1. 2. 3. 4. 5. 6. Motivation Competitive Markets Defined The Market Demand Curve The Market Supply Curve Equilibrium Characterizing Demand and Supply: Elasticity 7. Back of the Envelope Techniques Chapter 2: Demand and Supply Analysis 2 tells us how the quantity of a good demanded by the sum of all consumers in the market depends on various factors. are those with sellers and buyers that are small and numerous enough that they take the market price as given when they decide how much to buy and sell. Qd = (Q,p,po, I,…) Plots the 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. Qd= Q(p) 3 4 The Demand for New Automobiles in The United States The Demand for New Cars in Price (thousands of dollars) Price (thousands of £) 53 53 Demand curve for cars 0 5.3 0 Quantity (millions of automobiles per year) 5 5.3 Quantity (millions of cans per year) 6 1 Note: We always graph P on vertical axis and Q on horizontal axis, but we write demand as Q as a function of P… If P is written as function of Q, it is called the inverse demand. states that the quantity of a good demanded decreases when the price of this good increases. Normal Form: Qd= 100-2P Inverse form: P = 50 - Qd/2 • ¾ Empirical regularity The demand curve: shifts when factors other than own price change… Markets defined by commodity, geography, time. •If the change increases the willingness of consumers to acquire the good, the demand curve shifts right •If the change decreases the willingness of consumers to acquire the good, the demand curve shifts left 7 8 tells us how the quantity of a good supplied by the sum of all producers in the market depends on various factors Qs= Q(p,po, W, …) A move along the demand 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 consumers’ willingness to pay for the good results in a shift in the demand curve for the good. Plots the aggregate quantity of a good that will be offered for sale at different prices. Qs= Q(P) 9 10 Definition: The Law of Supply states that the quantity of a good offered increases when the price of this good increases. 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. ¾ Empirical regularity The supply curve shifts when factors other than own price change… •If the change increases the willingness of producers to offer the good at the same price, the supply curve shifts right •If the change decreases the willingness of producers to offer the good at the same price, the supply curve shifts left 11 12 2 Price (£) QS = p + .05r QS = quantity of beer (millions of pints) p = price of beer (pounds per pint) r = football matches on TV... 0 Quantity, million pints 13 Price (£) 14 Price (£) r=0 r=0 r=3 Supply with 0 matches Supply with no matches Supply with matches 0 0 .15 Quantity, Billion bushels Quantity, Million pints 15 16 Qd = 500 – 4p QS = -100 + 2p Definition: A market equilibrium is a price such that, at this price, the quantities demanded and supplied are the same. p = price of pint Q = demand or supply in millions of pints per year (Demand and supply curves intersect at equilibrium) 17 18 3 a. The equilibrium price of pints is calculated by equating demand to supply: Example: The Market For Beer Price Qd = QS … or… 500 – 4p = -100 + 2p …solving, Market Supply: P = 50 + QS/2 p* = £100 P*=100 b. plug equilibrium price into either demand or supply to get equilibrium quantity: Quantity 19 20 Example: The Market For Beer Example: The Market For Beer Price 125 Price 125 Market Supply: P = 50 + QS/2 Market Supply: P = 50 + QS/2 • P*=100 P*=100 Market Demand: P = 125 - Qd/4 Market Demand: P = 125 - Qd/4 Q* = 100 Quantity Quantity 21 Definition: If sellers cannot sell as much as they would like at the current price, there is excess supply. 22 Definition: If sellers cannot sell as much as they would like at the current price, there is excess supply. Example: Excess Supply in the Market for Beer Example: Excess Supply in the Market for Beer Price 125 Price 125 Market Supply P*=100 Market Supply: P = 50 + QS/2 P*=100 Market Demand Market Demand: P = 125 - Qd/4 Quantity Qd Q* 23 QS Quantity 24 4 Definition: If sellers cannot sell as much as they would like at the current price, there is excess supply. •If there is no excess supply or excess demand, there is no pressure for prices to change and we are in equilibrium. Example: Excess Supply in the Market for Cranberries Price 125 • Excess Supply • •When a change in an exogenous variable causes the demand curve or the supply curve to shift, the equilibrium shifts as well. Market Supply: P = 50 + QS/2 P*=100 Market Demand: P = 125 - Qd/4 Qd Q* QS Quantity 25 26 Elasticity is not slope •Slope is the ratio of absolute changes in quantity and price. (= ∆Q/∆P). Definition: The own price elasticity of demand is the percentage change in quantity demanded brought about by a one-percent change in the price of the good. • Elasticity is the ratio of relative (or percentage) changes in quantity and price. εQ,P= (∆Q/Q) = (∆Q/∆p)(p/Q) (∆p/p) 27 28 •When a one percent change in price leads to a greater than one-percent change in quantity demanded, the demand curve is elastic. (εQ,P < -1) •When a one-percent change in price leads to a less than one-percent change in quantity demanded, the demand curve is inelastic. (0 > εQ,P > -1) Qd = a – bp a,b are positive constants p is price •When a one-percent change in price leads to an exactly one-percent change in quantity demanded, the demand curve is unit elastic. (εQ,P = -1) •-b is the slope •a/b is the choke price 29 30 5 Example: Elasticity with a Linear Demand Curve P •the elasticity is εQ,P = (∆Q/∆p)(p/Q) …definition… = -b[p/(a-bp)] so…elasticity falls from 0 to -∞ along the linear demand curve, but slope is constant. •if Qd = 400 – 10p, and p = 30, εQ,P = (-10)(30)/(100) = -3 "elastic" Q 0 31 32 Example: Elasticity with a Linear Demand Curve Example: Elasticity with a Linear Demand Curve P P a/b Elastic region ? region a/2b • ? region Inelastic region a 0 Q 0 a/2 a Q 33 Example: Elasticity with a Linear Demand Curve Example: Constant Elasticity Demand Curve P a/b Qd = Apε εQ,P = -∞ ε = elasticity of demand and is negative p = price A = constant ? region a/2b •ε Q,P = -1 •Elasticity is constant, but the slope of demand falls from 0 to -∞. ? region Example: If demand can be expressed as QP = 100, what is the price elasticity of demand? εQ,P = 0 0 34 a/2 a Q 35 36 6 Example: A Constant Elasticity versus a Linear Demand Curve Example: A Constant Elasticity versus a Linear Demand Curve Price Price Constant elasticity demand curve Linear demand curve 0 0 Quantity Quantity 37 38 •Elasticity varies with (among other factors): Example: A Constant Elasticity versus a Linear Demand Curve -factors affecting substitutability (such as level of aggregation, product differentiation or switching costs) Price • Observed price and quantity P Constant elasticity demand curve Linear demand curve 0 Q Quantity 39 Definition: A durable good is a good that provides valuable services over a long time (usually many years). 40 Example: Demand for Commercial Aircraft Price (£/airplane) Demand for non-durables less elastic in the short run when consumers can only partially adapt their behavior. Demand for durables more elastic in the short run because consumers can delay purchase. Quantity (aircraft/yr) 41 42 7 Example: Demand for Commercial Aircraft -Other Elasticities -- Elasticity of "X" with respect to "Y": (∆X/∆Y)(Y/X) Price ($/airplane) •Price elasticity of supply (∆QS/∆p)(p/QS) …measures curvature of supply curve Long run demand curve for commercial airplanes •Income elasticity of demand (∆Qd/∆I)(I/Qd) …measures degree of shift of demand curve as income changes… Short run demand curve for commercial airplanes •Cross price elasticity of demand (∆Qd/∆Po)(Po/Qd)…measures degree of shift of demand curve… Quantity (aircraft/yr) 43 44 Example: Suppose demand is linear: Qd = a-bp Hence, elasticity is εQ,P = -bp/Q 1. Estimating Demand and Supply from Own Price Elasticities and Equilibrium Price and Quantity -Choose a general shape for functions -Estimate parameters of demand and supply using elasticity and equilibrium information If we have data on ε, Q and P, we can calculate b from elasticity equation and then calculate a by substituting into demand. 45 46 but… ε= -bp/Q Ù b = -εQ/p b = -(-.55(70/.7)) = 55 a = Qd + bp = 108.5 •If…Qd = a – bP Per capita consumption 70pints/person Price £.70/pint. εQ,P = -.55 => Qd = 108.5 – 55p 47 48 8 •If…Qd = Apε Example: Beer in the U.K Price εQ,P = -.55 A = Qp-ε = 70(.7).55 = 57.53 => Qd = 57.53P-.55 0 Quantity 49 50 Example: Beer in the UK Example: Beer in the UK Price Price • .7 Constant elasticity demand curve Constant elasticity demand curve Linear demand curve 0 Observed price and quantity Linear demand curve 0 Quantity 70 Quantity 51 2. Estimating Demand and Supply from Information on Past Shifts 52 -Suppose, then, that the supply curve shifts back. Both the old equilibrium point (p1,Q1) and the new equilibrium point (p2,Q2) lie on the same (linear) demand curve. Therefore, if QD = a-bp, - A shift in the supply curve reveals the slope of the demand curve while a shift in the demand curve reveals the slope of the supply curve. b = ∆Q/∆p = (Q2 – Q1)/(p2 – p1) a = Q1 + bp1 53 54 9 Example: Identifying demand by a shift in supply. -We can “identify” the slope of supply by a shift in demand Price -We can "identify" the slope of demand by a shift in supply, similarly. Supply Market Demand 0 Quantity 55 Example: Identifying demand by a shift in supply. 56 Example: Identifying demand by a shift in supply. Price Price New Supply New Supply Old Supply Old Supply • P2 P1 • Market Demand 0 Market Demand 0 Quantity Q2 Q1 Quantity 57 -This technique only works if one or the other of the curves stays constant. 58 -This technique only works if one or the other of the curves stays constant. Price Price New Supply Supply Old Supply Demand Old Demand New Demand 0 0 Quantity Example: Identifying demand when both curves shift Quantity Example: Identifying demand when both curves shift 59 60 10 -This technique only works if one or the other of the curves stays constant. Price 1. First example of a simple microeconomic model of supply and demand (two equations and an equilibrium condition) New Supply • • P2 P1 Old Supply 2. Elasticity as a way of characterizing demand and supply 3. Elasticity changes as market definition changes (commodity, geography, time) Old Demand New Demand 0 Q2 = Q1 Quantity Example: Identifying demand when both curves shift 61 62 4. Elasticity a very general concept 5. Back of the envelope calculations: •Estimating demand and supply from own price elasticity and equilibrium price and quantity •Estimating demand and supply from information on past shifts, assuming that only a single curve shifts at a time. 63 11