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Dartmouth College, Department of Economics: Economics 1, Fall 02Dartmouth College, Department of Economics: Economics 1, Fall 02Dartmouth College, Department of Economics: Economics 1, Fall 02
Topic 2: Supply and DemandTopic 2: Supply and Demand
Economics 1, Fall 2002Andreas Bentz
Based Primarily on Frank Chapters 2, 4
Dartmouth College, Department of Economics: Economics 1, Fall 02Dartmouth College, Department of Economics: Economics 1, Fall 02Dartmouth College, Department of Economics: Economics 1, Fall 02
Supply and Demand: EquilibriumSupply and Demand: Equilibrium
Example: The Market for Apartments
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The (Market) Demand CurveThe (Market) Demand Curve
Demand curve for one bedroom apartments:
The demand curvefor a good tells ushow much of thatgood is demandedat each price.
D
price (100s of $)
10
8
6
4
2
0
0 1 2 3 4 5 quantity (100s)
4
The Demand Curve, contdThe Demand Curve, contd
A downward-sloping demand curve tells usthat:
The higher the price, the less the demand for thegood.
Why?
As price increases, fewer potential buyers canafford to buy the good (income/wealth effect).
As price increases, some potential buyerssubstitute other goods (substitution effect).
We can write the (inverse) demand curve asp(q). Then we know that dp / dq < 0.
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The (Industry) Supply CurveThe (Industry) Supply Curve
The supply curve fora good tells us howmuch of that good issupplied at each
price.
S
price (100s of $)
10
8
6
4
2
0
0 1 2 3 4 5 quantity (100s)
Supply curve for one bedroom apartments:
6
The Supply Curve, contdThe Supply Curve, contd
An upward-sloping supply curve tells us that:
The higher the price, the greater the supply for thegood.
Why?
Typically: the more you produce, the greater theproduction cost for each additional unit. In order tobe willing to supply more, you therefore need to be
able to charge a higher price for each unit. (Theprice must cover the production cost.)
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EquilibriumEquilibrium
In equilibrium,prices are such thatthe quantitydemanded equalsthe quantitysupplied.
D
S
price (100s of $)
10
8
6
4
2
0
0 1 2 3 4 5 quantity (100s)
Equilibrium in the market for apartments:
8
D
S
Excess Supply / Excess DemandExcess Supply / Excess Demand
excess supply: theamount by whichquantity suppliedexceeds quantitydemanded
excess demand: theamount by whichquantity demanded
exceeds quantitysupplied
price (100s of $)
10
8
6
4
2
0
0 1 2 3 4 5 quantity (100s)
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D
S
Price Ceiling (Rent Control)Price Ceiling (Rent Control)
Theprice ceilingcauses excessdemand: somepotential buyerswho would want topay more than theceiling cannotobtain the good(rationing).
price (100s of $)
10
8
6
4
2
0
0 1 2 3 4 5 quantity (100s)
Price ceiling at $400:
10
D
S
Price FloorPrice Floor
Theprice floorcauses excesssupply: somepotential supplierswho would want tosupply at a lower
price cannot sellthe good.
price (100s of $)
10
8
6
4
2
0
0 1 2 3 4 5 quantity (100s)
Price floor at $800:
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D
S
Welfare Properties of EquilibriumWelfare Properties of Equilibrium
Equilibrium has nice welfare properties:
Example: Prices arefixed at $400, so 200apartments are rented.
Now suppose somebuyer offered $700 forone more apartment. Aseller should be happyto provide one moreapartment (since the
cost of providing thatapartment is $400).
price (100s of $)
10
8
6
4
2
0
0 1 2 3 4 5 quantity (100s)
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PricesPrices
Prices serve two important functions:
Rationing function:
We live in a world of scarcity. If all goods were free, howcould we ration peoples unlimited wants?
Allocative function:
Since we live in a world of scarcity, we need to allocatethe available resources so that:
those who value goods most highly obtain them;
those goods that are most wanted are being produced(suppose there is excess demand in one market: firmswould have an incentive to expand production in thatmarket, because supernormal profits can be made).
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Dartmouth College, Department of Economics: Economics 1, Fall 02Dartmouth College, Department of Economics: Economics 1, Fall 02Dartmouth College, Department of Economics: Economics 1, Fall 02
Using Supply and DemandUsing Supply and Demand
Changes in DemandChanges in SupplyApplication: Taxes
Elasticity
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Changes in DemandChanges in Demand
What shifts the demand curve? (Alternatively:What causes a rise (fall) in the quantitydemanded at every price?)
Changes in income/wealth: as consumersincome/wealth increases, they will want to buymore of a good at each price.
Prices of substitutes/complements:
complements (e.g. coffee and cream): if the price of coffeerises, your demand for cream will fall;
substitutes (e.g. coffee and tea): if the price of coffee rises,your demand for tea will increase.
etc.
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Changes in SupplyChanges in Supply
What shifts the supply curve? (Alternatively:What causes a rise (fall) in the quantitysupplied at every price?)
Technology: better technology reduces cost ofproduction.
Factor prices: higher factor prices (e.g. cost oflabor) means higher cost of production.
Number of suppliers (e.g. computer manufacturers)
etc.
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Demand v. Quantity DemandedDemand v. Quantity Demanded Distinguish between:
a change in demand (the entire demand curve shifts), and
a change in the quantity demanded (a movement along thedemand curve).
price
quantity
D
S
Example: consumers
expect a future price rise
price
quantity
Example: good weather
before harvest
S
D
S
D
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Supply v. Quantity SuppliedSupply v. Quantity Supplied
Similarly
Distinguish between:
a change in supply (the entire supply curve shifts),and
a change in the quantity supplied (a movementalong the supply curve).
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Using Supply and DemandUsing Supply and Demand Example: Why do airfares increase in summer?
price
quantity
D
S
Example (a): carriers can
expand capacity
price
quantity
D
S
Example (b): carriers
cannot expand capacity
D D
Think about your own example with a fall in demand!
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Using Supply and Demand, contdUsing Supply and Demand, contd
price
quantity
D
Example (b): demand for
gas is (relatively) inelastic
S
Sprice
quantity
D
S
Example (a): demand for
gas is (relatively) elastic
S
Example: What happened during the oil price shock?
Think about your own example with a supply increase!
Dartmouth College, Department of Economics: Economics 1, Fall 02Dartmouth College, Department of Economics: Economics 1, Fall 02Dartmouth College, Department of Economics: Economics 1, Fall 02
Application: TaxesApplication: Taxes
Producer/Consumer Taxes(Economic) Tax Incidence
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TaxesTaxes
Suppose a tax of T is levied on each unit soldby the producer.
price
quantity
S
Supply curve shifts up by
the amount T.
S
T
In order to cover cost, theproducer needs to charge Tmore for each unit sold.
price
quantity
Tax incidence: who bears
the tax?
S
S
D
But some of the cost T of thetax is borne by consumers.
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Taxes, contdTaxes, contd
In order to buy the samequantity as before, the pricehas to fall by T.
But some of the cost T of thetax is borne by producers.
price
quantity
Demand curve shifts down
by the amount T.
DD
T
price
quantity
Tax incidence: who bears
the tax?
DD
S
Suppose a tax of T is levied on each unitbought by the buyer.
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Tax IncidenceTax Incidence
Who bears the tax depends on the elasticitiesof supply and demand. Example: demand.
price
quantity
Example (a): Relatively
elastic demand curve
S
S
D
Tax borne largely byproducers.
Tax borne largely byconsumers.
price
quantity
Example (b): Relatively
inelastic demand curve
S
S
D
24
Tax Incidence, contdTax Incidence, contd
price
quantity
Example (a): Relatively
elastic supply curve
S
S
D
Tax borne largely byconsumers.
Tax borne largely byproducers.
price
quantity
Example (b): Relatively
inelastic supply curve
S
S
D
Who bears the tax depends on the elasticitiesof supply and demand. Example: supply.
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Tax Incidence, contdTax Incidence, contd
Similarly, supply and demand elasticitiesdetermine the incidence of a tax levied onconsumers.
Workout: Try this at home!
Dartmouth College, Department of Economics: Economics 1, Fall 02Dartmouth College, Department of Economics: Economics 1, Fall 02Dartmouth College, Department of Economics: Economics 1, Fall 02
ElasticityElasticity
Price Elasticity of DemandCross-Price Elasticity of Demand
Income Elasticity of Demand
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Price Elasticity of DemandPrice Elasticity of Demand
The price elasticity of demand measures theresponsiveness of demand for a good withrespect to changes in the price of that good.
Definition: Theprice elasticity of demandis thepercentage change in the quantity demandedthat results from a 1 percent change in price.
Precisely, it is:
or, rewritten:
pp
/
/
=
q
p
dp
dq =q
p
p
q =
q
p
dq
dp
= /1
pp
=
/
/
28
Price Elasticity of Demand, contdPrice Elasticity of Demand, contd
says that:
The price elasticity of demand at some point on thedemand curve is
the inverse of the slope of the (inverse) demand curve,
times the ratio of price to quantity at that point on thedemand curve.
Implications: the price elasticity of demand is (probably) different at every point on the demand
curve;
nonpositive.
q
p
dq
dp
= /1
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Price Elasticity of Demand, contdPrice Elasticity of Demand, contd
We call demand (at some point) elastic, if the quantitydemanded is relatively responsive to changes in price.
Definition: demand is elastic whenever < -1.
We call demand (at some point) inelastic, if thequantity demanded is relatively unresponsive tochanges in price.
Definition: demand is inelastic whenever -1 < < 0.
We call demand (at some point) unit elastic, if thequantity demanded changes proportionately to
changes in price. Definition: demand is unit elastic whenever = -1.
30
Price Elasticity of Demand, contdPrice Elasticity of Demand, contd
Perfectly elastic demand( = -)
Perfectly inelasticdemand ( = 0)
Demand curve with slope
dp/dq = 0
D
price
quantity
Demand curve with slope
dp/dq =
D
price
quantity
Two extreme cases:
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Using Price Elasticity of DemandUsing Price Elasticity of Demand
Example: Suppose you know that the priceelasticity of demand for pizza at Thayer is -2.
That is, every 1% increase in price results in a 2%reduction in the quantity demanded.
Currently, 100 slices of pizza are sold, at$1.75 each. So revenue from pizza is $175.
If the price of pizza increased to $2.10, would
total revenue increase or decrease?
32
Using Price Elasticity, contdUsing Price Elasticity, contd
An increase from $1.75 to $2.10 is an increaseof 20%.
Since the elasticity is -2, we know that demand willfall by 40%.
Only 60 slices of pizza will be sold after theprice increase.
60 slices of pizza at $2.10 each create revenue of
$126, which is less than $175.
Total revenue would decrease.
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Buzz GroupBuzz Group
What effect does a 20% increase in price haveon total revenue from pizza if the priceelasticity of demand were -0.5?
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Cross-Price Elasticity of DemandCross-Price Elasticity of Demand
We have already seen that prices of othergoods may influence demand for a good.
Example: If tea and coffee are substitutes, anincrease in the price of coffee will increase yourdemand for tea.
The cross-price elasticity of demand measuresthe responsiveness of demand for a good with
respect to changes in the price of some othergood.
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Cross-Price Elasticity, contdCross-Price Elasticity, contd
Definition: The cross-price elasticity of demandis the percentage change in the quantitydemanded of one good that results from a 1percent change in price of some other good.
Precisely, for two goods, x and y, it is:
yy
xxxy
pp
/
/
=
36
Cross-Price Elasticity, contdCross-Price Elasticity, contd
We can now be specific about substitutes andcomplements:
Two goods, x and y, are substitutes if anincrease in price of good y increases demandfor good x.
Definition: x and y are substitutes ifxy > 0.
Two goods, x and y, are complements if anincrease in price of good y decreases demandfor good x.
Definition: x and y are complements ifxy < 0.
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Cross-Price Elasticity, contdCross-Price Elasticity, contd
38
Income Elasticity of DemandIncome Elasticity of Demand
We have also seen that changes inincome/wealth may have an effect on thequantity demanded of some good.
Example: As your income/wealth rises, you canafford to buy more of everything.
The income elasticity of demand measures theresponsiveness of demand for a good with
respect to changes in a consumersincome/wealth.
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Income Elasticity, contdIncome Elasticity, contd
Definition: The income elasticity of demandisthe percentage change in the quantitydemanded of some good that results from a 1percent change in a consumersincome/wealth.
Precisely, it is:
(where m is income/wealth).
mm
/
/
=
40
Income Elasticity, contdIncome Elasticity, contd
Income elasticity of demand is usually positive(normal goods).
But there are goods of which you want to buyless as your income increases (inferior goods).
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Income Elasticity, contdIncome Elasticity, contd
We can now be specific about which goodsare necessities and which are luxuries:
A good is a necessity if quantity demanded isrelatively unresponsive to changes inincome/wealth.
Definition: a good is a necessityif 0 < < 1.
A good is a luxury if quantity demanded isrelatively responsive to changes in
income/wealth. Definition: a good is a luxuryif > 1.