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Demand and Supply Analysis and Elasticity

Demand and Supply Analysis and Elasticity. Topics. Demand and quantity demanded Movement along a demand curve Shift of a demand curve Supply and quantity supplied Movement along a supply curve Shift of a supply curve Markets and equilibrium Disequilibrium Elasticity. DEMAND

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Demand and Supply Analysis and Elasticity

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  1. Demand and Supply Analysis and Elasticity

  2. Topics • Demand and quantity demanded • Movement along a demand curve • Shift of a demand curve • Supply and quantity supplied • Movement along a supply curve • Shift of a supply curve • Markets and equilibrium • Disequilibrium • Elasticity

  3. DEMAND A relation between the price of a good and the quantity that consumers are willing and able to buy LAW OF DEMAND The quantity of a good demanded relates inversely (negatively) to its price, other things constant E.g. When price is high, quantity demanded is small; when the price is low, quantity demanded will be high

  4. Law of Demand Two effects Substitution effect Income effect A fall in the price of a good increases consumers’ real income, making consumers more able to purchase goods – the quantity demanded increases When the price of a good falls, consumers substitute that good for other goods which become relatively expensive

  5. Demand curve • A curve showing the relation between the price of a good and the quantity demanded, other things constant (ceteris paribus) • Slopes downward reflecting law of demand Quantity demanded (Qd) - The amount demanded at a particular price ( a point on demand curve)

  6. Demand Curve Price of pizza ●a 15 12 ●b ●c 9 ●d 6 3 ●e 32 8 14 26 20 Quantity pizza

  7. Shifts of the Demand Curve Variables that can affect market demand (other than price) are: • Money income of consumers • Prices of related goods • Consumer expectations • The number or composition of consumers in the market • Consumer tastes

  8. i. Changes of money income P a b $12 D1 D Qd 14 20 When Y (income) ↑ , consumers willing to buy more, Qd ↑, market demand ↑, D shifts rightward to D1, Thus at price of $ 12 per pizza, demand increases from 14 to 20 , movement from point a to b Depends on type of goods : i) normal goods (Y ↑ , Qd ↑, DD shifts rightward) ii) inferior goods (Y ↑ , Qd ↓, DD shifts leftward)

  9. ii. Changes in the prices of related goods Depends on whether the goods is a substitutes or complements Substitutes – such as Coke and Pepsi – if price of Coke ↑, Qc ↓ but Qp↑ - demand for Pepsi will increase while demand for Coke will decrease Complements – such as petrol and car – if price of petrol ↑, demand for car will ↓, demand curve will shift leftward iii. Changes in consumer expectations of price increase Expect price to ↑ in the future, buy more now, demand ↑, demand curve will shift rightward.

  10. iv. Changes in the number of consumers If the population grow, the demand will increase which shift the curve rightward v. Changes in consumer tastes Consumer preferences; likes and dislikes of particular goods – will shift the demand curve

  11. Supply • A relation between the price of a good and the quantity that producers are willing and able to sell during a given period, other things constant Law of Supply The quantity of a good supplied during a given period is usually directly related to its price, other things constant Thus, lower the price, the smaller the quantity supplied; the higher the price, the greater the quantity supplied

  12. The Supply Schedule and Supply Curve Price, P S 15 12 9 6 3 S Quantity, Qs

  13. Shift in the Supply Curve • Distinguish between movement along a supply curve and shift of a supply curve. • A change in price, other things constant, causes a movement along a supply curve, changing the quantity supplied • A change in one of the determinants of supply other than price causes a shift of a supply curve

  14. Determinants of Supply • Changes in Technology If a more efficient technology discovered, production costs will ↓, suppliers will be more willing and able to supply the good at each price; supply will ↑ - supply shift rightward • Changes in the prices of relevant resources If prices of resources ↓, production costs will ↓; supply will ↑ - supply shift rightward • Changes in the producer expectations If producer expects the price of their products to increase; supply ↑ • Changes in the number of producers If number of producers increases, supply will increase; shifting supply to right, vice versa.

  15. Market Equilibrium • A market reaches equilibrium when the quantity demanded (Qd) equals quantity supplied (Qs) • The demand and supply curves intersect at the equilibrium point where we can find the equilibrium price and quantity

  16. Surplus • When there surplus – producers will creates downward pressure on the price, as the price falls, producers reduce their quantity supplied, consumers increase their quantity demanded. • The price continues to fall as long as quantity supplied exceeds quantity demanded

  17. Shortage • When there is shortage, producers and consumers create markets pressure for a higher price. • As price rises, producers increase their quantity supplied and consumers reduce their quantity demanded • The price continues to rise as long as quantity demanded exceeds quantity supplied

  18. Market Equilibrium

  19. Market curves Price S 15 surplus 12 9 ● C 6 3 shortage D Quantity 20 14 16 24 26

  20. Changes in Equilibrium Price and Quantity 1. Shifts of the Demand Curve (P↑, Q↑) P S $12 ●d ●c 9 D1 D Qd and Qs 20 24 30 Initial equilibrium P= $9, Q = 20 When D → D1, at P=$9, D > S, shortage, upward pressure on the price, S↑ and D↓, achieve equilibrium when D1=S at P=$12, Q = 24

  21. P 2. Shifts of the Supply Curve (P↓, Q↑) S S1 ●c 9 6 ●d D Qd and Qs 20 26 30 Initial equilibrium P= $9, Q = 20 When S → S1, at P=$9, S > D, surplus, downward pressure on the price, S ↓ and D ↑, achieve equilibrium when D = S1 at P=$ 6, Q = 26

  22. P S 3. Simultaneous Shifts of Demand and Supply Curves i. Shift of demand dominates S1 ● B P1 P ● A D1 D Q Q Q1 When both DD and SS curve move increase, the equilibrium Q ↑. While the effect on P depends on which curve shifts more Here the DD curve shifts more than SS curve, so P↑

  23. ii. Shift of supply dominates P S S1 P ● A ● B P1 D1 D Q Q Q1 Here the SS curve shifts more than DD curve, so P↓, but Q↑

  24. Disequilibrium • Markets do not always reach equilibrium quickly – disequilibrium • A condition that exist in a market when DD do not match SS • Disequilibrium is usually temporary but sometimes, often as a result of government intervention (price floor and price ceiling, disequilibrium can last a while

  25. Price Floor • A minimum legal price below which a good or service cannot be sold. To have an impact, a price floor must be set above the equilibrium price E.g. agriculture prices in an attempt to ensure farmers a higher and more stable income Price Ceiling A maximum legal price above which a good or service cannot be sold. To have an impact, a price ceiling must be set below the equilibrium price

  26. Price per gallon Monthly rental price S S surplus $2.50 ●a ●b $1,000 ● ● $1.90 $600 ●a ●b shortage D D 50 60 40 Thousands of rental units per month 19 24 14 Millions of gallon ii. Price Ceiling At ceiling price 60,000 unit of house of demanded, but only 40,000 units supplied resulting housing shortage of 20,000 units • Price Floor • $2.50 per gallon is the price floor for milk. At that price SS (24) > DD (14) = surplus in milk supply. • To maintain the price at $2.50, government intervene by buying the surplus

  27. Elasticity of Demand and Supply • Price elasticity of demand • Determinants of price elasticity • Price elasticity and total revenue • Price elasticity of supply • Income elasticity of demand • Cross-price elasticity of demand

  28. Price elasticity of demand • Law of demand says a lower price increases quantity demanded, but by how much? How sensitive is quantity demanded to a change in price? • Measures how responsive quantity demanded is to a price change Ed = Percentage change in quantity demanded (Qd) Percentage change in price

  29. Calculating Price Elasticity of Demand Price ED = ∆q X 100 divide ∆p X 100 (q + q’)/2 (p + p’)/2 = 10,000 X 100 divide (- $0.20) X 100 100,000 $1.00 = 10 % (-20%) = - 0.5 ●a $1.10 ●b 0.90 D 0 95 105 Quantity (Thousands) *Law of demand states that P and Q demanded are inversely related. In elasticity formula, the numerator and the denominator have opposite signs leaving the price elasticity of demand with a negative sign. But we just focus on the absolute value (0.5) Because the average quantity and average price are used as the bases for computing percentage change, the same elasticity results can be used whether going from the higher price to the lower price or the other way around

  30. Calculating Price Elasticity of Demand Price ED = Percentage change in Qd Percentage change in P = % ∆ Qd % ∆ P = 2/10 1/20 = 4 ●Original point $20.50 ●Elasticity 4 20.00 ∆P=$1 19.50 ●New point D ∆Q=2 0 9 10 11 Quantity P average Q average Because the average quantity and average price are used as the bases for computing percentage change, the same elasticity results can be used whether going from the higher price to the lower price or the other way around

  31. Categories of Price Elasticity of Demand • The price elasticity of demand varies along a given demand curve. The price elasticity of demand can be divided into 3 categories, depending on how responsive quantity demanded is to a change in price • Inelastic Demand • If percentage change in Qd is smaller than the percentage change in P (%∆ Qd < % ∆ P), the resulting price elasticity has an absolute value between 0 and 1. Inelastic demand means that Qd is relatively unresponsive to a change in price • ii. Unit-elastic Demand • If the percentage change in Qd equals the percentage change in price (%∆ Qd = % ∆ P), the resulting price elasticity has an absolute value of 1 and that portion of a demand curve has unit-elastic demand • iii. Elastic Demand • If the percentage change in Qd is more that the percentage change in price (%∆ Qd > % ∆ P), the resulting price elasticity has an absolute value exceeding 1, and that portion of a demand curve is said to be elastic

  32. Elasticity and Total Revenue Demand and price elasticity P • Price elasticity important to producers because it indicates the effect of a P change on total revenue • TR = PxQ, if P decrease, Qd ↑ , so TR ↑ • But lower P also means that producers will sell smaller units which decreases TR • Thus if ↑ Qd is > decrease in P, TR ↑ • If DD is elastic (%∆ Qd > % ∆ P), TR will ↑ • If DD is unit-elastic , TR unchanged • If DD is inelastic (%∆ Qd < % ∆ P), TR decrease Elastic, Ed >1 90 ●a 80 ●b 50 ●c Unit-elastic, Ed = 1 Inelastic, Ed < 1 ●d 20 ●e 10 D 100 200 500 800 900 Qd Total Revenue (P x Q) $2500 0 1,000 500 Quantity

  33. Constant-elasticity demand curves P Perfectly elastic A horizontal line reflecting any price increase reduces Qd to zero. Consumer will demand all that is offered for sale at the given price, P. If price rises above P, Qd drops to zero. Consumer are sensitive to price changes especially for products supplied by many producers Ed= ∞ D P Q P D Perfectly inelastic The demand curve is vertical – reflecting that any price change has no effect on the Qd. (e.g. when you rich and need something to survive) Ed = 0 Q Q P Unit elastic Everyway along the demand curve, the percentage change in P causes an equal percentage change in Qd. Ed =1 $10 D 6 Q 100 60

  34. Price elasticity of Supply • Measures how responsive producers are to a price change • The elasticity calculated the same way as price elasticity of demand • Price elasticity of supply usually a positive number because higher P results in an increase in Qs

  35. P S p’ p Qs q q’ ES = ∆q divide ∆p (q + q’)/2 (p + p’)/2 Inelastic = supply elasticity is less than 1 Unit elastic = supply elasticity = 1 Elastic = supply elasticity more than 1

  36. Constant Elasticity Supply Curves P Perfectly elastic supply curve A horizontal line reflecting a situation in which any P decrease drops the Qs to zero Es= ∞ S P Q P S Perfectly inelastic A vertical line reflecting a situation in which a price change has no effect Es = 0 Q Q P Unit elastic A percentage change in P causes an identical percentage change in Qs S Es =1 $10 S 5 Q 20 10

  37. Other Elasticity Measures i. Income elasticity of demand Measures the responsiveness of demand to changes in consumer income The percentage change in demand divided by the percentage change in consumer income The value is positive for normal good and negative for inferior goods

  38. ii. Cross-price elasticity of demand The responsiveness of the demand for one good to changes in the price of another good The percentage change in the demand of one good divided by the percentage change in the price of another good Its numerical value can be positive, negative or zero depending on whether the 2 goods are substitutes, complements or unrelated

  39. Cross-price elasticity of demand • Substitutes (Coke and Pepsi) If ↑ in the price of one good leads to an ↑ in the demand for another good, their cross-price elasticity is positive – two goods are substitutes ii. Complements (Car and petrol) If ↑ in the price of one good leads to a ↓ in the demand for another goods, their cross-price elasticity is negative and the goods are complements

  40. Price Elasticity and Tax Incidence b. More elastic demand a. Less elastic demand P P St St S S $1.05 ● ● ● $1.15 1.00 ● D ● 1.00 0.85 $0.20 tax $0.20 tax 0.95 D Q 0 9 10 Q 7 10 For less elastic DD curve, imposition of a $0.20 tax on tea shifts the SS curve to St, market P rises from $1 to $1.15, market Q falls from 10 to 9 million. Because of tax, consumer pay $1.15 (or 0.15 more) and producers receive $0.95 (or 0.05 less). Thus, consumers pay $0.15 of the $0.20 tax as higher price and producers pay $0.05 as a lower receipt. For more elastic DD curve the burden of the tax is more on producers.

  41. Supply Elasticity and Tax Incidence b. More elastic supply a. Less elastic supply P P S St St S ● $1.05 ● $1.15 ● D ● 1.00 1.00 ● 0.95 $0.20 tax $0.20 tax 0.85 D Q 0 8 10 Q 7 10 The more elastic the supply curve, the more tax is paid by consumers as a higher price

  42. Summary • The concept of demand and supply • Law of demand and Law of supply • Derivation of demand and supply curve • Movement along the curve vs Shift of the curve • The concept of shortage, surplus and market equilibrium • Disequilibrium due to price floor and price ceiling • The price elasticity of demand and supply • Calculating the price elasticity • Categories of elasticity • Other elasticity measures

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