Economic Principles I

Lecture 4:
More on Demand and Supply
Outline
Shifts in demand and supply and their
effects on price and quantity
The concepts of elasticities of demand and
supply
Using Supply and Demand to
Analyse Changes
Equilibrium price and quantity depend on the
position of the supply and demand curves
If one or both of the curves move equilibrium will
have to change
The analysis of such a change is called comparative
static analysis
Does the change shift the demand curve or supply curve (or
both)?
In which direction do the curves shift?
Where is the new equilibrium relative to the old one?
An Increase in Demand
For example, this may
be caused by higher
income, changed
tastes, a change in the
price of a related good
S
D
1

price
quantity
0
D
2

Increase in
demand
p
2

q
2

New
equilibrium
p
1

q
1

Initial
equilibrium
The increase in
demand has resulted
in both an increase in
price and an increase
in quantity

An Increase in Supply
An increase in supply
(caused for example by
lower input prices or a
technological
improvement)
D
price
quantity
0
p
1

q
1

Initial
equilibrium
p
2

q
2

New
equilibrium
S
2

Increase in
supply
S
1

The increase in supply
has resulted in an
decrease in price and
an increase in quantity
A Shift in both Supply and
Demand
The effects on price
and quantity can be
ambiguous
In this case the
equilibrium price
increases, and the
equilibrium quantity
increases
S
2

Decrease in
supply
D
2

Increase in
demand
price
quantity
0
D
1

S
1

p
1

q
1

Initial
equilibrium
p
2

q
2

New
equilibrium
Alternative Shifts in Supply and
Demand
Here the shift in supply is
relatively large and the
shift in demand is smaller
The equilibrium price still
increases, but the
equilibrium quantity falls
The effects on equilibrium
price and quantity depend
on the slopes of the
curves and the relative
size of the shifts D
2

Increase in
demand
D
1

S
1

p
1

q
1

Initial
equilibrium
S
2

Decrease in
supply
p
2

q
2

New
equilibrium
price
quantity
0
The Impacts of Different Changes
It is possible to sign the effects on equilibrium price and
quantity for the various combinations of shifts in the demand
and supply curves
Supply:

Demand:
No change Increase Decrease
No change P +
Q |
P |
Q +
Increase P |
Q |
P ?
Q |
P |
Q ?
Decrease P +
Q +
P +
Q ?
P ?
Q +
Price Elasticity of Demand:
Defined
The law of demand states that if the price of a
good falls then quantity demanded will rise
For a given fall in price, by how much does
quantity demanded rise?
How much is measured by the price elasticity of
demand:
price in change
demanded quantity in change
ped
%
%
=
Price Elasticity of Demand:
Illustrated
Example:
Suppose the price of CDs rises by 10% and this causes
a 15% fall in demand
Price elasticity of demand = 15%/10% = 1.5
The change in quantity is proportionately 1.5 times as
large as the change in price
Strictly speaking price elasticity of demand is a
negative number, but by convention the minus
sign is left off
Price Elasticity of Demand:
Influences
What determines the price elasticity of
demand?
Necessity or luxury
Availability of close substitutes
How broadly or narrowly we have defined the
market
The length of time over which we are
considering the changes
Technical Issues
Problem: measuring percentages depends on
whether you measure from the start point or the
end point
(1) (2) (3) (4) (5)
Point Price % change Quantity
demanded
% change Elasticity
(4)(2)
from A 4 12
to B 6 +50% 8 -33% (-)0.67
back to A 4 -33% 12 +50% (-)1.50
The Mid-Point Method
Point Price % change Quantity
demanded
% change Elasticity
from A 4 12
to B 6 8
Midpoint 5 2/5 = 40% 10 4/10 = 40% (-)1.0
Midpoint method: price elasticity of demand =

( ) ( ) | |
( ) ( ) | | 2 / /
2 / /
A B A B
A B A B
P P P P
Q Q Q Q
ped
+
+
~
Elasticity and Slope
Price elasticity of demand is not the same as the
slope of the demand curve
Why not just use the slope of the demand curve
to measure price responsiveness?
Answer: because the responsiveness of quantity
to price changes, as we move along a linear
(straight-line) demand curve
P Q P*Q % A in Q % A in P Elasticity
20 0 0
17.5 2 35 200 13 15.4
15 4 60 67 15 4.5
12.5 6 75 40 18 2.2
10 8 80 29 22 1.3
7.5 10 75 22 29 0.8
5 12 60 18 40 0.5
2.5 14 35 15 67 0.2
0 16 0 13 200 0.1
Quantity demanded
Price
17.5
15
12.5
10
7.5
5
0 2 4 8 6 10 12 14
20
2.5
16
PED > 1
PED < 1
Slope is Constant:
Elasticity is not
10
12.5
10
P
Q
0
Demand P
Q
0
12.5
10
12 11
Demand
P
Q
0
10
Demand
P
Q
0
12.5
10
12 5
Demand
Perfectly
inelastic
PED = 0
Perfectly elastic
PED=
Inelastic
PED < 1
e.g. a
necessity
Elastic
PED > 1
e.g. a
luxury
Elasticity at Various Values
Elasticity and Revenue
Total revenue = P Q
If PED < 1 (inelastic demand) then an increase in price
leads to a less than proportionate fall in quantity
demanded and total revenue increases
If PED > 1 (elastic demand) then an increase in price leads
to a more than proportionate fall in quantity demanded
and total revenue decreases
If PED=1 (unit elastic) then an increase in price leads to
the same proportionate change in quantity demanded
and total revenue stays the same
Other Demand Elasticities (1)
Income elasticity of demand =

IED positive: normal good
Higher income raises quantity demanded
Luxury or necessity: i.e.d. over 1, or between 0 and 1)
IED negative: inferior good
Higher income lowers quantity demanded
income in change
demanded quantity in change
ied
%
%
=
Other Demand Elasticities (2)
Cross-price elasticity of demand =
CPED positive: goods are substitutes
Higher price of good 2 raises quantity demanded of
good 1
CPED negative: goods are complements
Higher price of good 2 lowers quantity demanded of
good 1
2 %
1 %
Good of price in change
Good of demanded quantity in change
cped =
Supply Elasticity
Price elasticity of supply =

12 11
P
Q
0
12.5
10
Supply
P
Q
0
12.5
10
12 5
Supply
a) Inelastic supply: b) Elastic supply:
price in change %
plied sup quantity in change %
pes =
Conclusion
This lecture analysed has the comparative static
effects of shifts in supply and demand
It has also introduced the concept of elasticity
Price elasticity of demand
Income elasticity of demand
Cross price elasticity of demand
Price elasticity of supply
Lecture 5 will illustrate government intervention
in markets, using demand and supply analysis
Economic Principles I
Lecture 4:
More on Demand and Supply