Demand, Supply, and Elasticity in Economics
The demand curve
The law of demand establishes thatwhen price goes up there is a decrease in quantity demanded, and when price goes down, there is an increase in quantity demanded. We illustrate this by movements up and down the demand curve.
Shifts in the demand curve
-Financial ability to pay for the product
An individual’s income, or the purchasing power of their income after taxation
Availability of loans/credit and the interest rate that must be paid on loans or credit card balances
NORMAL GOODS (negative sign value) : As income rises, demand for the majority of goods and services also increases.
INFERIOR GOODS (positive sign value): As income increases, demand decreases. This happens, for example, with second hand products.
Note: for all Normal goods, PED will be negative, as there is a negative relationship between price and quantity.
-Our attitudes towards the product itself
-The price, availability and attractiveness of related products
Two categories:
Substitute goods: Alternatives that satisfy essentially the same wants or needs. In other words, products bought in place of each other. E.G. Tea and coffee.
Complementary goods: Products that enhance the satisfaction we derive from another product. Basically, products bought with each other. E.G. Toothbrush and tooth paste. Changes in price attractiveness of one of these products will have an impact on the demand for the complementary good. This is known as joint demand.
-Other demand-influencing factors
This would include weather, population changes, expectations of the future, etc.
The concept of elasticity
Any change in price or change in another influencing factor on the equilibrium position.
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Elastic demand (a strong response to change in price)
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Inelastic demand (a weak response to change in price)
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Unitary (or unit elastic)
demand (a proportional response to price change)
Price Elasticity of Demand (PED)
Numerical measure of the responsiveness of demand for a product following a change in the price of that product.
If demand is ELASTIC, (1<>∞) then a small change in price will result in a relatively large change in quantity demanded.
If demand is INELASTIC, (0<><1) then=”” a=”” large=”” change=”” in=”” price=”” will=”” result=”” in=”” a=”” lesser=”” change=”” in=”” quantity=””>1)>
The formula we use is: (% change in quantity demanded / % change in price of that product.)
Factors affecting price elasticity of demand
-The range and attractiveness of substitutesLarge number of substitutes = Elastic (+PED). -the quality and accessibility of information that consumers have about products that are available to satisfy particular wants and needs. -the degree to which people consider the product to be a necessity.-the addictive properties of the product. -the brand image of the product
-The relative expense of the product: Luxuries have high PED whilst necessities have low PED. A rise in price will reduce the purchasing power of a person’s income. The larger the proportion of income that the price represents, the larger will be the impact on the consumer’s real income level of change in the product’s price.
-Time:If the price of a product goes up and stays up then over time people will find ways of adapting and adjusting, so the PED is likely to increase over time.
Income Elasticity of Demand (YED)
YED is a numerical measure of the responsiveness of demand following a change in income alone. Once again if demand is responsive to changes, it will be classified as elastic; if unresponsive, it is inelastic.
YED: (% change in quantity demanded / % change in income)
If an increase in income leads to an increase in demand (normal good) the YED will be a positive value. If an increase in income causes a decrease in demand (inferior good) the YED will be a negative value.
If sign is (+) normaal good. If is (-) inferior good. If number is (>1) elastic. (<1)>1)>
Cross Elasticity of Demand (XED)
Is a numerical measure of the responsiveness of demand for one product following a change in the price of another related product alone.
XED: (% change in quantity demanded of product A / % change in price of product b).
-Products that are substitutes for each other will have positive values for XED. (If the price of B goes up, then people will begin to turn to product A because of its more favorable price)
-Products that are compliments will have negative values of XED. (If the price of B goes up, the quantity demanded of B will drop and so will the complementary demand of A)
The supply curve
The LAW OF SUPPLY establishes:
-When price goes up, there is an increase in quantity supplied
-When price goes down, there is a decrease in quantity supplied
Main causes of shifts in the supply curve
-The costs associated with supplying the product:
Companies will make supply decisions on the basis of the price they can get for selling the product in relation to the cost of supplying it.
-The size, structure and nature of the industry
-Government policy:
Legislation designed to protect consumers or workers may impose additional costs on companies and this may affect the supply curve. Governments mat also impose a specific tax as excise duties (indirect taxes on the consumption or the use of certain products) on the output of companies or an ad valorem tax such as value added tax on sales.
-Other supply-influencing factors:
Weather conditions, e.G. Affecting agricultural production; expectations of future prices;
joint supply cases (where the supply of one product increases the supply of another, e.G. Beef and leather);
competitive supply (where the supply of one product reduces the supply of another), etc.
Price Elasticity of Supply (PES)
Numerical measure of the responsiveness of supply to change in the price of the product alone.
PES: (% Change in quantity supplied / % change in price).
Since the relationship between price and quantity supplied is normally a direct one, the PES will tend to take on a positive value.
-If PES is greater than 1, then we say supply is relatively price elastic i.E. Supply is responsive
-If PES is less than 1, supply is relatively price inelastic i.E. Supply is unresponsive
Factors affecting price elasticity of supply
-The ease with which firms can accumulate or reduce stocks of goods. Stocks allow companies to meet variations in demand through output changes rather than price changes. The more easily manufacturing firms can do this, the higher the PES. Companies that provide services are, of course, unable to provide stocks.
-The ease with which they can increase production. Firms and industries with spare productivity capacity will tend to have a higher PES. Shortages of critical factor inputs (skilled workers, components, fuel) will often lead to an inelastic PES.
-Time: Over time, companies can increase their productive capacity by investing in more capital equipment, often taking advantage of technological advances. Equally, over time, more firms can enter or leave an industry and this will increase the flexibility of supply.
Changes in the equilibrium
The term equilibrium refers to a situation of balance where at least under present circumstances there is no tendency for change to occur.
Will happen if there is a disturbance to the present market conditions.
Any change in demand or supply.
Change in supply: If there is an increase in supply (shift to the right), then at the original price there is disequilibrium due to the excess supply. This would be eliminated as price falls towards its new equilibrium level and the quantity traded in equilibrium rises.
-Change in demand
Consumer surplus
Consumer surplus arises because some consumers are willing to pay more than the given price for all but the last unit they buy.
-If the price increases then consumer surplus is reduced as some consumers are unwilling to pay the higher price.
´-A fall in the market price will lead to an increase in the consumer surplus because consumers who were previously willing to pay above the new market price now end up paying less.
Prices as rationing and allocative mechanism
-If a producer has limited capacity or wishes to restrict the supply of products, then increasing the price would be a good solution.
-Government may use the price mechanism as a means of rationing. E.G. Taxes
-The use of minimum price rations demand in relation to supply. To be effective it must be above the equilibrium price as determined by the free market.
-At the minimum price producers are willing to supply more than consumers are willing to demand. Therefore there is an excess supply. In this way the price mechanism rations demand, in, for example, demerit goods.