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Chapter 2

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Chapter 2

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  1. Chapter 2 The Basics of Supply and Demand

  2. Supply and Demand • Supply and demand analysis can: • Help us understand and predict how real world economic conditions affect market price and production • Analyze the impact of government price controls, minimum wages, price supports, and production incentives on the economy • Determine how taxes, subsidies, tariffs and import quotas affect consumers and producers Chapter 2

  3. Supply and Demand • The Supply Curve • The relationship between the quantity of a good that producers are willing to sell and the price of the good • Measures quantity on the x-axis and price on the y-axis Chapter 2

  4. S P2 P1 Q1 Q2 The Supply Curve Price ($ per unit) The Supply Curve, Graphically Depicted The supply curve slopes upward, demonstrating that at higher prices firms will increase output Quantity Chapter 2

  5. The Supply Curve • Other Variables Affecting Supply • Costs of Production • Labor • Capital • Raw Materials • Lower costs of production allow a firm to produce more at each price and vice versa Chapter 2

  6. S S’ P1 P2 Q0 Q1 Q2 Change in Supply P • The cost of raw materials falls • Produced Q1 at P1 and Q0 at P2 • Now produce Q2 at P1 and Q1 at P2 • Supply curve shifts right to S’ Q Chapter 2

  7. The Supply Curve • Change in Quantity Supplied • Movement along the curve caused by a change in price • Change in Supply • Shift of the curve caused by a change in something other than the price of the good • Change in costs of production Chapter 2

  8. Supply and Demand • The Demand Curve • The relationship between the quantity of a good that consumers are willing to buy and the price of the good • Measures quantity on the x-axis and price on the y-axis Chapter 2

  9. P2 P1 D Q2 Q1 The Demand Curve Price ($ per unit) The demand curve slopes downward, demonstrating that consumers are willing to buy more at a lower price as the product becomes relatively cheaper. Quantity Chapter 2

  10. The Demand Curve • Other Variables Affecting Demand • Income • Increases in income allow consumers to purchase more at all prices • Consumer Tastes • Price of Related Goods • Substitutes • Complements Chapter 2

  11. D P D’ P2 P1 Q0 Q1 Q2 Q Change in Demand • Income Increases • Purchased Q0, at P2 and Q1 at P1 • Now purchased Q1 at P2 and Q2 at P1 • Same for all prices • Demand curve shifts right Chapter 2

  12. The Demand Curve • Changes in quantity demanded • Movements along the demand curve caused by a change in price • Changes in demand • A shift of the entire demand curve caused by something other than price • Income • Preferences Chapter 2

  13. Friday, April 1, 2005 • Homework due Friday, April 8: • Chapter 1: #2 • Chapter 2: #4, 7, 11 • Course website: people.ucsc.edu/~jhgonzal/ • Nothing on it yet!!! Chapter 2

  14. The Market Mechanism • The market mechanism is the tendency in a free market for price to change until the market clears • Markets clear when quantity demanded equals quantity supplied at the prevailing price • Market clearing price – price at which markets clear Chapter 2

  15. S Price ($ per unit) P0 D Quantity Q0 The Market Mechanism The curves intersect at equilibrium, or market- clearing, price. Quantity demanded equals quantity supplied at P0 Chapter 2

  16. The Market Mechanism • In equilibrium • There is no shortage or excess demand • There is no surplus or excess supply • Quantity supplied equals quantity demanded • Anyone who wants to buy at the current price can and all producers who want to sell at that price can Chapter 2

  17. Market Surplus1 • The market price is above equilibrium • There is excess supply - surplus • Downward pressure on price • Quantity demanded increases and quantity supplied decreases • The market adjusts until new equilibrium is reached Chapter 2

  18. Price ($ per unit) S Surplus P1 P0 D Quantity QD Q0 QS The Market Mechanism • At P1, price is above the market clearing price • Qs > QD • Price falls to the market-clearing price • Market adjusts to equilibrium Chapter 2

  19. The Market Mechanism • The market price is below equilibrium: • There is excess demand - shortage • Upward pressure on prices • Quantity demanded decreases and quantity supplied increases • The market adjusts until the new equilibrium is reached Chapter 2

  20. Price ($ per unit) S P3 P2 D Shortage Quantity QS QD Q3 The Market Mechanism • At P2, price is below the market clearing price • QD > QS • Price rises to the market-clearing price • Market adjusts to equilibrium Chapter 2

  21. Changes in Market Equilibrium • Changes in supply and/or demand will cause change in the equilibrium price and/or quantity in a free market • Markets must be competitive for the mechanism discussed here to be efficient Chapter 2

  22. D P S S’ P1 P3 Q1 Q3 Q Q2 Changes in Market Equilibrium • Raw material prices fall • S shifts to S’ • Surplus at P1 between Q1, Q2 • Price adjusts to equilibrium at P3, Q3 Chapter 2

  23. D D’ P S P1 P3 Q1 Q3 Q2 Q Changes in Market Equilibrium • Income Increases • Demand increases to D’ • Shortage at P1 of Q1 to Q2 • Equilibrium at P3 and Q3 Chapter 2

  24. P2 P1 D P D’ S S’ Q1 Q2 Q Changes in Market Equilibrium • Income increases and raw material prices fall • Quantity increases • If the increase in D is greater than the increase in S price also increases Chapter 2

  25. Shifts in Supply and Demand • When supply and demand change simultaneously, the impact on the equilibrium price and quantity is determined by: • The relative size and direction of the change • The shape of the supply and demand models Chapter 2

  26. The Price of a College Education • The real price of a college education rose 55 percent from 1970 to 2002 • Increases in costs of modern classrooms and wages increased costs of production – decrease in supply • Due to a larger percentage of high school graduates attending college, demand increased Chapter 2

  27. S2002 P (annual cost in 1970 dollars) $3,917 S1970 $2,530 D2002 D1970 Q (millions enrolled)) 8.6 13.2 Market for a College Education New equilibrium was reached at $4,573 and a quantity of 12.3 million students Chapter 2

  28. The Long-Run Behaviorof Natural Resource Prices • Consumption of copper has increased about a hundredfold from 1880 through 2002 • The long term real price for copper has remained relatively constant • Increased demand as world economy grew • Decreased production costs increased supply Chapter 2

  29. S1900 S1950 Price S2002 Long-Run Path of Price and Consumption D1900 D2002 D1950 Quantity Resource Market Equilibrium Chapter 2

  30. Price Elasticity of Demand • Measures the sensitivity of quantity demanded to price changes • It measures the percentage change in the quantity demanded of a good that results from a one percent change in price Chapter 2

  31. Price Elasticity of Demand • The percentage change in a variable is the absolute change in the variable divided by the original level of the variable • Therefore, elasticity can also be written as: Chapter 2

  32. Price Elasticity of Demand • Usually a negative number • As price increases, quantity decreases • As price decreases, quantity increases • When |EP| > 1, the good is price elastic • |%Q| > |%P| • When |EP| < 1, the good is price inelastic • |%Q| < |% P| Chapter 2

  33. Price Elasticity of Demand • The primary determinant of price elasticity of demand is the availability of substitutes • Many substitutes, demand is price elastic • Can easily move to another good with price increases • Few substitutes, demand is price inelastic Chapter 2

  34. Price Elasticity of Demand • As we move along a linear demand curve Q/P is constant, but P and Q will change • Must be measured at a particular point on the demand curve • Elasticity will change along the demand curve in a particular way Chapter 2

  35. Price Elasticity of Demand • Given a linear demand curve • Elasticity depends on slope and on the values of P and Q • The top portion of demand curve is elastic • Price is high and quantity small • The bottom portion of demand curve is inelastic • Price is low and quantity high Chapter 2

  36. EP = - Price 4 Elastic Ep = -1 2 Inelastic Ep = 0 4 8 Q Price Elasticity of Demand Demand Curve Q = 8 – 2P Chapter 2

  37. Price Elasticity of Demand • The steeper the demand curve, the more inelastic the demand for the good becomes • The flatter the demand curve, the more elastic the the demand for the good becomes • Two extreme cases of demand curves • Completely inelastic demand – vertical • Perfectly elastic demand – horizontal Chapter 2

  38. Price D P* Quantity Infinitely Elastic Demand EP =  Chapter 2

  39. Price Quantity Completely Inelastic Demand D EP = 0 Q* Chapter 2

  40. Other Demand Elasticities • Income Elasticity of Demand • Measures how much quantity demanded changes with a change in income Chapter 2

  41. Other Demand Elasticities • Cross-Price Elasticity of Demand • Measures the percentage change in the quantity demanded of one good that results from a one percent change in the price of another good Chapter 2

  42. Other Demand Elasticities • Complements: Cars and Tires • Cross-price elasticity of demand is negative • Price of cars increases, quantity demanded of tires decreases • Substitutes: Butter and Margarine • Cross-price elasticity of demand is positive • Price of butter increases, quantity of margarine demanded increases Chapter 2

  43. Price Elasticity of Supply • Measures the sensitivity of quantity supplied given a change in price • Measures the percentage change in quantity supplied resulting from a 1 percent change in price Chapter 2

  44. Point vs. Arc Elasticities • Point elasticity of demand • Price elasticity of demand at a particular point on the demand curve • Arc elasticity of demand • Price elasticity of demand calculated over a range of prices Chapter 2

  45. Short-Run Versus Long-Run Elasticity • Price elasticity varies with the amount of time consumers have to respond to a price • Short-run demand and supply curves often look very different from their long-run counterparts Chapter 2

  46. Short-Run Versus Long-Run Elasticity • Demand • In general, demand is much more price elastic in the long run • Consumers take time to adjust consumption habits • Demand might be linked to another good that changes slowly • More substitutes are usually available in the long run Chapter 2

  47. DSR Price DLR Quantity of Gas Gasoline: Short-Run and Long-Run Demand Curves • People cannot easily adjust consumption in the short run. • In the long run, people tend to drive smaller and • more fuel efficient cars. Chapter 2

  48. Short-Run Versus Long-Run Elasticity • Demand and Durability • For some durable goods, demand is more elastic in the short run • If goods are durable, then when price increases, consumers choose to hold on to the good instead of replacing it • But in long run, older durable goods will have to be replaced Chapter 2

  49. DLR Price DSR Quantity of Cars Cars: Short-Run and Long-Run Demand Curves • Initially, people may put off immediate car purchase • In long run, older cars must be replaced Chapter 2

  50. Short-Run Versus Long-Run Elasticity • Income elasticity also differs from short run to long run • For most goods and services, income elasticity is larger in the long run • When income changes, it takes time to adjust spending Chapter 2