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MBA512 Dr. Tanova MARKET FUNDAMENTALS Every society must find a way to answer the three economic questions: what to produce, how to produce and for whom to produce. The problem is that we do not know what and how much exactly people want to consume. If even we were able to find out an answer to this question, we still have to make a decision how to use our scarce resources, because they are not enough to satisfy all our needs. On the other hand, people constantly change their needs. Therefore, people must find a way to coordinate their economic decisions. 1. Market functions: a) market prices tell firms what is more profitable to produce and firms direct their resources to these industries. On the other hand, if prices of some goods and services cause lower profits and even losses, people withdraw resources from these industries. This is the allocative function of the market. b) Since there is always a risk not to be able to sell the goods at a high enough price, firms are motivated to reduce their costs to minimum and to look for more efficient technologies. This is the motivating function of the market. c) Markets distribute goods and services between people according to their success in the solution of the first two economic problems. This is the distributive function of the market. If producers have been efficient and have allocated resources to the industries, most preferred by the society, they have made good profits and they have improved their welfare. In summary: Under the market economy the prices tell people what to produce, how to produce and for whom to produce. Firms study the market and make decisions. They want to produce goods and services that will provide them with good profits. Therefore, the first step to learn how markets work is to study what buyers are willing to buy. 2. The demand for a good The behavior of buyers is called demand. In fact, there is demand for all goods and services. If no one wants a good, this good is not produced at all. However, if prices are higher, people want to buy less; if prices are lower, people want to buy more. In order to study the demand, we have to find out how much people are willing to buy at different price levels. Let’s study the demand for chocolates “Milka”. The first thing that we learn is that there is not just demand. The demand is always for a particular good. Further, the demand is always in a particular market. If chocolates “Milka” are five cents cheaper in Larnaka, George would not go from Limasol to Larnaka to buy chocolates there. Therefore, we shell study the demand for chocolates “Milka” in a specified market.1 We know that if the price of chocolates is higher, people will be willing to buy less. If the price is lower, they are willing to buy more. Therefore, in order to present the demand, we have to build a table with all the quantities of the good that buyers are willing to buy at different prices. On the schedule on the next page we have such information. The Demand schedule A B C D E F G H I 1 P (€) 2,5 2 1,6 1,5 1,4 1,3 1,2 1,1 1 Q 5 8 12 15 22 28 36 50 100 For many goods today the demand is global. For example, the demand for software and for some information services is studied in the global market. Now we just start with a simple example and a simple market. In your courses in marketing you will study in details of studying demand in different markets. The demand for chocolates is presented by all the quantities and all the prices on the schedule. In other words, the demand for chocolates is presented by the entire schedule. We can now give a second definition of demand. The Demand for a good – all the quantities of the good buyers are willing and able to buy at every different price. Three things are important in this definition: a) the demand for a good is presented by all the quantities at every price; b) the demand itself does not tell how much buyers buy, but how much they are willing to buy depending on the price; c) the demand for a good is not only a willingness to buy, but an ability to buy, as well. The demand schedule is a good instrument to study demand. However, it does not present all the possible prices and all the quantities demanded, indeed. It is not possible to build such a table. This is why, we use a better tool to present demand. This is the demand curve. We build the demand curve on a graph. On the vertical axis we put the price (P), and on the horizontal axes we put the quantity demanded. Then we take the numbers from the demand schedule and draw the demand curve. It is shown on the graph bellow. (fig. 1). P D B 2.00 C 1.60 D 8 12 Q Fig. 1. The Demand for chocolates “Milka” The Demand curve shows the relationship between the price and quantity demanded. Every point along the curve indicates the quantity demanded, while the entire curve presents the demand. If, for example, the price of chocolates falls from €2.00 to €1.60, the quantity demanded rises from 8 bars to 12 bars. The demand for chocolates does not change. Only the quantity demanded changes. The first combination of price and quantity demanded is presented by point B and the second one – by point C. There is a movement along the demand curve, but there is not any change in demand. The demand is still the same – presented in the same demand schedule and by the same demand curve. The demand curve shows that always, when the price falls, the quantity demanded increases. Alternatively, when the price increases, the quantity demanded falls. This relationship holds of course, when all other conditions remain the same. Now we can articulate the law of demand. The law of demand states that the decrease in the price of the good raises the quantity of the good demanded, other factors held equal. Factors, determining demand Now we shell find out which are those factors that are held equal along the demand curve. In other words – which are the factors that can change the entire demand? a) buyers income Let’s assume that the income of buyers increases. If, for example, our demand schedule presents the demand for chocolates at the cafeteria in the university, and all students have more money to spend, than before, they will be willing to buy more chocolates at every price level. The previous demand schedule will not present the current demand for chocolates. We have to study the demand again and to build a new demand schedule. It might look like the one below. The New Demand schedule A1 B1 C1 D1 E1 F1 G1 H1 I1 P (€) 2,5 2 1,6 1,5 1,4 1,3 1,2 1,1 1 Q 13 16 20 23 30 36 44 58 108 If we compare this schedule to the first one, at every price of the chocolates, we have greater quantities. Let’s build the new demand curve on the same graph. (fig. 2.) P D D1 D 8 D1 12 Q Fig. 2. The increase in the demand for chocolates “Milka” We can see that the new demand curve is located to the right. The new demand for chocolates is greater. We say that the demand has increased and the demand curve has shifted to the right. If buyers’ income falls, the demand for chocolates will fall, too and the demand curve will shift to the left. b) the prices of other goods Let’s assume now, that students’ income does not change, but the price of chocolates “Lindt” falls significantly. Probably, some of the buyers of “Milka” will shift their demand to the other brand – “Lindt”, because they consider it to be a substitute for “Milka”. The demand for “Milka” will fall. At every price buyers will be willing to buy lower quantities. The demand curve for “Milka” will shift leftwards. (fig. 3) P D1 D D D1 Q Fig. 3. The decrease in the demand for chocolates “Milka” If the price of a substitute good decreases, the demand for chocolates “Milka” falls. Alternatively, if the price of the substitute good (chocolates “Lindt”) increases, some of the buyers of “Lindt” will reduce their purchases of “Lindt” and increase their purchases of “Milka”. The demand for “Milka” will increase because of the increase in the price of the substitute. The demand for a good depends not only on the prices of substitutes, but on the prices of complementary goods, as well. For example, cigarettes and lighters are complementary goods. If the price of cigarettes increases significantly, some smokers might give up smoking. The quantity demanded of cigarettes will fall. (This is the law of demand). This will affect the demand for lighters. Since cigarettes are a complementary good for the lighters, the demand for lighters will fall even though their price has not changed. c) buyers expectations Let’s take the demand for the US dollars. If the potential buyers of the US dollars expect the US dollars to increase in price, many of them will prefer to buy dollars now. This means that the entire demand schedule for the US dollars will be different. At every price level, buyers will be willing to buy more US dollars and the demand curve, indicating this demand will shift to the right. The demand for the US dollars will increase. The demand curve for the US dollars will shift rightwards. d) buyers’ taste and preferences Let’s take the market for coca cola. During the last years many people who used to buy coca cola were convinced that it was unhealthy and they changed their taste and preferences. They prefer now natural juices. The demand for coca cola has decreased. The demand for juices has increased, because of the change in taste and preferences. e) the size of the market In Summer Limasol is full of tourists. The number of buyers increases and the demand for hotel services rises. In November, some hotels will close because the number of tourists falls and the demand for these services falls too. d) institutions Institutions are the rules of economic decision making. Taxes are such a rule. If the government raises income taxes, people will have less money to spend and the demand for many goods will decrease. 3. The Supply of a good Supply is the behavior of sellers. As opposed to the buyers, sellers are happy if they can sell at a higher price. Alternatively, if the price of the good is falling, sellers cannot make much money on it and they are willing to sell less. The relationship between the price and the quantity supplied is positive. The greater the price, the greater the quantity supplied. It is presented on the supply schedule below. The Supply Schedule A B C D E F G H I P (€) 2,5 2 1,6 1,5 1,4 1,3 1,2 1,1 1 Q 120 100 70 60 50 42 36 15 2 We can use the supply schedule to draw the supply curve. (fig. 4). P S S Q Fig. 4. The supply curve for chocolates “Milka” The supply of chocolates is presented by all the quantities and all the prices on the schedule. In other words, the supply of chocolates is presented by the entire schedule and by the entire supply curve. We can now give a second definition of supply. The Supply of a good – all the quantities of the good seller are willing and able to sell at every different price. Three things are important in this definition: a) the supply of a good is presented by all the quantities at every price; b) the supply itself does not tell how much sellers sell, but how much they are willing to sell depending on the price; c) the supply of a good is not only a willingness to sell, but an ability to sell, as well. The supply curve is a picture of the law of supply. The law of supply states that the increase in the price of the good raises the quantity of the good supplied, other factors held equal. Factors, determining supply a) sellers’ expectations Expectations are a powerful factor affecting supply. If potential sellers of the US dollars expect an increase in the price of the dollar, they will be willing to sell less today and more in the future. This means that at every particular price of the US dollar, quantities supplied will be less. On the graph it will be presented by a new supply curve, which will be located closer to the origin of the coordinate system. (fig. 5). S1 P S S1 S Q Fig. 5. A leftward shift in the supply curve. A fall in supply As we can see on figure 5, the supply curve shifts to the left. The supply of the US dollars falls. b) cost of production With the increase in the price of gasoline, transportation services become more costly. Transportation firms will be willing to sell the same quantities of transportation services, at a higher price which should compensate for the higher price of gasoline. The supply of these services will fall. The supply curve will shift to the left. c) technological changes Technological progress reduces the cost of production. Firms can produce the same quantities of the goods at a lower cost, or (which is the same), they can produce more at the same cost. This means that the new supply curve, presenting such a change, will be located to the right from the supply curve before the technological changes. (fig. 6). S P S1 S S1 Q Fig. 6. An increase in supply d) the size of the market. The increase in the number of sellers raises supply and the supply curve shifts to the right. e) institutions If the government would raise the taxes on production, the cost of production will increase. Thus, the supply curve shifts to the left. Supply falls. A reduction in the tax rates raises supply and the supply curve shifts rightwards. 4. Market Equilibrium One does not need going to school to realize that buyers are willing to buy more at lower prices, while sellers are willing to sell more only at higher prices. Economists just articulate these uniformities of buyers’ and sellers’ motivation and derive the law of demand and the law of supply. The concepts of supply and demand present motivation and behavior of buyers and sellers. Demand is presented by the demand schedule and the demand curve. Supply is presented by the supply schedule and the supply curve. When we analyze supply and demand we can realize that they indicate entirely different attitudes of sellers and buyers. Sellers want to sell for more, and buyers want P to buy for less. However, there is one only price, at which quantity demanded equals quantity supplied at the same price. In our example with the market for chocolates Milka, it is the price of €1.20. At this price, buyers want to buy exactly the same quantity of chocolates, that sellers want to sell = 36 bars of chocolates. This situation is market equilibrium. (Fig. 7) P D S E Pe Qe Fig. 7. Market equilibrium. Q The market comes at equilibrium when quantity demanded = quantity supplied at the same price. The price, at which the market is in equilibrium, is equilibrium price, and the quantity is equilibrium quantity. Market equilibrium is unique. At any price above ₤1.20 buyers want to buy less, but sellers want to sell more. At any price below ₤1.20, buyers want to buy more, but sellers want to sell less. Only at the equilibrium price, all sellers find buyers for all their quantity supplied and all buyers find as much as they are willing to buy at this price. No one is motivated to change anything. Any change in the price will lead to a worst situation and there will be unsatisfied buyers or sellers. If the price is greater than the equilibrium price, Qs > Qd and this will produce a surplus. If the price is lower than the equilibrium price Qs < Qd and this will produce a shortage. (Fig. 8). P a surplus qs > qd D S E Pe a shortage qd > qs Q qd qe qs Fig. 8. A surplus and a shortage The Dynamics of Market Equilibrium Shortages can occur always when demand rises, or when supply falls. (You know the factors, affecting supply and demand and you can think of examples). If, for instance, buyers’ income would increase, they will be willing to buy more at any price and the demand will increase. The demand curve will shift rightwards and the equilibrium will be destroyed. At the equilibrium price, buyers will be willing to buy more: Qd>Qs. The shortage will push the price upwards. According to the law of supply, quantity supplied will increase – as the price rises, sellers are willing to sell more. According to the law of demand, quantity demanded will fall – as the price rises, buyers are willing to buy less. Thus, the shortage will be cleared and the market will come to a new equilibrium at a higher equilibrium price and greater equilibrium quantity. Economists say, that the market clears the shortage and the equilibrium price is a market clearing price. Market equilibrium is restored. (Fig. 9) P D’ D E’ P’ E Pe S Qe Q’ Qd Q Fig. 9. Restoration of market equilibrium after a shortage Surpluses can occur always when supply rises, or when demand falls. Then, at the equilibrium price Qs > Qd. The surplus will push the price down and the surplus will be cleared at a new, lower, equilibrium price. (Fig. 10). P S D S’ E Pe E’ Qe Qs Q Fig. 10. Restoration of market equilibrium after a surplus Price ceiling If government would decide that the equilibrium price is too high, it might set a price ceiling – a maximum price, at which the good could legally be sold. When this price is below the equilibrium price, the shortage created cannot be cleared by price increase, because it is illegal. This permanent shortage will create a black market. (fig 11). P Shortage = (Qd-Qs) x Pc D Pb.m. Profits of the blackmarketeers = (Pb.m. – Pc) x Qs Pe Pc S shortage Qs Qe Qd Fig. 11. The black market clears the shortage Q Black marketeers will buy all the quantity supplied at the ceiling price and will illegally sell it at the highest possible price, which buyers will be willing to pay for this quantity. This price is greater, that the equilibrium price. Therefore, government intervention in price determination would not reduce prices, but would create more disturbances. 5. Arbitrage and speculation There are many cases, when different markets of the same good can produce different equilibrium prices. For instance, the market in Oz (a hypothetical country) sets the equilibrium price for widgets at a very high level, while the market for widgets in Zo (another hypothetical country) comes to equilibrium at a lower price. If widgets can easily be traded between these two countries, buyers from Oz will go to Zo to buy at a lower price (the demand in Oz will fall and the demand in Zo will increase), and sellers from Zo will shift part of their supplies to Oz (the supply in Zo will fall and the supply in Oz will increase). Theses shifts in supply and demand will persist until prices in both countries become equal. (Fig. 12a) and 12 b) Oz widget market P P Zo widget market E1Oz P1Oz D S E1Zo PZo D S QOz Q Q Demand shifts to Zo market (imports) QZo Supply shifts to Oz market (exports) Shifts in Supply and Demand until price differences are eliminated Fig. 12 a) Different prices of widgets in Oz and in Zo Oz widget market P P1Oz Pa P Zo widget market E1Oz E2 E2 P1Zo D S D E1Zo S Q1Oz Q Q Q1Zo Fig. 12 b) Arbitrage and the establishment of one equal prices The process of price equalization is arbitrage. People, who take the risk to perform it are speculators. They perform the most important function in the market economy, because markets balance the forces of supply and demand thanks to speculators’ actions. Arbitrage took place in Cyprus after the accession to the European Union. Prices of many goods were lower in Cyprus, than in the other countries in the European Union. Speculators from the EU shifted their demand to Cyprus market in order to buy at a lower price and then sell in the EU market at a higher price. Sellers from Cyprus shifted their supply to the EU market, too, in order to sell at higher prices. As a result, equilibrium prices in Cyprus increased. The impact on the EU market was not significant and prices did not fall there, because the European market was much larger than Cyprus market. Quantifying market responses – elasticity 1. Price elasticity of demand If you ask a shop owner whether he is interested in studying the law of demand in order to make more money, he will probably tell you, that one does not need reading books to intuitively understand, that if he reduces the price, he will sell more. The problem, however, occurs if price reduction is not compensated for by enough increase in the quantity sold. If, for example, he reduces the price of carrots by 50%, but buyers increase purchases of carrots by only 20%, his revenues, will actually fall. Let’s assume, that he used to sell 100 kilos of carrots at a price ₤1. Now, he has reduced the price to ₤0.50. His buyers raised their purchases by 20% and now they are buying 120 kilos. Before, his total revenues (TR) = ₤1 x 100 = ₤100. Now his TR = ₤0.50 x 120 = ₤60. It seems, that his buyers were not sensitive enough to the price reduction and price reduction was a failure. If he had raised the price by 50% up to ₤1.50 and his buyers would have reduced the quantity demanded by 20% to approximately 80 kilos, his TR = ₤1.50 x 80 = ₤120. On the other hand, if buyers would have been more responsive to price changes, and if they would have raised the quantity demanded not by 20% when price is reduced by 50%, but, say, they would have been willing to buy two times more carrots (200 kilos, which is 100% increase), TR would have risen from ₤100 to ₤200. Therefore, sellers need to know which pricing policy will be more profitable and this depends on buyers’ sensitivity to price changes. Buyers’ sensitivity (responsiveness) to price changes is called price elasticity of demand. It can be measured by the coefficient of price elasticity of demand: E = % change in quantity demanded : % change in price Since quantity falls, when price increases, E is always negative. We will take it in absolute terms |E| in order to avoid negative numbers. |E| could be less 1 and then demand is inelastic, i.e. buyers are not quite sensitive to price changes and price reductions are not compensated for by increase in quantity demanded enough to raise TR (the first case in our example). If |E| > 1, demand is elastic and price reduction will lead to san increase in TR. If |E| = 1, demand is unit elastic. If E = 0, demand is perfectly inelastic, which means that buyers do not react at all to price changes and keep buying the same quantities. The demand curve is vertical. Another extreme situation can occur, if buyers are that sensitive, that they would change quantity demanded if even the price does not change. In this case demand is perfectly elastic. E = ∞ Our next point is to learn how to calculate percentage changes in price and quantity demanded. Let’s take our example with the carrots. The seller used to sell Q1 = 100 kilos of carrots at a price P1 = ₤1. Now he reduced the price and P2 = ₤0.50 and he sells Q2 = 120 kilos. We took the percentage changes approximately just in order to understand the concept of price elasticity of demand. Now we will calculate the percentage changes more accurately, according to the rule of calculating percentage changes. Percentage change in Q = Q 2 Q1 (Q1 Q 2) : 2 Percentage change in P = P 2 P1 ( P1 P 2) : 2 Let’s substitute the numbers for the symbols: Percentage change in Q = 120 100 (120 100) : 2 Percentage change in P = 0.50 1.00 (1.00 0.50) : 2 E= 0.18 = - 0.27 0.66 Or in absolute terms |E| = 0.27 The demand for carrots is inelastic. 2. Price elasticity of demand and total revenue We saw that if the seller of carrots reduces the price, he will make less money. (₤60 < ₤100). If he raises the price, he will make more money (₤120 > ₤100). We can conclude that: if demand is inelastic, price reduction leads to a fall in total revenue, while price increase leads to an increase in TR. The opposite holds for price elastic demand. if demand is elastic, price reduction leads to an increase in total revenue, while price increase leads to a fall in TR. If demand is unit elastic, the change in price is compensated by the change in quantity demanded and TR stays the same. The table below summarized our conclusions. Price Elasticity of Demand and Total Revenue P Q |E| < 1 |E| > 1 TR If the price rises, TR increases If the price rises, TR falls If |E| = 1, TR does not change 3. Factors, affecting price elasticity of demand It seems that everyone will want to have inelastic demand. Then if the price rises, buyers will reduce purchases, but anyway total revenues will increase. Therefore, the question is how to make demand inelastic? Is it possible? Which are the factors that make demand inelastic, or elastic? We will first check whether price elasticity of demand is constant along the demand curve. Let’s assume that Mr. Happy sells pizza at €1 a piece. He decides to raise the price by €1 and now the price is €2. Buyers react to the price change and the quantity demanded falls from 10 to 9 pieces. % change in Q = (10-9) : (9+10)/2 = 0.10 % change in P = (1-2) : (2+1)/2 = - 0.67 E =- 0.14 |- 0.14| < 1 The demand for pizza is inelastic and TR increase from €10 (10x 1) to €18 (9x2). Mr. Happy is encouraged to raise the price further. His TR increases. Every day he raises the price by €1 and the quantity of pizza demanded falls by 1 piece. This is presented in the table below. P 10 9 8 7 Q 1 2 3 4 A B C D 6 5 F 5 6 G 4 7 H 3 8 I 2 9 J 1 10 K When the price is raised from €5 to €6, the quantity demanded falls from 6 to 5 pieces and TR does not change. The demand is unit elastic. (Calculate it to make sure!). If Mr. Happy would raise the price further, he will not be that happy because his total revenues will fall. The demand will become elastic! Let’s check it for the price increase from €9 to €10. The quantity of pizza demanded will fall from 2 to 1 piece. % change in P = (9- 10) : (9+10)/2 = - 0.10 % change in Q = (2-1) : (2+1)/2 = 0.67 E = 0.67 : - 0.10 = - 670 |-670| > 1 Therefore, price elasticity of demand is not the same along the demand curve. As we move upwards along the demand curve, price elasticity of demand increases. The reason for this is that the price of pizza becomes relatively higher and buyers spend a larger part of their income on pizza. The smaller the share of income spent on the good, the lower is the price elasticity of demand for this good, ceteris paribus. We identified one of the factors, affecting price elasticity of demand – the share of buyer’s income spent on this good. Another factor, determining price elasticity of demand is the availability of substitutes for the good. If the good does not have substitutes, the increase in price will not affect significantly purchases. Such a good is electricity. When its price rises, people try to consume less, but since they cannot find a substitute for it, the reduction in quantity demanded is quite small. The demand is inelastic. If the good has many substitutes, and its price increases, buyers can easily shift their demand to another good. The quantity demanded will fall significantly. Demand is elastic. The availability of substitutes depends on the definition of the market. We know that the demand for cigarettes is inelastic – price increases do not lead to a significant reduction in quantity demanded. If, however, sellers of Marlboro increase the price, many smokers might shift their demand to another brand of cigarettes, because they might consider it as a substitute for Marlboro. The demand for Marlboro is more elastic than the demand for cigarettes. The broader the market definition, the lower is the price elasticity of demand. Many firms invest in advertisement of their brand name. They want to create loyal buyers, who will not shift their demand to other brand names if the price of the good increases. Therefore, buyers’ loyalty is a factor, affecting price elasticity of demand. The greater this loyalty, the lower is the price elasticity of demand. Another factor is the time horizon. Immediately after the price of a good increase, people do not reduce significantly their purchases, because they cannot change their plans and figure out substitutes so quickly. Over time their reaction to price increase is stronger and the reduction in quantity demanded is more significant. The longer the time period, the greater is the price elasticity of demand. Price elasticity of demand depends also on traditions in demand and consumption. For example, milk is a good that people use traditionally and they do not change significantly their purchases with the changes of its price. 4. Income elasticity of demand Buyers change purchases not only as a response to the changes in prices, but also when their income change. Buyers’ responsiveness to changes in their income is called income elasticity of demand. Income elasticity of demand is measured by the coefficient of income elasticity Ey. Ey = % change in quantity demanded : % change in buyer’s income Income elasticity of demand is usually positive. If Ey > 1 demand is income elastic. If Ey = 1 demand is income unit elastic. If 0 < Ey < 1 demand is income inelastic. If Ey = 0 demand is perfectly inelastic as regard income. If Ey < 0 income elasticity of demand is negative. Negative income elasticity of demand is observed when buyers increase their purchases of a good when their income falls and reduce purchases of this good when their income rises. Goods with negative income elasticity of demand are inferior goods. Goods with positive income elasticity of demand are normal goods. A typical example of an inferior good are shoe repair services. When income falls, people would prefer to repair their shoes instead if buying new shoes. When income increases, they will rather buy new shoes instead of repairing the old ones. During recessions when unemployment increase and income falls we realize that people with low skills and no educations are the first to loose their jobs and have more difficulties to find employment. This is perhaps the reason of their greater interest to university education. It is observed that during tough economic times, the demand for higher education increases. Therefore, university education is an inferior good during recessions. Ordinary cosmetics, like lip stick turn out to be an inferior good too. When income falls, women often decide that it is easier and cheaper to buy new lip stick than a new dress. Another explanation could be that during recessions people invest in their appearance in their efforts to find a job. Income elasticity of demand depends on the share of income spent on the good. If people spend a very small share of their income on a good, price elasticity of demand for this good is very low and often close to zero. Goods with a very low, close to zero, price and income elasticity of demand are called necessities. If people spend a large share of their income on a particular good, its income elasticity of demand tend to be high. 5. Cross price elasticity of demand Buyers change purchases of some goods as a response to the changes in the price of some other goods. If, for example, the price of Coca cola increases, but the price of Pepsi stays the same, many buyers would substitute Pepsi for Coke. The demand for Pepsi will increase as a response to the change in the price for Coke. Such a reaction of buyers is called cross-price elasticity of demand. The responsiveness of buyers of one good to the change in the price of another good is cross-price elasticity of demand. Cross price elasticity of demand is measured by the coefficient of cross price elasticity Eab Eab = percentage change in quantity demanded of good a : percentage change in the price of good b. In the case of Coke and Pepsi, Eab > 0. When the price of Coke rises, the quantity of Pepsi demanded increases. Therefore, if Eab > 0 the goods are substitutes. If Eab < 0, the goods are complements. If Eab = 0, purchases of good a do not depend on the price of good b. They are independent. Firms need to know the cross price elasticity of demand for the goods that they sell, because this is the way to find out whether these goods have substitutes, produced by other firms, or not. 6. Price elasticity of supply Sellers react to the changes in the price of the goods that they sell, as well. The responsiveness of sellers of a good to the change in its price is called price elasticity of supply. Price elasticity of supply is measured by the coefficient of price elasticity of supply. E = % change in quantity supplied : % change in price If E > 1 supply is price elastic. If E = 1 supply is price unit elastic. If E < 1 supply is price inelastic. If E = 0 supply is perfectly inelastic. If E = ∞ supply is perfectly elastic. On the graphs below are presented supply curves with different price elasticities of supply. P E<1 E=1 E>1 Q P E=1 E=∞ Q 7. Factors, affecting price elasticity of supply a) time horizon Price elasticity of supply depends heavily on the time horizon. For example, sellers of kiwi go to the open market with a given amount of kiwi. On the same day a doctor announces on TV that eating kiwi is very healthy and would prevent flu. The news drives buyers to the market and the demand for kiwi increases significantly. Sellers are happy, but at the moment they cannot increase the quantity supplied. The only thing they can do is to raise the price as a response to the increase in demand. Supply is perfectly inelastic in the very short run. It is shown on the graph below. P D1 S D P1 p0 Q On the next day sellers can mobilize their families and pick up more kiwi to take to the market. Their response to the change in price is however not significant, because the increase in the quantity supplied depends on the scale of their production. They cannot grow more kiwi at the moment. Supply is inelastic in the short run. On the next graph we can see price inelastic supply in the short run. P D1 D S S1 P1 p0 Q For the next year producers can grow more kiwi and then they will be able to respond fully to the price increase. In the long run supply will be elastic. It is presented below. P D1 D S S1 P1 p0 Q A short run is a period when firms can just partially respond to the changes in the market, because they have some production factors that are fixed and cannot be changed at the moment. A long run is a period when firms can fully respond to the changes in the market because the can change all the factors of production. The longer the time period, the higher is the price elasticity of supply. b) availability of resources When the price rises, producers are willing to increase the quantity supplied, but they might have difficulties with finding extra resources in the market. Raw materials or labor might be in short supply and then the response to the price increase will be smaller. The greater the availability of resources in the market, the greater is the price elasticity of demand. c) mobility of the production factors The increase in the price of real estate motivates the developing and construction companies to build more houses. This means that they will need more architecturers, more engineers and more workers. However, it takes long time and efforts to become an architecturer or an engineer. Thus, labor is not mobile and this reduces price elasticity of supply. d) the level of inventories When the price of a good increases, sellers can respond to it by using their inventories – stored raw materials, stored final goods, etc. The greater the level of inventories, the greater is the price elasticity of supply. However, large levels of inventories are expensive. The capital stored in inventories does not bring more money, and at the same time the firm has to pay for the warehouses, electricity, etc.