Supply and Demand and Applications

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Supply and Demand and Applications

• Class 3

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Many of our interactions occur in the market
system, many do not

• Market System and Other Interactions
• Market system decentralized, characterized by
  demand-supply equilibrium
• Restaurants on Telegraph use the market system.
  
• This class does not use the market system.
• Grades are not distributed based on supply and
  demand.
• I am your benevolent dictator. Hello.
• Benevolent dictators are a good idea in theory,
  but it is often hard to find dictators that are
  benevolent
• so lets focus on the market system.

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The market system is good at allocating resources
and rationing prices

• Resource Allocation and Price Rationing
• Prices and quantities are determined through the
  equilibrium point where the market clears
• Supply, demand, and prices in input and output
  markets determine the allocation of resources and
  the ultimate combinations of things produced.
• Lobsters in Maine It all works out well

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Messing with the market system can be messy

• Example Price Ceilings
• When regulation determines a market ceiling
• price on a good that is below the equilibrium
• price, shortages can ensue
• Black markets and non-currency payments
• often arise to erase the shortage and get back
• to the market equilibrium

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Using other pricing systems can result in greater
loss of welfare than originally thought

• Non market price systems
• May cause more trouble than its worth
• Sometimes, societies choose that price control is
  worth the extra cost
• BUT! Normative questions sometimes ignores
  positive questions
• What would we like end result to be? (Normative)
• What will end result be? (Positive)

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Market efficiency can help parts of the
population through consumer/producer surpluses

• Consumer Surplus
• Difference between the maximum amount a person is
  willing to pay for a good and its current market
  price.
• Some consumers are willing to pay as much as 5
  each for hamburgers. Since the price is only
  2.50, they receive a consumer surplus of 2.50.
• Others are willing to pay something less than
  5.00 but more than 2.50.
• Consumer surplus is the area below the demand
  curve and above the price level.

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Market efficiency can help parts of the
population through consumer/producer surpluses

• Producer Surplus
• Difference between the maximum amount a producer
  is willing to accept to supply a good and its
  current market price.
• Some producers are willing to accept as little as
  75 cents each for hamburgers. Since the price is
  2.50, they receive a producer surplus of 1.75
  per hamburger
• Others producers are willing to receive something
  less than 2.50 but higher than 75 cents.
• Producer surplus is the area above the supply
  curve and below the price level.

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To calculate total consumer and/or producer
surplus, you need to remember your geometry

• The Area of a Triangle
• ½ length height
• Consumer surplus for hamburger market
• Height 5.4-2.50 2.90
• Length 7-0 7
• Area ½ 2.9 7 10.15
• Hint Commit formula to memory

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Markets maximize the sum of producer and consumer
surplus

• Maximization and Deadweight Loss

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Price elasticity of demand measures how much
people care about changes in price

• Elasticity of Demand
• How responsive are customers to changes in price
  of a product?
• There are products for which we are very
  sensitive to price think accessories, trifles,
  easily substitutable items
• There are products for which we are very
  insensitive to price think necessities,
  medicines, water
• Demand elasticity will be negative (recall that
  price and quantity demanded are negatively
  related)

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Inelastic Insensitive Necessity

• Elasticity of Demand Quick and Dirty
• Inelastic
• Demand curve is steep
• Not so sensitive to prices
• Necessities
• Elasticity is between 0 and -1
• Elastic
• Demand curve is shallow, flatter
• Sensitive to prices
• Unimportant, Easily substituted
• Elasticity is -1 and lower

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We characterize products as inelastic (little
price sensitivity) or elastic (fair/high price
sensitivity)

• Hypothetical Demand Elasticities

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At the extremes, demand can be perfectly
inelastic or perfectly elastic

• Extremes

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We use the midpoint formula to calculate
elasticities in order to be able to compare
increases and decreases in demand

• Midpoint Formula
• Calculate the demand elasticity of steak

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Price elasticity of demand decreases as we move
downward along a straight line demand curve.

• Demand Elasticity on Straight Demand Curve

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Producers care about elasticity of the product

• Revenue
• Producers want to increase their TOTAL REVENUE
  PQ
• If price or quantity goes down, and nothing else
  changes, TR goes down
• But if price goes down and quantity goes up, TR
  does not necessarily go down
• Does it pay to shift their supply curve to the
  left/right?
• If consumers quantity demanded wont go down too
  much with a decrease in supply, then it might be
  worthwhile to shift supply to the left.
• If consumers quantity demanded will shift a lot,
  then it may not be worthwhile to shift supply to
  the left

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The effect of a price change on revenue depends
on the elasticity of demand

• Effects of Price Change

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Even without calculating it, we can determine the
general elasticity of demand

• Determinants of Demand Elasticity
• Availability of substitutes demand is more
  elastic when there are more substitutes for the
  product
• Importance of the item in the budget demand is
  more elastic when the item is a more significant
  portion of the consumers budget
• Time dimension demand becomes more elastic over
  time

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Practice Questions, Chapter 4, Question 14 and 15

• Would you recommend that Ben and Jerrys move
  forward with a plan to raise prices if the
  companys only goal is to increase revenues?
• Would you recommend that beer stands cut prices
  to increase revenues at 49ers games next year?

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Next class

• Household budget constraints
• Utility analysis
• Short-run profit maximization decisions
• HAPPY JULY 4th!