Chapter 3 Comparative Statics and Demand

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Meaning of comparative statics

The analysis which enables us to arrive at new optimal decisions when underlying assumptions change

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Changes in equilibrium when prices change

Relative price changes get reflected in changes in slope of the budget line. New point of tangency between the indifference curve and the new budget line

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Changes in equilibrium
Joining all these points of tangency gives the Price Consumption Curve. (PCC)
Y
PCC

Price of X is falling.

X
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Derivation of the demand curve

Data contained in the PCC: - Optimal level of consumption of X - Optimal level of consumption of Y - Prices of X and Y Demand curve for X requires - Price of X. - Quantity consumed of X.
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Demand Curve
Every point on the PCC gives the price of X and quantity demanded/consumed of X Thus,
Px

Qx
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Shifts in and movements along a Demand Curve

Effect on demand of changes in its own price results in movement along the demand curve. Effect on demand of changes in other factors results in shifts in demand curve

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Changes in equilibrium when income changes

Income changes show up as parallel shifts of the budget line New points of tangency between indifference curves and the new budget lines

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Changes in equilibrium
Joining all these points of tangency gives the Income Consumption Curve (ICC)
Y ICC

X
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Slope of the ICC

If the goods are Superior, the ICC is upward sloping
If one of the goods is Inferior, the ICC is downward sloping

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Slope of the PCC

If the goods are normal, PCC is upward sloping If PCC is downward sloping, then one of them is a Giffen Good

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Giffen good

Income effect Price effect + Substitution effect Substitution effect is inversely related to price. Income effect can be inversely related to changes in income Inferior Good Income effect can be positively related to income-Superior good
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Giffen Good

If income effect is inverse and large enough to offset the substitution effect, then it is a Giffen Good The Demand curve for Giffen Good will have a positive slope

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Elasticity
Price Elasticity: Proportionate change in quantity demanded due to a proportionate change in price - Qx/ Px * Px/Qx - negative for normal goods - negative sign is ignored while making comparisons among normal goods
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Elasticity
Pe Greater than1 (ignoring sign): Elastic Pe Equal to 1 (ignoring sign) : Unit Elastic Pe Less than 1 ( ignoring sign): Inelastic Price Elasticity and Expenditure: - Pe less than 1 a fall in price lower exp - Pe equal to 1 a fall in price exp constant - Pe greater than 1 a fall in price higher exp
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Elasticity
Income Elasticity Qx/I * I/Qx Could be negative or positive: Negative for Inferior goods Positive for Superior goods

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Elasticity
Cross Price Elasticity: Qx/Py * Py/Qx Could be negative or positive - Negative for complements - Positive for substitutes

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Point and arc elasticity

Point Elasticity: when price is very small Arc Elasticity: when price change is large Price Elasticity measurements: i) Proportionate method: Q/ P x P/Q Examples: if demand function is Q =30 -5P + P2
or

Therefore Q/ P = 5+ 2P and average function, or Q/P = (30 -5P + P2)/ P

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Now ed = Q/ P x P/Q, so it equals Marginal function/average function, or Ed= (-5 +2P) x P/( 30 -5P + P2) If P = Rs. 5, ed = (-5 + 10) x 5/( 30 10 + 25) = 50/45 = 1.1, Find ed when P = Rs.3/2, Rs 10
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Hyperbolic demand functions

Q = ap-n or Q = a/Pn where a and n are constants, Suppose a = 1800 and n = 2, demand funct Q = 1800/P2 = 1800x p-2 , the resulting demand
schedule at different prices can be as follows:

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Demand schedule
Price Rs.
6 5 4 3 2
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Quantity demanded
50 72 112.5 200 450
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Elasticity .
The interesting feature of this type of demand function is that price elasticity of demand is constant and is equal to to the exponent of P. Let P = 3, ed = P/Q> dQ/dP = 3/200X 3600/27 = -2, Let P = 2, ed = 2/450X -3600/8 = -2
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Elasticity
If Q = 20/(P + 1), find elasticity with respect to price. Now dQ/dP = -20( P +1)-2, Ed = P/Q. dQ/dP = P/Q X -20P/ Q( P + 1)2 = -20P/20/(P + 1)( P + 1)2 = -P/( P + 1) If, P = 5, ed = -5/6 = .833
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Income elasticity
Q. If income increases from Rs. 80,000 to Rs. 81000, the quantity demanded of good Q1 increases from 3000 to 3050, find income elasticity of demand. Given a small change in income, we use point elasticity method, therefore Ed (income) = I/Q1XdQ1/dI= (80000/3000) X 50/1000 = 1.33
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Cross price elasticity of demand

The price of desktop computers declines from Rs.50,000 to rs.25,000, sale of printers goes up from 50 to 150 per month: Ed (cross price) = dQx/dPy x Py/Qx, Since the the change is large, we use arc elasticity measure, so Qx = (50 + 150)/2 = 100, Py = (50000 + 25000)/2 = 37500, dQx = 100, and dPy = 25000, Ed = 100/25000(37500/100) = - 1.5
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Elasticity
If price elasticity of petrol is 0.5, how much of price increase would be required to reduce consumption by 10%? Ed = (dQ/Q)/ dP/P= 0.5 Now dQ/Q = 10% = 0.1, so dP/P = .1/.5= .2 or 20%

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Elasticity of demand
Elasticity of demand can also be expressed as: ed = Marginal quantity demanded divided by Average quantity demanded= Q/ P divided by Q/P,

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Determinants of price elasticity

Availability of substitutes: Cases of close substitutes like cold drinks and no substitutes like salt Number of uses for a commodity: greater uses leads to greater elasticity like for electricity, when restricted uses like for wheat demand is relatively inelastic Relative importance of a commodity in total expenditure of a consumer: Salt/ match box cases vs cloth/ readymade garments. Consider the impact of doubling of their prices on total demand of consumer
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Determinants of elasticity continued

Nature of the need being satisfied by a commodity, like necessities, comforts, luxuries Time allowed for adjustment to price change, the longer the time period greater the elasticity and vice versa * Habits tend to make demand inelastic * Joint demand like for machine oil and machines makes demand relatively inelastic
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Determinants of elasticity continued

Nature of the need being satisfied by a commodity, like necessities, comforts, luxuries Time allowed for adjustment to price change, the longer the time period greater the elasticity and vice versa * Habits tend to make demand inelastic * Joint demand like for machine oil and machines makes demand relatively inelastic
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Distinctive types of elasticity

Industry elasticity: Refers to the change in total industry sales with a change in the general level of prices for the industry as a whole. The industry demand has elasticity with respect to competition from other industries.

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Distinctive types of ela

Market share elasticity: Relates the change in companys share of industry-wide sales to the price differential between the companys price and industrywise price level. Expectations elasticity: Refers to responsiveness of sales to buyers
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Distinctive types.
guesses about the values of demand determinants, such as the future price of a commodity or of its substitutes, future incomes of buyers, prospects of easy availability or otherwise in the future, or future promotional outlays.
Interest rate elasticity and demand for consumers durables: In USA elasticity of interest rates to housing demand is estimates at .15 which means a ten per cent increase in interest rates would result in 1.5% change in housing demand.
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Engles Law of Consumption

Dr. Engle was a German statistician. He made a study of family budgets around the middle of the nineteenth century He arrived at the following major conclusions: i) As income increases the percentage expenditure on food decreases and vice versa ii) The percentage expenditure on clothing, etc. remains more or less constant at all levels of income
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Engles
iii) The percentage expenditure on fuel, light, rent, etc. also remains practically the same at all levels of income. iv) However, the percentage expenditure on what may be called comforts and luxuries of life increases with increase in income and vice versa.
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Propensity to consume and save concepts

These are macro-economic concepts. The propensity to consume refers to the proportion of income consumed Average propensity to consume refers to economy as a whole, say like C/I Marginal propensity to consume refers to the proportion of change in consumption to proportion of change in income, say, C/ I income to
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Propensity to save and consume..

The propensity to save is reverse of propensity to consume. The concepts, especially marginal propensity to consume and save, exercise considerable influence on the growth performance of an economy

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Propensity continued
A higher marginal propensity to consume leads to faster economic growth through its multiplier effects, unless there exist bottlenecks on the supply side like in the developing world The propensity to consume declines as incomes keep on increasing
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