CHAPTER 5 DEMAND

5.1. DEMAND AND THE LAW OF DEMAND

Demand is a schedule which summarizes the willingness of buyers to purchase a given product during a specific time period at each of the various prices at which it might be sold . Demand does not reflect what buyers want or need, but only what they are willing and able to pay for.

5.1.1. Expressing Demand Information concerning the demand can be expressed in three different, but dependent, ways: demand tables (schedules , demand cur!es, and"or demand functions. (1 Demand schedule suppose data are shown in tables (#ab.5.1 . $s a tabular statement of a buyer%s plans or intentions, with respect to the purchase of a product demand for construction surface, for instance, is represented in table 5.1. It is !ery important to obser!e, the &uantity demanded at each price le!el must relate to some specific time period (an hour, a day, a wee', a month, a year, etc. .

((

Economics
Tab.5.!. An "ndividual #uyer$s %emand for Construction &urface 'hypothetical data(

)rice of the construction surface (monetary unit"s&uare metre + ( , 1.

*uantity demanded (s&uare metre"year 1.. /. -. 0. ,.

(+ Demand curve is the line showing the relationship between price per unit and the ma)imum *uantity buyers would be willing to buy . In economics texts, demand cur!e could be usually a straight line which is assumed to ha!e a negative slope (1ig.5.1 . 2ther things being e&ual, as price falls the corresponding *uantity demanded rises and conversely as price increases the corresponding *uantity demanded falls. 3enerally, if the price of a good rises, then other goods might loo' a little more attracti!e, and buyers would demand less of this good. 4ut that assume that consumers5incomes, tastes etc. stay constant. If they change, then we would ha!e an entirely new demand cur!e. #his is the law of demand.

%emand

(5

+ig.5.!. An "ndividual #uyer$s %emand Curve

(6 Demand function is a mathematical relationship between price and *uantity demanded. In the graph (1ig.5.1 we obser!e that as price increases by + monetary units, &uantity demanded falls by 1. units (s&uare metres in our case . #his suggest a demand function. 5.1.+. The Quantity Demanded #he quantity demanded is the amount of a good that will be purchased in the mar,et at a given price . #he graph from figure 5.1 shows different price and &uantity demanded combinations: 7 at mar'et price ). (,m.u. , &uantity demanded is *1 (-. s&uare metres 8 7 at mar'et price )+ (1. m.u. , &uantity demanded is *+ (,. s.m. 8 7 at mar'et price )( (+ m.u. , &uantity demanded is *( (1.. s.m. .

(,

Economics

#he effects of changes in price of the &uantities demanded are different. 9uppose that price starts out at )., with associated &uantity demanded of *. (1ig.5.1 : 7 if price rises from ). to )+, &uantity demanded will fall from *. to *+8 at higher prices, a lower &uantity will be demanded8 7 if price falls from ). to )(, &uantity demanded will rise from *. to *(8 at lower prices, &uantity demanded will be higher.

5.1.6. Market Demand Curve

4ecause consumers are willing to buy different amounts at different prices, market demand curve is found by ta'ing the hori-ontal summation of all the individual demand curves for a good. #his way, the demand cur!e D shows how much of the good * buyers will purchase in the mar'et at each possible price ) (1ig.5.+ . E)emple 9uppose that there were :ust two consumers in the mar'et for the good 3: consumer $ and consumer 4. #heir indi!idual demand cur!es will be different, according to their different preferences for the good 3. 1igure 5.6 represents the two indi!idual demand cur!es along with the mar'et demand cur!e for good 3, obtained by a horizontal summation of the two indi!idual cur!es.

%emand

(0

+ig.5... /ar,et %emand Curve '%( as the &um of the "ndividual %emand Curves '%!0%.0...0%n(

(-

Economics

+ig.5.1. /ar,et %emand Curve 'An E)emple(

%emand

(/

#he mar'et demand cur!e for good 3 is found by summing together the *uantities that both consumers demand at each price . 1or exemple, at a price of one monetary unit, consumer $ demands two units, while consumer 4 demands :ust one unit, and the mar'et demand will be: + units ; 1 unit < 6 units of good 3.

5.2. CHANGES IN DEMAND

5.2.1. Shifts in Demand

Demand on the mar'et does not alway stay the same. )rices change and, conse&uently, &uantities demanded change. $ change in demand refers to a shift in the entire demand curve either (1ig.5.( .: 7 outward, to the right (an increase in demand , or 7 inward, to the left (a decrease in demand .

5.

Economics

+ig.5.2. A Change in 3ne or /ore of the %eterminants of %emand

#he demand cur!e will shift: 7 outward, if the mar'et demand increases from, say, the original cur!e D. to cur!e D1, so that &uantity demanded at the price le!el ) will be greater (*+ 8 4 inward, if mar'et demand decreases from, say, the original cur!e D . to cur!e D1, so that the &uantity demanded at the price le!el ) is now less (*+ .

5.2.2. Demand Shifters In the simple demand model we are discused up to now, =other things being e&ual= (or ceteris paribus assumption ignores exogenous !ariables (things that happen outside the model . 4ut there are some common exemples of exogenous, real>world causes of shifts in demand. $n increase or decrease in the demand for a specific product can be caused by some nonprice determinants (demand shifters : changes in consumer tastes, number of buyers, changes in money income, price of related goods, and consumer expectations.

%emand

51

(1 $ change in the number of buyers in a mar'et, in terms of the increasing or decreasing of consumers will constitute an increase or decrease of their demand. (+ A change in consumer tastes, prompted by ad!ertising, fashion or technological changes can increase or decrease the demand for this product. (6 Consumer e)pectations about different aspects of the future, such as changes in the product le!el, can determine a shift in demand in terms of its increase or decrease. (( The change in income has an impact more complex upon the demand. It depends on the type of the specific product: normal inferior or lu)ury goods. ! "ormal goods are those for which demand varies directly with the money income: a rise in income cause an increase in demand and, alternati!ely, a fall in income cause an decline in demand. ?ost products are commodities, normal goods and their demand cur!es slope downward from left to right (negati!ely . ! #nferior goods are those for which demand varies inversely with a change in money income: a rise in income cause a decline in demand and a fall in income cause an increase in demand. ! $uxury goods do not obey the law of demand. #heir demand cur!es go an un>typical way: *uantity demanded is higher at high prices than at low prices. 1amous brands of some product (fashion brands, for instance are desirable especially because they are expensi!e8 their main destination is to express the owner%s weath, but they aren%t much use for anything else. If they were cheap, they wouldn%t ser!e this purpose, and the &uantity demanded of them would be less. (5 The price of related goods has, once again, a complex impact on the demand for a specific product depending on the type of relationship. @e distinguish here three types of relationship between two different goods: substitute goods, complementary 'associated( goods and independent goods. ! %u&stitutes are two or more products for which the price of one good and the demand for the other are directly related. A Complements (associated are two or more products for which the price of one good and the demand for the other are inversely related. A #ndependents are two or more products for which a change in the price of one would ha!e little or no impact upon the demand of the other.

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5. . DEMAND ELASTICIT! 5. .1. E"asti#it$ %f Demand

Economics

#he most basic thing about elasticities is that they are measures of how sensiti!e, how responsi!e, one !ariable is to change in another !ariable. #he specific measure of sensiti!ity we choose is the ratio of percentage change, for exemple, the percentage change in the dependent !ariable per unit percentage change in the independent !ariable. 1or any relationship between a dependent !ariable and one or more independent !ariables, an elasticity can be calculated between the dependent !ariable and each of the independent !ariable. 3enerally, elasticity is a measure of the percentage change in one variable 'say 5( compared to the percentage change in another 'say 6(7

E xy =

% X % Y

$ccording to the laws of algebra, elasticity is: 7 positive if the slope of the function it describes is a positi!e one8 7 negative if the slope of the function it describes is a negati!e one. In our case, a demand cur!e, for which &uantity demanded changes in the opposite direction from a change in price (as price rises, &uantity demanded falls and !ice !ersa , except luxury goods, has a negative elasticity. $lthough elasticity usually is mathematically negati!e, economists generally show it as positi!e. $s we already saw, demand changes o!er time as response to changes in prices and income. #he point is how much could be these changes8 #here are two main factors which determine changes in demand: the level of price in the mar,et and consumers$income. 7 'rice elasticity of demand describes the relationship between changes in price 'P( and changes in *uantity demanded (*D , whether &uantity demanded changes more or less rapidly than does price. )rice elasticity of demand shows: A how *uantity demanded reacts to changes in price8 A what happens to total revenue, the total sum of money spent in the mar'et on the good in &uestion, when price changes and the demand cur!e does not shift.

%emand

56

7 #ncome elasticity of demand measures the response of the *uantity demanded of a good when consumers$income change.

5.6.+. Meas&rin' (ri#e E"asti#it$ %f Demand )rice elasticity of demand is measured as the percentage change in &uantity demanded di!ided by the percentage change in price:

ED =

percentage change in quantity demanded percentage change in price

, or

ED =

change in quantity demanded change in price : original quantity demanded original price

#he &uantity demanded leads us to a specific le!el of the total revenue (spending ( the total sum spent on the good in the mar,et for a specific price. Total revenue = Price Quantity demanded 2n the mar'et, can be identified three generic situations (1ig.5.6 : elastic demand, inelastic demand, and unit elastic demand. (1 Demand is elastic if a gi!en percentage change in price is accompanied by a relati!ely larger percentage change in the &uantity demanded. )rice and total re!enue change in opposite direction: A when price rises, total re!enue falls8 A when price falls, total re!enue rises.

% QD > % P,

so Ep > 1,

where:

5(
% QD is the percentage change in the quantity demanded;

Economics

% P is the percentage change in the level of price;

Ep is the price elasticity of demand.

%emand

55

+ig.5.5. Price Elasticity of %emand

5,
E)emple B ) < (1. > - " - < +5B B *D < (1.. > ,. " ,. < ,0B Cp < B *D " B ) < ,0B " +5B < 2)*+

Economics

(+ Demand is inelastic if a gi!en percentage change in price is accompanied by a relati!ely smaller percentage change in the &uantity demanded. )rice and total re!enue change in the same direction. @hen: A price rises, total re!enue rises8 A price falls, total re!enue falls, too.

% QD < % P, so Ep < 1,

where:

% QD is the percentage change in the quantity demanded;

% P is the percentage change in the level of price; Cp is the price elasticity of demand. E)emple B ) < (1. > - " - < +5B B *D < (1.. > /. " /. < 11B Cp < B *D " B ) < 11B " +5B < ,)--

(6 Demand has a unit elasticity if a gi!en percentage change in price is accompanied by a e&ually percentage change in the &uantity demanded.

%emand
% QD = % P, so Ep = 1,

50

where:

% QD is the percentage change in the quantity demanded;

% P is the percentage change in the level of price; Ep is the price elasticity of demand.

E)emple B ) < (1. > - " - < +5B B *D < (1.. > -. " -. < +5B Cp < B *D " B ) < +5B " +5B < 1),,

#hese different cases of the price elasticity of demand array between two extreme situations (1ig.5., : perfectly elastic demand and perfectly inelastic demand. (1 Demand is .erfe#t"$ e"asti# when there is a small price reduction which would cause buyers to increase their purchases from -ero to all they could obtain8 a perfectly elastic demand cur!e is a line parallel to the hori-ontal a)is.

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Economics

+ig.5.9. Perfectly Elastic '%!( and "nelastic '%.( %emand (+ Demand is perfectly inelastic when a change in price results in no change whatever in the *uantity demanded8 a perfectly inelastic demand cur!e is a line parallel to the !ertical axis (D+ . $ particular case of the demand elasticity concerne the relationship between the product demand and resource demand. 3enerally, the elasticity of demand for any resource will depend upon the elasticity of demand for the product which it helps produce. The greater the elasticity of product demand the greater the elasticity of resources demand. #he explanation consists in the deri!ed nature of resources demand. $ small rise in the price of a product with great elasticity of demand will gi!e rise to a sharp drop in output and, therefore, a relati!ely large decline in the amounts of the !arious resources demanded. #his correctly implies that the demand for the resource is elastic.

5.6.6. Determinants %f (ri#e E"asti#it$ %f Demand #here are se!eral factors which can affect the direction and the magnitude of consumers%ad:ustments to price changes, depending on their sensibility. #he main of these factors are: importance of the good in the consumer%s budget, substituibility of the product, type of goods, and the ad:ustment time a!ailable.

%emand

5/

(1 #mportance of the good in the consumer)s &udget . 2ther things being e&ual, the larger a good portion in one$s budget the greater tend to be the elasticity of demand for this product. Donsumers are not !ery concerned about prices of goods upon which they spend a small percent of their income. #heir demand for them tends to be inelastic. 4ut price changes of goods that they spend a large percent of their budget on ha!e much more significant impacts8 demand for such goods tends to be more elastic. (+ %u&stitui&ility of the product means the degree to which a good could be replaced in consumption by another good. #he larger the number of substitute products a!ailable, the greater the elasticity of demand. (6 Type of goods* necessities or luxuries . #he demand for goods that consumers consider to be necessities is li'ely to be more inelastic !ersus the demand for luxuries and frills, which tends to be elastic. (( +d,ustment time. Demand changes pertain to a time frame, therefore, for most goods it is important to distinguish between short:run and long:run elasticities.

Demand tends to be more elastic the longer the time a!ailable to ad:ust to changes in the price le!el. #he explanation of this phenomenon consist in the fact that many consumers, e!en organizations, are creatures of habits. @hen the price of a product rises, it is necessary a specific time period to see' out and experiment with other products to !erify if they are acceptable.

5. .-. Cr%ss E"asti#it$ %f Demand

If price elasticity of demand expresses the effect of a change in a product%s price upon the &uantity of that product, another !irtual influence ha!e to be measured: the price of a different product. Cross elasticity of demand shows how sensitive consumer purchases of one product 'say /( are to change in the price of some other product 'say ;(. #he formula for the coefficient of cross elasticity of demand is similar to simple price elasticity ,except that we are relating the percentage change in the consumption of E to a percentage change in the price of F:

,.

Economics

E MN

percentage change in quantity demanded of M = percentage change in price of N

Dross elasticity concept allow us to more deeply understand substitute and complementary goods. If cross elasticity of demand is: 7 positive &uantity demanded of good ? !aries directly with a change in the price of good G, then ? and G are substitute goods (for instance: coffee and tea 8 7 negative &uantity demanded of good ? !aries indirectly with a change in the price of good G, then ? and G are complementary goods that means they =go together= in consumption (for exemple: gaz and cars .

5. .5. In#%me E"asti#it$ %f Demand )rice is not the only factor which influences the &uantity demanded. #here are many other economic influence and a !ery important one is consumers%income. #he core logic of elasticity also apply in this particular case. #ncome elasticity of demand measures the sensibility of *uantity demanded of a good in response to changes in the incomes of consumers who buy it.

EI =

% QD % I

1or normal goods, income elasticity of demand is positive: &uantity demanded rises or falls as income does. #here are two generic situation: income elasticity above 1, and income elasticity below 1. (1 'ositive income elasticity- Income elasticity is above 1 when the percentage change in *uantity demanded e)ceeds the percentage change in income. #hat means &uantity demanded rises or falls faster than income does. % QD > % I,

%emand
where:

,1

% QD is the percentage change in quantity demanded.

% I is the percentage change in income. Donsumers will spend a larger fraction of their incomes on the good as their incomes rise, and a smaller fraction of their incomes on it when their incomes fall. 1or most goods the income elasticity coefficient will be positi!e, but it still !aries greatly among products.

(+ "egative income elasticity- Income elasticity of demand is below 1 when the percentage change in *uantity demanded is less than it is for income. % QD < % I,

where:

% QD is the percentage change in quantity demanded.

% I is the percentage change in income.

#hat means consumers will spend a smaller fraction of their incomes on the good as their incomes rise, and a larger fraction of their incomes on it when their incomes fall.

5.(. NECESSITIES AND L/0/1IES2 NO1MAL AND INFE1IO1 GOODS Depending on their income elasticity of demand, goods are classified in lu)uries and necessities.

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!.

Economics
. $uxuries are those goods with income elasticity of demand above !. . "ecessities are and those with income elasticity of demand below

@hen income falls, consumers cut bac' more on goods they can do without. Don!ersely, when income rises, they feel they can better afford these luxuries, for which income elasticity of demand, then, exceeds 1. $nother classification of goods regards their income elasticity of demand. #hey are normal 'superior( and inferior goods. . "ormal (superior goods are those for which the income elasticity of demand is positive.#hat is, as consumer income increases or falls, the &uantity demanded of normal goods rises and falls with income. ?ost goods are normal goods. $ll inferior goods are necessities, but normal good are necessities only if they are not luxuries (1ig.5.0 .

+ig.5.<. Relationships between ;ormal "nferior =oods ;ecessities and >u)uries

. #nferior goods( are those for which the income elasticity of demand is negative. 1or inferior goods, &uantity demanded of them: 7 decreases as income rises8 7 increases as income falls. #his negati!e income elasticity of demand for inferior goods usually occurs because there are more desirable, but also more e)pensive, close substitutes for them. Donsumers% beha!ior is different depending to changes in their incomes:

%emand

,6

7 when their incomes fall, consumers can ad:ust by substituting the other way8 they buy more of the inferior good, substituting it for the more expensi!e normal good8 7 when their incomes increase, consumers are more easily able to buy the preffered, but more expensi!e substitute, close substitutes for them. #he practical significance of income elasticity coefficients is that they help us predict which industries are li'ely to expand in the future and which to decline. 2ther things being e&ual: 7 a high positive income elasticity implies that industry will share more than proportionately in the o!erall income growth of the economy8 7 a small positive or, worse yet, a negati!e coefficient implies a declining industry.

3E! CONCE(TS %emand %emand schedule 'table( %emand curve %emand function 'e*uation( ?uantity demanded /ar,et demand curve >aw of demand Elasticity Elasticity of demand Price elasticity of demand Total revenue 'spending( "nelastic demand Elastic demand @nit elastic demand Perfectly elastic demand Perfectly inelastic demand Elasticity of product demand Elasticity of resource demand %eterminants of demand Change in demand &hift in demand %emand shifters Cross elasticity of demand &ubstitute goods Complementary goods "ncome elasticity of demand Positive income elasticity ;egative income elasticity ;ecessities >u)uriy goods ;ormal 'superior( goods "nferior goods

CHAPTER 9 S/((L!

*.1. S/((L! AND LAW OF S/((L!

%upply is a schedule which summari-es the willingness of firm as sellers to produce a given product during a specific time period at each of the various price at which it might be sold. ,.1.1. E4.ressin' S&.."$ Hust as with demand, the information concerning supply can be expressed in three different, but related ways: supply schedules (tables , supply cur!es, and"or supply functions.

(1 $ supply schedules suppose data are shown in tables. $s a tabular statement of a producer%s plans or intentions with respect to the production of a specific good, supply for construction surface, for instance, is represented in table ,.1. It is !ery important to obser!e, the &uantity supplied at each price le!el must relate to some specific time period (an hour, a day, a wee', a month, a year etc. .

&upply
Tab.9.!. An "ndividual Producer$s 3ffer for Construction &urface 'hypothetical data( )rice of the construction surface (monetary unit"s&uare metre + ( , 1. *uantity supplied (s&uare metre"year ,.. 0.. -.. /.. 1....

,5

(+ $ supply curve shows the ma)imum *uantity sellers would be willing to offer at each possible price and at any given level of other variables that might affect supply. In economics texts supply cur!e usually could be a straight line which is assumed to be positi!ely sloped (1ig.,.1 .

2ther things being e&ual:

7 as price increases, the corresponding &uantity supplied rises8 7 as price falls, the corresponding &uantity supplied falls.

It is the law of supply. It states the producers are stimulated or dissapointed according to the mo!ement of price: an increase or a decrease. 7 $ higher price would encourage sellers to offer more, partly because it would help co!er the costs of expansion. If any of the !ariables that affect production costs change, then the whole supply cur!e would shift. 7 $ lower price would discourage sellers to continue offering on the mar'et and, conse&uently, it is most li'ely, they will restrain their production capacities. #he supply cur!e in a graph usually slopes upward from left to right 'positively( reflecting the law of supply.

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Economics

+ig.9.!. An "ndividual Producer$s &upply Curve

(6 $ supply function is a mathematical relationship between price and *uantity supplied. In the graph (1ig.,.1 we obser!e as price increases by + monetary units, &uantity supplied rises by 1.. units (&uadrat metres in our case . #his suggest a supply function. ,.1.+. The 5&antit$ S&.."ied Quantity supplied is the amount of a good that will be produced for the mar,et at a given price. #he graph from figure ,.1. shows different price and &uantity supplied combinations: 7 at mar'et price ). (, m.u. , &uantity supplied will be * . (-.. s&uare metres 8 7 at mar'et price )+ (1. m.u. , &uantity supplied will be *+ (1.... s.m. 8 7 at mar'et price )( (+m.u. , &uantity supplied will be *( (,.. s.m. . #he effects of changes in price on the &uantity supplied are different. 9uppose that price starts out at )., with associated &uantity demanded of *. (1ig.,.1 :

&upply

,0

7 if price rises from ). to )+, &uantity supplied will rise from *. to *+8 at higher prices, &uantity supplied will be higher8 7 if prices falls from ). to )(, &uantity supplied will fall from *1 to *+8 at lower prices, a lower &uantity will be supplied.

,.1.6. Mar6et S&.."$ C&r7e 4ecause producers are willing and able to offer different amounts at different price le!els for a specific good, market supply curve is the cumulati!e indi!idual supplies for that good. It is found by ta'ing the hori-ontal summation of all the individual supply curves for a good. #his way, the supply cur!e 9 shows how much of the good * producers will offer in the mar'et at each possible price ) (1ig.,.+ . E)emple 9uppose that there were :ust two suppliers in the mar'et for the good 3: supplier $ and supplier 4. #heir indi!idual supply cur!es will be different, according to their different productions for the good 3. 1igure ,.+ represents the two indi!idual supply cur!es along with the mar'et supply cur!e for good 3, obtained by a horizontal summation of the two indi!idual cur!es. #he mar'et supply cur!e for good 3 is found by summing together the *uantities that both producers offer at each price. 1or exemple, at a price of one monetary unit, supplier $ offers two units, while supplier 4 offers :ust one unit, and the mar'et supply will be +;1<6 units of good 3.

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Economics

+ig.9... /ar,et &upply Curve '&( as a &um of "ndividual &upply Curves '&! 0 &. 0......0&n(

&upply

,/

*.2. CHANGES IN S/((L!

*.2.1. Shifts in S&.."$

9upply on the mar'et does not always stay the same. )rices change and, conse&uently, &uantities supplied change. $ change in supply refers to a shift in the entire supply cur!e that mo!es either (1ig.,.6 : 7 outward, to the right (an increase in supply 8 7 inward, to the left (a decrease in supply .

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Economics

+ig.9.1. A Change in 3ne or /ore of the %eterminants of &upply

#he supply cur!e will shift: 7 outward if mar'et supply increases from, say, the original position 9 . to cur!e 91, so that &uantity supplied at the price le!el ) will be greater (*1 8 4 inward if mar'et supply decreses from the original position 9 . to cur!e 9+, so that &uantity supplied at the price le!el ) will be now less (*+ .

*.2.2. S&.."$ Shifters

&upply

01

$n increase or decrease in the supply for a specific product can be caused by some non/price determinants (supply shifters : price of production factors, expectations about future le!el of product price, price of related goods, le!el of taxes and subsidies, technological changes, and the characteristics of the industry. (1 + decrease in the resource price will lower production costs and, conse&uently, shifts the supply cur!e to the right. Don!ersely, an increase in input prices will raise production costs and reduce supply, shifting the supply cur!e to the left. (+ E4.e#tati%ns #%n#ernin' the f&t&re .ri#e %f a .r%d&#t can affect a producer%s current willigness to supply that product. Ie will be stimulated to increase its own supply if he anticipate a future rise of the price or to decrease its own supply if he anticipate a future fall down of the price. (6 + change in the price of other goods can also shift supply cur!e for a product, especially if this will be further manufacturated (exemple: the supply for iron minerals will depend on the demand and price of steel in the mar'et . (( #ncreasing taxes usually reduces supply, because businesses treat most of them as costs. Don!ersely, su&sidies stimulate producers to increase their supply in such area. (5 Technological changes and the perspecti!e of producing at lower costs will stimulate producers to increase their supply. (, Industries that ha!e in their structure lots of small firms differ from those with few firm in the way supply is determined. 3i!en the scale of operations of each firm, the larger the number of suppliers, the greater will be mar'et supply and the supply cur!e will shift to the right. Don!ersely, the smaller the number of firms in an industry, the less the mar'et supply will be, firms lea!e that industry and supply cur!e will shift to the left.

*. . S/((L! ELASTICIT!

*. .1. (ri#e E"asti#it$ %f S&.."$

$s we already saw, supply changes o!er times as response (reaction to changes in price. #he point is how much could be these changes8

0+

Economics

'rice elasticity of supply describes the relationship between changes in price 'P( and changes in *uantity supplied '? s(7 whether &uantity supplied changes more or less rapidly than does price. )rice elasticity of supply is measured as the percentage change in &uantity supplied di!ided by the percentage change in price. @hen calculated, price elasticity of supply should be positi!e. #herefore, when mar'et price changes, total re!enue will change in the same direction as price: 7increases in price lead to increases in total re!enue8 7decreases in price lead to decreses in total re!enue.

ES =

% Q S % P

9upply elasticity is calculated in the same fashion as demand elasticity. In the mar'et, can be identified three generic situations (1ig.,.( : elastic supply, inelastic supply, and unit elastic supply.

&upply

06

+ig.9.2. Price Elasticity of &upply

0(

Economics

(1 %upply is elastic if a gi!en percentage change in price is accompanied by a relati!ely larger percentage change in the &uantity supplied. )rice and supply change in the same direction: 7 when price rises, supply rises8 7 when price falls, supply falls, too.

% Qs > % P,

so Es > 1,

where:

% Qs is the percentage change in the quantity supplied;

% P is the percentage change in the level of price.

Es is the price elasticity of supply.

E)emple: B ) < (1. > - " - < +5B B *s < (1.. > ,. " ,. < ,0B Cp < B *s " B ) < ,0B " +5B < 2)*+

(+ %upply is inelastic if a gi!en percentage change in price is accompanied by a relati!ely smaller percentage change in the &uantity supplied.

% Qs < % P,

so Ep < 1,

where:

&upply
% Qs is the percentage change in the quantity supplied;

05

% P is the percentage change in the level of price. Cs is the price elasticity of supply. E)emple: B ) < (1. > - " - < +5B B *s < (1.. > /. " /. < 11B Cp < B *s " B ) < 11B " +5B < ,)--

(6 %upply has a unit elasticity if a gi!en percentage change in price is accompanied by a e*ually percentage change in the &uantity supplied.

% Qs = % P,

so Ep = 1,

where:

% Qs is the percentage change in the quantity supplied;

% P is the percentage change in the level of price. Cs is the price elasticity of supply. E)emple: B ) < (1. > - " - < +5B B *s < (1.. > -. " -. < +5B Cp < B *s " B ) < +5B " +5B < 1),,

0,

Economics

*. .2. Im.a#t %f Time

Clasticity of supply depends partly on the time a!ailable for firms to ad:ust to mar'et price changes. #he amount of time which a producer has to respond to a gi!en change in product price is the main determinant of the elasticity of supply. 3enerally spea'ing, a greater output response is expected the longer the amount of time a producer has to ad:ust to a gi!en price change. #his is because a producer%s response to an increase in the price of product E depends upon its ability to shift resources (factor of production from the production of other goods to the production of E. #his resources shifting ta'es time. @e distinguishes between immediate mar'et period, short>run, and long> run (1ig.,.5 .

(1 In the immediate market period, there is insufficient time to change output, so supply will be perfectly inelastic. (+ In the short/run( firms are restricted by plant capacity, factory, supplies etc., but output can be altered by changing the intensity of its use, so supply will be more elastic. (6 In the long/run( all necessary ad:ustments, including changes in plant capacity, can be made and supply become still more elastic.

*. . . (erfe#t"$ Ine"asti# S&.."$ 'erfectly inelastic supply occur when supply cur!e is graphed as a vertical line. In this situation, supply cannot change at all no matter how high or low prices go. @hen supply is perfectly inelastic, shifts in demand change only price and total re!enue, since &uantity supplied cannot change.

&upply

00

+ig.9.5. Time and Elasticity of &upply

0-

Economics

$s we already saw, the immediate run is a time period so short that firms cannot ma'e any ad:ustments at all8 during this time, supply must remain perfectly inelastic. 1or some goods that are very e)pensive and ta'e a long time to produce (buildings, factories etc. , the immediate run can be &uite a while. Jntil new ones can be planned, designed, built and brought on line, the fixed, perfectly inelastic supply of existing ones will be all there is. 9ome other goods ha!e, by their nature, a permanently limited supply available and their supplied &uantity can ne!er be augmented. Kand and certain rarities (faimous paintings, stamps, coins etc. are exemples. 1or each there is a fixed amount in existence, and no more can be made.

0E1 C2"CE'T% &upply &upply schedule 'table( &upply curve &upply function 'e*uation( >aw of supply ?uantity supplied /ar,et supply curve %eterminants of supply shifters( Change in supply &hift in supply Price elasticity of supply Elastic supply "nelastic supply @nit elastic supply Time and elaticity of supply "mmediate mar,et period 'supply &hort:run >ong:run Perfectly inelastic supply

CHAPTER < T3E241 25 C2"%6ME4 7E3+8#24

Cconomic theory of consumer beha!ior explaines how consumers allocate their incomes and how this determines the demands for !arious goods and ser!ices. #his, in turn, can help economists to understand how changes in income and prices affect demand and why the demand for some products are more sensiti!e than others to changes in price and income.

#here are three main aspects here:

7 consumer preferences L how people might prefer one good to another8 7 budget constrains L the limited incomes which ha!e to be allocated among consumption items8 7 consumer choices L which means putting together consumer preferences and budget constrains.

-.
0.1. D2G9J?CM DI2IDC

Economics

#he theory of consumer &ehavior describes how indi!idual consumers ma'e economic choices, gi!en their preferences, their incomes and the price of good that they desire to purchase. #he 'ey concept is here marginal utility. #he model of consumer choice allows us to predict how consumers will respond to changes in mar'et conditions. #he theory of consumer choice is built on the assumption that people beha!e rationally in attempting to maximize the satisfaction they can obtain by purchasing a specific combination of goods and ser!ices. $ typical consumer can be described li'e this: 7 he is a fairly rational person who attempts to dispose of his income in such a way as to deri!e the greatest amount of satisfaction (utility of it (a rational behavior 8 7 he has rather clear>cut preferences for !arious goods and ser!ices a!ailable in the mar'et8 7 he has a limited money income (&udget because he supplies limited amounts of human and property resources to businesses8 7 because the products he wants ha!e price tags on them, he will be able to purchase only a limited amount of goods. #he consumer must ma'e compromises. #hat means choices (trade/ offs must be made among alternati!e goods to obtain with limited money resources the most satisfying mix of goods and ser!ices. Donse&uently, consumer choice can be !iewed in two related parts: 7 the study of consumer preferences8 7 the analysis of the budget line, which constrains the choices a person can ma'e.

8.2. LAW OF DIMINISHING MA1GINAL /TILIT! Donsumers allocate their limited resources in order to buy goods and ser!ices that yield them the most satisfaction (utility . 6tility is the satisfaction obtained from the consumption of goods and services. Jtility is a subAective measure of satisfaction that !aries from a people to another, according to each indi!idual%s preferences. It is not possible to measure different utilities, nor is it possible to claim that one indi!idual%s utility is higher than another%s. Jtility is :ust a unitless measure that economists use in their explanation of consumer beha!ior.

Theory of Consumer #ehavior

Jtility has two specific characteristics:

-1

7 it is different from =usefulness=8 7 it is a subAective concept, because it will !ary widely from person to person for the same product. #here are four aspects of the economic utility: cardinal utility, ordinal utility, marginal utility, and total utility. (1 Cardinal utility refers to putting an absolute measure of utility upon goods and ser!ices that form in their different combinations !arious mar'et bas'ets. In this case, the !alue :udgement is: =I li'e this product twice as much I li'e that product=. It is an interpersonal utility comparison. Dardinal utility cannot be measured. (+ 2rdinal utility expresses the utility only by ran,ing the consumer%s preferences among goods and mar,et bas,ets. #his time, ordinal utility can be measured. #he !alue :udgement is: =I li'e this product the most, this one next, this one third > best, a.s.o.=. 4y as'ing costumers if they li'e product ? more, less or the same as 4, responses ma'e possible ran'>ordering goods and ser!ices in order of preferences. (6 Marginal utility of a good or ser!ice is the additional utility a consumer recei!es from the consumption of one more unit of it, while holding consumption of e!erything else constant. (( Total utility is the utility that an indi!idual recei!es from consuming a certain amount of a particular good or ser!ice. $aw of diminishing marginal utility states that the marginal utility that ones recives from consuming succesive units of the same good or service will decrease as the number of units consumed increases . #his law is a 'ey element in the theory of consumer beha!ior. E)emple Donsider the thirst specific to a hot sommer day and many glasses of mineral water. @e assume all the units of mineral water glasses are considered here to be identical. #he utilities that one obtains from drin'ing succesi!e glasses of mineral water are different. #he first glass :ust begins to &uench its thirst8 the utility recei!ed is &uite high and it is !ery satisfying because the consumer is !ery thirsty. If the consumer drin's a second one, the utility recei!ed from it is less than the utility recei!ed from the first one. #he marginal utility of the

-+

Economics

second glass is lower because the consumer already has had one and he is no more thirsty as before. $ third glass of water might also pro!ide some utility, but not as much as the second glass. $ fourth glass cannot be finished. #o sum up, for each additional unit consumed the marginal utility of normal good is declining while the total utility is increasing but by less.

8. . CONS/ME1 E5/ILI91I/M Donsumers ha!e limited incomes with which to buy goods and ser!ices, so they can%t consume all of e!erything that they may want. Donse&uently, their ob:ecti!e will be to allocate their incomes so as to buy the one combination of goods and ser!ices that allows to maximize utility by getting the most utility possible from spending their incomes. #his is the principle of utility ma)imi-ation. In maximi9ing total utility , the consumer faces a number of constraints7 4 the consumer$s incomeB 4 the price of the good and services consume etc. that the consumer wishes to

#he consumer%s effort to maximize total utility is refered to as the consumer$s problem. In this respect, the consumer e*uilibrium is referred to as solution to the consumer%s problem. #his entails decisions about how much the consumer will consume of a number of goods and ser!ices.

8. .1. Determinin' the C%ns&mer E:&i"i;ri&m Donsumers maximize utility by allocating their incomes so that the marginal utility per monetary unit spent to be the same for all goods and ser!ices consumed. #he marginal utility of the last unit of good 1 consumed (?J1 di!ided by the price of good 1 ()1 must e&ual the result of the same calculation for good +, good 6, etc. MU1/P1 = MU /P = !!!!!!!!!! = MUn/Pn

E)emple

Theory of Consumer #ehavior

-6

#o illustrate how the consumer e&uilibrium condition determines the &uantity of goods that the consumer demands, consider the simplier case of a consumer who is choosing among only two goods: good $ and good 4. #his consumer 'nows the prices of good $ and good 4 and has a fixed income (budget that can be used to purchase &uantities of goods $ and 4. It is expected the consumer will buy &uantities of good $ and 4 so as to completely exhaust the budget for such purchases. #he actual &uantities purchased of each good are determined by the condition for consumer e&uilibrium: MU"/P" = MU#/P# #his condition states that the marginal utility per monetary unit spent on good $ must e&ual the marginal utility per monetary unit spent on good 4. If, for exemple: the marginal utility per monetary unit spent on good $ were higher than the marginal utility per monetary unit spent on good 4, then it would ma'e sense for the consumer to purchase more of good $ rather than purchasing any more of good 4. $fter purchasing more and more of good $, the marginal utility of good $ will e!entualy fall due to the law of diminishing marginal utility, so that the marginal utility per monetary unit spent on good $ will e!entually e*uali-e that of good 4. 2f course, the amount purchased of good $ and 4 cannot be unlimited and will depend not only on the marginal utilities per monetary unit spent, but also on the consumer%s budget. #he condition for consumer e&uilibrium can be further extended to the more realistic case where the consumer must choose how much to consume of many different goods. #he consumer e&uilibrium condition for this general situation is to e&ualize all of the marginal utilities per monetary unit spent, sub:ect to the constraint that the consumer%s purchases do not exceed his budget.

8. .2. An E4em."e 9uppose: 7 the price of good $ is + monetary unit per unit8 7 the price of good 4 is 1 monetary unit per unit. 7 the consumer has a budget limited to 5 monetary unit. #he marginal utility (?J that the consumer recei!es from consuming 1 to ( units of good $ and 4 is represented in table 0.1. ?arginal utility is here measured in fictional units called =utils=, which ser!e to &uantify the consumer%s additional utility (satisfaction recei!ed from the consumption of different &uantities of goods $ and 4. #he rule is: the larger the number of

-(

Economics

utils the greater is the consumer$s marginal utility from consuming that unit of the good. #able 0.1 also contains the ratio of the consumer%s marginal utility to the price of each good, obtained by di!iding the marginal utility corresponding to different units of the good to the price of that good. Tab.<.!. Consumer E*uilibrium for Two =oods 3ood Jnits (* 1 + 6 ( $: )rice () + + + + ?arginal utility (?J +( 11+ , ?J") 1+ / , 6 3ood Jnits (* 1 + 6 ( 4: )rice () 1 1 1 1 ?arginal utility (?J / 5 1 ?J") / 5 1

In order to find the consumer e&uilibrium, we compare the marginal utility per monetary unit spent (the ratio of the marginal utility to the price of a good for goods $ and 4, sub:ect to the constraint that the consumer does not exceed her budget limited to 5 monetary units. #he marginal utility per monetary unit spent on the first unit of good $ is greater than the marginal utility per monetary unit spent on the first unit of good 4 (1+utilsN/utils . #he consumer can afford to purchase this firs unit of good 4, because its price is + monetary unit per unit. $fter this, he has 5> +<6 monetary units remaining in his budget. In the next stage, the consumer will compare the marginal utility per monetary unit spent on the second unit of good $ with marginal utility per monetary unit spent on the first unit of good 4. #hese rations are both e&ual to / utils and, conse&uently, consumer is indifferent between purchasing the second unit of good $ and first unit of good 4. 9o he purchases both. Ie can afford this because the second unit of good $ costs + monetary units per unit and the first unit of good 4 cost 1 monetary unit per unit, that is a total of 6 monetary units. $t this moment, the consumer has exhausted his budget of 5 monetary units and has reached the consumer e&uilibrium, where the marginal utilities per monetary unit spent are e&ual. #he resolution about the consumer%s e&uilibrium choice will be to purchase + units of good $ and 1 unit of good 4.

Theory of Consumer #ehavior

-5

The total utility was ma)imi-ed and there will be no point to any further switching.

8. . . The Mar'ina" 1ate %f S&;stit&ti%n

$long with the price ratio between goods, the marginal rate of substitution can be used to determine utility maximization. #he marginal rate of su&stitution (M4% is the ratio at which consumers are willing to trade between pairs of goods and services at the margin. 1or instance, for two products, $ and 4, the marginal rate of substitution will be: M$%"/# = MU"/MU# It describes how consumer are willing to trade $ for 4, and con!ersely. E)emple: If ?M9$4 < 5, this means that one unit of good $ is fi!e times as !aluable (has fi!e times the utility for the consumer as one unit of good 4. #he consumer, then, is willing to trade 5 units of 4 for 1 unit of $. #he marginal rate of substitution (?M9$4 depends upon how much of $ and 4 the consumer is consuming. It will be different for the !arious cmbinations of the two goods. Gow we turn to the condition of the utility maximization: MU1/P1 = MU /P = !!!!!!= MUn/Pn 4y algebric manipulation, the expression abo!e can be rewritten as follows: MU1/MU = P1/P = !!!!!!MU"/MU# = P"/P# =!!!! 4ut ?J$"?J4 < ?M9$"4. #hus, another statement of the condition for utility maximization is:

-,
M$%"# = P"/P#

Economics

E)emple: If the price of a unit of E is fi!e times the price of a unit of 4, the price ratio ()$")4 will be 5. #o maximize utility, ?M9 $4 also must be 5, which means that ?J$ is fi!e times ?J4.

8.-. IM(ACT OF (1ICE CHANGE /(ON CONS/ME1 E5/ILI91I/M #he consumer%s choice of how much to consume of !arious goods depends on the price of those goods. $ change in price le!el of products determines the consumer%s e&uilibrium choice consumption patterns to change. 1or considering an exemple, we turn to table 0.1 where the consumer must decide how much to consume of goods $ and 4. 9uppose the price of good $ increases from + to 6 monetary units per unit, while the price of good 4 remains unchanged and e!erything else remains constant. #he ratio of the marginal utility of good $ to the price of good $ is now changed and this new situation is described in table 0.+.

Tab. <... "mpact of Price Change upon Consumer E*uilibrium 3ood Jnits 1 + 6 ( $: )rice ()$ 6 6 6 6 ?arginal utility (?J +( 11+ , ?J")$ , ( + 1 + 6 ( 3ood Jnits )rice ()4 + + + + 4: ?arginal utility ()4 / 5 1 ?J")4 / 5 1

Theory of Consumer #ehavior

-0

#he increase in the price le!el of good $ to 6 monetary units lowers the marginal utility per monetary unit spent on good $ relati!e to the pre!ious case, where the price of good $ was + monetary units. $s before, the new consumer e&uilibrium is found by comparing the marginal utility per monetary unit spent on good $ with the marginal utility per monetary unit spent on good 4. #he new e&uilibrium choice made by the consumer will be 1 unit of good $ and + units of good 4. #he reason consists in the similarity of the marginal utilities per monetary unit spent of these two &uantities, for which the purchase completely exhausts the consumer%s budget of 5 monetary units. #he effect of a price change on the consumption patterns (consumer%s e&uilibrium choice is often di!ided into two effects: substitution effect and income effect of a price change.

8.-.1. S&;stit&ti%n Effe#t %f a (ri#e Chan'e $ change in the price of good $ affects the total &uantity of goods and ser!ices that an indi!idual or a household can consume. The su&stitution effect measures the change in consumption brought on by the change in price of a related good. Melati!e price changes cause consumers to switch from one good to another. #he change in its price ma'es it more or less attracti!e relati!e to other goods. E)emple In the exemple considered abo!e, as the price of good $ rises from + monetary units to 6 monetary units, good $ becomes more expensi!e relati!e to good 4, thus less attracti!e for the consumer, while good 4 becomes less expensi!e relati!e to good $, thus more attracti!e. It is conse&uently expected that the consumer to respond to this price increase by substituting her consumption away from good $ and toward good 4. Ie is going to change his consumption choice from + units of good $ and 1 unit of good 4 to a new pattern: 1 unit of good $ and + units of good 4.

8.-.2. In#%me Effe#t %f a (ri#e Chan'e $ change in the price of a good also affects the total &uantity of goods and ser!ices that a consumer or a household can consume. The income effect measures the change in consumption brought on by the change in a consumer$s effective income due to a change in price of a good.

--

Economics

$s a result of a change in price of a good, the real purchasing power <real income= of the consumer will change. 7 If the price of good $ rises, the consumer%s purchase power decreases. #he consumer can no longer afford to buy e!erything he used to and his total consumption will ha!e to be cut bac'. #he same income buys less total utility than before8 effecti!e income has fallen. 7 If price of good $ decreases, the consumer5s purchase power increases. #he consumer can afford to buy more, conse&uently its consumption will increase. #he same income buys more total utility than before8 effecti!e income has rised. E)emple In the exemple abo!e, the increase in the price of good $ from + monetary units to 6 monetary units reduces the consumer%s real purchasing power. )rior to the price change, the consumer was able to purchase + units of good $ and 1 unit of good 4 using his budget of 5 monetary units. $fter the price of good $ rises to 6 monetary units, the consumer is no longer able to purchase the same bundle of goods because it would cost 0 monetary units and his budget is limited at only 5 monetary units. #hat%s because he must reduce his spending. #he income effect is here the portion of the consumer%s change in the consumption of good $ as conse&uences of the change in his real purchasing power (real income .

8.-. . C%ns&mer>s (er#e.ti%n %f S&.."$ @e explained that the consumer maximizes utility when the marginal utility per monetary unit spent on each good consumed is the same. If he consumes any more of a good, its marginal utility will fall because of the law of diminishing marginal utility. If the consumer is to continue maximizing utility, then, in order for the e&uality ?J$")$ < ?J4")4 <....to hold, )n, the price of good n, also must fall. #herefore, the utility>maximizing consumer will buy more of a good only if its price falls and the consumer%s demand cur!e for the good is sloping downwards. Jsually, the consumers are thought of by economists as price/takers. #his means that, since each consumer is only one of a great many, none of them has enough power in the mar,et to influence the mar,et price level by his action alone. #he consumers expect the mar'et price for each good or ser!ice to stay unchanged no matter how much"little the indi!idual consumer chooses

Theory of Consumer #ehavior

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to buy. #herefore, to the consumer, mar'et supply is percei!ed as perfect elastic.

8.-.-. C%ns&mer 9eha7i%r t%?ard C%m."ementar$ and S&;stit&te G%%ds Complementary goods are those that consumers usually consume together in his consumption patterns. #heir complementary use leads the consumer to consider the complementary combination of goods, to some extend, to be a single good. 1or exemple: computers and dis'ettes, ODMs and !ideotapes, automobiles, gas and tires etc. #he consumer beha!ior toward complementary goods is: if the price of a complementary good rises then the consumption of that good and its complement will fall and vice versa. &ubstitute goods are those that the consumer can exchange for one another in his consumption patterns. 1or exemple, tea and coffee, li&uid and solid soap, etc. 4ecause the consumer is not able to distinguish between perfect substitutes at all, he will consume only the cheapest, and none of the others. #he consumer can tell the difference between close substitutes and may consume some of each, but he is still !ery sensiti!e to their substitutability. $ change in price of one will determine changes in the consumption of all of them. #he consumer beha!ior toward substitute goods is: if the price of one close substitute rise the consumer will buy less of it and more of the other and vice versa.

8.5. CONS/ME1 S/1(L/S Donsider the consumer%s demand cur!e (D for a good and the consumer%s perfect elastic perception of the mar'et supply at price le!el ) 9 (1ig.0.1 .

/.

Economics

+ig.<.!. Consumer &urplus is the &haded Area 5 P& /.

#he consumer tray to maximize his utility. #he ) 9 is a monetary measure of what the last unit consumed of the good (the marginal unit is !aluable to the consumer. Due to the law of diminishing marginal utility, marginal utility (?J of the other units consumed will exced the marginal utility (?J of the marginal unit. @hile demand cur!e (D shows that the consumer would ha!e been willing to pay more than )? for each of those units because of their higher marginal utility, they still cost only )? per unit. Donse&uently, for this other units, the consumer recei!es more marginal utility per monetary unit spent than for the marginal unit. #he e)tra total utility determined as difference between the ma)imum price that consumers are willing to pay for a good and the mar,et price that they actually pay for a good is called consumer surplus. In the graph from fig.0.1, it is represented as the shadel area E, )9, ?. E)emple @e assume the mar'et price of 5 monetary unit and the e&uilibrium &uantity demanded of 5 units of a specific good (1ig.0.+ .

Theory of Consumer #ehavior

/1

+ig.<... Calculation of Consumer &urplus for a &pecific g=od

#he mar'et demand cur!e shows that consumers are willing to pay: 7 at least / monetary units for the first unit of the good8 7 - monetary units for the second unit8 7 0 monetary units for the third8 7 , monetary units for the fourth unit. 4ecause they can purchase 5 units of the good for :ust 5 monetary units, their surplus from the first unit purchased will be: C m.u. : 5 m.u. D : monetary units. #heir surpluses from the next units purchased (the second, the third and the fourth will be, similarly, 6 m.u., + m.u., and 1 m.u., respecti!ely. #he consumer surplus will be the total sum of the surpluses calculated abo!e: 4 m.u. + 3 m.u. + 2 m.u. + 1 m.u. = 1& monetary units Iowe!er, this is only an approximation of the real consumer surplus. #o calculate the true consumer surplus, we must consider the whole area of the triangle born below the mar,et demand curve and above the mar,et price . #his triangle ha!ing the base of lenght 5 and height of length 5, applying the

/+

Economics

rule of triangle area (one half the base multiplied by height , the true !alue of the consumer surplus in this exemple become ;<(= monetary units.

8.*. INDIFE1ENCE C/1@E Donsumer beha!ior can be understood through a more sofisticated explanation based upon budget line and indifference cur!e.

8.*.1. The 9&d'et Line #he &udget line (constraint= shows all the various combinations of any two goods which can be purchased given their prices and the consumer$s income (#ab.0.6 (1ig.0.6 . 4ecause the consumer prefers more to less, he will always select a point on the budget line. #he consumer has then a problem of choice (trade> off . $long the budget line, more of the good can be obtained only by sacrificing some of the other good.

Tab.<.1. Combinations of Two 3btainable =oods A and # with an "ncome of !5 monetary units 3ood )rice 1,5 1,5 1,5 1,5 1,5 1,5 $: Jnits 1. , ( + . Cxpenditur e 15 1+ / , 6 . 3ood )rice 6,. 6,. 6,. 6,. 6,. 6,. 4: Jnits . 1 + 6 ( 5 #otal Cxpenditur Cxpenditure e s . 6 , / 1+ 15 15 15 15 15 15 15

Theory of Consumer #ehavior

/6

#he location of the budget line (constraint depends upon the prices of the two goods: 7 if no A is bought, the consumer can buy the maximum affordable &uantity *4 (5 units 8 7 if no # is bought, the consumer can by the maximum affordable &uantity *$ (1. units 8 7 other intermediate points on the budget line are the other affordable combinations between $ and 48 for instance, the disposable budget of 15 monetary units can be used to buy , units of good $ and + units of good 4.

+ig.<.1. Consumer$s #udget >ine for Two =oods

#he location of the budget line !aries with changes in both money income of the consumer and prices of the goods in the mar'et. (1 Dhanges in money income of the consumer will determine a shift of the budget line as follows: 7 an increase in money income will shift the budget line to the right8 7 a decrease in money income will mo!e the budget line to the left8 (+ Changes in the price of the goods in the mar'et will determine a shift of the budget line as follows:

/(

Economics
7 a decline in the prices of both products (e&ui!alent of a real income increase , will determine the budget line to mo!e to the right8 7 an increase in the prices of both goods will shift the budget line to the left.

8.*.2. The Indifferen#e C&r7es $n indifference curve shows all combinations of two products which will bring to the consumer the same level of satisfaction 'utility(. 9ince all the combinations on one line are of e&ual utility to the consumer, he is indifferent to which is actually consumed. #hat is why they are called indifference cur!es. E)emple 9uppose a two>goods model (#ab. 0.( and (1ig. 0.( .

Tab.<.2. An "ndifference Table 'hypothetical case( Dombination l m n p & 3ood $ (units 1 + ( 0 1+ 3ood 4 (units 5 6 + 1

#he indifference cur!es cannot intersect and they ha!e se!eral particular characteristics: they are downsloping8 they are con!ex8 they are many in an indifference map.

Theory of Consumer #ehavior

/5

+ig.<.2. A Consumer$s "ndifference Curve (1 Indifference cur!es are downsloping because both products yield utility to the consumer. (+ Indifference cur!es are conve) as !iewed from the origine because the slope diminishes as we down along the cur!e. #he slope of the indifference cur!e measures the marginal rate of substitution (?M9 because it shows the rate, at the margin, at which the consumer is prepared to substitute one good for another so as to remain totally satisfied. In other words, the diminishing slope of the indifference cur!e means the willingness to substitute $ for 4 diminishes as we more down along the cur!e. (6 Indifference cur!es are many in a whole set which describes an indifference map (1ig.0.5 8 each cur!e reflects a different le!el of total utility for the consumer, the le!el being higher as we more out from origin to the right.

/,

Economics

+ig.<.5. "ndifference /ap

E)emple 2ne combination on cur!e J1 is &uantity $1 of good $ and 4 1 of good 4. ?o!ing to cur!e J+, the consumer can consume the same amount of $ while increasing consumption of 4 to 4+. It is a demonstration of the fact that indifference cur!e J+ represents a greater total utility, since it can allow consumption of more of 4 without re&uiring any $ to be gi!en up.

8.*. . /ti"it$ Ma4imiAati%n @e now combine the last two concepts studied, the budget line and the indifference map, in order to explain the consumer)s utility maximi9ation (1ig.0., .

Theory of Consumer #ehavior

/0

+ig.<.9. The Consumer$s E*uilibrium Position '@tility /a)imi-ation(

#he consumer reaches the e&uilibrium position, where his utility is maximized, at point G, where the budget line is tangent to the highest indifference cur!e. #his specific point indicates the one combination of goods and the corresponding &uantities of each good. In our graph, this combination will be &uantity $G for good $ and &uantity 4G for good 4, which pro!ides the most total utility obtainable with the consumer%s limited income. $ny other affordable combination (say, ? or 9 , also represents attainable combination of $ and 4, but yield less total utility as is e!idenced by the fact they are on lower indifference cur!e. 2n the other hand, point M entails more utility than G, but it is outside the budget line and therefore unattainable.

8.8. OTHE1 A((LICATIONS 8.8.1. 1e.resentin' the In#%meBS&;stit&ti%n Effe#ts @e can now re!iew the income and substitution effects studied before using the indifference map (1ig.0.0 .

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Economics

+ig.<.<. "ncomeE&ubstitution Effects Represented by "ndifference /ap

9uppose the consumer starts out with budget line E $E4. Ie choose the combination ? of the goods $ and 4, in order to maximize his utility. #he consumer is on the highest indifference cur!e attainable > J 1. #he choosen &uantity of 4 will be b?. #hen, the price of 4 falls, and the budget line mo!es to E $E4 because for each possible &uantity of $ purchased, the money left o!er to buy 4 will buy more 4 at the lower price. 2n the new budget line, at combination G, the consumer increases purchases of 4 from b? to bG without changing the consumption of $. #his additional consumtion of 4 (the &uantity b ?bG results from the income effect of the fall in price of 4. #he drop in price of 4 lea!es the consumer with income left o!er when the original combination ? is bought8 the consumer%s effective income has increased. $lthough combination G represents more total utility than combination ?, the consumer still has not maximized his utility from the descrease in price of the good 4. #he budget line reaches the highest indifference cur!e possible (J+ at combination of the point M. Dombination G is bellow J +, so the consumer can increase total utility e!en more, by changing consumption to combination M. #o mo!e from the point G to the point M, the consumer buys an additional &uantity bGbM of 4, reducing the consumption of $ from a ? to aM.

Theory of Consumer #ehavior

//

#his is the substitution effect. #his means the additional &uantity bGbM of 4 was substituted in place of the &uantity a?aM of $ which is gi!en up. #his way, utility is now maximized.

8.8.2. 1e.resentin' the D%?n?ardCS"%.in' Demand $ pre!iously discussed concept, the downward>sloping demand, can also be explained using the indifference map (the top graph in the figure 0.correlated with the consumer%s demand cur!e (the lower graph in the figure 0.- .

1..

Economics

+ig.<.F. %ownward:&loping %emand Represented by "ndifference /ap

Theory of Consumer #ehavior

1.1

#he indifference map shows different &uantities of $ and 4 consumed at three different price le!els for 4: p., p1, and p+. If we suppose the price of $ does not change, then we can depict three separate budget lines, reflecting the different prices of 4. #he consumer will buy &uantity b. of 4 at the price le!el p., &uantity b1 of 4 at the price le!el p1, and &uantity b+ of 4 at the price le!el p+. Donsumer%s demand cur!e (D for 4 is represented in the lower graph. #he horizontal axes on both graphes in the figure are the same: the &uantity demande of 4. #he resulting demand cur!e D slopes downward, meaning that larger &uantities of 4 will be consumed as price of the product 4 falls (the law of demand . 0E1 C2"CE'T% Consumer behavior Consumer choice 'trade:off( Consumer preferences >imited income 'budget( Cardinal utility 3rdinal utility /arginal utility Total utility >aw of diminishing marginal utility /a)imi-ing total utility 'consumer e*uilibrium( /arginal utility per monetary unit spent /arginal rate of substitution &ubstitution effect of a price change "ncome effect of a price change Real purchasing power Consumer surplus #udget line 'constraint( "ndifference curve "ndifference map @tility ma)imi-ation

CHAPTER F MA13ET E5/ILI91I/M

$ market is a mechanism which brings together buyers and sellers of particular goods and services and operates in order to allocate resources. ?ar'ets exists in a wide and complex !ariety of forms: resources mar'et8 labor mar'et8 capital mar'et8 monetary mar'et. Cach of them has its own subdi!isions. Megardless the specific type, any mar'et has three crucial elements: 7 &uyers L those who are see'ing to ac&uire the good or ser!ice, forming the demand8 7 sellers L those who are offering the good or ser!ice, forming the supply8 7 prices L established so that to satisfy both groups simultaneously. Cconomic acti!ities that determine society%s allocation of its resources depend upon supply and demand. #hese are the forces that dri!e mar'ets and are the fundamental aspects of microeconomics. In this context, the firms decide what to produce, how to produce it, and how much to consume.

+.1. DEFINING MA13ET E5/ILI91I/M #he pre!ious two chapters ha!e examined the demand decisions of buyers and the supply decisions of sellers, separately. Iowe!er, in the mar'et for a particular good E, the decisions of buyers interact simultaneously with the decisions of sellers. #he mar'et mechanism is the tendency for supply and demand to e&uilibrate, so that there is neither excess demand nor excess supply. @hen

/ar,et E*uilibrium

1.6

the demand for good E e&uals the supply of good E, the mar'et for good E is said to be in equili&rium (market clearing . 9upply>demand analysis is one of the basic tools of microeconomics. In competiti!e mar'ets, supply and demand cur!es tell us how much will be produced by firms and how much will be demanded by consumers as a function of price. If we could estimate, at least approximati!ely, the supply and demand cur!es for a particular mar'et, we could calculate the mar'et>clearing price by e&uating supply and demand. $lso, if we 'now how supply and demand depend on other economic !ariable, such as income or the prices of other goods, we could calculate how the mar'et>clearing price and &uantity will change as these other !ariables change. #his is a means of explaining or predicting mar'et beha!ior. #he intersection of demand cur!e (D and the supply cur!e (9 , point C on the graph (1ig.-.1 , expresses e*uilibrium between mar'et supply and mar'et demand.

+ig.F.!. /ar,et E*uilibrium

1.(

Economics

In the graph from figure -.1, the intersection of demand (D and supply (9 is the only point where &uantity demanded and &uantity supplied are e&ual at the same price. #his condition defines mar'et e&uilibrium. &o long as demand '%( and supply '&( do not change the mar,et will remain in this e*uilibrium and will be stable. $ssociated with any mar'et e&uilibrium will be an e&uilibrium &uantity and an e&uilibrium price. 7 #he equili&rium quantity of good 5 is that *uantity for which the *uantity demanded of good 5 e)actly e*uals the *uantity supplied of good 5. . #he equili&rium price for good 5 is that price per unit of good 5 for which the *uantity demanded of good 5 e)actly e*uals the *uantity supplied for good 5. It is the single price at which both sellers and buyers are satisfied. #he e&uilibrium price will tend to change if either the supply or the demand cur!e shifts. $ crucial assumption of the mar'et model is that price will ad:ust until the &uantity being demanded and the &uantity being supplied are the same. $t any other price, there would either be: (1 excess demand (a PshortageQ , when demand exceeds supply8 (+ excess supply (a PsurplusQ , when supply exceeds demand. In either case, we assume that price will ad:ust upward or downward until there is e&uilibrium, or mar'et clearing. #he determination of e&uilibrium &uantity and e&uilibrium price, 'nown as equili&rium analysis( can be achie!ed in two different ways: algebraic approach and graphical approach. (1 #he algebraic approach to e&uilibrium analysis is to sol!e, simultaneously, the algebraic e&uations for demand and supply. In the exemple gi!en abo!e, the demand e&uation for good E was P = 1 ! 2Q, and the supply e&uation for good E was P = 1"2 Q. Donse&uently, by sol!ing the algebraic system we find: ) < + monetary units8 * < ( units of good E.

/ar,et E*uilibrium

1.5

(+ #he graphical approach to e&uilibrium analysis is illustrated in figure -.+ which combines the demand and supply cur!es into a single graph. #he e&uilibrium price and &uantity are determined by the intersection of the two cur!es.

+ig.F... /ar,et E*uilibrium for =ood 5 #he e&uilibrium &uantity is -. units for good E, and the e&uilibrium price is , monetary units per unit of good E.

+.2. MA13ET DISE5/ILI91I/M AND 1ESTO1ING MA13ET E5/ILI91I/M Market disequili&rium (departure from equili&rium occurs when the price prevailing in the mar,et is in another point as P E. #hat means, &uantity demanded and &uantity supplied are not the same either.

1.,

Economics

+ig.F.1. /ar,et %ise*uilibriums #here are two main situations : surplus 'e)cess supply( and shortage 'e)cess demand(.

/ar,et E*uilibrium

1.0

+ig.F.2. /ar,et %ise*uilibriums

1.-

Economics

(1 %urplus (excess supply or shortfall in demand which would exists at abo!e>e&uilibrium prices, push price down and thereby increases the &uantity demanded and reduces the &uantity supplied until e&uilibrium is achie!ed. #his happens because the surplus of good E would prompt competing sellers to bid down the price to incourage buyers to ta'e this surplus off their hands. In figure -.(a, at price le!el )?, &uantity demanded is only *+, much less than *1. $s a result, firms will ha!e to cut bac' their production and reduce price to sell the surplus. 4y the law of demand, the &uantity demanded (* D , will rise as price falls. 4y the law of supply, the &uantity supplied (* 9 will fall as price falls. #his will continue until &uantity supplied (*9 and &uantity demand (*D both are e&ual (at &uantity *C . #his will be at the e&uilibrium point C, where price is )C. (+ %hortage (excess demand or shortfall in supply ,which would exists at below>e&uilibrium prices, drives price up, and in doing so, increases the &uantity supplied and reduces the &uantity demanded until e&uilibrium is achie!ed. #his happens because many potential consumers, in order to ensure that they will not ha!e to do without, will express a willingness to pay a price in excess. In figure -.(b, at price le!el )H, &uantity demanded is *6, which is much more than *(. #his situation will encourage firms to increase price and increase production. 4y the law of demand, the &uantity demanded (* D will fall as price rises. 4y the law of supply, the &uantity supplied (*9 will rise as price rises. #his will continue until &uantity supplied (* 9 and &uantity demanded (*D both are e&ual (at &uantity *C . #his will be at the e&uilibrium point C, where price is )C.

+. . SHIFTS IN DEMAND AND S/((L! +. .1. Shifts in Demand $ shift in demand usually leads to a change in the *uantity demanded. It designates the mo!ement from one point to another point (from one price>&uantity combination to another on a fixed demand cur!e. #he only time it won%t is if the supply cur!e happens to shift at the same time so that, by coincidence, the same price or the same &uantity demanded"supplied exists at the new e&uilibrium. If only the supply cur!e shifts, then a change in e&uilibrium &uantity demanded also will occur, but on the same demand cur!e as before.

/ar,et E*uilibrium

1./

@e ha!e to a!oid the !irtual confusion of a =shift in demand= with a =change in the &uantity demanded=: 7 a shift in demand means that the mar'et demand cur!e actually has mo!ed to a new position8 7 a change in the *uantity demanded means that there is a new e&uilibrium, but not necessarily a new demand cur!e. $ change in &uantity demanded can occur on the same demand cur!e when only the supply cur!e shifts.

+. .2. Shifts in S&.."$ $ shift in supply usually leads to a change in e&uilibrium price, and e&uilibrium &uantity supplied. #he only time it won%t is if the demand cur!e happens to shift at the same time in such a way that, by coincidence, the same price or the same &uantity demanded"supplied exists at the new e&uilibrium. If only the demand cur!e shifts, then a change in &uantity supplied will occur, but on the same supply cur!e as before. @e ha!e to a!oid the !irtual confusion of a =shift in supply= with a =change in &uantity supplied=: 7 a shift in supply means that the mar'et supply cur!e has actually mo!ed to a new position: 7 a change in *uantity supplied means that there is a new e&uilibrium but not necessarily a new supply cur!e. $ change in &uantity supplied can occur on the same supply cur!e by mo!ing from one point to another if it is the demand cur!e that shifts.

+. . . Demand ShiftsB5&antit$ S&.."ied 9hifts in demand along the same supply cur!e lead to new e&uilibrium positions, with both price and &uantity demanded and supplied different from the original e&uilibrium C, where price is ) . and &uantity demanded"supplied is *. (1ig.-.5a . #here are two possible moves for the demand cur!e: outward shift and inward shift. (1 2utward shift in demand (from D. to D1 in the graph . In this situation, e&uilibrium mo!es along the supply cur!e (9 from C to ?. )rice will be higher ()1 and &uantity demanded"supplied will be higher (*1 .

11.

Economics

(+ #nward shift in demand (from D. to D+ in the graph . In this situation, e&uilibrium mo!es along the supply cur!e (9 from C to G. )rice will be lower ()+ , and &uatity demanded"supplied will be lower (*+ . In brief, we found a direct relationship between a change in demand and the resulting changes in both e&uilibrium price and &uantity. It is important to understand that, in both cases, since the supply cur!e remains the same, mar'et supply has not changed. 2nly the &uantity supplied changes. ?ar'et e&uilibrium has changed, but along the same supply cur!e.

/ar,et E*uilibrium

111

+ig.F.5. &hifts in demand and supply

11+
+. .-. S&.."$ ShiftsB5&antit$ Demanded

Economics

%hifts in supply along the same supply cur!e lead to new e&uilibrium positions, with both price and &uantity demanded and supplied different from the original e&uilibrium C, where price is ). and &uantity demanded" supplied is *. (1ig.-.5b . #here are two possible moves for the supply cur!e: outward shift and inward shift. (1 2utward shift in supply (from 9. to 91 in the graph . In this situation, e&uilibrium mo!es along the demand cur!e (D from C to ?. )rice will be lower ()1 , and &uantity demanded"supplied will be higher (*1 . (+ #nward shift in supply (from 9. to 9+ in the graph . In this situation, e&uilibrium mo!es along the demand cur!e (D from C to G. )rice will be higher ()+ , and &uantity demanded"supplied will be lower (*+ . It is important to understand that, in both cases, since the demand cur!e remains the same, mar'et demand has no changed. 2nly the &uatity demanded changes. ?ar'et e&uilibrium has changed, but along the same demand cur!e. In brief: 7 an increase in supply has a price:decreasing and a *uantity: increasing effectB 4 a decrease in supply has a price:increasing and a *uantity: decreasing effect. #here is an inverse relationship between a change in supply and the resulting change in e&uilibrium price, but the relationship between a change in supply and the resulting change in e&uilibrium &uantity is direct.

+.-. COM(LE0 CASES IN CHANGING DEMAND AND S/((L! ?ore complex cases arise if in the mar'et mo!es in!ol!e changes in both supply and demand. #here are two possible cases: supply and demand change in opposite directions8 supply and demand change in the same direction. (1 %upply and demand change in opposite direction . 1urther, we can find here other two situations: when supply increases and demand decreases8 when supply decreases and demand increases.

/ar,et E*uilibrium

116

a. &upply increases demand decreases situation can conduct to following conse&uences: because there are coupled two decreasing effects, the net results will be a fall in the e*uilibrium price greater than that which would result from either change ta'en in isolation8 because the effects of the changes in supply and demand are opposed (the increase in supply tends to increase e&uilibrium &uantity, while the decrease in demand tends to reduce the e&uilibrium &uantity , the direction of the change in e&uilibrium &uantity depends upon the relative si-es of the changes in supply and demand. &. &upply decreases demand increases situation in!ol!es two price> increasing effects. Donse&uently: an increase in e*uilibrium price greather than that caused by either change ta'en separately8 the effect upon e*uilibrium *uantity is indeterminate, depending upon the relati!e size of the changes in supply and demand: if the decrease in supply is relati!ely larger than the increase in demand, the e&uilibrium &uantity will be less than it is initially8 if the decrease in supply is relati!ely smaller than the increase in demand, the e&uilibrium &uantity will increase as a result. (+ %upply and demand change in the same direction . 1urther, we can find here other two situations: when supply and demand both increase8 when supply and demand both decreas. a. #oth supply and demand increasing situation can conduct to following conse&uences: if the increase in supply is of greater magnitude than the increase in demand, the net result will be for e*uilibrium price to decrease8 if the opposite is true, e&uilibrium price will increase8 the effect upon e*uilibrium *uantity is certain: this will increase by an amount greater than that which either change would ha!e entailed in insolation due to the &uantity>increasing effects of both increases in supply and demand. &. #oth supply and demand decreasing situation can conduct to following conse&uences: if the decrease in supply is greater than the decrease in demand, e*uilibrium price will rise8 if the re!erse is true, e&uilibrium price will fall8 e*uilibrium *uantity will be less than that which pre!ailed initially because decreases in supply and demand both ha!e &uantity> decreasing effects. 9pecial cases arise where a decrease in demand and a decrease in supply, on the one hand, and an increase in demand and an increase in supply, on the other hand, e)actly cancel out. In both cases, the net effect upon e&uilibrium price will be -ero and, conse&uently, price will not change.

11(

Economics

$nother special case in the analysis of demand and supply model concerns the government price controls for any gi!en goods or ser!ices. ?ar'ets are rarely free of go!ernment inter!ention. 4esides imposing taxes and granting subsidies, go!ernments often regulate mar'ets in a !ariety of ways. #his is a!ailable e!en for competiti!e mar'ets. #he price ceiling means the government mandate that the price can be no higher than a ma)imum allowable level. #he &uantitati!e impact of effecti!e price ceilings is an e)cess demand caused by an increase in the &uantity demanded (consumers will demand more at this low price and a decrease in the &uantity supplied (producers, particularly those with higher costs, will produce less . In this situation, the economic analisys has to estimate how large that excess demand might ha!e been. 0E1 C2"CE'T% /ar,et /ar,et e*uilibrium E*uilibrium analysis E*uilibrium price E*uilibrium *uantity /ar,et dise*uilibrium &urplus 'e)cess supply( &hortage 'e)cess demand( &hift in demand &hift in supply =overnment price control Price ceiling