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Chapter 2

Chapter 2. The Basics of Supply and Demand. S. P 2. P 1. Q 1. Q 2. The Supply Curve. Price ($ per unit). The Supply Curve Graphically. The supply curve slopes upward demonstrating that at higher prices firms will increase output. Quantity. Introduction.

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Chapter 2

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  1. Chapter 2 The Basics of Supply and Demand

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

  3. Introduction • What are supply and demand? • What is the market mechanism? • What are the effects of changes in market equilibrium? • What are elasticities of supply and demand? Chapter 2

  4. Topics to Be Discussed • How do short-run and long-run elasticities differ? • How do we understand and predict the effects of changing market conditions? • What are the effects of government intervention – price controls? Chapter 2

  5. Supply and Demand • Supply and demand analysis can: • Help us understand and predict how 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

  6. 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

  7. 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

  8. 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

  9. 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 price • Change in costs of production Chapter 2

  10. 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

  11. 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

  12. 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

  13. 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

  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. Oun Lopez: Start of Lecture 3 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 wished to buy at the current price can and all producers who wish to sell at that price can Chapter 2

  17. S Price ($ per unit) P0 D Quantity Q0 The Market Mechanism -Market S and D curves include the S and D curves of individual consumers and producers. Who Supplies? -Producers with willingness-to-accept (WTA) prices below P*. Who Buys? -Only those consumers who are willing-to-pay (WTP) above P*. Chapter 2

  18. Market Surplus • 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

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

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

  21. The Market Mechanism • The market price is below equilibrium: • There is a 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

  22. The Market Mechanism • Supply and demand interact to determine the market-clearing price. • When not in equilibrium, the market will adjust to alleviate a shortage or surplus and return the market to equilibrium. • Markets must be competitive for the mechanism to be efficient. Chapter 2

  23. Changes In Market Equilibrium • Equilibrium prices are determined by the relative level of supply and demand. • Changes in supply and/or demand will change in the equilibrium price and/or quantity in a free market. Chapter 2

  24. 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

  25. D D’ P S P1 P3 Q1 Q3 Q2 Q Changes In Market Equilibrium • Income Increases • Demand increases to D1 • Shortage at P1 of Q1, Q2 • Equilibrium at P3, Q3 Chapter 2

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

  27. 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

  28. 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

  29. S Price ($ per unit) P0 D Quantity Q0 The Market Mechanism -Market S and D curves include the S and D curves of individual consumers and producers. Who Supplies? -Producers with willingness-to-accept (WTA) prices below P*. Who Buys? -Only those consumers who are willing-to-pay (WTP) above P*. Chapter 2

  30. 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

  31. S1900 S1950 Price S2002 Long-Run (LR) Path of Price and Consumption (LR demand) D1900 D2002 D1950 Quantity Resource Market Equilibrium Chapter 2

  32. Elasticities of Supply and Demand • How much do markets change? • Elasticity gives a way to measure how a variable will change when another variable changes. • Elasticity (Def): the percentage change in one variable resulting from a one percent change in another. Chapter 2

  33. 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

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

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

  36. Price Elasticity of Demand • Primary determinant of -Availability of substitutes. • Many substitutes: demand is price elastic • Few substitutes demand is price inelastic Chapter 2

  37. Price Elasticity of Demand • Linear demand curve: Q/P is constant • Values of P and Q change • Price elasticity of demand must therefore be measured at a particular point on the demand curve • Elasticity will change along the demand curve in a particular way Chapter 2

  38. 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

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

  40. Price Elasticity of Demand • The steeper the demand curve becomes, the more inelastic the good. • The flatter the demand curve becomes, the more elastic the good Chapter 2

  41. Price D P* Quantity Infinitely Elastic Demand (Extreme Case) QD changes infinitely with the smallest possible change in price. EP =  Chapter 2

  42. Price Quantity Completely Inelastic Demand (Extreme Case) D EP = 0 QD never changes, even with large changes in price. Q* Chapter 2

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

  44. 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

  45. 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

  46. 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

  47. Point v. 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

  48. Elasticity: An Application • Wheat Market Changes (1980s and 1990s) • Analyzing the Wheat Market Chapter 2

  49. Elasticity: An Application • Supply: QS = 1800 + 240P • Demand: QD = 3550 – 266P Analyze this market. 1)What are the initial P* and Q*? 2)How does demand change when price changes? 3)How does supply change when price changes? Chapter 2

  50. Elasticity: An Application QD = QS 1800 + 240P = 3550 – 266P 506P = 1750 P = $3.46 per bushel Q = 1800 + (240)(3.46) = 2630 million bushels Chapter 2

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