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Chapter 2 Demand and Supply Analysis: 

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 Outline

Example: Oil Market: 

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 Example: Oil Market Crude oil prices 1947 – 2004 OPEC oil production Some experts predict that prices will rise to 100

Example: Oil Market (cont’d): 

Example: Oil Market (cont’d) How could we bring prices down? Reduce Demand – short run? Find new reserves Develop new technologies that are not reliant on oil These become more feasible as oil prices rise

Competitive Markets: 

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. Competitive Markets

Competitive Market Assumptions: 

Competitive Market Assumptions Fragmented market: many buyers and sellers Implies buyers and sellers are price takers Undifferentiated Products: consumers perceive the product to be identical so don’t care who they buy it from Perfect Information about price: consumers know the price of all sellers 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

Slide7: 

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)

Slide8: 

0 Quantity (millions of automobiles per year) Price (thousands of dollars) Demand curve for automobiles in the United States in 2000 53 5.3 The Demand for New Automobiles in The United States 40 2

Note:: 

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.

Law of Demand: 

Empirical regularity states that the quantity of a good demanded decreases when the price of this good increases. If the change increases the willingness of consumers to acquire the good, the demand curve shifts right The demand curve: shifts when factors other than own price change… If the change decreases the willingness of consumers to acquire the good, the demand curve shifts left Law of Demand

Some Demand Shifters: 

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.

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. Rule

Slide13: 

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, …) Plots the aggregate quantity of a good that will be offered for sale at different prices. Qs= Q(P) Po = price of other goods

Slide14: 

Example: Supply Curve for Wheat in Canada

Slide15: 

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

Supply Shifters: 

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?

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. Rule

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) Example: Canadian Wheat

Slide19: 

QS = p + .05r 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)

Slide20: 

Price ($) Quantity, Billion bushels 0 r = 0 Supply with no rain QS = p + .05r

Slide21: 

QS = p + .05r

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) Market Equilibrium

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 Example: Finding Equilibrium Price and Quantity The Market for Cranberries

Slide24: 

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 plug equilibrium price into either demand or supply to get equilibrium quantity: Q* =100

Slide25: 

Example: The Market For Cranberries Price Quantity Market Supply: P = 50 + QS/2 50 Price Quantity Market Demand: P = 125 - Qd/4 Market Supply: P = 50 + QS/2 125 Q* = 100 P* = 100 Equilibrium

Elasticity: 

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.

Elasticity is not 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 unit less 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 $ Elasticity is not Slope

Slide28: 

Price Elasticity of Demand for Selected Grocery Products, Chicago, 1990s

Elasticity Continued: 

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.

Types of Elasticity: 

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)

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 Example: Linear Demand Curve

Slide32: 

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.

Slide33: 

0 P Q a/2 a a/2b a/b • Q,P = -1 Inelastic region Elastic region Q,P = - Q,P = 0 Example: Elasticity with a Linear Demand Curve

Example: Determining Elasticity: 

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.

Slide35: 

Example: Constant Elasticity Demand Curve Qd = Ap  = 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? This is how the demand function looks in general Q=100P-1 , so elasticity is -1

Slide36: 

Example: A Constant Elasticity versus a Linear Demand Curve

Elasticity Continued: 

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.

How Elastic are these Curves?: 

How Elastic are these Curves? P Q D1 D2 Perfectly Elastic Perfectly Inelastic P1 Q2

What Affects Elasticity?: 

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

Elasticity Continued: 

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.

Importance of Brands: 

Example: Price Elasticities of Demand for Automobile Makes, 1990. Importance of Brands Demand for individual models is highly elastic Market-level price elasticity of demand for automobiles -1 to -1.5 Compact automobiles have lots of substitutes Luxury cars have less substitutes Demand for compact cars more elastic than luxury cars.

Slide42: 

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, have a certain kind of heating system. Takes time to move to smaller cars and solar panels

Slide43: 

Price ($/airplane) Quantity (aircraft/yr) Example: Demand for Commercial Aircraft Which demand curve is the short-term and which long-term?

Slide44: 

Price ($/airplane) Quantity (aircraft/yr) Long run demand curve for commercial airplanes Short run demand curve for commercial airplanes Example: Demand for Commercial Aircraft

Slide45: 

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

The Cross-Price Elasticity of Cars: 

If the price of the Escort increases by 10 %, the demand for the Sentra will increase by 4.54 % What is the cross price elasticity of demand of the Sentra with respect to Escort (0.454)? The Cross-Price Elasticity of Cars Demand Price

Elasticities of Demand for Coke and Pepsi: 

What is the income elasticity of demand of Coke? If income increases by 10%, the demand for coke will increase by 5.8%. Elasticities of Demand for Coke and Pepsi

Long-run vs Short-run Elasticity Crude Oil Example: 

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

Back of the Envelope Calculations: Estimating Supply and Demand Functions: 

We can estimate Demand and Supply curves by: Choose a general shape for functions (i.e. linear) Q=a-bP ( could have chosen constant elasticity) Knowing: Own Price Elasticities Equilibrium Price Eqilibrium Quantity Usually we would want to collect data and estimate the model but this can be time consuming and costly Back of the Envelope Calculations: Estimating Supply and Demand Functions

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. Back of the Envelope Calculations Example

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? E.G: Broiler in the US, 1990

Broiler Linear Demand Example: 

Q* = 70 P*= .7 elastiticty = -.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 Broiler Linear Demand Example

Broiler: Constant Elasticity Example: 

If…Qd = Ap Q,P = -.55 A = Qp- = 70(.7).55 = 57.53 => Qd = 57.53P-.55 Broiler: Constant Elasticity Example

Estimating Demand and Supply for a Supply Shift: 

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.

Slide55: 

Quantity Price 0 Market Demand New Supply Q2 • • Q1 Old Supply P2 P1 Example: Identifying demand by a shift in supply. So can figure out b from change in price and change in quantity.

Slide56: 

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

Slide57: 

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.

Slide58: 

Quantity Price 0 Demand Supply This technique only works if one or the other of the curves stays constant. Example: Identifying demand when both curves shift

Slide59: 

Quantity Price 0 Old Demand New Supply Q2 = • • Q1 Old Supply P2 P1 New Demand This technique only works if one or the other of the curves stays constant. Would estimate demand incorrectly here. Example: Identifying demand when both curves shift