CHAPTER 1 DEMAND AND SUPPLY ANALYSIS: INTRODUCTION Presenter’s name Presenter’s title dd Month...

CHAPTER 1DEMAND AND SUPPLY ANALYSIS: INTRODUCTIONPresenter’s namePresenter’s titledd Month yyyy

Copyright © 2014 CFA Institute 2

1. INTRODUCTION

EconomicsThe study of

production, distribution, and consumption

MicroeconomicsThe study of markets and

decision making of individual economic units

Macroeconomics

The study of aggregate economic quantities


2. TYPES OF MARKETS

• Factor markets are markets for the factors of production.

- The factors of production are the inputs to production.

- Factor markets include labor markets.

• Goods markets are markets for the outputs of production.

- The outputs of production are goods and services, which may be intermediate goods and services or final goods and services.

• Capital markets serve as a means for providers of capital (that is, the providers or suppliers of long-term sources of funding, or savers) to exchange their capital for long-term claims on a firm’s cash flow and assets (that is, debt and equity securities).


3. BASIC PRINCIPLES AND CONCEPTS

Demand• Willingness

and ability to purchase a good or service at a given price

Supply• Willingness

of sellers to offer a good or service for a given price


THE DEMAND FUNCTION

The demand function is

where is the quantity demanded of good x

Px is the price of good x

I is the consumer’s income

Py is the price of good y

In equation form:

The demand curve depicts the quantity demanded for each price.

The law of demand: inverse relationship between price and quantity demanded.

(1-1)


THE SUPPLY FUNCTION

The supply function is

where is the quantity supplied of good x

Px is the price of good x

W is the wage rate paid to labor

In equation form:

The supply curve depicts the quantity producers are willing to supply at each price (or lowest price accepted for each quantity).

The law of supply: a positive relationship between price and quantity.

(1-7)


CHANGES AND MOVEMENTS

Changes in quantity demanded

Change in its own-price Movement along the demand curve

Change in price of other goods Shift in the demand curve

Changes in quantity supplied

Change in its own-factor prices Movement along the demand curve

Change in supply Shift in the supply curve

Demand 1

Demand 2

Quantity

Pri

ce

Supply 1

Supply 2

Quantity

Pri

ce


AGGREGATING SUPPLY AND DEMAND CURVES

• Moving from the individual consumer or firm to the aggregate:

- Aggregating demand curves requires adding the individual quantities demanded at each price.

- Aggregating supply curves requires adding the firms’ quantities supplied at each price.

• A market equilibrium is the situation in which the quantity demanded at a given price is equal to the quantity supplied at that price.

Price

Quantity


SOLVING FOR THE EQUILIBRIUM

• Solving for the equilibrium price or quantity requires setting the demand function equal to the supply function and then solving.

- We can specify the functions in terms of variables that model behavior (hence, behavioral equations) or in terms of variables other than own price and quantity.

- Price and quantity are endogenous variables.

- Other variables, such as the wage rate or consumer income, are exogenous variables.

• There are two equations (supply function and demand function) and three unknowns, so we must also introduce the fact that the quantity demanded must be equal to the quantity supplied. That is,

This is the equilibrium condition. Now there are three equations and three unknowns.


EQUILIBRIA

• A stable equilibrium occurs when the price adjusts so that demand = supply.

• An unstable equilibrium occurs when the demand or supply curves are such that an upward change of price does not reduce excess demand or supply (or a downward change does not reduce excess demand or supply).

- Price bubbles are an example of an unstable equilibrium.


DEMAND AND SUPPLY FUNCTIONS

• Consider an individual’s demand curve:

This means that if the price is €0.5, the quantity demanded is 24.5 units.

The inverse demand curve is the price as a function of the quantity demanded:

This means that at the quantity of 100 units, the price is €15.

• Consider a firm’s supply curve:

This means that if the quantity supplied is 10 units, the price is €15.

The inverse supply curve is the quantity supplied as a function of price:

This means that if the quantity supplied is 10, the price required is €1.5.


AGGREGATE SUPPLY AND DEMAND

• The aggregate demand curve is the total quantity of goods that would be demanded at each price.

- We calculate the aggregate demand curve by adding up the quantities (across individuals) at each price.

• The aggregate supply curve is the total quantity of goods that would be produced for each level of price.

- We calculate the aggregate supply curve by adding up what sellers are willing to sell at each level of price.

• If the aggregate demand curve is

and the aggregate supply curve is

,

we calculate the equilibrium price by equating the demand and supply and solving for the price. The equilibrium price is €1, and the equilibrium quantity is 15.


EXCESS SUPPLY AND DEMAND

If the price of a good is not in equilibrium, we can calculate the excess supply or demand. Consider the last example:

The equilibrium price is €1. But what if the price were €1.5, instead?

There would be excess supply of 20 – 10 = 10 units.

What if the price were €0.5, instead?

There would be excess demand of 20 – 10 = 10 units.


TYPES OF AUCTIONS

• Common value auction: The item’s true value is revealed after bidding.

• Private value auction: Each bidder places a subjective value on the item, but these valuations differ.

• Ascending price auction: Also known as an English auction; highest bidder wins auction for item.

• First price sealed-bid auction: Bidders submit sealed bids that are not known to other bidders; winning bidder is the one submitting the highest price.

• Second price sealed-bid auction: Also known as a Vickery auction; the bidder that submits the highest bid wins, but the price paid for the item is the next-lowest bid price.

• Descending price auction: Also known as a Dutch auction; the auctioneer begins with a very high price and lowers the price in increments until there is a willing buyer.

- In a multiple-unit format, price is lowered until all units are sold.


DUTCH AUCTION: US TREASURY SECURITIES

Discount Rate Bid

Bid Price per $100

Competitive Bids

(in billions)

Cumulative Competitive

Bids (in billions)

Noncompetitive Bids

(in billions)

Total Cumulative

Bids(in billions)

0.0280% 99.99782 $5 $5 $5 $10

0.0285% 99.99778 $10 $15 $5 $30

0.0287% 99.99777 $15 $30 $5 $65

0.0290% 99.99774 $20 $50 $5 $120

0.0291% 99.99774 $15 $65 $5 $190

0.0292% 99.99773 $10 $75 $5 $270

Example: Dutch auction for $120 billion of US Treasury 28-day bills


SURPLUS

Consumer surplus is the difference between the maximum price the consumer was willing to pay and the actual price.

Producer surplus is the difference between what the producer sells a good or service for and the price at which the supplier was willing to sell.

Pric

e

Quantity

Producer surplus

Consumer surplus

Total surplus = Consumer surplus + Producer surplus


CALCULATING SURPLUS

Suppose we have the following demand and supply curves:

The equilibrium price is €1, and the equilibrium quantity is 15.

What is the amount of total surplus if the price per unit is €1?

If the price is €1, = 15.

- Intercept with vertical axis (Q = 0): Px = €2.5 – 0.1 = €2.4.

- Consumer surplus = Area of triangle = 0.5 × (€2.4 – 1) × 15 = €10.5.

If the price is €1.0, = 15.

- Intercept with the vertical axis (Q = 0): Px = –0.5 + (0.10 × 0) = €0.5.

- Producer surplus = Area of triangle = 0.5 × (€1 – 0.5) × 15 = €3.75.

If the price is €0.8, total surplus = €10.5 + €3.75 = €14.25.


MARKET INTERFERENCE

• A government-imposed ceiling on a price that is less than the market equilibrium price results in a reduction of surplus: Buyers want more than sellers are willing to supply at that price.

- Some consumers gain consumer surplus lost by suppliers, but some consumer surplus is lost and not picked up by suppliers.

- The loss in surplus is deadweight loss, which is a loss of surplus that is not transferred to another party.

• A government-imposed price floor that is higher than the market equilibrium results in a reduction of surplus.

- Sellers want to sell more, but buyers purchase less.

- Sellers gain some producer surplus lost by consumers, but some of this producer surplus is lost and not picked up by consumers.

• In general, market interference inhibits the role of the market to allocate resources efficiently.


EFFECT OF MARKET INTERFERENCEEQUILIBRIUM PRICE = €1

Price Ceiling Price Floor

5 7 9 11 13 15 17 19 21 23 25€0.0

€0.5

€1.0

€1.5

€2.0

€2.5

Demand SupplyEquilibrium price Price ceiling

Quantity

Pri

ce

B

5 7 9 11 13 15 17 19 21 23 25€ 0.0

€ 0.5

€ 1.0

€ 1.5

€ 2.0

€ 2.5

Demand SupplyEquilibrium price Price floor

Quantity

Pri

ce

A

C

A


4. DEMAND ELASTICITIES

Own-price elasticity is the sensitivity of the quantity demanded of a good to changes in the price of the good.

Example for good x:,

where

is the quantity of good x demanded;

is the price of good x;

is the intercept; and

is the slope.

Because the slope depends on the unit of measure of Q, it is preferred to use the own-price elasticity of demand, , specified as

slope coefficient

Px

Qx

a

b


ELASTICITIES

• Elasticity is the sensitivity of the change in quantity for a given change in the price of a good.

- The ratio of the percentage change in the quantity to the percentage change in the price.

• Own-price elasticity refers to the sensitivity of the quantity of a good demanded to its own-price change.

• Cross-price elasticity of demand is the response in the demand of a good to a change in the price of another good.

- A substitute is a good that has a positive cross-price elasticity.

- A complement is a good that has a negative cross-price elasticity.


ELASTICITIES: SUMMARY

If the elasticity coefficient is …

Then demand is …

Interpretation

> 1 elastic% in price results in a larger % in quantity demanded

= –1 unit elastic% in price results in a similar % change in quantity demanded

< 1 inelastic% in price results in a smaller % in quantity demanded

= 0 perfectly inelastic % in price does not affect quantity demanded

perfectly elastic % in price results in zero quantity demanded


ELASTICITIES: EXAMPLE

Consider the case of the sensitivity of the demand for tires, in response to the price of gas per gallon:

Tires = 95 million – 3.2 Price per gallon of gas

• There is negative cross-elasticity between tires and gas; therefore, gas and tires are complements.

• If the price per gallon increases by $1, the number of tires declines by 3.2 million.


FACTORS THAT AFFECT ELASTICITIES

1. Degree of substitutability

- The greater the degree of substitutability, the greater the elasticity.

2. Portion of budget spent on the good

- The greater the portion, the greater the elasticity.

3. Time allowed to respond to the change in price

- The longer the time allowed, the greater the elasticity.

4. Extent to which the good is deemed necessary

- The greater the extent to which the good is deemed as necessary, the more inelastic its demand.


INCOME ELASTICITIES

• Income elasticity of demand is the change in the quantity demanded of a good in response to the change in income:

• An income-elastic good is a good that has positive income elasticity: As income increases, demand for the good increases; also known as a normal good.

• An inferior good is one that has a negative income elasticity: The demand for the good falls as incomes rise.


5. CONCLUSIONS AND SUMMARY

• The basic model of markets is the demand and supply model: Equilibrium occurs at the price at which the quantity demanded is equal to the quantity supplied.

• Markets are interactions between buyers and sellers.

• The price of a good in a market is determined by supply and demand.

• Auctions are sometimes used to seek equilibrium prices.

• Markets ensure that the total surplus is maximized.

- Sometimes, government policies interfere with the free working of markets, shifting surplus between consumers and producers, with some loss.

• Elasticity is the ratio of the percentage change in the dependent variable to the percentage change in the independent variable of interest.

- Elasticities are sensitivities of the quantity demanded to either the good’s own price, the price of other goods, or income.

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