EconS 451: Lecture # 6
Demand Review
•
Understand the definition of Demand.
•
Explain the difference between Marshallian and Hicksian Demand.
•
Be able to describe and explain the substitution and income effect in
product space from a change in price.
•
Understand how proportion of expenditure allocated to a specific good
impacts the substitution and income effect.
•
Understand the difference between demand shifts and structural change.
•
Calculate Own-Price, Income and Cross-Price Elasticity of Demand.
Why review demand relationships?
• Helps us understand market behavior!
• Explains price fluctuations!
• Provides a foundation for empirical research
and analysis!
• Equips you with necessary analytical capability
to evaluate market dynamics!
Demand Review
• Demand Defined:
• The various quantities of a particular commodity that
an individual consumer is willing and able to buy as
the price varies, all other factors held constant.
Demand Review
• Begins at the individual level……then summed
across all individuals to the market level.
Individual Attempting to Solve
Max U(x x ) s.t.
1,
2
px + p x = I
1
1
2
2
Demand Review
• Marshallian Demand
Max U(x x ) s.t.
1,
2
px + p x = I
1
1
2
2
• Hicksian (or Compensated) Demand
Min Expenditures E(p, U) s.t. U(x x ) = U
1,
2
F
Individual Demand
Price
10
5
Demand
25
45
Quantity X
Product Space
Y
100
r
s
U2
t
U1
X
25
u
37 45 50
v
w
100
Observations
• If the commodity in questions represents a
large proportion of expenditures, then the
income effect from a change in the price will be
relatively large.
• Both Income and Substitution effect usually
inversely related to price changes.
Static and Dynamic Demand
• Static :
• Quantity movements or responses to price while all
other factors are assumed constant.
• Movements along a demand curve.
• Dynamic:
• Shifts and changes in demand that happen with the
passage of time to account for changes in income,
population, taste and preferences, etc.
• Structural Change
• Change in the shape of the demand curve due to
changes in technology or information.
Graphical Changes in Demand
Price
Parallel Shift
Shift and Structural Change
Quantity
Demand Changes
• Shift
• Parallel shifts from
changes such as
income, population.
• Structural Change
Q    P  Y
Q    P  Y
• Changes in the
parameters or functional
form.
2
Short Run……….Long Run
• Short Run :
• Time period too short for complete quantity
adjustment from a price change (a snapshot).
• Long Run:
• The time required for a complete quantity adjustment
to occur in response to a “once-and-for-all” price
change.
Distributed Lag Models
• Refers to a delayed
adjustment in quantity as
a result of a price change.
• And the adjustment may
be spread over a period
of time.
Qdt  f (Yt , Pt , Pt  1 )
Speculative Demand
• Consumer demand for current consumption
• Speculative demand
• Anticipated demand and uses
• Future cost > current cost + all storage costs
• Commodity market financial investment
• “open interest”
• Current market price impacted by current and
expected events.
Primary and Derived Demand
Price
Pr
Pd
Primary Demand
Derived Demand
Quantity
Own-Price Elasticity of Demand
• Relates changes in the
price of the commodity
back to the changes in
quantity demanded.
• Defined at a point along
the demand curve.
• At the average
• Arc formula
• Assuming Q = f(P)
dQ P
Ep 

dP Q
Own-Price Elasticity of Demand
Range
• Elastic
Ep  1
• Unitary Elasticity
Ep
• Inelastic
Ep  1
• Revenue and elasticity
• TR = P(Q)
 1
Income Elasticity of Demand
• Relates changes in
income back to the
changes in quantity
demanded.
• Defined at a point along
the demand curve.
dQ Y
EY 

dY Q
Income Elasticity of Demand
Range
• Inferior
EY  0
• Normal
EY  0
Cross-Price Elasticity of Demand
• Relates changes in the
price of the jth product
back to the changes in
the quantity demanded
for the ith product.
• Defined at a point along
the demand curve.
Qi Pj
Eij 

 Pj Qi
Cross-Price Elasticity of Demand
Range
• Independent
Eij  0
• Substitute
Eij  0
• Complement
Eij  0
• Generalizations because of the “income and
substitution effects” of a price change of inferior
goods.
Summary Questions
• Explain the difference between individual and market demand.
• Describe the difference between the short and long run as it relates
to market demand.
• What is meant by a distributed-lag……as it relates to demand?
• Explain what the own-price, income, and cross-price elasticity of
demand are each measuring.