Chapter 2

Demand and Supply Analysis

Outline
1. Competitive Markets Defined
2. The Market Demand Curve
3. The Market Supply Curve
4. Equilibrium
5. Characterizing Demand and Supply:
Elasticity
6. Back of the Envelope Techniques

2
Example: Oil Market
Crude oil prices 1947 – 2004
OPEC oil production

•Some experts predict that prices will rise to 100

Why?
 Weather, Hurricanes in Gulf

 China and India economies booming

 Political Crisis with Iran, Iraq, Russia, Nigeria

 Oil production per day in Non-OPEC countries declining

 Uncertainty over OPEC production capabilities

3
Example: Oil Market (cont’d)

How could we bring prices down?

• Reduce Demand – short-run
• Find new reserves – short-run
• Develop new technologies that are not
reliant on oil
 Forward thinking solution
 These become feasible as oil prices
rise. Many are now feasible
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Competitive Markets

Definition: Are those with sellers and buyers

that are small and numerous enough that they
take the market price as given when they
decide how much to buy and sell.

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Competitive Market
Assumptions
1. Fragmented market: many buyers and sellers
 Implies buyers and sellers are price takers
2. Undifferentiated Products: consumers perceive
the product to be identical so don’t care who they
buy it from
3. Perfect Information about price: consumers
know the price of all sellers
4. Equal Access to Resources: everyone has
access to the same technology and inputs.
 Free entry into the market, so if profitable for
new firms to enter into the market they will

6
tells us how the quantity of a good
demanded by the sum of all consumers in
the market depends on various factors.
Qd = (Q,p,po, I,…)

Plots the aggregate quantity of a good that

consumers are willing to buy at different
prices, holding constant other demand drivers
such as prices of other goods, consumer
income, quality.
Qd= Q(p)
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The Demand for New Automobiles in the United States

Price (thousands of dollars)

53

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Demand curve for automobiles in the
United States in 2000

0 2 5.3 Quantity (millions of

automobiles per year)

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 Note:
We always graph P on vertical axis and Q on horizontal
axis, but we write demand as Q as a function of P… If P is
written as function of Q, it is called the inverse demand.

Normal Form: Qd= 100-2P

Inverse form: P = 50 - Qd/2

 Markets defined by commodity, geography, time.

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Law of Demand
Law of Demand states that the quantity of a good
demanded decreases when the price of this good
increases.
 Empirical regularity
The demand curve: shifts when factors other
than own price change…

If the change increases the willingness of consumers

to acquire the good, the demand curve shifts right
If the change decreases the willingness of consumers
to acquire the good, the demand curve shifts left

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Some Demand Shifters
 Consumer incomes
 Consumer tastes

 Advertising

What would a rise in tax rate do?

Note: For a given demand curve we assume everything

else but price is held fixed.

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Rule

A move along the demand curve for a good can only be

triggered by a change in the price of that good. Any
change in another factor that affects the consumers’
willingness to pay for the good results in a shift in the
demand curve for the good.

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tells us how the quantity of a good supplied by
the sum of all producers in the market depends
on various factors
Qs= Q(p,po,w, …)
Po = price of other goods

Plots the aggregate quantity of a good that will

be offered for sale at different prices.

Qs= Q(P)

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 Example: Supply Curve for Wheat in
Canada
Price (dollars per bushel)

Supply curve for wheat

in Canada in 2000

0 0.15 Quantity (billions of

bushels per year)
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Definition: The Law of Supply states that the quantity of a
good offered increases when the price of this good increases.

 Empirical regularity

The supply curve shifts when factors other than own price
change…

If the change increases the willingness of

producers to offer the good at the same price,
the supply curve shifts right
If the change decreases the willingness of
producers to offer the good at the same price,
the supply curve shifts left
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Supply Shifters
 Price of factors of production e.g. wage
 Technology changes
 Weather conditions
 Hurricane Katrina reduced supply of oil
 Number of producers change

What is the effect of a rise in the minimum wage?

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Rule
A move along the supply curve for a good can only be
triggered by a change in the price of that good. Any
change in another factor that affects the producers’
willingness to offer for the good results in a shift in
the supply curve for the good.

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Example: Canadian Wheat

QS = p + .05r

QS = quantity of wheat (billions of bushels)

p = price of wheat (dollars per bushel)
r = average rainfall in western Canada,
May – August (inches per month)

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 Q = p + .05r
S

a. Quantity of wheat supplied at price of $2 and rainfall of 3

inches per month = 2.15

b. Supply curve when rainfall is 3 inches per month:

QS = p + 0.15

c. Law of supply holds: we know because the constant in

front of p is positive

d. As rainfall increases, supply curve shifts right (e.g., r = 4

=> Q = p + 0.2)

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 Q = p + .05r
S

Price ($)
r=0

Supply with
no rain

0 Quantity,
Billion bushels

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 Q = p + .05r
S

Price ($)
r=0
r=3
Supply with
no rain

Supply with 3” rain

0 .15 Quantity,
Billion bushels

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Market Equilibrium

Definition: A market equilibrium is a price such

that, at this price, the quantities demanded and
supplied are the same.

(Demand and supply curves intersect at equilibrium)

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Example: Finding Equilibrium Price and
Quantity The Market for Cranberries

Qd = 500 – 4p
QS = -100 + 2p

p = price of cranberries (dollars per barrel)

Q = demand or supply in millions of
barrels per year

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 Qd = 500 – 4p
Qs = -100 + 2p
a. The equilibrium price of cranberries is
calculated by equating demand to supply:
Qd = Qs … or…

500 – 4p = -100 + 2p …solving,

P* = $100
b. plug equilibrium price into either demand
or supply to get equilibrium quantity:

Q* =100
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 Example: The Market For Cranberries
Price

125
Market Supply: P = 50 + QS/2

P* = 100 Equilibrium

50

Market Demand: P = 125 - Qd/4

Q* = 100 Quantity

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Elasticity
 Definition: The own price elasticity of demand is
the percentage change in quantity demanded
brought about by a one-percent change in the price
of the good.
Q (Q 2  Q1 )
% Q *100 Q1
Q
  
% P P *100 ( P2  P1 )
P p 1

Q P Q P
*  *
P Q P Q
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Elasticity is not the slope
 Slope is the ratio of absolute changes in quantity
and price. (= Q/P).
 Elasticity is the ratio of relative (or percentage)
changes in quantity and price.
 Why elasticity is more useful?
 it is unitless so allows us to easily compare across
countries and goods
 Units of quantities will be different for different goods.
How to compare snow boards to oranges.
 Prices are different across different countries. More
difficult to compare Yemeni Ryials to US $

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Category Estimated Q,P When reading
these remember
Soft Drinks -3.18 the denominator is
Canned Seafood -1.79 1.
Canned Soup -1.62
Cookies -1.6 Price Elasticity of Demand
Breakfast Cereal -0.2 for Selected Grocery
Toilet Paper -2.42 Products, Chicago, 1990s
Laundry -1.58
Detergent
Toothpaste -0.45
Snack Crackers -0.86
Frozen Entrees -0.77
Paper Towels -0.05
Dish Detergent -0.74
Fabric Softener -0.73

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Elasticity Continued
• The price elasticity of demand for records is -2. Tell
me in words what this means.
• A 1 percent increase in price of records will lead to a
2 percent decrease in quantity of records
demanded.

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Types of Elasticity
 When a one percent change in price leads to a greater than
one-percent change in quantity demanded, the demand curve
is elastic. (Q,P < -1)

 When a one-percent change in price leads to a less than one-

percent change in quantity demanded, the demand curve is
inelastic. (0 > Q,P > -1)

 When a one-percent change in price leads to an exactly one-

percent change in quantity demanded, the demand curve is
unit elastic. (Q,P = -1)

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Example: Linear Demand Curve

Qd = a – bp

a, b are positive constants

p is price

 b is the slope
 a/b is the choke price

Choke price: price at which quantity

demanded is zero

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 the elasticity is

Q,P = (Q/p)(p/Q) …definition…

=-b(p/Q)

When Q=0, elasticity is -

When p=0, elasticity is 0

so…elasticity falls from 0 to - along the linear demand

curve, but slope is constant.

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 Example: Elasticity with a Linear Demand Curve
P

Q,P = -
a/b
Elastic region

a/2b • Q,P = -1

Inelastic region

Q,P = 0
Q
0 a/2 a

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Example: Determining Elasticity

if Qd = 400 – 10p, and p = 30,

Q,P = (-b)(P)/(Q)
Q = 400 – 10 (30) = 100
Q,P = (-10)(30)/(100) = -3 "elastic"

Why is elasticity negative – demand curve downward

sloping.

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 Example: Constant Elasticity Demand Curve

Qd = Ap
This is how the demand function
looks in general
 = elasticity of demand and is
negative
p = price
A = constant

Example: If demand can be expressed as QP = 100, what

is the price elasticity of demand?

Q=100P-1 , so elasticity is -1

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 Example: A Constant Elasticity
versus a Linear Demand Curve
Price

P • Observed price and quantity

Constant elasticity demand curve

Linear demand curve

0 Q Quantity

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Elasticity Continued

Price Elasticity of Demand is very useful.

 Suppose own a car business total revenue is: price *

quantity= P.Q
 You can increase the price (P), but if you do that

demand (Q) for your good will drop

 The price elasticity of demand tell you how much the

quantity will drop.

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How Elastic are these Curves?

D2 Perfectly
P Inelastic

P1 D1 Perfectly
Elastic

Q2
Q
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What Affects Elasticity?
 Availability of Substitutes:
 Demand is more(less) elastic when there are
more(fewer) substitutes for a product.
 % of income spending on product
 Demand is more(less) when the consumer’s
expenditure on the product is large(small)
 Necessity Products
 The demand is less price elastic when the product
is a necessity.
 Market Level vs Brand-Level Price
 Demand tends to be more elastic for a particular
brand of a good, than for the good in general
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Elasticity Continued
 Elasticity varies with (among other factors):
 Substitutability
 Example: Demand for all beverages less elastic than
demand for Coca-Cola
 There are substitute for Coca-Cola, drink Pepsi
 It is harder to find a substitute for soda if you love soda.

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 Importance of Brands
• Demand for individual
models is highly elastic
Model Price Estimated
Q,P • Market-level price
elasticity of demand for
Mazda 323 $5,039 -6.358 automobiles -1 to -1.5
Nissan $5,661 -6.528 • Compact automobiles
Sentra have lots of substitutes
Ford $5,663 -6.031 Luxury cars have less
Escort substitutes
Lexus $27,544 -3.085
LS400  Demand for compact cars
more elastic than luxury
BMW 735i $37,490 -3.515
cars.

Example: Price Elasticities of Demand for Automobile Makes, 1990.

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Definition: A durable good is a good that provides
valuable services over a long time (usually many
years). – airplane, car

Demand for non-durables (e.g. oil) less elastic in the

short run when consumers can only partially adapt
their behavior. Demand for durables more elastic in
the short run because consumers can delay
purchase.
Demand for Oil : short-run is less elastic (inelastic? )
• We own a car with a given mileage.
• Takes time to move to smaller cars and solar panels

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 Example: Demand for
Commercial Aircraft
Price ($/airplane)

Which demand curve is the short-

term and which long-term?

Quantity (aircraft/yr)

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 Example: Demand for
Commercial Aircraft
Price ($/airplane)

Long run demand curve for commercial airplanes

Short run demand curve for commercial

airplanes

Quantity (aircraft/yr)

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 Other Elasticities -- Elasticity of "X" with respect to
"Y": (X/Y)(Y/X)
 Price elasticity of supply (QS/p)(p/QS) …measures
curvature of supply curve
 Income elasticity of demand (Qd/I)(I/Qd) …
measures degree of shift of demand curve as
income changes…
 Cross price elasticity of demand (Qd/Po)(Po/Qd)…
measures degree of shift of demand curve when the
price of a substitute changes

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 The Cross-Price Elasticity of Cars
Price
Sentra Escort LS400 735i What is the cross price
elasticity of demand of
Sentra -6.528 0.454 0.000 0.000 the Sentra with respect
to Escort (0.454)?
Escort 0.078 -6.031 0.001 0.000
If the price of the
Demand Escort increases by 10
LS400 0.000 0.001 -3.085 0.032
%, the demand for
the Sentra will
735i 0.000 0.001 0.093 -3.515 increase by 4.54 %

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Elasticities of Demand for Coke and
Pepsi
Elasticity Coke Pepsi

Price -1.47 -1.55 What is the

elasticity of income elasticity
demand of demand of
Cross-price 0.52 0.64 Coke?
elasticity of
demand If income increases
Income 0.58 1.38 by 10%, the demand
elasticity of for coke will increase
demand by 5.8%.

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Long-run vs Short-run Elasticity
Crude Oil Example
Table 2.8

48
Back of the Envelope Calculations:
Estimating Supply and Demand
Functions
We can estimate Demand and Supply curves by:
1. Choose a general shape for functions (i.e. linear)
• Q=a-bP ( could have chosen constant elasticity)
2. Knowing:
• Own Price Elasticities
• Equilibrium Price
• Equilibrium Quantity

- Usually we would want to collect data and

estimate the model but this can be time
consuming and costly

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Back of the Envelope
Calculations Example

Suppose demand is linear: Qd = a-bP

Hence, elasticity is Q,P = -bP/Q

If we have data on , Q and P, we can calculate b

from elasticity equation and then calculate “a” by
substituting into demand.

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E.G: Broiler in the US, 1990

If…Qd = a – bP

Per capita consumption 70lbs/person

Price $.70/lb.
Q,P = -.55

What are a and b in the demand equation?

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Broiler Linear Demand Example

Q* = 70 P*= .7 elasticity = -.55

Using the definition of elasticity we solve for

b = -bP*/Q*  b = -Q*/P*

b = -(-.55(70/.7)) = 55

a = Q*+ bP*, sub in for b

a= Q* + (-Q*/P*)P* = (1- )Q*
a=[1-(-.55)]*70=108.5

Demand Function=> Qd = 108.5 – 55p

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Broiler: Constant Elasticity Example

If…Qd = Ap

Q,P = -.55
A = Qp- = 70(.7).55 = 57.53

=> Qd = 57.53P-.55

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Estimating Demand and Supply for a
Supply Shift

A shift in the supply curve reveals the

slope of the demand curve while a shift
in the demand curve reveals the slope
of the supply curve.

54
Example: Identifying demand by a shift in supply.

Price

So can figure
out b from
New Supply change in price
and change in
Old Supply quantity.
P2
•
P1 •
Market Demand

0 Q2 Q1
Quantity

55
-Suppose, then, that the supply curve shifts back.
Both the old equilibrium point (p1,Q1) and the new
equilibrium point (p2,Q2) lie on the same (linear)
demand curve. Therefore, if QD = a-bp,

b = Q/P = (Q2 – Q1)/(P2 – P1)

a = Q1 + bP1 (can use original price and
quantity to determine a).
Q = a + bP

56
-We can “identify” the slope of supply by a shift
in demand

-We can "identify" the slope of demand by a

shift in supply, similarly.

Make sure you go through the book example.

57
-This technique only works if one or the other of the
curves stays constant.
Price

Supply

Demand

0
Quantity
Example: Identifying demand when both curves shift
58
-This technique only works if one or the other of the
curves stays constant. Would estimate demand
incorrectly here.
Price

New Supply

P2 • Old Supply

P1 •
Old Demand

New Demand

0 Q 2 = Q1
Quantity
Example: Identifying demand when both curves shift
59