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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

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what is a market
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 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
Types of Demands
  • Individual Demand – Demand of goods and services by an individual/household
    • Joint 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)
  • Market Demand – Demand for all Individuals/ households
types of demands1
Types of Demands
  • Non Durable and Durable Good demand
    • Non-durable good – goods that are perishable (like vegetables, milk)
    • Durable good – goods that can last for long (furniture, electronics)
  • Company demand and Industry demand
    • Company demand – demand of a single firm
    • Industry demand – demand of all firms in the industry
  • Demand for consumer goods (consumed immediately) and producer goods (capital goods)
  • Short-Run and Long-Run demand
demand definition
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
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
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
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 curve
Demand Curve

Also known as the inverse demand curve as the diagram is the inverse of the demand function Qx =f(P)

The demand curve has a negative slope, consistent with the law of demand.

D

slide15

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
slide16
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
Demand curve shifts to the right

This demand curve has shifted to the right. Quantity demanded is now higher at any given price.

D

demand curve shifts to the left
Demand curve shifts to the left

This demand curve has shifted to the left. Quantity demanded is now lower at any given price.

D

important to remember
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
Market Demand

To get the Market Demand: Horizontal Summation across the individual Demand Curves

consumer surplus
Consumer Surplus

Price

D

  • 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 = Total Willing to pay – Actual Payment

= 0DEQ – OPEQ

= DEP

Consumer Surplus

E

P

Actual Expenditure

O

Q

Qty

supply definition
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
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
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 curve
Supply Curve

The supply curve has a positive slope, consistent with the law of supply.

S

market equilibrium determination market price
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
At $ 35,

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 Surplus

The Market clearing process

Price of tomatoes (dollars per kg.)

40

Supply

Excess supply

Case 1

35

1

2

3

30

Market equilibrium

25

Demand

0

200

170

300

Hence 200 unit is said to be the equilibrium quantity and the market (equilibrium) price is said to be 30

market equilibrium case of a shortage
At $ 25,

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

Market Equilibrium: Case of a Shortage

The Market clearing process

Price of tomatoes (dollars per kg.)

40

Supply

35

30

Market equilibrium

5

4

6

Case 2

25

Excess demand

Demand

0

100

200

220

Hence 200 unit is said to be the equilibrium quantity and the market (equilibrium) price is said to be 30

what is an elasticity
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
slide31

Elasticity

3 basic types of demand elasticities:

  • Price elasticity of demand
  • Income elasticity of demand
  • Cross elasticityof demand
price elasticity of demand ped
Price Elasticity of Demand (PED)
  • Price elasticity of demandmeasures 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.
slide33

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.
examples of own price demand elasticities
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
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
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.
slide37

$5

1. A 25%

increase

in price...

$4

50

100

2. ...leads to a 50% decrease in quantity.

Elastic Demand- Elasticity is less than -1

Price

Quantity

slide38

$5

1. A 25%

increase

in price...

$4

90

100

2. ...leads to a 10% decrease in quantity.

Inelastic Demand- Elasticity is greater than -1

Price

Quantity

slide39

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.
slide40

Demand

$5

1. An

increase

in price...

4

100

Perfectly Inelastic Demand- Elasticity equals 0

Price

Quantity

2. ...leaves the quantity demanded unchanged.

slide41

Demand

$4

Perfectly Elastic Demand- Elasticity equals minus infinity

Price

At any price

above $4, quantity

demanded is zero.

At a price of $4,

quantity demanded is infinite.

Quantity

slide42

$5

1. A 25%

increase

in price...

$4

Demand

75

100

2. ...leads to a 25% decrease in quantity.

Unit Elastic Demand (Rectangular Hyperbola)- Elasticity equals 1

Price

Quantity

slide43

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.
slide44

Computing Income Elasticity

  • If YED > 1 demand is income elastic (Luxury/Superior)
  • If YED > 0 and < 1 demand is income inelastic
slide45

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 incomeraises the quantity demanded fornormal goodsbut lowers the quantity demanded forinferior goods.
slide46

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
slide47

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)
slide49

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
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??

slide51

How can elasticities be useful??Elasticity and Total Revenue

  • Total revenueis 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
Elasticity and Total Revenue

Price

Total revenue is price x quantity sold. In this example, TR = £5 x 100,000 = £500,000.

This value is represented by the grey shaded rectangle.

£5

Total Revenue

D

100

Quantity Demanded (000s)

slide53

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

TotalRevenue

D

100

140

Quantity Demanded (000s)

elasticity and total revenue1
Elasticity and Total Revenue

Price (£)

Producer decides to lower price to attract sales

10

% Δ Price = -50%

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 revenue2
Elasticity and Total Revenue

Price (£)

Producer decides to reduce price to increase sales

% Δ in Price = - 30%

% Δ in Demand = + 300%

Ped = - 10 (Elastic)

Total Revenue rises

10

Good Move!

7

D

20

5

Quantity Demanded

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.

slide56

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
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 elasticity1
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
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 behaviour1
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 whohas 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
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 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 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
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:
slide66

Diagram: Total and Marginal Utility

Important to note that Marginal values are plotted against the midpoint of unit consumed

slide67
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
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
indifference curve approach
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 approach1
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
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
        • then, X > Y and X > Z or X > 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
    • 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
An Indifference Curve
  • All these combinations can be represented on a simple graph
slope of the indifference curve
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
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
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:
    • 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

  • The Budget Line can be re-written as:
slide76
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
The Optimal Consumption point

At point t

MUx/MUy = Px/Py