Supply and Demand Chapter 2 Lecture Outline Math Review Chapter 2 Supply and Demand Market Equilibrium Elasticities Basics of Supply and Demand Model of Supply and Demand Economic Model designed to explain how prices are determined in certain types of markets The Demand Curve demand curve Relationship between the quantity of a good that consumers are willing to buy and the price of the good We can write this relationship between quantity demanded and price as an equation QD QD P The Demand Curve Law of demand the claim that the quantity demanded of a good falls when the price of the good rises other things equal Demand Curve Shifters The demand curve shows how price affects quantity demanded other things being equal These other things are non price determinants of demand i e number of buyers income price of related goods taste expectations Changes in them shift the D curve ACTIVE LEARNING 1 Demand Curve Draw a demand curve for music downloads What happens to it in each of the following scenarios Why A The price of iPods falls B The price of music downloads falls C The price of CDs falls The Supply Curve supply curve Relationship between the quantity of a good that producers are willing to sell and the price of the good We can write this relationship as an equation QS QS P The Supply Curve Law of supply the claim that the quantity supplied of a good rises when the price of the good rises other things equal Supply Curve Shifters The supply curve shows how price affects quantity supplied other things being equal These other things are nonprice determinants of supply i e input prices technology number of sellers Changes in them shift the S curve ACTIVE LEARNING 2 Supply Curve Draw a supply curve for tax return preparation software What happens to it in each of the following scenarios A Retailers cut the price of the software B A technological advance allows the software to be produced at lower cost C Professional tax return preparers raise the price of the services they provide 11 Market Equilibrium Supply and Demand The market clears at price P0 and quantity Q0 At the higher price P1 a surplus develops so price falls At the lower price P2 there is a shortage so price is bid up Changes in Market Equilibrium New Equilibrium Following Shift in Supply When the supply curve shifts to the right the market clears at a lower price P3 and a larger quantity Q3 Changes in Market Equilibrium New Equilibrium Following Shift in Demand When the demand curve shifts to the right the market clears at a higher price P3 and a larger quantity Q3 Changes in Market Equilibrium Consumption and the Price of Copper Although annual consumption of copper has increased about a hundredfold the real inflationadjusted price has not changed much A scenario You You design design websites websites for for local local businesses businesses You You charge charge 200 200 per per website website and and currently currently sell sell 12 12 websites websites per per month month Your Your costs costs are are rising rising including including the the opportunity opportunity cost cost of of your your time time so so you you consider consider raising raising the the price price to to 250 250 The The law law of of demand demand says says that that you you won t won t sell sell as as many many websites websites ifif you you raise raise your your price price How How many many fewer fewer websites websites How How much much will will your your revenue revenue fall fall or or might might itit increase increase Elasticities of Supply and Demand elasticity Percentage change in one variable resulting from a 1 percent increase in another price elasticity of demand Percentage change in quantity demanded of a good resulting from a 1 percent increase in its price Elastic vs Inelastic Demand Type of Elasticity Relatively elastic E 1 Airline travel long run Fresh fish New cars short run Unitary elastic E 1 Private education Radios and televisions Shoes Relatively inelastic E 1 Cigarettes Coffee Gasoline short run Long distance telephone calls Estimate 2 4 2 2 1 2 1 5 1 1 1 2 0 9 0 4 0 3 0 2 0 1 Elasticities of Supply and Demand Linear Demand Curve The price elasticity of demand depends not only on the slope of the demand curve but also on the price and quantity The elasticity therefore varies along the curve as price and quantity change Slope is constant for this linear demand curve Near the top because price is high and quantity is small the elasticity is large in magnitude The elasticity becomes smaller as we move down the curve Calculating Percentage Changes Standard method of computing the percentage change Demand for your websites end value start value x 100 start value P 250 B Going from A to B the change in P equals A 200 D 8 12 Q 250 200 200 25 Calculating Percentage Changes Demand for your websites P 250 B A 200 8 12 Problem The standard method gives different answers depending on where you start From A to B P rises 25 Q falls 33 elasticity 33 25 1 33 From B to A D P falls 20 Q rises 50 Q elasticity 50 20 2 50 Calculating Percentage Changes midpoint method arc elasticity end value start value x 100 midpoint The midpoint is the number halfway between the start end values the average of those values It doesn t matter which value you use as the start and which as the end you get the same answer either way Calculating Percentage Changes Using the midpoint method the change in P equals 250 200 x 100 22 2 225 The change in Q equals 12 8 x 100 40 0 10 The price elasticity of demand equals 40 22 2 1 8 We will still use the former point elasticity unless otherwise stated What determines price elasticity To learn the determinants of price elasticity we look at a series of examples Each compares two common goods In each example Suppose the prices of both goods rise by 20 The good for which Qd falls the most in percent has the highest price elasticity of demand Which good is it Why What lesson does the example teach us about the determinants of the price elasticity of demand EXAMPLE 1 Breakfast cereal vs Sunscreen The prices of both of these goods rise by 20 For which good does Qd drop the most Why Breakfast cereal has close substitutes e g pancakes Eggo waffles leftover pizza so buyers can easily switch if the price rises Sunscreen has no close substitutes so consumers would probably not buy much less if its price rises Lesson Price elasticity is higher when close substitutes are available EXAMPLE 2 Blue Jeans vs Clothing The prices of both