chapter 2 the basics of supply and demand. ©2005 pearson education, inc.chapter 22 introduction...

Chapter 2

The Basics of Supply and Demand

©2005 Pearson Education, Inc. Chapter 2 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?


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

S

The supply curve slopesupward demonstrating that

at higher prices firmswill increase output

The SupplyCurve Graphically

Quantity

Price($ per unit)

P1

Q1

P2

Q2


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


Change in Supply

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’

P S

Q

P1

P2

Q1Q0

S’

Q2


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

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


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


Change in Demand

Other Variables Affecting Demand Income

Increases in income allow consumers to purchase more at all prices

Consumer Tastes Price of Related Goods

SubstitutesComplements


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


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



D

S

The curves intersect atequilibrium, or market-

clearing, price. Quantity demanded

equals quantity supplied at P0

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


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



D

S

P0

Q0

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

P1

Surplus

Quantity

Price($ per unit)

QSQD



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.



D

S

QS QD

P2

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

Q3

P3

Shortage



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.


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


D’S

D

Q3

P3


Income Increases Demand increases to

D1 Shortage at P1 of Q1,

Q2 Equilibrium at P3, Q3

P

QQ1

P1

Q2


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

P

Q

S

P2

Q2

D

P1

Q1


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


Market for a College Education

Q (millions enrolled))

P(annual cost

in 1970dollars)

D1970

S1970

S2002

D2002

$3,917

13.2

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

$2,530

8.6


The Long-Run Behaviorof Natural Resource Prices

Consumption of copper has increased about a hundred fold 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


S2002

D2002

D1900

S1900 S1950

D1950

Long-Run Path ofPrice and Consumption

Resource Market Equilibrium

Quantity

Price


Resource Market

Conclusion Decreases in the costs of production have

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


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 change.

Elasticity gives a way to measure by how much a variable will change with the change in another variable.

Specifically, it gives 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.

P

QE

DDP

%

%



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

Therefore, elasticity can also be written as:

P

Q

Q

P

PP

QQE D

P



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



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



Looking at a linear demand curve, as we move along the curve Q/P will change

Price 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



Q

Price

4

8

2

4

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

Two extreme cases of demand curves Completely inelastic demand – vertical Infinitely elastic demand - horizontal


Infinitely Elastic Demand

DP*

Quantity

Price

EP =


Completely Inelastic Demand

Quantity

Price

Q*

D

EP = 0


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



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



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

Price of cars increases, quantity demanded of tired 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.

P

QE

SSP Δ%

Δ%


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

QP

PQE D

P ΔΔ


Elasticity: An Application

During 1980’s and 1990’s, market for wheat went through changes that had great implications for American farmers and US agricultural policy

Using the supply and demand curves for wheat, we can analyze what occurred in this market



Supply: QS = 1900 + 240P

Demand: QD = 3550 – 266P



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

035.)266(630,2

46.3

P

Q

Q

PE DD

P

032.)240(630,2

46.3

P

Q

Q

PE SS

P



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

PE



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

Price of wheat fell in nominal terms.


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

DSR

DLR

•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

Price



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 so its quantity demanded fall sharply.

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


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



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


SSR

Quantity Primary Copper

Price


SLR

Due to limitedcapacity, firmsare limited by

output constraintsin the short-run.

In the long-run, theycan expand.


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.


Supply of Copper


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


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


S’

D

S

P0

Q0

P2

Q2

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


Quantity

Price


SP0

Q0

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


Quantity

Price

D


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 dataGiven 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



We know Equilibrium Price, P*=$0.75 Equilibrium Quantity, Q*=7.5 Price elasticity of supply, ES=1.6 Price elasticity of demand, ED=-0.8



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.



The slope of the demand curve above equals Q/P which equals –b

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

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

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


Demand: Q = a - bP

a/bSupply: Q = c + dP

-c/d

P*

Q*

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


Quantity

Price



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

ES = d(P*/Q*)1.6 = d(0.75/7.5) = 0.1d

d = 16Q = c + dP

7.5 = c + (16)(0.75) = c + 12c = -4.5



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) = –0.1b

b = 8Q = a – bP

7.5 = a – (8)(0.75) = a – 6a = 13.5



We now have equations for supply and demand

Supply: Q = –4.5 + 16P

Demand: Q = 13.5 – 8PSetting them equal will give up

equilibrium price and quantity with which we began


Supply: QS = -4.5 + 16P

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

a/b

.75

7.5


Mmt/yr

Price



We have written supply and demand so that they only depend upon price

Demand could also depend upon other variable such as income

Demand would then be written as:

fIbPaQ



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



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

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

1.3 = (1.0/7.5)(f)

f = 9.75Substituting back into demand equation

gives a = 3.75


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


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



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 created an excess demand of 7 trillion cubic feet.

chapter 2 the basics of supply and demand. ©2005 pearson education, inc.chapter 22 introduction...

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