Partial and general equilibrium, law of demand and demand analysis

Unit 1 Introduction to Demand Theory 2

Unit 3 Theories of Demand 40

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  The concept of microeconomics and relevance of Demand
  
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  The need to identify or define the concept of Demand.
  
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  How to define elasticity of Demand
  
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  Relevance of Price Elasticity of Demand
  
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  Understand the approach to Income Elasticity of Demand
  
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  The concept of Cross Price Elasticity
  
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  Know the other forms of Markets in context of Microeconomics
  

1.2 Basic concepts of Demand

1.3 Concept of Elasticity of Demand

1.4 Price Elasticity of Demand

1.5 Income Elasticity of Demand

1.6 Cross Price Elasticity

1.7 Other Market Forms

1.8 Summary

1.9Further readings
1.1 INTRODUCTION
Besides Macroeconomics, the other basic way to view economics is the “Microeconomic” view.  This view concerns itself with the particulars of a specific segment of the population or a specific industry within the larger population of good and service providers.   More importantly, from a financial standpoint microeconomics concerns itself with the distribution of products, income, goods and services.  Of course it is this distribution, which directly affects financial markets and the overall value of any particular resource at a specific point in time.   If there is one concept integral to an understanding of microeconomics it is the law of supply and demand.   A more detailed look at supply and demand as well as how they affect price will be helpful in understanding microeconomics.
Before discussing supply and demand it is helpful to understand what price is as a concept and how it relates to supply and demand.  Price is essentially the feedback both the buyer and seller receive about the relative demand of a product, good or service.  When the price is high then demand will be low and when the price is low demand will be high.

There are two laws intrinsically related to microeconomics.  These two laws are the Law of Supply and the Law of Demand.   A closer look at each will illustrate how they relate to pricing and the distribution of goods and services.

Supply and demand is an economic model based on price, utility and quantity in a market. It concludes that in a competitive market, price will function to equalize the quantity demanded by consumers, and the quantity supplied by producers, resulting in an economic equilibrium of price and quantity. An increase in the quantity produced or supplied will typically result in a reduction in price and vice-versa. Similarly, an increase in the number of workers tends to result in lower wages and vice-versa. The model incorporates other factors changing equilibrium as a shift of demand and/or supply.

1. 
   Income - Generally, as income increases, we are able to buy more of most goods. When demand for a good increases when incomes increase, we call that good a "normal good". When demand for a good decreases when incomes increase, then that good is called an inferior good.
   

2. 
   Price of related products - Related goods come in two types, the first of which are "substitutes". Substitutes are similar products that can be used as alternatives. Examples of substitute goods are Coke/Pepsi, and butter/margarine. Usually, people substitute away to the less expensive good. Other related products are classified as "complements". Complements are products that are used in conjunction with each other. Examples of complements are pencil/eraser, left/right shoes, and coffee/sugar.
   

3. 
   Tastes and preferences - Tastes are a major determinant of the demand for products, but usually does not change much in the short run.
   

4. 
   Expectations - When you expect the price of a good to go up in the future, you tend to increase your demand today. This is another example of the rule of substitution, since you are substituting away from the expected relatively more expensive future consumption.
   

1. 
   Input prices - As the prices of inputs such as labour, raw materials, and capital increase, production tends to be less profitable, and less will be produced. This leads to a decrease in supply.
   

2. 
   Technology - Technology relates to methods of transforming inputs into outputs. Improvements in technology will reduce the costs of production and make sales more profitable so it tends to increase the supply.
   

3. 
   Expectations - If firms expect prices to rise in the future, may try to product less now and more later.
   

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  price is too high to be at equilibrium
  
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  suppliers find that inventories increase
  
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  suppliers react by lowering prices
  
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  this continues until price falls to equilibrium
  

Excess Demand occurs when Quantity demanded > Quantity supplied, and results in

shortages at current prices. In cases of excess demand:

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  buyers cannot buy all they want at the going price
  
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  sellers find that their inventories are decreasing
  
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  sellers can raise prices without losing sales
  
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  prices increase until market reaches equilibrium
  

In microeconomic theory, demand is defined as the willingness and ability of a consumer to purchase a given product in a given frame of time.

The demand schedule, depicted graphically as the demand curve, represents the amount of goods that buyers are willing and able to purchase at various prices, assuming all other non-price factors remain the same. The demand curve is almost always represented as downwards-sloping, meaning that as price decreases, consumers will buy more of the good.

Just as the supply curves reflect marginal cost curves, demand curves can be described as marginal utility curves.

The main determinants of individual demand are: the price of the good, level of income, personal tastes, the population (number of people), the government policies, the price of substitute goods, and the price of complementary goods.

The shape of the aggregate demand curve can be convex or concave, possibly depending on income distribution. In fact, an aggregate demand function cannot be derived except under restrictive and unrealistic assumptions.

As described above, the demand curve is generally downward sloping. There may be rare examples of goods that have upward sloping demand curves. Two different hypothetical types of goods with upward-sloping demand curves are a Giffen good (an inferior, but staple, good) and a Veblen good (a good made more fashionable by a higher price).

Similar to the supply curve, movements along it are also named expansions and contractions. A move downward on the demand curve is called an expansion of demand, since the willingness and ability of consumers to buy a given good has increased, in tandem with a fall in its price. Conversely, a move up the demand curve is called a contraction of demand, since consumers are less willing and able to purchase quantities of the product in question.

Elasticity is a central concept in the theory of demand. In this context, elasticity refers to how demand respond to various factors, including price as well as other stochastic principles. One way to define elasticity is the percentage change in one variable divided by the percentage change in another variable (known as arc elasticity, which calculates the elasticity over a range of values, in contrast with point elasticity, which uses differential calculus to determine the elasticity at a specific point). It is a measure of relative changes.

Often, it is useful to know how the quantity demanded or supplied will change when the price changes. This is known as the price elasticity of demand and the price elasticity of supply. If a monopolist decides to increase the price of their product, how will this affect their sales revenue? Will the increased unit price offset the likely decrease in sales volume? If a government imposes a tax on a good, thereby increasing the effective price, how will this affect the quantity demanded?

Elasticity corresponds to the slope of the line and is often expressed as a percentage. In other words, the units of measure (such as gallons vs. quarts, say for the response of quantity demanded of milk to a change in price) do not matter, only the slope. Since supply and demand can be curves as well as simple lines the slope, and hence the elasticity, can be different at different points on the line.

Elasticity is calculated as the percentage change in quantity over the associated percentage change in price. For example, if the price moves from $1.00 to $1.05, and the quantity supplied goes from 100 pens to 102 pens, the slope is 2/0.05 or 40 pens per dollar. Since the elasticity depends on the percentages, the quantity of pens increased by 2%, and the price increased by 5%, so the price elasticity of supply is 2/5 or 0.4.

Since the changes are in percentages, changing the unit of measurement or the currency will not affect the elasticity. If the quantity demanded or supplied changes a lot when the price changes a little, it is said to be elastic. If the quantity changes little when the prices changes a lot, it is said to be inelastic. An example of perfectly inelastic supply, or zero elasticity, is represented as a vertical supply curve. (See that section below)

Elasticity in relation to variables other than price can also be considered. One of the most common to consider is income. How would the demand for a good change if income increased or decreased? This is known as the income elasticity of demand. For example, how much would the demand for a luxury car increase, if average income increased by 10%? If it is positive, this increase in demand would be represented on a graph by a positive shift in the demand curve. At all price levels, more luxury cars would be demanded.

Another elasticity sometimes considered is the cross elasticity of demand, which measures the responsiveness of the quantity demanded of a good to a change in the price of another good. This is often considered when looking at the relative changes in demand when studying complement and substitute goods. Complement goods are goods that are typically utilized together, where if one is consumed, usually the other is also. Substitute goods are those where one can be substituted for the other, and if the price of one good rises, one may purchase less of it and instead purchase its substitute.

Cross elasticity of demand is measured as the percentage change in demand for the first good that occurs in response to a percentage change in price of the second good. For an example with a complement good, if, in response to a 10% increase in the price of fuel, the quantity of new cars demanded decreased by 20%, the cross elasticity of demand would be -2.0.

In a perfect economy, any market should be able to move to the equilibrium position instantly without travelling along the curve. Any change in market conditions would cause a jump from one equilibrium position to another at once. So the perfect economy is actually analogous to the quantum economy. Unfortunately in real economic systems, markets don't behave in this way, and both producers and consumers spend some time travelling along the curve before they reach equilibrium position. This is due to asymmetric, or at least imperfect, information, where no one economic agent could ever be expected to know every relevant condition in every market. Ultimately both producers and consumers must rely on trial and error as well as prediction and calculation to find an the true equilibrium of a market.