Income, Price And Substitution Effects And Demand

Income, Price and Substitution Effects And Demand Theory

Income Effect (IC) • The effect on consumer equilibrium when income of the consumer changes while prices remain the same Y e1 e0

X

Price Effect (PE) • The effect on consumer equilibrium when price of one commodity changes while price (s) of other commodity (ies) and income of the consumer remain the same

Y e0

e1

X

Substitution Effect (SE) • The effect on consumer's equilibrium when price of a commodity falls/rises the consumer increases/decreases the purchase of the commodity, but it is assumed that there is no increase/decrease in his/her real income, so he/she remain on the same indifference curve

Y e0 e1 X

Demand • Scarcity is the consequence of the mismatch between wants and ability of the economy to meet the wants • Unlimited wants (desire) Vs Demand • Willingness and ability generate demand

Demand The demand for a commodity is the amount of the commodity that consumers are prepared to buy at a given price

Demand Curve Demand Curve

6 4 Price

• A consumer’s demand curve represents how much of a commodity is purchased at different prices.

2 0 0

20

40

Quntity Demanded

60

Why demand curve sloped down from left to right? • Diminishing Marginal Utility • Price ↓ implies Real-income ↑(income effect) • Cheaper commodity tends to be substituted for other commodities (substitution effect) • Price decrease leads to less urgent uses of the commodities

Law of Demand • Holding other factors constant, there is a negative relationship between the price of a commodity and quantity demand • Limitations  Change in taste or Fashion  Expectation about price  Change in income  Change in other price (s)  Discover of the substitution

Change in Quantity Demanded and Change in Demand • Change in Quantity Demanded (Qd)

∆Qd due to ∆P • Change in Demand (D)

∆D (shift) is due to change in factors other

than price (i.e. related good, income, preference, expectation and number of buyers )

Contraction and Extension of Demand • Contraction and Extension are associated with Change in Quantity Demanded (Qd) P1 P2 P3

a b c dc Q1

Q2

Q3

Increase and Decrease in demand • Increase (rise) and Decrease (fall) in demand are associated with Change in Demand (D)

P

a

b

c dc3 dc1 dc2

Q2

Q1

Q3

Elasticity of Demand • Elasticity of demand is the measure of the responsiveness of demand to changing prices • A small change in price may lead to a great change in quantity demanded, in such case we shall say that the demand is elastic/sensitive or responsive • If a large change in price causes a small change in quantity demanded, then the demand is in elastic

Five Cases of Elasticity •

Perfectly elastic/ infinite elasticity

p

D Qd

2) Perfectly inelastic or zero elasticity p2 p1 Qd

3) Relatively elastic: ٪∆Qd > ∆٪p p

Qd 4) Relatively inelastic: ∆٪p > ٪∆Qd

p

Qd

5) Unitary elastic: ∆٪p = ٪∆Qd p

Qd

Types of Elasticity • Price Elasticity (PE): it is the ratio of percentage changes in quantity demanded in response to a percentage change in price PE = ∆q/q ÷ ∆p/p • Income Elasticity (PE): it shows how the demand will change when the income of the purchaser changes, the price of the commodity remaining the same IE = ∆q/q ÷ ∆I/I

Types of Elasticity • Cross Elasticity (CE): a change in the price of one good cause a change in the demand for another ∆qx/qx ÷ ∆Py/Py

Measurement of Elasticity • Total outlay method: in this method we compare the total outlay of the purchaser before and after the variations in price Unity: the total amount spent remains the same even though the price has changed Greater than unity: with the fall in price, the total amount spent increases or the total amount spent decreases as the price rises Less than unity: with the rise in price, the total amount spent increases or the total amount spent decreases with a fall in price

Total outlay method S.no

P

Qd

1

8

3

Total outlay 24

2

7

4

28

3

6

5

30

4

5

6

30

5

4

7

28

6

3

8

24

Measurement of Elasticity • Proportional method: the elasticity is the ratio of the percentage change in the quantity demanded to the percentage change in price changed PE = ∆Qd/Qd ÷ ∆p/p PE = 200/400 ÷100/500 PE = 2.5

P

Qd

500

400

400

600

Firm’s Behavior • In the last few lectures, we focused on the demand side of the market; the preferences and behavior of the consumer • Now we turn to the supply side and examine the behavior of producers Consumer behavior

Demand market

firm’s behavior

supply

Production function (PF) • Production is the result of joint efforts of the four factors of production • Production function is the process of transforming input into output • Rojer. R. Millor defined PF as “it is a mathematical equation that gives a maximum quantity of output that can be produced from specific sets of inputs while technique of production are given”

• PF is the relationship between input and output • The most efficient method of production • Classical production function Q = f(L) where Q= output L= labor while capital K is constant, there it is a short-run production function

Return to Factor of Production and Return to scale • The increase in total output that results from increase in the employment of one factor of production (generally labor), assuming that the fixed input remains unchanged Q = f(L) • When firm changes both labor and capital, the effects on production will be analyzed with the name of “Return to Scale” Q = f (L,K) where L is labor and K is capital,

• Total production (TP= Q): total output of a firm produced by certain number of labor • Average product (AP): we get average product when we divide total product by the units of labor AP = TP/L = 40/5 • Marginal product (MP): the addition to total output that results from a unit increase in the employment of labor, assuming that the fixed input remains unchanged

Q

L

50

10

54

11

MP = 4