CHEM3401 ECONOMICS

Supply, Demand and Elasticity

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Overview
Market Demand Market Supply

Market Equilibrium
Short-run Analysis, Long-run Analysis

Supply, Demand, and Price

Chapter Three Copyright 2009 Pearson Education, Inc. Publishing as Prentice Hall. 2

Learning Objectives
Define supply, demand, and equilibrium price Identify non-price determinants of supply and demand Distinguish between short-run rationing function and long-run guiding function of price Illustrate how supply and demand can be used to improve management decisions Use supply and demand diagrams to determine price in the short and long run
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Market Demand
Demand for a good or service is defined as quantities that people are ready (willing and able) to buy at various prices within some given time period.
Other factors besides price are held constant (ceteris paribus).
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Market Demand
Non-price Determinants of Demand
Tastes and preferences

Income
Prices of related products

Future expectations
Number of buyers
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Market Demand
Market demand is the sum of all the individual demands
Demand Schedule: Table showing quantities of a good a consumer is willing and able to buy at alternative prices in a given time period, ceteris paribus. Example: demand for pizza

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Market Demand
The inverse relationship between price and the quantity demanded of a good or service is called the Law of Demand
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Market Demand
What does the demand curve above tells us about the relationship between price and quantity demanded? What is the direction of the slope of the demand curve? Why? Law of Demand: The quantity of a good demanded in a given time period increases as its price falls, ceteris paribus.

Market Demand
The demand schedule and curve remain unchanged only so long as the underlying determinants of demand remain constant.

Shifts in Demand: A change in any of the determinants of

demand (except price) will cause demand curve to shift.

Changes in demand: shifts of the demand curve due to

changes in other determinants, and not prices
E.g. Does an increase in income cause the demand curve to shift inward or outward? Show this graphically. 9

Market Demand
Movements Along a Demand Curve: Movements along
a demand curve are a response to price changes for that good. Change in Quantity Demanded Such movements assume that the other determinants of demand are unchanged.

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Market Demand
Questions
What would happen to the market demand for steak as a result of each of the following? 1. 2. 3. 4. 5. 6. An increase in the average income of consumer. An increase in the size of the population. Increased advertising for lamb and pork. An increase in the price of lamb. A decrease in the price of pork. An increase in the price of steak
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Market Supply
The supply of a good or service is defined as quantities that people are ready (willing and able) to sell at various prices within some given time period
Other factors besides price held constant

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Market Supply
Non-price Determinants of Supply
Costs and technology Prices of other goods or services offered by the seller Taste of producers Expectations Number of sellers

Weather conditions
Taxes and subsidies
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Market Supply
Changes in price result in changes in the quantity supplied
movement along the supply curve

Changes in non-price determinants result in changes in supply a shift in the supply curve

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Market Equilibrium
Equilibrium price: the price that equates the quantity demanded with the quantity supplied
Equilibrium quantity: the amount that people are willing to buy and sellers are willing to offer at the equilibrium price level

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Market Equilibrium
Shortage (Excess Demand): A market situation in which the quantity demanded exceeds the quantity supplied.

Shortage occurs at a price below the equilibrium level

Surplus (Excess Supply): A market situation in which the quantity supplied exceeds the quantity demanded.

Surplus occurs at a price above the equilibrium level

Begin analysis by assuming that the market is in equilibrium

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Market Equilibrium
Assume all factors except the price of pizza are constant Buyers demand and sellers supply are represented by lines shown

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Market Equilibrium
Assume that a new study shows pizza to be the most nutritious of all fast foods Consumers increase their demand for pizza as a result

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Market Equilibrium
The shift in demand results in a new equilibrium price (P2) And a new equilibrium quantity (q2)

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Market Equilibrium
Comparing the new equilibrium point with the original one, we see that both equilibrium price and quantity have increased

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Short-Run
The short run is the period of time in which:
Sellers already in the market respond to a change in equilibrium price by adjusting variable inputs Buyers already in the market respond to changes in equilibrium price by adjusting the quantity demanded for the good or service

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Short-Run
Short run changes show the rationing function of price The rationing function of price is the change in market price to eliminate the imbalance between quantities supplied and demanded.

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Long-Run
The long run is the period of time in which:
New sellers may enter a market Existing sellers may exit from a market Existing sellers may adjust fixed factors of production Buyers may react to a change in equilibrium price by changing their tastes and preferences

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Long Run
Long run changes show the allocating function of price The allocating function of price is the movement of resources into or out of markets in response to a change in the equilibrium price

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Supply, Demand, and Price: The Managerial Challenge

In the extreme case, the forces of supply and demand are the sole determinants of the market price, not any single firm This type of market is perfect competition In many cases, individual firms can exert market power over price because of their:
Dominant size Ability to differentiate their product through advertising, brand name, features, or services
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Consumer Surplus
The value the consumer derives above the price he is willing to pay when a good is purchased.

Producer Surplus
The value the producer derives above the price he is willing to sell his good when a transaction takes place.

Total Surplus

Pulling it all Together

Problem:Trendy Fry
Trendy Fry sells fry fish and festival on the beach at Hellshire. There are many other vendors on the beach selling a variety of meals. The demand for Trendy Fry fish is given by Qd =240 -2p The Supply is given by Qs = 30 + p. Where: Qd/Qs = quantity of fish demanded/supplied per kg; p = price per kg
a. b. Determine equilibrium price and quantity Explain with the use of diagrams. How each of the following factors will affect the demand for and or supply of Trendy Fry fish : i. Jerk chicken vendors reduce the price of chicken. ii. The cost of the wood used for fuel decreases. iii. It is summer and many more people visit the beach. iv. Bad weather led to a decrease in the fish catch v. The price of festival increases.

State any assumptions that you make (within the context of the question)

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Introduction to Elasticity

Facilitator: Oswald Thomas ossiet@hotmail.com

Elasticity: The Responsiveness of Demand and Supply

Definition of Elasticity

A measure of how much one economic variable responds to changes in another economic variable
percent change in A Coefficien t of Elasticity percent change in B

The Price Elasticity of Demand and its Measurement

Price Elasticity of Demand

o

Percentage change in quantity demanded caused by a 1 percent change in price (Interpretation)

Measuring the Price Elasticity of Demand

Price Elasticity of Demand

Price Elasticity of Demand:
The percentage change in quantity demanded caused by a 1 percent change in price

% Quantity Ep % Price
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Price Elasticity of Demand

Arc elasticity: elasticity which is measured over a
discrete interval of a curve

Q2 Q1 P2 P 1 Ep (Q1 Q2 ) / 2 ( P 1P 2) / 2
Ep = coefficient of arc price elasticity Q1 = original quantity demanded Q2 = new quantity demanded P1 = original price P2 = new price
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Price Elasticity of Demand

Point Elasticity: elasticity measured at a given point of a demand (or a supply) curve

dQ P 1 P = x dP Q1
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Price Elasticity of Demand

The point elasticity of a linear demand function can be expressed as:

Q P1 p P Q1

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The Price Elasticity of Demand and Its Measurement

Elastic Demand and Inelastic Demand

Elastic demand
o

Percentage change in quantity demanded greater than the percentage change in price Price elasticity is greater than 1 in absolute value. Ed > 1

Inelastic demand
o o

Percentage change in quantity demanded less than percentage change in price Price elasticity is less than 1 in absolute value. Ed < 1

Unit-elastic demand
o

Percentage change in quantity demanded equal to percentage change in price. Ed = 1

The Price Elasticity of Demand and its Measurement

An Example of Computing Price Elasticities *

Elastic and Inelastic Demand Curves

Methods of Calculating Price Elasticity of Demand

Three Methods
1. Simple Method: Basic percentage calculation 2. Mid-Point Method: Modified percentage approach using the data mid-points 3. Point Method : Calculus Elasticity at a specific point

The Price Elasticity of Demand and its Measurement

CALCULATING PERCENTAGE CHANGES
% change in quantity demanded price elasticity of demand % change in price
% change in quantity demanded change in quantity demanded x 100% Q1
Q2 - Q1 x 100% Q1

% change in price

change in price x 100% P 1

P 2 - P 1 x 100% P 1

The Price Elasticity of Demand and its Measurement

The Midpoint Formula
Price elasticity of demand =

Point Elasticity Formula

Price elasticity of demand =

Calculating the Price Elasticity of Demand for Electricity Using the Midpoint Formula

YEAR 2010 2011

PRICE (PER kWh) $3.00 $3.60

QUANTITY (PER kWh) 3.0 2.8

The price elasticity of demand is _________

The Price Elasticity of Demand and its Measurement

Polar Cases of perfectly elastic and perfectly inelastic demand

Perfectly Inelastic Demand

Change in price results in no change in quantity demanded.

Perfectly Elastic Demand

Change in price results in an infinite change in quantity demanded.

The Price Elasticity of Demand and its Measurement

Dont Confuse Inelastic with Perfectly Inelastic

Determinants the Price Elasticity of Demand

Key Determinants of Price Elasticity of Demand:

Availability of close substitutes Passage of time Necessities versus luxuries

Definition of the market

Share of good in the consumers budget Durability of product

The Relationship Between Price Elasticity and Total Revenue

The relationship between price and revenue depends on elasticity
Why? By itself, a price fall will reduce receipts BUT because the demand curve is downward sloping, the drop in price will also increase quantity demanded

Q: Which effect will be stronger?

Chapter Four

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The Relationship Between Price Elasticity and Total Revenue

Total Revenue - The total amount of funds received by a seller
of a good or service, calculated by multiplying price per unit by the number of units sold.

Summary: Elasticity of Demand and Total Revenue

Elasticity Coefficient ED >1 % Qd > % P ED = 1 Unitary Elasticity. Somewhat Inelastic. % Qd < % Elasticity Somewhat Elastic. When Price Increases Quantity changing a lot so you could lose lots of money. Quantity/price changing same % Quantity doesn't change much, so you could make lots of money Total Revenue

Decreases No change

ED <1

Increases

What happens to total revenue when price decreases?

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Cross-Price Elasticity
1. Recall again the demand function 2. Cross-Price Formula: Ea,b = %Qda / %Pb 3. Interpretation of values
a. If Ea,b > 0 => Substitutes; Why? b. If Ea,b < 0 => Complements; Why?
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Two products are considered good substitutes or complements when the coefficient is larger than 0.5 (in ab. Value)

Price Elasticity of Demand

Empirical Elasticities: Examples
Coffee: short run -0.2, long run -0.33 Meals at restaurants: -2.27 Beer: -0.84, wine: -0.55cigarettes: short run -0.4, long run -0.6 Wine imports: -0.15

Crude oil: -0.06

White pan bread:-0.69, premium white pan bread 1.01
Chapter Four Copyright 2009 Pearson Education, Inc. Publishing as Prentice Hall. 53

Extensions, Problem & Discussion

1. Relevance to Business
a. Can a firm raise price and revenue fall? b. Does elasticity matter when setting price? c. Does income elasticity make a difference?

2. Sample Problems
a. Tropical Vibes Restaurant
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The Price Elasticity of Demand and its Measurement

Point Elasticity Formula

Price elasticity of demand =

Some demand curves have constant elasticity such a curve has a nonlinear equation:

Q = aP-b
where b is the elasticity coefficient

e.g.Qd1 = 2.5P1-1.3 Inc0.3 P20.4 P3-0.1

Elasticity: Linear Demand & TR

1.

Linear Demand: E.g. Qds = 5,000 1,000Ps + 0.1I + 100Pr

Let Qd = a1 +a2*P Then, Ed = a2*(P/Qd) Variable elasticity: what happens to Ed as P falls?

2.

Elasticity & Total Revenue (TR)

How does revenue change as we change price -given that sales vary inversely with price? TR/P = Q*[1+Ed] Graph: elastic versus inelastic case

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Price Discrimination, Elasticity & Revenue

1. What is price discrimination? Why discriminate? 2. Types of price discrimination 3. Under what conditions is price discrimination possible? a. Elasticity differences b. Market separation 4. Effect of price discrimination on revenue 5. Price discrimination, consumer & producer surplus

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Price Discrimination
Segmenting the market into separate classifications or regions Assuming that each class of consumers have different demand, a firm can charge different prices in each market segment
Enables firm to achieve higher revenue from given unit of sales

Some consumers are willing to pay more than the market price for a good which leads to a consumer surplus.
Firm eats into consumer surplus by charging higher prices E.g. charging higher prices for business travel than to tourists.

Examples of Price Discrimination

Senior citizen, youth, and student discounts
Airlines charge less for flyers willing to fly off peak, i.e. early morning and late night.

MatineesTheaters charge less for earlier shows. Evening meals in restaurants often cost more than the same meal at lunch

Price Discrimination
To Price-discriminate:
Firm must identify consumer groups/classes with different downward-sloping demand curves and therefore different elasticities of demand
Business travellers may be less sensitive to air fare levels than tourists Charge customers with more inelastic demands higher price Charge customers with more elastic demands lower price.

Firm must be able to prevent consumers of one class from reselling its product to the consumers of another class; no intermarket redistribution of the product is allowed e.g. dental treatment; barber Firm must have some market power Buyers can be separated at reasonable cost