Unit 1 Part 2 - The Forces of Demand and Supply.pdf

Microeconomics Unit 1 Part 2: Demand and Supply The Content of Microeconomics The term ‘micro’ is derived from the Greek word ‘mikros’ meaning small. This field of economics studies the economic behaviour of individual economic units (households, firms and industries) and variables. It is thus...

Microeconomics Unit 1 Part 2: Demand and Supply The Content of Microeconomics The term ‘micro’ is derived from the Greek word ‘mikros’ meaning small. This field of economics studies the economic behaviour of individual economic units (households, firms and industries) and variables. It is thus concerned with product pricing, factor pricing and economic welfare. It takes a bottom-up view of the economy, using the technique of ‘partial equilibrium analysis’. The assumption of ‘ceteris paribus’ is of core importance for this technique. It means ‘other things remaining equal’, (e.g. the law of demand).  Introduction to Demand Demand for a commodity refers to the quantities of a commodity which consumers are willing and able to purchase at various possible prices during a particular period of time (demand is a flow variable), other things remaining constant. Classifications of Demand Individual demand refers to the quantity of a good or service a single consumer is willing and able to purchase at different prices. On the other hand, market demand is the total demand of all consumers in a market for that particular good or service at various prices. Ex ante demand means the amount of any commodity or service that a consumer is willing or expected to consume or purchase and ex post demand indicates the amount of the commodity or service that is actually purchased or consumed by the consumer or buyer. Joint demand occurs when the demand for two or more goods is interdependent, such that the demand for one good is linked to the demand for another (e.g., printers and ink cartridges). Derived demand is the demand for a product that arises from the demand for another related good or service, often seen in production processes (e.g., demand for steel due to demand for cars). Composite demand refers to the demand for a good that has multiple uses, meaning the demand for the good comes from different applications (e.g., milk used for drinking, cheese, yogurt, etc.). The law of demand says that quantity demanded varies inversely with price, other things constant (ceteris paribus). Thus, the higher the price, the smaller the quantity demanded; the lower the price, the greater the quantity demanded.  Ceteris Paribus Importance of the Assumption: Simplifies Analysis, Facilitates Theoretical Models, Focus on Specific Relationships, Policy Analysis Substitution Effect of a Price Change When the price of a good falls, consumers substitute that good for other goods, which become relatively more expensive. This could also happen the other way around. Remember that it is the change in the relative price—the price of one good relative to the prices of other goods—that causes the substitution effect. If all prices changed by the same percentage, there would be no change in relative prices and no substitution effect. Income Effect of a Price Change MONEY INCOME: The number of dollars a person receives per period, such as INR 12000 per week. REAL INCOME: Income measured in terms of the goods and services it can buy. INCOME EFFECT OF A PRICE CHANGE: A fall in the price of a good increases consumers’ real income, making consumers more able to purchase goods. For a normal good, the quantity demanded increases. The Determinants of Demand Price Consumer Income (Normal, Inferior-Giffen, Inexpensive Necessities) Prices of Related Goods Changes in Consumer Expectations Changes in Consumer Tastes Miscellaneous Other Factors Changes in Consumer Income When consumer income increases, consumers are willing and able to buy more of a good at each price, causing market demand to increase (and vice versa). This results in a rightward shift of the demand curve. For instance, at a given price, the quantity demanded increases, indicated by a rightward shift of the demand the curve. Demand for normal goods increases as consumer income increases. This results in a rightward shift in the demand curve. Most goods fall into this category. Demand for inferior goods decreases as consumer income increases, shifting the demand curve leftward. Examples include low-cost or second-hand items. As income increases, consumers switch from inferior goods to normal goods (e.g., higher-quality or new items). There is an upper limit to the consumption of inexpensive necessities such as salt. Therefore, the demand for such goods increases as income levels rise, but only up to a certain level, following which the demand for such goods remains constant. Relation between Income and Demand Changes in the Prices of Related Goods Prices of other goods are assumed to remain constant along a given demand curve. Two goods are substitutes if an increase in the price of one good shifts the demand for the other good rightward. Example: E-Books and Audiobooks Two goods are complements if an increase in the price of one good shifts the demand for the other good leftward. Example: Smart Home Devices and High-Speed Internet Most pairs of goods are unrelated, meaning changes in the price of one have no effect on the demand for the other. Example: 3D Printers and Organic Vegetables The way the demand for one product is affected by a change in the price of another product is known as the ‘cross demand’ or cross price effect’. Changes in Consumer Expectations Consumer expectations about income and prices are assumed constant along a given demand curve. However, changes in consumers' income expectations can shift the demand curve. Example: A consumer expecting a pay raise might increase their demand for goods before the raise takes effect, such as a college senior buying a new car before graduation. Changes in consumers' price expectations can also shift the demand curve. Example: If consumers expect the price of a good to increase next week, they may buy more of it now, shifting the current demand curve rightward. Conversely, if consumers expect prices to fall, they might postpone purchases, shifting the current demand curve leftward. Similarly, consumers’ expectations about the interest rates, inflation levels, taxation levels, etc. also shapes demand. Changes in Consumer Tastes Choices in food, music, clothing, books, movies, TV, etc. are influenced by consumer tastes, which are personal likes and dislikes. Determinants of taste: - Biological Needs: Desires for food, drink, comfort, rest, shelter, friendship, love, status, personal safety, and a pleasant environment. - Family Background: Influences such as home cooking shape tastes, especially in food. - Cultural and Social Influences: Surrounding culture, peer influence, and religious convictions impact tastes. Economists acknowledge that tastes affect demand but do not claim expertise in understanding their development. Tastes are assumed to be given and relatively stable in demand analysis. Changes in Consumer Tastes A change in tastes for a good can shift the demand curve. For example, discovering health benefits of a good could shift its demand curve rightward. Attributing demand curve shifts solely to changes in tastes is challenging due to the complexity of isolating such changes from other economic factors. Miscellaneous Other Factors Good Credit Facilities: Access to favorable credit terms can significantly boost demand for goods and services, particularly luxury and comfort items. Demonstration Effect: Middle-income consumers may increase demand for high-end goods influenced by exposure to such products in malls and other settings. Population and Demographics: The size, composition, and demographics of a population can shape demand patterns for various goods and services. Income Distribution: The distribution of income within a country impacts purchasing power and thereby influences overall demand. Climatic Factors: Weather conditions and climate variations can affect demand for seasonal products and services. Government Policies: Subsidies, taxation policies, and regulatory measures implemented by governments can significantly influence consumer demand. MOVEMENT ALONG A DEMAND CURVE SHIFT OF A DEMAND CURVE Change in quantity demanded resulting from a Movement of a demand curve right or left change in the price of the good, other things resulting from a change in one of the constant. determinants of demand other than the price of the good. Exceptions to the Law of Demand Giffen Goods: Giffen goods are a rare type of inferior good where an increase in price leads to an increase in demand, contrary to the law of demand. This paradoxical behavior typically occurs when the good is a staple or necessity for the consumer, and its price increase disproportionately affects the consumer’s budget for other goods (real income). Some examples could include bread and rice in poor communities. Articles of Snob Appeal: Items of snob appeal see an increase in demand with higher prices as they become more desirable due to their exclusivity and prestige. Emergencies: In emergencies, demand for essential goods may increase regardless of price, as people prioritize acquiring necessary items over cost. Exceptions to the Law of Demand Expectations About Future Prices: If consumers expect prices to rise in the future, they may buy more now, increasing current demand despite higher prices. Quality-Price Relationships: Higher prices can lead to higher demand if they signal higher quality, making consumers willing to pay more for perceived better value. Change in Fashion: Demand for fashion items can increase with higher prices if the items become trendy or fashionable, prompting consumers to buy more to stay in style.  Elasticity of Demand The degree of responsiveness of quantity demanded of a commodity to a change in any of its determinants. Usually, the price, income and cross elasticities of demand are most important. Price Elasticity of Demand Definition Degrees of Price Elasticity of Demand The degree of responsiveness of quantity demanded of a commodity in response to a change in its price. Elasticity of the Demand Curve A demand curve need not not have the same elasticity over its entire range. A demand curve is typically more elastic at higher price ranges since the product takes up a larger portion of the consumer’s income and there may be substitutes available at these high price levels. At lower price ranges, the product might already be affordable, so consumers are less sensitive to price changes. There also maybe fewer substitutes available, hence the demand is relatively inelastic at these points. Methods of Measurement- Percentage Method The convention is to refer to the price elasticity of demand as a number with the understanding that it is negative. Remember: Elasticity of demand and slope of demand curve are different concepts. Methods of Measurement - Total Expenditure Method Also called the total outlay method, elasticity of demand can be measured by considering the change in total expenditure incurred on a commodity as a result of the change in its price. Methods of Measurement - Total Expenditure Method Methods of Measurement - Total Expenditure Method Methods of Measurement - Geometric or Point Method Factors Affecting Price Elasticity of the Demand Curve The more substitutes available, the more elastic the demand. Example: If the price of Pepsi rises, consumers can switch to Coke, making the demand for Pepsi elastic. Necessities have inelastic demand, while luxuries have elastic demand. Example: Milk (necessity) has inelastic demand; air conditioners (luxury) have elastic demand. Goods that take a small proportion of income have inelastic demand. Example: Salt has inelastic demand because it represents a tiny fraction of income. More uses lead to higher elasticity. Example: Electricity is used for lighting, heating, and cooking, making its demand elastic. Factors Affecting Price Elasticity of the Demand Curve Demand is more elastic in the long run as consumers find alternatives. Example: Demand for gasoline is inelastic in the short term but elastic in the long term. Goods whose consumption can be postponed have elastic demand. Example: Furniture demand is elastic because buying can be delayed. Demand is inelastic at very high and very low prices but elastic within moderate price ranges. Example: Luxury cars have inelastic demand at high prices, while mid-range cars have elastic demand. Habitual goods have inelastic demand. Example: Cigarettes have inelastic demand because smokers continue to buy even at higher prices. Normally rich consumers have inelastic demand while middle-income and poor people have generally elastic demand patterns. Significance of Price Elasticity of Demand Elasticity of demand helps firms decide on pricing and output levels. It assists monopolists in implementing price discrimination strategies. It influences wages and other factor prices in the labor market. Elasticity guides government tax policies, subsidies, and public utility pricing. It determines terms of trade and the impact of export/import duties in international trade. Elasticity affects decisions on currency devaluation or revaluation. It determines the distribution of the tax burden between buyers and sellers. Elasticity explains the 'Paradox of Plenty' in agricultural economics. Income Elasticity of Demand Definition The degree of responsiveness of the quantity demanded of a commodity to a change in the income of consumers. Cross Elasticity of Demand Definition The degree of responsiveness of the quantity demanded of a commodity to a change in the price of its related commodities.  Introduction to Supply Supply indicates how much producers are willing and able to offer for sale per period (just like demand, supply too is a flow variable) at each possible price, other things constant. The law of supply states that the quantity supplied is usually directly related to its price, other things constant. Thus, the lower the price, the smaller the quantity supplied; the higher the price, the greater the quantity supplied.  The supply curve isolates the relation between the price of a good and the quantity supplied, other things constant. Assumed Shifts in the Supply constant along a supply curve are the determinants of supply other Curve than the price of the good, including (1) the state of technology, (2) the prices of relevant resources, (3) the prices of alternative goods, (4) producer expectations, and (5) the number of producers in the market. A movement along a supply curve occurs when the price of the good changes, affecting the quantity supplied. A shift in the supply curve happens when factors other than price change, affecting the overall supply of the good. Reasons for a Shift of the Supply Curve - through examples Changes in Technology: Suppose a new type of drone technology allows farmers to plant crops twice as fast. This technological advancement would lower production costs and enable farmers to supply more crops at every price level. Thus, the supply curve for crops shifts rightward, meaning more crops are available at each price point. Changes in the Prices of Relevant Resources: If the price of cement drops, building a house becomes cheaper. Consequently, construction companies can afford to build more houses at each price level, shifting the supply curve for housing to the right. Conversely, if cement prices rise, the cost of building houses increases, reducing the supply and shifting the curve to the left. Reasons for a Shift of the Supply Curve - through examples Changes in the Prices of Alternative Goods: If the price of solar panels decreases, some manufacturers might switch from producing traditional energy equipment to solar panels because the opportunity cost of producing solar panels is lower. This shift increases the supply of solar panels, moving the supply curve to the right. On the other hand, if solar panel prices rise, manufacturers may revert to producing traditional energy equipment, reducing the supply of solar panels. Changes in Producer Expectations: If a farmer expects higher prices for apples in the coming months, they might store their current apple harvest instead of selling it immediately. This expectation of future higher prices could decrease the current supply of apples, shifting the supply curve to the left. Conversely, if they expect prices to drop, they might sell more now, increasing the current supply. Reasons for a Shift of the Supply Curve - through examples Changes in the Number of Producers: If the number of tech startups producing smartwatches increases, the overall supply of smartwatches in the market will rise, shifting the supply curve to the right. Conversely, if many startups exit the market, the supply of smartwatches will decrease, shifting the supply curve to the left. MOVEMENT ALONG A SUPPLY CURVE SHIFT OF A SUPPLY CURVE Change in quantity supplied resulting from a Movement of a supply curve right or left change in the price of the good, other things resulting from a change in one of the constant. determinants of supply other than the price of the good. Time Period and Supply Market Period: A very short period where supply is fixed. Supply consists of goods already produced, such as perishable items like vegetables. Producers cannot adjust output in response to price changes. Short-Run: A period where supply can be adjusted to some extent. Producers can increase production by running existing plants longer, such as through additional shifts. Not long enough for firms to set up new plants or machinery. Long-Run: A period where firms can build new plants or close old ones. New firms can enter the industry by setting up new plants. Allows for significant changes in the quantity supplied. Exceptions to the Law of Supply Vertical Supply Curve: Applies to certain commodities where supply cannot be adjusted, such as rare goods (classical paintings, old manuscripts, rare stamps, old coins). Supply is fixed and cannot change regardless of price. In cases like agricultural products (e.g., wheat), supply is fixed once the crop is grown and can only be increased in the long run. Exceptions to the Law of Supply Backward Sloping Supply Curve: Occurs in certain cases where part of the supply curve slopes backward. Indicates that a smaller quantity is supplied at a higher price than at a lower price. For example, in labor supply, as wage rate increases, workers initially supply more labor, but beyond a certain point (T), they prefer leisure over work, reducing the quantity supplied. As a result, they prefer to work fewer hours, leading to a decrease in the quantity of labour supplied despite the higher wage rates. The backward sloping supply curve is a theoretical concept that occurs in specific conditions, primarily among high-income earners or highly skilled workers who can afford to prioritize leisure over additional income. While it illustrates that higher wages can lead to a reduced quantity of labor supplied, this phenomenon is not commonly observed in general labor markets. Most workers, especially in lower-wage jobs, tend to supply more labor as wages increase. Thus, the backward sloping supply curve is context-dependent and not universally practical.  Elasticity of Supply The degree of responsiveness of quantity supplied of a commodity to a change in any of its determinants. The price elasticity of supply is the most commonly studies economic variable under this category. Degrees of Supply Elasticity It is the ratio of the proportionate change in Perfectly inelastic supply refers to a quantity supplied to the proportionate case of no supply response, no matter change in price, and is always a positive how large a price change (increase) number. takes place. Example: supply of the Independent of the unit of measurement of Mona Lisa painting. supply or prices. Unitary elasticity of supply refers to a Infinite or perfectly elastic supply represents a case represents a case in which situation where the percentage change the quantity supplied of a commodity in quantity supplied of a commodity is responds by an infinite amount to a very exactly equal to the percentage change small change in price. This refers to a in its price. Any straight line supply situation where any amount will be supplied curve drawn through the origin has an at the going price but nothing will be elasticity of unity over its entire length, supplied at a lower price. Hypothetical no matter what its slope is. example: Steel manufacturers will supply as much steel as needed at the agreed price, but none if the price is lowered. Degrees of Supply Elasticity Supply is said to be elastic when the Supply is said to be inelastic when the percentage change in the quantity supplied percentage change in the quantity of a commodity is greater than the supplied of a commodity is lesser than percentage change in its price. Any straight the percentage change in its price. Any line supply curve that cuts through the Y-axis straight line supply curve that cuts has elastic supply all through. Example: A through the X-axis has inelastic supply technology firm increases production by 20% all through. Example: A mining company when the price of its gadgets rises by 10%, increases coal output by only 5% when showing elastic supply as the quantity the price rises by 15%, demonstrating supplied responds more than the price inelastic supply as the quantity supplied change. responds less than the price change. Factors Influencing the Elasticity of Supply The elasticity of supply depends on how the cost of producing additional units changes. If costs increase only slightly with increased production, supply tends to be elastic. Conversely, if costs rise significantly, supply is relatively inelastic. The time period considered is crucial. In the short run, supply is often inelastic because production capacity is fixed. In the long run, supply becomes more elastic as firms can expand capacity or enter the market. Durable goods typically have a more elastic supply because they can be stored and sold later, while perishable goods have inelastic supply due to their short shelf life. If production facilities like raw materials, power, and equipment are readily available, supply will be more elastic. Limited access to these resources makes supply inelastic. Factors Influencing the Elasticity of Supply Supply elasticity depends on the availability of inputs. Easily accessible inputs lead to more elastic supply, while specialized or scarce inputs result in inelastic supply. Commodities produced using simple and flexible techniques have elastic supply, as production can be easily adjusted. Complex and rigid production methods make supply inelastic. If factors of production (like labor and capital) can be easily moved between different uses, supply will be more elastic. Limited mobility reduces supply elasticity. The willingness of producers to take risks influences supply elasticity. More risk-taking leads to elastic supply, while reluctance to take risks results in inelastic supply. An expected price rise in the future leads to supply being less elastic in the current period, and vice versa.  Percentage Method es= Percentage Change in Quantity Supplied / Percentage Change in Price Geometric or Point Method