Demand and Supply

ECO 162 – MICROECONOMICS

Chapter 2: The Theory of Demand and Supply

Page 1

Supply • Supply – the quantity of a good that is offered for sale at all possible prices

Page 2

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

Q S  Q S (P) ©2005 Pearson Education, Inc.

Page 3

The Supply Curve S

Price ($ per unit)

The Supply Curve, Graphically Depicted P2 The supply curve slopes upward, demonstrating that at higher prices firms will increase output

P1

©2005 Pearson Education, Inc.

Q1

Q2

Quantity

Page 4

The Supply Curve • Other Variables Affecting Supply – Costs of Production • Labor • Capital • Raw Materials

– Lower costs of production allow a firm to produce more at each price and vice versa

Chapter ©2005 Pearson 2 Education, Inc.

Page 5

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

P1 P2

Q0 ©2005 Pearson Education, Chapter 2 Inc.

S’

Q1

Q2

Q

Page 6

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 the price of the good • Change in costs of production


Page 7

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

QD  QD(P) Chapter ©2005 Pearson 2 Education, Inc.

Page 8

The Demand Curve Price ($ per unit)

The demand curve slopes downward, demonstrating that consumers are willing to buy more at a lower price as the product becomes relatively cheaper.

P2 P1 D


Q1

Q2

Quantity Page 9

The Demand Curve • Other Variables Affecting Demand – Income • Increases in income allow consumers to purchase more at all prices

– Consumer Tastes – Price of Related Goods • Substitutes • Complements


Page 10

Change in Demand • Income Increases

P

D

D’

– Purchased Q0, at P2 P2 and Q1 at P1 – Now purchased Q1 at P2 and Q2 at P1 – Same for all prices P1 – Demand curve shifts right

Q0 ©2005 Pearson Education, Chapter 2 Inc.

Q1

Q2

Q Page 11

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 • Income • Preferences Chapter ©2005 Pearson 2 Education, Inc.

Page 12

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 Chapter ©2005 Pearson 2 Education, Inc.

Page 13

The Market Mechanism S

Price ($ per unit)

The curves intersect at equilibrium, or marketclearing, price. Quantity demanded equals quantity supplied at P0

P0

D


Q0

Quantity Page 14

The Market Mechanism • In equilibrium – There is no shortage or excess demand – There is no surplus or excess supply – Quantity supplied equals quantity demanded – Anyone who wants to buy at the current price can and all producers who want to sell at that price can


Page 15

Market Surplus1 • 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


Page 16

The Market Mechanism Price

S

($ per unit)

1.

Surplus

P1 2. 3.

P0

4.

D


Q D

Q0

QS

At P1, price is above the market clearing price Qs > QD Price falls to the market-clearing price Market adjusts to equilibrium

Quantity Page 17

The Market Mechanism • The market price is below equilibrium: – There is excess demand - shortage – Upward pressure on prices – Quantity demanded decreases and quantity supplied increases – The market adjusts until the new equilibrium is reached


Page 18

The Market Mechanism Price

($ per unit) 1.

2. 3.

P3

4.

P2

D

Shortage Chapter ©2005 Pearson 2 Education, Inc.

QS

Q 3

At P2, price is below the market clearing price Q D > QS Price rises to the marketclearing price Market adjusts to equilibrium

QD

Quantity Page 19

The Market Mechanism • 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 Chapter ©2005 Pearson 2 Education, Inc.

Page 20

Changes in Market Equilibrium • Equilibrium prices are determined by the relative level of supply and demand • Changes in supply and/or demand will cause change in the equilibrium price and/or quantity in a free market


Page 21

Changes in Market Equilibrium • Raw material prices fall

P

D

S

S’

– S shifts to S’ – Surplus at P1 between Q 1, Q 2 P1 – Price adjusts to equilibrium at P3, Q3 P3

©2005 Pearson Education, Chapter 2 Inc.

Q1 Q3Q2

Q Page 22

Changes in Market Equilibrium P

• Income Increases

D

D’

S

– Demand increases to D’ – Shortage at P1 of Q1 P3 to Q2 P1 – Equilibrium at P3 and Q3

Q1 Q3 Q ©2005 Pearson Education, Chapter 2 Inc.

2

Q Page 23

Changes in Market Equilibrium • Income increases and raw material prices fall – Quantity increases – If the increase in D is greater than the increase in S price also increases

©2005 Pearson Education, Chapter 2 Inc.

P

D

D’

S

S’

P2 P1

Q1

Q2

Q Page 24

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


Page 25

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 Chapter ©2005 Pearson 2 Education, Inc.

Page 26

Market for a College Education S2002

P

(annual cost

in 1970 dollars)

$3,917

S1970

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

$2,530

D1970 Chapter ©2005 Pearson 2 Education, Inc.

8.6

13.2

D2002 Q (millions

enrolled))

Page 27

The Long-Run Behavior of Natural Resource Prices – Consumption of copper has increased about a hundredfold 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


Page 28

Resource Market Equilibrium Price

S1900

S1950

S2002

Long-Run Path of Price and Consumption

D1900 Chapter ©2005 Pearson 2 Education, Inc.

D1950

D2002

Quantity

Page 29

Resource Market • Conclusion – Decreases in the costs of production have increased the supply by more than enough to offset the increase in demand


Page 30

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


Page 31

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

%QD E  %P D P


Page 32

Price Elasticity of Demand • 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 Q Q P Q D as: EP   P P Q P Chapter ©2005 Pearson 2 Education, Inc.

Page 33

Price Elasticity of Demand • 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| Chapter ©2005 Pearson 2 Education, Inc.

Page 34

Price Elasticity of Demand • 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


Page 35

Price Elasticity of Demand • Looking at a linear demand curve, as we move along the curve Q/P is constant, but P and Q 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 Chapter ©2005 Pearson 2 Education, Inc.

Page 36

Price Elasticity of Demand • 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 inelastic • Price is low and quantity high


Page 37

Price Elasticity of Demand Price

4

EP = -

Demand Curve Q = 8 – 2P

Elastic

Ep = -1

2

Inelastic


4

8

Q

Ep = 0 Page 38

Price Elasticity of Demand • The steeper the demand curve, the more inelastic the demand for the good becomes • The flatter the demand curve, the more elastic the the demand for the good becomes • Two extreme cases of demand curves – Completely inelastic demand – vertical – Infinitely elastic demand – horizontal Chapter ©2005 Pearson 2 Education, Inc.

Page 39

Infinitely Elastic Demand Price

EP =  P*


D

Quantity Page 40

Completely Inelastic Demand Price

D

EP = 0


Q*

Quantity Page 41

Other Demand Elasticities • Income Elasticity of Demand – Measures how much quantity demanded changes with a change in income

Q/Q I Q EI   I/I Q I Chapter ©2005 Pearson 2 Education, Inc.

Page 42

Other Demand Elasticities • 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

EQb Pm Chapter ©2005 Pearson 2 Education, Inc.

Qb Qb Pm Qb   Pm Pm Qb Pm Page 43

Other Demand Elasticities • Complements: Cars and Tires – Cross-price elasticity of demand is negative • Price of cars increases, quantity demanded of tires decreases

• Substitutes: Butter and Margarine – Cross-price elasticity of demand is positive • Price of butter increases, quantity of margarine demanded increases


Page 44

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

%QS E  %P S P


Page 45

Point vs. 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

E PD Chapter ©2005 Pearson 2 Education, Inc.



 ΔQ



P  ΔP  Q  Page 46

Elasticity: An Application • During the 1980’s and 1990’s, the 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


Page 47

Elasticity: An Application • Supply: QS = 1900 + 24P • Demand: QD = 3550 – 266P


Page 48

Elasticity: An Application QD = QS 1800 + 240P = 3550 – 266P 506P = 1750 P = $3.46 per bushel

Q = 1800 + (240)(3.46) = 2630 million bushels Chapter ©2005 Pearson 2 Education, Inc.

Page 49

Elasticity: An Application • We can find the elasticities of demand and supply at these points D EP

P ΔQD 3.46   ( 2.66)  .035 Q ΔP 2,630

S EP

P ΔQS 3.46   (2.40 )  .032 Q ΔP 2,630


Page 50

Elasticity: An Application • Assume the price of wheat is $4.00/bushel due to decrease in supply

QD  3,550  (266)(4.00)  2,486

4.00 Q  (266)  0.43 2,486 D P


Page 51

Elasticity: An Application • In 2002, the supply and demand for wheat were: – Supply: QS = 1439 + 267P – Demand: QD = 2809 – 226P


Page 52

Elasticity: An Application 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. Chapter ©2005 Pearson 2 Education, Inc.

Page 53

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


Page 54

Short-Run Versus Long-Run Elasticity • Demand – In general, demand is much more price elastic in the long run • Consumers take time to adjust consumption habits • Demand might be linked to another good that changes slowly • More substitutes are usually available in the long run


Page 55

Gasoline: Short-Run and Long-Run Demand Curves Price

DSR

• People cannot easily adjust consumption in the short run. • In the long run, people tend to drive smaller and more fuel efficient cars.

DLR


Quantity of Gas Page 56

Short-Run Versus Long-Run Elasticity • 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 – But in long run, older durable goods will have to be replaced Chapter ©2005 Pearson 2 Education, Inc.

Page 57

Cars: Short-Run and Long-Run Demand Curves Price

DLR

• Initially, people may put off immediate car purchase • In long run, older cars must be replaced

DSR


Quantity of Cars Page 58

Short-Run Versus Long-Run Elasticity • 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


Page 59

Short-Run Versus Long-Run Elasticity • 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 are replaced, purchases will only be to replace old cars • Less purchases from income increase in long run than in short run Chapter ©2005 Pearson 2 Education, Inc.

Page 60

Demand for Gasoline


Page 61

Demand for Automobiles


Page 62

Short-Run Versus Long-Run Elasticity • 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


Page 63

Short-Run Versus Long-Run Elasticity

Price

SSR

SLR Due to limited capacity, firms are limited by output constraints in the short run. In the long run, they can expand.


Quantity Primary Copper Page 64

Short-Run Versus Long-Run Elasticity Price

SLR

SSR

Price increases provide an incentive to convert scrap copper into new supply. In the long run, this stock of scrap copper begins to fall.


Quantity Secondary Copper Page 65

Supply of Copper


Page 66

Short-Run vs. Long-Run Elasticity – An Application • Why are coffee prices very volatile? – Most of the world’s coffee is 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 Chapter ©2005 Pearson 2 Education, Inc.

Page 67

Price of Brazilian Coffee


Page 68

Short-Run vs. Long-Run Elasticity – An Application • Demand and supply are more elastic in the long run • In the short run, supply is completely inelastic – Weather may destroy part of the fixed supply, decreasing supply

• Demand is relatively inelastic as well • Price increases significantly Chapter ©2005 Pearson 2 Education, Inc.

Page 69

An Application - Coffee S’

S

Price A freeze or drought decreases the supply of coffee Price increases significantly due to inelastic supply and demand

P1

P0 D Chapter ©2005 Pearson 2 Education, Inc.

Q1

Q0

Quantity

Page 70

An Application - Coffee Price

S’

S

Intermediate-Run 1) Supply and demand are more elastic 2) Price falls back to P2.

P2 P0

D Chapter ©2005 Pearson 2 Education, Inc.

Q2 Q0

Quantity

Page 71

An Application - Coffee Price

Long-Run 1) Supply is extremely elastic 2) Price falls back to P0. 3) Quantity back to Q0.

S

P0

D Chapter ©2005 Pearson 2 Education, Inc.

Q0

Quantity Page 72

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 data • Given 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 Chapter ©2005 Pearson 2 Education, Inc.

Page 73

Predicting the Effects of Changing Market Conditions • We know – Equilibrium Price, P* – Equilibrium Quantity, Q* – Price elasticity of supply, ES – Price elasticity of demand, ED


Page 74

Predicting the Effects of Changing Market Conditions • 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. Chapter ©2005 Pearson 2 Education, Inc.

Page 75

Predicting the Effects of Changing Market Conditions • 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*) Chapter ©2005 Pearson 2 Education, Inc.

Page 76

Predicting the Effects of Changing Market Conditions Price

Supply: Q = c + dP

a/b

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

P*

Demand: Q = a - bP

-c/d


Q*

Quantity Page 77

Predicting the Effects of Changing Market Conditions

• Using P*, Q* and the elasticities, we can solve for b and c from supply ES = d(P*/Q*) 1.6 = d(0.75/7.5) = 0.1d d = 16 Q = c + dP 7.5 = c + (16)(0.75) = c + 12 c = -4.5 Chapter ©2005 Pearson 2 Education, Inc.

Page 78

Predicting the Effects of Changing Market Conditions

• 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=8 Q = a – bP 7.5 = a – (8)(0.75) = a – 6 a = 13.5 Chapter ©2005 Pearson 2 Education, Inc.

Page 79

Predicting the Effects of Changing Market Conditions • We now have equations for supply and demand Supply: Q = –4.5 + 16P Demand: Q = 13.5 – 8P • Setting them equal will give us equilibrium price and quantity with which we began


Page 80

Predicting the Effects of Changing Market Conditions Price

Supply: QS = -4.5 + 16P

a/b

.75

Demand: QD = 13.5 - 8P

-c/d


7.5

Mmt/yr Page 81

Predicting the Effects of Changing Market Conditions • We have written supply and demand so that they only depend upon price • Demand could also depend upon other variables such as income • Demand would then be written as:

Q  a  bP  fI Chapter ©2005 Pearson 2 Education, Inc.

Page 82

Predicting the Effects of Changing Market Conditions • We know the following information regarding the copper industry: – I = 1.0 – P* = 0.75 – Q* = 7.5 –b=8 – Income elasticity: EI= 1.3


Page 83

Predicting the Effects of Changing Market Conditions • Using the elasticity of income formula, we can solve for f EI = (I/Q)(Q/I) 1.3 = (1.0/7.5)(f) f = 9.75 • Substituting back into demand equation gives a = 3.75 Chapter ©2005 Pearson 2 Education, Inc.

Page 84

Declining Demand and the Behavior of Copper Prices • Copper has gone through difficult market changes leading the significantly reduced prices most from decreased demand from – A decrease in the growth rate of power generation – The development of substitutes: fiber optics and aluminum


Page 85

Real versus Nominal Prices of Copper 1965 - 2002


Page 86

Declining Demand and the Behavior of Copper Prices • Given producers’ concerns about further declines in demand, we can calculate by how much prices will fall with future declines in demand • Assume that demand will fall by 20% – What is the resulting decrease in price? – Demand curve will shift to left by 20%


Page 87

Declining Demand and the Behavior of Copper Prices • We want to consider 80% of the past demand Q = (0.80)(13.5 - 8P) Q = 10.8 - 6.4P • Recall the equation for supply: Q = -4.5 + 16P


Page 88

Declining Demand and the Behavior of Copper Prices • Setting supply equal to demand: -4.5 + 16P = 10.8 - 6.4P -16P + 6.4P = 10.8 + 4.5 P = 15.3/22.4 P = 68.3 cents/pound • A decline in demand of 20% will lead to a drop in price about 7% Chapter ©2005 Pearson 2 Education, Inc.

Page 89

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 Chapter ©2005 Pearson 2 Education, Inc.

Page 90

Effects of Price Controls Price

S • Price is regulated to be no higher than Pmax • Quantity supplied falls and quantity demanded increases • A shortage results

P0

Pmax Shortage


Q S

Q0

D QD Quantity Page 91

Effects of Price Controls • 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. Chapter ©2005 Pearson 2 Education, Inc.

Page 92

Price Controls and Natural 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


Page 93

Price Controls and Natural Gas Shortages • Price controls created an excess demand of 7 trillion cubic feet • Price regulation was a major component of US energy policy in the 1960s and 1970s, and it continued to influence the natural gas markets in the 1980s


Page 94

Demand and Supply

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