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Chapter 2: The Basics of Supply and Demand Slide 1
Supply and Demand
The Supply CurveThe 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
This price-quantity relationship can be shown by the equation:
)(PQQ ss
Chapter 2: The Basics of Supply and Demand Slide 2
Supply and Demand
S
The supply curve slopesupward demonstrating that
at higher prices, firmswill increase output
The SupplyCurve Graphically
The SupplyCurve Graphically
Quantity
Price($ per unit)
P1
Q1
P2
Q2
Chapter 2: The Basics of Supply and Demand Slide 3
Supply and Demand
The cost of raw materials falls
At P1, produce Q2
At P2, produce Q1
Supply curve shifts right to S’
More produced at any price on S’ than on S
P S
Change in SupplyChange in Supply
Q
P1
P2
Q1Q0
S’
Q2
Chapter 2: The Basics of Supply and Demand Slide 4
Supply and Demand
The Demand CurveThe 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:
(P)QQ DD
Chapter 2: The Basics of Supply and Demand Slide 5
Supply and Demand
D
The demand curve slopesdownward demonstrating that consumers are willing
to buy more at a lower price
Quantity
Price($ per unit)
Chapter 2: The Basics of Supply and Demand Slide 6
DP
QQ1
P2
Q0
P1
D’
Q2
Change in DemandChange in Demand
Supply and Demand
Income Increases At P1, purchase Q2
At P2, purchase Q1
Demand Curve shifts right
More purchased at any price on D’ than on D
Chapter 2: The Basics of Supply and Demand Slide 7
The Market Mechanism
Quantity
D
S
The curves intersect atequilibrium, or market-
clearing, price. At P0 thequantity supplied is equalto the quantity demanded
at Q0 .
P0
Q0
Price($ per unit)
Chapter 2: The Basics of Supply and Demand Slide 8
The Market Mechanism
D
S
Q1
Assume the price is P1 , then:1) Qs : Q2 > Qd : Q1 2) Excess supply is Q2 – Q1.3) Producers lower price.4) Quantity supplied decreases
and quantity demanded increases.
5) Equilibrium at P2Q3
P1
Surplus
Q2 Quantity
Price($ per unit)
P2
Q3
Chapter 2: The Basics of Supply and Demand Slide 9
The Market Mechanism
D
S
Q1 Q2
P2
Shortage
Quantity
Price($ per unit)
Assume the price is P2 , then:1) Qd : Q2 > Qs : Q1
2) Shortage is Q2 – Q1.3) Producers raise price.
4) Quantity supplied increases and quantity demanded decreases.
5) Equilibrium at P3, Q3
Q3
P3
Chapter 2: The Basics of Supply and Demand Slide 10
D’ S’ Income Increases & raw material prices fall
The increase in D is greater than the increase in S
Equilibrium price and quantity increase to P2, Q2
P
Q
S
P2
Q2
D
P1
Q1
Changes In Market Equilibrium
Chapter 2: The Basics of Supply and Demand Slide 11
Example 1: Market for Eggs
Q (million dozens)
P(1970
dollars perdozen)
D1970
S1970
$0.61
5,500
D1998
S1998
Prices fell untila new equilibrium
was reached at $0.26and a quantity
of 5,300 million dozen
$0.26
5,300
Chapter 2: The Basics of Supply and Demand Slide 12
Example 2: Market for a College Education
Q (millions of students enrolled))
P(annual cost
in 1970dollars)
D1970
S1970
S1995
D1995
$4,573
12.3
Prices rose untila new equilibrium
was reached at $4,573and a quantity
of 12.3 million students
$2,530
7.4
Chapter 2: The Basics of Supply and Demand Slide 13
Elasticities of Supply and Demand
Measures the sensitivity of quantity demanded to price changes.
It measures the % change in the quantity demanded for a good or service that results from a one percent change in the price.
The price elasticity of demand is:
Price Elasticity of DemandPrice Elasticity of Demand
P)Q)/(%(% EP
Chapter 2: The Basics of Supply and Demand Slide 14
Elasticities of Supply and Demand
The % change in a variable is the absolute change in the variable divided by the original level of the variable. So the price elasticity of demand is also:
Price Elasticity of DemandPrice Elasticity of Demand
P
Q
Q
P
P/P
Q/Q EP
Chapter 2: The Basics of Supply and Demand Slide 15
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| > 1, the % change in quantity demanded is greater than the % change in price. We say demand is price elastic.
3) If |EP| < 1, the % change in quantity demanded is less than the % change in price. We say demand is price inelastic.
Chapter 2: The Basics of Supply and Demand Slide 16
Price Elasticities of Demand
Q
Price
Q = 8 - 2P
Ep = -1
Ep = 0
- EP The lower portion of a downward sloping
demand curve is less elasticthan the upper portion.
4
8
2
4
Linear Demand CurveQ = a - bPQ = 8 - 2P
Chapter 2: The Basics of Supply and Demand Slide 17
Elasticities of Supply and Demand
Income elasticity of demand measures the % change in quantity demanded resulting from a one percent change in income. The income elasticity of demand is:
Other Demand ElasticitiesOther Demand Elasticities
I
Q
Q
I
I/I
Q/Q EI
Chapter 2: The Basics of Supply and Demand Slide 18
Elasticities of Supply and Demand
Cross price elasticity of demand = the % change in the quantity demanded of one good that results from a one percent change in the price of another good.
The cross price elasticity for substitutes is positive, while that for complements is negative. For example, consider the substitute goods, butter and margarine.
Other Demand ElasticitiesOther Demand Elasticities
m
b
b
m
mm
bbPQ
P
Q
Q
P
/PP
/QQ E mb
Chapter 2: The Basics of Supply and Demand Slide 19
Elasticities of Supply and Demand
Price elasticity of supply measures the % change in quantity supplied resulting from a 1% change in price.
The elasticity is usually positive because price and quantity supplied are positively related (Higher price gives producers an incentive to increase output)
We can refer to elasticity of supply with respect to interest rates, wage rates, and the cost of raw materials.
Elasticities of SupplyElasticities of Supply
Chapter 2: The Basics of Supply and Demand Slide 20
SR Versus LR Elasticities
Price elasticity of demand varies with the amount of time consumers have to respond to a price.
Most goods and services: Short-run elasticity is less than long-run elasticity (e.g.
gasoline). People tend to drive smaller and more fuel efficient cars in the long-run
Other Goods (durables): Short-run elasticity is greater than long-run elasticity (e.g.
automobiles). People may put off immediate consumption, but eventually older cars must be replaced.
Price Elasticity of DemandPrice Elasticity of Demand
Chapter 2: The Basics of Supply and Demand Slide 21
Most goods and services: Income elasticity is greater in the long-run than in the
short run. For example, higher incomes may be converted into bigger cars so the income elasticity of demand for gasoline increases with time.
Other Goods (durables): Income elasticity is less in the long-run than in the
short-run. For example, consumers will initially want to hold more cars. Later, purchases will only to be to replace old cars.
SR Versus LR Elasticities
Income ElasticitiesIncome Elasticities
Chapter 2: The Basics of Supply and Demand Slide 22
Most goods and services: Long-run price elasticity of supply is greater than short-run
price elasticity of supply. Due to limited capacity, firms are output constrained in the short-run. In the long-run, they can expand.
Other Goods (durables, recyclables): Long-run price elasticity of supply is less than short-run price
elasticity of supply. For example, consider the secondary copper market. Copper price increases provide an incentive to convert scrap copper into new supply. In the long-run, this stock of scrap copper begins to fall.
SR Versus LR Elasticities
Price Elasticity of SupplyPrice Elasticity of Supply
Chapter 2: The Basics of Supply and Demand Slide 23
D
S
P0
Q0 Quantity
Price
P1
Short-Run1) Supply is completely inelastic2) Demand is relatively inelastic3) Very large change in price
Coffee prices are volatile: A freeze or drought
decreases the supplyof coffee in Brazil
S’
Q1
SR Versus LR Elasticities: CoffeeCoffeeCoffee
Chapter 2: The Basics of Supply and Demand Slide 24
1. We must learn how to “fit” linear demand and supply curves to market data.
2. We determine numerically how a change in one variable will cause supply or demand to shift and so affect the equilibrium price and quantity.
3. Assume the Available Data are: Equilibrium Price, P* Equilibrium Quantity, Q*
Price elasticity of supply, ES, and demand, ED.
Understanding and Predicting the Effects of Changing Market Conditions
Chapter 2: The Basics of Supply and Demand Slide 25
Demand: Q = a - bP
a/bSupply: Q = c + dP
-c/d
P*
Q*
ED = -bP*/Q*ES = dP*/Q*
Understanding and Predicting the Effects of Changing Market Conditions
Quantity
Price
Chapter 2: The Basics of Supply and Demand Slide 26
Let’s begin with the equations for supply and demand, and the elasticities:
Demand: QD = a - bP
Supply: QS = c + dP
Understanding and Predicting the Effects of Changing Market Conditions
P)Q/(P/Q)( E
Chapter 2: The Basics of Supply and Demand Slide 27
Note: for linear demand curves, ∆Q/ ∆P is constant (equal to the slope of the curve).
Substituting the slopes for each into the formula for elasticity, we get:
Understanding and Predicting the Effects of Changing Market Conditions
/Q*)*b(P- ED
/Q*)*d(P ES
Chapter 2: The Basics of Supply and Demand Slide 28
Suppose we have values for ED, ES, P*, and Q*, we can then solve for b & d, and a & c.
Understanding and Predicting the Effects of Changing Market Conditions
** bPaQD ** dPcQS
Chapter 2: The Basics of Supply and Demand Slide 29
Suppose we want to derive the long-run supply and demand for copper:The data are:
Q* = 7.5 mmt/yr.P* = 75 cents/pound
ES = 1.6
ED = -0.8
Example: The Copper Market
Chapter 2: The Basics of Supply and Demand Slide 30
Supply: QS = -4.5 + 16P
+.28 = -c/d Demand: QD = 13.5 - 8P
1.69 = a/b
.75
7.5
Understanding and Predicting the Effects of Changing Market Conditions
Mmt/yr
Price
Chapter 2: The Basics of Supply and Demand Slide 31
Example 1: Real versus Nominal Prices of Copper 1965 - 1999
Chapter 2: The Basics of Supply and Demand Slide 32
Declining Demand and the Behavior of Copper Prices
The relevant factors leading to a decrease in the demand for copper are:
1) A decrease in the growth rate of power generation
2) The development of substitutes: fiber optics and aluminum
We will try to estimate the impact of a 20% decrease in the demand for copper.
Recall the equation for the demand curve:
Q = 13.5 - 8P
Chapter 2: The Basics of Supply and Demand Slide 33
Multiply the demand equation by 0.80 to get the new equation. This gives:
Q = (0.80)(13.5 - 8P) = 10.8 - 6.4P
Recall the equation for supply:
Q = -4.5 + 16P
The new equilibrium price is:
-4.5 + 16P = 10.8 - 6.4P
-16P + 6.4P = 10.8 + 4.5
P = 15.3/22.4 = 68.3 cents/pound
Real versus NominalPrices of Copper 1965 - 1999
Chapter 2: The Basics of Supply and Demand Slide 34
Example 2: Government Intervention - Price Controls
If the government decides that the equilibrium price is too high, they may establish a ceiling price.
Natural Gas Market: In 1954, the federal government began regulating the wellhead price of natural gas.
In 1962, the ceiling prices that were imposed became binding and shortages resulted.
Price controls created an excess demand of 7 trillion cubic feet.
Price regulation was a major component of U.S. energy policy in the 1960s and 1970s, and it continued to influence the natural gas markets in the 1980s.
Chapter 2: The Basics of Supply and Demand Slide 35
D
Effects of Price Controls
Quantity
Price
P0
Q0
S
Pmax
Excess demand
If price is regulated tobe no higher than Pmax,quantity supplied falls
to Q1 and quantitydemanded increases toQ2. A shortage results.
Q1 Q2
Chapter 2: The Basics of Supply and Demand Slide 36
Price Controls andNatural Gas Shortages
The Data: Natural GasThe Data: Natural Gas
TcF/yr 7 Shortage
TcF 25 and TcF
$1.00/TcF At
$1.00 price regulated 1975
QQS 18