A Primer on Demand Analysis and Market Equilibrium

A Primer on Demand Analysis and Market Equilibrium Chapter 3 (Hirschey) pp 77 -109

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

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

Demand Curve • The Demand Curve shows 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, Q=2500 – 500 P • Key question: How are these numbers obtained?

Demand Curve for Lipton Tea Average price per package 5 Demand Curve 4 Q = 2, 500 – 500 P P = 5 –. 002 Q 3 inverse demand curve 2 1 500 1000 1500 2000 2500 packages of Lipton tea

Own-Price Effects • 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.

Other Factors Affecting Demand § Prices of other products § Income § Advertising (positive information) § Food Recalls or Food Scares (negative information) § Health and nutrition factors § Lifestyle factors § Tastes and preferences

Translations of the Theoretical Construct into a Quantitative Appraisal 1. Q = a-b. P 2. Q = a 0 – a 1 P + a 2 I + a 3 A + a 4 PS own-price effect (-) • • • income effect (+) advertising effect (+) price of substitute product (+) The coefficients a 0, a 1, a 2, a 3, and a 4 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.

Demand Curve: Example

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

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

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).

Supply Curve (con’t. )

Market Equilibrium § Supply = Demand § Example: § Automobile: § Supply: Qs = -42, 000+2, 000 p § Demand: Qd = 20, 500, 000 -500 p

Surplus, Shortage, and Market Equilibrium

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, how effectively can firms pass on the full amount of these mandatory fees to consumers? § If a proposed tax on sugar-sweetened beverages occurs, what are the implications concerning sales for those beverages?

Elasticity (con’t. ) § Elasticity: the percentage change in y due to a unit percentage change in x: § change from (x 1, y 1) into (x 2, y 2) y y 1 § Point elasticity y 2 x 1 x 2 x

Demand Elasticity § Own-price elasticity § Cross-price elasticity § Income elasticity § Other elasticity concepts

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 ε% decrease (increase) in quantity demanded.

Own Price Elasticity (Con’t. ) § Price Elasticity Formula: § The product price changes from p 1 to p 2, and the quantity changes from Q 1 to Q 2 correspondingly. § Point Elasticity:

Own-Price Elasticity: Examples § Linear demand: Q = a-b*P § Constant elasticity demand: Q = a*p-b § Why is the own-price elasticity negative?

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

Perfectly Inelastic Demand Curve: εp = 0 Price per unit ($)

Perfectly Elastic Demand Curve: εp = ∞

Price Elasticity of Demand Varies Along Linear Demand Curve Figure 4. 10

Price Elasticity and Revenue Maximization § Revenue: R = p*Q, Marginal revenue MR: § The change in revenue if the price goes down: Elastic demand Inelastic demand Unitary demand ↑ ↓ No change § Linear demand case: P = a-b*Q § Price elasticity: § Marginal revenue: MR = a-2*b*Q § Total revenue is maximized where MR = 0

Own-Price Elasticity, Marginal Revenue, and Revenue Maximization

Own-Price Elasticity and Optimal Pricing § Optimal pricing (in what sense? ): MR=MC § Assumption: a firm can affect market price (under what conditions? ) § Optimal price:

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

Cross Price Elasticity (cont’) § Formula: § Point elasticity: § Examples

Demand Curve for Lipton Tea PLipton Tea Rightward demand shift due to a rise in the price of Nestea D 1 D 0 QLipton Tea § Suppose the price of Nestea rises, all other factors invariant?

Demand Curve for Lipton Tea PLipton Tea Leftward demand shift due to a rise in the price of hamburgers D 0 D 1 QLipton Tea § Suppose the price of hamburgers rises, all other factors invariant?

Cross-Price Elasticity (Con’t. ) § 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.

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

PLipton Tea Rightward shift in the demand curve for Lipton Tea due to a rise in income D 1 D 0 QLipton Tea § Suppose the income of consumers rises, all other factors invariant?

Income IB IA QA QB QLipton Tea § As drawn, what kind of good is Lipton Tea?

Income Elasticity (Con’t. ) § Necessary goods: products for which demand is positively related to income; EI>0 and EI<1. (Engel curve is positively sloped) § Luxury goods: products for which demand is positively related to income; EI > 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; EI<0. (Engel curve is negatively sloped)

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