Equation (5) on page 20
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 = %(Qd,own /%( 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 = %(Qd,own /%( 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 = %( Pown/%(Qs,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).
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Price
Quantity
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Quantity
Price
P1
E1
E2
P2
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Q1
Q2
E1
E2
Inelastic Demand
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Elastic Demand
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