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Overview
Inchapter2,wedealwithdemandandsupplyanalysisin

perfectlycompetitivemarkets.
DemandandSupply

Perfectlycompetitivemarketsconsistofalargenumberof

buyersandsellers.
Thetransactionsofanyindividualbuyerorsellerareso

small,incomparisontotheoverallvolumeofthegoodor
theservicetradedinthemarket,thatthebuyerorseller
hasnochoicebuttotakesthepricesetbythemarket.

DemandCurves
MarketDemandCurve:Acurvethatshowsusthe

quantityofgoodthatconsumersarewillingtobuyat
differentprices.
LawofDemand:Thenegativerelationshipbetween

thepriceofagoodandthequantitydemanded,when
allotherfactorsthatinfluencedemandareheldfixed.
Asillustratedinthefollowinggraph

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Thedirectdemandcurvewillgenerallytakethelinear

form

Example
DirectDemandCurve:Q=1002P
Q -100 = -2p
2P =100 - Q

InverseDemandhencebecomes:

Q=a bP
wherea=verticalintercept,andb=slope

TheChokePriceisthepriceatwhichQ=0,orsimply

put,atwhatpriceconsumersdemand0unitsofthe
good.SettingQ=0,theChokePrice=50

RearrangingandsolvingforP,weget

Vertical intercept
slope

Andso,thegraphlookslikeastraightline...

a 1
*Q
b b

ThisistheInverseDemandCurve

Ormoregenerally...
Demand:Q=a bP,thenInverseDemand:
P
Choke Price
(a/b)

a
b

a Q

b b

0=
a

a Q
Q a
b a

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SupplyCurve
MarketSupplyCurve: Acurvethatshowsusthetotal

quantityofgoodsthattheirsuppliersarewillingtosell
atdifferentprices.

Example
LinearSupplyCurve:QS =0.15+P
Findthequantityofwheatsuppliedif
P=$2 QS =.15+2=2.15
P=$3 QS =.15+3=3.15
Letussketchthissupplycurve

QS =0.15+PandsolvingforP,wegettheinverse
supplycurveP=QS 0.15
Sotheslope=1(coefficientofQS)
Intercept=0.15

Thefollowingfigureillustratesthissupplycurve

Equilibrium
Inequilibrium,aperfectlycompetitivemarketwillset

apriceandquantitysuchthatthereisnoexcesssupply
andnoexcessdemand,hencedemandequalssupply.

Qs =Qd
IfthereisexcesssupplyQs>Qd prices should go down
If there is excess demand Qs< Qd prices should go up

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Example

InverseDemandCurve

DemandCurve:Qd =500 4P
SupplyCurve:QS =100+2P

Solving for P:
4p = 500 - Qd
p = 500/4 Qd /4

InverseSupplyCurve

Solving for P:
2p = Qs + 100
p = Qs /2 + 50
P = 100

Beforefindingtheequilibriumoutputandpricelevel

Letussketchthesecurvesonthesamegraphwith
quantityonthehorizontalaxisandpriceonthe
verticalaxis.

Atwhatpriceandquantitydoyoureachequilibrium?

Q = 100
WhenP=0,Qd=5004.0=500

ComparativeStatics:AnIncreasein
Demand,foranygivenprice

QS =Qd
500 4P=100+2P
600=6P
100=P
Andthentakethisp=100andplugitintoeitherthe

demandorsupplycurvetofindtheequilibrium
quantity
P=100
QS =500 4(100)=100
Andso,equilibriumoccursatP=100andQ=100

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Adecreaseinsupply,foranygivenprice
Anincreaseindemandastheonedepictedabovecan

originatefromanincreaseinincome,orinthe
consumerspreferenceforthegood.Foranygiven
price,thequantitythatconsumersdemandhasnow
goneup.
Youcanvisuallyseethatbyextendingalonghorizontal

dottedlinewhichmaintainsyourfocusonagiven(fixed
price).Thepointwherethedottedlinecrosseseach
demandcurverepresentsthequantitydemanded.

Example:MarketforAluminum
Adecreaseinsupplymightoriginatefromanincrease

inproductioncosts,whichleadproducersofthegood
tosupplyloweramountsofthegoodatanygivenprice.
[Followsimilargraphicalrepresentationasabove]

Demand:Qd =500 50P+10IwhereP=priceand

I=income
Supply:QS =400+50P
LetsanalyzetheequilibriumwhenincomeisI=10andhowitis
affectedwhenincomedecreasestoI=5

First,EquilibriumwhenI=10
Extendahorizontaldottedlineatthepricep=$10.The

quantitysuppliedisloweraftertheincreasein
productioncosts(S2)thanbeforetheincrease(S1).

PluginI=10intoQd togetQd =500 50P+10(10)=600 50P

EquatingQd=QS weobtain
6005p=40050p
1000=100p
Orp=$10QS = -400 + 50($10) = 100

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Second,EquilibriumwhenI=5

Qd

PlugI=5intoQd toget
=500 50P+10(5)=550 50P
NowequateQd toQS,
Qd

Qs

550 50P=400+50P
950+100P
9.5=PQS=400+50(9.5)=75

(1)Demandshiftsinward,
(2)equilibriumoutputdecreasesfrom100to75,
(3)equilibriumpricedecreasesfrom$10to$9.50

Query#1

Answer

ConsiderthedemandCurve

B,shifttotheright

Qd =100020P6r
Ifthevalueofrfalls,thedemandcurvewill:
a)Shifttotheleft
b)Shifttotheright
c)Remainunchanged
d)Rotatealongthequantityaxis

Inparticular,differentiatingthedemandfunctionwith

respecttor,
Qd/r=6<0
HencerproducesareductioninQd andviceversa,a
decreaseinrproducesanincreaseinQd

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Achangeinboththedemandand
supplycurve

Adecrease indemandandanincrease insupply:

Unambiguouslyproduceareductionintheequilibrium

price;but
theeffectontheequilibriumquantityismore

ambiguous.Inthefigure,theoutwardshiftinthesupply
curvedominatestheinwardshiftinthedemandcurve,
producinganoverallincreaseintheequilibrium
quantity.Otherwise,theequilibriumquantitywould
decrease.
CanyoudrawafigureinwhichDemandincreasesand
Supplydecreases,butequilibriumoutputdecreases?
Interpretation

PriceElasticityofDemand

Wecanexpresstheelasticityofdemandas

Nowthatweknowhowtoconstructademand
curve,towhatextentdoesachangeinone
variableaffectquantitydemanded?
where

PriceElasticityofDemand:Ameasureofthe

percentagechangeofquantitydemandedasaresultof
a1%increaseinprice,holdingallotherdeterminants
ofdemandconstant.

Q Q1 Q0

Q
Q0

and

P P1 P0

P
P0

Q
P

Noticethatthefirstterm

issimplythederivativeof
quantitydemandedwithrespecttoP.

Letslookatanexample

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Example
Supposethatwehaveapricechangethatresultsinthe

WhyisQ,P always negative?

followingchangesinquantitydemanded
WhenP=10,quantityisQ=50
WhenP=12,quantityfallstoQ=45(SoQ=5)

Where

representstheslopeofthedemandcurve,
whichisnegativebytheLawofDemand.

Whatistheelasticityofdemand?

Where

1% in P 0.5% in Q (less-than-proportional decrease)

Example
Letslookatanotherexampleofelasticity

DemandcurveQ=100 2(P)

Hence,theproduct()(+)mustbenegative,making
theelasticityQ,p anegativenumber.

Rememberthatourdemandcurveisintheform

Q=a bP,andthatthefirsttermofourelasticity
equationissimplythederivativewithrespecttoP
(i.e.,b)soourelasticityequationis
Q
2
P

Letsfindtheelasticitieswhen...
Ed

A)P=40,soQ=20

sincebothp>0andQ>0.

Q P
*
P Q

Sonow,wesimplyplugintheparticularvaluesofP
B)P=25,soQ=50

andQtofindtheelasticityforeachprice.

C)P=10,soQ=80

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A)WhenP=40

Constant slope (-2), but

not constant elasticity d

Whatabouttheelasticitiesforthisdemandcurveat

theverticalandhorizontalintercepts?
VerticalIntercept

B)WhenP=25

HorizontalIntercept

C)WhenP=10

Elasticityofdemandinthelinear
demandcurve,Q=abP
P

50
40
25
10

Wecanactuallysummarizewherealineardemandwill

be

d 4

d 1

(1)Elastic,when||>1
(2)UnitElastic,when||=1

1
d
4

d 0

(3)Inelastic,when||<1

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Whynotuseslopeofthedemandfunction,
ratherthanEQ,p?
Thereasonweusepriceelasticityofdemand(andnot

simplytheslopeofthedemandcurve)isbecauseby
usingtheformerwecanproduceaunitfreemeasure
ofhowsensitiveisthedemandcurvetochangesin
prices.

Remember,elasticityofdemanddoesnotequalthe
slope.Thatis,alineardemandcurve(constantslope)
canhavedifferentelasticities,aswejustshowed.

Indeed,notethatunitscanceloutwhenyouusethe

Inthiswaywecanalsocomparethesensitivityof

formulaofpriceelasticityofdemand,butthey
wouldntifyouweresimplyusingtheslopeofthe
demandcurve.
Qd
Qd in tons
A number
Q
Qin tons
P
P inUS$
P
P inUS$

demandtopricechangesacrossdifferentgoods:

Measuredindifferentunits(uraniumversussteel)
Consumedindifferentcountries(pricesexpressedin

differentcurrencies)
Etc

WeneedaunitfreemeasureofQd andPricetobeable

tocomparethechangesinonewiththechangesinthe
other.

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Examplesofpriceelasticities of
demand:
Cigarettes

0.107

Petfood

0.061

Airtravel,leisure

1.52

Airtravel,business

0.70

ConstantElasticityDemandCurve
ConstantElasticityDemandCurve:
AdemandcurveoftheformQ=aPb whereaandb
arepositiveconstants.
Thetermbisthepriceelasticityofdemandalongall
pointsinthiscurve.

Intuition:a10%increaseinthepriceofcigarettes
producesa1.07%reductioninthequantitydemanded.
Hence,wecanclaimthatdemandforcigarettesisrelatively
insensitive topricechanges.

ConstantElasticityDemandCurve
dQ
We will just find dP , and then plug into the d formula;

Therefore,

Letusseewhy
First,recalltheformulaofpriceelasticity;

dQ P

dP Q

Query#2
ConsiderthedemandCurve
Qd=5P1
Theelasticityofdemandalongthisdemandcurve:
A. Isinelastic
B. Iselastic
C. Isunitaryelastic
D. Fallsasthepricefalls

Q a * p b

ConstantinP

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Answer
C,itisunitaryelastic
TheelasticityofdemandofademandcurveQd =Apb

isb
Inthiscase,Qd =5p1,sotheexponent1isthe
elasticity,whichisconstantinprices.

DifferentTypesofElasticitiesof
Demand
Sofarwehaveonlycomparedhowquantitydemanded

varieswithprice,inordertoseehowpricesensitive
certaincommoditiesare.
Thisanalysis,however,canbeextendedtocompare
morethanjustquantitywithprice.
LetsextendthiselasticityanalysistocompareQd with
otherfactors

Whataboutchangesinincome?Howdotheyaffect
demand?

ExamplesofIncomeelasticityof
demand
Apples=1.32

IncomeElasticityofDemand:Thepercentage

changeinquantitydemandedresultingfroma1%
increaseinincome,holdingpriceandallother
determinantsofdemandconstant.

1% in the one produces a 1.32% increase in the

quantity of apples demanded

Flour = -0.36

1% in the one produces a 0.36% decrease in the

quantity of flour demanded

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Whataboutchangesinthepriceofothergoods?
Forinstance,howthechangeinthepriceof
PepsichangethequantityofCokedemanded?

ExampleofCrossPriceelasticityof
demand(Application2.4intextbook)
1% in the price of Nissan Sentra

CrossPriceElasticityofDemand:Thepercentage

changeofthequantityofonegooddemanded(goodi)
thatresultsfroma1%increaseinthepriceofanother
good(goodj).

produces a change in the demand of

Ford Escort

ExampleofCrossPriceelasticityof
demand(Application2.4intextbook)

BMW 735

Application:Cokevs.Pepsi

1% in the price of Nissan Sentra produces a

0.454% in the quantity demanded of Ford Escort
0% in the quantity demanded of Lexus or BMW 735

Generally
If Qi,Pj >0, goods i and j are regared as substitutes.

(i.e. two brands of mineral water, Nissan Sentra and Ford Escort)

If Qi,Pj <0, goods i and j are regarded as complements.

(i.e. left and right shoe, cars and gasoline, etc)

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Application:Cokevs.Pepsi
Coke
Pepsi
Price
Elasticityof
DemandQ,P
CrossPrice
Elasticityof
Demand
Income
Elasticityof
Demand

Therefore,a1% in the Pcoke produces

1.47

1.55

0.52

0.64

1.47%inthequantitydemandedofCoke,but

0.64%inthequantitydemandedofPepsi
(Sopeople,onaverage,regardCokeandPepsiassubstitutes!)

Ontheotherhand,a1% in the income level

produces
0.58% in the quantity demanded of coke

0.58

1.38

(You can repeat a similar analysis starting with 1% in the

price of Pepsi)

Intuition

BackofEnvelopecalculationsaboutlinear
Asyoumighthaveguessed,wecanevenextendthis

analysistohowchangesinpricesaffectthequantity
supplied.
ThisiscalledthePriceElasticityofSupply.
Itshowsushowa1%changeinpriceaffectstheamount

ofthegoodsupplied.Or,howpricesensitiveissupply?

demandcurves:
Nowthatweknowhowademandcurveisconstructed
andhowtouseitsvariouspartstoanalyzethe
relationshipbetweenquantitydemanded,quantity
supplied,andprice,wecanworkbackwardstoactually
constructademandcurve.
ConsiderthatweknowtheprevailingQ,theP,andQ,P.
We want to find the value of a and b in Q=a-bp, where
a(verticalinterceptorchokeprice)
b(slopeofdemandwhichwecanderivefromelasticity)

Qd =a-bP

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We know that, from Q a bP,

Q
b
P

Letsfirstfindparameter

Example:
Q=70,

p=$0.70,

[Recall that Q= a bP]

Q,P =-0.55

We to find parameters a and b , so we find the demand function

Now,letsfind

Andusingthevalueofbwefoundabove,

(1)
(2)
Hence, the demand curve is Qd = 108.5 55p

Q (Q,P Q) a Q(1 Q,P )

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