ECON 100 Lecture 12 Wednesday, March 13

Announcements PS #4 is posted on web page. It is big and not all questions are very easy. It is time to start studying. PS#5 will be even bigger. (also more challenging) A sample exam will be posted on webpage next week, and possibly more study questions for the exam. Email me to set up an office hour appointment (for study help)

Review Equilibrium refers to a situation in which the price has reached the level where quantity supplied equals quantity demanded. Equilibrium Price The price at which quantity supplied equals quantity demanded. On a graph, it is the price at which the supply and demand curves intersect. Equilibrium Quantity The quantity supplied and the quantity demanded at the equilibrium price. 36

Terms you need to know: Shortage (excess demand): quantity demanded > quantity supplied Surplus (excess supply): quantity supplied > quantity demanded The market price of any good adjusts to bring the quantity supplied and the quantity demanded for that good into balance.

The equilibrium in the ice-cream market Demand Schedule Supply Schedule At $2.00, quantity demanded = quantity supplied The equilibrium price is Pe = $2.00. The equilibrium quantity is Qe = 7 units. 36

Same thing with equations The equation for the market demand is QD = 19 – 6P The equation for the market supply is QS = –5 + 6P, if P ≥ 5/6, QS = 0 if P < 5/6 Let’s compute the equilibrium price and quantity. QD = QS (this means demand equals supply) 19 – 6P = –5 + 6P Solve for P: 24 = 12P  Pe = 2 To compute the equilibrium quantity, substitute 2 for P in the demand (or the supply) equation: Qe = 19 – 6(2) = 7.

Same thing with the supply and demand graph Price of Demand: QD = 19 – 6P Supply: QS = –5 + 6P, (if P ≥ 5/6) Ice-Cream 3.17 Demand Supply 2.00 7 5/6 19 Quantity of Ice-Cream Copyright©2003 Southwestern/Thomson Learning

Changes in the market equilibrium How do equilibrium price and quantity change when the supply of demand change?

Analyzing Changes in Equilibrium: The three steps method 0. Something (an event) happens: e.g., a meteor hits the earth. Decide whether the event shifts the supply or demand curve. Decide whether the curve shifts to the left or to the right. Use the supply-and-demand diagram to see how the shift affects equilibrium price and quantity. 45

Figure 10 How an Increase in Demand Affects the Equilibrium 1. News says that regular consumption of vanilla ice-cream reduces cardiovascular diseases Price of Ice-Cream Cone D D Supply New equilibrium $2.50 10 2. . . . resulting in a higher price . . . 2.00 7 Initial equilibrium Excess demand at P = 2 12 Quantity of 3. . . . and a higher quantity sold. Ice-Cream Cones Copyright©2003 Southwestern/Thomson Learning

This is what prices do: Prices communicate information Demand rises: people want more ice-cream. There must be more production to meet the higher demand. How can you convince/make the sellers supply more? They are self interested, they need higher prices to work harder and supply more. So. The price must rise to create more supply (raise the quantity supplied) The “demand-induced-higher-price” is a message from the buyers to the sellers: We want more ice-cream.

This is how the ice-cream produces learn the relative desirability (consumption value, benefit to consumers etc) of ice-cream: they learn it through its higher price. Prices act as signals that guide the allocation of scarce resources in a market economy.

One more example A supply shift

Figure 11 How a Decrease in Supply Affects the Equilibrium Price of 1.There is an increase in the price of sugar (a major input In the production of ice cream) Ice-Cream Cone Excess demand, shortage S2 S1 Demand New equilibrium $2.50 4 2. . . . resulting in a higher price of ice cream . . . Initial equilibrium 2.00 7 Quantity of 3. . . . and a lower quantity sold. Ice-Cream Cones Copyright©2003 Southwestern/Thomson Learning

Again, prices communicate Ice-cream production is now more costly. Demand must be reduced. How can you make the buyers reduce their consumption? They are self interested, they respond to prices: Higher prices will make them consume less. As the price of ice-cream rises, buyers will reduce their quantity demanded and substitute towards other goods. Buyers find out about the relative scarcity of a good through its price. Each individual buyer then decides what to do him/herself; decision making is decentralized.

A “real world” application

The food vs. fuel dilemma A study in demand and supply

The Food vs. fuel dilemma is about using farmland or crops for bio-fuels production (mostly ethanol) so as to threaten the food supply on a global scale. There is discussion about how significant the issue is, what is causing it, and what can be done about it.

But a fair statement of the issue would be that.. The main problem with subsidizing the production of ethanol (bio-fuel) from corn is that it is causing people in low-income countries to go hungry.

A few fact (from wiki!) From 1974 to 2005 food prices (adjusted for inflation) dropped by 75%. Prices were stable after reaching lows in 2000 and 2001. Prices sharply increased in 2005 despite record production levels worldwide. From January 2005 until June 2008, maize prices almost tripled, wheat increased 127 percent, and rice rose 170 percent. MAIZE (looks like corn)

This is Paul Bulcke, chief executive of Nestlé He says that US and EU must change biofuel targets to avert food crisis. Nestlé, the world's largest food company, has added its weight to calls by the UN and development groups for the US and EU to change their bio-fuel targets because of food shortages and price rises. http://www.guardian.co.uk/global-development/2012/sep/04/us-eu-biofuel-food-crisis-nestle This is Paul Bulcke, chief executive of Nestlé "We say no food for fuel," said Paul Bulcke, chief executive of Nestlé, at the end of the World Water Week conference in Sweden. "Agricultural food-based bio-fuel is an aberration. We say that the EU and US should put money behind the right bio-fuels."

This form Guardian Sept 2012 Under laws intended to reduce foreign oil imports, 40% of US maize (corn) harvest must be used to make bio-fuels, even though one of the deepest droughts in the past 100 years is expected to reduce crop yields significantly. In addition, EU countries are expected to move towards drawing 10-20% of their energy supply for transport from bio-fuels to reduce carbon emissions.

More facts

Cost for developing countries Source http://www.ase.tufts.edu/gdae/Pubs/rp/ActionAid_Fueling_Food_Crisis.pdf

All scarce goods must be rationed! Food vs. bio-fuel debate: a simple numerical example

INDIVIDIAL P demand supply 1 5 2 4 3 6 Imagine a competitive markets with 4 buyers and 3 sellers. MARKET P demand supply 1 5X4=20 0X3=0 2 4X4=16 2X3=6 3 3X4=12 4X3=12 4 2X4=8 6X3=18 The equilibrium price is P = 3. each consumer buys 3 units. Each seller produces 4 units.

Now, a big buyer comes into the market! P DEMAND 1 16 2 14 3 12 4 10 The equilibrium price is P = 4. The 3 buyers buy 2 units each, and pay a higher price. Each seller produces 6 units. MARKET P demand supply 1 20+16 2 16+14 6 3 12+12 12 4 8+10 18 The new market demand is the sum of the 3 buyers and the newly arrived big buyer.

Now you try

The three step approach 1 The three step approach 1. Decide whether the event shifts the supply or demand curve (or both). 2. Decide whether the curve(s) shift(s) to the left or to the right. 3. Use the supply-and-demand diagram to see how the shift affects equilibrium price and quantity. The price of coal fell and the quantity sold also fell. Everything else being equal, which of the following three events could be the reason: (A.) Decrease in the price of oil (oil and coal are substitutes). (B.) Large increase in the wages of coal miners. Please draw one well-labeled demand supply graph for each event to say yes or no for each.

Now we start something new

The price elasticity of demand

Elasticity and Its Applications 5 Elasticity and Its Applications

Elasticity and applications The law of demand: As the price of a good rises the quantity demanded falls. But how much does it fall? Will there be a large decrease in quantity? Or a small decrease? How responsive is demand to changes in the price?

The price elasticity of demand Price elasticity of demand is a “measure” of how responsive the quantity demanded is to a change in price.

More generally… Elasticity is a measure of the responsiveness of quantity demanded or quantity supplied to one of its determinants.

…has no effect on the quantity demanded. Case 1 Price Demand 100 $5.00 $4.00 An increase in price… Quantity …has no effect on the quantity demanded.

Case 2 Demand 50 100 $11 $10 a small increase in price… 50 100 Quantity leads to a large decrease in quantity demanded.

Elasticity of Demand Price Inelastic Demand … Causes a Small Decrease in Quantity Demanded if Demand is Inelastic $50 A Price Increase 75 Elastic Demand … Causes a Big Decrease in Quantity Demanded if Demand is Elastic 20 $40 80 Instructor Notes: Figure 4.1: The Same Price Increase Causes a Big Decrease in Quantity Demanded if Demand is Elastic, and a Small Decrease in Quantity Demanded if the Demand Curve is Inelastic Students should note that elastic demand curves are relatively flat while inelastic demand curves are relatively steep. However, it is important that students do not confuse elasticity and slope. They are not the same! Footnote 3 in the text has a nice mathematical presentation of this point. Quantity The More Responsive Quantity Demanded is to a Change in Price, the More Elastic is the Demand Curve

What makes the demand more elastic? Demand tends to be more elastic if, … If there are close substitutes. If the market is more narrowly defined (food versus milk). If we consider a longer time period after the price change. If the good is a luxury. (Necessities have inelastic demand)

Substitutes? When the patent expires on a brand-name drug and 5 generic drugs come on the market. As a result, the elasticity of demand… rises falls

Demand for fresh fruits vs demand for green apples The classification of the good matters. The more broad (general) the classification, the fewer substitutes there are and this makes demand inelastic. e.g. the elasticity of demand is higher for “lettuce” than for “food.” vs. Instructor Notes:

Time is on our side… The time horizon matters. Less time to adjust means lower elasticity Over time consumers can adjust their behavior by finding substitutes (making demand more elastic). Instructor Notes:

Luxuries vs. necessities The nature of the good to the consumer can also affect the elasticity of demand. For necessities, we do not change Q much when P changes For luxuries, we are more sensitive to P changes Instructor Notes: vs.

Computing the Price Elasticity of Demand, EP The measure of responsiveness of quantity demanded to a change in price in a given situation is quantified in a single number EP that is computed as… The percentage change in quantity demanded divided by the percentage change in price.

Computing the Price Elasticity of Demand The formula: The example: When the price of ice cream is ₺2, quantity demanded is 10 units (cones of ice-cream). When the price is ₺2.20, the quantity demanded is 8 units. Compute your elasticity of demand at P = ₺2:

Computing the EP Price = ₺2.00, QD = 10 Price = ₺2.20, QD = 8 Change in price is +0.20 % change in price is +(0.20/2)x100 = +10 Change in QD is –2. % change in QD is –(2/10)x100 = –20. EP = –20/10 = –2.

End of lecture