Chapter 2

Chapter 2

The Basics of Supply and Demand

©2005 Pearson Education, Inc. Chapter 2 2

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?


Supply and Demand

Supply and demand analysis can:1. Help us understand and predict how

economic conditions affect market price

2. Analyze the impact of government price controls, minimum wages, and price supports

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


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

(P)QQ SS


The Supply Curve

S

The supply curve slopesupward demonstrating that

at higher prices firmswill increase output

The SupplyCurve Graphically

Quantity

Price($ per unit)

P1

Q1

P2

Q2


The Supply Curve

Other Variables Affecting Supply Costs of Production

LaborCapitalRaw Materials

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


Change in Supply

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’

P S

Q

P1

P2

Q1Q0

S’

Q2


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 priceChange in costs of production


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

(P)QQ DD


The Demand Curve

D

The demand curve slopesdownward demonstrating that consumers are willing

to buy more at a lower priceas the product becomes

relatively cheaper.

Quantity

Price($ per unit)

P2

Q1

P1

Q2


The Demand Curve

Other Variables Affecting Demand Income Consumer Tastes Price of Related Goods

SubstitutesComplements


DP

Q

D’

Q1

P2

Q0

P1

Q2

Change in Demand

Income Increases Purchased Q0, at P2

and Q1 at P1 Now purchased Q1 at

P2 and Q2 at P1 Same for all prices Demand Curve shifts

right


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.IncomePreferences


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



D

S

The curves intersect atequilibrium, or market-

clearing, price. Quantity demanded

equals quantity supplied at P0

P0

Q0Quantity

Price($ per unit)



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


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



D

S

P0

Q0

1. Price is above the market clearing price – P1

2. Qs > QD

3. Price falls to the market-clearing price

4. Market adjusts to equilibrium

P1

Surplus

Quantity

Price($ per unit)

QSQD



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.



D

S

QS QD

P2

Quantity

Price($ per unit)

1. Price is below the market clearing price – P2

2. QD > QS

3. Price rises to the market-clearing price

4. Market adjusts to equilibrium

Q3

P3

Shortage



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.


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.


S’


Raw material prices fall S shifts to S’ Surplus at P1

between Q1, Q2 Price adjusts to

equilibrium at P3, Q3

P

Q

SD

P3

Q3Q1

P1

Q2


D’S

D

Q3

P3


Income Increases Demand increases to

D1 Shortage at P1 of Q1,

Q2 Equilibrium at P3, Q3

P

QQ1

P1

Q2


D’S’


Income Increases & raw material prices fall Quantity increases If the increase in D is

greater than the increase in S price also increases

P

Q

S

P2

Q2

D

P1

Q1


Shifts in Supply and Demand

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

1. The relative size and direction of the change

2. The shape of the supply and demand models


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


Market for a College Education

Q (millions enrolled))

P(annual cost

in 1970dollars)

D1970

S1970

S2002

D2002

$3,917

13.2

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

$2,530

8.6


Elasticities of Supply and Demand

Not only are we concerned with what direction price and quantity will move when the market changes, but we are concerned about how much they change.

Elasticity gives a way to measure by how much a variable will change with the change in another variable.

Specifically, it gives the percentage change in one variable resulting from a one percent change in another.


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.

P

QE

DDP

%

%



The percentage change in a variable is the absolute change in the variable divided by the original level of the variable.

Therefore, elasticity can also be written as:

P

Q

Q

P

PP

QQE D

P



Usually a negative number As price increases, quantity decreases As price decreases, quantity increases

When EP > 1, the good is price elastic %Q > % P

When EP < 1, the good is price inelastic %Q < % P



The primary determinant of price elasticity of demand is the availability of substitutes. Many substitutes demand is price elastic Few substitutes demand is price inelastic



Looking at a linear demand curve, as we move along the curve Q/P will 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



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 The bottom portion of demand curve is

inelastic



Q

Price

4

8

2

4

Ep = -1

Ep = 0

EP = -

Elastic

Inelastic

Demand Curve

Q = 8 – 2P



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

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

Two extreme cases of demand curves Completely inelastic demand – vertical Infinitely elastic demand - horizontal


Infinitely Elastic Demand

DP*

Quantity

Price

EP =


Completely Inelastic Demand

Quantity

Price

Q*

D

EP = 0


Other Demand Elasticities

Income Elasticity of Demand Measures how much quantity demanded

changes with a change in income.

I

Q

Q

I

I/I

Q/Q EI



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.

m

b

b

m

mm

bbPQ P

Q

Q

P

PP

QQE

mb



Complements: Cars and Tires Cross-price elasticity of demand is negative

Substitutes: Butter and Margarine Cross-price elasticity of demand is positive


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.

P

QE

SSP Δ%

Δ%


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


D


Quantity

Price

P0

Q0

S

Pmax

•Price is regulated to be no higher than Pmax,•Quantity supplied falls and quantity demanded increases•A shortage results

QS

QD

Shortage



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.

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