Economics for CED

Economics for CED Noémi GiszpencSpring 2004Lecture 2: Micro: Demand February 17, 2004

Another definition • Dignified: “the forces which determine the detailed composition and distribution of the national product.” • Short:“who makes what, when, how, and who gets it.” • Shortest:“microeconomics” Economics for CED: Lecture 2, Noémi Giszpenc

Production comes from Demand • But where does demand come from? • People want goods and services • Marketers would say: people want certain needs met--don’t especially want a particular product • And they want them supplied in particular ways • Modes of supply include household production, government/public supply, or market supply Economics for CED: Lecture 2, Noémi Giszpenc

2 types of demand • primary & derived • derived demand is demand caused by suppliers’ desire to meet primary demand • the causes of primary demand include Tastes and Prices • What else has an effect on primary demand? Economics for CED: Lecture 2, Noémi Giszpenc

The proximate causes of demand Tastes: A Effective Demand Prices: B Economics for CED: Lecture 2, Noémi Giszpenc

people want to know about longer causal chains if they are interested in intervention(e.g. marketers, do-gooders,the government) Tastes: A1 A2 A3 Effective Demand Prices: B1 B2 B3 Other: (e.g.laws) C1 C2 C3 Economics for CED: Lecture 2, Noémi Giszpenc

Demand Theory • The Quantity of a good that a consumer demands is likely influenced by… • Price (if P,  QD) • Exceptions include: • Expectations (future Price) • Natural limits (“inelastic demand”): salt, TP • Inferior goods • Showing off • Price as signal of quality (fooling people) Economics for CED: Lecture 2, Noémi Giszpenc

The Quantity of a good that a consumer demands is likely influenced by… • Prices of other goods • If A, B are substitutes, then (PA QDB) • If A, B are complements, then (PA QDB) • Income effects • Caused if one of the goods that you are consuming a lot of costs much more or much less--this will shift your consumption of many other goods as you adjust your spending Economics for CED: Lecture 2, Noémi Giszpenc

The Quantity of a good that a consumer demands is likely influenced by… • Amount of Income • The amount you can buy is called “real income” • Determines some saving v. spending decisions • Effects are different for different goods • Normal goods (if Income (Y) ,  QD ) • Inferior goods (Y  QD ) • Sufficient goods (Y  QD ≈) (Enough is enough!) • Nation’s distribution of income affects overall country’s spending patterns Economics for CED: Lecture 2, Noémi Giszpenc

The Quantity of a good that a consumer demands is likely influenced by… • Tastes & Preferences • The “x” factor! Economics for CED: Lecture 2, Noémi Giszpenc

Tastes & Preferences: Utility • Each good has diminishing marginal Utility (MU) • As long as MU is positive (+), more of the good brings more total U but diminishing MU U oz. salmon Economics for CED: Lecture 2, Noémi Giszpenc

Tastes & Preferences: Utility • Although “utility” is not comparable from person to person (remember Pareto?), people can compare their own MUs for different goods. • They demonstrate this by spending such that the last dollar spent on every good brings the same MU as every other good bought • Leads to “consumer equilibrium” • As long as income, prices, and tastes don’t change! Economics for CED: Lecture 2, Noémi Giszpenc

Tastes & Preferences: Utility straw-berries “iso-utils” or “indifference curves” U strawberries oz. salmon oz. salmon Economics for CED: Lecture 2, Noémi Giszpenc

Tastes & Preferences: Utility… straw-berries • At A, “price” of salmon in strawberries is high • At B, “price” of strawberries in salmon is high • (not market prices, but what person would give up) A B oz. salmon Economics for CED: Lecture 2, Noémi Giszpenc

Tastes & Preferences: Indifference straw-berries • Say: household income is fixed: $8/day. All is spent on salmon & s.b. • Budget: Psalmon=$1/oz,Psb=20 cents ea. 40 Budget constraint oz. salmon 8 Economics for CED: Lecture 2, Noémi Giszpenc

Tastes & Preferences: Indifference straw-berries • WhenMUsal PsalMUsb Psbconsumer is maximizing U subject to the budget constraint Infeasible, given budget 40 = higher utility Feasible,but not asdesirable(lower utility) oz. salmon 8 Economics for CED: Lecture 2, Noémi Giszpenc

Utility & Indifference theory • Not very useful for practical purposes • BUT economists use it as a theoretical basis for recommendations • For example, against dedicated funds such as food stamps • Theory says: just giving people an equivalent amount of money (“lump-sum”) will make them better off (see graph) Economics for CED: Lecture 2, Noémi Giszpenc

The case of unwanted food Food • Say: household income is fixed: $10/day. All is spent on food & cigarettes. • Budget: Pcigs=$2/pack,Pfood=$5/meal. Budget constraint 2 cigs 5 Economics for CED: Lecture 2, Noémi Giszpenc

The case of unwanted food Food • Before: equilibrium spending is for 4 packs of cigs + 2/5 meal. • Add $10 in food stamps:where will spending be? new budget constraint 4 2 cigs 5 Economics for CED: Lecture 2, Noémi Giszpenc

The case of unwanted food Food • “corner solution”:5 packs of cigs + 2 meals • Higher U • What if person had simply received an extra $10 in cash? 4 budget if +$10 2 cigs 5 10 Economics for CED: Lecture 2, Noémi Giszpenc

The case of unwanted food Food • New equilibrium: 8 packs of cigs+ 4/5 meal. • Even higher U • What is “right” policy? • What are the goals? • What about “fungibility”? 4 2 cigs 5 10 Economics for CED: Lecture 2, Noémi Giszpenc

Tastes & preferences: Elasticity • In cigarette case, as Income went up, demand for food did not change much. • “Elasticity” ≈ “responsiveness” • If P,  QD, but by how much? (cet. par.) • If Y,  QD, by how much? • Also applies to supply: If P,  Qs, by how much? Economics for CED: Lecture 2, Noémi Giszpenc

Tastes & preferences: Elasticity • Some responses are fairly predictable • For bread, butter, etc. • Others influenced more by ads, weather, etc. • Ice cream, sports cars, etc. • Producers (marketers) want to know • Guided by PROFIT = Revenue - Costs∏ = PxQ - C(Q) • Note that it is possible to have lower total revenue (PxQ) but higher total Profit--depends on Elasticity, costs Economics for CED: Lecture 2, Noémi Giszpenc

Classifying Elasticity Economics for CED: Lecture 2, Noémi Giszpenc

Measuring Elasticity • E = %QD %P • If E < 1, demand is inelastic • If E = 1, demand is unit-elastic • If E > 1, demand is elastic Economics for CED: Lecture 2, Noémi Giszpenc

Measuring Elasticity: Caveats • Works better for small ∆s in P, Q, close to mid-range • Exaggerates at extremes: • At high P & low Q, small ∆s lead to BIG E • At low P & high Q, small ∆s lead to small E • In general, measurements very local, and only valid if nothing else changes (ceteris paribus) Economics for CED: Lecture 2, Noémi Giszpenc

Using Elasticity for Description • Necessaries (e.g. shelter, clothing, food, transport) tend to be relatively inelastic • If P,QD≈, spending cut on other things) • Luxuries more elastic • These two categories overlap: there are plain and fancy ways to meet needs Economics for CED: Lecture 2, Noémi Giszpenc

Using Elasticity for Description • Depends on how broad or narrow category of good is • If supply of necessary good is competitive (e.g. clothing), inelastic demand for (say) “underwear in general” coexists with highly elastic demand for each competing brand • In general, more narrow good: E more generic: E (e.g., “food”) Economics for CED: Lecture 2, Noémi Giszpenc

Using Elasticity for Description • As always: WHO WANTS TO KNOW determines what to calculate • Ex: E of demand for fresh vegetables for: • Manager of farmer’s market • Government taxer • Ingenious farmer who wants to know which vegetables to grow to get premium price Economics for CED: Lecture 2, Noémi Giszpenc

Cross-Elasticity • Complements (cars & gas) • If Pcars, QD(gas) • Substitutes (cars & public transport) • If Pcars, QD(public transport) • Close complements (sand & cement) • One pretty useless without the other • Loose complements (bread & butter) • Lots of uses for one without the other Economics for CED: Lecture 2, Noémi Giszpenc

Graphing Elasticity P P P elastic inelastic unit-elastic A A A B B B Q Q Q A<B A>B A=B Economics for CED: Lecture 2, Noémi Giszpenc

actually fairly common Graphing Elasticity P variably elastic elastic: “are you kidding with that P?” A middling: in the OK range B B2 inelastic: “enough’s enough” B1 C Q A<B+B1; B+B2>C Economics for CED: Lecture 2, Noémi Giszpenc

Income Elasticity of demand • EY = %∆QD (where Y=Income) %∆Y Economics for CED: Lecture 2, Noémi Giszpenc

Calculating Elasticity: Practicalities • Useful for: • Price/income (e.g. farm income) smoothing • Monopolist pricing • Taxation • For change in behavior (e.g. tobacco) • For revenue generation • Tariffs (similar to taxation) • Employment/Macro policy • Ex: tax breaks--what will people spend $ on? Economics for CED: Lecture 2, Noémi Giszpenc

Calculating Elasticity: Practicalities • Lots of uncertainties in measuring • Without ceteris paribus, there can be ∆ in: • Tastes • Propensity to save & spend • Consumers’ confidence • Supply conditions • International exchange rates, terms of trade • Past is a rough guess • Future forecast based on past patterns, which could change Economics for CED: Lecture 2, Noémi Giszpenc

Economics for CED