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MKTG 4P28 (15)
Lecture

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School
Department
Marketing
Course
MKTG 4P28
Professor
Martin Kusy
Semester
Winter

Description
Principles of Microeconomics: Demand and Supply DEMAND AND SUPPLY This lecture examines the basic Demand/Supply model that is central to microeconomics. We do so by defining the relationship between Price and Quantity in Demand and Supply without analyzing the cause of those relationships. We analyze the cause of the relationships later in the course. We begin with a definition of Microeconomics and Partial Equilibrium Analysis before explaining the importance of Demand/Supply for markets. Definition: Microeconomics is the study of individual units in an economy (households, firms, markets, etc.) and their relationships. This entails the study of the allocation of resources and the distribution of income. Methodology Modern economics relies heavily on two methodological tools: partial equilibrium analysis and atomism. Definition: Equilibrium is a state of rest with no tendency to change given existing forces (variables) Definition: Partial Equilibrium Analysis is the analysis of the relationship between two variables while holding other relevant variables constant (ceteris paribus = other things equal), then examining the effect of the other variables by systematically examining their variation. Example At what temperature does water boil? Most people would answer 100 C but in fact this is only true holding at least two other variables constant: atmospheric pressure (sea level) and purity of the water (not salty, for example). Scientists use partial equilibrium analysis all the time to isolate relationships before they analyze the variations caused by changes in other variables. - 1 - Principles of Microeconomics: Demand and Supply Definition: General Equilibrium Analysis is the analysis of the relationship between all variables simultaneously. (We won’t use this approach in this class) General Equilibrium analysis is highly prized because it analyzes all the variables at once but this is a disadvantage because it requires more sophisticated mathematics and it doesn’t tell us about the cause-effect relationships between specific variables. We can approximate general equilibrium analysis by relaxing successively relaxing the ceteris paribus assumptions of partial equilibrium analysis. Definition: Atomism is the perspective that society (whole) is the sum of its parts (households and firms). Modern economics builds theory by analyzing the behaviour of the basic components of consumption (households) and production (firms). Demand is the aggregation of the behaviour of the individual consumers (households) and Supply is the aggregation of the behaviour of the individual producers (firms). Late in the course we will examine some of the issues that arise theoretically because of this methodological approach. Types of Economic Systems: There have been various types of economic systems historically, such as patriarchal, slave, feudal, socialist, and communistic. This course concentrates on the market system. Definition: Purchase and sale transactions between economic actors (households and firms) determine the allocation of resources in a market. => Price mechanism determines the allocation of resources in a market. Governments affect the allocation of resources in market economies in 5 ways. 1. Government Spending (roads, education, transfer payments, and wars, for example) 2. Taxation (income, sales, and property taxes, for example - 2 - Principles of Microeconomics: Demand and Supply 3. Public Enterprises (e.g., Ontario Hydro, LCBO, TTC, etc.) 4. Regulation (e.g., environmental, building, etc.) 5. Monetary Policy (control of money supply effects prices, interest rates, and exchange rates) Competitive Markets Definition: Competition is Price Taking Analysis of competition dates from at least Aristotle. Adam Smith described competition as ‘many buyers and sellers’ in his revolutionary discussion of the benefits of competitive markets in his 1876 The Wealth of Nations, but it was only at the end of the nineteenth century that economists formulated the modern analytic definition. The modern definition captures Smith’s meaning that buyers or sellers cannot influence price in a competitive market. It also simplifies the analysis of competitive behaviour since households and firms respond to a given price with no ability to change that price. Imperfect competition occurs when a buyer or seller can influence price. The most extreme examples are monopoly (single seller), which we shall discuss later in the course, and monopsony (single buyer). We shall see that Demand and Supply determine price in a competitive market. DEMAND (function, curve, schedule) Definition: Demand is the quantities of goods and services demanded by consumers 1 (households) at each market price ceteris paribus. Demand is the relationship between 2 variables, price (P) and quantity demanded (q for the household and Q for the market), holding all other variables constant. The most important of the 1 Economists analyse households as the smallest unit of consumption rather than ‘consumers’ because there are consumers such as babies that do not make economic decisions. - 3 - Principles of Microeconomics: Demand and Supply other variables are prices of other goods (Pi where ‘i’ represents one of n commodities), income (Y), and preferences (tastes). We can express the Demand for the X commodity as D(qXor Q X: q Xr Q X f(P |XY, Pi, Preferences) (everything after | is fixed) NOTE: We analyze Demand as a quantity response to price [Q = f(P)] not as a price response to quantity [P = f(Q]. (Alfred Marshall, the first economist to depict the Demand/Supply diagram, derived demand as a quantity response to price. Since price was the dependent variable and quantity was the independent variable, Marshall put quantity on the horizontal axis and price on the vertical axis following the mathematical convention of Y = f(X)). This concept of Demand satisfies our competitive definition that buyers are price takers. Example. The following table shows the number of kilograms of ground beef demanded by an individual during a year at given prices of ground beef, ceteris paribus. Price \$5 \$4 \$3 \$2 \$1 Quantity 10 15 25 40 60 We graph this relation with Price on the vertical axis and quantity on the horizontal axis. Price (\$s) 5 4 3 2 Demand 1 10 30 Quantity (kilos) Law of Demand: ((ΔQx/ΔPx < 0 or dQx/dPx < 0 for Qx = quantity of x and Px = price of x) - 4 - Principles of Microeconomics: Demand and Supply The Law of Demand says that an increase in price causes a decrease in quantity demanded and a decrease in price causes an increase in quantity demanded. (The change in Qx in response to the change in Px is less than zero) => A Demand curve is negatively sloped. The negative slope can be linear, concave, or convex. I will usually draw convex demand functions but use linear demand functions for calculations. Positive sloped demand functions can exist but are rare. Some positively sloped demand functions are called Giffen goods. NOTE.Do not confuse Demand and Quantity Demanded. Quantity demanded is the quantity response to one price whereas Demand is the set of all the prices and quantities. Perhaps the most common mistake in economics is the statement that the Demand for a commodity (e.g., gas) falls because of a rise in the price of the commodity. A fall in the price of a commodity causes a rise in the quantity demanded of the commodity (movement along the demand curve) but the demand curve itself does not change. A change in one of the ceteris paribus conditions, however, does change Demand. CHANGES IN DEMAND (shifts in the Demand Curve) Factors other than the price of a commodity affected the quantity demanded of a commodity. Changes in these variables change the Demand function, not merely the quantity demanded, since the price of the commodity need not change. We now look at the most common variables affecting Demand. 1. Income a) Normal Good: Demand is positively related to Income (ΔQd/ΔY > 0 or dQd/dY > 0) - 5 - Principles of Microeconomics: Demand and Supply An increase/decrease in the consumer’s income normally results in an increase in quantity demanded at every given price of a commodity. Suppose that the consumer’s income was \$2,000/month in our ground beef example above. The table and graph below show the effect on Demand of an increase in income to \$3,000 month. Price \$5 \$4 \$3 \$2 \$1 Quantity (Income = \$2,000/month) 10 15 25 40 60 Quantity (Income = \$3,000/month) 15 21 32 48 69 Price (\$s) 5 4 3 2 D 1 1 Do 10 20 30 40 50 Quantity (kilos) a) Inferior Good: Demand is inversely related to Income (ΔQd/ΔY < 0 or dQd/dY < 0) Some goods are called ‘inferior’ because an increase (decrease) in income causes a decrease (increases) in Demand, i.e., a decrease (increase) in quantity demanded at every price. An inferior good is a poorer quality good purchased by a consumer with relatively low income because it is affordable. An increase in income causes the consumer to buy more preferred normal goods and less inferior goods. Students, for example, go to pizza joints rather than better restaurants or use the TTC rather than a car. Example: Suppose that margarine is an inferior good (relative to butter) for a consumer. An increase in income causes the consumer to buy more butter and less margarine at any price of margarine. - 6 - Principles of Microeconomics: Demand and Supply Inferior Good: Increase in Income Price (\$s) Po Do D1 Q1 Qo Quantity 2. Changes in Prices of related Consumption Goods and Services a) Substitutes in Consumption: Demand is positively related to the price of a Substitute (ΔQd/ΔP SubC> 0 or dQd/ΔP SubC> 0) Substitute goods are goods that are used in place of each other. Honey, saccharine, and Splendida are common substitutes of refined sugar. Bicycles, walking, or public transportation are substitutes for travel by car. An increase in the price of a substitute (P ) for good X causes Sub the consumer to buy less of the substitute and more of good X. An increase in the price of cars, for example, would cause an increase in the Demand for public transportation (i.e., an increase in quantity demanded of public transportation at any given price of transportation). The diagram below shows an increase in demand for public transportation due to an increase in the prices of cars (perhaps because a fall in the supply of cars caused a fall in the quantity demanded of cars). Increase in the Price of Subsitute for Public Transportation Public Transportation Price (\$s) Cars Price (\$s) S 1So Po P 1 Po D 1
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