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Chapter 2 Supply and Demand McGraw-Hill/Irwin Copyright © 2008 by The McGraw-Hill Companies, Inc. All Rights Reserved.

Main Topics Demand Supply Market equilibrium Elasticities of demand and supply 2-2

Questions… Why are Lamborghinis so expensive whereas cheese burgers are not? How are prices determined for products? 2-3

Questions… There are several steps in analyzing a market. Determine product demand Determine the supply of the product Using demand and supply, equilibrium can be identified Elasticity will measure the responsiveness to change. What is demand? What is supply? 2-4

Demand Curves Product’s demand curve shows: How much buyers of the product want to buy at each possible price (willing and able) 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 (Law of Demand: buying the product is less attractive when the price is high than when the price is low) 2-5

Determinants of Demand Demand curve holds all factors other than the product’s price constant: Population growth 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 2-6

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 What could cause this price change? Change in another factor causes the entire demand curve to shift A change in demand What could cause this shift in demand? 2-7

Figure 2.1: Demand Curve for U.S. Corn Market (hypothetical) 2-8

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 2-9

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 What would be an economic term for butter? Increases in the price of potatoes will increase the amount of corn buyers demand What would be the economic term for potatoes? 2-10

Supply Curves Product’s supply curve shows: How much sellers of the product want to sell at each possible price (willing and able) 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 (Law of Supply: selling the product is less attractive when the price is low than when the price is high) 2-11

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 2-12

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 What could cause a price change? Change in another factor causes the entire supply curve to shift A change in supply What could cause a supply shift? 2-13

Figure 2.2: Demand Curve for U.S. Corn Market (hypothetical) 2-14

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 2-15

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 2-16

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

Figure 2.3: Equilibrium in the Corn Market 2-18

Excess Supply, Excess Demand If price is above equilibrium price: Amount supplied will be greater than amount demanded (excess supply or surplus) 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 or shortage) Incentive for buyers to offer higher prices Market prices adjust so that amount supplied equals amount demanded 2-19

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 prices shift the corn supply curve out 2-20

Figure 2.5: Change in Market Equilibrium 2-21 Example: falling diesel fuel prices shift the corn supply curve out

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 2-22

Figure 2.6: Changes in Market Equilibrium 2-23

Table 2.1 Effects of Changes in Demand or Supply Source of Change Effect on Price Effect on Amount Bought/Sold Increase in DemandRises Decrease in DemandFalls Increase in SupplyFallsRises Decrease in SupplyRisesFalls 2-24

Changes in Market Equilibrium Sometimes supply and demand will both shift Ultimate effect on equilibrium is the 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

Figure 2.9: Increase in Both Demand and Supply 2-26

Table 2.2 Effects of Simultaneous Changes in Demand and Supply Source of Change Effect on Price Effect on Amount Bought/Sold Demand and supply both increase AmbiguousRises Demand and supply both decrease AmbiguousFalls Demand increases, Supply decreases RisesAmbiguous Demand decreases, Supply increases FallsAmbiguous 2-27

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 2-28

Figure 2.11: Changes in Equilibrium for Two Extreme Demand Curves 2-29

Figure 2.13: Changes in Equilibrium for Two Extreme Supply Curves 2-30

Figure 2.14: Changes in Equilibrium for Two Supply Curves 2-31 If the price rises, which curve (S1 or S2) produces a greater change in price and quantity? Why? What could be examples of goods with supply curves that look like these?

Elasticities of Demand and Supply Elasticity is 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 Slope of the curve depends on the units used to measure the quantity of the good and its price Elasticity does not depend on units (e.g., gallons, dozens, dollars per pound) but looks at % changes. 2-32

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: 2-33

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. 2-34

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 2-35

Price Elasticity of Demand Formula: Note: the triangle is also called delta and stands for change. Expect E d to be negative: When P increases, amount demanded typically decreases When P decreases, amount demanded typically increases In Principles of Economics, the book used the absolute value of the elasticity. Here, we will be spending a little more time looking at whether the numbers are negative or positive. 2-36

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 have less money and are thus sensitive to changes in their expenditures In general, elasticity of demand varies at different points along a demand curve 2-37

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 2-38

Elasticities for Linear Demand Curves Notice that: Slope is constant along linear demand curve but (P/Q) varies, so elasticity varies along the demand curve Demand is more elastic at higher prices since P is larger and Q is smaller Demand is less elastic at lower prices since P is smaller and Q is larger 2-39

Categories of Elasticity of Demand Condition for E d ElasticE d <-1 Inelastic0>E d >-1 Perfectly ElasticE d =infinity Perfectly InelasticE d =0 Unit ElasticE d =1 2-40

Figure 2.15: Elasticities Along a Linear Demand Curve 2-41

Elasticity for Nonlinear Demand Curves Calculating elasticity of demand is possible when the demand curves are nonlinear. Isoelastic demand curves have the same elasticity at every price. 2-42

Elasticity Example Consider the linear demand curve for oranges below. This graph depicts the effects of a series of hurricanes on the US orange market. What is the elasticity of demand at a price of \$2.35 per box? At \$3.49? 2-43

Elasticity Example What is the elasticity of demand at a price of \$2.35 per box? At \$3.49? For \$2.35… (150-242)/(3.49-2.35)=-92/1.14= -80.7 -80.7(2.35/242)= -.78 For \$3.49… -1.88 Elastic/Inelastic? What does this mean? 2-44

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 2-45

Total Expenditure and Elasticity of Demand TE is largest at a price for which elasticity equals -1 What does this mean? A Buyer’s Total Expenditure = Seller’s Total Revenue so…this point signifies the revenue maximizing point. 2-46

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 E d = -1; when price = \$3.75 2-47

Elasticity Example - Revisited We determined that the price elasticity of oranges was -.78 at \$2.35 per box and -1.88 at \$3.49. If we take total consumer expenditures into account….what does the above mean for orange farmers after the storms? How badly did the storms hurt farm revenue? 2-48

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 2-49

Price Elasticity of Supply What does it mean if the Supply Curve is: Perfectly inelastic (b) Perfectly elastic (a) Elastic Inelastic 2-50

Other Elasticities Income Elasticity of Demand % change in the amount demanded divided by the % change in income. Or…the % change in the amount demanded for each 1% increase in income. Normal Good / Inferior Good More in Ch 5 Cross-price elasticity Measure the elasticity of demand for a product with respect to the price of another product. Substitutes have a positive cross-price elasticity. Complements have a negative cross-price elasticity 2-51

Elasticity – What Good is It? Who might want to figure out elasticity? What would they use it for? 2-52

Summary Demand Curve… shows the amount people wish to buy at each possible price. Determined by the demand function which gives the total demand for every combo of price and factors. Changes can move the point or the curve. Supply Curve… shows the amount people wish to sell at each possible price. Determined by the supply function which gives the total supply for every combo of price and factors. Changes can move the point or the curve. 2-53

Summary Market Equilibrium… Demand & Supply curves intersect. Will change based on changes in demand, prices, availability, etc. Elasticity of Demand and Supply How responsive is demand/supply to changes in price %s If inelastic, changes have less effect If elastic changes have greater effect Elasticity affects total revenue earned by suppliers. Elas. applicable to changes in income or the prices of substitutes/complements. 2-54

Appendix We used demand functions to figure out the demand for corn. Where do those functions come from? Use historical or modeled data and econometrics (linear regression, etc.) to derive the function and the “average” curve. We wont be doing much of this in class. This subject will be covered in much more detail in Prof. Wong’s exciting Econometrics course! 2-55

Final Exercise Consider again the demand function for corn in formula (1), (A)graph the corresponding demand curve when potatoes and butter cost \$.075 and \$4 per pound respectively, and average income is \$40,000 per year. (B) At what price does the amount demanded equal 15 billion bushels a year? Show your answer. 2-56

Final Exercise - Answer Step 1: Plug in new information. Qdcorn = 5 – 2Pcorn + 4Ppotatoes – 0.25Pbutter +.0003M Qdcorn = 5 – 2Pcorn + 4(0.75) – 0.25(4.00) +.0003(40,000) Qdcorn = 5 – 2Pcorn + 3 – 1 + 12 Qdcorn = 19 – 2Pcorn Step 2: Find intercepts…(a) P=0 and (b) Solve for P (a) Q=19…billion bushels (b) P=\$9.50 Step 3: Price at 15 b. bushels…. Qdcorn = 19 – 2Pcorn 15 = 19 – 2Pcorn 2Pcorn = 4 Pcorn = 2 2-57

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