Demand and Supply Analysis
Headlines:
• On August 2, 1990, when Iraq invaded Kuwait, market
price of crude petroleum jumped from $21.54 to $30.50
per barrel (almost 42% increase) before any physical
reduction in the current amount of oil available for sale.
One year later, the price of oil was $21.32 per barrel.
• In August 1987, a 386 PC sold at $6,995.
In March 1992, the same computer sold at $1,495.
Today Pentiums are cheaper then original 386 PCs.
Market Demand Curve
• Amounts of a good purchased at alternative prices.
• Inverse demand shows the maximum price paid for
given quantity of a good.
• Law of Demand (ceteris paribus)
• Downward demand due to income and wealth effects.
• Downward inverse demand diminishing marginal utility.
• Giffen's Paradox
Quantity
Price
D
ID
Price
Quantity
The Demand Function
• An equation representing the demand curve
Qxd = f(Px , PY , I, N, A, Z)
Qxd = a0+a1Px+a2Py+a3I+a4N+a5A+a6Z
•
•
•
•
•
•
•
Qxd = quantity demand of good X.
Px = price of good X.
PY = price of a substitute good Y.
I = income.
N = population
A = advertisement
Z = any other variable affecting demand
(expectations, credit conditions)
Change in Quantity Demanded
Price
A to B: Increase in quantity demanded
(due to change in the price of the good)
A
10
B
6
D0
4
7
Quantity
Change in Demand
Price
D0 to D1: Increase in Demand
(due to change in
demand determinants)
6
D1
D0
7
13
Quantity
Market Supply Curve
• Amounts of a good produced at alternative prices.
• Inverse supply shows the minimum price required
to produce given quantity of a good.
• Law of Supply (ceteris paribus)
• The supply curve is upward sloping
Price
S
Quantity
Quantity
IS
Price
The Supply Function
• An equation representing the supply curve:
QxS = f(Px , PR ,PVI, PFI, Z)
Qxs = a0+a1Px+a2PR+a3PVI+a4PFI+a5Z
•
•
•
•
•
•
QxS = quantity supplied of good X.
Px = price of good X.
PR = price of a related good (substitutes in production)
PVI = price of variable inputs (labor, material, utilities)
PFI = price of fixed inputs (land, buildings, machines)
Z = other variable affecting supply (technology,
government, number of firms, expectations)
Change in Quantity Supplied
A to B: Increase in quantity supplied
(due to change in the price of the good)
Price
S0
B
20
A
10
5
10
Quantity
Change in Supply
S0 to S1: Increase in supply
(due to change in
supply determinants)
S0
Price
S1
8
6
5
7
Quantity
Mathematics of Equilibrium
Demand curve: Qd = 400 - ½P,
Supply curve: Qs = 200 + P
Price (P)
a=800
Market
equilibrium
P = dQs - c = Qs - 200
Supply
Slope is d = 1
P* = 133.33
Slope is -b = -2
Demand
P = a - bQd = 800 - 2Qd
0
c=-200
Q* = 333.33 Quantity supplied (Q ) and
s
Quantity demanded (Qd)
Consumer Surplus:
The Continuous Case
Price $
10
8
6
4
Consumer
Surplus
Value
of 4
units
2
Total Cost of 4 units
1
2
3
D
4
5
Quantity
Producer Surplus
• The amount producers receive in excess of the amount
necessary to induce them to produce the good.
Price
S0
P* Producer
Surplus
Cost of
Production
Q*
Quantity
If price is too low…
Price
S
7
6
5
D
Shortage
12 - 6 = 6
6
12
Quantity
If price is too high…
Surplus
14 - 6 = 8
Price
S
9
8
7
D
6
8
14
Quantity
Comparative Statics: Effects of
Changes in Demand and/or Supply
Increase in D increases both Q and P.
Increase in S increases Q and decreases P.
Increase in D and S increases Q and P = ?.
Decrease in D and increase in S decreases P and Q = ?.
Price Restrictions
• Price Ceilings
• The maximum legal price that can be charged
• Examples:
• Gasoline prices in the 1970s
• Housing in New York City
• Proposed restrictions on ATM fees
• Price Floors
• The minimum legal price that can be charged.
• Examples:
• Minimum wage
• Agricultural price supports
Impact of a Price Ceiling
Price
S
PF
Deadweight loss of
consumer and
producer surplus
Opportunity
Cost (Search & P*
Black Market)
Ceiling
Price
D
Shortage
Qs
Q*
Qd
Quantity
Full Economic Price
• The dollar amount paid to a firm under a price ceiling, plus
the nonpecuniary price:
PF = PC + (PF - PC)
• PF = full economic price
• PC = price ceiling
• PF - PC = nonpecuniary price
• In 1970s ceiling price of gasoline = $1
• 3 hours in line to buy 15 gallons of gasoline
• Opportunity cost: $5/hr
• Total value of time spent in line:
3  $5 = $15
• Non-pecuniary price per gallon:
$15/15 = $1
• Full economic price of a gallon of gasoline: $1 + $1 = $2
Impact of a Price Floor
Price
Surplus
S
PF
Cost of purchasing
excess supply
P*
Decreased
Demand
Qd
D
Increased
Supply
Q*
Qs
Quantity
The Excise Tax (Fixed per Unit)
Price ($/CD player)
130
Consumer
surplus
S + tax
S
Buyer pays
(with tax)
$10 tax
P =105
Tax Revenue
Price before 2
P1=100
tax
P2 - P1
Buyer tax burden
Deadweight
loss
P2-T=95
P1 - (P2 - T)
Seller tax burden
Seller receives
(without tax)
75
0
D
Producer
surplus
1
2
3
4
5
6
7
8
9
10
Quantity (thousands of CD players per week)
Excise Tax and the Demand
Price
P
 Inelastic D
Buyer pays
entire tax
S + tax
P2=P1+T=2.20
Price Seller pays
entire tax
P1=P2=1.00
S + tax
S
 Elastic D
S
P2-T=0.90
P1 = 2.00
100
Thousands of insulin doses
The more inelastic D, the more
buyer pays: P2 = P1 + T
Buyer burden: P2 - P1 =
(P1 + T) - P1 = T
Seller burden: P1 - (P2 - T) =
P1 - (P1 + T - T) = 0
1
4
Thousands of pencils
The more elastic D, the more
seller pays: P2 = P1
Buyer burden: P2 - P1 =
P1 - P1 = 0
Seller burden: P1 - (P2 - T) =
P1 - (P1 - T) = T
Excise Tax and the Supply
Price
P1=P2=50
 Inelastic S
Price
Seller pays
entire tax
S + tax
P2=P1+T=11
P1=10
P2-T=45
100
Bottles of spring water
The more inelastic S, the more
seller pays:
P2 = P1
Buyer pays
entire tax
 Elastic S
D
3
5
Thousands of pounds of send
for computer chips
The more elastic S, the more
buyer pays: P2 = P1 + T
D
The Ad Valorem Tax (% of Value)
Price ($/CD player)
130
Consumer
surplus
S(1 + tax)
S
Buyer pays
(with tax)
$10 tax
P =105
Tax Revenue
Price before 2
P1=100
tax
P2 - P1
Buyer tax burden
Deadweight
loss
P2-T=95
P1 - (P2 - T)
Seller tax burden
Seller receives
(without tax)
75
0
D
Producer
surplus
1
2
3
4
5
6
7
8
9
10
Quantity (thousands of CD players per week)
Static Effects of a Tariff
Sus
P
Pt
PW
Tt
PIt
QSt
QSW
G
Mt
MW
CIt
Dus
QDt
QDW
Loss of Consumer Surplus
= Tt + PIt + G + CIt
Transfer to Producer Surplus
= Tt
Government Revenues from Tariff = G
Dead Weight Loss due to Tariff = PIt + CIt
Production Inefficiencies
= PIt
Consumption Inefficiencies
= CIt
Static Effects of a Quota
Sus
P0
PQ
PW
Sus + Quota
Tq
PIq
W
CIq
Dus
QSq
QSW
Quota QDq
MW
QDW
Loss of Consumer Surplus
Transfer to Producer Surplus
Windfall to Importer
Dead Weight Loss due to Quota
Production Inefficiencies
Consumption Inefficiencies
= Tq + PIq + W + CIq
= Tq
=W
= PIq + CIq
= PIq
= CIq