12154528Topic3DemandAndSupplyAnalysis

8/9/2019 12154528Topic3DemandAndSupplyAnalysis

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INTRODUCTION

Because the demand for a firm's goods and services plays such an important and

central role in determining the amount of cash flow which the firm will be able togenerate, and thus, the economic value of the firm, it is essential that we have astrong and deep understanding of demand and supply concepts. Thisunderstanding permits us as managers, to react to changes or shifts in demandfor our firmÊs goods and services in a manner that maximises profits andshareholders' wealth. The essential tools for predicting changes in the demandfunction include price , income and cross-price elasticities. Thus, demandanalysis, in particular, could easily satisfy two critical managerial objectives –provide the insight necessary for effective management of demand and assist inforecasting sales and revenue for the firm.

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DemandandSupplyAnalysis

LEARNING OUTCOMESBy the end of this topic, you should be able to:

1. Discuss demand analysis;

2. Discuss supply analysis;

3. Determine equilibrium price and quantity;

4.

Compute and interpret price elasticity of demand;5. Compute and interpret income elasticity;

6. Compute and interpret cross-price elasticity; and

7. Identify other useful elasticities.


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TOPIC 3 DEMAND AND SUPPLY ANALYSIS26

DEMAND RELATIONSHIP3.1

3.1.1 What is Demand Analysis?In general, the demand for a goods or services can be defined as quantities of agoods or services that people are ready (willing and able) to buy at various priceswithin a given time period, with factors other than price, held constant (orunchanged). An important contributor to the risk of a firm is the sudden shiftsin demand for a product or service due to and as a result of changes in the otherfactors such as income level and population size.

Conducting demand analysis serves two managerial objectives:

(a)

Provides the insight necessary for effective management of demand; and(b)

Assists in forecasting sales and revenues.

The most prominent feature of the demand curve (the simplest form of thedemand relationship) is its downward slope. Price ($/Q) and quantity (Q/time unit) are negatively related (Figure 3.1). The higher the price, the lower will be thequantity demanded and vice versa, with other factors constant. In Figure 1,when the price was RM8, the quantity demanded was 12 units; when the pricedropped to RM 5, the quantity demanded increased to 20 units.

Figure 3.1: The individual demand curve

Basically, there are two economic reasons for the downward slope:

(a) Income effect – As the price of a type of goods declines, the consumer canpurchase more of the goods as his real income is increased.

(b) Substitution effect– As the price declines, the goods become relativelycheaper.


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TOPIC 3 DEMAND AND SUPPLY ANALYSIS 27

Rational consumers are those people who seek to maximise satisfaction. Theywill reorganise consumption until the marginal utility (MU) in each goods perdollar is equal. This is shown in the equation below.

Optimality Condition is MUA/PA = MUB/PB = MUC/PC =…

If MU per dollar in A and B differ, the consumer can improve utility bypurchasing more of the one with the higher MU per dollar and less of the other.

3.1.2 Market Demand Curve

The market demand curve

is the horizontal sum of the individual demandcurves. In Figure 3.2, there are two consumers in the market. The market demandcurve is the horizontal summation of the two demand curves (panel 3).

Figure 3.2: The market demand curve

Source:

McGuigan, J. R., Moyer, R. C., & Harris, F. H. (2005) Managerial economics:

Applications, strategy and tactics (10th ed.). Mason, Ohio: South-Western.

3.1.3 What is Demand Function?

The Demand Curve, as discussed above, only considers the relationship betweenprice and quantity; „other factors" being constant. The Demand Functionincludes all of the factors which significantly influence the quantity demanded,including the price. A general demand function can be written in the form of amathematical expression as shown below:

QD = f (P, Ps, Pc, Y, Pe, A, Ac, TA, X.)

P = Price of the good itselfPs = Price of substitute


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Pc = Price of complementsY = IncomePe = Expected price

A = FirmÊs advertisement expenditureAc = CompetitorÊs expenditure on advertisementTA = Taste and preferenceX = Other factors

The expected effects of the various factors (or variables or influences) on thequantity demanded are as follows:

The price of the goods, P, is negatively related to QD.

The higher the price of substitute goods, Ps, the greater the quantitydemanded of one's own goods. Two goods are substitutes if an increase in theconsumption of one leads to the decline in the consumption of the other; forexample, coffee and tea; butter and margarine.

The higher the price of complementary goods, Pc, the smaller the quantitydemanded. Two goods are complements if an increase in the consumption ofone also leads to an increase in the consumption of the other; for example,coffee and creamer; bread and butter.

The effect of income on quantity demanded depends on the types of goods(or service). For „normal‰ goods, if income increases, the quantity demandedwill also increase. If income increases but the quantity demanded decreases,it is called „inferior‰ goods.

By now, you should be able to determine the relationships (positive or negative) between the quantity demanded and other factors such as expected price ofgoods, amount of advertisement expenditure by your firm, amount ofadvertisement expenditure by your competitor, consumer tastes and preferences,etc.

3.1.4 Changes in Quantity Demanded and Changes in

Demand

Changes in price result in changes in the quantity demanded. This implies amovement along a demand curve. As shown in Figure 3.3, the movement is fromone point to another along the same demand curve such as DD’.

Changes in non-price determinants result in changes in demand. This is shownas a shift in the entire demand curve, say, from DD’ to D1D1Ê if it results in anincrease in demand or to D2D2Ê if there is a decrease in demand.


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D

Figure 3.3

: Shifts in demand

Source: McGuigan, J. R., Moyer, R. C., & Harris, F. H. (2005) Managerial economics:


SELF-CHECK 3.1

1. What is demand analysis and what are the objectives of studyingdemand analysis?

2. What is demand function and what are the factors affecting thequantity demanded?

3. Discuss the relationship between quantity demanded and each ofthe factors identified in (2).

4.

Show the differences between changes in quantity demanded

and changes in demand.


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MARKET SUPPLY3.2

The supply of a particular goods or service is defined as quantities of a particular

goods or service that people or firms are ready to sell at various prices within agiven time period, with other factors besides price, being held constant.

Figure 3.4: Individual supply curve

The supply curve usually slopes upward, i.e. the higher the price, the greater thequantity of goods or services an individual is willing to sell, holding constant allother factors affecting supply. Non-price determinants of supply include:

(a)

Costs and technology

(b)

Prices of other goods or services offered by the seller

(c) Future expectations

(d) Number of sellers

(e)

Weather conditions

Similar to market demand, the market supply curve is the horizontal summationof all the individual supply curves.

Changes in price result in changes in the quantity supplied. This implies amovement along the supply curve. On the other hand, changes in non-pricedeterminants result in changes in supply. This is shown as a shift in the supplycurve.


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MARKET EQUILIBRIUM3.3

We are now able to combine supply with demand into a complete analysis of the

market where price and quantity are determined (Figure 3.5).

Figure 3.5: Market equilibrium

From Figure 3.5, it is clear that both the supply and demand curves determinemarket equilibrium price and quantity:

Equilibrium price: The price that equates the quantity demanded with thequantity supplied.

Equilibrium quantity: The amount that people are willing to buy and sellersare willing to offer at the equilibrium price level.

More often than not, due to the dynamic nature of the economy, equilibriumprice and quantity are not easily attainable or sustainable. There are alwaysshortages and surpluses; however, prices will always tend to move towardsequilibrium.

Shortage: A market situation in which the quantity demanded exceeds thequantity supplied. A shortage occurs at a price below the equilibrium level.

Surplus: A market situation in which the quantity supplied exceeds thequantity demanded. A surplus occurs at a price above the equilibriumlevel.


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ECONOMIC CONCEPT OF ELASTICITY3.4

Elasticity is a measure of the sensitivity of one variable to another or, more

precisely, the percentage change in one variable relative to a percentage changein another.

Percentage change in ACoefficent of Elasticity =

Percentage change in B

3.4.1 Price Elasticity of Demand

The slope of the demand curve gives some indications of how sensitive the

quantity demanded is to price. But slopes are quite different, using differentunits of measure. Economists therefore, developed the concept of elasticity whichis completely independent of the units of measurement.

Price elasticity of demand , ED, is the percentage change in quantity demandeddivided by the percentage change in its price, other things being equal (ceteris

paribus). It is the percentage change in the quantity demanded caused by a onepercent change in price.

ED = % ∆ Quantity

% ∆ Price

There are two methods of computing elasticity – arc elasticity and pointelasticity. We use arc elasticity when we have two points on a demand curve andwe use point elasticity if we have a demand curve in an equation form.

rc Price E lasticity – is used to calculate price elasticity between two prices.Since we do not want the calculation to be altered by the direction of theprice movement, we use the "average" quantity (QAVE) and the "average"price (PAVE).

E = %∆QD = ∆Q/QAVE = (Q2-Ql)/(Q1+Q2)/2 = (Q2-Q1)/Q1+Q2) %∆P ∆P/PAVE (P2 - P1)/(P1+P2)/2 (P2 - Pl)/(P1+P2)

Example of Arc Price Elasticity:Given:

Q = 1000 when the price is $10Q= 1200 when the price is reduced to $6


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Arc price elasticity

ED = (+200/1100)/(-4/8) = - 0.3636

The answer is a number. The elasticity is 0.3636. The negative in front of thenumber indicates that quantity is inversely related to price. A 1% increase inprice reduces the quantity demanded by 0.36%.

Point Price Elasticity – When the demand curve is known, the priceelasticity at each point on the curve is called the point price elasticity. Thepoint price elasticity is:

ED = (∂Q/∂P)(P/Q)

Example of Point Price Elasticity:Given a demand equation Q = 500 - 5P, find the price elasticity at a pointwhere price = 30.

Point price elasticity ED = - 5(30/500) = - 0.43A 1% increase in price reduces the quantity demanded by 0.43%.

(a) Categories of ElasticityElasticity coefficients range from zero to infinity. In general, they can be

divided into five categories. The categories for price elasticity of demand (inabsolute values) are shown below.

Range DescriptionED = 1 unit elastic ED < 1 inelastic ED > 1 elastic ED = ∞ perfectly elastic ED = 0 perfectly inelastic

It should be noted that elasticity coefficients along a linear demand curveare different at various points (Figure 3.6).


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Figure 3.6

: Elasticity along a Linear Demand Curve.

Source:



Educational Publishing.

(b) Factors Affecting Price ElasticitiesElasticity coefficients vary across different goods and services. Some of thefactors affecting elasticity are as follows:

(i) Availability and Closeness of Substitutes – The greater the number ofsubstitute goods available to consumers, the more price elastic thegoods.

(ii) Percentage of Budget – The demand for high-priced goods tends to bemore elastic than the demand for inexpensive items, as they typically

take up a large portion of one's budget.

(iii) Durable Goods – The demand for durable goods tends to be moreprice elastic than the demand for non-durable goods.

(iv) Time Frame – The demand for many products tends to become moreelastic over longer time periods. LetÊs say right now, tickets for around trip to Paris leaving tomorrow are offered at RM30. A fewmanagerial economics students would immediately start packing togo! But if the offer says that you can leave any time within the next sixmonths, it becomes almost irresistible.


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(v) Luxury Goods vs. Necessities – Luxury items tend to be more elasticthan necessity items.

(c) Price Elasticity and Total Revenue

Imagine that you have a firm which produces a particular product. Shouldyou increase the price of the product because you want to increase the totalrevenue of your firm? The answer is – not necessarily. There is arelationship between the price elasticity of demand and the revenuereceived (see Figure 3.7):

If price decreases and, in percentage terms, quantity rises more thanthe price dropped, then the total revenue will increase.

If price decreases and, in percentage terms, quantity rises less than theprice dropped, then the total revenue will decrease.

Figure 3.7: Total revenue and price elasticities

Source:




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SELF-CHECK 3.2

1.

Show how you calculate price elasticity.2.

What is the relationship between price elasticity and revenue?

3. Identify and discuss the factors which determine the priceelasticity of demand.

3.4.2 Income Elasticity

Income elasticity (EY) is the percentage change in the quantity demanded divided by the percentage change in income.

Arc Income Elasticity,

where Y is the income:

E = %∆QY = ∆Q/QAVE = (Q2 - Ql)/(Q1 - Q2)/2 = (Q2 - Q1)/Q1+Q2) %∆Y ∆Y/YAVE (Y2 - Y1)/(Y1+Y2)/2 (Y2 - Yl)/(Y1+Y2)

Example of arc income elasticity:

Suppose food expenditures (a proxy measure of all food in Ringgit) for familieswith an income of RM20,000 is RM5,200; and food expenditure rises to RM6,760for families earning RM30,000. Find the income elasticity of food.

EY =% Q /% Y = (6760 – 5200/(5200 + 6760)/2

(30,000 – 20,000/(30,000 + 20,000)/2

= (1560/5980) x (10,000/25,000) = 0.652

With a 1% increase in income, food purchases rise by 0.652%.

Point Income Elasticity – Provides a measure of this responsiveness of quantity toincome at a specific point on a demand function, where ¿Q/∂Y = the partialderivative of quantity with respect to income.

EY = (∂Q/∂Y)(Y/Q).


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Example of point income elasticity:

Suppose the demand function is Q = 10 - 2P + 3Y, find the income and price

elasticities when price of P = 2 and income Y = 10.

When P = 2 and Y = 10, Q = 10 - 2(2) + 3(10) = 36

EY = (∂Q/∂Y)( Y/Q) = 3( 10/ 36) = 0.833

ED = (∂Q/∂P)(P/Q) = -2(2/ 36) = - 0.111

A 1% increase in income will increase the quantity of food demanded by 0.833%.

Categories of Income Elasticity

IfE

Y

> 0, then it is a normal or income superior goods.Some goods are

luxuries:

EY > 1 with a high-income elasticity.Some goods are

necessities:

EY < 1 with a low-income elasticity.In this case, increase in income leads to an increase in the quantity demanded.

IfE

Y

is negative, it is an inferior goods. Here, an increase in income leads to adecrease in the quantity demanded. This happens in the case of rice, where thereis a tendency for people with higher income to consume less rice since they canafford to eat more meat and vegetables.

SELF-CHECK 3.3

Using the income elasticity coefficient, how do you categorisegoods and services into (a) normal, (b) inferior, (c) luxury and (d)necessity?

3.4.3 Cross-price Elasticity

Cross-price elasticity, EX, is the percentage change in the quantity demanded forgoods, A, divided by the percentage change in the price of the second goods, B,with other things being equal (ceteris paribus).

ED = %∆ Quantity of A

%∆ Price of B


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If you knew the price, income and cross-price elasticities, then you canforecast the percentage changes in quantity. Find out more about this.

ACTIVITY 3.2

Demand relationships can be represented in the form of a schedule (table),graph or algebraic function. Each of these methods of presentation providesinsight into the demand concept.

Usually, the demand curve slopes downward, indicating that consumers arewilling to purchase more units of a good or service at lower prices, whenother factors are constant.

Changes in price result in movements along the demand curve, whereaschanges in any of the other variables in the demand function result in shiftsof the entire demand curve.

Some of the factors that cause a shift in the entire demand curve are changesin the income level of consumers, the price of substitutes and complementarygoods, the level of advertising, competitorsÊ advertising expenditures,

population, consumer preferences, time period of adjustment, taxes orsubsidies and price expectation.

The supply of a particular goods or service is defined as quantities of aparticular goods or service that people or firms are ready to sell at variousprices within a given time period, other factors besides price being heldconstant.

Equilibrium price is the price that equates the quantity demanded with thequantity supplied.

Equilibrium quantity is the amount that people are willing to buy and sellers

are willing to offer at the equilibrium price level. Elasticity refers to the responsiveness of one economic variable to change in

another related variable. Thus, price elasticity of demand refers to thepercentage change in the quantity demanded associated with a percentagechange in price, holding constant the effects of other factors thought toinfluence demand.

Demand is said to be relatively price elastic if a given percentage change inprice results in a greater percentage change in the quantity demanded.


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Demand is to be relatively price inelastic if a given percentage change inprice, results in a lesser percentage change in the quantity demanded.

When demand is elastic, an increase in price will result in a decrease in total

revenue and vise-versa. When demand is inelastic, an increase, in price willresult in an increase in total revenue. The same goes in the case if there is adecrease in price, then thre willbe an increase in total revenue.

Income elasticity of demand refers to the percentage change in the quantitydemanded associated with a percentage change in income, holding constantthe effects of other factors thought to influence demand.

Cross elasticity of demand refers to percentage change in the quantitydemanded of Goods A associated with a percentage change in the price ofGoods B.

An understanding of the magnitude of various elasticity measures for aproduct can be very helpful in forecasting demand and formulatingmarketing or operations plans.

Arc and point elasticity

Cross-price elasticity

Demand

Elasticity

Goods

Income elasticity

Luxury and necessity

Normal and inferior

Price elasticity of demand

Substitute and complement

Supply

Total revenue

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12154528Topic3DemandAndSupplyAnalysis