Figure 1: Fuel efficient car market
(Source: as created by Author)
The law of demand suggests an inverse relation between price and quantity demanded of a commodity (Varian 2014). An increase in the price of petrol has a direct impact of reducing petrol demand. People now want to reduce their petrol demand and prefers fuel efficient cars. As a result, demand for fuel efficient curve increases shifting the demand curve to the right. The sudden increase in demand given the supply creates a shortage of cars in the market. With a general shift in the demand curve from DD to D1D1, price reaches to P1 from equilibrium level of P* and number of cars increases to Q1.
Figure 2: Car market using liquefied petroleum gas
(Source: as created by Author)
When petrol price raises then people will either switch to fuel efficient cars or try to find some alternative of petrol. Consequently, demand for cars using petroleum substitute products increases (Azevedo and Leshno 2016). In figure 2, increases in demand for such cars is indicated by the rightward shift of the demand curve. The new demand curve is B1B1. At the new demand curve there is an excess demand for cars using liquid gas. At the shifted demand curve, the new equilibrium is obtained where B1B1 cut the supply curve FF. The increased demand expands this car market with a higher price and greater number of cars sold than earlier.
Figure 3: Beef market with increased income
(Source: as created by Author)
In addition to own price, several factors determine the level of demand. Income is one significant determinant of demand. For a normal good, income and demand are positively related. Therefore, being a normal good an increases in average income causes an increase in demand for beef (Case, Fair and Oster 2014). The change in demand is captured by an outward shift in the demand curve from D1D1 to D2D2. Corresponding equilibrium shifts from E to E1. The beef market now faces a higher equilibrium price and quantity.
Figure 4: Beef market with high quality cattle food
(Source: as created by Author)
The high quality cattle feed reduces the time taken to get ready the cattle for the market. This implies more beefs are now available in the market for the same period. Thus, supply of beef in the market increases. The exogenous change in supply is indicated by the outer shift of the supply curve to S1S1. At the existing equilibrium price more beefs are now available causing a surplus. The excess supply of beef in the market reduces price of beef to P3 and increases available quantity to B3. The market is settled to a new equilibrium point at E2.
In order to restrict the spread of mad cow diseases government in beef producing countries have ordered mass slaughter of cows. This will reduce the supply of beef in these countries. At the same time government spreads awareness regarding the harmful effect of beef consumption. Consumers being aware now reduces their consumption of beef. Therefore, there are two simultaneous forces that work on the equilibrium beef market. A decrease in demand and supply reduces equilibrium quantity of beef. However, the effect on equilibrium price is ambiguous and depends of the magnitude of demand and supply change (Li, Chen and Dahleh 2015). The possible effects on beef market is described below.
Case 1
It might happen that the change in demand is greater than the change in supply. In this case, the supply force dominates and in the new equilibrium both price and quantity declines.
Figure 5: A greater proportionate change in demand
(Source: as created by Author)
Case 2
In case where magnitude of supply change is greater than demand change then price will increase while quantity in new equilibrium decreases as usual.4
Figure 6: A greater proportionate change in Supply
(Source: as created by Author)
Case 3
There is one hypothetical extreme where change in demand exactly matches with change in supply. In this situation the opposing forces on price offsets leaving the equilibrium price unchanged. At the new equilibrium there will be only a decrease in available quantity.
Figure 7: Equivalent change in demand and supply
(Source: as created by Author)
Given the situation where an increase in the supply of commercial apartment is associated with a decrease in demand of these apartments, there will be a change in both demand and supply condition. With a decline in demand and increase in supply price will reduce unambiguously (Maurice and Thomas 2015). However, the impact on quantity depends on the magnitude of demand and supply forces. Accordingly, the possible cases are classified into three cases.
Case 1
First consider the case where demand changes in a greater proportion than supply. The change in demand is shown as a shift in the demand curve from DD to D2D2 and change in supply is indicated from leftward shift of the supply curve. As demand changes more than supply, there is a decline in both price and number of houses.
Figure 8: a greater proportionate change in demand
(Source: as created by Author)
Case 2
A second possible case is where supply changes by a large magnitude as compared to demand. Under this circumstances the forces of supply dominate. As a result, there will be an increase in number of apartment while a decline in price.
Figure 9: A greater proportionate change in supply
(Source: as created by Author)
Case 3
One extreme situation is where demand and supply changes by the same magnitude. In this situation, the number of apartment remain unchanged (Tian 2016). There will be only a reduction in price.
Figure 10: Equivalent change in demand and supply
(Source: as created by Author)
The formal definition of price elasticity of demand signifies elasticity as a percentage change in demand resulted from a percentage change in price. Under mid-point method, price elasticity of demand is given as
The computed price elasticity of demand is -2.59.
The concept of elasticity is very crucial in practical life especially in business. The pricing decision of business depends on the measure of elasticity. Revenue of a business is obtained by multiplying quantity with volume of output. For goods having a relatively inelastic demand brings a larger revenue when price reduces. On contrary, if price of goods with elastic demand increases then demand reduces by greater proportion and hence dampens revenue. Elasticity again depends on nature of the commodity (McKenzie and Lee 2016). The elasticity value is estimated is -2.59. This means for 1 percent increase in price quantity demand will decrease by 2.59%. Hence, if the business owner raises price then it will reduce its revenue. Therefore, knowledge regarding elasticity value is important for the business owner.
Business conducts its operation with the objective of maximizing profit. Profit is the amount left to the firm after deducting total cost from its total earnings. Now total earning is quantity multiplied by unit price. Total cost of the firm includes both fixed and variable cost. In order to choose profit maximizing output, firms have two alternative approaches.
i)Total Revenue-Total Cost approach
Total Revenue- Total Cost approach
It is the direct approach towards maximizing profit. This method estimates profit as a difference between total revenue and total cost for every unit of output. The vertical distance between total revenue and total cost measures the profit. The quantity that maximizes the vertical distance is the profit maximizing output level. Graphically, this can be shown as follows
Figure 11: Total revenue – Total cost method
(Source: as created by Author)
In the above figure Q* shows the profit maximizing output choice. This occurs at point M where total revenue is maximized as well as total cost is minimized.
Marginal Revenue- Marginal Cost approach
Under this method, instead of considering total revenue and total cost, unit changes in the revenue and cost are considered. Unit change in total revenue is captured by marginal revenue and that of total cost is captured by marginal cost. Mathematically, first order condition for profit maximization requires marginal revenue to be equal to marginal cost. The second order condition is marginal cost curve cuts the marginal revenue curve from below.
Figure 12: Marginal revenue- marginal cost approach
(Source: as created by Author)
Under profit maximization, the equilibrium occurs at a point where marginal revenue equals marginal cost. In the above figure, E is the profit maximizing point with price and quantity equals P* and Q* respectively. The shaded region in the figure shows resulting profit.
References
Azevedo, E.M. and Leshno, J.D., 2016. A supply and demand framework for two-sided matching markets. Journal of Political Economy, 124(5), pp.1235-1268.
Case, K.E., Fair, R.C. and Oster, S., 2014. Principles of economics. Pearson Higher Ed.
Gershkov, A., Moldovanu, B. and Strack, P., 2016. Revenue Maximizing Mechanisms with Strategic Customers and Unknown Demand.
Li, N., Chen, L. and Dahleh, M.A., 2015. Demand response using linear supply function bidding. IEEE Transactions on Smart Grid, 6(4), pp.1827-1838.
Maurice, S.C. and Thomas, C., 2015. Managerial Economics. McGraw-Hill Higher Education.
McKenzie, R.B. and Lee, D.R., 2016. Microeconomics for MBAs: The economic way of thinking for managers. Cambridge University Press.
Tian, G., 2016. On the existence of price equilibrium in economies with excess demand functions. Economic Theory Bulletin, 4(1), pp.5-16.
Varian, H.R., 2014. Intermediate Microeconomics: A Modern Approach: Ninth International Student Edition. WW Norton & Company.
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