Chapter 2

The Basics of Supply and Demand

The Supply Curve

The supply curve slopesupward demonstrating that

at higher prices firmswill increase output

The SupplyCurve Graphically

Quantity

Price($ per unit)

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?

Topics to Be Discussed

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?

Supply and Demand

Supply and demand analysis can:1. Help us understand and predict how world

economic conditions affect market price and production

2. Analyze the impact of government price controls, minimum wages, price supports, and production incentives on the economy

3. Determine how taxes, subsidies, tariffs and import quotas affect consumers and producers

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

(P)QQ SS

The Supply Curve

Other Variables Affecting Supply Costs of Production

LaborCapitalRaw Materials

Lower costs of production allow a firm to produce more at each price and vice versa

Change in Supply

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’

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 priceChange in costs of production

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

(P)QQ DD

The Demand Curve

The demand curve slopesdownward demonstrating that consumers are willing

to buy more at a lower priceas the product becomes

relatively cheaper.

Quantity

Price($ per unit)

The Demand Curve

Other Variables Affecting Demand Income

Increases in income allow consumers to purchase more at all prices

Consumer Tastes Price of Related Goods

SubstitutesComplements

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.IncomePreferences

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

The curves intersect atequilibrium, or market-

clearing, price. Quantity demanded

equals quantity supplied at P0

Q0Quantity

Price($ per unit)

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

Oun Lopez:

Start of Lecture 3

Oun Lopez:

Start of Lecture 3

S-Market S and D curves

include the S and D curves of individual

consumers and producers.

Who Supplies?-Producers with

willingness-to-accept (WTA) prices below P*.

Who Buys?-Only those consumers who are willing-to-pay

(WTP) above P*.

Q0Quantity

Price($ per unit)

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

1. Price is above the market clearing price – P1

2. Qs > QD

3. Price falls to the market-clearing price

4. Market adjusts to equilibrium

Surplus

Quantity

Price($ per unit)

Quantity

Price($ per unit)

1. Price is below the market clearing price – P2

2. QD > QS

3. Price rises to the market-clearing price

4. Market adjusts to equilibrium

Shortage

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.

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.

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.

Raw material prices fall S shifts to S’ Surplus at P1

between Q1, Q2 Price adjusts to

equilibrium at P3, Q3

Income Increases Demand increases to

D1 Shortage at P1 of Q1,

Q2 Equilibrium at P3, Q3

D’S’

Income Increases & raw material prices fall Quantity increases If the increase in D is

greater than the increase in S price also increases

Shifts in Supply and Demand

When supply and demand change simultaneously, the impact on the equilibrium price and quantity is determined by:

1. The relative size and direction of the change

2. The shape of the supply and demand models

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

S-Market S and D curves

include the S and D curves of individual

consumers and producers.

Who Supplies?-Producers with

willingness-to-accept (WTA) prices below P*.

Who Buys?-Only those consumers who are willing-to-pay

(WTP) above P*.

Q0Quantity

Price($ per unit)

Market for a College Education

Q (millions enrolled))

P(annual cost

in 1970dollars)

$3,917

New equilibriumwas reached at $4,573 and a quantity of 12.3 million students

$2,530

S1900 S1950

Long-Run (LR) Path ofPrice and Consumption (LR demand)

Resource Market Equilibrium

Quantity

Elasticities of Supply and Demand

How much do markets change?Elasticity gives a way to measure how a

variable will change when another variable changes.

Elasticity (Def): the percentage change in one variable resulting from a one percent change in another.

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.

The percentage change in a variable is the absolute (actual) change in the variable divided by the original level of the variable.

Therefore, elasticity can also be written as:

Usually a negative number As price increases, quantity decreases As price decreases, quantity increases

When EQ,P > 1, the good is price elastic %Q > % P

When EQ,P < 1, the good is price inelastic %Q < % P

Primary determinant of

-Availability of substitutes.

Many substitutes: demand is price elasticFew substitutes demand is price inelastic

Linear demand curve: Q/P is constantValues of P and Q changePrice 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

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

Price is high and quantity small The bottom portion of demand curve is

inelasticPrice is low and quantity high

Ep = -1

Ep = 0

EP = -

Elastic

Inelastic

Demand Curve

Q = 8 – 2P

The steeper the demand curve becomes, the more inelastic the good.

The flatter the demand curve becomes, the more elastic the good

Infinitely Elastic Demand (Extreme Case)

Quantity

EP = QD changes infinitely with the smallest

possible change in

price.

Completely Inelastic Demand (Extreme Case)

Quantity

EP = 0

QD never changes, even with

large changes in price.

Other Demand Elasticities

Income Elasticity of Demand Measures how much quantity demanded

changes with a change in income.

Q/Q EI

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.

bbPQ P

Complements: Cars and Tires Cross-price elasticity of demand is negative

Price of cars increases, quantity demanded of tires decreases

Substitutes: Butter and Margarine Cross-price elasticity of demand is positive

Price of butter increases, quantity of margarine demanded increases

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.

Point v. Arc Elasticities

Point elasticity of demand Price elasticity of demand at a particular

point on the demand curve

Arc elasticity of demand Price elasticity of demand calculated over a

range of prices

QE DP Δ

Elasticity: An Application

Wheat Market Changes (1980s and 1990s)

Analyzing the Wheat Market

Supply: QS = 1800 + 240P

Demand: QD = 3550 – 266P

Analyze this market.

1)What are the initial P* and Q*?

2)How does demand change when price changes?

3)How does supply change when price changes?

QD = QS

1800 + 240P = 3550 – 266P

506P = 1750

P = $3.46 per bushel

Q = 1800 + (240)(3.46) = 2630 million bushels

We can find the elasticities of demand and supply at these points

35.)266(630,2

32.)240(630,2

Assume the price of wheat is $4.00/bushel due to decrease in supply

486,2)00.4)(266(550,3 DQ

43.0)266(486,2

In 2002, the supply and demand for wheat were: Supply: QS = 1439 + 267P

Demand: QD = 2809 – 226P

QD = QS

2809 - 226P = 1439 + 267P

P = $2.78 per bushel

Q = 2809 - (226)(2.78) = 2181 million bushels

Short-Run Versus Long-Run Elasticity

Price elasticity varies with the amount of time consumers have to respond to a price.

Short run demand and supply curves often look very different from their long-run counterparts.

Demand In general, demand is much more price

elastic in the long runConsumers take time to adjust consumption

habitsDemand might be linked to another good that

changes slowlyMore substitutes are usually available in the

long run

Gasoline: Short-Run and Long-Run Demand Curves

•People cannot easily adjust consumption in short run.•In the long run, people tend to drive smaller and more fuel efficient cars.

Quantity of Gas

Demand and Durability For some durable goods, demand is more

elastic in the short run If goods are durable, then when price

increases, consumers choose to hold on to the good instead of replacing it

But in long run, older durable goods will have to be replaced

•Initially, people may put off immediate car purchase•In long run, older cars must be replaced.

Cars: Short-Run and Long-Run Demand Curves

Quantity of Cars

Income elasticity also varies with the amount of time consumers have to respond to an income change. For most goods and services, income

elasticity is larger in the long run When income changes, it takes time to adjust

spending

Income elasticity of durable goods Income elasticity is less in the long-run than

in the short-run.Increases in income mean consumers will want

to hold more cars. Once older cars replaced, purchases will only to

be to replace old cars.Less purchases from income increase in long

run than in short run

Demand for Gasoline

Demand for Automobiles

Most goods and services: Long-run price elasticity of supply is greater

than short-run price elasticity of supply.

Other Goods (durables, recyclables): Long-run price elasticity of supply is less than

short-run price elasticity of supply

Quantity Primary Copper

Due to limitedcapacity, firmsare limited by

output constraintsin the short-run.

In the long-run, theycan expand.

Quantity Secondary Copper

Price increasesprovide an incentive

to convert scrapcopper into new supply.

In the long-run, thisstock of scrap copper

begins to fall.

Supply of Copper

Declining Demand and the Behavior of Copper Prices

Copper has gone through difficult market changes leading to significantly reduced prices most from decreased demand from A decrease in the growth rate of power

generation The development of substitutes: fiber optics

and aluminum

Short-Run v. Long-Run Elasticity – An Application

Why are coffee prices very volatile? Most of the world’s coffee produced in Brazil. Many changing weather conditions affect the

crop of coffee, thereby affecting price Price following bad weather conditions is

usually short-lived In long run, prices come back to original

levels, all else equal

Price of Brazilian Coffee

Short-Run v. Long-Run Elasticity – An Application

Demand and supply are more elastic in the long run

In short-run, supply is completely inelastic Weather may destroy part of the fixed supply,

decreasing supply

Demand relatively inelastic as wellPrice increases significantly

Q0 Quantity

PriceA freeze or drought

decreases the supplyof coffee

An Application - Coffee

Price increases significantly due to inelastic supply and

demand

Intermediate-Run1) Supply and demand are more elastic2) Price falls back to P2.

Quantity

Long-Run1) Supply is extremely elastic.2) Price falls back to P0.3) Quantity back to Q0.

Quantity

Price of Brazilian Coffee

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

Effects of Price Controls (Price Ceiling)

Quantity

•Price is regulated to be no higher than Pmax,•Quantity supplied falls and quantity demanded increases•A shortage results

Shortage

Effects of Price Controls (Price Ceiling)

Quantity

•Price is regulated to be no higher than Pmax

•This price ceiling is not binding.•Equilibrium P is maintained.

Effects of Price Controls (Price Floor)

Quantity

•Price is regulated to be no lower than Pmax

•This price floor creates a surplus

Surplus

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.

Price Controls andNatural Gas Shortages

In 1954, the federal government began regulating the wellhead price of natural gas.

In 1962, the ceiling prices that were imposed became binding and shortages resulted.

Price Controls andNatural Gas Shortages

Price controls created an excess demand of 7 trillion cubic feet.

Price regulation was a major component of U.S. energy policy in the 1960s and 1970s, and it continued to influence the natural gas markets in the 1980s.

Chapter 2

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