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**Chapter 2 Supply and Demand McGraw-Hill/Irwin**

Copyright © 2008 by The McGraw-Hill Companies, Inc. All Rights Reserved.

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**Main Topics Demand Supply Market equilibrium**

Elasticities of demand and supply 2-2

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**Demand Curves Product’s demand curve shows:**

How much buyers of the product want to buy at each possible price Holding fixed all other factors that affect demand On a graph: vertical axis shows $ per unit of the good, horizontal axis shows quantity demanded per unit of time Downward sloping (buying the product is less attractive when the price is high than when the price is low) 2-3

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**Determinants of Demand**

Demand curve holds all factors other than the product’s price constant: Population growth; # of consumers Consumer tastes and incomes Prices of other products Substitutes (An increase in the price of one product causes buyers to demand more of the other, all else equal) Complements (An increase in the price of product causes buyers to demand less of the other, all else equal) Government taxes or regulations 2-4

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**Shifts and Movements Along a Demand Curve**

Change in price of the product causes a movement along the demand curve A change in the quantity demanded Change in another factor causes the entire demand curve to shift A change in demand 2-5

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**Figure 2.1: Demand Curve for U.S. Corn Market (hypothetical)**

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Demand Functions Product’s demand function is a mathematical representation of its demand Describes the amount of the product buyers demand for each possible combination of price and other factors Can be determined by applying statistical techniques to historical data 2-7

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**Sample Demand Function**

Demand for corn affected by: price of corn, price of potatoes, price of butter, consumer incomes Increases in the prices of corn and butter will decrease the amount of corn buyers demand Increases in the price of potatoes will increase the amount of corn buyers demand 2-8

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**Sample Problem 1 Plot the following demand curve for wine:**

Qd = 20 – 4PW + 5PB + 0.2I Where PB (the price of beer) is $2, and I (income) is $20 How does the demand curve change if average income rises to $50 or the price of beer falls to $1?

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**Supply Curves Product’s supply curve shows:**

How much sellers of the product want to sell at each possible price Holding fixed all other factors that affect supply On a graph: vertical axis shows $ per unit of the good, horizontal axis shows quantity supplied per unit of time Upward sloping (selling the product is less attractive when the price is low than when the price is high) 2-10

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**Determinants of Supply**

Supply curve holds all factors other than the product’s price constant: Technology Prices of inputs Prices of other possible outputs Government taxes or regulations 2-11

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**Shifts and Movements Along a Supply Curve**

Change in price of the product causes a movement along the supply curve A change in the quantity supplied Change in another factor causes the entire supply curve to shift A change in supply 2-12

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**Figure 2.2: Supply Curve for U.S. Corn Market (hypothetical)**

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Supply Functions Product’s supply function is a mathematical representation of its supply Describes the amount of the product sellers supply at each possible combination of price and other factors Can be determined by applying statistical techniques to historical data 2-14

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**Sample Supply Function**

Supply of corn affected by: price of corn, price of diesel fuel, price of soybeans Increases in the price of diesel fuel and soybeans will decrease the amount of corn sellers supply Increases in the price of corn will increase the amount of corn sellers supply 2-15

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**Sample Problem 2 Plot the following supply curve for wine:**

Qs = 2PW - PB - 0.3PF Where PB (the price of beer) is $2 and PF (the price of fertilizer) is $10.

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Market Equilibrium Supply and demand for a product interact to determine the market equilibrium The equilibrium price is the price at which the amounts supplied and demanded are equal Graphically, the price at which the supply and demand curves intersect 2-17

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**Figure 2.3: Equilibrium in the Corn Market**

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**Excess Supply, Excess Demand**

If price is above equilibrium price: Amount supplied will be greater than amount demanded (excess supply) Incentive for sellers to lower prices to boost sales If price is below equilibrium price: Amount demanded will be greater than amount supplied (excess demand) Incentive for buyers to offer higher prices Market prices adjust so that amount supplied equals amount demanded 2-19

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Sample Problem 3 Find the market equilibrium given the following supply and demand functions: Qd = 20 – 4PW + 5PB + 0.2I Where PB (the price of beer) is $2, and I (income) is $20 Qs = 2PW - PB - 0.3PF Where PB (the price of beer) is $2 and PF (the price of fertilizer) is $10.

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**Changes in Market Equilibrium**

Changing market conditions alter the market equilibrium Changes in the determinants of supply (or demand) other than the product price cause the supply (or demand) curve to shift Example: falling diesel fuel and soybean prices shift the corn supply curve out 2-21

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**Figure 2.5: Change in Market Equilibrium**

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**Changes in Market Equilibrium**

Four possible ways either supply or demand curve can shift: Demand can increase or decrease Supply can increase or decrease Effect on market equilibrium: If demand curve shifts, price and quantity change in the same direction as the curve If supply curve shifts, quantity changes in the same direction as the curve but price changes in the opposite direction 2-23

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**Figure 2.6: Changes in Market Equilibrium**

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**Changes in Market Equilibrium**

Sometimes supply and demand will both shift Ultimate effect on equilibrium is combination of the separate effects of changes in demand and supply Will be able to determine the necessary direction of price or quantity movement, but not both 2-25

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**Figure 2.9: Increase in Both Demand and Supply**

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**Size of Changes in Market Equilibrium**

What determines the size of changes in market equilibrium? Size of change in demand (or supply) The larger the shift in demand (or supply), the larger the effect on price) Steepness of the curve that does not shift If the supply curve shifts, the steeper demand curve the more the price changes the less the amount bought and sold changes Steepness reflects responsiveness to prices 2-27

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**Figure 2.11: Changes in Equilibrium for Two Extreme Demand Curves**

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**Figure 2.13: Changes in Equilibrium for Two Extreme Supply Curves**

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**Elasticities of Demand and Supply**

A measure of the responsiveness of the amounts demanded and supplied to changes in prices Not the same as the slope of the supply or demand curve, which depends on unit of measurement. Elasticity does not depend on units (e.g., gallons, dozens, dollars per pound) Can compare elasticity across goods and services. 2-30

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**General Elasticity Formula**

Suppose that a change in X causes a change in Y. Then the elasticity of Y with respect to X is the percentage change in Y divided by the percentage change in X: 2-31

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**Interpreting an Elasticity**

Suppose Then Y increases 2% for each 1% increase in X If instead Y decreased 2% when X increased by 1%, the elasticity would be negative. Note that the elasticity is unit-free; its meaning is clear without information about the units of X or Y. 2-32

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**Price Elasticity of Demand**

Elasticity of demand for a product with respect to its price Usually called “elasticity of demand” Denoted Elasticity of demand equals the percentage change in the amount demanded divided by the percentage change in the price 2-33

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**Price Elasticity of Demand**

Formula: Expect Ed to be negative: When P increases, amount demanded typically decreases When P decreases, amount demanded typically increases 2-34

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**Price Elasticity of Demand**

Goods tend to have more price elastic demand when: They have close substitutes Buyers of the product consider it a luxury Buyers of the product are strapped for cash and thus sensitive to changes in their expenditures In general, elasticity of demand varies at different points along a demand curve 2-35

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**Elasticities for Linear Demand Curves**

For linear demand curves re-write the price elasticity of demand formula as: Notice that the first term is related to the slope of the demand curve The second term is the initial price divided by the initial quantity 2-36

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**Categories of Elasticity of Demand**

Condition for Ed Elastic Ed<-1 Inelastic 0>Ed>-1 Perfectly Elastic Ed=infinity Perfectly Inelastic Ed=0 Unit Elastic Ed=1 2-37

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**Total Expenditure and Elasticity of Demand**

Total expenditure equals P*Q, the product of the price and the total amount demanded Elasticity of demand shows how total expenditure changes when price increases TE will increase with a small increase in price when demand is inelastic and decrease when demand is elastic TE is largest at a price for which elasticity equals -1 2-38

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**Figure 2.18: Price, Elasticity, and Total Expenditure**

TE increases where demand is inelastic; for prices below $3.75 TE falls where demand is elastic TE is largest where Ed = -1; when price = $3.75 2-39

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**Income Elasticity If EI>0, the good is a normal good.**

Consumption rises as income increases. If EI<0, the good is an inferior good. Consumption falls as income increases.

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**Cross Price Elasticity**

If Exy >0, the two goods are substitutes. If Exy <0, the two goods are complements.

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**Price Elasticity of Supply**

Responsiveness of a product’s supply to changes in its price Elasticity of supply equals the percentage change in the amount supplied divided by the percentage change in the price Basic ideas are the same as for elasticity of demand 2-42

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Sample Problem 4 You are the marketing manager for XYZ Corp. You have this regression result for your product: Q = 2000 – 3.5*P + 1.2*I. Right now, your price is 10, and the average income of your customers is $30,000. compute income elasticity is your good a normal good or an inferior good? You expect a recession. You estimate that your customer's average income will fall 5% due to this recession. Estimate the impact on your sales.

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