Download Supply and Demand Interactions

SUPPLY AND
DEMAND
INTERACTIONS
OPERATION OF A FREE MARKET SYSTEM
 Choosing how to best handle scarce resources is a
challenge for many markets. Decisions have to be made:
 What products and services are these resources going to produce?
 Who will receive these products and services when they are available?
 These questions can be answered by the price system
technique.
The price system is the technique by which scarce
resources are allocated to the production of those
products and services that provide the greatest
return to the resource owner.
In this way, the system of prices, rents, wages, and
interest organizes economic activity.
 The greatest return on investment drives production and service.
People will seek highest paying jobs. Buildings are rented under
circumstances that provide the highest return
 The price system has two distinct advantages in
allocating resources:
1. It is efficient in allowing thousands of individuals to
cooperate in making economic decisions, and
2. It transmits information to buyers and sellers
which assists consumers in allocating their limited
income to various purchases and encourages
sellers to adopt the least costly and most efficient
means of production.
1. People are unaware they are involved but their decision making, often
based on prices and price changes, influence the markets and in-turn the
prices for goods and services.
2. If information is not transmitted then shortages and surpluses tend to
persist
The free-market system and its establishment of
prices through the interaction of demand and
supply provides insight into the concept of value.
What is the value of a diamond ring?
a new car?
a glass of water?
 The only indicator of value is the marketplace and what someone is
willing to spend to get a product/service.
ELASTICITY
The law of downward-sloping demand states that, all
other factors remaining constant, the quantity
demanded of a product increases as the price falls.
Price elasticity of demand measures the extent to
which the quantity of a product demanded responds
to a change in price.
 Price Elasticity of Demand Coefficient =
 Ex. If a 10% cut in the price of an item brought about a 20% increase in
the quantity demanded the elasticity coefficient would be 20/10 = 2.0
 Essentially, we need to consider how sensitive consumers are to the
changes in price.
Elastic demand is one in which a price change
brings about a greater than proportional change in
the quantity that consumers demand.
 %ΔQs > % ΔP thus Es > 1
 Ex. A small increase in the price of chocolate bars will likely have a
large impact in the number of bars sold.
If a supplier is not able to adjust supply readily when
the price changes, the supply is referred to as
inelastic.
%ΔQs < % ΔP thus Es < 1
 Milk has an inelastic demand curve as price changes have little impact on
the amount of milk sold.
Unitary elastic supply is one in which a price
change brings about a proportional change in the
quantity supplied.
 %ΔQs = % ΔP thus Es =
1
CHARACTERISTICS THAT AFFECT ELASTICITY
1. Luxury or necessity
2. The number of close substitutes
3. Percentage of budget spent on the product
4. Length of time since price change
TOTAL REVENUE APPROACH TO PRICE
ELASTICITY OF DEMAND
The total amount of money that people spend on a
product is referred to as Total Revenue.
TR = P x Qd
 If the demand for a product is elastic, any decrease in price
will increase total revenue; conversely any increase in price
will decrease total revenue.
P
TR
when
P
TR
If the demand for a product is inelastic, any decrease in
price will decrease total revenue; conversely any
increase in price will increase total revenue.
Pwhen
P
TR
TR
When the elasticity of demand is unitary, any change in
price leaves total revenue unchanged.
SPECIAL CASES OF PRICE ELASTICITY OF
DEMAND
 There are two special cases of a demand curve where the
price and quantity demanded are not inversely related.
 The first is where the price is set and the quantity
demanded is unlimited, a perfectly elastic demand (Ed = ∞).
 An example of a perfectly elastic demand curve is when
U.S. citizens were required to sell all their gold to the
government at a price of $35 an ounce.
 In the 1930’s the US govt instituted the Gold Reserve Act. The act
changed the nominal price of gold from $20.67 per ounce to $35. This
price change incentivized foreign investors to export their gold to the
United States, while simultaneously devaluing the U.S. dollar in an
attempt to spark inflation. The increase in gold reserves due to the price
change as well as the confiscation clause resulted in a large
accumulation of gold in the Federal Reserve and U.S. Treasury. The
increase in the money
The second is where a certain quantity is
demanded and any price will be paid to acquire
that amount, a perfectly inelastic demand (Ed = 0).
This curve may reflect the demand for a necessary
drug in which individuals will pay any price to
acquire it.
 Last year, ipilimumab, also known as MDX-010 and MDX-101, marketed
as Yervoy was approved by the Food and Drug Administration (FDA) for
the treatment of metastatic melanoma. The benefit in survival over and
above standard treatment arms was 3.7 months in previously treated
patients and 2.1 months in previously untreated patients. The cost:
$120,000 for 4 doses.
PRICE ELASTICITY OF SUPPLY
 The law of upward-sloping supply states that, all other
factors remaining constant, the quantity supplied of a
product increases as the price increases.
 Price elasticity of supply measures the extent to which
the quantity of a product supplied responds to a
change in price.
 Price Elasticity of Supply Coefficient =
 If the coefficient is greater than one, supply is elastic, if it is
less than one it is inelastic and if the coefficient is equal to
one the supply is unitary elastic.
 Three major characteristics help determine price elasticity
of supply:
1. Time
2. Ability to store product
3. Ability to substitute during production
1. The longer the time allowed to adjust to price changes the more likely it
is to increase production. If the price of green peppers stays constant
farmers will be able to adjust production. If prices increase the farmer
will produce more green peppers.
2. Some items are perishable and cannot be stored for long or are
expensive to store, their elasticity of supply is inelastic. They have to be
sold no matter the price.
3. Shifting production to make alternative products in response to price
changes affects elasticity of supply. If the switch is easy it is elastic, if not
it is inelastic.
OTHER TYPES OF ELASTICITY
 Income elasticity measures the responsiveness of the
change in quantity demanded to changing income
levels.
 Products with negative income elasticity are inferior
goods.
 Products with positive income elasticity are normal
goods.
 Cross-elasticity of demand measures the impact that
changes in the price of one product have on the
quantity demanded of another product. It is measured as
the percentage change in demand for the first good that
occurs in response to a percentage change in price of the
second good.
 Products with negative cross-elasticity are
complementary.
 Products with positive cross-elasticity are substitutes.