ENGINEERING
ECONOMICS
WHAT
IS DEMAND ?
Demand
is defined as the amount of good or service a consumer is willing and able to
buy per period of time. It is essential to understand the term “willing and
able.” Many people want to buy products that they cannot afford at prices they
cannot pay. However, because they are not able to purchase the product, we
cannot include them in the demand.
The
Demand can be plotted on a graph or even shown in a table. It shows how
much of the product is desired at a certain price.
The
Demand Curve
The graph below shows a movement
along the curve, which
illustrates how price (P) affects the quantity demanded (QD). At Price P2
the QD is Q2. When the price increases to P1, then the QD falls to Q1.
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The Demand
Function
The
demand function shows the relation between the quantity demanded of a
commodity by the consumers and the price of the product. It is generally
represented by a straight line. To graph it, you need at least sets of data
points to show how many goods were purchased at what price.
The demand function represents
a more general relation between the price and demand for the good, but also the
relationship between the other determinants of demand and the demand
for the good.
The Law of
Demand
The Law
of Demand states that the quantity demanded for a good or service
rises as the price falls, ceteris paribus (or with all other things being
equal). The other-things-being-equal assumption is very important in law
because the demand for goods also varies with several other factors than just the price.
Therefore,
the Law of Demand is an inverse relationship between price and quantity
demanded. However, there are a few exceptions to this law such as Giffen
goods and Veblen goods.
Generally, the Law holds true because of two factors:
1. The Substitution Effect
The Substitution Effect occurs when there is a change
in the price of a product. For example, we say that the price of olive oil has
gone up. In comparison to olive oil, other cooking oils such as canola oil or
peanut oil suddenly seem less expensive. Therefore, people will switch to a
close substitute if the price goes up and the demand will increase.
To
put it another way, if the price of a substitute of good X goes up, then good
will become relatively cheaper and people will move towards good X. There will
be an increase in demand for good X.
To take a real-world example, consider Coke and Pepsi.
They are universally recognized to be good substitutes for each other. The
Substitution Effect states that when the price of Coke goes up, then more
people will more likely purchase Pepsi.
2. The Income Effect
The Income Effect also occurs when there is a change
in the price of a product. For example, let’s say you buy four loaves of bread
a month and then one day the price of a loaf of bread goes up. This increase in
price will likely mean that you cannot afford to buy four loaves. Instead, you
buy two. You’ve lowered your demand for bread because the price increase has
reduced your disposable income. You won’t necessarily stop buying bread or
switch over to something cheaper; you buy less.
Stated differently, if the
price of good X rises, then the consumer’s purchasing power will drop and
then people will tend to buy less of good X will the same income. The Income
Effect simply means that when a good becomes more expensive then people can
afford less of it
Determinants Of Demand
The determinants of demand are
factors that cause fluctuations in the economic demand for a product or a
service. A shift in the demand curve occurs when the
curve moves from D to D₁, which can lead to a change in the quantity demanded
and the price. There are six determinants of demand.
These
six factors are not the same as a movement along the demand curve, which is affected by price or
quantity demanded. A shift can be an increase in demand, moves towards the
right or upwards, while a decrease in demand is a shift downwards or
to the left.
An increase or decrease in any of these factors affecting demand will
result in a shift in the demand curve. Depending on whether it is an inward or
outward shift, there will be a change in the quantity demanded and price.
1. Normal Goods
When there is an increase in the
consumer’s income, there will be an increase in demand for a good. If the
consumer’s income falls, then, there will be a fall in demand.
2. Change in Preferences
If there is a change in preferences, then there
will be a change in demand. For example, yoga became mainstream a couple
of years ago, and health enthusiasts promoted its benefits. This trend led
to an increase in demand for yoga classes.
3.
Complimentary Goods
When there is a decrease
in the price of compliments, then the demand for its compliments will
increase. Complementary goodsare goods you usually
buy together, like bread and butter, tea and milk. If the price of one
goes up, the demand for the other good will fall. For example, if the price of
yoga classes fell, then there would be an increase in demand for yoga mats.
4.
Substitutes
An increase in the price of substitutes will
affect the demand curve. Substitutes are goods that can consumers buy
in place of the other like how Coca-Cola & Pepsi are very close
substitutes. If the price of one goes up, the demand for the other will rise.
For example, if meditation classes became more expensive, then there would be
an increase in demand for yoga classes.
5.
Market Size
If the size of the market increases, like if
a country’s population increases or there is an increase in the number of
people in a certain age group, then the demand for products would increase.
Simply put, the higher the number of buyers, the higher the quantity
demanded. For example, if the birth rate suddenly skyrocketed, then there would
be an increase in demand for baby products.
6. Price Expectations
When there is an expectation
of a price change, this means that people expect the price of a good to increase
shortly. These people are then more likely to purchase sooner, which would
increase demand for the product. For example, if people are expecting the price
of a laptop to fall, then they will delay their purchase until the price lowers.
Demand
is said to be elastic demand has a higher proportionate response to a
smaller change in price. On the other hand, demand is inelastic when there is
little movement in demand with a significant difference in price.
Price
Elasticity of Demand is also the slope of the demand curve.
We can calculate the slope as “rise over run.”
or example, if I increase the price of a mobile phone from Rs3000 to
Rs5000, then how much can I expect my demand to fall? This answer will depend
on various factors mentioned below that will help the firm calculate its Price
Elasticity of Demand.
Factors Affecting Price
Elasticity of Demand
1. Substitutes
If there is a greater
availability of substitutes,
then the good is likely to be more elastic. For example, if the price of
one soda brand goes up, people can turn to other brands. So, a small change in
price is likely to cause a greater fall in quantity demanded.
2.
Necessities
If a good is a necessity, then the demand tends
to be inelastic. For example, if the price for drinking water rises, then
there is unlikely to be a huge drop in the quantity demanded since drinking
water is a necessity.
3.
Time
Over time, a good tends to become more elastic because
consumers and businesses have more time to find alternatives or substitutes.
For example, if the price of gasoline goes up, over time people will
adjust for the change, i.e., they may drive less or use public transportation
or form carpools.
4. Habit
The demand for addictive or
habitual products is usually inelastic. This is because the consumer has no
choice but no pay whatever the producer is demanding. For example, if the
price for a pack of cigarettes goes up, it will likely not have any effect on
demand.
Uses of
Price Elasticity of Demand
- Allows a firm
or business to predict the change in total revenue with a projected change
in price.
- Firms can
charge different prices in different markets if elasticities differ in
income groups. This practice is known as price discrimination.
For example, airlines have segmented airplane seats into different classes
– economy, business and first in order to charge the less price sensitive
customer a higher price for premium seats.
- Allows a firm
to decide how much tax to pass on to a consumer. If a
product is inelastic, then the firm can force the customer to pay the tax.
This is a common tactic used by cigarette manufacturers who pass on any
health tax directly to the consumer.
- Enables the
government to predict the impact of taxation policies on products.
Elasticity of Demand
How much does quantity demanded change
when price changes? By a lot or by a little? Elasticity can help us understand
this question. The of elasticity of
demand determines such as availability of substitutes,
time horizon, classification of goods, nature of goods (is it a necessity or a
luxury?), and the size of the purchase relative to the consumer’s budge
MARKET STRUCTURE
Monopolistic Competition
In Monopolistic Competition, there are many small firms who all have
minimal shares of the market. Firms have many competitors, but each one sells a
slightly different product. Firms are neither price takers (perfect
competition) nor price makers (monopolies).
Example
In Monopolistic Competition, there are many small firms who all have
minimal shares of the market. Firms have many competitors, but each one sells a
slightly different product. Firms are neither price takers (perfect
competition) nor price makers (monopolies).
Characteristics of Monopolistic completion
1. Product Differentiation
Products are differentiated (based
on things like service, quality or design). The product of a
firm is close, but not a perfect substitute for another firm. This
differentiation gives some monopoly power to an individual firm to influence
the market price of its product.
2.
Barriers to Entry
There are no barriers to
entry. It ensures that there are neither supernormal profits nor
any supernormal losses to a firm in the long run.
3.
Number of Sellers
There are large numbers of firms selling closely
related, but not homogeneous products. Each firm acts independently and has a
limited share of the market. So, an individual firm has limited control over
the market price.
4.
Marketing
Products are differentiated, and these differences are
made known to the buyers through advertisement and promotion. These
costs constitute a substantial part of the total cost under monopolistic
competition.
MONOPOLY MARKET STRUCTURE
In a Monopoly Market
Structure, there is only one firm prevailing in a particular industry. However,
from a regulatory view, monopoly power exists when a single firm controls 25%
or more of a particular market. For example, De Beers is known to
have a monopoly in the diamond industry.
A Natural Monopoly Market
Structure is the result of natural advantages like a strategic location or
an abundance of mineral resources. For example, many Gulf countries have
a monopoly in crude oil exploration because of abundant naturally
occurring oil resources.
ADVANTAGE OF MONOPOLY
Characteristics
of a Monopoly Market Structure
The following are key features that are
typically found in a monopoly market structure:
1. A Lack of Substitutes
One firm producing a good without close substitutes. The product is often
unique. Ex: When Apple started producing the iPad, it arguably had a monopoly
over the tablet market.
2. Barriers to Entry
There are significant barriers to entry set up by the
monopolist. If new firms enter the industry, the monopolist will not
have complete control of a firm on the supply. These barriers
imply that under a monopoly there is no difference between a firm and an
industry.
3. Competition
There are no close competitors in the market for that product.
4. Price Maker
The monopolist decides the price of the product, since it has the market
power. This makes the monopolist a price maker.
5. Profits
While a monopolist can maintain supernormal profits in the long run, it doesn’t
necessarily make profits. A monopolist can be a loss making or revenue
maximizing too. This is not possible under perfect competition. If
abnormal profits are available in the long run, other firms will enter the
competition with the result abnormal profits will be eliminated.
1. Stability of prices
In
a monopoly market structure the prices are pretty stable. This
is because there is only one firm involved in the market that sets the
prices since there is no competing product. In other types of market structures
prices are not stable and tend to be elastic as a result of the
competition.
2. Economies of Scale
Since
there is a single seller in the market it leads to economics of
scale because big scale production which lowers the cost per unit for
the seller. The seller may pass this benefit down to the consumer in terms
of a lower price.
3. Research and Development
Since the monopolist is making abnormal or
supernormal profits, the firm can invest that money into research and
development. Customers may get better a quality product at reduced
price leading to enhanced consumer surplus and satisfaction.
Oligopoly Market Structure
In an
Oligopoly market structure, there are a few interdependent firms dominate the
market. They are likely to change their prices according to
their competitors. For example, if Coca-Cola changes their price, Pepsi is
also likely to. In the wireless cell phone service
industry, the providers that tend to dominate the industry are Verizon, Sprint,
AT&T and T-Mobile. Similarly, for smartphone operating systems,
Android, iOS and Windows are the most prevalent options.
1. Interdependence
There are a few interdependent firms that cannot act independently. Firms operating in an oligopoly market with a few competitors must take the potential reaction of its closest rivals into account when making its own decisions.
2. Barriers to Entry
There are a few barriers to entry and exit. Some of these markets require large economies of scale for firms to be viable. They could also require scarce resources to operate like slots at an airport. Firms often try to lower their price as much as possible to deter new entrants. They also heavily advertise and often employ loyalty programs.
3. Information
The market is characterized by imperfect knowledge, where customers don’t know the best price or availability.
Duopoly
Market Structure
A duopoly is a kind of
oligopoly: a market dominated by a small number of firms. In the case of a
duopoly, a particular market or industry is dominated by just two firms (this
is in contrast to the more widely-known case of the monopoly when just one
company dominates).In very rare cases, this means they are the only two firms
in the entire…
A duopoly is a kind of oligopoly:
a market dominated by a small number of firms. In the case of a duopoly, a
particular market or industry is dominated by just two firms (this is in
contrast to the more widely-known case of the monopoly when just one
company dominates).
In very rare cases, this means they are the only two
firms in the entire market (this almost never occurs); in practice, it usually
means the two duopolistic firms have a great deal of influence, and their
actions, as well as their relationship to each other, powerfully shape their
industry. Duopolistic markets are imperfectly competitive, so entry
barriers are typically significant for those attempting to enter the
market, but there are usually still other, smaller businesses persisting
alongside the two dominant firms.
- Smartphones: Apple and Android
- Electronic payments: MasterCard and Visa
- Soft drinks: Coca-Cola and Pepsi
- High-end auctions for art and antiques: Sotheby’s and Christie’s
- Aircraft manufacture: Boeing and Airbus
- Shipping: UPS and FedEx (although this is in decline, with players like Amazon and USPS gaining traction)
