Demand ReviewEconS 451: Lecture # 6

• Understand the definition of Demand.

• Explain the difference between Marshallian and Hicksian Demand.

• Be able to describe and explain the substitution and income effect in product space from a change in price.

• Understand how proportion of expenditure allocated to a specific good impacts the substitution and income effect.

• Understand the difference between demand shifts and structural change.

• Calculate Own-Price, Income and Cross-Price Elasticity of Demand.

Why review demand relationships?

• Helps us understand market behavior!

• Explains price fluctuations!

• Provides a foundation for empirical research and analysis!

• Equips you with necessary analytical capability to evaluate market dynamics!

Demand Review

• Demand Defined:

• The various quantities of a particular commodity that an individual consumer is willing and able to buy as the price varies, all other factors held constant.

Demand Review

• Begins at the individual level……then summed across all individuals to the market level.

Individual Attempting to Solve

Max U(x1 , x2) s.t. p1x1 + p2 x2 = I

Demand Review

• Marshallian Demand

Max U(x1 , x2) s.t. p1x1 + p2 x2 = I

• Hicksian (or Compensated) Demand

Min Expenditures E(p, U) s.t. U(x1 , x2) = UF

Individual Demand

Quantity X

Price

25

Demand

5

45

10

Product Space

v wu

X

Y

25 100

U 1

U 2

100

r s

t

37 5045

Observations

• If the commodity in questions represents a large proportion of expenditures, then the income effect from a change in the price will be relatively large.

• Both Income and Substitution effect usually inversely related to price changes.

Static and Dynamic Demand

• Static :• Quantity movements or responses to price while all

other factors are assumed constant.

• Movements along a demand curve.

• Dynamic:• Shifts and changes in demand that happen with the

passage of time to account for changes in income, population, taste and preferences, etc.

• Structural Change• Change in the shape of the demand curve due to

changes in technology or information.

Graphical Changes in Demand

Quantity

Parallel Shift

Shift and Structural Change

Price

Demand Changes

• Shift

• Parallel shifts from changes such as income, population.

• Structural Change

• Changes in the parameters or functional form.

YPQ

2YPQ

Short Run……….Long Run

• Short Run :

• Time period too short for complete quantity adjustment from a price change (a snapshot).

• Long Run:

• The time required for a complete quantity adjustment to occur in response to a “once-and-for-all” price change.

Distributed Lag Models

• Refers to a delayed adjustment in quantity as a result of a price change.

• And the adjustment may be spread over a period of time.

),,( 1 tttdt PPYfQ

Speculative Demand

• Consumer demand for current consumption

• Speculative demand• Anticipated demand and uses

• Future cost > current cost + all storage costs

• Commodity market financial investment• “open interest”

• Current market price impacted by current and expected events.

Primary and Derived Demand

Quantity

Derived Demand

Primary Demand

Pr

Pd

Price

Own-Price Elasticity of Demand

• Relates changes in the price of the commodity back to the changes in quantity demanded.

• Defined at a point along the demand curve.

• At the average• Arc formula

• Assuming Q = f(P)

Q

P

Pd

QdEp

Own-Price Elasticity of Demand

Range

• Elastic

• Unitary Elasticity

• Inelastic

• Revenue and elasticity • TR = P(Q)

1pE

1pE

1pE

Income Elasticity of Demand

• Relates changes in income back to the changes in quantity demanded.

• Defined at a point along the demand curve.

Q

Y

Yd

QdEY

Income Elasticity of Demand

Range

• Inferior

• Normal0YE

0YE

Cross-Price Elasticity of Demand

• Relates changes in the price of the jth product back to the changes in the quantity demanded for the ith product.

• Defined at a point along the demand curve.

i

j

j

iij Q

P

P

QE

Cross-Price Elasticity of Demand

Range

• Independent

• Substitute

• Complement

• Generalizations because of the “income and substitution effects” of a price change of inferior goods.

0ijE

0ijE

0ijE

Summary Questions

• Explain the difference between individual and market demand.

• Describe the difference between the short and long run as it relates to market demand.

• What is meant by a distributed-lag……as it relates to demand?

• Explain what the own-price, income, and cross-price elasticity of demand are each measuring.