Untitled Quiz

Course Information

• Course Name: Agricultural Economics I
• Course Code: AEC 211
• Year Offered: 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 showing the various amounts of a product consumers are willing and able to purchase at different prices during a specific period (ceteris paribus).
• Willingness alone is insufficient for effective demand; it must be backed by purchasing power.
• Effective demand is created through willingness and ability to purchase.

3.1.1 Ways of Showing Demand

• Demand can be described in three ways:
  • Demand schedule (table form)
  • Demand curve (Geometric or Graphic)
  • Demand function (Mathematical form)

Presentation of Demand (1): Demand Schedule (Table Form)

• A hypothetical demand schedule for beef from a single consumer shows the quantity demanded at various prices.

• Table 3.1 shows the relationship between prices per kg of beef (in Malawi Kwacha) and the quantity demanded per month (in kg).

Presentation of Demand (2): Demand Curve (Geometric or Graphic Form)

• The inverse relationship between price and quantity demanded is graphically represented by a demand curve.
• Quantity demanded is plotted on the horizontal axis.
• Price is plotted on the vertical axis.
• Connecting price-quantity points results in the demand curve.

Presentation of Demand (2) Cont'd: Law of Demand

• The law of demand states that price and quantity demanded have an inverse relationship, meaning that as price decreases, quantity demanded increases, and vice-versa.

Presentation of Demand (3): Demand Function (Mathematical Form)

• Demand function shows the functional relationship between price (P) and quantity demanded (Qd).
• The general form of demand function Qd_x = f(Px_x).
• For linear relationship, the function is: Qd_x = a + bP_x, where a is intercept and b is coefficient.

Why Inverse Relationship Between Price and Quantity?

• The law of demand aligns with common sense; people buy more at lower prices and less at higher prices, driven by the need to avoid the obstacles of high prices.
• Consumption follows the principle of diminishing marginal utility; each successive unit of a product consumed offers less satisfaction.

Law of Demand further explained

• It can be explained in terms of income and substitution effects:
  • Income effect: Lower prices increase purchasing power, leading to greater quantities demanded.
  • Substitution effect: Lower prices encourage consumers to substitute less expensive items for more expensive similar products.

3.2 Market Demand

• Individual demand is aggregated to determine market demand.

• By adding the quantities demanded by all consumers at each of the various possible prices a market demand schedule is ascertained.

Horizontal summation of individual demand schedules to produce market demand

• If there are multiple buyers in a market, summing their quantities at each price, and multiplying by the number of buyers yields the market demand schedule.

Determinants of Demand (Factors Affecting Demand)

• Demand is a multivariate relationship, defined by several interconnected factors acting simultaneously.
• Key determinants include the commodity's price, consumers' tastes/preferences, number of consumers, income, prices of related goods, and future expectations of prices/incomes.
• Demand function can be written in functional notation: Qd_x = f [(P_x ... P_xn), T, N, Y, (P_y ... P_yn), E]

(1) Price as a determinant of demand

• The inverse relationship between price and quantity demanded, already observed in previous discussions, illustrates the effect of price on demand.

(2) Consumer Tastes as a determinant of demand

• Favorable changes increase demand, shifting the curve to the right due to desirability.
• Changes in tastes may be influenced by new products, affecting demand as demonstrated by cassette tapes losing demand to CDs.
• In advanced economies, attitudes toward health concerns also influenced consumption, for example, increased broccoli, low-calorie items whereas decreases were observed with beef, eggs, and whole milk.

(3) Number of consumers as a determinant of demand

• An increase in buyers increases demand; vice-versa.
• Population increases in urban areas often correspond with increased demand for goods.

(4) Consumers' Income as a determinant of demand

• A rise in income typically increases demand for normal goods.
• For superior goods, the demand varies proportionately more than income.
• Conversely, demand for inferior goods declines with increases in income. For instance, people generally buy more steak, furniture, and computers as income increases. Conversely, the demand for inferior goods (such as used clothing, retread tires, or secondhand items) may decrease as income rises.

Consumer Income and Demand: Normal and Inferior Goods

• Normal goods exhibit a direct relationship with income (as income increases, demand increases).
• Inferior goods exhibit an inverse relationship with income (as income increases, demand declines).

(5) Prices of Related Goods as a determinant of demand

• Related goods can either be substitutes or complements:
  • Substitutes: if the price of one rises, demand for the other increases; if the price of one falls, demand for the other falls (e.g., beef and chicken).
  • Complements: if the price of one rises demand for the other falls; if the price of one falls demand for the other increases (e.g., petrol and motor oil).

(6) Consumer Expectations as a determinant of demand

• Expectations about future prices/income can influence current demand:
  • If prices are expected to rise in the future, current demand increases to prevent future price hikes
  • If prices are expected to fall, current demand decreases.
• Expectations about the future availability of a product—or a shortage—affect current demand (e.g., Y2K fears causing fuel demand to spike in 1999).

Summary of Determinants of Demand

• An increase in demand is caused by an increase in consumer tastes or the number of buyers; rising incomes for normal goods; or falling incomes for inferior goods ; a decrease in price for substitutes or an increase in price for complements and a new consumer expectation that future prices or income will be higher.

Change in Demand (versus Change in Quantity Demanded)

• A change in one or more determinants causes a shift of the entire demand curve which is a change in demand.
• A change in the price of the product causes a movement along a fixed demand curve—this is a change in quantity demanded.

Elasticity of Demand

• Elasticity of demand measures responsiveness (sensitivity) of quantity demanded to changes in determinants of demand, such as own price, price of related goods, or income. Three types of elasticity include own-price elasticity, income elasticity, and cross-price elasticity.

Price Elasticity of Demand (E_d)

• Measures the responsiveness of quantity demanded to a change in price.

• Indicates the proportionate change in quantity demanded for a given percentage change in the price.

• E_d = (-ΔQd/Qd) / (ΔP/P).

Mathematical Definition of Price Elasticity of Demand

• A simple formula that demonstrates price elasticity of demand over a small segment of the demand curve: Ed = [(Q1-Q2)/(Q1+Q2)] / [(P1-P2)/(P1+P2)]

Calculating Price Elasticity of Demand

• Example calculations to determine elasticity values.

Interpreting the Elasticity Coefficient

• Classify demand as elastic, inelastic, or unitary based on values greater than 1, less than 1, or equal to 1 respectively.

Characteristics of Elasticity of Demand

• Elasticity values usually vary along a demand curve, with greater elasticity at higher prices than lower prices.
• Examples in farm commodity elasticity are shown.

Factors that Influence Price Elasticity of Demand

• The availability of substitutes for the product.
• The existence of many alternative uses for the product.
• The extent in which a product is included in a consumer’s total budget.

(2) Income Elasticity of Demand (E_i)

• Measures responsiveness of quantity demanded to changes in income.
• The formula for income elasticity can be determined by percentage change of income and quantity demanded through the arc income elasticity formula: E_i = (ΔQ/Q) / (ΔI/I).

Income Elasticity and the Engel Curve

• The relationship between income and quantity demanded is graphically represented by the Engel curve.
• Different consumer demands for commodities such as food show different patterns.

Positive and Negative Income Elasticities

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

(3) Cross-Price Elasticity of Demand (E_xy)

• Measures the responsiveness of the quantity demanded of one good (e.g., X) to a change in the price of another good (e.g., Y).
• Positive E_xy suggests that the two goods are substitutes.
• Negative E_xy suggests that the two goods are complements.

Cross Price Elasticity of Demand for Complementary Goods

• Typically, complementary goods exhibit negative cross elasticities of demand (e.g., bread and butter).
• A positive price for one reduces the demand for the other.

Supply Theory

• Supply is a schedule or curve illustrating the amounts of a product producers are willing and able to offer at differing prices during a defined period.

Ways of Describing Supply (Showcasing Supply)

• Supply schedules (table form)
• Supply curves (graphic form).
• Supply function (algebraic form).

(1) Supply Schedule (Table Form)

• A hypothetical supply schedule for maize from a single producer reflecting quantity supplied (Q_sx) at different prices (P) is shown.

(2) Supply Curve (Geometric or Graphic Form)

• The graphical representation of a supply curve plots price against quantity supplied, reflecting the direct relationship between them. It slopes upwards due to the producers' willingness to offer higher quantities as price increases.

(3) Supply Function (Algebraic Form)

• The functional relationship between price (P) and quantity supplied (Q_sx) is represented.
• Commonly represented in linear form as: Q_sx = a + bP, or Q_sx = α + βP

Law of Supply

• As price rises, producers are incentivized to increase supply by increasing their output; conversely, as price drops, the resultant fall in profits discourages producers and supply decreases.

Law of Supply Explained

• Factors underlying the law of supply are:
  • Incentives of producers to increase supply.
  • Increasing production costs beyond some point.

Market Supply

• Aggregate (summing quantities supplied by all producers) results in market supply.

Change in Supply vs. Change in Quantity Supplied

• A change in one or more determinants causes a shift of the entire supply curve (a change in supply);
• A change in the price of the product causes a movement along a fixed supply curve (a change in quantity supplied).

Determinants of Supply

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

(1) Resource Prices

• Higher resource prices increase production costs and reduce supply; lower resource prices reduce production costs and increase supply.

(2) Technology

• Improvement in technology increases output at lower costs, thereby increasing supply.

(3) Taxes and Subsidies

• Taxes increase production costs, reducing supply; subsidies reduce production costs, increasing supply.

(4) Prices of Other Goods

• Higher prices of related goods can lead to substitution and decrease supply of the original good. Lower prices of related goods can encourage production, thereby increasing supply of the original good.

(5) Price Expectations

• Expectations of higher future prices discourage current supply, whereas lower future prices encourage current supply.

(6) Number of Sellers

• More sellers increase market supply; fewer sellers reduce market supply.

Supply and Demand: Market Equilibrium

• The intersection of the supply and demand curves represents the market equilibrium, specifying the price (P_e) and quantity (Q_e) where supply equals demand.

Surplus and Shortage or Deficit

• Surplus: Quantity supplied exceeds demand, leading to price reductions.
• Shortage: Quantity demanded exceeds supply, inducing price increases.

Equilibrium Price and Quantity

• The equilibrium price is the price at which quantity demanded equals quantity supplied.

Rationing Function of Prices

• Prices allocate goods to buyers, rationing goods based on willingness and ability to pay.

Changes in Supply, Demand, and Equilibrium

• Shifts in supply and demand affect equilibrium price and quantity.

Summary of Effects of Changes in Supply and Demand (Table Form)

• Shows the effect, from increase/decrease of supply and demand, on equilibrium prices and quantities.

Government-Set Prices

• Price ceilings (maximum legal prices) and price floors (minimum legal prices) may be imposed, altering market equilibrium.

Price Ceilings: Effects and Rationing Problem

• Price ceilings impose a legal maximum price, often below the equilibrium price. This can create a shortage, impacting the ability for buyers to obtain desired goods and services and potentially leading to black market activity.
• Issues of rationing—first come, first served or based on favoritism.
• Issues of quotas will often be implemented.

Price Floors: Effects and Surpluses

• Price floors establish a legal minimum price, frequently above the equilibrium price, leading to a surplus.
• Excess supply results because farmers are more motivated to supply than buyers are motivated to purchase.
• Strategies for addressing the surplus may include: decreasing supply, increasing demand through value addition, and the purchase of the surplus units.

Price Elasticity of Supply

• Elasticity of supply measures how responsive quantity supplied is to an increase in prices, measured through the percentage change in quantity supplied over a defined time unit given the percentage change in the price.

-Supply can be elastic or inelastic depending upon the producer’s responsiveness to price changes.

• A revenue test is not applicable to supplies because supply relationships are direct (higher prices mean greater supply).

Determinants of Price Elasticity of Supply

• The amount of time suppliers have to adjust their output will impact elasticity.

Price Elasticity of Supply: The Immediate Market Period

• Supply is often perfectly inelastic in the immediate market period.
• Producers are unable to adjust supply quantity with short-term price changes and therefore a resultant supply quantity does not reflect the price elasticity.

Price Elasticity of Supply: The Short Run

• Producers have more time to respond regarding supply quantity and therefore exhibit a greater degree of price elasticity.

Price Elasticity of Supply: The Long Run

• Producers can alter their output to better adjust supply quantity, particularly in long-run situations, thereby altering the elasticity of supply in response to price changes.

Market Prices in Agricultural Markets, and Behaviour of Farm Prices

• Prices signal production and consumption decisions in the market, reflecting an interplay among consumer demands, producer supplies, and marketing system functions.

Economic Functions of Prices

• Prices provide fundamental roles for an economy, to establish the standards of value, organizing production, distributing products over time and space (both geographically and between consumers, and in creating a framework for the sustainability of the economy.

Forces that Influence Farm Prices

• Four key forces that influence farm prices are supply conditions, demand conditions, market sector (price and cost behaviors, procurement strategies, etc., and government intervention through policies such as subsidies, quotas, or policies that influence domestic demand.

Fluctuations in Prices of Agricultural Commodities

• Agricultural prices are usually unstable due to the dependence on natural factors and the often low price elasticity of demand.

Factors Behind Fluctuating Prices of Agricultural Commodities (on the Demand Side)

• International demand changes that affect domestic production and pricing.
• Domestic factors such as consumer incomes, employment, and business conditions.

Factors Behind Fluctuating Prices of Agricultural Commodities (on the Supply Side)

• Natural factors (e.g., weather, disease) influence agricultural production.
• Time lags affect the supply response.

Cobweb Theorem

• A theoretical model used in supply analysis that may explain how a cyclical change in supply may result in price fluctuation in a market, generally in agricultural commodities markets. This cyclical nature tends to influence seasonal agricultural commodities, like maize.
• Invariants include the ability of sellers to react to price signals, the time lag between production decisions and the commodity availability, and that the factors of prices and demand relationships remain constant.

Inconsistency among the three cobweb models

• In practice, the straight-line models are not realistic for agricultural markets.
• Supply functions for agricultural products usually have inverted S shapes rather than straight lines.