Transcript Chapter 2
Chapter 2
Supply and Demand
McGraw-Hill/Irwin
Copyright © 2008 by The McGraw-Hill Companies, Inc. All Rights Reserved.
Main Topics
Demand
Supply
Market equilibrium
Elasticities of demand and supply
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Questions…
Why are Lamborghinis so expensive
whereas cheese burgers are not?
How are prices determined for products?
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Questions…
There are several steps in analyzing a
market.
Determine product demand
Determine the supply of the product
Using demand and supply, equilibrium can
be identified
Elasticity will measure the responsiveness
to change.
What is demand? What is supply?
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Demand Curves
Product’s demand curve shows:
How much buyers of the product want to buy at
each possible price (willing and able)
Holding fixed all other factors that affect demand
On a graph: vertical axis shows $ per unit of
the good, horizontal axis shows quantity
demanded per unit of time
Downward sloping (Law of Demand: buying the
product is less attractive when the price is high
than when the price is low)
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Determinants of Demand
Demand curve holds all factors other than the
product’s price constant:
Population growth
Consumer tastes and incomes
Prices of other products
Substitutes (An increase in the price of one product causes
buyers to demand more of the other, all else equal)
Complements (An increase in the price of product causes
buyers to demand less of the other, all else equal)
Government taxes or regulations
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Shifts and Movements Along a
Demand Curve
Change in price of the product causes a
movement along the demand curve
A change in the quantity demanded
What could cause this price change?
Change in another factor causes the
entire demand curve to shift
A change in demand
What could cause this shift in demand?
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Figure 2.1: Demand Curve for
U.S. Corn Market
(hypothetical)
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Demand Functions
Product’s demand function is a
mathematical representation of its
demand
Describes the amount of the product
buyers demand for each possible
combination of price and other factors
Can be determined by applying statistical
techniques to historical data
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Sample Demand Function
Demand for corn affected by: price of corn,
price of potatoes, price of butter, consumer
incomes
d
Qcorn
5 2Pcorn 4Ppotatoes 0.25Pbutter 0.0003M
Increases in the prices of corn and butter will
decrease the amount of corn buyers demand
What would be an economic term for butter?
Increases in the price of potatoes will
increase the amount of corn buyers demand
What would be the economic term for potatoes?
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Supply Curves
Product’s supply curve shows:
How much sellers of the product want to sell at each
possible price (willing and able)
Holding fixed all other factors that affect supply
On a graph: vertical axis shows $ per unit of
the good, horizontal axis shows quantity
supplied per unit of time
Upward sloping (Law of Supply: selling the
product is less attractive when the price is low
than when the price is high)
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Determinants of Supply
Supply curve holds all factors other than
the product’s price constant:
Technology
Prices of inputs
Prices of other possible outputs
Government taxes or regulations
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Shifts and Movements Along a
Supply Curve
Change in price of the product causes a
movement along the supply curve
A change in the quantity supplied
What could cause a price change?
Change in another factor causes the
entire supply curve to shift
A change in supply
What could cause a supply shift?
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Figure 2.2: Demand Curve for U.S.
Corn Market
(hypothetical)
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Supply Functions
Product’s supply function is a
mathematical representation of its supply
Describes the amount of the product
sellers supply at each possible
combination of price and other factors
Can be determined by applying statistical
techniques to historical data
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Sample Supply Function
Supply of corn affected by: price of corn,
price of diesel fuel, price of soybeans
s
Qcorn
9 5Pcorn 2Pfuel 1.25Psoybeans
Increases in the price of diesel fuel and
soybeans will decrease the amount of corn
sellers supply
Increases in the price of corn will increase
the amount of corn sellers supply
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Market Equilibrium
Supply and demand for a product interact
to determine the market equilibrium
The equilibrium price is the price at
which the amounts supplied and
demanded are equal
Graphically, the price at which the supply
and demand curves intersect
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Figure 2.3: Equilibrium in the
Corn Market
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Excess Supply, Excess Demand
If price is above equilibrium price:
Amount supplied will be greater than amount
demanded (excess supply or surplus)
Incentive for sellers to lower prices to boost sales
If price is below equilibrium price:
Amount demanded will be greater than amount
supplied (excess demand or shortage)
Incentive for buyers to offer higher prices
Market prices adjust so that amount supplied
equals amount demanded
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Changes in Market Equilibrium
Changing market conditions alter the
market equilibrium
Changes in the determinants of supply
(or demand) other than the product price
cause the supply (or demand) curve to
shift
Example: falling diesel fuel prices shift
the corn supply curve out
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Figure 2.5: Change in Market
Equilibrium
Example:
falling
diesel
fuel
prices
shift the
corn
supply
curve out
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Changes in Market Equilibrium
Four possible ways either supply or demand
curve can shift:
Demand can increase or decrease
Supply can increase or decrease
Effect on market equilibrium:
If demand curve shifts, price and quantity change in
the same direction as the curve
If supply curve shifts, quantity changes in the same
direction as the curve but price changes in the
opposite direction
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Figure 2.6: Changes in Market Equilibrium
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Table 2.1 Effects of Changes in
Demand or Supply
Source of
Change
Effect on
Price
Effect on Amount
Bought/Sold
Increase in Demand
Rises
Rises
Decrease in Demand
Falls
Falls
Increase in Supply
Falls
Rises
Decrease in Supply
Rises
Falls
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Changes in Market Equilibrium
Sometimes supply and demand will both
shift
Ultimate effect on equilibrium is the
combination of the separate effects of
changes in demand and supply
Will be able to determine the necessary
direction of price or quantity movement,
but not both
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Figure 2.9: Increase in Both Demand and Supply
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Table 2.2 Effects of Simultaneous
Changes in Demand and Supply
Source of
Change
Effect on
Price
Effect on Amount
Bought/Sold
Demand and supply
both increase
Ambiguous
Rises
Demand and supply
both decrease
Ambiguous
Falls
Demand increases,
Supply decreases
Rises
Ambiguous
Demand decreases,
Supply increases
Falls
Ambiguous
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Size of Changes in Market
Equilibrium
What determines the size of changes in
market equilibrium?
Size of change in demand (or supply)
The larger the shift in demand (or supply), the
larger the effect on price)
Steepness of the curve that does not shift
If the supply curve shifts, the steeper demand
curve the more the price changes the less the
amount bought and sold changes
Steepness reflects responsiveness to prices
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Figure 2.11: Changes in Equilibrium for Two
Extreme Demand Curves
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Figure 2.13: Changes in Equilibrium for Two
Extreme Supply Curves
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Figure 2.14: Changes in Equilibrium for Two
Supply Curves
If the price rises,
which curve (S1 or
S2) produces a
greater change in
price and quantity?
Why?
What could be
examples of goods
with supply curves
that look like these?
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Elasticities of Demand and Supply
Elasticity is a measure of the responsiveness
of the amounts demanded and supplied to
changes in prices
Not the same as the slope of the supply or
demand curve
Slope of the curve depends on the units used
to measure the quantity of the good and its
price
Elasticity does not depend on units (e.g.,
gallons, dozens, dollars per pound) but looks
at % changes.
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General Elasticity Formula
Suppose that a change in X causes a change in
Y.
Then the elasticity of Y with respect to X is the
percentage change in Y divided by the
percentage change in X:
E
Y
X
% changein Y
% changein X
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Interpreting an Elasticity
Suppose E XY 2
Then Y increases 2% for each 1% increase
in X
If instead Y decreased 2% when X increased
by 1%, the elasticity would be negative.
Note that the elasticity is unit-free; its
meaning is clear without information about
the units of X or Y.
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Price Elasticity of Demand
Elasticity of demand for a product with
respect to its price
Usually called “elasticity of demand”
d
Denoted E
Elasticity of demand equals the percentage
change in the amount demanded divided by
the percentage change in the price
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Price Elasticity of Demand
Formula:
% amountdemanded Q Q
E
P P
% price
d
Note: the triangle is also called delta and stands for change.
Expect Ed to be negative:
When P increases, amount demanded typically
decreases
When P decreases, amount demanded typically
increases
In Principles of Economics, the book used the
absolute value of the elasticity. Here, we will be
spending a little more time looking at whether
the numbers are negative or positive.
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Price Elasticity of Demand
Goods tend to have more price elastic
demand when:
They have close substitutes
Buyers of the product consider it a luxury
Buyers of the product have less money and
are thus sensitive to changes in their
expenditures
In general, elasticity of demand varies at
different points along a demand curve
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Elasticities for Linear Demand Curves
For linear demand curves, re-write the price
elasticity of demand formula as:
Q P
E
P Q
d
Notice that the first term is related to the
slope of the demand curve
The second term is the initial price divided by
the initial quantity
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Elasticities for Linear Demand Curves
Notice that:
Slope is constant along linear demand curve
but (P/Q) varies, so elasticity varies along
the demand curve
Demand is more elastic at higher prices
since P is larger and Q is smaller
Demand is less elastic at lower prices since
P is smaller and Q is larger
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Categories of Elasticity of Demand
Condition for Ed
Elastic
Ed<-1
Inelastic
0>Ed>-1
Perfectly Elastic
Ed=infinity
Perfectly Inelastic
Ed=0
Unit Elastic
Ed=1
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Figure 2.15: Elasticities Along a
Linear Demand Curve
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Elasticity for Nonlinear Demand
Curves
Calculating elasticity of demand is
possible when the demand curves are
nonlinear.
Isoelastic demand curves have the same
elasticity at every price.
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Elasticity Example
Consider the linear
demand curve for
oranges below. This
graph depicts the effects
of a series of hurricanes
on the US orange market.
What is the elasticity of
demand at a price of
$2.35 per box? At $3.49?
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Elasticity Example
What is the elasticity of demand at a price of
$2.35 per box? At $3.49?
For $2.35…
(150-242)/(3.49-2.35)=-92/1.14= -80.7
-80.7(2.35/242)= -.78
For $3.49…
-1.88
Elastic/Inelastic?
What does this mean?
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Total Expenditure and Elasticity of
Demand
Total expenditure equals P*Q, the
product of the price and the total amount
demanded
Elasticity of demand shows how total
expenditure changes when price
increases
TE will increase with a small increase in
price when demand is inelastic and
decrease when demand is elastic
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Total Expenditure and Elasticity of
Demand
TE is largest at a price for which elasticity
equals -1
What does this mean?
A Buyer’s Total Expenditure =
Seller’s Total Revenue so…this
point signifies the revenue
maximizing point.
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Figure 2.18: Price, Elasticity, and
Total Expenditure
TE increases where
demand is inelastic;
for prices below
$3.75
TE falls where
demand is elastic
TE is largest where
Ed = -1; when price =
$3.75
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Elasticity Example - Revisited
We determined that the
price elasticity of oranges
was -.78 at $2.35 per box
and -1.88 at $3.49.
If we take total consumer
expenditures into
account….what does the
above mean for orange
farmers after the storms?
How badly did the storms
hurt farm revenue?
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Price Elasticity of Supply
Responsiveness of a product’s supply to
changes in its price
Elasticity of supply equals the percentage
change in the amount supplied divided by
the percentage change in the price
Basic ideas are the same as for elasticity of
demand
% amountsupplied Q Q
E
P P
% price
s
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Price Elasticity of Supply
What does it mean if the Supply Curve is:
Perfectly inelastic (b)
Perfectly elastic (a)
Elastic
Inelastic
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Other Elasticities
Income Elasticity of Demand
% change in the amount demanded divided by
the % change in income.
Or…the % change in the amount demanded for
each 1% increase in income.
Normal Good / Inferior Good
More in Ch 5
Cross-price elasticity
Measure the elasticity of demand for a product
with respect to the price of another product.
Substitutes have a positive cross-price elasticity.
Complements have a negative cross-price
elasticity
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Elasticity – What Good is It?
Who might want to figure out elasticity?
What would they use it for?
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Summary
Demand Curve…
shows the amount people wish to buy at each
possible price.
Determined by the demand function which gives
the total demand for every combo of price and
factors.
Changes can move the point or the curve.
Supply Curve…
shows the amount people wish to sell at each
possible price.
Determined by the supply function which gives
the total supply for every combo of price and
factors.
Changes can move the point or the curve.
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Summary
Market Equilibrium…
Demand & Supply curves intersect.
Will change based on changes in demand, prices,
availability, etc.
Elasticity of Demand and Supply
How responsive is demand/supply to changes in
price %s
If inelastic, changes have less effect
If elastic changes have greater effect
Elasticity affects total revenue earned by
suppliers.
Elas. applicable to changes in income or the
prices of substitutes/complements.
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Appendix
We used demand functions to figure out the
demand for corn. Where do those functions
come from?
Use historical or modeled data and
econometrics (linear regression, etc.) to
derive the function and the “average” curve.
We wont be doing much of this in class. This
subject will be covered in much more detail in
Prof. Wong’s exciting Econometrics course!
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Final Exercise
Consider again the demand function for corn
in formula (1), (A)graph the corresponding
demand curve when potatoes and butter cost
$.075 and $4 per pound respectively, and
average income is $40,000 per year. (B) At
what price does the amount demanded equal
15 billion bushels a year? Show your answer.
d
Qcorn
5 2Pcorn 4Ppotatoes 0.25Pbutter 0.0003M
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Final Exercise - Answer
d
Qcorn
5 2Pcorn 4Ppotatoes 0.25Pbutter 0.0003M
Step 1: Plug in new information.
Qdcorn = 5 – 2Pcorn + 4Ppotatoes – 0.25Pbutter + .0003M
Qdcorn = 5 – 2Pcorn + 4(0.75) – 0.25(4.00) + .0003(40,000)
Qdcorn = 5 – 2Pcorn + 3 – 1 + 12
Qdcorn = 19 – 2Pcorn
Step 2: Find intercepts…(a) P=0 and (b) Solve for P
(a) Q=19…billion bushels
(b) P=$9.50
Step 3: Price at 15 b. bushels….
Qdcorn = 19 – 2Pcorn
15 = 19 – 2Pcorn
2Pcorn = 4
Pcorn = 2
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