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Law of demand: "If the price of the good increases, the quantity demanded decreases, while if price of the

good decreases, its quantity demanded increases." The law of demand is an economic law that states that consumers buy more of a good when its price decreases and less when its price increases (ceteris paribus).Law of demand states that the amount demanded of a commodity and its price are inversely related, other things remaining constant. That is, if the income of the consumer, prices of the related goods, and tastes and preferences of the consumer remain unchanged, the consumers demand for the good will move opposite to the movement in the price of the good. Mathematical expression The negative relation (i.e., higher price attracts lower demand & lower prices encourages high quantity to be bought by the consumers) is based on logic and experience. Mathematically, the inverse relation may be stated with causal relation as: Qx = f(Px) Where, Qx is the quantity demanded of x goods f is the function, and Px is the price of x goods. Hence, in the above model, the function (f) is a varying one i.e., the law of demand postulates Px as the causal factor (independent variable) and Qx is the dependent variable. The two variables move in the opposite direction. When Px falls Qx rises and the reverse. Assumption: Every law will have limitation or exceptions. While expressing the law of demand, the assumptions that other conditions of demand were unchanged. If remain constant, the inverse relation may not hold well. In other words, it is assumed that the income and tastes of consumers

and the prices of other commodities are constant. This law operates when the commoditys price changes and all other prices and conditions do not change. The main assumptions are

Habits, tastes and fashions remain constant Money, income of the consumer does not change. Prices of other goods remain constant The commodity in question has no substitute The commodity is a normal good and has no prestige or status value. People do not expect changes in the prices.

DETERMINANTS OF DEMAND PRICES OF RELATED COMMODITIES INCOME OF THE INDIVIDUAL TASTES AND PREFERENCES TASTES OF THE CONSUMERS WEALTH EXPECTATIONS REGARDING THE FUTURE CLIMATE AND WEATHER STATE OF BUSINESS LIMITATION

Change in taste or fashion. Change in income Change in other prices. Discovery of substitution. Anticipatory change in prices. Rare or distinction goods.

There are certain goods which do not follow this law. These include Veblen goods and Giffen goods.

Price elasticity of demand (PED or Ed) is a measure used in economics to show the responsiveness, or elasticity, of the quantity demanded of a good or service to a change in its price. More precisely, it gives the percentage change in quantity demanded in response to a one percent change in price (holding constant all the other determinants of demand, such as income). It was devised by Alfred Marshall. HISTORY

The illustration that accompanied Marshall's original definition of PED, the ratio of PT to Pt

Together with the concept of an economic "elasticity" coefficient, Alfred Marshall is credited with defining PED ("elasticity of demand") in his book Principles of Economics, published in 1890. He described it thus: "And we may say generally: the elasticity (or responsiveness) of demand in a market is great or small according as the amount demanded increases much or little for a given fall in price, and diminishes much or little for a given rise in price. He reasons this since "the only universal law as to a person's desire for a commodity is that it diminishes... but this diminution may be slow or rapid. If it is slow... a small fall in price will cause a comparatively large increase in his purchases. But if it is rapid, a small fall in price will cause only a very small increase in his purchases. In the former case... the elasticity of his wants, we may say, is great. In the latter case... the elasticity of his demand is small." Mathematically, the Marshallian PED was based on a point-price definition, using differential calculus to calculate elasticities. Calculating the Percentage Change in Quantity Demanded

The formula used to calculate the percentage change in quantity demanded is: [Quantity Demand (NEW) - Quantity Demand (OLD)] / Quantity Demand (OLD) By filling in the values we wrote down, we get: [110 - 150] / 150 = (-40/150) = -0.2667 We note that % Change in Quantity demanded = -0.2667 (We leave this in decimal terms. In percentage terms this would be -26.67%). Now we need to calculate the percentage change in price. Calculating the Percentage Change in Price Similar to before, the formula used to calculate the percentage change in price is: [Price (NEW) - Price (OLD)] / Price (OLD) By filling in the values we wrote down, we get: [10 - 9] / 9 = (1/9) = 0.1111 We have both the percentage change in quantity demand and the percentage change in price, so we can calculate the price elasticity of demand. Final Step of Calculating the Price Elasticity of Demand The formula is Price elasticity of Demand = (% Change in Quantity Demanded)/(% Change in Price) The two percentages in this equation using the figures we calculated earlier. Price elasticity of Demand = (-0.2667)/(0.1111) = -2.4005 Here we conclude that the price elasticity of demand when the price increases from $9 to $10 is 2.4005. Interpretation of the Price Elasticity of Demand

The case of price elasticity of demand it is used to see how sensitive the demand for a good is to a price change. The higher the price elasticity, the more sensitive consumers are to price changes. Very high price elasticity suggests that when the price of a good goes up, consumers will buy a great deal less of it and when the price of that good goes down, consumers will buy a great deal more. Very low price elasticity implies just the opposite, that changes in price have little influence on demand. The rule of thumb: If Price elasticity of Demand > 1 then Demand is Price Elastic (Demand is sensitive to price changes) If Price elasticity of Demand = 1 then Demand is Unit Elastic If Price elasticity of Demand < 1 then Demand is Price Inelastic (Demand is not sensitive to price changes)

INTERPRETING VALUES OF PRICE ELASTICITY COEFFICIENTS

Perfectly inelastic demand

Perfectly elastic demand

Elasticities of demand are interpreted as follows: Value Ed = 0 - 1 < Ed < 0 Ed = - 1 - < Ed < - 1 Ed = - Descriptive Terms Perfectly inelastic demand Inelastic or relatively inelastic demand Unit elastic, unit elasticity, unitary elasticity, or unitarily elastic demand Elastic or relatively elastic demand Perfectly elastic demand

A decrease in the price of a good normally results in an increase in the quantity demanded by consumers because of the law of demand, and conversely, quantity demanded decreases when price rises. As summarized in the table above, the PED for a good or service is referred to by different descriptive terms depending on whether the elasticity coefficient is greater than, equal to, or less than 1. That is, the demand for a good is called:

Relatively inelastic when the percentage change in quantity demanded is less than percentage change in price (so that Ed > - 1); Unit elastic, unit elasticity, unitary elasticity, or unitarily elastic demand when percentage change in quantity demanded is equal to the percentage change in price that Ed = - 1); and Relatively elastic when the percentage change in quantity demanded is greater than percentage change in price (so that Ed < - 1).

the the (so the

As the two accompanying diagrams show, perfectly elastic demand is represented graphically as a horizontal line, and perfectly inelastic demand as a vertical line. These are the only cases in which the PED and the slope of the demand curve (P/Q) are both constant, as well as the only cases in which the PED is determined solely by the slope of the demand curve (or more precisely, by the inverse of that slope). DETERMINANTS The overriding factor in determining PED is the willingness and ability of consumers after a price change to postpone immediate consumption decisions concerning the good and to search for substitutes. A number of factors can thus affect the elasticity of demand for a good

Availability of substitute goods: the more and closer the substitutes available, the higher the elasticity is likely to be, as people can easily switch from one good to another if an even minor price change is made. There is a strong substitution effect. If no close substitutes are available the substitution of effect will be small and the demand inelastic. Percentage of income: the higher the percentage of the consumer's income that the product's price represents, the higher the elasticity tends to be, as people will pay more attention when purchasing the good because of its cost; the income effect is substantial.

When the goods represent only a negligible portion of the budget the income effect will be insignificant and demand inelastic, Necessity: the more necessary a good is, the lower the elasticity, as people will attempt to buy it no matter the price, such as the case of insulin for those that need it. Duration: for most goods, the longer a price change holds, the higher the elasticity is likely to be, as more and more consumers find they have the time and inclination to search for substitutes. When fuel prices increase suddenly, for instance, consumers may still fill up their empty tanks in the short run, but when prices remain high over several years, more consumers will reduce their demand for fuel by switching to carpooling or public transportation, investing in vehicles with greater fuel economy or taking other measures. This does not hold for consumer durables such as the cars themselves, however; eventually, it may become necessary for consumers to replace their present cars, so one would expect demand to be less elastic. Breadth of definition of a good: the broader the definition of a good (or service), the lower the elasticity. For example, Company X's fish and chips would tend to have a relatively high elasticity of demand if a significant number of substitutes are available, whereas food in general would have an extremely low elasticity of demand because no substitutes exist. Brand loyalty: an attachment to a certain brandeither out of tradition or because of proprietary barrierscan override sensitivity to price changes, resulting in more inelastic demand. Who pays: where the purchaser does not directly pay for the good they consume, such as with corporate expense accounts, demand is likely to be more inelastic.

Cross elasticity of demand The cross elasticity of demand or cross-price elasticity of demand measures the responsiveness of the demand for a good to a change in the price of another good. It is measured as the percentage change in demand for the first good that occurs in response to a percentage change in price of the second good. For example, if, in response to a 10% increase in the price of fuel, the demand of new cars that are fuel inefficient decreased by 20%, the cross elasticity of demand would be:

. FORMULA The formula used to calculate the coefficient cross elasticity of demand is

Or

RESULTS FOR MAIN TYPES OF GOODS Complementary goods: In the example above, the two goods, fuel and cars (consists of fuel consumption), are complements; that is, one is used with the other. In these cases the cross elasticity of demand will be negative, as shown by the decrease in demand for cars when the price of fuel increased. Substitution goods: Where the two goods are substitutes the cross elasticity of demand will be positive, so that as the price of one goes up the demand of the other will increase. For example, in response to an increase in the price of carbonated soft drinks, the demand for non-carbonated soft drinks will rise. In the case of perfect substitutes, the cross elasticity of demand is equal to positive infinity. Independent goods: Where the two goods are independent, or, as described in consumer theory, if a good is independent in demand then the demand of that good is independent of the quantity consumed of all other goods available to the consumer, the cross elasticity of demand will be zero: as the price of one good changes, there will be no change in demand for the other good.

Two goods that complement Two goods that are substitutes Two goods that are independent

each other show a negative have a positive cross elasticity have a zero cross elasticity of cross elasticity of demand: as of demand: as the price of good demand: as the price of good Y the price of good Y rises, the Y rises, the demand for good X rises, the demand for good X demand for good X falls rises stays constant When goods are substitutable, the diversion ratio, which quantifies how much of the displaced demand for product j switches to product i, is measured by the ratio of the cross-elasticity to the own-elasticity multiplied by the ratio of product i's demand to product j's demand. In the discrete case, the diversion ratio is naturally interpreted as the fraction of product j demand which treats product i as a second choice measuring how much of the demand diverting from product j because of a price increase is diverted to product i can be written as the product of the ratio of the cross-elasticity to the own-elasticity and the ratio of the demand for product i to the demand for product j. In some cases, it has a natural interpretation as the proportion of people buying product j who would consider product i their "second choice". PROPERTIES if, we assume that both A and B are ordinary goods (quantity demanded decreases with increase in price) and normal goods (quantity demanded increases with increase in disposable income). In the absence of these assumptions, more interesting and complicated variations of the possibilities below can occur. FACTORS AFFECTING CROSS-PRICE ELASTICITY OF DEMAND There are three kinds of factors affecting cross-price elasticity of demand. As above, B is the good whose price is changed and we measure the effect of this change on the quantity of A demanded. Condition on relationship between goods none How it affects cross-price elasticity of demand

Effect income effect

Explanation of effect

A finite income imposes a This depends on the (own)budget constraint. An price elasticity of demand of increase in the price of B B. If its magnitude is greater changes the quantity than 1, the total money spent consumed and hence the on B declines with an total money spent on B. increase in price, leaving This in turn changes the more money free for effective available income consuming A -- thus it tends for other purposes, to make the cross-price including the consumption elasticity of demand more of A. positive. If the magnitude of own-price elasticity of demand of B is less than 1,

the total money spent on B increases as price increases, leaving less money for A, thus it tends to make the cross-price elasticity of demand more negative. A change in the price of B A and B are substitute affects the quantity of B goods: they substitute demanded. By the law of (partially or wholly) for demand, the quantity substitution each other -- i.e., having demanded decreases with effect more of A reduces the an increase in price. This marginal utility of in turn affects the utility obtaining B, and vice function of A, and hence, versa the quantity demanded at a given price. A change in the price of B affects the quantity of B A and B are demanded. By the law of complementary goods: demand, the quantity complementary having more of A demanded decreases with effects increases the marginal an increase in price. This utility of B and vice in turn affects the utility versa. function of A, and hence, the quantity demanded at a given price. SIGN The sign of the cross-price elasticity of demand depends on the relative extent of operation of the various factors that influence the cross-price elasticity of demand noted above. In some cases, the sign is unambiguous, while in others, it is ambiguous. Is the magnitude of ownprice elasticity of demand of B greater than or less than 1? less than 1 less than 1 Do A and B complement or substitute for each other? complement substitute This tends to make the crossprice elasticity of demand more positive, because increasing price of B lower quantity of B increase in utility of consuming A increase in quantity of A demanded at a given price

This tends to make the crossprice elasticity of demand more negative, because increasing price of B lower quantity of B decrease in utility of consuming A decrease in quantity of A demanded at a given price

Conclusion about sign of cross-price elasticity negative ambiguous but typically positive; positive if substitution effect dominates, which would be the case for close substitutes. ambiguous; sign depends on whether the complementary effect or income effect is stronger.

greater than 1

complement

greater than 1

substitute

positive

IMPORTANCE OF CROSS PRICE ELASTICITY OF DEMAND FOR BUSINESS Business strategies evaluation: If a business can accurately estimate cross elasticity of demand then it can evaluate the impact of the pricing strategies of their rivals on their products. In the same time, they can be useful in formulating pricing strategies of complementary products. For example a firm can formulate pricing strategies if they have complementary products depending on the cross elasticities of demand to increase sales and improve profitability by analyzing the cross elasticities of demand. Another application is to the pricing strategies to reduce congestion and to promote public mass transport in peak hour by charging or increasing tolls at peak hour and its impact of reducing in congestion on major roads. Formulation of wage policies: The cross elasticity of demand is also useful in analyzing wage policies on different groups. For example if cross elasticities for different groups of young people say male and female then it may show the impact of setting wage levels on the replacement by females by men and the degree they are replaced. Impact of indirect taxes on products: It is also useful for government to study the impact of indirect taxes on the complementary and substitute products. For example if say government say introduces and indirect tax on tobacco then it can study the price changes on complementary and substitute products and there fore evaluate the effectiveness of indirect taxes to curb tobacco products and reduce health problems. Power generation: The concept is also useful in power generation. For example, one can study the impact of the price of one source of energy on the other sources if cross elasticity of demand can estimated fairly accurately.

Income elasticity of demand Income elasticity of demand measures the responsiveness of the demand for a good to a change in the income of the people demanding the good, holding all prices constant. It is calculated as the ratio of the percentage change in demand to the percentage change in income. For example, if, in response to a 10% increase in income, the demand for a good increased by 20%, the income elasticity of demand would be 20%/10% = 2. MATHEMATICAL DEFINITION

More formally, the income elasticity of demand, for a good is

, for a given Marshallian demand function

Or alternatively:

This can be rewritten in the form:

With income I, and vector of prices . Many necessities have an income elasticity of demand between zero and one: expenditure on these goods may increase with income, but not as fast as income does, so the proportion of expenditure on these goods falls as income rises. This observation for food is known as Engel's law.

INTERPRETATION

Inferior goods' demand falls as consumer income increases.

A negative income elasticity of demand is associated with inferior goods; an increase in income will lead to a fall in the demand and may lead to changes to more luxurious substitutes. A positive income elasticity of demand is associated with normal goods; an increase in income will lead to a rise in demand. If income elasticity of demand of a commodity is less than 1, it is a necessity good. If the elasticity of demand is greater than 1, it is a luxury good or a superior good. A zero income elasticity (or inelastic) demand occurs when an increase in income is not associated with a change in the demand of a good. These would be sticky goods.

Income elasticity of demand can be used as an indicator of industry health, future consumption patterns and as a guide to firms investment decisions. For example, the "selected income elasticities" below suggest that an increasing portion of consumer's budgets will be devoted to purchasing automobiles and restaurant meals and a smaller share to tobacco and margarine. PRICE ELASTICITY OF SUPPLY: Price elasticity of supply (PES) is an elasticity defined as A numerical measure of the responsiveness of the supply of a given good to a change in the price of that good. DETERMINANTS OF PRICE ELASTICITY OF SUPPLY: Availability of raw materials: for example, availability may cap the amount of gold that can be produced in a country regardless of price. Likewise, the price of Van Gogh paintings is unlikely to affect their supply. Length and complexity of production: Much depends on the complexity of the production process. Textile production is relatively simple. The labor is largely unskilled and production facilities are little more than buildings - no special structures are needed. Thus the PES for

textiles is elastic. On the other hand, the PES for specific types of motor vehicles is relatively inelastic. Auto manufacture is a multi-stage process that requires specialized equipment, skilled labor, a large suppliers network and large R&D costs. Time to respond: The more time a producer has to respond to price changes the more elastic the supply. Supply is normally more elastic in the long run than in the short run for produced goods, since it is generally assumed that in the long run all factors of production can be utilized to increase supply, whereas in the short run only labor can be increased, and even then, changes may be prohibitively costly. For example, a cotton farmer cannot immediately (i.e. in the short run) respond to an increase in the price of soybeans because of the time it would take to procure the necessary land. Excess capacity: A producer who has unused capacity can (and will) quickly respond to price changes in his market assuming that variable factors are readily available. Inventories: A producer who has a supply of goods or available storage capacity can quickly increase supply to market. Various research methods are used to calculate price elasticities in real life, including analysis of historic sales data, both public and private, and use of present-day surveys of customers' preferences to build up test markets capable of modeling such changes. Alternatively, conjoint analysis (a ranking of users' preferences which can then be statistically analyzed) may be used. Graphical representation of Price elasticity of supply Graphical representation of Price elasticity of supply is stated as under Figure-1

Figure-2

When supply is perfectly inelastic, a shift in the demand curve has no effect on the equilibrium quantity supplied onto the market. Examples include the supply of tickets for sports or musical venues, and the short run supply of agricultural products (where the yield is fixed at harvest time) the elasticity of supply = zero when the supply curve is vertical. When supply is perfectly elastic a firm can supply any amount at the same price. This occurs when the firm can supply at a constant cost per unit and has no capacity limits to its production. A change in demand alters the equilibrium quantity but not the market clearing price. When supply is relatively inelastic a change in demand affects the price more than the quantity supplied. The reverse is the case when supply is relatively elastic. A change in demand can be met without a change in market price.

CONCLUSION In conclusion, economics is a social science of human needs and wants that must be satisfied. In market economies, consumers can exercise their right to buy whatever they want. However, consumers will only purchase certain goods in certain quantities at certain prices; if there is a price change, quantity demanded will adjust correspondingly. This is where price elasticity of demand comes in, measuring the responsiveness or sensitivity of the quantity demanded to changes in price using methods such as the total outlay method. Finally, this information is important to businesses, which need to find their optimal pricing policy in order to achieve their goal of maximizing profits, as well as to governments, which need to price their own goods and services and determine indirect taxes imposed on goods and services. The price elasticity of supply is used to see how sensitive the supply of a good is to a price change. The higher the price elasticity, the more sensitive producers and sellers are to price changes. Very high price elasticity suggests that when the price of a good goes up, sellers will supply a great deal less of the good and when the price of that good goes down, sellers will supply a great deal more. A very low price elasticity implies just the opposite, that changes in price have little influence on supply. The concept of cross price elasticity of demand is an important concept in microeconomics. The concept is useful for business and government in formulating pricing strategies and their micro effects. In addition, it also useful to classify products in to substitutes and complimentary products so that it can be studied separately. In summary, the concept of cross elasticity of demand with other concepts related to elasticity of demand is useful to business and government in a micro economic sense to formulate policies and to study their impact on demand patterns and evaluate policy effectiveness. Income elasticity of demand can be used as an indicator of industry health, future consumption patterns and as a guide to firms investment decisions.

Table of Contents

Law of demand
Mathematical expression Assumption Determinants of demand Limitation

Price elasticity of demand


HISTORY Calculating the Percentage Change in Quantity Demanded Interpretation of the Price Elasticity of Demand INTERPRETING VALUES OF PRICE ELASTICITY COEFFICIENTS DETERMINANTS

Cross elasticity of demand


FORMULA RESULTS FOR MAIN TYPES OF GOODS Properties Importance of Cross Price Elasticity of Demand for Business

Income elasticity of demand


MATHEMATICAL DEFINITION Interpretation

Price elasticity of supply

Determinants Of Price elasticity of supply Graphical representation of Price elasticity of supply

Conclusion References

Submitted to
Ms Samera Azmat

Submitted by
Maryam Shahid Gulzar Roll no-52 Bs-Hon (I) Economics Section-A