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64 THE ECONOMIC SYSTEM
2.9 A M A R K E T AT W O R K : T H E L A B O U R
MARKET
The labour market can be analysed using the supply and demand framework
but in many respects it is a unique market and a number of different elements
require analysis in considering how it functions. As labour is one of the factors of
production, the labour market is also described as a factor market. Since labour is
an input into production, labour demand is a derived demand since it depends on
the demand for goods and services.
Firms demand labour taking into account, among other factors, the cost of the
labour, which in turn depends on the wage rate that must be paid. At higher wage
rates we expect firms to hire fewer workers than at lower rates. Labour supply
refers to people’s willingness to make some of their time available for paid work
and also depends on the wage rate. We expect more people to wish to supply
their labour if wage rates are high rather than relatively low. When we discuss
price in relation to the labour market we refer to the price of labour, which is
the wage rate. The wage rate in a labour market is determined similarly to any
equilibrium price, i.e. via supply and demand for labour, which are discussed in
more detail below.
2.9.1 LABOUR DEMAND

Labour demand is graphed like other demand curves with quantity (of labour) on
the horizontal axis and the price (wages) on the vertical axis, as in the example
in Figure 2.9. Firms in the industry shown wish to employ 60 000 workers if wages
are £10 per hour; at higher wage rates, firms would demand fewer workers because
costs rise as wages rise.
Price
£/hour
20 Labour
Demand
15
10
5
0 Quantity (000, workers)
0 30 60
FIGURE 2.9 INDUSTRY LABOUR DEMAND CURVE

M A R K E T A N A LY S I S : D E M A N D A N D S U P P LY 65
The wage rate enters into the labour demand decision of firms but the firm must
also take into account the output that the workers they employ can produce for the
firm, and the revenue the firm can earn from that output. The firm must try to work
out how many workers it can profitably employ. This process involves consideration
of the output of each worker.
The following example is considered to figure out the number of workers

demanded by Safelock, a hypothetical company manufacturing steering locks
(anti-theft devices for steering wheels).
Given the available machinery and equipment in the steering lock factory, the firm
considers that output could be produced as shown in Table 2.3. In the second
column Table 2.3 shows the output that could be produced if the firm employed
between one and 10 workers. One worker could produce 25 locks per day, rising
to 55 if two workers were employed and so on. In the third column the marginal
physical product of Labour is computed.
The marginal physical product of labour is the change in the quantity of output
(Q) produced by each additional worker (L).
TA B L E 2 . 3 LABOUR OUTPUT
No. of workers Output (per day)∗ MPPL
1 25 25
2 55 30
3 82 27
4 102 20
5 116 14
6 124 8
7 130 6
8 132 2
9 130 −2
10 125 −5
∗
A working day is assumed to consist of 8 hours.
A B
Daily output MPPL
30
140 25
120 20
100 15
80 10
60 5
40 0
20 –5
0 –10
1 2 3 4 5 6 7 8 9 10 11 1 2 3 4 5 6 7 8 9 10 11
Workers Workers
F I G U R E 2 . 1 0 T O TA L O U T P U T A N D M A R G I N A L P H Y S I C A L
PRODUCT OF LABOUR
For example, the change in output generated by hiring the first worker is 25
(Q/L = 25/1) since when no workers are hired output is zero. In hiring the
second worker output increases from 25 to 55, a change of 30. The second worker
adds 30 steering locks extra to total output, the third adds 27 locks and so on.
When a second worker is hired the two can cooperate to divide up the work
between them and there are advantages of this division of labour that allows them
to produce more than double the output of the first worker (55 compared to 25).
Hiring the third worker changes the division of labour too but in this case the
additional output is 27 locks extra. This happens because of how the materials and
equipment are shared and used among the workers. The total output increases with
each worker up until worker 8 but when the next worker is hired, they do not add
any additional output. In fact output falls by half a unit – this is because given the
available equipment, there is nothing for this worker to do. Hiring the ninth worker
leads to a fall in output (from 132 to 130 locks) because the worker actually gets
in the way of others trying to do their job. The total output of the factory and the
marginal physical product of labour are shown in Figure 2.10.
Once any more than two workers are employed, the additions to total output
decline (from 30 to 27 to 20 to 14, etc.) by diminishing amounts. This is reflected
in the flattening slope of the total output curve in panel A of Figure 2.10 and in
the downward (negative) slope of the MPPL in panel B. This reveals the law of
diminishing marginal returns.
The law of diminishing marginal returns states that when a firm adds workers to
a given amount of capital – machinery, equipment, etc. – it eventually leads to a
less efficient match between labour and capital to the extent that if all capital is
used by workers, hiring an additional worker will only lead to workers getting in
each other’s way and the marginal product of labour declines.
The law of diminishing returns helps us to understand why when capital input
is fixed supply curves slope up and the marginal costs of production rise.
This is relevant over short periods of time when firms use their available cap-
ital rather than changing it by building new factories, buying new
machinery, etc.
Safelock uses the above information in considering how many workers it should
profitably hire. It also takes into account the price it can earn for its output. There
are a large number of competing products and Safelock is aware that if it wants
to be successful in selling its product it cannot charge above a price of £30. Using
this price information, the firm can move from an analysis of output to the revenue
it can expect to earn from its product. Each worker’s MPPL can be considered in
terms of MRPL .
MRPL – marginal revenue product of labour. This is the change in total revenue
(price of output × number of units sold) generated by each additional worker. It
is computed by multiplying the product price by the MPPL .
In Table 2.4 these additional estimations are shown for the Safelock example, with
some blanks left for you to fill in. Table 2.4 shows how the first worker adds £750
to Safelock’s total revenue which is computed as the worker’s MPPL × P = 25 × 30.
With the second worker, the total revenue (output × P) earned by the firm increases
to £1650 which represents an MRPL of £900 (since £1650 − £750 = £900).
A final element in the firm’s decision on how many workers to employ is the cost
to the firm of the workers (the cost to the firm is assumed here to be the wage rate
only). If the firm knows it will only attract workers by paying £10 per hour, it can
calculate its labour costs for varying numbers of workers as shown in Table 2.5 and
Figure 2.11. When the working day is 8 hours and the wage rate is £10, it costs the
firm £80 to employ each worker each day.
Hence, total labour costs per day rise steadily by £80 for each worker employed
and the extra costs to the firm of employing each additional worker is computed as
the daily wage. This is the marginal cost of labour for the firm.
All of the previous information on the output of workers, the revenue they
generate for the firm and the costs of employing them enter into the firm’s decision
about its demand for labour. In particular, the information regarding marginal
revenue and marginal cost are central to the demand for labour.
TA B L E 2 . 4 L A B O U R O U T P U T: E X T E N D E D
A N A LY S I S
No. of workers Output (per day)∗ MPPL TR (P = £30) MRPL
1 25 25 750 750
2 55 30 1650 900
3 82 27 810
4 102 20 3060 600
5 116 14 3480
6 124 8 3720 240
7 130 6 180
8 132 2 3960 60
9 130 −2 3900 −60
10 125 −5 3750 −150
∗A working day is assumed to consist of 8 hours.
T A B L E 2 . 5 L A B O U R C O S T S : W A G E S O F £8 0 P E R
W O R K E R D AY
Workers 1 2 3 4 5 6 7 8 9 10
Labour cost: total (£) 80 160 240 320 400 480 560 640 720 800
Labour cost: marginal (£) 80 80 80 80 80 80 80 80 80 80
It is possible to consider how many workers it makes economic sense for Safelock
to hire at the (daily) wage rate of £80. Simply put, if the benefits to the firm outweigh
the costs they should continue to hire additional workers:
• First worker: benefit = MRPL of £750 cost = £80 £750 > £80
• Second worker: benefit = MRPL of £900 cost = £80 £900 > £80
• ... ... ... ...
• Eighth worker: benefit = MRPL of £60 cost = £80 £60 < £80
A B
Daily labour cost Marginal labour cost
1000 100
800 80
600 60
400 40
200 20
0 0
1 2 3 4 5 6 7 8 9 10 1 2 3 4 5 6 7 8 9 10
Workers Workers
FIGURE 2.11 L A B O U R C O S T S : T O TA L A N D M A R G I N A L
When the decision of whether to hire the eighth worker is taken, the cost outweighs
the benefit so the most efficient workforce for Safelock is seven workers. This
solution could also be found graphically by drawing marginal cost and MRPL on
the same graph and examining where they intersect.
The hiring decision would differ under different economic circumstances
(another case of ceteris paribus). For example, at a wage rate of £25 per hour
(£200 per day) it would make sense to keep hiring workers up to the sixth
worker since the seventh worker would add more to the costs of Safelock (£200)
than to the revenue (£180). The sixth worker will be hired as long as their
MRPL is sufficient to cover their wage costs which means that once the wage
rate does not rise above £30 per hour (£240 per day) it makes economic sense
to hire the worker. This process shows that Safelock continues to hire work-
ers once their MRPL (marginal revenue product of labour) is greater than or
equal to the MLC (marginal labour cost), i.e. the wage rate. We can also see
from Table 2.4 that it will never make economic sense to hire any more than
eight workers (if price remains at £30) because after this level, MRPL is nega-
tive – given the available equipment and factory space more than eight workers
leads to losses.
The above information allows us to conclude that Safelock’s demand for labour
differs for different wage rates:
• at a wage rate of £10 demand is seven workers;

• at a wage rate of £25 demand would be six workers and at £30, five workers
would be employed.
The demand for labour follows the general law of demand – the higher the price,
the lower the quantity demanded, ceteris paribus. To find the demand for labour
in an industry (or a country) requires the summing up of the demand for labour
across each firm in the industry (or the country).
2.9.2 LABOUR SUPPLY: INDIVIDUAL SUPPLY DECISION

Whether to supply labour to firms is a subjective decision made by individuals who
vary with regard to their incentives to supply their labour and the amount of time
they are willing to supply. One factor that individuals usually take into account
in this decision is the price that they expect to receive for their labour, the wage
rate. Generally speaking, the higher the wage rate, the more attractive it is to work
because the reward is higher. This can be restated in terms of opportunity costs.
People wish to work or not, and those that do seek employment. There is an
opportunity cost of working, which is the leisure time given up. Or, there is an
opportunity cost of not working, which is the income foregone.
In choosing between alternative employment possibilities, people also take the

wage rate into account and will usually try to secure the highest wage possible,
ceteris paribus.
In the case of labour supply for individuals, supply does not keep rising indefinitely
as wages increase, simply because there is a limit to the hours any individual can
and is willing to work. Someone who works 35 hours a week for £10 per hour might
be enticed to work additional hours at a higher wage rate – this would happen if the
person placed a higher value on the extra income they could earn rather than the
extra leisure time given up. Someone else working 55 hours a week might actually
cut down on their labour supply if they could earn a higher wage because they
consider 55 hours to be the limit of the time they are willing to devote to work.
A higher wage rate would cause the person to cut back on their labour supply
if they place a higher value on their leisure time compared to the income they
forego. Hence, the labour supply decision is different for different individuals and
opportunity cost of work (or leisure) is a subjective and personal value. The supply
of labour for one worker is shown in Figure 2.12.
A reservation wage indicates the lowest wage a worker will accept to take a job.
No labour is supplied if wages are below £4 per hour, the reservation wage, as the
worker does not consider it worthwhile to work for less than this wage. If the wage
rate rises to £16, the worker is willing to work 55 hours (income = £880). At any
Price Labour supply

£/hour 24
20
16
12
4
Quantity (labour
0 hours per week)
0 25 50 55
F I G U R E 2 . 1 2 I N D I V I D U A L L A B O U R S U P P LY C U R V E :
BACKWARD BENDING
higher wage than £16, the worker prefers to cut back on hours worked and labour
supply declines to 50 hours if the wage rises to £24 (income = £1200).
Moving from the individual to industry labour supply, we can think of labour
supply as consisting of a mix of different skills. High skills command higher wages,
ceteris paribus. So too do more ‘dangerous’ jobs, and some unpleasant jobs also
attract a premium wage unrelated to skill levels but as recompense for the perceived
unpleasantness. The supply curve for an occupation is likely to display a positive
slope implying that to increase the quantity of labour supplied to one occupation
the wage rate must rise.
2.9.3 EQUILIBRIUM IN THE LABOUR MARKET

By considering labour demand and supply together, as shown in Figure 2.13,
we can see how equilibrium wages and hours worked are determined. The
demand and supply curves shown are those for the European Steering Lock
industry, for manufacturing workers. The equilibrium wage in the industry is
£10 per hour in equilibrium, and 10 000 workers are employed in the indus-
try. Safelock is one average firm in this industry, and it pays the equilibrium
wage rate.
As long as there are no changes in the factors determining either demand or
supply, the equilibrium situation will prevail. Since information on the output of
workers, the revenue they generate for the firm and the costs of employing them
enter into the labour demand decision, a change in any one of these factors will
impact on the demand curve. Going back to Tables 2.4 and 2.5, for instance any
Price
£/hour Labour supply
20
15
10
Labour demand
5
0
Quantity (workers)
0 5000 10 000 15 000
FIGURE 2.13 EQUILIBRIUM IN THE LABOUR MARKET
factor that changes element in these tables will give rise to a new demand curve.
Any factors that change supply (such as a change in the rate of income tax) would
generate a new supply curve, with implications for equilibrium workers and wages.
Government policies too might have an impact if, for example, a minimum wage
was imposed. The effects of all such changes can be analysed using the demand and
supply model outlined in this chapter.
2.10 SUMMARY
• The demand and supply model is the framework that allows us to examine how
markets function. We can consider the most relevant features that need to be taken
into account for any market we wish to consider.
• Both buyers and sellers benefit from exchange.
• The equilibrium situation in a market is an outcome that is the intention of no single
buyer or seller. It is the result of all buyers’ and sellers’ decisions in that market,
and includes all available information used when making those decisions.
• Prices act as a signal that create incentives for exchange and help to explain the
behaviour of both buyers and sellers in markets.
• If a market is in disequilibrium, that information creates incentives for the behaviour
of buyers and sellers to change and move the market towards equilibrium.
• Where governments are unhappy with the prices determined in markets, they may
intervene to change the market-determined outcome.
• One of the most interesting markets to analyse is that for labour because of the
need to understand the underlying principles governing firms’ decisions to hire or
demand labour and people’s decisions to supply labour. Once these principles are
understood, however, equilibrium in the market is found just as in any other and it
is possible to consider the effects of changes on demand, or supply on equilibrium.
REVIEW PROBLEMS AND QUESTIONS

1. Explain how differences in (1) preferences and (2) opportunity costs of pro-
duction can give rise to gains from exchange.
2. Using examples, illustrate that you understand the concepts of absolute and
comparative advantage.
3. Arguments are sometimes put forward that countries should reduce their
imports from other countries – reducing the amount of exchange that takes
place. Does this argument make sense, given what you know about absolute and
comparative advantage?
4. Use a diagram to explain what would happen to the quantity demanded of
personal stereos if their price doubled, ceteris paribus. Add in supply curves
to your diagram to indicate how the doubling of equilibrium price would be
caused by a movement in supply. What possible effects on supply might be
responsible for a doubling of the price?
5. Use a diagram to explain what would happen to demand for personal stereos if
MP3s become a preferred substitute by a substantial portion of the population.
Add in a supply curve for personal stereos and explain what happens to
equilibrium price and quantity.
6. Explain how the principle of opportunity cost underlies the supply curve.
7. Use Table 2.4 to examine the equilibrium implications of a fall in workers’
output on the demand for labour. Update the table if output per worker falls
by 5 units for each worker. What are the implications for MPPL , and MRPL (if
price is £30)? What are the effects on the demand for labour? Would you expect
any changes in the supply of labour? Can you think of any factors that might
cause the average worker’s output to fall?
8. Read the following case study on the ELV initiative and answer the questions
that follow.
The end of life vehicle case

Each year across the EU somewhere between 8 and 10 million cars are scrapped
(out of a car ‘population’ of around 170 million). Before the 1990s the impera-
tive to recycle had not been taken on board by car manufacturers and the issue
was only beginning to be considered by consumers and governments. In May
2002, an EU directive came into force which means that from 2006 onwards end-
of-life-vehicles (ELVs) will be categorized as hazardous waste requiring careful
disposal. The directive will force the final owner of a vehicle to return their ELV
to an authorized collection point to deregister the vehicle. Furthermore, the
directive indicates that delivery of the vehicle to this point should not involve
any cost for the vehicle owner. Essentially this means that car manufacturers
must have networks in place to support the collection and treatment cost.
Treatment of vehicles that reach their end of life between 2006 and 2014 must
ensure that 85% of materials (based on the weight) must be reused/recovered.
From 2015, this percentage rises to 95%. Currently, about 75% of materials
are recovered.
Support from car manufacturers for the directive has been generally positive
except in relation to the decision to force them, from 2007, to bear recollection
cost for all cars they produced (not just those produced from 2002).
a. What do you see as the potential implications of the ELV initiative for each
of the following: car manufacturers, dismantlers and recyclers?
b. What arguments do you see for/against the initiative?
c. Can you think of any obstacles to reaching high recycling targets?
d. Do you expect any effects on either demand or supply of cars by the
imposition of this law?
e. Look up the websites of car companies or car associations (such as the
ACEA) across Europe to consider their views on this directive and how they
are currently dealing with meeting this directive.
FURTHER READING AND RESEARCH

• An interesting example of market analysis can be found in Lindsey, 2003. Using
this and other publicly available information, such as
• Coffee Research Institute: www.coffeeresearch.org
• International Coffee Organization: www.ico.org/ed/edmark.htm
you could apply the demand and supply framework to explain:
a. what has been happening to equilibrium price in this market;
b. what has been happening to equilibrium quantity in this market;

c. why equilibrium has changed.
You should be able to identify demand-related issues of relevance, supply-related
issues of relevance and any other relevant issues to a, b and c.
• Writings by Friedrich August von Hayek (1899–1992) are insightful and thought
provoking for market analysis. Hayek was awarded the Nobel Prize in Economic
Sciences in 1974 (jointly with Gunnar Myrdal). See Hayek, 1948, 1984.
• For statistical and other information on labour markets in terms of the pro-
portion of the employed population, unemployment rates, check out the
World Bank’s annual World Development Report, Eurostat’s Basic Statistics of the
EU and Statistical Review and various OECD labour and employment-related
publications.
REFERENCES
Hayek, F. (1945) ‘The use of knowledge in society’, American Economic Review, 35,
1–18.
Hayek, F. (1948) ‘The meaning of competition’, in Individualism and Economic Order .
University of Chicago Press, Chicago, 92–106.
Hayek, F. (1984) ‘Competition as a discovery procedure’, in Nishiyama, C. and
Leube, K. (eds) The Essence of Hayek. Hoover Institution Press, Stanford, 254–265.
Lindsey, B. (2003) Grounds for Complaint? Understanding the ‘Coffee Crisis’ , Trade
Briefing Paper No. 16, CATO Institute, May.
Smith, A. (1970) An Inquiry into the Nature and Causes of the Wealth of Nations. Penguin,
Harmondsworth [original publication 1776].
Stewart, A. (1997) Intellectual Capital: The New Wealth of Organizations. Currency.
CHAPTER 3
BEYOND DEMAND:
CONSUMERS IN THE
ECONOMIC SYSTEM

LEARNING OUTCOMES
By the end of this chapter you should be able to:
✪ Identify how demand is related to consumers’ choices at a microeconomic level

and to macroeconomic consumption behaviour.
✪ Highlight the importance of consumers’ spending across international
economies.
✪ Explain consumers’ choices in terms of consumer satisfaction.
✪ Relate the law of demand to consumer satisfaction.
✪ Consider how price changes impact on consumer choices and demand.
✪ Illustrate how consumers’ welfare can be estimated using the demand curve.
✪ Show how consumers’ responsiveness to price changes can be measured and
explain why it is useful for economic decision-making.
✪ Analyse how consumers choose between different varieties of similar products.
✪ Describe macroeconomic consumption behaviour using the consumption
function.
✪ Discuss how governments try to influence consumers at macro- and micro-
economic levels.

3.1 INTRODUCTION
Understanding the ‘demand side’ of the economy is important in appreciating
how an economy works and this chapter delves into an important component of
demand – the consumer. Much of the economic system is organized to meet the
demands of consumers. Consumers’ demands and moreover their willingness to
pay for products and services provide incentives for entrepreneurs that attempt to
meet their requirements and produce what consumers wish to buy. Purchases of
‘consumption’ goods represent a substantial component of economic activity, as
shown in section 3.2. The choices that consumers make are based on their expected
benefit or utility, which is discussed in section 3.3.
As rational people, consumers take all available information into account in mak-
ing their consumption decisions. As explained in section 3.4, information about
prices is relevant to consumers’ decisions and, taken with consumers’ subjective
views of their expected utility, serves to help us understand why consumers make
the choices they do. Using demand analysis it is possible to examine the benefit
or utility that consumers earn when they consume and this is shown in section 3.5.
How consumers’ decisions about what to buy are affected when prices change is
examined, again using demand analysis, in section 3.6. Many consumer decisions
are between different brands of quite similar products and section 3.7 focuses on
how such choices are made. The focus of the chapter moves to macroeconomics
when the behaviour of all consumers together is considered in section 3.7 through
analysis of the consumption function. This allows for consideration of how con-
sumption spending relates to a country’s national income. The final section in
this chapter considers some examples of how and why governments try to affect
consumption decisions.
3.2 D E M A N D A N D T H E I M P O R TA N C E
OF CONSUMERS
Governments buy goods and services both for current (everyday) use and to make
capital expenditures that are expected to meet more long-term requirements (e.g.
road building or providing funds for future pensions). Firms also make purchases
for current and longer-term purposes. But consumers buy the vast majority of goods
and services produced.
The value of all economic activity is the sum of the output or income of that
economy over a specific period of time – this is discussed in more detail in Chapter
5. For now, note that national output or national income is conventionally denoted
as Y .
National output or income, denoted Y , is calculated as the value of
• all the goods bought for consumption purposes; C plus

• all the investment expenditures by firms; I plus
• all government expenditures; G plus
• the net value of all goods traded by the economy, exports minus imports:
X − M.
BEYOND DEMAND: CONSUMERS IN THE ECONOMIC SYSTEM 79
Economic Activity (Y ) = C + I + G + (X − M)
When classifying the purchases and expenditure that occur in an economy (as C, I
or G, X or M ), economists classify them according to their purpose or function. A pair
of shoes bought by a consumer for the purpose of wearing them would be part of
consumption expenditure (C). The same pair of shoes in the manufacturer’s factory
before being distributed for sale is a component of investment – inventory investment
(I ). If the pair of shoes were bought by the government for a member of the army
the expenditure would be part of G – government expenditure. Shoes produced
abroad and imported appear under imports while if the shoes are produced for
an external market they appear as exports. To ensure that output is not counted
twice, imported shoes would not also be included in consumption or government
expenditure.
Each component of economic activity can be studied separately and in this
chapter we deal with consumption, the most substantial component. Table 3.1
shows the percentage share of consumption expenditures out of the value of total
economic activity for a number of economies.
Table 3.1 illustrates the sizeable share of consumption in economic activity for
those countries considered. Almost 70% of the income in the USA was spent
on consumption goods and the value of US consumption is estimated at 20% of
world output. It is important for economists to understand what impacts on this
component of economic activity.
TA B L E 3 . 1 C O N S U M P T I O N S H A R E ( % ) O F E C O N O M I C
A C T I V I T Y, 2 0 0 0
USA UK France Ireland Germany Japan
Consumption Share 68 75 66 60 69 62
Source: Excerpted from the Penn World Table 6.1 (Heston et al., 2002).
3.2.1 CONSUMPTION GOODS

Consumers derive benefit, satisfaction or utility from the goods they consume.
Consumption goods are made up of three broad categories of goods that consumers
demand – durable and non-durable goods, and services.
If consumer confidence is low or declining, it indicates that consumers consider

economic activity to be slowing down or that the economy is in a recession so they
prefer to put off durable purchases because they expect the economy to improve in
the future. An economy is in recession if economic activity declines for a substantial
period. Recessions are characterized by periods when consumers buy fewer goods
and services than previously and when many people who are willing and able to
work lose their jobs as demand for their output declines. A recession that lasts for
a long period is called a depression – as in the Great Depression that followed the
Wall Street Crash of 1929.
T H E G R E AT D E P R E S S I O N
Economically speaking, the roaring twenties were a good time in the USA
for business growth, jobs, share prices and profits. Stock market specula-
tion, riotous spending and real estate booms sent prices skyrocketing. On
24 October 1929, many shareholders began to lose confidence and, believ-
ing that the prices of the shares they owned could not rise forever, decided
to sell.
Within the first few hours of the stock market opening that day, prices fell
so much that all the gains that had been made in the previous year were
wiped out. Public confidence was shattered because the stock market had been
viewed as a chief indicator of the state of the American economy.
The cause of the crash has been much debated. Some blame an interest
rate increase a couple of months before, others the fact that naı̈ve investors
had bought stock with credit which was too freely available, believing that
stock prices only moved in an upward direction. Some observers believed that
stock market prices in the first six months of 1929 were overpriced, but not
all agreed. The most likely scenario is that a combination of factors united
together to bring about such dramatic outcomes.
Clearly, no one knew what the outcome of the crash would be. Given the
economic uncertainty, many firms cut back their plans to purchase producer
durables, until a clearer picture emerged. But this caused a further decrease in
the demand for producer durables, and led to a fall in production. As produc-
tion fell, firms needed fewer workers. Unemployed consumers and those who
feared they might soon be out of work cut back on their consumer durable pur-
chases. Therefore, firms producing consumer durables faced falling demand
as well.
The vicious circle continued as America sank steadily into the worst de-
pression in its history. Millions of people lost every cent they owned. Half of all
US banks failed, factories shut down, shops closed and almost every business
seemed paralysed. By the end of 1930 more than 6 million Americans were
out of work; by 1931 that had doubled to 12 million. Between 1929 and 1939
real output fell by 30% and living standards in 1939 were lower than in 1929.
Over 5000 banks failed and over 32 000 businesses went bankrupt. The slide
into the Depression, with increasing unemployment, falling production, and
falling prices, continued until the effort for World War Two started.
The USA was far from the only country affected by the Depression.
Unemployment rates of over 30% in Germany into the 1930s provided an
environment for the policies of the National Socialist German Workers Party,
and the career of its leader Adolf Hitler, to flourish with the devastating
consequences that ensued internationally.
Non-durable goods include food, clothes, petrol, drugs, and top-up cards for mobile
phones and these are usually consumed in less than one year. Services include things
like telephone calls, health services (a visit to the doctor, or an operation), or a trip
to the cinema.
Services are non-material or intangible items of consumption that are consumed

as they are created.
In proportionate terms, consumption spending in developed economies is made

up of mostly services (60% plus of total consumption spending), with non-durable
goods of approximately 30% and the remainder made up by durable goods. Services
are the least volatile component of consumption tending not to vary too much over
time, with non-durables next and durable goods the most volatile of the three.
3.3 C O N S U M E R S AT I S FA C T I O N –
UTILITY
Using the concept of utility, it is possible to consider consumer behaviour and
how it underlies demand. Utility increases with the consumption of goods up to
a point. For example, the utility or satisfaction from consuming a fifth chocolate
bar in a day will surely not be as great as that derived from the first, and this is
TA B L E 3 . 2 T O TA L A N D
MARGINAL UTILITY: CONSUMING
C H O C O L AT E B A R S
Number of bars Total utility Marginal utility
(Q) (TU) (TU/Q)
0 0 –
1 33 33
2 53 20
3 65 12
4 71 6
5 71 0
6 65 −5
the same for the majority of goods. Table 3.2 shows the total utility and marginal
utility from consuming chocolate bars for one consumer who was asked to try to
quantify and rank the satisfaction they derive from consuming chocolate bars over
one day.
Total utility (TU ) is the total benefit perceived by the consumer from consump-
tion of a good/service.
Marginal utility is the change in total utility for each additional good/service
consumed. It is estimated as TU /Q .
Considering the total utility column in Table 3.2, we see that the satisfaction derived
from consuming four bars is 71 and has risen with each bar consumed. Above four
bars, the consumer’s utility rises no more and with six bars, total utility actually
declines because the consumer has chocolate overload!
Looking at the marginal utility column in Table 3.2, we consider the additional
benefit derived from each extra bar consumed. This shows a decline from 33 units
of satisfaction from the first bar, to 20 units from the second and so on. By the time
the consumer consumes the fifth bar, they derive no additional satisfaction as their
appetite for chocolate has been adequately satisfied.
A: Total utility per bar B: Marginal utility per bar
35
80 30
25
60
20
40 15
10
20 5
0
0 –5
1 2 3 4 5 6 7 1 2 3 4 5 6 7
FIGURE 3.1 T O TA L A N D M A R G I N A L U T I L I T Y: C H O C O L AT E
Consuming a sixth bar makes little sense because it leads to a decline in overall
satisfaction, reflected in negative marginal utility. This information is also presented
in Figure 3.1, with total utility in panel A and marginal utility in panel B.
When using the concept of utility, economists analyse consumption as if people
can rank and quantify their preferences and can establish how much satisfaction
they acquire from consuming different quantities of goods or services. In practice
if you were asked to explain your satisfaction from consuming various quantities
of chocolate, you might find it difficult and even more so if a number of different
goods and cross-rankings were involved.
Economists do not assume that people engage in this process every time they
consume something. However, economists do consider that rational people reveal
their preferences by what they purchase and that they know what they like, what
provides them with consumer satisfaction and that the utility generated from total
and marginal consumption follow the general patterns as shown above; initially
increasing and eventually falling total utility and declining marginal utility.
3.3.1 THE ASSUMPTION OF RATIONALITY IN ECONOMICS

When economists use the term ‘rational’ in relation to consumers, the implications
are that consumers are capable of estimating the satisfaction they derive from
consuming goods or services, they can rank their preferences (e.g. if they prefer
chocolate to cheese and cheese to sausages, they prefer chocolate to sausages)
and that they act generally to maximize their own utility. Rationality assumes
that consumers use all available information in making their decisions. It must
be acknowledged that consumers do not have full information at all times to
support their decisions, hence they are bounded by their knowledge and the
available information, or, people possess, as Herbert Simon put it, bounded rationality.
This means that people do not always make the choices that would objectively
maximize their utility – if they had more complete information their choice might
be different. It is relevant in complex decisions where receiving, storing, retrieving,
transmitting (i.e. processing) relevant information can be complicated and time-
consuming. In many economic models people are assumed to display approximately
rational behaviour.
If a choice arose between consuming a chocolate bar or a packet of crisps, the
rational consumer would compare the utility they would derive from each product
and make their preferred and subjective choice. They would also take an additional
piece of information into account in this decision – the prices of the goods. Why?
Because consumption preferences are limited by individuals’ income and they
rationally make decisions about what to buy with this in mind, taking prices into
consideration.
3.4 M A R G I N A L U T I L I T Y, P R I C E S A N D
THE LAW OF DEMAND
Consider a person trying to decide how to spend money she has received and who
knows her top preferences are either nights out (including taxi fare, entrance to a
night club and food/drinks) which cost on average £50 or call credit for her mobile
phone, at the same price. Analysis of marginal utility for both goods is provided in
Table 3.3.
Her prime choice is a night out because the extra utility generated from one
night out is greater than the extra utility generated by £50 call credit. After spending
one night out, the next best choice for consumption would be a second night out
because 19 units of utility is greater than 16 units generated from the first unit of
call credit consumed. The next preferred option is call credit and so on. If she has
received £200, it is possible to list what her preferred purchases will be because she
will be rational and consume the goods that provide her with the greatest utility.
The preferences can be estimated simply as the marginal utility per pound
generated by the goods. The marginal utility per pound for both goods is shown in
Table 3.4 with the ranked preferences for consumption shown in parentheses.
With £200 to spend, the top four choices are a night out, followed by a second
night out, followed by £50 call credit, followed by a third night out. With more
money to spend, the remaining choices would come into play. After making six
TA B L E 3 . 3 M A R G I N A L U T I L I T Y: C A L L C R E D I T
AND NIGHTS OUT
Marginal utility Marginal utility
Quantity call credit (£50) nights out (£50)
1 16 21
2 14 19
3 12 15
4 10 13
5 9 12
6 7 11
TA B L E 3 . 4 M A R G I N A L U T I L I T Y A N D
P R I C E R AT I O S
Quantity MU call credit MU/P (P = £50) MU nights out MU/P (P = £50)
1 16 0.32 (3) 21 0.42 (1)

2 14 0.28 (5) 19 0.38 (2)
3 12 0.24 (7) 15 0.30 (4)
4 10 0.20 (10) 13 0.26 (6)
5 9 0.18 (11) 12 0.24 (7)
6 7 0.14 (12) 11 0.22 (9)
choices, the consumer is indifferent between either a night out or call credit because
they yield the same marginal utility/price ratio.
Such analysis indicates what the individual’s demand for nights out and call
credit are, given prices, income and preferences. All consumers’ demand decisions
summed together give rise to the demand curve. From the information here, when
the price of call credit or a night out is £50, and this individual has £200 to spend,
one unit of call credit and three nights out are demanded.
Since demand decisions result from the marginal utility/price ratio, demand
decisions would be different if prices changed. Consider what happens if the cost
of a night out increased to £60. This changes the ranking of preferences since the
marginal utility per pound changes, as shown in Table 3.5. The result is that with
£200 to spend, two nights out and two units of call credit would be demanded.
Consumers change their mind about what to consume in response to the changes
in the marginal utility/price ratio. In other words the quantity demanded changes
in response to price changes.
Although the price of call credit is unchanged in Table 3.5, the relative price of
call credit decreased as the price of a night out increased and so the quantity
demanded of call credit increased. It is in terms of relative prices that economists
conduct their analysis. Another way of stating the same idea in terms of the concepts
already introduced is to say that following the price rise, the opportunity cost of a
night out has increased. More call credit must to be foregone to release the money
for a night out. When prices change the consumer rearranges their consumption
choices, always preferring goods with the highest possible ratio of marginal utility
to price.
We can go further than this to say that the rational consumer will make their
consumption choices so that the marginal utility/price is equal for all goods
consumed. This is logical since consumers would always prefer to allocate their
money to goods that yield the highest marginal utility per pound but each time
they consume one more of any good, the marginal utility from that good declines
while the marginal utility of another good which they buy one unit less of increases.
In equilibrium, consumers make their consumption choices so that they end up
TA B L E 3 . 5 M A R G I N A L U T I L I T Y A N D P R I C E
R AT I O S – N E W P R I C E S
Q MU call credit MU/P (P = £50) MU nights out MU/P (P = £60)
1 16 0.32 (2) 21 0.35 (1)

2 14 0.28 (4) 19 0.32 (2)
3 12 0.24 (6) 15 0.25 (5)
4 10 0.20 (8) 13 0.22 (7)
5 9 0.18 (10) 12 0.20 (8)
6 7 0.14 (12) 11 0.18 (10)
consuming quantities of goods where the last pound spent on each good yields the
same marginal utility per pound as the last pound spent on every other good. If this
were not the case total utility could be further maximized of consuming less of one
good and more of another.
3.4.1 THE LAW OF DEMAND – INCOME AND SUBSTITUTION

EFFECTS
The foregoing analysis can be further examined making reference to Income and
Substitution effects, as mentioned in Chapter 2. The income limits facing consumers
can be presented using a graphical tool called the budget constraint, which shows
the different combinations of goods that can be purchased with a set income, given
prevailing prices.
A consumer’s preferences can be illustrated using another graphical tool, the
indifference curve, which illustrates various consumption combinations of two
goods, which generate the same utility for a consumer. These tools are presented in
Figure 3.2 using the information from Tables 3.3 and 3.4. Since the consumer has
an income of £200 and the prices of credit or a night out are £50, the maximum
amount of either good that could be purchased is 4 units, reflected in the budget
line/constraint.
The indifference curve has a curved shape because of the diminishing marginal
utility from consuming additional units of each good. The more of one good
being consumed, say nights out, the lower the marginal utility from additional
consumption of that good. If a consumer consumes many nights out, they would
be willing to forego a night out for some call credit, and when little call credit is
Call
4 IC3 Indifference curves (IC)
credit IC2
IC1
3
x Budget line/constraint
1
Nights out
1 2 3 4
FIGURE 3.2 BUDGET LINE AND INDIFFERENCE

C U R V E A N A LY S I S
consumed, its marginal utility is high. This is why different combinations of credit
and nights out on the indifference curve give rise to the same level of utility.
At different points on the indifference curve, the consumer is willing to trade

different amounts of call credit for nights out reflecting the marginal rate of
substitution of the goods. This is also reflected in the slope of the indifference
curve at any point.
Consumers have a set or map of indifference curves, each with the same shape,
that reflect their preferences. Each indifference curve refers to one specific level of
utility. On indifference curve IC3 , the consumer has a higher utility level than on
IC2 or IC1 . Rational consumers attempt to maximize their utility which is equivalent
to a desire to consume on the highest possible indifference curve. The actual
consumption decision results from preferences indicated by the set of indifference
curves and limited income represented by the budget line.
In line with our earlier observation, the consumer in Figure 3.2 chooses to
consume 3 nights out and 1 unit of call credit with income of £200, prices of £50
for both goods and given their preferences. Consumption is at point x on IC2 .
The indifference curves drawn for this consumer lie closer to the nights out axis
than the call credit axis, which indicates this consumer’s tastes. Another consumer
may prefer fewer nights out relative to call credit (if they are new to an area, have
not yet made too many friends and prefer to chat to friends back home).
The consumer’s demand decision changes with a price change. If the price of
a night out rises to £60, then the maximum number that could be purchased
with £200 is 3.3 (£200/60 = 3.33). The budget line changes as shown in Figure 3.3
and consumption moves from x to y. The steeper slope of the line indicates that
following the price rise, more call credit must be sacrificed, in opportunity cost
terms, to afford one night out. The consumer’s decision to change their quantity
demanded of both goods can be broken down into a substitution effect and an
income effect.
A price change induces consumers to change their demand decisions. The

substitution effect indicates the adjustment in quantity demanded by a consumer
due to the change in relative prices alone.
The income effect reflects the adjustment in quantity demanded due to the
change in real income alone.
The substitution effect can be examined by considering the price effect alone on
the consumer’s choice. To see this we draw a line with the same slope as the new
Credit
4
IC1 IC2
3
2 z
y x
1
Nights out
1 2 3 3.33 4
FIGURE 3.3 CONSUMPTION WITH NEW BUDGET LINE
budget line and examine where it intersects the original indifference curve IC2 . In
Figure 3.3, this occurs at point z.
The substitution effect is measured from x to z. The change in relative prices
alone leads to a reduction in quantity demanded of nights out but an increase in
the quantity demanded of call credit. The rational consumer substitutes away from
the relatively more expensive good towards the relatively cheaper good.
The income effect involves examining the effect on quantity demanded of the
reduction in real income caused by the price rise in one good holding relative prices
constant. It is shown by the comparison of point z with point y where the same
relative prices are used, reflected in the same slope of the two lines. Less of both
goods are consumed at point y on IC1 compared to point z on IC2 . The increased
price reduces the consumer’s purchasing power and is reflected in reduced demand
for all goods, not simply for the good which has become more expensive. This is
the pure income effect of the price rise for one good, a normal good.
Normal good: one for which demand falls if real income falls or for which
demand rises if income rises.
Inferior good: one for which demand rises if real income falls or for which
demand falls if real income rises.
Inferior goods are bought when consumers do not have the required purchasing
power to buy other preferred goods. Examples would be many of the goods bought
by low-income households – cheaper cuts of meat, non-brand items, etc. The pure
income effect of a price fall leads to increased purchasing power and an increase in
demand for all normal goods, which are most goods.
CONSUMER PREFERENCES
Where do our preferences come from? Parents, school, friends, experi-
ence, advertising? Interesting new research has revealed that neuromar-
keting – brain scanning via electroencephalogram mapping and functional
magnetic-resonance imaging – can be used to analyse consumers’ purchasing
decisions and reveal how preferences feed into purchasing decisions.
Neuromarketing is particularly useful for explaining the value of branding.
Blind taste tests repeatedly put Pepsi ahead of Coke, which shows up in brain
scans that identify greater response of ‘reward centres’ in the brain to Pepsi.
Yet Pepsi is not the brand leader. In non-blind taste tests, where subjects were
told which cola they were tasting, Coke won out.
Such consumer behaviour was explained in terms of the strength of its
brand in the minds of the subjects, which was evident in activity in another
area of the brain associated with thinking and judging.
If such thinking and judging activity can be stimulated and influenced by
advertising, for example, companies will be able to shape our preferences more
clearly! Such research is in its infancy but holds interest for anyone interested
in processes that create and change our preferences.
Before we get too carried away with such tests, it has also been pointed
out that there is a clear difference between a taste test using a small quan-
tity of product and consuming a larger quantity. Specifically in the cola
example, the immediate sugar ‘reward’ from drinking Pepsi is apparently
much higher and is preferred in taste tests for this reason. Drinking more
than a taste changes the consumer’s perception and the product is found
‘too sweet’ by a majority of the population – no neuromarketing explanation
required.
3.5 DEMAND, CONSUMERS

AND CONSUMER SURPLUS
Since consumer satisfaction is examined by means of utility, it should be possible
to consider the satisfaction of more than one person in isolation. A problem arises
though because utility is subjective and while it is possible to consider one person’s
preferences, by asking them to rank them and try to quantify the satisfaction
derived from consumption, it is impossible to sum up the satisfaction of more
Price
150
100 S
75
50
D
Quantity (000)
18 27 36
FIGURE 3.4 DEMAND FOR CALL CREDIT AND

CONSUMER SURPLUS
than one consumer or try to rank their different preferences. Economists try to
get around this problem by means of moving analysis from utility to demand, in
the knowledge that the sum of individuals’ consumption choices (based on their
marginal utilities) are revealed in the demand for any good. (Economists also use
community indifference curves as approximations for the preferences that may be
gauged for a group of individuals, despite the difficulties involved.)
Consider the demand for call credit shown in Figure 3.4, with supply included
also. Given demand and supply as shown, the equilibrium in the call credit market is
for 36 000 units at £50 per unit (the single consumer considered in earlier analysis is
just one buyer in the market). The demand at this price is the result of the decisions
of many different individuals based on their derived utility from consuming call
credit, and their marginal utility/price ratios.
The overall satisfaction generated by the equilibrium consumption can be
estimated using the concept of consumer surplus.
Consumer surplus – the benefit to consumers due to the difference between

what consumers actually pay to consume a good and what they would have been
willing to pay.
In Figure 3.4, although the equilibrium price is £50, many people are willing to pay
a higher price. At a price of £75, 27 000 units are demanded while at a price of
£100, 18 000 units are in demand. In fact the area under the demand function and
above the price provides an estimate of the value of satisfaction generated from
consumption of this product (shown as the shaded triangle). The area of this triangle
is computed as £1.8 million (the area of a triangle is half the base × perpendicular
height which here is 18 000 × 100 = 1 800 000). This indicates the estimated value
of the satisfaction generated from the consumption of equilibrium call credit.
3.5.1 CONSUMER SURPLUS AND CONSUMER WELFARE

Welfare economics focuses on assessing the effects of economic policies on both
consumers and producers. Such assessments depend to a large extent on the
values (or normative judgements) of the assessors because issues of fairness come
into play. Issues considered include the conditions under which an economy
is most efficient and how goods and income are distributed within economies,
and how different economic policies impact on stakeholders. The effect of an
economic policy on consumers can be investigated by looking at changes to
consumer surplus.
For example, if a government ensures that there is additional competition in the
taxi market (by allowing extra taxis to be registered), this could lead to an increased
supply of taxis. This is shown in Figure 3.5 as the increase in supply in panel B
compared to panel A.
The result of expanded supply (from S1 to S2) with the same demand, is a
lower price for taxi fares with a greater quantity supplied: compare P ∗ to P ∗∗ and
Q ∗ to Q ∗∗ . The welfare effects can be considered by examining consumer surplus
(CS) in both cases, which is the area above the price and below the demand
curve. At lower taxi fares, in panel B, consumers’ welfare is improved since some
consumers unwilling to pay higher taxi fares become willing to demand taxis and
those who were willing to pay higher prices still benefit given the gap between
the price paid and willingness to pay. Consumer welfare can be said to have
increased since a comparison shows that CS1 in panel A is smaller than CS2 in
panel B.
A B
Price Price
P P S1
S2
S1
CS1
CS2
P*
D P** D
Q Q
Q* Quantity Q** Quantity
FIGURE 3.5 C O N S U M E R W E L FA R E A N D T H E TA X I M A R K E T
3.6 CONSUMERS’ RESPONSE TO PRICE

CHANGES
The quantity of goods demanded changes in response to price changes, resulting
from new marginal utility/price ratios. If the price of all goods fell by 10% consumers
would demand more of most if not all goods, but the rise in demand in response
to the price fall would not be the same across all goods. This is because consumers
are more or less price-sensitive for some goods relative to others. No matter what
price cow’s tongue is I will never choose to increase my demand for it from zero!
While individual preferences play a key role in demand decisions and in reactions
to price changes we know they are not the only explanatory factor for consumers’
responses to price changes.
A 10% fall in the price of standard pens will not substantially change the quantity
demanded for most people since pens are inexpensive and only a small portion
of consumers’ income is spent on them. In the case of goods that are not bought
very often, and for which the income share is very small, demand is usually not
very price-sensitive. This information is useful in drawing a demand curve because
it helps us to decide whether the demand curve is relatively steep or flat. For pens
the demand curve will be relatively steep indicating that a change in price has little
impact on quantity demanded (see panel A in Figure 3.6).
Demand for theatre tickets is somewhat more responsive to changes in price as
they can be relatively expensive and are quite a discretionary purchase. Hence, the
demand curve is relatively flat such as in panel B in Figure 3.6.
The extent to which substitutes are available for a good also impacts on its price-
sensitivity. If the price of one brand of pen were to fall by 10%, rational consumers
A: Pens B: Theatre tickets

Price Price
P1 P1
P2 P2
D
D
Quantity Quantity
Q1 Q2 Q1 Q2
FIGURE 3.6 PRICE SENSITIVITY AND DEMAND

would substitute away from more expensive pens to the cheaper available brand.
For a specific brand, price sensitivity is higher than for a broad category of goods.
In general it is also the case that the higher consumers’ income, the less price-
sensitive they are because there are fewer limitations on what can be purchased than
for people on lower incomes. This means that the demand curves of higher-income
households would be steeper than for lower-income households and their quantities
demanded would change relatively little in response to price changes.
The issue of time is also relevant for analysis of price sensitivity since con-
sumers can adjust their purchasing behaviour more easily over longer periods.
If one supermarket chain cuts its prices overnight, many people will continue
to shop at their usual shops until they become aware of the price cuts else-
where and until they are willing and able to change their shopping patterns to
take advantage of the cheaper prices (clearly convenience, location and other
factors matter for the consumer). This may take time but over longer time peri-
ods economists expect consumers to be more price-sensitive than over shorter
time periods.
FACTORS EXPLAINING SENSITIVITY OF QUANTITY

DEMANDED TO PRICE CHANGE
Ceteris paribus, sensitivity of quantity demanded to price change is low
• for inexpensive goods;

• for goods with a low income share (e.g. clothes pegs);
• for goods in general rather than a specific good, e.g. all pens vs. Paper-
mate pens;
• for consumers on high incomes;
• over short relative to longer periods.
3.6.1 PRICE ELASTICITY OF DEMAND

In the taxi example, when supply expanded the result in equilibrium was a lower
price. As predicted by the law of demand, at a lower equilibrium price consumers
demanded more taxis. The reaction of quantity demanded can be quantified if
information is available on the quantities demanded over a range of prices.
The responsiveness of quantity demanded to a change in price is called the price

elasticity of demand (PED).
PED = %Qd/%P
Price
150
Price Q (000) PED
125 Elastic: PED > 1
100 125 9 –2.5
75 100 18 –1.0
Inelastic: PED < 1 75 27 –0.5
50
50 36
D
Quantity (000)
18 27 36
FIGURE 3.7 ELASTICITY AND THE DEMAND FOR

CALL CREDIT
If the quantity of taxi rides rose by 10% following a price fall of 5%, price elasticity of
demand is −2 (%Qd is 10 and %P is −5 so PED is −2). Demand elasticities are
always negative numbers but many economists report demand elasticities without
the negative sign, assuming that other economists correctly interpret the number.
As the following example shows, information on elasticity is of particular interest
to firms in terms of the effects of price changes on their revenues. Returning to the
call credit example, price elasticity can be computed, based on the formula above
and the information in Figure 3.7.
• Price rise from £50 to £75: PED = 25%/50% = −0.50

decline in quantity from 36 to 27 is 9, expressed as a percentage of
36 = 25%
price rise of £25, expressed as a percentage of £50 = 50%.
• Price rise from £75 to £100: PED = 33%/33% = −1.00
decline in quantity from 27 to 18 is 9, expressed as a percentage of
27 = 33%
price rise of £25, expressed as a percentage of £75 = 33%. Here, the
percentage changes in price and quantity exactly cancel each other out.
This is called unit elasticity.
• Price rises from £100 to £125: PED = 50%/20% = −2.50
the decline in quantity from 18 to 9 is 9, expressed as a percentage of
18 = 50%
price rise of £25, expressed as a percentage of £125 = 20%.
PED differs at different points on the demand curve.

In absolute terms (ignoring the minus sign) PED is greater than one when the
percentage change in quantity demanded is greater than the percentage change
in price. This is elastic PED.
PED is less than one when the percentage change in quantity demanded is less
than the percentage change in price. This is inelastic PED.
An alternative estimation method may be used. Instead of computing elasticity

relative to one point on the demand function, it can be estimated as an average
over a section of the demand function:
Arc price elasticity of demand:
Qd 1/2[P 1 + P 2]
×
P 1/2[Qd1 + Qd2]
Arc price elasticity differs to the earlier method by estimating average price and
average quantity demanded. It is most appropriately used for large price changes.
Re-calculating elasticities from the data above according the arc elasticity
method reveals:
9 1/2[50 + 75]
• Price rise from £50 to £75: Arc PED = − × = −0.72
25 1/2[36 + 27]
9 1/2[75 + 100]
• Price rise from £75 to £100; Arc PED = − × = −1.40
25 1/2[27 + 18]
9 1/2[100 + 125]
• Price rise from £100 to £120; Arc PED = − × = −3.00
25 1/2[18 + 9]
Price elasticity of demand and total revenue

If a firm wishes to change the price of a good, it can estimate the impact on the
quantity demanded of its product by using PED. Staying with Figure 3.7, if the firm
is considering an increase in price it can consider the impact on its revenues. From
consumers’ perspectives firm revenue is the same as consumers’ expenditure.
A firm’s total revenue is price times the quantity of goods sold: TR = P × Q

Example: following Figure 3.7
P = £0 Q =0 TR = £0
P = £50 Q = 36 000 TR = £1 800 000 Price ↑ 0–50 TR ↑
P = £75 Q = 27 000 TR = £2 025 000 Price ↑ 50–75 TR ↑
P = £100 Q = 18 000 TR = £1 800 000 Price ↑ 75–100 TR ↓
P = £125 Q = 9 000 TR = £1 125 000 Price ↑ 100–125 TR ↓
Conclusion: increasing price can lead to rises in TR OR to falls in TR .
The relationship between quantity demanded, price, elasticity and total revenue is
also evident from Figure 3.8. In the elastic part of the demand curve, where quantity
demanded is very responsive to changes in price, a fall in price leads to an increase
in total revenue.
In the elastic portion of the demand curve, TR changes in the opposite direction
to a price change: in the case of a price increase TR falls and in the case of a price
fall TR rises.
In the inelastic portion of the demand curve, TR changes in the same direction
as a price change implying that if price increases TR rises also.
Changes in the price of a good almost always result in changes in total revenue. The
exception is at the point on the demand curve where PED = −1 at point c in panel
A B
Price TR
Elastic: PED > 1 2 025 000 c*
150 d*
a 1 800 000 b*
125 Unit elastic:
b PED = 1 a*
100 1 125 000
c
75
d Inelastic:
50 PED < 1
D
9 18 27 36 Q (000) 9 18 27 36 Q (000)
FIGURE 3.8 D E M A N D , E L A S T I C I T Y A N D T O TA L R E V E N U E
A when the PED is neither elastic nor inelastic but unit elastic. We saw earlier that
unit elasticity arises when the percentage change in quantity demanded is the exact
same as the percentage change in price so that there is no change in total revenue.
Price elasticity of demand: some special cases

It is possible to envisage situations where irrespective of what price is charged for
a product, the quantity demanded would remain constant. Some necessities would
fall into such categories where irrespective of price consumers have to bear any price
change. Demand functions for goods to which consumers are addicted might also
display such characteristics. Such a demand function would be a vertical line, shown
in Figure 3.9. Since quantity demanded does not react at all to any change in price,
it is described as a demand function with perfectly inelastic demand. At a relatively
high price of P1 in panel A, the same quantity is demanded as at the lower price of
P2. At the higher price, the firms’ revenue and consumers expenditure is higher.
At the opposite end of the spectrum it is also possible that demand exists for a
product at only one price, also shown in Figure 3.9. This is possible if we consider
the output of a single firm with many competitors which can only charge the market
price for their product, i.e. the price determined by market demand and supply (this
case is considered in more detail later in Chapter 6). Quantity demanded reacts
perfectly to any change in price by completely disappearing! The firm can sell as
much as it wishes to produce at P3 in Panel B of Figure 3.9. If the firm produces Q2
it will earn higher revenues than if it chooses to produce Q1.
A Perfectly inelastic demand B Perfectly elastic demand

Price Price
D
P1
D
P3
P2
Quantity Quantity
Q1 Q1 Q2
FIGURE 3.9 PRICE SENSITIVITY AND DEMAND
3.6.2 APPLICATIONS OF ELASTICITY ANALYSIS

If a firm seeks to increase its revenue and wishes to change the price it charges for
a product, it needs to know to what extent quantity demanded is responsive to the
price change. The above analysis shows that there would be little point in a firm
raising its price with the intention of boosting its revenues if quantity demanded
was in the elastic part of the demand curve. In terms of a firm’s pricing strategy,
therefore, it makes sense for the firm to have information on the price elasticity of
demand for its product(s).
Information on elasticity is not just of interest to business but can be useful for
policy-makers also.
If a government is thinking about increasing taxes on cigarettes with the

intention of reducing the quantity demanded, it needs to have an estimate of
the PED for cigarettes.
If the function of the tax is to reduce aggregate expenditure on cigarettes,
a price increase (via the tax) would have to result in the price rising to
the elastic portion of the demand curve. The result of the tax would be
that the percentage increase in price would bring about a larger propor-
tionally percentage fall in quantity demanded – consumers would buy fewer
cigarettes, and the total revenue to cigarette firms would decline. Hence,
the responsiveness of consumers to price provides useful information for
decision-making.
3.6.3 OTHER ELASTICITY EXAMPLES

Income elasticity of demand
In general if a consumer’s income increases, it is expected that their demand for
goods and services would increase too, but not necessarily by the same proportion.
The relationship between the quantity demanded of any goods and income is
described by the income elasticity of demand.
Income elasticity of demand measures the responsiveness of the quantity

demanded of a good to changes in consumers’ income (I ).
It is computed as %Qd/%Y
Goods are described as normal goods, if their income elasticities are greater
than zero implying the quantity demanded changes in the same direction as a
change in income. Most goods fall into this category – we buy more of them if
our income rises. In the case of inferior goods their quantity demanded declines
if income increases. Income elasticities for inferior goods are negative because a
percentage increase (fall) in income leads to a decline (rise) in quantity demanded
of the good.
Goods for which the percentage change in quantity demanded is greater than the
percentage change in income are described as income elastic (with income elasticity
greater than one). This would be the case if income rose by 15% and the quantity
demanded of package holidays, for example, increased by 20%. Other goods are
called price inelastic when a change in income results in a less than proportionate
change in quantity demanded: an example would be a 3% increase in quantity
demanded of electricity following a 15% increase in income. Income elastic goods
are also known as luxury goods whereas income inelastic goods are necessities.
Cross-price elasticity
The relationship between the quantity demanded of one good and the price of
another good is described by the Cross-price elasticity.
Cross-price elasticity indicates the responsiveness of the quantity demanded of

one good (good A) when the price of another good (good B) changes.
It is computed as %QdA /%PB
Cross-price elasticity is of interest for goods that display some economic relationship,
such as complement or substitute goods.
If car insurance rises by 20%, this may have an impact on the quantity of
new cars demanded, a complement good for car insurance, which might be
expected to fall and so the cross-price elasticity would be negative. Since new
cars are substantially more expensive than insurance, the effect on demand
should not be close to 20% and so the cross-price elasticity would be less
than one. Among young drivers and focusing on the first-time drivers’ second-
hand car market, the cross-price elasticity might be considerably higher, when
annual insurance costs may even be greater than the price many pay for their
first car.
If Indian and Chinese takeaway food are substitute products, it would be

expected that if the price of Chinese takeaways rises, the demand for Indian
food would rise as consumers substitute away from the more expensive to the
cheaper good, presuming the consumer is indifferent between the goods. This
means that the cross-price elasticity would be positive since the price change
(rise or fall) in one good leads to a change in quantity demanded of the
substitute good in the same direction (rise or fall) as the price change.

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64 THE ECONOMIC SYSTEM

2.9.1 LABOUR DEMAND

FIGURE 2.9 INDUSTRY LABOUR DEMAND CURVE

The following example is considered to ﬁgure out the number of workers

• at a wage rate of £10 demand is seven workers;

2.9.2 LABOUR SUPPLY: INDIVIDUAL SUPPLY DECISION

In choosing between alternative employment possibilities, people also take the

Price Labour supply

2.9.3 EQUILIBRIUM IN THE LABOUR MARKET

FIGURE 2.13 EQUILIBRIUM IN THE LABOUR MARKET

REVIEW PROBLEMS AND QUESTIONS

The end of life vehicle case

FURTHER READING AND RESEARCH

b. what has been happening to equilibrium quantity in this market;

✪ Identify how demand is related to consumers’ choices at a microeconomic level

• all the goods bought for consumption purposes; C plus

3.2.1 CONSUMPTION GOODS

If consumer conﬁdence is low or declining, it indicates that consumers consider

Services are non-material or intangible items of consumption that are consumed

In proportionate terms, consumption spending in developed economies is made

A: Total utility per bar B: Marginal utility per bar

3.3.1 THE ASSUMPTION OF RATIONALITY IN ECONOMICS

1 16 0.32 (3) 21 0.42 (1)

1 16 0.32 (2) 21 0.35 (1)

3.4.1 THE LAW OF DEMAND – INCOME AND SUBSTITUTION

FIGURE 3.2 BUDGET LINE AND INDIFFERENCE

At different points on the indifference curve, the consumer is willing to trade

A price change induces consumers to change their demand decisions. The

FIGURE 3.3 CONSUMPTION WITH NEW BUDGET LINE

3.5 DEMAND, CONSUMERS

FIGURE 3.4 DEMAND FOR CALL CREDIT AND

Consumer surplus – the beneﬁt to consumers due to the difference between

3.5.1 CONSUMER SURPLUS AND CONSUMER WELFARE

3.6 CONSUMERS’ RESPONSE TO PRICE

A: Pens B: Theatre tickets

FIGURE 3.6 PRICE SENSITIVITY AND DEMAND

FACTORS EXPLAINING SENSITIVITY OF QUANTITY

• for inexpensive goods;

3.6.1 PRICE ELASTICITY OF DEMAND

The responsiveness of quantity demanded to a change in price is called the price

FIGURE 3.7 ELASTICITY AND THE DEMAND FOR

• Price rise from £50 to £75: PED = 25%/50% = −0.50

PED differs at different points on the demand curve.

An alternative estimation method may be used. Instead of computing elasticity

Arc price elasticity of demand:

Price elasticity of demand and total revenue

A ﬁrm’s total revenue is price times the quantity of goods sold: TR = P × Q

Example: following Figure 3.7

Conclusion: increasing price can lead to rises in TR OR to falls in TR .

Price elasticity of demand: some special cases

A Perfectly inelastic demand B Perfectly elastic demand

FIGURE 3.9 PRICE SENSITIVITY AND DEMAND

3.6.2 APPLICATIONS OF ELASTICITY ANALYSIS

If a government is thinking about increasing taxes on cigarettes with the

3.6.3 OTHER ELASTICITY EXAMPLES

Income elasticity of demand measures the responsiveness of the quantity

Cross-price elasticity indicates the responsiveness of the quantity demanded of

If Indian and Chinese takeaway food are substitute products, it would be

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