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

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? ©2005 Pearson Education, Inc. Chapter 2 2

Supply and Demand Supply and demand analysis can: Help us understand and predict how economic conditions affect market price Analyze the impact of government price controls, minimum wages, and price supports 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 slopes upward demonstrating that Price ($ per unit) The Supply Curve Graphically 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 price 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 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

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 wished to buy at the current price can and all producers who wish to sell at that price can ©2005 Pearson Education, Inc. Chapter 2 13

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 ©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 Price is above the market clearing price – P1 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 a 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 Price is below the market clearing price – P2 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

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. ©2005 Pearson Education, Inc. Chapter 2 25

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. ©2005 Pearson Education, Inc. Chapter 2 26

Changes In Market Equilibrium D Raw material prices fall S shifts to S’ Surplus at P1 between Q1, Q2 Price adjusts to equilibrium at P3, Q3 P Q S S’ Q1 P1 Q2 P3 Q3 ©2005 Pearson Education, Inc. Chapter 2 34

Changes In Market Equilibrium D D’ P Q S Income Increases Demand increases to D1 Shortage at P1 of Q1, Q2 Equilibrium at P3, Q3 Q3 P3 Q1 P1 Q2 ©2005 Pearson Education, Inc. Chapter 2 44

Changes In Market Equilibrium D Income Increases & 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

Elasticities of Supply and Demand Not only are we concerned with what direction price and quantity will move when the market changes, but we are concerned about how much they change. Elasticity gives a way to measure by how much a variable will change with the change in another variable. Specifically, it gives the percentage change in one variable resulting from a one percent change in another. ©2005 Pearson Education, Inc. Chapter 2 69

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

Price Elasticity of Demand 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

Price Elasticity of Demand 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

Price Elasticity of Demand The primary determinant of price elasticity of demand is the availability of substitutes. Many substitutes demand is price elastic Few substitutes demand is price inelastic ©2005 Pearson Education, Inc. Chapter 2 75

Price Elasticity of Demand Looking at a linear demand curve, as we move along the curve Q/P will 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 ©2005 Pearson Education, Inc. Chapter 2

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 The bottom portion of demand curve is inelastic ©2005 Pearson Education, Inc. Chapter 2

Price Elasticity of Demand Q Price 4 8 2 Ep = -1 Ep = 0 EP = - Elastic Demand Curve Q = 8 – 2P Inelastic ©2005 Pearson Education, Inc. Chapter 2 76

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 Two extreme cases of demand curves Completely inelastic demand – vertical Infinitely 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

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. ©2005 Pearson Education, Inc. Chapter 2 81

Other Demand Elasticities Complements: Cars and Tires Cross-price elasticity of demand is negative Substitutes: Butter and Margarine Cross-price elasticity of demand is positive ©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

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

Effects of Price Controls 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

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. ©2005 Pearson Education, Inc. Chapter 2