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Chapter 2 The Basics of Supply and Demand Introduction What are supply and demand? What is the market mechanism? What are the effects of changes in market equilibrium? What are elasticities of supply and demand? Chapter 2 Topics to Be Discussed How do short-run and long-run elasticities differ? How do we understand and predict the effects of changing market conditions? What are the effects of government intervention – price controls? Chapter 2 Supply and Demand Supply and demand analysis can: 1. 2. 3. Help us understand and predict how real world economic conditions affect market price and production Analyze the impact of government price controls, minimum wages, price supports, and production incentives on the economy Determine how taxes, subsidies, tariffs and import quotas affect consumers and producers Chapter 2 Supply and Demand The Supply Curve The relationship between the quantity of a good that producers are willing to sell and the price of the good Measures quantity on the x-axis and price on the y-axis Q S Q S (P) Chapter 2 The Supply Curve S Price ($ per unit) The Supply Curve, Graphically Depicted P2 The supply curve slopes upward, demonstrating that at higher prices firms will increase output P1 Q1 Q2 Chapter 2 Quantity The Supply Curve Other Variables Affecting Supply Costs of Production Labor Capital Raw Materials Lower costs of production allow a firm to produce more at each price and vice versa Chapter 2 Change in Supply The cost of raw materials falls P Produced Q1 at P1 and Q0 at P2 Now produce Q2 at P1 and Q1 at P2 Supply curve shifts right to S’ S S’ P1 P2 Q0 Chapter 2 Q1 Q2 Q The Supply Curve Change in Quantity Supplied Movement along the curve caused by a change in price Change in Supply Shift of the curve caused by a change in something other than the price of the good Change in costs of production Chapter 2 Supply and Demand The Demand Curve The relationship between the quantity of a good that consumers are willing to buy and the price of the good Measures quantity on the x-axis and price on the y-axis QD QD(P) Chapter 2 The Demand Curve Price ($ per unit) The demand curve slopes downward, demonstrating that consumers are willing to buy more at a lower price as the product becomes relatively cheaper. P2 P1 D Q1 Q2 Chapter 2 Quantity The Demand Curve Other Variables Affecting Demand Income Increases in income allow consumers to purchase more at all prices Consumer Tastes Price of Related Goods Substitutes Complements Chapter 2 Change in Demand Income Increases P D D’ Purchased Q0, at P2 P2 and Q1 at P1 Now purchased Q1 at P2 and Q2 at P1 P1 Same for all prices Demand curve shifts right Q0 Chapter 2 Q1 Q2 Q The Demand Curve Changes in quantity demanded Movements along the demand curve caused by a change in price Changes in demand A shift of the entire demand curve caused by something other than price Income Preferences Chapter 2 The Market Mechanism The market mechanism is the tendency in a free market for price to change until the market clears Markets clear when quantity demanded equals quantity supplied at the prevailing price Market clearing price – price at which markets clear Chapter 2 The Market Mechanism S Price ($ per unit) The curves intersect at equilibrium, or marketclearing, price. Quantity demanded equals quantity supplied at P0 P0 D Q0 Chapter 2 Quantity The Market Mechanism In equilibrium There is no shortage or excess demand There is no surplus or excess supply Quantity supplied equals quantity demanded Anyone who wants to buy at the current price can and all producers who want to sell at that price can Chapter 2 Market Surplus The market price is above equilibrium There is excess supply - surplus Downward pressure on price Quantity demanded increases and quantity supplied decreases The market adjusts until new equilibrium is reached Chapter 2 The Market Mechanism Price ($ per unit) S 1. Surplus P1 2. 3. P0 4. D Q D Q0 Chapter 2 QS Quantity At P1, price is above the market clearing price Qs > QD Price falls to the marketclearing price Market adjusts to equilibrium Market Shortage The market price is below equilibrium: There is excess demand - shortage Upward pressure on prices Quantity demanded decreases and quantity supplied increases The market adjusts until the new equilibrium is reached Chapter 2 The Market Mechanism Price ($ per unit) 1. 2. 3. P3 4. P2 D Shortage QS Q 3 Chapter 2 QD Quantity At P2, price is below the market clearing price Q D > QS Price rises to the marketclearing price Market adjusts to equilibrium The Market Mechanism Supply and demand interact to determine the market-clearing price When not in equilibrium, the market will adjust to alleviate a shortage or surplus and return the market to equilibrium Markets must be competitive for the mechanism to be efficient Chapter 2 Changes in Market Equilibrium Equilibrium prices are determined by the relative level of supply and demand Changes in supply and/or demand will cause change in the equilibrium price and/or quantity in a free market Chapter 2 Changes in Market Equilibrium Raw material prices fall S shifts to S’ Surplus at P1 between Q1, Q2 Price adjusts to equilibrium at P3, Q3 P D S S’ P1 P3 Q1 Q3Q2 Chapter 2 Q Changes in Market Equilibrium P Income Increases D D’ S Demand increases to D’ P3 Shortage at P1 of P1 Q1 to Q2 Equilibrium at P3 and Q3 Q1 Q3 Q 2 Chapter 2 Q Changes in Market Equilibrium P Income increases and raw material prices fall Quantity increases If the increase in D is greater than the increase in S price also increases D D’ S S’ P2 P1 Q1 Chapter 2 Q2 Q Shifts in Supply and Demand When supply and demand change simultaneously, the impact on the equilibrium price and quantity is determined by: 1. 2. The relative size and direction of the change The shape of the supply and demand models Chapter 2 The Price of a College Education The real price of a college education rose 55 percent from 1970 to 2002 Increases in costs of modern classrooms and wages increased costs of production – decrease in supply Due to a larger percentage of high school graduates attending college, demand increased Chapter 2 Market for a College Education S2002 P (annual cost in 1970 dollars) $3,917 S1970 $2,530 D1970 8.6 13.2 Chapter 2 D2002 Q (millions enrolled)) The Long-Run Behavior of Natural Resource Prices Consumption of copper has increased about a hundredfold from 1880 through 2002 The long term real price for copper has remained relatively constant Increased demand as world economy grew Decreased production costs increased supply Chapter 2 Resource Market Equilibrium Price S1900 S1950 S2002 Long-Run Path of Price and Consumption D1900 Chapter 2 D1950 D2002 Quantity Resource Market Conclusion Decreases in the costs of production have increased the supply by more than enough to offset the increase in demand Chapter 2 Elasticities of Supply and Demand Not only are we concerned with what direction price and quantity will move when the market changes, but we are concerned about how much they change Elasticity gives a way to measure by how much a variable will change with the change in another variable Specifically, it gives the percentage change in one variable resulting from a one percent change in another Chapter 2 Price Elasticity of Demand Measures the sensitivity of quantity demanded to price changes It measures the percentage change in the quantity demanded of a good that results from a one percent change in price %QD E %P D P Chapter 2 Price Elasticity of Demand The percentage change in a variable is the absolute change in the variable divided by the original level of the variable Therefore, elasticity can also be written as: Q Q P Q D EP P P Q P Chapter 2 Price Elasticity of Demand Usually a negative number As price increases, quantity decreases As price decreases, quantity increases When |EP| > 1, the good is price elastic |%Q| > |%P| When |EP| < 1, the good is price inelastic |%Q| < |% P| Chapter 2 Price Elasticity of Demand The primary determinant of price elasticity of demand is the availability of substitutes Many substitutes, demand is price elastic Can easily move to another good with price increases Few substitutes, demand is price inelastic Chapter 2 Price Elasticity of Demand Looking at a linear demand curve, as we move along the curve Q/P is constant, but P and Q will change Price elasticity of demand must therefore be measured at a particular point on the demand curve Elasticity will change along the demand curve in a particular way Chapter 2 Price Elasticity of Demand Given a linear demand curve Elasticity depends on slope and on the values of P and Q The top portion of demand curve is elastic Price is high and quantity small The bottom portion of demand curve is inelastic Price is low and quantity high Chapter 2 Price Elasticity of Demand Price 4 EP = - Demand Curve Q = 8 – 2P Elastic Ep = -1 2 Inelastic 4 8 Chapter 2 Q Ep = 0 Price Elasticity of Demand The steeper the demand curve, the more inelastic the demand for the good becomes The flatter the demand curve, the more elastic the the demand for the good becomes Two extreme cases of demand curves Completely inelastic demand – vertical Infinitely elastic demand – horizontal Chapter 2 Infinitely Elastic Demand Price EP = D P* Quantity Chapter 2 Completely Inelastic Demand Price D EP = 0 Q* Chapter 2 Quantity Other Demand Elasticities Income Elasticity of Demand Measures how much quantity demanded changes with a change in income Q/Q I Q EI I/I Q I Chapter 2 Other Demand Elasticities Cross-Price Elasticity of Demand Measures the percentage change in the quantity demanded of one good that results from a one percent change in the price of another good EQb Pm Qb Qb Pm Qb Pm Pm Qb Pm Chapter 2 Other Demand Elasticities Complements: Cars and Tires Cross-price elasticity of demand is negative Price of cars increases, quantity demanded of tires decreases Substitutes: Butter and Margarine Cross-price elasticity of demand is positive Price of butter increases, quantity of margarine demanded increases Chapter 2 Price Elasticity of Supply Measures the sensitivity of quantity supplied given a change in price Measures the percentage change in quantity supplied resulting from a 1 percent change in price %Q S E %P S P Chapter 2 Point vs. Arc Elasticities Point elasticity of demand Price elasticity of demand at a particular point on the demand curve Arc elasticity of demand Price elasticity of demand calculated over a range of prices E PD ΔQ P ΔP Q Chapter 2 Elasticity: An Application During the 1980s and 1990s, the market for wheat went through changes that had great implications for American farmers and U.S. agricultural policy Using the supply and demand curves for wheat, we can analyze what occurred in this market Chapter 2 Elasticity: An Application QD = QS 1800 + 240P = 3550 – 266P 506P = 1750 P = $3.46 per bushel Q = 1800 + (240)(3.46) = 2630 million bushels Chapter 2 Elasticity: An Application We can find the elasticities of demand and supply at these points P QD 3.46 E (266) .35 Q P 2,630 D P P QS 3.46 E (240) .32 Q P 2,630 S P Chapter 2 Elasticity: An Application Assume the price of wheat is $4.00/bushel due to decrease in supply QD 3,550 (266)(4.00) 2,486 4.00 Q (266) 0.43 2,486 D P Chapter 2 Elasticity: An Application In 2002, the supply and demand for wheat were: Supply: QS = 1439 + 267P Demand: QD = 2809 – 226P Chapter 2 Elasticity: An Application QD = QS 2809 - 226P = 1439 + 267P P = $2.78 per bushel Q = 2809 - (226)(2.78) = 2181 million bushels Chapter 2 Short-Run Versus Long-Run Elasticity Price elasticity varies with the amount of time consumers have to respond to a price Short-run demand and supply curves often look very different from their long-run counterparts Chapter 2 Short-Run Versus Long-Run Elasticity Demand In general, demand is much more price elastic in the long run Consumers take time to adjust consumption habits Demand might be linked to another good that changes slowly More substitutes are usually available in the long run Chapter 2 Gasoline: Short-Run and LongRun Demand Curves Price DSR • People cannot easily adjust consumption in the short run. • In the long run, people tend to drive smaller and more fuel efficient cars. DLR Quantity of Gas Chapter 2 Short-Run Versus Long-Run Elasticity Demand and Durability For some durable goods, demand is more elastic in the short run If goods are durable, then when price increases, consumers choose to hold on to the good instead of replacing it But in long run, older durable goods will have to be replaced Chapter 2 Cars: Short-Run and Long-Run Demand Curves Price DLR • Initially, people may put off immediate car purchase • In long run, older cars must be replaced DSR Quantity of Cars Chapter 2 Short-Run Versus Long-Run Elasticity Income elasticity also varies with the amount of time consumers have to respond to an income change For most goods and services, income elasticity is larger in the long run When income changes, it takes time to adjust spending Chapter 2 Short-Run Versus Long-Run Elasticity Income elasticity of durable goods Income elasticity is less in the long run than in the short run Increases in income mean consumers will want to hold more cars Once older cars are replaced, purchases will only be to replace old cars Less purchases from income increase in long run than in short run Chapter 2 Short-Run Versus Long-Run Elasticity Most goods and services: Long-run price elasticity of supply is greater than short-run price elasticity of supply Other Goods (durables, recyclables): Long-run price elasticity of supply is less than short-run price elasticity of supply Chapter 2 Short-Run Versus Long-Run Elasticity SSR Price SLR Due to limited capacity, firms are limited by output constraints in the short run. In the long run, they can expand. Chapter 2 Quantity Primary Copper Short-Run Versus Long-Run Elasticity SLR Price SSR Price increases provide an incentive to convert scrap copper into new supply. In the long run, this stock of scrap copper begins to fall. Quantity Secondary Copper Chapter 2 Short-Run vs. Long-Run Elasticity – An Application Why are coffee prices very volatile? Most of the world’s coffee is produced in Brazil Many changing weather conditions affect the crop of coffee, thereby affecting price Price following bad weather conditions is usually short-lived In long run, prices come back to original levels, all else equal Chapter 2 Price of Brazilian Coffee Chapter 2 Short-Run vs. Long-Run Elasticity – An Application Demand and supply are more elastic in the long run In the short run, supply is completely inelastic Weather may destroy part of the fixed supply, decreasing supply Demand is relatively inelastic as well Price increases significantly Chapter 2 An Application - Coffee Price S’ S A freeze or drought decreases the supply of coffee Price increases significantly due to inelastic supply and demand P1 P0 D Q1 Q0 Chapter 2 Quantity An Application - Coffee Price S’ S Intermediate-Run 1) Supply and demand are more elastic 2) Price falls back to P2. P2 P0 D Q2 Q0 Chapter 2 Quantity An Application - Coffee Price Long-Run 1) Supply is extremely elastic 2) Price falls back to P0. 3) Quantity back to Q0. S P0 D Q0 Chapter 2 Quantity Predicting the Effects of Changing Market Conditions Supply and demand analysis can be used to predict the effects of changing market conditions Linear demand and supply must be fit to market data Given equilibrium price and quantity along with elasticities of supply and demand, we can calculate the curves that fit the information We can then calculate changes in the market Chapter 2 Predicting the Effects of Changing Market Conditions We know Equilibrium Price, P* Equilibrium Quantity, Q* Price elasticity of supply, ES Price elasticity of demand, ED Chapter 2 Predicting the Effects of Changing Market Conditions Let’s begin with the equations for supply, demand, elasticity: Demand: Q = a – bP Supply: Q = c + dP Elasticity: (P/Q)(Q/P) We must calculate numbers for a, b, c, and d. Chapter 2 Predicting the Effects of Changing Market Conditions The slope of the demand curve above equals Q/P which equals -b The slope of the supply curve above equals Q/P which equals d Demand: ED = -b(P*/Q*) Supply: ES = d(P*/Q*) Chapter 2 Predicting the Effects of Changing Market Conditions Price Supply: Q = c + dP a/b ED = -bP*/Q* ES = dP*/Q* P* Demand: Q = a - bP -c/d Q* Chapter 2 Quantity Predicting the Effects of Changing Market Conditions Using P*, Q* and the elasticities, we can solve for b and c from supply ES = d(P*/Q*) 1.6 = d(0.75/7.5) = 0.1d d = 16 Q = c + dP 7.5 = c + (16)(0.75) = c + 12 c = -4.5 Chapter 2 Predicting the Effects of Changing Market Conditions Using P*, Q* and the elasticities, we can solve for a and b from demand ED = –b(P*/Q*) -0.8 = -b(0.75/7.5) = –0.1b b=8 Q = a – bP 7.5 = a – (8)(0.75) = a – 6 a = 13.5 Chapter 2 Predicting the Effects of Changing Market Conditions We now have equations for supply and demand Supply: Q = –4.5 + 16P Demand: Q = 13.5 – 8P Setting them equal will give us equilibrium price and quantity with which we began Chapter 2 Predicting the Effects of Changing Market Conditions Price Supply: QS = -4.5 + 16P a/b .75 Demand: QD = 13.5 - 8P -c/d 7.5 Chapter 2 Mmt/yr Predicting the Effects of Changing Market Conditions We have written supply and demand so that they only depend upon price Demand could also depend upon other variables such as income Demand would then be written as: Q a bP fI Chapter 2 Predicting the Effects of Changing Market Conditions We know the following information regarding the copper industry: I = 1.0 P* = 0.75 Q* = 7.5 b=8 Income elasticity: EI= 1.3 Chapter 2 Predicting the Effects of Changing Market Conditions Using the elasticity of income formula, we can solve for f EI = (I/Q)(Q/I) 1.3 = (1.0/7.5)(f) f = 9.75 Chapter 2 Declining Demand and the Behavior of Copper Prices Copper has gone through difficult market changes leading the significantly reduced prices most from decreased demand from A decrease in the growth rate of power generation The development of substitutes: fiber optics and aluminum Chapter 2 Real versus Nominal Prices of Copper 1965 - 2002 Chapter 2 Declining Demand and the Behavior of Copper Prices Given producers’ concerns about further declines in demand, we can calculate by how much prices will fall with future declines in demand Assume that demand will fall by 20% What is the resulting decrease in price? Demand curve will shift to left by 20% Chapter 2 Declining Demand and the Behavior of Copper Prices We want to consider 80% of the past demand Q = (0.80)(13.5 - 8P) Q = 10.8 - 6.4P Recall the equation for supply: Q = -4.5 + 16P Chapter 2 Declining Demand and the Behavior of Copper Prices Setting supply equal to demand: -4.5 + 16P = 10.8 - 6.4P -16P + 6.4P = 10.8 + 4.5 P = 15.3/22.4 P = 68.3 cents/pound A decline in demand of 20% will lead to a drop in price about 7% Chapter 2 Effects of Price Controls Markets are rarely free of government intervention Imposed taxes and granted subsidies Price controls Price controls usually hold the price above or below the equilibrium price Excess demand – shortage Excess supply – surplus Chapter 2 Effects of Price Controls Price S • Price is regulated to be no higher than Pmax • Quantity supplied falls and quantity demanded increases • A shortage results P0 Pmax Shortage QS Q0 Chapter 2 D QD Quantity Effects of Price Controls Excess demand sometimes takes the form of lines (queues) Lines at gas stations during 1974 shortage Sometimes get curtailments and supply rationing Natural gas shortage of the mid 1970s Producers typically lose, but some consumers gain. Some consumers lose. Chapter 2 Price Controls and Natural Gas Shortages In 1954, the federal government began regulating the wellhead price of natural gas In 1962, the ceiling prices that were imposed became binding and shortages resulted Chapter 2