Chapter 2: The Basics of Supply and Demand Eco 100 Chapter 2: The Basics of Supply and Demand

Demand and Supply With Demand and Supply we are dealing with a Market for a good or commodity. Simplify the Market to 2 Axis. Vertical Axis for: Price Horizontal Axis for: Quantity

The law of Demand The law states that consumers will buy more of a commodity at lower price and fewer at higher prices, all other things being equal. In other words, this law is in most cases valid if all other things (like income, taste, price of other goods, etc) that may affect the consumer’s preference, keep unchanged.

Demand Curve

Demand Curve The Demand curve has a Downward slope. The Demand curve is simply charting out the relationship between Price and Quantity Demanded. When the Price is high the consumer is less likely to purchase, so we have low quantity demanded. When the Price is low the consumer is more likely to purchase, so we have high quantity demanded.

Example of Demand Curve Demand for Bananas Price Quantity Demanded 30 DH 200 20 DH 1000 15 DH 2000 10 DH 4000 7 DH 6000 5 DH 10000 3 DH 50000

Shifts in the Demand Curve What shifts Demand? At every given price, the quantity demanded has changed. Changes in Income. (Shift out) Changes in taste. (Outward shift) (if all of the sudden, people have a preference of a product that is now fashionable, we would see an increase in demand) Changes in expectations. Either expecting the price to increase in the future (shift out), or decrease (shift in) (Example if we expect an increase in the price of oil, and we have a way to store it, then we should see an increase in quantity demanded). Changes in Market size. (more consumers in the market Shift out) Changes in the price of related goods and services (substitutes and compliments: a decrease in the price of gasoline increases the quantity demanded for cars)

Change in Demand vs. change in Demand curve Movement along the Demand Curve. Changes in Quantity Demanded. Change in Demand Curve: Reflects changes in Demand. (using any of the Demand shift reasons).

The law of supply As in the case of demand, general observations of the behavior of producers and sellers have led to the formulation of the law of supply. This law states that, in general, suppliers are normally willing to offer more quantities of a commodity for sale at higher prices than at lower ones. In other words, the law says that the higher the price, the greater will be the quantities made available for sale; and the lower the price, the smaller will be the supply.

Supply Curve

Supply curve The supply curve has a upward slope. The Supply curve is charting out the relationship between Price and Quantity supplied. When the Price of a good or service is high then there is high quantities that firms are willing to supply. When the Price is low the firms is less likely to produce, so we have low quantity supplied.

Shifts of the supply curve What shifts supply? At every given price, the quantity supplied has changed. Changes in technology. (outward shift- example: wheat market, if there is a new technology that makes it easier for companies to produce wheat faster and cheaper like a new tractor, then there will be more quantity supplied for the same price which will essentially shift the supply curve) Changes in input prices. (example: car market, if steel prices go up, then we would expect a decrease in supply of cars) Changes in expectations. Changes in the number of producers.(if more producers enter the market, then the supply curve will move outward) Changes in the price of related goods and services. (an increase in the price of aluminum will increase supply of aluminum and decrease supply of copper)

Change in Supply vs. change in Supply curve Movement along the Supply Curve. Changes in Quantity Supplied. Change in Supply Curve: Reflects changes in Supply. (using any of the Supply shift reasons).

Market Equilibrium We bring in the demand and supply curve together. Where the Supply curve and Demand curve intersect, we now have an Equilibrium Price (P*) and an Equilibrium Quantity (Q*)

Changes in the Market Equilibrium Changes in the supply curve from S to S’ perhaps as a result of a decrease in the price of raw materials. the market price drops (from Pl to P3), and the total quantity produced increases (from Q1 to Q3), this is what we would expect: Lower costs result in lower prices and increased sales. (Indeed, gradual decreases in costs resulting from technological progress and better management are an important driving force behind economic growth.)

Changes in the Market Equilibrium A right shift in the demand curve resulting from, say, an increase in income. A new price and quantity result after demand comes into equilibrium with supply. Figure 2.5, we would expect to see consumers pay a higher price P3 and firms produce a greater quantity Q3, as a result of an increase in income.

Changes in the Market Equilibrium New Equilibrium following shifts in Supply and Demand Curves.

Shortage vs. Surplus Shortage: Surplus: Price below the equilibrium price, demand exceeds supply. Surplus: Price is above the equilibrium price, supply exceeds demand.

Supply and Demand curves showing Shortage and Surplus

Problem 1 Indicate whether the following statement is true or false and explain why? “An increase in the price of bananas will shift the demand curve for bananas to the left.”

Solution to Problem 1 This is FALSE.  The price of the good is not a demand shifter.  The negative slope of the demand curve already shows how a change in price will affect the quantity demanded.  A change in the price moves us to a new point along the same demand curve.  The curve does not shift.  Did I catch you on this? 

Problem 2 Draw typically shaped supply and demand curves for hot dogs and indicate the equilibrium price and quantity.  Use the graph to illustrate what will happen to the equilibrium price and quantity of hot dogs if there is an increase in income in the economy and explain.

Solution to Problem 2 The effect of the increase in income depends upon whether hot dogs are a normal or inferior good.  If hot dogs are a normal good, the increase in income will cause an increase in the demand for hot dogs.  This increased demand will raise both the equilibrium price and quantity.

Solution to Problem 2 However, some undiscerning families might perceive of hot dogs as an inferior good. They might look at the increase in income as an opportunity to eat fewer hot dogs and shift to more expensive foods instead (a plausible although gastronomically unfortunate choice).  If so, the demand for the hot dogs will shift to the left and both the equilibrium price and quantity will fall.

Problem 3 Suppose that both consumers and producers expect prices of Bananas to be much higher in three months. Use supply and demand to illustrate the impact of this on the current market for Bananas.  Label your diagram clearly and explain.

Solution to Problem 3  If consumers expect future prices to be higher they will try to stock up on Apples now while the price still is low.  This will increase the current demand (more apples will be demanded at each price) and shift the demand curve to the right.  Producers will react as well.  Since they also expect prices to be higher in three months, they have an incentive to hold onto their inventories and wait until the prices rise to sell.  As a result, the current supply of Apples will drop or shift to the left.  The combination of higher demand and lower supply will drive the price up.  The effect on quantity is unclear and will depend upon which of the curves shifts the most.  In the graph below, the curves shift by the same amount and the quantity stays the same.

Elasticity of Supply and Demand Price elasticity of demand: is a number representing the percentage change in quantity demanded resulting from each 1% change in the price of the good. Price elasticity of demand = %change in quantity demanded / %change in price For example, suppose the price of cars went up by 1% this year and the resulting decline in cars purchases was 2%. The price elasticity of demand would be: E=-2%/1% = -2, we use absolute value of the results, thus E= 2. E > 1, we can say that demand for cars is elastic, If E <1 then we would have said that demand for cars is inelastic. Price elasticity of supply measures the responsiveness of supply to a change in Price.

Problem #4 Suppose a clothing store sells 25 t-shirt/week for the price of $15, and when the store drops the price to $10, the store starts selling 60 t-shirt/week. Calculate the Price Elasticity of the Demand.

Solution to problem #4 % change in Qty Demanded= [(final Qty – initial Qty) / initial Qty ] *100% % change in Qty Demanded= [(60 – 25)/25]*100% % change in Qty Demanded= 140% % change in Price= [(final Price– initial Price) / initial Price ] *100% % change in Price= [(10-15)/10]*100% % change in Price= 33% Elasticity = 140/33 = 4.24 Interpretation : For every 1% change in the price, there will be 4.24 percent change in quantity. The demand for t-shirts is elastic since the E > 1.

Problem #5 Yesterday, the price of envelopes was $3 a box, and Julie was willing to buy 10 boxes. Today, the price has gone up to $3.75 a box, and Julie is now willing to buy 8 boxes. Is Julie's demand for envelopes elastic or inelastic? What is Julie's elasticity of demand?

Problem#6 Problem : If Neil's elasticity of demand for hot dogs is constantly 0.9, and he buys 4 hot dogs when the price is $1.50 per hot dog, how many will he buy when the price is $1.00 per hot dog?

Solution to Problem#6 This time, we are using elasticity to find quantity, instead of the other way around. We will use the same formula, plug in what we know, and solve from there. Elasticity = And, in the case of John, %Change in Quantity = (X – 4)/4 Therefore : Elasticity = 0.9 = |((X – 4)/4)/(% Change in Price)| % Change in Price = (1.00 - 1.50)/(1.50) = -33% 0.9 = |(X – 4)/4)/(-33%)| |((X - 4)/4)| = 0.3 0.3 = (X - 4)/4 X = 5.2 Since Neil probably can't buy fractions of hot dogs, it looks like he will buy 5 hot dogs when the price drops to $1.00 per hot dog.

Problem #7 Which of the following goods are likely to have elastic demand, and which are likely to have inelastic demand? Home heating oil Pepsi Chocolate Water Heart medication Oriental rugs

Problem#8 Katherine advertises to sell cookies for $4 a dozen. She sells 50 dozen, and decides that she can charge more. She raises the price to $6 a dozen and sells 40 dozen. What is the elasticity of demand? Assuming that the elasticity of demand is constant, how many would she sell if the price were $10 a box?