Review of basic demand and supply concepts

Qd,own = n + b(Pown) +c(Y)

(-) (+)

where:

n intercept

b change in quantity demanded with respect to a change in price, and also the slope of the demand curve (b < 0 or have a negative sign)

P price of the product

c change in demand with respect to a change in disposable income (c > 0 if this product is a normal good)

Y personal disposable income

We can expand this demand equation to read:

Qd,own = n + b(Pown) +c(Y) + d(Pcross) + e(Wealth) + f(Tastes)

(-) (+) (±) (+) (±)

where:

d change in demand with respect to a change in the price of substitutes or complements

e change in demand with respect to a change in wealth

f change in demand with respect to a change in tastes

The market supply equation begins with the basic notion that

Qs,own = m + g(Pown)

(+)

where:

m intercept of supply curve

g change in quantity supplied with respect to a change in price, and also the slope of the supply curve (g > 0 or have a positive sign)

we can expand this equation to read

Qs,own = m + g(Pown) + h(MIC)

(+) (-)

where:

MIC marginal input cost for production inputs

h change in quantity supplied with respect to a change in input costs

Market equilibrium then occurs where demand equals supply, or:

Qd = Qs

Concept of Elasticity:

1.  Own price elasticity of demand

ED,own = %DQd,own /%D Pown = b(Pown/Qd,own)

An own price elasticity of demand of -.25 implies that a 1% increase in the price of the product will decrease the quantity demanded by 0.25. A decrease in price has the opposite effect on the quantity demanded. Remember “b” represents the slope of the demand curve, or the change in quantity with respect to a change in the price of the product, and is expected to be negative.

2.  Cross price elasticity of demand

ED,cross = %DQd,own /%D Pcross = d(Pcross/Qd,own)

A cross price elasticity of demand of 0.50 implies that a 1% increase in the price of another product will increase the quantity demanded of the own product by 0.50%. These two products are substitutes in this case. A cross price elasticity of demand of -0.50 implies that a 1% increase in the price of another product will decrease the quantity demanded of the own product by 0.50%. These two products are complements in this case.

3.  Income elasticity of demand

EIncome = c(Y/Qd)

An income elasticity of demand of 0.75 implies that a 1% increase in consumer disposable income will increase the demand for the product by 0.75%. This response suggests that the product is both a normal good and a necessity. If the income elasticity had been greater than 1.0, then the product is both a normal good and a luxury. Finally if the income elasticity had been less than 1.0, then the product is said to be an inferior good.

Concept of Price flexibility:

F = 1/ ED,own = %D Pown/%DQs,own

If ED,own = .25, then F = 4.0

So if supply increases by 1%, prices would fall by 4 %. Or, if supply decreases by 1%, price would increase by 4 %. This statistic is very helpful in forming expectations about the price response to a sudden change in supply (drought or flood).