Chapter 2
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Chapter 2. The Basics of Supply and Demand. S. P 2. P 1. Q 1. Q 2. The Supply Curve. Price ($ per unit). The Supply Curve Graphically. The supply curve slopes upward demonstrating that at higher prices firms will increase output. Quantity. Introduction.

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Chapter 2

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Chapter 2

Chapter 2

The Basics of Supply and Demand


The supply curve

S

P2

P1

Q1

Q2

The Supply Curve

Price

($ per unit)

The Supply

Curve Graphically

The supply curve slopes

upward demonstrating that

at higher prices firms

will increase output

Quantity

Chapter 2


Introduction

Introduction

  • What are supply and demand?

  • What is the market mechanism?

  • What are the effects of changes in market equilibrium?

  • What are elasticities of supply and demand?

Chapter 2


Topics to be discussed

Topics to Be Discussed

  • How do short-run and long-run elasticities differ?

  • How do we understand and predict the effects of changing market conditions?

  • What are the effects of government intervention – price controls?

Chapter 2


Supply and demand

Supply and Demand

  • Supply and demand analysis can:

    • Help us understand and predict how world economic conditions affect market price and production

    • Analyze the impact of government price controls, minimum wages, price supports, and production incentives on the economy

    • Determine how taxes, subsidies, tariffs and import quotas affect consumers and producers

Chapter 2


Supply and demand1

Supply and Demand

  • The Supply Curve

    • The relationship between the quantity of a good that producers are willing to sell and the price of the good.

    • Measures quantity on the x-axis and price on the y-axis

Chapter 2


The supply curve1

The Supply Curve

  • Other Variables Affecting Supply

    • Costs of Production

      • Labor

      • Capital

      • Raw Materials

    • Lower costs of production allow a firm to produce more at each price and vice versa

Chapter 2


Change in supply

S

S’

P1

P2

Q0

Q1

Q2

Change in Supply

P

  • The cost of raw materials falls

    • Produced Q1 at P1 and Q0 at P2

    • Now produce Q2 at P1 and Q1 at P2

    • Supply curve shifts right to S’

Q

Chapter 2


The supply curve2

The Supply Curve

  • Change in Quantity Supplied

    • Movement along the curve caused by a change in price

  • Change in Supply

    • Shift of the curve caused by a change in something other than price

      • Change in costs of production

Chapter 2


Supply and demand2

Supply and Demand

  • The Demand Curve

    • The relationship between the quantity of a good that consumers are willing to buy and the price of the good.

    • Measures quantity on the x-axis and price on the y-axis

Chapter 2


The demand curve

P2

P1

D

Q2

Q1

The Demand Curve

Price

($ per unit)

The demand curve slopes

downward demonstrating

that consumers are willing

to buy more at a lower price

as the product becomes

relatively cheaper.

Quantity

Chapter 2


The demand curve1

The Demand Curve

  • Other Variables Affecting Demand

    • Income

      • Increases in income allow consumers to purchase more at all prices

    • Consumer Tastes

    • Price of Related Goods

      • Substitutes

      • Complements

Chapter 2


The demand curve2

The Demand Curve

  • Changes in quantity demanded

    • Movements along the demand curve caused by a change in price.

  • Changes in demand

    • A shift of the entire demand curve caused by something other than price.

      • Income

      • Preferences

Chapter 2


The market mechanism

The Market Mechanism

  • The market mechanism is the tendency in a free market for price to change until the market clears

  • Markets clear when quantity demanded equals quantity supplied at the prevailing price

  • Market Clearing price – price at which markets clear

Chapter 2


The market mechanism1

S

Price

($ per unit)

P0

D

Quantity

Q0

The Market Mechanism

The curves intersect at

equilibrium, or market-

clearing, price.

Quantity demanded equals quantity supplied at P0

Chapter 2


The market mechanism2

Oun Lopez:

Start of Lecture 3

The Market Mechanism

  • In equilibrium

    • There is no shortage or excess demand

    • There is no surplus or excess supply

    • Quantity supplied equals quantity demanded

    • Anyone who wished to buy at the current price can and all producers who wish to sell at that price can

Chapter 2


The market mechanism3

S

Price

($ per unit)

P0

D

Quantity

Q0

The Market Mechanism

-Market S and D curves include the S and D curves of individual consumers and producers.

Who Supplies?

-Producers with willingness-to-accept (WTA) prices below P*.

Who Buys?

-Only those consumers who are willing-to-pay (WTP) above P*.

Chapter 2


Market surplus

Market Surplus

  • The market price is above equilibrium

    • There is excess supply - surplus

    • Downward pressure on price

    • Quantity demanded increases and quantity supplied decreases

    • The market adjusts until new equilibrium is reached

Chapter 2


The market mechanism4

Price

($ per unit)

S

Surplus

P1

P0

D

Quantity

QD

Q0

QS

The Market Mechanism

  • Price is above the market clearing price – P1

  • Qs > QD

  • Price falls to the market-clearing price

  • Market adjusts to equilibrium

Chapter 2


The market mechanism5

Price

($ per unit)

S

P3

P2

D

Shortage

Quantity

QS

QD

Q3

The Market Mechanism

  • Price is below the market clearing price – P2

  • QD > QS

  • Price rises to the market-clearing price

  • Market adjusts to equilibrium

Chapter 2


The market mechanism6

The Market Mechanism

  • The market price is below equilibrium:

    • There is a excess demand - shortage

    • Upward pressure on prices

    • Quantity demanded decreases and quantity supplied increases

    • The market adjusts until the new equilibrium is reached.

Chapter 2


The market mechanism7

The Market Mechanism

  • Supply and demand interact to determine the market-clearing price.

  • When not in equilibrium, the market will adjust to alleviate a shortage or surplus and return the market to equilibrium.

  • Markets must be competitive for the mechanism to be efficient.

Chapter 2


Changes in market equilibrium

Changes In Market Equilibrium

  • Equilibrium prices are determined by the relative level of supply and demand.

  • Changes in supply and/or demand will change in the equilibrium price and/or quantity in a free market.

Chapter 2


Changes in market equilibrium1

D

P

S

S’

P1

P3

Q1

Q3

Q

Q2

Changes In Market Equilibrium

  • Raw material prices fall

    • S shifts to S’

    • Surplus at P1 between Q1, Q2

    • Price adjusts to equilibrium at P3, Q3

Chapter 2


Changes in market equilibrium2

D

D’

P

S

P1

P3

Q1

Q3

Q2

Q

Changes In Market Equilibrium

  • Income Increases

    • Demand increases to D1

    • Shortage at P1 of Q1, Q2

    • Equilibrium at P3, Q3

Chapter 2


Changes in market equilibrium3

P2

P1

D

P

D’

S

S’

Q1

Q2

Q

Changes In Market Equilibrium

  • Income Increases & raw material prices fall

    • Quantity increases

    • If the increase in D is greater than the increase in S price also increases

Chapter 2


Shifts in supply and demand

Shifts in Supply and Demand

  • When supply and demand change simultaneously, the impact on the equilibrium price and quantity is determined by:

    • The relative size and direction of the change

    • The shape of the supply and demand models

Chapter 2


The price of a college education

The Price of a College Education

  • The real price of a college education rose 55 percent from 1970 to 2002.

  • Increases in costs of modern classrooms and wages increased costs of production – decrease in supply

  • Due to a larger percentage of high school graduates attending college, demand increased

Chapter 2


The market mechanism8

S

Price

($ per unit)

P0

D

Quantity

Q0

The Market Mechanism

-Market S and D curves include the S and D curves of individual consumers and producers.

Who Supplies?

-Producers with willingness-to-accept (WTA) prices below P*.

Who Buys?

-Only those consumers who are willing-to-pay (WTP) above P*.

Chapter 2


Market for a college education

S2002

P

(annual cost

in 1970

dollars)

$3,917

S1970

$2,530

D2002

D1970

Q (millions enrolled))

8.6

13.2

Market for a College Education

New equilibrium

was reached at $4,573 and a quantity of 12.3 million students

Chapter 2


Resource market equilibrium

S1900

S1950

Price

S2002

Long-Run (LR) Path of

Price and Consumption

(LR demand)

D1900

D2002

D1950

Quantity

Resource Market Equilibrium

Chapter 2


Elasticities of supply and demand

Elasticities of Supply and Demand

  • How much do markets change?

  • Elasticity gives a way to measure how a variable will change when another variable changes.

  • Elasticity (Def): the percentage change in one variable resulting from a one percent change in another.

Chapter 2


Price elasticity of demand

Price Elasticity of Demand

  • Measures the sensitivity of quantity demanded to price changes.

    • It measures the percentage change in the quantity demanded of a good that results from a one percent change in price.

Chapter 2


Price elasticity of demand1

Price Elasticity of Demand

  • The percentage change in a variable is the absolute (actual) change in the variable divided by the original level of the variable.

  • Therefore, elasticity can also be written as:

Chapter 2


Price elasticity of demand2

Price Elasticity of Demand

  • Usually a negative number

    • As price increases, quantity decreases

    • As price decreases, quantity increases

  • When EQ,P > 1, the good is price elastic

    • %Q > % P

  • When EQ,P < 1, the good is price inelastic

    • %Q < % P

Chapter 2


Price elasticity of demand3

Price Elasticity of Demand

  • Primary determinant of

    -Availability of substitutes.

  • Many substitutes: demand is price elastic

  • Few substitutes demand is price inelastic

Chapter 2


Price elasticity of demand4

Price Elasticity of Demand

  • Linear demand curve: Q/P is constant

  • Values of P and Q change

  • Price elasticity of demand must therefore be measured at a particular point on the demand curve

  • Elasticity will change along the demand curve in a particular way

Chapter 2


Price elasticity of demand5

Price Elasticity of Demand

  • Given a linear demand curve

    • Elasticity depends on slope and on the values of P and Q

    • The top portion of demand curve is elastic

      • Price is high and quantity small

    • The bottom portion of demand curve is inelastic

      • Price is low and quantity high

Chapter 2


Price elasticity of demand6

EP = -

Price

4

Elastic

Ep = -1

2

Inelastic

Ep = 0

4

8

Q

Price Elasticity of Demand

Demand Curve

Q = 8 – 2P

Chapter 2


Price elasticity of demand7

Price Elasticity of Demand

  • The steeper the demand curve becomes, the more inelastic the good.

  • The flatter the demand curve becomes, the more elastic the good

Chapter 2


Infinitely elastic demand extreme case

Price

D

P*

Quantity

Infinitely Elastic Demand (Extreme Case)

QD changes infinitely with the smallest possible change in price.

EP = 

Chapter 2


Completely inelastic demand extreme case

Price

Quantity

Completely Inelastic Demand (Extreme Case)

D

EP = 0

QD never changes, even with large changes in price.

Q*

Chapter 2


Other demand elasticities

Other Demand Elasticities

  • Income Elasticity of Demand

    • Measures how much quantity demanded changes with a change in income.

Chapter 2


Other demand elasticities1

Other Demand Elasticities

  • Cross-Price Elasticity of Demand

    • Measures the percentage change in the quantity demanded of one good that results from a one percent change in the price of another good.

Chapter 2


Other demand elasticities2

Other Demand Elasticities

  • Complements: Cars and Tires

    • Cross-price elasticity of demand is negative

      • Price of cars increases, quantity demanded of tires decreases

  • Substitutes: Butter and Margarine

    • Cross-price elasticity of demand is positive

      • Price of butter increases, quantity of margarine demanded increases

Chapter 2


Price elasticity of supply

Price Elasticity of Supply

  • Measures the sensitivity of quantity supplied given a change in price

    • Measures the percentage change in quantity supplied resulting from a 1 percent change in price.

Chapter 2


Point v arc elasticities

Point v. Arc Elasticities

  • Point elasticity of demand

    • Price elasticity of demand at a particular point on the demand curve

  • Arc elasticity of demand

    • Price elasticity of demand calculated over a range of prices

Chapter 2


Elasticity an application

Elasticity: An Application

  • Wheat Market Changes (1980s and 1990s)

  • Analyzing the Wheat Market

Chapter 2


Elasticity an application1

Elasticity: An Application

  • Supply: QS = 1800 + 240P

  • Demand: QD = 3550 – 266P

Analyze this market.

1)What are the initial P* and Q*?

2)How does demand change when price changes?

3)How does supply change when price changes?

Chapter 2


Elasticity an application2

Elasticity: An Application

QD = QS

1800 + 240P = 3550 – 266P

506P = 1750

P = $3.46 per bushel

Q = 1800 + (240)(3.46) = 2630 million bushels

Chapter 2


Elasticity an application3

Elasticity: An Application

  • We can find the elasticities of demand and supply at these points

Chapter 2


Elasticity an application4

Elasticity: An Application

  • Assume the price of wheat is $4.00/bushel due to decrease in supply

Chapter 2


Elasticity an application5

Elasticity: An Application

  • In 2002, the supply and demand for wheat were:

    • Supply: QS = 1439 + 267P

    • Demand: QD = 2809 – 226P

Chapter 2


Elasticity an application6

Elasticity: An Application

QD = QS

2809 - 226P = 1439 + 267P

P = $2.78 per bushel

Q = 2809 - (226)(2.78) = 2181 million bushels

Chapter 2


Short run versus long run elasticity

Short-Run Versus Long-Run Elasticity

  • Price elasticity varies with the amount of time consumers have to respond to a price.

  • Short run demand and supply curves often look very different from their long-run counterparts.

Chapter 2


Short run versus long run elasticity1

Short-Run Versus Long-Run Elasticity

  • Demand

    • In general, demand is much more price elastic in the long run

      • Consumers take time to adjust consumption habits

      • Demand might be linked to another good that changes slowly

      • More substitutes are usually available in the long run

Chapter 2


Gasoline short run and long run demand curves

DSR

Price

DLR

Quantity of Gas

Gasoline: Short-Run and Long-Run Demand Curves

  • People cannot easily adjust consumption in short run.

  • In the long run, people tend to drive smaller and

  • more fuel efficient cars.

Chapter 2


Short run versus long run elasticity2

Short-Run Versus Long-Run Elasticity

  • Demand and Durability

    • For some durable goods, demand is more elastic in the short run

    • If goods are durable, then when price increases, consumers choose to hold on to the good instead of replacing it

    • But in long run, older durable goods will have to be replaced

Chapter 2


Cars short run and long run demand curves

DLR

Price

DSR

Quantity of Cars

Cars: Short-Run and Long-Run Demand Curves

  • Initially, people may put off immediate car purchase

  • In long run, older cars must be replaced.

Chapter 2


Short run versus long run elasticity3

Short-Run Versus Long-Run Elasticity

  • Income elasticity also varies with the amount of time consumers have to respond to an income change.

    • For most goods and services, income elasticity is larger in the long run

    • When income changes, it takes time to adjust spending

Chapter 2


Short run versus long run elasticity4

Short-Run Versus Long-Run Elasticity

  • Income elasticity of durable goods

    • Income elasticity is less in the long-run than in the short-run.

      • Increases in income mean consumers will want to hold more cars.

      • Once older cars replaced, purchases will only to be to replace old cars.

      • Less purchases from income increase in long run than in short run

Chapter 2


Demand for gasoline

Demand for Gasoline

Chapter 2


Demand for automobiles

Demand for Automobiles

Chapter 2


Short run versus long run elasticity5

Short-Run Versus Long-Run Elasticity

  • Most goods and services:

    • Long-run price elasticity of supply is greater than short-run price elasticity of supply.

  • Other Goods (durables, recyclables):

    • Long-run price elasticity of supply is less than short-run price elasticity of supply

Chapter 2


Short run versus long run elasticity6

SSR

Price

SLR

Quantity Primary Copper

Short-Run Versus Long-Run Elasticity

Due to limited

capacity, firms

are limited by

output constraints

in the short-run.

In the long-run, they

can expand.

Chapter 2


Short run versus long run elasticity7

SLR

SSR

Price

Quantity Secondary Copper

Short-Run Versus Long-Run Elasticity

Price increases

provide an incentive

to convert scrap

copper into new supply.

In the long-run, this

stock of scrap copper

begins to fall.

Chapter 2


Supply of copper

Supply of Copper

Chapter 2


Declining demand and the behavior of copper prices

Declining Demand and the Behavior of Copper Prices

  • Copper has gone through difficult market changes leading to significantly reduced prices most from decreased demand from

    • A decrease in the growth rate of power generation

    • The development of substitutes: fiber optics and aluminum

Chapter 2


Short run v long run elasticity an application

Short-Run v. Long-Run Elasticity – An Application

  • Why are coffee prices very volatile?

    • Most of the world’s coffee produced in Brazil.

    • Many changing weather conditions affect the crop of coffee, thereby affecting price

    • Price following bad weather conditions is usually short-lived

    • In long run, prices come back to original levels, all else equal

Chapter 2


Price of brazilian coffee

Price of Brazilian Coffee

Chapter 2


Short run v long run elasticity an application1

Short-Run v. Long-Run Elasticity – An Application

  • Demand and supply are more elastic in the long run

  • In short-run, supply is completely inelastic

    • Weather may destroy part of the fixed supply, decreasing supply

  • Demand relatively inelastic as well

  • Price increases significantly

Chapter 2


An application coffee

S’

S

Price

P1

P0

D

Quantity

Q1

Q0

An Application - Coffee

A freeze or drought

decreases the supply

of coffee

Price increases significantly due to inelastic supply and demand

Chapter 2


An application coffee1

S

S’

Price

P2

P0

D

Quantity

Q0

Q2

An Application - Coffee

Intermediate-Run

1) Supply and demand are

more elastic

2) Price falls back to P2.

Chapter 2


An application coffee2

Price

S

P0

D

Quantity

Q0

An Application - Coffee

Long-Run

1) Supply is extremely elastic.

2) Price falls back to P0.

3) Quantity back to Q0.

Chapter 2


Price of brazilian coffee1

Price of Brazilian Coffee

Chapter 2


Effects of price controls

Effects of Price Controls

  • Markets are rarely free of government intervention

    • Imposed taxes and granted subsidies

    • Price controls

  • Price controls usually hold the price above or below the equilibrium price

    • Excess demand – shortage

    • Excess supply - surplus

Chapter 2


Effects of price controls price ceiling

Price

S

P0

Pmax

Shortage

D

Q0

QD

QS

Quantity

Effects of Price Controls (Price Ceiling)

  • Price is regulated to be no higher than Pmax,

  • Quantity supplied falls and quantity demanded increases

  • A shortage results

Chapter 2


Effects of price controls price ceiling1

Price

S

P0

Pmax

D

Q0

Quantity

Effects of Price Controls (Price Ceiling)

  • Price is regulated to be no higher than Pmax

  • This price ceiling is not binding.

  • Equilibrium P is maintained.

Chapter 2


Effects of price controls price floor

Price

S

Surplus

P*

Pmax

D

Q*

QS

Quantity

Effects of Price Controls (Price Floor)

  • Price is regulated to be no lower than Pmax

  • This price floor creates a surplus

Chapter 2


Effects of price controls1

Effects of Price Controls

  • Excess demand sometimes takes the form of queues

    • Lines at gas stations during 1974 shortage

  • Sometimes get curtailments and supply rationing

    • Natural gas shortage of the mid ’70’s

  • Producers typically lose, but some consumers gain. Some consumers lose.

Chapter 2


Price controls and natural gas shortages

Price Controls andNatural Gas Shortages

  • 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.

Chapter 2


Price controls and natural gas shortages1

Price Controls andNatural Gas Shortages

  • 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


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