Demand, Supply and Price Elasticity

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Lecture 3
Demand, Supply and Market Equilibrium
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Overview

• Demand Supply
• Shifts in a Demand/Supply Curve and Movements
  Along a Demand/Supply Curve.
• Market Equilibrium
• The Four laws of Demand and Supply
• Effect of a Sales Tax
• Elasticities of Demand and Supply

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Quantity Demanded

• Quantity demanded is the total amount of any good
  or service that consumers wish to purchase in
  some time period at a particular price.
• The total amount consumers wish to purchase may
  differ from what is actually purchased.
• Quantity demanded is an example of a flow
  variable.

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Demand

• Demand is the quantity of a good or service that
  buyers wish to purchase at each given price.
• Note the distinction between demand and quantity
  demanded. Demand describes the behaviour of
  buyers at every price, where as quantity demanded
  describes behaviour at a particular price.

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Quantity Demanded and Price

• The Law of Demand the basic hypothesis is that
  other things being equal the price of a
  product and the quantity demanded are negatively
  related. That is, the lower the price, the higher
  the quantity demanded.
• This relationship between price and quantity
  demanded is true for most goods in the economy.

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Demand Curve and Demand Schedule
Monthly Demand of Laptops in Timmins
Demand Schedule
2800 2400 2000 1600 1200 800 400
Price
Demand Curve
40 60 80 100 120 140 160 180 200
Quantity Demanded
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Graphing Linear Demand Curves
Notice that price is on the y-axis and quantity
on the x-axis.
Price
QD 100 - 2p
p 50, QD 0
50 40 30 20 10 0
Sometimes it is easier to use the inverse demand
curve price as a function of quantity demanded.
2p 100 QD
p 50 (1/2)QD
p 0, QD 100
Quantity
10 20 30 40 50 60 70 80 90
100 110
The same method can be used for linear supply
curves.
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Changes in Demand

• Demand curves are drawn assuming that all factors
  affecting demand for a commodity other than the
  price of the commodity are held constant. If
  these other factors change, then we get a shift
  of the demand curve, called a change in demand.
• Other factors
• Consumer incomes and distribution of income
• Tastes and Networks
• The prices of related goods
• Expectations about the future
• Population and Demographic changes.

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D2
D0
D1
A rightward shift in the demand curve from D0 to
D1 indicates an increase in demand.
Price
A leftward shift from D0 to D2 indicates a
decrease in demand.
0
Quantity Demanded
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A change in demand is a change in quantity
demanded at every price. That is, a change in
demand is a shift of the entire demand curve.
Price
Change in quantity demanded
A change in quantity demanded refers to a
movement from one point on a demand curve to
another point, either on the same demand curve or
on a new one.
p3
Change in demand
p2
p0
D1
D0
q3
q0
q2
q1
Quantity
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Quantity Supplied

• Quantity supplied is the total amount of any good
  or service that producers wish to sell in some
  time period at a particular price.
• The total amount producers wish to sell may
  differ from what is actually sold.
• Quantity supplied is also an example of a flow
  variable.

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Supply

• Supply is the quantity of a good or service that
  producers wish to sell at each given price.
• The distinction between supply and quantity
  supplied is the same as the distinction between
  demand and quantity demanded.
• The Law of Supply the basic hypothesis is that
  other things being equal the price of a
  product and the quantity supplied are positively
  related. That is, the higher the price, the
  higher the quantity supplied.

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Supply Curve and Supply Schedule
Monthly Supply of Laptops in Timmins
Supply Schedule
Supply Curve
2800 2400 2000 1600 1200 800 400
Price
40 60 80 100 120 140 160 180 200
Quantity Supplied
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Changes in Supply

• Supply curves are drawn assuming that all factors
  affecting the supply of a commodity other than
  the price of the commodity are held constant. If
  these other factors change, then we get a shift
  of the supply curve, called a change in supply.
• Other factors
• Technology
• Input costs
• Competing Products
• Number of Suppliers
• Expectations about the future

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A change in supply is a change in quantity
supplied at every price. That is, a change in
supply is a shift of the entire supply curve.
A change in quantity supplied refers to a
movement from one point on a supply curve to
another point, either on the same supply curve or
on a new one.
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Market Equilibrium

• A market is a set of arrangements where by buyers
  and sellers exchange goods and services.
• The equilibrium price clears the market, so it is
  sometimes called the market-clearing price. It is
  the price at which the quantity demanded equals
  the quantity supplied.
• Excess Supply this exists when the quantity
  supplied exceeds the quantity demanded at the
  current price.
• Excess Demand this exists when the quantity
  demanded exceeds the quantity supplied at the
  current price.

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Market Equilibrium
The Market for Laptops in Timmins
Supply Curve
Excess Supply
2800 2400 2000 1600 1200 800 400
Price
Demand Curve
Excess Demand
40 60 80 100 120 140 160 180 200
Quantity
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Changes in Market Prices
There are four laws of supply and demand.
D1
D0
1. An increase in demand causes an increase in
both the equilibrium price and equilibrium
quantity.
S
Price
E1
2. A decrease in demand causes a decrease in both
equilibrium price and equilibrium quantity.

p1
E0

p0
q0
q1
Quantity
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3. An increase in supply causes a decrease in the
equilibrium price and an increase in the
equilibrium quantity.
D
S1
S0
Price
E0
p0

E1

p1
4. A decrease in supply causes an increase in the
equilibrium price and a decrease in the
equilibrium quantity.
q1
q0
Quantity
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Exercise 1

• Suppose that the demand function for some product
  is given by

QD 100 - 4p
And that the supply function for some product is
given by
QS p
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Graphically
Price
QS p
40
30
20
10
QD 100 - 4p
Quantity
10 20 30 40 50 60 70
80 100
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Numerically, QD QS implies that 100 4p
p 100 5p p 20 Q p 20 or Q 100 4p
20
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Effect of a Sales Tax

• After the imposition of a sales tax, the price
  paid by consumers is higher, whereas the price
  received by producers is lower. The new
  equilibrium quantity is less than the quantity
  before the tax was imposed.
• Let pc denote the price paid by consumers, and ps
  denote the price received by suppliers.
• The difference between the consumer and seller
  prices is equal to the tax (i.e. tax pc ps).
• The effect of sales tax on equilibrium price and
  quantity is the same regardless of whether it is
  levied on producers or consumers.

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Stax
tax pc ps
S0
S0
tax
pc
pc
Price
Price
p
p
ps
ps
tax
D0
D0
Dtax
q1
q0
q1
q0
Quantity
Quantity
In this case, the tax is levied on consumers and
the demand decreases.
In this case, the tax is levied on producers and
the supply decreases.
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Price Elasticity of Demand

• Price elasticity of demand measures how much the
  quantity demanded of a good responds to a change
  in the price of that good. It is symbolized by
  the Greek letter eta ?.

?
percentage change in quantity demanded

percentage change in price
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• Since demand curves have negative slopes, price
  and quantity demanded move in opposite directions
  along the demand curve.
• Because the changes in price and quantity have
  opposite signs, demand elasticity is negative.
• However, economists usually ignore the negative
  sign and speak of the measure as a positive
  number that is, they emphasize the absolute
  value.

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Determinants of Price Elasticity of Demand

• Availability of close substitutes goods with
  close substitutes tend to have more elastic
  demand because it is easier for consumers to
  switch from that good to others.
• Necessities vs. Luxuries necessities tend to
  have inelastic demands whereas luxuries have
  elastic demands.
• Definition of the Market narrowly-defined
  markets tend to have more elastic demand than
  broadly-defined markets because it is easier to
  find close substitutes for narrowly-defined
  goods.
• Time Horizon goods tend to have more elastic
  demand over longer time horizons.

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Exercise 2

• If the price of a commodity increases by 3 and
  quantity demanded decreases by 6, then the price
  elasticity of demand is 2.
• If the price elasticity of demand for a commodity
  is 0.5, a 10 decrease in price leads to a 5
  increase in quantity demanded.

change in QD
?
6 2
change in P
3
change in QD
? 0.5
5 0.5
change in P
10
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If the percentage change in quantity demanded is
less than the percentage change in price, then
demand is inelastic and 0 lt ? lt 1.
Inelastic
Unit Elastic
If the percentage change in quantity demanded is
equal to the percentage change in price, then
demand is unit elastic and ? 1.
Elastic
If the percentage change in quantity demanded is
greater than the percentage change in price, then
demand is elastic and ? gt 1.
? ?
? 0
? 1
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Price Elasticity of Supply

• Price elasticity of supply measures the
  responsiveness of the quantity supplied to a
  change in the products own price. It is denoted
  by ?s, and is defined as

percentage change in quantity supplied
?S
percentage change in price
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Determinants of Price Elasticity of Supply

• The price elasticity of supply will depend on the
  flexibility of sellers to change the amount of
  the good they produce.
• Technical ease of substitution in production if
  it is easy for firms to switch inputs from the
  production of one good to another, then supply
  will be more elastic.
• Time horizon supply is usually more elastic in
  the long run than in the short run
• The nature of production costs if production
  costs rise sharply as firms output increases,
  then supply will tend to be inelastic.

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Income Elasticity of Demand

• The income elasticity of demand measures the how
  the quantity demanded of a good changes as
  consumer income changes.
• Normal goods Higher income raises quantity
  demanded.
• Inferior goods Higher income lowers the quantity
  demanded.

?Y
percentage change in quantity demanded
percentage change in income
?Y gt 0
?Y lt 0
Sign Matters
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Determinants of Income Elasticity of Demand
The more necessary an item is in the consumption
pattern of consumers, the lower its income
elasticity.
Income elasticities for any one product also vary
with the level of a consumers income.
The distinction between luxuries and necessities
also helps to explain differences in income
elasticities between countries.
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Cross-Price Elasticity of Demand

• The cross-price elasticity of demand measures how
  the quantity demanded of one good changes as the
  price of another good changes.

percentage change in quantity demanded of good X
?XY
percentage change in price of good Y
Substitutes are goods that are typically used in
place of one another (e.g. margarine and butter).
Complements are goods that are typically used
together (such as computers and software). If ?XY
gt 0, then X and Y are substitutes. If ?XY lt 0,
then X and Y are complements.
Sign Matters