Economic Analysis Economic Analysis for Businessfor Business

Session V: Market Forces of Session V: Market Forces of Supply and Demand-IISupply and Demand-II

InstructorInstructorSandeep BasnyatSandeep Basnyat98418922819841892281Sandeep_basnyat@yahoo.comSandeep_basnyat@yahoo.com

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P

Q

Recall: Supply and Demand Recall: Supply and Demand TogetherTogether

D S Equilibrium: P has reached

the level where

quantity supplied equals quantity demanded

Recall: Equilibrium in Automobile Recall: Equilibrium in Automobile marketmarket

Market demand curve: Qd = 20,500,000 – 500P

Market supply curve: Qs = - 42000000 +2000P

Equilibrium is at: Qd = Qs 20,500,000 – 500P = - 42000000 +2000P2500P = 62500000

Therefore, P = $25000Q = 20,500,000 – 500(25000) = 8,000,000

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P

Q

D S

Surplus:Surplus:

when quantity supplied is greater than quantity demanded

Surplus Example: If P = $5,

then QD = 9 lattes

and QS = 25 lattes

resulting in a surplus of 16 lattes

Disequilibrium in Automobile market- Disequilibrium in Automobile market- SurplusSurplusMarket demand curve: Qd = 20,500,000

– 500PMarket supply curve: Qs = - 42000000

+2000PSuppose a car is being sold at $27000.How many cars will be bought and sold? Qd = 20,500,000 – 500(27000)= 7,000,000Qs = - 42000000 +2000(27000) =

12,000,000Surplus = 5 million cars.

CHAPTER 4 THE MARKET FORCES OF

SUPPLY AND DEMAND

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P

Q

D S

when quantity demanded is greater than quantity supplied

Example: If P = $1,

then QD = 21 lattes

and QS = 5 lattes

resulting in a shortage of 16 lattes

Shortage

ShortageShortage

Disequilibrium in Automobile market- Disequilibrium in Automobile market- ShortageShortageMarket demand curve: Qd = 20,500,000

– 500PMarket supply curve: Qs = - 42000000

+2000PSuppose a car is being sold at $23000.How many cars will be bought and sold? Qd = 20,500,000 – 500(23000)= 9,000,000Qs = - 42000000 +2000(23000) =

4,000,000Shortage = 5 million cars.

Comparative Static AnalysisComparative Static AnalysisSensitivity analysis or “what-if” analysis.Comparison of various points of

equilibrium: price and quantityThe role of factors influencing demand is

analyzed while holding supply conditions constant.

Or, the role of factors influencing supply is analyzed by studying changes in supply while holding demand conditions constant

Short and Long run analyses

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D S Facing a surplus, sellers try to increase sales by cutting the price.

This causes QD to rise

Surplus

…which reduces the surplus.

and QS to fall…

Short-run market change: Rationing Short-run market change: Rationing Mechanism of Price: Surplus caseMechanism of Price: Surplus case

CHAPTER 4 THE MARKET FORCES OF

SUPPLY AND DEMAND

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D S Facing a surplus, sellers try to increase sales by cutting the price.

Falling prices cause QD to rise and QS to fall.

Surplus

Prices continue to fall until market reaches equilibrium.

Short-run market change: Rationing Short-run market change: Rationing Mechanism of Price: Surplus caseMechanism of Price: Surplus case

CHAPTER 4 THE MARKET FORCES OF

SUPPLY AND DEMAND

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D S Facing a shortage, sellers raise the price,

causing QD to fall

…which reduces the shortage.

and QS to rise,

Shortage

Short-run market change: Rationing Short-run market change: Rationing Mechanism of Price: Shortage caseMechanism of Price: Shortage case

CHAPTER 4 THE MARKET FORCES OF

SUPPLY AND DEMAND

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D S

Facing a shortage, sellers raise the price,

causing QD to falland QS to rise.

Shortage

Prices continue to rise until market reaches equilibrium.

Short-run market change: Rationing Short-run market change: Rationing Mechanism of Price: Shortage caseMechanism of Price: Shortage case

Rationing Mechanism: Price adjustment to balance demand and supply in market

CHAPTER 4 THE MARKET FORCES OF

SUPPLY AND DEMAND

Rationing function: The Market for Hybrid Rationing function: The Market for Hybrid Cars: Increase in Price of GasCars: Increase in Price of Gas

P

Q

D1

S1

P1

Q1

price of hybrid cars

quantity of hybrid cars

CHAPTER 4 THE MARKET FORCES OF

SUPPLY AND DEMAND

D curve shifts to the right because increased price of gas increases demand for hybrid cars.

S curve does not shift, because price of gas does not affect cost of producing hybrids.

A Change in DemandA Change in Demand

Assumption: Increase in price of gas. P

Q

D1

S1

P1

Q1

D2

P2

Q2

The shift causes an increase in price and quantity of hybrid cars.

Price Rationing: A Change in DemandPrice Rationing: A Change in Demand

P

Q

D1

S1

P1

Q1

D2

P2

Q2

Notice: When P rises, producers supply a larger quantity of hybrids, even though the S curve has not shifted.

S curve shifts because event affects cost of production.

D curve does not shift, because production technology is not one of the factors that affect demand.

S shifts rightbecause event reduces cost, makes production more profitable at any given price.

EXAMPLE 2: EXAMPLE 2: A Change in SupplyA Change in Supply

P

Q

D1

S1

P1

Q1

S2

P2

Q2

EVENT: New technology reduces cost of producing hybrid cars.

The shift causes price to fall and quantity to rise.

Long run analysis: Guiding or Allocating Long run analysis: Guiding or Allocating Mechanism: Market for Mechanism: Market for Hybrid CarsHybrid Cars

P

Q

D1

S1

P1

Q1

S2

D2

P3

Q3

EVENTS: 1. Price of gas rises2.New technology reduces production costs

P2

Q2

Short-run Analysis

Long-run Analysis

Short-run vs Long-runShort-run vs Long-runShort-run or Rationing Mechanism: Period

of time buyers and sellers already in market respond to change in equilibrium price by adjusting the amount of resources (variable inputs)

Long run or Guiding or Allocating Mechanism: Period of time buyers and sellers, new or existing in market respond to change in equilibrium price by moving the amount of resources (variable/fixed inputs) in or out from the market.

Variations: Variations: A Change in Both Supply and A Change in Both Supply and DemandDemand

P

Q

D1

S1

P1

Q1

S2

D2

P2

Q2

EVENTS: Price of gas rises AND New technology reduces production costs

But supply increases more than demand.

Note: P falls compared to the original price.

AA CC TT II VV E LE L EE AA RR NN II NN G G 33: : Changes in supply and demandChanges in supply and demand

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For a hypothetical market, use Short-run and Long analysis for the following cases:

1. When Demand and Supply both increases but D > S

2. When Demand increases and Supply decreases but D > S

3. When Demand increases and Supply decreases but D < S

4. When Demand decreases and Supply increases but D < S

5. When Demand decreases and Supply increases but D > S

Terms for Shift vs. Movement Along Terms for Shift vs. Movement Along CurveCurve

Change in supply: a shift in the S curve◦occurs when a non-price determinant of

supply changes (like technology or costs)Change in the quantity supplied:

a movement along a fixed S curve ◦occurs when P changes

Change in demand: a shift in the D curve◦occurs when a non-price determinant of

demand changes (like income or No. of buyers)

Change in the quantity demanded: a movement along a fixed D curve◦occurs when P changes

Estimated Industry Demand for New AutomobilesParameter Estimated Value

Independent Variable Estimate for Variable(1) (2) (3)

Average Price for New Cars (P) –500 $25,000Average Price for New Luxury Cars(PX) 210 $50,000Disposable Income, per Household (I) 200 $45,000 Population (Pop) (millions) 20,000 300Average Interest Rate (i) (percent) –1,000,000 8%Industry Advertising Expenditures (A) 600 $5,000 million

Ex 1: Automobile Market Demand and Supply Ex 1: Automobile Market Demand and Supply AnalysisAnalysis

Estimated Industry Supply for New AutomobileParameter Estimated Value

Independent Variable Estimate for Variable(1) (2) (3)

Average Price for New Cars (P) 2,000 $25,000Average Price for SUV(Psuv) -400 $35,000Average Hourly Wage Rate (W) -100,000 $85 Average Cost of Steel/Ton (S) -13,750 800Average Cost of Energy/mcf (E) –125,000 $4Average Interest Rate (i) in percent -1,000,000 8%

Practice 1-Market Demand-Supply Practice 1-Market Demand-Supply AnalysisAnalysis

Considering the Estimated demand and supply conditions of the new automobile in the previous slide, find the followings:1.With the increased competition in the market, the automobile industry increased its advertising expenditure by $5000 million. Will the industry be able to sell more automobile or less now? By how much? Show your results using demand and supply diagram.2.In response to part 1, the SUV sellers decreased their price of SUV by $2000. How will this affect the new automobile industry now? Is it necessary for the industry to decrease the price of new automobile? By how much? How many new cars will the industry be able to sell now? Show your results using demand and supply diagram.

(Hint: Use increased advertising expenses in demand function, keep supply function constant and find equilibrium. Use similar method for case 2.)

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