Demand Review EconS 451: Lecture # 6 Understand the definition of Demand. Explain the difference between Marshallian and Hicksian Demand. Be able to describe and explain the substitution and income effect in product space from a change in price. Understand how proportion of expenditure allocated to a specific good impacts the substitution and income effect. Understand the difference between demand shifts and structural change. Calculate Own-Price, Income and Cross-Price Elasticity of Demand.

Why review demand relationships? Helps us understand market behavior! Explains price fluctuations! Provides a foundation for empirical research and analysis! Equips you with necessary analytical capability to evaluate market dynamics!

Demand Review Demand Defined: The various quantities of a particular commodity that an individual consumer is willing and able to buy as the price varies, all other factors held constant.

Demand Review Begins at the individual level……then summed across all individuals to the market level. Individual Attempting to Solve Max U(x 1, x 2 ) s.t. p 1 x 1 + p 2 x 2 = I

Demand Review Marshallian Demand Max U(x 1, x 2 ) s.t. p 1 x 1 + p 2 x 2 = I Hicksian (or Compensated) Demand Min Expenditures E(p, U) s.t. U(x 1, x 2 ) = U F

Individual Demand Quantity X Price 25 Demand

Product Space vwu X Y U 1 U rs t

Observations If the commodity in questions represents a large proportion of expenditures, then the income effect from a change in the price will be relatively large. Both Income and Substitution effect usually inversely related to price changes.

Static and Dynamic Demand Static : Quantity movements or responses to price while all other factors are assumed constant. Movements along a demand curve. Dynamic: Shifts and changes in demand that happen with the passage of time to account for changes in income, population, taste and preferences, etc. Structural Change Change in the shape of the demand curve due to changes in technology or information.

Graphical Changes in Demand Quantity Parallel Shift Shift and Structural Change Price

Demand Changes Shift Parallel shifts from changes such as income, population. Structural Change Changes in the parameters or functional form.

Short Run……….Long Run Short Run : Time period too short for complete quantity adjustment from a price change (a snapshot). Long Run: The time required for a complete quantity adjustment to occur in response to a “once-and-for-all” price change.

Distributed Lag Models Refers to a delayed adjustment in quantity as a result of a price change. And the adjustment may be spread over a period of time.

Speculative Demand Consumer demand for current consumption Speculative demand Anticipated demand and uses Future cost > current cost + all storage costs Commodity market financial investment “open interest” Current market price impacted by current and expected events.

Primary and Derived Demand Quantity Derived Demand Primary Demand PrPr PdPd Price

Own-Price Elasticity of Demand Relates changes in the price of the commodity back to the changes in quantity demanded. Defined at a point along the demand curve. At the average Arc formula Assuming Q = f(P)

Own-Price Elasticity of Demand Range Elastic Unitary Elasticity Inelastic Revenue and elasticity TR = P(Q)

Income Elasticity of Demand Relates changes in income back to the changes in quantity demanded. Defined at a point along the demand curve.

Income Elasticity of Demand Range Inferior Normal

Cross-Price Elasticity of Demand Relates changes in the price of the jth product back to the changes in the quantity demanded for the ith product. Defined at a point along the demand curve.

Cross-Price Elasticity of Demand Range Independent Substitute Complement Generalizations because of the “income and substitution effects” of a price change of inferior goods.

Summary Questions Explain the difference between individual and market demand. Describe the difference between the short and long run as it relates to market demand. What is meant by a distributed-lag……as it relates to demand? Explain what the own-price, income, and cross-price elasticity of demand are each measuring.