Presentation on theme: "Fundamental Concepts & Basic Framework of Demand and Supply:"— Presentation transcript:
1Fundamental Concepts & Basic Framework of Demand and Supply: Prof. Samar K. DattaSession 128th June, 2007
2Materials intended to be covered in this session Objectives of EA – fundamentals of microeconomic analysisConcerns of micro & macro-economicsRace between human wants & scarcity of economic resources giving rise to the fundamental economic choice problemFunctions of an economic system – role of prices, government & institutionsNotion of marketThe demand sideLaw of demandFactors affecting demandFeatures of a market demand curveMovement along & off (i.e., shift of) the demand curveThe supply sideLaw of supplyFactors affecting supplyFeatures of a supply curveMovement along & off the supply curvePrice determination through interaction between demand & supplyExistence & stability of equilibriumShifts in demand & supplyConcepts of point & arc elasticity; Price, income & cross elasticity of demand; Certain properties of elasticitySome applications & food for thought
3Objectives of EA etc. Why EA dealing with micro-economics? Perhaps the most important component of any business analysis, providing clues towards answering a whole lot of questions;Provides insights thro’ analysis of decision-making process by economic agents and their interaction with the marketProvides basis for a number of applied fields in managementDistinctive feature of micro-economics vis-à-vis macro-economics:Macro dealing with behavior of aggregative variables like price, income, employment, money supply, exchange rate etc.
4Fundamental issue & methodology used Race between human wants & scarce economic resources – land, labor, capital and entrepreneurial skillExample, asking a poor man about his demand for credit: why does he specify his demand as a very large number, a small number & even a zero, depending upon how we pose the question? What are his wants and demand?Broad methodology used:Marginal analysis;Positive rather than normative analysis;Trade off involved in most choicesQuestion: Why heath care expenses increasing steadily in the US?
5Functioning of an economic system Role of prices in resolving issues like what to produce & for whom to produce (i.e., issues on marketing), how to produce (i.e., issues on technology & institutions)Role of prices (interest, wages, rent, profit etc.) in fostering economic growthCan prices ensure rationing over time & achieve sustainability?Is there any role for government and other institutions?
6The MarketA market is an institutional arrangement under which buyers and sellers can voluntarily exchange some quantity of a good or service at a mutually agreeable price.It can, but need not be a specific place or location where buyers and sellers actually come face to face for the purpose of transacting their business – e.g. market for professors has no physical location
7The Concept of DemandHuman wants are all the goods, services, and conditions of life that individuals desire (i.e., has use value)Demand in economics is want backed by purchasing power (note difference between effective demand and notional demand)A consumer’s claim on a good/service is recognized by the producer only if it is backed by sufficient purchasing power
8Law of Demand & the Market Demand Curve Other things remaining the same, the quantity demanded of a commodity is inversely related to its price.A lower price may encourage existing consumers to consume larger quantitiesAlso, other consumers who were previously unable to afford the commodity may now begin consuming itThe market demand curverefers to the behavior of an aggregate of economic agentsover a given period of timewhile holding constant all other relevant economic variables on which demand depends (ceteris paribus assumption)On the presumption that different units of the commodity are homogeneous (else weights of product composition to be taken into consideration)
9Example: Demand For Ice Cream Price of Ice CreamInterpret points above& below the demand curveQ(d) = f(P)Quantity of Ice Cream9
10Ceteris Paribus . . ....implies that all the relevant variables (e.g. determinants of demand) are held constant, except the one(s) being studied at the time. Among other variables held constant are consumers’ incomes, tastes and preferences, prices of related commodities (substitutes and complements), number of consumers in the market, weather, future expectations, etc.18
11Determinants of Demand Market PriceConsumer IncomePrices of Related GoodsTastesExpectationsNumber of Consumers11
12Determinants of Demand: Market Price Law of Demand:There exists an inverse relationship between Price and Quantity Demanded.Q12
13Determinants of Demand: Income PAs income increases, the demand for a normal good will increase.Q13
14Determinant of Demand: Income PAs income increases, the demand for an inferior good decreases (e.g., in case of coarse cereals).Q14
15Determinants of Demand: Prices of Related Goods When the fall in price of one good reduces the demand for another good, the two goods are substitutes.15
16Determinants of Demand: Prices of Related Goods When the fall in price of one good increases the demand for another good, the two goods are complements.16
17Advertisement, for example, may shift up demand. Determinants of Demand: Tastes & preferences, consumer expectations of future income & priceAdvertisement, for example, may shift up demand.Expectations of future income rise or price rise may shift up current demand.
18Demand function general form Qx = function ofPx (own price) (-)Pz (price of related goods) (+/-)Y (consumer income) (+/-)N (size of population) (+)α (tastes/preferences) (+/-)Pe/P or Ye/Y (expectations about future price or income) (+/-)
19Demand Schedule and Demand Curve A table that shows the relationship between the price of the good and the quantity demandedQx Px50 220 3Demand Curve:The downward-sloping line relating price and quantity demanded17
20Movements vs. Shifts in the Demand Curve Change in Quantity DemandedMovement along the demand curve caused by a change in the market price of the product.Change in DemandA shift in the demand curve, either to the left or right i.e. a change in the quantity demanded at each commodity priceThe demand curve shifts when there is a change in (a) consumers’ incomes, (b) tastes and preferences, (c) prices of related commodities, and (d) number of consumers in the market, etc.19
21Changes in Quantity Demanded Price$2.00$1.00Quantity71321
23GEOMETRIC FEATURES OF A DEMAND CURVE Its level, depending on role of non-price factors (interpret intercepts on both axes)Its shape – i.e., inverse relationship, decided by law of demandIts slope, is decided by units of P & Q (the curve becoming flatter with rise in unit of Q or P), the reference period (usually flatter in long run), & role of non-price factors (e.g., flatter for luxury goods)Its curvature – can be concave, convex, straight line or a combination (theory proving no further clue)If you can delay the buying (Car) then flatter in short run.If you can not delay the buying (Gasoline) then flatter in long run.
24The Concept of Supply.PQuantity Supplied refers to the amount (quantity) of a good that sellers are willing and able to make available for sale at alternative prices in a given point in time. Interpret points above & below the supply curveQ(s) = f(P)Q25
25Determinants of Supply Market price (+)Input prices (-)Cheaper technology (+)Price of alternative goods (-)Government tax (-) or subsidy (+)Expectations of future price rise (-)Number of Producers (+)27
26Determinant of Supply: Market Price Law of SupplyThere exists an direct (positive) relationship between Price and Quantity Supplied.Q28
27Interpreting features of a supply curve Level/interceptDirectionSlopeCurvature
28Change in quantity supplied verses change in supply Movement along the supply curve, caused by a change in the market price of the product.Change in SupplyA shift in the supply curve, either to the left or right.30
29Supply: Schedule and Curve A table that shows the relationship between the price of the good and the quantity supplied.Supply CurveThe upward-sloping line relating price and quantity supplied.29
30Changes in Quantity Supplied Price$2.00$1.00Quantity1732
32Supply and Demand Together Equilibrium Price is one at which the supply and demand curve intersect (i.e., D=S) (assimilating interests of two conflicting groups thro’ negotiation & adjustment in terms of price)Generally, there is one stable equilibrium, as shown in next slide.However, adjustments may not always lead to a stable equilibrium (i.e., convergence).Moreover, there may be multiple equilibrium, some of which may not be fully stable, as we shall see shortly.
33Forces of Demand and Supply At Rest Market Equilibrium Price$2.00Quantity739
34Actions of buyers and sellers that move toward equilibrium. Excess SupplyPrice is above equilibrium price, therefore producers are unable to sell all they want at the going price.Excess DemandPrice is below equilibrium price, therefore consumers are unable to buy all they want at the going price.40
35Actions of buyers and sellers that move toward equilibrium. PriceExcess SupplyQuantity42
36Actions of buyers and sellers that move toward equilibrium. PriceExcessDemandQuantity44
37Stability of Market Equilibrium The backward bending supply curve of labor may cause multiple equilibrium - some unstable (e.g. at A), some stable (e.g., at B).
38Comparative Statics: Analyzing Changes in Equilibrium Determine if event shifts supply curve, the demand curve, or both.Determine if curve(s) shift to left or right.Determine how shift affects equilibrium price and quantity.Example: Demand for ice cream given hot weather.45
39Change in demand for ice cream due to hot weather PriceNewEquilibriumPePeQuantityQeQe49
40A point to noteFor analytical convenience, an artificial dichotomy is created between producers and consumers; and demand and supplyVery often in the real world, producers and consumers are eitherthe same person e.g. a farmer who eats his own crop, orplay both roles simultaneously – a person who produces one product, consumes othersAlso, demand and supply may be dependent on each other – e.g. generation of income during production may expand the customer base for the product e.g. workers in Ford buying the Ford motor car.
41Price Elasticity of Demand Price elasticity of demand measures the percentage change in the quantity demanded resulting from a 1-percent change in price.
46Problems Using Point Elasticity We may need to calculate price elasticity over portion of the demand curve rather than at a single point.The price and quantity used as the base will alter the price elasticity of demand (point elasticity of demand is not symmetric).
47Arc Elasticity of Demand Arc elasticity calculates elasticity over a range of pricesIts formula is:
48Income Elasticity of Demand Income elasticity of demand measures the percentage change in the quantity demanded resulting from a 1-percent change in income.Its formula is:
49Income Elasticity of Demand and type of Good Positive0 < e < 1e > 1NegativeType of GoodNormal GoodNecessityLuxuryInferior Good
50Cross-price Elasticity of Demand Cross-price elasticity of demand measures the percentage change in the quantity demanded of good Y resulting from a 1-percent change in price of good X.Its formula is:
51Cross-Price Elasticity of Demand and type of Good PositiveNegativeType of goodSubstitutesComplements
52Some applications & food for thought How to cut down cigarette smoking ?Does minimum wages really help the workers ?Why is rent control often found to create more shortage of urban housing ?Why do we often observe greater wage inequality between unskilled and skilled workers ?Why is coffee price found declining, whereas Nestle and coffee shops are found to be making huge profits ?Why is long run price of natural resources like copper declining in spite of the fact that it is exhaustible ?Why did average rental price fall in NY Mahattan following 9/11, 2001?
53Some applications & food for thought Why and how does imposition of price ceiling (rationing) on an essential item often lead to emergence of a black market in that good?Although in general longer run supply curves are flatter as compared to their shorter run counterparts, why do we then often observe a reversal in case of supply of secondary copper (i.e., new supply based on scrap copper), for example?Why is demand curve for gasoline flatter in the long-run, but steeper in the short-run, while the opposite is true for automobiles?For what type of products the long-run supply curve is steeper as compared to its short-run counterpart?(answer in terms of the basic supply-demand framework and shifts in one or both curves)