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**Part 2 Markets: 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

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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

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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

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**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

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**Changes in Quantity Demanded**

P Decrease in quantity demanded P’ P Increase in quantity demanded P” Q’ Q Q” Q Change in quantity demanded—a movement along the demand curve

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**Demand Curves Can be linear or non-linear A linear demand curve P**

P = a + bQ Where a is the P intercept and b is the slope variable and is negative 20 30 Q P = /3Q

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Demand Curves A demand curve is more usually written with Q as the dependent variable P Q = a + bP Where a is the Q intercept and b is the inverse of the slope and is negative 20 Q 30 Q = 30 – 3/2P

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**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

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An Increase in Demand An increase in demand—a rightward shift P D’ D Q

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**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

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A Decrease in Demand A decrease in demand—a leftward shift P D D’ Q

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**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.

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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

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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

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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

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**Supply Functions and Supply Curves**

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

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**Changes in Quantity Supplied**

Increase in quantity supplied P P’ Decrease in quantity supplied Q’ Q Q” Q Change in quantity supplied—a movement along the supply curve

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**Supply Curves A linear supply curve:**

P = a + bQ where a is the P intercept And b is the slope which is positive P S Slope is = 2 10 Q P = Q

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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 S Slope = 2 inverse of Slope = 1/2 10 Q = -5 + ½ P -5 Q

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**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

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**An Increase in Supply An increase in supply—a rightward shift in**

the supply curve S S’ P Q

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**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

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**A Decrease in Supply P S’ S Q A decrease in supply is a leftward**

shift in the supply curve

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**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

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**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

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**Market Equilibrium P Surplus- price falls S E P* Shortage- Price rises**

D Q* Q

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**Market Equilibrium in 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*

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**Market Equilibrium in Equations**

Demand curve D = 400 – .5P Supply Curve S = – P Solve for P* 400 – .5P* = – P* 600 = 1.5P* P* = 400 Solve for Q* Q* = 400 – 200 Q* = 200

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**Market Equilibrium in Equations**

Diagram of the equations P 800 S = P 400 D = P Q -200 200 400

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**Equilibrium Price and Quantity Changes**

A change in demand with a given supply curve P S E’ P’ E P D’ D Q Q’ Q Rightward shift in demand leads to a movement along the supply curve. P and Q both rise.

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**Equilibrium Price and Quantity Changes**

A change in supply with a given demand curve S P S’ E P E’ P’ D Q Q Q’ A rightward shift in supply leads to a movement along the demand curve. P falls and Q rises.

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**Equilibrium Price and Quantity Changes**

A change in supply and demand —same directions S P S’ E E’ P D’ D Q Q Q’ A rightward shift in both demand and supply leads to a higher Q. P may rise, fall, or stay the same.

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**Equilibrium Price and Quantity Changes**

A change in supply and demand —opposite directions P S E S’ P E’ P’ D D’ Q 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.

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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?

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**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

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**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

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**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

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**Inelastic and Elastic Demand**

P Elasticity = 0 Q P D Elasticity = Q P Elasticity = 1 D Q

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**Price Elasticity of Demand Over an Arc**

Px ($) If measuring price elasticity of demand over an arc use the average P and Q 15 12.5 5 10 100 Dx Qx (Kgs) 100 200 150 EDxPx= 100/150 / 5/12.5 = .66/.4 = 1.66 EDxPx= 100/5 x 12.5/150 = 20 x .083 = 1.66

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**Price Elasticity of Demand at a Point**

EDxPx= ΔQ/ΔP • P/Q ΔQ/ΔP = inverse of the slope of the demand curve P 100 Slope = 2 Inverse of slope = 0.5 Elasticity = 0.5 x 4 = 2 80 D 20 50 Q

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**Price Elasticity Along a Straight Line Demand Curve**

EDxPx > 1 Slope = 2/3 Inverse of slope = 1.5 200 EDxPx = 1 100 EDxPx < 1 Q 150 300 EDxPx > 1 Elastic Demand EDxPx = 1 Unit Elastic Demand EDxPx < 1 Inelastic Demand

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**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.

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**Price Elasticity of Demand and Total Revenue**

Q TR Max TR TR rising TR falling Q

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**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

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**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

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**Complements and Substitutes**

The demand curve for good X shifts with changes in the price of good Y P Price of a complement falls Price of a substitute rises D’ Price of a complement rises Price of a substitute falls D D” Q

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**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

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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

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**Elasticity of Supply P S 50 10 40 100 Q 200 100**

ESxPx = 100/10 x 45/150 = 3

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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?

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University of Greenwich Business school MSc in Financial Management and Investment Analysis.

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