Demand and Supply 1. 2. 3.
Demand Schedule and Demand Curve Supply Schedule and the Supply Curve Elasticity of demand and supply
Demand - Total quantity customers are willing and able to purchase. A demand function is a behavior function for consumers. A supply function is a behavior function for producers. We describe market behavior using these two functions.
Direct Demand and Derived Demand ď Ź
Direct Demand-for consumption goods Goods and services that satisfy consumer desires. Derived Demand-These are sometimes called intermediate goods. For example, demand for steel (an intermediate good) is derived from the demand for final goods (e.g., automobiles).
Quantity Demanded – amount of a good that the consumer is willing to buy and able to buy at a given price over a period of time. Law of Demand :All other things remaining unchanged, the quantity demanded of a good increases when its price decreases and vice versa. This relationship can be shown by a demand schedule, a demand curve or a demand function.
Demand Schedule ď Ź
Demand Schedule shows the different quantities of goods that a consumer is willing to buy at various prices. Prices and quantities normally move in opposite directions
Demand Curve : A curve showing the relationship between the price of a good and the quantity demanded. price
A demand function is a causal relationship between a dependent variable (i.e., quantity demanded) and various independent variables (i.e., factors which are believed to influence quantity demanded) Q = f(P)
Where Q= quantity and P = price of a good. Example Q = 2 – 4P
Determinants of Demand
Own Price Income of the consumer Price of other goods- 1. complements 2. substitutes Tastes and preferences Expectations of future prices Advertising Distribution of income
Types of goods
Complementary goods are a pair of goods consumed together. As the price of one goes up the demand for the other falls. Example- car and petrol Substitute goods are alternatives to each other. As the price of one goes up the demand for the other also goes up. Example – pepsi and coke
Normal goods are those goods whose demand goes up when the consumer’s income increases. Inferior goods are those goods whose demand falls when the consumer’s income increases. Example : autotravel, kerosene Giffen goods are those goods whose demand moves in same direction as price Snob or Veblen goods are those goods whose demand falls when price falls
Shift of the Demand Curve ď Ź
A change in demand is reflected by shift of the Demand curve and is caused by a change in any of the non price determinants of demand price Here, the curve shifts due to an increase in income or an increase in price of a substitute good etc qty
A change in quantity demanded is however reflected in a movement along the demand curve and is called an extension or contraction in demand. The movement from A to B is due to the change in price of the good all other factors remaining unchanged A
Elasticity ď Ź
Elasticity: A measure of the responsiveness of one variable to changes in another variable; the percentage change in one variable that arises due to a given percentage change in another variable. By converting each of these changes into percentages, the elasticity measure does not depend on the units in which we measure the variables.
ELASTICITY Sensitivity of the quantity demanded to price is called: price elasticity of demand:
% change in quantity demanded âˆ† Q / Q EP = = % change in price âˆ†P/ P
Arc Elasticity To get the average elasticity between two points on a demand curve we take the average of the two end points (for both price and quantity) and use it as the initial value: q2-q1/(q2+q1)/2 p2-p1/(p2+p1)/2
Own Price Elasticity of Demand ď Ź
Own price elasticity: A measure of the responsiveness of the quantity demanded of a good to a change in the price of that good; the percentage change in quantity demanded divided by the percentage change in the price of the good. Elastic demand: Demand is elastic if the absolute value of the own price elasticity is greater than 1.
Types of elasticities ď Ź
elastic: the quantity demanded changes more than in proportion to a change in price
inelastic: the quantity demanded changes less than in proportion to a change in price
Elastic demand : Demand is elastic if the absolute value of own price elasticity is greater than 1. Inelastic demand: Demand is inelastic if the absolute value of the own price elasticity is less than 1. Unitary elastic demand: Demand is unitary elastic if the absolute value of the own price elasticity is equal to 1. Perfectly elastic demand : e= infinity Perfectly inelastic demand : e = 0
Slope of the Demand Curve
∆P is the change in price. (∆P<0) ∆Q is the change in quantity.
∆P slope = ∆Q
P P+ ∆P
slope = ∆P/ ∆Q Q
Q + ∆Q
Elasticity and slope Price The demand curve can be a range of shapes each of which is associated with a different relationship between price and the quantity demanded.
Linear Demand Curve: price E = infinity
e=lower segment/upper segment
DETERMINANTS OF ELASTICITY:
Number and closeness of substitutes – the greater the number of substitutes, the more elastic
The proportion of income taken up by the product – the smaller the proportion the more inelastic
Price of the product- lower the price, lower the elasticity
Luxury or Necessity - for example, addictive drugs
Time period – the longer the time under consideration the more elastic a good is likely to be
Cross-Price Elasticity ď Ź
ď Ź ď Ź
Cross-price elasticity: A measure of the responsiveness of the demand for a good to changes in the price of a related good; the percentage change in the quantity demanded of one good divided by the percentage change in the price of a related good. The cross-price elasticity is positive whenever goods are substitutes. The cross-price elasticity is negative whenever goods are complements.
Cross-price elasticity of demand how quantity of one good changes as price of another good increases
%change in quantity demanded %change in price of another good EQ , P o
∆Q / Q ∆Q Po = = ∆Po / Po ∆Po Q
Income Elasticity ď Ź
Income elasticity: A measure of the responsiveness of the demand for a good to changes in consumer income; the percentage change in quantity demanded divided by the percentage change in income. The income elasticity is positive whenever the good is a normal good. The income elasticity is negative whenever the good is an inferior good.
Income elasticity of demand % change in quantity demanded EI = % change in income ∆Q / Q ∆Q I = = ∆Y / Y ∆Y Q
Factors affecting Income elasticity:
Nature of the good: inferior goods have negative income elasticity Normal goods have positive income elasticity Luxury goods have income elasticity greater than one Necessary goods have income elasticity less than one
Advertising Elasticity ď Ź
The own advertising elasticity of demand for good X defines the percentage change in the consumption of X that results from a given percentage change in advertising spent on X.
Elasticity and Total Revenue
If demand is elastic, an increase (decrease) in price will lead to a decrease (increase) in total revenue. If demand is inelastic, an increase (decrease) in price will lead to an increase (decrease) in total revenue. Total revenue is maximized at the point where demand is unitary elastic.
MARGINAL REVENUE TR = P.Q MR = P + Q dP/dQ = P(1 + Q/P. dP/dQ) = P(1- 1/e) = AR(1-1/e) Hence if e=1, MR =0 if e =0 , MR = INFINITY if e = infinity, MR = AR
Tr is max
Supply ď Ź
The quantity supplied is the number of units that sellers want to sell over a specified period of time at a particular price. Law of Supply states that all other factors remaining unchanged the supply of a good increases as its price increases. This can be shown by a supply schedule, a supply curve or a supply function.
Supply schedule There exists a positive relation between quantity and price
• Supply function shows the relation between quantity and price. It is a positive relation. Example : q= 4+3p
Determinants Of Supply
Price Cost of production Technological progress Prices of related outputs Govt policy All factors other than price cause a shift of the supply curve and is called a change in supply
Elasticity of Supply
Price Elasticity of Supply:
The responsiveness of supply to changes in price If es is inelastic (<1)- it will be difficult for suppliers to react swiftly to changes in price If es is elastic(>1) – supply can react quickly to changes in price
% Δ Quantity Supplied ____________________ es = % Δ Price
EQUILIBRIUM ď Ź
Equilibrium - perfect balance in supply and demand Determines market output and price p p
Market forces drive market to equilibrium
at prices < equilibrium level: excess demand (amount by which quantity demanded exceeds quantity supplied at the specified price) at price > equilibrium level: excess supply equilibrium price is market clearing price: no excess demand or excess supply
Equilibrium in a Market Demand
Surplus and Shortage
Any price above the equilibrium causes an excess supply and any price below the equilibrium causes a shortage. The market if uncontrolled will automatically arrive at the equilibrium price at which supply equals demand. Any shift in demand and supply curves will result in a new equilibrium Comparison of equilibrium is called comparative -statics
Price Rationing A decrease in supply creates a shortage at P0. Quantity demanded is greater than quantity supplied. Price will begin to â€˘ The lower total supply rise. ď Ź
is rationed to those who are willing and able to pay the higher price.
Alternative Price- Control Mechanisms • A price ceiling is a maximum price that sellers may charge for a good, usually set by government. • Example: rent control • A price floor is a price above equilibrium price that the buyers have to pay. • Example : agricultural support price, minimum wages
Paradox of the Bumper harvest
When prices of food crops increase, the demand does not increase proportionally. Hence the revenue earned by farmers fall. The Govt announces a floor price for the farmers- agricultural price subsidy. This interference with prices comes at a cost to the Govt in form of storage costs of Govt granaries.
Application of elasticity: ď Ź
Incidence of taxation: Supply after tax supply