CHAPTER 1
DEMAND AND SUPPLY ANALYSIS:
INTRODUCTION
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Presenter’s title
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1. INTRODUCTION
Economics
The study of production,
distribution, and
consumption
Microeconomics
The study of markets and
decision making of
individual economic units
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Macroeconomics
The study of aggregate
economic quantities
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2. TYPES OF MARKETS
• Factor markets are markets for the factors of production.
- The factors of production are the inputs to production.
- Factor markets include labor markets.
• Goods markets are markets for the outputs of production.
- The outputs of production are goods and services, which may be
intermediate goods and services or final goods and services.
• Capital markets serve as a means for providers of capital (that is, the
providers or suppliers of long-term sources of funding, or savers) to exchange
their capital for long-term claims on a firm’s cash flow and assets (that is, debt
and equity securities).
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3. BASIC PRINCIPLES AND CONCEPTS
Demand
Supply
• Willingness and ability
to purchase a good or
service at a given price
• Willingness of sellers
to offer a good or
service for a given
price
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THE DEMAND FUNCTION
The demand function is
𝑄𝑥𝑑 = 𝑓(𝑃𝑥 , 𝐼, 𝑃𝑦 , … )
(1-1)
where
𝑄𝑥𝑑 is the quantity demanded of good x
Px is the price of good x
I is the consumer’s income
Py is the price of good y
In equation form:
Sensitivity
Sensitivity
Income
to its
𝑄𝑥𝑑 = Intercept −
𝑃𝑥 +
𝐼 − to the price 𝑃𝑦
sensitivity
own price
of good Y
The demand curve depicts the quantity demanded for each price.
The law of demand: inverse relationship between price and quantity demanded.
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THE SUPPLY FUNCTION
The supply function is
𝑄𝑥𝑠 = 𝑓(𝑃𝑥 , 𝑊, … )
(1-7)
where
𝑄𝑥𝑠 is the quantity supplied of good x
Px is the price of good x
W is the wage rate paid to labor
In equation form:
Sensitivity
Wage
to its
𝑄𝑥𝑠 = Intercept +
𝑃𝑥 −
𝑊
sensitivity
own price
The supply curve depicts the quantity producers are willing to supply at each
price (or lowest price accepted for each quantity).
The law of supply: a positive relationship between price and quantity.
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CHANGES AND MOVEMENTS
Changes in quantity demanded
Changes in quantity supplied
Change in its own-price
Movement along the demand curve
Change in its own-factor prices
Movement along the demand curve
Change in price of other goods
Shift in the demand curve
Change in supply
Shift in the supply curve
Demand 2
Supply 2
Price
Supply 1
Price
Demand 1
Quantity
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Quantity
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AGGREGATING SUPPLY AND DEMAND CURVES
• Moving from the individual consumer or firm to the aggregate:
- Aggregating demand curves requires adding the individual quantities
demanded at each price.
- Aggregating supply curves requires adding the firms’ quantities supplied at
each price.
• A market equilibrium is the situation in which the quantity demanded at a
given price is equal to the quantity supplied at that price.
Price
Quantity
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SOLVING FOR THE EQUILIBRIUM
• Solving for the equilibrium price or quantity requires setting the demand
function equal to the supply function and then solving.
- We can specify the functions in terms of variables that model behavior
(hence, behavioral equations) or in terms of variables other than own price
and quantity.
- Price and quantity are endogenous variables.
- Other variables, such as the wage rate or consumer income, are exogenous
variables.
• There are two equations (supply function and demand function) and three
unknowns, so we must also introduce the fact that the quantity demanded must
be equal to the quantity supplied. That is,
𝑄𝑥𝑑 = 𝑄𝑥𝑠
This is the equilibrium condition. Now there are three equations and three
unknowns.
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EQUILIBRIA
• A stable equilibrium occurs when the price adjusts so that demand = supply.
• An unstable equilibrium occurs when the demand or supply curves are such
that an upward change of price does not reduce excess demand or supply (or
a downward change does not reduce excess demand or supply).
- Price bubbles are an example of an unstable equilibrium.
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DEMAND AND SUPPLY FUNCTIONS
• Consider an individual’s demand curve:
𝑄𝑥𝑑 = 25 − 10𝑃𝑥
This means that if the price is €0.5, the quantity demanded is 24.5 units.
The inverse demand curve is the price as a function of the quantity demanded:
𝑃𝑥 = 2.5 − 0.1𝑄𝑥𝑑
This means that at the quantity of 100 units, the price is €15.
• Consider a firm’s supply curve:
𝑄𝑥𝑠 = 5 + 10𝑃𝑥
This means that if the quantity supplied is 10 units, the price is €15.
The inverse supply curve is the quantity supplied as a function of price:
𝑃𝑥 = −0.5 + 0.10𝑄𝑥𝑠
This means that if the quantity supplied is 10, the price required is €1.5.
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AGGREGATE SUPPLY AND DEMAND
• The aggregate demand curve is the total quantity of goods that would be
demanded at each price.
- We calculate the aggregate demand curve by adding up the quantities
(across individuals) at each price.
• The aggregate supply curve is the total quantity of goods that would be
produced for each level of price.
- We calculate the aggregate supply curve by adding up what sellers are
willing to sell at each level of price.
• If the aggregate demand curve is
𝑄𝑥𝑑 = 25 − 10𝑃𝑥
and the aggregate supply curve is
𝑄𝑥𝑠 = 5 + 10𝑃𝑥 ,
we calculate the equilibrium price by equating the demand and supply and
solving for the price. The equilibrium price is €1, and the equilibrium quantity is
15.
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EXCESS SUPPLY AND DEMAND
If the price of a good is not in equilibrium, we can calculate the excess supply or
demand. Consider the last example:
𝑄𝑥𝑑 = 25 − 10𝑃𝑥
𝑄𝑥𝑠 = 5 + 10𝑃𝑥
The equilibrium price is €1. But what if the price were €1.5, instead?
𝑄𝑥𝑑 = 25 − 10 × €1.5 = 10 units
𝑄𝑥𝑠 = 5 + 10 × €1.5 = 20 units
There would be excess supply of 20 – 10 = 10 units.
What if the price were €0.5, instead?
𝑄𝑥𝑑 = 25 − 10 × €0.5 = 20 units
𝑄𝑥𝑠 = 5 + 10 × €0.5 = 10 units
There would be excess demand of 20 – 10 = 10 units.
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TYPES OF AUCTIONS
• Common value auction: The item’s true value is revealed after bidding.
• Private value auction: Each bidder places a subjective value on the item, but
these valuations differ.
• Ascending price auction: Also known as an English auction; highest bidder
wins auction for item.
• First price sealed-bid auction: Bidders submit sealed bids that are not known
to other bidders; winning bidder is the one submitting the highest price.
• Second price sealed-bid auction: Also known as a Vickery auction; the
bidder that submits the highest bid wins, but the price paid for the item is the
next-lowest bid price.
• Descending price auction: Also known as a Dutch auction; the auctioneer
begins with a very high price and lowers the price in increments until there is a
willing buyer.
- In a multiple-unit format, price is lowered until all units are sold.
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DUTCH AUCTION: US TREASURY SECURITIES
Example: Dutch auction for $120 billion of US Treasury 28-day bills
Competitive
Bids
(in billions)
Cumulative
Competitive
Bids
(in billions)
Noncompetitive
Bids
(in billions)
Total
Cumulative
Bids
(in billions)
Discount
Rate Bid
Bid Price
per $100
0.0280%
99.99782
$5
$5
$5
$10
0.0285%
99.99778
$10
$15
$5
$30
0.0287%
99.99777
$15
$30
$5
$65
0.0290%
99.99774
$20
$50
$5
$120
0.0291%
99.99774
$15
$65
$5
$190
0.0292%
99.99773
$10
$75
$5
$270
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SURPLUS
Consumer surplus is the difference
between the maximum price the
consumer was willing to pay and the
actual price.
Producer surplus is the difference
between what the producer sells a
good or service for and the price at
which the supplier was willing to sell.
Price
Consumer surplus
Producer surplus
Quantity
Total surplus = Consumer surplus + Producer surplus
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CALCULATING SURPLUS
Suppose we have the following demand and supply curves:
𝑄𝑥𝑑 = 25 − 10𝑃𝑥
𝑄𝑥𝑠 = 5 + 10𝑃𝑥
The equilibrium price is €1, and the equilibrium quantity is 15.
What is the amount of total surplus if the price per unit is €1?
If the price is €1, 𝑄𝑥𝑑 = 15.
- Intercept with vertical axis (Q = 0): Px = €2.5 – 0.1 = €2.4.
- Consumer surplus = Area of triangle = 0.5 × (€2.4 – 1) × 15 = €10.5.
If the price is €1.0, 𝑄𝑥𝑠 = 15.
- Intercept with the vertical axis (Q = 0): Px = –0.5 + (0.10 × 0) = €0.5.
- Producer surplus = Area of triangle = 0.5 × (€1 – 0.5) × 15 = €3.75.
If the price is €0.8, total surplus = €10.5 + €3.75 = €14.25.
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MARKET INTERFERENCE
• A government-imposed ceiling on a price that is less than the market
equilibrium price results in a reduction of surplus: Buyers want more than
sellers are willing to supply at that price.
- Some consumers gain consumer surplus lost by suppliers, but some
consumer surplus is lost and not picked up by suppliers.
- The loss in surplus is deadweight loss, which is a loss of surplus that is not
transferred to another party.
• A government-imposed price floor that is higher than the market equilibrium
results in a reduction of surplus.
- Sellers want to sell more, but buyers purchase less.
- Sellers gain some producer surplus lost by consumers, but some of this
producer surplus is lost and not picked up by consumers.
• In general, market interference inhibits the role of the market to allocate
resources efficiently.
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EFFECT OF MARKET INTERFERENCE
EQUILIBRIUM PRICE = €1
Price Ceiling
Price Floor
Demand
Supply
Demand
Supply
Equilibrium price
Price ceiling
Equilibrium price
Price floor
€2.5
€ 2.5
€2.0
€ 2.0
€1.5
A
€1.0
B
€0.5
€0.0
Price
Price
C
€ 1.5
A
€ 1.0
€ 0.5
€ 0.0
5
7
9 11 13 15 17 19 21 23 25
Quantity
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7
9 11 13 15 17 19 21 23 25
Quantity
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4. DEMAND ELASTICITIES
Own-price elasticity is the sensitivity of the quantity demanded of a good to
changes in the price of the good.
Q
Example for good x:
𝑄𝑥𝑑 =
x
𝑎 − 𝑏𝑃𝑥 ,
a
where
𝑄𝑥𝑑 is the quantity of good x demanded;
b
𝑃𝑥 is the price of good x;
Px
𝑎 is the intercept; and
𝑏 is the slope.
Because the slope depends on the unit of measure of Q, it is preferred to use
the own-price elasticity of demand, 𝐸𝑝𝑑 , specified as
𝐸𝑝𝑑
%∆ Quantity of good demanded %∆ 𝑄𝑥𝑑
=
=
=
%∆ Price of good
%∆𝑃𝑋
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slope
coefficient
∆𝑄𝑋
∆𝑃𝑋
𝑃𝑋
𝑄𝑥𝑑
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ELASTICITIES
• Elasticity is the sensitivity of the change in quantity for a given change in the
price of a good.
- The ratio of the percentage change in the quantity to the percentage change
in the price.
• Own-price elasticity refers to the sensitivity of the quantity of a good
demanded to its own-price change.
• Cross-price elasticity of demand is the response in the demand of a good to
a change in the price of another good.
- A substitute is a good that has a positive cross-price elasticity.
- A complement is a good that has a negative cross-price elasticity.
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ELASTICITIES: SUMMARY
If the elasticity Then demand is
coefficient is … …
Interpretation
>1
elastic
% in price results in a larger % in quantity
demanded
= –1
unit elastic
% in price results in a similar % change in
quantity demanded
<1
inelastic
% in price results in a smaller % in quantity
demanded
=0
perfectly inelastic
% in price does not affect quantity demanded
∞
perfectly elastic
% in price results in zero quantity demanded
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ELASTICITIES: EXAMPLE
Consider the case of the sensitivity of the demand for tires, in response to the
price of gas per gallon:
Tires = 95 million – 3.2 Price per gallon of gas
• There is negative cross-elasticity between tires and gas; therefore, gas and
tires are complements.
• If the price per gallon increases by $1, the number of tires declines by 3.2
million.
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FACTORS THAT AFFECT ELASTICITIES
1. Degree of substitutability
- The greater the degree of substitutability, the greater the elasticity.
2. Portion of budget spent on the good
- The greater the portion, the greater the elasticity.
3. Time allowed to respond to the change in price
- The longer the time allowed, the greater the elasticity.
4. Extent to which the good is deemed necessary
- The greater the extent to which the good is deemed as necessary, the more
inelastic its demand.
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INCOME ELASTICITIES
• Income elasticity of demand is the change in the quantity demanded of a
good in response to the change in income:
Income elasticity of demand =
%∆ in quantity of good demanded
%∆ in income
• An income-elastic good is a good that has positive income elasticity: As
income increases, demand for the good increases; also known as a normal
good.
• An inferior good is one that has a negative income elasticity: The demand for
the good falls as incomes rise.
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5. CONCLUSIONS AND SUMMARY
• The basic model of markets is the demand and supply model: Equilibrium
occurs at the price at which the quantity demanded is equal to the quantity
supplied.
• Markets are interactions between buyers and sellers.
• The price of a good in a market is determined by supply and demand.
• Auctions are sometimes used to seek equilibrium prices.
• Markets ensure that the total surplus is maximized.
- Sometimes, government policies interfere with the free working of markets,
shifting surplus between consumers and producers, with some loss.
• Elasticity is the ratio of the percentage change in the dependent variable to the
percentage change in the independent variable of interest.
- Elasticities are sensitivities of the quantity demanded to either the good’s
own price, the price of other goods, or income.
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