Unit 2 The Product Market 20 to 30%

Supply & Demand

LAW OF DEMAND An inverse relationship exists between price and quantity demanded As Price Falls… …Quantity Demanded Rises As Price Rises… …Quantity Demanded Falls

DOWNWARD SLOPE Diminishing Marginal Utility Income Effect Substitution Effect

GRAPHING DEMAND Increase in Quantity Demanded P QD $5 4 3 2 1 10 20 35 Price of Corn P Increase in Quantity Demanded $5 4 3 2 1 CORN P QD $5 4 3 2 1 10 20 35 55 80 30 40 60 80 + Increase in Demand D2 D1 o 10 20 30 40 50 60 70 80 Q Quantity of Corn

DETERMINANTS OF DEMAND Tastes (Preferences) Prices of Related Goods Substitutes & Complements Unrelated Goods Income Normal (Superior) & Inferior Goods Number of Buyers Expectations

LAW OF SUPPLY A direct relationship exists between price and quantity supplied As Price Rises… …Quantity Supplied Rises As Price Falls… …Quantity Supplied Falls

GRAPHING SUPPLY Increase in Supply P QS $5 4 3 2 1 60 50 35 20 5 80 70 Price of Corn P Increase in Supply S2 S1 $5 4 3 2 1 CORN P QS $5 4 3 2 1 60 50 35 20 5 80 70 60 45 30 Increase in Quantity Supplied o 10 20 30 40 50 60 70 80 Q Quantity of Corn

DETERMINANTS OF SUPPLY Resource Prices Prices of Other Goods Technology Taxes & Subsidies Price Expectations Number of Sellers

DETERMINANTS OF SUPPLY Resource Prices Technology Taxes & Subsidies Prices of Other Goods Price Expectations Number of Sellers Combining with Demand

MARKET DEMAND & SUPPLY Surplus Shortage P QD P QS $5 4 3 2 1 2,000 Price of Corn P CORN MARKET CORN MARKET Surplus S $5 4 3 2 1 P QD P QS $5 4 3 2 1 2,000 4,000 7,000 11,000 16,000 $5 4 3 2 1 12,000 10,000 7,000 4,000 1,000 Shortage D 7 11 o 2 4 6 8 10 12 14 16 Q Quantity of Corn

Consumer and Producer Surplus in the Market Equilibrium Price A C B D E Consumer surplus Demand Supply Equilibrium price quantity Producer surplus Quantity

  % Q % P Commonly Expressed as… PRICE ELASTICITY OF DEMAND P D Q The percentage change in quantity The percentage change in price %  Q d  % P P2 P1 Elasticity is .5 D Q2 Q1 Q

 Price Elasticity is... Inelastic 0 < X < 1 PRICE ELASTICITY OF DEMAND Price Elasticity is... Inelastic 0 < X < 1 Typical of necessities one must have Elastic from 1 < X <  Typical of luxuries one wants Unit elastic when exactly = 1 Quantity change offsets Price change

Extreme Cases PRICE ELASTICITY OF DEMAND Perfectly Inelastic Demand Ed = 0 Q Perfectly Elastic Demand P D2 Ed =  Q

 Ed = More Accurate Calculation – The Midpoint Formula PRICE ELASTICITY OF DEMAND More Accurate Calculation – The Midpoint Formula Ed = ΔQ AVG Q ΔP AVG P 

TOTAL REVENUE TEST Another way to determine elasticity P x Q = TR P and Q move opposite each other So how do we know what happens to TR? If P and TR move together demand is inelastic If Q and TR move together demand is elastic If TR doesn’t move demand is unit elastic

CONTROLS ON PRICES Price Ceiling Price Floor A legal maximum on the price at which a good can be sold. Price Floor A legal minimum on the price at which a good can be sold. 4 4

A Market with a Price Ceiling (b) A Price Ceiling That Is Binding Price of Ice-Cream Cone Supply Demand Equilibrium price $3 2 Price ceiling 75 125 Shortage Quantity of Ice-Cream Quantity supplied Quantity demanded Cones

A Market with a Price Floor (b) A Price Floor That Is Binding Price of Ice-Cream Supply Cone Demand Surplus $4 Price floor 80 120 3 Equilibrium price Quantity of Ice-Cream Quantity demanded Quantity supplied Cones

How a Tax Affects Market Participants Tax Revenue T = the size of the tax Q = the quantity of the good sold T  Q = Tax Revenue

Tax Revenue Price Demand Supply Quantity with tax Price buyers pay Price sellers receive Tax revenue (T × Q) Size of tax (T) Quantity without tax Quantity sold (Q) Quantity

How a Tax Affects Welfare Price Demand Supply = PB Q2 PS Price buyers pay sellers receive A F B D C E = P1 Q1 Price without tax Quantity

DETERMINANTS OF DEADWEIGHT LOSS What determines whether the deadweight loss from a tax is large or small? Elasticities of Demand & Supply More elastic curves bring more loss

Tax Incidence Who pays for the tax? The more inelastic curve pays more

the last dollar spent on UTILITY MAXIMIZING COMBINATION Product A: Price = $1 Product B: Price = $2 $ 10 income Marginal utility per dollar (MU/price) Marginal utility per dollar (MU/price) Marginal utility, utils Marginal utility, utils Unit of product First 10 10 24 12 Second 8 8 20 10 Third 7 7 18 9 Fourth 6 6 16 8 Fifth 5 5 12 6 Sixth 4 4 6 3 Seventh 3 3 4 2 Income is gone... the last dollar spent on each good gave the same utility (8) per dollar

Algebraic Restatement of the Utility Maximization Rule Consumption Bundles Algebraic Restatement of the Utility Maximization Rule MU of A Price of A MU of B Price of B = 8 Utils $1 16 Utils $2 =