DEMAND(PRICE) THEORY 1 Oyugi J. Nyanjong’ Economics Department Twitter: @ohyouguy Oyugi J. Nyanjong' 10:31:06 AM DEMAND THEORY •Def: A theory is an analytical structure or framework designed to explain a set of empirical observations. •Economic theory typically proceeds with an assumption of ceteris paribus 2 i.e. holding other variables constant. Oyugi J. Nyanjong' 10:31:06 AM DEMAND THEORY ‘ctd 3 An economic theory can therefore be defined as a statement or a set of related statements about cause and effect relationships between two or more economic variables. Demand Theory.; when a price of a product rises, ceteris paribus, people tend to buy less of it i.e. when the price rises, the quantity demanded falls. Conversely, a fall in the price of a good or service, ceteris paribus will result in more of it being purchased. Oyugi J. Nyanjong' 10:31:06 AM 4 DEMAND THEORY ‘ctd Consider the following hypothetical demand schedule for a Safaricom mobile service user in a typical month. Oyugi J. Nyanjong' 10:31:06 AM 5 Demand Schedule Price (per Quantity demanded minute) (calls per day) 0 30 5 25 8 7 12 3 20 1 25 0 Oyugi J. Nyanjong' 10:31:06 AM 6 Demand Schedule’ctd The demand schedule above can be plotted graphically to form a demand curve a demand curve is a graphic representation that shows the relationship between the price of a commodity and the quantity demanded of the same. Oyugi J. Nyanjong' 10:31:06 AM Demand Curve 7 Oyugi J. Nyanjong' 10:31:06 AM 8 Terminologies Demand –the desire or want of a consumer to acquire a good or service provided he/she is willing and able to pay for the same. Quantity demanded – this is the amount (or no. of units) of a good or a service that a consumer is willing and able to purchase in a given period and for a given price. Oyugi J. Nyanjong' 10:31:06 AM 9 Terminologies ‘ctd Normal good: A good or service whose demand increases with increase in consumer’s income. Inferior good: : A good or service whose demand decreases with increase in consumer’s income. Engel’s curve: A graph that plots the combination of points of a consumer’s income and the quantity demanded of a good or service. Oyugi J. Nyanjong' 10:31:06 AM 10 Engel curve for a normal good Oyugi J. Nyanjong' 10:31:06 AM 11 Engel curve for an inferior good Oyugi J. Nyanjong' 10:31:06 AM 10:31:06 AM 12 Determinants of Dd Own price –ve Price of related goods.May either be: Substitutes Complements Income Accumulated wealth Tastes & Preferences Future expectations Oyugi J. Nyanjong' 10:31:06 AM 13 Movements along dd curve result from a change in quantity demanded of a good or service. Caused by a change in price of a good or service resulting in a movement along the demand curve, as illustrated. Oyugi J. Nyanjong' 10:31:06 AM 14 Movements along dd curve ‘ctd Oyugi J. Nyanjong' 10:31:06 AM Movements along dd curve ‘ctd 15 An increase in price from P1 to P2 moves the level of demand from point a. to b. at the same time the quantity decreases from Q1 to Q2. Oyugi J. Nyanjong' 10:31:06 AM Shifts in dd curve 16 When other factors other than a good’s own price price change, a shift in the demand curve ensues. This is referred to as change in demand. For a normal good, an increase in income results in an outward(rightward) shift of the demand curve i.e. an increase in demand, as shown below. Oyugi J. Nyanjong' 10:31:06 AM Shifts in dd curve: effect of increase in income 17 for a Normal Good Oyugi J. Nyanjong' 10:31:06 AM 18 Shifts in dd curve For an inferior good, an increase in income results in an inward(leftward) shift of the demand curve i.e. a decrease in demand, as shown below. Oyugi J. Nyanjong' 10:31:06 AM 19 Shifts in dd curve: effect of increase in income for an Inferior Good Oyugi J. Nyanjong' 10:31:06 AM Demand Functions 20 Def: Are mathematical expressions of the relationship between a goods own price and the quantity demanded of the same. Take the following form: P=a + bQ Where, P= goods own Price Q=quantity demanded. a= y-intercept b= slope of dd curve. Oyugi J. Nyanjong' 10:31:06 AM 21 Demand functions’ctd In some instances, e.g. in calculating elasticities, the inverse form of the dd function is used, i.e. Q=a + bP Oyugi J. Nyanjong' 10:31:06 AM 22 ELASTICITY Def: Given two variables, say x & y, elasticity measures the degree of responsiveness of x to 1% changes in y. Is a ratio, is independent of units, thus simplifying data analysis. Oyugi J. Nyanjong' 10:31:06 AM . 23 Mathematical definition Given two variables, x and y, their elasticity will be as below: x, y ln x x y . ln y y x Oyugi J. Nyanjong' 10:31:06 AM Price elasticity of demand 24 Def:it’s the ratio of percentage change in quantity demanded to the 1% change in price. Mathematically, ln Qd Qd P X ln P P Qd where, =Price elasticity of demand P Ln Qd = own price of a good or service =natural logarithm = quantity demanded Oyugi J. Nyanjong' 10:31:06 AM Types of elasticities: Perfect inelasticity 25 When the quantity demanded of a good a service doesn’t respond at all to a change in price, the percentage change in quantity demanded is zero. This implies that its elasticity is zero and this Is said to be perfectly inelastic. Oyugi J. Nyanjong' 10:31:06 AM Types of elasticities: Perfect 26 inelasticity Oyugi J. Nyanjong' 10:31:06 AM 27 Types of elasticities: Perfect elasticity a small increase in price causes quantity demanded to drop immediately to zero. In reality, markets exhibiting perfect elasticity’s are rare, e.g. agricultural goods market, where due to high supply of the same, farmers aren’t able to change more than the current market price for their produce. Oyugi J. Nyanjong' 10:31:06 AM Types of elasticities: Perfect elasticity 28 Oyugi J. Nyanjong' 10:31:06 AM 29 Types of elasticities: Unitary Elasticity It is a demand relationship in which the percentage change in quantity demanded equals the percentage change in price in absolute value. i.e.%ΔQd=%ΔP Oyugi J. Nyanjong' 10:31:06 AM Types of elasticities: Point & Arc Elasticity 30 Arc elasticity Def: the coefficient of price elasticity between two points on the demand curve. Point elasticity Def: the coefficient of price elasticity of a unique point on the demand curve. Point elasticity more accurate. Oyugi J. Nyanjong' 10:31:06 AM 31 Arc elasticity Oyugi J. Nyanjong' 10:31:06 AM 32 Arc elasticity formula Oyugi J. Nyanjong' 10:31:06 AM 33 Point elasticity Oyugi J. Nyanjong' 10:31:06 AM 34 Interpreting elasticities Oyugi J. Nyanjong' 10:31:06 AM 35 Determinants of Elasticity Availability of Close Substitutes Necessary vs Luxury goods Duration/ Time Horizon Proportion of purchase Oyugi J. Nyanjong' 10:31:06 AM 36 Calculating elasticity Recall: Given y f ( x) x dy n 1 nx dx Oyugi J. Nyanjong' n 10:31:06 AM Calculating elasticity 37 Given the following demand function: Q 50 5.5 P Calculate the price elasticity of demand at, P 20 and Q 50 Solution Recall: =5.5*(20/50)=2.2 Oyugi J. Nyanjong' 10:31:06 AM Interpretation: the good’s dd is elastic. 38 Calculating elasticity Calculate elasticity at P=30, Q=165 Solution =5.5*(30/165)=1.0 Interpretation: the good’s dd is unitary elastic. Oyugi J. Nyanjong' 10:31:06 AM 39 Calculating Elasticity At P=30, Q=200 Solution =5.5*(30/200)=0.825 Interpretation: the good’s dd is inelastic. Oyugi J. Nyanjong' 10:31:06 AM Cross-price elasticity of demand(cpe) 40 measures the responsiveness of quantity demanded of one good (good x) due to a 1% change in price of another related good (good y).i.e. ξ y,x = %∆in Qd of y / % ∆ in price of x Substitute goods have +ve cpe. Complement goods have –ve cpe. Oyugi J. Nyanjong' 10:31:06 AM 41 Computation of cpe Is computed using the following formulae: Q x Py . P y Qx x, y y,x Qy x x y P . P Q Oyugi J. Nyanjong' 10:31:06 AM 42 Calculating cpe The following two demand functions represent the demand for two related goods, x and y, at Njokerio market. Qx = 1,000 -2.5Px +3.2Py Qy = 750 +5.8Px – 4.5Py Calculate cpe of good X at Py = 20 and Qx = 35 Oyugi J. Nyanjong' 10:31:06 AM Calculating cpe 43 ANSWER x, y but Qx Py Qx Py x, y 1.829 Oyugi J. Nyanjong' P . Q y x 3 .2 20 3 .2 ( ) 35 10:31:06 AM Worked example 44 The demand functions of two related goods, x and y ,bought in Toi Market are as below: Qx 1,000 4.8Px 3.2 Py Q y 750 5.5Px 4.5Py Given the demand schedule below, calculate cpe at the following points. Px 10, Px 45 Py 28, Py 45 Oyugi J. Nyanjong' 10:31:06 AM Worked example continued 45 10 15 20 25 30 35 40 45 50 500 485 450 417 400 375 300 270 250 Oyugi J. Nyanjong' 45 42 35 30 28 25 22 20 18 255 312 330 347 370 379 390 395 400 10:31:06 AM 46 Solution 1 At 𝑃𝑥 =10 Q P P .Q Q but 5 .5 P y x x y y,x y x y,x 10 5.5( ) 255 0.216 Oyugi J. Nyanjong' 10:31:06 AM 47 Solution 2 At 𝑃𝑥 =45 Q P P .Q Q but 5 .5 P y x x y y,x y x y,x 45 5.5( ) 395 0.627 Oyugi J. Nyanjong' 10:31:06 AM 48 Solution 3 Qx y y x P P .Q Q but 3 .2 P x, y At 𝑃𝑦 =28 x y x, y 28 3 .2 ( ) 400 0.224 Oyugi J. Nyanjong' 10:31:06 AM Solution 4 49 Qx y y x P P .Q Q but 3 .2 P x, y At 𝑃𝑦 =45 x y x, y 45 3 .2 ( ) 500 0.288 Oyugi J. Nyanjong' 10:31:06 AM 50 Interpreting cross price elasticities Oyugi J. Nyanjong' 10:31:06 AM Exceptions to the Law of Demand 51 Giffen goods Veblen goods:Goods of ostentation(conspicuous consumption) Expectation to price changes Conspicuous necessities(TVs, fridges) Emergencies:natural calamities,depression Ignorance Change in fashion: Oyugi J. Nyanjong' 10:31:06 AM 52 Uses of elasticities Business: In considering increase prices of g & s. whether to Government: In levying taxes(beer, cigarrettes),Welfare distribution(Cnmsr, producer, govt surplus) Balance of payments: Environment: Helps explain price instabilities. Price discrimination: Oyugi J. Nyanjong' 10:31:06 AM 53 𝜺𝝆 & indirect taxation policy Success of indirect taxation policy depends on whether 𝜺𝝆 is elastic or inelastic. More successful if good has inelastic dd(Why) Also depends on taxation policy objective Change consumption behaviour? Change production behaviour? Oyugi J. Nyanjong' 10:31:06 AM 54 𝜺𝝆 & indirect taxation policy continued Suppose the policy is targeted at reduction in consumption of a certain good or service(say cigarettes), whose 𝜺𝝆 is inelastic. Policy likely to fail, since ↑ taxes= ↑ P, but Qd will fall less than proportionately to consumer expenditure. →A rise in total expenditure, →policy objective defeated Oyugi J. Nyanjong' 10:31:06 AM 55 𝜺𝝆 & indirect taxation policy: Example of inelastic good 1. Suppose a litre of petrol costs KSh 100, as a result 10 litres are demanded 2. Suppose the govt. introduces an indirect tax of KSh 50. 3. Suppose that, as a result, Qd falls from 10l to 8l 1. Total exp. B4 tax=𝟏𝟎𝟎 ∗ 𝟏𝟎𝒍 = 𝑲𝑺𝒉 𝟏, 𝟎𝟎𝟎 2. Total exp after tax=𝟏𝟓𝟎 ∗ 𝟖𝒍 = 𝑲𝑺𝒉 𝟏, 𝟐𝟎𝟎 3. Total ∆exp(↑)=𝟏, 𝟐𝟎𝟎 − 𝟏, 𝟎𝟎𝟎 = 𝑲𝒔𝒉 𝟐𝟎𝟎 Observations: %∆P=50% %∆Qd=20% →inelastic gd Conclusion: policy fails, since ↑ 𝑷 →↑ consumer exp. Oyugi J. Nyanjong' 10:31:06 AM 56 𝜺𝝆 & indirect taxation policy: Example of inelastic good Oyugi J. Nyanjong' 10:31:06 AM 𝜺𝝆 & indirect taxation policy: Example of elastic good 1. Suppose a litre of petrol costs KSh 100, as a result 10 litres are demanded 57 2. Suppose the govt. introduces an indirect tax of KSh 50. 3. Suppose that, as a result, Qd falls from 10l to 4l 1. Total exp. B4 tax=100 ∗ 10𝑙 = 𝐾𝑆ℎ 1,000 2. Total exp after tax=150 ∗ 4𝑙 = 𝐾𝑆ℎ 600 3. Total ∆exp(↓)=1,000 − 600 = 𝐾𝑠ℎ 400 Observations: %∆P=50% %∆Qd=60% →elastic gd 10:31:06 AM Conclusion: policy succeeds, since ↑ 𝑃 →↓ consumer exp. Oyugi J. Nyanjong' 58 𝜺𝝆 & indirect taxation policy: Example of elastic good Oyugi J. Nyanjong' 10:31:06 AM 59 comparison Inelastic good Oyugi J. Nyanjong' Elastic good 10:31:06 AM 60 Demand curves & Price Elasticity of Demand Oyugi J. Nyanjong' 10:31:06 AM 61 Law of Supply Refers to the positive relationship between price and quantity of a good or service supplied i.e. an increase in the market price will lead to an increase in quantity supplied, ceteris paribus. Conversely, a decrease in the market price will lead to a decrease in quantity supplied . Oyugi J. Nyanjong' 10:31:06 AM 62 Supply Curve Oyugi J. Nyanjong' 10:31:06 AM 63 Determinants of Supply Cost of production Production costs depend mainly on two factors: The price and quantities of input by the firm The available technology Price of related products Cow vs Hide Oyugi J. Nyanjong' 10:31:06 AM 64 MOVEMENT/SHIFT IN SUPPLY CURVES Movement – when the price of a good or service changes ceteris paribus a change in quantity supplied follows i.e. a movement along the supply curve takes place. Oyugi J. Nyanjong' 10:31:06 AM MOVEMENT 65 Oyugi J. Nyanjong' 10:31:06 AM 66 SHIFT Oyugi J. Nyanjong' 10:31:06 AM 67 Price Elasticity of Supply This measure the response of a quantity of a good or service supplied to a 1% change in price of that good. ξ S = %∆ in Qs / %∆ in price In output markets the elasticity of supply is likely to be a positive number. Oyugi J. Nyanjong' 10:31:06 AM 68 Price Elasticity of Supply ‘CTD 3 conditions for price elasticity s 1 : Pr ice elastic s 1 : Pr ice inelastic s 1 : Unitary Oyugi J. Nyanjong' 10:31:06 AM Determinants of elasticity of supply 69 Adjustment time Availability of spare capacity Inventory levels Availability of production. variable factors of Ease with which resources can be shifted from one industry to another Ease of substitution Number of firms Oyugi J. Nyanjong' 10:31:06 AM 70 Price Determination At any moment, 3 conditions prevail in every market: Excess demand – Qd>Qs Excess supply – Qd<Qs Equilibrium – Qd=Qs Oyugi J. Nyanjong' 10:31:06 AM 71 Equilibrium A mkt is in eq. when: No need for change in strategy by economic agents. Economic agents’ decisions are compatible with each other, can take place simultaneously. Eq.occurs at the intersection between demand, supply curves. Oyugi J. Nyanjong' 10:31:06 AM 72 Market equilibrium Oyugi J. Nyanjong' 10:31:06 AM 73 Excess supply(Price floors) Oyugi J. Nyanjong' 10:31:06 AM 74 Excess demand(Price ceilings) Oyugi J. Nyanjong' 10:31:06 AM 75 Effect of quantity regulation Oyugi J. Nyanjong' 10:31:06 AM 76 CONSUMER SURPLUS Oyugi J. Nyanjong' 10:31:06 AM 77 Effects of increase in supply Oyugi J. Nyanjong' 10:31:06 AM 78 Effect of increase in demand Oyugi J. Nyanjong' 10:31:06 AM