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Demand and Supply

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Demand and Supply

- On August 2, 1990, when Iraq invaded Kuwait, market price of crude petroleum jumped from $21.54 to $30.50 per barrel (almost 42% increase) before any physical reduction in the current amount of oil available for sale. One year later, the price of oil was $21.32 per barrel.
- In August 1987, a 386 PC sold at $6,995.In March 1992, the same computer sold at $1,495.Today Pentiums are cheaper then original 386 PCs.

Amounts of a good purchased at alternative prices

Inverse demand: maximum price paid for given quantity

Law of Demand (ceteris paribus)

Downward demand due to income and wealth effects

Downward inverse demand due to diminishing MU

Giffen's Paradox

Quantity

Price

D

ID

Price

Quantity

- An equation representing the demand curve
Qxd = f(Px ,PY , I, N, A, Z)

Qxd = a0+a1Px+a2Py+a3I+a4N+a5A+a6Z

- Qxd = quantity demand of good X.
- Px = price of good X.
- PY = price of a substitute good Y.
- I = income.
- N = population
- A = advertisement
- Z = any other variable affecting demand (expectations, credit conditions)

Price

A

10

B

6

D0

4

7

Quantity

A to B: Increase in quantity demanded (due to change in the price of the good)

Price

6

D1

D0

Quantity

7

13

D0 to D1: Increase in Demand (due to change in demand determinants)

Price

Quantity

IS

S

Quantity

Price

- Amounts of a good produced at alternative prices
- Inverse supply: minimum price to produce given amounts
- Law of Supply (ceteris paribus)
- Upward supply due to substitution effect

- An equation representing the supply curve:
QxS = f(Px ,PR ,PVI, PFI, Z) Qxs = a0+a1Px+a2PR+a3PVI+a4PFI+a5Z

- QxS = quantity supplied of good X.
- Px = price of good X.
- PR = price of a related good (substitutes in production)
- PVI = price of variable inputs (labor, material, utilities)
- PFI = price of fixed inputs (land, buildings, machines)
- Z = other variable affecting supply (technology, government, number of firms, expectations)

Price

S0

Quantity

A to B: Increase in quantity supplied(due to change in the price of the good)

B

20

A

A

10

5

10

Price

S0

5

Quantity

S0 to S1: Increase in supply (due to change in supply determinants)

S1

8

6

7

Mathematics of Equilibrium

Demand curve: Qd = 400 - ½P,Supply curve: Qs = 200 + P

Price (P)

a=800

P = dQs - c = Qs - 200

Market

equilibrium

Inverse Supply

Slope is d = 1

P* = 133.33

Slope is -b = -2

Inverse Demand

P = a - bQd = 800 - 2Qd

0

Q* = 333.33

Quantity supplied (Qs) and

Quantity demanded (Qd)

c=-200

S

7

6

5

D

Shortage

12 - 6 = 6

6

12

Price

Quantity

Surplus

14 - 6 = 8

S

7

8

9

D

6

8

14

Price

Quantity

Price $

10

8

6

Consumer

Surplus

4

2

Total Cost of 4 units

D

1 2 3 4 5

Quantity

Value

of 4 units

- The amount producers receive in excess of the amount necessary to induce them to produce the good.

Price

S0

P*

Producer

Surplus

Cost of Production

Q*

Quantity

- Price Ceilings
- The maximum legal price that can be charged
- Examples:
- Gasoline prices in the 1970s
- Housing in New York City

- Price Floors
- The minimum legal price that can be charged.
- Examples:
- Minimum wage
- Agricultural price supports

Price

S

PF

P*

Ceiling

Price

D

Shortage

Quantity

Q*

Qs

Qd

Deadweight loss ofconsumer andproducer surplus

Opportunity Cost (Search &

Black Market)

- The dollar amount paid to a firm under a price ceiling, plus the nonpecuniary price:
PF= PC+ (PF - PC)

- PF= full economic price
- PC= price ceiling
- PF - PC= nonpecuniary price

- In 1970s ceiling price of gasoline = $1
- 3 hours in line to buy 15 gallons of gasoline
- Opportunity cost: $5/hr
- Total value of time spent in line: 3 $5 = $15
- Non-pecuniary price per gallon: $15/15 = $1

- Full economic price of a gallon of gasoline: $1 + $1 = $2

Surplus

Price

S

P*

D

Quantity

Qd

Q*

Qs

PF

Cost of purchasingexcess supply

Increase in D increases both Q and P.

Increase in S increases Q and decreases P.

Increase in D and S increases Q and P = ?.

Decrease in D and increase in S decreases P and Q = ?.

Consumer

surplus

$10 tax

Deadweight

loss

Tax Revenue

Producer

surplus

Price ($/CD player)

130

S + tax

S

Buyer pays (with tax)

P2 - P1Buyer tax burden

P2=105

Price beforetax

P1=100

P2-T=95

P1 - (P2 - T) Seller tax burden

Seller receives(without tax)

75

D

D

0 1 2 3 4 5 6 7 8 9 10

Quantity (thousands of CD players per week)

Inelastic D

Seller pays

entire tax

Buyer paysentire tax

Price

P

S + tax

S

P1 = 2.00

100

Thousands of insulin doses

Price

S + tax

S

P1=P2=1.00

P2=P1+T=2.20

Elastic D

P2-T=0.90

1 4

Thousands of pencils

- The more inelastic D, the more buyer pays: P2 = P1 + TBuyer burden: P2 - P1 = (P1 + T) - P1 = TSeller burden: P1 - (P2 - T) = P1 - (P1 + T - T) = 0

- The more elastic D, the more seller pays: P2 = P1Buyer burden: P2 - P1 = P1 - P1 = 0Seller burden: P1 - (P2 - T) = P1 - (P1 - T) = T

Inelastic S

Price

Buyer paysentire tax

Price

S + tax

P1=P2=50

Seller pays

entire tax

P1=10

P2-T=45

Elastic S

100

3 5

Bottles of spring water

Thousands of pounds of sendfor computer chips

P2=P1+T=11

D

D

The more inelastic S, the more seller pays: P2 = P1

The more elastic S, the more buyer pays: P2 = P1 + T

Consumer

surplus

$10 tax

Deadweight

loss

Tax Revenue

Producer

surplus

Price ($/CD player)

130

S(1 + tax)

S

Buyer pays (with tax)

P2 - P1Buyer tax burden

P2=105

Price beforetax

P1=100

P2-T=95

P1 - (P2 - T) Seller tax burden

Seller receives(without tax)

75

D

D

0 1 2 3 4 5 6 7 8 9 10

Quantity (thousands of CD players per week)

MR

P or AR

- Demand FunctionQ = 70,000 – 100P
- Inverse Demand FunctionP = 700 – .01Q
- Total RevenueTR = P * Q = 700Q – .01Q2
- Average RevenueAR = TR / Q = 700 – .01Q = P
- Marginal RevenueMR = dTR / dQ = 700 – .02Q
For linear demand MR has the sameintercept and twice the slope of AR

- ARC Marginal RevenueArc MR = TR / Q = (TR2-TR1) / (Q2-Q1)