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Chapter 2
Demand and Supply Analysis
Outline
1. Competitive Markets Defined
2. The Market Demand Curve
3. The Market Supply Curve
4. Equilibrium
5. Characterizing Demand and Supply:
Elasticity
6. Back of the Envelope Techniques
2
Example: Oil Market
Crude oil prices 1947 – 2004
OPEC oil production
•Some experts predict that prices will rise to 100
Why?
 Weather, Hurricanes in Gulf
 China and India economies booming
 Political Crisis with Iran, Iraq, Russia, Nigeria
 Oil production per day in Non-OPEC countries declining
 Uncertainty over OPEC production capabilities
3
Example: Oil Market (cont’d)
How could we bring prices down?
• Reduce Demand – short-run
• Find new reserves – short-run
• Develop new technologies that are not
reliant on oil
 Forward thinking solution
 These become feasible as oil prices
rise. Many are now feasible
4
Competitive Markets
Definition: Are those with sellers and buyers
that are small and numerous enough that they
take the market price as given when they
decide how much to buy and sell.
5
Competitive Market Assumptions
1. Fragmented market: many buyers and sellers
 Implies buyers and sellers are price takers
2. Undifferentiated Products: consumers perceive
the product to be identical so don’t care who they
buy it from
3. Perfect Information about price: consumers
know the price of all sellers
4. Equal Access to Resources: everyone has
access to the same technology and inputs.
 Free entry into the market, so if profitable for
new firms to enter into the market they will
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tells us how the quantity of a good
demanded by the sum of all consumers in
the market depends on various factors.
Qd = (Q,p,po, I,…)
Plots the aggregate quantity of a good that
consumers are willing to buy at different
prices, holding constant other demand drivers
such as prices of other goods, consumer
income, quality.
Qd= Q(p)
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The Demand for New Automobiles in the United States
Price (thousands of dollars)
53
40
0
Demand curve for automobiles in the
United States in 2000
2
5.3
Quantity (millions of
automobiles per year)
8
Note:
We always graph P on vertical axis and Q on horizontal axis,
but we write demand as Q as a function of P… If P is
written as function of Q, it is called the inverse demand.
Normal Form: Qd= 100-2P
Inverse form: P = 50 - Qd/2

Markets defined by commodity, geography, time.
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Law of Demand
Law of Demand states that the quantity of a good
demanded decreases when the price of this good
increases.

Empirical regularity
The demand curve: shifts when factors other
than own price change…
If the change increases the willingness of consumers
to acquire the good, the demand curve shifts right
If the change decreases the willingness of consumers
to acquire the good, the demand curve shifts left
10
Some Demand Shifters
Consumer incomes
 Consumer tastes
 Advertising
What would a rise in tax rate do?

Note: For a given demand curve we assume everything
else but price is held fixed.
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Rule
A move along the demand curve for a good can only be
triggered by a change in the price of that good. Any
change in another factor that affects the consumers’
willingness to pay for the good results in a shift in the
demand curve for the good.
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tells us how the quantity of a good supplied by
the sum of all producers in the market depends
on various factors
Qs= Q(p,po,w, …)
Po = price of other goods
Plots the aggregate quantity of a good that will
be offered for sale at different prices.
Qs= Q(P)
13
Example: Supply Curve for Wheat in
Canada
Price (dollars per bushel)
Supply curve for wheat
in Canada in 2000
0
0.15
Quantity (billions of
bushels per year)
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Definition: The Law of Supply states that the quantity of a
good offered increases when the price of this good increases.
 Empirical regularity
The supply curve shifts when factors other than own price
change…
If the change increases the willingness of
producers to offer the good at the same price,
the supply curve shifts right
If the change decreases the willingness of
producers to offer the good at the same price,
the supply curve shifts left
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Supply Shifters



Price of factors of production e.g. wage
Technology changes
Weather conditions


Hurricane Katrina reduced supply of oil
Number of producers change
What is the effect of a rise in the minimum wage?
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Rule
A move along the supply curve for a good can only be
triggered by a change in the price of that good. Any
change in another factor that affects the producers’
willingness to offer for the good results in a shift in the
supply curve for the good.
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Example: Canadian Wheat
QS = p + .05r
QS = quantity of wheat (billions of bushels)
p = price of wheat (dollars per bushel)
r = average rainfall in western Canada,
May – August (inches per month)
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QS = p + .05r
a. Quantity of wheat supplied at price of $2 and rainfall of 3
inches per month = 2.15
b. Supply curve when rainfall is 3 inches per month:
QS = p + 0.15
c. Law of supply holds: we know because the constant in
front of p is positive
d. As rainfall increases, supply curve shifts right (e.g., r = 4
=> Q = p + 0.2)
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QS = p + .05r
Price ($)
r=0
Supply with
no rain
0
Quantity,
Billion bushels
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QS = p + .05r
Price ($)
r=0
r=3
Supply with
no rain
Supply with 3” rain
0 .15
Quantity,
Billion bushels
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Market Equilibrium
Definition: A market equilibrium is a price such
that, at this price, the quantities demanded and
supplied are the same.
(Demand and supply curves intersect at equilibrium)
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Example: Finding Equilibrium Price and Quantity
The Market for Cranberries
Qd = 500 – 4p
QS = -100 + 2p
p = price of cranberries (dollars per barrel)
Q = demand or supply in millions of
barrels per year
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Qd = 500 – 4p
Qs = -100 + 2p
a. The equilibrium price of cranberries is
calculated by equating demand to supply:
Qd = Qs … or…
500 – 4p = -100 + 2p …solving,
P* = $100
b. plug equilibrium price into either demand
or supply to get equilibrium quantity:
Q* =100
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Example: The Market For Cranberries
Price
125
Market Supply: P = 50 + QS/2
P* = 100
Equilibrium
50
Market Demand: P = 125 - Qd/4
Q* = 100
Quantity
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Elasticity

Definition: The own price elasticity of demand is
the percentage change in quantity demanded
brought about by a one-percent change in the price
of the good.
Q
(Q 2  Q1 )
*100
Q1
%Q
Q



P
( P2  P1 )
%P
*100
P
p
1
Q P
Q P
*

*
P Q
P Q
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Elasticity is not the slope



Slope is the ratio of absolute changes in quantity
and price. (= Q/P).
Elasticity is the ratio of relative (or percentage)
changes in quantity and price.
Why elasticity is more useful?

it is unitless so allows us to easily compare across
countries and goods


Units of quantities will be different for different goods.
How to compare snow boards to oranges.
Prices are different across different countries. More
difficult to compare Yemeni Ryials to US $
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Category
Estimated Q,P
Soft Drinks
-3.18
Canned Seafood -1.79
Canned Soup
-1.62
Cookies
-1.6
Breakfast Cereal -0.2
Toilet Paper
-2.42
Laundry
Detergent
Toothpaste
-1.58
Snack Crackers
-0.86
Frozen Entrees
-0.77
Paper Towels
-0.05
Dish Detergent
-0.74
Fabric Softener
-0.73
When reading
these remember
the denominator is
1.
Price Elasticity of Demand
for Selected Grocery
Products, Chicago, 1990s
-0.45
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Elasticity Continued
• The price elasticity of demand for records is -2. Tell
me in words what this means.
• A 1 percent increase in price of records will lead to a
2 percent decrease in quantity of records
demanded.
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Types of Elasticity

When a one percent change in price leads to a greater than
one-percent change in quantity demanded, the demand curve
is elastic. (Q,P < -1)

When a one-percent change in price leads to a less than onepercent change in quantity demanded, the demand curve is
inelastic. (0 > Q,P > -1)

When a one-percent change in price leads to an exactly onepercent change in quantity demanded, the demand curve is
unit elastic. (Q,P = -1)
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Example: Linear Demand Curve
Qd = a – bp
a, b are positive constants
p is price
 b is the slope
 a/b is the choke price
Choke price: price at which quantity
demanded is zero
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 the elasticity is
Q,P = (Q/p)(p/Q) …definition…
=-b(p/Q)
When Q=0, elasticity is -
When p=0, elasticity is 0
so…elasticity falls from 0 to - along the linear demand
curve, but slope is constant.
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Example: Elasticity with a Linear Demand Curve
P
a/b
Q,P = -
Elastic region
a/2b
•
Q,P
= -1
Inelastic region
Q,P = 0
0
a/2
a
Q
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Example: Determining Elasticity
if Qd = 400 – 10p, and p = 30,
Q,P = (-b)(P)/(Q)
Q = 400 – 10 (30) = 100
Q,P = (-10)(30)/(100) = -3 "elastic"
Why is elasticity negative – demand curve downward
sloping.
34
Example: Constant Elasticity Demand Curve
Qd = Ap
This is how the demand function
looks in general
 = elasticity of demand and is
negative
p = price
A = constant
Example: If demand can be expressed as QP = 100, what is
the price elasticity of demand?
Q=100P-1 , so elasticity is -1
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Example: A Constant Elasticity
versus a Linear Demand Curve
Price
•
P
Observed price and quantity
Constant elasticity demand curve
Linear demand curve
0
Q
Quantity
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Elasticity Continued
Price Elasticity of Demand is very useful.
 Suppose own a car business total revenue is: price *
quantity= P.Q
 You can increase the price (P), but if you do that
demand (Q) for your good will drop
 The price elasticity of demand tell you how much the
quantity will drop.
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How Elastic are these Curves?
D2 Perfectly
Inelastic
P
P1
D1
Q2
Perfectly
Elastic
Q
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What Affects Elasticity?




Availability of Substitutes:
 Demand is more(less) elastic when there are
more(fewer) substitutes for a product.
% of income spending on product
 Demand is more(less) when the consumer’s
expenditure on the product is large(small)
Necessity Products
 The demand is less price elastic when the product
is a necessity.
Market Level vs Brand-Level Price
 Demand tends to be more elastic for a particular
brand of a good, than for the good in general
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Elasticity Continued

Elasticity varies with (among other factors):


Substitutability
Example: Demand for all beverages less elastic than
demand for Coca-Cola


There are substitute for Coca-Cola, drink Pepsi
It is harder to find a substitute for soda if you love soda.
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Importance of Brands
Model
Price
Estimated
Q,P
Mazda 323 $5,039
-6.358
Nissan
Sentra
$5,661
-6.528
Ford
Escort
$5,663
-6.031
Lexus
LS400
$27,544
-3.085
BMW 735i $37,490
-3.515
• Demand for individual
models is highly elastic
• Market-level price
elasticity of demand for
automobiles -1 to -1.5
• Compact automobiles
have lots of substitutes
Luxury cars have less
substitutes
 Demand for compact cars
more elastic than luxury
cars.
Example: Price Elasticities of Demand for Automobile Makes, 1990.
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Definition: A durable good is a good that provides
valuable services over a long time (usually many
years). – airplane, car
Demand for non-durables (e.g. oil) less elastic in the
short run when consumers can only partially adapt
their behavior. Demand for durables more elastic in
the short run because consumers can delay purchase.
Demand for Oil : short-run is less elastic (inelastic? )
• We own a car with a given mileage.
• Takes time to move to smaller cars and solar panels
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Example: Demand for
Commercial Aircraft
Price ($/airplane)
Which demand curve is the shortterm and which long-term?
Quantity (aircraft/yr)
43
Example: Demand for
Commercial Aircraft
Price ($/airplane)
Long run demand curve for commercial airplanes
Short run demand curve for commercial
airplanes
Quantity (aircraft/yr)
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 Other Elasticities -- Elasticity of "X" with respect to
"Y": (X/Y)(Y/X)

Price elasticity of supply (QS/p)(p/QS) …measures
curvature of supply curve
 Income elasticity of demand (Qd/I)(I/Qd)
…measures degree of shift of demand curve as
income changes…
 Cross price elasticity of demand
(Qd/Po)(Po/Qd)…measures degree of shift of
demand curve when the price of a substitute
changes
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The Cross-Price Elasticity of Cars
Price
Sentra Escort LS400 735i
Sentra -6.528 0.454
0.000
0.000
Escort 0.078
-6.031 0.001
0.000
LS400 0.000
0.001
-3.085 0.032
735i
0.001
0.093
Demand
0.000
-3.515
What is the cross price
elasticity of demand of
the Sentra with respect
to Escort (0.454)?
If the price of the
Escort increases by 10
%, the demand for
the Sentra will
increase by 4.54 %
46
Elasticities of Demand for Coke and Pepsi
Elasticity
Coke
Pepsi
Price
elasticity of
demand
Cross-price
elasticity of
demand
Income
elasticity of
demand
-1.47
-1.55
0.52
0.64
0.58
1.38
What is the
income elasticity
of demand of
Coke?
If income increases
by 10%, the demand
for coke will increase
by 5.8%.
47
Long-run vs Short-run Elasticity
Crude Oil Example
Table 2.8
48
Back of the Envelope Calculations:
Estimating Supply and Demand Functions
We can estimate Demand and Supply curves by:
1. Choose a general shape for functions (i.e. linear)
• Q=a-bP ( could have chosen constant elasticity)
2. Knowing:
• Own Price Elasticities
• Equilibrium Price
• Equilibrium Quantity
-
Usually we would want to collect data and
estimate the model but this can be time
consuming and costly
49
Back of the Envelope
Calculations Example
Suppose demand is linear: Qd = a-bP
Hence, elasticity is Q,P = -bP/Q
If we have data on , Q and P, we can calculate b
from elasticity equation and then calculate “a” by
substituting into demand.
50
E.G: Broiler in the US, 1990
If…Qd = a – bP
Per capita consumption 70lbs/person
Price $.70/lb.
Q,P = -.55
What are a and b in the demand equation?
51
Broiler Linear Demand Example
Q* = 70 P*= .7 elasticity = -.55
Using the definition of elasticity we solve for b
= -bP*/Q*  b = -Q*/P*
b = -(-.55(70/.7)) = 55
a = Q*+ bP*, sub in for b
a= Q* + (-Q*/P*)P* = (1- )Q*
a=[1-(-.55)]*70=108.5
Demand Function=> Qd = 108.5 – 55p
52
Broiler: Constant Elasticity Example
If…Qd = Ap
Q,P = -.55
A = Qp- = 70(.7).55 = 57.53
=> Qd = 57.53P-.55
53
Estimating Demand and Supply for a
Supply Shift
A shift in the supply curve reveals the
slope of the demand curve while a shift
in the demand curve reveals the slope
of the supply curve.
54
Example: Identifying demand by a shift in supply.
Price
New Supply
Old Supply
•
P2
P1
So can figure
out b from
change in price
and change in
quantity.
•
Market Demand
0
Q2 Q1
Quantity
55
-Suppose, then, that the supply curve shifts back.
Both the old equilibrium point (p1,Q1) and the new
equilibrium point (p2,Q2) lie on the same (linear)
demand curve. Therefore, if QD = a-bp,
b = Q/P = (Q2 – Q1)/(P2 – P1)
a = Q1 + bP1 (can use original price and
quantity to determine a).
Q = a + bP
56
-We can “identify” the slope of supply by a shift
in demand
-We can "identify" the slope of demand by a
shift in supply, similarly.
Make sure you go through the book example.
57
-This technique only works if one or the other of the
curves stays constant.
Price
Supply
Demand
0
Quantity
Example: Identifying demand when both curves shift
58
-This technique only works if one or the other of the
curves stays constant. Would estimate demand
incorrectly here.
Price
New Supply
•
•
P2
P1
Old Supply
Old Demand
New Demand
0
Q2 = Q1
Quantity
Example: Identifying demand when both curves shift
59