Demand & Supply

Dr. Alok Kumar Pandey

Dr. Alok Pandey

Agenda for Discussion

Equilibrium: Demand and Supply Change in the Equilibrium Elasticity Demand, types of elasticity, effect of elasticity on revenue, effect of time on elasticity Elasticity of Supply, effect of time on elasticity Income elasticity Cross elasticity

Dr. Alok Pandey

The Supply Function

Includes all variables that influence the quantity supply Q = f( P, Pa, C, Nf, T, PE .)
P is price of the good Pa is the price of alternative goods C is the input price Nf is number of firms, T Technological advancement 3 Dr. Alok Pandey PE is the expected future price

The Supply Curve

a) Price Move leftward along the supply curve

b) Price Move rightward along the supply curve

P1 P2 B

P2 P1 A

Q2 Q1

Q
Dr. Alok Pandey

Q1

Q2

Q
4

The Supply Curve

P S1 S2 Price of input Price of alternatives Number of firms Expected price Technological advance Favorable weather Q

c) The Supply curve shifts rightward

Dr. Alok Pandey

The Supply Curve

P
S2 S1 Price of input Price of alternatives Number of firms Expected price Unfavorable weather Q

d) The Supply curve shifts leftward

Dr. Alok Pandey

Supply and Demand

Equilibrium
both

P and Q have settled into a state of rest

Equilibrium price and quantity

once

achieved - remain constant until either the demand curve or supply curve shifts

Dr. Alok Pandey

Equilibrium
Price S E

3.00

1.00

D
25,000 50,000 75,000 Quantity

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Excess Demand

the amount by which quantity demanded exceeds quantity supplied - at a given price
Buyers

compete with each other to get more of the good than is available The price will rise Equilibrium is reached

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Excess Demand
Price

2. causes the price to rise . . .

S E 3. shrinking the excess demand until price reaches its equilibrium value of 3.00

3.00

1.00

Excess Demand 25,000 50,000 75,000

J D

1. At a price of 1.00 per Bottle, an excess demand of 50,000 units . . .

Quantity

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Excess Supply

the amount by which quantity supplied exceeds quantity demanded - at a given price
Sellers

compete with each other to sell more than buyers want The price will fall Equilibrium is reached

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Excess Supply
Price 1. At a price of 5.00 per bottle an excess supply of 30,000 units . . . Excess Supply 5.00 3. shrinking the excess supply . . . S

K
E

L 4. until price reaches its equilibrium value of 3.00

3.00

D
2. causes the price to drop 35,000 50,000
Dr. Alok Pandey

65,000

Quantity
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What Happens When Things Change

Income rises normal good the demand increases (rightward shift of the demand curve)

Rightward

movement along the supply curve Equilibrium price rises Equilibrium quantity rises
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Income rises, causing an increase in D

Price
4. equilibrium price increases 3. to a new equilibrium S 4.00 3.00 E E' 1. An increase in demand . . . 2. moves us along the supply curve

D2 D1
5. equilibrium quantity increases too 50,000 60,000
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Quantity
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What Happens When Things Change

Example - Weather changes will shift the supply curve

Decrease in supply (the supply curve shifts leftward)

Equilibrium

price rises Equilibrium quantity falls

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Bad weather hits, decreasing the S

Price S2 5.00 E'

S1

3.00

D 35,000 50,000
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Quantity
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Both Curves Shift

Just one curve shifts (D or S)

we

can determine the direction that BOTH equilibrium price AND quantity will move

Both curves shift (D and S)

we

can determine the direction that EITHER equilibrium price OR equilibrium quantity will move direction of the other which curve shifts by more

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Income rises and Bad weather hits

Price 6.00 S2 E'

S1

3.00

E D2 D1 Quantity
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Price Elasticity of Demand

Elasticity
Degree

of Responsiveness responsiveness to a change in

Price elasticity of demand

Consumers

price Percentage change in the quantity demanded divided by percentage change in price

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Price Elasticity of Demand

%q ED %p q p ED (q q' ) / 2 ( p p' ) / 2
Law of demand ED negative Absolute value of ED positive

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Computing the Price Elasticity of Demand

Example: If the price of an ice cream cone increases from Rs. 2.00 to Rs. 2.20 and the amount you buy falls from 10 to 8 cones, then your elasticity of demand would be calculated as:

(10 8) 100 20% 10 2 (2.20 2.00) 100 10% 2.00

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The Midpoint Method: A Better Way to Calculate Percentage Changes and Elasticities

The midpoint formula is preferable when calculating the price elasticity of demand because it gives the same answer regardless of the direction of the change.

(Q 2 Q1 ) / [(Q 2 Q1 ) / 2] Price elasticity of demand = (P2 P1 ) / [(P2 P1 ) / 2]

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The Midpoint Method: A Better Way to Calculate Percentage Changes and Elasticities

Example: If the price of an ice cream cone increases from Rs. 2.00 to Rs.2.20 and the amount you buy falls from 10 to 8 cones, then your elasticity of demand, using the midpoint formula, would be calculated as:

(10 8) 22% (10 8) / 2 2.32 (2.20 2.00) 9.5% (2.00 2.20) / 2

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Computing the Price Elasticity of Demand

(100 - 50)
Price

ED

(100 50)/2 (4.00 5.00)/2

(4.00 - 5.00)

5
4 Demand

67 percent -3 - 22 percent

50

100 Quantity

Demand is price elastic

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The Variety of Demand Curves on the basis of elasticity

Perfectly Inelastic
Quantity

demanded does not respond to price changes. demanded changes infinitely with any change in price. demanded changes by the same percentage as the price.
Dr. Alok Pandey

Perfectly Elastic
Quantity

Unit Elastic
Quantity
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The Variety of Demand Curves on the basis of elasticity

Inelastic Demand
Quantity

demanded does not respond strongly to price changes. Price elasticity of demand is less than one.

Elastic Demand
Quantity

demanded responds strongly to changes in price. Price elasticity of demand is greater than one.
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The Price Elasticity of Demand

(a) Perfectly Inelastic Demand: Elasticity Equals 0 Price Demand 5

4
1. An increase in price . . .

100

Quantity

2. . . . leaves the quantity demanded unchanged.

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The Price Elasticity of Demand

(b) Inelastic Demand: Elasticity Is Less Than 1

Price

5 4 Demand

90

100

Quantity

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The Price Elasticity of Demand

(c) Unit Elastic Demand: Elasticity Equals 1 Price

4
Demand

75

100

Quantity

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The Price Elasticity of Demand

(d) Elastic Demand: Elasticity Is Greater Than 1

Price

5 4 Demand

50

100

Quantity

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The Price Elasticity of Demand

(e) Perfectly Elastic Demand: Elasticity Equals Infinity Price 1. At any price above 4, quantity demanded is zero. 4 2. At exactly 4, consumers will buy any quantity. Demand

0 3. At a price below 4, quantity demanded is infinite.

Dr. Alok Pandey

Quantity

31

Total Revenue and the Price Elasticity of Demand

Total revenue is the amount paid by buyers and received by sellers of a good. Computed as the price of the good times the quantity sold.

TR = P x Q

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Total Revenue
Price

P Q = 400 (revenue)

Demand

0 Q

100
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Quantity
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Elasticity and Total Revenue along a Linear Demand Curve

With a relatively inelastic demand curve, an increase in price leads to a decrease in quantity that is proportionately smaller. Thus, total revenue increases.

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How Total Revenue Changes When Price Changes: Inelastic Demand

Price An Increase in price from 1 to 3

Price leads to an Increase in total revenue from 100 to 240

Revenue = 240 1 Revenue = 100 0 100 Demand Quantity 0 80 Demand Quantity

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Elasticity and Total Revenue along a Linear Demand Curve

With an elastic demand curve, an increase in the price leads to a decrease in quantity demanded that is proportionately larger. Thus, total revenue decreases.

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How Total Revenue Changes When Price Changes: Elastic Demand

Price
An Increase in price from 4 to 5

Price
leads to an decrease in total revenue from 200 to 100

5
4 Demand Revenue = 200 Revenue = 100 Demand

50

Quantity

20

Quantity

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Copyright2003 Southwestern/Thomson Learning

Summary of price elasticity of demand :Effects of a 10 percent increase in price

Absolute value of price elasticity Type of demand ED = 0 What happens to quantity demanded What happens to total revenue Increases by 10 percent Increases by less than 10 percent

Perfectly inelastic No change

0 < ED < 1

Inelastic

Drops by less than 10 percent

ED = 1 1 < ED <

Unit elastic Elastic

Drops by 10 percent No change Drops by more than 10 percent Drops to 0 Decreases

ED =

Perfectly elastic

Drops to 0
38

Dr. Alok Pandey

Determinants of Price Elasticity of Demand

ED is greater:
The

greater the availability of substitutes, and the more similar the substitutes The more important the good as a share of the consumers budget The longer the period of adjustment (time)

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Demand becomes more elastic over D : one week after the price increase time
w

Dm: one month after the price increase

Price per unit 1.25

Dy: one year after the price increase

e

1.00

Dw

Dm

Dy

50

75 95 100

Quantity per day

40

Dy is more elastic than Dm , which is more elastic than Dw

Dr. Alok Pandey

Elasticity Estimates

Short run
Consumers

have little time to adjust can fully adjust to a price change

Long run
Consumers

Demand is more elastic in the long run

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Selected price elasticities of D (absolute values)

Product Electricity (residential) Air travel Medical care and hospitalization Gasoline Milk Fish (cod) Wine Movies Natural gas (residential) Automobiles Short run 0.1 0.1 0.3 0.4 0.4 0.5 0.7 0.9 1.4 1.9 Long run 1.9 2.4 0.9 1.5 1.2 3.7 2.1 2.2

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Price Elasticity of Supply

Elasticity
Responsiveness

Price elasticity of supply

Producers

responsiveness to a change in

price Percentage change in quantity supplied divided by percentage change in price

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Price Elasticity of Supply

%q ES %p q p ES (q q' ) / 2 ( p p' ) / 2

Law of supply ES positive

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Price elasticity of supply

S Price per unit p

If the price increases from p to p, the quantity supplied increases from q to q. Price and quantity supplied move in the same direction, so the price elasticity of supply is a positive number.

Quantity per period

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Categories of ES

If %q < %p
ES

between 0 and 1 Less elastic S

If %q > %p
ES

greater than 1 Elastic S

If %q = %p
ES

=1 Unit elastic S

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Elasticity Supply Curves

Perfectly elastic S curve

ES = Producers supply 0 at a price below P
Horizontal;

Perfectly inelastic S curve

Vertical;

ES = 0 Goods in fixed supply

Unit-elastic S curve
%p causes an exact opposite %q S curve starts from the origin.

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Elasticity supply curves

(a) Perfectly elastic
Price per unit

(b) Perfectly inelastic

Price per unit

(c) Unit elastic

Price per unit ES = 1
S

ES = 0
10

ES =
S

Quantity per period

Quantity per period

10

20

Quantity per period

Firms supply any amount of output demanded at p, but supply 0 at prices below p.

Quantity supplied is independent of the price

Dr. Alok Pandey

Any %p results in the same %q supplied.

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Supply becomes more elastic over time

Sw Sm
Sy 1.25 Price per unit

Sw: one week after the price increase

1.00

Sm: one month after the price increase Sy: one year after the price increase

100 110 140

200

Quantity per day

Sw is less elastic than Sm , which is less elastic than Sy

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Income Elasticity of Demand

Demand responsiveness to a change in consumer income Percentage change in demand divided by the percentage change in income.

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Selected income elasticities of demand

Product
Wine Private education Automobiles Owner-occupied housing Furniture Dental service Restaurant meals Spirits (hard liquor) Shoes Chicken Clothing Income Elasticity 5.03 2.46 2.45 1.49 1.48 1.42 1.40 1.21 1.10 1.06 0.92

Product
Physicians services Coca-Cola Beef Food Coffee Cigarettes Gasoline and oil Rental housing Pork Beer Flour

Income Elasticity 0.75 0.68 0.62 0.51 0.51 0.50 0.48 0.43 0.18 -0.09 -0.36

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Cross-Price Elasticity of Demand

Responsiveness of D for one good to changes in P of another good % in demand for one good divided by % in price of another good

If

positive: substitutes If negative: complements If zero: unrelated

52

Dr. Alok Pandey

Price Elasticity and Tax Incidence

Tax
Decrease

in S by the amount of tax

Tax incidence
Consumers

: high P Producers: net-of-tax receipt

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Price Elasticity and Tax Incidence

The more price elastic the D:

The

more tax producers pay The less tax consumers pay

The more elastic the S:

The

less tax producers pay The more tax consumers pay

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Effects of price elasticity of D on tax incidence

(a) Less elastic demand
St 1.15 1.00 0.95

(b) More elastic demand

0.20 Tax St

S
0.20 Tax

1.05 1.00 0.85

S
D

Price

D 0 9 10

Millions of ounces per day

Price

10

The more elastic the D curve, the more tax is paid by producers (lower net-of-tax receipt) Dr. Alok Pandey

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Effects of price elasticity of S on tax incidence

(a) More elastic supply
0.20 Tax St

(b) Less elastic supply

St S

1.15

1.00 0.95

S
D

1.05 1.00 0.85

0.20 Tax

D
Price

Price 0

10

quantity

9 10

The more elastic the S curve, the more tax is paid by consumers as a higher price.
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Bandwagon Effect
Individual demand is influenced by number of other households consuming a commodity The greater the number of households consuming a commodity Key to marketing most toys and clothing is to create a bandwagon effect Results in market demand curve shifting outward

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Some instances where the law of demand does not hold good
Giffen Goods: Example: when the price of bread increase consumer curtailed their consumption of meat.
Veblen effect: Example: when the rise in price take place , consumer may be misguided to think that quality improved. Expectation
Example:

of rise in price: Share Market:

Price of particular share rise its demand will also increased.
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