product or consumer demand, the term derived demand describes the demand for all producer goods and services. Although the demand for producer goods and services is related to the demand for the final products that they are used to make, this relation is not always as close as one might suspect.
In some instances, the demand for intermediate goods is less price sensitive than demand for the resulting final product. This is because intermediate goods sometimes represent only a small portion of the cost of producing the final product. For example, suppose the total cost to build a small manufacturing plant is $1 million, and $25,000 of this cost represents the cost of electrical fixtures and wiring. Even a doubling in electrical costs from $25,000 to $50,000 would have only a modest effect on the overall costs of the plant—which would increase by only 2.5 percent from $1 million to $1,025,000. Rather than being highly price sensitive, the firm might select its electrical contractor based on the timeliness and quality of service provided. In such an instance, the firm's price elasticity of demand for electrical fixtures and wiring is quite low, even if its price elasticity of demand for the overall project is quite high.
In other situations, the reverse might hold. Continuing with our previous example, suppose that steel costs represent $250,000 of the total $1 million cost of building the plant. Because of its relative importance, a substantial increase in steel costs has a significant influence on the total costs of the overall project. As a result, the price sensitivity of the demand for steel will be close to that for the overall plant. If the firm's demand for plant construction is highly price elastic, the demand for steel is also likely to be highly price elastic.
Although the derived demand for producer goods and services is obviously related to the demand for resulting final products, this relation is not always close. When intermediate goods or services represent only a small share of overall costs, the price elasticity of demand for such inputs can be much different from that for the resulting final product. The price elasticity of demand for a given input and the resulting final product must be similar in magnitude only when the costs of that input represent a significant share of overall costs.
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