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Chapter 2
Review of S and D
• Supply Curve:
• Shows quantity supplied at each
possible price, ceteris paribus (c.p.).
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Slopes upward (positive relationship)
Qs = Qs(P)
Shift S Curve if change c.p. factor
Movement along vs shift
C.P. factors: change in cost of
production; change S from bad weather.
– Interpret shift S curve: change
willingness to supply at each price.
Demand Curve
• Shows quantity demanded at
each possible price, ceteris
paribus (c.p.)
– Slopes downward (negative
relationship)
– Qd = Qd(P)
– Movement along versus shift.
– C.P. factors: change income;
change demand for related good.
– Interpret shift D curve: change
willingness to buy at each price.
Substitutes and
Complements
• Given two goods X and Y, if they are
consumed together they are called
complements and if one is used
instead of the other, they are called
substitutes.
• Substitutes:  Px  Dy
– When price of X , the demand for X
falls. So demand for Y .
– Example: beef and chicken
• Complements:  Px   Dy
– When price of X , its demand . So
demand for Y  also.
– Example: bread and butter
Market Mechanism
• Put Supply and Demand Together
• Equilibrium
– Point at which Qs=Qd;
– Market-clearing P;
• Describe re-equilibrating process by
changing C.P. factor:
– Increase in income causes increase in
demand (shift D rightward)
– At old P, Qd greater than Qs: so
individuals bid up price till reach new
equilibrium.
Example of Shifts
in S and D
• Effects of 9/11: Example 2.4 in
text.
• Much destruction of office
space; suggests shortage (lower
vacancy rate) should drive up
rental rates.
• Result was different because as
supply fell, demand fell also.
• See Figure 2.10
In-Class Exercise
• Note in text on pg. 28:
– Fact: top 20% of income distribution
had 40% increase in real take-home
earnings; bottom 10% of distribution
had decline of  10%.
• Consider: two separate labor markets
for skilled and unskilled workers.
Start in equilibrium for both; then
show:
– Unskilled workers: big S, small D
– Skilled workers: small S, big D.
– Outcome will explain observed trend:
big increase in inequality in 1980s and
1990s; or, increase in working poor.
Homework Assignment
• Consider the two separate markets
for peanut butter and jelly. Assume
that the two products are
complements for consumers.
– 1. Sketch and describe the initial
equilibrium in both markets.
– 2. Show the effect of new health
warnings about all the fat in peanut
butter in first the market for peanut
butter and then in the market for jelly.
– 3. Draw and label completely and
describe in words.
Elasticity
• Definition: %Qd in response to a
1% P
• Or: %Qd / %P
• What is %? Absolute change in
variable divided by original level of
variable.
• Ep = (Qd/Q) / (P/P)
•
= (P/Q) (Q/P)
• Remember: (Q/P) is 1/slope.
• Ep = price elasticity of demand;
usually negative.
Relate Elasticities
to S and D Equations
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Demand: Q = a – bP
Supply: Q = c + dP
E = (P/Q )*(Q/P)
(Q/P) = constant
= d for supply
= –b for demand.
• Demand: ED = -b(P*/Q*)
• Supply: ES = d(P*/Q*)
More About Elasticities
Elastic:
Ep 1
Inelastic:
Ep 1
Unitary Elastic: Ep 1
Fact: While slope is constant along a
linear demand curve, elasticity is
not.
• Fact: At top of demand curve, when
P is high and Q is low, Ep is big
negative number so D curve is very
elastic.
• Fact: As move down D curve to
right, Ep falls (because P is  while
Q is , so P/Q is ).
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Example
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Price
60
80
100
120
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1. What is P*, Q*?
2. When P=$80, what is ED?
Homework:.
Textbook page 58; Exercises #1 and
#2.
Demand
22
20
18
16
Supply
14
16
18
20
Relative Elasticities
• Rule: the steeper the slope of
the curve, the less elastic.
• Completely horizontal demand
curve: infinitely elastic:
consumers will buy as much as
they can at a single P*
• Completely vertical demand
curve: completely inelastic:
consumers will buy fixed
quantity, no matter what the P.
Nearly Horizontal
Demand Curve
• Elasticity approaches infinity:
Recall: 1/slope = Q/P
• If nearly flat curve: small  P
causes a huge Q. This is same
as: huge  / small  , which
equals a very big number.
• This will help you remember
elasticity for completely flat
versus completely vertical.
Income Elasticity of
Demand
• Measure responsiveness of Qd
to change in income (note this is
a ceteris paribus factor).
• EI = %in Qd resulting from a
1%  in income.
• EI = (Q/Q) / (I/I)
•
= I/Q  (Q/I).
Cross-Price Elasticity of
Demand
• Measures responsiveness in Qd of
one good to change in price of a
related good (note this is a change in
a c.p. factor).
• Cross-price elasticity of demand =
% in Qd resulting from a 1%  in
the price of a related good.
• EQ1P2 = (Q1/Q1) / (P2/P2)
•
 P2/Q1  Q1/P2.
• EQP  0: the two goods are
substitutes.
• EQP  0: the two goods are
complements.
Price Elasticity of
Supply
• Price Elasticity of Supply:
Responsiveness of Qs to P.
• ESP = %Qs / %P
• = (Qs/Qs) / (P/P)
•  P/Qs  Qs/P
• Usually positive.
Wage Elasticity of
Supply
• Measures responsiveness of Qs
to changes in the cost of labor (a
ceteris paribus factor).
• ESW = %Qs / %W
• = (Qs/Qs) / (W/W)
•  W/Qs  Qs/W.
• Usually negative.
• Remember: W   cost of
production.
Example
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Qs = 3 + 12P
Qd = 19 – 4P
1. Find P* by setting Qs=Qd.
2. Find Q* by putting P* into
either Qs or Qd.
• Solve for Ep of demand at
equilibrium:
• EDP* = (P*/Q*)  (Q/P)
Short-Run versus
Long-run Elasticities
• Focal point: how much time do
sellers and consumers have to
respond (in their Qs and Qd) to
changes in price?
• In general: LR adjustment is more
full, free adjustment so that LR
elasticity is larger; BUT not true all
the time.
• Key factors:
– Durability.
– Availability of substitutes
– % of consumer’s budget
Government Price
Controls
• Key: If government sets P so
that there is no single P for
which Qs=Qd, then there will
be a shortage or surplus.
• Be able to show the Qs and Qd
for any price.
• Price ceiling: prevents price
from rising above the ceiling.
• Price floor: prevents price from
falling below floor.
In-Class Exercise
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Rent control in NYC:
Qd = 100 – 5P
Qs = 50 + 5P
1. Find P* and Q*.
2. What if rent control agency
sets Price ceiling at $1?
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A.
B.
C.
D.
What is Qd?
What is Qs?
What is resulting Q sold?
What is # newly homeless?