Demand and supply theory

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Demand and supply theory

• Syllabus theme 1
• Module 3

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Utility Theory

• Total utility quantity of Y x quantity of Z
• Thus, if consumer consumes 2.5 hamburgers and
• 10 slices of pizza his/her total utility will be
  25
• Different consumption levels will have
  different utility

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Marginal Utility

• The question one should ask is how total utility
  changes if the quantity of a specific product
  changes
• This change is referred to as Marginal Utility
• The term Marginal is synonymous to the term
  Change
• Thus, Marginal Utility of hamburgers
• Muhamburgers Change in Utility / Change in
  hamburgers
• In other words, the change in utility associated
  with the change in consumption of hamburgers

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Calculation of marginal utility
10
9
8
7
6
5
4
3
2
0
-4
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Total Utility
Marginal Utility
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Law of Diminishing Marginal Utility

• Let assume you consume one unit of commodity A,
  then you consume a second unit.
• The second unit gives you less satisfaction
• This is called the law of diminishing marginal
  utility

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Indifference curves

• Concept of Iso-utility
• Iso is a Greek term for equal, thus equal
  utility. (We are interested if a consumer prefer
  commodity M over commodity N, not by how much)
• Iso-utility also referred to as Indifference
  curve
• Consumer indifferent to bundles of commodities
  that yield equal level of utility

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Indifference Curve
Increasing utility
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Marginal rate of substitution

• A consumer may decide to change his bundle of
  commodities.
• In order to stay at the same level of utility he
  will substitute one commodity for another
• The rate that a consumer is willing to do this is
  called the marginal rate of substitution (MRS).
• I.e. the MRS tells you how much of a commodity Z
  a consumer is willing to give up to obtain
  additional units of commodity X. THUS
• MRShamburgers for ice cream Change in ice cream
  / change in hamburgers

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-2/1 -2
-1/1 -1

• Why does MRS falls as we move down indifference
  curve?
• As hamburger consumption falls, its marginal
  utility increases
• As ice cream consumption increases, its marginal
  utility decreases
• Thus, MRS falls as one movers down indifference
  curve

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The budget constraint

• Engels law The greater the per capita income,
  the lower the proportion of income spent on food.
• USA Total consumption expenditure on food
  12.2
• Philippines 50
• Slope budget line - price of hamburgers /
• price of ice cream

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Budget line
Change in income
Doubling
Halving
Hamburger price change
Ice cream price change
Halving
Halving
Doubling
Doubling
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Consumer equilibrium

• No budget line consumption where marginal
  utility of each good or service zero
• With budget line consumer decision to choose
  products where total utility is max, given a
  certain budget constraint

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Budget line
Consumer equilibrium
10
Ice cream consumption per week
5
I3400
I2200
I1100
4
2
6
8
Hamburger consumption per week
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Changes in the budget line
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Income and substitution effects
Price change in hamburger price
increase Hypothetical budget line this is if
one assume the consumers income increase to
stay on same indifference curve substitution
effect Move from hypothetical budget line to new
indifference curve income effect
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• Market demand
• Summation of individual demand curves of a
  population
• Change in quantity demanded vs change in demand

Change in demand
Change in quantity demanded
Price of hamburgers
P2
P1
O
t
w
u
s
Hamburger consumption per week
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Decision making criteria

• The manager should decide on the amount of input
  to use or what production level that will
  generate the highest profit (Optimum point).
• This entails that one must think of the price of
  inputs and the price of outputs.
• The optimum point occurs where the additional
  income from an additional unit of output is equal
  to the cost involved in its production.

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• Hence, if the additional cost is less than the
  additional income, profit can be increased by
  producing more. To produce more one will need
  more inputs, ceteris paribus.
• On the other hand, if the additional cost is
  higher, profit could be increased by producing
  less. When producing less, less inputs are used.
• Thus, for maximum profit, the marginal income
  should be equal to the marginal cost (MI MC).

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MI MC

• MI ?Y ? Py (Change in Production ? Unit price
  of product)
• MC ?X ? Px (Change in input use ? Unit price of
  input)
• MI MC
• ?Y ? Py ?X ? Px
• ?Y ? Py Px
• ?X
• VMP (Value of the marginal product) Px

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Calculation where MI MC
Input cost R2/kg (Px)
Output price R0.50/kg (Py)
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Calculation where MI MC
Input cost R2/kg (Px)
Output price R0.50/kg (Py)
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The supply curve

• A static supply schedule shows how much of a
  given commodity will be offered for
• sale per unit of time as its price varies, all
  other factors constant.
• The static supply function can be derived from
  knowledge on input-output relationship
• Supply curve based on the assumption that
  producers wants to maximise net returns
• This is done by equating marginal revenue with
  marginal costs
• Producers are price takers, therefore marginal
  revenue is equal to prevailing market price

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Factors that influence supply (ceteris paribus)

• Prices of inputs
• Availability of input
• Technology
• Government policy (quotas, subsidies, tax)
• Prices of alternative commodities
• Nature
• Socio circumstances

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Consumer surplus Tool for economic policy
analysis
Box 2
Consumer well-being will increase if the price
drops That is, consumers surplus will increase
from ABC to DBE
Box 1

• Consumer pays R6 for 5 units
• Consumer is, however, was willing to R10 per
  unit or R9 for 2 units
• Conclusion is that consumer is willing to pay
  more for smaller quantities
• Hence, area ABC measure of consumers willingness
  to pay
• Therefore, difference between willingness to pay
  and what is actually paid
• is referred to as consumer surplus

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Elasticities
Convenient way to think of a price elasticity
The percentage change in quantity corresponding
to a 1 per cent change in price
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How do we calculate own price elasticity of
demand?
Lets assume price increase from R1 to R1.25 and
quantity demanded decreases from 3 units to 2
units
Thus, a 1 fall (rise) in price is associated
with a 1.8 increase (decrease) in quantity
demanded, all other factors constant (ceteris
paribus)
Note that the ARC formula is to compute an
elasticity at an average between two points (not
the average of elasticities)
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• Range of price elasticity is from zero to minus
  infinity
• Absolute value gt 1 - demand is elastic ( change
  in quantity demanded is greater than
• corresponding change in price)
• Absolute value lt 1 - demand is inelastic (
  change in quantity demanded is less than
• corresponding change in price)
• Absolute value 1 unitary elasticity ( change
  in quantity demanded is equal to
• corresponding change in price)

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(No Transcript)
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When one refers to an elasticity it is usually
the point elasticity and is determined by
econometric analysis For example, one would
say the demand for food is price inelastic thus
change in quantity is less than change in
price. But it was illustrated that elasticity
changes along the demand curve, hence when one
says that the demand for a product is inelastic
one refers to an elasticity within a usual range
of prices.
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Income elasticity of demand
Income elasticity of demand is a measure of the
responsiveness of quantity to changes in income,
all other factors held constant
A one per cent increase in income is associated
with a 2.2 per cent increase in the demand for a
commodity, all other factors constant
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• Income elasticity gt 1 Luxury good
• Income elasticity lt 1 Normal good
• Income elasticity lt 0 Inferior good

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Cross-price elasticity
Cross-price elasticity of demand are measures of
howthe quantity purchased of one commodity
responds to changes in the price of another
commodity, all other factors constant.
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• If cross-price elasticity is positive then
  substitute
• (If price of X increases then demand for Y will
  increase)
• If cross-price elasticity is negative then
  complement
• (If price of X increases then demand for Z will
  decrease)
• If cross-price elasticityis zero then independent

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Use of elasticities
Point elasticity in a given price range
P
P
P1
P2
D
Q
Q
Q1
Q2
Demand elastic
Demand inelastic
Change in quantity smaller than change in price
Change in quantity larger than change in price
Large number substitutes Aggregates
(hamburgers) Budget share (large) Long run
(adjust over time) Type of market (retail level)
Little substitutes Aggregates (food) Budget share
(small) Short run (cant adjust fast) Type of
market (farm level)
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Total elasticity
In the real world if the price of commodity X
changes, the price of substitutes will change as
well. This will again influence the price for X.
Hence, a new price structure.
Total response is more inelastic that the ceteris
paribus demand curve, i.e. the net quantity
response is less than that indicated by
own-price elasticity of demand
Ti Ei EijSji Ei own-price elasticity Eij
cross-price elasticity Sji change in price of
j given a 1 change in the price of i
Ti -.94 (0.72)(0.29) -0.73 Ei
-0.94 Eij 0.72 Sji 0.29
Thus, net change in quantity of product i in
response to a 1 change in the price of product
i is 0.73 after taking into account cross-price
effects
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The price mechanism

• Assume perfect competitiveness, then price
  mechanism solves three problems
• What should be produced with available resources
• How available resources should be allocated
• For who should be produced
• The above is referred to as the allocations,
  production and distribution choices
• Forces of demand and supply will work against and
  with each other until an equilibrium price is
  determined

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What should be produced with available resources?

• Assume higher demand for product at current
  prices, then demand
• curve will shift to the right
• This will cause surplus demand and hence upwards
  pressure on prices

• Due to higher prices production will
• increase since new producers will enter
• Increase in prices will again dampen
• the quantity demanded
• This process will lead to market
• equilibrium

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How available resources should be allocated

• In order to maximise profit one should always
  minimise costs
• Thus, always employ cheapest production methods
• Producer that can satisfy consumer demand at the
  lowest price will survive
• Price competition will determine how commodities
  are produced

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For whom should the producer produce

• Forces of demand and supply will determine for
  whom the producer will produce
• Each market has its own specific characteristics
• Price and availability of resources will also
  influence producers decisions.

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The price mechanism

• Assume perfect competitiveness, then price
  mechanism solves three problems
• What should be produced with available resources
• How available resources should be allocated
• For who should be produced
• The above is referred to as the allocations,
  production and distribution choices
• Forces of demand and supply will with against and
  with each other until an equilibrium price is
  determined

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What happens if demand of supply changes?

• It will have an effect on three things
• Price
• Quantity
• Income (Income price quantity)

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EXAMPLE 1

• The following is known about demand and supply of
  three products
• Demand Supply
• Bread Relative unelastic Unitary elastic
• White maize meal Relative unelastic Relative
  unelastic
• Margerine Relative elastic Relative elastic
• Bread and maize meal is substitutes, whilst
  margerine and bread is complements
• It is further known that people in urban areas
  eat more bread than maize meal
• Now assume that the urbanisation process in SA
  inceases.
• Show the effect of this on the market for these
  commodities.

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Bread
Maize meal
Margerine
P
D2
P
D1
S
D2
P2
S
P2
P1
D1
P1
0
0
Q
Q
Q2
Q1
Q2
Q1
Change in P gt change in H Negative effect om
total income
Change in P lt change in H Positive effect om
total income Much more margerine is sold
Change in P change in H Positive effect on
total income
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EXAMPLE 2

• Demand for potatoes and rice are relative price
  inelastic
• Potatoes and rice are substitutes
• Demand for greenbeans is relative price elastic
• Potatoes and greenbeans are complements
• Supply for potatoes and greenbeans are price
  inelastic, whilst that of rice is price elastic
• Now assume that the supply of potatoed decrease,
  whilst that of greenbeans and rice stays the
  same.
• Show the effect of this on prices of potatoes,
  greenbeans and rice. Also show quantities sold
  and total sales value.

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Potatoes
P
S1
S2
D1
P2
P1
0
Q
Q1
Q2
Supply decrease Price increase to P2 Quantity
decrease to Q2 Change in P gt change in
Q Therefore total income (PQ) higher after
decrease in supply
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EXAMPLE 3

• Price elasticity Supply elasticity
• Beef -2.2 0.5
• Poultry -1.9 0.8
• Yellow maize -infinite 1.5
• Decline (increase) of 1 in beef production leads
  to a decrease (increase) of 0.6 in use of maize
  in feedlots
• Decline (increase) of 1 in poultry demand leads
  to a decrease (increase) of 1.2 in use of maize
• Increase (decrease) of 1 in beef prices leads to
  an increase (decrease) of 1 in consumption of
  poultry
• Assume a quota is implemented that reduce beef
  production with 10.
• Show the following
• Effect on prices of beef, poultry
• Effect on total value of beef, poultry and yellow
  maize
• Effect on quantity of poultry and yellow maize
• (Assume a fixed price for yellow maize)

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Beef
P
S1
S2
D1
P2
P1
0
Q
Q1
Q2
Supply decrease with 10 Price increase to P2 -
if elasticity of demand is -2.2, then the price
of beef will increse with (10/2.2) 4.54
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Positive vs normative economics

• Positive economics analise facts
• Describes the way in which the economics unit
  functions without making statements such as, it
  is good or bad.
• E.g. High inflation will lead to high interest
  rates which will lead to lower per capita income
• Normative economics is prescriptive
• It deals with what ought to be as contrasted
  with what is. Hence, it rests on value
  judgments
• E.g. High inflation in bad for economic growth
• Positive economics serves as a basis for making
  judgments in normative areas

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Traditional price mechanism

• Assumptions
• Perfect competition
• Large amount of buyers
• Large amount of sellers
• No one individual is able to influence product
  prices
• All buyers will try to maximise their utility and
  all sellers will try to maximise their profits
• Everyone has perfect knowledge regarding the
  market
• There exist perfect mobility in the market
• Therefore
• All producers are price takers and ask the same
  price for the produce
• All buyers will pay the same price for that
  produce

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Economic systems

• Centrally controlled economic systems
• Government is solely responsible for basic
  economic activities.
• Market economy
• Own interest is the main motivational factors
• Competitiveness regulates the market.
• That is, the market regulates what and for whom
  are produced.
• South Africa is a mixture between the above.

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Monopoly
One buyer of a product, hence such firms are no
longer price-takers. Prices can be set higher and
output lowered under monopoly conditions.
Remember under perfect competition equilibrium is
reached were price is equal to marginal cost
(supply). Under monopoly the firm will max.
profits where marginal revenue marginal cost
Hence, lower quantity supplied at higher
price. What is the economic (welfare) effect of
this?
Marginal costs (supply)
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Price per unit
a
Marginal costs (supply)
b
P1
d
P
c
f
Demand
e
Marginal revenue
Q
Q2
Quantity per unit time
Under perfect competition Producer surplus
Pde Under monopoly producer surplus increases
with P1bcP and decreases with bdf, hence net
increase in profit Under perfect competition
Consumer surplus Pad Under monopoly consumer
surplus is reduced by P1bdP P1bdP gt P1bcP,
therefore loss in welfare for community as a whole
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Von Thunens Theory Impact of distance from the
market
Place of production influenced by transportation
cost Farm price market price transp.
Cost Transp. Cost influenced by Perishableness B
ulkiness Special care Hence, the more
perishable, bulky and special care, the higher
transport cost. Thus, the further away from the
market the lower the farm price Therefore,
producers closer the market will produce more
perishable, bulky and special care products.
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Tomatoes produced the closest to the
market.(Intensive) Wheat produced further away
from the market (semi-intensive) Wool produced
the furthest away from the market (extensive)