Initial, Reversionary & Equivalent Yields

In this video I conceptually explain initial, reversionary and equivalent yields. This is fundamental to understanding how property is valued.

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The Graphical Representation of PED

Price Elasticity of Demand (PED) can look like one of the three graphs shown below:

 
So what is the diagram above?

The diagram above shows the three different shapes you may expect to see a demand curve – remember that a demand curve can look like anything though. As I say in my theory of demand video, theoretically demand could even be upward sloping if for example we are looking at an antique painting or designer handbag where as price increases so does the demand.

What different PEDs do the demand curves represent?

D0 – This represents the standard demand that most products have which is that demand falls from the highest prices the curve is elastic. This is because when prices fall more people are able to afford it (income effect). Then as we go to that bendy bit in the middle (sorry to write in such an informal manner) we see unitary elasticity where the percentage changes in demand are equal to the percentage changes in prices. The last vertical but shows inelasticity. When prices are low to begin with there is a limit to how much demand can increase when prices fall further. Compare the difference when a price falls from £20 to £10 and that of £2.50 to £1.25.

D1 – This is an absolutely inelastic demand curve. No matter how much price changes demand is not affected. This is a more theoretical concept than one that exists in real life. An example of a good which has almost zero elasticity like this curve is the class A drug Heroin. No matter how much price increases demand is not likely to be affected because people are addicted and are prepared to pay the premium. However, even the demand for heroin is not absolutely inelastic simply because the price will affect the demand from those who want to try the drug for the first time. [Please note I am not trying to encourage drug abuse – I’m simply using it to prove a point]

D2 – This is the opposite to D1. This is an infinitely elastic demand curve. What this means is that any changes in price will kill all the demand as demand is only present for that particular price. Again this is a more theoretical abstract concept than one that actually exists in real life. For example, a good may be valued at £5 and any increase even £5.01 will kill demand 100% because people are not prepared to pay even a pence more. It is the same if the price were to fall to £4.99. The demand is absolutely elastic meaning that it is 100% affected by changes in price.

The Theory of Supply

What is the theory of supply?
At higher prices, a larger quantity will generally be supplied than at lower prices, ceteris paribus (all other thing being constant). So at a lower price a smaller quantity is produced.

This simply describes the upward sloping supply curve. The curve denotes that there is a ‘positive’ or ‘direct’ relationship between price and quantity. As one factor increases so does the other.

But why does this happen?

Suppliers have the incentive of profits, if a crop is doing well they will try and shift supply up so that they can make more profits.
The law of increasing opportunity costs means that as you increases supply of one good you must sacrifice greater and greater amounts of other resources. Therefore, as output increases , costs of producing goods increases thus the supplier must charge higher prices.

The supply curve

A supply schedule is simply a table of data showing the quantity that suppliers plan to supply at each level e.g.

A supply curve is a line which shows the quantity that suppliers plan to supply at each level e.g.:

Notice that as price increases the level of supply increases. (Positive correlation)

Shifts

The supply can shift left of right if there is a change in the quantity that supplier would supply at every price.

For example in this diagram we can see that the supply shifts to the right which is an increase in supply.
At price of P1, we can see supply increase (Sorry not that clear on this particular diagram) Notice a shift in the opposite direction from S1 to S0 would be a decrease in supply.

What causes these shifts to occur?

A shift in supply is caused by non-price determinants. There are 5 main ones you need to know:

1. Changes in costs of production: The lower the costs the greater the profit for producers. Examples of this are; input prices (raw material, rent etc.) , changes in technology (e.g. internet) , organisational changes , subsidies and taxes.

2. Profitability of alternatives; if another good becomes more profitable then a firm will switch t produce more of that e.g. the transition between cd players to MP3 players.

3. Profitability of goods in joint supply; If the supply of one good e.g. cattle increases then so will the joint good e.g.leather

4. Random shocks e.g. strikes, weather, wars, earthquakes etc.

5. Expectations of future price changes; for example if a firm expects price to rise they will either produce more or hold onto stock.

IMPORTANT:
NON-PRICE DETERMINANTS CAUSES SHIFTS AND PRICE DETERMINANTS CAUSES MOVEMENTS ALONG SUPPLY CURVE.

Need more help…check my video out!

Consumer Surplus

This is a short explanation of consumer surplus. I hope this helps make things simpler

In any given product there will be demand no matter what the price. I realise the magnitude of the demand may vary but the point is if, for example we are looking at the demand for exercise machines – whether the price is £400 or £4 there will always be someone ready to buy it (the amount of people who want to buy it will vary with the price).

We can see a similar situation in reality whether it is Primark or Harrods there is still a demand just the amount of it varies.

Now you must be wondering how does consumer surplus fit into this but it does. The market equilibrium for exercise machines may be £100 so the vast majority of supply will sell them for £100. If we imagine that all suppliers sold them for £100 then the consumers who were already ready to pay to pay over £100 will be gaining an advantage. It is almost like a profit they are making.

Subsequently, consumer surplus is defined as the value that consumers gain from consuming a good or service over and above the price paid.

We can see this clearly in a diagram:

The orange bit shows the consumer surplus – the consumers who are benefitting from the current market equilibrium price.

However, this is not all your need to know! You must know how to valuate consumer surplus. This is done through simple maths…calculating area of a triangle.

The formula for the area of a triangle is 0.5 X Base X height…

So in the diagram above the quantity OP1 is equal to the base which in this case is 100. The next bit is to identify the height and this is the difference between the market equilibrium price and the price where the demand is lowest. In this case it is the from £50 to £100 so the height is 50 (100-50).

The we multiply 50 by 100 by 0.5 and we get a consumer surplus of 2500.

That is how simple it is….

However, in exams the may frighten you by shifting the demand curve and saying what is the new consumer surplus. So remember the same principles apply you are looking at the price where there is demand is lowest and the new equilibrium price!

In economics consumers always just feel price changes.

What I have learnt when doing questions is that I miss read the questions so you have to be careful as to whether the question says what is the difference in the consumer surplus and what is the consumer surplus.

I hope this helps 🙂

Income Elasticity of Demand (YED)

Income elasticity of demand = YED

What is income elasticity of demand?

It is the responsiveness/sensitivity of demand to income.

How do economists calculate income elasticity of demand?

Income elasticity of demand = Percentage change in quantity demanded
Percentage change in income

How do you interpret income elasticity of demand values?

If YED has a negative value (i.e. less than zero)…

The good is an inferior good. Demand decreases as income increases. It is a negative correlation. For example ASDA’s Smart Price notebooks.

If YED is between 0 and 1…

The good is a necessity – it is income inelastic. Demand will increase if income increases, although demand will increase by a smaller percentage than what income will increase by. For example, If income rises by 10% then demand for lets say apples will increase by less than 10%.It has a positive correlation.

If YED is greater than 1…

This good is a luxury, a normal good. Demand will increase as income increases. The good is income elastic. However this time if income increases by 10% the demand for lets say TVs will increase by more than 10%.

Want to test yourself?

Try out this quiz – beware it contains other elasticities too!

http://wps.aw.com/aw_miller_econtoday_14/60/15397/3941646.cw/content/index.html

Demand

What is demand?

It is desire from consumers for a particular good/service/commodity.
The demand curve…
demand_supply_demand1
The demand curve shows the quantity demanded by consumers at each price of a good/service.
Price and demand are inversely related i.e. as price increases the quantity demand decreases. This describes the demand curve is downward sloping.
There are two reasons one must know for why price and demand have an inverse relationship.

1. The real income effect

As the price of a good/service increases it will eat a bigger chunk of the consumers income making them feel poorer so there are only a few people who are rich enough not to feel this impact. Also, the purchasing power has decreased (and all this means is that only a few people can afford expensive goods and services as they have the financial power.)
2. The substitution effect
This is that in our economy there is a lot of competition which keep prices low which is good for consumers. This means that there are many alternatives to the particular product you are looking for. For example if you wanted to buy window cleaning spray and saw it was £5.99 that may be relatively expensive for you so you might go into another shop and buy a different brand or similar cleaning product which will be cheaper therefore as the price of a good increases the demand decreases as consumers’ will switch to alternatives.

Important key term:

Demand schedule: This is a table showing quantity demanded by consumers at each price level. This is table used to draw a demand curve.

Demand Schedule
What about shifts?
Well a shift in the demand curve will only exist if a non-price determinant changes and the quantity demanded by consumers changes at every price.
shift of demand
In the demand curve above we can see that the demand for shares has decreased and this can be for several reasons.

Why does the demand curve shift?

1. Tastes – social trends and fashion changes and this affects the demand for a good, For example at one point cassettes were very popular but as soon as CDs came the fashion changed to listening to CDs. The demand for cassette tapes decreased.

2. Income – If income increases then people have more purchasing power so the demand at every price level will increase. Vice versa if incomes suddenly decreased than the demand would decrease as people do not have a strong purchasing power.

3. Price of substitutes – substitutes as we mentioned before are alternatives. So if these decrease people are likely too buy more of them as their consumer surplus increases. This means that the good itself will incur a reduction in demand. For example if Pantene Pro-V hairspray became cheaper the demand for L’oreal hairspray would decrease because people would switch to the pantene Pro-V hairspray.

4.The price of complements – these are goods which complement each other i.e. go with each other. For example tea and milk. If the price of complement increases then the demand decreases. So for example if the price of milk rises then the demand for tea will decrease as people may switch tcheapero other cheaper alternative like black coffee or herbal tea,

5. Expectation of future price change – this doesn’t tend to be as big as other factors. But in markets such as the housing industry or the share it has a big impact. If for example houses were supposed to increase prices in the future then the demand for houses will increase because people will wan to buy as they know they can sell it at a later date for a profit.

6. Population increase/migration- If there are more people then the demand for a product is likely to be be bigger. The two main ways in which a population can change are (i) population increase/ decrease through baby boom or increased availability of contraception and (ii) migration – this means people moving in and out of a country.

7. Distribution of income – This is by far the most interesting one. this suggest if the government increased taxes or benefits to the poor then demand for necessities will increase as that is what poor people will demand and the demand for luxuries will decrease as rich people loose some of their purchasing power for it,

Quiz:

1. Demand for a normal product may cause the demand curve to shift outwards if…
a) price increases
b) price decreases
c)the price of a substitute falls
d) the price of a substitute rises.

2.A decrease in income should:
a) Shift demand for an inferior product outwards
b) Shift demand for an inferior product inwards
c) Shift supply for an inferior product inwards
d) Shift supply for an inferior product outwards

Answers under photo…

ANSWERS!

1) D- The demand curve will only shift outwards because of non-price factors such as the price of substitutes. If the price of substitutes increases then people are more likely to switch and buy this product. For example; orange juice and apple juice are close substitutes and if the price of apple juice goes people more people will be attracted to buy orange juice.

2) A – if income decreases then the quantity demand of an inferior will increase as they have an inverse relationship. Supply is not affected by the income elasticity of a product.