chapter 2 demand and supply analysis
DESCRIPTION
intermediate miceconomicsTRANSCRIPT
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CHAPTER 2
DEMAND AND SUPPLY
ANALYSIS
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Market Demand
• Demand function
– Quantity of a good all consumers in the market are
willing to buy
• Demand curve
– Aggregate quantity of a good that consumers are
willing to buy at different prices, holding constant
other demand drivers such as prices of other
goods, consumer income, quality
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Market Demand (cont.)
• Derived demand
– Demand for a good that is derived from the
production and sale of other goods
• E.g. demand for sugar is derived from demand for soft
drink
• Direct demand
– Demand for a good that comes from the desire of
buyers to directly consume the good itself
• E.g. rice is purchased by brokers, who then sell it to
retailers, who then resell it to final consumer
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Market Demand (cont.)
• Law of demand
– Quantity of a good demanded decreases when the
price of this good increases
• Holding all other factors that affect demand constant
• Demand curve rule
– A move along the demand curve for a good can
only be triggered by a change in own price
• Any change in another factor that affects the consumers’
willingness to pay for the good results in a shift in the
demand curve for the good
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Market Demand (cont.)
• Demand curve shifts
– When factors other than own price change
– If the change increases the willingness of
consumers to acquire the good
• Demand curve shifts right
– If the change decreases the willingness of
consumers to acquire the good
• Demand curve shifts left
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Market Demand (cont.)
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Market Demand (cont.)
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Market Supply
• Supply function
– Quantity of a good supplied by all producers in the
market depends on various factors
• Supply curve
– Aggregate quantity of a good that producers are
willing to sell at different prices
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Market Supply (cont.)
• Law of supply
– Quantity of a good offered increases when the
price of this good increases
• Supply curve rule
– A move along the supply curve for a good can
only be triggered by a change in the price of that
good
• Any change in another factor that affects the producers’
willingness to offer for the good results in a shift in the
supply curve for the good
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Market Supply (cont.)
• Supply curve shift
– When factors other than own price change
– If the change increases the willingness of
producers to offer the good at the same price
• Supply curve shifts right
– If the change decreases the willingness of
producers to offer the good at the same price
• Supply curve shifts left
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Market Supply (cont.)
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Market Supply (cont.)
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Market Equilibrium
• Market Equilibrium
– A price such that, at this price, the quantities
demanded and supplied are the same.
– A point at which there is no tendency for the
market price to change as long as exogenous
variables remain unchanged.
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Market Equilibrium (cont.)
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Market Equilibrium (cont.)
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Market Equilibrium (cont.)
• Excess demand
– A situation in which the quantity demanded at a given price exceeds the quantity supplied
• Excess supply
– A situation in which the quantity supplied at a given price exceeds the quantity demanded
• No excess supply or excess demand
– No pressure for prices to change (i.e. equilibrium)
• When demand curve or the supply curve shift
– Equilibrium shifts as well
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Market Equilibrium (cont.)
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Shifts in Demand, Supply Unchanged
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Shifts in Supply, Demand Unchanged
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Shifts in Supply and Demand
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Basics Laws of Supply & Demand
• Increase in demand + unchanged supply
– Higher price and larger quantity
• Decrease in supply + unchanged demand
– Higher price and smaller quantity
• Decrease in demand + unchanged supply
– Lower price and smaller quantity
• Increase in supply + unchanged demand
– Lower price and larger quantity
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Market Equilibrium
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Market Equilibrium (cont.)
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Price Elasticity
• Price elasticity of demand
– Percentage change in quantity demanded brought
about by a one-percent change in the price of the
good
εQ,P = %∆Q / %∆P = ∆Q / ∆P (P / Q)
– Elasticity is not slope
• Slope is the ratio of absolute changes in quantity and
price.
• Elasticity is the ratio of relative (or percentage)
changes in quantity and price
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Price Elasticity (cont.)
• Key characteristics
– |εQ,P > 1| = elastic
• One percent change in price leads to a greater than one-
percent change in quantity demanded
– |0 < εQ,P < 1| = inelastic
• One percent change in price leads to a less than one-
percent change in quantity demanded
– |εQ,P = 1| = unit elastic
• One percent change in price leads to an exactly one-
percent change in quantity demanded
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Price Elasticity (cont.)
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Price Elasticity (cont.)
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Elasticity – Linear Demand Curve
• Linear demand curve
– Q = a – bp
• a and b are positive constants, p is price, b is the slope
• Inverse demand curve
– P = a/b – (1/b)Q
• a/b is the choke price
• εQ,P = (ΔQ/ΔP)(P/Q) = -b(P/Q)
– Elasticity falls from 0 to -∞ along the linear
demand curve, but slope is constant
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Elasticity – Linear Demand Curve
(cont.)
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Elasticity – Linear Demand Curve
(cont.)
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Quantity
Price
0 Q
P • Observed price and quantity
Constant elasticity demand curve
Linear demand curve
Linear Demand Curve:
Qd = a -bP
εQ,P = (ΔQ/ ΔP)(P/Q) = -b(P/Q)
Constant Elasticity Demand
Curve:
Qd = aP-b
εQ,P = -b
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Elasticity – Linear Demand Curve
(cont.)
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Price Elasticity and Total Revenue
• Total Revenue (TR) = P*Q
– When P↑ Q↓ and when P↓ Q↑
• Demand is elastic
– Fall in Q > Rise in P
• ↓P → ↑TR
• Demand is inelastic
– Fall in Q < Rise in P
• ↑P → ↑TR
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Determinants of Price Elasticity
• Availability of substitutes
– More substitutes → more price elastic
• Goods which have price inelastic at the market level,
like cigarettes, is highly price elastic at the brand level
• Buyer’s budget
– Large expenditure → more price elastic
• Necessities vs luxuries
– Necessities → less price elastic
• Time Horizon
– Long-run → more price elastic
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Income Elasticity of Demand
• Income elasticity of demand
– Ratio of the percentage change of quantity
demanded to the percentage change of income
εQ,I = %∆Q / %∆I = ∆Q / ∆I (I / Q)
– εQ,I > 0
• ↑income → ↑demand
• Normal goods: consume more as income rises
– εQ,I < 0
• ↑income → ↓demand
• Inferior goods: consume less as income rises
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Cross-Price Elasticity of Demand
• Cross-price elasticity of demand
– Ratio of the percentage change of the quantity of
one good demanded with respect to the percentage
change in the price of another good
εQi,Pj = %∆Qi / %∆Pj = ∆Qi / ∆Pj (Pj / Qi)
– εQi,Pj > 0 = demand substitutes
– εQi,Pj < 0 = demand complements
– εQi,Pj = 0 = irrelevant
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Price Elasticity of Supply
• Price elasticity of supply
– Percentage change in quantity supplied for each
percent change in price
εQ,P = %∆Q / %∆P = ∆Q / ∆P (P / Q)
– εQ,P > 0 = Elastic
– εQ,P < 0 = Inelastic
– εQ,P = 0 = Unit elastic
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Elasticity – Long-run vs Short-run
• Long-run demand/supply curves
– Consumers/sellers can fully adjust their
purchase/supply decisions to changes in price
• Short-run demand/supply curves
– Consumers/sellers cannot fully adjust their
purchase/supply decisions to changes in price
• Example:
– Consumer substitute solar for gas
– Producer build new plant
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Elasticity – Long-run vs Short-run
(cont.)
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Elasticity – Long-run vs Short-run
(cont.)
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Estimating Demand & Supply
• Demand estimation
– Estimating demand from own price elasticity and
equilibrium price and quantity
– Choose a general shape for functions
Q = a - bp
– Estimating parameters of demand using elasticity
and equilibrium information
εQ,P = ∆Q / ∆P (P / Q)
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Estimating Demand & Supply
(cont.)
• Demand and supply estimation from past shifts
– A shift in the supply curve reveals the slope of the
demand curve
• We can identify the slope of demand by a shift in supply
– A shift in the demand curve reveals the slope of
the supply curve
• We can identify the slope of supply by a shift in demand
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Estimating Demand & Supply
(cont.)
Example:
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Estimating Demand & Supply
(cont.)
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Impact of Shift on Price
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