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Chapter 2

Chapter 2. The Basics of Supply and Demand. Outline. What are supply and demand? What is the market mechanism? What are the effects of changes in market equilibrium? What are elasticities of supply and demand? How do short-run and long-run elasticities differ?

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Chapter 2

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  1. Chapter 2 The Basics of Supply and Demand

  2. Outline • What are supply and demand? • What is the market mechanism? • What are the effects of changes in market equilibrium? • What are elasticities of supply and demand? • How do short-run and long-run elasticities differ? • How do we understand and predict the effects of changing market conditions • What are the effects of government intervention- price controls?

  3. Supplyand Demand • Supply and demand analysis can: • Help us understand and predict how world economic conditions affect market price and production • Analyze the impact of government price controls, minimum wages, price supports, and production incentives on the economy • Determine how taxes, subsidies, tariffs and import quotas affect consumers and producers

  4. The supply curve Price • The relationship between the quantity of a good that producers are willing to sell and the price of the good • Measures Q on the x-axis and P on the y-axis Qs = Qs (P) • Supply curve slopes upward demonstrating that at higher prices firms will increase output S P2 P1 Q1 Q2 Quantity

  5. Other variables affecting supply • Costs of Production - labor, capital and raw materials - Lower costs of production allow a firm to produce more at each price and vice versa • Suppose the cost of raw materials falls • Supply curve shifts right to S’ • Initially produce Q1 at P1 and Qo at P2 • Now produce Q2 at P1 and Q1 at P2 Price S S’ P1   P2   Qo Q1 Q2 Quantity

  6. Movement and shifting of supply curve • Changes in the quantity supplied - movement along the curve caused by a change in price • Change in supply - shift of the curve caused by a change in something other than price (such as change in costs of production due to changes in input prices, technology improvement and increase in number of producers)

  7. The Demand Curve Price • The relationship between the quantity of a good that consumers are willing to buy and the price of the good • Measures Q on the x-axis and price on the y-axis Qd = Qd (P) • Demand curve slopes downward demonstrating that consumers are willing to buy more at a lower price as the product becomes relatively cheaper P2 P1 D Q1 Q2 Quantity

  8. Other variables affecting demand • Income - increases in income allow consumers to purchase more at all prices - normal goods (positive) versus inferior goods (negative) • Consumer tastes • Price of related goods - substitutes (positive) - complements (negative) • Number of consumer

  9. Change in Demand Price • Income increases • Initially purchased Qo at P2 and Q1 at P1 • Now purchased Q1 at P2 and Q2 at P1 • Increase in income  ↑DD  demand curve shifts right P2   P1   D’ D Qo Q1 Q2 Quantity

  10. Movement and shifting of demand curve • Changes in the quantity demand - movements along the demand curve caused by a change in price • Change in demand - a shift of the entire demand curve caused by a change in something other than price (such as income, taste and preferences, number of consumer, etc)

  11. The market mechanism • Is the tendency in a free market for price to change until the market clears. • Markets clear when quantity demanded equals quantity supplied at the prevailing price. • Market clearing price – price at which markets clear.

  12. The market mechanism Price In equilibrium • There is no shortage or excess demand • There is no surplus or excess supply • Quantity supplied equals quantity demanded (Qd = Qs) • Anyone who wished to buy at the current price can buy and all producers who wish to sell at that price can sell their products. S Market equilibrium Po  D Qo Quantity

  13. Market surplus Price • The market price is above equilibrium • There is excess SS (surplus) • Downward pressure on price • Qd ↑ and Qs ↓ • Market adjust until new equilibrium is reached. S surplus P1 Po  E D Qd Qo Qs Quantity

  14. Market shortage Price • The market price is below equilibrium • There is excess DD (shortage) • Upward pressure on prices • Qd ↓ and Qs ↑ • Market adjust until new equilibrium is reached. S Po  E P1 shortage D Qs Qo Qd Quantity

  15. The Market Mechanism • Supply and demand interact to determine the market clearing price • When not in equilibrium, the market will adjust to alleviate a shortage or surplus and return to equilibrium. • Market must be competitive for the mechanism to be efficient.

  16. Changes in market equilibrium (SS change) Price • Initial equilibrium at A. • Suppose raw material prices fall • S shifts to S’ • Surplus at Po between Q1 and Q2 • Price adjust downward to reach equilibrium at P3 and Q3 S S’ surplus A Po   B  P3 D Q3 Q1 Q2 Quantity

  17. Changes in market equilibrium (DD change) Price • Suppose income increases • D shifts to D’ • Shortage at Po between Q1 and Q2 • Price adjust upward to reach equilibrium at P3 and Q3 D’ D S B P3  A Po   shortage Q3 Q1 Q2 Quantity

  18. Changes in market equilibrium (DD and SS change) Price • Initially market in equilibrium at A (P1, Q1) • Suppose income ↑ & raw material prices ↓. • Both DD and SS curve shifts rightward to D’ and S’. • New equilibrium at B (P2, Q2) • Price and quantity increases D’ D S S’ P2  B  P1 A Q1 Q2 Quantity

  19. Shifts in supply and demand • When supply and demand change simultaneously, the impact on the equilibrium price & quantity is determined by: • The relative size and direction of the change. • The shape of the supply and demand curve.

  20. An Application: Market for a College Education Price (annual cost) • The supply curve for a college education shifted up as the costs of equipment, maintenance and wages rose - increased costs of production (S1970 shifts to S2002). • DD curve shifted to the right as a growing number of high school graduates desired a college education (D1970 shifts to D2002). • Both price and enrollments rose sharply. s2002 S1970 $3,917 B  A $2,530  D2002 D1970 8.6 13.2 Quantity (millions enrolled)

  21. Elasticities of Supply and Demand • Not only are concerned with what direction price and quantity will move when the market changes, but we are concerned about how much they change • Elasticity gives a way to measure by how much a variable will change with the change in another variable. • It gives the percentage change in one variable resulting from a 1 % change in another.

  22. Price elasticity of demand • Measures the sensitivity of quantity demanded to price changes. • It measures the percentage change in the quantity demanded of a good that results from a one percent change in price • Can be written as: Ed = % Δ Qd % Δ P Ed = Δ Q/ Q X 100 Δ P/ P Ed = PΔ Q Q Δ P

  23. Price elasticity of demand • Usually a negative number because: • As price increases, quantity decreases • As price decreases, quantity increases • When Ed > 1, the good is price elastic (%ΔQ > %ΔP) • When Ed < 1, the good is price inelastic (%ΔQ < %ΔP)

  24. Linear demand curve and elasticity • Price elasticity of demand is the change in quantity associated with a change in price (Δ Q/ ΔP) times the ratio of price to quantity (P/Q). • As we move down the demand curve, Δ Q/ ΔP may change, and the P and Q will always change. • Thus, the price elasticity of demand must be measured at a particular point on the demand curve. • Suppose a linear demand curve is represented by : Q= a – bP  Q = 8 – 2P

  25. Price elasticity of demand P Ed = -  • Given a linear DD curve: • Elasticity depends on the slope and on the values of P and Q. • Top portion of DD curve is elastic – P is high and Q small. • The bottom portion of demand curve is inelastic – P is low & Q high. • The steeper the DD curve becomes, the more inelastic the good. • The flatter the demand curve becomes, the more elastic the good. • Two extreme cases of demand curve: • Completely inelastic demand – vertical • Infinitely elastic demand - horizontal elastic Ed = 1 2 inelastic Ed = 0 8 4 Q

  26. Extreme cases of demand curves Price Price Ed = 0 Ed = -  Quantity Quantity Completely elastic demand - horizontal Completely inelastic demand - vertical

  27. Other demand elasticities • Income elasticity of demand • Measures how much quantity demanded changes with a change in come. EI = Δ Q/ Q X 100 Δ I/ I EI = IΔ Q Q Δ I Normal good (positive) Inferior good (negative)

  28. Other demand elasticities • Cross-price elasticity of demand • Measures the percentage change in the quantity demanded of one good that results from a one percent change in the price of another good. • EQbPm = Δ Qb / Qb X 100 Δ Pm / P EQbPm= PmΔQb Qb ΔPm Complements : Gasoline and Cars : (negative) (Pgasoline ↑, Qcar demanded ↓) Substitutes: Butter and margarine (positive) (Pbutter ↑, Qmargarine demanded ↑)

  29. Price elasticity of supply • Measures the sensitivity of quantity supplied given a change in price. • measures the percentage change in the quantity supplied resulting from a one percent change in price • Can be written as: Es = % Δ Qs % Δ P Es = Δ Q/ Q X 100 Δ P/ P Es = PΔ Qs Qs Δ P

  30. Point versus Arc Elasticities • Point elasticity of demand • Price elasticity of demand at a particular point on the demand curve Example: Suppose P ↑ from $8 to $10 and Q↓ from 6 to 4 units. • Using original P & Q Ed = (4-6) / 6 X 100 = - 33 % = - 1.32 (10-8) / 8 X 100 25 % • Using new P & Q Ed = (4-6) / 4 X 100 = - 50 % = - 2.5 (10-8) / 10 X 100 20 % The difference between 2 calculated elasticities is large & neither seems preferable. Solve this problem by using arc elasticity of demand

  31. Arc elasticity of demand • Price elasticity of demand calculated over a range of prices • Ed = (ΔQ / ΔP) (Paverage / Qaverage) • ΔQ and ΔP = - 2 • Paverage = ( 8 + 10/2) = 9 • Qaverage = ( 6 + 4 / 2) = 5 • Ed = ( -2 / $2) ($9 / 5) = - 1.8

  32. Short-run vs long-run elasticity • To examine how much demand or supply changes in response to a change in price – must consider how much time is allowed for the quantity demanded or supplied to respond to the price change. • Short-run demand and supply curves look very different from the long-run. • Influenced by • Demand & durability • Income elasticities • Supply & durability

  33. Short-run vs long-run elasticity i. Demand and durability • For many goods – DD is more price elastic in long-run than short-run because it takes time for consumer to change their consumption habits. • E.g. if P of coffee rises , the Qd will fall only gradually • If P of gasoline rises, Qd decrease in the short-run but it has greatest impact on demand by inducing consumers to buy smaller & more fuel-efficient cars.

  34. Gasoline: Short-run and Long-run Demand Curves • In the short-run, an increase in price has only a small effect on the quantity of gasoline demanded. • Motorists may drive less, but they will not change the kinds of cars they are driving overnight. • In the long-run – there is tendency for drivers to shift to smaller and more fuel-efficient cars, so the effect of the price increase will be larger • Thus demand is more elastic in the long run than in the short run. P DSR DLR Q

  35. ii. Income elasticities • Also varies with the amount time consumers have to an income change. • For most goods & services – food, beverages, fuel, etc. – income elasticity of demand is larger in the long run than in the short run • This is because the change in consumption takes time, and demand initially increases only by a small amount. • The long-run elasticity will be larger than the short-run elasticity.

  36. Income elasticity of durable goods • Income elasticity of durable goods is less in the long-run than in the short-run • Example : Increase in income and purchase of cars • Increases in income mean consumers will want to hold more cars ( older cars will be replaced) • Less purchases from income increase in long run than in short run

  37. Elasticity of supply Supply and durability • Elasticities of supply also differ from the long run to the short run. • For most products (agricultural products), long run supply is much more price elastic than short run supply. • Firms face capacity constraints in the short run and need time to expand capacity by building new production and hiring workers. • The output can be expanded more in the long run than in the short run. • For some goods & services, short-run supply is completely inelastic. E.g. rental housing. • In short run, there is only fixed number of rental units. An increase in demand will only pushes rents up. Only in the long run the quantity supplied increases.

  38. Predicting the effects of changing market conditions • Given the equilibrium price (P*) and quantity (Q*) along with elasticities of supply (Es) and demand (Ed), the efffect of changes in the market can be calculated. • The equations for supply, demand, elasticity is represented by: • Demand: Qd = a – bP • Supply: Qs = c + dP • Elasticity: (P/Q) ( ΔQ/ Δ P) Ed = -b (P*/Q*) Es = d (P*/Q*) Slope of DD curve = ΔQ/ ΔP which equals -b Slope of SS curve = ΔQ/ ΔP which equals d

  39. Predicting the effects of changing market conditions Price Supply: Qs = c + dP a/b  P* -c/d Demand: Qd = a - bP Quantity Q*

  40. Effects of Price controls • Markets are rarely free of government intervention • Imposed taxes, grant subsidies and implement price controls • Price controls [price ceilings (max) and price floors (min)] usually hold the price above or below the equilibrium price. • When price is below equilibrium price – there is excess demand (shortage) • When price is above equilibrium price – there is excess supply (surplus)

  41. Effects of Price controls Price • Price is regulated to be no higher than Pmax • Qs falls and Qd increases • A shortage created in the market S Po E P max shortage D Quantity Qo Qs Qd

  42. Example 1 • Suppose the market demand and supply for rice is represented by Qd = 1,600 – 125P Qs = 440 + 165P • Calculate the equilibrium price and quantity? • Calculate the price elasticities of supply and demand at the equilibrium? • Suppose government has a $4.50 support price for rice. What impact will this support price have on the market?

  43. To calculate P* and Q*, equate Qd = Qs 1600 – 125P = 440 + 165P 1160 = 290P P* = $4 To obtain Q*, Qd = 1600 – 125P Qd = 1600 – 125 (4) Qd = 1100 2. Price elasticity of demand and supply Ed = ( ΔQ/ Δ P)(P/Q) = (-125) ( 4/1100) = - 0.45 Es = ( ΔQ/ Δ P)(P/Q) = (165) (4/1100) = 0.60

  44. 3. Support price = $4.50, calculate Qd and Qs at the new price ($4.50). Qd = 1600 – 125 (4.50) = 1037.5 Qs = 440 + 165 (4.50) = 1182.5 To determine the impact on market, Since Qs > Qd, there is surplus = Qs – Qd = 1182.5 – 1037.5 = 145 * The support price would create an excess supply of $145 that the government would be forced to buy to maintain the price at $4.50 .

  45. Example 2 The market for corn has been estimated to have these supply and demand relationships: Supply P = 10 + 0.01Q Demand P = 100 ‑ 0.01Q, where P represents price, and Q represents sales. i. Determine the equilibrium price and sales. ii. Determine the amount of shortage or surplus that would develop at P = $40/ton. Solution: The equilibrium price can be found by equating S to D in terms of Q. 10 + 0.01Q = 100 - 0.01Q 0.02Q = 90 Q = 4,500 tons/week P = 10 + 0.01(4,500) = $55/ton At P = $40/ton, the quantity demanded is: 40 = 100 - 0.01Q –or– Q = 6,000 tons/week The quantity supplied is: 40 = 10 + 0.01Q –or– Q = 3,000 tons/week Since Qd > Qs, the shortage is 3,000 tons/week.

  46. Example 3 • Suppose a new discovery in computer manufacturing has just made computer production cheaper. Also, the popularity and usefulness of computers continues to grow. How these shocks will affect equilibrium price and quantity of computers. Is there enough information to determine if market prices will rise or fall? Why?

  47. • Initially equilibrium at Po and qo. • Demand ↑ due to the usefulness of computers & will shift the demand curve to the right (Do to D1’ or D1’’). • This effect alone on the market will ↑market P and Q. • The reduction in the cost of producing computers will result in an ↑SS (a rightward shift of the supply curve from So to S1). • This effect alone on the market will ↓P of computers while the Q will ↑. • The supply and demand effects on price work in opposite directions. • If the SS effect dominates the DD effect, the equilibrium P will ↓. This is exhibited by the increase in DD to only D1’. On this demand curve, the net effect is for prices to fall from P0 to P1’. • On the other hand if the DD effect dominates, equilibrium P will ↑. This is exhibited by the increase in demand to D1’’. On this demand curve, the net effect is for prices to rise from P0 to P1’’. • Since the information on which effect dominates is not provided, we cannot perfectly predict the change in price. The change in quantity is unambiguously increased.   

  48. Summary • Supply and demand • market mechanism • Effects of changes in market equilibrium • Elasticities of supply and demand • Difference of short-run and long-run elasticities • Understand and predict the effects of changing market conditions (price controls) – mathematically and graphically • Examples

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