The Basics of Supply and Demand

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The Basics of Supply and Demand
Chapter 2 The Basics of Supply and Demand

Supply and Demand Supply and demand analysis can:
Help us understand and predict how real world economic conditions affect market price and production Analyze the impact of government price controls, minimum wages, price supports, and production incentives on the economy Determine how taxes, subsidies, tariffs and import quotas affect consumers and producers ©2005 Pearson Education, Inc. Chapter 2 4

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 ©2005 Pearson Education, Inc. Chapter 2 5

The Supply Curve S The Supply Curve, Graphically Depicted P2 Q2 P1 Q1
Price ($ per unit) The Supply Curve, Graphically Depicted P2 Q2 The supply curve slopes upward, demonstrating that at higher prices firms will increase output P1 Q1 Quantity ©2005 Pearson Education, Inc. Chapter 2 7

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 ©2005 Pearson Education, Inc. Chapter 2 27

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 S’ Q2 P1 P2 Q1 Q0 Q ©2005 Pearson Education, Inc. Chapter 2 31

The Supply Curve Change in Quantity Supplied Change in Supply
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 ©2005 Pearson Education, Inc. Chapter 2 35

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 ©2005 Pearson Education, Inc. Chapter 2 8

The Demand Curve P2 P1 D Q1 Q2 Quantity 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 Q1 P1 Q2 Quantity ©2005 Pearson Education, Inc. Chapter 2 10

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 ©2005 Pearson Education, Inc. Chapter 2 36

Change in Demand Income Increases Purchased Q0, at P2 and Q1 at P1
Now purchased Q1 at P2 and Q2 at P1 Same for all prices Demand curve shifts right P Q D’ Q1 P2 Q0 P1 Q2 ©2005 Pearson Education, Inc. Chapter 2 41

The Demand Curve Changes in quantity demanded Changes in demand
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 ©2005 Pearson Education, Inc. Chapter 2 45

Friday, April 1, 2005 Homework due Friday, April 8: Chapter 1: #2
Course website: people.ucsc.edu/~jhgonzal/ Nothing on it yet!!! ©2005 Pearson Education, Inc. Chapter 2

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 ©2005 Pearson Education, Inc. Chapter 2

The Market Mechanism S P0 D Q0 Price ($ per unit)
Quantity Price ($ per unit) D The curves intersect at equilibrium, or market- clearing, price. Quantity demanded equals quantity supplied at P0 P0 Q0 ©2005 Pearson Education, Inc. Chapter 2 12

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 ©2005 Pearson Education, Inc. Chapter 2 13

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 ©2005 Pearson Education, Inc. Chapter 2 19

The Market Mechanism S Surplus P1 P0 D QD Q0 QS Price ($ per unit)
Quantity Price ($ per unit) D S At P1, price is above the market clearing price Qs > QD Price falls to the market-clearing price Market adjusts to equilibrium Surplus P1 QD QS P0 Q0 ©2005 Pearson Education, Inc. Chapter 2 14

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 ©2005 Pearson Education, Inc. Chapter 2 24

The Market Mechanism S D Q3 P3 P2 QS Shortage QD Price ($ per unit)
Quantity Price ($ per unit) S D At P2, price is below the market clearing price QD > QS Price rises to the market-clearing price Market adjusts to equilibrium Q3 P3 P2 QS Shortage QD ©2005 Pearson Education, Inc. Chapter 2 22

Changes in Market Equilibrium
Changes in supply and/or demand will cause change in the equilibrium price and/or quantity in a free market Markets must be competitive for the mechanism discussed here to be efficient ©2005 Pearson Education, Inc. Chapter 2 26

D Income increases and raw material prices fall Quantity increases If the increase in D is greater than the increase in S price also increases P Q S D’ S’ P2 Q2 P1 Q1 ©2005 Pearson Education, Inc. Chapter 2 49

Shifts in Supply and Demand
When supply and demand change simultaneously, the impact on the equilibrium price and quantity is determined by: The relative size and direction of the change The shape of the supply and demand models ©2005 Pearson Education, Inc. Chapter 2 50

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 ©2005 Pearson Education, Inc. Chapter 2 55

Market for a College Education
Q (millions enrolled)) P (annual cost in 1970 dollars) S2002 D2002 New equilibrium was reached at $4,573 and a quantity of 12.3 million students D1970 $3,917 13.2 S1970 $2,530 8.6 ©2005 Pearson Education, Inc. Chapter 2 58

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 ©2005 Pearson Education, Inc. Chapter 2 59

Resource Market Equilibrium
D1950 Quantity Price S2002 D2002 D1900 Long-Run Path of Price and Consumption ©2005 Pearson Education, Inc. Chapter 2 63

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 ©2005 Pearson Education, Inc. Chapter 2 70

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 as: ©2005 Pearson Education, Inc. Chapter 2 72

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| ©2005 Pearson Education, Inc. Chapter 2

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 ©2005 Pearson Education, Inc. Chapter 2 75

As we move along a linear demand curve Q/P is constant, but P and Q will change Must be measured at a particular point on the demand curve Elasticity will change along the demand curve in a particular way ©2005 Pearson Education, Inc. Chapter 2

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 ©2005 Pearson Education, Inc. Chapter 2

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 Perfectly elastic demand – horizontal ©2005 Pearson Education, Inc. Chapter 2

Infinitely Elastic Demand
Quantity Price EP =  D P* ©2005 Pearson Education, Inc. Chapter 2 77

Completely Inelastic Demand
Quantity Price D EP = 0 Q* ©2005 Pearson Education, Inc. Chapter 2 78

Other Demand Elasticities
Income Elasticity of Demand Measures how much quantity demanded changes with a change in income ©2005 Pearson Education, Inc. Chapter 2 79

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 ©2005 Pearson Education, Inc. Chapter 2 81

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. Chapter 2 83

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 ©2005 Pearson Education, Inc. Chapter 2 84

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 ©2005 Pearson Education, Inc. Chapter 2

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 ©2005 Pearson Education, Inc. Chapter 2 85

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 ©2005 Pearson Education, Inc. Chapter 2 86

Gasoline: Short-Run and Long-Run Demand Curves
DSR Quantity of Gas Price People cannot easily adjust consumption in the short run. In the long run, people tend to drive smaller and more fuel efficient cars. DLR ©2005 Pearson Education, Inc. Chapter 2 87

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 ©2005 Pearson Education, Inc. Chapter 2

Cars: Short-Run and Long-Run Demand Curves
DLR Quantity of Cars Price Initially, people may put off immediate car purchase In long run, older cars must be replaced DSR ©2005 Pearson Education, Inc. Chapter 2 88

Income elasticity also differs from short run to long run For most goods and services, income elasticity is larger in the long run When income changes, it takes time to adjust spending ©2005 Pearson Education, Inc. Chapter 2 89

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 increase in purchases of new cars is achieved, purchases will only be to replace old cars Less purchases from the income increase in long run than in short run Cyclical industries ©2005 Pearson Education, Inc. Chapter 2 91

Demand for Automobiles
©2005 Pearson Education, Inc. Chapter 2

Short-Run Versus Long-Run Elasticity of Supply
Most goods and services: Long-run price elasticity of supply is greater than short-run price elasticity of supply Sometimes short run perfectly inelastic Other Goods (durables, recyclables): Long-run price elasticity of supply is less than short-run price elasticity of supply Ex: Recyclables: increase in price leads to increase in secondary supply Long run – secondary S exhausted ©2005 Pearson Education, Inc. Chapter 2 96

SSR Quantity Secondary Copper Price SLR Price increases provide an incentive to convert scrap copper into new supply. In the long run, this stock of scrap copper begins to fall. ©2005 Pearson Education, Inc. Chapter 2 98

Short-Run vs. Long-Run Elasticity – An Application
Why are coffee prices so 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 ©2005 Pearson Education, Inc. Chapter 2 100

Price of Brazilian Coffee

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 ©2005 Pearson Education, Inc. Chapter 2

An Application - Coffee
S’ Q1 S Q0 Quantity Price D A freeze or drought decreases the supply of coffee Price increases significantly due to inelastic supply and demand P1 P0 ©2005 Pearson Education, Inc. Chapter 2 101

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 ©2005 Pearson Education, Inc. Chapter 2 106

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. ©2005 Pearson Education, Inc. Chapter 2 109

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*) ©2005 Pearson Education, Inc. Chapter 2

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 ©2005 Pearson Education, Inc. Chapter 2

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 ©2005 Pearson Education, Inc. Chapter 2

We now have equations for supply and demand Supply: Q = – P Demand: Q = 13.5 – 8P Setting them equal will give us equilibrium price and quantity with which we began ©2005 Pearson Education, Inc. Chapter 2 117

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: ©2005 Pearson Education, Inc. Chapter 2 119

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 ©2005 Pearson Education, Inc. Chapter 2 121

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 ©2005 Pearson Education, Inc. Chapter 2 124

Real versus Nominal Prices of Copper 1965 - 2002

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% ©2005 Pearson Education, Inc. Chapter 2 125

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 ©2005 Pearson Education, Inc. Chapter 2

Quantity Price S D Price is regulated to be no higher than Pmax Quantity supplied falls and quantity demanded increases A shortage results P0 Q0 Pmax QS QD Shortage ©2005 Pearson Education, Inc. Chapter 2 141

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. ©2005 Pearson Education, Inc. Chapter 2

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 ©2005 Pearson Education, Inc. Chapter 2 143

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 ©2005 Pearson Education, Inc. Chapter 2 144

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