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Chapter 2 The Basics of Supply and Demand Topics to Be Discussed Supply and Demand The Market Mechanism Changes in Market Equilibrium Elasticities of Supply and Demand Short-Run Versus Long-Run Elasticities Chapter 2: The Basics of Supply and Demand Slide 2 Supply and Demand The Supply Curve The supply curve shows how much of a good producers are willing to sell at a given price, holding constant other factors that might affect quantity supplied Chapter 2: The Basics of Supply and Demand Slide 3 Supply and Demand The Supply Curve This price-quantity relationship can be shown by the equation: Qs QS (P ) Chapter 2: The Basics of Supply and Demand Slide 4 Supply and Demand The Supply Curve Graphically Price ($ per unit) Vertical axis measures price (P) received per unit in dollars Horizontal axis measures quantity (Q) supplied in number of units per time period Quantity Chapter 2: The Basics of Supply and Demand Slide 5 Supply and Demand Price ($ per unit) S The Supply Curve Graphically P2 The supply curve slopes upward demonstrating that at higher prices firms will increase output P1 Q1 Q2 Chapter 2: The Basics of Supply and Demand Quantity Slide 6 Supply and Demand Non-price Determining Variables of Supply Costs of Production Labor Capital Raw Materials Technology Government regulations Chapter 2: The Basics of Supply and Demand Slide 7 Supply and Demand Change in Supply The cost of raw materials falls At P1, produce Q2 At P2, produce Q1 Supply curve shifts right to S’ P S’ S P1 P2 More produced at any price on S’ than on S Q0 Chapter 2: The Basics of Supply and Demand Q1 Q2 Slide 8 Q Supply and Demand The Demand Curve The demand curve shows how much of a good consumers are willing to buy as the price per unit changes holding non-price factors constant. This price-quantity relationship can be shown by the equation: QD QD(P) Chapter 2: The Basics of Supply and Demand Slide 9 Supply and Demand Price ($ per unit) Vertical axis measures price (P) paid per unit in dollars Horizontal axis measures quantity (Q) demanded in number of units per time period Quantity Chapter 2: The Basics of Supply and Demand Slide 10 Supply and Demand 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 and the consumer’s real income increases. D Quantity Chapter 2: The Basics of Supply and Demand Slide 11 Supply and Demand Non-price Determining Variables of Demand Income Consumer Tastes Price of Related Goods Substitutes Complements Chapter 2: The Basics of Supply and Demand Slide 12 Supply and Demand Change in Demand Income Increases P D’ D P2 At P1, demand Q2 At P2, demand Q1 Demand Curve shifts right P1 More purchased at any price on D’ than on D Q0 Chapter 2: The Basics of Supply and Demand Q1 Q2 Slide 13 Q The Market Mechanism Price ($ per unit) S The curves intersect at equilibrium, or marketclearing, price. At P0 the quantity supplied is equal to the quantity demanded at Q0 . P0 D Q0 Chapter 2: The Basics of Supply and Demand Quantity Slide 14 The Market Mechanism Characteristics of the equilibrium or market clearing price: QD = QS No shortage No excess supply No pressure on the price to change Chapter 2: The Basics of Supply and Demand Slide 15 The Market Mechanism Price ($ per unit) S Surplus P1 If price is above equilibrium: 1) Price is above the market clearing price 2) Qs > Qd 3) Price falls to the market-clearing price P0 D Q0 Chapter 2: The Basics of Supply and Demand Quantity Slide 16 The Market Mechanism A Surplus The market price is above equilibrium There is excess supply Producers lower prices Quantity demanded increases and quantity supplied decreases The market continues to adjust until the equilibrium price is reached. Chapter 2: The Basics of Supply and Demand Slide 17 The Market Mechanism Price ($ per unit) S Surplus P1 Assume the price is P1 , then: 1) Qs = Q2 > Qd = Q1 2) Excess supply is Q2Q1 3) Producers lower price. 4) Quantity supplied decreases and quantity demanded increases. 5) Equilibrium at P2Q3 P2 D Q1 Q3 Q2 Quantity Chapter 2: The Basics of Supply and Demand Slide 18 The Market Mechanism Price ($ per unit) S Assume the price is P2 , then: 1) Qd = Q2 > Qs = Q1 2) Shortage is Q1Q2. 3) Producers raise price. 4) Quantity supplied increases and quantity demanded decreases. 5) Equilibrium at P3, Q3 P3 P2 Shortage Q1 Q3 D Q2 Quantity Chapter 2: The Basics of Supply and Demand Slide 19 The Market Mechanism Shortage The market price is below equilibrium: There is a shortage Producers raise prices Quantity demanded decreases and quantity supplied increases The market continues to adjust until the new equilibrium price is reached. Chapter 2: The Basics of Supply and Demand Slide 20 The Market Mechanism Market Mechanism Summary 1) Supply and demand interact to determine the market-clearing price. 2) When not in equilibrium, the market will adjust to alleviate a shortage or surplus and return the market to equilibrium. 3) Markets must be competitive for the mechanism to be efficient. Chapter 2: The Basics of Supply and Demand Slide 21 Changes In Market Equilibrium Equilibrium prices are determined by the relative level of supply and demand. Supply and demand are determined by particular values of supply and demand determining variables. Changes in any one or combination of these variables can cause a change in the equilibrium price and/or quantity. Chapter 2: The Basics of Supply and Demand Slide 22 Changes In Market Equilibrium Raw material prices fall P D S S’ S shifts to S’ Surplus @ P1 of Q 1, Q 2 Equilibrium @ P3, Q3 P1 P3 Q1 Q3 Q2 Chapter 2: The Basics of Supply and Demand Slide 23 Q Changes In Market Equilibrium Income Increases P Demand shifts to D1 Shortage @ P1 of Q1, Q2 P3 Equilibrium @ P3, Q3 D D’ S P1 Q2 Q1 Q3 Chapter 2: The Basics of Supply and Demand Slide 24 Q Changes In Market Equilibrium Income Increases & raw material prices fall The increase in D is greater than the increase in S P D D’ S S’ P2 P1 Equilibrium price and quantity increase to P2, Q2 Q1 Chapter 2: The Basics of Supply and Demand Q2 Slide 25 Q Shifts in Supply and Demand When supply and demand change simultaneously, the impact on the equilibrium price and quantity is determined by: 1) The relative size and direction of the change 2) The shape of the supply and demand curves Chapter 2: The Basics of Supply and Demand Slide 26 Elasticities of Supply and Demand Generally, elasticity is a measure of the sensitivity of one variable to another. It tells us the percentage change in one variable in response to a one percent change in another variable. Chapter 2: The Basics of Supply and Demand Slide 27 Elasticities of Supply and Demand Price Elasticity of Demand Measures the sensitivity of quantity demanded to price changes. It measures the percentage change in the quantity demanded for a good or service that results from a one percent change in the price. Chapter 2: The Basics of Supply and Demand Slide 28 Elasticities of Supply and Demand The price elasticity of demand is: EP (%Q)/(% P) Chapter 2: The Basics of Supply and Demand Slide 29 Elasticities of Supply and Demand Price Elasticity of Demand So the price elasticity of demand is: Q/Q P Q EP P/P Q P Chapter 2: The Basics of Supply and Demand Slide 30 Elasticities of Supply and Demand Interpreting Price Elasticity of Demand Values 1) Because of the inverse relationship between P and Q; EP is negative. 2) If EP (absolute value) > 1, the percent change in quantity is greater than the percent change in price. Demand is price elastic. Chapter 2: The Basics of Supply and Demand Slide 31 Elasticities of Supply and Demand Interpreting Price Elasticity of Demand Values 3) If EP (absolute value) < 1, the percent change in quantity is less than the percent change in price. We say the demand is price inelastic. Chapter 2: The Basics of Supply and Demand Slide 32 Elasticities of Supply and Demand Price Elasticity of Demand The primary determinant of price elasticity of demand is the availability of substitutes. Many substitutes, demand is price elastic Few substitutes, demand is price inelastic Chapter 2: The Basics of Supply and Demand Slide 33 Price Elasticities of Demand Price EP - The lower portion of a downward sloping demand curve is less elastic than the upper portion. 4 Q = 8 - 2P Ep = -1 2 Linear Demand Curve Q = a - bP Q = 8 - 2P Ep = 0 4 Chapter 2: The Basics of Supply and Demand 8 Q Slide 34 Price Elasticities of Demand Price Infinitely Elastic Demand D P* EP - Quantity Chapter 2: The Basics of Supply and Demand Slide 35 Price Elasticities of Demand Completely Inelastic Demand Price EP 0 Q* Chapter 2: The Basics of Supply and Demand Quantity Slide 36 Elasticities of Supply and Demand Other Demand Elasticities Income elasticity of demand measures the percentage change in quantity demanded resulting from a one percent change in income. Chapter 2: The Basics of Supply and Demand Slide 37 Elasticities of Supply and Demand Other Demand Elasticities The income elasticity of demand is: Q/Q I Q EI I/I Q I Chapter 2: The Basics of Supply and Demand Slide 38 Income Elasticities of Demand EI <0: inferior goods EI >0: normal goods EI <1: essential goods EI >1: luxury goods Chapter 2: The Basics of Supply and Demand Slide 39 Elasticities of Supply and Demand Other Demand Elasticities Cross 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. Chapter 2: The Basics of Supply and Demand Slide 40 Elasticities of Supply and Demand The cross elasticity of demand is: Qb/Qb Pm Qb EQbPm Pm/Pm Qb Pm The cross elasticity for substitutes is positive, while that for complements is negative. Chapter 2: The Basics of Supply and Demand Slide 41 Elasticities of Supply and Demand Elasticities of Supply Price elasticity of supply measures the percentage change in quantity supplied resulting from a 1 percent change in price. The elasticity is usually positive because price and quantity supplied are directly related. Chapter 2: The Basics of Supply and Demand Slide 42 Elasticities of Supply and Demand Elasticities of Supply We can refer to elasticity of supply with respect to interest rates, wage rates, and the cost of raw materials. Chapter 2: The Basics of Supply and Demand Slide 43 Short-Run Versus Long-Run Elasticities Demand Most goods and services: Short-run elasticity is less than long-run elasticity. (e.g. gasoline) Other Goods (durables): Short-run elasticity is greater than long-run elasticity (e.g. automobiles) Chapter 2: The Basics of Supply and Demand Slide 44 Gasoline: Short-Run and Long-Run Demand Curves Price DSR People tend to drive smaller and more fuel efficient cars in the long-run Gasoline DLR Quantity Chapter 2: The Basics of Supply and Demand Slide 45 Automobiles: Short-Run and Long-Run Demand Curves Price DLR People may put off immediate consumption, but eventually older cars must be replaced. Automobiles DSR Quantity Chapter 2: The Basics of Supply and Demand Slide 46 Short-Run Versus Long-Run Elasticities Supply 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: The Basics of Supply and Demand Slide 47 Short-Run Versus Long-Run Elasticities Primary Copper: Short-Run and Long-Run Supply Curves Price SSR SLR Due to limited capacity, firms are limited by output constraints in the short-run. In the long-run, they can expand. Quantity Chapter 2: The Basics of Supply and Demand Slide 48 Short-Run Versus Long-Run Elasticities Secondary Copper: Short-Run and Long-Run Supply Curves SLR SSR Price 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 Chapter 2: The Basics of Supply and Demand Slide 49 Short-Run Versus Long-Run Elasticities Coffee S’ S Price A freeze or drought decreases the supply of coffee P1 P0 Short-Run 1) Supply is completely inelastic 2) Demand is relatively inelastic 3) Very large change in price D Q1 Q0 Chapter 2: The Basics of Supply and Demand Quantity Slide 50 Short-Run Versus Long-Run Elasticities Coffee Price S’ S P2 P0 Intermediate-Run 1) Supply and demand are more elastic 2) Price falls back to P2. 3) Quantity falls to Q2 D Q2 Q 0 Chapter 2: The Basics of Supply and Demand Quantity Slide 51 Short-Run Versus Long-Run Elasticities Coffee Price Long-Run 1) Supply is extremely elastic. 2) Price falls back to P0. 3) Quantity increase to Q0. S P0 D Q0 Chapter 2: The Basics of Supply and Demand Quantity Slide 52 Effects of Government Intervention -Price Controls If the government decides that the equilibrium price is too high, they may establish a maximum allowable ceiling price. Chapter 2: The Basics of Supply and Demand Slide 53 Effects of Price Controls Price S If price is regulated to be no higher than Pmax, quantity supplied falls to Q1 and quantity demanded increases to Q2. A shortage results P0 Pmax D Excess demand Q0 Chapter 2: The Basics of Supply and Demand Quantity Slide 54 Summary Supply-demand analysis is a basic tool of microeconomics. The market mechanism is the tendency for supply and demand to equilibrate, so that there is neither excess demand nor excess supply Chapter 2: The Basics of Supply and Demand Slide 55 Summary Elasticities describe the responsiveness of supply and demand to changes in price, income, and other variables. Elasticities pertain to a time frame. Chapter 2: The Basics of Supply and Demand Slide 56 End of Chapter 2