Partial and general equilibrium, law of demand and demand analysis

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Unit 1 Introduction to Demand Theory 2

Unit 2 Concepts of Demand and Supply 20

Unit 3 Theories of Demand 40

After studying this unit, you should be able to understand and appreciate:

  • The concept of microeconomics and relevance of Demand

  • The need to identify or define the concept of Demand.

  • How to define elasticity of Demand

  • Relevance of Price Elasticity of Demand

  • Understand the approach to Income Elasticity of Demand

  • The concept of Cross Price Elasticity

  • Know the other forms of Markets in context of Microeconomics

1.1 Introduction

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
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.

According to the LAW OF DEMAND, as price goes up; the quantity demanded by consumers goes down.  As the price falls, the quantity demanded by consumers goes up.  This law concerns itself with the consumer side of microeconomics.  It tells us the quantity desired of a given product or service at a given price.
The LAW OF SUPPLY concerns itself with the entrepreneur or business, which supplies the products and services.  This law tells us the amount of a product or service businesses will provide at a given price.  Essentially, if everything else remains the same, businesses will supply more of a product or service at a higher price than they will at a lower price.  This is because the higher price will attract more providers who seek to make a profit on the good or service.  By the same token a low price will not attract additional suppliers and as a result the overall supply will remain low.
These two laws help to determine the overall price level of a product with a defined market.   When evaluating the prices of an undefined market then another factor must be considered.  This additional factor is called OPPORTUNITY COST.  Opportunity cost is the relative loss of opportunity one must deal with in making a decision to invest time and money in something else.  Needless to say, determining opportunity cost is very complicated and hard to evaluate in terms of economics.
Opportunity Cost is also used in evaluating the net cost of any good or service currently being utilized by an individual or the market as a whole.  This can be illustrated by the decision a city makes to allocate a zone of land toward public recreation in the form of a park.  The opportunity cost in this situation would be the loss of revenue the city would suffer by allocating the park instead of zoning the land for industrial use.  Most situations involving opportunity cost are not so clear though.
The important concept to take away from opportunity costs is that for every purchasing or investing decision made there are other alternatives, which one is giving up. Therefore one is not just investing $5000 in government bonds but one is choosing to invest in bonds over funding the education of a child or of taking a vacation to the Bahamas for the entire family.  Whether the investment is good or not depends on the value the family and the individual places on the alternative.  These are the type of insights a microeconomic view can give the individual investor when applied correctly.

1.2 basic concepts of demand

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.

1.2.1 Law of Demand
The Law of Demand states that other things held constant, as the price of a good increases, the quantity demanded will fall. Other factors that can influence demand include:

  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.

  1. 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.

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

  1. 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.

1.2.2 Demand Curves
Demand curves isolate the relationship between quantity demanded and the price of the product, while holding all other influences constant (in latin: ceteris paribus). These curves show how many of a product will be purchased at different prices. Note that demand is represented by the entire curve, not just one point on the curve, and represents all the possible price-quantity choices given the ceteris paribus assumptions. When the price of the product changes, quantity demanded changes, but demand does not change. Price changes involve a movement along the existing demand curve.
Market demand is the summation of all the individual demand curves of those in the market. It is the horizontal sum of individual curves and add up all the quantities demanded at each price. The main interest is in market demand curves, because they are averages of individual behaviour tend to be well-behaved.
When any influence other than the price of the product changes, such as income or tastes, demand changes, and the entire demand curve will shift (either upward or downward). A shift to the right (and up) is called an increase in demand, while a shift to the left (and down) is called a decrease in demand. In example, there are two ways to discourage smoking: raise the price through taxes or; make the taste less desirable.
1.2.3 Law of Supply
As the price of a product rises, ceteris paribus, suppliers will offer more for sale. This implies that price and quantity supplied are positively related. The major factor that influences supply is the "cost of production", and includes:

  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.

  1. 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.

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

1.2.4 Supply Curves and Schedules
The relationship between the price of a product and the quantity supplied, holding all other things constant is generally sloping upwards. Supply is represented by the entire curve and not just one point on the curve. When the price of the product changes, the quantity supplied changes, but supply does not change. When cost of production changes, supply changes, and the entire supply curve will shift.
Market Supply is the summation of all the individual supply curves, and is the horizontal sum of individual supply curves. It is influenced by the factors that determine individual supply curves, such as cost of production, plus the number of suppliers in the market. In general, the more firms producing a product, the greater the market supply.
When quantity supplied at a given price decreases, the whole curve shifts to the left as there is a decrease in supply. This is generally caused by an increase in the cost of production or decrease in the number of sellers. An increase in wages, cost of raw materials, cost of capital, ceteris paribus, will decrease supply. Sometimes weather may also affect supply, if the raw materials are perishable or unattainable due to transportation problems.
1.2.5 Reaching Equilibrium
We can analyze how markets behave by matching (or combining) the supply and demand curves. Equilibrium is defined as the intersection of supply and demand curves. The equilibrium price is the price where the quantity demanded matches the quantity supplied. The equilibrium quantity is the quantity where price has adjusted so that QD = QS. At the equilibrium price, the quantity that buyers are willing to purchase exactly equals the quantity the producers are willing to sell. Actions of buyers and sellers naturally tend to move a market towards the equilibrium. The concept and relationship between demand and supply and equilibrium will be discussed in depth in later units.
1.2.6 Excess Supply/Demand
Excess Supply is where Quantity supplied > Quantity demanded, and results in surpluses at the current price. A large surplus is known as a "glut". In cases of excess supply:

  • price is too high to be at equilibrium

  • suppliers find that inventories increase

  • suppliers react by lowering prices

  • 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:

  • buyers cannot buy all they want at the going price

  • sellers find that their inventories are decreasing

  • sellers can raise prices without losing sales

  • prices increase until market reaches equilibrium

1.2.7 Demand schedule

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.

1.3 concept of Elasticity of demand

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.

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