4 Market Demand and Elasticity In this chapter, we show how individual demand curves are “added up” to create the market demand curve for a good. Market demand curves reflect the actions of many people and show how these actions are affected by market prices. This chapter also describes a few ways of measuring market demand. We introduce the concept of elasticity and show how we can use it to summarize how the quantity demanded of a good changes in response to changes in income and prices. MARKET DEMAND CURVES Market demand The market demand for a good is the total quantity of the good demanded by all The total quantity of potential buyers. The market demand curve shows the relationship between this a good or service total quantity demanded and the market price of the good, when all other things demanded by all that affect demand are held constant. The market demand curve’s shape and posi- potential buyers. tion are determined by the shape of individuals’ demand curves for the product in Market demand curve question. Market demand is nothing more than the combined effect of many eco- The relationship nomic choices by consumers. between the total quantity demanded of a good or service Construction of the Market Demand Curve and its price, holding Figure 4.1 shows the construction of the market demand curve for good X when all other factors there are only two buyers. For each price, the point on the market demand curve constant. is found by summing the quantities demanded by each person. For example, at a price of P*X, individual 1 demands X*1, and individual 2 demands X*2. The total quantity demanded at the market at P*X is therefore the sum of these two = + amounts: X* X*1 X*2. Consequently the point X*, P*X is one point on the market 126 Chapter 4: Market Demand and Elasticity 127 PX PX PX P*X D 0 X*1 X1 0 X*2 X2 0 X* X (a) Individual 1 (b) Individual 2 (c) Market Demand FIGURE 4.1 Constructing a Market Demand Curve from Individual Demand Curves A market demand curve is the horizontal sum of individual demand curves. At each price, the quantity in the market is the sum of the amounts each person demands. For example, at P*X the demand in the + = market is X*1 X*2 X*. demand curve D. The other points on the curve are plotted in the same way. The market curve is simply the horizontal sum of each person’s demand curve. At every possible price, we ask how much is demanded by each person, and then we add up these amounts to arrive at the quantity demanded by the whole market. The demand curve summarizes the ceteris paribus relationship between the quan- tity demanded of X and its price. If other things that influence demand do not change, the position of the curve will remain fixed and will reflect how people as a group respond to price changes. Shifts in the Market Demand Curve Why would a market demand curve shift? We already know why individual demand curves shift. To discover how some event might shift a market demand curve, we must first find out how this event causes individual demand curves to shift and then compare the horizontal sum of these new demand curves with the old market demand. In some cases, the direction of a shift in the market demand curve is reasonably predictable. For example, using our two-buyer case, if both of their incomes increase and both regard X as a normal good, then each person’s demand curve would shift outward. Hence, the market demand curve would also shift outward. At each price, more would be demanded in the market because each person could afford to buy more. This situation in which a general rise in income increases market demand is illustrated in Figure 4.2. Application 4.1: Why the 2001 Tax Cut Was a Dud shows how this notion can be used to study the effects of tax cuts, although, as is often the case in economics, the story is not quite as simple as it appears to be. 128 Part 2: Demand D؅ PX PX PX D P*X 0 X*1 X*1* X1 0 X*2 X*2* X2 0 X* X**X (a) Individual 1 (b) Individual 2 (c) The Market FIGURE 4.2 Increases in Each Individual’s Income Cause the Market Demand Curve to Shift Outward An increase in income for each individual causes the individual demand curve for X to shift out (assuming X is a normal good). For example, at P*X, individual 1 now demands X**1 instead of X*1. ′ The market demand curve shifts out to D . X* was demanded at P*X before the income increase. Now = + X** ( X**1 X**2 ) is demanded. In some cases, the direction that a market demand curve shifts may be ambiguous. For example, suppose that one person’s income increases but a sec- ond person’s income decreases. The location of the new market demand curve now depends on the relative shifts in the individual demand curves that these income changes cause. The curve could either shift inward or shift outward. What holds true for our simple two-person example also applies to much larger groups of demanders—perhaps even to the entire economy. In this case, the market demand summarizes the behavior of all possible consumers. If personal income in the United States as a whole were to rise, the effect on the market demand curve for pizza would depend on whether the income gains went to peo- ple who love pizza or to people who never touch it. If the gains went to pizza lovers, the U.S. market demand for pizza would shift outward significantly. It would not shift at all if the income gains went only to pizza haters. A change in the price of some other good (Y) will also affect the market demand for X. If the price of Y rises, for example, the market demand curve for X will shift outward if most buyers regard X and Y as substitutes. On the other hand, an increase in the price of Y will cause the market demand curve for X to shift inward if most people regard the two goods as complements. A Simplified Notation Often in this book we look at only one market. In order to simplify the notation, we use the letter Q for the quantity of a good demanded (per week) in this mar- ket, and we use P for its price. When we draw a demand curve in the Q, P plane, APPLICATION 4.1 In May 2001, the U.S. Congress passed one of the largest cuts in personal Why the 2001 Tax income taxes in history. The cuts are to be implemented over a 10-year period Cut Was a Dud and will (over that period) amount to more than $1.6 trillion. As a “down payment” on this sum, the law provided that most U.S. taxpayers receive an immediate check for $300 (or $600 for a married couple), and these checks rolled out of the Treasury at the rate of 9 million per week during the summer of 2001. Many politicians argued that such a large tax reduction would have an important effect on fighting the recession that was then beginning by boosting the demand for virtually every good. But such a prediction ignored both economic theory and the realities of the bizarre U.S. tax system. Ultimately, the tax cut seems to have had virtually no impact on consumer spending. The Permanent Income Hypothesis Our discussion of demand theory showed that changes in people’s incomes do indeed shift demand curves outward. But we were a bit careless in defining exactly what income is. Milton Friedman made one of the most important discoveries that clarify this question in the 1950s. He argued that spending decisions are based on a person’s long-term view of his or her economic circumstances.1 Short-term increases or decreases in income have little effect on spending patterns. Friedman’s view that spending decisions are based on a per- son’s “permanent” income is now widely accepted by economists. Virtually all studies of actual spending behavior rely on this insight. Tax Cuts and Permanent Income According to Friedman’s theory, a tax reduction will affect a person’s spending only to the extent that it affects his or her permanent income. This insight suggests that the 2001 tax act had little impact for two reasons. First, consider the $300 checks. These came to people “out of the blue,” and everyone knew that such largess would not continue. The checks were too small to stimulate spending on any major goods, so they were largely saved. People made no changes in what they were already intending to buy. In this, they were exhibiting exactly the same sort of nonresponse that they had shown in many previous episodes including temporary tax increases in the late 1960s and temporary reductions in the 1970s. Now consider the effect of the overall tax act, a plan that was intended to be imple- mented over a 10-year period. Because of wrangling in Congress, the actual schedule of tax cuts is “back-loaded.” That is, most of the cuts do not begin until 2006, and the largest cuts are reserved until 2009–10. Such distant tax cuts probably have little impact on peo- ple’s perceptions of their economic situations.