DEMAND, SUPPLY AND ELASTICITY

Overview
I. Market Demand Curve

The Demand Function Determinants of Demand Consumer Surplus

III. Market Equilibrium IV. Price Restrictions V. Comparative Statics

II. Market Supply Curve

The Supply Function Supply Shifters Producer Surplus

Market Demand Curve

Shows the amount of a good that will be purchased at alternative prices. Law of Demand
The

demand curve is downward sloping.

Price

Quantity

Determinants of Demand

Income Prices of substitutes Prices of complements Advertising Population Consumer expectations

The Demand Function

An equation representing the demand curve Qxd = f(Px , PY , M, H,)

quantity demand of good X. Px = price of good X. PY = price of a substitute good Y. M = income. H = any other variable affecting demand

Change in Quantity Demanded

10 6

D0
4 7 Quantity

Change in Demand
Price D0 to D1: Increase in Demand

6 D1

D0
7 13 Quantity

Market Supply Curve

The supply curve shows the amount of a good that will be produced at different prices. Law of Supply
The

supply curve is upward sloping

Price

S0

Quantity

Supply Shifters

Input prices Technology or government regulations Number of firms Substitutes in production Taxes Producer expectations

The Supply Function

An equation representing the supply curve: QxS = f(Px , PR ,W, H,)

quantity supplied of good X. Px = price of good X. PR = price of a related good W = price of inputs (e.g., wages) H = other variable affecting supply

Change in Quantity Supplied

20
A 10

10

Quantity

Change in Supply
Price
S0 to S1: Increase in supply S0 S1

6 5
7

Quantity

Market Equilibrium

Balancing supply and demand QxS = Qxd Steady-state

If price is too low

7 6

5 Shortage 12 - 6 = 6 6
12 D

Quantity

If price is too high

14

Quantity

Price Restrictions

Price Ceilings
The

maximum legal price that can be charged minimum legal price that can be charged.

Price Floors
The

Impact of a Price Ceiling

Ceiling Price
Shortage Q*

D Quantity

Qs

Qd

Impact of a Price Floor

P*

D Qd QS Quantity

Q*

Summary

Use supply and demand analysis to

the big picture (the general impact of a current event on equilibrium prices and quantities) organize an action plan (needed changes in production, inventories, raw materials, human resources, marketing plans, etc.)

PRICE, INCOME AND CROSS ELASTICITY

Elasticity the concept

The responsiveness of one variable to changes in another When price rises, what happens to demand? Demand falls BUT! How much does demand fall?

Elasticity the concept

If price rises by 10% - what happens to demand? We know demand will fall By more than 10%? By less than 10%? Elasticity measures the extent to which demand will change

Elasticity

4 basic types used: Price elasticity of demand Price elasticity of supply Income elasticity of demand Cross elasticity

Elasticity

Price Elasticity of Demand

responsiveness of demand to changes in price Where % change in demand is greater than % change in price elastic Where % change in demand is less than % change in price - inelastic

Elasticity
The Formula: Ped = % Change in Quantity Demanded ___________________________ % Change in Price

If answer is between 0 and -1: the relationship is inelastic If the answer is between -1 and infinity: the relationship is elastic
PED has sign in front of it; because as price rises demand falls and vice-versa (inverse relationship between price and demand)

Elasticity
Price (Rs.)
The demand curve can be a range of shapes each of which is associated with a different relationship between price and the quantity demanded.

Quantity Demanded

Elasticity
Price
Totalimportance of elasticity The revenue is price x quantity sold. In this is the information it example,on theRs.5 x on provides TR = effect 100,000 = Rs.500,000. in total revenue of changes

price. This value is represented by the grey shaded rectangle.

Rs .5

Total Revenue

D 100 Quantity Demanded (000s)

Elasticity
Price
If the firm decides to decrease price to (say) Rs.3, the degree of price elasticity of the demand curve would determine the extent of the increase in demand and the change therefore in total revenue.

Rs .5 Rs. 3

Total Revenue
D
100 140 Quantity Demanded (000s)

Elasticity
Price (Rs.) 10

Producer decides to lower price to attract sales

% Price = -50% % Quantity Demanded = +20% Ped = -0.4 (Inelastic) Total Revenue would fall

D
5 6
Quantity Demanded

Elasticity
Price (Rs.)

Producer decides to reduce price to increase sales % in Price = - 30% % in Demand = + 300% Ped = - 10 (Elastic) Total Revenue rises

10 7

Quantity Demanded

20

Elasticity

If demand is price elastic: Increasing price would reduce TR (% Qd > % P) Reducing price would increase TR (% Qd > % P)

If demand is price inelastic: Increasing price would increase TR (% Qd < % P) Reducing price would reduce TR (% Qd < % P)

Elasticity

Income Elasticity of Demand:

responsiveness of demand to changes in incomes

Normal Good demand rises as income rises and vice versa Inferior Good demand falls as income rises and vice versa

Elasticity

Income Elasticity of Demand:

Elasticity

For example: Yed = - 0.6: Good is an inferior good but inelastic a rise in income of 3% would lead to demand falling by 1.8% Yed = + 0.4: Good is a normal good but inelastic a rise in incomes of 3% would lead to demand rising by 1.2% Yed = + 1.6: Good is a normal good and elastic a rise in incomes of 3% would lead to demand rising by 4.8% Yed = - 2.1: Good is an inferior good and elastic a rise in incomes of 3% would lead to a fall in demand of 6.3%

Elasticity

Cross Elasticity: The responsiveness of demand of one good to changes in the price of a related good either a substitute or a complement
% Qd of good t __________________ % Price of good y

Xed =

Elasticity

Goods which are complements:

Elasticity will have negative sign (inverse relationship between the two) Elasticity will have a positive sign (positive relationship between the two)

Goods which are substitutes:

Elasticity

Price Elasticity of Supply:

Pes =

% Quantity Supplied ____________________ % Price

Determinants of Elasticity

Time period the longer the time under consideration the more elastic a good is likely to be Number and closeness of substitutes the greater the number of substitutes, the more elastic The proportion of income taken up by the product the smaller the proportion the more inelastic Luxury or Necessity - for example, addictive drugs

Importance of Elasticity

Relationship between changes in price and total revenue Importance in determining what goods to tax (tax revenue) Importance in analysing time lags in production Influences the behaviour of a firm