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Unit1.Basic Model of Supply and Demand

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Unit 1. The Basics of
Supply and Demand
MICROECONOMICS: CONSUMPTION AND PRODUCTION
Prof. BRINDUSA ANGHEL
COURSE 2015-2016
Introduction

Analysis of the applications of supply and demand:

Understanding and predicting how world economic
conditions affect the market price and production.

Assessing the impact of government price controls, minimum
wages, price supports and production incentives.

Determining the impact of taxes, subsidies and quotas on
imports on consumers and producers.
2
1.Supply and demand

The supply curve

Shows the quantity of a good that producers are willing to sell, at
a given price, holding constant other factors that may affect the
amount supplied.

The relationship between quantity supplied and the price can be
expressed as follows:
Qs  QS (P )
3
Supply and demand
Graph of the supply curve
Price
(dollars
per unit)
The vertical axis measures
price (P) received
per unit (in dollars).
The horizontal axis measures
quantity (Q) offered
(number of units
per period of time).
Quantity
4
Supply and Demand
Graph of the supply curve
Price
(dollars
per
unit)
S
P2
The supply curve
slopes upward, showing that if prices
increase, firms are willing to
produce and sell more.
P1
Q1
Q2
Quantity
5
Supply and demand

Apart from the price, other variables may
affect the supply curve
- Production costs:

Labor.

Capital.

Raw materials.
6
Supply and Demand
Shifts in the supply curve

The cost of raw
materials goes down:

For P1, it is produced Q2

For P2, it is produced Q1


The supply curve shifts to the
right (from S to S’)
P
S’
S
P1
P2
For a given price, a higher
production in S‘ than in S.
Q0
Q1
Q2
Q
7
Supply and Demand

The demand curve

Indicates the quantity of a good that consumers are willing to
buy as the price per unit changes.

The relationship between quantity demanded and the price can
be expressed as follows :
QD  QD(P)
8
Supply and demand
Price
(dólares
por
unidad)
The vertical axis measures
price (P) paid
per unit (in dollars).
The horizontal axis measures
quantity (Q) demanded
(number of units
per period of time).
Quantity
9
Supply and Demand
Price
(dollars
per unit)
The demand curve slopes
downward, showing that
consumers prefer to buy
more at lower prices.
D
Quantity
10
Supply and demand

Apart from the price, other variables may
affect the demand curve:
 Income.
 Consumer’s
preferences.
 Price of related goods:
Substitute goods
 Complementary goods.

11
Supply and demand
Shifts in the demand curve

Income increases:

For P1, it is produced Q2

For P2, it is produced Q1

The demand curve shifts to
the right.

For a given price, a higher
amount demanded in D‘
than in D.
P
D’
D
P2
P1
Q0
Q1
Q2
Q
12
2. The market mechanism
Price
(dollars
per unit)
S
The curves intersect at
equilibrium price (or
market clearing
condition).
At P0, the quantities
supplied and
demanded are equal (Q0).
P0
D
Q0
Quantity
13
The market mechanism

Characteristics of the equilibrium price
(or market clearing condition):
 QD
= QS
 No shortage (excess of demand).
 No surplus (excess supply).
 No pressures to change the price.
14
The market mechanism
Price
(dollars
per unit)
S
Surplus
P1
If the price is higher than the
equilibrium price:
1) The price is above
price that clears
the market.
2) Qs > Qd
3) There is a tendency for
price to decreases until the
market clears.
P0
D
Q0
Quantity
15
The market mechanism
A surplus: how is the adjustment?

The market price is above the equilibrium
price:
 There
is an excess of supply.
 Producers lower the prices.
 The quantity demanded increases and the
quantity supplied decreases.
 The market continues to adjust until market
clears.
16
The market mechanism
Price
(dollars
S
per unit)
Surplus
P1
P2
Assuming that price is P1, then:
1) Qs: Q2> Qd: Q1
2) The surplus is Q2-Q1.
3) Producers lower prices.
4) The quantity
supplied decreases and
the quantity demanded
increases.
5) Equilibrium is reached at
(P2 ,Q3)
D
Q1
Q3
Q2 Quantity
17
The market mechanism
Price
(dollars
S
per unit)
P3
P2
Shortage
Q1
Q3
Assuming that price is P2 , then:
1) Qd : Q2 > Qs : Q1
2) The shortage is Q2-Q1
3) Producers raise prices..
4) The quantity
supplied increases as
the quantity demanded
decreases.
5) Equilibrium is reached at
(P3, Q3)
D
Q2 Quantity
18
The market mechanism
Shortage: how is the adjustment?

The market price is below the equilibrium price
 There is a shortage.
 Producers raise prices.
 Quantity demanded decreases and quantity
supplied increases.
 The market continues to adjust until market
clears.
19
3. Changes in market equilibrium

The prices of
raw material
decrease:

S shifts to S’
 For
P1 there is a
surplus of Q2 – Q1
 Equilibrium
P
D
S’
S
P1
P3
at P3, Q3
Q1 Q3 Q2
Q
20
Changes in market equilibrium

The income increases:
P

Demand shifts to D1.

Shortage in P1 :(Q4-Q1)
P3

Equilibrium in (P3, Q3)
P1
D
D’
S
Q2 Q1 Q3 Q4
Q
21
Changes in market equilibrium

Income increases
and prices of
raw material decrease:
P
D
D’
S
S’
 The
shift in the D curve
P2
is greater than the shift P
1
in the S curve.
 The
price
and equilibrium
quantity increase to P2,
Q 2.
Q1
Q2
Q
22
Shifts in the supply and the demand

When the supply and demand vary at
the same time, the impact on price
and equilibrium quantity is determined by:
1) The relative size and direction of the change.
2) The slopes of the supply and the demand.
23
4.The elasticities of supply and demand

The elasticity measures how sensitive are
demand or supply to changes in the price.

It indicates the percentage change
in one variable (quantity) resulting from a 1
percent increase in another variable
(price).
24
The elasticities of supply and demand
Price elasticity of demand

Measures the sensitivity of the quantity
demanded to price changes.
 It
indicates the percentage change in
quantity demanded of a good resulting from a
1-percent increase in its price.
25
The elasticities of supply and demand

The price elasticity of demand can be expressed as
follows:
EP  (%Q)/(% P)
Q/Q P Q
EP 

P/P Q P
26
The elasticities of supply and demand

Interpretation of price elasticity of demand values​​:

EP is negative due to the inverse relationship between P and Q.

If EP > 1, we say that demand is price elastic with respect to
price because the percentage change in quantity demanded is
greater than the percentage change in price.

If EP < 1, we say that demand is price inelastic because
the percentage change in quantity demanded is less than
the percentage change in price.
27
The elasticities of supply and demand
The price elasticity of demand

The price elasticity of demand depends mainly
on the existence of close substitutes.
When there are many substitutes, demand is
elastic with respect to price.
 When there are few substitutes, demand
is price inelastic.

28
Price elasticities of demand
Price
Infinitely elastic demand
D
P*
EP  - 
Quantity
29
Price elasticities of demand
Totally inelastic demand
Price
EP  0
Q*
Quantity
30
The elasticities of supply and demand
Elasticities of supply

The price elasticity of supply measures
the percentage change in quantity supplied of a
good resulting from a 1 percent increase in its
price.

The elasticity is usually positive because price
and quantity supplied are positively related.
31
Short-run versus long-run elasticities
S’
S
Price
A drought
produces a drop in
supply of coffee.
P1
P0
Short -run:
1) The supply is completely
inelastic
2) Demand is relatively
inelastic
D3) A large change in price
Q1
Q0
Quantity
32
Short-run versus long-run elasticities
Price
S’
S
P2
P0
Medium-run:
1) The supply and the demand
are more elastic
2) The price increases less than
in the previous case P2
3) The quantity drops to Q2
D
Q2 Q0
Quantity
33
Short-run versus long-run elasticities
Price
Long-run:
The supply is extremely elastic
S
P0
D
Q0
Quantity
34
5. Economic Analysis
The model of supply and demand

First, we must learn to "adjust" the linear
curves of supply and demand for market data.

Then we study how changes in other variables
affect supply and/or demand, and consequently
the price and quantity of equilibrium in the
market.
35
Economic Analysis
The model of supply and demand

Let's start with the equations of the supply
and the demand:
Demand: QD = a - bP
Supply:

QS = c + dP
We must choose numbers for a, b, c, d.
36
Economic Analysis
The model of supply and demand

Data available:
 Equilibrium
price, P *.
 Equilibrium quantity, Q *.
 Price elasticity of supply, ES, and demand, ED.
37
Economic Analysis
The model of supply and demand
Price
Supply: Q = c + dP
a/b
ED = -bP*/Q*
ES = dP*/Q*
P*
-c/d
Demand: Q = a - bP
Q*
Quantity
38
Effects of Price Controls
Maximum Price
Price
S
If the price can not exceed
Pmax, the quantity supplied
falls to Q1 and the quantity
demanded increases to Q2
As a result:
There is EXCESS OF DEMAND
P0
Pmax
D
Excess demand
Q1
Q0
Q2
Quantity
39
Effects of Price Controls
Minimum Price
Surplus
Price
S
If the price must be at least
Pmin, the quantity supplied
increases to Q2 and the quantity
demanded decreases to Q1
As a result:
There is EXCESS OF SUPPLY
Pmin
P0
D
Q1
Q0
Q2
Quantity
40