Eco 100
Chapter 2: The Basics of Supply and
Demand
Demand and Supply
• With Demand and Supply we are dealing with a Market
for a good or commodity.
• Simplify the Market to 2 Axis.
• Vertical Axis for: Price
• Horizontal Axis for: Quantity
The law of Demand
• The law states that consumers will buy more
of a commodity at lower price and fewer at
higher prices, all other things being equal. In
other words, this law is in most cases valid if
all other things (like income, taste, price of
other goods, etc) that may affect the
consumer’s preference, keep unchanged.
Demand Curve
Demand Curve
• The Demand curve has a Downward slope.
• The Demand curve is simply charting out the
relationship between Price and Quantity Demanded.
• When the Price is high the consumer is less likely to
purchase, so we have low quantity demanded.
• When the Price is low the consumer is more likely to
purchase, so we have high quantity demanded.
Example of Demand Curve
• Demand for Bananas
Price
Quantity Demanded
30 DH
200
20 DH
1000
15 DH
2000
10 DH
4000
7 DH
6000
5 DH
10000
3 DH
50000
Shifts in the Demand Curve
• What shifts Demand? At every given price, the quantity demanded has
changed.
• Changes in Income. (Shift out)
• Changes in taste. (Outward shift) (if all of the sudden, people have a
preference of a product that is now fashionable, we would see an increase
in demand)
• Changes in expectations. Either expecting the price to increase in the
future (shift out), or decrease (shift in) (Example if we expect an increase
in the price of oil, and we have a way to store it, then we should see an
increase in quantity demanded).
• Changes in Market size. (more consumers in the market Shift out)
• Changes in the price of related goods and services (substitutes and
compliments: a decrease in the price of gasoline increases the quantity
demanded for cars)
Change in Demand vs. change in
Demand curve
• Change in Demand:
– Movement along the Demand Curve.
– Changes in Quantity Demanded.
• Change in Demand Curve:
– Reflects changes in Demand. (using any of the
Demand shift reasons).
The law of supply
• As in the case of demand, general observations of
the behavior of producers and sellers have led to
the formulation of the law of supply. This law
states that, in general, suppliers are normally
willing to offer more quantities of a commodity
for sale at higher prices than at lower ones. In
other words, the law says that the higher the
price, the greater will be the quantities made
available for sale; and the lower the price, the
smaller will be the supply.
Supply Curve
Supply curve
• The supply curve has a upward slope.
• The Supply curve is charting out the
relationship between Price and Quantity
supplied.
• When the Price of a good or service is high
then there is high quantities that firms are
willing to supply.
• When the Price is low the firms is less likely to
produce, so we have low quantity supplied.
Shifts of the supply curve
What shifts supply? At every given price, the quantity supplied
has changed.
• Changes in technology. (outward shift- example: wheat market, if there is
a new technology that makes it easier for companies to produce wheat
faster and cheaper like a new tractor, then there will be more quantity
supplied for the same price which will essentially shift the supply curve)
• Changes in input prices. (example: car market, if steel prices go up, then
we would expect a decrease in supply of cars)
• Changes in expectations.
• Changes in the number of producers.(if more producers enter the market,
then the supply curve will move outward)
• Changes in the price of related goods and services. (an increase in the
price of aluminum will increase supply of aluminum and decrease supply
of copper)
Change in Supply vs. change in Supply
curve
• Change in Supply:
– Movement along the Supply Curve.
– Changes in Quantity Supplied.
• Change in Supply Curve:
– Reflects changes in Supply. (using any of the
Supply shift reasons).
Market Equilibrium
• We bring in the demand and supply curve
together.
• Where the Supply curve and Demand curve
intersect, we now have an Equilibrium Price
(P*) and an Equilibrium Quantity (Q*)
Changes in the Market Equilibrium
• Changes in the supply curve from S to S’ perhaps as a result of a decrease
in the price of raw materials.
• the market price drops (from Pl to P3), and the total quantity produced
increases (from Q1 to Q3), this is what we would expect: Lower costs result
in lower prices and increased sales. (Indeed, gradual decreases in costs
resulting from technological progress and better management are an
important driving force behind economic growth.)
Changes in the Market Equilibrium
• A right shift in the demand curve resulting from, say, an
increase in income. A new price and quantity result after
demand comes into equilibrium with supply.
• Figure 2.5, we would expect to see consumers pay a higher
price P3 and firms produce a greater quantity Q3, as a result of
an increase in income.
Changes in the Market Equilibrium
• New Equilibrium following shifts in Supply and Demand
Curves.
Shortage vs. Surplus
• Shortage:
– Price below the equilibrium price, demand
exceeds supply.
• Surplus:
– Price is above the equilibrium price, supply
exceeds demand.
Supply and Demand curves showing
Shortage and Surplus
Problem 1
• Indicate whether the following statement is
true or false and explain why?
“An increase in the price of bananas will shift the
demand curve for bananas to the left.”
Solution to Problem 1
• This is FALSE. The price of the good is not a
demand shifter. The negative slope of the
demand curve already shows how a change in
price will affect the quantity demanded. A
change in the price moves us to a new point
along the same demand curve. The curve
does not shift. Did I catch you on this?
Problem 2
• Draw typically shaped supply and demand
curves for hot dogs and indicate the
equilibrium price and quantity. Use the graph
to illustrate what will happen to the
equilibrium price and quantity of hot dogs if
there is an increase in income in the economy
and explain.
Solution to Problem 2
• The effect of the increase in income depends upon whether
hot dogs are a normal or inferior good. If hot dogs are a
normal good, the increase in income will cause an increase in
the demand for hot dogs. This increased demand will raise
both the equilibrium price and quantity.
Solution to Problem 2
• However, some undiscerning families might perceive of hot dogs as an
inferior good. They might look at the increase in income as an opportunity
to eat fewer hot dogs and shift to more expensive foods instead (a
plausible although gastronomically unfortunate choice). If so, the demand
for the hot dogs will shift to the left and both the equilibrium price and
quantity will fall.
Problem 3
• Suppose that both consumers and producers expect
prices of Bananas to be much higher in three
months. Use supply and demand to illustrate the
impact of this on the current market for
Bananas. Label your diagram clearly and explain.
Solution to Problem 3
•
If consumers expect future prices to be higher they will try to stock up on Apples
now while the price still is low. This will increase the current demand (more
apples will be demanded at each price) and shift the demand curve to the
right. Producers will react as well. Since they also expect prices to be higher in
three months, they have an incentive to hold onto their inventories and wait until
the prices rise to sell. As a result, the current supply of Apples will drop or shift to
the left. The combination of higher demand and lower supply will drive the price
up. The effect on quantity is unclear and will depend upon which of the curves
shifts the most. In the graph below, the curves shift by the same amount and the
quantity stays the same.
Elasticity of Supply and Demand
• Price elasticity of demand: is a number representing the percentage
change in quantity demanded resulting from each 1% change in the price
of the good.
•
Price elasticity of demand = %change in quantity demanded / %change in price
• For example, suppose the price of cars went up by 1% this year and the
resulting decline in cars purchases was 2%. The price elasticity of demand
would be: E=-2%/1% = -2, we use absolute value of the results, thus E= 2.
• E > 1, we can say that demand for cars is elastic, If E <1 then we would
have said that demand for cars is inelastic.
• Price elasticity of supply measures the responsiveness of supply to a
change in Price.
Problem #4
• Suppose a clothing store sells 25 t-shirt/week
for the price of $15, and when the store drops
the price to $10, the store starts selling 60 tshirt/week. Calculate the Price Elasticity of
the Demand.
Solution to problem #4
•
•
•
•
•
•
•
•
•
% change in Qty Demanded= [(final Qty – initial Qty) / initial Qty ] *100%
% change in Qty Demanded= [(60 – 25)/25]*100%
% change in Qty Demanded= 140%
% change in Price= [(final Price– initial Price) / initial Price ] *100%
% change in Price= [(10-15)/10]*100%
% change in Price= 33%
Elasticity = 140/33 = 4.24
Interpretation :
For every 1% change in the price, there will be 4.24 percent change in
quantity.
• The demand for t-shirts is elastic since the E > 1.
Problem #5
• Yesterday, the price of envelopes was $3 a
box, and Julie was willing to buy 10 boxes.
Today, the price has gone up to $3.75 a box,
and Julie is now willing to buy 8 boxes. Is
Julie's demand for envelopes elastic or
inelastic? What is Julie's elasticity of demand?
Problem#6
• Problem : If Neil's elasticity of demand for hot
dogs is constantly 0.9, and he buys 4 hot dogs
when the price is $1.50 per hot dog, how
many will he buy when the price is $1.00 per
hot dog?
Solution to Problem#6
• This time, we are using elasticity to find quantity, instead of the
other way around. We will use the same formula, plug in what we
know, and solve from there.
Elasticity =
And, in the case of John, %Change in Quantity = (X – 4)/4
Therefore :
Elasticity = 0.9 = |((X – 4)/4)/(% Change in Price)|
% Change in Price = (1.00 - 1.50)/(1.50) = -33%
0.9 = |(X – 4)/4)/(-33%)|
|((X - 4)/4)| = 0.3
0.3 = (X - 4)/4
X = 5.2
Since Neil probably can't buy fractions of hot dogs, it looks like he
will buy 5 hot dogs when the price drops to $1.00 per hot dog.
Problem #7
• Which of the following goods are likely to have
elastic demand, and which are likely to have
inelastic demand?
Home heating oil
Pepsi
Chocolate
Water
Heart medication
Oriental rugs
Problem#8
• Katherine advertises to sell cookies for $4 a
dozen. She sells 50 dozen, and decides that
she can charge more. She raises the price to
$6 a dozen and sells 40 dozen. What is the
elasticity of demand? Assuming that the
elasticity of demand is constant, how many
would she sell if the price were $10 a box?