Supply and Demand

Micro Unit 2: chapters 4, 5, 6

Chapter 4

The market forces of Supply and Demand

THE MARKET FORCES OF SUPPLY AND DEMAND

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Markets and Competition• A market is a group of buyers and sellers of a

particular product. • A competitive market is one with many buyers

and sellers, each has a negligible effect on price. • In a perfectly competitive market:– All goods exactly the same– Buyers & sellers so numerous that no one can affect

market price – each is a “price taker”• In this chapter, we assume markets are perfectly

competitive.

THE MARKET FORCES OF SUPPLY AND DEMAND

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Demand

• The quantity demanded of any good is the amount of the good that buyers are willing and able to purchase.

• Law of demand: the claim that the quantity demanded of a good falls when the price of the good rises, other things equal

THE MARKET FORCES OF SUPPLY AND DEMAND

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Summary: Variables that Influence Sellers

Variable A change in this variable…

Price …causes a movement along the S curve

Input Prices …shifts the S curve

Technology …shifts the S curve

# of Sellers …shifts the S curve

Expectations …shifts the S curve

THE MARKET FORCES OF SUPPLY AND DEMAND

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Supply

• The quantity supplied of any good is the amount that sellers are willing and able to sell.

• Law of supply: the claim that the quantity supplied of a good rises when the price of the good rises, other things equal

THE MARKET FORCES OF SUPPLY AND DEMAND

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Summary: Variables that Influence Sellers

Variable A change in this variable…

Price …causes a movement along the S curve

Input Prices …shifts the S curve

Technology …shifts the S curve

# of Sellers …shifts the S curve

Expectations …shifts the S curve

THE MARKET FORCES OF SUPPLY AND DEMAND

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$0.00

$1.00

$2.00

$3.00

$4.00

$5.00

$6.00

0 5 10 15 20 25 30 35

P

Q

Supply and Demand Together

D S Equilibrium: P has reached the level where quantity supplied equals quantity demanded

Equilibrium

• Equilibrium price: the price that equates quantity supplied with quantity demanded

• Equilibrium Quantity: the quantity supplied and quantity demanded at the equilibrium price

• Surplus: when quantity supplied is greater than quantity demanded

• Shortage: when quantity demanded is greater than quantity supplied

THE MARKET FORCES OF SUPPLY AND DEMAND

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Three Steps to Analyzing Changes in Eq’m

To determine the effects of any event,

1. Decide whether event shifts S curve, D curve, or both.

2. Decide in which direction curve shifts.

3. Use supply-demand diagram to see how the shift changes eq’m P and Q.

To determine the effects of any event,

1. Decide whether event shifts S curve, D curve, or both.

2. Decide in which direction curve shifts.

3. Use supply-demand diagram to see how the shift changes eq’m P and Q.

Chapter 5

Elasticity and application

Elasticity

• Elasticity is a numerical measure of the responsiveness of Qd or Qs to one of its determinants.

• Price elasticity of demand measures how much Qd responds to a change in P.

Price elasticity of demand =

Percentage change in Qd

Percentage change in P

How to calculate percentage change?• Standard method

of computing the percentage (%) change:End value – start value/ start value= x times 100Problem: The standard method gives different answers depending on where you start. So we use the midpoint method – End value- start value/ midpoint = x times 100Where midpoint is the value halfway between the start and end value

Lessons of elasticity

• Lesson: Price elasticity is higher when close substitutes are available.

• Lesson: Price elasticity is higher for narrowly defined goods than broadly defined ones.

• Lesson: Price elasticity is higher for luxuries than for necessities.

• Lesson: Price elasticity is higher in the long run than the short run.

Types of demand• Perfectly inelastic demand – Vertical Demand

curve with an elasticity of 0• Inelastic demand – relatively steep demand

curve with elasticity < 1• Unit elastic demand – Diagonal demand curve

with elasticity of 1• Elastic demand – relatively flat demand curve

with elasticity > 1• Perfectly elastic demand – Horizontal demand

curve with elasticity of infinity

Effects of elasticity on revenue

• If demand is elastic, then when Q decreases as P increases, revenue falls because the % change in Q is greater than the % change in P

• If demand is inelastic, then when Q decreases as P increases, revenue rises because the % change in P is greater than the % change in Q

ELASTICITY AND ITS APPLICATION

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Price Elasticity of Supply

• Price elasticity of supply measures how much Qs responds to a change in P.

Price elasticity of supply =

Percentage change in Qs

Percentage change in P

Loosely speaking, it measures sellers’ price-sensitivity.

Again, use the midpoint method to compute the percentage changes.

Different classifications of supply

• Perfectly inelastic Supply – Vertical supply curve with a elasticity of 0

• Inelastic supply – relatively steep curve with elasticity < 1

• Unit elastic supply – diagonal curve with elasticity of 1

• Elastic Supply – relatively flat curve with elasticity > 1

• Perfectly Elastic Supply – Horizontal Supply with elasticity of infinity

Income Elasticity

• Income elasticity – measures the response of Qd to a change In consumer income

• Normal Good – As income increases, demand increases – income elasticity > 0

• Inferior Good – As income increases, demand decreases – income elasticity < 0

Income elasticity of demand =

Percent change in Qd

Percent change in income

Cross-price elasticity• Cross-price elasticity of demand:

measures the response of demand for one good to changes in the price of another good

• Substitutes – Cross-price elasticity> 0• Complements – Cross-price elasticity<0

Cross-price elast. of demand

=% change in Qd for good 1

% change in price of good 2

Chapter 6

Supply, Demand and Government Policies

Government policies that change market outcome

•Price controls– Price ceiling: a legal maximum on the price

of a good or service Example: rent control – Price floor: a legal minimum on the price of

a good or service Example: minimum wage

• Taxes– The govt can make buyers or sellers pay a specific

amount on each unit bought/sold.

Price ceilings and price floors

• Price ceilings above equilibrium are not binding, must be below equilibrium to be considered binding

• Price floors on the other hand must be above equilibrium in order to be binding.

Taxes

• The govt levies taxes on many goods & services to raise revenue to pay for national defense, public schools, etc.

• The govt can make buyers or sellers pay the tax.

• The tax can be a % of the good’s price, or a specific amount for each unit sold.

Taxes continued

• When a tax is placed on buyers, the demand curve shifts left by the amount of the tax. The same occurs for sellers with the supply curve

• Whether the tax is placed on sellers or buyers, the end result is the same, the tax creates a wedge between the price buyers pay and the price sellers receive.

Tax Incidence

• Is how the burden of the tax is shared among market participants.

• Whichever curve is more elastic, it hold less of the burden because it is easier to leave the market .