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Demand and Supply. Headlines:.

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Headlines:

- 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

Demand CurveQuantity

Price

D

ID

Price

Quantity

The Demand Function

- 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

Change in Quantity DemandedA to B: Increase in quantity demanded (due to change in the price of the good)

Change in Demand

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

Supply Curve- 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

The Supply Function

- 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

Change in Quantity SuppliedA 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

Change in SupplyS0 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

Price $

10

8

6

Consumer

Surplus

4

2

Total Cost of 4 units

D

1 2 3 4 5

Quantity

Consumer Surplus:The Continuous CaseValue

of 4 units

Producer Surplus

- 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 Restrictions

- 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

Impact of a Price Ceiling

Price

S

PF

P*

Ceiling

Price

D

Shortage

Quantity

Q*

Qs

Qd

Deadweight loss ofconsumer andproducer surplus

Opportunity Cost (Search &

Black Market)

Full Economic Price

- 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

Comparative Statics: Effects of Changes in Demand and/or 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

The Excise TaxPrice ($/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

Excise Tax and the DemandPrice

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 + T Buyer 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

Excise Tax and the SupplyP2=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

The Ad Valorem Tax (% of Value)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)

MRDemand and Revenue

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)

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