|
2.7 Demand & Elasticity
1. Market Demand Curve
While preferences and tastes of consumers differ, for any given good or
service (x) each consumer is willing to pay a price to obtain a given
quantity of the good. If the quantities each consumer is willing to
buy at a given price are added horizontally the market demand curve for the
commodity can be constructed (M&Y 10th
Fig. 5.1; M&Y 11th Fig. 4.1; B&Z Fig. 4.6; B&Z not displayed; B&B not displayed). Thus while the demand curves for
individual consumers will show different levels of purchases at different
prices, at any given price one can sum up the amount all consumers are
willing to buy. Hence, the industry or market demand curve is equal to the
horizontal summation of the individual demand curves of each consumer.
All things being equal, the higher the price of a good or services, the
smaller the quantity demanded. This is the Law of Demand. Among other things
the law reflects the substitution and income effect of a price increase on
the quantity of a good demanded by consumers.
i - Substitution Effect: when the price of a good increases it does so
relative to all other goods. Although each good is unique it has substitutes
- other goods that will serve almost as well. As the opportunity cost of a
good rises, people will tend to buy less of it and more of its substitutes.
ii - Income Effect: when the price of a good rises, all things being equal,
it rises relative to income. Faced with a higher price and an unchanged
income, the quantity of at least some goods and services must decrease.
The demand curve (and schedule) shows the relationship between the price of
a good or service and the quantity demanded. In effect the curve shows
consumers' 'willingness to pay' and 'ability to pay' to obtain a given
quantity of a good or service. All things being equal, the demand curve will
be downward sloping reflecting the law of demand: the higher the price, the
lower the demand; the lower the price, the greater the demand. Assuming
other prices remain constant and other factors do not change, there will be
movement along the demand curve as the price of the good or service changes.
The demand curve can, however, shift, if other prices or other factors
change (M&Y 10th
Fig. 5.3; M&Y 11th Fig. 4.8; B&Z not displayed; B&B not displayed). A shift in
the demand curve can result due to changes in:
i - Price of Related Goods or Services;
ii - Income;
iii - Expected Future Prices;
iv - Population; and,
v - Preferences.
2. Elasticity
Elasticity refers to the sensitivity of a variable to change in another
variable. Economic theory recognizes three principal types of elasticity:
a) Price Elasticity of Demand
Price elasticity
refers to the percentage change in the quantity of a commodity demanded
compared to a percentage change in its price. In the case of demand
elasticity, an increase in price causes a decrease in quantity, that is the
demand curve is negatively sloped. Accordingly, elasticity would be
negative. However, elasticity is always reported in terms of its absolute
value regardless of sign (except for inferior goods in calculating the cross
elasticity of a complementary or substitute good - see below).
For a given price change, the amount demanded can increase (P&B
Fig 5.3: M&Y not displayed; B&Z not displayed; B&B not displayed):
i - more than proportionately, i.e. elasticity is greater than one - at the
extreme a horizontal demand or supply curve is perfectly elastic - a small
increase in price results in a large change in the quantity demanded or
supplied;
ii - proportionately, i.e. elasticity is equal to one (unitary elasticity);
or,
iii - less than proportionately. i.e. elasticity is less than one
(inelastic) - at the extreme, a vertical demand curve is perfectly inelastic
- any change in price results in no change in the amount of the commodity
demanded or supplied; and,
Price Elasticity of Demand = %ΔQ/%ΔP
b) Income Elasticity
Income elasticity of demand - assuming all prices are held constant - refers
to the percentage change in the quantity of a commodity demanded compared to
a percent change in income (M&Y 10th
Fig. 5.2; M&Y 11th Fig. 4.6; B&Z not displayed; B&B not displayed):
Income Elasticity of Demand = %ΔQ/%ΔI
c) Cross-Price Elasticity
Elasticity of
substitution or cross-elasticity refers to the percentage change in the
amount of a commodity (x) substituted for another by a consumer in response
to a change in the price of a substitute (y).
Cross Elasticity of Demand = %ΔQx/%ΔPy
> 1 (normal good, income elastic)
0 - 1 (normal good, income inelastic)
< 0 (inferior good) |
