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DEMAND
Is a full description of how the quantity demanded changes as the price of the good
changes.
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consumed by the rich will decrease. However, the net effect of an equitable
distribution of income is an increase in the level of demand.
6. Price expectations:
Expectations of people regarding the future prices of goods also influence their
demand. If people anticipate a rise in the prices of goods in future due to some
reasons, the demand for goods will rise to avoid more prices in future. Contrarily, if
the people expect a fall in price, the demand for the commodity will fall.
Demand schedule
Is a list showing the quantities of a good that consumers would choose to purchase
at different prices, with all other variables held constant.
Demand Curve:
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Demand function
Is the mathematical relationship between the quantity demanded and factors
affecting demand
It is expressed as
Qdx=f(Px, Py, Y,T,P e.t.c)
The law of demand states that, “when the price of a good rises and everything else
remains the same, the quantity of the good demanded will fall”.
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– Consumers’ expectations about future prices and incomes
– Number of buyers, etc
• The Law of Demand says that the quantity demanded of a good is inversely
related to its price, provided all other factors are unchanged
A consumer always equalises marginal utility with price. The law states that a consumer
derives less and less satisfaction (utility) from the every additional increase in the stock of a
commodity. When price of a commodity falls the consumer's price utility equilibrium is
disturbed i.e. price becomes smaller than utility.
The consumer in order to restore the new equilibrium between price and utility buys more of
it so that the marginal utility falls with the rise in the amount demanded. So long the price of
a commodity falls, the consumer will go on buying more amount of it so as to reduce the
marginal utility and make it equal with new price.
Thus the shape and slope of a demand curve is derived from the slope of marginal
utility curve.
Another cause behind the operation of law of demand is income effect. As the price of a
commodity falls, the consumer has to buy the same amount of the commodity at less amount
of money. After buying his required quantity he is left with some amount of money.
This constitutes his rise in his real income. This rise in real income is known as income effect.
This increase in real income induces the consumer to buy more of that commodity. Thus
income effect is one of the reasons why a consumer buys more at falling prices.
When the price of a commodity falls, it becomes relatively cheaper than other commodities.
The consumer substitutes the commodity whose price has fallen for other commodities which
becomes relatively dearer.
For example with the fall in price of tea, coffees. Price being constant, tea will be substituted
for coffee. Therefore the demand for tea will go up.
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(4) New consumers:
When the price of a commodity falls many other consumers who were deprived of that
commodity at the previous price become able to buy it now as the price comes within their
reach. For example the units of colour TV. increases with a remarkable fall in price of it. The
opposite will happen with a rise in prices.
There are some commodities which have multiple uses. Their uses depend upon their
respective, prices. When their prices rise they are used only for certain selected purposes.
That is why their demand goes down.
For example electricity can be put to different uses like heating, lighting, cooling, cooking etc.
If its price falls people use it for other uses other than that. A rise in price of electricity will
force the consumer to minimise its use. Thus with a fall and rise in price of electricity
its demand rises and falls accordingly.
Inferior goods:
Some goods like potato, bread, vegetable oil etc. are called inferior goods. In
the case of these goods when their price falls, the real income or the
purchasing power of the consumer increases, this purchasing power is used
to buy other superior goods. Such inferior goods are named as 'Giffen goods'.
An Irish economist Sir Robert Giffen observed this tendency of the
individuals in the 19th century.
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Price illusion:
There are certain consumers those who are always guided by the price of the
commodity. They always believe that higher the price, better the quality.
Hence they purchase larger quantities of high priced goods.
Ignorance:
Sometimes due to ignorance of existing market price, and people buy more at
a higher price.
Fear of serious shortage in the future:
Interrelated Demand
The demand for one product is affected by changes in the market for other related
products. The demand for all products is related because all products compete for
the scarce budget, the increase in the price of one product can affect all other
purchases.
The products are used in conjunction with one another. A shift in demand for one
product will shift the demand curve of its complementary product as well e.g. DVD
players and DVDs.
Demand arises from several sources, and an increase in demand for products for use
in one sector will decrease the availability of the products for use in another sector
e.g. electricity for domestic or commercial uses.
Demand for one product is derived from the demand for another product. This is
akin to Complementary Demand, but different in that for Derived Demand, one good
is involved in the production process of the other product e.g. cars and the steel
used to make cars.
Are two goods that could be used for the same purpose. If the price of one good
increases, then demand for the substitute is likely to rise.
ELASTICITY OF DEMAND
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Different elasticities of demand measures the responsiveness of quantity demanded
to changes in variables which affect demand so:
1. Price elasticity of demand- measures the responsiveness of quantity demanded by
changes in the price of the good
2. Income elasticity of demand – measures the responsiveness of quantity
demanded by changes in consumer incomes.
3. Cross elasticity of demand – measures the responsiveness of quantity demanded
by changes in price of another good
Ped=∆Q×P
∆P Q
Where, Q = quantity demanded of a commodity; P= Price.
Example, quantity demanded originally is 100 at a price of $2. There is a rise in price
to $3 resulting in a fall in demand to 75. Calculate the price elasticity of demand
1. Perfectly elastic demand: It refers to the situation where the slightest rise in price
causes the quantity demanded of a commodity to fall to zero and at the present level
of price people demand infinitely large quantity of the commodity. The coefficient of
elasticity of demand is infinite.
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5. Unitary elastic demand: It refers to a situation where a given proportionate
change in price is accompanied by an equally proportionate change in the quantity
demanded. In other words, a given proportionate fall in the price is followed by an
equally proportionate increase in demand and vice versa. The co efficient of
elasticity of demand is unity.
1. Point price elasticity, this measure elasticity of price at only one point or at a
single point.
2. Arc elasticity of demand, this measure elasticity between two points
Quiz 1. If the demand for butter rose by 2% when the price of margarine rose by 8%,
then the cross price elasticity of demand of butter with respect to the price of
margarine will be 0.25, they are substitutes
Quiz 2. If a 4% rise in the price of bread led to a 3% fall in the demand for butter, the
cross-price elasticity of demand for butter with respect to bread would be -0.75,
they are complementary
Total revenue (TR) = Price x Quantity; when the demand curve is inelastic, TR
increases as the price goes up, and vice versa; when the demand curve is elastic, TR
falls as the price goes up, and vice versa, and for unitary things remain as they are
The elastic or inelastic nature of the demand for a commodity is determined by the
following factors.
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1) Degree of necessity: Other things being equal, the demand for necessities is
inelastic or less elastic than that for comforts and luxuries. The reason is simple. The
necessities must be bought whatever be the price because no one can live without
them. The demand for a necessity without a substitute is less elastic than the
demand for a necessity with a substitute. For example, the demand for salt is less
elastic than that for paddy.
4) Several uses of the commodity: The demand for a commodity is said to be more
elastic, if it can be put to a variety of uses. A fall in the price of electricity will result
in the substantial increase in its demand.
5) Time: The elasticity of demand varies with the length of time. In general, demand
is more elastic for longer period of time. For instance, if the price of kerosene rises,
it may be difficult to substitute it with cooking gas within a very short time. But if
sufficient time is given, people will make adjustments and use firewood or cooking
gas instead of kerosene
6) Habit
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Income Elasticity of Demand
It may be defined as the ratio of proportionate change in the quantity demanded of
commodity to a given proportionate change in income of the consumer
Symbolically, Ei = Δ Q × Y
ΔY Q
Example, consumer’s income rises from Tshs. 1000 to Tshs. 1200 his purchase of the
good X (say, rice) increases from 25 kgs per month to 28 kgs, then his income elasticity
of demand for rice is 0.60
(1). Normal products (positive income elasticity): if income rises, demand rises.
(2). Inferior products (negative income elasticity): if income rises, demand falls.
Ex=∆Qx X Py
∆Py Qx
Example, when the price of commodity X increased from 200/= to 400/= the quantity
demanded of commodity Y increased from 10kg to 15kg. Calculate cross elasticity of
demand.
Two goods, which are substitutes, will have a positive cross elasticity. Two goods,
which are complements, will have a negative cross elasticity.
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i. In price determination, inelastic goods high prices and elastic goods low
prices
ii. In imposition of taxation, inelastic goods high tax rate and elastic goods low
tax rate
iii. In determination of tax incidence, means who pays large proportion of tax i.e.
if inelastic consumer and for elastic producer
iv. In devaluation, devaluation will successful if the elasticity of export and
import will be elastic
v. Price discrimination by monopoly, for discrimination to be successful the
elasticity between the two market should be different
A change in a good’s price causes us to move along the demand curve. We call this a
change in quantity demanded. A rise in price causes a leftward movement along the
demand curve—a decrease in quantity demanded. A fall in price causes a rightward
movement along the demand curve—an increase in quantity demanded
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SUPPLY
Supply refers to the amount of a product that producers and firms are willing to sell
at a given price when all other factors being held constant.
Good's own price: The basic supply relationship is between the price of a good and
the quantity supplied. Although there is no "Law of Supply", generally, the
relationship is positive, meaning that an increase in price will induce an increase in
the quantity supplied.
Expectations: Sellers' are concerning future market conditions can directly affect
supply. If the seller believes that the demand for his product will sharply increase in
the foreseeable future the firm owner may immediately increase production in
anticipation of future price increases. The supply curve would shift out.
Price of inputs: Inputs include land, labor, energy and raw materials. If the price of
inputs increases the supply curve will shift left as sellers are less willing or able to
sell goods at any given price. For example, if the price of electricity increased a seller
may reduce his supply of his product because of the increased costs of production.
Number of suppliers: The market supply curve is the horizontal summation of the
individual supply curves. As more firms enter the industry the market supply curve
will shift out driving down prices.
Supply schedule
Is a table which contains values for the price of a good and the quantity that would
be supplied at that price. If the data from the table is charted, it is known as a supply
curve.
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Market supply schedule
Is the list of all goods and services that many producers are willing and able to offer
at a certain price level. It involves the horizontal summation of quantities supplied
at a certain price level.
Supply curve
The curve is generally positively sloped. The curve depicts the relationship between
two variables only; price and quantity supplied. All other factors affecting supply are
held constant. However, these factors are part of the supply equation and are
implicitly present in the constant term.
The law of supply is a fundamental principle of economic theory which states that,
all else equal, an increase in price results in an increase in quantity supplied. In
other words, there is a direct relationship between price and quantity: quantities
respond in the same direction as price changes. This means that producers are
willing to offer more products for sale on the market at higher prices by increasing
production as a way of increasing profits
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Supply function
Qsx=a+bPx
Change in supply is the shift of the supply curve caused by a change in one of the
supply determinants. A change in supply is caused by any factor affecting supply
EXCEPT price.
Change in quantity supplied is the movement along a given supply curve caused by a
change in supply price. The only factor that can cause a change in quantity supplied
is price. A related, but distinct, concept is a change in supply.
A change in quantity supplied is a change in the specific quantity of a good that
sellers are willing and able to sell. This change in quantity supplied is caused by a
change in the supply price. It is illustrated by a movement along a given supply
curve.
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Exceptional supply curve
In some situations the slope of the supply curve may be reversed.
Regressive Supply. In this case, the higher the price within a certain range, the
smaller the amount offered to the market. This may occur for example in some
labor markets where above certain level, higher wages have disincentive effects as
the leisure preference becomes high. This may also occur in undeveloped peasant
economies where producers have a static view of the income they receive. Lastly
regressive supply curves may occur with target workers. Or
Is a graph showing a situation in which, as "real" wages increase beyond a certain
level, people will substitute leisure (non-paid time) for paid work-time and thus
higher wages lead to less labor-time being offered for sale
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Interrelated Supply
This show the relationship between supply of commodities as a result of the change
in the price or supply of related commodity
Competitive supply
Good that can be produced using the same factors of production. These commodities
compete in the use of resource in their production
Joint Supply
An economic term referring to a product that can yield two or more outputs.
Common examples occur within the livestock industry: cows can be utilized for
milk, beef and hide; sheep can be utilized for meat, wool and sheepskin. If the supply
of cows increases, so will the supply of dairy and beef products.
Elasticity of Supply
Elasticity of supply may also be defined as the ratio of the percentage change or the
proportionate change in quantity supplied to the percentage or proportionate
change in price
Example: Suppose that the price of an article rises from $4 to $5 and as a result,
supply rises from 200 to 300. Then
Es = (100/1) × (4/200) = 2.
Elastic Supply. When the proportionate change in quantity is greater than the
proportionate change in price. Elastic supply means that quantity changes by a
greater percentage than the percentage change in price. Es > 1
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Inelastic Supply. When the proportionate change in quantity is less than the
proportionate change in price. Inelastic supply means that quantity doesn't change
much with a change in price. Es < 1
Unitary Elastic Supply. When elasticity of supply is unitary, a change in price will
cause a proportionate change in quantity supplied. Es = 1
Perfectly Elastic Supply. Perfectly or infinitely elastic supply signifies that a fall in
price will completely cut off supply and a rise in price will cause an infinite
expansion of supply. Es = ∞
Perfectly Inelastic Supply. Perfectly inelastic supply means that changes in price will
not bring about any change in supply. Es = 0
There are a few factors that determine how elastic supply (i.e. how responsive
quantity supply is to changes in prices) for a particular good is:
Time: Supply will be different in the short and long run with time. In the short run,
firms will only be able to increase input of labour to increase supply of commodities.
Supply change will be little because other factors of production may not be
increased in the same proportion as the change in price and may limit the supply.
However, in the long run a firm will increase the input of all factors of production
and thus the supply becomes more price elastic.
Number of producers: If there are more producers, this means that the output can
be increased more easily. Thus supply is more elastic as a result.
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Ease of storing stocks: The type of good that a producer supplies will affect
elasticity. If goods can be stocked with ease and have a long shelf life, then supply
will be elastic. Otherwise the goods will be inelastic. For example, perishable goods
such as fresh flowers, vegetables have comparatively inelastic supply because it is
difficult to store them for longer periods.
Economic Equilibrium
Equilibrium is a state in which there are no shortages and surpluses; in other words
the quantity demanded is equal to the quantity supplied.
Equilibrium price is the price prevailing at the point of intersection of the demand
and supply curves; in other words, it is the price at which the quantity demanded is
equal to the quantity supplied.
Equilibrium quantity is the quantity that clears the market; in other words, it is it is
the quantity at which the quantity demand is equal to the quantity supplied.
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Characteristics of the equilibrium or market clearing price:
– QD = QS
– No shortage
– No excess supply
– No pressure on the price to change
–
Algebraic Representation of Equilibrium
If we have following demand and supply functions,
Qd = 100 – 10 P Qs = 40 + 20 P
In equilibrium,
Qd = Qs
Therefore
100 - 10P = 40 + 20P
20P + 10P = 100 – 40
30P = 60 P = 60/30
P=2
Putting the value of price in any of demand and supply equation,
Q = 100 – 10x2 (or 40 + 20x2)
Q = 100 – 20
Q = 80
The equilibrium price is 2 and the equilibrium quantity is 80.
Quiz 1 What effect will each of the following have on the demand of product B
a. Product B become more fashionable
b. The price of substitute C falls
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c. Incomes declines and product b is an inferior good
d. Consumers anticipate that the price of B will be lower in the near future
e. The price of complimentary product D falls
Quiz 2 Discuss, and illustrate with a graph, how each of the following events will
affect the demand for coffee:
a. A blight on coffee plants kills off much of the Brazilian crop.
b. The price of tea declines.
c. Coffee workers organize themselves into a union and gain higher wages.
d. Coffee is shown to cause cancer in laboratory rats.
e. Coffee prices are expected to rise rapidly in the near future.
Price Floors is the lowest legal price a commodity can be sold at. Price floors are
used by the government to prevent prices from being too low. The most common
price floor is the minimum wage--the minimum price that can be paid for labor.
Price floors are also used often in agriculture to try to protect farmers.
For a price floor to be effective, it must be set above the equilibrium price. If it's not
above equilibrium, then the market won't sell below equilibrium and the price floor
will be irrelevant.
A few crazy things start to happen when a price floor is set. First of all, the price
floor has raised the price above what it was at equilibrium, so the demanders
(consumers) aren't willing to buy as much quantity. The demanders will purchase
the quantity where the quantity demanded is equal to the price floor, or where the
demand curve intersects the price floor line. On the other hand, since the price is
higher than what it would be at equilibrium, the suppliers (producers) are willing to
supply more than the equilibrium quantity. They will supply where their marginal
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cost is equal to the price floor, or where the supply curve intersects the price floor
line.
As you might have guessed, this creates a problem. There is less quantity demanded
(consumed) than quantity supplied (produced). This is called a surplus. If the
surplus is allowed to be in the market then the price would actually drop below the
equilibrium. In order to prevent this, the government must step in. The government
has a few options:
They can buy up the entire surplus
They can strictly enforce the price floor and let the surplus go to waste. This
means that the suppliers that are able to sell their goods are better off while
those who can't sell theirs (because of lack of demand) will be worse off.
Minimum wage laws, for example, mean that some workers who are willing
to work at a lower wage don't get to work at all. Such workers make up a
portion of the unemployed (this is called "structural unemployment").
The government can control how much is produced.
They can also subsidize consumption. To get demanders to purchase more of
the surplus, the government can pay part of the costs. This would obviously
get expensive really fast.
Price ceiling
A price ceiling occurs when the government puts a legal limit on how high the price
of a product can be. In order for a price ceiling to be effective, it must be set below
the natural market equilibrium.
When a price ceiling is set, a shortage occurs. For the price that the ceiling is set at,
there is more demand than there is at the equilibrium price. There is also less
supply than there is at the equilibrium price, thus there is more quantity demanded
than quantity supplied.
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Price Mechanism
Price mechanism refers to the system where the forces of demand and supply
determine the prices of commodities and the changes therein. It is the buyers and
sellers who actually determine the price of a commodity.
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