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NOTE Exchange and Demand

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This is the lecture on exchange and demand, and it follows up on yesterday's lecture on scarcity, choice and value.

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When we talk about exchange, we can focus on a single individual and see that even in the case of that individual, every single action is in a sense an exchange.

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What he's doing is substituting a situation which he thinks is more satisfactory for one which he thinks is less satisfactory, that is, catching fish with his hands is less productive, and he believes that productivity will increase sufficiently that it will repay the time he spent catching with the net.

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That is, catching fish with his hands is less productive and he believes that productivity will increase sufficiently that it will repay the time he spent catching with the net.

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So he conceives of a better situation in the future and he acts to obtain that situation.

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In that sense, all action, for example, actually taking your daily lives, like making yourself a ham sandwich at home, substitutes a more satisfactory for a less satisfactory state of affairs from the point of view of the actor.

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So in that sense, again, action is exchange.

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but in economics, of course, we're most interested in interpersonal action

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there are two types, voluntary and aggressive

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and voluntary exchange is a category of voluntary action

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along with gift giving

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we'll also deal, to some extent, with aggressive action because we're interested in coerced exchanges

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and coerced exchanges like taxation, conscription, eminent domain, these are all government policies.

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And since they are a species of aggressive action, they're very much like murder and robbery in that only one party benefits at the expense of the other party.

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So the taxpayer is injured in the sense that he's forced to accept a situation which has a low utility and we'll talk about that in a moment.

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and the tax consumer, the government that coerces the taxes and the people who receive the taxes are benefited.

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All right, so let's first focus on voluntary exchange.

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There are two preconditions for voluntary exchange.

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One obviously is that each individual has to value the good that he is getting in exchange more than the good that he's giving up.

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We call that in economics reverse valuations of the goods exchange.

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In other words, they value the goods in reverse order.

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If I traded this full bottle of water for that bottle of iced tea that's half empty with Daniel there,

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I would demonstrate that, in fact, I preferred that bottle of tea for the bottle of water.

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But they wouldn't be equal in their values, because obviously I value what I'm getting more than what I'm giving up.

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And on the other hand, there's really a double reverse valuation of the goods exchange, because he values the water he's getting more than the iced tea that he's giving up.

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I wouldn't really do that. But in any case, that would be the situation. That's hypothetical.

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So, in the case then of voluntary exchange, both parties demonstrably benefit.

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They demonstrate this by the very action of accepting the good from the other party in exchange.

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You might also say that they improve their utility or their welfare because they move from a lower valued good to a higher valued good on their value scales.

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Another way of putting it is that they earn a psychic profit.

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So, just to give you a simple example, in the case of Crusoe and Friday exchanging horses for cows, and we're assuming that the goods that are in parentheses are the goods that the individual does not have, which you can still obviously place the value on.

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So, if A has a cow and B has a horse, a successful exchange will take place as long as B values the cow more than the horse and A values the horse that he's getting in exchange more than the cow that he gives up.

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So that's what we mean by reverse valuations. So the classically economists were wrong in saying that exchange showed an equality of value between goods.

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It shows a double inequality of value. That's what it demonstrates.

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Obviously, a second precondition of exchange is that A and B know of each other's existence.

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Again, we live in a world of imperfect knowledge, so that if A is Crusoe and B is Friday, Crusoe could be on one side of the island

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and have those valuations Friday on the other side. They may not know of each other's existence.

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That's where the arbitrage, arbitrageur comes into play, the entrepreneur, someone who has knowledge of A&B's existence and they can then, as a middleman, affect that exchange.

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Well, let's talk about some other types of exchange. I mean, everyday exchanges, such as me purchasing a Wall Street Journal today for one dollar,

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shows that I value the Wall Street Journal more than the dollar I've given up and likewise with the seller, or conversely with the seller.

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Does this change, however, when people live on different sides of government borders?

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In other words, we always hear the claim that, well, if you buy that cheap, or let's even make it more of an enormity,

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Cheap imports from Japan of automobiles are destroying the American economy.

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Make that claim or hear that claim made.

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Well, that obviously doesn't focus on the units of analysis, the individuals making those exchanges.

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So if an individual purchases, let's say, a Toyota, so you have an American, you have a Japanese manufacturer,

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And the American believes that the Toyota, I'll put it up, is worth more than the $25,000 that he pays for it.

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It's zoomed too much.

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I'll fix it in a moment. He gives up the $25,000 to the Japanese manufacturer who prefers that to Toyota.

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Okay, so the American values of Toyota more than the 25,000 that he gives in exchange and on the other hand the Japanese manufacturer values 25,000 more than Toyota.

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So Americans demonstrably benefit from this particular case of international exchange, okay.

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It's no different from the case of domestic exchange. International trade is analyzed in the exact same way, at least it's direct effects on people's utility.

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The parties involved always improve their utility from a voluntary international exchange.

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What about things like sweatshops or plasma clinics?

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clinics. I have an example for you of plasma clinics that have grown up on the Mexican-U.S. border. At least this was something that was an issue in the 1980s. It turns out that there were a number of clinics in the El Paso area that were thriving on the border and what they were doing was they were taking Mexican citizens who would come over for the day and donate plasma.

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Now plasma, unlike blood, can be donated every 72 hours because most of the blood is then returned to the donor and only the plasma is extracted.

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In any case, the clinic was paying between $10 and $20 for each donation.

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And many people were taking advantage of this. I think one hospital in particular, one clinic in particular, was getting from $1,500 to $2,000 a month.

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People were going back multiple times.

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Okay, what do we hear from some Americans?

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Okay, well critics of the clinic say that aliens who sell their plasma are being victimized

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and that the risk of hepatitis is increased.

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Okay, well how are they being victimized?

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They're getting $20 and they prefer that to the time given up

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and the procedure, the plasma that they have to give up.

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They're certainly being, they're certainly benefited otherwise they wouldn't engage in that exchange.

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We had a few other sorts of statements in a similar vein.

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Hematologists say that the plasma for pay operations are statistically riskier than plasma donations.

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They were just looking at that statistically.

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You have the lowest incidence of hepatitis with volunteer donors,

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as if someone who is giving their plasma in exchange for money isn't doing it voluntarily.

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So they put in their volunteer donors.

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And your most likely chance of getting hepatitis with professional donors.

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And then finally, the president of the League of United Latin American Citizens, a Hispanic activist group, says,

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I call them border draculas. It is another form of cheap exploitation of a neighboring country of the United States' attitude of indifference and paternalism.

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Okay, so how can indifference be also paternalism at the same time?

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That strikes me as a little odd.

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Okay, indifference is indifference.

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Okay, paternalism is something else. Well, it's neither.

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In fact, what it is is a voluntary exchange that benefits both parties.

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Another form of exchange that has come under attack

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is that of

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giving donations of organs for money. That's been outlawed in the United States. We'll talk more about that under the price control.

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But I do want to talk about one Twilight Zone, an interesting Twilight Zone episode. The original Twilight Zone series is a great series.

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And in this episode, there was a very rich woman who was blind.

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Okay, I guess it's politically correct to say she was unsighted.

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And her lifelong wish was to see the New York skyline at night.

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So in this episode, she finds someone who's an individual whose son needs a very expensive operation.

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So of course, she's very, very wealthy and he's poor.

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So you know which way this is going to turn out, of course.

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So she, and she finds a surgeon that has perfected an operation in which

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the, and this is before you could actually have corneal transplants, this is back in the sixties when this episode ran or early seventies,

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in which corneas can be transplanted, okay, but in this case you're going to use a live donor

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and so he's going to give up his sight in exchange for this large sum of money to save his son's life.

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So you know the attitude of the writers because it's successful,

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he gets the money, she gets the eyes, and she's

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taken to a place where she can observe the New York skyline, of course that's

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the night of the famous blackout in New York

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so she sees nothing

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and it was only going to be a twenty four hour window when these eyes would operate

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so of course, what's the attitude of the writers, of the liberal writers, and that is

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this is evil, you're exploiting someone else's misfortune

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well all exchange is an exploitation of people's misfortune

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We're all misfortunate in the sense that we have things that we would like to have that we don't presently have.

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An exchange allows us to alleviate the misfortunate circumstances that we are all in.

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Misfortune in the sense that, as we talked about, we are all in a veil of tears brought on by scarcity.

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So in this case, though, notice as opposed to the transplant case,

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It's the person who is receiving the organ that's blamed, okay?

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And the person who, because that person is poor, who's receiving the money, that is sort of the victim.

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Usually in transplant cases, and we'll talk about this, when you're paid for a transplant,

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it's the person who receives the money that is evil, right?

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But again, they're criticizing implicitly exchange,

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volunteer exchange.

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We also, one great cases is,

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which Walter Block has written about extensively,

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is extortion, okay?

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I'm sorry, not extortion, rather blackmail.

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And there was an interesting article written

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a few years ago by the free market economist,

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Walter Williams, and it was written on the case of William Bill Cosby when he was blackmailed by an alleged daughter of his that he had had an illicit affair, allegedly, and her name, I guess, was Autumn Jackson, and she was sentenced.

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What she had done was she demanded forty million dollars from Coresby in exchange for her silence about being his illegitimate daughter.

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So I don't know what actually happened when she was sentenced, but she faced up to twelve years in prison and a fine of seven hundred fifty thousand dollars.

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In any case, Walter Williams, as is his want, makes a joke out of all of this, but yet with a point.

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He says, imagine you catch me leaving a hotel with a young lady who's obviously not Mrs. Williams, you proposition, Williams,

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rights guaranteed me under the First Amendment to the United States Constitution, allow me to tell the world about your affair,

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eliminating any chance you have to become the nation's first black president.

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Let's stop here and ask, this is Williams writing now, have you done anything immoral or wicked?

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I think not, you are simply stating a human right protected by a constitution.

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Constitution. Then you say, I'll tell you what, if you give me $10,000, I will not exercise that right. Now the ball is in my court, I must decide whether to forgo any presidential aspirations, plus risk Mrs. Williams going upside my head, or I could fork over $10,000 if you're not exercising your God-given right to spill the beans. It's simply a choice where I decide which is more valuable, giving up $10,000 and retaining my presidential chances and no attacks from Mrs. Williams or keeping my $10,000

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and Suffering the Consequences, and he goes on to say, you have a God-given right to sleep and watch TV all day, yet the president of his university where he works, George Mason University,

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in effect, when he goes to work for that person, the president says to him, Williams, if you don't exercise your right to sleep and watch television all day and teach instead, I'll give you so many thousands of dollars each year.

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So in other words, there's no difference between the exchange that occurs in a blackmail, because that's what the essence of a blackmail is, it's simply an exchange.

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On the one hand, everyone has the right to tell a secret about someone else, as long as they've obtained that information legally.

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That is, without violating the person's property by going on their property and stealing things from their house to get the secret.

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And everyone agrees with that. We might call that person a gossip and say that person is immoral, but the person hasn't done anything illegal.

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On the other hand, people can come up to people and ask them not to undertake a certain action or not to say something and pay them money.

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There's nothing wrong with that.

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Yet, when these two actions are taken in conjunction with one another, when the person who has a secret initiates comes to you and says,

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Don't tell the secret about me, or rather, I will tell the secret about you if you don't pay me a certain sum of money. That's called blackmail.

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What would have happened, on the other hand, if Bill Cosby, and this happens all the time with big stars and people in politics, goes to Autumn Jackson and says,

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I'll give you, I know you know this about me, I don't want you to tell me or tell anyone about it, I'll give you $40 million for your silence.

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That's not legally actionable. That's not blackmail, okay?

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You just simply buy someone something. But if the other person initiates the exchange, the person that would be the secret teller, then it's blackmail, okay?

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It's simply voluntary exchange, okay? Both parties benefit.

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Bill Cosby is better off if he agrees to it because not having a secret told means more to him than $40 million.

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And of course, Lord M. Jackson would have been better off.

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Now, what about forced exchanges such as taxation, eminent domain, conscription?

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If we just take a simple example like conscription, basically what happens when someone is drafted into a state army is that that person is given a sum of money.

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And by the way, slaves are also given a sum of money, or rather they're given a consideration. Slaves are given room and board and so on. And when someone's drafted into the army, they're mainly given room and board and a small salary, nominal salary.

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Is the slave better off? Well, people would say no, it's a coerced exchange.

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The slave would rather labor at some other job that he voluntarily gets because he can make more money.

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If not, he would go to work for that person at the low wage, but he doesn't do that.

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So he's certainly worse off. Slave master is better off. Same thing with conscription or the draft.

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The state is better off, the conscriptee, the draftee is worse off.

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People may then claim, well, we can't depend on voluntary exchange because we need a lot of soldiers, or we need X amount of soldiers.

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Well, there's a market for people who want to be mercenaries, that works very well.

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People want to hire mercenaries, and mercenaries are hiring, in fact the U.S. hires mercenaries in Iraq and so on.

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and so on. They call them private contractors, quote unquote.

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Supply and demand works, as we'll see, in all markets, including the market for people

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who want to be in the military. So any sort of coerced exchange, even if it's for a worthy

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cause, makes one person better off, another person worse off. So the example Mises uses

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is if someone or if a local government wants to fund a hospital and taxes everyone in the county, let's say, $100 for that hospital, that person has a better use for the $100 or he would have donated the money to that hospital.

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So the person that's taxed is worse off, the person receiving the taxes, the government and then also the people working at the hospital are benefited.

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On the other hand, if the hospital is completely voluntarily funded, that same $100 that's given by a voluntary donor makes the donor better off.

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He ranks that use of the $100 higher than any other use that he can think of at that point in time.

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Let's move on from the utility effects of exchange to a little more complicated analysis, and that is how the law of marginal utility determines the limits of exchange.

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What happens when two parties possess more than one unit of the two goods that are being exchanged?

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exchange, okay? Well, they will exchange up to the point where there are no longer mutual benefits, where at least one party says an additional unit of the good that you're giving me is not worth the good I have been giving up.

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Now, in this case, we're going to be assuming that the price has been determined, okay? And we'll use cows and horses again for simplicity.

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In any case, when you reach a point where voluntary exchange is no longer mutually beneficial, we call that in economics a momentary equilibrium.

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Both parties are better off and all possible gains from exchange have been exhausted.

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We also call it, and I'll write it here, the plain state of rest, which happens again and again.

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When you go to a supermarket, for example, I'm going to use this example in more detail, and you purchase three bottles of wine, two pounds of steak, five pounds of potatoes, and you go home.

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When you leave that supermarket, you have exhausted all gains from exchange.

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You haven't bought a third pound of steak or a fourth bottle of wine because the fourth bottle of wine would be worth less than the price to you.

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The third pound of steak would have been worth less than the price, whereas the first two pounds of steak were worth more than the price.

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That's the operation of the law of marginal utility. The more units of a good you purchase, the lower and lower ends they serve, and therefore the less money you'll be willing to give up for it.

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So as you obtain more units, the units become lower in relation to the money price that you're paying for them.

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So, the plain state of rest, PSR, is what we call a situation after which the exchange process ceases because people have exhausted all benefits from it.

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Also, it might be called the momentary equilibrium, because people's wants continuously change.

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Let me give you an example and then I'll sort of give you a more, actually first let me just show you what I mean here before I give you an actual example.

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We're going to take a simple exchange of cows and horses, we're going to assume, for the time being, that A possesses no horses and four cows, and B possesses four horses and no cows.

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This is no horses and four cows, I think I said that wrong before.

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Let me just zoom out a little bit here so we can see the whole thing.

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Okay, so notice A's value scale first.

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Ignore the shaded entries, okay?

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We're going to assume that A has four cows, and the cows are ranked first, second, third, fourth, okay?

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And they're ranked in relation to horses that he does not possess, okay, the horses in parentheses.

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B ranks the four horses that he possesses, and again in relation to the cows that he does not possess.

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Is there room there for mutual benefits?

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Well, notice that the first and second horses, the most highly valued of horses that A has ranked there,

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which he does not have, are above the third and fourth cow which he does possess.

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So he's certainly willing to trade his lowest valued cow for the first horse,

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and in fact to give up his next lowest valued cow for a horse.

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He improves his utility by both of those exchanges, he improves his welfare.

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Would be consent to that exchange?

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Well, let's look at B's value scale.

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B values the first three cows that he could obtain above three of the horses that he possesses.

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So he would certainly be willing to give up the fourth horse, the lowest valued horse, and the third horse, okay,

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for two cows, yeah, for the first two cows from A, okay.

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In fact, he would like to make a third exchange.

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He would even give up his second most highly valued horse for a third cow.

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So at the end, he would like to have three cows and one horse.

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However, A would not consent to that.

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Everyone see why A wouldn't consent to that?

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A wouldn't consent because were he to give up another cow and accept a third horse, he would lower his value scale.

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So, the shaded entries here show you how the marginal utilities of the goods after the exchange is completed.

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Both parties value the goods in the same order, not in different orders, so there can be no further exchange.

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Here's, actually I should have shaded the, no, I'm correct, so the second cow, so there's two cows that A possesses,

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the second cow is ranked above the third horse, which he could get if he wanted from B, okay.

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So he ranks a cow above a horse, and B ranks a cow above the horse.

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So the exchange will not take place, okay?

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B would like to get that third cow, but the cow is ranked above the horse by both of them,

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so A will not give up the cow for a horse because the horse has lower value, at least the third horse does.

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So exchange comes to an end, okay?

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And if I just put it up here, we can read A exchanges two cows for two of B's horses, exchange will cease at this point because the marginal utility of A's second cow is greater than the marginal utility of the additional third horse.

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I'll show you that there, okay?

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For B, the marginal utility of the additional third cow is greater than the second horse, so he would like to continue exchanging, but there no longer exists reverse valuations.

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They both value the goods in the same order.

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At that point, they walk away from each other because there is no further scope for beneficial exchange.

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Now that's a hypothetical example. Let me give you a real example.

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A couple of weeks ago, when I first got down here, I went to the Super Walmart in Auburn, across from my apartment complex.

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And they had a Father's Day sale on DVDs. And they had some fairly new DVDs for $4.88. And I purchased three.

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I didn't purchase four, I didn't purchase two, I purchased exactly three, because the fourth one would have been worth less than the four dollars and eighty-eight cents, that's all it was, that the asking price was, and the second, if I stopped at two, it would have been a waste of resources because I actually valued the third one more than the four dollars and eighty-eight cents, so I walked out of the store with three. At that point, for that good, I was in momentary equilibrium. Now, I thought about it a couple days later,

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Later, I went back and I bought a fourth DVD, for $4.88. My wants had changed. My wife gave me more money. I had more money in my pocket.

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The more money you have, obviously, the lower its value in relation to other goods because of the marginal utility, so I walked back and I got it.

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Now, Super Walmart is sort of a microcosm of the market economy and let me show you what I mean by that.

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During the day, let's assume that Walmart doesn't change its prices during the course of the day.

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It probably does, but let's assume it doesn't for simplicity.

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During the day, people come and go, they buy certain things and a certain amount of these things and they abstain from buying other things.

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Some people come in the store and walk out without buying anything.

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The reason why they would do that? Because the price of anything that they see there is above the marginal utility of the goods that they would get in exchange.

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That's what we call shopping sometimes, where you're just comparing prices and you think there's a better deal elsewhere. So you walk out.

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So, I actually, I'll just give you some of the things that I purchased there and then I'll show you sort of a more sophisticated example of a plain state of rest, okay.

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So, I bought a number of things, I bought a lot of things, but some of the stuff I bought, I bought a box of cereal, I bought about two pounds of bananas, I bought toothpaste, I bought a George Foreman grill, okay, because I learned how to cook on them, they're pretty cool.

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And I bought a pound of coffee and a number of others.

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Oh, I bought a mystery novel and a Def Leppard CD, which they do covers of 70s and 80s tunes.

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So I bought that and I bought the three CDs and so on.

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Okay, here's what my plain state of rest looked like.

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And not only me, now we're going to assume that these are everybody.

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That everybody who went to the store had the opportunity that day to purchase these...

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to purchase these items.

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There we go.

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All right.

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Let me go through it a little bit.

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Okay.

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Yeah.

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No, some of them were good.

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Anyway, so notice what happened.

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Everybody, now not just me, everyone who purchased a George Foreman grill that day,

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some people could have purchased two, the last unit they purchased exceeded what?

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The value of the $19.44, okay?

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Now, at the end of the day, there were still some George Foreman grills left.

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That is, Walmart didn't sell those George Foreman grills,

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which indicates that they, the seller, also valued the George Foreman grill above the $19.44.

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So at the end of the day, all possessors of those grills valued the unit they possessed above the market price

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and any additional unit what? Below the market price. That's why I only bought one.

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same thing with the novels and other people bought these things also

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this is called the collective scale

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we're not actually adding up people's utilities or anything

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this collective scale concept comes from Philip Wickstein, it's sort of dropped out of economics but it's very important

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this can be extended to the whole market economy

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at any given moment in time

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or if you want to put it this way, on any given market day

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Everybody who purchased, or anyone at the end of the day who owns a unit of the good, values the good above the market price that was established during that day, including the sellers.

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That is, the sellers would prefer to hold the good off the market, it's called the reservation demand, and wait until another day when they maybe could sell it at a higher price rather than sell it.

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So now, the only people that value the good less than the price are people that didn't purchase any units.

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So there are people that walked by, George Forman Grill didn't purchase it, didn't purchase the Def Leppard CD, didn't purchase Folgers Coffee or any bananas.

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And those people then must value the good. At the end of the day, they don't have any.

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So what does that imply? Since they did have the opportunity of purchasing it, they value it below the market price.

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So there are no more gains from exchange.

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Why? Because everybody in the market, at the end of the day, values the goods and money in the same order.

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Everyone see that? Everyone purchased up to the point where the next unit, in my case, the second unit, was somewhere below.

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For a second grill as a backup, I might pay a dollar or two for it, if it was available.

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But I certainly wouldn't purchase a second grill for 1944.

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Are there any questions on this analysis?

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Okay, so this is what it's called. Now, this collective scale, which ranks the equilibrium price of the good, of all goods in the economy, including automobiles and very expensive goods, computers, so on, right down to bananas, okay, there is a collective scale, right, at least to the extent that people have knowledge of prices in different markets. Yes.

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I'm fudging here. In retail markets, they tend to set reservation prices because they believe over the course of the time that they have those grills in stock, people will pay 1944, let's say.

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So you're right, but let's say you go into a fish or a fruit market, they want to sell it at whatever price they can get for it, okay?

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And if they hold off the market, it means because they would prefer to use it themselves.

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Or let's talk about a market with a speculation, okay?

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So at that price, in other words, if they really wanted to sell it more, they would lower the price slightly and they would sell more units of it.

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But you're right, in this particular case, in the case of retail markets, where you have durable goods, they are, they may very well prefer to sell a few, the units that they hold might be below 1944, okay, but they're holding them because they believe they can get that tomorrow, so they're not going to cut it to 1943 or 1942 to sell more units, okay, but they would if you or I went in late, you know, right before they closed, they would have, they'd sell additional units.

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The key is that there's no room for exchange anymore, because both value the goods in the same order.

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That is, they both value the market price above the good.

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So in your case, what you're saying is that they would take the market price.

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But me and other people that bought one George Foreman grill value the market price also above it, so there is no gain from exchange.

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So the analysis still holds. Does that make sense?

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Now let's talk a little bit about exchange, division of labor and money.

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I'm going to skip through this fairly quickly.

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All exchange implies that there's specialization.

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That is that the producers produce more in relation to their wants.

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and their wants. That is that there's a disproportion between what they produce and their wants.

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So when exchange begins, even in primitive times, we can assume some degree of specialization.

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Even though people might be trying to produce everything for themselves initially before they begin exchanging,

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there is a disproportion. They see certain opportunities for trading some of the things that they produce for things that other people have produced.

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Over time, as more and more people get involved in the network of exchange, markets for any given good become much broader.

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So people then become more intensively specialized in various goods because they know that, look, if I produce only wheat,

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the market for wheat is so large that I can get, that the tailor wants the wheat so I can get a suit of clothes,

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that the shoemaker wants the wheat, that the person who sells eggs wants the wheat.

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So as exchange expands and the market for all goods expand, more people get involved, we get more specialization and more productivity.

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Everybody becomes more productive because they specialize according to their comparative advantage.

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And that's self-reinforcing.

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The more specialization we have and the greater the variety of goods, the more other people see the advantages of exchange.

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So eventually, exchange becomes world embracing, which it became in the 17th, 18th, 19th century.

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So eventually, in the modern world, I'm interested in analyzing the modern economy, everyone is a specialist.

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Everyone is a specialist, accountant, a doctor, and so on.

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Very, very, very few people try to produce most of the goods that they will consume themselves.

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They depend on the division of labor and exchange to get what they need.

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Now, in order to support such an intricate network of exchanges that's based on a really complex structure of specialized production, you need money.

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And we'll talk about how money gets introduced later in the course.

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But you need money in order to obtain these various items.

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So people then begin to rank money along with, as we saw, along with all goods on their value scales.

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And remember now, in a modern economy, one-half of all exchanges involve money.

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So people must buy money by selling their labor services or selling other things, holding

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that money in their possession while they're looking around for the things that they desire.

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So people regularly accept and hold money, which means if they're willing to accept it

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All right, so now what we want to do is talk about the law of demand, because the law of demand is always expressed in, or the demand for goods and services in a market economy is always expressed in terms of money.

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Let's just start with the simple law of demand, which those who had economics or even read any economics know about.

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Let's just start with the simple law of demand, which those who had economics or even read any economics know about.

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And that law says that the lower the price of a good, the greater the quantity demanded.

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Quantity demanded being defined as the amount buyers are willing to purchase at a given price.

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So let me restate the law. The lower the price of the good, the greater the quantity demanded, all other things equal.

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Assuming people's money hasn't changed, or their incomes haven't changed.

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Assuming that the prices of other goods and services have not changed.

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Assuming that their tastes have not suddenly changed.

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This law is illustrated throughout history.

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Not proved by looking at history, but it's illustrated.

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In other words, when hand calculators first came out, I remember I was in college,

330
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Everyone, well many of us were still walking around with slide rules, okay, and depending on where you carried it, if you carried it in your breast pocket you were kind of a nerd, if you carried it in your back pocket you were kind of cool.

331
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You broke a lot of them, you had to rebuy them when you sat down, but that's another story. It was worth the price of being cool.

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All right, so they were $350 and very, very few college students had them.

333
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But now they're as abundant as bags of potato chips. I mean, they're $5.

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What happened? Well, as the price fell, obviously the quantity demand had expanded tremendously.

335
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And even the cheapest one today is much more sophisticated than the original ones.

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The Texas Instruments, I think, had introduced. They could barely add and subtract.

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Same thing is true with computers. Who would have dreamed back in the 1970s that they would have had a computer in their homes?

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I mentioned this last class.

339
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The mainframe computers were the only way you could get a computer, and they were $3 million, $2-3 million.

340
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And when PCs were introduced, they were over $20,000 in 1980.

341
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Prices fell from 1980 to 1995 or 1999. They fell at a rate of 35% per year.

342
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So that today you can get a computer for $500 that has more sophisticated, faster, has more memory than the original PCs and Macs.

343
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Ballpoint pens when they were introduced in 1946 were sold at Mises and Gimbals in New York at around $18 or $20.

344
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Now that's $1946. That's probably over $200 today.

345
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So instead of leaving, you know, think in terms of conspicuous consumption, when these pens first came out,

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instead of leaving something like a portion of your driveway so that people could see how rich you were,

347
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when people came over you left like a ballpoint pen on your coffee table or something like that, because they were so expensive.

348
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But within two years, they had fallen, by 1948 they had fallen to 20 cents in 1948 dollars, which is much more today,

349
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and they became ubiquitous, that is everyone had them, that was a very rapid decline in price that brought about a very rapid increase in quantity demanded

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and the law as we know works with cell phones, DVD players, all of these things were extremely, people had a very low quantity demanded of these things when the prices, when they were first introduced the prices were higher

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And of course things work in the opposite direction. If you've ever seen the movie American Graffiti, it was a slice of American culture in the early 1970s and it showed teenagers just, you know, spending their whole evening, Friday evening or Saturday evening at night, driving around, just driving around aimlessly, which you know, I used to do. That was when gas was 30 cents, between 30 and 40 cents a gallon, okay. Whereas as gasoline shot up in price from

352
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From 1970 to 1980, oil went from something like $3 a barrel to something like $36 a barrel, gasoline, which was obviously a petroleum product, went from something like $0.30 a gallon to about $1, I think at its height then, it was maybe $1.30 a gallon or something like that.

353
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So, what happened? What you saw happening was dating patterns of teenagers changing radically.

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So, that was the law of demand operating in reverse.

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And you can state the law, conversely. The higher the price of a good, the lower the quantity demanded.

356
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And then we saw as prices began to collapse, oil prices collapsed in 1985 and kept coming down, SUVs were introduced, which used large amounts of gas.

357
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Now with gasoline prices shooting up again, Americans are changing their driving habits.

358
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What was interesting though was that by 1979 when the price of gasoline was something like

359
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over a dollar, which was really a sticker shock to Americans who had always thought

360
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that they had sort of a divine right to 30 cents a gallon of gas, all of these commentators,

361
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economically ignorant commentators or commentators that were innocent of economics in the media

362
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were saying things like, Americans are never going to change their driving habits, okay?

363
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We're going to have a gasoline shortage, you know, well into the next century, well into the 2000s.

364
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And this was probably in the mid-1970s, actually, when there were still price controls on gasoline.

365
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Even though the Nixon price controls, President Nixon had imposed wage and price control, had been phased out,

366
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they were still kept on gasoline.

367
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So gasoline prices were fixed at 75 cents a gallon, and there was a great shortage.

368
00:46:11.200 --> 00:46:16.760
So in 1973 and then again in 1979, we were all waiting on lines, okay?

369
00:46:16.760 --> 00:46:25.880
And the government tried to ration the gasoline by saying that people with odd numbers on their license plates can only come on Monday, Wednesday, or Friday to get gas,

370
00:46:25.880 --> 00:46:28.160
and people with even numbers can come on the other days, okay?

371
00:46:28.160 --> 00:46:31.440
So there was actually a rationing mechanism beginning to be put in place.

372
00:46:31.440 --> 00:46:35.640
The economists simply said, look, you have to allow the price of gasoline to rise

373
00:46:35.640 --> 00:46:38.440
and supply and demand will be equilibrated

374
00:46:38.440 --> 00:46:39.800
and in fact

375
00:46:39.800 --> 00:46:43.440
the Carter administration removed the gasoline price controls

376
00:46:43.440 --> 00:46:45.160
in the summer

377
00:46:45.160 --> 00:46:47.160
of nineteen seventy nine

378
00:46:47.160 --> 00:46:52.300
and gasoline shot up from something like seventy five cents to a dollar, went up by thirty three cents very quickly

379
00:46:52.300 --> 00:46:55.160
and within two weeks the lines were gone

380
00:46:55.160 --> 00:46:57.240
the lines were completely gone

381
00:46:57.240 --> 00:47:00.800
despite the fact that all of these pundits were telling us that

382
00:47:00.800 --> 00:47:04.320
uh... you know american americans better uh...

383
00:47:04.320 --> 00:47:07.360
resign themselves to these long lines

384
00:47:07.360 --> 00:47:10.520
through the next century

385
00:47:10.520 --> 00:47:12.680
right now how do we uh...

386
00:47:12.680 --> 00:47:14.380
in economics we we

387
00:47:14.380 --> 00:47:18.780
illustrate

388
00:47:18.780 --> 00:47:20.640
law of demand

389
00:47:20.640 --> 00:47:22.680
through what we call a demand schedule

390
00:47:22.680 --> 00:47:29.680
and then through a curve. We'll first look at the schedule.

391
00:47:30.460 --> 00:47:37.460
We'll take an example of milk for a simple example.

392
00:47:41.440 --> 00:47:44.760
This is a hypothetical example. These numbers aren't real.

393
00:47:44.760 --> 00:47:49.000
At ten dollars, the amount of milk demanded

394
00:47:49.000 --> 00:47:53.000
It's two million per day, let's say in the US economy.

395
00:47:53.000 --> 00:47:58.000
And as the price falls, the price per gallon falls, the dollar per gallon falls,

396
00:47:58.000 --> 00:48:01.000
the quantity demanded of milk will increase.

397
00:48:01.000 --> 00:48:07.000
All that is important is that at lower prices, quantity demanded is greater than at higher prices.

398
00:48:07.000 --> 00:48:10.000
As we'll see in a little while when we talk about elasticity of demand,

399
00:48:10.000 --> 00:48:18.000
the degree to which a fall in price brings about an increase in quantity demanded is relevant to business decision makers.

400
00:48:18.000 --> 00:48:27.000
But the law of demand doesn't deal with that. The law of demand simply says it's a qualitative law. The lower the price, the greater the quantity demanded, all other things equal.

401
00:48:34.000 --> 00:48:41.000
Now, let's talk about the demand curve, which is the graphical representation of the law of demand.

402
00:48:41.000 --> 00:48:54.000
It's interesting, from the 1920s, when the demand curve first came into economics, until about mid-1940s, the demand curve was drawn as a rectangular hyperbola.

403
00:48:54.000 --> 00:49:05.000
Let me show you what that looks like. It has a very strange implication. It implies that no matter what the price is, people will spend the same amount of money, total amount of money on the good.

404
00:49:05.000 --> 00:49:11.000
That is, if prices fall, people will buy enough more that they're still spending the same amount of money.

405
00:49:11.000 --> 00:49:25.000
Now, let me make this larger. This is the way demand curves were initially represented in textbooks for about 25 years.

406
00:49:25.000 --> 00:49:34.000
These, the demand curve asymptotically approached, meaning it came closer and closer to the quantity axis and the price axis without ever really reaching it.

407
00:49:34.000 --> 00:49:46.000
And what this shows us is that no matter how large the price change was, the same amount of money would be spent on goods.

408
00:49:46.000 --> 00:49:50.240
on Goods. So, as the price went up, people would buy a few units of the good,

409
00:49:50.240 --> 00:49:55.840
but it would be enough fewer that you would have the same amount of money spent on it.

410
00:49:55.840 --> 00:50:02.000
So, if you look at this example, if the price goes from four to five dollars, well, people do buy less, they buy eighty units.

411
00:50:02.000 --> 00:50:08.960
Everyone see that? Rather than a hundred, but they spend the same amount of money. They spend four hundred dollars in each case.

412
00:50:08.960 --> 00:50:15.680
So, if the price were to fall to two dollars, that means that people would have to buy two hundred units.

413
00:50:15.680 --> 00:50:21.680
There's no reason, there was no warrant for drawing it this way, it just happened to be drawn this way.

414
00:50:21.680 --> 00:50:29.680
I'll come back to that. Now, in 1943, a Chicago economist named George Stigler in his textbook said there's no reason to draw it like that.

415
00:50:29.680 --> 00:50:39.680
In fact, it's simpler simply to draw it like this, as a straight line. It's easier to work with, it's easier to teach with.

416
00:50:39.680 --> 00:50:44.680
And most demand curves today are represented as straight lines.

417
00:50:44.680 --> 00:50:53.680
And there's nothing wrong with representing a demand curve as a straight line, as long as you realize that this is for pedagogical simplicity.

418
00:50:53.680 --> 00:50:56.680
Demand curves are not straight lines, never.

419
00:50:56.680 --> 00:51:04.680
A straight line demand curve implies that the unit of money and the good that's being sold are infinitely divisible.

420
00:51:04.680 --> 00:51:16.680
Because at every point on this line, I mean, you could sell 10.0001 pounds of coffee or, you know, 10.0001 pounds, whatever, okay?

421
00:51:16.680 --> 00:51:25.680
That is that you can vary the quantity of the good in infinitesimal amounts and the quantity of money that you're paying in infinitesimal amounts, okay?

422
00:51:25.680 --> 00:51:27.680
And that's just not possible, okay?

423
00:51:27.680 --> 00:51:32.680
Think about selling a stove or selling, you know, an automobile, okay?

424
00:51:32.680 --> 00:51:38.680
You can't sell 1.1 or 1.1 tenth units of an automobile, okay?

425
00:51:38.680 --> 00:51:44.680
So, though we will be using this representation of demand curves,

426
00:51:44.680 --> 00:51:53.680
the actual demand curve looks more like this, and I've actually graphed the demand schedule for milk I put up there.

427
00:51:53.680 --> 00:51:58.680
First of all, it's not linear by any means.

428
00:51:58.680 --> 00:52:03.680
Okay, let me make it a little bit smaller.

429
00:52:03.680 --> 00:52:10.480
And secondly, it's not smooth.

430
00:52:10.480 --> 00:52:13.180
They're simply disconnected points.

431
00:52:13.180 --> 00:52:22.180
That is, at $1, 30 million gallons of milk is sold.

432
00:52:22.180 --> 00:52:27.280
At $10, 3 million, I think it was 2 million gallons of milk is sold.

433
00:52:27.280 --> 00:52:39.720
So these are simply, this is the way the demand curve looks. It's jagged, it's lumpy, meaning that goods can't be varied in infinitesimal amounts.

434
00:52:39.720 --> 00:52:51.640
And there's not necessarily any connection between, I could have connected those points, but in fact we don't. In the real world they're not.

435
00:52:51.640 --> 00:52:54.400
So that's the actual demand curve.

436
00:52:54.400 --> 00:52:57.160
What you must know about the demand curve though is that

437
00:52:57.160 --> 00:53:02.800
the law of demand tells us that it always slopes downward to the right.

438
00:53:02.800 --> 00:53:05.520
It always must slope downward to the right, indicating that

439
00:53:05.520 --> 00:53:09.960
the lower the price, the greater the quantity demanded.

440
00:53:09.960 --> 00:53:14.480
Why is that so? What causes that to be the case?

441
00:53:14.480 --> 00:53:19.760
Well, what causes that to be the case is the fact that

442
00:53:19.760 --> 00:53:23.800
the law of marginal utility operates

443
00:53:23.800 --> 00:53:29.240
and secondly people's value scales differ so let me just show you

444
00:53:29.240 --> 00:53:33.160
what I mean by that why as price falls you have to have

445
00:53:33.160 --> 00:53:40.160
a downward sloping demand curve

446
00:53:40.720 --> 00:53:47.720
I took the liberty here of using

447
00:53:49.760 --> 00:54:19.760
As you'll see, the familiar people, okay, Nick and Mila, okay, these are their value scales for milk, okay, let's say per week, okay, so Nick has, is a bigger milk drinker, okay, a little bit of scotch in there, anyway, Nick would pay up to ten dollars for the first gallon of milk, okay, but in order to get Nick to buy a second gallon, you'd have to lower the price to seven, so at seven dollars, he'd buy two gallons,

448
00:54:19.760 --> 00:54:27.760
and if the price were $4, he'd buy $3 and once the price fell to $2, he would rank the fourth gallon above the two, okay?

449
00:54:27.760 --> 00:54:36.760
Mila, on the other hand, isn't a big milk drinker, so she wouldn't buy her first gallon unless the price was as low as $3 and she would buy two gallons if the price was $1.

450
00:54:36.760 --> 00:54:50.760
So we can, in effect, construct a demand schedule, and then a demand curve, which I don't do here, but a demand schedule from their value scales.

451
00:54:50.760 --> 00:55:02.760
Now this is what happens economy-wide, demand for milk. You sum up horizontally everybody's, the quantity demanded by each person at any given price, and you get the overall demand curve.

452
00:55:02.760 --> 00:55:32.760
So in this case the demand curve for Nick and Mila is at $10 they demand one or one is demanded and as the price falls to seven there's two units demanded, at four there's three units demanded and at three Mila comes in and so there's fourth so you have Nick's declining utility, the Lord March utility governing the increase in quantity up to three units and then the fact that Mila now comes in because she has a different value scale, values that lower, there's a fourth unit at three and then you have

453
00:55:32.760 --> 00:55:38.760
have the law of marginal utility governing both of their value scales, okay?

454
00:55:38.760 --> 00:55:49.760
So, since value scales are an implication of scarcity and since value scales exist in the real world

455
00:55:49.760 --> 00:55:54.760
and people, when they make their choices, make it on the basis of these value scales,

456
00:55:54.760 --> 00:55:58.760
you will always have, and because the law of marginal utility is true,

457
00:55:58.760 --> 00:56:02.760
These things have a downward sloping demand curve for any given product.

458
00:56:02.760 --> 00:56:10.760
There's no such thing as a Giffen good in which over some ranges at higher prices people buy more.

459
00:56:10.760 --> 00:56:21.760
For example, people will buy more fur coats at higher prices and lower prices because fur coats are a status symbol.

460
00:56:21.760 --> 00:56:25.760
So if fur coats were only $50, no one would buy them, let's say.

461
00:56:25.760 --> 00:56:30.760
But because they're a thousand dollars, you know, like say a mink, it's a thousand dollars, people will buy them.

462
00:56:30.760 --> 00:56:34.760
Okay, more people buy them than will buy them a fifty dollars. That's nonsense.

463
00:56:34.760 --> 00:56:43.760
The point is this, the demand, as we'll see, the whole demand curve shifts up because at high prices there may be the idea that in fact this is a status symbol.

464
00:56:43.760 --> 00:56:52.760
Okay, so you're talking about a different good. In other words, people perceive the good completely differently because they attach something subjective to it, a certain status to that good.

465
00:56:52.760 --> 00:57:00.760
So it's not a given demand curve sloping upward, it's two different demand curves on two different graphs.

466
00:57:00.760 --> 00:57:04.760
It's a different good once the status attaches to it.

467
00:57:04.760 --> 00:57:06.760
For example, same thing with diamonds.

468
00:57:06.760 --> 00:57:16.760
But as I mentioned in the Amish example, diamonds are an example of vanity or reveal somebody's vanity or manifest vanity.

469
00:57:16.760 --> 00:57:26.760
So people who are part of the Amish community shun these things, so it's a different good, in a sense, to them.

470
00:57:31.760 --> 00:57:39.760
Having showed you that, we now want to address the question of,

471
00:57:39.760 --> 00:57:52.760
Well, is it important that people know by how much a change in price will affect the quantity demanded?

472
00:57:52.760 --> 00:57:54.760
Will it affect it a lot or a little?

473
00:57:54.760 --> 00:57:59.760
Well, it's certainly important to business decision makers, to entrepreneurs and businessmen,

474
00:57:59.760 --> 00:58:03.760
because they're not only interested in whether they can sell more at lower prices, they know that,

475
00:58:03.760 --> 00:58:19.760
I want to know, if I cut the price and sell more, will my total revenue go up or down, or on the other hand, if I raise the price and sell fewer units but at a higher price, am I going to earn more revenue or less revenue?

476
00:58:19.760 --> 00:58:25.760
That's where elasticity of demand comes into play.

477
00:58:25.760 --> 00:58:30.320
The law of demand tells us only that the demand curve is always and everywhere down and sloping,

478
00:58:30.320 --> 00:58:35.400
but as I said, businessmen for their pricing and production decisions, they want to know,

479
00:58:35.400 --> 00:58:42.160
if I cut the price, for example, if GM cuts the price of a Cadillac CTS by 10%, okay,

480
00:58:42.160 --> 00:58:49.200
the price is 10% lower, will their sales increase by 5% or will their sales increase by 100%?

481
00:58:49.200 --> 00:58:54.360
In other words, will their sales double or will their sales only increase by 5%?

482
00:58:54.360 --> 00:59:02.360
What are the different significance attached to that price cut if your sales increase by a great amount than if they increase by little?

483
00:59:02.360 --> 00:59:08.360
When sales increase a lot when you cut your prices, we'll see you have an increase in total revenue.

484
00:59:08.360 --> 00:59:15.360
But if you cut your price and your sales increase very little, even though people are buying a few more units,

485
00:59:15.360 --> 00:59:23.360
the price is lower and the price effect is going to outweigh the quantity demanded effect, and so you're going to get a lower total revenue.

486
00:59:23.360 --> 00:59:40.360
So let me give you an example, and that is an example of a hot dog vendor that's outside my university in New York, Pace University, where I teach.

487
00:59:40.360 --> 00:59:45.360
And let's look at what his demand curve might be for hot dogs in a given day.

488
00:59:45.360 --> 00:59:49.360
If he were to charge, and these are New York prices we're talking about, not Auburn prices.

489
00:59:49.360 --> 00:59:56.360
If he were to charge $10, he would sell only $10 during the day and his total revenue would be,

490
00:59:56.360 --> 01:00:03.360
total revenue is always defined as price times quantity, so total revenue would be $10 times the 10 units sold or $100.

491
01:00:03.360 --> 01:00:11.360
Notice what happens as he lowers the price to $9, $8, $7 and so on, for a while what's happening to total revenue?

492
01:00:11.360 --> 01:00:23.360
It's increasing. It's increasing because people are buying enough more at the lower price that the percentage increase in quantity demand is greater than the percentage cut in price.

493
01:00:23.360 --> 01:00:33.360
So at $9 you get $180 in total revenue and so on. After a certain price though, after $6 he cuts the price and he finds that his total revenue doesn't change.

494
01:00:33.360 --> 01:00:38.360
People buy more units but total revenue doesn't go up. And then eventually it falls.

495
01:00:38.360 --> 01:00:47.360
Notice that at $2 total revenue is less than it is at $3, and at $3 it's less than it is at $4.

496
01:00:47.360 --> 01:00:53.360
Total revenue is the total income received, it's not profit, it's the total income received,

497
01:00:53.360 --> 01:00:57.360
because we're not talking about costs here at all, we don't know what this person's costs are.

498
01:00:57.360 --> 01:01:05.360
Total income received from selling the good at a given price, which also means it's the total spending on that good by the consumers.

499
01:01:05.360 --> 01:01:09.360
They have to be identical, the two sides of the same coin.

500
01:01:09.360 --> 01:01:15.360
Now, let's see how, you know, if you're good entrepreneurs.

501
01:01:15.360 --> 01:01:22.360
There's clearly a range of prices that this person would, this vendor would never sell at,

502
01:01:22.360 --> 01:01:25.360
because it is not maximizing profit.

503
01:01:25.360 --> 01:01:28.360
And right here, let me just write in the profit equation.

504
01:01:28.360 --> 01:01:31.360
It's a very simple equation.

505
01:01:31.360 --> 01:01:39.360
We're going to use the Greek symbol pi to represent profit. Why do we do that? Well, because we use p to represent price.

506
01:01:39.360 --> 01:01:49.360
It's always equal to the total revenue, total money income from selling the good, minus the total costs.

507
01:01:49.360 --> 01:02:00.360
So keeping that in mind now, what the entrepreneur wants to do is have the biggest difference between his money income and his money costs.

508
01:02:00.360 --> 01:02:18.360
Okay? So, let's say this hot dog vendor is currently selling hot dogs at $3, and he's earning $240 in total revenue, and he has certain costs that he has to pay, so it's not his profit.

509
01:02:18.360 --> 01:02:27.360
You have to subtract the costs out before you can find his profit. All right. How can he increase his profits? Very simple way of increasing his profits.

510
01:02:27.360 --> 01:02:37.360
Well, let's do it step by step. And six, by the way, is not necessarily right, but it's more right.

511
01:02:37.360 --> 01:02:51.360
Well, if he sells it at four, what happens? TR goes up, right? He goes up from 240 to 280, and what happens to his total cost?

512
01:02:51.360 --> 01:03:02.360
What happens to total cost? He's selling fewer hot dogs, it means his total cost must do what? Go down, he has to buy fewer hot dogs.

513
01:03:02.360 --> 01:03:09.360
So his total revenue goes up, total cost goes down, so it pays him to raise the price to four.

514
01:03:09.360 --> 01:03:16.360
If you raise it to five, his total cost, his total revenue goes up again, total costs go down again because he's selling fewer.

515
01:03:16.360 --> 01:03:26.360
But it still pays them to raise it to six, because there, there will be no change in total revenue, but what will happen is total cost will fall.

516
01:03:26.360 --> 01:03:43.360
We define this range of the demand curve where, if you raise the price, the total revenue increases, and I'll put up a chart here, we define that as an inelastic portion of the demand curve.

517
01:03:43.360 --> 01:04:00.360
No profit maximizing entrepreneur will ever produce and sell in the inelastic portion of his or her demand curve.

518
01:04:00.360 --> 01:04:17.360
Now, let's say all other things equal. That's not to say that people will not have sales in which they might want to use a certain good as a loss leader where they take losses so they can sell other goods.

519
01:04:17.360 --> 01:04:26.360
But if that's the good that they're selling, if that's the only good they're selling, that law holds. They will not ever sell in the inelastic portion of their demand curve.

520
01:04:26.360 --> 01:04:31.000
their demand curve, nor will they sell in what we call the unit elastic portion.

521
01:04:31.000 --> 01:04:34.880
Unit elasticity refers to that range of the demand curve where

522
01:04:34.880 --> 01:04:38.240
when price increases or price decreases

523
01:04:38.240 --> 01:04:42.320
the total revenue does not change.

524
01:04:42.320 --> 01:04:47.000
So this person will sell at least at a price of six dollars.

525
01:04:47.000 --> 01:04:50.360
Now, depending on how fast his costs fall

526
01:04:50.360 --> 01:04:54.860
he may raise his price to seven or eight dollars

527
01:04:54.860 --> 01:04:59.260
because his costs are falling. If his costs fall more than his total revenue,

528
01:04:59.260 --> 01:05:05.260
okay, let's say if he cuts back to 40, he can use, he can rent a smaller cart.

529
01:05:05.260 --> 01:05:08.900
So not only does he have to buy fewer hot dogs, but the rents go down, okay.

530
01:05:08.900 --> 01:05:12.340
So it might be worth taking a cut in his total revenue

531
01:05:12.340 --> 01:05:15.780
because his costs are low and fall sufficiently

532
01:05:15.780 --> 01:05:19.300
and increases profit, okay.

533
01:05:19.300 --> 01:05:23.980
In any case, entrepreneurs are always selling the elastic portion. Elastic means

534
01:05:23.980 --> 01:05:32.540
The buyer is responsive, very responsive to a change in price or more responsive to a change in price.

535
01:05:32.540 --> 01:05:41.220
Inelastic means buyers are relatively unresponsive to a change in price.

536
01:05:41.220 --> 01:05:52.900
So the technical way of putting it is that an entrepreneur will always price or will always set a price above which the demand curve is inelastic,

537
01:05:52.900 --> 01:06:02.900
which above, if he raises the price, the total revenue will fall because if he raises price and total revenue rises, he is not maximizing his profit.

538
01:06:03.900 --> 01:06:12.900
Because when you raise your price, you sell less so your total costs go down and your total revenue goes up in that in the amount of demand curve.

539
01:06:12.900 --> 01:06:25.900
Let me just give you the chart here.

540
01:06:25.900 --> 01:06:29.900
Okay, so demand is elastic in the following two cases.

541
01:06:29.900 --> 01:06:35.900
It's elastic when you cut the price and your total revenue goes up.

542
01:06:35.900 --> 01:06:38.900
Or if you raise the price, your total revenue falls.

543
01:06:38.900 --> 01:06:53.900
So demand is elastic when people react to a cut in price by a larger change in their quantity, because it's quantity that's going up when you cut the price, and that's what's driving total revenue up in the elastic range of the demand curve.

544
01:06:53.900 --> 01:07:01.900
In the case of the unit elastic segment of the demand curve, no matter what you do with your price, you have an unchanged total revenue.

545
01:07:01.900 --> 01:07:11.900
That is, the change in quantity just matches the change in price. They're always moving in opposite directions because of the law of demand, remember, and that will result in an unchanged total revenue.

546
01:07:11.900 --> 01:07:16.900
In the inelastic segment, people aren't very, very responsive.

547
01:07:16.900 --> 01:07:28.900
Yeah, if you lower the price, they'll raise their quantity somewhat, but the total revenue will fall because they don't buy enough additional units to offset the decline in price.

548
01:07:28.900 --> 01:07:36.900
All right, so let me now talk about, well, let me mention one thing here.

549
01:07:36.900 --> 01:07:39.900
What you're seeing here is a straight-line demand curve.

550
01:07:39.900 --> 01:07:44.900
For every $1 cut in price, there's a 10-unit increase in quantity demanded.

551
01:07:44.900 --> 01:07:52.900
So the slope of this demand curve is negative 1 over 10.

552
01:07:52.900 --> 01:07:55.900
The slope is the same as the straight-line demand curve.

553
01:07:55.900 --> 01:08:09.900
and in a straight line demand curve, you always have a segment, the higher segment is always elastic, the mid-range is unit elastic and the lower part of the demand curve is inelastic, okay?

554
01:08:09.900 --> 01:08:19.900
But in the real world, demand curves aren't nice straight lines as we talked about. In fact, you know, we have, they're actually much more uneven, okay?

555
01:08:19.900 --> 01:08:36.900
So here's a situation in which you have a nonlinear demand curve, where things, where a given price doesn't always result in the same change in quantity demanded, okay?

556
01:08:36.900 --> 01:08:44.900
And in this demand curve, we can see it's a little bit more difficult to figure out where this guy should price, okay?

557
01:08:44.900 --> 01:09:00.660
First of all, he certainly wouldn't price anywhere below four dollars, right? Because as he raises the price, total revenue goes up, goes up to three forty, and he cuts back on his quantity. His costs go down because quantity demanded it's falling, right?

558
01:09:00.660 --> 01:09:02.820
So he would certainly,

559
01:09:02.820 --> 01:09:13.120
that might be one price he could charge, four dollars for eighty-five units, but notice, at higher prices, if the price were five dollars,

560
01:09:13.120 --> 01:09:21.320
He would now be in any last segment of his demand curve, so he would not price at $5, okay? What would he do?

561
01:09:21.320 --> 01:09:33.120
He would either go back to $4 or he would go up to $8, because notice at $5, as he raises the price to $6, total revenue increases until it reaches the maximum here at $3.20.

562
01:09:33.120 --> 01:09:42.120
So, two prices that he may charge, okay, are $4 or $8, depending on what his costs do.

563
01:09:42.120 --> 01:10:12.020
If the cost of selling 40 hot dogs is sufficiently below the cost of selling 85 hot dogs, he may very well set a high price, because his profits will be higher here, but we don't know, he could also set the price of $4, or even one of $9, but again, his total revenue is falling, so his costs have to fall by more than that, in order for him to maximize his profit.

564
01:10:12.120 --> 01:10:15.120
We're going to come back to that when we talk about the entrepreneur.

565
01:10:17.120 --> 01:10:22.120
Let me just talk a little bit about the shape of the demand curve.

566
01:10:26.120 --> 01:10:34.120
The general rule is that the flatter the demand curve is, the more responsive people are to a change in price, so the more elastic the demand curve is.

567
01:10:35.120 --> 01:10:39.120
Let's just take a demand curve here. You can see that.

568
01:10:39.120 --> 01:10:46.120
Okay, in this example, let's assume that the seller is selling at $8 and he's selling 10 units.

569
01:10:46.120 --> 01:10:48.120
I'll make that a little bit bigger.

570
01:10:52.120 --> 01:10:54.120
Okay, selling 10 units.

571
01:10:55.120 --> 01:11:01.120
If his demand curve was, and let's say he's deciding whether or not he should cut the price to $5, okay?

572
01:11:01.120 --> 01:11:07.120
If his demand curve looks like OE, is it worth cutting the price?

573
01:11:07.120 --> 01:11:10.620
Well, it may very well be worth cutting the price.

574
01:11:10.620 --> 01:11:14.040
Okay, notice, he cuts the price by three dollars,

575
01:11:14.040 --> 01:11:17.720
quantity demanded more than doubles, it goes from 10 to 24 units.

576
01:11:17.720 --> 01:11:20.600
Okay? On the other hand,

577
01:11:20.600 --> 01:11:24.760
if this were his demand curve, people's value, by the way, people's value scales determine what

578
01:11:24.760 --> 01:11:29.360
demand curves will look like. If people's value scales were such that they only bought a few more units

579
01:11:29.360 --> 01:11:30.760
when the price fell to five dollars,

580
01:11:30.760 --> 01:11:34.040
he'd only sell two more units, okay? In which case

581
01:11:34.040 --> 01:11:41.040
Is the demand curve more elastic, or are people more responsive?

582
01:11:41.040 --> 01:11:52.040
Yeah, OE, absolutely, right? Because he increases his quantity of demand by 140% when he cuts the price.

583
01:11:52.040 --> 01:11:57.040
Here he increases it only by 20%, an OI, okay?

584
01:11:57.040 --> 01:12:13.040
So, bottom line is that entrepreneurs are vitally interested not only in the law of demand, but in figuring out if their demand curve is elastic or inelastic in the range of prices that they're looking at, okay?

585
01:12:13.040 --> 01:12:21.040
And I could show you the same thing for rise in price, but it's the same. You'll note that it will be the same, okay?

586
01:12:21.040 --> 01:12:28.040
is that the steeper the demand curve, the more inelastic it is. Now let me just

587
01:12:28.040 --> 01:12:33.440
show you some of the extreme examples of what of elasticities. If I can go back

588
01:12:33.440 --> 01:12:47.640
to that one of the original. Yeah here it is, okay. Extreme examples, none of these

589
01:12:47.640 --> 01:13:05.640
These examples can exist in the real world, however, they're interesting because they shed light on, or they can tell us something about what the relationship is between the demand, the shape of the demand curve and elasticity.

590
01:13:05.640 --> 01:13:16.640
So let me just focus on the first one there.

591
01:13:16.640 --> 01:13:19.840
Note that this is a completely vertical demand curve.

592
01:13:19.840 --> 01:13:23.920
This demand curve has elasticity equal to zero.

593
01:13:23.920 --> 01:13:27.520
So, the steeper the demand curve, the less responsive consumers are.

594
01:13:27.520 --> 01:13:30.120
In this case, consumers are completely what?

595
01:13:30.120 --> 01:13:33.920
Unresponsive to a change in price.

596
01:13:33.920 --> 01:13:37.880
They will still buy a hundred at five dollars and because this is vertical,

597
01:13:37.880 --> 01:13:41.120
whether the price is five dollars or a million dollars or ten million dollars,

598
01:13:41.120 --> 01:13:43.640
they'll still buy one hundred.

599
01:13:43.640 --> 01:13:50.640
Now, that's how the non-economist thinks about things like gasoline.

600
01:13:50.640 --> 01:13:54.440
Oh, no matter how high the price is, people will never cut back.

601
01:13:54.440 --> 01:13:58.640
They think that the demand curve is perfectly inelastic, or about cigarettes,

602
01:13:58.640 --> 01:14:04.640
or about necessary medicines like insulin, or about addictive drugs.

603
01:14:04.640 --> 01:14:08.640
The way they talk, they imply that, in fact, the demand curve is perfectly vertical.

604
01:14:08.640 --> 01:14:11.640
But it can never be that way. People will cut back at higher prices.

605
01:14:11.640 --> 01:14:21.140
They will substitute, okay. Obviously, at some price, their whole income will be exhausted, so a demand curve can never be perfectly inelastic, okay.

606
01:14:21.140 --> 01:14:25.440
That's as steep as you can get, okay. There always has to be some elasticity.

607
01:14:25.440 --> 01:14:32.440
It can be very inelastic, but it always has to slope downward to the right, okay. It can't be vertical.

608
01:14:32.440 --> 01:14:35.340
That's one example.

609
01:14:35.340 --> 01:14:48.940
Another example of a demand curve that's an extreme is this perfectly horizontal demand curve.

610
01:14:48.940 --> 01:14:54.140
This implies elasticity of infinity.

611
01:14:54.140 --> 01:14:56.240
Okay, think of it this way.

612
01:14:56.240 --> 01:15:03.540
If this is, let's say, some wheat farmer and economists use this kind of perfectly elastic demand curve

613
01:15:03.540 --> 01:15:09.700
to represent what they call perfect competition, or the firm under perfect competition.

614
01:15:09.700 --> 01:15:17.420
Let's say you're a wheat farmer somewhere in Kansas, and the market price is $4.

615
01:15:17.420 --> 01:15:22.260
So if you sell at $4, you can theoretically, this curve goes on forever, you can sell an infinite amount.

616
01:15:22.260 --> 01:15:25.460
You can sell as much as you want at $4.

617
01:15:25.460 --> 01:15:32.300
No matter how much you sell, because you're so small, a part of the world wheat market, price won't fall.

618
01:15:32.300 --> 01:15:39.900
But, if you try to sell at $4.01, no one will buy from you, even your mother will abandon you, she won't even buy.

619
01:15:39.900 --> 01:15:50.200
So, it goes from quantity demanded of infinity to quantity demanded of zero, as a result of a one-cent increase, okay?

620
01:15:50.200 --> 01:15:58.400
Once again, this is useful in showing that the flatter the demand curve, the more elastic the demand curve is, okay?

621
01:15:58.400 --> 01:16:01.800
However, this can never exist in the real world, even among wheat farmers.

622
01:16:01.800 --> 01:16:06.880
If the wheat farmer becomes large enough to keep producing more and more, he's going to have a downward impact on the price.

623
01:16:06.880 --> 01:16:17.680
So you have to draw the demand curve for a wheat farmer as very, very, very flat, but still sloping ever so slightly downward to the right.

624
01:16:17.680 --> 01:16:26.760
Eventually, if he doubles, triples, quadruples, the price will fall by one cent, then by two cents, and so on, because he will have an impact on the world market.

625
01:16:26.760 --> 01:16:35.860
But again, obviously, a wheat former does, a particular wheat, one wheat former does have a very, very flat demand curve.

626
01:16:35.860 --> 01:16:37.560
Demand is very, very elastic.

627
01:16:37.560 --> 01:16:46.760
Okay, let me show you a few others that are impossible that economists tend to use.

628
01:16:46.760 --> 01:16:53.760
This is a nonlinear demand curve that is inelastic.

629
01:16:53.760 --> 01:17:00.000
okay that it has the elasticity is is is constant so let's say it's it's it's

630
01:17:00.000 --> 01:17:07.040
equal to the u less elasticity is equal to minus or one-half minus 0.5 this is

631
01:17:07.040 --> 01:17:12.840
impossible because it implies that the as you raise price remember if this

632
01:17:12.840 --> 01:17:18.480
whole curve is elastic or is it elastic the higher the price the more the total

633
01:17:18.480 --> 01:17:28.480
So what price did this person set? An infinite price. And consumers will pay those higher prices.

634
01:17:28.480 --> 01:17:38.480
Not only that, they'll spend more and more income as the price rises. So demand curves must have, as the price rises, eventually they must become what?

635
01:17:38.480 --> 01:17:49.280
What? Elastic. They must become elastic. You cannot have an inelastic demand curve like this throughout its whole length. It's ridiculous.

636
01:17:49.280 --> 01:18:00.280
Unfortunately, economists, mainstream economists, who do empirical work, use what these are called constant elasticity demand curves in their work.

637
01:18:00.280 --> 01:18:03.760
and one other impossible demand curve

638
01:18:03.760 --> 01:18:09.680
is that of a constant elastic demand curve

639
01:18:09.680 --> 01:18:12.840
that implies that as they cut the price

640
01:18:12.840 --> 01:18:16.040
consumers will continue to spend more and more and more

641
01:18:16.040 --> 01:18:21.320
and it will go out into infinity and the more units there are the more people will spend in total

642
01:18:21.320 --> 01:18:22.780
which of course

643
01:18:22.780 --> 01:18:24.920
would exhaust their entire income

644
01:18:24.920 --> 01:18:31.920
so these constant elasticity demand curves do not exist in the real world

645
01:18:34.960 --> 01:18:39.000
the other point I want to make, well it's actually a couple more points but we can save them for next

646
01:18:39.000 --> 01:18:42.300
class

647
01:18:42.300 --> 01:18:45.200
let me just introduce it though

648
01:18:45.200 --> 01:18:51.540
what causes a demand curve to be more or less elastic? what factors cause that?

649
01:18:51.540 --> 01:18:53.620
well what's one factor?

650
01:18:53.620 --> 01:18:57.100
I think it would come to us right away.

651
01:18:57.100 --> 01:19:04.260
What has to be, to be more elastic, the demand for the good must, or the good itself must have what?

652
01:19:04.260 --> 01:19:12.500
Substitutes, okay? The more substitutes a good has, the more responsive buyers are to a change in the price of that good.

653
01:19:12.500 --> 01:19:19.980
Let me just give you one example and then I'll take questions and we'll finish this up tomorrow.

654
01:19:19.980 --> 01:19:25.380
Let's say Coca-Cola at the local Winn-Dixie,

655
01:19:25.380 --> 01:19:30.380
six pack of Coca-Cola, the price rises.

656
01:19:30.380 --> 01:19:34.260
We're just talking about Coca-Cola at the local Winn-Dixie.

657
01:19:34.260 --> 01:19:37.100
Are a lot of people likely to

658
01:19:37.100 --> 01:19:39.940
reduce their quantity demanded

659
01:19:39.940 --> 01:19:41.500
at that store?

660
01:19:41.500 --> 01:19:48.380
Sure, because Coca-Cola is available at many other stores in the area.

661
01:19:48.380 --> 01:19:53.380
The more narrow the market is for the good that we're talking about, the more elastic the demand curve is.

662
01:19:53.380 --> 01:19:54.940
What if all

663
01:19:54.940 --> 01:19:58.500
stores selling, what if all Coca-Cola products went up?

664
01:19:58.500 --> 01:20:02.980
Let's say Coke has a policy of repricing its product.

665
01:20:02.980 --> 01:20:04.060
Well then,

666
01:20:04.060 --> 01:20:07.000
there are fewer substitutes, so the demand for Coke

667
01:20:07.000 --> 01:20:09.000
in general at any location

668
01:20:09.000 --> 01:20:10.260
is more what?

669
01:20:10.260 --> 01:20:12.160
Inelastic.

670
01:20:12.160 --> 01:20:15.140
Now, the only substitutes are other forms of colas,

671
01:20:15.140 --> 01:20:19.740
okay, Pepsi and so on, as well as other forms of carbonated sodas. Well, what about,

672
01:20:19.740 --> 01:20:21.820
let's say, cocoa beans go up, whatever

673
01:20:21.820 --> 01:20:23.180
colas are made from.

674
01:20:23.180 --> 01:20:26.700
They go up in price, so the prices of all colas go up.

675
01:20:26.700 --> 01:20:29.500
Now, what's left is substitutes.

676
01:20:29.500 --> 01:20:32.580
Other forms of carbonated sodas, right,

677
01:20:32.580 --> 01:20:37.140
and then non-carbonated soft drinks. So, the demand becomes progressively more

678
01:20:37.140 --> 01:20:39.500
inelastic, the broader the market is.

679
01:20:39.500 --> 01:20:44.500
Finally, what if the price of sugar and corn syrup goes up, so that

680
01:20:44.500 --> 01:20:47.060
all sodas and soft drinks go up

681
01:20:47.060 --> 01:20:49.780
then the demand becomes very what?

682
01:20:49.780 --> 01:20:54.220
Inelastic. If you could have a cartel

683
01:20:54.220 --> 01:20:59.060
that could combine, take over all the brands of soft drinks

684
01:20:59.060 --> 01:21:02.060
what would they likely do with their price?

685
01:21:02.060 --> 01:21:03.300
They'd raise it

686
01:21:03.300 --> 01:21:06.780
because the demand would be very very inelastic for the cartel's product

687
01:21:06.780 --> 01:21:09.260
okay they'd raise it

688
01:21:09.260 --> 01:21:13.640
the same thing is true of different automobiles. Ford Taurus

689
01:21:13.640 --> 01:21:20.040
has a very, very flat demand curve because not only are there other brands of other companies selling cars,

690
01:21:20.040 --> 01:21:24.240
but because there are other brands that Ford has, okay?

691
01:21:24.240 --> 01:21:32.540
But if you had some sort of cartel that control the production of all automobiles in the world, let's say,

692
01:21:32.540 --> 01:21:39.940
then you would have a very, very inelastic demand curve and it would pay producers to raise the price tremendously, okay?

693
01:21:39.940 --> 01:21:45.940
So, bottom line is that people say that having many brands and many different companies supplying the same product is wasteful.

694
01:21:45.940 --> 01:21:47.940
But in fact, it benefits consumers.

695
01:21:47.940 --> 01:21:51.940
The more brands you have, the more elastic the demand for any product.

696
01:21:51.940 --> 01:21:57.940
So the more difficult it is for a given seller to raise his or her price.

697
01:21:57.940 --> 01:21:59.940
So the general rule, and I'll end, the general rule is this.

698
01:21:59.940 --> 01:22:08.940
The greater the availability of close substitutes, the more elastic the demand is for a given good.

699
01:22:08.940 --> 01:22:28.940
That's why if you have an isolated town that has one small pharmacy, as opposed to a city with many pharmacies, even though the pharmacies themselves might be much bigger than the small town, it's more likely that the small pharmacy and the small town will have a higher price because of inelastic demand.

700
01:22:28.940 --> 01:22:32.940
I'll stop there and take questions on anything I've spoken on.

701
01:22:32.940 --> 01:22:52.940
Yes, I'll put that the question is putting the table back up that relates changes in price, a change in total revenue.

702
01:22:52.940 --> 01:22:57.940
Oh, let me just make it a little slower.

703
01:22:57.940 --> 01:23:01.440
Okay.

704
01:23:01.440 --> 01:23:04.140
Oh, you just wanted to copy it? Okay.

705
01:23:04.140 --> 01:23:08.240
Any other questions, comments?

706
01:23:08.240 --> 01:23:13.240
Okay, thank you.