Introduction to Economic InstitutionsECON 1500

Week 2 Lectures 1 & 2

4 & 6 September

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Topics covered

• Demand curve and what causes shifts in demand curve

• Supply curve and what causes shifts in supply curve

• Equilibrium

• Elasticity of supply and demand and what affects it

• Reading: Mankiw, Chapter 4 & 5

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Let someone else explain it to you

https://www.youtube.com/watch?v=RP0j3Lnlazs

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Basics: what is supply and demand?

• quantity demanded is the amount of good that buyers arewilling and able to purchase

• quantity supplied is the amount of good that sellers are willingand able to sell

• both determine how much good is produced and the price atwhich it is sold• we will consider here what is called a perfectly competitive

marketI many buyers and sellersI no buyer or seller has impact on the market priceI goods offered for sale are exactly the same

• question: what other types of markets do you know? what aretheir characteristics?

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What affects shifts in demand curve

• IncomeI Normal good: a good for which an increase in income leads to

an increase in demandI Inferior good: a good for which an increase in income leads to

a decrease in demand (can you think of an example of inferiorgood? )

• prices of related goodsI Complements: two goods for which an increase in the price of

one leads to decrease in the demand for the otherI Substitutes: two goods for which an increase in the price of

one leads to an increase in the demand for the other

• Tastes

• Expectations

• Number of Buyers

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What affects shifts in supply curve

• Input prices

• Technology

• Expectations

• Number of Sellers

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Slopes of supply and demand curves?

• Do all demand curves slope down?I the Irish potato famine of 1845 was once thought to be a

counterexample, but Sherwin Rosen ”Potato Paradoxes ” inJournal of Political Economy (December 1999) argues tatconsumer’s demand curve for potatoes still sloped downwards

• Do all supply curves slopes upwards?I John Shea ”Do Supply Curves Slope Up?” Quarterly Journal

of Economics (February 1993) findsI upward sloping curves in 16 of 26 US manufacturing industriesI only 3 industries (aircraft, construction equipment, and animal

feeds) where supply curves appear instead to slope down

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there is surplus of ice cream in the market

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there is shortage of ice cream in the market

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LAW OF SUPPLY AND DEMAND

the price of any good adjusts to bring the quantity supplied andquantity demanded for that good into balance

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Analysing changes in equilibrium

• To determine how an event will affect the equilibrium quantityand price in market:

• decide whether the event shifts supply or demand curve

• decide which direction

• use the supply and demand diagram to see how the shiftchanges the equilibrium price and quantity

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Example 1: Shift in Demand

• Suppose a hot summer makes people want to eat more icecream• Following the steps outlined above:

1. Change in taste shifts the demand curve for ice creams2. hot weather makes people want to eat more ice cream ⇒

demand curve shifts to the right3. at old price there is excess demand ⇒ firms raise prices

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Example 1: Shift in Demand

• Change in demand

• Change in quantity demanded

• Change in quantity supplies

• NO change in supply (supply is position of the supply curve)

• the increase in prices made sellers of ice creams willing toproduce more to satisfy and increased demand

• increase in quantity supplies is represented by movementalong the supply curve

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Example 2: Shift in Supply

• Suppose a bad weather destroys sugar crop, making it moreexpensive to make ice cream• Following the steps outlined above:

1. Change in the price of sugar which is input in the ice creamshifts the supply curve

2. crops were destroyed ⇒ the price of sugar goes up ⇒ supplycurve shifts to the left

3. at old price there is excess demand ⇒ firms raise prices

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Example 2: Shift in Supply

• Change in supply

• Change in quantity supplied

• Change in quantity demanded

• NO change in demand

• the increase in prices makes buyers of ice cream lower thequantity purchased

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Example 3: Shifts in Supply and Demand

On the board...

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Recap from Tuesday

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LAW OF SUPPLY AND DEMAND

the price of any good adjusts to bring the quantity supplied andquantity demanded for that good into balance

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Recap from Tuesday

• supply and demand determine the prices of economy’s goodsand services

• prices guide allocation of resources• How so? suppose there is limited amount of houses available

in London; who gets them?I whoever is willing and able to pay the price

• prices determine who produces each good and how much isproducedI wage and prices of good adjust to ensure that enough people

choose to produce the good

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Adam’s Smith ’invisible hand’

• In the market economy, price adjustments work to coordinatethe activities of buyers and sellers

• each reacts to events without worrying about the overalleffects on the market or the economy

• the price of food and wages adjust to ensure that enoughpeople choose to take up jobs and that there is enoughdemand for food

• prices are what guides those decisions

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Exercise

Suppose that an unusually snowy winter makes people willing tobuy more snow blowers at any given price.

1. Would this unexpectedly bad weather shift the supply curve orthe demand curve for snow blowers?

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Exercise

Suppose that an unusually snowy winter makes people willing tobuy more snow blowers at any given price.

1. Would this unexpectedly bad weather shift the supply curve orthe demand curve for snow blowers?

2. In a graph with the quantity of snow blowers increasing alongthe x (horizontal) axis and the price of snow blowers increasingalong the y (vertical) axis, would this bad weather shift thecurve you mentioned above to the left or to the right?

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Exercise

Suppose that an unusually snowy winter makes people willing tobuy more snow blowers at any given price.

1. Would this unexpectedly bad weather shift the supply curve orthe demand curve for snow blowers?

2. In a graph with the quantity of snow blowers increasing alongthe x (horizontal) axis and the price of snow blowers increasingalong the y (vertical) axis, would this bad weather shift thecurve you mentioned above to the left or to the right?

3. Assuming that in this same graph, as usual, the demand curveslopes down and the supply curve slopes up, what wouldhappen to the equilibrium price of snow blowers as a result ofthis unexpectedly bad weather: would it rise or fall?

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Exercise

Suppose that an unusually snowy winter makes people willing tobuy more snow blowers at any given price.

1. Would this unexpectedly bad weather shift the supply curve orthe demand curve for snow blowers?

2. In a graph with the quantity of snow blowers increasing alongthe x (horizontal) axis and the price of snow blowers increasingalong the y (vertical) axis, would this bad weather shift thecurve you mentioned above to the left or to the right?

3. Assuming that in this same graph, as usual, the demand curveslopes down and the supply curve slopes up, what wouldhappen to the equilibrium price of snow blowers as a result ofthis unexpectedly bad weather: would it rise or fall?

4. What would happen to the equilibrium quantity of snowblowers supplied and demanded: would it rise or fall?

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Elasticity

• we know that people buy less goods when the price of thegood increases

• what if we want to know exactly how much less of a good

• elasticity!

• what does it measure? how willing consumers are to buy lessof the good when the price rises

• today we will talk more about how the slopes of supply anddemand curve affect the response of prices and quantities tochanges in demand and supply shifts

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Slopes of demand curves

• What does the slope the demand curve tell us?I elasticity: a measure of how responsive the quantity demanded

is to changes in one of its determinantsI price elasticity of demand measures how much the quantity

demanded changes in response to change in priceI demand is elastic if if quantity demanded responds a lot to

changes in the priceI demand is inelastic if quantity demanded responds only a little

to changes in price

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Elastic demand

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Inelastic demand

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Slopes of demand curves

• what affects the slope of demand curveI availability of substitutesI necessities vs luxuriesI definition of the marketI time horizon

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How to calculate elasticity?

price elasticity of demand =percentage change in quantity demanded

percentage change in price

• if 10% increase in the price of ice cream cone causes theamount of ice cream you buy to fall by 20% then the elasticityis.....

• note: change in price and demand go in opposite direction,drop the minus sign

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the flatter the demand curve the greater the elasticity of demand

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Total revenue

• total revenue: amount paid by buyers and received by sellersof a good

• revenue=price x quantity

• Example...

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Total revenue and elasticity

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Other demand elasticities

• Income elasticity of demandI how the quantity demanded changes as consumer income

changesI normal goods - positive elasticitiesI inferior good - negative elasticities

• Cross-price elasticity of demandI how the quantity demanded of one good responds to a change

in price of another goodI complementsI substitutes

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Slopes of supply curves

• What does the slope the supply curve tell us?I elasticity: a measure of how responsive the quantity supplied

are to changes in one of its determinantsI supply is elastic if if quantity supplied responds a lot to

changes in the priceI supply is inelastic if quantity supplied responds only a little to

changes in price

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Slopes of supply curves

• what affects the slope of supply curveI flexibility of sellers to change the amount of good they produceI time horizon

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How to calculate elasticity?

price elasticity of supply =percentage change in quantity supplied

percentage change in price

• if 10% increase in the price of milk causes the amount of diaryproduced to increase by 20% then the elasticity is.....

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Why is this relevant

• the same change in supply may have a different effect onprices and quantities supplied depending on the elasticity ofsupply (same holds for demand)

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