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DEMAND and SUPPLY

DEMAND ANALYSIS

The subject of demand analysis is to determine the amount of a product that

households (consumers) are willing and able to buy in a given period of time.

•• TheThe mainmain determinants ofof demanddemand includeinclude:

The price of the product

Consumer income

The price of related goods—substitutes and complements

Consumer preferences—tastes and advertising

Consumer expectations about future prices

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Example: Consider the demand for X jeans.

Q=f(price of X jeans, prices of other jean brands, income of consumers, tastes, expectations about the future price)

Hence, demand for X jeans, the amount that households wish to buy in a given period of time, is determined by the

price of X jeans,

prices of other jean brands,

income of consumers,

tastes

expectation about the future prices of X jeans

Let us think about the “Direction of Effects”, under the ceteris paribus assumption (other things remaining constant)

Q= f (price of X jeans (-), prices of other jean brands (+), income of consumers (+), expectation about the future price (+) )

Demand Curve (Schedule)

A demand schedule (curve) shows the relation between the market price and the quantity demanded of a product during a given period of time, all other determinants held constant (ceteris paribus)

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• Quantity demanded of a good varies inversely with the price of the good. That

Quantity demanded of a good varies inversely with the price of the good. That is, an increase in P x , ceteris paribus, will result in a fall in Q x .

Mathematically this means that the partial derivate of Q x with respect to P x is negative

Two Reasons for Negative Slope:

Substitution Effect:

As the product becomes more expensive, people switch to substitute

Price Coke Price Coke

Substitutepeople switch to substitute Price Coke ↑ Price Coke ↓ Substitute Pepsi for Coke Coke for

Substituteto substitute Price Coke ↑ Price Coke ↓ Substitute Pepsi for Coke Coke for Pepsi Quantity

Pepsi for Coke

Coke for Pepsi

↓ Substitute Substitute Pepsi for Coke Coke for Pepsi Quantity of Coke ↓ Quantity of Coke

Quantity of Coke Quantity of Coke

Income Effect:

As the product becomes more expensive, people can’t afford to buy as much of it.

Price Coke Price Coke

Purchasing Power ↓

Purchasing Power ↑

Quantity of Coke ↓

Quantity of Coke ↑

The inverse relation between the quantity and the price is called the fundamental law of demand

LawLaw ofof Demand:Demand: The higher the price, the smaller the quantity demanded, ceteris paribus.

This is depicted as the download sloping demand curve.

Note that along the demand curve, all variables other than the price of x itself are kept constant at specific levels (ceteris paribus assumption) We assume that only the price of x changes, while other determinants of the demand for x(income, tastes and preferences, the price of related goods, etc.) remain constant, or ceteris paribus.

VERY IMPORTANT !!!

If the own price changes: a movement along the demand curve

If another variable changes: a shift in demand curve.

Generalizing;

• Changes in any factors other than price causes the demand curve to shift.

Consumer incomes

Tastes

The price of substitute goods

The price of complementary goods

Changes in the price of the good itself cause a movement along the demand curve.

Relative Prices

Relative price of a good is its price in terms of another good. For example if P x =10 and P y =5, then P x /P y =2 → So the relative price of x in terms of y is 2

An increase in the relative price of a good means that the good becomes expensive relative to other goods.

As the price of X changes along Demand curve with other prices remaining constant, the relative price of X changes

• As we move upward along the demand curve, X becomes more expansive relative to

As we move upward along the demand curve, X becomes more expansive relative to all other goods and its relative price increases.

Example:

Suppose that the money income of consumer is M=1000. Real income (relative) in terms of y is 200 and x is 100. Real income is the consumer’s income measured in terms of the goods the consumer can buy Now suppose that all prices and money income double:

P x =20, P y =10 and M=2000. In this case there would be no change in relative prices and real income. → No change in quantity demanded.

Quantity demanded depends on relative prices, not on nominal prices.

A Change in Demand

•• AA changechange inin demanddemand is a change in the amount of a good demanded

resulting from a change in something other than the price of the good, which causes a shift of the entire demand curve.

An increaseincrease inin demanddemand (rightward shift) results in higher quantity demanded at each price level. A decreasedecrease inin demanddemand (leftward shift) results in less quantity demanded at each price level.

• On the new demand curve higher (smaller) amounts are demanded at each price level.

On the new demand curve higher (smaller) amounts are demanded at each price level.

Causes of an Increase (Rightward Shift) in Demand

An increase in income (normal goods) and a decrease in income (inferior goods)

A normalnormal goodgood is a good for which the demand increases as real income rises.

An inferiorinferior goodgood is a good for which demand decreases as real income rises.

Inexpensive foods like, hamburger, frozen or canned goods are some examples for inferior goods. As incomes rise, one tends to purchase more expensive and more delicious goods.

An increase in the price of a substitute good

Suppose the price of the other jean brand (Y-jeans) has increased from 2 to 4

X-jeans are relatively cheaper, so we would expect an increase in the demand of X-jeans

A decrease in price of a complementary good

Suppose that X and Y are complementary goods,

like coffee and sugar and there is a decrease in the price of sugar

This may cause an increase in the demand for coffee

An expectation of higher future prices

Favorable advertising

Causes of a Decrease (Leftward Shift) in Demand

A decrease in income (normal goods) and an increase in income (inferior goods)

A decrease in the price of a substitute good

An increase in price of a complementary good

An expectation of lower future prices

The Impact of a Change in Income

• Higher income decreases the demand for an inferior good

Higher income decreases the demand for an inferior good • Higher income increases the demand for

• Higher income increases the demand for a normal good

Higher income decreases the demand for an inferior good • Higher income increases the demand for

The Impact of a Change in the Price of Related Goods

The Impact of a Change in the Price of Related Goods • Price of hamburger rises

• Price of hamburger rises

• Quantity of hamburger demanded falls

• Demand for substitute good (chicken) shifts right

Price of hamburger rises • Quantity of hamburger demanded falls • Demand for substitute good (chicken)

From Household To Market Demand

Market demand is the sum of all the quantities of a good or service demanded per period by all the households buying in the market.

It is obtained by taking the horizontal sum of demand curves of all households.

It shows the total quantity demanded at each price.

Assuming there are only two households in the market, market demand is derived as follows:

• Assuming there are only two households in the market, market demand is derived as follows:

Elasticity of Demand

Suppose P x =1, Q x =10, Total revenue is TR=1.10=10.

1. Suppose further that P x has increased to 1.1 then Q x =8.5

In this case TR=1.1x8.5=9.35

Hence, in this case TR decreased.

Since, 10 % price increase resulted in a 15 % decrease in quantity

2. Now, suppose that P x has increased to 1.1 with Q x =9.5

In this case TR=1.1x9.5=10.45

Hence, in this case TR increased.

Since, 10 % price increase resulted in only a 5 % decrease in quantity

Conclusion: The percentage changes both in prices and quantities are effective on the Total Revenue (TR).

We need a general measure

This is known as “Elasticity” in economics

Elasticity can be used to measure the responsiveness of something to another thing.

Price Elasticity of Demand= ( % change in the quantity demanded / % change in the price)

Thus, elasticity of demand measures price responsiveness of demand.

Because price and quantity demanded are inversely related, the price elasticity of demand has a negative sign.

The formal definition of (point) elasticity of demand is as follows:

Q

x

Q

x

P

x

P

x

P

x

Q

x

Q

x

P

x

or using the differential calculus form,

P

x

dQ

x

Q

x

dP

x

where Q

x

g

P

x

Elasticity is independent of units as it depends on percentage changes.

Due to the opposite directions, elasticity is a negative number. Consider our example:

1.

Q

x

Q

x

P

x

8.5

10

10

 

1.1

1

P

x

1

10   1.1  1     P x 1  0.15  0.1

 0.15

0.1

Q

x

Q

x

0.15

 

 1.5

P

x 0.1

P

x

10% increase in price will result in a 15% decrease in quantity demanded

2.

 Q  9.5  10  x   0.05 Q 10 x 
Q
9.5
10
x
 0.05
Q
10
x
P
1.1
1
x
 0.1
P
1
x
Q
x
Q
0.05
x
 
 0.5
P
0.1
x
P
x

10% increase in price will result in a 5% decrease in quantity demanded

Thus, in the first case , the price elasticity is higher in absolute values. This means that in the first case, the quantity demanded is more responsive to price changes.

What is the price elasticity of Demand for D 1 & D 2 when P = $4?

12 D 1 6 4 D 2 4 6 12 Price
12
D
1
6
4
D
2
4
6
12
Price

Quantity

P dQ  Q dP P 1  Q slope
P
dQ

Q
dP
P
1
Q
slope
   4  1 1        
4
1
1

D 1
 
4
12
2
6
 
   4  1       2  
 4 
1
 2
D
2
4
6
 
12
 

We might have three cases for the demand elasticity:

Demand Elasticity

Magnitudes of Change

Response to Price Changes

1 Inelastic

1 Unit Elastic

1 Elastic

Q

x

Q

x



P

x



P

x

Q P

x

x

Unresponsive

Proportional

Responsive

In addition to these three common cases:

  0  Perfectly (or completely) inelastic    Perfectly (or infinetely) elastic
 
0
Perfectly (or completely) inelastic
 
Perfectly (or infinetely) elastic
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Examples:

1. Suppose a university increases tuition from $4,000 to $4,400 (a 10% increase in price) and wants to predict how many fewer students will enroll as a result of the high price. The elasticity of demand for higher education is given as -1.4.

Q

Q

P

P

-1.4

Q

Q

Q

10 Q



14 %

2. Suppose a certain good has a demand curve Q = 1000 − 0.6P. We wish to determine the point-price elasticity of demand at P = 80. Remember the differential calculus form of the elasticity

P dQ

Q dP

First take the derivative of the demand function Q with respect to P

dQ

dP

-0.6

Next, apply the equation for point price elasticity at P=80, Q=952

P

dQ

Q

dP

=

80

952

0.6



0.05

Determinants of Price Elasticity of Demand

Availability of substitutes.

Proportion of the income used to buy the product.

Temporary versus permanent change in price.

Estimated price elasticities of demand for selected products

Product

Price elasticity of demand

Salt

0.1

Water

0.2

Coffee

0.3

Cigarettes

0.3

Shoes and footwear

0.7

Housing

1.0

Automobiles

1.2

Foreign travel

1.8

Restaurant meals

2.3

Jo;o

Air travel

2.4

Motion pictures

3.7

Specific brands of coffee

5.6

The price elasticity for water (0.20) suggests that a 10% increase in the price of water would decrease the quantity demanded by only 2%.

The elasticity for specific brands of coffee (5.6) suggests that a 10% increase in the price of a specific brand would decrease its quantity demanded by 56%.

Elasticity and Revenue

Our examples shows the net effect of a change in price on revenue depends on the price elasticity of demand.

Recall that Total Revenue is given by TR=P.Q , where we know that Q=f(P).

Let us analyze the relationship between elasticity and TR.

TR

dTR

dP

dTR

dP

dTR

dP

P Q

.

Q

Q

Q


1

1

P

 

dQ

dP

 

 

P

 

dQ

Q

dP



Hence, given that

dTR

dP

Q

1

, a price increase results in:

Total revenue falls (dTR/dP<0) when the elasticity of demand (ε) is higher than 1 in absolute values,

TR remains constant (dTR/dP=0) when ε is equal to 1 in absolute values,

TR increases (dTR/dP>0) when ε is lower than 1 in absolute values.

TR increases (dTR/dP>0) by Q when ε is zero. This means that Q is not a function of price in this case. Consumer purchases do not respond at all to any change in price.

TR decreases infinitely (dTR/dP →-∞) when ε is ∞

Note that:

Slope and elasticity are different things. Slope indicates change in units, while elasticity indicates changes in percentages Although the slope of a straight line demand curve remains constant throughout its length, its elasticity does not. Along a straight-line demand curve, the price elasticity of demand increases as the quantity decreases.

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Cross-Price Elasticity of Demand

Percentage change in the demand of one good divided by the percentage change in the price of another good.

Cross Price Elasticity of Demand= (% change in the quantity demanded of X / % change in the price of Y)

If an increase in the price of one good leads to an increase in the demand for another good, their cross-price elasticity is positive the two goods are substitutes. If the cross-price elasticity between two goods approaches infinity, then these two goods are said to be perfect substitutes.

If an increase in the price of one good leads to a decrease in the demand for another, their cross-price elasticity is negative the two goods are complements

Income Elasticity of Demand

Income Elasticity of Demand= (% change in the quantity demanded of X / % change in money income)

Income elasticity of demand is negative for inferior goods.

Income elasticity of demand is positive for normal goods.