Scarcity and Demand
MA and Mc Business Economics
Lecture1
Learning outcomes
After the lecture you should understand:
Problem of scarcity
Demand curves represent the relationship between price and quantity
Factors leading to a change in demand
The elasticity of demand
Managerial insights from demand theory: Revenue price discrimination, consumer surplus, and pricing and product life cycles
Characteristics of the economic approach
Resources produce goods and services to satisfy wants
Infinite wants
Limited resources (Natural resources, labour, capital, and organisation)
Choices, resource allocation, and opportunity cost
What to produce, how to produce it, and for whom?
Production possibility frontier and opportunity cost
HOUSES
P0
P1
B0
B1
DP
DB
a
b
CARS
c
d
Production possibility curve
CONSUMER GOODS
CAPITAL GOODS
I2
c1
c2
A
B
C
D
E
I1
Resource Allocation mechanisms
Market economies
Planned economies
Mixed economies
Why Study Economics For Business?
Economic influences on:
Revenues
Economic influences on:
- Costs
Economic understanding of
= Profit
Price of the product
The price of substitutes and complements
Consumers’ income and preferences
Population and age distribution
Price expectations
Product quality
The determinants of demand
Other things equal, THE LAW OF DEMAND states that as a product’s price falls more will be demanded.
Demand curve
PRICE
QUANTITY
QD
PRICE
P0
P1
Q0
Q1
QUANTITY
QD
Demand curve
P0
Q0
Q1
QUANTITY
QD
QD1
a
b
PRICE
Shift in the demand curve
Demand and product quality
P
Q
SUPERIOR (LUXURY) PRODUCT
P
Q
INFERIOR PRODUCT
Demand
Demand
% Change in Quantity Demanded
% Change in Price
Change in quantity demanded
0 < <
Price Elasticity of demand
=
=
Price
Change in price
Quantity demanded
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Important Price Elasticity measures
Percentage change in price
Percentage change in demand
Numerical calculations
Elasticity value
Description
1
10%
0%
0/10
= 0
Perfectly inelastic
2
10%
5%
5/10
< 1
Inelastic demand
3
10%
10%
10/10
= 1
Unit elasticity
4
10%
20%
20/10
> 1
Elastic demand
5
10%
Infinitely large
=
Perfectly elastic
Q0
Q1
Q
P
P0
P1
INELASTIC
Demand
P
P0
P1
Q0
Q1
Q
ELASTIC
Demand
Different demand curves
Special cases
P
Q
P
P
Q
Q
PERFECTLY ELASTIC
UNIT ELASTICITY
PERFECTLY INELASTIC
1. Proximity of substitutes
ROLLS ROYCE - low number of substitutes
Inelastic demand
COCA COLA - high number of substitutes
Elastic demand
Time elapsed since price change
Proportion of income spent on the good
Determinants of elasticity
Oil Demand Sensitivity
Percentage change in demand for a 10% rise in oil price:
Middle East -1%
OECD, N. America -2%
OECD, Europe -3%
Latin America -5%
Africa -5%
China %
OECD, Asia -9%
Source IEA, Merill Lynch in FT 12 Sept 2006
Income elasticity
% Change in Quantity Demanded
% Change in Income
Cross price elasticity
% Change in Quantity Demanded of Good X
% Change in Price of Good Y
Other elasticities
Y =
YX =
Business application: Price changes, total revenue and elasticity (I)
P0
P1
Q0
Q1
PRICE
QUANTITY
QD
LOST Revenue
GAINED Revenue
Business application: Price changes, total revenue and elasticity (II)
P0
P1
Q0
Q1
PRICE
QUANTITY
QD
LOST Revenue
GAINED Revenue
Total revenue = Price * Quantity
Inelastic demand % change in P > % change in Q TR
% change in P > % change in Q TR
Elastic demand % change in P < % change in Q TR
% change in P < % change in Q TR
Elasticity and total revenue
Consumer surplus
P
Q
QD
P1
Q1
Consumer surplus
Price discrimination
UNDIFFERENTIATED MARKET
MARKET SEGMENT 1
P
P
Q
Q
P
Q
Pt
Qt
P1
Q1
P2
Q2
MARKET SEGMENT 2
Pricing and product life cycles
DEMAND
SALES
TIME
Launch
Growth
Maturity
Decline
Key learning points
You have been introduced to:
Problem of scarcity
Demand curves represent the relationship between price and quantity
Factors leading to a change in demand
The elasticity of demand
Managerial insights from demand theory: Revenue price discrimination, consumer surplus, and pricing and product life cycles
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Economics seeks to understand the functioning of market places so who for, how and why goods and services are produced
As Bryan outlined on Thursday economics can be split into two main areas: macro and micro
Macro - examines the whole economy as one very large market – it seeks to understand how the government might manage the entire economy to deliver stable economic growth
Micro- examines individuals, so consumers, firms, and workers with in markets, more particular micro seeks to understand why prices change for particular products, what influences the cost of firms and in particular what influences the firms level of productivity
To start the micro lectures we will today look at scarcity and demand and more particular at:
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Whether considering consumers, firms, or government all tend to have limitless desires to consume good and services. We as consumers have a very long wish list – and a resource list that is very short, Question that arises is what we will spend our resources on and what will we decide to leave in the shop. Firms also have infinite wants – they would for example like to operate in more countries selling larger product ranges, but firms are limited by their access to shareholders funds and good labour. Government too have infinite wants, providing more healthcare and better education, but they are limited to their tax receipts.
These limited amount of resources needed to make goods and services are also referred to as factors of production and comprise four categories: Land, labour capital, and organisation sometimes also referred to as enterprise.
1. Land = Inputs into production that are provided by nature such as gas, oil, minerals
2. Labour = All forms of human input both physical as well as mental that go into production of goods and services.
3. Capital = All inputs into production that have themselves been produced such as production machinery, computers, office space.
4. Enterprise = final factor of production that brings land labour and capital together and organise them into units that can produce products/services.
So everybody always wants more but we only have limited or finite amount of resources that enable the purchase of goods and services. Economics is the study of how society resolves the problem of scarcity whereby scarcity represents the excess of human wants over what can actually be produced to fulfil these wants.
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To illustrate the the consequences of finite resources for the production of goods and services economics use the PPF or often just referred to as PPF. The PPF is an important tool because it helps to highlight important economic concepts: Scarcity, finite resources, resource allocation, opportunity Costs
In this case the we have an imaginary economy that only produces only two goods: houses and cars.
With a fixed amount of recourses an infinite amount of houses and cars cannot be produced if all resources be allocated to the production of houses we would be at point c with the max of houses being produced and no cars. On the other hand if all recourses being allocated to the production of cars we would end up in d. The curve between c and d represents hence all maximum combinations of houses and cars that can be produced with the finite resources. The PPF hence shows the maximum amount of products that can be produced by an economy with a given amount of resources.
The concept of opportunity cost emphasises the need for choice by measuring the cost of anything that is chosen in terms of the best alternative that could have been chosen instead. The amount of the sacrificed. Opportunity costs are the benefits forgone from the next best alternative. So if the house production is reduced to produce more cars than than the opportunity cost is the benefit that could have been received from the houses that have not been made – The opportunity costs give the PPS the negative slope – simply more houses mean less cars. Recalling the economic problem of scarcity – hence infinite wants but only finite resources it is optimally to make the opportunity costs as low as possible – with the limited resources you will try to maximise the gains from consumption.
The increasing steepness of the PPS as one moves along it from left to right indicates that the higher the production of either type of good the greater the opportunity cost of obtaining a further increase in its production.
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As illustrated in the previous slide operating on the frontier is optimal as all finite resources are employed. Hence operating at point A is inefficient because some resources must be unemployed. More output could be employed by moving all factors of production and moving towards the frontier. Below the optimal level attainable on the frontier.
C is currently not possible because the economy has not got the resources. However over time the economy may become more efficient producing more output for a given level of input or may gain to access to additional factors of production which will enable to increase the existing maximum output. Hence economic growth shifts the PPS boundary outward.
Scarcity is shown by the unattainable combinations beyond the boundary. Choice arises because of the need to select one of the attainable points on the boundary. No economy can be at more than one point at one time.
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MARKET ECONOMIES
The government plays no important role in allocating resources Instead markets allocate allocate resources to the production of various products. In a market economy there are two important groups – consumers who buy products and firms that produce products. In the market place information is exchanged between consumers and firms – the information relates to prices that consumers are willing to pay and and the prices the firms are willing to sell at. – the problem of what should be produced and what should not be produced is solved by the price system.
PLANNED ECONOMIES (or Command economies)
The government plans on which point of the PPS the economy should operate, hence the government plans how the resources are allocated to the production of a particular product. Examples are the former Soviet bloc.
MIXED ECONOMIES
Combination of the planned and market economy and represents more of a reality. In a mixed economy the government and the private sector jointly solve economic problems.
Example UK: Sale of groceries is purely a market solution – private supermarkets deciding what they will offer to consumers in their own supermarkets. NHS is an example where the UK government decides on which health treatments should be offered.
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The demand curve shows a negative relationship between price and quantity demanded . The willingness to buy a product does however not only depend on the price.
The price of substitutes and complements
Substitutes are competing products or rivalry products: EXAMPLE Tee and coffee, Mercedis and BMW
Complements are products that are bought jointly, demanded together – EXAMPLE : Car and petrol, DVD and DVD player
Consumers’ income and preferences
To understand the effect of income on demand we need to distinguish between
Normal goods – demand increases as peoples income increases EXAMPLE
Inferior goods – demand increases as income level drop – EXAMPLE cheaper brands switch to higher quality
Gifffen goods – XXXXX
Preferences - attitude of consumers changes – Technological improvement (mobile phones), fashion
Population and age distribution
XXXXX
Price expectations
Beliefs how prices in the future will differ from the prices today. Example computers
Product quality
XXXXX
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A demand curve illustrates the relationship between price and quantity demanded of a particular product or service.
Quantity demanded is illustrated on the horizontal axis and P on the vertical axis. A demand curve can be for an individual consumer or a group of consumers a market.
The slope of the demand is negative which depicts the rather obvious argument that as prices fall more of a product will be demanded by consumers.
The quantity of a good demanded per period of time will fall as the price rises and rise as the price falls other things being equal. This relationship is referred to as the law of demand. There are two reasons for this:
Income effect – price rise -> people feel poorer -> will not be able to afford to buy as much as they wanted with their money -> purchasing power of their income has fallen
Substitution effect – price increases -> good is now more expensive relative to other goods -> people switch to substitute
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Movement along the demand curve is referred to as change in the quantity demanded it occurs only when there is a change in price.
EXAMPLES
BT broadband - Example recent BT broadband – from -> 13 to attract more than 1 million additional users.
‘Buy one get one free’
However when we have a shift in the demand curve, ie when a determinant other than price changes we do not call this change in the quantity demanded but change in demand
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For a business person it is however not only interesting to know what causes changes in the quantity demanded but they want to know the impact of price changes on the quantity demanded – elasticity.
Elasticity is a measure of the responsiveness of demand to a change in price.
Mathematically economist can measure elasticity or the responsiveness of demand to change in price by using the following formula.
The value for elasticity lies between zero and infinity. As this is a very large range economists generally break this down into 5 ranges.
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Extreme case where price increase of 10% has no impact in the quantity demanded (this does not really exist in reality, a proximity could however be cigarettes) it is referred to as perfectly inelastic demand. EXAMPLE
Second case 10 % change in price leads to an increase in quantity demanded of 5% - price change leads to a proportionally smaller change in demand elasticity is less than 1– EXAMPLE High branded products
Third case the 10% change in price leads to an equal change in demand – This scenario is referred to as unit elasticity EXAMPLE
Fourth case a 10% change in price leads to a proportionally larger change in quantity demanded, hence elasticity is greater than 1 EXAMPLE mobile phone contracts
Last row, perfectly elastic demand the other extreme case, where a 10% change in price leads to a very large change in demand – demand is very responsive to a change in price – EXAMPLE stock markets, currencies.
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Elasticity is determine by a number of factors:
Number and closeness of substitutes – the most important determinant. The more substitutes there are and the closer they are the greater will be the price elasticity of demand. The reason is that people will switch to the substitute when the price of the good rises.
Time elapsed since price changes – people take time to adjust their consumption patters to find alternatives, the longer the time period after the change the more elastic demand.
Proportion of income spend on the good - the higher the proportion of income spend on one good the more we will be forced out of consumption when the price rises. EXAMPLE More elastic example mortgage interest rates rise people will have to cut down substantially on their demand for housing. Salt we spend a very small fraction of our income - a rise in price would not make a huge difference.
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There are two related elasticity measures: Income and cross price elasticity.
Income elasticity measures the responsiveness of demand to change in income.
Normal goods - elasticity is above zero ie as income increases demand will grow at a faster rate
Inferior goods - income elasticity lies between zero and minus infinity as income rises consumers will buy less goods
EXAMPLES
Cross price elasticity
It measures the responsiveness of demand to a change in the price of a substitute or complement.
EXAMPLES
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TR= the price multiplied by number of units sold
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Need to be careful that changes are difficult to achieve as it takes time to develop new pricing plans and prices can result in price wars. Price wars can have detrimental effect on a business so instead of changing prices companies tend to offer buy one get one free, end of seasons sales
In reality level of competition provides a good indication of the immediate response.
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Another useful tool to use demand for is to understand consumer surplus.
Consumer surplus is the excess of what a person would have been prepared to pay for a good over what the person really pays.
It is very difficult to find out what consumers are willing to pay to catch the consumer surplus or the lost profits! Companies can de-bundling product offerings . Consumers can be offered a base package but extras are offered at much higher prices
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Price differentiation: Cable TV (SEE TUTORIAL LAST YEAR)
