CHAPTER 2 THEORETICAL TOOLS OF PUBLIC FINANCE 45

FIGURE 2-12

(a)
Deriving the Demand Curve
Quantity
of CDs, QC Changes in the price of movies
rotate the budget constraint, chang-
6
ing the number of movies demand-
A
BC2 (PM = $12) ed by individuals. When the price of
C
3 movies rises to $12, then the num-
B BC1 (PM = $8)
ber of movies demanded falls to 4,
BC3 (PM = $6) and when the price of movies
0 4 6 8 12 16 Quantity of
demanded falls to $6, the number
movies, QM of movies demanded rises to 8. We
can use this relationship between
(b) the price and utility-maximizing
Price of choices to trace out the demand
movies, PM
B curve for movies, DM, as shown in
$12 panel (b).
A
8
C
6
Demand curve
for movies, DM

0 4 6 8 Quantity of
movies, QM

the relationship between the price of movies and the quantity of movies
demanded.

Elasticity of Demand A key feature of demand analysis is the elasticity of elasticity of demand The per-
demand, the percentage change in quantity demanded for each percentage centage change in the quantity
demanded of a good caused by
change in prices. each 1% change in the price of
that good.
percentage change in quantity demanded Q/Q
percentage change in price P/P

For example, when the price of movies rises from $8 to $12, the number of
movies purchased falls from 6 to 4. So a 50% rise in price leads to a 33%
reduction in quantity purchased, for an elasticity of 0.666.
There are several key points to make about elasticities of demand:
They are typically negative, since quantity demanded typically falls as

price rises.
They are typically not constant along a demand curve. So, in our previous

example, the price elasticity of demand is 0.666 when the price of movies
rises, but is 1.32 when the price of movies falls (a 25% reduction in price
from $8 to $6 leads to a 33% increase in demand from 6 to 8 movies).