Download Supply and Demand 1. Some Course Setup Issues 2. What is a

Supply and Demand
Some Course Setup Issues
1. Some Course Setup Issues
• Rules on Problem Sets
2. What is a Market?
– On time at the beginning of class, or else ...
– Must be your own work.
3. The Demand Curve
• Movement along the demand curve versus shifts in the demand curve
• Sections
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4. The Supply Curve
• Movement along the supply curve versus shifts in the supply curve
5. Equilibrium of Supply and Demand
– Integral part of the course
– Be prepared to discuss and raise questions on lectures and readings.
• Some Wisdom
6. Let’s Work through Some Examples
– Keep up with the course
– Be active and aggressive with the material
– Economics is like skiing.
7. The Role Prices Play in Answering the Three Fundamental Questions
8. Elasticities
9. Elasticities in the Long and Short Run
The Demand Curve
What is a Market?
• Quantity demanded is the amount (number of units) of a product that
households would buy in a given period if it could buy all that it
wanted at the given market price, other things held constant.
• One definition is that a market is a mechanism by which buyers and
sellers interact to determine the price and quantity of a good or
service.
• Households’ demand decision depends on:
• A market may be a physical place or may just exist electronically.
• But in a market, prices get determined for every good traded. Prices
represent the terms on which people are voluntarily exchange goods.
• And prices send critical signals to buyers and sellers.
• Prices are the balance wheel of the market mechanism.
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• A market may be centralized, such as the NYSE, or decentralized, such
as the market for labor.
1. The price of the product in question.
2. The income available to households.
3. The households’ amount of accumulated wealth.
4. The price of other products available to households.
5. The households’ tastes and preferences.
6. The households’ expectations about future income, wealth, and
prices.
Tracing out the Demand Schedule (or Curve)
• A demand schedule shows the quantities of product that consumers
would be willing to buy at different prices.
• Hypothetical demand schedule for small cup of coffee on Chapel Street
on a typical morning.
ceteris paribus or “all else equal”
Price Quantity Demanded
(per cup)
(cups)
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• But for the time being we are going to hold all of these other things constant and just focus on the relationship between the price and quantity
demanded.
• That is, we want to derive a relationship between quantity demanded
of a good per time period and the price of that good, holding income,
household wealth, other prices, tastes and expectations constant.
$ 1.20
1.40
1.60
1.80
2.00
2.20
2.40
2.60
2.80
1200
1175
1125
1050
950
825
700
550
400
Demand Schedule for Small Coffees
Shifts in the demand curve versus movements along the demand curve
• Changes in the price of a product affect the quantity demanded per
period. That’s a movement along the demand curve.
• Changes in any other factor, such as
affect the entire demand curve. The entire curve will shift.
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1. The income available to the households.
2. Households’ amount of accumulated wealth.
3. The price of other products available to the households.
4. The households’ tastes and preferences.
5. The households’ expectations about future income, wealth, and
prices.
• We often say that an increase in the price of coffee is likely to cause a
decrease in the quantity of coffee demanded. However we say that an
increase in income is likely to cause an increase in the demand for most
goods including coffee.
• A demand curve always holds everything but the good’s own price
constant.
The Supply Curve
• Quantity supplied is the amount of a particular product that firms
would be willing and able to offer for sale at a particular price during a
given time period, other things held constant.
• The supply curve is upward sloping due to the “law of diminishing
returns” If Starbucks wants to produce more coffee, then it will have
hire more employees, perhaps get an additional cash register. But each
new worker will be less and less efficient than the previous worker.
The price needed to then coax out additional coffee output is therefore
higher. If the price of coffee rises, holding all other things constant,
society can persuade Starbucks to produce and sell more coffee.
• A supply schedule shows how much of product firms will sell at various
prices.
Price Quantity Supplied
(per cup)
(cups)
450
575
700
825
950
1075
1200
1325
1450
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$ 1.20
1.40
1.60
1.80
2.00
2.20
2.40
2.60
2.80
• Other factors that effect the supply curve
1. the cost of production and technological advances
2. price of inputs
3. price of related goods.
4. government policy
5. Special factors
Supply Schedule for Small Coffees on Chapel Street
Shifts in the supply curve versus movements along the supply curve
• Changes in the price of a product affect the quantity supplied per
period. That’s a movement along the supply curve.
• Changes in any other factor, such as
affect the entire supply curve. The entire curve will shift.
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1. technological advances
2. price of inputs
3. price of related goods.
4. government policy
5. Special factors (e.g. weather)
• We often say that an increase in the retail price of coffee is likely to
cause an increase in the quantity of coffee supplied. However we say
that an increase in cost of production is likely to cause an decrease in
the supply of coffee.
• A supply curve always holds everything but the good’s own price constant.
• When other factors change, this will lead to a shift of the supply curve.
Quantity Quantity
Price Demanded Supplied
(per cup) (cups)
(cups)
Equilibrium of Supply and Demand
• At any point in time, one of three conditions prevails in a market
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1. excess demand or shortage – when quantity demanded exceeds
quantity supplied at the current price.
2. excess supply or surplus – when quantity supplied exceeds quantity
demanded at the current price.
3. equilibrium – when quantity supplied equals the quantity demanded
a the current price.
$ 1.20
1.40
1.60
1.80
2.00
2.20
2.40
2.60
2.80
1200
1175
1125
1050
950
825
700
550
400
450
575
700
825
950
1075
1200
1325
1450
State of
the market
pressure
on price
excess demand
excess demand
excess demand
excess demand
equilibrium
excess supply
excess supply
excess supply
excess supply
↑
↑
↑
↑
—
↓
↓
↓
↓
Equilibrium in the Chapel Street Coffee Market
Let’s Work Through Some Examples
• Supply and demand are in equilibrium when:
1. A Severe drought in Columbia wipes out this year’s coffee crop.
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– The quantity that consumers are willing to buy equals equals the
quantity that firms are willing to sell.
– There is no pressure on prices to go up or down.
– This is the intersection of the supply and demand curves.
2. Coffee is found to be a good source of a newly discovered nutrient.
3. It becomes terribly uncool to be seen in a coffee shop or with coffee in
your hand.
4. Scientists find a way to double the production of coffee beans.
The Role of Prices in Answering the Three Fundamental Questions
• The three fundamental questions: what is produced? how is it produced? and for whom is it produced?
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• How much coffee gets produced? How as a world community do we decide how much coffee to produce? Simple answer: supply and demand.
• Do we all get an equal vote in deciding how much gets produced?
– Example: the sinking of Hawaii
– Example: demand surge
– No. There is a kind of proportional representation in which the influence of each person or country is not necessarily fixed or shared
equally. Representation is strictly proportional to a person’s or country’s wealth. Influence is exerted by offering to exchange wealth for
goods and services that are desired.
• All a supplier needs to know is price is high, produce more; price is low,
produce less.
Elasticities
• We want to know the sensitivity of quantity demanded or supplied to
changes in prices.
• Prices also determine how production is organized.
– Think about production will change when these countries become
more developed.
– Ultimately it is the power of the purse. In general, the goods and
services each person receives are payments for the factors of production each person owns. That is they are payments for the land we
rent, the labor we sell, the capital we rent.
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• For whom does coffee get produced?
• Elasticity is a measure of the responsiveness of quantity demanded or
quantity supplied to one of its determinants. More precisely, it is the
percentage change in one variable resulting from a 1-percent increase
in another.
• Price elasticity of demand is the percentage change in quantity demanded of a good resulting from a 1-percent increase in its price.
– It is a measure of how much the quantity demanded of a good responds to a change in the price of that computed as the percentage
change in quantity demanded divided by the percentage change in
price.
Example: Suppose that an increase in the price of coffee from $2.00 per
cup to $2.20 per cup causes the amount of coffee you buy to fall from 10
to 8 cups per week. What is your price elasticity of demand for coffee?
Some notation: The Greek capital letter ∆ is delta. It means “change in.”
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Ep = Price elasticity of demand
Percentage change in quantity demanded
=
Percentage change in price
%∆Q
=
%∆P
∆Q/Q
=
∆P/P
P ∆Q
=
Q ∆P
Percentage change in price = %∆P
= (2.20 − 2.00)/2.00 × 100
= 10 percent
Percentage change in quantity demanded = %∆Q
= (10 − 8)/10 × 100
= 20 percent
Ep = Price elasticity of demand
Percentage change in quantity demanded
=
Percentage change in price
20 percent
=
10 percent
= 2
Some more definitions
• Infinitely elastic demand Consumers will buy as much of a good as
they can get at a single price , but for any higher price the quantity of
demand drops to zero, while for any lower price the quantity demanded
increases without limit.
• Elasticities are unitless. It doesn’t matter whether prices are measured
in dollars or euros. It doesn’t matter whether quantities are measured
in bushels or gallons.
• Completely inelastic demand Consumers will buy a fixed quantity of
a good regardless of the price.
• Because the quantity demanded of a good is negatively related to its
price, the percentage change in quantity will always have an opposite
sign as the percentage change in price. Thus the price elasticity of demand is usually a negative number. We usually just report the absolute
value.
• What determines whether demand for a good is price elastic or inelastic?
– necessities versus luxuries
– availability of close substitutes
– time horizon (short-run versus long-run)
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• When the price elasticity is greater than 1 in absolute value, we say
that demand is price elastic. If the price elasticity is less than 1 in
absolute value, we say that demand is price inelastic.
• Income elasticity of demand Percentage change in the quantity demanded resulting from a 1-percent increase in income
• Cross-price elasticity of demand Percentage change in the quantity
demanded of one good resulting from a 1-percent increase in the price
of another.
– The sign on the cross-price elasticity depends on whether the two
goods are substitutes or complements.
– If two goods are substitutes, then an increase in the price of one
leads to an increase in quantity demanded in the other. Thus the
cross price elasticity will be positive.
– If two goods are complements, then an increase in the price of one
leads to an decrease in quantity demanded in the other. Thus the
cross price elasticity will be negative.
Linear demand curves
• A commonly used form of the demand curve is the linear demand curve,
represented by the equation
Q = a − bP,
where a and b are positive constants.
Price elasticity of supply
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• Price elasticity of supply is a measure of how much the quantity supplied
of a good responds to a change in the price of that good, computed as
the percentage change in quantity supplied divided by the percentage
change in price.
• In this equation, the constant a embodies the effects of all other factors
(e.g. income, prices of all other goods) than price that affect demand
for the good. The coefficient b, which is the slope of the demand curve,
reflects how the price affects the quantity demanded.
• But b is not the elasticity of demand. It is the slope. Mathematically
b = ∆Q
∆P
• What is the elasticity?
P ∆Q
Q ∆P
P
= b
Q
Ep =
• With a linear demand curve, the elasticity varies over the demand curve
Long-run versus short-run demand elasticities
– In the region between Q = 0 and the midpoint Q = a/2, the price
elasticity of demand is between −∞ and −1. This is the elastic
region of the demand curve.
– In the region between Q = a/2 and Q = a, the price elasticity of
demand is between −1 and 0. This is the inelastic region of the
demand curve.
• Since elasticities are ratios of percentages, they do not depend on the
units used to measure prices or quantities.
• We could go over linear supply curves, but we won’t.
• For example, if there is an increase in the price of gasoline consumers
can adjust the demand for gasoline in the short-run by simply driving
less.
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• The slope of the demand curve is not necessarily the same thing as the
elasticity. The slope depends on the units used to measure the price
and the quantity. Thus comparisons of slopes across goods depends
on the units of measurement (e.g. using pennies or dollars to measure
prices)
• Consumers cannot always adjust their purchasing decisions instantly in
response to a change in price.
• But over time consumers can reduce their consumption of gasoline even
further by purchasing smaller, more fuel efficient cars. They could also
move closer to their work or move closer to public transportation.
• The long-run demand curve pertains to the period of time in which
consumers fully adjust their purchase decisions to changes in price.
• The short-run demand curve pertains to the period of time during which consumers can not fully adjust their purchase decisions to
changes in price.
Long-run versus short-run supply elasticities
• In the case of gasoline, we would expect the long-run demand to flatter
or more price-elastic than the short-run.
• But in the long run, eventually everyone must replace the cars demand
will pick up again. So we will think that in the long-run demand for
cars is less elastic than in the short-run.
The Price of Gasoline in the Long-Run
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• What do you think the price of gasoline will be ten years from now?
• In general most firms faces capacity constraints in the short-run. If
demand for their goods increases there is only so much they can produce.
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• The opposite can hold true for large goods in which consumers have
more control in the timing of their purchases. Classic example is automobiles. If the price of automobiles shoot up, demand may fall considerably, as consumers hold on to their old cars and wait the high price
period to end.
• Think of a New Haven restaurant. There are only so many tables that
can be fit into a particular space. At some point supply is completely
inelastic.
• But if demand for a particular restaurant remains strong, in the longrun new space can be built and supply can increase.
• In most cases, long-run supply is more elastic than short-run supply.