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LEARNING OUTCOME 2 & 3 DEMAND AND SUPPLY DEMAND EFFECTIVE DEMAND • desire to purchase backed by the ability to pay DETERMINANTS OF DEMAND: Price Tastes Income Fashion Advertising Availability and price of substitutes Price of compliments Time of year Consumers’ expectations Availability of credit Population Utility yielded UTILITY UTILITY • the satisfaction which we obtain from goods and services MARGINAL UTILITY • the satisfaction obtained from the last unit • will diminish with each successive unit consumed - the law of diminishing marginal utility TOTAL UTILITY • the satisfaction obtained from all units consumed CONSUMER OPTIMUM • maximising total utility - the theory of equi-marginal returns: MU A = MU B = MU C = MU n Price A Price B Price C Price n THE LAW OF DEMAND More will be demanded at lower prices and less at higher price. Reasons for slope of Demand Curve: Price P1 P D Q1 Q • Law of Diminishing Marginal Utility • Substitution Effect • Income Effect Quantity When price rises from P to P1 quantity demanded contracts from Q to Q1. Price P When price falls from P to P2 quantity demanded extends from Q to Q2 P2 D Q Q2 Quantity QUIZ What is meant by effective demand? Name any 4 determinants of demand How do we refer to the satisfaction yielded by the last unit consumed? Wants backed up by money Price, tastes, availability of substitutes and the price of compliments Marginal Utility What happens to satisfaction as we consume more of a commodity? Marginal utility decreases with each unit consumed How can individuals maximise their total satisfaction? By equalising the marginal utility: price ratio for all goods consumed Describe the relationship between price and quantity demanded. It is an inverse relationship What explains this relationship? Law of Diminishing Marginal Utility The Substitution Effect The Income effect What happens on the demand curve when price rises? What happens on the demand curve when price falls? There is a contraction of demand There is an extension of demand PRICE ELASTICITY OF DEMAND Measures the responsiveness of demand to price changes E = % change in Quantity Demanded % change in Price Price D Quantity Demanded > 1 is relatively price elastic < 1 is relatively price inelastic = 1 is unit price elasticity Products which are price elastic have a relatively flat demand curve so that in response to even a relatively small price change, quantity demanded changes more than in proportion to price. Products which are price inelastic have a relatively steep demand curve so that even relatively large price changes generate proportionately smaller changes in quantity demanded. Price D Quantity Demanded PRICE ELASTICITY OF DEMAND With straight line demand curves elasticity will vary along the length of the curve. E=% Change in Quantity Demanded % Change in Price 5 4 10 x 100 10 = 100% 1 x 100 = 20% = 5 5 Relatively Elastic 3 2 1 D 10 x 100 40 = 25% 1 x 100 = 50% = 0.5 2 Relatively Inelastic 10 20 30 40 50 60 Perfectly Elastic Demand Perfectly Inelastic Demand Price Price D D Quantity Demanded Quantity Demanded PRICE ELASTICITY OF DEMAND When using the formula for price elasticity of demand, the sign is assumed to be negative (-). This is because normal goods follow the law of demand and have a normal, downward sloping demand curve. Products whose quantity demanded increases when price increases would give a positive (+) value for price elasticity and have an exceptional demand curve. If a positive (+) value is obtained this is an exceptional good – one which does not follow the law of demand ie one which has an exceptional demand curve. An example of this could be the demand for a painting by a particular artist, which only becomes desirable as an investment by a collector, when the price starts to rise. QUIZ What is the price elasticity of demand if the price of Commodity X rises from 80p to 85p and, as a result, the demand falls from 100 per week to 75 per week? 25 x 100 100 1 5 x 100 80 1 = 25% = 4 ie fairly elastic 6.25% If the demand for commodity Y rises from 1,200 to 1,500 in response to a price reduction from £2.00 to £1.50, calculate the price elasticity of demand. 300 x 100 1200 = 25% = 50 x 100 25% 200 1 ie unit elasticity INCOME ELASTICITY OF DEMAND Measures the responsiveness of demand to changes in income E = % change in Quantity Demanded % change in Income > 1 is relatively income elastic < 1 is relatively income inelastic = 1 is unit income elasticity Products for which quantity demanded increases when income increases and vice versa have a positive(+) income elasticity value. These would be normal goods ie goods which follow the law of demand eg steak. Products for which quantity demanded increases when income decreases and vice versa have a negative (-) income elasticity value. These would be giffen goods ie of inferior quality eg sausages QUIZ Calculate the income elasticity of demand for commodity A if, in response to an increase in income of 5%, quantity demanded increases from 200 per week to 275 per week. What kind of commodity is A? + 75 x 100 200 1 = + 37.5% = + 7.5 A normal good eg biscuits + 5% + 5% What is the income elasticity of demand for commodity B if demand increases from 5,000 to 5,500 units per week when when real income falls by 2.5%. +500 X 100 5,000 1 = + 10% = - 4 -2.5% - 2.5% What kind of commodity is B? A giffen good eg bread CHANGES IN DEMAND When there is a change in a determinant of demand other than price then the demand curve shifts . Price D1 If tastes change in favour D of a commodity then more is demanded at all prices and the demand curve shifts D D1 forward to the right. Quantity Demanded Price D D1 D1 D Quantity Demanded If the price of a substitute falls then less of the commodity will be demanded at all prices and the demand curve shifts backward to the left. QUIZ Say what happens to demand in each of the following cases: The demand for a normal good A contraction in quantity when its price rises. demanded. The demand for a luxury good An extension in quantity when its price falls. demanded The demand for a giffen good A backward shift in demand when income rises. to the left. A forward shift in demand The demand for a good when the price of its complement falls. to the right. The demand for a good when the A forward shift in demand price of a close substitute rises. to the right. The demand for a good which has A backward shift in demand recently been declared bad for to the left. health. SUPPLY the willingness to sell a commodity at a given price THE LAW OF SUPPLY More will be supplied at higher prices and less at lower prices. Price s s Quantity Supplied A fall in price results in a contraction of supply There is a direct relationship between price and quantity supplied resulting in a supply curve sloping upwards from left to right. An increase in price results in an extension of supply Price Price Quantity Supplied Quantity Supplied ELASTICITY OF SUPPLY measures the responsiveness of supply to changes in price E = % change in Quantity Supplied % change in Price Depends on the ability of suppliers to respond to price changes therefore depends on: the time it takes to alter production levels availability of stocks availability of factors of production the ease of entry of new firms into the market An increase in costs will A decrease in costs will shift supply to the left. shift supply to the right. Price S1 Quantity Supplied P rice S S Quantity Supplied S1 THE PRICE MECHANISM Prices are determined by market forces ie the interaction of supply and demand. Price D S Ep D Eq QuantityDemanded & Supplied The interaction of supply and demand determines the market clearing price ie equilibrium price – the price at which all goods supplied are demanded. Any price above this will mean excess supply which will force price down. Any price below this will mean excess demand which will push up price. Equilibrium price will change with changes in demand and/or supply in Response to changes in the determinants of demand and supply. INTERVENTION IN THE MARKET This happens when there is market failure or the price system is not working properly ie the price is too low or too high for those involved The Government may set a maximum price to protect the purchasers. Price D S E MaxP S If the maximum price set (Maxp) is below equilibrium price, there will be excess demand which could result in a “black market” for the commodity. D Quantity The Government may set a minimum price to protect the incomes of the suppliers eg the minimum wage in the labour market. Price If the minimum price set (Minp) is above equilibrium price, there will be excess supply which, in the labour market, too high a minimum wage would cause unemployment. D S MinP E S D Quantity TAXES AND SUBSIDIES Intervention in the market can also be by means of government taxes and subsidies. Indirect taxes eg excise duty are placed on products in order to raise revenue for the government and/or to discourage consumption of certain commodities such as cigarettes and alcohol. P Taxes have the effect of shifting the supply curve to the left thereby increasing price. D S1 S P1 P S1 S Q Subsidies are given to producers to encourage the production of certain products. P D S S1 P P1 S S1 Q Subsidies have the effect of shifting the supply curve to the right thereby lowering price. CHANGES IN EQUILIBRIUM PRICE Equilibrium price will change whenever there is a change in any of the determinants of demand and/or supply. Any of these changes in determinants (other than price) cause shifts in the demand and/or supply curves, altering the market clearing price. P FORWARD SHIFT IN DEMAND BACKWARD SHIFT IN DEMAND FORWARD SHIFT IN SUPPLY INCREASES EQUIL PRICE DECREASES EQUIL PRICE DECREASES EQUIL PRICE D D S D1 P P P S S1 S D1 D P D D1 Q Q BACKWARD SHIFT IN SUPPLY COMBINATION OF SHIFTS INCREASES EQUIL PRICE INCREASING EQUIL PRICE P D S1 S P D1 D Q COMBINATION OF SHIFTS DECREASING EQUIL PRICE D P S1 S S D D1 D Q S1 D1 D D D1 Q Q AND FINALLY …… Complements such as CDs and CD players are said to be in joint demand since one is no use without the other. Close substitutes such as butter and margerine are said to be in competitive demand since they both perform the same function and consumers will choose between them. Joint supply is where the production of one product eg oil automatically leads to the production of another eg petrol or paint or plastics Where the total supply of one commodity is fixed because of limited resources, a reduction in the supply of one necessitates the reduction of another – these are said to be in competitive supply eg milk and cheese. QUIZ What factors changes equilibrium Changes in any of the determinants price? of demand and/or supply. Give 2 examples of market intervention. The minimum wage and price capping. Why might governments intervene in markets? To encourage the consumption of some products and discourage others. Tennis racquets and tennis balls. Name 2 products in joint demand. Name 2 products in joint supply. Give an example of products in competitive demand. Give an example of competitive supply. Beef and leather Gas and electricity Land for housing and land for recreation