10 : Theory of Demand

Transcription

1 10 : Theory of Demand 1

2 Recap from last session Change in Demand Supply, Law of Supply Market Equilibrium Change in Equilibrium 2

3 A Shift in Both Supply and Demand Price of Ice-Cream Cone Large increase in demand New equilibrium S 2 S 1 P 2 Small decrease in supply P 1 Initial equilibrium D 2 D 1 0 Q Quantity of 1 Q 2 Ice-Cream Cone 3

4 A Shift in Both Supply and Demand Price of Ice-Cream Cone Small increase in demand New equilibrium S 2 S 1 P 2 Large decrease in supply P 1 Initial equilibrium D 2 D 1 0 Q Quantity of 2 Q 1 Ice-Cream Cone 4

5 Simultaneous Shifts When demand & supply shift simultaneously Can predict either the direction in which price changes or the direction in which quantity changes, but not both The change in equilibrium price or quantity is said to be indeterminate when the direction of change depends on the relative magnitudes by which demand & supply shift 5

6 What Happens to Price and Quantity when Supply or Demand Shifts? 6

7 Session Summary The demand curve shows how the quantity of a good depends upon the price. According to the law of demand, as the price of a good falls, the quantity demanded rises. Therefore, the demand curve slopes downward. 7

8 Session Summary In addition to price, other determinants of how much consumers want to buy include income, the prices of complements and substitutes, tastes, expectations, and the number of buyers. If one of these factors changes, the demand curve shifts. 8

9 Session Summary The supply curve shows how the quantity of a good supplied depends upon the price. According to the law of supply, as the price of a good rises, the quantity supplied rises. Therefore, the supply curve slopes upward. 9

10 Session Summary In addition to price, other determinants of how much producers want to sell include input prices, technology, expectations, and the number of sellers. If one of these factors changes, the supply curve shifts. 10

11 Session Summary Market equilibrium is determined by the intersection of the supply and demand curves. At the equilibrium price, the quantity demanded equals the quantity supplied. The behavior of buyers and sellers naturally drives markets toward their equilibrium. 11

12 Elasticity of Demand From the managerial point of view, the knowledge of the nature of relationship between product s demand and its determinants is not sufficient. What is more important is the degree of responsiveness of demand to changes in its determinants. 12

13 Elasticity of Demand It allows us to analyze demand with greater precision. It is a measure of how much buyers and sellers respond to changes in market conditions 13

14 Elasticity of Demand measures the degree of responsiveness of the quantity demanded of a commodity to a given change in any of the determinants of demand.

15 Types of Elasticity of Demand Price elasticity of Demand Income Elasticity of Demand Cross Elasticity of Demand

16 Price elasticity of demand is a measure of how much the quantity demanded of a good responds to a change in the price of that good. Percentage change in quantity demanded given a percent change in the price.

17 Price Elasticity of Demand % Q E % P P & Q are inversely related by the law of demand so E is always negative. The larger the absolute value of E, the more sensitive buyers are to a change in price

18 Degree of Price Elasticity of Demand Inelastic Demand Quantity demanded does not respond strongly to price changes. Elastic Demand Quantity demanded responds strongly to changes in price.

19 Degree of Price Elasticity of Demand Perfectly Inelastic Quantity demanded does not respond to price changes. Perfectly Elastic Quantity demanded changes infinitely with any change in price. Unit Elastic Quantity demanded changes by the same percentage as the price.

20 Degree of Price Elasticity of Demand Price Price D D Perfectly Elastic Quantity Perfectly Inelastic Quantity E = Ep = 0

21 Inelastic Demand Price Demand E < A 25% increase in price 0 Quantity Leads to a 10% decrease in quantity demanded. 21

22 Unit Elastic Demand Price Demand E = A 25% increase in price 0 Quantity Leads to a 25% decrease in quantity demanded. 22

23 Elastic Demand Price E > 1 Demand A 25% increase in price 50 0 Quantity Leads to a 50% decrease in quantity demanded. 23

24 The own-price elasticity can be measured between two points on a demand curve (for arc elasticity) or on a point ( for point elasticity) 24

25 Measurement of Price Elasticity of Demand Point Elasticity of Demand E % Q % P Q Q P P Q P P Q

26 ARC Elasticity of Demand E Q P Average Average P Q

27 Total Revenue and Price Elasticity of Demand Price 4.00 P x Q = 400 (revenue) Demand Quantity 27

28 How Total Revenue Changes When Prices Changes: Inelastic Demand Price P x Q = 240 (revenue) P x Q = 100 (revenue) Demand Quantity 28

29 How Total Revenue Changes When Prices Changes: Elastic Demand Price Change in Total Revenue when Price Changes Demand Revenue = 200 Revenue = Quantity 29

30 A Linear Demand Curve Price 7 6 Elasticity is larger than Elasticity is smaller than Quantity 30

31 Price Elasticity & Total Revenue Elastic Unitary elastic Inelastic Price rises Price falls Q-effect dominates No dominant effect P-effect dominates % Q % P % Q % P % Q % P TR falls No change in TR TR rises TR rises No change in TR TR falls 31

32 Determinants of Price Elasticity of Demand Nature of Commodity : The demand for luxury goods is more price-elastic than the demand for necessities and comforts. The demand for necessity goods is price-inelastic. Comforts have more elastic demand than necessities, and less elastic demand than luxuries.

33 Determinants of Price Elasticity of Demand Availability and proximity of Substitutes : The higher the degree of closeness between the commodity and its substitutes, the greater the price-elasticity of demand for the commodity.

34 Determinants of Price Elasticity of Demand Proportion of Income Spent on the Commodity: The larger the proportion of income spent on a commodity, the greater will be the elasticity of demand for such commodity, and vice versa.

35 Determinants of Price Elasticity of Demand Time: The longer the adjustment time, the greater the priceelasticity of demand

36 Determinants of Price Elasticity of Demand Durability of the Commodity Items of addiction

37 Income Elasticity of Demand Income elasticity (E M ) measures the responsiveness of quantity demanded to changes in income, holding the price of the good & all other demand determinants constant. E M % Qd Qd M % M M Q d

38 Income Elasticity of Demand Positive for a normal good Negative for an inferior good Zero for a neutral goods

39 Income Elasticity of Demand If Em > 1, Luxury good If Em < 1, Necessity Goods If Em = 1, Semi Luxury goods

40 Cross-Price Elasticity of demand Cross-price elasticity of demand (E XY ) measures the responsiveness of quantity demanded of good X to changes in the price of related good Y, holding the price of good X & all other demand determinants for good X constant 40

41 Cross-Price Elasticity of demand E XY % Q Q P X X Y % P P Q Y Y X Positive when the two goods are substitutes Negative when the two goods are complements 41

42 Promotional/ Advertising Elasticity of Demand It measures the response of quantity demanded to change in the expenditure on advertising and other sales promotion activities. 42

43 Promotional/ Advertising Elasticity of Demand Ea = Q/ A.A/Q Q= quantity of goods sold A= unit of advertising expenditure on goods 43

44 Session References Managerial Economics; D N Dwivedi, 7 th Edition Managerial economics Christopher R Thomas, S Charles Maurice and Sumit Sarkar Managerial economics Geetika, Piyali Ghosh and Purba Roy Choudhury Managerial economics- Paul G Keat, Philip K Y Young and Sreejata Banerjee Micro Economics : ICFAI University Press 44

45 Numericals Demand Schedule Price Quantity Demanded Compute point price elasticity of demand for decrease in price from Rs 6 to 5. Compute point price elasticity of Demand for a increase in price from Rs 5 to 6. 45

46 Price Quantity Demanded The current price is Rs 12 per kg. Compute E using arc method for an increase in price by one rupee per kg. 46