Demand & Supply Dr. Alok Kumar Pandey Dr. Alok Pandey

Agenda for Discussion Equilibrium: Demand and Supply Change in the Equilibrium Elasticity Demand, types of elasticity, effect of elasticity on revenue, effect of time on elasticity Elasticity of Supply, effect of time on elasticity Income elasticity Cross elasticity Dr. Alok Pandey

The Supply Function Includes all variables that influence the quantity supply Q = f( P, Pa, C, Nf, T, PE ………….) P is price of the good Pa is the price of alternative goods C is the input price Nf is number of firms, T Technological advancement PE is the expected future price Dr. Alok Pandey 4

The Supply Curve Price ↓ Move leftward along the supply curve Price ↑ Move rightward along the supply curve P P S S A B P1 P2 P2 P1 B A Q2 Q1 Q Q1 Q2 Q Dr. Alok Pandey

The Supply Curve The Supply curve shifts rightward P S1 S2 Price of input ↓ Price of alternatives ↓ Number of firms ↑ Expected price ↓ Technological advance Favorable weather Q Dr. Alok Pandey

The Supply Curve The Supply curve shifts leftward P S2 S1 Price of input ↑ Price of alternatives ↑ Number of firms ↓ Expected price ↑ Unfavorable weather Q Dr. Alok Pandey

Supply and Demand Equilibrium Equilibrium price and quantity both P and Q have settled into a state of rest Equilibrium price and quantity once achieved - remain constant until either the demand curve or supply curve shifts Dr. Alok Pandey

Equilibrium Quantity Price S E 3.00 1.00 D 25,000 50,000 75,000 Dr. Alok Pandey

Excess Demand the amount by which quantity demanded exceeds quantity supplied - at a given price Buyers compete with each other to get more of the good than is available The price will rise Equilibrium is reached Dr. Alok Pandey

Excess Demand Quantity Price 2. causes the price to rise . . . S 3. shrinking the excess demand until price reaches its equilibrium value of 3.00 E 3.00 H J 1.00 Excess Demand D 25,000 50,000 75,000 1. At a price of 1.00 per Bottle, an excess demand of 50,000 units . . . Dr. Alok Pandey

Excess Supply the amount by which quantity supplied exceeds quantity demanded - at a given price Sellers compete with each other to sell more than buyers want The price will fall Equilibrium is reached Dr. Alok Pandey

Excess Supply 1. At a price of 5.00 per bottle an excess supply of 30,000 units . . . 3. shrinking the excess supply . . . Quantity Price S Excess Supply 5.00 L K 4. until price reaches its equilibrium value of 3.00 3.00 E D 2. causes the price to drop… 35,000 50,000 65,000 Dr. Alok Pandey

What Happens When Things Change Income rises normal good the demand increases (rightward shift of the demand curve) Rightward movement along the supply curve Equilibrium price rises Equilibrium quantity rises Dr. Alok Pandey

Income rises, causing an increase in D Quantity Price 4. equilibrium price increases 3. to a new equilibrium S 2. moves us along the supply curve… 4.00 E' 1. An increase in demand . . . 3.00 E D2 D1 5. equilibrium quantity increases too 50,000 60,000 Dr. Alok Pandey

What Happens When Things Change Example - Weather changes will shift the supply curve Decrease in supply (the supply curve shifts leftward) Equilibrium price rises Equilibrium quantity falls Dr. Alok Pandey

Bad weather hits, decreasing the S Quantity Price S2 S1 5.00 E' 3.00 E D 35,000 50,000 Dr. Alok Pandey

Both Curves Shift Just one curve shifts (D or S) we can determine the direction that BOTH equilibrium price AND quantity will move Both curves shift (D and S) we can determine the direction that EITHER equilibrium price OR equilibrium quantity will move direction of the other – which curve shifts by more Dr. Alok Pandey

Income rises and Bad weather hits Quantity Price S2 S1 6.00 E' 3.00 E D2 D1 Dr. Alok Pandey

Price Elasticity of Demand Degree of Responsiveness Price elasticity of demand Consumers’ responsiveness to a change in price Percentage change in the quantity demanded divided by percentage change in price Dr. Alok Pandey 19

Price Elasticity of Demand Law of demand ED negative Absolute value of ED positive Dr. Alok Pandey

Computing the Price Elasticity of Demand Example: If the price of an ice cream cone increases from Rs. 2.00 to Rs. 2.20 and the amount you buy falls from 10 to 8 cones, then your elasticity of demand would be calculated as: Dr. Alok Pandey

The Midpoint Method: A Better Way to Calculate Percentage Changes and Elasticities The midpoint formula is preferable when calculating the price elasticity of demand because it gives the same answer regardless of the direction of the change. Dr. Alok Pandey

The Midpoint Method: A Better Way to Calculate Percentage Changes and Elasticities Example: If the price of an ice cream cone increases from Rs. 2.00 to Rs.2.20 and the amount you buy falls from 10 to 8 cones, then your elasticity of demand, using the midpoint formula, would be calculated as: Dr. Alok Pandey

Computing the Price Elasticity of Demand 5 4 Demand 50 100 Quantity Demand is price elastic Dr. Alok Pandey

The Variety of Demand Curves on the basis of elasticity Perfectly Inelastic Quantity demanded does not respond to price changes. Perfectly Elastic Quantity demanded changes infinitely with any change in price. Unit Elastic Quantity demanded changes by the same percentage as the price. Dr. Alok Pandey

The Variety of Demand Curves on the basis of elasticity Inelastic Demand Quantity demanded does not respond strongly to price changes. Price elasticity of demand is less than one. Elastic Demand Quantity demanded responds strongly to changes in price. Price elasticity of demand is greater than one. Dr. Alok Pandey

The Price Elasticity of Demand (a) Perfectly Inelastic Demand: Elasticity Equals 0 Price Demand 100 5 1. An increase in price . . . 4 Quantity 2. . . . leaves the quantity demanded unchanged. Dr. Alok Pandey

The Price Elasticity of Demand (b) Inelastic Demand: Elasticity Is Less Than 1 Price Demand 5 90 4 100 Quantity Dr. Alok Pandey

The Price Elasticity of Demand (c) Unit Elastic Demand: Elasticity Equals 1 Price Demand 5 75 4 100 Quantity Dr. Alok Pandey

The Price Elasticity of Demand (d) Elastic Demand: Elasticity Is Greater Than 1 Price Demand 5 50 4 100 Quantity Dr. Alok Pandey

The Price Elasticity of Demand (e) Perfectly Elastic Demand: Elasticity Equals Infinity Price 1. At any price above 4, quantity demanded is zero. 4 Demand 2. At exactly 4, consumers will buy any quantity. 3. At a price below 4, quantity demanded is infinite. Quantity Dr. Alok Pandey

Total Revenue and the Price Elasticity of Demand Total revenue is the amount paid by buyers and received by sellers of a good. Computed as the price of the good times the quantity sold. TR = P x Q Dr. Alok Pandey

Total Revenue Price 4 P × Q = 400 P (revenue) Demand 100 Quantity Q Quantity Q Dr. Alok Pandey

Elasticity and Total Revenue along a Linear Demand Curve With a relatively inelastic demand curve, an increase in price leads to a decrease in quantity that is proportionately smaller. Thus, total revenue increases. Dr. Alok Pandey

How Total Revenue Changes When Price Changes: Inelastic Demand An Increase in price from 1 to 3 … … leads to an Increase in total revenue from 100 to 240 Demand Demand 3 80 Revenue = 240 1 100 Revenue = 100 Quantity Quantity Dr. Alok Pandey

Elasticity and Total Revenue along a Linear Demand Curve With an elastic demand curve, an increase in the price leads to a decrease in quantity demanded that is proportionately larger. Thus, total revenue decreases. Dr. Alok Pandey

How Total Revenue Changes When Price Changes: Elastic Demand An Increase in price from 4 to 5 … … leads to an decrease in total revenue from 200 to 100 5 20 Demand Demand Revenue = 100 4 50 Revenue = 200 Quantity Quantity Dr. Alok Pandey Copyright©2003 Southwestern/Thomson Learning

Summary of price elasticity of demand :Effects of a 10 percent increase in price Absolute value of price elasticity Type of demand What happens to quantity demanded total revenue ED = 0 Perfectly inelastic No change Increases by 10 percent 0 < ED < 1 Inelastic Drops by less than Increases by less than 10 percent ED = 1 Unit elastic Drops by 10 percent 1 < ED <∞ Elastic Drops by more than Decreases ED = ∞ Perfectly elastic Drops to 0 Dr. Alok Pandey

Determinants of Price Elasticity of Demand ED is greater: The greater the availability of substitutes, and the more similar the substitutes The more important the good as a share of the consumer’s budget The longer the period of adjustment (time) Dr. Alok Pandey

Demand becomes more elastic over time Dw: one week after the price increase Dw Price per unit 1.25 1.00 Dm Dm: one month after the price increase Dy Dy: one year after the price increase e Quantity per day 95 100 75 50 Dy is more elastic than Dm , which is more elastic than Dw Dr. Alok Pandey

Elasticity Estimates Short run Long run Consumers have little time to adjust Long run Consumers can fully adjust to a price change Demand is more elastic in the long run Dr. Alok Pandey

Selected price elasticities of D (absolute values) Product Short run Long run Electricity (residential) Air travel Medical care and hospitalization Gasoline Milk Fish (cod) Wine Movies Natural gas (residential) Automobiles 0.1 0.3 0.4 0.5 0.7 0.9 1.4 1.9 2.4 1.5 - 1.2 3.7 2.1 2.2 Dr. Alok Pandey

Price Elasticity of Supply Responsiveness Price elasticity of supply Producers’ responsiveness to a change in price Percentage change in quantity supplied divided by percentage change in price Dr. Alok Pandey

Price Elasticity of Supply Law of supply ES positive Dr. Alok Pandey

Price elasticity of supply Price per unit p p’ S If the price increases from p to p’, the quantity supplied increases from q to q’. Price and quantity supplied move in the same direction, so the price elasticity of supply is a positive number. Quantity per period q q’ Dr. Alok Pandey

Categories of ES If %∆q < %∆p If %∆q > %∆p If %∆q = %∆p ES between 0 and 1 Less elastic S If %∆q > %∆p ES greater than 1 Elastic S If %∆q = %∆p ES = 1 Unit elastic S Dr. Alok Pandey

Elasticity Supply Curves Perfectly elastic S curve Horizontal; ES = ∞ Producers supply 0 at a price below P Perfectly inelastic S curve Vertical; ES = 0 Goods in fixed supply Unit-elastic S curve %∆p causes an exact opposite %∆q S curve starts from the origin. Dr. Alok Pandey

Elasticity supply curves (a) Perfectly elastic (b) Perfectly inelastic (c) Unit elastic S’ Price per unit p Price per unit Price per unit 10 5 S’’ ES’’ = 1 ES’ = 0 ES = ∞ S Quantity per period Quantity per period Q Quantity per period 10 20 Firms supply any amount of output demanded at p, but supply 0 at prices below p. Quantity supplied is independent of the price Any %∆p results in the same %∆q supplied. Dr. Alok Pandey

Supply becomes more elastic over time Sw Price per unit 1.00 1.25 Sy Sw: one week after the price increase Sm: one month after the price increase Sy: one year after the price increase Quantity per day 110 200 100 140 Sw is less elastic than Sm , which is less elastic than Sy Dr. Alok Pandey

Income Elasticity of Demand Demand responsiveness to a change in consumer income Percentage change in demand divided by the percentage change in income. Dr. Alok Pandey

Selected income elasticities of demand Product Income Elasticity Wine Private education Automobiles Owner-occupied housing Furniture Dental service Restaurant meals Spirits (‘hard’ liquor) Shoes Chicken Clothing 5.03 2.46 2.45 1.49 1.48 1.42 1.40 1.21 1.10 1.06 0.92 Physicians’ services Coca-Cola Beef Food Coffee Cigarettes Gasoline and oil Rental housing Pork Beer Flour 0.75 0.68 0.62 0.51 0.50 0.48 0.43 0.18 -0.09 -0.36 Dr. Alok Pandey

Cross-Price Elasticity of Demand Responsiveness of D for one good to changes in P of another good %∆ in demand for one good divided by %∆ in price of another good If positive: substitutes If negative: complements If zero: unrelated Dr. Alok Pandey

Price Elasticity and Tax Incidence Decrease in S by the amount of tax Tax incidence Consumers : high P Producers: net-of-tax receipt Dr. Alok Pandey

Price Elasticity and Tax Incidence The more price elastic the D: The more tax producers pay The less tax consumers pay The more elastic the S: The less tax producers pay The more tax consumers pay Dr. Alok Pandey

Effects of price elasticity of D on tax incidence (a) Less elastic demand (b) More elastic demand Price 1.15 1.00 0.95 Price 1.05 1.00 0.85 0.20 Tax St St D 0.20 Tax S D’ S Millions of ounces per day 10 9 10 7 The more elastic the D curve, the more tax is paid by producers (lower net-of-tax receipt) Dr. Alok Pandey

Effects of price elasticity of S on tax incidence (a) More elastic supply (b) Less elastic supply St” Price 1.15 1.00 0.95 0.20 Tax Price 1.05 1.00 0.85 St’ S” D’’ D’’ 0.20 Tax S’ quantity 10 8 10 9 The more elastic the S curve, the more tax is paid by consumers as a higher price. Dr. Alok Pandey

Bandwagon Effect Individual demand is influenced by number of other households consuming a commodity The greater the number of households consuming a commodity Key to marketing most toys and clothing is to create a bandwagon effect Results in market demand curve shifting outward Dr. Alok Pandey

Some instances where the law of demand does not hold good Giffen Goods: Example: when the price of bread increase consumer curtailed their consumption of meat. Veblen effect: Example: when the rise in price take place , consumer may be misguided to think that quality improved. Expectation of rise in price: Share Market: Example: Price of particular share rise its demand will also increased. Dr. Alok Pandey