chapter 2 the basics of supply and demand

Chapter 2

The Basics of Supply and

Demand

Chapter 2: The Basics of Supply and Demand

Slide 2

Topics to Be Discussed

Supply and Demand

The Market Mechanism

Changes in Market Equilibrium

Elasticities of Supply and Demand

Short-Run Versus Long-Run Elasticities


Slide 3

Topics to Be Discussed

Understanding and Predicting the Effects of Changing Market Conditions

Effects of Government Intervention--Price Controls


Slide 4

Introduction

Applications of Supply and Demand AnalysisUnderstanding and predicting how world

economic conditions affect market price and production

Analyzing the impact of government price controls, minimum wages, price supports, and production incentives


Slide 5

Introduction

Applications of Supply and Demand AnalysisAnalyzing how taxes, subsidies, and import

restrictions affect consumers and producers


Slide 6

Supply and Demand

The Supply CurveThe supply curve shows how much of a good

producers are willing to sell at a given price, holding constant other factors that might affect quantity supplied


Slide 7

Supply and Demand

The Supply CurveThis price-quantity relationship can be shown

by the equation:

)(PQQ Ss


Slide 8

Horizontal axis measures quantity (Q) supplied innumber of units per time period

Vertical axis measures price (P) receivedper unit in dollars

Supply and Demand

The SupplyCurve Graphically


Quantity

Price($ per unit)


Slide 9

Supply and Demand

S

The supply curve slopesupward demonstrating that

at higher prices firmswill increase output



Quantity

Price($ per unit)

P1

Q1

P2

Q2


Slide 10

Supply and Demand

Non-price Determining Variables of SupplyCosts of Production

LaborCapitalRaw Materials


Slide 11

Supply and Demand

The cost of raw materials falls

At P1, produce Q2

At P2, produce Q1

Supply curve shifts right to S’

More produced at any price on S’ than on S

P S

Change in SupplyChange in Supply

Q

P1

P2

Q1Q0

S’

Q2


Slide 12

Supply and Demand

Supply - A ReviewSupply is determined by non-price supply-

determining variables as such as the cost of labor, capital, and raw materials.

Changes in supply are shown by shifting the entire supply curve.


Slide 13

Supply and Demand

Supply - A ReviewChanges in quantity supplied are shown by

movements along the supply curve and are caused by a change in the price of the product.


Slide 14

Supply and Demand

The Demand CurveThe demand curve shows how much of a

good consumers are willing to buy as the price per unit changes holding non-price factors constant.

This price-quantity relationship can be shown by the equation:

(P)QQ DD


Slide 15

Supply and Demand

Quantity

Horizontal axis measures quantity (Q) demanded innumber of units per time period

Vertical axis measures price (P) paidper unit in dollars

Price($ per unit)


Slide 16

Supply and Demand

D

The demand curve slopesdownward demonstrating that consumers are willing

to buy more at a lower priceas the product becomes

relatively cheaper and the consumer’s real income

increases.

Quantity

Price($ per unit)


Slide 17

Supply and Demand

Non-price Determining Variables of DemandIncome

Consumer Tastes

Price of Related GoodsSubstitutesComplements


Slide 18

DP

QQ1

P2

Q0

P1

D’

Q2

Change in DemandChange in Demand

Supply and Demand

Income Increases At P1, produce Q2

At P2, produce Q1

Demand Curve shifts right

More purchased at any price on D’ than on D


Slide 19

Shifts in Supply and Demand

Demand - A ReviewDemand is determined by non-price demand-

determining variables, such as, income, price of related goods, and tastes.

Changes in demand are shown by shifting the entire demand curve.

Changes in quantity demanded are shown by movements along the demand curve.


Slide 20


Quantity

D

S

The curves intersect atequilibrium, or market-

clearing, price. At P0 thequantity supplied is equalto the quantity demanded

at Q0 .

P0

Q0

Price($ per unit)


Slide 21


Characteristics of the equilibrium or market clearing price:

QD = QS

No shortage

No excess supply

No pressure on the price to change


Slide 22


Quantity

D

S

P0

Q0

If price is above equilibrium:

1) Price is above the market clearing price2) Qs > Qd

3) Price falls to the market-clearing price

P1

Surplus

Price($ per unit)


Slide 23


The market price is above equilibriumThere is excess supplyProducers lower pricesQuantity demanded increases and quantity

supplied decreasesThe market continues to adjust until the

equilibrium price is reached.

A SurplusA Surplus


Slide 24


D

S

Q1

Assume the price is P1 , then:1) Qs : Q1 > Qd : Q2 2) Excess supply is Q1:Q2.3) Producers lower price.4) Quantity supplied decreases

and quantity demanded increases.5) Equilibrium at P2Q3

P1

Surplus

Q2 Quantity

Price($ per unit)

P2

Q3


Slide 25


The market price is above equilibrium:There is excess supply

Producers lower prices

Quantity demanded increases and quantity supplied decreases

The market continues to adjust until the equilibrium price is reached

Surplus - Review:Surplus - Review:


Slide 26


D

S

Q1 Q2

P2

Shortage

Quantity

Price($ per unit)

Assume the price is P2 , then:1) Qd : Q2 > Qs : Q1

2) Shortage is Q1:Q2.3) Producers raise price.

4) Quantity supplied increases and quantity

demanded decreases.5) Equilibrium at P3, Q3

Q3

P3


Slide 27


The market price is below equilibrium:There is a shortage

Producers raise prices

Quantity demanded decreases and quantity supplied increases

The market continues to adjust until the new equilibrium price is reached.

ShortageShortage


Slide 28


Market Mechanism Summary

1) Supply and demand interact to determine the market-clearing price.

2) When not in equilibrium, the market will adjust to alleviate a shortage or surplus and return the market to equilibrium.

3) Markets must be competitive for the mechanism to be efficient.


Slide 29

Changes In Market Equilibrium

Equilibrium prices are determined by the relative level of supply and demand.

Supply and demand are determined by particular values of supply and demand determining variables.

Changes in any one or combination of these variables can cause a change in the equilibrium price and/or quantity.


Slide 30

S’

Q2

Raw material prices fall

S shifts to S’

Surplus @ P1 of Q1, Q2

Equilibrium @ P3, Q3

P

Q

SD

P3

Q3Q1

P1



Slide 31

D’ SD

Q3

P3

Q2

Income Increases

Demand shifts to D1

Shortage @ P1 of Q1, Q2

Equilibrium @ P3, Q3

P

QQ1

P1



Slide 32

D’ S’ Income Increases & raw material prices fall

The increase in D is greater than the increase in S

Equilibrium price and quantity increase to P2, Q2

P

Q

S

P2

Q2

D

P1

Q1



Slide 33

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


Slide 34

The Price of Eggs and the Priceof a College Education Revisited

The real price of eggs fell 59% from 1970 to 1998.

Supply increased due to the increased mechanization of poultry farming and the reduced cost of production.

Demand decreased due to the increasing consumer concern over the health and cholesterol consequences of eating eggs.


Slide 35

Market for Eggs

Q (million dozens)

P(1970

dollars perdozen)

D1970

S1970

$0.61

5,500

D1998

S1998

Prices fell untila new equilibrium

was reached at $0.26and a quantity

of 5,300 million dozen

$0.26

5,300


Slide 36

The Price of a College Education

The real price of a college education rose 68 percent from 1970 to 1995.

Supply decreased due to higher costs of equipping and maintaining modern classrooms, laboratories and libraries, and higher faculty salaries.

Demand increased due a larger percentage of a larger number of high school graduates attending college.


Slide 37

Market for a College Education

Q (millions of students enrolled))

P(annual cost

in 1970dollars)

D1970

S1970

S1995

D1995

$4,248

14.9

Prices rose untila new equilibrium

was reached at $4,573and a quantity

of 12.3 million students

$2,530

8.6


Slide 38


Wage Inequality in the United States

Real after-tax income from 1977 to 1999:

Rose 40+% for the top 20% of the income distribution

Fell 10+% for the bottom 20%


Slide 39


Question

Why did the income distribution become more unequal for 1977 to 1999?


Slide 40

Consumption & Price of Copper 1880-1998


Slide 41

The Long-Run Behaviorof Natural Resource Prices

ObservationsConsumption of copper has increased about

a hundred fold from 1880 through 1998 indicating a large increase in demand.

The real price for copper has remained relatively constant.


Slide 42

S1998

D1998D1900

S1900 S1950

D1950

Long-Run Path ofPrice and Consumption


Quantity

Price


Slide 43

ConclusionDecreases in the costs of production have

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



Slide 44

ObservationTo accurately predict the future price of a

product or service, it is necessary to consider the potential change in supply and demand.

1970 predictions for oil and other minerals proved incorrect because they only considered the demand side of the market.



Slide 45


Generally, elasticity is a measure of the sensitivity of one variable to another.

It tells us the percentage change in one variable in response to a one percent change in another variable.


Slide 46


Measures the sensitivity of quantity demanded to price changes.It measures the percentage change in the

quantity demanded for a good or service that results from a one percent change in the price.

Price Elasticity of DemandPrice Elasticity of Demand


Slide 47


The price elasticity of demand is:

P)Q)/(%(% EP


Slide 48


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



Slide 49


So the price elasticity of demand is also:

P

Q

Q

P

P/P

Q/Q EP



Slide 50


Interpreting Price Elasticity of Demand Values

1) Because of the inverse relationship between P and Q; EP is negative.

2) If EP > 1, the percent change in quantity is greater than the percent change in

price. We say the demand is price elastic.


Slide 51


Interpreting Price Elasticity of Demand Values

3) If EP < 1, the percent change in quantity is less than the percent change in price. We say the

demand is price inelastic.


Slide 52


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

Few substitutes demand is price inelastic



Slide 53

Price Elasticities of Demand

Q

Price

Q = 8 - 2P

Ep = -1

Ep = 0

- EP The lower portion of a downward sloping

demand curve is less elasticthan the upper portion.

4

8

2

4

Linear Demand CurveQ = a - bPQ = 8 - 2P


Slide 54


DP*

- EP

Quantity

Price Infinitely Elastic Demand


Slide 55


Q*

0 EP

Quantity

PriceCompletely Inelastic Demand


Slide 56


Income elasticity of demand measures the percentage change in quantity demanded resulting from a one percent change in income.

Other Demand ElasticitiesOther Demand Elasticities


Slide 57


The income elasticity of demand is:

I

Q

Q

I

I/I

Q/Q EI



Slide 58


Cross 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.

For example consider the substitute goods, butter and margarine.



Slide 59


The cross elasticity of demand is:

m

b

b

m

mm

bbPQ

P

Q

Q

P

/PP

/QQ E mb

The cross elasticity for substitutes is positive, while that for complements is negative.


Slide 60


Price elasticity of supply measures the percentage change in quantity supplied resulting from a 1 percent change in price.

The elasticity is usually positive because price and quantity supplied are directly related.

Elasticities of SupplyElasticities of Supply


Slide 61


We can refer to elasticity of supply with respect to interest rates, wage rates, and the cost of raw materials.

Elasticities of SupplyElasticities of Supply


Slide 62


1981 Supply Curve for Wheat

QS = 1,800 + 240P

1981 Demand Curve for Wheat

QD = 3,550 - 266P

The Market for WheatThe Market for Wheat


Equilibrium: Q S = Q D

PP 266550,3240800,1

750,1506 P

bushelP /46.3

bushels million 630,2)46.3)(240(800,1 Q


Chapter 2: The Basics of Supply and Demand Slide 63


Inelastic 035.)66.2(630,2

46.3

P

Q

Q

PE DD

P

Inelastic 032.)40.2(630,2

46.3

P

Q

Q

PE SS

P


Chapter 2: The Basics of Supply and Demand Slide 64


Slide 65


Assume the price of wheat is $4.00/bushel

486,2)00.4)(266(550,3 DQ

43.0)266(486,2

00.4D

PQ



Slide 66

1981 1800 + 240P 3550 - 266P 1800+240P = 3550-266P506P = 1750

P1981 = $3.46/bushel

1998 1,944 + 207P 3,244 - 283P 1,944+207P = 3,244-283P P1998 = $2.65/bushel

Supply (Qs) Demand (QD) Equilibrium Price (Qs = QD)

Changes in the Market: 1981-1998



Slide 67


Price elasticity of demand varies with the amount of time consumers have to respond to a price.

DemandDemand


Slide 68

Most goods and services:Short-run elasticity is less than long-run

elasticity. (e.g. gasoline, Drs.)

Other Goods (durables):Short-run elasticity is greater than long-run

elasticity (e.g. automobiles)


DemandDemand


Slide 69

Gasoline: Short-Run andLong-Run Demand Curves

DSR

DLR

People tend to drive smaller and more fuel efficient

cars in the long-run

Gasoline

Quantity

Price


Slide 70

DSR

DLR

People may putoff immediate

consumption, buteventually older cars

must be replaced.

Automobiles

Automobiles: Short-Run andLong-Run Demand Curves

Quantity

Price


Slide 71

Income elasticity also varies with the amount of time consumers have to respond to an income change.


Income ElasticitiesIncome Elasticities


Slide 72

Most goods and services:Income elasticity is greater in the long-run

than in the short run.Higher incomes may be converted into

bigger cars so the income elasticity of demand for gasoline increases with time.




Slide 73

Other Goods (durables):Income elasticity is less in the long-run than

in the short-run.Originally, consumers will want to hold

more cars. Later, purchases will only to be to replace

old cars.




Slide 74

Gasoline and automobiles are complementary goods.


The Demand forGasoline and Automobiles



Slide 75

GasolineThe long-run price and income elasticities

are larger than the short-run elasticities.

AutomobilesThe long-run price and income elasticities

are smaller than the short-run elasticities.





Slide 76

Price -0.11 -0.22 -0.32 -0.49 -0.82 -1.17

Income 0.07 0.13 0.20 0.32 0.54 0.78

Years Following Price or Income Change

Elasticity 1 2 3 4 5 6

The Demand for GasolineThe Demand for Gasoline



Slide 77

Price -1.20 -0.93 -0.75 -0.55 -0.42 -0.40

Income 3.00 2.33 1.88 1.38 1.02 1.00

Years Following Price or Income Change

Elasticity 1 2 3 4 5 6

The Demand for AutomobilesThe Demand for Automobiles



Slide 78

Data Explains:

1) Why the price of oil did not continue to rise above $30/barrel even though it rose very rapidly in the early 1970s.

2) Why automobile sales are so sensitive to the business cycle.





Slide 79

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


SupplySupply


Slide 80

SSR

Primary Copper: Short-Run and Long-Run Supply Curves

Primary Copper: Short-Run and Long-Run Supply Curves

Quantity

Price


SLR

Due to limitedcapacity, firmsare limited by

output constraintsin the short-run.

In the long-run, theycan expand.


Slide 81

SSR

Secondary Copper: Short-Run and Long-Run Supply Curves

Secondary Copper: Short-Run and Long-Run Supply Curves

Quantity

Price


SLR

Price increasesprovide an incentive

to convert scrapcopper into new supply.

In the long-run, thisstock of scrap copper

begins to fall.


Slide 82

Primary supply 0.20 1.60

Secondary supply 0.43 0.31

Total supply 0.25 1.50

Price Elasticity of: Short-run Long-run

Supply of CopperSupply of Copper



Slide 83

Elasticity explains why coffee prices are very volatile.Due to the differences in supply elasticity in

the long-run and short run.


Weather in Brazil andthe price of Coffee

in New York

Weather in Brazil andthe price of Coffee

in New York


Slide 84

Price of Brazilian Coffee


Slide 85

D

S

P0

Q0 Quantity

Price

P1

Short-Run1) Supply is completely inelastic2) Demand is relatively inelastic3) Very large change in price

A freeze or drought decreases the supply

of coffee

S’

Q1

Short-Run Versus Long-Run ElasticitiesCoffeeCoffee


Slide 86

S’

D

S

P0

Q0

P2

Q2

Intermediate-Run1) Supply and demand are more elastic2) Price falls back to P2.3) Quantity falls to Q2


Quantity

Price

CoffeeCoffee


Slide 87

D

SP0

Q0

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

Short-Run Versus Long-Run ElasticitiesCoffeeCoffee

Quantity

Price


Slide 88

First, we must learn how to “fit” linear demand and supply curves to market data.

Then we can determine numerically how a change in a variable will cause supply or demand to shift and thereby affect the market price and quantity.



Slide 89

Available DataEquilibrium Price, P*

Equilibrium Quantity, Q*

Price elasticity of supply, ES, and demand, ED.



Slide 90

Demand: Q = a - bP

a/bSupply: Q = c + dP

-c/d

P*

Q*

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


Quantity

Price


Slide 91

Let’s begin with the equations for supply and demand:

Demand: QD = a - bP

Supply: QS = c + dP

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



Slide 92

Step 1:

Recall:

P)Q/(P/Q)( E



Slide 93

For linear demand curves, the change in quantity divided by the change in price is constant (equal to the slope of the curve).



Slide 94

Substituting the slopes for each into the formula for elasticity, we get:

/Q*)*b(P- ED

/Q*)*d(P ES



Slide 95

Since we will have values for ED, ES, P*, and Q*, we can solve for b & d, and a & c.


** bPaQD ** dPcQS


Slide 96

Deriving the long-run supply and demand for copper:The relevant data are:

Q* = 7.5 mmt/yr.P* = 75 cents/pound

ES = 1.6

ED = -0.8



Slide 97

Es = d(P*/Q*)

1.6 = d(75/7.5) = 0.1d

d = 1.6/0.1 = 16

Ed = -b(P*/Q*)

-0.8 = -b(.75/7.5) = -0.1b

b = 0.8/0.1 = 8



Slide 98

Supply = QS* = c + dP*

7.5 = c + 16(0.75)

7.5 = c + 12

c = 7.5 - 12

c = -4.5

Q = -4.5 + 16P

Demand = QD* = a -bP*

7.5 = a -(8)(.75)

7.5 = a - 6

a = 7.5 + 6

a =13.5

Q = 13.5 - 8P



Slide 99

Setting supply equal to demand gives:

Supply = -4.5 + 16p = 13.5 - 8p = Demand

16p + 8p = 13.5 + 4.5

p = 18/24 = .75



Slide 100

Supply: QS = -4.5 + 16P

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

a/b

.75

7.5


Mmt/yr

Price


Slide 101

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

Demand could also depend upon income.

Demand would then be written as:


fIbPaQ


Slide 102

We know the following information regarding the copper industry:I = 1.0

P* = 0.75

Q* = 7.5

b = 8

Income elasticity: E = 1.3



Slide 103

f can be found by substituting known values into the income elasticity formula:

IQf /

)/)(/( IQQIE and



Slide 104

Solving for f gives:

1.3 = (1.0/7.5)f

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



Slide 105

Solving for a gives:

7.5 = a - 8(0.75) + 9.75(1.0)

a = 3.75


fIbPaQ **


Slide 106

Declining Demand and the Behavior of Copper Prices

The relevant factors leading to a decrease in the demand for copper are:

1) A decrease in the growth rate of power generation

2) The development of substitutes: fiber optics and aluminum


Slide 107

Real versus NominalPrices of Copper 1965 - 1999


Slide 108

We will try to estimate the impact of a 20 percent decrease in the demand for copper.

Recall the equation for the demand curve:

Q = 13.5 - 8P



Slide 109

Multiply this equation by 0.80 to get the new equation. This gives:

Q = (0.80)(13.5 - 8P)

Q = 10.8 - 6.4P

Recall the equation for supply:

Q = -4.5 + 16P



Slide 110

The new equilibrium price is:

-4.5 + 16P = 10.8 - 6.4P

-16P + 6.4P = 10.8 + 4.5

P = 15.3/22.4

P = 68.3 cents/pound



Slide 111

The twenty percent decrease in demand resulted in a reduction in the equilibrium price to 68.3 cents from 75 cents, or 10 percent.



Slide 112

Price of Crude Oil


Slide 113

Upheaval in the World Oil Market

We can predict numerically the impact of a decrease in the supply of OPEC oil.

In 1995:P* = $18/barrel

World demand and total supply = 23 bb/yr.

OPEC supply = 10 bb/yr.

Non-OPEC supply = 13 bb/yr


Slide 114

Price Elasticity Estimates

World Demand: -0.05 -0.40

Competitive Supply 0.10 0.40(non-OPEC)

Short-Run Long-Run


Slide 115


Short-Run Impact of a stoppage of Saudi Production equal to 3 bb/yr.

Short-run Demand

D = 24.08 - 0.06P

Short-run Competitive Supply

SC = 11.74 + 0.07P


Slide 116


Short-Run Impact of a stoppage of Saudi Production equal to 3 bb/yr.Short-run Total Supply--before supply

reduction (includes OPEC, 10bb/yr)

ST = 21.74 + 0.07P

Short-run Total Supply--after supply reduction

ST = 18.74 + 0.07P


Slide 117


New Price After Reduction

Demand = Supply

24.08 - 0.06P = 18.74 + 0.07P

P = 41.08


Slide 118

D

Quantity(billions barrels/yr)

Price($ per barrel)

5

18

ST

0 5 15 20 25 30 3510

10

15

20

25

30

35

40

45

23

Impact of Saudi Production CutSC

Short-RunEffect

S’T


Slide 119


Long-Run Impact of a stoppage Saudi Production equal to 3 bb/yr..

Long-run Demand

D = 32.18 - 0.51P

Long-run Total Supply

S = 17.78 + 0.29P


Slide 120


New Price is found setting long-run supply equal to long-run demand:

32.18 - 0.51P = 14.78 + 0.29P

P = 21.75


Slide 121

D

Quantity(billions barrels/yr)

Price($ per barrel)

5

ST

0 5 15 20 25 30 3510

10

15

20

25

30

35

40

45

23

18

Impact of Saudi Production Cut

SC

Due to the elasticityof the long-run

supply and demand curves, the long-run

effect of a cutin production is

much less.

S’T Long-run Effect


Slide 122

Effects of Government Intervention --Price Controls

If the government decides that the equilibrium price is too high, they may establish a maximum allowable ceiling price.


Slide 123

D

Effects of Price Controls

Quantity

Price

P0

Q0

S

Pmax

Excess demand

If price is regulated tobe no higher than Pmax,quantity supplied falls

to Q1 and quantitydemanded increases toQ2. A shortage results


Slide 124

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.


Slide 125

Price controls created an excess demand of 7 trillion cubic feet.

Price regulation was a major component of U.S. energy policy in the 1960s and 1970s, and it continued to influence the natural gas markets in the 1980s.



Slide 126

$2/TcF @

1.5 oil for demand of elasticity Cross

0.1 oil forsupply of elasticity Cross

DemandSupply

PPQDemand

PPQSupply

P

P

OG

OG

DE

SE

75.35:

25.214:

5.0

2.0


The Data: Natural GasThe Data: Natural Gas


Slide 127


The Data: Natural GasThe Data: Natural Gas

TcF/yr 7 Shortage

TcF 25 and TcF

$1.00/TcF At

$1.00 price regulated 1975

QQS 18


Slide 128

Summary

Supply-demand analysis is a basic tool of microeconomics.

The market mechanism is the tendency for supply and demand to equilibrate, so that there is neither excess demand nor excess supply


Slide 129

Summary

Elasticities describe the responsiveness of supply and demand to changes in price, income, and other variables.

Elasticities pertain to a time frame.

If we can estimate the supply and demand curves for a particular market, we can calculate the market clearing price.


Slide 130

Summary

Simple numerical analysis can often be done by fitting linear supply and demand curves to data on price and quantity and to estimates of elasticities.

End of Chapter 2

The Basics of Supply and

Demand

chapter 2 the basics of supply and demand

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