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Why review demand relationships? EconS 451: Lecture # 6 • Helps us understand market behavior! Demand Review • Understand the definition of Demand. • Explain the difference between Marshallian and Hicksian Demand. • Explains price fluctuations! • Be able to describe and explain the substitution and income effect in product space from a change in price. • Provides a foundation for empirical research • Understand how proportion of expenditure allocated to a specific good impacts the substitution and income effect. • Understand the difference between demand shifts and structural change. • Calculate Own-Price, Income and Cross-Price Elasticity of Demand. and analysis! • Equips you with necessary analytical capability to evaluate market dynamics! Demand Review Demand Review • Demand Defined: • Begins at the individual level……then summed across all individuals to the market level. • The various quantities of a particular commodity that an individual consumer is willing and able to buy as the price varies, all other factors held constant. Individual Attempting to Solve Max U(x x ) s.t. 1, • Marshallian Demand 1, 2 px + p x = I 1 1 2 2 Individual Demand Demand Review Max U(x x ) s.t. 2 Price px + p x = I 1 1 2 2 10 • Hicksian (or Compensated) Demand 5 Min Expenditures E(p, U) s.t. U(x x ) = U 1, 2 F Demand 25 45 Quantity X 1 Observations Product Space Y • If the commodity in questions represents a large proportion of expenditures, then the income effect from a change in the price will be relatively large. 100 r • Both Income and Substitution effect usually s inversely related to price changes. U2 t U1 X 25 u 37 45 50 v 100 w Static and Dynamic Demand Graphical Changes in Demand • Static : Price • Quantity movements or responses to price while all other factors are assumed constant. Parallel Shift • Movements along a demand curve. • Dynamic: • Shifts and changes in demand that happen with the passage of time to account for changes in income, population, taste and preferences, etc. Shift and Structural Change • Structural Change • Change in the shape of the demand curve due to changes in technology or information. Quantity Short Run……….Long Run Demand Changes • Short Run : • Shift • Parallel shifts from changes such as income, population. • Time period too short for complete quantity adjustment from a price change (a snapshot). Q = α − β P + γY • Long Run: • Structural Change Q = α − βP + γY • Changes in the parameters or functional form. 2 • The time required for a complete quantity adjustment to occur in response to a “once-and-for-all” price change. 2 Distributed Lag Models • Refers to a delayed Speculative Demand • Consumer demand for current consumption adjustment in quantity as a result of a price change. • Speculative demand • Anticipated demand and uses • Future cost > current cost + all storage costs • And the adjustment may be spread over a period of time. Qdt = f (Yt , Pt , Pt − 1 ) • Commodity market financial investment • “open interest” • Current market price impacted by current and expected events. Primary and Derived Demand Price Own-Price Elasticity of Demand • Relates changes in the price of the commodity back to the changes in quantity demanded. Pr • Defined at a point along Pd Ep = the demand curve. Primary Demand dQ P × dP Q • At the average • Arc formula Derived Demand Quantity • Assuming Q = f(P) Own-Price Elasticity of Demand Income Elasticity of Demand • Relates changes in Range • Elastic Ep > 1 • Unitary Elasticity E • Inelastic Ep < 1 p = 1 income back to the changes in quantity demanded. • Defined at a point along EY = dQ Y × dY Q the demand curve. • Revenue and elasticity • TR = P(Q) 3 Income Elasticity of Demand Cross-Price Elasticity of Demand • Relates changes in the Range • Inferior EY < 0 price of the jth product back to the changes in the quantity demanded for the ith product. • Normal EY > 0 • Defined at a point along Eij = ∂Qi Pj × ∂ Pj Qi the demand curve. Cross-Price Elasticity of Demand Range Summary Questions • Explain the difference between individual and market demand. • Independent E ij = 0 • Describe the difference between the short and long run as it relates • Substitute E ij > 0 • What is meant by a distributed-lag……as it relates to demand? • Complement Eij < 0 to market demand. • Explain what the own-price, income, and cross-price elasticity of demand are each measuring. • Generalizations because of the “income and substitution effects” of a price change of inferior goods. 4