Chapter 2Review of S and D

• Supply Curve:• Shows quantity supplied at each

possible price, ceteris paribus (c.p.).– Slopes upward (positive relationship)

– Qs = Qs(P)

– Shift S Curve if change c.p. factor

– Movement along vs shift

– C.P. factors: change in cost of production; change S from bad weather.

– Interpret shift S curve: change willingness to supply at each price.

Demand Curve

• Shows quantity demanded at each possible price, ceteris paribus (c.p.)– Slopes downward (negative

relationship)– Qd = Qd(P)– Movement along versus shift.– C.P. factors: change income;

change demand for related good.– Interpret shift D curve: change

willingness to buy at each price.

Substitutes and Complements

• Given two goods X and Y, if they are consumed together they are called complements and if one is used instead of the other, they are called substitutes.

• Substitutes: Px Dy – When price of X , the demand for X

falls. So demand for Y .– Example: beef and chicken

• Complements: Px Dy

– When price of X , its demand . So demand for Y also.

– Example: bread and butter

Market Mechanism

• Put Supply and Demand Together• Equilibrium

– Point at which Qs=Qd;

– Market-clearing P;

• Describe re-equilibrating process by changing C.P. factor:– Increase in income causes increase in

demand (shift D rightward)

– At old P, Qd greater than Qs: so individuals bid up price till reach new equilibrium.

Example of Shifts in S and D

• Effects of 9/11: Example 2.4 in text.

• Much destruction of office space; suggests shortage (lower vacancy rate) should drive up rental rates.

• Result was different because as supply fell, demand fell also.

• See Figure 2.10

In-Class Exercise

• Note in text on pg. 28: – Fact: top 20% of income distribution

had 40% increase in real take-home earnings; bottom 10% of distribution had decline of 10%.

• Consider: two separate labor markets for skilled and unskilled workers. Start in equilibrium for both; then show:– Unskilled workers: big S, small D– Skilled workers: small S, big D.– Outcome will explain observed trend:

big increase in inequality in 1980s and 1990s; or, increase in working poor.

Homework Assignment

• Consider the two separate markets for peanut butter and jelly. Assume that the two products are complements for consumers.– 1. Sketch and describe the initial

equilibrium in both markets.

– 2. Show the effect of new health warnings about all the fat in peanut butter in first the market for peanut butter and then in the market for jelly.

– 3. Draw and label completely and describe in words.

Elasticity

• Definition: %Qd in response to a 1% P

• Or: %Qd / %P• What is %? Absolute change in

variable divided by original level of variable.

• Ep = (Qd/Q) / (P/P)• = (P/Q) (Q/P)• Remember: (Q/P) is 1/slope.• Ep = price elasticity of demand;

usually negative.

Relate Elasticities to S and D Equations

• Demand: Q = a – bP

• Supply: Q = c + dP

• E = (P/Q )*(Q/P)

• (Q/P) = constant = d for supply

= –b for demand.

• Demand: ED = -b(P*/Q*)

• Supply: ES = d(P*/Q*)

More About Elasticities

• Elastic: Ep 1• Inelastic: Ep 1• Unitary Elastic: Ep 1• Fact: While slope is constant along a

linear demand curve, elasticity is not.

• Fact: At top of demand curve, when P is high and Q is low, Ep is big negative number so D curve is very elastic.

• Fact: As move down D curve to right, Ep falls (because P is while Q is , so P/Q is ).

Example

• Price Demand Supply• 60 22 14• 80 20 16• 100 18 18• 120 16 20

• 1. What is P*, Q*?• 2. When P=$80, what is ED?• Homework:.• Textbook page 58; Exercises #1 and

#2.

Relative Elasticities

• Rule: the steeper the slope of the curve, the less elastic.

• Completely horizontal demand curve: infinitely elastic: consumers will buy as much as they can at a single P*

• Completely vertical demand curve: completely inelastic: consumers will buy fixed quantity, no matter what the P.

Nearly Horizontal Demand Curve

• Elasticity approaches infinity: Recall: 1/slope = Q/P

• If nearly flat curve: small P causes a huge Q. This is same as: huge / small , which equals a very big number.

• This will help you remember elasticity for completely flat versus completely vertical.

Income Elasticity of Demand

• Measure responsiveness of Qd to change in income (note this is a ceteris paribus factor).

• EI = %in Qd resulting from a 1% in income.

• EI = (Q/Q) / (I/I)

• = I/Q (Q/I).

Cross-Price Elasticity of Demand

• Measures responsiveness in Qd of one good to change in price of a related good (note this is a change in a c.p. factor).

• Cross-price elasticity of demand = % in Qd resulting from a 1% in the price of a related good.

• EQ1P2 = (Q1/Q1) / (P2/P2) • P2/Q1 Q1/P2.• EQP 0: the two goods are

substitutes.• EQP 0: the two goods are

complements.

Price Elasticity of Supply

• Price Elasticity of Supply: Responsiveness of Qs to P.

• ESP = %Qs / %P

• = (Qs/Qs) / (P/P) P/Qs Qs/P

• Usually positive.

Wage Elasticity of Supply

• Measures responsiveness of Qs to changes in the cost of labor (a ceteris paribus factor).

• ESW = %Qs / %W

• = (Qs/Qs) / (W/W) W/Qs Qs/W.

• Usually negative.

• Remember: W cost of production.

Example

• Qs = 3 + 12P

• Qd = 19 – 4P

• 1. Find P* by setting Qs=Qd.

• 2. Find Q* by putting P* into either Qs or Qd.

• Solve for Ep of demand at equilibrium:

• EDP* = (P*/Q*) (Q/P)

Short-Run versus Long-run Elasticities

• Focal point: how much time do sellers and consumers have to respond (in their Qs and Qd) to changes in price?

• In general: LR adjustment is more full, free adjustment so that LR elasticity is larger; BUT not true all the time.

• Key factors: – Durability.

– Availability of substitutes

– % of consumer’s budget

Government Price Controls

• Key: If government sets P so that there is no single P for which Qs=Qd, then there will be a shortage or surplus.

• Be able to show the Qs and Qd for any price.

• Price ceiling: prevents price from rising above the ceiling.

• Price floor: prevents price from falling below floor.

In-Class Exercise

• Rent control in NYC:

• Qd = 100 – 5P

• Qs = 50 + 5P

• 1. Find P* and Q*.

• 2. What if rent control agency sets Price ceiling at $1?– A. What is Qd?– B. What is Qs?– C. What is resulting Q sold?– D. What is # newly homeless?