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Chapter 2

Chapter 2. The Basics of Supply and Demand. Introduction. 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?. Supply and Demand. Supply and demand analysis can:

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Chapter 2

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  1. Chapter 2 The Basics of Supply and Demand

  2. Introduction • 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? Chapter 2

  3. Supply and Demand • Supply and demand analysis can: • Help us understand and predict how economic conditions affect market price • Analyze the impact of government price controls, minimum wages, and price supports • Determine how taxes, subsidies, tariffs and import quotas affect consumers and producers Chapter 2

  4. Supply and Demand • The Supply Curve • The relationship between the quantity of a good that producers are willing to sell and the price of the good. • Measures quantity on the x-axis and price on the y-axis Chapter 2

  5. S P2 P1 Q1 Q2 The Supply Curve Price ($ per unit) The Supply Curve Graphically The supply curve slopes upward demonstrating that at higher prices firms will increase output Quantity Chapter 2

  6. The Supply Curve • Other Variables Affecting Supply • Costs of Production • Labor • Capital • Raw Materials • Lower costs of production allow a firm to produce more at each price and vice versa Chapter 2

  7. S S’ P1 P2 Q0 Q1 Q2 Change in Supply P • The cost of raw materials falls • Produced Q1 at P1 and Q0 at P2 • Now produce Q2 at P1 and Q1 at P2 • Supply curve shifts right to S’ Q Chapter 2

  8. The Supply Curve • Change in 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 • Change in costs of production Chapter 2

  9. Supply and Demand • The Demand Curve • The relationship between the quantity of a good that consumers are willing to buy and the price of the good. • Measures quantity on the x-axis and price on the y-axis Chapter 2

  10. P2 P1 D Q2 Q1 The Demand Curve Price ($ per unit) The demand curve slopes downward demonstrating that consumers are willing to buy more at a lower price as the product becomes relatively cheaper. Quantity Chapter 2

  11. The Demand Curve • Other Variables Affecting Demand • Income • Consumer Tastes • Price of Related Goods • Substitutes • Complements Chapter 2

  12. D P D’ P2 P1 Q0 Q1 Q2 Q Change in Demand • Income Increases • Purchased Q0, at P2 and Q1 at P1 • Now purchased Q1 at P2 and Q2 at P1 • Same for all prices • Demand Curve shifts right Chapter 2

  13. The Demand Curve • Changes in quantity demanded • Movements along the demand curve caused by a change in price. • Changes in demand • A shift of the entire demand curve caused by something other than price. • Income • Preferences Chapter 2

  14. The Market Mechanism • 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 Chapter 2

  15. S Price ($ per unit) P0 D Quantity Q0 The Market Mechanism The curves intersect at equilibrium, or market- clearing, price. Quantity demanded equals quantity supplied at P0 Chapter 2

  16. The Market Mechanism • In equilibrium • There is no shortage or excess demand • There is no surplus or excess supply • Quantity supplied equals quantity demanded • Anyone who wished to buy at the current price can and all producers who wish to sell at that price can Chapter 2

  17. Market Surplus • The market price is above equilibrium • There is excess supply - surplus • Downward pressure on price • Quantity demanded increases and quantity supplied decreases • The market adjusts until new equilibrium is reached Chapter 2

  18. Price ($ per unit) S Surplus P1 P0 D Quantity QD Q0 QS The Market Mechanism • Price is above the market clearing price – P1 • Qs > QD • Price falls to the market-clearing price • Market adjusts to equilibrium Chapter 2

  19. The Market Mechanism • The market price is below equilibrium: • There is a excess demand - shortage • Upward pressure on prices • Quantity demanded decreases and quantity supplied increases • The market adjusts until the new equilibrium is reached. Chapter 2

  20. Price ($ per unit) S P3 P2 D Shortage Quantity QS QD Q3 The Market Mechanism • Price is below the market clearing price – P2 • QD > QS • Price rises to the market-clearing price • Market adjusts to equilibrium Chapter 2

  21. 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 the market to equilibrium. • Markets must be competitive for the mechanism to be efficient. Chapter 2

  22. Changes In Market Equilibrium • Equilibrium prices are determined by the relative level of supply and demand. • Changes in supply and/or demand will change in the equilibrium price and/or quantity in a free market. Chapter 2

  23. D P S S’ P1 P3 Q1 Q3 Q Q2 Changes In Market Equilibrium • Raw material prices fall • S shifts to S’ • Surplus at P1 between Q1, Q2 • Price adjusts to equilibrium at P3, Q3 Chapter 2

  24. D D’ P S P1 P3 Q1 Q3 Q2 Q Changes In Market Equilibrium • Income Increases • Demand increases to D1 • Shortage at P1 of Q1, Q2 • Equilibrium at P3, Q3 Chapter 2

  25. P2 P1 D P D’ S S’ Q1 Q2 Q Changes In Market Equilibrium • Income Increases & raw material prices fall • Quantity increases • If the increase in D is greater than the increase in S price also increases Chapter 2

  26. Shifts in Supply and Demand • When supply and demand change simultaneously, the impact on the equilibrium price and quantity is determined by: • The relative size and direction of the change • The shape of the supply and demand models Chapter 2

  27. The Price of a College Education • The real price of a college education rose 55 percent from 1970 to 2002. • Increases in costs of modern classrooms and wages increased costs of production – decrease in supply • Due to a larger percentage of high school graduates attending college, demand increased Chapter 2

  28. S2002 P (annual cost in 1970 dollars) $3,917 S1970 $2,530 D2002 D1970 Q (millions enrolled)) 8.6 13.2 Market for a College Education New equilibrium was reached at $4,573 and a quantity of 12.3 million students Chapter 2

  29. Elasticities of Supply and Demand • Not only are we 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. • Specifically, it gives the percentage change in one variable resulting from a one percent change in another. Chapter 2

  30. 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. Chapter 2

  31. Price Elasticity of Demand • The percentage change in a variable is the absolute change in the variable divided by the original level of the variable. • Therefore, elasticity can also be written as: Chapter 2

  32. Price Elasticity of Demand • Usually a negative number • As price increases, quantity decreases • As price decreases, quantity increases • When EP > 1, the good is price elastic • %Q > % P • When EP < 1, the good is price inelastic • %Q < % P Chapter 2

  33. Price Elasticity of Demand • The primary determinant of price elasticity of demand is the availability of substitutes. • Many substitutes demand is price elastic • Few substitutes demand is price inelastic Chapter 2

  34. Price Elasticity of Demand • Looking at a linear demand curve, as we move along the curve Q/P will change • Price elasticity of demand must therefore be measured at a particular point on the demand curve • Elasticity will change along the demand curve in a particular way Chapter 2

  35. Price Elasticity of Demand • Given a linear demand curve • Elasticity depends on slope and on the values of P and Q • The top portion of demand curve is elastic • The bottom portion of demand curve is inelastic Chapter 2

  36. EP = - Price 4 Elastic Ep = -1 2 Inelastic Ep = 0 4 8 Q Price Elasticity of Demand Demand Curve Q = 8 – 2P Chapter 2

  37. Price Elasticity of Demand • The steeper the demand curve becomes, the more inelastic the good. • The flatter the demand curve becomes, the more elastic the good • Two extreme cases of demand curves • Completely inelastic demand – vertical • Infinitely elastic demand - horizontal Chapter 2

  38. Price D P* Quantity Infinitely Elastic Demand EP =  Chapter 2

  39. Price Quantity Completely Inelastic Demand D EP = 0 Q* Chapter 2

  40. Other Demand Elasticities • Income Elasticity of Demand • Measures how much quantity demanded changes with a change in income. Chapter 2

  41. 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. Chapter 2

  42. Other Demand Elasticities • Complements: Cars and Tires • Cross-price elasticity of demand is negative • Substitutes: Butter and Margarine • Cross-price elasticity of demand is positive Chapter 2

  43. Price Elasticity of Supply • Measures the sensitivity of quantity supplied given a change in price • Measures the percentage change in quantity supplied resulting from a 1 percent change in price. Chapter 2

  44. Effects of Price Controls • Markets are rarely free of government intervention • Imposed taxes and granted subsidies • Price controls • Price controls usually hold the price above or below the equilibrium price • Excess demand – shortage • Excess supply - surplus Chapter 2

  45. Price S P0 Pmax Shortage D Q0 QD QS Quantity Effects of Price Controls • Price is regulated to be no higher than Pmax, • Quantity supplied falls and quantity demanded increases • A shortage results Chapter 2

  46. Effects of Price Controls • Excess demand sometimes takes the form of queues • Lines at gas stations during 1974 shortage • Sometimes get curtailments and supply rationing • Natural gas shortage of the mid ’70’s • Producers typically lose, but some consumers gain. Some consumers lose. Chapter 2

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