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Supply meets demand

23rdOctober 2013

ECON 314

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Supply and demand Consumer theory

links consumer preferences and spending power(budget) to produce a demand

Shows that consumers only consume up to the pointwhere marginal utility equals price

Producer theory

links production technology and profit maximization toproduce a supply

Shows that firms produce only so much so that marginalrevenue (=price, usually) equals marginal cost

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Now they meet

Q

P

a market equilibriumis born!

Q*

P*

S

D

Total revenue = total expenditure

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At the point of equilibrium market clears:

All those willing and able to consume the

product at the going price obtain as muchconsumption as they desire

All those willing to supply and sell the product at

the going price are able to sell all they produced consumers get utility, firms realize profits

...costs & preferences areequalized

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Shifts and changing equilibrium

Q

P

Q*

P*

D

S

S

An upward shift in supplycauses an increase inmarket price and adecrease in quantitydemanded, ceterisparibus.

Q**

P**

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Shifts and changing equilibrium

Q

P

Q*

P*

D

S

D

An upward shift in

demand causes anincrease in marketprice and an increase inquantity demanded,ceteris paribus.

Q**

P**

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Elasticity and changing equilibrium

Q

P

Q*

P*

D

S

D

When the supply isperfectly inelastic, there isno adjustment to anincrease in demand interms of quantity.

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Elasticity and changing equilibrium

Q

P

Q*

P*

D

S

D

When the supply isperfectly elastic, there isno adjustment to anincrease in demand interms of market price.

Q**

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Elasticity and changing equilibrium

Q

P

Q*

P*

D

S

SWhen the demand isperfectly inelastic, there isno adjustment to anincrease in demand interms of quantity.

P**

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Elasticity and changing equilibrium

Q

P

Q*

P* D

S

SWhen the demand isperfectly elastic, there isno adjustment to anincrease in demand interms of price.

Q**

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Elasticity affects who bears how much of the

adjustment

Lower elasticity means smaller responsiveness

Whoever can respond least, bears the bulk ofthe adjustment (for good or ill)

(call it the sitting-duck rule) In extreme cases, all of the adjustment is

born by only one side (either D or S)

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So when D and S meet

pMU MCMRp )(

MCpMU

Consumers side: Producers side:

There is something nicely efficient about this:

It is the optimal outcome from individual points of view

It also shows certain economy-wide efficiency: goods areproduced only as long as they bring enough utility to coverthe costs.

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Consumer surplus

X

PX

CS

CS = the extra valueindividuals receive from

consuming a good overwhat they pay for it.

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Welfare of the economy

Q

P

S

Consumer surplus andproducer surplus

index the overall levelof welfare in theeconomy.

D

Q*

P*

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Welfare and price ceiling

Q

P

S

D

Q*

P*

Pcap

DEAD-WEIGHT LOSS!

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Welfare and price floor

Q

P

S

D

Q*

P*

Pcap

DEAD-WEIGHT LOSS!

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Tax hike and welfare

Q

P

S

D

Q*

P*

SAd remtax

Tax revenue

DEAD-WEIGHT LOSS!

Q**

P**

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Tax hike and welfaresteeper supply curve

Q

P

S

D

Q*

P*

SAd remtax

Tax revenue

DEAD-WEIGHT LOSS!

Q**

P**

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Tax hike and welfare

Q

PS

D

Q*

P*

Ad remtax

Tax revenue

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Tax hike and welfare

Q

P

S

D

Q*

P*

S

Ad remtax

Tax revenue

DEAD-WEIGHT LOSS!

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Welfare and trade opening

Q

P

S

D

Q*

P*

Sw

Net gain fromopening trade.

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Welfare and tariff

Q

P

S

D

Q*

P*

Sw

There is net lossfrom imposing atariff on trade.

tariffSw+tariff

Trade diversion Trade destruction

tariffrevenue

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Concepts to take home

Market equilibrium

Clearing price

Consumer surplus + producer surplus =welfare

Elasticity and burden of adjustment

Effects of price controls

Effects of taxes and who bears the cost

Deadweight loss