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.
Demand Curve• 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
Quantity
ID
Price
Price
D
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)
Change in Quantity DemandedPrice
Quantity
D0
4 7
10
6
A
A to B: Increase in quantity demanded (due to change in the price of the good)
B
Price
Quantity
D0
D1
6
7
D0 to D1: Increase in Demand (due to change in demand determinants)
Change in Demand
13
Supply Curve• Amounts of a good produced at alternative prices.
• Inverse supply shows the minimum price required to produce given quantity of a good.
• Law of Supply (ceteris paribus)
• The supply curve is upward sloping
Quantity
Price
SPrice
Quantity
IS
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)
Change in Quantity Supplied
Price
Quantity
S0
20
10
B
A
5 10
A to B: Increase in quantity supplied(due to change in the price of the good)
A
Price
Quantity
S0
S1
8
5 7
S0 to S1: Increase in supply (due to change in supply determinants)
Change in Supply
6
Mathematics of Equilibrium
Inverse Supply
Quantity supplied (Qs) and
Inverse Demand
P* = 133.33
Q* = 333.33 0
P = dQs - c = Qs - 200
P = a - bQd = 800 - 2Qd
a=800
Price (P)
c=-200
Slope is -b = -2
Slope is d = 1
Quantity demanded (Qd)
Marketequilibrium
Demand curve: Qd = 400 - ½P,Supply curve: Qs = 200 + P
Consumer Surplus:The Continuous Case
Valueof 4 units
Price $
Quantity
D
10
8
6
4
2
1 2 3 4 5
Total Cost of 4 units
Consumer Surplus
Producer Surplus• The amount producers receive in excess of the amount
necessary to induce them to produce the good.
Price
Quantity
S0
Q*
P* Producer Surplus
Cost of Production
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 = ?.
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
Price
Quantity
S
D
P*
Q*
CeilingPrice
Qs
PF
Impact of a Price Ceiling
Shortage
Qd
Deadweight loss ofconsumer and
producer 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 = $2
The Excise Tax
Quantity (thousands of CD players per week)
0 1 2 3 4 5 6 7 8 9 10
75
P1=100
130
DD
S
P2=105
P2-T=95
Tax Revenue
Consumersurplus
Producersurplus
S + tax
Deadweightloss
Price ($/CD player)
$10 taxBuyer pays (with tax)
Price beforetax
Seller receives(without tax)
P2 - P1 Buyer tax burden
P1 - (P2 - T) Seller tax burden
Excise Tax and the Demand
P2=P1+T=2.20
Thousands of insulin doses
P1 = 2.00
100
S
S + taxBuyer paysentire taxPPrice
Inelastic D
Thousands of pencils 1 4
P2-T=0.90
P1=P2=1.00S
Price Seller paysentire tax
Elastic D
S + tax
The more inelastic D, the more buyer pays: P2 = P1 + TBuyer burden: P2 - P1 =
(P1 + T) - P1 = TSeller burden: P1 - (P2 - T) =
P1 - (P1 + T - T) = 0
The more elastic D, the more seller pays: P2 = P1 Buyer burden: P2 - P1 =
P1 - P1 = 0Seller burden: P1 - (P2 - T) =
P1 - (P1 - T) = T
Excise Tax and the Supply
D
Bottles of spring water
P2-T=45
P1=P2=50
100
Inelastic S
Seller paysentire tax
Price
P2=P1+T=11
D
Thousands of pounds of sendfor computer chips
P1=10
3 5
Price
Elastic S
S + tax
Buyer paysentire tax
The more inelastic S, the more seller pays: P2 = P1
The more elastic S, the more buyer pays: P2 = P1 + T
The Ad Valorem Tax (% of Value)
Quantity (thousands of CD players per week)
0 1 2 3 4 5 6 7 8 9 10
75
P1=100
130
DD
S
P2=105
P2-T=95
Tax Revenue
Consumersurplus
Producersurplus
S(1 + tax)
Deadweightloss
Price ($/CD player)
$10 taxBuyer pays (with tax)
Price beforetax
Seller receives(without tax)
P2 - P1 Buyer tax burden
P1 - (P2 - T) Seller tax burden
MR
Demand and Revenue• Demand Function
Q = 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)
-800
-600
-400
-200
0
200
400
600
800
0 10 20 30 40 50 60 70
P or AR
0
2
4
6
8
10
12
14
0 10 20 30 35 40 50 60 70