ECO 162

MICROECONOMICS

Chapter 2: The Theory of

Demand and Supply

Page 1

Supply
Supply the quantity of a good that is
offered for sale at all possible prices

Page 2

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

Q S Q S (P)
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Page 3

The Supply Curve

S

Price
($ per unit)

The Supply Curve,

Graphically Depicted
P2
The supply curve slopes
upward, demonstrating that
at higher prices firms
will increase output

P1

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Q1

Q2

Quantity

Page 4

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

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Page 5

Change in Supply
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

P1
P2

Q0
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Q1

Q2

Page 6

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

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Page 7

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

QD QD(P)
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Page 8

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.

P2
P1
D

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Q1

Q2

Quantity
Page 9

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

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Page 10

Change in Demand
Income Increases

Purchased Q0, at P2
P2
and Q1 at P1
Now purchased Q1 at
P2 and Q2 at P1
Same for all prices P1
Demand curve shifts
right

Q0
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Q1

Q2

Q
Page 11

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
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Page 12

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
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Page 13

The Market Mechanism

S

Price
($ per unit)

The curves intersect at

equilibrium, or marketclearing, price.
Quantity demanded
equals quantity supplied
at P0

P0

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Q0

Quantity
Page 14

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

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Page 15

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

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Page 16

The Market Mechanism

Price

($ per unit)

1.

Surplus

P1
2.
3.

P0

4.

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Q
D

Q0

QS

At P1, price is
above the
market clearing
price
Qs > QD
Price falls to the
market-clearing
price
Market adjusts to
equilibrium

Quantity
Page 17

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

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Page 18

The Market Mechanism

Price

($ per unit)
1.

2.
3.

P3

4.

P2

Shortage
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QS

Q
3

At P2, price is
below the
market clearing
price
Q D > QS
Price rises to
the marketclearing price
Market adjusts
to equilibrium

QD

Quantity
Page 19

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
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Page 20

Changes in Market Equilibrium

Equilibrium prices are determined by the
relative level of supply and demand
Changes in supply and/or demand will
cause change in the equilibrium price
and/or quantity in a free market

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Page 21

Changes in Market
Equilibrium
Raw material prices
fall

S shifts to S
Surplus at P1 between
Q 1, Q 2
P1
Price adjusts to
equilibrium at P3, Q3 P3

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Q1 Q3Q2

Q
Page 22

Changes in Market
Equilibrium
P

Income Increases

Demand increases to
D
Shortage at P1 of Q1 P3
to Q2
P1
Equilibrium at P3 and
Q3

Q1 Q3 Q
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Q
Page 23

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

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P2
P1

Q1

Q2

Q
Page 24

Shifts in Supply and Demand

When supply and demand change

simultaneously, the impact on the
equilibrium price and quantity is
determined by:
1. The relative size and direction of the change
2. The shape of the supply and demand
models

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Page 25

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
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Page 26

Market for a College Education

S2002

(annual cost

in 1970
dollars)

$3,917

S1970

New
equilibrium
was reached at
$4,573 and a
quantity of 12.3
million
students

$2,530

D1970
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8.6

13.2

D2002
Q (millions

enrolled))

Page 27

The Long-Run Behavior

of 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

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Page 28

Resource Market Equilibrium

Price

S1900

S1950

S2002

Long-Run Path of
Price and Consumption

D1900
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D1950

D2002

Quantity

Page 29

Resource Market
Conclusion
Decreases in the costs of production have
increased the supply by more than enough to
offset the increase in demand

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Page 30

Elasticities of Supply and Demand

Not only are we concerned with what direction price
and quantity will move when the market changes, but
we are concerned about how much they change
Elasticity gives a way to measure by how much a
variable will change with the change in another
variable
Specifically, it gives the percentage change in one
variable resulting from a one percent change in
another

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Page 31

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

%QD
E
%P
D
P

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Page 32

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
Q Q P Q
D
as:
EP

P P Q P
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Page 33

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|
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Page 34

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

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Page 35

Price Elasticity of Demand

Looking at a linear demand curve, as we
move along the curve Q/P is constant,
but P and Q will 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
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Page 36

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

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Page 37

Price Elasticity of Demand

Price

EP = -

Demand Curve
Q = 8 2P

Elastic

Ep = -1

Inelastic

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Ep = 0
Page 38

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
Infinitely elastic demand horizontal
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Page 39

Infinitely Elastic Demand

Price

EP =
P*

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Quantity
Page 40

Completely Inelastic Demand

Price

EP = 0

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Q*

Quantity
Page 41

Other Demand Elasticities

Income Elasticity of Demand
Measures how much quantity demanded
changes with a change in income

Q/Q I Q
EI

I/I Q I
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Page 42

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

EQb Pm
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Qb Qb Pm Qb

Pm Pm Qb Pm
Page 43

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

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Page 44

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

%QS
E
%P
S
P

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Page 45

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

E PD
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P
P Q
Page 46

Elasticity: An Application
During the 1980s and 1990s, the market
for wheat went through changes that had
great implications for American farmers
and US agricultural policy
Using the supply and demand curves for
wheat, we can analyze what occurred in
this market

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Page 47

Elasticity: An Application
Supply: QS = 1900 + 24P
Demand: QD = 3550 266P

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Page 48

Elasticity: An Application
QD = QS
1800 + 240P = 3550 266P
506P = 1750
P = $3.46 per bushel

Q = 1800 + (240)(3.46) = 2630 million

bushels
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Page 49

Elasticity: An Application
We can find the elasticities of demand and
supply at these points
D
EP

P QD
3.46

( 2.66) .035
Q P
2,630

S
EP

P QS
3.46

(2.40 ) .032
Q P
2,630

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Page 50

Elasticity: An Application
Assume the price of wheat is $4.00/bushel
due to decrease in supply

QD 3,550 (266)(4.00) 2,486

4.00
Q
(266) 0.43
2,486
D
P

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Page 51

Elasticity: An Application
In 2002, the supply and demand for wheat
were:
Supply: QS = 1439 + 267P
Demand: QD = 2809 226P

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Page 52

Elasticity: An Application
QD = QS
2809 - 226P = 1439 + 267P
P = $2.78 per bushel
Q = 2809 - (226)(2.78) = 2181 million
bushels
Price of wheat fell in nominal terms.
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Page 53

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

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Page 54

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

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Page 55

Gasoline: Short-Run and Long-Run Demand

Curves
Price

DSR

People cannot easily

adjust consumption in the
short run.
In the long run, people
tend to drive smaller and
more fuel efficient cars.

DLR

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Quantity of Gas
Page 56

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
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Page 57

Cars: Short-Run and Long-Run

Demand Curves
Price

DLR

Initially, people may put

off immediate car purchase
In long run, older cars
must be replaced

DSR

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Quantity of Cars
Page 58

Short-Run Versus Long-Run

Elasticity
Income elasticity also varies with the
amount of time consumers have to
respond to an income change
For most goods and services, income
elasticity is larger in the long run
When income changes, it takes time to adjust
spending

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Page 59

Short-Run Versus Long-Run

Elasticity
Income elasticity of durable goods
Income elasticity is less in the long run than in
the short run
Increases in income mean consumers will want to
hold more cars
Once older cars are replaced, purchases will only
be to replace old cars
Less purchases from income increase in long run
than in short run
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Page 60

Demand for Gasoline

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Page 61

Demand for Automobiles

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Short-Run Versus Long-Run

Elasticity
Most goods and services:
Long-run price elasticity of supply is greater
than short-run price elasticity of supply

Other Goods (durables, recyclables):

Long-run price elasticity of supply is less than
short-run price elasticity of supply

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Page 63

Short-Run Versus Long-Run Elasticity

Price

SSR

SLR
Due to limited
capacity, firms
are limited by
output constraints
in the short run.
In the long run, they
can expand.

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Quantity Primary Copper

Page 64

Short-Run Versus Long-Run

Elasticity
Price

SLR

SSR

Price increases
provide an incentive
to convert scrap
copper into new supply.
In the long run, this
stock of scrap copper
begins to fall.

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Quantity Secondary Copper

Page 65

Supply of Copper

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Page 66

Short-Run vs. Long-Run

Elasticity An Application
Why are coffee prices very volatile?
Most of the worlds coffee is produced in
Brazil
Many changing weather conditions affect the
crop of coffee, thereby affecting price
Price following bad weather conditions is
usually short-lived
In long run, prices come back to original
levels, all else equal
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Page 67

Price of Brazilian Coffee

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Page 68

Short-Run vs. Long-Run

Elasticity An Application
Demand and supply are more elastic in
the long run
In the short run, supply is completely
inelastic
Weather may destroy part of the fixed supply,
decreasing supply

Demand is relatively inelastic as well

Price increases significantly
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Page 69

An Application - Coffee
S

Price
A freeze or drought
decreases the supply
of coffee
Price increases
significantly due to
inelastic supply and
demand

P1

P0
D
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Q1

Q0

Quantity

Page 70

An Application - Coffee
Price

Intermediate-Run
1) Supply and demand are
more elastic
2) Price falls back to P2.

P2
P0

D
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Q2 Q0

Quantity

Page 71

An Application - Coffee
Price

Long-Run
1) Supply is extremely elastic
2) Price falls back to P0.
3) Quantity back to Q0.

P0

D
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Q0

Quantity
Page 72

Predicting the Effects of

Changing Market Conditions
Supply and demand analysis can be used
to predict the effects of changing market
conditions
Linear demand and supply must be fit to
market data
Given equilibrium price and quantity along with
elasticities of supply and demand, we can
calculate the curves that fit the information
We can then calculate changes in the market
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Page 73

Predicting the Effects of

Changing Market Conditions
We know
Equilibrium Price, P*
Equilibrium Quantity, Q*
Price elasticity of supply, ES
Price elasticity of demand, ED

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Page 74

Predicting the Effects of

Changing Market Conditions
Lets begin with the equations for supply,
demand, elasticity:
Demand: Q = a bP
Supply: Q = c + dP
Elasticity: (P/Q)(Q/P)

We must calculate numbers for a, b, c,

and d.
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Page 75

Predicting the Effects of

Changing Market Conditions
The slope of the demand curve above
equals Q/P which equals -b
The slope of the supply curve above
equals Q/P which equals d
Demand: ED = -b(P*/Q*)
Supply: ES = d(P*/Q*)
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Page 76

Predicting the Effects of

Changing Market Conditions
Price

Supply: Q = c + dP

a/b

ED = -bP*/Q*
ES = dP*/Q*

P*

Demand: Q = a - bP

-c/d

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Q*

Quantity
Page 77

Predicting the Effects of

Changing Market Conditions

Using P*, Q* and the elasticities, we can

solve for b and c from supply
ES = d(P*/Q*)
1.6 = d(0.75/7.5) = 0.1d
d = 16
Q = c + dP
7.5 = c + (16)(0.75) = c + 12
c = -4.5
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Page 78

Predicting the Effects of

Changing Market Conditions

Using P*, Q* and the elasticities, we can

solve for a and b from demand
ED = b(P*/Q*)
-0.8 = -b(0.75/7.5) = 0.1b
b=8
Q = a bP
7.5 = a (8)(0.75) = a 6
a = 13.5
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Page 79

Predicting the Effects of

Changing Market Conditions
We now have equations for supply and
demand
Supply: Q = 4.5 + 16P
Demand: Q = 13.5 8P
Setting them equal will give us equilibrium
price and quantity with which we began

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Page 80

Predicting the Effects of

Changing Market Conditions
Price

Supply: QS = -4.5 + 16P

a/b

.75

Demand: QD = 13.5 - 8P

-c/d

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7.5

Mmt/yr
Page 81

Predicting the Effects of

Changing Market Conditions
We have written supply and demand so
that they only depend upon price
Demand could also depend upon other
variables such as income
Demand would then be written as:

Q a bP fI
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Page 82

Predicting the Effects of

Changing Market Conditions
We know the following information
regarding the copper industry:
I = 1.0
P* = 0.75
Q* = 7.5
b=8
Income elasticity: EI= 1.3

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Page 83

Predicting the Effects of

Changing Market Conditions
Using the elasticity of income formula, we
can solve for f
EI = (I/Q)(Q/I)
1.3 = (1.0/7.5)(f)
f = 9.75
Substituting back into demand equation
gives a = 3.75
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Page 84

Declining Demand and the

Behavior of Copper Prices
Copper has gone through difficult market
changes leading the significantly reduced
prices most from decreased demand from
A decrease in the growth rate of power
generation
The development of substitutes: fiber optics
and aluminum

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Page 85

Real versus Nominal

Prices of Copper 1965 - 2002

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Page 86

Declining Demand and the

Behavior of Copper Prices
Given producers concerns about further
declines in demand, we can calculate by
how much prices will fall with future
declines in demand
Assume that demand will fall by 20%
What is the resulting decrease in price?
Demand curve will shift to left by 20%

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Page 87

Declining Demand and the Behavior of

Copper Prices
We want to consider 80% of the past
demand
Q = (0.80)(13.5 - 8P)
Q = 10.8 - 6.4P
Recall the equation for supply:
Q = -4.5 + 16P

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Page 88

Declining Demand and the Behavior of

Copper Prices
Setting supply equal to demand:
-4.5 + 16P = 10.8 - 6.4P
-16P + 6.4P = 10.8 + 4.5
P = 15.3/22.4
P = 68.3 cents/pound
A decline in demand of 20% will lead to a
drop in price about 7%
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Page 89

Effects of Price Controls

Markets are rarely free of government
intervention
Imposed taxes and granted subsidies
Price controls

Price controls usually hold the price above

or below the equilibrium price
Excess demand shortage
Excess supply surplus
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Page 90

Effects of Price Controls

Price

S
Price is regulated to be
no higher than Pmax
Quantity supplied falls
and quantity demanded
increases
A shortage results

P0

Pmax
Shortage

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Q
S

Q0

D
QD Quantity
Page 91

Effects of Price Controls

Excess demand sometimes takes the form
of queues
Lines at gas stations during 1974 shortage

Sometimes get curtailments and supply

rationing
Natural gas shortage of the mid 70s

Producers typically lose, but some

consumers gain. Some consumers lose.
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Price Controls and

Natural Gas Shortages
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

Chapter
2005
Pearson
2
Education, Inc.

Page 93

Price Controls and

Natural Gas Shortages
Price controls created an excess demand
of 7 trillion cubic feet
Price regulation was a major component of
US energy policy in the 1960s and 1970s,
and it continued to influence the natural
gas markets in the 1980s

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2005
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2
Education, Inc.

Page 94