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# Demand curves

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### Demand curves

1. 1. Summer Camp 2012 Lecture 5 Economics 2281/02 Week 2nd June 4th 2012 Demand theory Consumer demand and price The relationship between price and quantity demanded is the starting point for building a model of consumer behaviour. Measuring the relationship between price and quantity demanded provides information which is used to create a demand schedule, from which a demand curve can be derived. Once a demand curve has been created, other determinants can be added to the model. The determinants of demand Demand schedules A demand schedule shows the relationship between price and demand over a hypothetical range of prices. For example, the schedule opposite is based on a survey of college students who indicated how many cans of cola they would buy in a week, at various prices. PRICE (£) QUANTITY DEMANDED 1.10 0 1.00 100 90 200 80 300 70 400 60 500 50 600 40 700 30 800 1
2. 2. Summer Camp 2012 Lecture 5 Economics 2281/02 Week 2nd June 4th 2012 Demand curves At higher prices, the quantity demanded is less than at lower prices. This relationship is easiest to see when a graph is plotted, as shown. Demand curves generally have a negative slope. There are at least three accepted explanations of why demand curves slope downwards: 1. 2. The law of diminishing marginal utility 3. The substitution effect The income effect Diminishing marginal utility One of the earliest explanations of the inverse relationship between price and quantity demanded is the law of diminishing marginal utility. This law suggests that as more of a product is consumed the marginal (additional) benefit to the consumer falls, hence consumers are prepared to pay less. This can be explained as follows: Most benefit is generated by the first unit of a good consumed because it satisfies all or a large part of the immediate need or desire. A second unit consumed would generate less utility - perhaps even zero, given that the consumer now has less need or less desire. With less benefit derived, the rational consumer is prepared to pay rather less for the second, and subsequent, units, because the marginal utility falls. Consider the following figures for utility derived by an individual when consuming bars of chocolate. While total utility continues to rise from extra consumption, the additional (marginal) utility from each bar falls. If marginal utility is expressed in a monetary form, the greater the quantity consumed the less the marginal utility and the less value derived - hence the rational consumer would be prepared to pay less for that unit. 2
3. 3. Summer Camp 2012 Lecture 5 Economics 2281/02 Week 2nd June 4th 2012 Utility TOTAL MARGINAL UTILITY UTILITY 1 100 2 190 90 3 270 80 340 70 5 400 60 6 450 50 7 490 40 8 520 30 8 be prepared to pay. BARS 4 While total utility continues to rise from extra consumption, the additional (marginal) utility from each bar falls. If marginal utility is expressed in a monetary form, the greater the quantity consumed the lower the marginal utility and the less the rational consumer would 540 20 The income effect The income and substitution effect can also be used to explain why the demand curve slopes downwards. If we assume that money income is fixed, the income effect suggests that, as the price of a good falls, real income - that is, what consumers can buy with their money income - rises and consumers increase their demand. Therefore, at a lower price, consumers can buy more from the same money income, and, ceteris paribus, demand will rise. Conversely, a rise in price will reduce real income and force consumers to cut back on their demand. The substitution effect In addition, as the price of one good falls, it becomes relatively less expensive. Therefore, assuming other alternative products stay at the same price, at lower prices the good appears cheaper, and consumers will switch from the expensive alternative to the relatively cheaper one. It is important to remember that whenever the price of any resource changes it will trigger both an income and a substitution effect. Exceptions It is possible to identify some exceptions to the normal rules regarding the relationship between price and current demand. Giffen Goods Giffen goods are those which are consumed in greater quantities when their price rises. These goods are named after the Scottish economist Sir Robert Giffen, who is credited with identifying them by Alfred Marshall in his highly influential Principles of Economics (1895). In essence, a Giffen good is a staple food, such as bread or rice, which forms are large percentage of the diet of the poorest sections of a society, and for which there are no close substitutes. From time to time the poor may supplement their diet with higher quality foods, and they may even consume the odd luxury, although their income will be such that they will not be able to save. A rise in the price of such a staple food will not result in a typical substitution effect, given there are no close substitutes. If the real incomes of the poor increase they would tend to reallocate some of this income to luxuries, and if real incomes decrease they would buy more of the staple good, meaning it is an inferior good. Assuming that 3
4. 4. Summer Camp 2012 Lecture 5 Economics 2281/02 Week 2nd June 4th 2012 the money incomes of the poor are constant in the short run, a rise in price of the staple food will reduce real income and lead to an inverse income effect. However, most inferior goods will have substitutes, hence despite the inverse income effect, a rise in price will trigger a substituion effect, and demand will fall. In the case of a Giffen good, this typical response does not happen as there are no substitutes, and the price rise causes demand to increase. Example For example, a family living on the equivalent of just \$150 a month, may purchase some bread (say 50 loaves at \$2 each, which is the minimum they need to survive), and a luxury item at \$50. If the price of bread rises by 25% to \$2.50 per loaf, continuing to purchase 50 loaves would cost the individual \$125, making the luxury unaffordable. They cannot reduce their consumption of bread, given that their current consumption is the minimum they require, and they cannot find a suitable substitute for their stable food. Not being able to afford the luxury would leave the family with an extra \$25 to spend, and, given no alternatives to bread, they would purchase 10 more loaves each month. Hence the 25% price increase has resulted in a 20% increase in the demand for bread - from 50 to 60 loaves. Veblen goods Veblen goods are a second possible exception to the general law of demand. These goods are named after the American sociologist, Thorsten Veblen, who, in the early 20th century, identified a 'new' highspending leisure class. According to Veblen, a rise in the price of high status luxury goods might lead members of this leisure class to increase in their consumption, rather than reduce it. The purchase of such higher priced goods would confer status on the purchaser - a process which Veblen called conspicuous consumption. Shifts in demand The position of the demand curve will shift to the left or right following a change in an underlying determinant of demand. Increases in demand Increases in demand are shown by a shift to the right in the demand curve. This could be caused by a number of factors, including a rise in income, a rise in the price of a substitute or a fall in the price of a complement. Demand schedule ORIGINAL NEW Qd Qd 1.10 0 100 1.00 100 200 90 200 300 80 300 400 70 400 500 60 500 600 50 600 700 40 700 800 30 A shift in demand to the right means an increase in the quantity demanded at every price. For example, if drinking cola becomes more fashionable demand will increase at every price. PRICE (£) 800 900 Increases in demand An increase in demand can be illustrated by a shift in the demand curve to the right. 4
5. 5. Summer Camp 2012 Lecture 5 Economics 2281/02 Week 2nd June 4th 2012 Decreases in demand Conversely, demand can decrease and cause a shift to the left of the demand curve for a number of reasons, including a fall in income, assuming a good is a normal good, a fall in the price of a substitute and a rise in the price of a complement. Demand PRICE ORIGINAL schedule NEW Qd (£) Qd 1.10 0 1.00 100 as 90 200 100 the 80 300 200 70 400 300 60 500 400 50 600 500 40 700 600 30 800 700 For example, if the price of a substitute, such as fizzy orange, falls, then less cola is demanded at each price, consumers switch to substitute. Decreases in demand are shown by a shift of the demand curve to the left. 5
6. 6. Summer Camp 2012 Lecture 5 Economics 2281/02 Week 2nd June 4th 2012 Demand and income Consumer income (Y) is a key determinant of consumer demand (Qd). The relationship between income and demand can be both direct and inverse. Normal goods In the case of normal goods, income and demand are directly related, meaning that an increase in income will cause demand to rise and a decrease in income causes demand to fall. For example, luxuries like cars and computers are normal goods for most people. Inferior goods In the case of inferior goods income and demand are inversely related, which means that an increase in income leads to a decrease in demand and a decrease in income leads to an increase in demand. For example, necessities like bread are often inferior goods. It should be noted that ‘normal’ and ‘inferior’ are purely relative concepts. Any good or service could be an inferior one under certain circumstances. Even luxury goods can become inferior over time. Video players were once luxuries, but as incomes have risen consumers have switched to DVDs. Producer supply Production is the process of turning inputs of scarce resources into an output of goods or services. The role of a firm is to organise scarce resources to satisfy consumer demand in a profitable way. Supply is defined as the willingness and ability of firms to produce a given quantity of output in a given period of time, or at a given point in time, and take it to market. Not all output is taken to market, and some output may be stored and released onto the market in the future. Supply can be measured for a single factor of production, for a single firm, for an industry and for the whole economy. Determinants of supply 6
7. 7. Summer Camp 2012 Lecture 5 Economics 2281/02 Week 2nd June 4th 2012 Price The price of the product is the starting point in building a model of supply. The supply model assumes that price and quantity supplied are directly related. Non-price factors As well as price, there are several other underlying non-price determinants of supply, including: The availability of factors of production The availability of factors of production, such as labour or raw materials, can affect the amount that can be produced and supplied. For example, if a firm producing motor vehicles experiences a shortage of steel for its body panels, then its ability to produce vehicles will be reduced. Cost of factors Changes in costs will alter a firm’s calculation of how much to supply at a given price. For example, if the same motor manufacturer experiences an increase in labour costs due to an increase in the wage rate, the cost of producing each vehicle will rise. This means that the price the manufacturer expects to receive will increase. If the price does not increase, less will be produced, ceteris paribus. New firms entering the market In terms of total supply to a market, the number of firms in the market will affect the total supply. New firms in a market will increase market supply and firms leaving will reduce supply. New firms may be attracted into a market because of the expectation of profits and existing firms may leave because they cannot cover They may also leave because they cannot cover their opportunity cost, meaning that leaving becomes the best alternative. their costs, and make losses. Weather and other natural factors Changes in the weather can have a considerable impact on the ability to produce certain products, like farm produce and commodities. This tends to affect the primary sector more than manufacturing. Taxes on products Taxes on products, such as Value Added Tax (VAT), have a direct effect on supply. An indirect tax imposed on a product has an effect similar to that of a cos. which means that increased taxes affect a producer’s decision to supply, and how much to supply. Subsidies Subsidies are funds given to firms to enable them to increase their supply or to reduce the price of their product to the consumer. Subsidies can alter the firm’s willingness and ability to produce and supply. 7
8. 8. Summer Camp 2012 Lecture 5 Economics 2281/02 Week 2nd June 4th 2012 Video Supply and price Supply schedules A supply schedule shows the relationship between price and planned supply over a hypothetical range of prices. For example, this supply schedule shows how many cans of cola would be supplied by a school or college canteen in a single week. PRICE (£) QUANTITY SUPPLIED 1.10 1000 1.00 900 90 800 80 700 70 600 60 500 50 400 40 300 30 200 The higher the price, the greater the quantity supplied. A supply curve is derived from a supply schedule. The upward slope of a supply curve illustrates the direct relationship between supply decisions and price. In this case, the supplier of cola would supply 200 more cans at 80p compared with 60p. Why do supply curves slope upwards? 8
9. 9. Summer Camp 2012 Lecture 5 Economics 2281/02 Week 2nd June 4th 2012 There are a number of explanations of this relationship, including the law of diminishing marginal returns. The Law of diminishing returns The law of diminishing marginal returns explains what happens to the output of products when a firm uses more variable inputs while keeping a least one factor of production fixed. Real capital, such as buildings, machinery, and equipment, is usually the factor kept fixed when demonstrating this principle. Economic theory predicts that, when employing these extra variable factors, such as labour, the marginal returns (additional output) from each extra unit of input will eventually diminish. Take, for example, a hypothetical firm that has a factory in which computers are assembled. The machinery is fixed, and extra workers can be hired to increase the output of assembled computers. At first, the addition of extra workers creates a significant benefit because it becomes possible to divide up the labour, and for workers to specialise in undertaking one task. Initially, there are increasing marginal returns to each additional worker. However, marginal returns will eventually fall because the opportunity to divide labour and to specialise must eventually ‘dry up’. Gradually, each additional worker contributes less than the one before so that total output of computers continues to rise, but at a decreasing rate. The falling marginal returns from each successive worker leads to a rise in the cost of using them. Diminishing returns and increasing costs Firms need to sell their extra output at a higher price so that they can pay the higher marginal cost of production. Hence, decisions to supply are largely determined by the marginal cost of production. The supply curve slopes upward, reflecting the higher price needed to cover the higher marginal cost of production. The higher marginal cost arises because of diminishing marginal returns to the variable factors. Market equilibrium Consumers and producers react differently to price changes. Higher prices tend to reduce demand while encouraging supply, and lower prices increase demand while discouraging supply. Economic theory suggests that, in a free market there will be a single price which brings demand and supply into balance, called equilibrium price. Both parties require the scarce resource that the other has and hence there is a considerable incentive to engage in an exchange. Price discovery In its simplest form, the constant interaction of buyers and sellers enables a price to emerge over time. It is often difficult to appreciate this process because the retail prices of most manufactured goods are set by the seller. The buyer either accepts the price. or does not make the purchase. While an individual consumer in a shopping mall might haggle over the price, this is unlikely to work, and they will believe they have no influence over price. However, if all potential buyers haggled, and none accepted the set price, then the seller would be quick to reduce price. In this way, collectively, buyers have influence over market price. Eventually a price is found which enables an exchange to take place. A rational seller would take this a step further, and gather as much market information as possible in an attempt to set a price which achieves a given number of sales at the outset. For of information between buyer and seller is essential. markets to work, an effective flow Market clearing Equilibrium price is also called market clearing price because at this price the exact quantity that producers take to market will be bought by consumers, and there will be nothing ‘left over’. This is efficient because there is neither an excess of supply and wasted output, nor a shortage – the market clears efficiently. This is a central feature of the price mechanism, and one of its significant benefits. Video Example The weekly demand and supply schedule for a brand of soft drink at various prices (between 30p and £1.10p) is shown opposite. PRICE QUANTITY QUANTITY (£) DEMANDED SUPPLIED 1.10 0 1000 1.00 100 900 9
10. 10. Summer Camp 2012 Lecture 5 Economics 2281/02 Week 2nd June 4th 2012 90 300 700 70 As can be seen, this market will be in equilibrium at a price of 60p per soft drink. At this price the demand for drinks by students equals the supply, and the market will clear. 500 drinks will be offered for sale at 60p and 500 will be bought - there will be no excess demand or supply at 60p. 800 80 Equilibrium 200 400 600 60 500 500 PRICE QUANTITY QUANTITY (£) DEMANDED SUPPLIED 1.10 0 1000 1.00 100 900 90 200 800 80 300 700 70 400 600 60 500 500 50 600 400 40 700 300 30 800 200 10
11. 11. Summer Camp 2012 Lecture 5 Economics 2281/02 Week 2nd June 4th 2012 How is equilibrium established? At a price higher than equilibrium, demand will be less than 500, but supply will be more than 500 and there will be an excess of supply in the short run. Graphically, we say that demand contracts inwards along the curve and supply extends outwards along the curve. Both of these changes are called movements along the demand or supply curve in response to a price change. Demand contracts because at the higher price, the income effect and substitution effect combine to discourage demand, and demand extends at lower prices because the income and substitution effect combine to encourage demand. 11
12. 12. Summer Camp 2012 Lecture 5 Economics 2281/02 Week 2nd June 4th 2012 In terms of supply, higher prices encourage supply, given the supplier's expectation of higher revenue and profits, and hence higher prices reduce the opportunity cost of supplying more. Lower prices discourage supply because of the increased opportunity cost of supplying more. The opportunity cost of supply relates to the possible alternative of the factors of production. In the case of a college canteen which supplies cola, other drinks or other products become more or less attractive to supply whenever the price of cola changes. Changes in demand and supply in response to changes in price are referred to as the signalling and incentiveeffects of price changes. If the market is working effectively, with information passing quickly between buyer and seller (in this case, between students and a college canteen), the market will quickly readjust, and the excess demand and supply will be eliminated. In the case of excess supply, sellers will be left holding excess stocks, and price will adjust downwards and supply will be reduced. In the case of excess demand, sellers will quickly run down their stocks, which will trigger a rise in price and increased supply. The more efficiently the market works, the quicker it will readjust to create a stable equilibrium price. Changes in equilibrium Graphically, changes in the underlying factors that affect demand and supply will cause shifts in the position of the demand or supply curve at every price. Whenever this happens, the original equilibrium price will no longer equate demand with supply, and price will adjust to bring about a return to equilibrium. Changes in PRICE QUANTITY equilirium QD QD1 For example, if there is a particularly hot summer, students may prefer to drink more soft drinks at all prices, as indicated in the new demand schedule, QD1. (£) SUPPLIED 1.10 0 200 1000 1.00 100 300 900 90 200 400 800 80 300 500 700 70 400 600 600 60 500 700 500 50 600 800 400 40 700 900 300 30 800 1000 200 At the higher level of demand, keeping the price at 60p would lead to an excess of demand over supply, with demand at 700 and supply at 500, with an excess of 200. This will act as an incentive for the seller to raise price, to 70p. Equilibrium will now be re-established at the higher price. There are four basic causes of a price change: An increase in demand shifts the demand curve to the right, and raises price and output. Demand shifts to the right 12
13. 13. Summer Camp 2012 Lecture 5 Economics 2281/02 Week 2nd June 4th 2012 Demand shifts to the left A decrease in demand shifts the demand curve to the left and reduces price and output. Supply shifts to the right An increase in supply shifts the supply curve to the right, which reduces price and increases output. 13
14. 14. Summer Camp 2012 Lecture 5 Economics 2281/02 Week 2nd June 4th 2012 Supply shifts to the left A decrease in supply shifts the supply curve to the left, which raises price but reduces output. The entry and exit of firms In a competitive market, firms may enter or leave with little difficulty. Firms may be attracted into a market for a number of reasons, but particularly because of the expectation of profit. This causes the market supply curve to shift to the right. Rising prices may provide a sufficient incentive and provide a signal to potential entrants to enter the market. There is a chain reaction, starting with an increase in demand, from D to D1. This raises price to P1, which provides the incentive for existing firms to supply more, from Q to Q1. The higher price also provides the incentive for new firms to enter, and as they do the supply curve shifts from S to S1. 14
15. 15. Summer Camp 2012 Lecture 5 Economics 2281/02 Week 2nd June 4th 2012 A market where prices are rising provides the best opportunity for the entrepreneur. Conversely, lower prices encourage firms to leave the market. Non-market price In the real world, market price might not be allowed to find its own level, and markets might not clear efficiently. The prices of many goods, services, and resources in the real world might be kept artificially low or high by private firms, or by governments, for a number of reasons. Price ceilings A price ceiling may be set to prevent price from rising beyond a pre-determined level. A price ceiling will only have an effect on the market if it is set below the prevailing market clearing price. A price ceiling is also called a maximum price, and may be used if it is felt that the resource or commodity should be more widely available, as in the case of food or medicines, or where there are specific historical, political or cultural reasons why allowing price to rise to its natural level. For example, it is customary in London to make public transport free late on New Year’s Eve to enable revellers to get home safely. UK Premiership football clubs also limit the price of their tickets to levels well below the natural market rate for three main reasons. Firstly, football is the UK’s national winter sport and, historically, ticket prices have been affordable for those on average incomes. Secondly, a large share of club income is generated from the sale of broadcasting rights to TV companies, and this supplements revenue from ticket sales, as does revenue from merchandising and sponsorship. Thirdly, there would be considerable political uproar if ticket prices were not held down below market price. Demand for tickets outstrips supply at the artificially low price. 15
16. 16. Summer Camp 2012 Lecture 5 Economics 2281/02 Week 2nd June 4th 2012 As has been noted, when market price is allowed to rise whenever resources are especially scarce, as in the case of tickets to a football match, the price mechanism works to ration out the tickets based on the willingness and ability of consumers to pay a higher price. However, if a price ceiling exists exists, a different method of rationing resources must be found. Non-market allocation of resources In the case of a football club like Manchester United, fixing artificially low ticket prices means that the relative shortage of tickets must be dealt with in non-price ways. Football clubs may use all, or some of the following methods: 1. Arranging a ballot for ticket allocations. 2. Implementing a first come first served queuing system. 3. Sale of tickets through supporters clubs. 4. Setting up a ticket exchange scheme, as in the case of Manchester United’s One United system. 5. Bundling low priced tickets with an exclusive hospitality ticket. Parallel or black markets may emerge to satisfy the excess demand, with ticket touts paying more than the face value of the ticket, and then selling them to other buyers at even higher prices. 16
17. 17. Summer Camp 2012 Lecture 5 Economics 2281/02 Week 2nd June 4th 2012 Price floors Price may also be set above the natural market price. A price floor, which is also referred to as a minimum price, sets the lowest level possible for a price. Price floors, and minimum prices, only have an effect if they are set above the actual market clearing price. There are many instances of governments in the real world setting price floors, such as setting a national minimum wage for labour to ensure that individuals are able to earn a ‘living wage’. In addition, given the instability of agricultural prices and the need to ensure food security, farm prices may be set which guarantee a minimum price to farmers. Price floors If a price floor is set for rice, there would be an excess of supply over demand. When price floors are set above the natural market clearing price, suppliers are encouraged to over-supply, but consumers are discouraged from consumption. 17
18. 18. Summer Camp 2012 Lecture 5 Economics 2281/02 Week 2nd June 4th 2012 Black markets may also arise in this case to exploit the consumer’s desire to pay less, as in the case of illegal imports of cheap, non-taxed imported cigarettes, or illegal immigrants who will work for below the national minimum wage. Elasticity Elasticity is a central concept in economics, and is applied in many situations. Basic demand and supplyanalysis tells us that economic variables, like price, income and demand, are causally related. Elasticity can provide important information about the strength or weakness of such relationships. Elasticity refers to the responsiveness of one economic variable, such as quantity demanded, to a change in another variable, such as price. Types of elasticity There are four types of elasticity, each one measuring the relationship between two significant economic variables. They are: Price elasticity of demand (PED), which measures the responsiveness of the quantity demanded to a change in price. Price elasticity of supply (PES), which measures the responsiveness of the quantity supplied to a change inprice. Cross elasticity of demand (XED), which measures the responsiveness of the quantity demanded of one good, good X, to a change in the price of another good, good Y. Income elasticity of demand (YED), which measures the responsiveness of the quantity demanded to a change in consumer incomes. Price elasticity of demand (PED) Price elasticity of demand (PED) shows the relationship between price and quantity demanded and provides a precise calculation of the effect of a change in price on quantity demanded. The following equation enables PED to be calculated. 18
19. 19. Summer Camp 2012 Lecture 5 Economics 2281/02 Week 2nd June 4th 2012 We can use this equation to calculate the effect of price changes on quantity demanded, and on therevenue received by firms before and after any price change. For example, if the price of a daily newspaper increases from £1.00 to £1.20p, and the daily sales falls from 500,000 to 250,000, the PED will be: - 50% + 20% = (-) 2.5 The negative sign indicates that P and Q are inversely related, which we would expect for most price/demand relationships. This is significant because the newspaper supplier can calculate or estimate how revenue will be affected by the change in price. In this case, revenue at £1.00 is £500,000 (£1 x 500,000) but falls to £300,000 after the price rise (£1.20 x 250,000). Video The range of responses The degree of response of quantity demanded to a change in price can vary considerably. The key benchmark for measuring elasticity is whether the co-efficient is greater or less than proportionate. If quantity demanded changes proportionately, then the value of PED is 1, which is called ‘unit elasticity’. PED can also be: • • • • Less than one, which means PED is inelastic. Greater than one, which is elastic . Zero (0), which is perfectly inelastic. Infinite (∞), which is perfectly elastic. PED along a linear demand curve PED on a linear demand curve will fall continuously as the curve slopes downwards, moving from left to right. PED = 1 at the midpoint of a linear demand curve. PED and revenue There is a precise mathematical connection between PED and a firm’s revenue. There are three ‘types’ of revenue: 1. Total revenue (TR), which is found by multiplying price by quantity sold (P x Q). 2. Average revenue (AR), which is found by dividing total revenue by quantity sold (TR/Q). 3. Marginal revenue (MR), which is defined as the revenue from selling one extra unit. This is calculated by finding the change in TR from selling one more unit. 19
20. 20. Summer Camp 2012 Lecture 5 Economics 2281/02 Week 2nd June 4th 2012 Revenue Consider PRICE QUANTITY TOTAL MARGINAL AVERAGE theses (£) DEMANDED REVENUE REVENUE REVENUE figures 10 1 and calculate 9 2 Total, Marginal 8 3 and Average 7 4 Revenue. 6 5 5 6 4 7 3 8 2 9 1 10 Answer Study the patterns of numbers and see if you can analyse the relationships between the three measures of revenue – then answer the following: 1. How are price and average revenue connected? 2. What happens to total revenue as output increases? 3. What is the connection between total revenue and marginal revenue? 4. How are marginal revenue and average revenue connected? Observations and comments: When TR is at a maximum, MR = zero, and PED = 1. 20
21. 21. Summer Camp 2012 Lecture 5 Economics 2281/02 Week 2nd June 4th 2012 1. Price and AR are identical, because AR = TR/Q, which is P x Q/Q, and cancel out the Qs to get P. 2. A curve plotting AR (=P) against Q is also a firm’s demand curve. 3. TR increases, reaches a peak and decreases. 4. When TR is at a maximum, MR is zero. 5. MR falls at twice the rate of AR. Why does a firm want to know PED? There are several reasons why firms gather information about the PED of its products. A firm will know much more about its internal operations and product costs than it will about its external environment. Therefore, gathering data on how consumers respond to changes in price can help reduce risk and uncertainly. More specifically, knowledge of PED can help the firm forecast its sales and set its price. Sales forecasting The firm can forecast the impact of a change in price on its sales volume, and sales revenue (total revenue, TR). For example, if PED for a product is (-) 2, a 10% reduction in price (say, from £10 to £9) will lead to a 20% increase in sales (say from 1000 to 1200). In this case, revenue will rise from £10,000 to £10,800. Pricing policy Knowing PED helps the firm decide whether to raise or lower price, or whether to price discriminate. Price discrimination is a policy of charging consumers different prices for the same product. If demand is elastic, revenue is gained by reducing price, but if demand is inelastic, revenue is gained by raising price. Non-pricing policy When PED is highly elastic, the firm can use advertising and other promotional techniques to reduce elasticity. Determinants of PED There are several reasons why consumers may respond elastically or inelastically to a price change, including: The number and ‘closeness’ of substitutes A unique and desirable product is likely to exhibit an inelastic demand with respect to price. 21
22. 22. Summer Camp 2012 Lecture 5 Economics 2281/02 Week 2nd June 4th 2012 The degree of necessity of the good A necessity like bread will be demanded inelastically with respect to price. Whether the good is habit forming Consumers are also relatively insensitive to changes in the price of habitually demanded products. The proportion of consumer income which is spent on the good The PED for a daily newspaper is likely to be much lower than that for a new car! Whether consumers are loyal to the brand Brand loyalty reduces sensitivity to price changes and reduces PED. Life cycle of product PED will vary according to where the product is in its life cycle. When new products are launched, there are often very few competitors and PED is relatively inelastic. As other firms launch similar products, the wider choice increases PED. Finally, as a product begins to decline in its lifecycle, consumers can become very responsive to price, hence discounting is extremely common. The effects of advertising Firms may use persuasive advertising by to win new customers and retain the loyalty of existing ones. Advertisers use a range of media, including television, press, and electronic media. Advertising will shift demand to the right, and make demand less elastic. There are three extreme cases of PED. 1. 2. 3. Perfectly elastic, where only one price can be charged. Perfectly inelastic, where only one quantity will be purchased. Unit elasticity, where all the possible price and quantity combinations are of the same value. The resultant curve is called a rectangular hyperbola. 22
23. 23. Summer Camp 2012 Lecture 5 Economics 2281/02 Week 2nd June 4th 2012 23