Presentation on theme: "Part 2 Markets: Demand, Supply, and Elasticity"— Presentation transcript:
1 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 marketThis simple model of a market assumes competitive conditionsDistinguish between a demand side and a supply side of the marketTogether they determine the equilibrium price and quantity
2 DemandDemand is the quantity of a good people purchase over a given timeThe 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- IncomeIn the aggregate, demand will also depend on:- Population and demographics
3 The Law of DemandOther things remaining the same, the higher the price of a good, the smaller is the quantity demandedSubstitution effect—the effect of the change in relative priceIncome effect—the effect of the change in overall purchasing power
4 Demand Function and Demand Curves Demand function—demand as a function of a number of variablesDemand curve—demand as a function of price, everything else held constantWhat is held constant along a demand curve?Changes in the quantity demanded—movements along the demand curve
5 Changes in Quantity Demanded PDecrease in quantitydemandedP’PIncrease in quantitydemandedP”Q’QQ”QChange in quantity demanded—a movementalong the demand curve
6 Demand Curves Can be linear or non-linear A linear demand curve P P = a + bQWhere a is the Pintercept and b is the slopevariable and is negative2030QP = /3Q
7 Demand CurvesA demand curve is more usually written with Q as the dependent variablePQ = a + bPWhere a is the Q intercept andb is the inverse of the slopeand is negative20Q30Q = 30 – 3/2P
8 Changes in Demand Shift in a demand curve is a Change in Demand Change in tastes or preferencesChange in the prices of other goods- substitutes- complementsChanges in expected future pricesChanges in income- normal goods- inferior goodsChanges in population/demographics
9 An Increase in DemandAn increase in demand—a rightward shiftPD’DQ
10 An Increase in Demand Price of a substitute rises Price of a complement fallsExpected future price risesIncome rises (normal good) or income falls (inferior good)Preferences move toward the goodPopulation increases
11 A Decrease in DemandA decrease in demand—a leftward shiftPDD’Q
12 A Decrease in Demand Price of a substitute falls Price of a complement risesExpected future price fallsIncome falls (normal good) or income rises (inferior good)Preferences move away from the goodPopulation falls.
13 SupplySupply is the quantity of a good firms produce over a given timeThe firm has to have the resources and technology to produce the goodThe 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
14 SupplyThe 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 pricesIn the aggregate, supply will also depend on:- The number of firms in the market
15 The Law of SupplyOther things remaining the same, the higher the price of a good, the greater will be the quantity suppliedHigher prices mean it will be profitable to expand productionWith rising marginal costs higher prices are required for firms to be willing to increase production
16 Supply Functions and Supply Curves Supply curve—shapeSupply 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
17 Changes in Quantity Supplied Increase in quantitysuppliedPP’Decrease in quantity suppliedQ’QQ”QChange in quantity supplied—a movementalong the supply curve
18 Supply Curves A linear supply curve: P = a + bQ where a is the P interceptAnd b is the slope which is positivePSSlope is = 210QP = Q
19 Supply CurvesSupply 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 positivePSSlope = 2 inverse ofSlope = 1/210Q = -5 + ½ P-5Q
20 Changes in Supply Shift in a supply curve is a Change in Supply Change in input pricesChanges in technologyChanges in expected future pricesChange in the scale of the firmChanges in the number of firms—entry and exit of firms
21 An Increase in Supply An increase in supply—a rightward shift in the supply curveSS’PQ
22 An Increase in Supply Price of inputs fall More efficient technology Expected future price fall(ie natural resource production)Firms grow in sizeNumber of firms in the industry grows
23 A Decrease in Supply P S’ S Q A decrease in supply is a leftward shift in the supply curve
24 A Decrease in Supply Price of inputs rise Expected future price rise (natural resources)Loss of technological knowledgeFirms decline in sizeNumber of firms in the industry shrinks
25 Market Equilibrium Market equilibrium is where demand = supply Equilibrium priceEquilibrium quantityPrice adjusts to bring about an equilibriumIf D>S price rises which reduces quantity demanded and increases quantity suppliedIf S>D price falls which increases quantity demanded and reduces quantity supplied
26 Market Equilibrium P Surplus- price falls S E P* Shortage- Price rises DQ*Q
27 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 positiveIn equilibrium D = SSolve for P* then Q*
28 Market Equilibrium in Equations Demand curve D = 400 – .5PSupply Curve S = – PSolve for P*400 – .5P* = – P*600 = 1.5P*P* = 400Solve for Q*Q* = 400 – 200Q* = 200
29 Market Equilibrium in Equations Diagram of the equationsP800S = P400D = PQ-200200400
30 Equilibrium Price and Quantity Changes A change in demand with a given supply curvePSE’P’EPD’DQQ’QRightward shift in demand leads to a movementalong the supply curve. P and Q both rise.
31 Equilibrium Price and Quantity Changes A change in supply with a given demand curveSPS’EPE’P’DQQQ’A rightward shift in supply leads to amovement along the demand curve. P fallsand Q rises.
32 Equilibrium Price and Quantity Changes A change in supply and demand—same directionsSPS’EE’PD’DQQQ’A rightward shift in both demand and supplyleads to a higher Q. P may rise, fall, or staythe same.
33 Equilibrium Price and Quantity Changes A change in supply and demand—opposite directionsPSES’PE’P’DD’QQA rightward shift in supply and a leftwardshift in demand leads to a lower P. Q may rise,fall, or stay the same.
34 An ExampleFrom 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?
35 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 supplyElasticity measures are measures of proportionate responsiveness and are unit free
36 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 YEXY = % Δ X / % Δ Y orEXY= ΔX/X / ΔY/Y orEXY=ΔX/ΔY • Y/X
37 Price Elasticity of Demand Elasticity of Demand with respect to the good’s own priceEDxPx= %ΔQ/%ΔP orEDxPx= ΔQ/Q / ΔP/P orEDxPx= ΔQ/ΔP • P/QFor price elasticities of demand the sign is ignored as they are all negativeElastic demand > 1Inelastic demand < 1Unit elastic demand = 1
39 Price Elasticity of Demand Over an Arc Px ($)If measuring price elasticityof demand over an arc usethe average P and Q1512.5510100DxQx(Kgs)100200150EDxPx= 100/150 / 5/12.5 = .66/.4 = 1.66EDxPx= 100/5 x 12.5/150 = 20 x .083 = 1.66
40 Price Elasticity of Demand at a Point EDxPx= ΔQ/ΔP • P/QΔQ/ΔP = inverse of the slope of the demand curveP100Slope = 2Inverse of slope = 0.5Elasticity = 0.5 x 4 = 280D2050Q
41 Price Elasticity Along a Straight Line Demand Curve EDxPx > 1Slope = 2/3Inverse of slope = 1.5200EDxPx = 1100EDxPx < 1Q150300EDxPx > 1 Elastic DemandEDxPx = 1 Unit Elastic DemandEDxPx < 1 Inelastic Demand
42 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 unchangedIf the price elasticity of demand is < 1, then a reduction of price will increase quantity demanded less than proportionately and TR will fall.
43 Price Elasticity of Demand and Total Revenue QTRMax TRTRrisingTRfallingQ
44 Factors that Affect Price Elasticity of Demand The closeness of substitutes- the more close substitutes the higher the price elasticity of demandThe proportion of income spent on the good- the higher the proportion of income spent on the good the higher the price elasticity of demandThe time elapsed- The more time elapsed the more elastic the demand
45 Cross Price Elasticity of Demand The elasticity of the demand for good X with respect to the price of another good YEDxPy= %ΔQX/%ΔPY orEDxPy= ΔQX/QX / ΔPY/PY orEDxPy= ΔQX/ΔPY • PY/QXThe sign matters, positive cross price elasticities indicate substitutes, negative cross price elasticities indicate complements
46 Complements and Substitutes The demand curve for good X shiftswith changes in the price of good YPPrice of a complement fallsPrice of a substitute risesD’Price of a complement risesPrice of a substitute fallsDD”Q
47 Income Elasticity of Demand The elasticity of demand for good X with respect to income (I)EDxI= %ΔQX/%ΔI orEDxI= ΔQX/QX / ΔI/I orEDxI= ΔQX/ΔI • I/QXEDxI > 1 normal and income elasticEDxI < 1 > 0 normal and income inelasticEDxI <0 inferior goodNecessaries, luxuries and income levels
48 Elasticity of SupplyThe elasticity of the supply of good X with respect to its own priceESxPx= %ΔQS/%ΔP orESxPx= ΔQS/QS / ΔP/P orESxPx= ΔQS/ΔP • P/QSElasticities of supply can range from zero to infinity. Depends on technology, resource substitution, and time frameAll straight line supply curves through the origin will have elasticities of supply = 1
49 Elasticity of Supply P S 50 10 40 100 Q 200 100 ESxPx = 100/10 x 45/150 = 3
50 An ExampleTimes 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?