Part 2 Markets: Demand, Supply, and Elasticity • What determines the price of a good or service and the quantity bought and sold? • Demand and supply model of a market • This simple model of a market assumes competitive conditions • Distinguish between a demand side and a supply side of the market • Together they determine the equilibrium price and quantity
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Part 2 Markets: Demand, Supply, and Elasticity What determines the price of a good or service and the quantity bought and sold? Demand and supply model.
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Part 2Markets: Demand,
Supply, and Elasticity
• What determines the price of a good or service and the quantity bought and sold?
• Demand and supply model of a market
• This simple model of a market assumes competitive conditions
• Distinguish between a demand side and a supply side of the market
• Together they determine the equilibrium price and quantity
Demand• Demand is the quantity of a good
people purchase over a given time • The quantity of a good a person will
plan to purchase will depend on:
- Preferences (tastes)
- Price of the good
- Prices of other goods
- Expected future prices
- Income• In the aggregate, demand will also
depend on:
- Population and demographics
The Law of Demand
• Other things remaining the same, the higher the price of a good, the smaller is the quantity demanded
• Substitution effect—the effect of the change in relative price
• Income effect—the effect of the change in overall purchasing power
Demand Function and Demand Curves
• Demand function—demand as a function of a number of variables
• Demand curve—demand as a function of price, everything else held constant
• What is held constant along a demand curve?
• Changes in the quantity demanded—movements along the demand curve
Changes in Quantity Demanded
P
Q
P’
P
P”
Q’ Q Q”
Decrease in quantity demanded
Increase in quantitydemanded
Change in quantity demanded—a movement along the demand curve
Demand Curves
• Can be linear or non-linear
• A linear demand curve
P
Q
20
30
P = 20 - 2/3Q
P = a + bQWhere a is the P intercept and b is the slopevariable and is negative
Demand Curves• A demand curve is more usually
written with Q as the dependent variable
P
Q
20
30
Q = a + bPWhere a is the Q intercept and b is the inverse of the slope and is negative
Q = 30 – 3/2P
Changes in Demand
• Shift in a demand curve is a Change in Demand
• Change in tastes or preferences• Change in the prices of other goods
- substitutes
- complements• Changes in expected future prices• Changes in income
- normal goods
- inferior goods• Changes in population/demographics
An Increase in Demand
• An increase in demand—a rightward shift
P
Q
D
D’
An Increase in Demand
• Price of a substitute rises
• Price of a complement falls
• Expected future price rises
• Income rises (normal good) or income falls (inferior good)
• Preferences move toward the good
• Population increases
A Decrease in Demand
• A decrease in demand—a leftward shift
P
Q
D
D’
A Decrease in Demand
• Price of a substitute falls
• Price of a complement rises
• Expected future price falls
• Income falls (normal good) or income rises (inferior good)
• Preferences move away from the good
• Population falls.
Supply
• Supply is the quantity of a good firms produce over a given time
• The firm has to have the resources and technology to produce the good
• The firm has to think it can produce the good at a profit (at least in the long run)
• Short run and long run supply decisions
Supply• The amount of any particular good
or service supplied by a firm will depend on:
- The price of the good
- The prices of inputs needed to produce the good
- The available technology
- The available capital (short run)
- Prices of other goods
- Expected future prices• In the aggregate, supply will also
depend on:
- The number of firms in the market
The Law of Supply
• Other things remaining the same, the higher the price of a good, the greater will be the quantity supplied
• Higher prices mean it will be profitable to expand production
• With rising marginal costs higher prices are required for firms to be willing to increase production
Supply Functions and Supply Curves
• Supply function
• Supply curve—shape
• Supply curves can only be defined for competitive industries (where price is a given to the firm)
• What is held constant along a supply curve?
• Changes in the quantity supplied—movements along the supply curve
Changes in Quantity Supplied
P
Q
P
Q’ Q Q”
Change in quantity supplied—a movement along the supply curve
P”
P’
S
Increase in quantitysupplied
Decrease in quantity supplied
Supply Curves
P
Q
S
10
P = 10 + 2Q
Slope is = 2
A linear supply curve: P = a + bQ where a is the P interceptAnd b is the slope which is positive
Supply Curves
Supply curves are more usually written with Q as the dependent variable: Q = a + bP where a is the Q intercept and b is the inverse of the slope and positive
P
Q
S
-5
Slope = 2 inverse of Slope = 1/2
Q = -5 + ½ P10
0
Changes in Supply
• Shift in a supply curve is a Change in Supply
• Change in input prices
• Changes in technology
• Changes in expected future prices
• Change in the scale of the firm
• Changes in the number of firms—entry and exit of firms
An Increase in Supply
An increase in supply—a rightward shift inthe supply curve
S S’P
Q
An Increase in Supply
• Price of inputs fall
• More efficient technology
• Expected future price fall
(ie natural resource production)
• Firms grow in size
• Number of firms in the industry grows
A Decrease in Supply
P
Q
S
S’
A decrease in supply is a leftward shift in the supply curve
A Decrease in Supply
• Price of inputs rise
• Expected future price rise (natural resources)
• Loss of technological knowledge
• Firms decline in size
• Number of firms in the industry shrinks
Market Equilibrium
• Market equilibrium is where demand = supply
• Equilibrium price• Equilibrium quantity• Price adjusts to bring about an
equilibrium• If D>S price rises which reduces
quantity demanded and increases quantity supplied
• If S>D price falls which increases quantity demanded and reduces quantity supplied
Market Equilibrium
P
Q
S
D
E
P*
Q*
Surplus-price falls
Shortage-Price rises
Market Equilibriumin Equations
• Demand curve D = a + bP where a is the Q intercept and b is the inverse of the slope (and negative)
• Supply Curve S = c + dP where c is the Q intercept (usually zero or negative) and b the inverse of the slope and positive
• In equilibrium D = S
• Solve for P* then Q*
Market Equilibriumin Equations
• Demand curve D = 400 – .5P
• Supply Curve S = – 200 + 1P
• Solve for P*
• 400 – .5P* = – 200 + 1P*
• 600 = 1.5P*
• P* = 400
• Solve for Q*
• Q* = 400 – 200
• Q* = 200
Market Equilibrium in Equations
Diagram of the equations
Q400
800
-200
S = -200 + 1P
D = 400 - .5P
200
P
400
Equilibrium Price and Quantity Changes
• A change in demand with a given supply curve
P
Q
S
D
D’
E
E’
• Rightward shift in demand leads to a movement along the supply curve. P and Q both rise.
P’
P
Q Q’
Equilibrium Price and Quantity Changes
• A change in supply with a given demand curve
D
SS’
E
E’
P
P
P’
Q Q’ Q
• A rightward shift in supply leads to a movement along the demand curve. P falls and Q rises.
Equilibrium Price and Quantity Changes
• A change in supply and demand —same directions
D
SS’
E
P
P
Q Q
• A rightward shift in both demand and supply leads to a higher Q. P may rise, fall, or stay the same.
Q’
E’
D’
Equilibrium Price and Quantity Changes
• A change in supply and demand —opposite directions
D’
S S’P
Q
• A rightward shift in supply and a leftward shift in demand leads to a lower P. Q may rise, fall, or stay the same.
D
E
E’
Q
P
P’
An Example• From Slate Magazine June 2009
in a discussion of a campaign by Chevron to get people to drive less: “All other things being constant, if every gullible soul performed the conservation miracles Chevron proposes, energy consumption would fall, and so would prices. As prices fell the non-gullible would take advantage of the depressed prices to consume more and thus drive the price back up.” Is this right?
Elasticity
• Elasticity is a measure of responsiveness
• Many elasticities can be measured: price elasticity of demand, cross price elasticity of demand, income elasticity of demand, and elasticity of supply
• Elasticity measures are measures of proportionate responsiveness and are unit free
Elasticity
• General form:
The elasticity of X with respect to Y is given by the % or proportionate change in X divided by the % or proportionate change in Y
• EXY = % Δ X / % Δ Y or
• EXY= ΔX/X / ΔY/Y or
• EXY=ΔX/ΔY • Y/X
Price Elasticity of Demand
• Elasticity of Demand with respect to the good’s own price
• EDxPx= %ΔQ/%ΔP or
• EDxPx= ΔQ/Q / ΔP/P or
• EDxPx= ΔQ/ΔP • P/Q
• For price elasticities of demand the sign is ignored as they are all negative
• Elasticities of supply can range from zero to infinity. Depends on technology, resource substitution, and time frame
• All straight line supply curves through the origin will have elasticities of supply = 1
Elasticity of Supply
SP
Q100 200
50
40
ESxPx = 100/10 x 45/150 = 3
100
10
An Example
• Times Colonist editorial concerning BC Ferry fares, July 2009: “Increased fares have resulted in fewer passengers. BC Ferries own figures indicate an 8% rise in fares results in a 2.25% drop in travel. Last year fares rose by 7.3%. Fewer passengers means less revenue for the Corporation and more fare increases. It is the start of a vicious cycle.” Is this correct?