Demand and Supply CurvesEquilibrium in the MarketGovernment Interventions1 1 Demand and Supply Curves 14.01 Principles of Microeconomics, Fall 2007 Chia-Hui Chen September 7, 2007 Lecture 2 The Basics of Supply and Demand ⎧ ⎫ BUYERS =⇒ DEMAND ⎪ ⎪ ⎪ ⎪ ⎨ ⎬ MARKET EQUILIBRIUM ⎪ ⎪ ⎪ ⎪ ⎩ SELLERS =⇒ SUPPLY ⎭ Outline 1. Chap 2: Demand and Supply Curves 2. Chap 2: Equilibrium in the Market 3. Chap 2: Government Interventions 1 Demand and Supply Curves Quantity Demanded and Quantity Supplied QD (Quantity demanded). Depends on price. QD = D(P ). (1.1) QS (Quantity supplied). Depends on price. QS = D(P ). (1.2) Notes: 1. Market demand/supply is the sum of individual demands/supplies. 2. Assume individuals are price takers who cannot affect price. Demand and Supply Curves From Equations (1.1) and (1.2), draw demand curves and supply curves as follows: Cite as: Chia-Hui Chen, course materials for 14.01 Principles of Microeconomics, Fall 2007. MIT OpenCourseWare (http://ocw.mit.edu), Massachusetts Institute of Technology. Downloaded on [DD Month YYYY].2 Figure 1: Supply curve. Price higher, Figure 2: Demand curve. Price quantity supplied more. higher, quantity demanded less. Figure 3: Shift in supply curve. Figure 4: Shift in demand curve. Cite as: Chia-Hui Chen, course materials for 14.01 Principles of Microeconomics, Fall 2007. MIT OpenCourseWare (http://ocw.mit.edu), Massachusetts Institute of Technology. Downloaded on [DD Month YYYY].2 Equilibrium in the Market 3 Supply curve See Figure 1 and Figure 3: 1. Change in price causes change in quantity supplied, on the graph, there is movement along the curve accordingly. 2. Change in something other than price causes change in supply, on the graph, the supply curve shifts. Example. Production cost falls → supply curve S shifts to S’ (See Fig-ure 3). Demand curve See Figure 2 and Figure 4: 1. Change in price causes change in quantity demanded, on the graph, there is movement along the curve accordingly. 2. Change in something other than price causes change in demand, on the graph, the demand curve shifts. Example. People’s income increases → demand curve D shifts to D’ (Fig-ure 4). Substitutes and Complements Substitutes. Increase in the price leads to an increase in the demand of the other. Example (It alian and French bread). Price of Italian bread increases, de-mand of French bread increases. Complements. Increase in the price leads to a decrease in t he demand of the other. Example (Pasta and pasta sauce). Price of pasta increases, demand of pasta sauce decreases. 2 Equilibrium in the Market Equilibrium state: • No shortage • No surplus • Equilibrium price clears the market. Cite as: Chia-Hui Chen, course materials for 14.01 Principles of Microeconomics, Fall 2007. MIT OpenCourseWare (http://ocw.mit.edu), Massachusetts Institute of Technology. Downloaded on [DD Month YYYY].4 Figure 5: Demand and Supply curves. Equilibrium state. Refer to Figure 5. (P0, Q0) is the equilibrium state, which is the intersect ion point of the demand and supply curves. Supply Price Change in =⇒ Change in equilibrium Demand Quantity Surplus and Shortage Surplus. Price P1 is higher than P0 and will fall dow n. Shortage. Price P2 is lower than P0 and will raise up. Comparative Static Analysis and Comparative Dynamics Comparative static analysis. Compares the new and old equilibrium and not the actual path through time of the change. Comparative dynamic analysis. Traces out the pat h over time. This course will cover primarily Comparative Static analysis. Cite as: Chia-Hui Chen, course materials for 14.01 Principles of Microeconomics, Fall 2007. MIT OpenCourseWare (http://ocw.mit.edu), Massachusetts Institute of Technology. Downloaded on [DD Month YYYY].5 3 Government Interventions Figure 6: Decrease in raw material prices. Examples Example (Decrease in raw material prices). Raw material prices �→ Supply �→ Price � and Quantity � (Figure 6). Example (Increase in income). Income �→ Demand�→ Price � and Quantity � (Figure 7). Dual shifts in supply and demand When supply and demand change simultaneously, the impact on the equilibrium price and quantity is determined by the size and direction of the changes and the slope of two curves. 3 Government Interventions How can government help sellers? Discuss two methods. Problem Description Assume that QD = 10 − P, QS = −2 + P. Cite as: Chia-Hui Chen, course materials for 14.01 Principles of Microeconomics, Fall 2007. MIT OpenCourseWare (http://ocw.mit.edu), Massachusetts Institute of Technology. Downloaded on [DD Month YYYY].6 Figure 7: Increse in income. The original equilibrium point is P0 = 6, QD0 = QS0 = 4, and the revenue before government intervention is: REV EN UE = P0 × QD0 = 6 × 4 = 24. The government’s goal: increase sellers’ revenue. Price Floor The first method: set a price floor. Assume the lowest price is set to be 8, thus: QD = 2, QS = 6. The revenue after using method 1 is: REVENUE = P × QD = 8 × 2 = 16 < 24. Cite as: Chia-Hui Chen, course materials for 14.01 Principles of Microeconomics, Fall 2007. MIT OpenCourseWare (http://ocw.mit.edu), Massachusetts Institute of Technology. Downloaded on [DD Month YYYY].7 3 Government Interventions Subsidy The second method: provide subsidy. Customers get a 2 unit price refund per unit quantity bought, thus the quantity demanded changes: QD = 10 − (P − 2) = 12 − P. The new intersection point is P = 7, QD = QS = 5. The revenue after using method 2 is: REVENUE = P × QD = 7 × 5 = 35 > 24. For this example, providing subsidies achieves the government’s goal to increase seller’s revenue, but setting price floor does not and even makes the revenue less. Cite as: Chia-Hui Chen, course materials for 14.01 Principles of Microeconomics, Fall 2007. MIT OpenCourseWare (http://ocw.mit.edu), Massachusetts Institute of Technology. Downloaded on [DD Month