Supply and Demand

1. Supply and Demand • Demand is defined as the ability and willingness to pay a particular price for a product. An inverse relationship exists between price and level demanded. Normal goods follow the rule higher the price less demanded.

2. Factors other than price that effects demand • Consumer income – more purchasing power the higher demand for most products will be • Substitutes – the more substitutes for a product the lower the demand and price for that product will be • Quality – design, build-quality, reliability, features functions are factors that determine quality. (quality things can charge higher prices) • Marketing – persuasive advertisements can make people want a product or in some cases not want them. • Fashions, habits and tastes – What people want will affect demand

3. Factors other than price that effects demand • Utility – How much use is the product to the person that buys it (iphones) • Speculation – What do people think will happen in the future (stock prices) • State of the economy – when the economy is in a boom people will be much more free with spending then in an economic downturn. • Value for money – if something is seen as good value then demand for it will rise • Age, sex, ethnicity, religion all factors to demand

4. Exceptions to the law of demand • Ostentatious consumption – this is how high end or luxury goods effect demand. If price were to fall then people would think they are no longer high end so demand would fall. Rolex, Armani, Ferrari • Conspicuous consumption – When people spend a ridiculous amount of money to uphold their status in life. (rare coins, stamps, Rolls-Royce cars) • Expectations – when people think the price will rise in the future they may ignore laws of demand. (stocks, real estate) • Giffen goods – a theory that states because some people still need to buy inferior products even if their price rises that breaks the law of demand. (school store)

5. Supply is the willingness and ability of a business to provide a good or service to the public • The higher the price the more businesses are willing to supply the product. • Reason one a firm in a market will produce more if the price is higher • Reason two if the price for a product or service is higher then more businesses will want to enter the market.

6. What determines level of supply • Price of raw materials – If the price of a raw material rises then it will cost more to produce a product making it less attractive for a business to produce it. • Barriers to entry – markets that have high barriers of entry will have fewer businesses willing to produce which will have a negative impact on supply • Technology – if new productions methods make it cheaper to produce something that will shift the supply curve because more firms will be willing to make the product • Taxes – If a product is taxed by the gov’t then the suppliers will be less likely to produce them.

7. What determines level of supply con. • Subsidies – when a business is offered a subside from the gov’t that will make it more attractive for a business to enter a market • Price of related (substitute) goods some goods can be supplied very easily while others cannot. Some goods are also complements of each other • Climate – especially for fruits and vegetables weather conditions will determine what will be produced affecting the supply. • Time – it can take a while to produce more of a product and this will affect the level of supply a product will have

8. Equilibrium is the point that demand curve crosses the supply curve. At this point both producers and consumers should be happy and price is then determined. If there is excess demand for a product the price will rise which will cause more suppliers to enter a market. If there is excess supply the price should drop which will raise the level of demand for a product.

9. Elasticity of demand is a measure of how much quantity demanded is effected by some change in the market. (price changes, income advertising) • Measures of elasticity of demand • Price elasticity of demand – measures how much a change in price will affect demand. • Income elasticity of demand – how much a change in the income level of consumers affects the demand made by consumers • Cross-price elasticity of demand – a small change in the price of one product may affect the demand for another. (either compliment or substitute) • Advertising elasticity of demand – how much change in demand happens because of advertising

10. Price elasticity of demand (PED) • Price is considered inelastic if a small change in price results in a small change in demand • Price is considered elastic if a small change in price results in a large change in demand. • PED is measured by (percent change in quantity demanded)/(percent change in price) • PED will almost always be negative but we ignore the negative sign when analyzing the data. • Three possible PED calculations • If the calculation is between 0-1 then the product is considered inelastic • If the calculation (PED) is 1 the demand is said to be unitary price elastic • If the PED is greater then one demand is said to be elastic

11. Uses of price elasticity of demand • Helps determine pricing policy because if a product is inelastic then you can charge more for it • See which products will be hurt by a downturn in the economy (luxury goods) • If prices are elastic and the exchange rate lowers that will help the local exporters. • Governments can figure out how to maximize tax levels by looking at the elasticity of products. • Tobacco and petrol are inelastic products because demand does not lower with higher prices

12. Higher level extension: Relationship between price elasticity of demand and total revenue. • A product that is inelastic would mean that a business can do a price raise and it should not affect the level demanded which should raise revenue. • At the same time if they drop the price it will mean a drop in revenue because the same amount of sales with less money in per sale. • If a business has a product that is elastic than a drop in the price may actually raise total revenue because the demand should go up. At the same time a raise in the price should result in lower sales which should drop the total revenue in. • Page 544

13. Factors affecting price elasticity of demand • Substitution – most important factor in price elasticity what is a substitute for one person may not be a substitute for another. Some products do not have substitutes such as oil, medication. • Income - the greater the percentage of income a product is the higher the level of inelasticity of that product. (cars vs. lighter) • Time – Products are less elastic in the long term vs. the short term. • Durability – the longer a product lasts the more elastic the product is considered because people can wait to buy a new one • Fashion, addictions, habits and tastes – things that are addictive are inelastic by nature, people who really enjoy a sport or hobbie will usually do it no matter what the price. • Necessity – basic needs to live are inelastic but “luxury” versions of the same products can be price elastic. Also during holidays some products become price inelastic.

14. Income elasticity of demand – when the economy grows most businesses will expect their consumers demand level to grow because of a rise in income level. • YED = income elasticity of demand = (percentage change in quantity demanded) / (percentage change in income) • Possible outcomes for YED • YED is positive for normal goods 0<YED<1 these are necessities that will not necessarily go up or down in great amounts do to income • YED>1 luxury goods the higher the rise in income the higher the demand. • YED <0 is an inferior good something that is easily replaced by a superior good such as ground beef vs steak. Another great example is public transportation

15. Income elasticity • The value of YED affects different group differently. Some people like sales people will need to fly no matter what the price so it is inelastic for them but vacation travelers may be very elastic. • YED can change with time. Computers and Cell phones use to be luxuries but are now necessities to life. • YED is very important to elastic products especially superior goods. If an economic downturn is coming they are the first to be hit.

16. Cross price elasticity (CED)of demand measure the change in demand for one product because of a change in the price of another product. Could be substitutes or compliments • (percentage change in quantity demanded for good A)/(percent change in price of good B) • Substitutes are products that can be switched very easily. (coffee/tea, beef/pork, Lenovo/apple) When the price of one rises then the demand for the other should rise because consumers will switch what they buy. • When the CED is very high for two products then it is assumed that the consumers think the two products are substitutes.

17. Complements are products that are used together. Tennis racket/balls, computer/software, if the price of one falls then the demand for the other should rise. These will have a negative CED. • If the CED is 0 or very close to it then the products are considered to not have any correlation. On the other hand the higher the number either positive or negative the higher the correlation • Businesses use the knowledge of CED to try and get customers to buy one good at a discount and then buy the complimentary good at a marked up price. • Businesses will use branding strategies to lower there CED to substitute products.

18. Advertising elasticity of demand measures how successful an advertising campaign is. • AEG =(percent <> in quantity demanded)/(percent <> in advertising expenditure) • An AEG of over 1 for a product is considered very receptive to advertising expenditure. Below 1 is considered low reception • It can be hard to say what made demand increase. Family branding can have this problem because some products are associated with the business while others may not. Ex. If incomes level rise and advertising expenditure is raised then demand rises which is the one that caused the increase in demand. • If AEG is negative that usually means that advertising dollars where cut and demand went up. Or the advertising was in no way effective

19. Elasticity and product life cycle • During a products life cycle the price for a product can change dramatically depending on what is being sold. PED will increase the longer something is into it’s life cycle • Launch – because Economies of scale can not be utilized at this stage prices tend to be high. People who buy a product at this stage tend to really want to have the product or the status of being the first will give them so they will pay a high price which makes the product PED very low. • Growth – economies of scale start to kick in so prices fall and promotional or skim pricing strategies are useful. Competitors make “me to” products which can increase supply by a lot and make the product more PED sensitive. • Maturity – many substitutes exist for the product at this stage. Economies of scale should be at full rate lowering prices. PED will be high so businesses will try branding and advertising to make there products less susceptible to PED • Saturation – Many many substitutes are available so PED will be very high. Some customer loyalty may exist but most consumers will be very price sensitive • Decline – prices will tend to fall as businesses try and clear their stock of a product. Consumers are very price sensitive and the PED will be very high for the product