Topic 2

Price: The Role of Demand and Supply

Law of Demand
The quantity purchased of a good or

service is inversely related to the price, all other things being equal (ceteris paribus)

The Law of Demand

Price changes lead Price to qty demanded changing....... Represented by movements along 3 demand curve. 2 Inverse relationship between price and quantity demanded gives rise to a 5 downward- sloping demand curve.

A B
negative slope

DD
15

Quantity/wk

Quantity Demanded versus Demand

Quantity demanded The quantities of a good or service that people will purchase at a specific price over a given period of time Demand
A schedule of the total quantities of a

good or service that purchasers will buy at different prices at a given time
4

Demand
Individual demand
The quantity of a good or service that an

individual or firm stands ready to buy at various prices at a given time

Market demand
The sum of the individual demands in

the marketplace
5

Demand Schedule and Demand Curve

Demand schedule A table showing the various quantities of a good or service that will be demanded at various prices Demand curve A curve that indicates the number of units of a good or service that consumers will buy at various prices at a given time
6

Demand Curve for Internet Time

$1.55 1.50 1.45

Table 4-1 provides the detail for the demand curve presented here

Price per Hour

1.40 1.35 1.30 1.25 1.20 1.15 1.10 1.05 0 1 2 3 4 5 6 7 8 9 10 11 12 13

Quantity (millions of hours)

Changes in Quantity Demanded and in Demand

Change in quantity demanded Movement along the demand curve that occurs because the price of the product has changed Change in demand A change in the amounts of the product that would be purchased at the same given prices; a shift of the entire demand curve
8

Demand Curves for Internet Time

$1.55 1.50 1.45

Price per Hour

1.40 1.35 1.30 1.25 1.20 1.15 1.10 1.05 0 1 2 3 4 5 6

A shift from D to D1 is an increase in demand more will be purchased at each price A shift from D to D2 is a decrease in demand less will be purchased at each price D1

D D2
7 8 9

10 11 12 13

Quantity (millions of hours)

Determinants of Demand
Changes in income
Higher incomes increase in demand Lower incomes decrease in demand

Changes in tastes and preferences Change in consumer expectations

10

Determinants of Demand
Changes in the prices of other goods Substitutes Increase in the price

of substitutes increase in demand Complements Increase in the price of complements decrease in demand
11

Supply
Supply
The total quantities of a good or service that sellers

stand ready to sell at different prices at a given time

Individual supply
Quantities offered for sale at various prices at a given

time by an individual seller

Market supply
Sum of the individual supply schedules in the

marketplace

12

Supply
Supply schedule A table showing the various quantities of a good or service that sellers will offer at various prices at a given time Supply curve A line showing the number of units of a good or service that will be offered for sale at different prices at a given time
13

Law of Supply
The quantity offered by sellers of a good or service is directly related to price, all things being equal Why?
Producers are more willing to sell greater amounts of a

good at a higher price , because this good has become relatively more profitable to produce, compared to other gds

14

Changes in Quantity Supplied and in Supply

Change in the quantity supplied
Movement along the supply curve that occurs

because the price of the product has changed

Change in supply
A change in the amount of the product that would be

offered for sale at the same given price; a shift of the entire supply curve

15

Supply Curves for Internet Time

$1.55 1.50 1.45

Price per Hour

1.40 1.35 1.30 1.25 1.20 1.15 1.10 1.05 0

A shift from S to S2 S2 is a decrease in demand a smaller amount offered for sale at each price

S1 A shift from S to S1 is an increase in demand a larger amount offered for sale at each price

10 11 12 13

16

Quantity (millions of hours)

Determinants of Supply
Changes in the cost of resources
Increase in the cost of resources decrease in

supply
Technology
Improvements increase in supply

Expectations of future prices(Shift to the right) Prices of related products

17

Expectations of Future Prices

If sellers expect

price of the good to

fall in the future, they will sell more now before the price actually falls!! Supply increases today... ..rightward shift
18

Price of related goods

Related goods (Supply side of the market)

Substitutes in production Require the same resources to produce

Complements in production Jointly produced with the same pool of resources

Example Rubber bands Rubber erasers

Example Beef Leather

19

Price of related goods (substitutes in production)

Assume that the price of Rubber Erasers (RE) has increased. What impact does this have on the supply of Rubber Bands

(RB) ? Price SS

Price

SS SS

Supply of RE
20

Quantity Supply of RB

Quantity

Price of related goods (complements in production)

Assume that the price of beef has increased. What impact does this have on the supply of leather ?

Price

Price

SS SS

SS

21

Supply of Beef

Quantity

Quantity Supply of Leather

Equilibrium Price
The price at which the quantity demanded equals the quantity supplied Market Equilibrium A state whereby the forces of market demand and market supply exactly balance each other and there is no tendency for change
22

Demand, Supply, and Market Price for Internet Time

$1.55 1.50 1.45 1.40

Demand

Supply

Price per Hour

1.35 1.30 1.25 1.20 1.15 1.10 1.05 0 1 2 3 4 5 6 7 8 9 10 11 12 13

At a price of $1.21, 6 million hours of Internet time will be offered for sale and an equal amount purchased

23

Quantity (millions of hours)

24

Surplus of Internet Time

$1.55 1.50 1.45 1.40 1.35 1.30 1.25 1.20 1.15 1.10 1.05 0 1
25

Demand

Surplus

At a price of $1.30, 7.8 Supply million hours will be offered for sale but consumers are only willing to purchase 4.2 million hours Qs > Qd surplus of Internet hours Rather than hold on to these hours, sellers will offer to sell at lower prices with the result that more consumers enter the market price moves toward $1.20
9 10 11 12 13

Price per Hour

3 4

7 8

Quantity (millions of hours)

Shortage of Internet Time

$1.55 1.50 1.45 1.40

Demand

Supply

Price per Hour

1.35 1.30 1.25 1.20 1.15 1.10 1.05 0 1 2 3 4

At a price of $1.10, buyers want to buy 8.5 million hours but sellers are willing to offer only 3.6 million hours Qd > Q shortage Some buyers will be willing to pay more with the result that the price will increase and sellers will increase the amount they offer for sale move toward $1.20

Shortage
5 6 7 8

9 10

11 12 13

26

Quantity (millions of hours)

Changes in Equilibrium Price & Quantity

Once equilibrium is attained, there is no

tendency for change, unless demand, supply or both market forces change. Demand & supply change when there is a change in determinants of demand and/or supply.

27

Increase in Demand
Price
SS P P Increase in Pe & Qe DD

E E
DD Q Q

Quantity
28

Decrease in Demand
Price
SS E P P E Decrease in Pe & Qe DD

DD Q Q
29

Quantity

Increase in Supply
Price
E P P E DD Q
30

SS SS Decrease in Pe, Increase in Qe

Quantity

Decrease in Supply
Price
E P P E DD SS SS Increase in Pe, Decrease in Qe

Quantity
Q
31

Change In Both Demand & Supply At The Same Time

the effect on only either P or Q can be

determined straight away the impact on the other variable cannot be determined , unless given more information on the size of the relative shifts

32

What happens when:

Demand and supply increase simultaneously? The equilibrium qty will definitely increase, but whether the equilibrium price will increase or decrease depends on how much demand shifts relative to supply
33

Three Possible Situations:

Demand increases more than supply does
Price
DD P P E E DD SS SS Increase in Pe, Increase in Qe

Q
34

Quantity

Three Possible Situations:

Supply increases more than demand does
Price
DD P P Q
35

DD

SS SS Decrease in Pe, Increase in Qe

Quantity

Three Possible Situations:

Demand increases by the same amount as supply
Price
DD SS SS E E No change in Pe, Increase in Qe DD P

Q
36

Quantity

General Guidelines
An increase in demand relative to

supply higher price A decrease in demand relative to supply lower price An increase in supply relative to demand lower price A decrease in supply relative to demand higher price
37

Disequilibrium Due To Government Intervention

The government may
step in to restrict the free operation of the market and create disequilibrium prices by imposing a PRICE CEILING or PRICE FLOOR

38

Price Ceiling
A government-mandated maximum

price that can be charged for a good or a service below the market equilibrium Producers cannot sell at a price higher than the ceiling price

39

Why Imposed Price Ceiling ?

Prevent consumers from being overcharged

!!!! E.g. rent control Price control on necessities eg rice, sugar, oil, etc..
40

The Effects of a Price Ceiling on Rental Housing

S The effect of the price ceiling on rental housing is to cause a shortage and reduce housing opportunities to those families they are intended to accommodate D Monthly Price ($)

700

500

Shortage
0
41

18,000

30,000

40,000

Quantity (housing units)

How Are Consumers Affected By A Price Ceiling?

Since there is little incentive to maintain the quality of rent-controlled housing, consumers may have to put up with the deteriorating quality of such housing . The amount bought and sold with a price ceiling imposed is less than that at market equilibrium. The shortage caused by the price ceiling forces consumers to spend more time searching for an alternative. Some people are willing to pay more to get some of the good. These people may end up relying on political connections and paying coffee money.
42

Why Imposed Price Floor???

To ensure producers a higher and more stable income eg. Price floors on agricultural products, or min wage to ensure workers a min standard of living

43

The Effects of a Price Floor on Wheat

S PF Price per Bushel ($) Surplus

3.00 2.00

The impact of the price floor is to cause a surplus the government must then buy and store the surplus that is created by the price floor
D

0
44

75,000 100,000 115,000

Quantity (bushels)

Effects of Price Floors

Price floors create surpluses... govt intervention is needed

to prevent downward pressure on price Govt often steps in to buy up the surplus, as part of its support program towards producers

45

What Does The Government Do With The Surplus?

Surplus may be distributed to the poor But govt has to ensure that its actions

does not lead to falling demand Alternatively, surplus may simply be stored up .... wasteful if quality deteriorates over time

46

How Are Consumers Affected By A Price Floor?

Consumers pay a higher price than at market

equilibrium (PF higher than Pe).

Consumers pay taxes to cover government

support for producers. The amount bought and sold with a price floor imposed is less than that at market equilibrium.

47

Price Elasticity of Demand

A measure of the sensitivity or

responsiveness of quantity demanded to a change in price

Formula method Total revenue method

48

Formula Method
Price elasticity = percentage change in quantity demanded percentage change in price

Q2 Q1 (Q1 +Q2 )/2 = P2 P 1 ( P +P2 )/2 1

49

Demand Curve Showing Different Elasticities

$13 12 11 10 9 8 7 6 5 4 3 2 1 0
50

D1

D2 D

Price

Elastic demand

Unit elastic Inelastic demand

D1

1,600

2,000

2,400

Quantity/Time

Unit Elastic Demand

Demand that exists when a percentage

change in price causes an equal percentage change in quantity demanded Has an elasticity coefficient equal to 1.0
Demand curve D in Figure 4-9
51

Elastic Demand
Demand that exists when a

percentage change in price causes a greater percentage change in quantity demanded Has an elasticity coefficient greater than 1.0
Demand curve D1 in Figure 4-9
52

Inelastic Demand
Demand that exists when a percentage

change in price causes a smaller percentage change in quantity demanded Has an elasticity coefficient less than 1.0
Demand curve D2 in Figure 4-9
53

Total Revenue Method

If price changes but total revenue remains constant,

unit price elasticity of demand exists If price changes but total revenue moves in the opposite direction, demand is elastic If price changes and total revenue moves in the same direction, demand is inelastic

54

Characteristics Affecting Price Elasticity of Demand

Trend Toward Elastic Demand Luxuries Large expenditures Durable goods Substitute goods Multiple uses

Trend Toward Inelastic Demand Necessities Small expenditures Perishable goods Complementary goods Limited uses

55

Three Demand Curves Showing Different Elasticities

(a) P
Perfectly Elastic D1

(b)

(c)

D2 Perfectly Inelastic

P
Perfectly Unit Elastic D3

Q/t

Q/t

Q/t

56

Demand Curve Showing Different Elasticities

$12 11 10 9 8 7 6 5 4 3 2 1 0 10
57

Price

Un

it E

las

tic

Elasticity changes along the demand curve from elastic at the top to inelastic at the bottom

Ela De stic ma nd

20 30 40 50 60

70

Ine De las ma tic nd

80 90 100 110 120

Quantity/Time

Other Types of Elasticity

Cross elasticity of demand Income elasticity of demand Elasticity of supply

58

Cross Elasticity of Demand

A measure of the responsiveness of the quantity demanded of one product as a result of a change in the price of another product
Cross elasticity of demand = percentage change in the quantity demanded of product B percentage change in the price of product A

59

Cross Elasticity of Demand

Substitute goods Functionally equivalent goods Complementary goods Goods that are used together A change in the price of one product,

if it is substitute or complementary product, can affect the quantity demanded of the other

60

Cross Elasticity of Demand

The coefficient of cross elasticity can

be positive or negative

Positive in the case of substitutes Negative in the case of complements

The larger the coefficient, the greater

the cross elasticity

61

Income Elasticity of Demand

A measure of the responsiveness of quantity demanded to a change in income
Income elasticity of demand = percentage change in quantity percentage change in income

62

Income Elasticity of Demand

Normal goods Positive coefficient Demand varies in the same direction as income Inferior goods Negative coefficient Demand varies inversely with changes in income
63

Elasticity of Supply
A measure of responsiveness of quantity supplied to a change in price
Price elasticity of supply = percentage change in quantity supplied percentage change in price

64

Time and Elasticity of Supply Immediate

P

P1

Demand increases from D to D1 and because the sellers cannot adjust the quantity supplied on such short notice, the only impact is an increase in price
D1 D

Q
65

Q/t

Time and Elasticity of Supply Short Run

P

P2 P D1 D Q
66

In the short run, the seller has sufficient time to vary some productive resources supply becomes more elastic and the quantity supplied increases, causing the price to fall

Q2

Q/t

Time and Elasticity of Supply Long Run

P

P3 P

Over the long run, the supply curve becomes still more elastic because producers can S vary all productive resources and make use of new technology
D1 Q3
Q/t

D Q
67

Effects of a Tax on Cigarettes

Price per Pack ($)
S + $1 S

Price per Pack ($)

S + $1 S

5.25 5.00

e R

e
5.75 5.00

D
40 50 48 50

D Quantity (millions of packs)

Quantity (millions of packs)

68

Note that the same $1 tax has a much larger impact on quantity when demand is more elastic than when it is inelastic