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Chapter 2 Supply and Demand McGraw-Hill/Irwin Copyright © 2008 by The McGraw-Hill Companies, Inc. All Rights Reserved. Main Topics Demand Supply Market equilibrium Elasticities of demand and supply 2-2 Demand Curves Product’s demand curve shows: How much buyers of the product want to buy at each possible price Holding fixed all other factors that affect demand On a graph: vertical axis shows $ per unit of the good, horizontal axis shows quantity demanded per unit of time Downward sloping (buying the product is less attractive when the price is high than when the price is low) 2-3 Determinants of Demand Demand curve holds all factors other than the product’s price constant: Population growth Consumer tastes and incomes Prices of other products Substitutes (An increase in the price of one product causes buyers to demand more of the other, all else equal) Complements (An increase in the price of product causes buyers to demand less of the other, all else equal) Government taxes or regulations 2-4 Shifts and Movements Along a Demand Curve Change in price of the product causes a movement along the demand curve A change in the quantity demanded Change in another factor causes the entire demand curve to shift A change in demand 2-5 Figure 2.1: Demand Curve for U.S. Corn Market (hypothetical) 2-6 Demand Functions Product’s demand function is a mathematical representation of its demand Describes the amount of the product buyers demand for each possible combination of price and other factors Can be determined by applying statistical techniques to historical data 2-7 Sample Demand Function Demand for corn affected by: price of corn, price of potatoes, price of butter, consumer incomes d Qcorn 5 2Pcorn 4Ppotatoes 0.25Pbutter 0.0003M Increases in the prices of corn and butter will decrease the amount of corn buyers demand Increases in the price of potatoes will increase the amount of corn buyers demand 2-8 Supply Curves Product’s supply curve shows: How much sellers of the product want to sell at each possible price Holding fixed all other factors that affect supply On a graph: vertical axis shows $ per unit of the good, horizontal axis shows quantity supplied per unit of time Upward sloping (selling the product is less attractive when the price is low than when the price is high) 2-9 Determinants of Supply Supply curve holds all factors other than the product’s price constant: Technology Prices of inputs Prices of other possible outputs Government taxes or regulations 2-10 Shifts and Movements Along a Supply Curve Change in price of the product causes a movement along the supply curve A change in the quantity supplied Change in another factor causes the entire supply curve to shift A change in supply 2-11 Figure 2.2: Demand Curve for U.S. Corn Market (hypothetical) 2-12 Supply Functions Product’s supply function is a mathematical representation of its supply Describes the amount of the product sellers supply at each possible combination of price and other factors Can be determined by applying statistical techniques to historical data 2-13 Sample Supply Function Supply of corn affected by: price of corn, price of diesel fuel, price of soybeans s Qcorn 9 5Pcorn 2Pfuel 1.25Psoybeans Increases in the price of diesel fuel and soybeans will decrease the amount of corn sellers supply Increases in the price of corn will increase the amount of corn sellers supply 2-14 Market Equilibrium Supply and demand for a product interact to determine the market equilibrium The equilibrium price is the price at which the amounts supplied and demanded are equal Graphically, the price at which the supply and demand curves intersect 2-15 Figure 2.3: Equilibrium in the Corn Market 2-16 Excess Supply, Excess Demand If price is above equilibrium price: Amount supplied will be greater than amount demanded (excess supply) Incentive for sellers to lower prices to boost sales If price is below equilibrium price: Amount demanded will be greater than amount supplied (excess demand) Incentive for buyers to offer higher prices Market prices adjust so that amount supplied equals amount demanded 2-17 Changes in Market Equilibrium Changing market conditions alter the market equilibrium Changes in the determinants of supply (or demand) other than the product price cause the supply (or demand) curve to shift Example: falling diesel fuel and soybean prices shift the corn supply curve out 2-18 Figure 2.5: Change in Market Equilibrium 2-19 Changes in Market Equilibrium Four possible ways either supply or demand curve can shift: Demand can increase or decrease Supply can increase or decrease Effect on market equilibrium: If demand curve shifts, price and quantity change in the same direction as the curve If supply curve shifts, quantity changes in the same direction as the curve but price changes in the opposite direction 2-20 Figure 2.6: Changes in Market Equilibrium 2-21 Table 2.1 Effects of Changes in Demand or Supply Source of Change Effect on Price Effect on Amount Bought/Sold Increase in Demand Rises Rises Decrease in Demand Falls Falls Increase in Supply Falls Rises Decrease in Supply Rises Falls 2-22 Changes in Market Equilibrium Sometimes supply and demand will both shift Ultimate effect on equilibrium is combination of the separate effects of changes in demand and supply Will be able to determine the necessary direction of price or quantity movement, but not both 2-23 Figure 2.9: Increase in Both Demand and Supply 2-24 Table 2.2 Effects of Simultaneous Changes in Demand and Supply Source of Change Effect on Price Effect on Amount Bought/Sold Demand and supply both increase Ambiguous Rises Demand and supply both decrease Ambiguous Falls Demand increases, Supply decreases Rises Ambiguous Demand decreases, Supply increases Falls Ambiguous 2-25 Size of Changes in Market Equilibrium What determines the size of changes in market equilibrium? Size of change in demand (or supply) The larger the shift in demand (or supply), the larger the effect on price) Steepness of the curve that does not shift If the supply curve shifts, the steeper demand curve the more the price changes the less the amount bought and sold changes Steepness reflects responsiveness to prices 2-26 Figure 2.11: Changes in Equilibrium for Two Extreme Demand Curves 2-27 Figure 2.13: Changes in Equilibrium for Two Extreme Supply Curves 2-28 Elasticities of Demand and Supply A measure of the responsiveness of the amounts demanded and supplied to changes in prices Not the same as the slope of the supply or demand curve Slope of the curve depends on the units used to measure the quantity of the good and its price Elasticity does not depend on units (e.g., gallons, dozens, dollars per pound) 2-29 General Elasticity Formula Suppose that a change in X causes a change in Y. Then the elasticity of Y with respect to X is the percentage change in Y divided by the percentage change in X: E Y X % change in Y % change in X 2-30 Interpreting an Elasticity Suppose E XY 2 Then Y increases 2% for each 1% increase in X If instead Y decreased 2% when X increased by 1%, the elasticity would be negative. Note that the elasticity is unit-free; its meaning is clear without information about the units of X or Y. 2-31 Price Elasticity of Demand Elasticity of demand for a product with respect to its price Usually called “elasticity of demand” d Denoted E Elasticity of demand equals the percentage change in the amount demanded divided by the percentage change in the price 2-32 Price Elasticity of Demand Formula: % amount demanded Q Q d E P P % price Expect Ed to be negative: When P increases, amount demanded typically decreases When P decreases, amount demanded typically increases 2-33 Price Elasticity of Demand Goods tend to have more price elastic demand when: They have close substitutes Buyers of the product consider it a luxury Buyers of the product are strapped for cash and thus sensitive to changes in their expenditures In general, elasticity of demand varies at different points along a demand curve 2-34 Elasticities for Linear Demand Curves For linear demand curves re-write the price elasticity of demand formula as: Q P E P Q d Notice that the first term is related to the slope of the demand curve The second term is the initial price divided by the initial quantity 2-35 Elasticities for Linear Demand Curves Notice that: Slope is constant along linear demand curve but (P/Q) varies, so elasticity varies along the demand curve Demand is more elastic at higher prices since P is larger and Q is smaller Demand is less elastic at lower prices since P is smaller and Q is larger 2-36 Categories of Elasticity of Demand Condition for Ed Elastic Ed<-1 Inelastic 0>Ed>-1 Perfectly Elastic Ed=infinity Perfectly Inelastic Ed=0 Unit Elastic Ed=1 2-37 Figure 2.15: Elasticities Along a Linear Demand Curve 2-38 Total Expenditure and Elasticity of Demand Total expenditure equals P*Q, the product of the price and the total amount demanded Elasticity of demand shows how total expenditure changes when price increases TE will increase with a small increase in price when demand is inelastic and decrease when demand is elastic TE is largest at a price for which elasticity equals -1 2-39 Figure 2.18: Price, Elasticity, and Total Expenditure TE increases where demand is inelastic; for prices below $3.75 TE falls where demand is elastic TE is largest where Ed = -1; when price = $3.75 2-40 Price Elasticity of Supply Responsiveness of a product’s supply to changes in its price Elasticity of supply equals the percentage change in the amount supplied divided by the percentage change in the price Basic ideas are the same as for elasticity of demand % amount supplied Q Q E P P % price s 2-41