Micro Econ VEE 1.1 - Demand Analysis

Economics

Study of production, distribution, and consumption

Macroeconomics

Deals with aggregate economic quantities

Microeconomics

Focuses on individual economic units

Demand and supply analysis is key to microecon

Consumers drive demand and strive to maximize utility (happiness).

Firms create supply and seek to maximize profits

Quantity demanded by consumers depends on many factors such as

price of the good, consumer income, and prices of other goods

Law of Demand

Consumers will demand more of a good or service if its own price drops

Demand Function

Q(d,x) = f(P(x), I, P(y))

where

Q(d,x) = Quantity demanded for good X

P(x) = Price per unit of good X

I = Consumer income

P(y) = Price of another good Y

Demand functions often linear

Independent variables drive the demand. Impact of one independent variable is studied by keeping the other independent variables constant

Inverse Demand Function

When the price P(x) is calculated from the demand function

Demand Curve

Graph of the inverse demand function. Price on vertical axis and quantity demanded on the horizontal axis. Represents the highest quantity purchased at each price or the highest price paid for each quantity. Slope is the change in price divided by the change in quantity

Shortcut for slope of the demand curve

Slope is the reciprocal of the price coefficient in the demand function

Elasticity

Ratio of percentage changes and does not depend on underlying units

Own-Price Elasticity of Demand

E(d,P(x))

= % Change Q(d,x) / % Change P(x)

= (Change in Q(d,x) / Change in P(x)) * (P(x) / Q(d,x))

Interpretation: If the price increases by 1%, the quantity demanded would inc/dec by xxx%

Inelastic Own-Price Elasticity

Demand that is not very sensitive to price.

Elasticity value between -1 and +1

Elastic Own-Price Elasticity

Demand that is sensitive to price changes.

Elasticity value less than -1 or greater than +1

Unit Elastic

When elasticity = -1. Midpoint of the demand curve when linear

If the law of demand holds,

own-price elasticity should be negative.

i.e. increase in own price leads to decrease in quantity demanded and vice versa

For typical linear demand curves with negative slopes, demand is elastic for lower quantities and inelastic for higher quantities

Because the slope is constant (change in quantity / change in price in elasticity formula) and the ratio of price to quantity (P/Q) decreases as quantity increases

Vertical Demand Curve

Quantity demand is same regardless of the price. Not possible at all prices but often true over specified price range. Then the demand is perfectly inelastic (zero elasticity)

Perfectly Inelastic

Zero elasticity, demand curve is vertical

Horizontal Demand Curve

Consumers will buy an infinite amount at a given price but none at a price just a bit higher. Often true for companies in perfectly competitive markets like the wheat market. Demand is perfectly elastic (infinite elasticity)

Perfectly Elastic

Infinite elasticity, horizontal line

Close Substitutes

If there are close substitutes for a product, then own-price elasticity of demand is likely high. Could just switch to competitor's product.

If no close substitutes then demand is much less elastic

Part of Budgets

If product is a small portion of people's budget, then the demand elasticity is low. Ex. toothpaste prices rising 10%

Long-Run vs Short-Run Demand

Long run demand is typically more elastic than short-run demand. Consumers have more time to adjust behaviors to changing prices. NOT true for durable goods like washing machines. React in the short run but not more quantity in long run

Discretionary vs Non-Discretionary Goods

Non-discretionary goods like flour have less price elasticity relative to discretionary goods like eating out at restaurants

Total Expenditure

Total Expenditure = Price * Quantity

As price increases, demand decreases but total exp may increase or decrease when price increases

If demand is elastic, price and total exp move in OPPOSITE directions. Price decreases, then Total exp increases. % change in quantity is larger than the % change in price

If demand is inelastic, price and total exp move in the same direction. Price increase, then total exp increases too

Maximized at the unit elastic point of the demand curve

Income Elasticity of Demand

Percentage change in quantity demanded divided by the percentage change in income

E(d,I) = % Change Q(d,x) / % Change I

= (Change Q(d,x) / Change(I)) * (I / Q(d,x))

Income Elasticity of Demand Interpretation

Can be negative, positive, or zero.

Most consumption goods have positive income elasticity, so they are called normal goods. Quantity demanded increases when income increases

Goods with negative income elasticity are called inferior goods. Ex. rice, cheap cuts of meat.

Same good or services can be normal for one market and inferior for another market

Cross-Price Elasticity of Demand

Like own price elasticity but this time with the price of a different good

E(d,P(y)) = (% Change Q(d,x)) / (% Change P(y))

= (Change Q(d,x) / Change P(y)) * (P(y) / Q(d,x))

Positive for close substitutes. As price rises on good Y, people more inclined to purchase more of good X

Negative for goods that are complements. Goods that are normally consumed together. Ex. Peanut butter and jelly, ice cream and ice cream cones, hot dogs and hot dog buns

The negative slope of the demand curve is caused by

the substitution and income effect

Substitution Effect

when a price changes, consumers have an incentive to consume less of the good with a relatively higher price and more of the good with a relatively lower price; always happens simultaneously with an income effect

Income Effect

the change in the quantity demanded of a good that results from the effect of a change in the good's price on consumers' purchasing power

Normal Goods

An increases in income causes the consumers to buy more of the good or service

Ex. Eating out at restaurants

Substitution and income effects work together; both cause the demand curve to have a negative slope

Inferior Goods

An increase in income causes the consumer to buy less of the good or service

Ex. Generic drinks

Income effect pushes demand curve to have a positive slope while the substitution effect will create a negative slope. The two are working against each other

Normal vs Inferior Goods

Same good could be normal for some groups and inferior for others.

Ex. Fast food for lower-income groups. Income rises, then eat more fast food.

vs

Fast good for Affluent groups. Income rises, then less fast food and more at fancy restaurants

Substitution effect always leads to buying more of a good when its price drops

Income effect will differ for normal goods and inferior goods.

Normal goods: Rise in income will trigger a rise in consumption.

Inferior goods: Rise in income will reduce consumption

Giffen Goods

When income effect overpowers the substitution effect for some inferior goods. More of a good is consumed as the price rises. Here the slope of the demand curve would be positive

Veblen Goods

Some goods where a high price tag may drive consumer demand. Ex. Fancy jewelry or cars. Have a positively sloped demand curve