Chapter 3 – Demand, Supply and the Market Prepared by : Takesh Luckho What is a Market? A market is a mechanism through which buyers comes in contact with sellers in order to complete a transaction. Market can take the form of Any geographical location (for example Portobello Road Market in London) Telecommunication Networks or Computer Networks (e.g Forex Markets or Stocks Markets) Actual and Effective Demand Actual Demand and Effective Demand Actual demand is what you want (your ends) Effective demand is what you want and this is backed by the desire/willingness to pay for it. Hence in Economics when you talk about demand it mean the effective demand Types of Demands Individual Demand – Demand of goods and services by an individual/household demand – demand for goods that are jointly consumed (e.g Car and Petrol) Competitive demand – demand competing goods that can provide the same satisfaction (e.g Tea and coffee) Derived Demand – demand subjective to the demand of the final product (demand for factors like labour are derived demands) Joint Market Demand – Demand for all Individuals/ households Types of Demands Non Durable and Durable Good demand good – goods that are perishable (like vegetables, milk) Durable good – goods that can last for long (furniture, electronics) Non-durable Company demand and Industry demand demand – demand of a single firm Industry demand – demand of all firms in the industry Company Demand for consumer goods (consumed immediately) and producer goods (capital goods) Short-Run and Long-Run demand Demand: Definition The demand for a good/service is the quantity that a household wants to buy during a period of time at a given price, providing this want is backed by the ability and willingness to pay. From these information we can write a mathematical function to represent demand Qxd = f (Px, Py, Pz, Y, Climate, Taste, Preferences, Expectations, Population,Etc..) X is the good, Y is a substitute Z is a complement and Y is household income The Law of Demand law of demand : Assuming Ceteris paribus Condition (all other things remain equal), as price of a good or service rises, its quantity demanded falls or as the price of a good or service falls, its quantity demanded increases. == > There is an inverse relationship between the price of a good and the quantity demanded of that good Demand Function = Qdx = f(Px) i.e: Qdx = α - β Px P Q or P Q What can explain the downwards sloping shape of the demand curve? Law of diminishing marginal utility Income effect Assuming that the price of a good goes down, you need to spend less money to buy the same amount of that good Your real income goes up and with the same money in the pocket you can buy more of the good Substitution effect When price of a good falls, it becomes cheaper relative to its other competitors A rational consumers will shift to the cheaper substitute Exceptions to the law of demand Giffen goods – a special type of inferior good that does not respect the law of demand. As price goes up, quantity also goes up. E.g Discounted products Conspicuous consumption – like art or diamonds (bought by the rich). Its only when the price goes up that people buy such product Expectation of a future rise in prices Emergencies – like in war time period Demand Schedule Price 1 5 Total Quantity Demanded 1 4 2 3 3 2 4 1 5 Demand Curve Also known as the inverse demand curve as the diagram is the inverse of the demand function Qx =f(P) 6 5 Price 4 3 2 1 D 0 1 2 3 4 Quantity demanded slope, The demand curve has a negative consistent with the law of demand. 5 Effect of Changes in the Determinants of Demand: Movements and Shifts Movement: Expansion of demand (Due to a fall in price) 6 5 A Price 4 3 B 2 1 D 0 1 2 3 Quantity demanded 4 5 Movement: Contraction of Demand (due to a rise in Price) 6 5 A Price 4 3 B 2 1 D 0 1 2 3 Quantity demanded 4 5 Shift in the Demand Curve A change in any variable other than price that influences quantity demanded produces a shift in the demand curve. Factors that shift the demand curve include: Change in consumer incomes Taste Climate Expectations Population Prices of related Complements and Substitutes Prices of related goods Complements - an increase in the price of a complement reduces the demand of the good, thus shifting the demand curve to the left. Substitutes - an increase in the price of a substitute increases the demand of the good, shifting the demand curve to the right. Income - an increase in income shifts the demand curve of normal goods to the right. Number of potential buyers - an increase in population or market size shifts the demand curve to the right. Demand curve shifts to the right This demand curve has shifted to the right. Quantity demanded is now higher at any given price. 6 5 Price 4 3 2 1 D 0 1 2 3 Quantity demanded 4 5 Demand curve shifts to the left This demand curve has shifted to the left. Quantity demanded is now lower at any given price. 6 5 Price 4 3 2 D 1 0 1 2 3 Quantity demanded 4 5 Important to Remember A quick recap on Movement and Shift in the demand curve A change in the price of the good will cause a movement along the demand curve A change in any other variable will lead to a shift in the demand curve Market Demand To get the Market Demand: Horizontal Summation across the individual Demand Curves Consumer Surplus Price D Consumer Surplus E P Actual Expenditure O Consumer surplus is the difference between the maximum price a consumer is willing to pay and the actual price he do pay when buying the product CS Q Qty = Total Willing to pay – Actual Payment = 0DEQ – OPEQ = DEP Supply: Definition The supply of a good/service is the quantity that a firm will offer for sale during a period of time at a given price. From these information we can write a mathematical function to represent supply Qxs = f (Px, Po, Pf, T, Govt, Scale, Objectives, Expectations, Etc..) X is the good, O is the price of other goods (rival or jointly supplied) f are the factors of production, T is technology Govt = Taxes or subsidy The Law of Supply law of supply: Assuming Ceteris Paribus Condition (other things remaining constant), as the price of a good rises, its quantity supplied will rise, and as the price of a good falls, its quantity supplied will fall. ===>There is a direct relationship between the price of the good and the quantity supplied of that good In algebra, Qxs = f (Px) i.e, Qxs = α + βPx The Law of Supply - cond Why do producers produce more output when prices rise? They make higher profits Exception to the law of Supply Non-profit maximising firms Subsistence farming – as price rises farmer can sell less of the product to get the same revenue and keep the excess balance for their own consumption Calculate market supply in the same way that we get market demand – sum of supply from all individual firm Supply Schedule Price 1 1 Total Quantity Supplied 1 2 2 3 3 4 4 5 5 Supply Curve 6 5 S Price 4 3 2 1 0 1 2 3 4 5 Quantity supplied The supply curve has a positive slope, consistent with the law of supply. Market Equilibrium: Determination Market Price In economics, an equilibrium is a situation in which unconstraint variable do not tend/want to change - that is they are in a state of rest. Hence, market equilibrium occurs where the free market price has no tendency to change, assuming ceteris paribus. Let show Market Equilibrium on a demand and supply diagram and find the market price Market Equilibrium: Case of a Surplus The Market clearing process Price of tomatoes (dollars per kg.) 40 Supply Excess supply 2 3 30 Market equilibrium 25 Demand 0 170 200 Case 1 35 1 At $ 35, 300 Hence 200 unit is said to be the equilibrium quantity and the market (equilibrium) price is said to be 30 Qty Demanded: 170 Qty Supply: 300 Excess supply (surplus in production) of 130 unit To much of the good on the market will cause the price to fall. Demand will expand, supply will contract until both reach 200 unit. At $30, neither demand nor supply want to change (they have reached a state of rest Market Equilibrium: Case of a Shortage The Market clearing process Price of tomatoes (dollars per kg.) 40 Supply 35 30 Market equilibrium 4 5 6 Case 2 25 Excess demand Demand 0 At $ 25, 100 200 220 Hence 200 unit is said to be the equilibrium quantity and the market (equilibrium) price is said to be 30 Qty Demanded: 220 Qty Supply: 100 Excess demand (shortage in production) of 120 Shortage of the good on the market will cause the price to rise. Demand will contact, supply will expand until both reach 200 unit. At $30, neither demand nor supply want to change (they have reached a state of rest WHAT IS AN ELASTICITY? An elasticity is a measure of the sensitivity of demand or supply to changes in their determinants. In other words elasticity are said to be measuring the responsiveness of one variable (i.e one determinant) to changes in the quantity of the good being demanded/supplied. The higher the value of elasticity, the greater will be the responsiveness of consumers to a change in the determinant. Elasticities are often used to show the steepness/flatness of the demand or supply curve Elasticity 3 basic types of demand elasticities: Price elasticity of demand Income elasticity of demand Cross elasticity of demand Price Elasticity of Demand (PED) Price elasticity of demand measures the responsiveness of the quantity demanded of a good to a change in price of that good, assuming ceteris paribus conditions. That is, it measures the rapidity and volume of the change in the quantity demand of that good as a response to change in its selling price. Computing the Price Elasticity of Demand The price elasticity of demand is obtained by dividing the percentage change in quantity demanded by the percentage change in prices. P ED = P ercent agechangein quant it ydemanded P ercent agechangein t heprice % Qt y Demandedof good X P ED = % in t heP riceof good X Q1 Q0 /Q0 PED = P1 P0 /P0 x 100 Examples of Own Price Demand Elasticities When the price of gasoline rises by 1% the quantity demanded falls by 0.2%, so gasoline demand is not very price sensitive. Price elasticity of demand is -0.2 . When the price of gold jewelry rises by 1% the quantity demanded falls by 2.6%, so jewelry demand is very price sensitive. Price elasticity of demand is -2.6 . Sign of Price Elasticity According to the law of demand, whenever the price rises, the quantity demanded falls. Thus the price elasticity of demand is always negative. Because PED is always negative, economists usually state the value without the sign. Range of PED: - ∞ ≤ PED ≤ 0 or 0 ≤ PED ≤ ∞ Classifying Demand and Supply as Elastic or Inelastic Demand is said to be elastic if the percentage change in quantity is greater than the percentage change in price. (i.e E < -1 or E > 1) This means that the change in the quantity demanded is more than proportionate to the change in the price level Demand is inelastic if the percentage change in quantity is less than the percentage change in price. (i.e E > -1 or E < 1) This means that the change in the quantity demanded is less than proportionate to the change in the price level An Inelastic Demand curve is steeper than an Elastic Demand Curve. Elastic Demand - Elasticity is less than -1 Price 1. A 25% $5 increase in price... $4 Quantity 50 100 2. ...leads to a 50% decrease in quantity. Inelastic Demand - Elasticity is greater than -1 Price $5 1. A 25% increase in price... $4 Quantity 90 100 2. ...leads to a 10% decrease in quantity. Special cases of Demand Curves Perfectly Inelastic: PED = 0 Quantity demanded does not respond to price changes. Perfectly Elastic: PED = - ∞ Quantity demanded changes infinitely with any change in price. Unit Elastic: PED = - 1 Quantity demanded changes by the same percentage as the price. Perfectly Inelastic Demand - Elasticity equals 0 Price Demand $5 1. An increase in price... 4 Quantity 100 2. ...leaves the quantity demanded unchanged. Perfectly Elastic Demand - Elasticity equals minus infinity Price At any price above $4, quantity demanded is zero. Demand $4 At a price of $4, quantity demanded is infinite. Quantity Unit Elastic Demand (Rectangular Hyperbola) - Elasticity equals 1 Price 1. A 25% $5 increase in price... $4 Demand 75 100 2. ...leads to a 25% decrease in quantity. Quantity Income Elasticity of Demand (YED) Income elasticity of demand measures the responsiveness of demand to a change in income. That is,how much the quantity demanded of a good responds to a change in consumers’ income. It is computed as the percentage change in the quantity demanded of a good divided by the percentage change in household/individual income. Computing Income Elasticity Percentagechangein quantitydemanded YED = Percentagechangein Income % Qty Demanded of good X YED = % in Household or Individual Income Q1 Q0 /Q0 YED = Y1 Y0 /Y0 x 100 If YED > 1 demand is income elastic (Luxury/Superior) If YED > 0 and < 1 demand is income inelastic Income Elasticity - Types of Goods Normal Goods (YED > 0) Income Elasticity is positive. YED > 1 Luxury Good YED = between 0 and 1 Necessity Inferior Goods (YED < 0) Income Elasticity is negative. Higher income raises the quantity demanded for normal goods but lowers the quantity demanded for inferior goods. Determinants of Income Elasticity • Goods consumers regard as necessities tend to be income inelastic Examples include food, fuel, clothing, utilities, and medical services. • Goods consumers regard as luxuries tend to be income elastic. Examples include sports cars, furs, and expensive foods. • Level of Income the consumer wants to spend on the good Cross Elasticity of Demand (XED) A measure of the degree of responsiveness of the demand for one good (X) to a change in the price of another good (Y) Computing Cross Price Elasticity Of Demand Between Good X And Good Y Percentagechangein quantitydemandedof good X XED = Percentagechangein thepriceof good Y % Qty Demandedof good X XED = % in thePriceof good Y Q XED = P Q x 0 /Q x 0 x 100 y y y 1 P 0 /P 0 x 1 Goods which are complements: Cross Elasticity will have negative sign (inverse relationship between the two) Goods which are substitutes: Cross Elasticity will have a positive sign (positive relationship between the two) Question: How would you interpret an Xed = 0 ? Any example you have in mind? How to calculate Elasticities from a given Equation?? If the demand for A is given by: QA = 100 - 2PA +PB + 0.5Y Where PA = 15, PB = 5, Y = 100, Find whether demand is elastic or not. • • Step 1: Calculate the Value of QA QA = 100 – 2(15) + 5 + 0.5 (100) = 125 Step 2:Recall: PED = %Change in Qty A/ % Change in Price A But when facing an equation, we can rewrite the formula as follows: PED = (dQA/QA) / (dPA/PA) = dQA/dPA . PA/QA • Step 3: dQA/dPA = the gradient w.r.t Price A = -2 Hence, PED = dQA/dPA . PA/QA = -2 . (15/125) = -0.24 Demand is inelastic Question: Find the Income and Cross Elasticity of Demand and say what it means?? How can elasticities be useful?? Elasticity and Total Revenue Total revenue is the amount paid by buyers and received by sellers of a good. Computed as the price of the good times the quantity sold. TR = P x Q Elasticity and Total Revenue Price Total revenue is price x quantity sold. In this example, TR = £5 x 100,000 = £500,000. £5 This value is represented by the grey shaded rectangle. Total Revenue D 100 Quantity Demanded (000s) Elasticity and Total Revenue If the firm decides to decrease price to (say) £3, the degree of price elasticity of the demand curve would determine the extent of the increase in demand and the change therefore in total revenue. Price £5 £3 Total Revenue D 100 140 Quantity Demanded (000s) Elasticity and Total Revenue Producer decides to lower price to attract sales Price (£) % Δ Price = -50% 10 Ped = -0.4 (Inelastic) % Δ Quantity Demanded = +20% Total Revenue would fall 5 Not a good move! D 5 6 Quantity Demanded Rule No 1: If demand is price inelastic, then a price change will affect total revenue directly – that is, in the same direction as that price change Elasticity and Total Revenue Price (£) 10 Producer decides to reduce price to increase sales % Δ in Price = - 30% % Δ in Demand = + 300% Ped = - 10 (Elastic) Total Revenue rises Good Move! 7 D 5 Quantity Demanded 20 Rule No 2: If demand is price elastic, then a price change will affect total revenue inversely – that is, in the opposite direction to that price change. Quick Recap Inelastic Demand Elastic Demand Increase in Price TR Increases TR falls Decrease in Price TR Falls TR Increases Question: What will happened to Total Revenue following a price rise/fall when the elasticity of demand is unity (Ped =1)?? DETERMINANTS OF DEMAND ELASTICITY Existence of substitutes The closer the substitutes and the more substitutes there are, the more elastic is demand is likely to be. The Degree of Necessity/addiction Goods that are terms as necessities tend to be more inelastic Addictive also tend to have inelastic demand curve Advertising – The aim of advertising is to show that the good as being a necessity (when if fact its not). The Share of Income Spent on the good – if you are spending a lower proportion of you income of the good then changes in price is expected to have a little effect on the amount of good being purchased. Hence PED for these goods are very low. DETERMINANTS OF DEMAND ELASTICITY The length of time allowed for adjustment The longer any price change persists, the greater is the elasticity of demand. Price elasticity is greater in the long run than in the short run. Habit forming goods or Brand Loyalty How to define the short run and the long run The short run is a time period too short for consumers to fully adjust to a price change. The long run is a time period long enough for consumers to fully adjust to a change in price, other things constant. The Theory of Consumer Behaviour Consumer theory gives a logical explanation of how rational consumers behave. In the real world: Limited Income that forces us to choose between our unlimited wants/ends How to choose: Cost/Benefits Analysis Priority List or Wish List Project Appraisal methods However, these methods depends a lot on value judgement and knowledge of future inflows of income. The Theory of Consumer Behaviour In Economics, we make use of a more scientific approach. We make use of the theory of consumer’s satisfaction as a decision making criteria. A Rational Consumer will want to consumer a product (or bundle of products) that maximises his/her satisfaction. A rational consumer is one who has clear aims and acts in the best way to achieve them. He uses his logic and available information to make the best decision. Hence, in order to know the bundle of products to buy, it is important to measure the level of consumer’s satisfaction. How can we measure consumer satisfaction? The technical term used in economics for consumer satisfaction is known as utility Utility is the satisfaction, pleasure or need-fulfilment gained from the consumption of goods or services. Two ways of measuring utility: The cardinal approach. The ordinal approach. The Cardinal Approach: Utility Theory Approach The cardinal measure approach assumes that straightforward numerical values (one, two, three, etc) can be given to levels of satisfaction. Each good consumed is assumed to generate a number of units of satisfaction. So the consumption of a particular good may be said to be worth, say, nine unit of utility to a given individual. The important feature of such cardinal measures is that they can be subjected to arithmetic manipulation. Values can be added together, subtracted, multiplied, etc. The Ordinal Approach: The Indifference Curve Approach The ordinal measure approach involves utility values taking the form of ‘first best’, ‘second best’, ‘third best’, ‘worst’, etc. In other words, they can be put in order but do not carry a value that implies how much better one item of consumption is compared to another. The Utility Theory Approach Suppose there is a consumer who likes drinking cola. The amount of satisfaction that he get from each successive can of the drink is likely to diminish the more he drink per day. This occurs as he quench his thirst, enjoy the taste, but then eventually get sick of more of the same product. Let’s say that the first can of cola gives him 20 u of unit of satisfaction, the second may give him 16 unit, the third 10 units and so on. The seventh can of the day could give him negative utility (called disutility) of –2 utils. From these information, we can draw up the following utility schedule: The Utility Theory Approach Quantity Consumed per day Total Utility Marginal Utility 1 20 20 2 36 16 3 46 10 4 52 6 5 54 2 6 54 0 7 52 -2 (Can of Cola) Diagram: Total and Marginal Utility Important to note that Marginal values are plotted against the midpoint of unit consumed Total utility is the aggregated units of satisfaction generated from several units of a particular product consumed in a given time period; whereas: Marginal utility is the extra units of satisfaction generated from one extra unit of a particular product consumed. As more and more unit extra unit of the good is being consumed over this period of time, marginal utility of consuming this extra unit tend to fall, this is known as the law of diminishing marginal utility. This explains the downward sloping nature of the MU curve. (MU = dTU/dX) The TU curve starts at the origin. Zero consumption yields zero utility. TU Curve reaches a peak when marginal utility is zero Utility Curves: Two or more goods How to calculate maximum satisfaction in the case of two or more goods : Assuming that the country produced two goods (let say good X and good Y at respective price of Px and Py). To get maximum satisfaction, we make use of the equi-marginal condition Mux Muy (assuming thatall disposable incomeis used) Px Py Indifference Curve Approach Even though the multi-commodity version of marginal utility theory is useful in demonstrating the underlying logic of consumer choice, it still has a major weakness. Utility cannot be measured in any absolute sense. We cannot really say, therefore, by how much the marginal utility of one good exceeds another. An alternative approach is to use indifference analysis. This does not involve measuring the amount of utility a person gains, but merely ranking various combinations of goods in order of preference. Economist prefer the use of ordinal approach of consumer’s decision making against the cardinal approach. Indifference analysis involves the use of indifference curves and budget lines Indifference Curve Approach An Indifference curve is a line showing all those combinations of two goods between which a consumer is indifferent. For example, let say that in a week, Clive likes to eat 10 pears and 13 oranges. However, he would not mind giving up 1 or 2 unit of pear to consume more orange and derive the same satisfaction level. The table below shows all the combination of pear and orange that Clive might consumer and attain the same level of satisfaction. Some assumptions when drawing an Indifference Curve Preferences are transitive If a persons prefer good x to good y but at the same time prefers good y to good z, we can say that the consumer prefers good x to good y i.e, X > Y (> meaning preferred to) and Y > Z More is always preferred to less Suppose that with a given amount of Money you can buy two different bundle/combination of good x and good y as follows: A(6,4) and B (7,5). You will always buy the higher bundles as its expected to bring more utility. Consumers have diminishing marginal utility then, X > Y and X > Z or X > Y > Z The Law of diminishing marginal utility helps to determine the shape of the curve – the IC is convex Indifferences curves never cross or intercept each other. This would violate the second assumption where more is always preferred to less. An Indifference Curve All these combinations can be represented on a simple graph Slope of the Indifference Curve The slope of the indifference curve shows the rate at which a consumer is willing to exchange one good for the other, holding his or her level of satisfaction the same. For example, consider the move from point a to point b. Clive gives up 6 units of pears and requires 1 orange to compensate for the loss. The slope of the indifference curve is thus −6/1 = −6. Now move from point e to point f, Clive is willing to gives up 2 pears and requires 2 oranges to compensate. Thus along this section of the curve, the slope is −2/2 = −1 Slope along the Indifference curve is know as the as the marginal rate of substitution (MRS). MRSxy = MUx/MUy Ignoring the negative sign on the slope, it can be seem that the MRS decrease as we are consuming more and more of pear and less of orange. As Clive consumes more pears and fewer oranges, his marginal utility from pears will diminish, while that from oranges will increase. He will be prepared to give up fewer and fewer pears for each additional orange. Hence, MRS diminishes. The law of diminishing marginal rate of substitution states that individuals will gain less and less additional satisfaction the more of a good that they consume. The decreasing MRS gives the shape of a convex Indifference curve. Indifference Map An indifference map is the collection of all indifference curves possessed by an individual. Higher curves on the map represent higher utility levels e.g: I5>I4>I3…….>I1 How to choose the optimal Consumption point from an indifference map? First we will need a budget line A budget line shows the income constraint binding on individual/household at a given price level and Income. The budget line is given as follows: PxX PyY m Where m = money income allocated to consumption (after saving and borrowing) Px = the price of a specific good Py = the price of all other goods x = amount purchased of a specific good y = amount purchased of all other goods Px can be re-written as: The Budget Line Y m X Py Second, the optimal consumption bundle happens at a point where the slope of the Indifference curve equals to the slope of the budget line Slope of indifference curve = MRS = - MUx/MUy Slope of budget line = -Px/Py Hence equilibrium occurs where -MUx/MUy = -Px/Py hence: MUx/MUy = Px/Py You will note that the marginal utility theory and the indifference curve theory give the same results in terms of equilibrium output The Optimal Consumption point At point t MUx/MUy = Px/Py THANK YOU !