there are many substitutes for
orange juice—soda, wine, prune juice, and so on—we would expect the demand for
orange juice to be more elastic than the demand for salt, which has fewer viable
alternatives. Yet even salt has synthetic substitutes. Furthermore, though human beings
need a certain amount of salt to survive, most of us consume much more than the
minimum and can easily cutback if the price of salt rises. The extra flavor that salt adds
is a benefit that can be partially recouped by buying other things.
At the other extreme from goods with no substitutes are goods with perfect
substitutes. Perfect substitutes exist for goods produced by an individual firm engaged in
perfect competition. An individual wheat farmer, for example, is only one among
thousands of producers of essentially the same product. The wheat produced by others is

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Chapter 8 Consumer Choice and Demand in
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a perfect substitute for the wheat produced by the single farmer. Perfect substitutability
can lead to perfect elasticity of demand.
The demand curve facing the perfect competitor is horizontal, like the one in
Figure 8.6. If the individual competitor raises his price even a minute percentage above
the going market price, consumers will switch to other sellers. The elasticity coefficient
of such a horizontal demand curve is infinite. Thus this demand curve is described as
perfectly elastic. A perfectly elastic demand is a demand that has an elasticity
coefficient of infinity. It is expressed graphically as a curve horizontal to the X-axis.
Time
Consumption requires time. Accordingly, a demand curve must describe some particular
time period. Over a very short period of time—say a day—the demand for a good may
not react immediately. It takes time to find substitutes. With enough time, however,
consumers will respond to a price increase. Thus a demand curve that covers a long
period will be more elastic than one for a short period.
___________________________________
FIGURE 8.6 Perfectly Elastic Demand
A firm that has many competitors may lose all its
sales if it increases its price even slightly. Its
customers can simply move to another producer.
In that case its demand curve is horizontal, with an
elasticity coefficient of infinity.

Oil provides a good example of how the elasticity of demand can change over
time. In 1973 Arab oil producers raised the price of their crude oil, and domestic oil
producers followed suit. For a time consumers were caught. Drivers were stuck with
big, gas-guzzling cars and with suburban homes located far from their work places.
Automakers were tooled up to produce big cars, not subcompacts. Over the long term,

however, alternative modes of transportation became available and alternative sources of
energy were found. People altered their lifestyles, walking or riding bicycles to work.
The long-term demand curve for oil is much more elastic than the short-term demand
curve.

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Chapter 8 Consumer Choice and Demand in
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Changes in Demand
The determinants of the elasticity of demand are fewer and easier to identify than the
determinants of demand itself. As we saw in Chapter 3, the demand for almost all goods
is affected in one way or another by (1) consumer incomes; (2) the prices of other goods;
(3) the number of consumers; (4) expectations concerning future prices and incomes; and
(5) that catchall variable, consumer tastes and preferences. Additional variables apply in
differing degrees to different goods. The amount of ice cream and the number of golf
balls bought both depend on the weather (very few golf balls are sold at the North Pole).
The number of cribs demanded depends on the birthrate. Together all these variables
determine the position of the demand curve. If any variable changes, so will the position
of the demand curve.
We saw in Chapter 3 that if consumer preference for a product—say, blue jeans—
increases, the change will be reflected in an outward movement of the demand curve (see
Figure 8.7). That is what happened during the late 1960s, when college students’ tastes
changed and wearing faded blue jeans became chic. By definition, such a change in taste
means that consumers are willing to buy more of the good at the going market price. If
the price is P1 , the quantity demanded will increase from Q2 to Q3 . A change in tastes
can also mean that people are willing to buy more jeans at each and every price. At P2
they are now willing to buy Q2 instead of Q1 blue jeans. We can infer from this pattern

that consumers are willing to pay a higher price for any given quantity. In Figure 8.7, the
increase in demand means that consumers are willing to pay as much as P2 for Q2 pairs of
jeans, whereas formerly they would pay only P1 . (If consumers’ tastes change in the
opposite direction, the demand curve moves downward to the left, as in Figure 8.8, a
quantity demanded at a given price decreases.)
Whether demand increases or decreases, the demand curve will still slope
downward. Everything else held constant, people will buy more of the good at a lower
price than a higher one. To assume that other variables will remain constant, of course, is
unrealistic because markets are generally in a state of flux. In the real world, all variables
just do not stay put to allow the price of a good to change by itself. Even if conditions
change at the same time that price changes, the law of demand tells us that a decrease in
price will lead people to buy more than they would otherwise, and an increase in price
will lead them to buy less.
For example, in Figure 8.8, the demand for blue jeans has decreased, because
consumers are less willing to buy the product. A price reduction can partially offset the
decline in demand. If producers lower their price from P2 to P1 , quantity demanded will
fall only to Q2 instead of Q1 . Although consumers are buying fewer jeans than they once
did (Q2 as opposed to Q3 ) because of changing tastes, the law of demand still holds.
Because of the price change, consumers have increased their consumption over what it
would otherwise have been.
A change in consumer incomes will affect demand in more complicated ways.
The demand for most goods, called normal goods, increases with income. A normal
good or service is any good or service for which demand rises with an increase in
income and falls with a decrease in income. The demand for a few luxury goods actually
outstrips increases in income. A luxury good or service is any good or service for which

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Chapter 8 Consumer Choice and Demand in
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demand rises proportionally faster than income. An inferior good or service is any good
or service for which demand falls with an increase in income and rises with a decrease in
income. Beans are an example of a good many people would consider inferior. People
who rely on beans as a staple or filler food when their incomes are low may substitute
meat and other higher-priced foods when their incomes rise.

___________________________________
FIGURE 8.7 Increase in Demand

FIGURE 8.8 Decrease in Demand

When consumer demand for blue jeans increases,
the demand curve shifts from D1 to D2 .
Consumers are now willing to buy a larger
quantity of jeans at the same price, or the same
quantity at a higher price. At price P1 , for
instance, they will buy Q3 instead of Q2 . And
they are now willing to pay P2 for Q2 jeans,
whereas before they wold pay only P1 .

A downward shift in demand, from D1 to D2 ,
represents a decrease in the quantity of blue
jeans consumers are willing to buy at each and
every price. It also indicates a decrease in the
price they are willing to pay for each and every
quantity of jeans. At price P2 , for instance,

consumers will now buy only Q1 jeans (not Q3 ,
as before); and they will now pay only P2 for Q1
jeans -- not P3 , as before.

_

Thus, while economists can confidently predict the directional movement of
consumption when prices change, they cannot say what will happen to the demand for a
particular good when income changes, because each individual determines whether a
particular good is a normal, inferior, or luxury good. Different people will tend to answer
this question differently in different markets. Beans may be an inferior good to most
low-income consumers and a normal good to many others.
For example, how do you think a change in income will affect the demand for
low-, medium-, and high-quality liquor? You may have some intuitive notion about the
effect, but you are probably not as confident about it as you are about the effect of a price


Chapter 8 Consumer Choice and Demand in
Traditional and Network Markets

decrease. In fact, during past recessions, the demand for both low- and high-quality
liquor has increased. Some consumers may have switched to high-quality liquor to
impress their friends, and to suggest that they have been unaffected by the economic
malaise. Others may have tried to maintain their old level of consumption by switching
to a low-quality brand.
The effect of a change in the price of other goods is similarly complicated. Here
the important factor is the relationship of one good—say, ice cream—to other
commodities. Are the goods in question substitutes for ice cream, like frozen yogurt?
Are they complements, like cones? Are they used independently of ice cream? Demand
for ice cream is unlikely to be affected by a drop in the price of baby rattles, but it may

well decline if the price of frozen yogurt drops.
Two products are generally considered substitutes if the demand for one goes up
when the price of the other rises. The price of a product does not have to rise above the
price of its substitute before the demand for the substitute is affected. Assume that the
price of sirloin steak is $6 per pound and the price of hamburger is $2 per pound. The
price difference reflects the fact that consumers believe the two meats are of different
quality. If the price of hamburger rises to $4 per pound while the price of sirloin remains
constant at $6, many buyers will increase their demand for steak. The perceived
difference in quality now outweighs the difference in price.
Because complementary products—razors and razor blades, oil and oil filters,
VCRs and videocassette tapes—are consumed jointly, a change in the price of one will
cause an increase or decrease in the demand for both products at once. An increase in the
price of razor blades, for instance, will induce some people to switch to electric razors,
causing a decrease in the quantity of razor blades demanded and a decrease in the
demand for safety razors. Again, economists cannot predict how many people will
decide the switch is worthwhile, they can merely predict from theory the direction in
which demand for the product will move.
Derivation of Demand from Indifference Curves
And the Budget Line
Our discussion of theoretical foundations of demand has, admittedly, been casual. Here
we can add greater precision to the analysis. Much of the discussion has been founded on
the notion of the rational pursuit of individual preferences. That is, we assume the
individual knows what he or she wants and will seek to accomplish those goals.
Preference, however, is a nebulous concept. To lend concreteness to the idea, economists
have developed the indifference curve.
Individuals face limits in what they can produce and buy, a point of earlier
chapters. That fact, together with the existence of indifference curves, can be used to
derive an individual’s demand for a product.

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Chapter 8 Consumer Choice and Demand in
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Derivation of the Indifference Curve
Consider a student whose wants include only two goods, pens and books. Figure 8.9
shows all the possible combinations of pens and books she may choose. The student will
prefer a combination far from the origin to one closer in. At point b, for instance, she
will have more books and more pens than at point a. For the same reason, she will prefer
a to c. In fact the student will prefer a to any point in the lower left quadrant of the graph
and will prefer any point in the upper right quadrant to a.
We can also reason that the student would prefer a to d, where she gets the same
number of pens but fewer books than at a. Likewise, she will prefer e to a because it
yields the same number of books and more pens than a. If a is preferred to d and e is
preferred to a, then as the student moves from d to e, she must move from a less
preferable to a more preferable position with respect to a. At some point along that path,
the student will reach a combination of books and pens that equals the value of point a.
Assuming that combination is f (it can be any point between d and e), we can say that the
individual is indifferent between a and f.
Using a similar line of logic, we can locate another point along the line gih that
will be equal in value to a and therefore to f. In fact, any number of points in the lower
right-hand and upper left-hand quadrants of the graph are of equal value to a. Taken
together, these points form what is called an indifference curve (see curve I1 in Figure
8.10).
_____________________________________
FIGURE 8.9 Derivation of an Indifference Curve
Because the consumer prefers more of a good to less,
point a is preferable to point c, and point b is
preferable to point a. If a is preferable to demand but

e is preferable to a, then when we move from point d
to e, we must move from a combination that is less
preferred the one that is more preferred. In doing so
we must cross a point—for example, f—that is equal
in value to a. Indifference curves are composed by
connecting all those points—a, f, i, and so on—that
are of equal value to the consumer.

Using a similar line of logic, we can locate another point along the line gih that
will be equal in value to a and therefore to f. In fact, any number of points in the lower
right-hand and upper left-hand quadrants of the graph are of equal value to a. Taken
together, these points form what is called an indifference curve (see curve I1 in Figure
8.10). An indifference curve shows the various combinations of two goods that yield
the same level of total utility.

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