Economics Principles Quiz

Course Information

• Course Name: Agricultural Economics I
• Course Code: AEC 211
• Offered to Year: 2
• Academic Calendar: 2013/2014
• Course Lecturer: Maonga B.B. (PhD)

Topic 3: Theories of Demand and Supply

3.1 Demand

• Demand is a schedule or curve that shows the quantities of a product consumers are willing and able to purchase at various prices during a specific time period (ceteris paribus).
• Willingness alone is not effective in the market; it needs to be backed by purchasing power to be effective demand.

3.1.1 Ways of Showing Demand

• Demand can be shown in three ways:
  • Demand schedule (table form)
  • Demand curve (geometric or graphic form)
  • Demand function (mathematical form)

Presentation of Demand (1) (Demand Schedule)

• A hypothetical demand schedule for beef from a single consumer is displayed in table form.
• The schedule shows the relationship between different beef prices and quantities demanded per month.

Presentation of Demand (2) (Demand Curve)

• The inverse relationship between price and quantity demanded for a product is shown graphically using a two-dimensional graph.
• Quantity demanded is measured on the horizontal axis, and price is measured on the vertical axis.

Presentation of Demand (2) (cont'd)

• The downward slope of the demand curve reflects the law of demand.
• Law of demand states that price and quantity demanded have an inverse relationship - meaning that as price falls, quantity demanded rises, and vice versa.

Presentation of Demand (3) (Demand Function)

• The demand function presents a functional relationship between price and quantity demanded.
• The general mathematical form is Qdx = f(Px), where Qd is quantity demanded, Px is price, and f means function of or depends on.
• A linear relationship can be expressed as Qd = a + bPx, where a and b are parameters, and a is an intercept (constant), b is a coefficient.

Why Inverse Relationship Between Price and Quantity?

• Consistent with common sense: People buy more of a product at a lower price than a higher price.
• Diminishing marginal utility: In a specific time period, each buyer of a product gets less satisfaction from each successive unit consumed.

Law of Demand Further Explained

• Income effect: Lower price increases purchasing power, enabling a buyer to purchase more of the product.
• Substitution effect: Lower price incentivizes buyers to substitute less expensive products for relatively more expensive ones.

3.1.3 Individual Demand and Market Demand

• Individual demand focuses on one consumer's demand for a commodity.
• Market demand is derived by horizontally adding the quantities demanded by all consumers at different prices.

Horizontal Summation of Individual Demand Schedules to Produce Market Demand

• If there are three buyers in the market, total quantities are added at each price point.
• The price and total quantity demanded plot a point on the market demand curve.
• If there are many buyers, their quantities at each price can be multiplied by the number of buyers to get total market demand.

Determinants of Demand (Factors Affecting Demand)

• Demand is determined by several factors simultaneously.
• Basic determinants include:
  • Price of commodity (P)
  • Consumer tastes and preferences (T)
  • Number of consumers (N)
  • Consumer incomes (Y)
  • Prices of related goods (Py)
  • Consumer expectations about future prices and incomes (E)
• The general formula for the demand function is: Qdx = f[(Px... Pxn), T, N, Y, (Py ... Pyn), E].

(1) Price as a Determinant of Demand

• Demand changes inversely with changes in the commodity price

(2) Consumer Tastes as a Determinant of Demand

• A favorable change in tastes increases demand, shifting the demand curve rightward.
• New products can affect tastes

(3) Number of Consumers as a Determinant of Demand

• An increase in buyers increases demand, vice-versa

(4) Consumers' Income as a Determinant of Demand

• A rise in income often leads to an increase in demand for most products.
• The demand for some products (inferior goods) may fall as income rises.

(5) Prices of Related Goods as a Determinant of Demand

• Substitute goods: When the price of one rises, the demand for the other rises (inverse relationship).
• Complementary goods: When the price of one rises, the demand for the other falls (inverse relationship).

(6) Consumer Expectations as a Determinant of Demand

• Expectations of higher future prices may lead to increased current demand.
• Expectations of falling prices may decrease current demand.

Summary of Determinants of Demand

• An increase in demand can be caused by a change in consumer tastes, an increase in the number of buyers, rising incomes for normal goods, a fall in incomes for inferior goods, a decrease in the price of a substitute good, an increase in the price of a complementary good, or a new expectation of higher future prices or incomes.

Change in Demand (versus Change in Quantity Demanded)

• A change in one or more demand determinants causes a shift in the demand curve.
• A change in quantity demanded is a movement along a fixed demand curve due to a price change.

Elasticity of Demand

• Measures the responsiveness of quantity demanded to changes in price, or other factors.
• Types of elasticity include: own price elasticity, income elasticity, and cross-price elasticity.

Price Elasticity of Demand (Ed)

• Measures responsiveness of QD to price change.
• Values can be considered inelastic (<1), elastic (>1), or unit elastic (=1).

Factors that Influence Price Elasticity of Demand

• Availability of substitutes
• Number of alternative uses for a product.
• Importance of expenditure relative to the budget

(2) Income Elasticity of Demand

• Measures responsiveness of QD to changes in income.
• Can be positive (normal goods) or negative (inferior goods).

Income Elasticity and the Engel Curve

• Plots income against quantity demanded.
• Normal goods show an increasing demand as income grows, whilst inferior goods show a falling demand as income rises.

Positive and Negative Income Elasticities

• Positive income elasticities indicate normal goods; negative elasticities indicate inferior goods.

(3) Cross-Price Elasticity of Demand

• Measures the responsiveness of the demand for one good to a change in the price of another good.
• Positive values indicate substitute goods; negative values indicate complementary goods.

Cross-Price Elasticity of Demand for Complementary goods

• Negative values indicate complementary goods

Supply Theory

• Supply is a schedule/curve showing the quantities of a product producers are willing and able to sell at various prices over a specific time period.
• Supply is depicted by a supply schedule (table form), a supply curve (graphic form), or a supply function (algebraic form).

Law of Supply

• There's a positive relationship between price and the quantity supplied.
• Higher prices incentivize producers to supply more.

Law of Supply Explained

• Explains why supply increases with price.
• Relates price to production costs, availability of resources, and incentives for producers.

Market Supply

• Market supply is the sum of individual firms' quantities supplied at different prices.

Change in Supply versus Change in Quantity Supplied

• Change in supply shows a shift in the supply curve due to a change in non-price factors.
• A change in quantity supplied is a movement along a fixed supply curve due to price change.

Determinants of Supply (Factors Affecting Supply)

• Factors affecting supply include: resource prices, technology, taxes and subsidies, prices of other goods, price expectations, and the number of sellers.

(1) Resource Prices (Prices of factors of production/input prices/costs)

• Prices of resources affect production costs.
• Higher resource costs reduce the incentive to supply output at each product price.
• Lower resource costs increase profits and supply.

(2) Technology (Change in Technology)

• Improves production efficiency.
• Increases available outputs with fewer resources.

(3) Taxes and Subsidies

• Taxes increase production costs, reducing supply.
• Subsidies lower production costs, increasing supply.

(4) Prices of Other Goods

• The price of alternative products influence producer decisions.
• Producers may switch production based on relative profitability.

(5) Price Expectations

• Expectations regarding future prices affect current supply decisions.
• Anticipated higher future prices may reduce current supply.

(6) Number of Sellers

• More firms in the market leads to greater supply, and the opposite is true, as supply curve shifts right or left.

Supply and Demand: Market Equilibrium

• Prices are established where supply equals demand, balancing buyer and seller forces.
• Supply and demand schedules show quantities for different prices to yield market equilibrium.

Surplus and Shortage or Deficit

• Surplus: Quantity supplied exceeds quantity demanded. Reduces price.
• Shortage: Quantity demanded exceeds quantity supplied. Increases price.

Equilibrium Price and Quantity

• Equilibrium price = price where supply equals demand.
• Equilibrium quantity = quantity bought and sold at equilibrium price.

Rationing Function of Prices

• Prices decide who gets a product based on willingness and ability to pay.

Changes in Supply, Demand and Equilibrium

• Changes in supply or demand alter equilibrium price and quantity.
• Increases in demand lead to higher price and quantity.
• Decreases in demand lead to lower price and quantity.
• Increases in supply lead to lower price and higher quantity.
• Decreases in supply lead to higher price and lower quantity.

Changes in Supply and Demand (Complex Cases)

• Changes in supply and demand simultaneously produce varied effects on equilibrium.

Summary of effects of changes in Supply and Demand

• Table summarizing effects of supply and demand changes on equilibrium price and quantity, accounting for increases and decreases in supply and demand.

Government-Set Prices

• Market prices may be unfairly high or low, leading to government intervention through price ceilings or floors.

(1) Price Ceilings

• Maximum legal price.
• Rationale: enables consumers to access essential goods.

Effect of State Intervention on Product Price (1)

• Price ceilings below the equilibrium price cause shortages, where QD > QS.

Ceiling Price and the Rationing Problem

• Government intervention disrupts the free market's rationing function.
• Shortages are common, leading to black markets and inefficiencies.

Ceiling Price and the Proliferation of Black Markets

• Black markets develop due to rationing schemes creating incentives for sellers to sell above the ceiling price.

(2) Price Floors

• Minimum legal prices.
• Rationale: to support producers.

Effect of Price Floor Explained

• Price floors above equilibrium cause surpluses, where QS > QD.

Coping with the Surplus resulting from the Price Floors

• Strategies to deal with surpluses caused by price floors include reducing supply, increasing demand, and purchasing surplus output.

Is government intervention on commodity prices necessary?

• Economic analysis of price controls show potential for unintended consequences: black markets and inefficiencies.
• Intervention may be justified to protect vulnerable groups, but needs careful consideration.

Price Elasticity of Supply

• Measures the sensitivity of quantity supplied to changes in price.
• A higher value indicates more responsiveness to price changes.

Calculating Price Elasticity of Supply (Example)

• Calculates price elasticity of supply when quantity supplied changes due to a price increase or decrease

Determinant(s) of Price Elasticity of Supply

• Time is the main factor that influences price elasticity of supply. Longer timeframes offer more flexibility for producers to adjust supply to price changes.

Price Elasticity of Supply: The Immediate Market Period

• Supply is nearly perfectly inelastic in the immediate market period because producers cannot adjust their supply quickly to price changes.

Es in the Short Run

• In the short run, producers can make some adjustments to resource allocation (e.g., using existing resources with greater or less intensity).
• Supply becomes less inelastic, but not as much as in the long run.

The Long Run Price Elasticity of Supply

• Over a long period, producers have more time to fully adjust resource allocation (e.g., expand or shrink their plants and facilities)
• Supply becomes very elastic.

Revenue test for price elasticity of supply?

• Total revenue and price tend to move together in supply, regardless of price elasticity, unlike demand where they may move in opposite directions.

Price Determination in Agricultural Markets: Behaviour of Farm Prices

• Farm prices derived from interaction of supply, demand, and the food marketing system.

(1) Prices fix standards of value

• Prices reflect consumer preferences.
• Producers aim for profit, allocating resources based on consumer demand.

(2) Prices organize production

• Input costs and output prices determine production decisions.
• Optimization requires that producers choose where marginal cost of input equals value of marginal product.

(3) Prices distribute products

• Prices determine who buys and how much they buy.
• Lower prices lead to broader distribution.

(4) Prices ration products

• Prices allocate resources over time, especially relevant in agriculture with seasonal production.

(5) Prices provide for maintenance and growth in the economy

• Capital equipment needs adequate returns for replacement.. Prices determine what (and how much) is produced, driving production, investment, and economic sustainability.

Forces that influence farm prices

• Categories of factors that influence farm prices include supply conditions, demand conditions, food marketing, and government policies.

Farm and nonfood price trends

• Although food and non-food prices generally follow similar long term trends, different short-term patterns are observed due to supply and demand characteristics.

Fluctuations in prices of agricultural commodities

• Agricultural markets often experience volatile price swings, unlike other markets often showing relative stability.

Factors behind fluctuating prices of agricultural commodities

• International demand changes affect production in certain countries, while increased domestic demand impacts prices.
• Unpredictable supply conditions caused by weather, disease, and other factors.

Factors behind fluctuating prices of agricultural commodities (continued)

• (i) Agricultural production is generally subject to natural factors.
• (ii) Most agricultural products have low price elasticities of demand.
• (iii) Revenue from sales often inversely correlates with quantity supplied.
• (iv) There is a significant production time lag, as producers respond to price changes with some delay.

Cobweb Theorem

• A theory that explains cyclical price behavior in agricultural markets.

Cobweb Theorem (continued)

• Explains how timelags in production response can maintain cycles in agricultural markets.

Types of cobweb

• Explains the different ways market prices and supply and demand interact over time in agricultural markets, leading to stable, diverging, or converging outcomes in market cycles.

Inconsistency among the three cobweb models

• Shows the limitations of the straight-line cobweb model and suggests agricultural markets are often more complex.

Test your understanding of key concepts in economics, including production cost, market supply, demand shifts, and pricing. This quiz covers essential principles that impact firm decisions and market dynamics.