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
Chapter 2
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
Chapter 2
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
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
Chapter 2
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
Chapter 2
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
Chapter 2
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
Chapter 2
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
Chapter 2
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
Chapter 2
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
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
Chapter 2
The Market Mechanism
D
S
The curves intersect atequilibrium, or market-
clearing, price. Quantity demanded
equals quantity supplied at P0
P0
Q0Quantity
Price($ per unit)
Chapter 2
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 wants to buy at the
current price can and all producers who want to sell at that price can
Chapter 2
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
The Market Mechanism
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
Chapter 2
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
Chapter 2
The Market Mechanism
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
Chapter 2
The Market Mechanism
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
Chapter 2
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
Chapter 2
S’
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
P
Q
SD
P3
Q3Q1
P1
Q2
Chapter 2
D’S
D
Q3
P3
Changes in Market Equilibrium
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’
Changes in Market Equilibrium
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
Chapter 2
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
Chapter 2
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
Chapter 2
S2002
D2002
D1900
S1900 S1950
D1950
Long-Run Path ofPrice and Consumption
Resource Market Equilibrium
Quantity
Price
Chapter 2
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
Chapter 2
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
%
%
Chapter 2
Price Elasticity of Demand
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
Chapter 2
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
Price Elasticity of Demand
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
Chapter 2
Price Elasticity of Demand
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
Chapter 2
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 Price is high and quantity small
The bottom portion of demand curve is inelastic Price is low and quantity high
Chapter 2
Price Elasticity of Demand
Q
Price
4
8
2
4
Ep = -1
Ep = 0
EP = -
Elastic
Inelastic
Demand Curve
Q = 8 – 2P
Chapter 2
Price Elasticity of Demand
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
Chapter 2
Infinitely Elastic Demand
DP*
Quantity
Price
EP =
Chapter 2
Completely Inelastic Demand
Quantity
Price
Q*
D
EP = 0
Chapter 2
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
Chapter 2
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
m
b
b
m
mm
bbPQ P
Q
Q
P
PP
QQE
mb
Chapter 2
Other Demand Elasticities
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
%
%
Chapter 2
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
Chapter 2
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
Chapter 2
Elasticity: An Application
QD = QS
1800 + 240P = 3550 – 266P506P = 1750
P = $3.46 per bushel
Q = 1800 + (240)(3.46) = 2630 million bushels
Chapter 2
Elasticity: An Application
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
Elasticity: An Application
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
Chapter 2
Elasticity: An Application
In 2002, the supply and demand for wheat were: Supply: QS = 1439 + 267P Demand: QD = 2809 – 226P
Chapter 2
Elasticity: An Application
QD = QS
2809 - 226P = 1439 + 267PP = $2.78 per bushel
Q = 2809 - (226)(2.78) = 2181 million bushels
Chapter 2
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
Chapter 2
Short-Run Versus Long-Run Elasticity
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
Chapter 2
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
Short-Run Versus Long-Run Elasticity
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
Chapter 2
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
Chapter 2
Short-Run Versus Long-Run Elasticity
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
Short-Run Versus Long-Run Elasticity
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
Chapter 2
Short-Run Versus Long-Run Elasticity
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
Chapter 2
SSR
Quantity Primary Copper
Price
Short-Run Versus Long-Run Elasticity
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
Short-Run Versus Long-Run Elasticity
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.
An Application - Coffee
Quantity
Price
Chapter 2
SP0
Q0
Long-Run1) Supply is extremely elastic2) Price falls back to P0.3) Quantity back to Q0.
An Application - Coffee
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
Chapter 2
Predicting the Effects of Changing Market Conditions
We know Equilibrium Price, P* Equilibrium Quantity, Q* Price elasticity of supply, ES
Price elasticity of demand, ED
Chapter 2
Predicting the Effects of Changing Market Conditions
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
Predicting the Effects of Changing Market Conditions
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*)
Chapter 2
Demand: Q = a - bP
a/bSupply: Q = c + dP
-c/d
P*
Q*
ED = -bP*/Q*ES = dP*/Q*
Predicting the Effects of Changing Market Conditions
Quantity
Price
Chapter 2
Predicting the Effects of Changing Market Conditions
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
Predicting the Effects of Changing Market Conditions
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
Chapter 2
Predicting the Effects of Changing Market Conditions
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
Predicting the Effects of Changing Market Conditions
Mmt/yr
Price
Chapter 2
Predicting the Effects of Changing Market Conditions
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
Chapter 2
Predicting the Effects of Changing Market Conditions
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
Predicting the Effects of Changing Market Conditions
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
Chapter 2
Real versus NominalPrices of Copper 1965 - 2002
Chapter 2
Declining Demand and the Behavior of Copper Prices
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
Declining Demand and the Behavior of Copper Prices
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
Declining Demand and the Behavior of Copper Prices
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
Effects of Price Controls
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
Effects of Price Controls
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