chapter 2: the basics of supply and demandslide 1 supply and demand the supply curve the supply...

Chapter 2: The Basics of Supply and Demand Slide 1

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

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

)(PQQ ss


Supply and Demand

S

The supply curve slopesupward demonstrating that

at higher prices, firmswill increase output

The SupplyCurve Graphically

The SupplyCurve Graphically

Quantity

Price($ per unit)

P1

Q1

P2

Q2


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


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


Supply and Demand

D

The demand curve slopesdownward demonstrating that consumers are willing

to buy more at a lower price

Quantity

Price($ per unit)


DP

QQ1

P2

Q0

P1

D’

Q2

Change in DemandChange in Demand

Supply and Demand

Income Increases At P1, purchase Q2

At P2, purchase Q1

Demand Curve shifts right

More purchased at any price on D’ than on D


The Market Mechanism

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)



D

S

Q1

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

and quantity demanded increases.

5) Equilibrium at P2Q3

P1

Surplus

Q2 Quantity

Price($ per unit)

P2

Q3



D

S

Q1 Q2

P2

Shortage

Quantity

Price($ per unit)

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

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

4) Quantity supplied increases and quantity demanded decreases.

5) Equilibrium at P3, Q3

Q3

P3


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

Changes In Market Equilibrium


Example 1: 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


Example 2: Market for a College Education

Q (millions of students enrolled))

P(annual cost

in 1970dollars)

D1970

S1970

S1995

D1995

$4,573

12.3

Prices rose untila new equilibrium

was reached at $4,573and a quantity

of 12.3 million students

$2,530

7.4


Elasticities of Supply and Demand

Measures the sensitivity of quantity demanded to price changes.

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

The price elasticity of demand is:

Price Elasticity of DemandPrice Elasticity of Demand

P)Q)/(%(% EP



The % change in a variable is the absolute change in the variable divided by the original level of the variable. So the price elasticity of demand is also:


P

Q

Q

P

P/P

Q/Q EP



Interpreting Price Elasticity of Demand Values

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

2) If |EP| > 1, the % change in quantity demanded is greater than the % change in price. We say demand is price elastic.

3) If |EP| < 1, the % change in quantity demanded is less than the % change in price. We say demand is price inelastic.


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



Income elasticity of demand measures the % change in quantity demanded resulting from a one percent change in income. The income elasticity of demand is:

Other Demand ElasticitiesOther Demand Elasticities

I

Q

Q

I

I/I

Q/Q EI



Cross price elasticity of demand = the % change in the quantity demanded of one good that results from a one percent change in the price of another good.

The cross price elasticity for substitutes is positive, while that for complements is negative. For example, consider the substitute goods, butter and margarine.

Other Demand ElasticitiesOther Demand Elasticities

m

b

b

m

mm

bbPQ

P

Q

Q

P

/PP

/QQ E mb



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

The elasticity is usually positive because price and quantity supplied are positively related (Higher price gives producers an incentive to increase output)

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


SR Versus LR Elasticities

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

Most goods and services: Short-run elasticity is less than long-run elasticity (e.g.

gasoline). People tend to drive smaller and more fuel efficient cars in the long-run

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

automobiles). People may put off immediate consumption, but eventually older cars must be replaced.



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

short run. For example, higher incomes may be converted into bigger cars so the income elasticity of demand for gasoline increases with time.

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

short-run. For example, consumers will initially want to hold more cars. Later, purchases will only to be to replace old cars.


Income ElasticitiesIncome Elasticities


Most goods and services: Long-run price elasticity of supply is greater than short-run

price elasticity of supply. Due to limited capacity, firms are output constrained in the short-run. In the long-run, they can expand.

Other Goods (durables, recyclables): Long-run price elasticity of supply is less than short-run price

elasticity of supply. For example, consider the secondary copper market. Copper price increases provide an incentive to convert scrap copper into new supply. In the long-run, this stock of scrap copper begins to fall.


Price Elasticity of SupplyPrice Elasticity of Supply


D

S

P0

Q0 Quantity

Price

P1

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

Coffee prices are volatile: A freeze or drought

decreases the supplyof coffee in Brazil

S’

Q1

SR Versus LR Elasticities: CoffeeCoffeeCoffee


1. We must learn how to “fit” linear demand and supply curves to market data.

2. We determine numerically how a change in one variable will cause supply or demand to shift and so affect the equilibrium price and quantity.

3. Assume the Available Data are: Equilibrium Price, P* Equilibrium Quantity, Q*

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

Understanding and Predicting the Effects of Changing Market Conditions


Demand: Q = a - bP

a/bSupply: Q = c + dP

-c/d

P*

Q*

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


Quantity

Price


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

Demand: QD = a - bP

Supply: QS = c + dP


P)Q/(P/Q)( E


Note: for linear demand curves, ∆Q/ ∆P is constant (equal to the slope of the curve).

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


/Q*)*b(P- ED

/Q*)*d(P ES


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


** bPaQD ** dPcQS


Suppose we want to derive the long-run supply and demand for copper:The data are:

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

ES = 1.6

ED = -0.8

Example: The Copper Market


Supply: QS = -4.5 + 16P

+.28 = -c/d Demand: QD = 13.5 - 8P

1.69 = a/b

.75

7.5


Mmt/yr

Price


Example 1: Real versus Nominal Prices of Copper 1965 - 1999


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

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

Recall the equation for the demand curve:

Q = 13.5 - 8P


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

Q = (0.80)(13.5 - 8P) = 10.8 - 6.4P

Recall the equation for supply:

Q = -4.5 + 16P

The new equilibrium price is:

-4.5 + 16P = 10.8 - 6.4P

-16P + 6.4P = 10.8 + 4.5

P = 15.3/22.4 = 68.3 cents/pound

Real versus NominalPrices of Copper 1965 - 1999


Example 2: Government Intervention - Price Controls

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

Natural Gas Market: 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.

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.


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.

Q1 Q2


Price Controls andNatural Gas Shortages

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

chapter 2: the basics of supply and demandslide 1 supply and demand the supply curve the supply...

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