Chapter 2 The Basics of Supply and Demand © 2005 Pearson Education, Inc. Chapter 2
The Supply Curve S Price ($ per unit) The Supply Curve Graphically P 2 The supply curve slopes upward demonstrating that at higher prices firms will increase output P 1 Q 1 © 2005 Pearson Education, Inc. Q 2 Chapter 2 Quantity 2
Introduction l What are supply and demand? l What is the market mechanism? l What are the effects of changes in market equilibrium? l What are elasticities of supply and demand? © 2005 Pearson Education, Inc. Chapter 2 3
Topics to Be Discussed l How do short-run and long-run elasticities differ? l How do we understand predict the effects of changing market conditions? l What are the effects of government intervention – price controls? © 2005 Pearson Education, Inc. Chapter 2 4
Supply and Demand l Supply and demand analysis can: 1. 2. 3. Help us understand predict how 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 © 2005 Pearson Education, Inc. Chapter 2 5
Supply and Demand l The Supply Curve m The relationship between the quantity of a good that producers are willing to sell and the price of the good. m Measures quantity on the x-axis and price on the y-axis © 2005 Pearson Education, Inc. Chapter 2 6
The Supply Curve l Other Variables Affecting Supply m Costs of Production l Labor l Capital l Raw Materials m Lower costs of production allow a firm to produce more at each price and vice versa © 2005 Pearson Education, Inc. Chapter 2 7
Change in Supply l The cost of raw materials falls m m m Produced Q 1 at P 1 and Q 0 at P 2 Now produce Q 2 at P 1 and Q 1 at P 2 Supply curve shifts right to S’ P S P 1 P 2 Q 0 © 2005 Pearson Education, Inc. S’ Chapter 2 Q 1 Q 2 Q 8
The Supply Curve l Change in Quantity Supplied m Movement along the curve caused by a change in price l Change in Supply m Shift of the curve caused by a change in something other than price l Change © 2005 Pearson Education, Inc. in costs of production Chapter 2 9
Supply and Demand l The Demand Curve m The relationship between the quantity of a good that consumers are willing to buy and the price of the good. m Measures quantity on the x-axis and price on the y-axis © 2005 Pearson Education, Inc. Chapter 2 10
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. P 2 P 1 D Q 1 © 2005 Pearson Education, Inc. Q 2 Chapter 2 Quantity 11
The Demand Curve l Other Variables Affecting Demand m Income l Increases in income allow consumers to purchase more at all prices m Consumer Tastes m Price of Related Goods l Substitutes l Complements © 2005 Pearson Education, Inc. Chapter 2 12
The Demand Curve l Changes in quantity demanded m Movements along the demand curve caused by a change in price. l Changes in demand m. A shift of the entire demand curve caused by something other than price. l Income l Preferences © 2005 Pearson Education, Inc. Chapter 2 13
The Market Mechanism l The market mechanism is the tendency in a free market for price to change until the market clears l Markets clear when quantity demanded equals quantity supplied at the prevailing price l Market Clearing price – price at which markets clear © 2005 Pearson Education, Inc. Chapter 2 14
The Market Mechanism S Price ($ per unit) The curves intersect at equilibrium, or marketclearing, price. Quantity demanded equals quantity supplied at P 0 D Q 0 © 2005 Pearson Education, Inc. Chapter 2 Quantity 15
Oun Lopez: Start of Lecture 3 The Market Mechanism l In equilibrium m There is no shortage or excess demand m There is no surplus or excess supply m Quantity supplied equals quantity demanded m Anyone who wished to buy at the current price can and all producers who wish to sell at that price can © 2005 Pearson Education, Inc. Chapter 2 16
The Market Mechanism S Price ($ per unit) Who Supplies? -Producers with willingness-to-accept (WTA) prices below P*. P 0 D Q 0 © 2005 Pearson Education, Inc. -Market S and D curves include the S and D curves of individual consumers and producers. Who Buys? -Only those consumers who are willing-to-pay (WTP) above P*. Quantity Chapter 2 17
Market Surplus l The market price is above equilibrium m There is excess supply - surplus m Downward pressure on price m Quantity demanded increases and quantity supplied decreases m The market adjusts until new equilibrium is reached © 2005 Pearson Education, Inc. Chapter 2 18
The Market Mechanism Price ($ per unit) S 1. Surplus P 1 2. 3. P 0 4. D QD Q 0 © 2005 Pearson Education, Inc. Chapter 2 QS Price is above the market clearing price – P 1 Qs > Q D Price falls to the market-clearing price Market adjusts to equilibrium Quantity 19
The Market Mechanism Price ($ per unit) S 1. 2. 3. P 3 4. P 2 D Shortage QS © 2005 Pearson Education, Inc. Q 3 Chapter 2 Price is below the market clearing price – P 2 QD > Q S Price rises to the marketclearing price Market adjusts to equilibrium QD Quantity 20
The Market Mechanism l The market price is below equilibrium: m There is a excess demand - shortage m Upward pressure on prices m Quantity demanded decreases and quantity supplied increases m The market adjusts until the new equilibrium is reached. © 2005 Pearson Education, Inc. Chapter 2 21
The Market Mechanism l Supply and demand interact to determine the market-clearing price. l When not in equilibrium, the market will adjust to alleviate a shortage or surplus and return the market to equilibrium. l Markets must be competitive for the mechanism to be efficient. © 2005 Pearson Education, Inc. Chapter 2 22
Changes In Market Equilibrium l Equilibrium prices are determined by the relative level of supply and demand. l Changes in supply and/or demand will change in the equilibrium price and/or quantity in a free market. © 2005 Pearson Education, Inc. Chapter 2 23
Changes In Market Equilibrium l Raw material prices fall m m m P D S S’ S shifts to S’ Surplus at P 1 between Q 1, Q 2 P 1 Price adjusts to equilibrium at P 3, Q 3 P 3 Q 1 Q 3 Q 2 © 2005 Pearson Education, Inc. Chapter 2 Q 24
Changes In Market Equilibrium P l Income Increases m m m D D’ S Demand increases to D 1 Shortage at P 1 of Q 1, P 3 Q 2 P 1 Equilibrium at P 3, Q 3 Q 1 Q 3 Q 2 © 2005 Pearson Education, Inc. Chapter 2 Q 25
Changes In Market Equilibrium l Income Increases & raw material prices fall m m Quantity increases If the increase in D is greater than the increase in S price also increases P D D’ S S’ P 2 P 1 Q 1 © 2005 Pearson Education, Inc. Chapter 2 Q 26
Shifts in Supply and Demand l 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 © 2005 Pearson Education, Inc. Chapter 2 27
The Price of a College Education l The real price of a college education rose 55 percent from 1970 to 2002. l Increases in costs of modern classrooms and wages increased costs of production – decrease in supply l Due to a larger percentage of high school graduates attending college, demand increased © 2005 Pearson Education, Inc. Chapter 2 28
The Market Mechanism S Price ($ per unit) Who Supplies? -Producers with willingness-to-accept (WTA) prices below P*. P 0 D Q 0 © 2005 Pearson Education, Inc. -Market S and D curves include the S and D curves of individual consumers and producers. Who Buys? -Only those consumers who are willing-to-pay (WTP) above P*. Quantity Chapter 2 29
Market for a College Education S 2002 P (annual cost in 1970 dollars) $3, 917 S 1970 New equilibrium was reached at $4, 573 and a quantity of 12. 3 million students $2, 530 D 1970 © 2005 Pearson Education, Inc. 8. 6 13. 2 Chapter 2 D 2002 Q (millions enrolled)) 30
Resource Market Equilibrium Price S 1900 S 1950 S 2002 Long-Run (LR) Path of Price and Consumption (LR demand) D 1900 D 1950 D 2002 Quantity © 2005 Pearson Education, Inc. Chapter 2 31
Elasticities of Supply and Demand l How much do markets change? l Elasticity gives a way to measure how a variable will change when another variable changes. l Elasticity (Def): the percentage change in one variable resulting from a one percent change in another. © 2005 Pearson Education, Inc. Chapter 2 32
Price Elasticity of Demand l Measures the sensitivity of quantity demanded to price changes. m It measures the percentage change in the quantity demanded of a good that results from a one percent change in price. © 2005 Pearson Education, Inc. Chapter 2 33
Price Elasticity of Demand l The percentage change in a variable is the absolute (actual) change in the variable divided by the original level of the variable. l Therefore, elasticity can also be written as: © 2005 Pearson Education, Inc. Chapter 2 34
Price Elasticity of Demand l Usually a negative number m As price increases, quantity decreases m As price decreases, quantity increases l When EQ, P > 1, the good is price elastic m % Q > % P l When EQ, P < 1, the good is price inelastic m % Q © 2005 Pearson Education, Inc. < % P Chapter 2 35
Price Elasticity of Demand l Primary determinant of -Availability of substitutes. m. Many substitutes: demand is price elastic m. Few substitutes demand is price inelastic © 2005 Pearson Education, Inc. Chapter 2 36
Price Elasticity of Demand l Linear demand curve: Q/ P is constant l Values of P and Q change l Price elasticity of demand must therefore be measured at a particular point on the demand curve l Elasticity will change along the demand curve in a particular way © 2005 Pearson Education, Inc. Chapter 2 37
Price Elasticity of Demand l Given a linear demand curve m Elasticity depends on slope and on the values of P and Q m The top portion of demand curve is elastic l Price is high and quantity small m The bottom portion of demand curve is inelastic l Price © 2005 Pearson Education, Inc. is low and quantity high Chapter 2 38
Price Elasticity of Demand Price 4 EP = - Demand Curve Q = 8 – 2 P Elastic Ep = -1 2 Inelastic 4 © 2005 Pearson Education, Inc. 8 Chapter 2 Q Ep = 0 39
Price Elasticity of Demand l The steeper the demand curve becomes, the more inelastic the good. l The flatter the demand curve becomes, the more elastic the good © 2005 Pearson Education, Inc. Chapter 2 40
Infinitely Elastic Demand (Extreme Case) Price EP = D P* QD changes infinitely with the smallest possible change in price. Quantity © 2005 Pearson Education, Inc. Chapter 2 41
Completely Inelastic Demand (Extreme Case) Price D EP = 0 QD never changes, even with large changes in price. Q* © 2005 Pearson Education, Inc. Chapter 2 Quantity 42
Other Demand Elasticities l Income Elasticity of Demand m Measures how much quantity demanded changes with a change in income. © 2005 Pearson Education, Inc. Chapter 2 43
Other Demand Elasticities l Cross-Price Elasticity of Demand m Measures the percentage change in the quantity demanded of one good that results from a one percent change in the price of another good. © 2005 Pearson Education, Inc. Chapter 2 44
Other Demand Elasticities l Complements: Cars and Tires m Cross-price elasticity of demand is negative l Price of cars increases, quantity demanded of tires decreases l Substitutes: Butter and Margarine m Cross-price elasticity of demand is positive l Price of butter increases, quantity of margarine demanded increases © 2005 Pearson Education, Inc. Chapter 2 45
Price Elasticity of Supply l Measures the sensitivity of quantity supplied given a change in price m Measures the percentage change in quantity supplied resulting from a 1 percent change in price. © 2005 Pearson Education, Inc. Chapter 2 46
Point v. Arc Elasticities l Point elasticity of demand m Price elasticity of demand at a particular point on the demand curve l Arc elasticity of demand m Price elasticity of demand calculated over a range of prices © 2005 Pearson Education, Inc. Chapter 2 47
Elasticity: An Application l Wheat Market Changes (1980 s and 1990 s) l Analyzing the Wheat Market © 2005 Pearson Education, Inc. Chapter 2 48
Elasticity: An Application l Supply: QS = 1800 + 240 P l Demand: QD = 3550 – 266 P Analyze this market. 1)What are the initial P* and Q*? 2)How does demand change when price changes? 3)How does supply change when price changes? © 2005 Pearson Education, Inc. Chapter 2 49
Elasticity: An Application QD = QS 1800 + 240 P = 3550 – 266 P 506 P = 1750 P = $3. 46 per bushel Q = 1800 + (240)(3. 46) = 2630 million bushels © 2005 Pearson Education, Inc. Chapter 2 50
Elasticity: An Application l We can find the elasticities of demand supply at these points © 2005 Pearson Education, Inc. Chapter 2 51
Elasticity: An Application l Assume the price of wheat is $4. 00/bushel due to decrease in supply © 2005 Pearson Education, Inc. Chapter 2 52
Elasticity: An Application l In 2002, the supply and demand for wheat were: m Supply: QS = 1439 + 267 P m Demand: QD = 2809 – 226 P © 2005 Pearson Education, Inc. Chapter 2 53
Elasticity: An Application QD = Q S 2809 - 226 P = 1439 + 267 P P = $2. 78 per bushel Q = 2809 - (226)(2. 78) = 2181 million bushels © 2005 Pearson Education, Inc. Chapter 2 54
Short-Run Versus Long-Run Elasticity l Price elasticity varies with the amount of time consumers have to respond to a price. l Short run demand supply curves often look very different from their longrun counterparts. © 2005 Pearson Education, Inc. Chapter 2 55
Short-Run Versus Long-Run Elasticity l Demand m In general, demand is much more price elastic in the long run l Consumers take time to adjust consumption habits l Demand might be linked to another good that changes slowly l More substitutes are usually available in the long run © 2005 Pearson Education, Inc. Chapter 2 56
Gasoline: Short-Run and Long-Run Demand Curves Price DSR • People cannot easily adjust consumption in short run. • In the long run, people tend to drive smaller and more fuel efficient cars. DLR Quantity of Gas © 2005 Pearson Education, Inc. Chapter 2 57
Short-Run Versus Long-Run Elasticity l Demand Durability m For some durable goods, demand is more elastic in the short run m If goods are durable, then when price increases, consumers choose to hold on to the good instead of replacing it m But in long run, older durable goods will have to be replaced © 2005 Pearson Education, Inc. Chapter 2 58
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 © 2005 Pearson Education, Inc. Chapter 2 59
Short-Run Versus Long-Run Elasticity l Income elasticity also varies with the amount of time consumers have to respond to an income change. m For most goods and services, income elasticity is larger in the long run m When income changes, it takes time to adjust spending © 2005 Pearson Education, Inc. Chapter 2 60
Short-Run Versus Long-Run Elasticity l Income elasticity of durable goods m Income elasticity is less in the long-run than in the short-run. l Increases in income mean consumers will want to hold more cars. l Once older cars replaced, purchases will only to be to replace old cars. l Less purchases from income increase in long run than in short run © 2005 Pearson Education, Inc. Chapter 2 61
Demand for Gasoline © 2005 Pearson Education, Inc. Chapter 2 62
Demand for Automobiles © 2005 Pearson Education, Inc. Chapter 2 63
Short-Run Versus Long-Run Elasticity l Most goods and services: m Long-run price elasticity of supply is greater than short-run price elasticity of supply. l Other Goods (durables, recyclables): m Long-run price elasticity of supply is less than short-run price elasticity of supply © 2005 Pearson Education, Inc. Chapter 2 64
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. © 2005 Pearson Education, Inc. Chapter 2 Quantity Primary Copper 65
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 © 2005 Pearson Education, Inc. Chapter 2 66
Supply of Copper © 2005 Pearson Education, Inc. Chapter 2 67
Declining Demand the Behavior of Copper Prices l Copper has gone through difficult market changes leading to significantly reduced prices most from decreased demand from m. A decrease in the growth rate of power generation m The development of substitutes: fiber optics and aluminum © 2005 Pearson Education, Inc. Chapter 2 68
Short-Run v. Long-Run Elasticity – An Application l Why are coffee prices very volatile? m Most of the world’s coffee produced in Brazil. m Many changing weather conditions affect the crop of coffee, thereby affecting price m Price following bad weather conditions is usually short-lived m In long run, prices come back to original levels, all else equal © 2005 Pearson Education, Inc. Chapter 2 69
Price of Brazilian Coffee © 2005 Pearson Education, Inc. Chapter 2 70
Short-Run v. Long-Run Elasticity – An Application l Demand supply are more elastic in the long run l In short-run, supply is completely inelastic m Weather may destroy part of the fixed supply, decreasing supply l Demand relatively inelastic as well l Price increases significantly © 2005 Pearson Education, Inc. Chapter 2 71
An Application - Coffee Price S’ S A freeze or drought decreases the supply of coffee Price increases significantly due to inelastic supply and demand P 1 P 0 D © 2005 Pearson Education, Inc. Q 1 Q 0 Chapter 2 Quantity 72
An Application - Coffee Price S’ S Intermediate-Run 1) Supply and demand are more elastic 2) Price falls back to P 2 P 0 D © 2005 Pearson Education, Inc. Q 2 Q 0 Quantity Chapter 2 73
An Application - Coffee Price Long-Run 1) Supply is extremely elastic. 2) Price falls back to P 0. 3) Quantity back to Q 0. S P 0 D Q 0 © 2005 Pearson Education, Inc. Chapter 2 Quantity 74
Price of Brazilian Coffee © 2005 Pearson Education, Inc. Chapter 2 75
Effects of Price Controls l Markets are rarely free of government intervention m Imposed taxes and granted subsidies m Price controls l Price controls usually hold the price above or below the equilibrium price m Excess demand – shortage m Excess supply - surplus © 2005 Pearson Education, Inc. Chapter 2 76
Effects of Price Controls (Price Ceiling) Price S • Price is regulated to be no higher than Pmax, • Quantity supplied falls and quantity demanded increases • A shortage results P 0 Pmax Shortage QS © 2005 Pearson Education, Inc. Q 0 Chapter 2 D QD Quantity 77
Effects of Price Controls (Price Ceiling) Price S • Price is regulated to be no higher than Pmax • This price ceiling is not binding. • Equilibrium P is maintained. Pmax P 0 D Q 0 © 2005 Pearson Education, Inc. Chapter 2 Quantity 78
Effects of Price Controls (Price Floor) Price S Surplus Pmax P* • Price is regulated to be no lower than Pmax • This price floor creates a surplus D QS © 2005 Pearson Education, Inc. Q* Chapter 2 Quantity 79
Effects of Price Controls l Excess demand sometimes takes the form of queues m Lines at gas stations during 1974 shortage l Sometimes get curtailments and supply rationing m Natural gas shortage of the mid ’ 70’s l Producers typically lose, but some consumers gain. Some consumers lose. © 2005 Pearson Education, Inc. Chapter 2 80
Price Controls and Natural Gas Shortages l In 1954, the federal government began regulating the wellhead price of natural gas. l In 1962, the ceiling prices that were imposed became binding and shortages resulted. © 2005 Pearson Education, Inc. Chapter 2 81
Price Controls and Natural Gas Shortages l Price controls created an excess demand of 7 trillion cubic feet. l Price regulation was a major component of U. S. energy policy in the 1960 s and 1970 s, and it continued to influence the natural gas markets in the 1980 s. © 2005 Pearson Education, Inc. Chapter 2 82
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