Transcript Class Lecture (Chp. 2)

Chapter 2
The Basics of Supply and
Demand
The Supply Curve
S
Price
($ per unit)
The Supply
Curve Graphically
P2
The supply curve slopes
upward demonstrating that
at higher prices firms
will increase output
P1
Q1
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Chapter 2
Quantity
2
Introduction
 What are supply and demand?
 What is the market mechanism?
 What are the effects of changes in
market equilibrium?
 What are elasticities of supply and
demand?
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3
Topics to Be Discussed
 How do short-run and long-run
elasticities differ?
 How do we understand and predict the
effects of changing market conditions?
 What are the effects of government
intervention – price controls?
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4
Supply and Demand
 Supply and demand analysis can:
1. Help us understand and predict how world
economic conditions affect market price and
production
2. Analyze the impact of government price
controls, minimum wages, price supports,
and production incentives on the economy
3. Determine how taxes, subsidies, tariffs and
import quotas affect consumers and
producers
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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)
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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
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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
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S’
Chapter 2
Q1
Q2
Q
8
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 price
 Change
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in costs of production
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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)
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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
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Quantity
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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
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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
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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
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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
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Quantity
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Oun Lopez:
Start of Lecture 3
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 wished to buy at the current
price can and all producers who wish to sell
at that price can
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The Market Mechanism
S
Price
($ per unit)
Who Supplies?
-Producers with
willingness-to-accept
(WTA) prices below P*.
P0
D
Q0
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-Market S and D curves
include the S and D
curves of individual
consumers and
producers.
Who Buys?
-Only those consumers
who are willing-to-pay
(WTP) above P*.
Quantity
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Market Surplus
 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
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The Market Mechanism
Price
($ per unit)
S
1.
Surplus
P1
2.
3.
P0
4.
D
Q
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D
Q0
Chapter 2
QS
Price is above
the market
clearing price –
P1
Qs > QD
Price falls to
the marketclearing price
Market adjusts
to equilibrium
Quantity
19
The Market Mechanism
Price
($ per unit)
1.
2.
3.
P3
4.
P2
D
Shortage
QS
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Q
3
Chapter 2
Price is below
the market
clearing price
– P2
Q D > QS
Price rises to
the marketclearing price
Market adjusts
to equilibrium
QD
Quantity
20
The Market Mechanism
 The market price is below equilibrium:
There is a excess demand - shortage
Upward pressure on prices
Quantity demanded decreases and quantity
supplied increases
The market adjusts until the new equilibrium
is reached.
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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.
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Changes In Market Equilibrium
 Equilibrium prices are determined by the
relative level of supply and demand.
 Changes in supply and/or demand will
change in the equilibrium price and/or
quantity in a free market.
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Changes In Market Equilibrium
 Raw material prices
fall
P
D
S
S’
 S shifts to S’
 Surplus at P1
between Q1, Q2
P1
 Price adjusts to
equilibrium at P3, Q3 P3
Q1 Q3Q2
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24
Changes In Market Equilibrium
P
 Income Increases
D
D’
S
 Demand increases to
D1
 Shortage at P1 of Q1, P3
Q2
P1
 Equilibrium at P3, Q3
Q1 Q3 Q
Q
2
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Changes In Market Equilibrium
 Income Increases &
raw material prices
fall
 Quantity increases
 If the increase in D is
greater than the
increase in S price
also increases
P
D
D’
S S’
P2
P1
Q1
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Q
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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
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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
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The Market Mechanism
S
Price
($ per unit)
Who Supplies?
-Producers with
willingness-to-accept
(WTA) prices below P*.
P0
D
Q0
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-Market S and D curves
include the S and D
curves of individual
consumers and
producers.
Who Buys?
-Only those consumers
who are willing-to-pay
(WTP) above P*.
Quantity
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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
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8.6
13.2
Chapter 2
D2002
Q (millions
enrolled))
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Resource Market Equilibrium
Price
S1900
S1950
S2002
Long-Run (LR) Path of
Price and Consumption
(LR demand)
D1900
D1950
D2002
Quantity
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Elasticities of Supply and Demand
 How much do markets change?
 Elasticity gives a way to measure how a
variable will change when another
variable changes.
 Elasticity (Def): the percentage change in
one variable resulting from a one percent
change in another.
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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.
D
EP
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%Q D

%P
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Price Elasticity of Demand
 The percentage change in a variable is
the absolute (actual) change in the
variable divided by the original level of
the variable.
 Therefore, elasticity can also be written
as:
D
EP
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Q Q P Q


P P Q P
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Price Elasticity of Demand
 Usually a negative number
As price increases, quantity decreases
As price decreases, quantity increases
 When EQ,P > 1, the good is price elastic
%Q > % P
 When EQ,P < 1, the good is price inelastic
%Q < % P
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Price Elasticity of Demand
 Primary determinant of E PD
-Availability of substitutes.
Many substitutes: demand is price elastic
Few substitutes demand is price inelastic
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Price Elasticity of Demand
 Linear demand curve: Q/P is constant
 Values of P and Q 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
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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
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is low and quantity high
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Price Elasticity of Demand
Price
4
EP = -
Demand Curve
Q = 8 – 2P
Elastic
Ep = -1
2
Inelastic
4
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Chapter 2
Q
Ep = 0
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Price Elasticity of Demand
 The steeper the demand curve becomes,
the more inelastic the good.
 The flatter the demand curve becomes,
the more elastic the good
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Infinitely Elastic Demand
(Extreme Case)
Price
EP = 
D
P*
QD changes
infinitely with
the smallest
possible
change in
price.
Quantity
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Completely Inelastic Demand
(Extreme Case)
Price
D
EP = 0
QD never
changes,
even with
large changes
in price.
Q*
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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
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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
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Qb Qb Pm Qb


Pm Pm Qb Pm
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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
©2005 Pearson Education, Inc.
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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.
% Q

% P
S
S
EP
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Point v. 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
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
 ΔQ

P 
ΔP  Q 
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Elasticity: An Application
 Wheat Market Changes (1980s and
1990s)
 Analyzing the Wheat Market
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Elasticity: An Application
 Supply: QS = 1800 + 240P
 Demand: QD = 3550 – 266P
Analyze this market.
1)What are the initial P* and Q*?
2)How does demand change when
price changes?
3)How does supply change when
price changes?
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Elasticity: An Application
QD = QS
1800 + 240P = 3550 – 266P
506P = 1750
P = $3.46 per bushel
Q = 1800 + (240)(3.46) = 2630 million
bushels
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Elasticity: An Application
 We can find the elasticities of demand
and supply at these points
E PD
P QD
3.46


( 266)  .35
Q P
2,630
E PS
P QS
3.46


( 240)  .32
Q P
2,630
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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
EPD
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4.00

( 266)  0.43
2,486
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Elasticity: An Application
 In 2002, the supply and demand for
wheat were:
Supply: QS = 1439 + 267P
Demand: QD = 2809 – 226P
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Elasticity: An Application
QD = QS
2809 - 226P = 1439 + 267P
P = $2.78 per bushel
Q = 2809 - (226)(2.78) = 2181 million
bushels
©2005 Pearson Education, Inc.
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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 longrun counterparts.
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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
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Gasoline: Short-Run and Long-Run
Demand Curves
Price
DSR
•People cannot easily
adjust consumption in
short run.
•In the long run, people
tend to drive smaller and
more fuel efficient cars.
DLR
Quantity of Gas
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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
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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
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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
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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 replaced, purchases will only to
be to replace old cars.
 Less purchases from income increase in long
run than in short run
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Demand for Gasoline
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Demand for Automobiles
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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
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Short-Run Versus Long-Run
Elasticity
SSR
Price
SLR
Due to limited
capacity, firms
are limited by
output constraints
in the short-run.
In the long-run, they
can expand.
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Chapter 2
Quantity Primary Copper
65
Short-Run Versus Long-Run
Elasticity
SLR
Price
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
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Supply of Copper
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Declining Demand and the
Behavior of Copper Prices
 Copper has gone through difficult market
changes leading to 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
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Short-Run v. Long-Run Elasticity
– An Application
 Why are coffee prices very volatile?
Most of the world’s coffee 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
©2005 Pearson Education, Inc.
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Price of Brazilian Coffee
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Short-Run v. Long-Run Elasticity
– An Application
 Demand and supply are more elastic in
the long run
 In short-run, supply is completely
inelastic
Weather may destroy part of the fixed supply,
decreasing supply
 Demand relatively inelastic as well
 Price increases significantly
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An Application - Coffee
Price
S’
S
A freeze or drought
decreases the supply
of coffee
Price increases
significantly due to
inelastic supply and
demand
P1
P0
D
©2005 Pearson Education, Inc.
Q1
Q0
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An Application - Coffee
Price
S’
S
Intermediate-Run
1) Supply and demand are
more elastic
2) Price falls back to P2.
P2
P0
D
©2005 Pearson Education, Inc.
Q2 Q0
Quantity
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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
Q0
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Price of Brazilian Coffee
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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
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Effects of Price Controls
(Price Ceiling)
Price
S
•Price is regulated to
be no higher than Pmax,
•Quantity supplied
falls and quantity
demanded increases
•A shortage results
P0
Pmax
Shortage
QS
©2005 Pearson Education, Inc.
Q0
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D
QD Quantity
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Effects of Price Controls
(Price Ceiling)
Price
S
•Price is regulated to
be no higher than Pmax
•This price ceiling is
not binding.
•Equilibrium P is
maintained.
Pmax
P0
D
Q0
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Effects of Price Controls
(Price Floor)
Price
S
Surplus
Pmax
P*
•Price is regulated to
be no lower than Pmax
•This price floor
creates a surplus
D
QS
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Q*
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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.
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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.
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Price Controls and
Natural Gas Shortages
 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.
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