Chapter 2

Chapter 2

The Basics of Supplyand Demand

Chapter 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

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?

Chapter 2

Supply and Demand

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

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

Chapter 2

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

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The Supply Curve

S

The supply curve slopesupward, demonstrating that

at higher prices firmswill increase output

The Supply Curve, Graphically Depicted

Quantity

Price($ per unit)

P1

Q1

P2

Q2

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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

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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’

P S

Q

P1

P2

Q1Q0

S’

Q2

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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 the price of the good Change in costs of production

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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

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The Demand Curve

D

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)

P2

Q1

P1

Q2

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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

Substitutes Complements

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DP

Q

D’

Q1

P2

Q0

P1

Q2

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

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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

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The Market Mechanism

The market mechanism is the tendency in a free market for price to change until the market clearsMarkets clear when quantity demanded equals quantity supplied at the prevailing priceMarket clearing price – price at which markets clear

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D

S

The curves intersect atequilibrium, or market-

clearing, price. Quantity demanded

equals quantity supplied at P0

P0

Q0Quantity

Price($ per unit)

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In equilibrium There is no shortage or excess demand There is no surplus or excess supply Quantity supplied equals quantity

demanded Anyone who wants to buy at the

current price can and all producers who want to sell at that price can

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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

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D

S

P0

Q0

1. At P1, price is above the market clearing price

2. Qs > QD

3. Price falls to the market-clearing price

4. Market adjusts to equilibrium

P1

Surplus

Quantity

Price($ per unit)

QSQD

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Market Shortage

The market price is below equilibrium: There is excess demand - shortage Upward pressure on prices Quantity demanded decreases and

quantity supplied increases The market adjusts until the new

equilibrium is reached

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D

S

QS QD

P2

Quantity

Price($ per unit)

1. At P2, price is below the market clearing price

2. QD > QS

3. Price rises to the market-clearing price

4. Market adjusts to equilibrium

Q3

P3

Shortage

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Supply and demand interact to determine the market-clearing priceWhen not in equilibrium, the market will adjust to alleviate a shortage or surplus and return the market to equilibriumMarkets must be competitive for the mechanism to be efficient

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Changes in Market Equilibrium

Equilibrium prices are determined by the relative level of supply and demandChanges in supply and/or demand will cause change in the equilibrium price and/or quantity in a free market

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S’


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

between Q1, Q2

Price adjusts to equilibrium at P3, Q3

P

Q

SD

P3

Q3Q1

P1

Q2

Chapter 2

D’S

D

Q3

P3


Income Increases Demand

increases to D’ Shortage at P1 of

Q1 to Q2

Equilibrium at P3

and Q3

P

QQ1

P1

Q2

Chapter 2

D’S’


Income increases and raw material prices fall Quantity

increases If the increase in

D is greater than the increase in S price also increases

P

Q

S

P2

Q2

D

P1

Q1

Chapter 2

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

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The Price of a College Education

The real price of a college education rose 55 percent from 1970 to 2002Increases in costs of modern classrooms and wages increased costs of production – decrease in supplyDue to a larger percentage of high school graduates attending college, demand increased

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Market for a College Education

Q (millions enrolled))

P(annual cost

in 1970dollars)

D1970

S1970

S2002

D2002

$3,917

13.2

$2,530

8.6

Chapter 2

The Long-Run Behaviorof Natural Resource Prices

Consumption of copper has increased about a hundredfold from 1880 through 2002

The long term real price for copper has remained relatively constant

Increased demand as world economy grew

Decreased production costs increased supply

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S2002

D2002

D1900

S1900 S1950

D1950

Long-Run Path ofPrice and Consumption

Resource Market Equilibrium

Quantity

Price

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Resource Market

Conclusion Decreases in the costs of production

have increased the supply by more than enough to offset the increase in demand

Chapter 2

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 changeElasticity gives a way to measure by how much a variable will change with the change in another variableSpecifically, it gives the percentage change in one variable resulting from a one percent change in another

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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

P

QE DDP

%

%

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The percentage change in a variable is the absolute change in the variable divided by the original level of the variableTherefore, elasticity can also be written as:

P

Q

Q

P

PP

QQE D

P

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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|

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The primary determinant of price elasticity of demand is the availability of substitutes Many substitutes, demand is price

elastic Can easily move to another good with

price increases Few substitutes, demand is price

inelastic

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Looking at a linear demand curve, as we move along the curve Q/P is constant, but P and Q will changePrice elasticity of demand must therefore be measured at a particular point on the demand curveElasticity will change along the demand curve in a particular way

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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 inelastic Price is low and quantity high

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Q

Price

4

8

2

4

Ep = -1

Ep = 0

EP = -

Elastic

Inelastic

Demand Curve

Q = 8 – 2P

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The steeper the demand curve, the more inelastic the demand for the good becomesThe flatter the demand curve, the more elastic the the demand for the good becomesTwo extreme cases of demand curves Completely inelastic demand – vertical Infinitely elastic demand – horizontal

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Infinitely Elastic Demand

DP*

Quantity

Price

EP =

Chapter 2

Completely Inelastic Demand

Quantity

Price

Q*

D

EP = 0

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Other Demand Elasticities

Income Elasticity of Demand Measures how much quantity

demanded changes with a change in income

I

Q

Q

I

I/I

Q/Q EI

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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

m

b

b

m

mm

bbPQ P

Q

Q

P

PP

QQE

mb

Chapter 2


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

Chapter 2

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

P

QE SSP

%

%

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Point vs. 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

Q

PP

QE DP Δ

Δ

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Elasticity: An Application

During the 1980s and 1990s, the market for wheat went through changes that had great implications for American farmers and U.S. agricultural policyUsing the supply and demand curves for wheat, we can analyze what occurred in this market

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QD = QS

1800 + 240P = 3550 – 266P506P = 1750

P = $3.46 per bushel

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

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

35.)266(630,2

46.3

P

Q

Q

PE DD

P

32.)240(630,2

46.3

P

Q

Q

PE SS

P

Chapter 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

00.4D

PQ

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In 2002, the supply and demand for wheat were: Supply: QS = 1439 + 267P Demand: QD = 2809 – 226P

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QD = QS

2809 - 226P = 1439 + 267PP = $2.78 per bushel

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

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Short-Run Versus Long-Run Elasticity

Price elasticity varies with the amount of time consumers have to respond to a priceShort-run demand and supply curves often look very different from their long-run counterparts

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Demand In general, demand is much more

price elastic in the long run Consumers take time to adjust

consumption habits Demand might be linked to another good

that changes slowly More substitutes are usually available in

the long run

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Gasoline: Short-Run and Long-Run Demand Curves

DSR

DLR

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

Quantity of Gas

Price

Chapter 2


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

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DSR

DLR

• 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

Price

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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

Chapter 2


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 are replaced, purchases

will only be to replace old cars Less purchases from income increase in

long run than in short run

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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

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SSR

Quantity Primary Copper

Price


SLR

Due to limitedcapacity, firmsare limited by

output constraintsin the short run.

In the long run, theycan expand.

Chapter 2

SSR

Quantity Secondary Copper

Price


SLR

Price increasesprovide an incentive

to convert scrapcopper into new supply.

In the long run, thisstock of scrap copper

begins to fall.

Chapter 2

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

Why are coffee prices very volatile? Most of the world’s coffee is 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

Chapter 2

Price of Brazilian Coffee

Chapter 2

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

Demand and supply are more elastic in the long runIn the short run, supply is completely inelastic Weather may destroy part of the fixed

supply, decreasing supply

Demand is relatively inelastic as wellPrice increases significantly

Chapter 2

D

P0

S

Q0 Quantity

PriceA freeze or drought

decreases the supplyof coffee

S’

Q1

An Application - Coffee

Price increases significantly due to inelastic supply and

demand

P1

Chapter 2

S’

D

S

P0

Q0

P2

Q2

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


Quantity

Price

Chapter 2

SP0

Q0

Long-Run1) Supply is extremely elastic2) Price falls back to P0.3) Quantity back to Q0.


Quantity

Price

D

Chapter 2

Predicting the Effects of Changing Market Conditions

Supply and demand analysis can be used to predict the effects of changing market conditions Linear demand and supply must be fit to

market data Given equilibrium price and quantity along

with elasticities of supply and demand, we can calculate the curves that fit the information

We can then calculate changes in the market

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We know Equilibrium Price, P* Equilibrium Quantity, Q* Price elasticity of supply, ES

Price elasticity of demand, ED

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Let’s begin with the equations for supply, demand, elasticity: Demand: Q = a – bP Supply: Q = c + dP Elasticity: (P/Q)(Q/P)

We must calculate numbers for a, b, c, and d.

Chapter 2


The slope of the demand curve above equals Q/P which equals -bThe slope of the supply curve above equals Q/P which equals d

Demand: ED = -b(P*/Q*)

Supply: ES = d(P*/Q*)

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Demand: Q = a - bP

a/bSupply: Q = c + dP

-c/d

P*

Q*

ED = -bP*/Q*ES = dP*/Q*


Quantity

Price

Chapter 2


Using P*, Q* and the elasticities, we can solve for b and c from supply

ES = d(P*/Q*)

1.6 = d(0.75/7.5) = 0.1dd = 16

Q = c + dP7.5 = c + (16)(0.75) = c + 12

c = -4.5

Chapter 2


Using P*, Q* and the elasticities, we can solve for a and b from demand

ED = –b(P*/Q*)

-0.8 = -b(0.75/7.5) = –0.1bb = 8

Q = a – bP7.5 = a – (8)(0.75) = a – 6

a = 13.5

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We now have equations for supply and demand

Supply: Q = –4.5 + 16PDemand: Q = 13.5 – 8P

Setting them equal will give us equilibrium price and quantity with which we began

Chapter 2

Supply: QS = -4.5 + 16P

-c/d Demand: QD = 13.5 - 8P

a/b

.75

7.5


Mmt/yr

Price

Chapter 2


We have written supply and demand so that they only depend upon priceDemand could also depend upon other variables such as incomeDemand would then be written as:fIbPaQ

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We know the following information regarding the copper industry: I = 1.0 P* = 0.75 Q* = 7.5 b = 8 Income elasticity: EI= 1.3

Chapter 2


Using the elasticity of income formula, we can solve for f

EI = (I/Q)(Q/I)

1.3 = (1.0/7.5)(f)f = 9.75

Chapter 2

Declining Demand and the Behavior of Copper Prices

Copper has gone through difficult market changes leading the 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

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Real versus NominalPrices of Copper 1965 - 2002

Chapter 2


Given producers’ concerns about further declines in demand, we can calculate by how much prices will fall with future declines in demandAssume that demand will fall by 20% What is the resulting decrease in price? Demand curve will shift to left by 20%

Chapter 2


We want to consider 80% of the past demand

Q = (0.80)(13.5 - 8P)Q = 10.8 - 6.4P

Recall the equation for supply:Q = -4.5 + 16P

Chapter 2


Setting supply equal to demand:-4.5 + 16P = 10.8 - 6.4P-16P + 6.4P = 10.8 + 4.5

P = 15.3/22.4P = 68.3 cents/pound

A decline in demand of 20% will lead to a drop in price about 7%

Chapter 2

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

D


Quantity

Price

P0

Q0

S

Pmax

• Price is regulated to be no higher than Pmax

• Quantity supplied falls and quantity demanded increases• A shortage results

QS

QD

Shortage

Chapter 2


Excess demand sometimes takes the form of lines (queues) Lines at gas stations during 1974 shortage

Sometimes get curtailments and supply rationing Natural gas shortage of the mid 1970s

Producers typically lose, but some consumers gain. Some consumers lose.

Chapter 2

Price Controls andNatural Gas Shortages

In 1954, the federal government began regulating the wellhead price of natural gasIn 1962, the ceiling prices that were imposed became binding and shortages resulted

Documents

Chapter 2