The Supply and Demand Model (continued)

Lecture 3 Part 1

Demand Curve
Demand curve is the relationship between two economic variables
Price of a given good Quantity of this good consumers are willing to buy at that price in a particular time period Ceteris paribus

Demand Curve
640 560 Price 480 400 320 240 0 10 20 Quantity Demanded
Fig 3.1

30

40

Shifts in Demand
Demand curve shows the relationship between Price and Quantity Demanded, keeping other things fixed

Graphically this corresponds to movement along the demand curve: change in price and quantity demanded What happens when some those other things change? Shift of the Demand Curve: increase or decrease in demand
Fig 3.2

Factors Which Shift Demand

Consumers preferences Consumers information Consumers incomes
Normal goods Inferior goods

Consumers expectations Number of consumers in the market Prices of closely related goods
Substitutes Complements

Change in Demand & Change in the Quantity Demanded

Decrease in the Quantity Demanded

Increase in Demand

A C

D1
Decrease in Demand

D0

D2 Q

Increase in the Quantity Demanded

Fig 3.3

Supply Curve
Supply curve is the relationship between two economic variables
Price of a given good Quantity of this good firms are willing to sell at that price in a particular time period Ceteris paribus

Supply Curve
640 560

Price

480 400 320 240 0 10 20 30 40

Quantity Supplied

Fig 3.4

Shifts in Supply
Supply curve shows the relationship between Price and Quantity Supplied, keeping other things fixed

Graphically this corresponds to movement along the supply curve: change in price and quantity supplied What happens when some those other things change? Shift of the Supply Curve: increase or decrease in supply
Fig 3.2

Factors Which Shift Supply

Technology Price of input goods Government taxes, subsidies and regulations Number of firms in the market Expectations of future price

Change in Supply & Change in the Quantity Supplied

Decrease in the Quantity Supplied Decrease in Supply

S1
E

S2

S0

Increase in Supply

Q
Increase in the Quantity Supplied
Fig 3.6

Equilibrium Price & Quantity

640 560
Equilibrium price ($400) Surplus S

Price

480 400 320

D

240 0 10 20 30 40 Equilibrium Quantity Shortage quantity (18000)

Fig 3.7

Increase in Demand
P S P1 P0 DNew DOld Q0 Q1 Q Pe & Qe
Fig 3.8

Decrease in Supply
P SNew P1 P0 D Q1 Q0 Q SOld

Pe & Qe
Fig 3.9

Effects of Shifts in Demand & Supply

Effect on Pe Effect on Qe

Shift Demand Demand Supply Supply

Table 3.4

Interference with Market Prices

Price controls Price ceilings
Rent control Making things worse

Price floors
Agricultural price stabilisation schemes Minimum wages

Price Ceilings
P S Pe Pmax Shortage QS QD D Q
Fig 3.10

Price Floors
P Pmin Pe Surplus S

QD

QS

D Q

Fig 3.11

Interference with Market Prices

Price floor on dry milk in US US Department of Agriculture used to keep price of dry milk above market clearing prices It guarantees to buy any quantity of milk at that price Support for dairy farmers

Interference with Market Prices

At some point in 2002 they were stuck with the surplus of 1.3 billion gallons 16 month of national consumption

Over 100,000 square feet of warehouse space is committed to storing dry milk in a Kansas City, Mo. underground warehouse (Associated Press)

Interference with Market Prices

Philip Brasher / AP Farm Writer (June 30, 2002):

The Agriculture Department is trying to get rid of the powder. Storage costs are approaching $20 million a year, and the powder keeps coming; about 386 million pounds has been purchased since October. Some of the powder is donated to domestic programs and overseas. Powder that is getting old -- the government has been storing some of this milk for up to three years -- is sold for use in animal feed.

Price Floors: Minimum Wage

W

Unemployment S

Wmin We

LD W wage, L numbers of workers

LS

D L

Fig 3.11

Interference with Market Prices

Price controls result in waste of resources Over-production and storage costs in the dry milk example Unemployment in the minimum wage example

Elasticity and Its Importance

Lecture 3 Part 2

Elasticity
A quantitative measure of how sensitive one economic variable is to another economic variable

Comparing Different Price Elasticities of Demand ...

Price of Coffee A 10% price increase ...
30 20 10

Quantity demanded is very sensitive to the price Highly elastic demand

lowers quantity demanded by 20%

10 20 30 40 50 60 70

Quantity Demanded

 Comparing Different Price Elasticities of Demand

Price of Coffee A 10% price increase ...
30 20 10

Quantity demanded is not very sensitive to the price Demand curve with low price elasticity

lowers the quantity demanded by 5%

10 20 30 40 50 60 70

Quantity Demanded

Importance of Price Elasticity of Demand ...

Price of Coffee Small price rise
30 20 10

Snew

Sold

More elastic demand Supply declines by 20 thousand kg per day

10 20 30 40 50 60 70

Quantity Demanded

 Importance of Price Elasticity of Demand

Price of Coffee Large price rise
30 20 10

Snew

Sold

Less elastic demand Supply declines by 20 thousand kg per day

10 20 30 40 50 60 70

Quantity Demanded

Price Elasticity of Demand

The percentage change in the quantity demanded of a good divided by the percentage change in the price of that good
ed = ed = percentage change in quantity demanded percentage change in the price

Qd
Qd

P
P

Qd / Qd P / P

P Qd Qd P

Terminology for Elasticity

Term Perfectly inelastic Inelastic Unit elastic Elastic Perfectly elastic A is relatively elastic compared with B Value of ed 0 Less than 1 1 Greater than 1 Infinity A has a higher elasticity than B

Table 4.1

The Midpoint Formula

Problem with ordinary formula: Which price and quantity should we use? Solution: Use average values for both.

change in quantity

ed =

average of old & new quantity

change in price average of old & new price

Special Cases
P Di Perfectly Inelastic Demand

De Perfectly Elastic Demand

Q
Fig 4.4

Elasticity and Revenue

Price ($) 0 1 2 3 4 5 6 7 8 9 10 Q 20 18 16 14 12 10 8 6 4 2 0 R=P*Q Elasticity 0 18 32 42 48 50 48 42 32 18 0 P Revenue:

Ed < 1

Ed > 1
Table 3.3

Elasticity & a Straight Line Demand Curve

12 11 10 9 8 7 6 5 4 3 2 1 0 0 2

ed > 1

ed = 1

ed < 1

Price (P)

10

12

14

16

18

20

22

Quantity Demanded (Q)

Fig 4.5a

Revenue & a Straight Line Demand Curve

60 50 Revenue (P x Q) 40 30 20 10 0 0 2 4 6 8 10 12 14 16 18 20 22 Quantity Demanded (Q)
Fig 4.5b

If ed > 1 then Revenue as P

If ed < 1 then Revenue as P

Revenue and the Price Elasticity of Demand

Effect of a Price Revenue Revenue Revenue Effect of a Price Revenue Revenue Revenue

ed <1 1 >1

Terminology Inelastic Unit elastic Elastic

Table 4.2

Revenue & a Price for Coffee ...

Price of Coffee Net revenue effect: $144 million

$2 price increase
30 20 10

Elastic Demand Revenue rises by $96 million

10 20 30 40 50 60

Revenue falls by $240 million

70

Quantity Demanded
Fig 4.6a

 Revenue & a Price for Coffee

Price of Coffee Net revenue effect: $54 million

$2 price increase
30 20 10

Inelastic Demand Revenue rises by $114 million

10 20 30 40 50 60

Revenue falls by $60 million

70

Quantity Demanded
Fig 4.6b

Estimated Price Elasticities of Demand

Type of good or service Eggs Petrol Shoes Foreign travel Alcoholic beverages Jewellery Price elasticity 0.1 0.2 0.9 1.2 1.5 2.6

Factors Affecting Price Elasticity of Demand

Degree of substitutability
More substitutes higher elasticity

Big-ticket versus little-ticket items

More expensive goods higher incentives to look for substitutes

Temporary versus permanent price changes

Temporary price decrease people will want to buy now at a lower price higher elasticity

Factors Affecting Price Elasticity of Demand

Long-run versus short-run elasticity
Long-run all adjustments are made Substitution takes time Example: Demand for petrol Inelastic in the short run, elastic in the long run

Elasticities Related to Shifts in Demand

Income elasticity of demand:
The percentage change in the quantity demanded of one good divided by the percentage change in income

Cross-price elasticity of demand:

The percentage change in the quantity demanded of one good divided by the percentage change in the price of another good

Estimated Income Elasticities of Demand

Type of good or service Food Beer Wine Cars

Income elasticity 0.3 0.4 1.0 1.2

Comparing Different Price Elasticities of Supply ...

P P1 P0 A Large in Q Q0 Q1 Q Quantity supplied is very sensitive to the price B Shigh el

 Comparing Different Price Elasticities of Supply

P P1 P0 A Quantity supplied is not very sensitive to price Slow el C Small in Q

Q0

Q2

Q
Fig 4.7b

Importance of Price Elasticities of Supply ...

P Small reduction in price

Shigh el P0 P1 Dold Dnew Q0 Q

Fig 4.8a

 Importance of Price Elasticities of Supply

Large change in price P Slow el P0 P2 Dnew Q0 Q
Fig 4.8b

Dold

Price Elasticity of Supply

The percentage change in the quantity supplied of a good divided by the percentage change in the price of that good
es = es = percentage change in quantity supplied percentage change in the price

Qs
Qs

P
P

Q s / Qs P / P

P Qs Qs P

Special Cases
P Si Perfectly Inelastic Supply

Se Perfectly Elastic Supply

Q
Fig 4.9

Applications of Elasticity
First Time Home Buyer Grant (again)
Between 14 October 2008 and 30 June 2009 first time home buyers got a subsidy of up to $14,000 Willingness to pay goes up (for example $400,000 before grant $414,000 after the grant)

Applications of Elasticity
First Time Home Buyer Grant
Demand increases (shifts up and to the right) Shortage of land - inelastic supply of housing One could even argue that perfectly inelastic supply curve would be a good approximation Who benefits from the grant?

Applications of Elasticity
P S

P1 D1 P0 D0 Q
Fig 4.9