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DEMAND AND SUPPLY

DEMAND AND SUPPLY . Elasticity of Demand and Supply. substitution effect - when the price of a good rises I naturally t end to substitute other similar goods for it: ↑P x è ↓RI è ↓Q x.

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DEMAND AND SUPPLY

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  1. DEMAND AND SUPPLY Elasticity of Demand and Supply

  2. substitution effect - when the price of a good rises I naturally tend to substitute other similar goods for it: ↑Px è↓RIè↓Qx income effect – when a price goes up, I have in effect less income, so I will naturally reduce my consumption. ↑ Pxè ↑relative price of commodity Xè↓Qx and ↑D for another commodity THE PRICE CHANGE

  3. THE CHANGE IN NOMINAL INCOME AND DEMAND The respond of consumers to the change in income will differ according to the type of commodity: • neccessary commodity – less sensitive to the change in income • luxury commodity – strongly sensitive to the income change • inferior commodity – demand for this type of commodity tends to decrease with an increase in income

  4. THE EFFECT OF PRICE CHANGE OF OTHER COMMODITIES ON DEMAND • indifferent commodities – as long as the change in price of one commodity doesn´t have any impact on demand for another commodity, • substitutes – commodities thatcan be mutually exchangable in consumption èincrease in price of one commodity will cause increase in demand for another commodity • complements – commodities that are complementary in consumption.

  5. PRICE ELASTICITY OF DEMAND • concept that measures how much the quantity demanded of a good changes when the price changes • Measurement of Elasticity: - The coefficient of demand elasticity between two different points on a demand curve is: - Note that P and Q move in opposite directions because of the law of downward-sloping demand.

  6. PRICE ELASTICITY – THREE CATEGORIES • price elastic demand – when a 1% rise in price calls for more than 1% decline in quantity demanded • unit-elastic demand – when a 1% rise in price results in an exactly compensating decline in quantity demanded • price inelastic demand – when a 1% rise in price evokes less than 1% fall in quantity demanded Two limiting cases of elasticity: a) infinite elasticity – D curve is horizontal (∞ elasticity) èthere is sold any amount of that commodity for the same price b) perfect inelasticity – D curve is vertical (0 elasticity) èquantity demanded is constant, doesn’t change with the price change.

  7. Factors affecting price elasticity of demand: 1) Character of needs, that the commodity aims to satisfy 2) The ratio of expenditure for that commodity to the whole consumer budget 3)  Existence and attainability of substitutes 4) Elasticity is changing over time – the longer time period, the higher the elasticity.

  8. Other Demand Elasticities 1. INCOME ELASTICITY of demand = measures the percentage response in demand for every 1% increase in income 2. CROSS ELASTICITY of demand = measures the percentage increase or decrease in the demand for a good in response to changes in the prices of other goods – according to the cross elasticity coefficient we can recognize, if the commodities are substitutes or complements.

  9. ELASTICITY AND REVENUE The three cases of elasticity correspond to three different relationships between total revenue and price changes • if a price decrease leads to a decrease in total revenue, this is a case of inelastic demand, • if a price decrease leads to an increase in total revenue, this is the case of elastic demand, • if a price decrease leads to no change in total revenue, this is the borderline case of unit-elastic demand

  10. PRICE ELASTICITY OF SUPPLY • measures the percentage change in quantity supplied in response to a 1 percent change in the good’s price The numerical coefficient of supply elasticity:

  11. Three important cases of supply elasticity: • perfectly inelastic supply – the vertical supply curve (Es= 0), the amount supplied is perfectly fixed, • perfectly elastic supply – the horizontal supply curve (Es= ∞), produced amount is independent on price, • unitary elasticity of supply – straight line going through the origin (Es= 1).

  12. Factors determining supply elasticity: 1) the time period – a given change in price tends to have greater effects on amount supplied in a long run, 2)  possibility and costs of storage, 3) character of technology and production process.

  13. MARKET DEMAND - horizontal sum of all individual demand by different prices MARKET SUPPLY - the sum of quantity supplied, which are all producers willing to supply by different prices (graphically horizontal sum of individual supply) Market Equilibrium

  14. THE COBWEB THEOREM • whether the economy will wind inwards or outwards depends primarily on elasticity of demand and supply č • converging cobweb – winds inward, when elasticity of demand is higher than those of supply ED>Es, • diverging cobweb - diverges outward, ED < Es, in this case isn’t possible to rely on market mechanism, • persistent oscillations – oscillates endlessly around equilibrium ED = Es.

  15. Converging Cobweb

  16. Government intervention in markets The government sometimes legislates maximum or minimum prices: a) price ceiling – economic effects of a maximum price (can’t be set higher) is a gap between demand and supply (deficiency of supply), b) price floor – minimum price (minimum wage rate - induces unemployment).

  17. Price Ceiling vs. Price Floor

  18. TASKS: 1. Calculate the coefficient of demand elasticity, as long as you know, that the price has increased from 56,- units to 92,- units, which led to decrease in quantity demanded from original 1400 to 1100 pieces. 2. The merchant has reduced the price of his good by 15 %. What for reaction as for quantity of good sold and for his revenue can be expected if ED= - 1,2. 3. The merchant sells 50 pieces/per day for price 670,-. Since he has bought new goods, he needs to vacate his warehouse. Therefore, he must increase sale to 75 pieces/per day. How high price he have to set in order to achieve his aim, if the ED= - 0,8. How will differ his daily revenue? 4. Explain mistakes in thinking: a) It is always advantageous for merchant to sell for highest possible price. b) Reduction of price represents for merchant always decline in his total revenue. 5. What for change in the market induces the increase in equilibrium price from original 200,- to 250,-, if ED= - 1,2 a ES = 0,9 and original equilibrium quantity of good was 1 000? 6. Demand side pressure has induced an increase in price of a good from 260,- by 30 units. What for reaction from sellers can be expected, as long as the original quantity produced was 640 pieces and ES = 1,1. Will the total revenue change?

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