Supply and Demand

The Supply Curve

The supply curve shows how much of a good
producers are willing to sell at a given price,
holding constant other factors that might
affect quantity supplied

This price-quantity relationship can be shown
by the equation:
Qs  Qs (P)
Chapter 2: The Basics of Supply and Demand
Slide 1
Supply and Demand
Price
($ per unit)
S
The Supply
Curve Graphically
P2
The supply curve slopes
upward demonstrating that
at higher prices, firms
will increase output
P1
Q1
Q2
Chapter 2: The Basics of Supply and Demand
Quantity
Slide 2
Supply and Demand
Change in Supply

The cost of raw
materials falls

At P1, produce Q2

At P2, produce Q1

Supply curve shifts right
to S’

P
S’
S
P1
P2
More produced at any
price on S’ than on S
Q0
Chapter 2: The Basics of Supply and Demand
Q1
Q2
Slide 3
Q
Supply and Demand

The Demand Curve

The demand curve shows how much of a
good consumers are willing to buy as the
price per unit changes holding non-price
factors constant.

This price-quantity relationship can be shown
by the equation:
QD  QD(P)
Chapter 2: The Basics of Supply and Demand
Slide 4
Supply and Demand
Price
($ per unit)
The demand curve slopes
downward demonstrating
that consumers are willing
to buy more at a lower price
D
Quantity
Chapter 2: The Basics of Supply and Demand
Slide 5
Supply and Demand
Change in Demand

Income Increases
P
D’
D
P2

At P1, purchase Q2

At P2, purchase Q1

Demand Curve shifts right P1

More purchased at any
price on D’ than on D
Q0
Chapter 2: The Basics of Supply and Demand
Q1
Q2
Slide 6
Q
The Market Mechanism
Price
($ per unit)
S
The curves intersect at
equilibrium, or marketclearing, price. At P0 the
quantity supplied is equal
to the quantity demanded
at Q0 .
P0
D
Q0
Chapter 2: The Basics of Supply and Demand
Quantity
Slide 7
The Market Mechanism
Price
($ per unit)
S
Surplus
P1
Assume the price is P1 , then:
1) Qs : Q2 > Qd : Q1
2) Excess supply is Q2 – Q1.
3) Producers lower price.
4) Quantity supplied decreases
and quantity demanded
increases.
5) Equilibrium at P2Q3
P2
D
Q1
Q3
Q2 Quantity
Chapter 2: The Basics of Supply and Demand
Slide 8
The Market Mechanism
Price
($ per unit)
S
Assume the price is P2 , then:
1) Qd : Q2 > Qs : Q1
2) Shortage is Q2 – Q1.
3) Producers raise price.
4) Quantity supplied increases
and quantity demanded
decreases.
5) Equilibrium at P3, Q3
P3
P2
Shortage
Q1
Q3
D
Q2 Quantity
Chapter 2: The Basics of Supply and Demand
Slide 9
Changes In Market Equilibrium

Income Increases &
raw material prices fall


The increase in D is
greater than the
increase in S
P
D
D’
S
S’
P2
P1
Equilibrium price and
quantity increase to P2,
Q2
Q1
Chapter 2: The Basics of Supply and Demand
Q2
Slide 10
Q
Example 1: Market for Eggs
P
S1970
(1970
dollars per
dozen)
Prices fell until
a new equilibrium
was reached at $0.26
and a quantity
of 5,300 million dozen
S1998
$0.61
$0.26
D1970
5,300 5,500
Chapter 2: The Basics of Supply and Demand
D1998
Q (million dozens)
Slide 11
Example 2: Market for a College Education
P
S1995
(annual cost
in 1970
dollars)
Prices rose until
a new equilibrium
was reached at $4,573
and a quantity
of 12.3 million students
$4,573
S1970
$2,530
D1970
7.4
12.3
Chapter 2: The Basics of Supply and Demand
D1995
Q (millions of students enrolled))
Slide 12
Elasticities of Supply and Demand
Price Elasticity of Demand

Measures the sensitivity of quantity demanded to price
changes.

It measures the % change in the quantity demanded
for a good or service that results from a one percent
change in the price.

The price elasticity of demand is:
EP  (%Q)/(% P)
Chapter 2: The Basics of Supply and Demand
Slide 13
Elasticities of Supply and Demand
Price Elasticity of Demand

The % change in a variable is the
absolute change in the variable divided
by the original level of the variable. So the
price elasticity of demand is also:
Q/Q P Q
EP 

P/P Q P
Chapter 2: The Basics of Supply and Demand
Slide 14
Elasticities of Supply and Demand

Interpreting Price Elasticity of Demand Values
1) Because of the inverse relationship between P and
Q; EP is negative.
2) If |EP| > 1, the % change in quantity demanded is
greater than the % change in price. We say demand is
price elastic.
3) If |EP| < 1, the % change in quantity demanded is
less than the % change in price. We say demand is
price inelastic.
Chapter 2: The Basics of Supply and Demand
Slide 15
Price Elasticities of Demand
Price
EP  - 
The lower portion of
a downward sloping
demand curve is less elastic
than the upper portion.
4
Q = 8 - 2P
Ep = -1
2
Linear Demand Curve
Q = a - bP
Q = 8 - 2P
Ep = 0
4
Chapter 2: The Basics of Supply and Demand
8
Q
Slide 16
Elasticities of Supply and Demand
Other Demand Elasticities

Income elasticity of demand measures the % change in
quantity demanded resulting from a one percent
change in income. The income elasticity of demand is:
Q/Q
I Q
EI 

I/I
Q I
Chapter 2: The Basics of Supply and Demand
Slide 17
Elasticities of Supply and Demand
Other Demand Elasticities

Cross price elasticity of demand = the % change in the quantity
demanded of one good that results from a one percent change in
the price of another good.

The cross price elasticity for substitutes is positive, while that for
complements is negative. For example, consider the substitute
goods, butter and margarine.
Qb/Qb Pm Qb
EQbPm 

Pm/Pm Qb Pm
Chapter 2: The Basics of Supply and Demand
Slide 18
Elasticities of Supply and Demand
Elasticities of Supply

Price elasticity of supply measures the % change in
quantity supplied resulting from a 1% change in price.

The elasticity is usually positive because price and
quantity supplied are positively related (Higher price
gives producers an incentive to increase output)

We can refer to elasticity of supply with respect to
interest rates, wage rates, and the cost of raw
materials.
Chapter 2: The Basics of Supply and Demand
Slide 19
SR Versus LR Elasticities
Price Elasticity of Demand

Price elasticity of demand varies with the amount of
time consumers have to respond to a price.

Most goods and services:


Short-run elasticity is less than long-run elasticity (e.g.
gasoline). People tend to drive smaller and more fuel efficient
cars in the long-run
Other Goods (durables):

Short-run elasticity is greater than long-run elasticity (e.g.
automobiles). People may put off immediate consumption, but
eventually older cars must be replaced.
Chapter 2: The Basics of Supply and Demand
Slide 20
SR Versus LR Elasticities
Income Elasticities

Most goods and services:
 Income elasticity is greater in the long-run than in
the short run. For example, higher incomes may be
converted into bigger cars so the income elasticity of
demand for gasoline increases with time.

Other Goods (durables):
 Income elasticity is less in the long-run than in the
short-run. For example, consumers will initially want
to hold more cars. Later, purchases will only to be to
replace old cars.
Chapter 2: The Basics of Supply and Demand
Slide 21
SR Versus LR Elasticities
Price Elasticity of Supply

Most goods and services:


Long-run price elasticity of supply is greater than short-run
price elasticity of supply. Due to limited capacity, firms are
output constrained in the short-run. In the long-run, they can
expand.
Other Goods (durables, recyclables):

Long-run price elasticity of supply is less than short-run price
elasticity of supply. For example, consider the secondary
copper market. Copper price increases provide an incentive to
convert scrap copper into new supply. In the long-run, this stock
of scrap copper begins to fall.
Chapter 2: The Basics of Supply and Demand
Slide 22
SR Versus LR Elasticities: Coffee
Coffee
S’
S
Coffee prices are volatile:
A freeze or drought
decreases the supply
of coffee in Brazil
Price
P1
P0
Short-Run
1) Supply is completely inelastic
2) Demand is relatively inelastic
3) Very large change in price
D
Q1
Q0
Chapter 2: The Basics of Supply and Demand
Quantity
Slide 23
Understanding and Predicting the Effects
of Changing Market Conditions
1.
We must learn how to “fit” linear demand and supply
curves to market data.
2.
We determine numerically how a change in one
variable will cause supply or demand to shift and so
affect the equilibrium price and quantity.
3.
Assume the Available Data are:

Equilibrium Price, P*

Equilibrium Quantity, Q*

Price elasticity of supply, ES, and demand, ED.
Chapter 2: The Basics of Supply and Demand
Slide 24
Understanding and Predicting the Effects
of Changing Market Conditions
Price
Supply: Q = c + dP
a/b
ED = -bP*/Q*
ES = dP*/Q*
P*
-c/d
Demand: Q = a - bP
Q*
Chapter 2: The Basics of Supply and Demand
Quantity
Slide 25
Understanding and Predicting the Effects
of Changing Market Conditions

Let’s begin with the equations for supply
and demand, and the elasticities:
Demand: QD = a - bP
Supply:
QS = c + dP
E  (P/Q)( Q/P)
Chapter 2: The Basics of Supply and Demand
Slide 26
Understanding and Predicting the Effects
of Changing Market Conditions

Note: for linear demand curves, ∆Q/ ∆P is
constant (equal to the slope of the curve).

Substituting the slopes for each into the
formula for elasticity, we get:
ED  - b(P * /Q*)
ES  d(P * /Q*)
Chapter 2: The Basics of Supply and Demand
Slide 27
Understanding and Predicting the Effects
of Changing Market Conditions

Suppose we have values for ED, ES, P*,
and Q*, we can then solve for b & d, and
a & c.
QD  a  bP
*
QS  c  dP
*
Chapter 2: The Basics of Supply and Demand
*
*
Slide 28
Example: The Copper Market

Suppose we want to derive the long-run
supply and demand for copper:

The data are:

Q* = 7.5 mmt/yr.

P* = 75 cents/pound

ES = 1.6

ED = -0.8
Chapter 2: The Basics of Supply and Demand
Slide 29
Understanding and Predicting the Effects
of Changing Market Conditions
Price
Supply: QS = -4.5 + 16P
1.69 = a/b
.75
+.28 = -c/d
Demand: QD = 13.5 - 8P
7.5
Chapter 2: The Basics of Supply and Demand
Mmt/yr
Slide 30
Example 1: Real versus Nominal Prices of Copper
1965 - 1999
Chapter 2: The Basics of Supply and Demand
Slide 31
Declining Demand and the Behavior of Copper Prices

The relevant factors leading to a decrease in the
demand for copper are:
1) A decrease in the growth rate of power generation
2) The development of substitutes: fiber optics and
aluminum

We will try to estimate the impact of a 20% decrease in
the demand for copper.

Recall the equation for the demand curve:
Q = 13.5 - 8P
Chapter 2: The Basics of Supply and Demand
Slide 32
Real versus Nominal
Prices of Copper 1965 - 1999

Multiply the demand equation by 0.80 to get the new equation.
This gives:
Q = (0.80)(13.5 - 8P) = 10.8 - 6.4P

Recall the equation for supply:
Q = -4.5 + 16P

The new equilibrium price is:
-4.5 + 16P = 10.8 - 6.4P
-16P + 6.4P = 10.8 + 4.5
P = 15.3/22.4 = 68.3 cents/pound
Chapter 2: The Basics of Supply and Demand
Slide 33
Example 2: Government Intervention - Price Controls

If the government decides that the equilibrium price is
too high, they may establish a ceiling price.

Natural Gas Market: In 1954, the federal government
began regulating the wellhead price of natural gas.

In 1962, the ceiling prices that were imposed became
binding and shortages resulted.

Price controls created an excess demand of 7 trillion
cubic feet.

Price regulation was a major component of U.S. energy
policy in the 1960s and 1970s, and it continued to
influence the natural gas markets in the 1980s.
Chapter 2: The Basics of Supply and Demand
Slide 34
Effects of Price Controls
Price
S
If price is regulated to
be no higher than Pmax,
quantity supplied falls
to Q1 and quantity
demanded increases to
Q2. A shortage results.
P0
Pmax
D
Excess demand
Q1
Q0
Chapter 2: The Basics of Supply and Demand
Q2
Quantity
Slide 35
Price Controls and
Natural Gas Shortages
The Data: Natural Gas
1975 regulated price  $1.00
At $1.00/TcF
QS  18 TcF and Q  25 TcF
Shortage  7 TcF/yr
Chapter 2: The Basics of Supply and Demand
Slide 36