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
2-2
Questions…
Why are Lamborghinis so expensive
whereas cheese burgers are not?
How are prices determined for products?
2-3
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?
2-4
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)
2-5
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
2-6
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?
2-7
Figure 2.1: Demand Curve for
U.S. Corn Market
(hypothetical)
2-8
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
2-9
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?
2-13
Figure 2.2: Demand Curve for U.S.
Corn Market
(hypothetical)
2-14
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
2-15
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
2-18
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
2-19
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
2-20
Figure 2.5: Change in Market
Equilibrium
Example:
falling
diesel
fuel
prices
shift the
corn
supply
curve out
2-21
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
2-23
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
2-24
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
2-25
Figure 2.9: Increase in Both Demand and Supply
2-26
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
2-27
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
2-28
Figure 2.11: Changes in Equilibrium for Two
Extreme Demand Curves
2-29
Figure 2.13: Changes in Equilibrium for Two
Extreme Supply Curves
2-30
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?
2-31
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.
2-32
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
2-33
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
2-35
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
2-39
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
2-40
Figure 2.15: Elasticities Along a
Linear Demand Curve
2-41
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
2-45
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.
2-46
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?
2-48
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
2-49
Price Elasticity of Supply
What does it mean if the Supply Curve is:
Perfectly inelastic (b)
Perfectly elastic (a)
Elastic
Inelastic
2-50
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
2-51
Elasticity – What Good is It?
Who might want to figure out elasticity?
What would they use it for?
2-52
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.
2-53
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.
2-54
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!
2-55
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
2-56
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
2-57