Module 2

Demand & Supply

The Law of Demand

The law of demand holds that other things equal, as the price of a good or service rises, its quantity demanded falls.

The reverse is also true: as the price of a good or service falls, its quantity demanded increases.

Factors affecting demand

Price of the good. Price of other goods- complementary goods & substitute goods. Income of consumers. Tastes & Preferences of consumers.

Demand Curve

The demand curve has a negative slope, consistent with the law of demand.

The Law of Supply

The law of supply holds that other things equal, as the price of a good rises, its quantity supplied will rise, and vice versa. Why do producers produce more output when prices rise?
They seek higher profits They can cover higher marginal costs of production

Factors affecting supply

Price of the good. Cost of inputs. Technology. Size of the industry.

Supply Curve

The supply curve has a positive slope, consistent with the law of supply.

Equilibrium

In economics, an equilibrium is a situation in which:

there is no inherent tendency to change, quantity demanded equals quantity supplied, and the market just clears.

Equilibrium

Equilibrium occurs at a price of $3 and a quantity of 30 units.

Shortages and Surpluses

A shortage occurs when quantity demanded exceeds quantity supplied.

A shortage implies the market price is too low.

A surplus occurs when quantity supplied exceeds quantity demanded.

A surplus implies the market price is too high.

Movement along demand curve

When the price of the good changes, there is a change in the quantity demanded of the good. This leads to a movement along the demand curve.

Shift in the Demand Curve

A change in any variable other than price that influences quantity demanded produces a shift in the demand curve or a change in demand. Factors that shift the demand curve include:

Change in consumer incomes Population change Consumer preferences Prices of related goods:

Substitutes: goods consumed in place of one another Complements: goods consumed jointly

Shift in the Demand Curve

This demand curve has shifted to the right. Quantity demanded is now higher at any given price.

Equilibrium After a Demand Shift

Movement along supply curve

Whenever there is a change in the quantity supplied due to a change in the price of the good itself, it is known as a movement along the supply curve.

Shift in the Supply Curve

A change in any variable other than price that influences quantity supplied produces a shift in the supply curve or a change in supply. Factors that shift the supply curve include:

Change in input costs Improvement in technology

Change in size of the industry

Shift in the Supply Curve

For an given rental price, quantity supplied is now lower than before.

Equilibrium After a Supply Shift

The shift in the supply curve moves the market equilibrium from point A to point B, resulting in a higher price and lower quantity.

Price Ceilings & Floors

A price ceiling is a legal maximum that can be charged for a good.

Results in a shortage of a product Common examples include apartment rentals and credit cards interest rates.

A price floor is a legal minimum that can be charged for a good.

Results in a surplus of a product Common examples include soybeans, milk, minimum wage.

Price Ceiling

A price ceiling is set at $2 resulting in a shortage of 20 units.

Price Floor

A price floor is set at $4 resulting in a surplus of 20 units.

Indirect taxes & subsidies

Indirect taxes are taxes levied on expenditure. It can be levied either on consumers or on producers. The effect is to shift the demand & supply curve, resp. to the left. Subsidies are a concession given to consumers to consume more, or to producers to produce more. The effect is to shift the demand & supply curve, resp. to the right.

Elasticity

Elasticity the concept

The responsiveness of one variable to changes in another When price rises, what happens to demand? Demand falls BUT! How much does demand fall?

Elasticity the concept

If price rises by 10% - what happens to demand? We know demand will fall By more than 10%? By less than 10%? Elasticity measures the extent to which demand will change

Elasticity
4 basic types used: Price elasticity of demand Price elasticity of supply Income elasticity of demand Cross elasticity of demand

Elasticity

Price Elasticity of Demand

The responsiveness of demand to changes in price Where % change in demand is greater than % change in price elastic Where % change in demand is less than % change in price - inelastic

Elasticity
The Formula: Ped = % Change in Quantity Demanded ___________________________ % Change in Price

If answer is between 0 and -1: the relationship is inelastic If the answer is between -1 and infinity: the relationship is elastic Note: Ped has sign in front of it; because as price rises demand falls and vice-versa (inverse relationship between price and demand)

Elasticity
Price ()
The demand curve can be a range of shapes each of which is associated with a different relationship between price and the quantity demanded.

Quantity Demanded

Elasticity
Price
Totalimportance of elasticity The revenue is price x quantity sold. In this is the information it example,on the5 x 100,000 provides TR = effect on = 500,000. of changes in total revenue price. This value is represented by the grey shaded rectangle.

Total Revenue

D 100 Quantity Demanded (000s)

Elasticity
Price
If the firm decides to decrease price to (say) 3, the degree of price elasticity of the demand curve would determine the extent of the increase in demand and the change therefore in total revenue.

Total Revenue

D
100 140 Quantity Demanded (000s)

Elasticity
Price () 10

Producer decides to lower price to attract sales

% Price = -50% % Quantity Demanded = +20% Ped = -0.4 (Inelastic) Total Revenue would fall

Not a good move!

D
5 6
Quantity Demanded

Elasticity
Price ()

Producer decides to reduce price to increase sales % in Price = - 30% % in Demand = + 300% Ped = - 10 (Elastic) Total Revenue rises Good Move!
D

10 7

Quantity Demanded

20

Elasticity
If demand is price If demand is price elastic: inelastic: Increasing price would Increasing price would reduce TR (% Qd > % increase TR P) (% Qd < % P) Reducing price would Reducing price would increase TR reduce TR (% Qd < % (% Qd > % P) P)

Elasticity

Income Elasticity of Demand:

The responsiveness of demand to changes in incomes

Normal Good demand rises as income rises and vice versa Inferior Good demand falls as income rises and vice versa

Elasticity
Income Elasticity of Demand:

A positive sign denotes a normal good A negative sign denotes an inferior good

Elasticity
For example: Yed = - 0.6: Good is an inferior good but inelastic a rise in income of 3% would lead to demand falling by 1.8% Yed = + 0.4: Good is a normal good but inelastic a rise in incomes of 3% would lead to demand rising by 1.2% Yed = + 1.6: Good is a normal good and elastic a rise in incomes of 3% would lead to demand rising by 4.8% Yed = - 2.1: Good is an inferior good and elastic a rise in incomes of 3% would lead to a fall in demand of 6.3%

Elasticity
Cross Elasticity: The responsiveness of demand of one good to changes in the price of a related good either a substitute or a complement
% Qd of good t Xed = __________________

% Price of good y

Elasticity

Goods which are complements:

Cross Elasticity will have negative sign (inverse relationship between the two)
Cross Elasticity will have a positive sign (positive relationship between the two)

Goods which are substitutes:

Elasticity
Price Elasticity of Supply:

The responsiveness of supply to changes in price If Pes is inelastic - it will be difficult for suppliers to react swiftly to changes in price If Pes is elastic supply can react quickly to changes in price
Pes =

% Quantity Supplied ____________________ % Price

Determinants of Elasticity

Time period the longer the time under consideration the more elastic a good is likely to be Number and closeness of substitutes the greater the number of substitutes, the more elastic The proportion of income taken up by the product the smaller the proportion the more inelastic Luxury or Necessity - for example, addictive drugs Broadness of product definition the more broadly the good is defined, the lower is its elasticity.

Importance of Elasticity

Relationship between changes in price and total revenue Importance in determining what goods to tax (tax revenue) Importance in analysing time lags in production Influences the behaviour of a firm