Economics

Economics

Elasticity of Demand

In markets with high concentration, it is the price elasticity of demand that will determine whether the supply will be predominantly spot driven or forward driven. Our analysis suggests various new hypotheses on the structure of supply in commodity markets. In the absence of demand uncertainty, the problem reduces to the one studied by Allaz and Vila (1993). They show that the ratio of forward sales to spot sales is an affine function of the number of (identical) producers in the market and the higher the number of producers, the higher the ratio. When there is uncertainty in demand and producers can buy-back some of the contractual quantity, then the problem reduces to the one studied by Allaz (1992).

Because production starts only after the uncertainty in demand is resolved and production plans can be changed instantaneously at no cost, he concludes that demand risk plays no role and market concentration remains as the only factor that determines the relative size of forward and spot markets in expectation, as in the Allaz and Vila (1993) model with deterministic demand (www.economicsonline.co.uk). However, such a frictionless setting is unrealistic for many industries where it is costly to modify production plans and firm quantity commitments between buyers and suppliers are the norm. Thus, it is wise to re-examine the effect of demand uncertainty on the supply structure under a different setting where the forward contract commitments are firm (Dang, 2012).

Cross-Price Elasticity (include substitutes and complements)

Price elasticity of demand measures how sensitive demand for a good or service is to a change in the price like how sensitive members are to a change in loan rates. Hence, when demand is uncertain, increased competition reduces the price fluctuations in the spot market. Even in periods of high (aggregate) demand, the equilibrium price will be close to the perfectly competitive price if there are enough sellers in the market. Thus, more intense competition implies lower price and availability risk for manufacturers as well as lower profit-making opportunities for speculators who buy in the forward market. However, there is a potentially high downside in the form of inventory risk that is, if demand turns out to be low and speculators and manufacturers are left with excess inventory (www.economicsonline.co.uk).

Income Elasticity (include normal and inferior goods)

The level of market concentration also plays a role, along with the price elasticity of demand, in determining how demand uncertainty affects ...