A Primer on Demand Analysis and Market Equilibrium

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A Primer onDemand Analysisand Market Equilibrium
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Key Concepts

• Demand
• Supply
• Market equilibrium
• Elasticity
• A number of issues arise in the agribusiness
  environment that center attention on demand.

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Consumer Demand or Customer Demand

• Demand is the quantity of a good/service that
  customers (consumers) are willing and able to
  purchase during a specified period of time under
  a given set of economic conditions.
• Derived from constrained utility (satisfaction)
  maximization

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Demand Curve

• The Demand Curve shows the theoretical relation
  between price and quantity demanded, holding all
  other factors constant.
• Axes price is on y-axis, quantity on the x-axis
• Example Demand curve for Lipton tea,
• Q2500 500P
• Key question How are these numbers obtained?

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Average price per package
5 4 3 2 1
Demand Curve Q 2,500 500P P 5 .002Q
inverse demand curve
500 1000 1500 2000 2500
packages of Lipton tea
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• Movement along a given demand curve reflects a
  change in price and quantity of the commodity in
  question.
• Answer the following question
• What happens to the quantity demanded if the
  price changes (exogenously) holding all other
  factors constant?
• Law of demand
• The demand curve is negatively sloped.
• An increase (a decrease) in own price leads to a
  decrease (an increase) in quantity demanded.
• A very important empirical finding in economics.

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• Prices of other products
• Income
• Advertising (positive information)
• Food Recalls or Food Scares (negative
  information)
• Health and nutrition factors
• Lifestyle factors
• Tastes and preferences

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Translations of the Theoretical Construct into a
Quantitative Appraisal

• 1. Q a-bP
• 2. Q a0 a1P a2I a3A a4PS
• The coefficients a0, a1, a2, a3, and a4 are
  labeled the demand parameters.
• We expect certain signs and magnitudes of the
  demand parameters according to economic theory.
• Different versions of the model for applied
  analysis are possible.

own-price effect (-)
income effect ()
advertising effect ()
price of substitute product ()
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Demand Curve Example
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Shifts in Demand

• Changes in any factors other than the product
  price lead to a shift of the demand curve.

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Supply

• Supply quantity that a firm is willing and able
  to provide at a given price, holding other
  factors constant.
• Factors affecting supply
• Price
• Production costs
• Technology
• Government policy (e.g. price supports, taxes,
  subsidies, etc)

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Supply Curve

• Supply curve shows the relation between price and
  the quantity supplied, holding all other factors
  constant.
• Question What happens to the quantity supplied
  if the product price changes?
• No Law of Supply supply curve can be
  upward/downward sloping, vertical, horizontal.
• Change in the supply curve
• A change in the product price leads to a movement
  along the supply curve (change in quantity
  supplied).
• A change in any factors other than the product
  price leads to a shift of the supply curve
  (change in supply).

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Supply Curve (cont.)
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Market Equilibrium

• Supply Demand
• Example
• Automobile
• Supply Qs -42,000,0002,000p
• Demand Qd 20,500,000-500p

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Surplus, Shortage, and Market Equilibrium
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Elasticity

• Concept a measure of responsiveness or
  sensitivity
• Elasticity analysis helps answer questions such
  as
• Can Microsoft increase revenue if it increases
  the price of any of its software products?
• How do oil prices change if OPEC restricts
  output?
• How large a tax is needed to discourage a
  substantial number of people from smoking?
• If Congress passes a law forcing firms to provide
  health care, will firm pass on the full amount of
  these mandatory fees to consumers?

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Elasticity (cont.)

• Elasticity the percentage change in y due to a
  unit percentage change in x
• change from (x1,y1) into (x2, y2)
• Point elasticity

y
y1
y2
x
x1
x2
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Demand Elasticity

• Own-price elasticity
• Cross-price elasticity
• Income elasticity
• Other elasticity concepts

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Own-Price Elasticity of Demand

• Own-Price Elasticity of Demand summarizes the
  sensitivity of the quantity demanded response due
  to own-price changes.
• Interpretation 1 increase (decrease) in the
  product price leads to an e decrease (increase)
  in quantity demanded.

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Own Price Elasticity (Cont.)

• Price Elasticity Formula
• The product price changes from p1 to p2, and the
  quantity changes from Q1 to Q2 correspondingly.
• Point Elasticity

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Own-Price Elasticity Examples

• Linear demand Q a-bP
• Constant elasticity demand Q ap-b
• Why is the own-price elasticity negative?

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Types of Own-Price Elasticity

• Elastic the change in quantity demanded is
  greater than the change in price.
• Inelastic the change in quantity demanded is
  less than the change in price.
• Unitary the changes in quantity demanded and
  price are the same.
• Special cases
• Perfectly elastic
• Perfectly inelastic

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Perfectly Inelastic Demand Curve ep 0
Price per unit ()
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Perfectly Elastic Demand Curve ep 8
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Price Elasticity of Demand Varies Along Linear
Demand Curve
Figure 4.10
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Price Elasticity and Revenue Maximization

• Revenue R pQ, Marginal revenue MR
• The change in revenue if the price goes down
• Linear demand case P a-bQ
• Price elasticity
• Marginal revenue MR a-2bQ
• Total revenue is maximized where MR 0

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Own-Price Elasticity, Marginal Revenue, and
Revenue Maximization
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Own-Price Elasticity and Optimal Pricing

• Optimal pricing (in what sense?) MRMC
• Assumption a firm can affect market price (under
  what conditions?)
• Optimal price

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Cross-price Elasticity

• What-if Question If the price of product x
  changes, how much does the quantity demanded of
  product y change?
• Interpretation Measures how responsive demand is
  to changes in prices of other goods, holding
  everything else constant.
• Examples

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Cross Price Elasticity (cont)

• Formula
• Point elasticity
• Examples

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Demand Curve for Lipton Tea
PLipton Tea
Rightward demand shift due to a rise in the price
of Nestea
D1
D0
QLipton Tea

• Suppose the price of Nestea rises, all other
  factors invariant?

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Demand Curve for Lipton Tea
PLipton Tea
Leftward demand shift due to a rise in the price
of hamburgers
D0
D1
QLipton Tea

• Suppose the price of hamburgers rises, all other
  factors invariant?

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Cross-Price Elasticity (Cont.)

• Substitutes vs Complements
• Two goods are Substitutes if a price increase
  (decrease) in one good leads to an increase
  (decrease) in quantity demanded of the other
  good. Examples butter and margarine cotton and
  polyester beef, pork, and chicken.
• Two goods are Complements if a price increase
  (decrease) in one good leads to a decrease
  (increase) in quantity demanded of the other
  good. Examples chips and salsa computers and
  software shoes and socks.

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Income Elasticity

• Income Elasticity a measure of
  responsiveness of the quantity demanded to
  income.
• Point elasticity

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PLipton Tea
Rightward shift in the demand curve for Lipton
Tea due to a rise in income
D1
D0
QLipton Tea

• Suppose the income of consumers rises, all other
  factors invariant?

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Income
IB
IA
QB
QA
QLipton Tea

• As drawn, what kind of good is Lipton Tea?

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Income Elasticity (Cont.)

• Necessary goods products for which demand is
  positively related to income EIgt0 and EIlt1.
  (Engel curve is positively sloped)
• Luxury goods products for which demand is
  positively related to income EI gt 1. (Engel
  curve is positively sloped)
• Normal goods either necessary goods or luxury
  goods
• Inferior goods products for which consumer
  demand declines as income rises EIlt0. (Engel
  curve is negatively sloped)

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Summary

• Demand, Supply, and Market Equilibrium
• Elasticity
• Own-price elasticity
• Cross-price elasticity (shift in the demand
  curve)
• Income elasticity (shift in the demand curve)
• Engel curve