Lesson 2: Demand and Supply Analysis

Theories and Predictions We need to be able to predict the consequences of alternative policies, and events that may be outside our control The mental tool we use to make such predictions is called a theory A theory is of no use if its predictions are inaccurate

We need a theory of prices The theory of demand and supply is a simple example of an economic theory It can be used to make predictions about the price and quantity of some commodity In a free-market economy, most economic decisions are guided by prices Therefore, without a reliable theory of prices, you will get nowhere in economic analysis

Assume perfect competition The theory of supply and demand assumes that commodities are traded in perfectly competitive markets A perfectly competitive market is a market in which there are many buyers many sellers and all sellers sell the exact same product As a result, each buyer and seller has a negligible impact on the market price

demand

Demand Quantity demanded is the amount of a good that buyers are willing and able to purchase Demand is a full description of how the quantity demanded changes as the price of the good changes.

Catherine’s Demand Schedule and Demand Curve Price of Ice-Cream Cone $3.00 2.50 1. A decrease in price ... 2.00 1.50 1.00 0.50 1 2 3 4 5 6 7 8 9 10 11 12 Quantity of 2. ... increases quantity of cones demanded. Ice-Cream Cones Copyright © 2004 South-Western

Market Demand is the Sum of Individual Demands

Law of Demand The law of demand states that the quantity demanded of a good falls when the price of the good rises, and vice versa, provided all other factors that affect buyers’ decisions are unchanged

“provided all other factors … are unchanged/ceteris paribus” That’s an important phrase in the wording of the Law of Demand The quantity demanded of a consumer good such as ice cream depends on The price of ice cream The prices of related goods Consumers’ incomes Consumers’ tastes Consumers’ expectations about future prices and incomes Number of buyers, etc The Law of Demand says that the quantity demanded of a good is inversely related to its price, provided all other factors are unchanged

Why Might Demand Increase? Quantity Demanded Price Situation A Situation B 0.00 12 20 0.50 10 16 1.00 8 1.50 6 2.00 4 2.50 2 3.00 How can we explain the difference in Catherine’s behaviour in situations A and B? Why does she consume more in situation B at every possible price? Price Quantity Demanded

Shifts in the Market Demand Curve … are caused by changes in: Consumer income Prices of related goods Tastes Expectations, say, about future prices and prospects Number of buyers 11

Shifts in the Demand Curve Price of Ice-Cream Cone Increase in demand Decrease in demand Demand curve, D 2 Demand curve, D 1 Demand curve, D 3 Quantity of Ice-Cream Cones

Shifts in the Demand Curve Consumer Income As income increases the demand for a normal good will increase As income increases the demand for an inferior good will decrease Prices of Related Goods When a fall in the price of one good reduces the demand for another good, the two goods are called substitutes When a fall in the price of one good increases the demand for another good, the two goods are called complements

The Law of Demand—Explanations There are two ways to explain the Law of Demand Substitution effect Income effect

Substitution Effect When the price of a good decreases, consumers substitute that good instead of other competing (substitute) goods 1. When the price of Coke decreases… 2. Consumption of Pepsi decreases… 3. Consumption of Coke increases Clothes Coke Books Movies Pepsi

Income Effect A decrease in the price of a commodity is essentially equivalent to an increase in consumers’ income

Lower Prices = Higher Income Situation A Price of an Apple $1.00 Price of an Orange $2.00 Income $10.00 If income rises, Situation A becomes Situation B. Situation B Price of an Apple $1.00 Price of an Orange $2.00 Income $20.00 If prices fall, Situation A becomes Situation C. Situation C Price of an Apple $0.50 Price of an Orange $1.00 Income $10.00 Q: Which change is better? A: They are both equally desirable. A fall in prices is equivalent to an increase in income.

Income Effect Consumers respond to a decrease in the price of a commodity as they would to an increase in income They increase their consumption of a wide range of goods, including the good that had a price decrease 1. When the price of Coke decreases… 2. Consumers feel richer… 3. Consumption of Coke and other goods increases Clothes Coke Books Movies Pepsi

supply

SUPPLY Quantity supplied is the amount of a good that sellers are willing and able to sell Supply is a full description of how the quantity supplied of a commodity responds to changes in its price 25

Ben’s supply schedule and supply curve $3.00 2.50 2.00 1.50 1.00 0.50 Price of Ice-Cream Cones Supply curve Price of Ice-cream cone Quantity of Cones supplied $0.00 0.50 1.00 1.50 2.00 2.50 3.00 0 cones 1 2 3 4 5 1. An increase in price . . . 2. . . . increases quantity of cones supplied. 12 10 11 9 1 2 3 4 5 6 7 8 Quantity of Ice-Cream Cones

Market supply and individual supplies Price of ice-cream cone Ben Jerry Market $0.00 0.50 1.00 1.50 2.00 2.50 3.00 1 2 3 4 5 + 6 8 = 7 10 13

Market supply and individual supplies Ben’s supply + Jerry’s supply = Market supply $3.00 2.50 2.00 1.50 1.00 0.50 Price of Ice Cream Cones $3.00 2.50 2.00 1.50 1.00 0.50 Price of Ice Cream Cones $3.00 2.50 2.00 1.50 1.00 0.50 Price of Ice Cream Cones SBen SMarket SJerry 12 10 11 9 1 2 3 4 5 6 7 8 Quantity of Ice-Cream Cones 1 2 3 4 5 6 7 Quantity of Ice-Cream Cones 18 2 4 6 8 10 12 14 16 Quantity of Ice-Cream Cones

Law of Supply The law of supply states that, the quantity supplied of a good rises when the price of the good rises, as long as all other factors that affect suppliers’ decisions are unchanged

Law of Supply—Explanation How can we make sense of the numbers in Ben’s supply schedule? The best guess is that his costs must be something like the cost schedule below. A specific ice-cream cone It’s cost ($) 1st 0.75 2nd 1.35 3rd 1.75 4th 2.30 5th 2.85 6th 3.10 In this way, the Law of Supply follows from the assumption of Increasing Costs (or, Diminishing Returns)

Shifts in the Supply Curve: What causes them? Price of Supply curve, S 3 Ice-Cream curve, Supply S 1 Cone Supply curve, S 2 Decrease in supply Increase in supply Quantity of Ice-Cream Cones

Supply Shift How could Ben’s supply have increased? Ben’s Supply Schedule Price ($) Quantity Supplied Before After 0.00 0.50 1 1.00 2 1.50 3 2.00 4 2.50 5 3.00 6 Ice-cream cone It’s cost ($) Before After 1st 0.75 0.45 2nd 1.35 0.85 3rd 1.75 1.45 4th 2.30 1.95 5th 2.85 2.45 6th 3.10 2.90 Anything that reduces production costs, shifts supply to the right.

Shifts in the Supply Curve… … are caused by changes in Input prices Technology Number of sellers (short run) The market supply will shift right if Raw materials or labor becomes cheaper The technology becomes more efficient Number of sellers increases 27

equilibrium

Interaction of demand and supply We have seen what demand and supply are We have seen why demand and supply may shift Now it is time to say something about how buyers and sellers collectively determine the market outcome To do this, we assume equilibrium

Equilibrium We assume that the price will automatically reach a level at which the quantity demanded equals the quantity supplied

SUPPLY AND DEMAND TOGETHER Demand Schedule Supply Schedule At $2.00, the quantity demanded is equal to the quantity supplied! 36

Equilibrium of supply and demand $3.00 2.50 2.00 1.50 1.00 0.50 Price of Ice-Cream Cones Supply Demand Equilibrium price Equilibrium Equilibrium quantity 12 10 11 9 1 2 3 4 5 6 7 8 Quantity of Ice-Cream Cones

Equilibrium Can we justify the assumption of equilibrium?

Markets Not in Equilibrium (a) Excess Supply Price of Ice-Cream Supply Cone Surplus Demand $2.50 10 4 2.00 7 Quantity of Quantity demanded Quantity supplied Ice-Cream Cones

Markets Not in Equilibrium Surplus When price exceeds equilibrium price, then quantity supplied is greater than quantity demanded There is excess supply or a surplus Suppliers will lower the price to increase sales, thereby moving toward equilibrium

Markets Not in Equilibrium (b) Excess Demand Price of Ice-Cream Supply Cone Demand $2.00 7 1.50 10 4 Shortage Quantity of Quantity supplied Quantity demanded Ice-Cream Cones

Markets Not in Equilibrium Shortage When price is less than equilibrium price, then quantity demanded exceeds the quantity supplied There is excess demand or a shortage Suppliers will raise the price due to too many buyers chasing too few goods, thereby moving toward equilibrium

Equilibrium Law of supply and demand The price of any good adjusts to bring the quantity supplied and the quantity demanded for that good into balance

Equilibrium: skepticism required Although the Law of Supply and Demand is a good place to start the discussion of prices, it should not be taken to be the gospel truth. In some cases the price might get stuck at some other level and quantity supplied and quantity demanded may not be equal. Example: unemployment

Unemployment: a failure of equilibrium when the wage is too high and stuck Labor Supply Labor demand Labor surplus (unemployment) Too-high wage Quantity demanded Quantity supplied Quantity of Labor

Let’s make some predictions We can use our understanding of the factors that shift the demand and supply curves to predict the consequences of Alternative policy proposals, and Events outside our control

How an Increase in Demand Affects the Equilibrium Price of Ice-Cream 1. Hot weather increases the demand for ice cream . . . Cone D D Supply New equilibrium $2.50 10 2. . . . resulting in a higher price . . . 2.00 7 Initial equilibrium Quantity of 3. . . . and a higher quantity sold. Ice-Cream Cones

How a Decrease in Supply Affects the Equilibrium Price of 1. An increase in the price of sugar reduces the supply of ice cream. . . Ice-Cream Cone S2 S1 Demand New equilibrium $2.50 4 2. . . . resulting in a higher price of ice cream . . . Initial equilibrium 2.00 7 Quantity of 3. . . . and a lower quantity sold. Ice-Cream Cones

A Shift in Both Supply and Demand Event Effect on Price Effect on Quantity Demand increases Up Supply decreases Down Both Ambiguous

A Shift in Both Supply and Demand

Prediction exercises Effect of a rise in the price of oil on the market for Hybrid cars Real estate Staple foods (corn, wheat, rice) Effect of the development of cheaper and better batteries for electric cars on the market for traditional cars gas

Maximum and Minimum Prices

Maximum Prices Governments can legally set a maximum price in a market that suppliers cannot go above. To be effective a maximum price has to be set below the free market price. The price for chicken is a good example of maximum price setting when a shortage of chicken threatens a very large rise in the free market price Other examples include price controls on other necessary food products such as wheat flour, sugar, beef, etc.

Illustrating the effects of a maximum price Chicken Free Market Equilibrium Supply Pe Demand Quantity of Chicken

Illustrating the effects of a maximum price Chicken Supply Free Market Equilibrium Pe P max Price (Rent) Ceiling Excess Demand The Government can set a legally imposed maximum price in a market that suppliers cannot exceed – in an attempt to prevent the market price from rising above a certain level. To be effective a maximum price has to be set below the free market price. Demand Q2 Q1 Quantity of Chicken

Black markets A parallel market can occur when the normal market price is higher than a legally imposed price ceiling (or maximum price). Black markets develop where there is excess demand (or a shortage) for a good/ service. Some consumers are prepared to pay higher prices in black markets in order to get the goods or services they want. When there is a shortage, higher prices act as a rationing device in the free market.

Potential black market for a good/ service Price £s Supply Free Market Equilibrium P1 Red area is a potential black market* Pe P max Price Ceiling Excess Demand It is worth noting that a price ceiling set above the free market equilibrium price would have no effect whatsoever on the market – because for a price floor to be effective, it must be set below the normal market-clearing price. Demand Q3 Q2 Q1 Quantity

Examples of black markets Tickets for major sporting events, rock concerts Black markets for children’s toys and designer products that are in scarce supply Black markets in the illegal distribution and sale of computer software products and pirated DVDs and music (the maximum price is zero! Or even negative if you include fines.)

Minimum prices Governments can legally set a minimum price in a market that suppliers cannot go below. To be effective the minimum price has to be set above the normal equilibrium price A good example of this is the minimum wage in Malaysia The main adult rate for the minimum wage in the Peninsular Malaysia is now RM4.33 per hour, Sabah and Labuan RM3.70 per hour, Sarawak RM3.75 per hour.

Illustrating the effects of a minimum price Wage Rate (W) Labour Supply Excess supply of labour due to the minimum wage Wmin Minimum Wage (Wage Floor) We A minimum price is a legally imposed price floor below which the normal market price cannot fall. To be effective the minimum price has to be set above the normal equilibrium price Excess unemployed willing to work Demand for Labour E3 Ee E1 Employment of Labour (E)

Main justifications for the minimum wage The equity justification: Fair rate of pay commensurate with the skills and experience of an employee To encourage unemployed people to start looking for work To reduce labour market discrimination/ exploitation To offset some of the effects of persistent discrimination of many low-paid female workers and younger employees

Disadvantages of a minimum wage Competitiveness and Jobs: A minimum wage may cost jobs because a rise in labour costs makes it more expensive to employ people. Effect on relative poverty:* The greatest risk of relative poverty is among the unemployed, elderly and single parent families where the parent is not employed. They don’t benefit from the NMW Rising prices due to supply costs increase

Elasticity of Demand And Supply

Price Elasticity of Demand Definition: Law of demand tells us that consumers will respond to a price drop by buying more, but it does not tell us how much more. The degree of sensitivity of consumers to a change in price is measured by the concept of price elasticity of demand. Price elasticity formula: Ed = percentage change in Qd / percentage change in Price. If the percentage change is not given in a problem, it can be computed using the following formula: Percentage change in Qd = (Q1-Q2) / [1/2 (Q1+Q2)] where Q1 = initial Qd, and Q2 =  new Qd. Percentage change in P = (P1-P2) / [1/2 (P1 + P2)] where P1 = initial Price, and P2 = New Price. Putting the two above equations together: Ed = {(Q1-Q2) / [1/2 (Q1+Q2)] } / {(P1-P2) / [1/2 (P1 + P2)]} Because of the inverse relationship between Qd and Price, the Ed coefficient will always be a negative number. But, we focus on the magnitude of the change by neglecting the minus sign and use absolute value Examples: 1.  If the price of Product A  increased by 10%,  the quantity demanded decreased by 20%. Then the coefficient for  price elasticity of the demand of Product A is: Ed = percentage change in Qd / percentage change in Price = (20%) / (10%) = 2 2. If the quantity demanded of Product B has decreased from 1000 units to 900 units as price increased from $2 to $4 per unit, the coefficient for Ed is: Ed = {(Q1-Q2) / [1/2 (Q1+Q2)] } / {(P1-P2) / [1/2 (P1 + P2)]} = {(1000 - 900) / 1/2(1000 + 900)} / {(2 - 4) / 1/2 (2+4)} = - 0.16 Take the absolute value of - 0.16, Ed = 0.16

Characteristics: Ed approaches infinity, demand is perfectly elastic. Consumers are very sensitive to price change. Ed > 1, demand is elastic. Consumers are relatively responsive to price changes. Ed = 1, demand is unit elastic. Consumers’ response and price change are in same proportion. Ed < 1, demand is inelastic. Consumers are relatively unresponsive to price changes. Ed approaches 0, demand is perfectly inelastic. Consumers are very insensitive to price change. Ed is usually greater in the higher price range than in lower price range. Demand is more elastic in upper left portion of the demand curve than in the lower right portion of the curve. However, it is impossible to judge elasticity of a demand curve by its flatness or steepness. Along a linear demand curve, its elasticity changes. This relationship is demonstrated in the following example:

An Example DEMAND FUNCTION FOR PRODUCT X: P = 2.5-0.01Q P = PRICE; Q = QUANTITY, TR = TOTAL REVENUE Ed = PRICE ELASTICITY OF DEMAND           A     B      C       D       E        F        G        H         I        J Q:       0    50   100    150   200    250    300   350   400   450 P:       4.5   4     3.5     3       2.5       2       1.5      1      0.5      0 Ed:      17    5     2.6   1.57       1     0.64   0.38    0.2    0.06 ELASTICITY OF DEMAND; FROM A TO E Ed >1 FROM E TO F Ed =1 FROM F TO J Ed <1

Determinants of Price Elasticity of Demand Various factors influence the price elasticity of demand. Here are some of them: 1. # of Substitutes: If a product can be easily substituted, its demand is elastic, like Gap's jeans. If a product cannot be substituted easily, its demand is inelastic, like gasoline. 2. Luxury Vs Necessity: Necessity's demand is usually inelastic because there are usually very few substitutes for necessities. Luxury product, such as leisure sail boats, are not needed in a daily bases. There are usually many substitutes for these products. So their demand is more elastic. 3. Price/Income Ratio: The larger the percentage of income spent on a good, the more elastic is its demand. A change in these products' price will be highly noticeable as  they affect consumers' budget with a bigger magnitude. Consumers will respond by cutting back more on these product when price increases. On the other hand, the smaller the percentage of income spent on a good, the less elastic is its demand. 4. Time lag: The longer the time after the price change, the more elastic will be the demand. It is because consumers are given more time to carry out their actions. A 1-day sale usually generate less sales change per day as a sale lasted for 2 weeks.

Total Revenue Test Total revenue (TR) is calculated by multiplying price (P) per unit and quantity (Q) of the good sold. TR = P x Q The total revenue test is a method of estimating the price elasticity of demand. As Ed will impact the total revenue, we can estimate the Ed by looking at the movement of the total revenue. Total Revenue Test Ed > 1, total revenue will decrease as price increases. P and TR moves in opposite directions. Producers can increase total revenue ( TR = Price x Quantity) by lowering the price. Therefore, most department stores will have sales to attract customers. Apparel's demand is elastic. Ed < 1, total revenue will increase as price increases. P and TR moves in the same direction. Producers can increase total revenue by raising the price. Inelastic demand for agricultural products helps to explain why bumper crops depress the prices and total revenues for farmers. You may look at the movement of TR in the example below. It demonstrated the relationship described above.

TR Test Example DEMAND FUNCTION FOR PRODUCT X: P = 2.5-0.01Q P = PRICE; Q = QUANTITY, TR = TOTAL REVENUE Ed = PRICE ELASTICITY OF DEMAND           A      B       C       D       E        F        G        H         I        J Q:       0     50   100     150     200    250    300   350   400   450 P:       4.5    4     3.5       3        2.5       2       1.5      1      0.5      0 TR:      0    200    350     450      500    500    450   350    200     0 Ed:         17     5      2.6      1.57       1     0.64    0.38    0.2    0.06 ELASTICITY OF DEMAND; FROM A TO E Ed >1     TR increases FROM E TO F Ed =1      TR remains same. FROM F TO J Ed <1       TR decreases.

Price Elasticity of Supply Definition: Law of supply tells us that producers will respond to a price drop by producing less, but it does not tell us how much less. The degree of sensitivity of producers to a change in price is measured by the concept of price elasticity of supply. Price elasticity formula: Es = percentage change in Qs / percentage change in Price. If the percentage change is not given in a problem, it can be computed using the following formula: Percentage change in Qs = (Q1-Q2) / [1/2 (Q1+Q2)] where Q1 = initial Qs, and Q2 =  new Qs. Percentage change in P = (P1-P2) / [1/2 (P1 + P2)] where P1 = initial Price, and P2 = New Price. Putting the two above equations together: Es = {(Q1-Q2) / [1/2 (Q1+Q2)] } / {(P1-P2) / [1/2 (P1 + P2)]} Because of the direct relationship between Qs and Price, the Es coefficient will always be a positive number. Examples: 1.  If the price of Product A  increased by 10%,  the quantity supplied increases by 5%. Then the coefficient for  price elasticity of the supply of Product A is: Es = percentage change in Qs / percentage change in Price = (5%) / (10%) = 0.5 2. If the quantity supplied of Product B has decreased from 1000 units to 200 units as price decreases from $4 to $2 per unit, the coefficient for Es is: Es = {(Q1-Q2) / [1/2 (Q1+Q2)] } / {(P1-P2) / [1/2 (P1 + P2)]} = {(1000 - 200) / 1/2(1000 + 200)} / {(4-2) / 1/2 (4+2)} = 2

Characteristics & Determinants Es approaches infinity, supply is perfectly elastic. Producers are very sensitive to price change. Es > 1, supply is elastic. Producers are relatively responsive to price changes. Es = 1, supply is unit elastic. Producers’ response and price change are in same proportion. Es < 1, supply is inelastic. Producers are relatively unresponsive to price changes. Es approaches 0, supply is perfectly inelastic. Producers are very insensitive to price change. It is impossible to judge elasticity of a supply curve by its flatness or steepness. Along a linear supply curve, its elasticity changes.   Determinants: 1. Time lag: How soon the cost of increasing production rises and the time elapsed since the price change influence the Es. The more rapidly the production cost rises and the less time elapses since a price change, the more inelastic the supply. The longer the time elapses, more adjustments can be made to the production process, the more elastic the supply. 2. Storage possibilities: Products that cannot be stored will have a less elastic supply. For example, produces usually have inelastic supply due to the limited shelf life of the vegetables and fruits.

Cross Elasticity of Demand Definition: Cross elasticity (Exy) tells us the relationship between two products. it measures the sensitivity of quantity demand change of product X to a change in the price of product Y. Formula: Exy = percentage change in Quantity demanded of X / percentage change in Price of Y. If the percentage change is not given in a problem, it can be computed using the following formula: Percentage change in Qx = (Q1-Q2) / [1/2 (Q1+Q2)] where Q1 = initial Qd of X, and Q2 =  new Qd of X. Percentage change in Py = (P1-P2) / [1/2 (P1 + P2)] where P1 = initial Price of Y, and P2 = New Price of Y. Putting the two above equations together: Exy = {(Q1-Q2) / [1/2 (Q1+Q2)] } / {(P1-P2) / [1/2 (P1 + P2)]}   Characteristics: Exy > 0,  Qd of X and Price of Y are directly related. X and Y are substitutes. Exy approaches 0, Qd of X  stays the same as the Price of Y changes. X and Y are not related. Exy < 0, Qd of X and Price of Y are inversely related. X and Y are complements. Examples: 1. If the price of Product A  increased by 10%,  the quantity demanded of B increases by 15 %. Then the coefficient for the cross  elasticity of the A and B is : Exy = percentage change in Qx / percentage change in Py = (15%) / (10%) = 1.5 > 0, indicating A and B are substitutes. 2. If the price of Product A  increased by 10%,  the quantity demanded of B decreases by 15 %. Then the coefficient for the cross  elasticity of the A and B is : Exy = percentage change in Qx / percentage change in Py = (- 15%) / (10%) = - 1.5 < 0, indicating A and B are complements.

Income Elasticity of Demand Definition: Income elasticity of demand (Ey, here y stands for income) tells us the relationship a product's quantity demanded and income. It measures the sensitivity of quantity demand change of product X to a change in income. Price elasticity formula: Ey = percentage change in Quantity demanded / percentage change in Income If the percentage change is not given in a problem, it can be computed using the following formula: Percentage change in Qx = (Q1-Q2) / [1/2 (Q1+Q2)] where Q1 = initial Qd, and Q2 =  new Qd. Percentage change in Y = (Y1-Y2) / [1/2 (Y1 + Y2)] where Y1 = initial Income, and Y2 = New income. Putting the two above equations together: Ey = {(Q1-Q2) / [1/2 (Q1+Q2)] } / (Y1-Y2) / [1/2 (Y1 + Y2)]   Characteristics: Ey > 1,  Qd and income are directly related. This is a normal good and it is income elastic. 0< Ey<1,  Qd and income are directly related. This is a normal good and it is income inelastic. Ey < 0, Qd and income are inversely related. This is an inferior good. Ey approaches 0, Qd   stays the same as income changes, indicating a necessity. Example: If income  increased by 10%,  the quantity demanded of a product increases by 5 %. Then the coefficient for the income  elasticity of demand for this product is:: Ey = percentage change in Qx / percentage change in Y = (5%) / (10%) = 0.5 > 0, indicating this is a normal good and it is income inelastic.