Download LN12_Wednesday_March13

ECON 100 Lecture 12
Wednesday, March 13
Announcements
• PS #4 is posted on web page. It is big and not all questions are
very easy. It is time to start studying.
• PS#5 will be even bigger. (also more challenging)
• A sample exam will be posted on webpage next week, and
possibly more study questions for the exam.
• Email me to set up an office hour appointment (for study
help)
Review
• Equilibrium refers to a situation in which the price has
reached the level where quantity supplied equals quantity
demanded.
• Equilibrium Price
– The price at which quantity supplied equals quantity
demanded.
– On a graph, it is the price at which the supply and demand
curves intersect.
• Equilibrium Quantity
– The quantity supplied and the quantity demanded at the
equilibrium price.
Terms you need to know:
• Shortage (excess demand): quantity demanded > quantity
supplied
• Surplus (excess supply): quantity supplied > quantity
demanded
• The market price of any good adjusts to bring the quantity
supplied and the quantity demanded for that good into
balance.
The equilibrium in the ice-cream market
Demand Schedule
Supply Schedule
At $2.00, quantity demanded = quantity supplied
The equilibrium price is Pe = $2.00.
The equilibrium quantity is Qe = 7 units.
Same thing with equations
The equation for the market demand is
QD = 19 – 6P
The equation for the market supply is
QS = –5 + 6P, if P ≥ 5/6, QS = 0 if P < 5/6
Let’s compute the equilibrium price and quantity.
QD = QS (this means demand equals supply)
19 – 6P = –5 + 6P
Solve for P: 24 = 12P  Pe = 2
To compute the equilibrium quantity, substitute 2 for P in the
demand (or the supply) equation: Qe = 19 – 6(2) = 7.
Same thing with the supply and demand graph
Price of
Ice-Cream
Demand: QD = 19 – 6P
Supply: QS = –5 + 6P, (if P ≥ 5/6)
3.17
Supply
2.00
5/6
Demand
0
7
19
Quantity of
Ice-Cream
Copyright©2003 Southwestern/Thomson Learning
Changes in the market
equilibrium
How do equilibrium price and
quantity change when the supply of
demand change?
Analyzing Changes in Equilibrium: The three steps
method
0. Something (an event) happens: e.g., a meteor hits the earth.
1. Decide whether the event shifts the supply or demand curve.
2. Decide whether the curve shifts to the left or to the right.
3. Use the supply-and-demand diagram to see how the shift
affects equilibrium price and quantity.
Figure 10 How an Increase in Demand Affects the Equilibrium
1. News says that regular consumption
of vanilla ice-cream reduces
cardiovascular diseases
Price of
Ice-Cream
Cone
Supply
New equilibrium
$2.50
2.00
2. . . . resulting
in a higher
price . . .
Initial
equilibrium
D
D
0
7
3. . . . and a higher
quantity sold.
10
12
Excess demand at P = 2
Quantity of
Ice-Cream Cones
Copyright©2003 Southwestern/Thomson Learning
This is what prices do: Prices communicate information
1. Demand rises: people want more ice-cream.
2. There must be more production to meet the higher demand.
3. How can you convince/make the sellers supply more?
4. They are self interested, they need higher prices to work
harder and supply more.
5. So.
6. The price must rise to create more supply (raise the quantity
supplied)
7. The “demand-induced-higher-price” is a message from the
buyers to the sellers: We want more ice-cream.
This is how the ice-cream produces learn the relative desirability
(consumption value, benefit to consumers etc) of ice-cream:
they learn it through its higher price.
Prices act as signals that guide the
allocation of scarce resources in a
market economy.
One more example
A supply shift
Figure 11 How a Decrease in Supply Affects the Equilibrium
Price of
Ice-Cream
Cone
Excess demand, shortage
S2
1.There is an increase in the
price of sugar (a major input
In the production of ice cream)
S1
New
equilibrium
$2.50
Initial equilibrium
2.00
2. . . . resulting
in a higher
price of ice
cream . . .
Demand
0
4
7
3. . . . and a lower
quantity sold.
Quantity of
Ice-Cream Cones
Copyright©2003 Southwestern/Thomson Learning
Again, prices communicate
1. Ice-cream production is now more costly.
2. Demand must be reduced.
3. How can you make the buyers reduce their consumption?
4. They are self interested, they respond to prices:
5. Higher prices will make them consume less.
6. As the price of ice-cream rises, buyers will reduce their
quantity demanded and substitute towards other goods.
7. Buyers find out about the relative scarcity of a good through
its price.
8. Each individual buyer then decides what to do him/herself;
decision making is decentralized.
A “real world” application
The food vs. fuel dilemma
A study in demand and supply
The Food vs. fuel dilemma is about using farmland or crops for
bio-fuels production (mostly ethanol) so as to threaten the food
supply on a global scale.
There is discussion about how significant the issue is, what is
causing it, and what can be done about it.
But a fair statement of the issue would be that..
The main problem with subsidizing the production of ethanol
(bio-fuel) from corn is that it is causing people in low-income
countries to go hungry.
A few fact (from wiki!)
• From 1974 to 2005 food prices (adjusted for inflation)
dropped by 75%.
• Prices were stable after reaching lows in 2000 and 2001.
• Prices sharply increased in 2005 despite record production
levels worldwide.
• From January 2005 until June 2008, maize prices almost
tripled, wheat increased 127 percent, and rice rose 170
percent.
• MAIZE (looks like corn)
He says that US and EU must
change biofuel targets to avert
food crisis.
This is Paul Bulcke,
chief executive of
Nestlé, the
world's largest food
Nestlé
company, has added its weight to
calls by the UN and development
groups for the US and EU to
change their bio-fuel targets
because of food shortages and
price rises.
http://www.guardian.co.uk/globaldevelopment/2012/sep/04/us-eubiofuel-food-crisis-nestle
"We say no food for fuel," said
Paul Bulcke, chief executive of
Nestlé, at the end of the World
Water Week conference in
Sweden. "Agricultural food-based
bio-fuel is an aberration. We say
that the EU and US should put
money behind the right bio-fuels."
This form Guardian Sept 2012
Under laws intended to reduce foreign oil imports, 40% of US
maize (corn) harvest must be used to make bio-fuels, even
though one of the deepest droughts in the past 100 years is
expected to reduce crop yields significantly.
In addition, EU countries are expected to move towards drawing
10-20% of their energy supply for transport from bio-fuels to
reduce carbon emissions.
More facts
Cost for developing countries
Source
http://www.ase.tufts.edu/gdae/Pubs
/rp/ActionAid_Fueling_Food_Crisis.p
df
All scarce goods must be
rationed!
Food vs. bio-fuel debate: a simple
numerical example
P
1
2
3
4
INDIVIDIAL
demand supply
5
0
4
2
3
4
2
6
The equilibrium price is P = 3.
each consumer buys 3 units.
Each seller produces 4 units.
Imagine a competitive markets
with 4 buyers and 3 sellers.
P
1
2
3
4
MARKET
demand supply
5X4=20
0X3=0
4X4=16
2X3=6
3X4=12 4X3=12
2X4=8
6X3=18
Now, a big buyer comes into the market!
P
DEMAND
1
2
3
4
16
14
12
10
The new market demand is the
sum of the 3 buyers and the
newly arrived big buyer.
• The equilibrium price is P = 4.
• The 3 buyers buy 2 units each,
and pay a higher price.
• Each seller produces 6 units.
P
1
2
3
4
MARKET
demand supply
20+16
0
16+14
6
12+12
12
8+10
18
Now you try
The three step approach
1. Decide whether the event shifts the supply or demand curve (or both).
2. Decide whether the curve(s) shift(s) to the left or to the right.
3. Use the supply-and-demand diagram to see how the shift affects
equilibrium price and quantity.
The price of coal fell and the quantity sold also fell. Everything
else being equal, which of the following three events could be
the reason:
(A.) Decrease in the price of oil (oil and coal are substitutes).
(B.) Large increase in the wages of coal miners.
Please draw one well-labeled demand supply graph for each
event to say yes or no for each.
Now we start something new
The price elasticity of demand
Chapter
5
Elasticity and Its Applications
Elasticity and applications
The law of demand: As the price of a good rises the quantity
demanded falls.
But how much does it fall?
Will there be a large decrease in quantity?
Or a small decrease?
How responsive is demand to changes in the price?
The price elasticity of demand
Price elasticity of demand is a “measure” of how responsive the
quantity demanded is to a change in price.
More generally…
Elasticity is a measure of the responsiveness of
– quantity demanded or quantity supplied
– to one of its determinants.
Case 1
Price
Demand
$5.00
$4.00
An increase
in price…
0
100
…has no effect on the quantity
demanded.
Quantity
Case 2
Price
Demand
$11
$10
a small
increase in
price…
0
50
100
leads to a large decrease in quantity
demanded.
Quantity
Elasticity of Demand
Price
A Price
Increase
$50
$40
Elastic Demand
Inelastic Demand
20
… Causes a Big Decrease in Quantity
Demanded if Demand is Elastic
Quantity
75 80
… Causes a Small Decrease in Quantity
Demanded if Demand is Inelastic
The More Responsive Quantity Demanded is to a Change in Price, the More Elastic is the Demand Curve
What makes the demand more elastic?
• Demand tends to be more elastic if, …
–
–
–
–
If there are close substitutes.
If the market is more narrowly defined (food versus milk).
If we consider a longer time period after the price change.
If the good is a luxury. (Necessities have inelastic demand)
Substitutes?
When the patent expires on a brandname drug and 5 generic drugs come on
the market. As a result, the elasticity of
demand…
a) rises
b) falls
Demand for fresh fruits vs demand for green apples
The classification of the good matters.
– The more broad (general) the classification, the fewer substitutes
there are and this makes demand inelastic.
– e.g. the elasticity of demand is higher for “lettuce” than for “food.”
vs.
Time is on our side…
The time horizon matters.
– Less time to adjust means lower elasticity
– Over time consumers can adjust their behavior by finding substitutes
(making demand more elastic).
Luxuries vs. necessities
The nature of the good to the consumer can also affect the
elasticity of demand.
– For necessities, we do not change Q much when P changes
– For luxuries, we are more sensitive to P changes
vs.
Computing the Price Elasticity of Demand, EP
The measure of responsiveness of quantity demanded to a
change in price in a given situation is quantified in a single
number EP that is computed as…
The percentage change in quantity demanded
divided by the percentage change in price.
Price elasticity of demand =
Percentage change in quantity demanded
Percentage change in price
Computing the Price Elasticity of Demand
• The formula:
Price elasticity of demand =
Percentage change in quantity demanded
Percentage change in price
• The example:
When the price of ice cream is ₺2, quantity demanded is 10
units (cones of ice-cream). When the price is ₺2.20, the
quantity demanded is 8 units. Compute your elasticity of
demand at P = ₺2:
Computing the EP
Price = ₺2.00, QD = 10
Price = ₺2.20, QD = 8
1. Change in price is +0.20
2. % change in price is +(0.20/2)x100 = +10
3. Change in QD is –2.
4. % change in QD is –(2/10)x100 = –20.
5. EP = –20/10 = –2.
End of lecture