Part 2Markets: Demand,

Supply, and Elasticity

• What determines the price of a good or service and the quantity bought and sold?

• Demand and supply model of a market

• This simple model of a market assumes competitive conditions

• Distinguish between a demand side and a supply side of the market

• Together they determine the equilibrium price and quantity

Demand• Demand is the quantity of a good

people purchase over a given time • The quantity of a good a person will

plan to purchase will depend on:

- Preferences (tastes)

- Price of the good

- Prices of other goods

- Expected future prices

- Income• In the aggregate, demand will also

depend on:

- Population and demographics

The Law of Demand

• Other things remaining the same, the higher the price of a good, the smaller is the quantity demanded

• Substitution effect—the effect of the change in relative price

• Income effect—the effect of the change in overall purchasing power

Demand Function and Demand Curves

• Demand function—demand as a function of a number of variables

• Demand curve—demand as a function of price, everything else held constant

• What is held constant along a demand curve?

• Changes in the quantity demanded—movements along the demand curve

Changes in Quantity Demanded

P

Q

P’

P

P”

Q’ Q Q”

Decrease in quantity demanded

Increase in quantitydemanded

Change in quantity demanded—a movement along the demand curve

Demand Curves

• Can be linear or non-linear

• A linear demand curve

P

Q

20

30

P = 20 - 2/3Q

P = a + bQWhere a is the P intercept and b is the slopevariable and is negative

Demand Curves• A demand curve is more usually

written with Q as the dependent variable

P

Q

20

30

Q = a + bPWhere a is the Q intercept and b is the inverse of the slope and is negative

Q = 30 – 3/2P

Changes in Demand

• Shift in a demand curve is a Change in Demand

• Change in tastes or preferences• Change in the prices of other goods

- substitutes

- complements• Changes in expected future prices• Changes in income

- normal goods

- inferior goods• Changes in population/demographics

An Increase in Demand

• An increase in demand—a rightward shift

P

Q

D

D’

An Increase in Demand

• Price of a substitute rises

• Price of a complement falls

• Expected future price rises

• Income rises (normal good) or income falls (inferior good)

• Preferences move toward the good

• Population increases

A Decrease in Demand

• A decrease in demand—a leftward shift

P

Q

D

D’

A Decrease in Demand

• Price of a substitute falls

• Price of a complement rises

• Expected future price falls

• Income falls (normal good) or income rises (inferior good)

• Preferences move away from the good

• Population falls.

Supply

• Supply is the quantity of a good firms produce over a given time

• The firm has to have the resources and technology to produce the good

• The firm has to think it can produce the good at a profit (at least in the long run)

• Short run and long run supply decisions

Supply• The amount of any particular good

or service supplied by a firm will depend on:

- The price of the good

- The prices of inputs needed to produce the good

- The available technology

- The available capital (short run)

- Prices of other goods

- Expected future prices• In the aggregate, supply will also

depend on:

- The number of firms in the market

The Law of Supply

• Other things remaining the same, the higher the price of a good, the greater will be the quantity supplied

• Higher prices mean it will be profitable to expand production

• With rising marginal costs higher prices are required for firms to be willing to increase production

Supply Functions and Supply Curves

• Supply function

• Supply curve—shape

• Supply curves can only be defined for competitive industries (where price is a given to the firm)

• What is held constant along a supply curve?

• Changes in the quantity supplied—movements along the supply curve

Changes in Quantity Supplied

P

Q

P

Q’ Q Q”

Change in quantity supplied—a movement along the supply curve

P”

P’

S

Increase in quantitysupplied

Decrease in quantity supplied

Supply Curves

P

Q

S

10

P = 10 + 2Q

Slope is = 2

A linear supply curve: P = a + bQ where a is the P interceptAnd b is the slope which is positive

Supply Curves

Supply curves are more usually written with Q as the dependent variable: Q = a + bP where a is the Q intercept and b is the inverse of the slope and positive

P

Q

S

-5

Slope = 2 inverse of Slope = 1/2

Q = -5 + ½ P10

0

Changes in Supply

• Shift in a supply curve is a Change in Supply

• Change in input prices

• Changes in technology

• Changes in expected future prices

• Change in the scale of the firm

• Changes in the number of firms—entry and exit of firms

An Increase in Supply

An increase in supply—a rightward shift inthe supply curve

S S’P

Q

An Increase in Supply

• Price of inputs fall

• More efficient technology

• Expected future price fall

(ie natural resource production)

• Firms grow in size

• Number of firms in the industry grows

A Decrease in Supply

P

Q

S

S’

A decrease in supply is a leftward shift in the supply curve

A Decrease in Supply

• Price of inputs rise

• Expected future price rise (natural resources)

• Loss of technological knowledge

• Firms decline in size

• Number of firms in the industry shrinks

Market Equilibrium

• Market equilibrium is where demand = supply

• Equilibrium price• Equilibrium quantity• Price adjusts to bring about an

equilibrium• If D>S price rises which reduces

quantity demanded and increases quantity supplied

• If S>D price falls which increases quantity demanded and reduces quantity supplied

Market Equilibrium

P

Q

S

D

E

P*

Q*

Surplus-price falls

Shortage-Price rises

Market Equilibriumin Equations

• Demand curve D = a + bP where a is the Q intercept and b is the inverse of the slope (and negative)

• Supply Curve S = c + dP where c is the Q intercept (usually zero or negative) and b the inverse of the slope and positive

• In equilibrium D = S

• Solve for P* then Q*

Market Equilibriumin Equations

• Demand curve D = 400 – .5P

• Supply Curve S = – 200 + 1P

• Solve for P*

• 400 – .5P* = – 200 + 1P*

• 600 = 1.5P*

• P* = 400

• Solve for Q*

• Q* = 400 – 200

• Q* = 200

Market Equilibrium in Equations

Diagram of the equations

Q400

800

-200

S = -200 + 1P

D = 400 - .5P

200

P

400

Equilibrium Price and Quantity Changes

• A change in demand with a given supply curve

P

Q

S

D

D’

E

E’

• Rightward shift in demand leads to a movement along the supply curve. P and Q both rise.

P’

P

Q Q’

Equilibrium Price and Quantity Changes

• A change in supply with a given demand curve

D

SS’

E

E’

P

P

P’

Q Q’ Q

• A rightward shift in supply leads to a movement along the demand curve. P falls and Q rises.

Equilibrium Price and Quantity Changes

• A change in supply and demand —same directions

D

SS’

E

P

P

Q Q

• A rightward shift in both demand and supply leads to a higher Q. P may rise, fall, or stay the same.

Q’

E’

D’

Equilibrium Price and Quantity Changes

• A change in supply and demand —opposite directions

D’

S S’P

Q

• A rightward shift in supply and a leftward shift in demand leads to a lower P. Q may rise, fall, or stay the same.

D

E

E’

Q

P

P’

An Example• From Slate Magazine June 2009

in a discussion of a campaign by Chevron to get people to drive less: “All other things being constant, if every gullible soul performed the conservation miracles Chevron proposes, energy consumption would fall, and so would prices. As prices fell the non-gullible would take advantage of the depressed prices to consume more and thus drive the price back up.” Is this right?

Elasticity

• Elasticity is a measure of responsiveness

• Many elasticities can be measured: price elasticity of demand, cross price elasticity of demand, income elasticity of demand, and elasticity of supply

• Elasticity measures are measures of proportionate responsiveness and are unit free

Elasticity

• General form:

The elasticity of X with respect to Y is given by the % or proportionate change in X divided by the % or proportionate change in Y

• EXY = % Δ X / % Δ Y or

• EXY= ΔX/X / ΔY/Y or

• EXY=ΔX/ΔY • Y/X

Price Elasticity of Demand

• Elasticity of Demand with respect to the good’s own price

• EDxPx= %ΔQ/%ΔP or

• EDxPx= ΔQ/Q / ΔP/P or

• EDxPx= ΔQ/ΔP • P/Q

• For price elasticities of demand the sign is ignored as they are all negative

• Elastic demand > 1• Inelastic demand < 1• Unit elastic demand = 1

Inelastic and Elastic Demand

P

Q

D

Elasticity = 0

D

Elasticity =

Elasticity = 1

P

Q

P

QD

Price Elasticity of Demand Over an Arc

Dx

Qx(Kgs)

Px ($)

15

10

100 200

100

5

150

12.5

EDxPx= 100/150 / 5/12.5 = .66/.4 = 1.66

EDxPx= 100/5 x 12.5/150 = 20 x .083 = 1.66

If measuring price elasticityof demand over an arc use the average P and Q

Price Elasticity of Demand at a Point

EDxPx= ΔQ/ΔP • P/Q

ΔQ/ΔP = inverse of the slope of the demand curve

100

50

80

20

Slope = 2Inverse of slope = 0.5Elasticity = 0.5 x 4 = 2

Q

P

D

Price Elasticity Along a Straight Line Demand

Curve

P

Q

Slope = 2/3Inverse of slope = 1.5

EDxPx = 1

EDxPx > 1

EDxPx < 1

300150

200

100

EDxPx > 1 Elastic DemandEDxPx = 1 Unit Elastic DemandEDxPx < 1 Inelastic Demand

Price Elasticity of Demand and Total

Revenue• If the price elasticity of demand is >

1, then a reduction in price will increase quantity demanded more than proportionately and TR (P x Q) will increase.

• If the price elasticity of demand = 1, then a reduction in price will increase quantity demanded in proportion and TR will be unchanged

• If the price elasticity of demand is < 1, then a reduction of price will increase quantity demanded less than proportionately and TR will fall.

Price Elasticity of Demand and Total

Revenue

E = 1

D

P

Q

Q

TR

E > 1

E < 1

TR falling

Max TR

TRrising

Factors that Affect Price Elasticity of Demand

• The closeness of substitutes

- the more close substitutes the higher the price elasticity of demand

• The proportion of income spent on the good

- the higher the proportion of income spent on the good the higher the price elasticity of demand

• The time elapsed

- The more time elapsed the more elastic the demand

Cross Price Elasticity of Demand

• The elasticity of the demand for good X with respect to the price of another good Y

• EDxPy= %ΔQX/%ΔPY or• EDxPy= ΔQX/QX / ΔPY/PY or• EDxPy= ΔQX/ΔPY • PY/QX

• The sign matters, positive cross price elasticities indicate substitutes, negative cross price elasticities indicate complements

Complements and Substitutes

D

D’

D”

Q

P

The demand curve for good X shiftswith changes in the price of good Y

Price of a complement fallsPrice of a substitute rises

Price of a complement risesPrice of a substitute falls

Income Elasticity of Demand

• The elasticity of demand for good X with respect to income (I)

• EDxI= %ΔQX/%ΔI or• EDxI= ΔQX/QX / ΔI/I or• EDxI= ΔQX/ΔI • I/QX

• EDxI > 1 normal and income elastic • EDxI < 1 > 0 normal and income inelastic• EDxI <0 inferior good

• Necessaries, luxuries and income levels

Elasticity of Supply

• The elasticity of the supply of good X with respect to its own price

• ESxPx= %ΔQS/%ΔP or• ESxPx= ΔQS/QS / ΔP/P or• ESxPx= ΔQS/ΔP • P/QS

• Elasticities of supply can range from zero to infinity. Depends on technology, resource substitution, and time frame

• All straight line supply curves through the origin will have elasticities of supply = 1

Elasticity of Supply

SP

Q100 200

50

40

ESxPx = 100/10 x 45/150 = 3

100

10

An Example

• Times Colonist editorial concerning BC Ferry fares, July 2009: “Increased fares have resulted in fewer passengers. BC Ferries own figures indicate an 8% rise in fares results in a 2.25% drop in travel. Last year fares rose by 7.3%. Fewer passengers means less revenue for the Corporation and more fare increases. It is the start of a vicious cycle.” Is this correct?