801212832-Micro-I-PPT-Chapter-Two-1.pptx

801212832-Micro-I-PPT-Chapter-Two-1.pptx

1. Chapter2;THEORY OF DEMAND AND SUPPLY 2.1 Definition and law of demand Definition ; D emand refers to the desire and ability to consume certain quantities at certain prices. The law of demand ; The law of demand states that there is inverse relationship between quantity demand and price of the commodity other factors being constant.

2. Cont… a higher price induces a reduction in quantity demanded and a lower price induces an increase in quantity demanded, ceteris paribus. Ceteris paribus is a Latin word which means ‘’other things being constant’’. The law of demand works if all other factors that affect demand are held constant.

3. Determinants of demand price is the most important determinant of the quantity demanded, It is expected as the price rises the quantity demand falls and vice versa . there are also various factors which determine it. These determinants are:-. Price of substituted and complementary goods The demand for a commodity depends also on the levels of the price of its substitute and complementary good. Substituted/related commodities are goods that are consumed in place .

4. Cont… If Goods are substitute for each other changes in the price of one affects the demand for the other in the same direction. Eg . Tea & coffee, Pepsi and coca, bread and injera . However, Complementary goods are goods that are consumed together. For example gun &gun powder, camera & film, petroleum & vehicle.

5. Cont … 3. Consumer’s income People with higher disposable income spend larger amount on goods & services than those with lower income. But since consumer’s income-demand analysis depends on the type of the good, we look this income -demand analysis with related to different categories of goods.

6. Cont… Inferior goods :-Are goods which are given low value / class/ by the society . The demand for such goods may initially increases with the increase in income up to a certain limit. But it decreases when income increases beyond that limit. Normal goods :-Technically normal goods are those goods which are demanded in increase quantities as consumer’s income increases.

7. Normal goods are divided into luxuries and necessities. i. Essential consumer goods / basic goods/: -Are goods which are essentially consumed by almost all parts of the society. E.g. food grains, cooking oil , sugar, salt etc .The quantity demand of such goods increases with the increase in consumer’s income only up to a certain limit. once their basic needs are satisfied, further income increases don’t lead to much higher consumption of such goods. So , the marginal utility (extra satisfaction) from consuming more of these goods decreases as income rises.

8. ii . Prestige or luxury goods : -Are goods which are mostly consumed by the rich section of society .E.g. designer clothes, jewelry, high-end cars, luxury vacations. Demand for such goods arises only beyond a certain level of consumer’s income. Demand for luxury goods only appears after income exceeds a certain threshold once people have satisfied their basic needs and start seeking products that provide pleasure, comfort, or prestige. A person with very low income won’t prioritize buying a luxury car, but once income rises beyond basic needs, they begin to demand such goods.

9. Cont… 4. Consumer’s future income Consumer’s future income has positive relationship with demand. That means if the consumer expects future income, he consumes more today and vice versa . 5. Consumer’s expected price It has also positive relationship with demand. That is if consumer expected price of goods increases in the future, his today’s demand for that good increases & vice versa.

10. Cont … 6 . Consumers preferences It also plays an important role in determining the demand for a product. consumer can change his or her preference for many different reasons. For example change in moral perception or fashion, advertising , observing other consumers and so on.

11. Cont … Demand Schedule It is a table that shows the relationship between quantity demanded of good or service and the price of that good and service, all other things being constant. Table 1. Demand schedule

12. Cont … Demand Curve; It is a graphical representation of a demand schedule. 50 40 30 20 10 20 40 60 80 100 Quantity demanded ( )   Price The negative slope (downward slope) of the demand curve suggests an inverse relationship between price and quantity demanded. All other things unchanged, the law of demand holds that, for virtually all goods and services, a higher price leads to a reduction in quantity demanded and a lower price leads to an increase in quantity demanded.

13. Cont … Demand Function It is a mathematical statement of the law of demand that expresses the relationship between the quantity demanded of product and its own price, Ceteris Paribus. It is generally stated in linear form as follows: = a- bP Where : = quantity demanded P = Price per unit a = intercept of the demand function which represent the quantity demanded that is independent of price i.e. It is the demand dependent on other factors. b = slope of the demand function.  

14. Cont … Movement along the Demand Curve Movement along the demand curve refers to that change in the quantity demanded of a good because of changes in the prices of that good while other factors affecting demand (such as price of other goods, income etc.) remaining the same (unchanged) In the Figure, reduction of price from P 1 to P 2 increases quantity demanded from Q 1 to Q 2 . This represents what is called change in quantity demanded .

15. Cont … Shift in the demand curve A change in other factors of demand (other than price of the product) will cause a shift in the demand curve. Shift in the demand curve for a good result from changes in one or more of the factors that affect demand except the price of own good. Increase in demand is shown by outward shift of the demand curve whereas inward shift of the demand curve represents decrease in demand.

16. Cont … An increase in income leads to an increase or a decrease in demand depending on the nature of the good . Demand increases with increase in income if the good is normal. ( Eg . Meat). If the good is inferior good, demand decreases with increase in income ( eg . Shiro wet ).

17. 2.2 Definition, law and determinants of supply Definition: Supply refers to the quantities that producers are willing and able to supply at alternative prices, ceteris paribus . The Law of Supply : states that the quantity supplied of a good or service is a positive function of price, ceteris paribus. Determinants of supply 1 . Price of the product (P): That the higher the price in the market the more the produce is usually to produce for sale other factors remaining constant.

18. 2 . Prices of Factors of Production: This change in the cost of production will change the quantity that suppliers are willing to offer at any price. An increase in factor prices should decrease the quantity suppliers will offer at any price. A reduction in factor prices increases the quantity suppliers will offer at any price. 3. Producers ’ Expectations If the sellers expect that future price will rise, there will be holding of goods to sell it later when the price is higher. Thus , there will be a decrease in supply. The reverse is also true.

19. Cont … 4. Price of other goods the firm can produce To produce one good or service means forgoing the production of another. If a large commercial farm produces both teff and wheat. If the price of teff rises in the market, it is likely to shift all resources (land, labor and machines) to the production of teff and less wheat will be produced. Consequently, the supply of wheat will decrease even if its price is unchanged.

20. Cont … 5. The Number of Suppliers When more suppliers enter the market, the supply for that particular good increases. Think of market supply as the sum of all individual suppliers' production . If one workshop in a town can produce 100 wooden chairs per day, the market supply at a given price is 100 chairs. If a second workshop opens and can also produce 100 chairs, the market supply at that same price doubles to 200 chairs. The reverse is also true. If suppliers leave the market, the total quantity available at each price decreases.

21. Cont … 6 . Technology (T): A change in technology alters the combinations of inputs or the types of inputs required in the production process. An improvement in technology usually means that fewer and/or less costly inputs are needed. If the cost of production is lower, the profits available at a given price will increase, and producers will produce more. Improved Technology means a more efficient production process. This could be better machinery (like a more efficient assembly line), automation (robots), or improved software and logistics . This higher efficiency leads to higher productivity (more output per worker per hour) and lower costs per unit (less waste, less energy, less labor time required per item)

22. Cont … Movement along the Supply Curve Price Supply P2 b P1 a 0 q1 q2 Quantity Figure: Movement along the supply curve Graphically, the effect of change in the price of the product concerned is shown by movement from one point on the supply curve to another point on the same curve. In the figure increase in price from P 1 to P 2 leads to increase in quantity supplied from Q 1 to Q 2 .

23. Shift in Supply Curve Note: In economics, a decrease in supply or demand is always shown by a shift to the left. An increase in supply or demand is always indicated by a shift to the right. Do not refer to these shifts as movements up or down; they are left or right shifts. P s p Q   A shift of the supply curve is caused by change in other factors that influence supply other than the price of the commodity.

24. 2.3 Market Equilibrium “Equilibrium” is perceived as the condition where the quantity demanded is equal to the quantity supplied. Once equilibrium is reached at the point of equality of the demand curve with the supply curve, it remains there as long as demand and supply remain unchanged.

25. Cont … Numerically: If demand is given as =a- bP and supply is given as = c+dP , the equilibrium condition is Supply = Demand a- bP = c+dP Graphically, economists represent a market equilibrium as the intersection of the demand and supply functions. p2 S E D Q  

26. Cont … At a price of the quantity demand is equal to quantity supply. Such a state is referred to as market equilibrium. The price corresponding to the equilibrium point is referred to as equilibrium price ( ) while the corresponding quantity is referred to as equilibrium quantity ( ). Point E is referred to as equilibrium point: the point of intersection between the demand curve and supply curve. T he market equilibrium price is determined by the interaction of demand and supply. At point E the quantity demanded is equal to quantity supplied. That’s there is no excess demand and excess supply.  

27. Cont … E.g. suppose the market demand curve for maize is given by the equation Qd = 500- 4P, while the market supply curve for maize is described by the equation Qs = -100 + 2P. At what price and quantity is the market for maize in equilibrium? Solution : At equilibrium, the quantity supplied equals the quantity demanded, and we can use this relationship to solve for P. Qd = Qs; 500-4P= -100+2P 600=6P P=100 br .

28. Cont … We can then find the equilibrium quantity by substituting the equilibrium price into the equation for either the demand curve or the supply curve: Qd = 500-4(100) = 100. Qs = -100+2(100) = 100. The equilibrium price is 100 br. And the equilibrium quantity is 100 unit .

29. 2.5 Elasticity’s of Demand and Supply of agricultural commodities and their determinants The law of demand and supply states only the nature of relationship between the change in the price of a commodity and the quantity demanded and supplied respectively the law does not quantity the relationship. The quantitative relationship is measured by the elasticity of demand and elasticity of supply. Definition : Elasticity is a measure of the sensitivity or responsiveness of quantity demanded or quantity supplied to changes in price .

30. Cont … Elasticity of demand In examining demand, it would be interesting to measure how quantity demanded responds to changes in price . Price elasticity of demand measures the responsiveness of quantity demanded to changes in output price, ceteris paribus. The price elasticity of demand (  ) is defined to be the percentage change in quantity demanded divided by the percentage change in price .

31. Cont … where  Q is change in quantity and  P is change in price. Rearranging , The sign of the elasticity of demand is generally negative, since demand curves invariably have a negative slope. In elasticity, we consider the absolute value of the coefficients.

32. Cont … Depending on the size of the elasticity coefficient, different types of price elasticity could be traced along a demand curve. Each of these is given in the table below. Table 2 .: Elasticity Coefficients Numerical coefficients Responsiveness of quantity demanded to changes in price Terminology e = 0 None Perfectly inelastic 0 < e < 1 Quantity demanded changes by a smaller percentage than the percentage change in price Inelastic e = 1 Quantity demanded changes by a percentage equal to the percentage change in price Unit elastic 1 < e <  Quantity demanded changes by larger percentage than the percentage change in price Elastic

33. Cont … e.g. 1, suppose that when the price of a good is 10br , the quantity demanded is 50 units and that when the price increases to 12br , the quantity demanded decreases to 45 units. Then the price elasticity of demand is; = * = * = * = -0.5; which implies that the DD is inelastic since |EP | < 1 . This suggests that a 1% increase in price will reduce the quantity demanded by 0.5 %.  

34. Cont … Suppose the demand function is Q =8−2P. When the price changes from 2 to 1, the price elasticity of demand is; When p=2, then =4 When p=1 then = 6 = = = -1, the good is unitary elastic, meaning a one percentage change in price result in one percentage change in the quantity demanded.  

35. Cont … Determinants of Price Elasticity of Demand T he number of substitutes a product has If a good has many close substitutes, it is generally held that its quantity demanded would be very responsive to price changes, its demand tends to be elastic. The greater the possibility of substitution , the greater the price elasticity of demand for it. On the other hand, if for a commodity substitutes are not available, people will have to buy it even when its price rises, therefore its demand would tend to be inelastic.

36. Cont … Another determinant of elasticity is time The longer the period of time consumers have to adjust, the more elastic the demand becomes. This is because there are more opportunities to modify behavior and substitute different products over a longer time period.

37. Cont … Price elasticity of Supply Price elasticity of supply measures the responsiveness of the quantity supplied to a change in the commodity’s price, ceteris paribus . It is defined as: Where , Q S is quantity supplied of a good and P is price. As with price elasticity of demand, if  s = 1 , supply is unit elastic. If  s > 1 , it is elastic; and if  s < 1 , it is inelastic.

38. Determinants of Price Elasticity of Supply The elasticity of supply depends on: The main determinant of the price elasticity of supply is the amount of time a producer has to respond to its price change . the more time a producer has to respond to price changes the more elastic the supply. Since as the time period increases, the possibility of obtaining new and different inputs increase the supply , elasticity of supply tends to be more elastic over longer periods than over shorter periods.

39. Cont … The availability of resources(substitutes); If a product has many substitutes then the producer can easily alter the pattern of production if its price rises or fall. Its elasticity will be relatively high. Unsold stocks(Inventories) ; if the industry has accumulated a large stock of unsold goods, supplies can quickly be increased. These mean, it is possible to quickly respond to an increase in price by increasing quantity supplied and hence, supply becomes more elastic.

40. 2.6. Theory of utility and consumer behavior The consumer choice between goods and services is guided by the anticipated satisfaction derived from consuming these goods and services. The anticipated satisfaction is known as Utility . Consumer preferences tell us how an individual would rank any two baskets. Of course, a consumer’s actual choice will ultimately depend on a number of factors in addition to preferences, including income and what the baskets cost.

41. Cont … consumer behavior is meant how consumers decide on the basket of goods and services they consume. It is essentially decision-making behavior. We shall see this consumer behavior analysis using cardinal and ordinal utility analysis . The cardinal utility approach Utility is assumed to be measured quantitatively in units called Utils . With a cardinal measurement, we not only know the preference of the consumers of basket A to basket D, but We can make a quantitative statement.

42. Cont … The cardinal approach is based on the following assumptions: 1.The consumer is rational - this means that the consumer’s objective to maximize utility subject to a given level income. 2. Utility is cardinal - this means that utility is measurable quantitatively. 3. Marginal utility depends on the quantity of a commodity consumed – that the more the units are consumed the more the total utility. 4. Diminishing marginal utility- the additional utility derived from consuming an extra unit of product gets smaller and smaller.

43. Cont … Total Utility (TU ) It refers to the total amount of satisfaction a consumer gets from consuming or possessing some specific quantities of a commodity at a particular time. As the consumer consumes more of a good per time period, his/her total utility increases. However , there is a saturation point for that commodity in which the consumer will not be capable of enjoying any greater satisfaction from it.

44. Cont … Marginal Utility (MU ) It refers to the additional (extra) utility obtained from consuming an additional unit of a commodity. In other words, marginal utility is the change in total utility resulting from the consumption of one more unit of a product per unit of time. Mathematically , the formula for marginal utility is: Where:  TU is the change in Total Utility, and  Q is change in the amount of product consumed.

45. Cont … The relationship between total utility and marginal utility can be shown in the following table. The MU can be visualized as the slope of the TU between two successive units of the good. E.g. the MU derived from consuming 2 and 3 unit of good x is: MU= = = 6.   Quantity of good x Total Utility Marginal Utility - 1 10 10 2 18 8 3 24 6 4 26 2 5 28 1 6 28 7 27 -1

46. Cont … The Law of Diminishing Marginal Utility It is believed that as a person consumes more and more of a (homogeneous) good in a given period of time, that eventually the total utility (TU) derived from that good will increase at a decreasing rate: the point of diminishing marginal utility (MU) will be reached. In other words, as a consumer takes more units of goods, the extra satisfaction that he drives from an extra unit of the good goes on failing .

47. Cont … Ordinalist Approach In the study of cardinal utility analysis we have assumed that utility is measurable. This approach suffers from a number of weaknesses; the most important weakness of this old approach was related to its cardinal measurement of utility. To overcome this difficulty the modern economists have developed an alternative approach based on in difference curve analysis. The indifference curve analysis does not deny the existence of utility but makes use of it in different way . It states that utility is measurable only in principle but its magnitude cannot be assigned in real number.

48. Cont … In general the concept of ordinal utility is based on the following assumptions. 1) It may not be possible for consumer to express his utility in quantative terms. But it is always possible for him to tell which of any two goods he prefers. 2) In view of assumption 2, the consumer can order all the commodities he consumes in the order of their preference. The consumer level of satisfaction is represented by an Indifference curve.

49. Cont … An indifference curve is the locus of points each representing a different combination of two goods which yield the same utility or level of satisfaction to the consumer . As you can see from the above figure the person gets equal satisfaction by consuming 12x+1y, 8x+2y,5x+3y and 3x+4y.