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The quantity demanded of a good usually is a strong function of its price. Suppose an experiment is run to determine the quantity demanded of a particular product at different price levels, holding everything else constant. Presenting the data in tabular form would result in a demand schedule, an example of which is shown below.
Demand Schedule
Price 5 4 3 2 1 Quantity Demanded 10 17 26 38 53
The demand curve for this example is obtained by plotting the data:
Demand Curve
By convention, the demand curve displays quantity demanded as the independent variable (the x axis) and price as the dependent variable (the y axis). The law of demand states that quantity demanded moves in the opposite direction of price (all other things held constant), and this effect is observed in the downward slope of the demand curve. For basic analysis, the demand curve often is approximated as a straight line. A demand function can be written to describe the demand curve. Demand functions for a straight-line demand curve take the following form: Quantity = a - (b x Price) 1
where a and b are constants that must be determined for each particular demand curve.When price changes, the result is a change in quantity demanded as one moves along the demand curve.
A number of factors may influence the demand for a product, and changes in one or more of those factors may cause a shift in the demand curve. Some of these demand-shifting factors are:
Customer preference Prices of related goods o Complements - an increase in the price of a complement reduces demand, shifting the demand curve to the left. o Substitutes - an increase in the price of a substitute product increases demand, shifting the demand curve to the right. Income - an increase in income shifts the demand curve of normal goods to the right. Number of potential buyers - an increase in population or market size shifts the demand curve to the right. Expectations of a price change - a news report predicting higher prices in the future can increase the current demand as customers increase the quantity they purchase in anticipation of the price change.
Supply Schedule
Price 1 2 3 4 5 Quantity Supplied 12 28 42 52 60
By graphing this data, one obtains the supply curve as shown below:
Supply Curve
As with the demand curve, the convention of the supply curve is to display quantity supplied on the x-axis as the independent variable and price on the y-axis as the dependent variable. The law of supply states that the higher the price, the larger the quantity supplied, all other things constant. The law of supply is demonstrated by the upward slope of the supply curve.As with the demand curve, the supply curve often is approximated as a straight line to simplify analysis. A straight-line supply function would have the following structure: Quantity = a + (b x Price) where a and b are constant for each supply curve. A change in price results in a change in quantity supplied and represents movement along the supply curve.
quantity supplied for a given price level. If the change causes an increase in the quantity supplied at each price, the supply curve would shift to the right:
There are several factors that may cause a shift in a good's supply curve. Some supply-shifting factors include:
Prices of other goods - the supply of one good may decrease if the price of another good increases, causing producers to reallocate resources to produce larger quantities of the more profitable good. Number of sellers - more sellers result in more supply, shifting the supply curve to the right. Prices of relevant inputs - if the cost of resources used to produce a good increases, sellers will be less inclined to supply the same quantity at a given price, and the supply curve will shift to the left. Technology - technological advances that increase production efficiency shift the supply curve to the right. Expectations - if sellers expect prices to increase, they may decrease the quantity currently supplied at a given price in order to be able to supply more when the price increases, resulting in a supply curve shift to the left.
On this graph, there is only one price level at which quantity demanded is in balance with the quantity supplied, and that price is the point at which the supply and demand curves cross. The law of supply and demand predicts that the price level will move toward the point that equalizes quantities supplied and demanded. To understand why this must be the equilibrium point, consider the situation in which the price is higher than the price at which the curves cross. In such a case, the quantity supplied would be greater than the quantity demanded and there would be a surplus of the good on the market. Specifically, from the graph we see that if the unit price is $3 (assuming relative pricing in dollars), the quantities supplied and demanded would be: Quantity Supplied = 42 units Quantity Demanded = 26 units Therefore there would be a surplus of 42 - 26 = 16 units. The sellers then would lower their price in order to sell the surplus. Suppose the sellers lowered their prices below the equilibrium point. In this case, the quantity demanded would increase beyond what was supplied, and there would be a shortage. If the price is held at $2, the quantity supplied then would be: Quantity Supplied = 28 units Quantity Demanded = 38 units Therefore, there would be a shortage of 38 - 28 = 10 units. The sellers then would increase their prices to earn more money. The equilibrium point must be the point at which quantity supplied and quantity demanded are in balance, which is where the supply and demand curves cross. From the graph above, one sees that this is at a price of approximately $2.40 and a quantity of 34 units.
To understand how the law of supply and demand functions when there is a shift in demand, consider the case in which there is a shift in demand:
Shift in Demand
In this example, the positive shift in demand results in a new supply-demand equilibrium point that in higher in both quantity and price. For each possible shift in the supply or demand curve, a similar graph can be constructed showing the effect on equilibrium price and quantity. The following table summarizes the results that would occur from shifts in supply, demand, and combinations of the two.
+ + -
In the above table, "+" represents an increase, "-" represents a decrease, a blank represents no change, and a question mark indicates that the net change cannot be determined without knowing the magnitude of the shift in supply and demand. If these results are not immediately obvious, drawing a graph for each will facilitate the analysis.
The average values for quantity and price are used so that the elasticity will be the same whether calculated going from lower price to higher price or from higher price to lower price. For example, going from $8 to $10 is a 25% increase in price, but going from $10 to $8 is only a 20% decrease in price. This asymmetry is eliminated by using the average price as the basis for the percentage change in both cases. For slightly easier calculations, the formula for arc elasticity can be rewritten as: ( Q2 - Q1 ) ( P2 + P1 ) ( Q2 + Q1 ) ( P2 - P1 ) To better understand the price elasticity of demand, it is worthwhile to consider different ranges of values. Elasticity > 1 In this case, the change in quantity demanded is proportionately larger than the change in price. This means that an increase in price would result in a decrease in revenue, and a decrease in price would result in an increase in revenue. In the extreme case of near infinite elasticity, the demand curve would be nearly 7
horizontal, meaning than the quantity demanded is extremely sensitive to changes in price. The case of infinite elasticity is described as being perfectly elastic and is illustrated below:
From this demand curve it is easy to visualize how an extremely small change in price would result in an infinitely large shift in quantity demanded.
Elasticity < 1 In this case, the change in quantity demanded is proportionately smaller than the change in price. An increase in price would result in an increase in revenue, and a decrease in price would result in a decrease in revenue. In the extreme case of elasticity near 0, the demand curve would be nearly vertical, and the quantity demanded would be almost independent of price. The case of zero elasticity is described as being perfectly inelastic.
From this demand curve, it is easy to visualize how even a very large change in price would have no impact on quantity demanded. 8
Elasticity = 1 This case is referred to as unitary elasticity. The change in quantity demanded is in the same proportion as the change in price. A change in price in either direction therefore would result in no change in revenue.
Availability of substitutes: the greater the number of substitute products, the greater the elasticity. Degree of necessity or luxury: luxury products tend to have greater elasticity than necessities. Some products that initially have a low degree of necessity are habit forming and can become "necessities" to some consumers. Proportion of income required by the item: products requiring a larger portion of the consumer's income tend to have greater elasticity. Time period considered: elasticity tends to be greater over the long run because consumers have more time to adjust their behavoir to price changes. Permanent or temporary price change: a one-day sale will result in a different response than a permanent price decrease of the same magnitude. Price points: decreasing the price from $2.00 to $1.99 may result in greater increase in quantity demanded than decreasing it from $1.99 to $1.98.
Point Elasticity
It sometimes is useful to calculate the price elasticity of demand at a specific point on the demand curve instead of over a range of it. This measure of elasticity is called the point elasticity. Because point elasticity is for an infinitesimally small change in price and quantity, it is defined using differentials, as follows: dQ Q 9
dP P and can be written as: dQ P dP Q The point elasticity can be approximated by calculating the arc elasticity for a very short arc, for example, a 0.01% change in price. In the previous section, supply and demand curves were drawn as straight lines. This is a simplification, as we are assuming that the rate of change of demand or supply is the same for all prices in the market. Many goods have demand curves that look like this. At some prices, a small change in price may cause a large change in the quantity demanded. This shown in the diagram as the movement from Pe to Pe1; a small change in price which causes an even larger percentage decrease in quantity demanded (from Qe to Qe1.
The price elasticity of demand refers to the relationship between changes in price and the subsequent change in quantity demanded. Economists are very interested in elasticity. Calculating it will answer important questions like : if price rises by a certain amount, by how much will demand fall, and total revenue change? We use the Greek letter ''eta'' or
To make the model easier to understand, we will continue using straight lines for the demand and supply curves. What we will now look at is the slope of these curves: are the curves ''flat'' or ''steep''? Be aware, though, that there is no necessary reason for a demand or supply curve to be a straight line. There are three methods that can be used to measure elasticity. The simplest is called the total outlays method
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Inelastic Demand - 10
If a given change in price causes a smaller proportionate change in quantity demanded, then the demand for the good or service is said to be inelastic. In the diagram to your left, Po, the initial price is 65 cents per litre, and P1, the new price, is 75 cents per litre; a 10 cent per litre increase. Demand for petrol is inelastic : petrol has no close substitute. Motorists can reduce their usage of their car, and perhaps drive fewer kilometres, but they can not fill their ''tank'' with water! Motorists can convert their cars to run on liquified petroleum gas (which is considerably cheaper than petrol), but the conversion cost is high. Petrol does have a substitute; but LPG is not a close substitute. The percentage change in price is 10 cents per litre / 65 cents per litre = a 15% increase. Qo, the initial quantity demanded is 20,000 litres; Q1, the new quantity demanded, is 19,500 litres. The Governments like demanded is 500 litres, on an initial demand level of 20,000 litres = a 2.5% of a 10 cents change in quantityto tax goods with inelastic demand curves. The diagram illustrates the effect decrease. per litre tax; a shift of the Supply Curve from S to S1. Petrol station owners will notice a small fall in sales; but price elasticity of demand for petrol is defined as the percentage change in quantity demanded divided Thethe effect on their profits is small. Governments do not like to be accused of driving small business out of business! by the percentage change in price. (Ignore any minus signs). In this example, the price elasticity of petrol is 2.5% / 15% = 0.167. Other goods with high levels of taxation include alcohol and cigarettes: both very inelastic. Goods with price elasticities less than 1.0 are called inelastic. Calculate the percentage increase in price, and the percentage decrease in quantity sold. Calculate the price elasticity of ''Moo''.
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or:
Two goods that complement each other show a negative cross elasticity of demand: as the price of good Y rises, the demand for good X falls
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In the example above, the two goods, fuel and cars(consists of fuel consumption), are complements - that is, one is used with the other. In these cases the cross elasticity of demand will be negative. In the case of perfect complements, the cross elasticity of demand is infinitely negative. Where the two goods are substitutes the cross elasticity of demand will be positive, so that as the price of one goes up the quantity demanded of the other will increase. For example, in response to an increase in the price of carbonated soft drinks, the demand for non-carbonated soft drinks will rise. In the case of perfect substitutes, the cross elasticity of demand is equal to infinity. Where the two goods are complements the cross elasticity of demand will be negative, so that as the price of one goes up the quantity demanded of the other will decrease. For example, in response to an increase in the price of fuel, the demand for new cars will decrease. Where the two goods are independent, the cross elasticity demand will be zero: as the price of one good changes, there will be no change in quantity demanded of the other good. When goods are substitutable, the diversion ratio - which quantifies how much of the displaced demand for product j switches to product i - is measured by the ratio of the cross-elasticity to the own-elasticity multiplied by the ratio of product i's demand to product j's demand. In the discrete case, the diversion ratio is naturally interpreted as the fraction of product j demand which treats product i as a second choice,[1] measuring how much of the demand diverting from product j because of a price increase is diverted to product i can be written as the product of the ratio of the cross-elasticity to the own-elasticity and the ratio of the demand for product i to the demand for product j. In some cases, it has a natural interpretation as the proportion of people buying product j who would consider product i their `second choice.'
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