Chapter 2

Supply and Demand

McGraw-Hill/Irwin Copyright © 2008 by The McGraw-Hill Companies, Inc. All Rights Reserved.

Main Topics

Demand SupplyMarket equilibriumElasticities of demand and supply

2-2

Questions…

Why are Lamborghinis so expensive whereas cheese burgers are not?

How are prices determined for products?

2-3

Questions…

There are several steps in analyzing a market.Determine product demandDetermine the supply of the productUsing demand and supply, equilibrium can

be identifiedElasticity will measure the responsiveness

to change.What is demand? What is supply?

2-4

Demand Curves

Product’s demand curve shows:How much buyers of the product want to buy at

each possible price (willing and able)Holding fixed all other factors that affect demand

On a graph: vertical axis shows $ per unit of the good, horizontal axis shows quantity demanded per unit of time

Downward sloping (Law of Demand: buying the product is less attractive when the price is high than when the price is low)

2-5

Determinants of Demand

Demand curve holds all factors other than the product’s price constant:Population growthConsumer tastes and incomesPrices of other products

Substitutes (An increase in the price of one product causes buyers to demand more of the other, all else equal)

Complements (An increase in the price of product causes buyers to demand less of the other, all else equal)

Government taxes or regulations

2-6

Shifts and Movements Along a Demand Curve

Change in price of the product causes a movement along the demand curveA change in the quantity demandedWhat could cause this price change?

Change in another factor causes the entire demand curve to shiftA change in demandWhat could cause this shift in demand?

2-7

Figure 2.1: Demand Curve for U.S. Corn Market (hypothetical)

2-8

Demand Functions

Product’s demand function is a mathematical representation of its demand

Describes the amount of the product buyers demand for each possible combination of price and other factors

Can be determined by applying statistical techniques to historical data

2-9

Sample Demand FunctionDemand for corn affected by: price of corn,

price of potatoes, price of butter, consumer incomes

Increases in the prices of corn and butter will decrease the amount of corn buyers demandWhat would be an economic term for butter?

Increases in the price of potatoes will increase the amount of corn buyers demandWhat would be the economic term for potatoes?

MPPPQ butterpotatoescorndcorn 0003.025.0425

2-10

Supply Curves

Product’s supply curve shows:How much sellers of the product want to sell at each

possible price (willing and able)Holding fixed all other factors that affect supply

On a graph: vertical axis shows $ per unit of the good, horizontal axis shows quantity supplied per unit of time

Upward sloping (Law of Supply: selling the product is less attractive when the price is low than when the price is high)

2-11

Determinants of Supply

Supply curve holds all factors other than the product’s price constant:TechnologyPrices of inputsPrices of other possible outputsGovernment taxes or regulations

2-12

Shifts and Movements Along a Supply Curve

Change in price of the product causes a movement along the supply curveA change in the quantity suppliedWhat could cause a price change?

Change in another factor causes the entire supply curve to shiftA change in supplyWhat could cause a supply shift?

2-13

Figure 2.2: Demand Curve for U.S. Corn Market (hypothetical)

2-14

Supply Functions

Product’s supply function is a mathematical representation of its supply

Describes the amount of the product sellers supply at each possible combination of price and other factors

Can be determined by applying statistical techniques to historical data

2-15

Sample Supply Function

Supply of corn affected by: price of corn, price of diesel fuel, price of soybeans

Increases in the price of diesel fuel and soybeans will decrease the amount of corn sellers supply

Increases in the price of corn will increase the amount of corn sellers supply

soybeansfuelcornscorn PPPQ 25.1259

2-16

Market Equilibrium

Supply and demand for a product interact to determine the market equilibrium

The equilibrium price is the price at which the amounts supplied and demanded are equal

Graphically, the price at which the supply and demand curves intersect

2-17

Figure 2.3: Equilibrium in theCorn Market

2-18

Excess Supply, Excess Demand

If price is above equilibrium price:Amount supplied will be greater than amount

demanded (excess supply or surplus)Incentive for sellers to lower prices to boost sales

If price is below equilibrium price:Amount demanded will be greater than amount

supplied (excess demand or shortage)Incentive for buyers to offer higher prices

Market prices adjust so that amount supplied equals amount demanded

2-19

Changes in Market Equilibrium

Changing market conditions alter the market equilibrium

Changes in the determinants of supply (or demand) other than the product price cause the supply (or demand) curve to shift

Example: falling diesel fuel prices shift the corn supply curve out

2-20

Figure 2.5: Change in Market Equilibrium

2-21

Example: falling diesel fuel prices shift the corn supply curve out

Changes in Market Equilibrium

Four possible ways either supply or demand curve can shift:Demand can increase or decreaseSupply can increase or decrease

Effect on market equilibrium:If demand curve shifts, price and quantity change in

the same direction as the curveIf supply curve shifts, quantity changes in the same

direction as the curve but price changes in the opposite direction

2-22

Figure 2.6: Changes in Market Equilibrium

2-23

Table 2.1 Effects of Changes in Demand or Supply

Source of Change

Effect on Price

Effect on Amount Bought/Sold

Increase in Demand Rises Rises

Decrease in Demand Falls Falls

Increase in Supply Falls Rises

Decrease in Supply Rises Falls

2-24

Changes in Market Equilibrium

Sometimes supply and demand will both shift

Ultimate effect on equilibrium is the combination of the separate effects of changes in demand and supply

Will be able to determine the necessary direction of price or quantity movement, but not both

2-25

Figure 2.9: Increase in Both Demand and Supply

2-26

Table 2.2 Effects of Simultaneous Changes in Demand and Supply

Source of Change

Effect on Price

Effect on Amount Bought/Sold

Demand and supply both increase

Ambiguous Rises

Demand and supply both decrease

Ambiguous Falls

Demand increases,

Supply decreases

Rises Ambiguous

Demand decreases,

Supply increases

Falls Ambiguous

2-27

Size of Changes in Market Equilibrium

What determines the size of changes in market equilibrium?Size of change in demand (or supply)

The larger the shift in demand (or supply), the larger the effect on price)

Steepness of the curve that does not shiftIf the supply curve shifts, the steeper demand

curve the more the price changes the less the amount bought and sold changes

Steepness reflects responsiveness to prices

2-28

Figure 2.11: Changes in Equilibrium for Two Extreme Demand Curves

2-29

Figure 2.13: Changes in Equilibrium for Two Extreme Supply Curves

2-30

Figure 2.14: Changes in Equilibrium for Two Supply Curves

2-31

If the price rises, which curve (S1 or S2) produces a greater change in price and quantity? Why?

What could be examples of goods with supply curves that look like these?

Elasticities of Demand and SupplyElasticity is a measure of the responsiveness

of the amounts demanded and supplied to changes in prices

Not the same as the slope of the supply or demand curve

Slope of the curve depends on the units used to measure the quantity of the good and its price

Elasticity does not depend on units (e.g., gallons, dozens, dollars per pound) but looks at % changes.

2-32

General Elasticity Formula

Suppose that a change in X causes a change in Y.

Then the elasticity of Y with respect to X is the percentage change in Y divided by the percentage change in X:

X

YEYX in change %

in change %

2-33

Interpreting an ElasticitySupposeThen Y increases 2% for each 1% increase

in XIf instead Y decreased 2% when X increased

by 1%, the elasticity would be negative.

Note that the elasticity is unit-free; its meaning is clear without information about the units of X or Y.

2YXE

2-34

Price Elasticity of Demand

Elasticity of demand for a product with respect to its price

Usually called “elasticity of demand”Denoted Elasticity of demand equals the percentage

change in the amount demanded divided by the percentage change in the price

dE

2-35

Price Elasticity of DemandFormula:

Note: the triangle is also called delta and stands for change.

Expect Ed to be negative:When P increases, amount demanded typically

decreasesWhen P decreases, amount demanded typically

increasesIn Principles of Economics, the book used the

absolute value of the elasticity. Here, we will be spending a little more time looking at whether the numbers are negative or positive.

PP

QQE d

price %

demandedamount %

2-36

Price Elasticity of Demand

Goods tend to have more price elastic demand when:They have close substitutesBuyers of the product consider it a luxuryBuyers of the product have less money and

are thus sensitive to changes in their expenditures

In general, elasticity of demand varies at different points along a demand curve

2-37

Elasticities for Linear Demand Curves

For linear demand curves, re-write the price elasticity of demand formula as:

Notice that the first term is related to the slope of the demand curve

The second term is the initial price divided by the initial quantity

Q

P

P

QE d

2-38

Elasticities for Linear Demand Curves

Notice that:Slope is constant along linear demand curve

but (P/Q) varies, so elasticity varies along the demand curve

Demand is more elastic at higher prices since P is larger and Q is smaller

Demand is less elastic at lower prices since P is smaller and Q is larger

2-39

Categories of Elasticity of Demand

Condition for Ed

Elastic Ed<-1

Inelastic 0>Ed>-1

Perfectly Elastic Ed=infinity

Perfectly Inelastic Ed=0

Unit Elastic Ed=1

2-40

Figure 2.15: Elasticities Along a Linear Demand Curve

2-41

Elasticity for Nonlinear Demand Curves

Calculating elasticity of demand is possible when the demand curves are nonlinear.

Isoelastic demand curves have the same elasticity at every price.

2-42

Elasticity Example

Consider the linear demand curve for oranges below. This graph depicts the effects of a series of hurricanes on the US orange market.

What is the elasticity of demand at a price of $2.35 per box? At $3.49?

2-43

Elasticity Example

What is the elasticity of demand at a price of $2.35 per box? At $3.49?

For $2.35…(150-242)/(3.49-2.35)=-92/1.14= -80.7-80.7(2.35/242)= -.78

For $3.49…-1.88

Elastic/Inelastic?What does this mean?

2-44

Total Expenditure and Elasticity of Demand

Total expenditure equals PQ, the product of the price and the total amount demanded

Elasticity of demand shows how total expenditure changes when price increases

TE will increase with a small increase in price when demand is inelastic and decrease when demand is elastic

2-45

Total Expenditure and Elasticity of Demand

TE is largest at a price for which elasticity equals -1

What does this mean?A Buyer’s Total Expenditure =

Seller’s Total Revenue so…this point signifies the revenue maximizing point.

2-46

Figure 2.18: Price, Elasticity, and Total Expenditure

TE increases where demand is inelastic; for prices below $3.75

TE falls where demand is elastic

TE is largest where Ed = -1; when price = $3.75

2-47

Elasticity Example - RevisitedWe determined that the

price elasticity of oranges was -.78 at $2.35 per box and -1.88 at $3.49.

If we take total consumer expenditures into account….what does the above mean for orange farmers after the storms?

How badly did the storms hurt farm revenue?

2-48

Price Elasticity of Supply

Responsiveness of a product’s supply to changes in its price

Elasticity of supply equals the percentage change in the amount supplied divided by the percentage change in the price

Basic ideas are the same as for elasticity of demand

PP

QQE s

price %

suppliedamount %

2-49

Price Elasticity of SupplyWhat does it mean if the Supply Curve is:

Perfectly inelastic (b)Perfectly elastic (a)ElasticInelastic

2-50

Other ElasticitiesIncome Elasticity of Demand

% change in the amount demanded divided by the % change in income.

Or…the % change in the amount demanded for each 1% increase in income.

Normal Good / Inferior GoodMore in Ch 5

Cross-price elasticityMeasure the elasticity of demand for a product

with respect to the price of another product. Substitutes have a positive cross-price elasticity.Complements have a negative cross-price

elasticity 2-51

Elasticity – What Good is It?

Who might want to figure out elasticity?What would they use it for?

2-52

SummaryDemand Curve…

shows the amount people wish to buy at each possible price.

Determined by the demand function which gives the total demand for every combo of price and factors.

Changes can move the point or the curve.Supply Curve…

shows the amount people wish to sell at each possible price.

Determined by the supply function which gives the total supply for every combo of price and factors.

Changes can move the point or the curve. 2-53

SummaryMarket Equilibrium…

Demand & Supply curves intersect.Will change based on changes in demand, prices,

availability, etc.Elasticity of Demand and Supply

How responsive is demand/supply to changes in price %s

If inelastic, changes have less effectIf elastic changes have greater effect

Elasticity affects total revenue earned by suppliers.

Elas. applicable to changes in income or the prices of substitutes/complements.

2-54

AppendixWe used demand functions to figure out the

demand for corn. Where do those functions come from?

Use historical or modeled data and econometrics (linear regression, etc.) to derive the function and the “average” curve.

We wont be doing much of this in class. This subject will be covered in much more detail in Prof. Wong’s exciting Econometrics course!

2-55

Final ExerciseConsider again the demand function for corn

in formula (1), (A)graph the corresponding demand curve when potatoes and butter cost $.075 and $4 per pound respectively, and average income is $40,000 per year. (B) At what price does the amount demanded equal 15 billion bushels a year? Show your answer.

MPPPQ butterpotatoescorndcorn 0003.025.0425

2-56

Final Exercise - Answer

Step 1: Plug in new information. Qdcorn = 5 – 2Pcorn + 4Ppotatoes – 0.25Pbutter + .0003M Qdcorn = 5 – 2Pcorn + 4(0.75) – 0.25(4.00) + .0003(40,000) Qdcorn = 5 – 2Pcorn + 3 – 1 + 12 Qdcorn = 19 – 2Pcorn

Step 2: Find intercepts…(a) P=0 and (b) Solve for P (a) Q=19…billion bushels (b) P=$9.50

Step 3: Price at 15 b. bushels…. Qdcorn = 19 – 2Pcorn 15 = 19 – 2Pcorn 2Pcorn = 4 Pcorn = 2

MPPPQ butterpotatoescorndcorn 0003.025.0425

2-57