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

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

3. Demand Curves Product’s demand curve shows:
How much buyers of the product want to buy at each possible price
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 (buying the product is less attractive when the price is high than when the price is low)
2-3

4. Determinants of Demand
Demand curve holds all factors other than the product’s price constant:
Population growth; # of consumers
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
2-4

5. 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
Change in another factor causes the entire demand curve to shift
A change in demand
2-5

6. Figure 2.1: Demand Curve for U.S. Corn Market (hypothetical)
2-6

7. 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
2-7

8. 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
Increases in the price of potatoes will increase the amount of corn buyers demand
2-8

9. Sample Problem 1 Plot the following demand curve for wine:
Qd = 20 – 4PW + 5PB + 0.2I
Where PB (the price of beer) is $2, and I (income) is $20
How does the demand curve change if average income rises to $50 or the price of beer falls to $1?

10. Supply Curves Product’s supply curve shows:
How much sellers of the product want to sell at each possible price
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 (selling the product is less attractive when the price is low than when the price is high)
2-10

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
2-11

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
Change in another factor causes the entire supply curve to shift
A change in supply
2-12

13. Figure 2.2: Supply Curve for U.S. Corn Market (hypothetical)
2-13

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
2-14

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
2-15

16. Sample Problem 2 Plot the following supply curve for wine:
Qs = 2PW - PB - 0.3PF
Where PB (the price of beer) is $2 and PF (the price of fertilizer) is $10.

17. 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

18. Figure 2.3: Equilibrium in the Corn Market
2-18

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

20. Sample Problem 3
Find the market equilibrium given the following supply and demand functions:
Qd = 20 – 4PW + 5PB + 0.2I
Where PB (the price of beer) is $2, and I (income) is $20
Qs = 2PW - PB - 0.3PF
Where PB (the price of beer) is $2 and PF (the price of fertilizer) is $10.

21. 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 and soybean prices shift the corn supply curve out
2-21

22. Figure 2.5: Change in Market Equilibrium
2-22

23. 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
2-23

24. Figure 2.6: Changes in Market Equilibrium
2-24

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

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

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
2-27

28. Figure 2.11: Changes in Equilibrium for Two Extreme Demand Curves
2-28

29. Figure 2.13: Changes in Equilibrium for Two Extreme Supply Curves
2-29

30. Elasticities of Demand and Supply
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, which depends on unit of measurement.
Elasticity does not depend on units (e.g., gallons, dozens, dollars per pound)
Can compare elasticity across goods and services.
2-30

31. 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:
2-31

32. 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.
2-32

33. 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
2-33

34. Price Elasticity of Demand
Formula:
Expect Ed to be negative:
When P increases, amount demanded typically decreases
When P decreases, amount demanded typically increases
2-34

35. 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 are strapped for cash and thus sensitive to changes in their expenditures
In general, elasticity of demand varies at different points along a demand curve
2-35

36. 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
2-36

37. Categories of Elasticity of Demand
Condition for Ed
Elastic
Ed<-1
Inelastic
0>Ed>-1
Perfectly Elastic
Ed=infinity
Perfectly Inelastic
Ed=0
Unit Elastic
Ed=1
2-37

38. 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
TE is largest at a price for which elasticity equals -1
2-38

39. 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 Ed = -1; when price = $3.75
2-39

40. Income Elasticity If EI>0, the good is a normal good.
Consumption rises as income increases.
If EI<0, the good is an inferior good.
Consumption falls as income increases.

41. Cross Price Elasticity
If Exy >0, the two goods are substitutes.
If Exy <0, the two goods are complements.

42. 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
2-42

43. Sample Problem 4
You are the marketing manager for XYZ Corp. You have this regression result for your product: Q = 2000 – 3.5*P + 1.2*I.
Right now, your price is 10, and the average income of your customers is $30,000.
compute income elasticity
is your good a normal good or an inferior good?
You expect a recession. You estimate that your customer's average income will fall 5% due to this recession. Estimate the impact on your sales.