Chapter 2 Demand Supply 2 1 Demand 2

Chapter 2: Demand Supply 2. 1 Demand 2. 2 Supply 2. 3 Equilibrium 2. 4 Elasticity

2. 1 Demand & Supply in Perfect Competition Assume a large number of buyers and sellers of a good with full information Ø No one buyer or seller has any market power; individuals are “price-takers” Ø A supply and demand curve exists for every good in every location at one time Ø Demand Supply are simplest in a PC (perfect competition) market Ø 2

Demand: Definition ØA schedule showing amounts of a product that consumers are willing and able to purchase at each specific price during some specified time period, everything else held constant (ceteris paribus) 3

Demand: Origins Demand for a good or service comes from two areas: 1) Derived Demand –desired to make something else (ie: iron is desired to make cars) 2) Direct Demand –desired to be used/consumed itself (ie: Pepsi Vanilla is desired to be drank) n 4

The Law of Demand n There is an inverse relationship between the quantity of anything that people will want to purchase and the price they must pay to obtain it: nceteris paribus (all else held equal) This causes demand curves to be downward sloping n When prices increase, people buy less n When prices decrease, people buy more n 5

The Individual’s Demand Schedule Price of Songs ($) 5 A B 4 C 3 2 Change in Price = Movement along 1 the Demand 0 10 20 30 D E 40 Number of Songs per Year 50 6

Math 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 -2 P Inverse form: P =50 - Qd/2 ØMarkets are defined by: 1) Commodity 2) Geography 3) Time. 7

Change A: Changes in Quantity Demanded A change in a good’s price Causes a change in quantity demanded (the same thing as a movement same demand curve) along the 8

A Change in Quantity Originally, song downloads Demanded cost $2 Price of Songs ($) 5 4 Due to a tax, song downloads increase to $3 3 2 1 0 D 3 20 30 40 50 60 D 1 70 80 Quantity of Songs Demanded 9

Change B: Shifts in Demand A change in non-price determinants of demand (income, tastes, etc) Causes a shift in demand* *The whole demand schedule 10

A Shift in the Demand Suppose universities Curve outlaw the use of Suppose the federal MP 3 Players Decrease in Demand Price of Songs ($) 5 government gives every student an Electrohome MP 3 player 4 3 Increase in Demand 2 1 0 D 3 20 30 40 50 60 D 2 D 1 70 80 Quantity of Songs Demanded 11

Non-Price determinants of Demand 1) Income, wealth 2) Tastes and preferences 3) The price of related goods Complements Substitutes 4) Expectations Future prices Income Product availability 5) Population (market size) What movement would these factors cause? 12

A policy to discourage smoking (no smoking in public buildings) shifts the demand curve left Price of Cigarettes, per pack Shift vrs. Movement $2 D’ 10 A tax raises the price of cigarettes, resulting in a movement along the demand curve $4 $2 D D 20 Number of Cigarettes smoked per day 10 20 Number of Cigarettes smoked per day 13

Normal vrs. Inferior Goods For inferior goods, Demand increases When income decrease Price of Kraft Dinner Price of Chicken For normal goods, Demand decreases With income $2 D’ 10 $2 D’ D 20 Chicken eaten in a month D 10 20 30 Kraft Dinner eaten in a month 14

2. 2 Supply The amount supplied depends on PROFITS, which depend on COSTS Ø Costs depend on Øthe kinds of inputs (factors of production) used Øthe amount of each input used Øprices of inputs used Øtechnology Ø 15

Supply: Definition n A schedule that shows how much of a product a firm will supply at alternative prices for a given time period, ceteris paribus. 16

The Law of Supply • The price of a product or service and the quantity supplied are directly related, ceteris paribus • This creates an upward sloping supply curve • The higher the price of a good, the more sellers will make available • The lower the price of a good, the fewer sellers will make available 17

The Individual Producer’s Supply Schedule Qnty of F $5 550 G 4 400 H 3 350 I 2 250 J 1 200 5 Price of Song ($) Price / Songs Supplied (thousands / year) G 4 H 3 I 2 1 F J Change in Price Movement along The Supply 0 100 200 300400500 600 Quantity of Songs Supplied (thousands of constant-quality units per year) 18

Change A: Change in Quantity Supplied A change in a good’s price Causes A change in quantity supplied. (This is also called a movement along the supply curve. ) 19

Change B: Shifts in Supply A change in non-price determinants of supply Causes A shift in supply 20

A Shift in the Supply Curve Price of Songs ($) 5 When supply decreases the quantity supplied will be less at each price: ie: Singers form a union and successfully negotiate higher wages S 2 b 4 3 a b c d S 2 S 1 d 2 1 0 20 40 60 When supply increases the quantity supplied will be greater at each price: ie: producer finds that she can use some cheaper singers from Newfoundland 80 100 120 140 Quantity of Songs Supplied (millions of constant-quality units per year) 21

Non-Price Determinants of Supply 1) 2) 3) 4) 5) Cost of inputs Technology and Productivity Taxes and Subsidies Price Expectations (in the input market) Number of firms in the industry How will these shift supply? 22

2. 3 Market Equilibrium Ø In the Market, buyers and sellers interact, resulting in a ØSingle Equilibrium of ØOne Equilibrium Price ØOne Equilibrium Quantity 23

Putting Demand Supply Together: Finding Market Equilibrium (1) (2) (3) Price per Constant-Quality Song Quantity Supplied (Songs per year) Quantity Demanded (Songs per year) (4) Difference (2) - (3) (Songs per year) (5) Condition $5 100 million 20 million 80 million Excess quantity supplied (surplus) 4 80 million 40 million Excess quantity supplied (surplus) 3 60 million 2 40 million 80 million -40 million Excess quantity demanded (shortage) 1 20 million 100 million -80 million Excess quantity demanded (shortage) 60 million 0 24

Market Equilibrium: Definition The condition in a S market when quantity supplied equals quantity demanded at a Market clearing, or Q D= Q S E equilibrium, price particular price; a point from where there A B tends to be no movement Excess quantity demanded at price $1 D Excess quantity supplied at price $5 Price pef Song ($) 5 4 3 2 1 0 20 40 60 80 100 Quantity of Songs (millions of constant-quality units per year) 25

The Law of Supply & Demand n The price of any good will adjust until the price is such that the quantity demanded is equal to the quantity supplied n A high price will result in excess supply, pushing price down, and a low price will result in excess demand, pushing price up n the market clears resulting in a single market clearing or equilibrium price. 26

Qd = 500 – 4 p S = -100 + 2 p Q p = price of cranberries (dollars per barrel) Q = demand or supply in millions of barrels per year 27

a. The equilibrium price of cranberries is calculated by equating demand to supply: b. plug equilibrium price into either demand or supply to get equilibrium quantity: 28

Example: The Market For Cranberries Price 125 P*=100 Market Supply: P = 50 + QS/2 • 50 Market Demand: P = 125 - Qd/4 Q* = 100 Quantity 29

Comparative Statics: Shifts in Demand &/or Supply How do you analyze a change in an exogenous variable? 1. ) Decide whether Demand &/or Supply is affected. 2. ) Decide in which direction the affected Ø Demand &/or Supply will move. 3. ) Use a Demand Supply diagram to determine the new equilibrium. 4. ) Calculate the new equilibrium (if possible) 30

Comparative Statics: Gas Prices n Summer 2009: Gas prices at equilibrium are $1. 07 per liter n Winter arrives and people drive less (shift in demand) –The new market equilibrium is $0. 87 per liter n Cold Weather causes a decrease in gas prices 31

Winter Gas Prices E 2 S $1. 07 $0. 87 E 1 D 2 Q 1 Q 2 D 1 32

Simultaneous Shifts Example of a double shift. – 2 events n 1. n 2. supply demand supply P, Q. n only demand P, Q. n only Ø Q is guaranteed 33

Increased Price Example S 1 S 2 P 1 E 2 E 1 D 1 Q 2 D 2 34

Decreased Price Example S 1 P 2 S 2 E 1 E 2 D 1 Q 2 D 2 35

Simultaneous Shifts Example of a double shift. Second possibility: – 2 events n 1. n 2. supply demand n only supply P, Q. n only demand P, Q Ø P is guaranteed 36

Increased Quantity Example S 1 S 2 E 1 P 2 E 2 D 1 Q 1 Q 2 37

Decreased Quantity Example S 1 S 2 E 1 P 2 E 2 D 2 Q 1 D 1 38

p = price of cranberries (dollars per barrel) Q = demand or supply in millions of barrels per year Assume that a plague reduced cranberry supply by 100 and fear of inflection likewise reduced cranberry demand by 100 so that: 39

a. The new equilibrium price of cranberries is calculated by equating demand to supply: b. plug equilibrium price into either demand or supply to get equilibrium quantity: 40

Example: The Market For Cranberries Price 125 POLD=PNew Market Supply: P = 100 + QS/2 Old Market Supply: P = 50 + QS/2 • 50 Old Market Demand: P = 125 - Qd/4 QNew QOLD Quantity New Market Demand: P = 100 - Qd/4 41

2. 4 Elasticity: Percentage Change n. Which is more common? – GDP increases by 1. 4% OR GDP increases by $2. 1 Billion – Inflation is 3. 2% OR “Prices have gone up between 5 cents and $350, 000 n. Percentage changes are easier to grasp than the amount of change – Economists often use elasticities to examine percentage change or responsiveness 42

Price Elasticity of Demand n Price Elasticity of Demand (Є Q, p) – The responsiveness of quantity demanded of a commodity to changes in its price – Related to the slope, but concerned with percentage changes 43

Price (dollars per pizza) One Impact of a Change in Supply S 0 40. 00 … a 30. 00 large fall in price. . . S 1 An increase in supply brings. . . Large price change and small quantity change 20. 00 10. 00 … and a small increase in quantity 5. 00 0 5 10 13 15 Da 20 25 Quantity (pizzas per hour) 44

Price (dollars per pizza) Another Impact of a Change in Supply… An increase in supply S 0 brings. . . 40. 00 30. 00 … a small fall in price. . . 20. 00 15. 00 Small price change and large quantity change Db 10. 00 0 S 1 … and a large increase in quantity 5 10 25 15 17 20 Quantity (pizzas per hour) 45

Solution: Price Elasticity of Demand ЄQ, P Percentage change in quantity demanded Percentage change in price The ratio of the two percentages is a number without units. 46

Price Elasticity n Example – Price of oil increases 10% – Quantity demanded decreases 1% When calculating the price elasticity of demand, we often ignore the minus sign for % change in Q. 47

TYPES OF ELASTICITY -Hypothetical Demand Elasticities 48

Price Elasticity Ranges: Extreme Price Elasticities Perfect elasticity, D Price P 1 P 0 0 8 Quantity Demanded per Year (millions of units) 30 D P 1 Price Perfect inelasticity, zero elasticity, no matter how much Price changes, Quantity stays the same; insulin infinite elasticity, the slightest increase in price will lead to zero sales. P 1 is the demand curve 0 Quantity Demanded per Year (millions of units) 49

Price Elasticity Ranges Summary from Table n Elastic Demand n Unit Elastic n Inelastic Demand 50

Elasticity of Demand n Calculating ЄQ, P or se ays u nt Alw i id-po the m la formu elasticity Change in Q Sum of quantities/2 Change in P Sum of prices/2 Change in Q ЄQ, P (Q 1 + Q 2 )/2 or Change in P (P 1 + P 2 )/2 Q ЄQ, P Avg. Q P Avg. P 51

Calculating the Elasticity of Demand Price (dollars/pizza) Original point 20. 50 Elasticity ΔP=1 /Qave = /Pave 20. 00 = 2/10 1/20 =4 New point 19. 50 D Qave =1/2(11+9)=10 Pave =1/2(20. 50+19. 50)=20 9 10 ΔQ=2 11 Quantity (pizzas/hour) 52

Elasticity of Demand (mid-point) Q =2 % Q =20% ЄQ, P = Q 1 + Q 2 (9 + 11) 2 P = $1. 00 % P =5% X 100 = 10 = ЄQ, P = P 1 + P 2 ($20. 50 + $19. 50) 20% 4 = 5% X 100 = $20 2 Always use the mid-point formula for calculating elasticity 53

Elasticity: Example You are the consulting economist to the Guelph transportation commission, n The current fare is $. 95 n There are 17, 500 riders per day n For each $. 10 increase in the fare, rider ship decreases by 10, 000 riders per day. n What is the price elasticity of demand at the current fare? n Should fares be raised or lowered? n What fare will maximize revenue? . . . n 54

Elasticity: Example Should fares be raised or lowered? n What fare will maximize revenue? . . . n 55

Total Revenue and Elasticity Total Revenue = Price Per Good X # of Goods Sold TR = P X Q Assumption : Costs are constant 56

Elastic demand Price . 80 Unit elastic . 55 Inelastic demand 0 55 3. 00 (dollars) Total Revenue Elasticity and Total Revenue 1. 10 When demand is elastic, price cut increases total revenue Quantity 110 Maximum total revenue When demand is inelastic, price cut decreases total revenue Quantity 0 55 110 57

Relationship Between Price Elasticity of Demand Total Revenues Price Elasticity of Demand Effect of Price Change on Total Revenues (TR) Price Decrease Inelastic (ЄQ, P < 1) TR Unit-elastic (ЄQ, P = 1) No change Elastic (ЄQ, P > 1) Price Increase TR No change TR Note: It is possible to classify elasticity by observing the change in revenue from a price change 58

Exercise • • • 2 drivers - Tom & Jerry each drive to to a gas station. Before looking at the price, each places an order. Tom says, “I’d like 10 litres of gas”. Jerry says, “I’d like $10 of gas”. What is each driver’s price elasticity of demand? 59

Determinants of Price Elasticity of Demand n Existence of substitutes – Goods are more price elastic if substitutes exist n Share of budget – Goods are more price elastic when a consumer’s expenditure on the good is large (in dollar terms or relatively) n Necessity – Goods are less price elastic when seen as a necessity 60

Market and Brand Elasticities n Market equal and Brand Elasticities are not – Although a water addict is very price inelastic to the price of bottled water in general, he/she would quickly switch to another brand if only 1 brand of water increased in price – GENERALLY, Brand price elasticity of demand is higher than market price elasticity of demand 61

Qd = a – bp a, b are positive constants p is price ·-b is the slope ·a/b is the choke price (price at which nothing is sold) 62

·the elasticity is Q, P = ( Q/ p)(p/Q) = -b(P/Q) Since the slope of the graph is –b. Therefore…elasticity falls from 0 to - along the linear demand curve, but slope is constant. ·if Qd = 400 – 10 p, and p = 30, Q, P = (-10)(30)/(100) Q, P = -3 "elastic" 63

Changes in Elasticity Along a Linear Demand 1. 10 Elastic (ЄQ, P > 1) 1. 00 Price per Minute ($) . 90 Unit-elastic (ЄQ, P = 1) . 80 Inelastic (ЄQ, P < 1) . 70. 60. 50. 40. 30 D . 20. 10 0 1 2 3 4 5 6 7 8 9 Quantity per Period (billions of minutes) 10 11 64

The Relationship Between Price Elasticity of Demand Total Revenues for Cellular Phone Service Quantity Price Demanded Total Elasticity Revenue ЄQ, P $1. 10 1. 00 0 1. 0 21. 000 . 90. 80 2 3 1. 8 2. 4 3. 400 4 5 2. 8 3. 0 . 50. 40 6 7 3. 0 2. 8 . 30. 20 8 9 2. 4 1. 8 . 10 10 1. 0 . 70. 60 6. 333 Elastic 2. 143 1. 144 1. 000 Unit-elastic. 692. 467. 294. 158 Inelastic 65

Qd = Ap or ln(Qd)=ln(A)+ Ln(p) = elasticity of demand (must be negative) p = price A = constant ·Elasticity is constant, but the slope of demand falls from 0 to -. 66

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 67

Elasticity of Supply n Calculating ЄQs, P elasticity Change in Q Change in P Sum of quantities/2 Sum of prices/2 or se ays u int Alw o mid-p the la ormu f Change in Q ЄQs, P (Q 1 + Q 2 )/2 or ЄQs, P Change in P (P 1 + P 2 )/2 Q Avg. Q P Avg. P 68

Price (dollars per pizza) One example of a Change in Demand 40. 00 An increase in demand brings. . . Sa Large price change and small quantity change 30. 00 20. 00 10. 00 0 … a large price rise. . . … and a small quantity increase 5 10 13 15 D 1 20 25 D 0 Quantity (pizzas per hour) 69

Price (dollars per pizza) Another example of a Change in Demand 40. 00 Small price change and large quantity change An increase in demand brings. . . 30. 00 21. 00 20. 00 10. 00 Sb … a small price rise. . . … and a large quantity increase D 1 D 0 0 5 10 15 20 25 Quantity (pizzas per hour) 70

Elasticity of Supply n Elasticity of supply ranges Ø(from) Perfectly Elastic Supply ØQuantity supplied falls to 0 when there is any decrease in price Ø(to) Perfectly Inelastic Supply ØQuantity supplied is constant no matter what happens to price 71

supply = 0 Price Supply Elasticity Ranges of S Elasticity S Quantity supplied is the same for any price! 0 Quantity Elasticity of supply = Suppliers will offer ANY quantity at this price 0 Quantity 72

Elasticity of Supply: Depends On: 1. Resource substitution possibilities, -The more unique the resource, the more inelastic the supply. 2. Time frame for the supply decision, Momentary supply Long-run supply Short-run supply - Typically, the longer producers have to adjust to a price change, the more elastic is supply. 73

Long-Run Elasticity of Demand -For most goods, elasticity of demand is greater in the long run (curves are “flatter”) Ø People are more able to adjust to changes over time (slowly switch consumption) -For essential durable goods (ie: Cars), long-run demand elasticity is less (curves are “steeper”) Ø People can change their purchases or suppliers now, but eventually they have 74

Long-Run Elasticity of Supply -For most goods, elasticity of supply is greater in the long run (curves are “flatter”) Ø Firms are more able to adjust to changes over time (slowly switch production) -For reusable goods (ie: Aluminum), longrun supply elasticity is less (curves are “steeper”) Ø People resell their supplies when prices go up, but eventually their supplies run out 75

Supply Elasticity and the Long Run (most non-durable, non-essential goods) Price per Unit S 1 S 2 S 3 P 1 Pe As time passes, the supply curve rotates to S 2 and then to S 3 and quantity supplied rises first to Q 1 and then to Q 2 Qe Q 1 Q 2 Quantity Supplied per Period 76

When is the Long Run? Ø The long run is how long a consumer or firm takes to fully adjust to a price change ØTime required to change ANY variable Øie) Give up Pepsi Vanilla, Build more cost efficient Pepsi factory, secure a US Pepsi Vanilla supplier Ø The short run is anything shorter than the long run ØAt least one variable cannot be changed 77

Cross Price Elasticity of Demand n Demand is affected by the price of substitutes and compliments – An increase in the price of a substitute increases demand – An increase in the price of a complement decrease demand n This effect can be measured using cross price elasticity n If the cross price elasticity is zero, the good is neither a complement nor a substitute 78

Cross Price Elasticity of Demand Є Qi, Pj = Percentage change in quantity demanded of X Percentage change in price of Y Change in X -------(X 1 + X 2)/2 / Change in Price of Y --------------(Py 1 + Py 2)/2 Substitutes – Positive Cross Price Elasticity Compliments – Negative Cross Price Elasticity 79

Cross Price Elasticity of Demand Example “Recent cat attacks have prompted cat owners to buy guns for selfdefense” n. Originally, 2 Econ students owned a cat. After the price of guns went from $100 to $200, only 1 Econ student owned a cat. n. Calculate the cross-price elasticity of 80

Cross-Price Elasticity Q = -1 % Qi =-66% ЄQ, P = Q 1 + Q 2 (2 + 1) 2 P = $100 % PJ =66% X 100 = 1. 5 = ЄQi, Pj = P 1 + P 2 ($100 + $200) -66% -1 = X 100 = $150 2 Are cats and guns substitutes or compliments? 81

Income Elasticity of Demand n Income Elasticity of demand refers to a HORIZONTAL SHIFT in the demand curve resulting from an income change n Price elasticity of demand refers to a MOVEMENT ALONG THE DEMAND CURVE in response to a price change 82

Income Elasticity of Demand Є Q, I= Percentage change in quantity demanded Percentage change in income Change in Q -------(Q 1 + Q 2)/2 / Change in M --------------(M 1 + M 2)/2 Normal Good – Positive Shift/Elasticity Inferior Good – Negative Shift/Elasticity 83

Income Elasticity of Demand Example n In New Zealand, the average family will own 4 Toyotas in their lifetime. n If average Kiwi family income rose from $140 K to $160 K a year, the average Kiwi family would own 2 Toyotas over their lifetime n Calculate Income Elasticity of Demand for Toyotas in New Zealand. n Are Toyotas normal or inferior goods in New Zealand? 84

Income Elasticity of Demand Q = -2 % Q =-66% ЄQ, I = Q 1 + Q 2 (4 + 2) 2 I = $20 K % I =13. 3 % X 100 =3 = ЄQi, Pj = -66% I 1 + I 2 ($140 K + $160 K) 13. 3% = -5 X 100 = $150 K 2 In New Zealand, are Toyotas normal or inferior goods? Guess which brand is the luxury car. 85

Chapter 2 Key Ideas Ø Supply and Demand ØSupply and Demand Movements Ø Equilibrium Ø Elasticity of Demand ØTotal Revenue Maximizing Ø Elasticity of Supply Ø Cross Price Elasticity of Demand Ø Income Elasticity 86