Micro Unit II

Demand

3 Important Requirements

  • Well-defined property rights

  • Response to incentives

  • The presence of constraints

Law of Demand

  • Decrease in price = increase in quantity demanded and vice-versa

    • Buyers determine the demand

  • Demand curves always slope downward

    • Diminishing Marginal Utility

    • Income Effect

      • When price falls, income purchasing power of consumers increases

    • Substitution Effect

      • When price increases, people will substitute the good with another

Market Demand Curves

  • To find a market demand curve:

    1. Market demand on the X axis

    2. Keep the price the same and put it on the Y axis

    3. Draw the new demand curve

  • Market Demand: adding the quantities that all consumers in the marketplace will buy at each price

Demand Shifters

  • Income

    • Increase in income = increase in demand and vice-versa

    • UNLESS the good is inferior, in which case demand decreases

  • Substitute good price

    • Increase in substitute price = increase in demand and vice-versa

  • Complimentary good price

    • Increase in compliment price = decrease in demand and vice-versa

  • Population

    • Increase in population = increase in demand and vice-versa

  • Future expectations

    • Increase in future expectations of price inflation = increase in demand and vice-versa

  • Style/Taste

    • Change in style over time; “fads”

Supply

Law of Supply

  • Increase in price = increase in quantity supplied and vice-versa

  • Producers/sellers determine supply

  • Supply curves always slope up to the right

Supply Shifters

  • Production Costs

    • Increase in cost production = decrease in supply and vice-versa

  • Technology

    • Increase in tech = increase in supply and vice-versa

  • Seller count

    • Increase in sellers = increase in supply and vice-versa

  • Expectations

    • Increase in future expectations of price inflation = decrease in supply and vice-versa

Price Elasticity of Demand

The price elasticity of demand

  • Measures how responsive quantity demanded is to changes in price

  • E_d = % change in Q_d / % change in P

Elastic vs inelastic demand

  • Elastic demand causes a significant decrease in Q_d for a price increase

    • The demand is extremely variable and dependent on demand

  • Inelastic demand causes an insignificant decrease in Q_d for a price increase

    • Quantity demanded is rather static

  • Shows the negative relationship between P and Q_d

  • Elasticity varies on a linear demand curve

    • More elastic at lower quantities

    • Less elastic at higher quantities

Value of demand price elasticity

  • For elastic:

    • E > 1

  • For inelastic:

    • E < 1

  • Unit elastic:

    • E = 1

    • Q_d changes by the same % as price changes

  • Perfectly elastic:

    • E = infinity

    • Q_d changes infinitely with any change in P

  • Perfectly inelastic:

    • E = 0

    • Q_d never changes with P

Total Revenue Test

  • If price and total revenue both increase/decrease, demand is inelastic

  • If they don’t, the demand is elastic

  • Total revenue = P * Q

Determinants of demand price elasticity

  1. Substitute availability

    • If there are many substitutes, the demand is elastic and vice versa

  2. Necessities vs luxuries

    • Necessary goods are more inelastic

  3. Proportion of budget

    • Major expenses will be much more susceptible to price changes and thusly more elastic the more percentage of a budget they are

  4. Time

    • Demand naturally becomes more elastic over time (more time to adjust)

    • Could also mean: demand becomes more elastic the longer customers have to adjust to a change (if there is a major upcoming event, buyers may plan for the causality)

Price Elasticity of Supply

The price elasticity of demand

  • % change in Q_s / % change in P

  • Abides by the same elasticity rules as demand

Determinants of supply price elasticity

  1. Price of alternative inputs

    • If it’s easier to use alternative inputs, the supply is more elastic

  2. Time

    • Supply becomes more elastic the longer producers have to adjust to price changes

    • Supply naturally becomes elastic in the long run

  3. “Ease and speed”

    • If it’s easy to get products out to market no matter the price of inputs, supply is more elastic

Other Elasticities

Income elasticity of demand

  • Elasticity can also be measured in terms of income, not just price

  • % change in Q_d / % change in income

  • If income elasticity is positive, the good is normal

  • If income elasticity is negative, the good is inferior

Cross price elasticity of demand

  • “If the price of one good increases, how does that affect the demand of another good?”

  • Determines whether goods are complements, substitutes, or unrelated

  • % change in Q_d,x / % change in P_y

  • If positive, the goods are substitutes

  • If negative, the goods are complements

  • If zero, the goods are unrelated

Market Equilibrium and Consumer and Producer Surplus

Market Equilibrium

  • The intersection of supply and demand

  • Q_d = Q_s

  • The price is such that buyers wish to purchase the same amount sellers wish to sell

  • There is no shortage or surplus

Surplus

  • Consumer surplus: the benefit a consumer receives from paying less than the price they are willing to pay

    • difference in price willing to pay and the equilibrium price (WTP - P_e)

  • Producer surplus: the benefit a seller receives from selling at a price higher than the price they are willing to sell

    • difference between the amount a seller charges and the price they would be willing to sell (P_e - WTS)

  • Both surpluses can be calculated at the individual level and then summed up for the entire market

  • The sum of CS and PS is maximized at equilibrium if there are no market failures

Market Disequilibrium and Changes in Equilibrium