Unit 2: Supply & Demand

The Law of Demand

Demand – the desire to own something and the ability to pay for it.

Law of Demand – consumers buy more of a good when its price decreases and less when its price increases.

study of the behavior and decision making of entire economies. This branch examines major trends of the

economy as a whole.

Quantity Demanded: amount (number) desires at a particular price

Effect of price on demand for Coffee

Price of Coffee Quantity Demanded

$1 20

$2 16

$3 12

$4 8

$5 4

Optional: https://www.khanacademy.org/economics-finance-domain/microeconomics/supply-demand-

equilibrium/demand-curve-tutorial/v/law-of-demand

Price

As Prices

go up

Demand

Quantity

demanded

goes down.

Price

As Prices

go down

Demand

Quantity

demanded

goes up.

Individual vs. Market Demand

Consumers can change their spending patterns. Two different ways that consumers change their spending

patterns is demonstrated by the substitution effect and the income effect.

Substitution Effect

Substitution Effect – when consumers react to an increase in a good’s price by consuming less of that good and

more of other goods.

Example: Dominoes comes in to school and sells Pizza for $1/slice at lunch. If Dominoes

raises its price, students will substitute the pizza they were buying with school lunches.

The same is true for the opposite. If Dominoes were to lower its price to $0.25/slice, the

quantity demanded of pizza would increase.

Quantity Demanded

Pizza for $1/slice 400

Pizza for $3/slice 100

Pizza for $0.25/slice 1000

Income Effect

Income Effect – the change in consumption resulting from a change in real income.

** Example: When the price of pizza goes up and you choose to NOT substitute the pizza fro

something else in the lunch room, and instead only purchase less pizza Income Effect

Price of A increases Price of A decreases

Consumption of A Consumption of

Other Goods Consumption of A

Consumption of

Other Goods

Income Effect Substitution Effect Combined Effect

Shifts of the Demand Curve

Ceteris Paribus – all other things held constant.

****Factors other than Price can influence Demand!!!****

Suppose that Andrew has a Hot Chocolate Stand in Buffalo, NY. Do you believe that Andrew’s

Hot Chocolate stand would prosper? What would happen if Buffalo received a heat wave?

Would people still purchase as much Hot Chocolate as before? Probably NOT.

Because of the decrease in amount of Hot Chocolate purchased as a result of the

heat wave, we would see a shift in the Demand Curve.

Change (Movement) Along the Curve Right (Increase) Shift of the Demand

Curve

Left (Decrease) Shift of Demand Curve

∆P – movement along the line (/ QD)

∆ anything else = shift the line (/ D)

What Factors affect Demand? AKA – Determinants of Demand

1. Price of that good – Will result in Movement along the Demand Curve (Quantity Demanded)

2. Tastes or Preferences (includes advertising) –

If a person believes that eating eggs is good for him, then he will have a strong taste for eggs.

IF a person believes that they will be cool (or look really hot) if they were a pair of expensive jeans

then that person will be more likely to purchase the expensive jeans regardless of price.

3. Consumer Expectations –

May purchase real estate with the expectation that the value will increase

4. # of Consumers / Population –

Population explosion or depletion

New Orleans after Hurricane Katrina. Population Depletion will result in a decrease in Demand as a

result of the decreased size of the population.

5. Income -

a. Normal Goods – as your income increases, you demand more of the product. (ex. Housing,

Vehicles, CDs, Movie Tickets, most goods)

b. Inferior Goods – as your income increases, you demand less of the product. (ex. SPAM, Used

Cars, Mac n’ Cheese)

Watch This: https://www.khanacademy.org/economics-finance-

domain/microeconomics/supply-demand-equilibrium/demand-curve-tutorial/v/normal-and-

inferior-goods

6. Price of Other Goods –

a. Substitute Good – goods used in place of one another

If the price of butter increases, then the demand for margarine will increase

b. Complementary Good

If the price of bacon increases, then the demand for eggs will decrease.

The Law of Supply

Supply – the amount producers are willing and able to sell at a given price

Law of Supply – the higher the price, the larger the quantity produced; the lower the price, the lower the

quantity supplied.

Individual v. Market Supply Curve

****

Fac

tors

that

will ca

use a

SHIFT

in

dem

and**

***

Price

As Prices

go up

Supply

Quantity

supplied

goes down.

Price

As Prices

go down

Supply

Quantity

supplied

goes up.

Optional: https://www.khanacademy.org/economics-finance-domain/microeconomics/supply-demand-

equilibrium/supply-curve-tutorial/v/law-of-supply

What Factors affect Supply? – AKA Determinants of Supply Watch This: https://www.khanacademy.org/economics-finance-domain/microeconomics/supply-demand-

equilibrium/supply-curve-tutorial/v/factors-affecting-supply

1. Price of good – Will result in Movement along the Demand Curve (Quantity Supplied)

2. Change in input prices –As costs increase, marginal costs increase. Since suppliers have NO control

over price, the only solution to higher costs for suppliers is to cut production and lower marginal costs

until marginal costs equals the lower price.

3. Change in Technology – Technology can have the opposite affect and cause the cost of production of a

good to drop

4. Price of alternate goods

5. Producer Expectations (of Prices)

6. Number of Producers/Sellers

7. Subsidies – a government payment or discount that supports a business or market.

8. Excise Taxes- a tax on the production or sale of a good

9. Regulation – government intervention in a market that affects the production of a good

Fac

tors

that

will ca

use a

SHIF

T in

sup

ply

curv

e

Left (Decrease) Shift of Supply Curve Movement Along Supply Curve Right (Increase) Shift of Supply Curve

Market Equilibrium – Putting it all together

In a world of scarcity there is competition for what is scarce. Once scarcity arises there has to be a method

to ration the available resources or good/services.

US Capitalism: How do we ration goods?

The Price System – one in which prices are constantly changing to reflect changes in demand and supply for

goods/services.

We must look at the interaction between DEMAND and SUPPLY to determine MARKET EQUILIBRIUM (market

clearing price) – a stable point at which there is NO movement unless there is a SHIFT in demand or supply.

Changes in Demand or Supply:

D ___ S ___ D ___ S ___ D ___ S ___ D ___ S ___

P ___ Q ___ P ___ Q ___ P ___ Q ___ P ___ Q ___

Watch This: https://www.khanacademy.org/economics-finance-domain/microeconomics/supply-demand-

equilibrium/market-equilibrium-tutorial/v/changes-in-market-equilibrium\\

What happens when Supply & Demand BOTH Shift? (this will only be a multiple choice question, not a free

response question).

http://www.youtube.com/watch?v=Ffcd6Wdkn5w

D

P S

Q Q

P

S S

D D

D1

D1

S1 S1 S2

S2

D2 D2

constant constant constant constant

Consumer Surplus, Producer Surplus, & Deadweight Loss

Consumer Surplus

difference between what a consumer is willing to pay and what they ultimately pay.

Producer Surplus

difference between what the seller is willing to accept for the product and what they actually get to

charge

Deadweight Loss

occurs when a restriction or inefficiency prohibits either entity (consumer or producer) from

maximizing their surplus

Deadweight Loss will equal the amount of total surplus that could have been divided up between the

producer and consumer had a transaction been able to occur

Example Below – a tax is placed on the good

Watch This: http://www.youtube.com/watch?v=xxygpwpG7mg

A – Consumer Surplus

B – Consumer Surplus Lost, now Tax Revenue received

by the government D – Producer Surplus Lost, now Tax Revenue received

by the government F – Producer Surplus

C + E = Deadweight Loss (efficiency loss)

Chapter 20: Supply and Demand, Elasticity and Government Set Prices

I. Price Floors and Ceilings

Watch This: http://www.youtube.com/watch?v=Ffcd6Wdkn5w

a. Price Ceilings – a government imposed limit on how high a price can be charged. (e.g. rent control in NYC)

Results in a shortage if the price is set below the equilibrium price.

NYC Apartments (rent controls imposed)

b. Price Floors – government imposed limit on how low a price can be charged. (e.g. milk prices, minimum

wage, union setting wages) Price floors result in a surplus if set above the market equilibrium price.

Wages (minimum wage imposed)

***predictions with minimum wage: increased unemployment & people with jobs will get a higher take-home wage.***

II. Elasticity, Elasticity, and Elasticity

a. Total Revenue (TR) = P x Q

S

D

P

Q

P

Q

Price Ceiling

Shortage

S

D

P

Q

P

Q

Price Floor

Surplus

Surplus of

workers with

minimum

wage!!!

b. Elasticity: measure of responsiveness of one variable to another. It measures the proportional change (%) in

one variable relative to the proportional change (%) in another variable.

c. Price Elasticity of Demand –

Watch This: https://www.khanacademy.org/economics-finance-

domain/microeconomics/elasticity-tutorial/price-elasticity-tutorial/v/price-elasticity-of-

demand

% ∆ QD = ∆Q/Q = (Q2 – Q1) / Q1

% ∆ P ∆P/P (P2 – P1) / P1

Example: compare the elasticity when price falls to the elasticity when it increases. When P1 = $50,

QD1 = 100, P2 = $30, QD2 = 300.

Price decreases: (300-100)/100 = 2 jj= 5

(30-50)/50 0.4

Price increases: (100-300)/300 = 2/3 jj= 1

(50-30)/30 2/3

d. Total Revenue & Elasticity:

1. Elastic Demand = elasticity >1

If P↓, Q↑ by more → TR increases (more revenue)

2. Unitary Elastic = elasticity = 1

%∆P does not effect TR

3. Inelastic Demand = elasticity < 1

If P↓, Q↑ by less → TR falls

Q

P

D

$30

$50

100 300

RULES:

If E>1, P↑ → TR↓

If E>1, P↓→ TR↑

If E<1, P↑ → TR↑

If E<1, P↓ → TR↓

If E=1, P↑ → TR same

If E=1, P↓ → TR same

Elastic

Unit Elastic

Inelastic

Five Degrees of Elasticity

4. Perfectly Elastic Demand

- Consumers are very responsive to a change in price

- ED = ∞

5. Elastic Demand

- Consumers are very responsive to a change in price

- Elasticity > 1

6. Unitary Elastic = 1

- Consumers change their consumption of goods in equal amount to the price change

7. Inelastic Demand

- Elasticity < 1

- Consumers are not very responsive to a change in price

P

Q

P

Q

P

Q

P

Q

D

D

D

D

8. Perfectly Inelastic Demand

- Consumers make no change to the quantity consumed when the price changes

- Elasticity = 0

III. More Elasticity

Refer back to yesterday’s example on the bottom of page 2.

When the P fell from $50 to $30 Ed = 2.5 Elastic

When the P rose from $30 to $50 Ed = 1 Unit Elastic

How is that the same #s can result in different elasticities on the graph? Which do we use to determine elasticity?

We need to use a better formula that Elasticity of Demand!!!

***Midpoint Formula for Elasticity of Demand / Arc Elasticity of Demand**

Ed = (Q2 – Q1) / midpoint Q ΔQ / (Sum Q / 2)

(P2-P1) / midpoint P ΔP / (Sum P / 2)

Total Revenue Test

What happened to TR as a result of Price? Was the demand for the good elastic, inelastic, or unit elastic?

Watch This: https://www.khanacademy.org/economics-finance-domain/microeconomics/elasticity-tutorial/price-

elasticity-tutorial/v/total-revenue-and-elasticity

P

Q

D

Elastic

Region

Inelastic

Region

Application:

Qd Tickets per

Week

Price per Ticket Elasticity

Coefficient

Total Revenue TR Test

1 $8 --- 8 Elastic

2 $7 8 14 Elastic

3 $6 3.5 18 Elastic

4 $5 2 20 Elastic

5 $4 1.25 20 Unit Elastic

6 $3 .8 18 Inelastic

7 $2 .5 14 Inelastic

8 $1 .07 8 Inelastic

Determinants of Price Elasticity of Demand

1. Substitutability – the larger the # of substitutes the greater the price elasticity of demand

2. Proportion of Income – the higher the price of the good relative to consumer’s income,

the greater the price elasticity of demand

a. Pencils – low priced items tend to have low elasticity

b. Automobile/housing – high priced items tend to have high elasticity

3. Luxuries vs. Necessities – the more a good is considered to be a luxury, the greater the

Ed.

4. Time – product demand is more elastic the longer the period of time considered.

a. Gasoline in the SR – more inelastic b/c people are stuck with their present vehicle

b. Gasoline in the LR – more elastic b/c people will switch to more fuel efficient

cars.

****Price Elasticity of Supply****

Es = %Δ in Qs

%Δ in P

Determinant of Price Elasticity of Supply is TIME. (page 383-4)

Market Period – Time is the most significant factor which affects the elasticity of supply. If the price of a commodity rises and the producers, have enough time to make adjustment in the level of output, the elasticity of supply will be more elastic. If the time period is short and the supply cannot be expanded after a price increase, the supply is relatively inelastic. o Short Run – relatively inelastic o Long Run - relatively elastic

Chapter 21 Notes

I. Explanation of the Law of Demand

1. The Income and Substitution Effect combine to make a consumer able and willing to buy more or

a specific good at a low price than at a high price.

a. Income Effect is the impact of a consumer’s real income of a change in the price of a

product and consequently the quantity of the product demanded. When the price of a good

decreases, people can buy more with the same income.

b. Substitution Effect is the impact on its relative expansiveness of a change in the product’s

price and consequently on the quantity demanded. When the price decreases, the good is less

expensive relative to other similar goods. We substitute with the now lower priced good.

2. Law of Diminishing Marginal Utility can be stated as the more a specific product consumer

obtains, the less they will want more units of the same product.

a. Utility is want-satisfying power. It is the satisfaction or pleasure one gets from consuming a

good or service. This is a subjective notion.

b. Total Utility is the total amount of satisfaction or pleasure a person derives from consuming

some quantity.

c. Marginal Utility is the EXTRA satisfaction a consumer realizes from an additional unit of

that product.

II. Theory of Consumer Behavior

1. Consumer Choice and Budget Restraints

a. Rational Behavior – derive the greatest satisfaction (“biggest bang for buck”)

b. Preferences – based on marginal utility

c. Budget Restraints – money income is limited

d. Prices – signal scarcity; consumer must compromise

When Total Utility is

at its peak, Marginal

Utility becomes zero.

Marginal utility

reflects the change in

total utility so its

negative when total

utility declines.

2. Utility Maximizing Rule – Consumer Equilibrium

a. The consumer’s money income should be allocated so that the last dollar spent on each

product purchased yields the same amount of marginal utility.

b. The rational consumer must compare the extra utility with its added cost.

Utility Maximizing with Income of $10

Units Product A $1 Product B $2

MU (utils) MU/$ MU (utils) MU/$

1st 10 10 24 12

2nd

8 8 20 10

3rd

7 7 18 9

4th

6 6 16 8

5th

5 5 12 6

6th

4 4 6 3

7th

3 3 4 2

Allocation Rule: consumer will maximize satisfaction when he allocates money income so that the last

dollar spent on A, on B, etc. will yield equal amounts of marginal utility.

MU of Product A = MU of Product B

Price of A Price of B

How many of A and how many of B? What is the combinations of A and B that can be had with $10?

Answer: 2 units of A and 4 units of B

MU of Product A = MU of Product B

Price of A Price of B

8 = 16

$1 $2

Watch This: http://www.youtube.com/watch?v=WglpOZOZyDI&list=PL6B2DBE4C2FC8F845