DEMAND AND CONSIDERATIONS OF BUYERS

BY: EDE KENECHUKWU KENNETH edekenechukwuk@gmail.com

The law of demand states that “as the price of goods rise, so less of that commodity will be purchased”. The question, then is seeking special circumstances when this law is broken. In order to find these, we must analyze the two effects of a price change. The substitution effect is concerned with changes in relative prices, while the income effect is concerned with changes in real income or purchasing power.

For a normal good, these two factors act in the same direction. A rise in the price of a commodity increases its price relative to other commodities and causes other goods to be substituted for it. A rise in the price of a commodity also reduces the individual’s real income in as much as he is now unable to purchase the same amount of commodities as before the price rise.

Usually, we expect this reduction in real income to cause a fall in demand. Hence, both the income and substitution effects operate in the same direction causing less of a commodity to be purchased when its price rises. The demand curve for such a commodity therefore slopes downwards as predicted by the law of demand.

For inferior goods, a fall in income is associated with a lager quantity being demanded. So the income effect of a price change is opposite to that of a normal good. Thus the income and substitution effects act in opposing directions. However, the demand curve would still slope downwards while the substitution effect was greater than the income effect. Only when the income effect is greater than substitution effects (and acts in the opposite direction) will the demand curve slope upwards. In this case the commodity is called a “Giffen good”.

This situation is illustrated in the fig 1 below which employs indifference theory for two commodities W and X. Given the individual’s income Y and initial prices P_W and P_X, we may construct his initial budget line FE, reflecting combinations of the two goods he could just afford to purchase if he spent all his income. Note that OF represents the amount of W he could buy if he purchased none of X.

i.e.

                         OF =  Y/PW

                         OE =Y/PX

Given also a set of convex indifference curves, each reflecting combinations of the two goods which yield equal satisfaction, then the highest indifference curve the individual can attain within his fixed budget will be one such as I₂ which just touches the budget line at point G. Here the amount of X purchased is OB, which is his utility maximizing quantity of X demanded at the price P_X, given constant values for Y and P_W.

Now consider the effect of a rise in the price of X to P_X¹. This causes the budget line to rotate inwards to FD. By the same reasoning as above

                        OD =                     

The highest indifference curve he can now attain is I₁, which just touches the new budget line at H, where an amount OC of X is purchased. Since OC exceeds OB, the quantity of X demanded has increased following a rise in its price. The demand curve therefore slopes upwards. As discussed above, this can only occur when the income effect acts in the opposite direction to the substitution effect and is greater in absolute magnitude. To determine the relative sizes of these income and substitution effects we require a third budget line F` D` drawn so as to have the same price ratio (and hence slope) as FD just touching I₂ at point J.

The substitution effect is caused purely by the change in relative prices, the individual being compensated for any change in real income so as to keep him on the same indifference curve I₂. In figure 1, the change in relative prices would cause the individual to move from G to J, hence the quantity of X demanded would fall from OB to OA.

The income effect is found by removing this income compensation, forcing the individual from J to H and increasing the quantity of X demanded from OA to OC. As this effect is greater than the substitution effect the overall impact on demand is positive. Thus, only when the income effect of a price change is greater than the substitution effect and acts in the opposite direction will the demand curve slope upwards. 

MONOPOLY POWER AND ECONOMIC CONSERNTRATION

AGRICULTURAL POLICY - COBWEB MODEL

AGRICULTURAL POLICY – COBWEB MODEL

BY: EDE KENNETH .K. & JOHN ANI .E.

Agricultural goods are subject to variations in production for a variety of natural reasons. Excess rainfall, drought, pests and disease occur sporadically to cause differences between the planned output and that actually harvested or produced. Now, the demand for foodstuff is typically inelastic, so that shortages will force up prices considerably and gluts will produce very low prices. If the elasticity of demand is – 0.25, for example, then when production falls by 10%, prices rise by 40%. This inherent instability has given rise to a history of government intervention in agricultural markets.

The objectives of such intervention have varied from time to time but two of the most popular advocated have been to stabilize either food prices or farmers’ income. Assuming the demand curve is relatively stable, price and income fluctuations will be caused by supply fluctuations. A simple way for the government to keep food prices constant would be for them to establish a “Buffer Stock”. Then in the time of scarcity when the shortage would have caused prices to rise the government releases sufficient stocks to keep the market price constant. In years of bumper crops, when the excess supply would have reduced prices considerably, the government adds to its stocks, again so as to maintain constant market prices.

Fig. below shows the level of planned output for each market price. D is the relatively inelastic market demand curve. P₁ and Q₁ represent the average market price and quantity sold respectively. When the actual output increases say to Q₂ the government buys (Q₂ – Q₁) to add to its stocks. When output falls below average, say to Q₃ then the government releases (Q₁ – Q₃) to be sold on the market.

This policy stabilizes farm prices completely at P₁ and given this would have been the average equilibrium price, the government can successfully operate this system indefinitely, provided it is prepared to subsidize  the scheme to the extent of covering the costs to storage, which are not recovered elsewhere.

The effect of such a price stabilization policy on farmers’ income may be seen as follows: whatever the level of current output, the farmers either sell it on the market at price P₁, or the government buys it to add to the buffer stocks, again at a price P₁, i.e. the farmers face a perfectly elastic demand curve at a price P₁. Thus, their income which is the total revenue (P x Q) they earn on the output they sell is directly proportional to the current output level. In poor years, their income will be low (as output is low), in good years, their output will be high (as output is high). Note that this effect on farmers’ income is the opposite of what would happen if the government had not intervened.

In order to stabilize farmers’ incomes, the government should stabilize their total revenue. If the farmers faced a demand curve for their product which was unitary elastic then their total revenue would be constant as the effect on revenue of quantity changes would be offset by compensating price changes. As we have said that market demand curve for agricultural goods is typically inelastic.

If the government chose to stabilize farmers’ income at their average level, i.e. at TR = P₁Q₁ in the fig above, then when fluctuation in output occur they must allow the market price to vary in the opposite direction by the same percentage amount, by adding or subtracting from their buffer stocks. Thus the actual demand curve facing producers D’ is unitary elastic and differs from the market demand curve D by the extent of government purchases or sales (the horizontal difference between D’ and D).

To maintain farmers’ income constant, when production falls to Q₃ we require a price P₅ (since P₁Q₁ = P₅Q₃ as both points lie on the same unitary elastic demand curve). At a price P₅, the market demand exceeds the producers’ output by an amount (Q₅ – Q₃), which the government must release from its buffer stock.

Stabilizing farmers’ incomes in this way reduce fluctuations in prices which would be observed in free markets and also may show an operating surplus. The government would add to its stocks when prices are low, and sell from them when prices are high. If storage costs are not excessive, this scheme will be profitable.

EQUILIBRIUM, DISEQUILIBRIUM, STATIC AND ANALYSIS

EQUILIBRIUM, DISEQUILIBRIUM, STATIC AND DYNAMICS CONDITIONS

BY: EDE KENECHUKWU KENNETH edekenechukwuk@gmail.com

Equilibrium is a state of balance; it is achieved at a point where two or more variables are equal. This is not to say that nothing changes but then rather than the actions are repetitive in nature. In the microeconomics model of demand and supply for instance, Q_dt is the planned quantity demanded per period of time while Q_st is the planned quantity supplied per period of time.

                             Q_dt     =       α       -         α₁P………………1

                             Q_st     =       α       +       α₁P………………2

The model is in equilibrium if

                             Q_dt     =       Q_st

This can be graphically illustrated as:

 From the above fig. quantity demanded and quantity supplied are at equilibrium at point E with price P₀. A shift in the supply curve from Q_SO to Q_S1 shifts the equilibrium from E to E₁. At point E₁ there are disequilibrium since we have excess supply.

STATIC AND DYNAMICS

In the static analysis only positions of equilibrium are considered while in the dynamic analysis the movement between one equilibrium position and another is explained. In constructing economic model, we incorporate time by splitting up into period and evaluating how what happened in one period affects the preceding periods and what expected to happen in the proceeding periods.

Specifically, the variables in the dynamic models are dated while variables in the static models are referred to the same period. The static analysis does not explain the process of change in a model because it ignores the passage of time. It can indicate the position of the model in a period but cannot reveal what the position will be in any other time. If the model is not changing but simply repeating the same result period after period, static analysis can reveal both where the system is in the present period and where is will be in the future period. We refer to this case as the stationary-state equilibrium because the equilibrium does not change from one period to another.

Dynamic analysis can only be applied to a model in which a single, non-shifting equilibrium position is established by the relationship among the variables. When static analysis is applied in a period of disequilibria, it can only show that for that particular period the values of the variables will be changing from that period to the next. Static analysis can explain why this is in disequilibrium, what is the relationship among the variables is useful for equilibrium and in what direction the system will move next. It cannot explain the actual process of adjusting from one equilibrium position to the next. It is only the dynamic analysis that can trace the adjustment path through time.

We can use demand and supply to illustrate static analysis. If the price and quantity combination in any period is not in equilibrium, price and quantity must change since equilibrium is assumed and demand and supply do not shift, the changes over time lead the model to this equilibrium position. There is no sufficient information to state what time path, price and quantity follow in adjusting to this new equilibrium, and it requires dynamic analysis. We use the method of dynamic comparative statics to compare the new equilibrium position with the initial equilibrium position.

Dynamic analysis needs some forms of adjustment mechanism to be specified. In the micro economics model of demand and supply, an excess supply brings a fall in price. Therefore, the rate of change in price is proportional to the excess demand or supply in the market.

                         ▲P        =       ¢(Q_d  - Q_s)………………………………1

Where: ▲P      =           change in price

                         Q_d          =       Quantity demanded

                         Q_s          =       Quantity supplied

                         Q_d          -         Q_s      =       Excess demand

                         ¢           =       the speed of adjustment.

If ¢ = 0 there will be no change in the price of the good. If the ¢ = α, the speed of adjustment will be high to the extent that there will be no disequilibrium. If ¢ ≤ 0≤ α, the speed of adjustment is finite. If both demand and supply are linear function of the price level then

Q_d                     =           α₀      -         α₁P………………………..2

Q_s                     =           β₀      -         β₁…………………………..3

Substituting for Q_d and Q_s in the equation (1) we have:

▲P                   =                     ¢(α0  -  β0) - ¢(α1         +       β1)……………4

COMPARATIVE ADVANTAGE AND ECONOMIES OF PRODUCTION

COMPARATIVE ADVANTAGE AND ECONOMIES OF PRODUCTION

BY: EDE KENECHUKWU KENNETH edekenechukwuk@gmail.com

International trade takes place because of differences in opportunity cost or comparative advantage. Trading economies will benefit by producing and exporting those commodities in which they have comparative advantage. Therefore, no country should lose by trading freely with another.

A country enjoys a comparative advantage when the opportunity cost of production (in terms of other goods) is lower than in other countries. Even if on country has a greater productivity than another in all commodities (i.e. enjoys an absolute advantage in all commodities) it will still benefit that country to specialize.

For simplification, consider two economies G and H, each capable of producing two goods Y and Z. Let us assume the G is technically more efficient than H in both commodities (G has an absolute advantage over H). This means that G uses fewer resources to produce one unit of either Y or Z than H.

Superficially, it would seem that G should not trade with H, since H uses more resources in production. But, this is not correct because the gains from trade are based on differences in opportunity costs, which are independent of many comparative advantages to explore from a nation.

For example, suppose the opportunity cost of producing one unit of Z in country G is sX, while in H it is tX, where s and t are constant. Without loss of generality, assume that s is greater than t. then the opportunity costs of the two commodities in the two countries may be represented below:

Country	Opportunity Cost of Y	Opportunity Cost of Z
G	1     y S	sX
H	1     y t	tX

                                                                                            Since S > t,    1/S < 1/tG has a comparative advantage in producing Y and a comparative disadvantage in producing Z. In the situation before we introduce trade, both countries would have to produce both commodities. Now consider the effect of allowing them to specialize and trade. If H increases its production of Y by one unit (by reducing output of X by tX and G produces one extra sX) then overall output of Y remains constant while output of X is raised by sX – tX = (s – t)X. Since s is greater than t, there is more X available, which can be distributed between the two countries. The rate of exchange will determine the proportion of additional output going to each country (i.e. who gains most from trade). Therefore, no country has to lose by trading with another, and both can gain.

This situation is depicted in the fig. above. There are two countries, each have a domestic production possibility curve, shown as PP_G and PP_H respectively. The slope of this curve is constant, reflecting the assumed constancy of opportunity costs. Country G specializes in X and H in Y. with an international exchange rate between the two opportunity costs then both countries gain by specialization and trade, as they may achieve combinations of both goods which lay beyond their domestic production boundaries. In the diagram, E_G and E_H indicate the trading possibilities open to both countries for a particular exchange rate. Thus country G could exchange an amount ED of X for HO of Y to reach Z_G. Consequently country H has obtained an amount OC (equal to ED) of X for GF (equal to HO) of Y to reach point ZB.

In practice, the assumption of a constant opportunity cost is not real. The Law of diminishing returns would suggest that in the short-run opportunity costs rise production of one commodity increases. This implies that economies will only partly specialize in producing goods until opportunity costs are equalized. In the lung-run however, there may be economies of scale derived from specialization, which would increase the gains from trade.