Chapter Two Overview

1.1. Motivation
Motivation––U.S.
U.S.corn
cornmarkets
markets

2.2. Competitive
CompetitiveMarkets
MarketsDefined
Defined

3.3. The
TheMarket
MarketDemand
DemandCurve
Curve

4.4. The
TheMarket
MarketSupply
SupplyCurve
Curve

5.5. Equilibrium
Equilibrium

6.6. Characterizing
CharacterizingDemand
Demandand
andSupply
Supply––Elasticity
Elasticity

7.7. Back
Backof
ofthe
theEnvelope
EnvelopeTechniques
Techniques
1

Chapter Two
 Motivation
Example: U.S. Corn Market

Historical
Historicalprice:
price:
$2.00
$2.00per
perbushel
bushel
Prices rose to $3.00 per bushel

Prices fell below to $2.00 per bushel

Prices rose above $5.00 per bushel

Prices fell to $3.90 per bushel

Why
Whydo
doprices
pricesvary
varyso
somuch?
much?
Changes
ChangesininSupply
Supplyand
andDemand
Demandconditions
conditionsaffects
affectsthe
thepattern
patternof
ofprices
prices 2

Chapter Two
 Motivations
Example: U.S. Corn Market
• 2002-2003
• Decrease in supply due to drought in the corn-growing states
• 2004-2005
• Unexpectedly large U.S. corn crops
• 2006-2008
• Changes in U.S. government policy
• Bubble years
• Increase in production costs due to oil price increases and
rains and flooding wiped out corn crop
• 2008-2009
• Weather conditions back to normal
3
• Economic Crisis

Chapter Two
 Competitive Markets

Competitive Markets are those with sellers

and buyers that are small and numerous
enough that they take the market price as
given when they decide how much to buy and
sell.

Chapter Two
The Market Demand Function

The Market Demand Function tells us

that the quantity of a good all
consumers in the market are willing to
buy is a function of various factors.

Qd = Q(p,I, ...)

Chapter Two
 The Market Demand Curve
The Market Demand Curve plots the aggregate
quantity of a good that consumers are willing to
buy at different prices, holding constant other
demand drivers such as prices of other goods,
consumer income, and quality.

The demand curve also tells us the highest price

that the “market will bear” for a given quantity or
supply of output. 6

Chapter Two
 The Law of Demand

The Law of Demand states that the

quantity of a good demanded
decreases when the price of this
good increases.

Chapter Two
 Demand Curve Rule

A move along the demand curve for a good

can only be triggered by a change in the price
of that good. Any change in another factor
that affects the consumers’ willingness to pay
for the good results in a shift in the demand
curve for the good.

Chapter Two
 Shifts of the Demand Curve

The
TheDemand
DemandCurve
Curveshifts
shiftswhen
whenfactors
factorsother
otherthan
thanown
own
price
pricechange
change

 If the change increases the willingness of consumers to

acquire the good, the demand curve shifts right

 If the change decreases the willingness of consumers to

acquire the good, the demand curve shifts left
9

Chapter Two
The Demand for Cars

10

Chapter Two
 The Demand for Cars

We always graph P on vertical axis and Q on horizontal

axis, but we write demand as Q as a function of P… If P is
written as function of Q, it is called the inverse demand.

Markets
Marketsdefined
definedby
bycommodity,
commodity,geography,
geography,time,...
time,...
11

Chapter Two
 Market Supply

Tells us that the quantity of a good

supplied by all producers in the
market depends on various factors

Plots the aggregate quantity of a good

that producers are willing to sell at
different prices.
12

Chapter Two
Supply Curve for Wheat

13

Chapter Two
 The Law of Supply

The Law of Supply states that the quantity

of a good offered increases when the price
of this good increases.

14

Chapter Two
 Supply Curve Rule

A move along the supply curve for a good can

only be triggered by a change in the price of
that good. Any change in another factor that
affects the producers’ willingness to offer for
the good results in a shift in the supply curve
for the good.

15

Chapter Two
 Shifts in the Supply Curve
The
TheSupply
SupplyCurve
Curveshifts
shiftswhen
whenfactors
factorsother
otherthan
thanown
ownprice
price
change
change
 If the change increases the willingness of producers to
offer the good at the same price, the supply curve shifts
right

 If the change decreases the willingness of producers to

offer the good at the same price, the supply curve shifts
left
16

Chapter Two
 Market Equilibrium
• Market Equilibrium
• is a price such that, at this price, the quantities
demanded and supplied are the same.
• is a point at which there is no tendency for the market
price to change as long as exogenous variables remain
unchanged.
Demand
Demand and
and supply
supply curves
curves intersect
intersect at
at equilibrium
equilibrium
Dem ly
a nd p p
Su

17

Chapter Two
 Example: Market Equilibrium for Cranberries
Qd = 500 – 4p
Qs = -100 + 2p
p = price of cranberries (dollars per barrel)
Q = demand or supply in millions of barrels per year
The equilibrium price of cranberries is calculated by
equating demand to supply:
QQdd==QQss……or…
or…
500
500––4p
4p==-100
-100++2p
2p…solving
…solving p*
p*==$100
$100
Plug equilibrium price into either demand or supply to get
equilibrium quantity: Q* = 500 – 4(100) = 100 units 18

Chapter Two
 Market Equilibrium for Cranberries
Price
125

Supply: Qs = 500 - 4 P

100

Demand: Qd = -100 + 2 P
50
19
100 500 Quantity
Chapter Two
 Excess Demand/Supply
Excess Demand: A situation in which the quantity demanded
at a given price exceeds the quantity supplied.

Excess Supply: A situation in which the quantity supplied at a

given price exceeds the quantity demanded.

If there is no excess supply or excess demand, there is no

pressure for prices to change and thus there is equilibrium.

When a change in an exogenous variable causes the

demand curve or the supply curve to shift, the equilibrium
shifts as well.
20

Chapter Two
 Excess Demand/Supply
Excess supply
Price (dollars Qs
when price is $5
per bushel)

5.00

E
4.00

Excess demand
3.00 when price is $3

Qd

8 9 11 13 14 21

Quantity (billions of bushels per year)

Chapter Two
Shifts in Demand, Supply Unchanged

Demand Increases:
P Q

Demand Decreases:
P Q 

22
Shifts in Supply, Demand Unchanged

Supply Increases:
P  Q

Supply Decreases:
PQ

23
Shifts in both Demand and Supply

24
 Price Elasticity
The Price Elasticity of Demand is the percentage
change in quantity demanded brought about by
a one-percent change in the price of the good.
percentage change in quantity
 Q,P 
percentage change in price
Q
100% Q
Q Q Q P
   
P P P Q
100% P
P 25

Chapter Two
 Price Elasticity: Example

Starting point: P = $10, Q = 50 units

After price increase: P = $12, Q = 45 units

Q 45  50
Q 50  0.5
 Q,P  
P 12  10
P 10

Note: Price elasticity must always be negative 26

Chapter Two
 Price Elasticity

•• Slope
Slope isis the
the ratio
ratio of
of absolute
absolute changes
changes in
in
quantity
quantityand price ==Q/P.
andprice Q/P.

•• Elasticity
Elasticity isis the
the ratio
ratio of
of relative
relative (or
(or
percentage)
percentage)changes
changesin inquantity
quantityand
andprice.
price.
27

Chapter Two
Price Elasticity

28

Chapter Two
 Price Elasticity
• When a one percent change in price leads to a greater than
one-percent change in quantity demanded, the demand
curve is elastic. (Q,P < -1 or |Q,P|> 1 )

• When a one-percent change in price leads to a less than one-

percent change in quantity demanded, the demand curve is
inelastic. (0 > Q,P > -1 or 0 < |Q,P|< 1 )

• When a one-percent change in price leads to an exactly one-

percent change in quantity demanded, the demand curve is
unit elastic. (Q,P = -1 or |Q,P|= 1 ) 29

Chapter Two
 Elasticity – Linear Demand Curve

Qd = a – bP, where a and b are positive constants (b is the slope)

Elasticity is:
Q
Q P
 Q,P   b 
P Q
P
Elasticity changes from - to 0 along the linear demand curve, but the
slope remains constant.

Example: Calculate elasticity when P = 30 and Qd =400 – 10P

30
Answer: εQ,P = -3 “elastic”

Chapter Two
Elasticity – Linear Demand Curve
P

Q,P = -
a/b
Elastic region

a/2b • Q,P = -1

Inelastic region

Q,P = 0
Q
0 a/2 a 31

Chapter Two
 Price Elasticity and Total Revenue

• Total Revenue (TR) = P ∙ Q

• When P Q and when P Q

• Demand is elastic
• Fall in Q > Rise in P TR falls
• Demand is inelastic
• Fall in Q < Rise in P TR increases
32

Chapter Two
 Determinants of Price Elasticity of Demand

• Availability of Substitutes
– More substitutes → more price elastic
– Goods which have price inelastic at the market level, like
cigarettes, can be highly price elastic at the brand level
• Necessities versus Luxuries
– Necessities → less price elastic
• Time Horizon
– Long-run → more price elastic

33

Chapter Two
 Other Elasticities
X Y
Elasticity of X with respect to Y:
Y X

Q P s

Price elasticity of supply:

P Q s

Q Id

Income elasticity of demand:

I Q d

34

Chapter Two