Demand and Supply Analysis

Headlines: On August 2, 1990, when Iraq invaded Kuwait, market price of crude petroleum jumped from $21.54 to $30.50 per barrel (almost 42% increase) before any physical reduction in the current amount of oil available for sale. One year later, the price of oil was $21.32 per barrel. In August 1987, a 386 PC sold at $6,995. In March 1992, the same computer sold at $1,495. Today Pentiums are cheaper then original 386 PCs.

Market Demand Curve Amounts of a good purchased at alternative prices. Inverse demand shows the maximum price paid for given quantity of a good. Law of Demand (ceteris paribus) Downward demand due to income and wealth effects. Downward inverse demand diminishing marginal utility. Giffen's Paradox Quantity Price D ID Price Quantity

Qxd = a0+a1Px+a2Py+a3I+a4N+a5A+a6Z The Demand Function An equation representing the demand curve Qxd = f(Px , PY , I, N, A, Z) Qxd = a0+a1Px+a2Py+a3I+a4N+a5A+a6Z Qxd = quantity demand of good X. Px = price of good X. PY = price of a substitute good Y. I = income. N = population A = advertisement Z = any other variable affecting demand (expectations, credit conditions)

Change in Quantity Demanded Price Quantity D0 A to B: Increase in quantity demanded (due to change in the price of the good) A 10 4 B 6 7

Change in Demand Price Quantity D0 D0 to D1: Increase in Demand (due to change in demand determinants) D1 6 7 13

Market Supply Curve Amounts of a good produced at alternative prices. Inverse supply shows the minimum price required to produce given quantity of a good. Law of Supply (ceteris paribus) The supply curve is upward sloping Price Quantity Price IS S Quantity

QxS = f(Px , PR ,PVI, PFI, Z) Qxs = a0+a1Px+a2PR+a3PVI+a4PFI+a5Z The Supply Function An equation representing the supply curve: QxS = f(Px , PR ,PVI, PFI, Z) Qxs = a0+a1Px+a2PR+a3PVI+a4PFI+a5Z QxS = quantity supplied of good X. Px = price of good X. PR = price of a related good (substitutes in production) PVI = price of variable inputs (labor, material, utilities) PFI = price of fixed inputs (land, buildings, machines) Z = other variable affecting supply (technology, government, number of firms, expectations)

Change in Quantity Supplied A to B: Increase in quantity supplied (due to change in the price of the good) Price Quantity S0 B 20 A 10 5 10

Change in Supply S0 to S1: Increase in supply (due to change in supply determinants) Price Quantity S0 S1 8 5 6 7

Mathematics of Equilibrium Demand curve: Qd = 400 - ½P, Supply curve: Qs = 200 + P Price (P) a=800 P = dQs - c = Qs - 200 Market equilibrium Supply Slope is d = 1 P* = 133.33 Slope is -b = -2 Demand P = a - bQd = 800 - 2Qd Q* = 333.33 Quantity supplied (Qs) and Quantity demanded (Qd) c=-200

Consumer Surplus: The Continuous Case Price $ 10 8 6 Consumer Surplus Value of 4 units 4 2 Total Cost of 4 units D 1 2 3 4 5 Quantity

Producer Surplus The amount producers receive in excess of the amount necessary to induce them to produce the good. Price S0 P* Producer Surplus Cost of Production Q* Quantity

If price is too low… Price S D 7 6 5 6 12 Shortage 12 - 6 = 6 Quantity

If price is too high… Surplus 14 - 6 = 8 Price S D 9 6 14 8 7 8 Quantity

Comparative Statics: Effects of Changes in Demand and/or Supply Increase in D increases both Q and P. Increase in S increases Q and decreases P. Increase in D and S increases Q and P = ?. Decrease in D and increase in S decreases P and Q = ?.

Price Restrictions Price Ceilings Price Floors The maximum legal price that can be charged Examples: Gasoline prices in the 1970s Housing in New York City Proposed restrictions on ATM fees Price Floors The minimum legal price that can be charged. Minimum wage Agricultural price supports

Impact of a Price Ceiling Quantity S D P* Q* PF Deadweight loss of consumer and producer surplus Opportunity Cost (Search & Black Market) Ceiling Price Qs Qd Shortage

Full Economic Price PF = PC + (PF - PC) The dollar amount paid to a firm under a price ceiling, plus the nonpecuniary price: PF = PC + (PF - PC) PF = full economic price PC = price ceiling PF - PC = nonpecuniary price In 1970s ceiling price of gasoline = $1 3 hours in line to buy 15 gallons of gasoline Opportunity cost: $5/hr Total value of time spent in line: 3  $5 = $15 Non-pecuniary price per gallon: $15/15 = $1 Full economic price of a gallon of gasoline: $1 + $1 = $2

Cost of purchasing excess supply Impact of a Price Floor Price Surplus S D PF Cost of purchasing excess supply P* Decreased Demand Increased Supply Qd Quantity Q* Qs

The Excise Tax (Fixed per Unit) Price ($/CD player) 130 Consumer surplus S + tax S Buyer pays (with tax) $10 tax P2 - P1 Buyer tax burden P2=105 Price before tax Tax Revenue Deadweight loss P1=100 P2-T=95 P1 - (P2 - T) Seller tax burden Seller receives (without tax) Instructor Notes: A deadweight loss also arises, which is shown by the gray area. Producer surplus 75 D D 0 1 2 3 4 5 6 7 8 9 10 Quantity (thousands of CD players per week) 62

Excise Tax and the Demand Thousands of insulin doses P1 = 2.00 100 S S + tax Buyer pays entire tax P Price  Inelastic D Price Seller pays entire tax S + tax S P1=P2=1.00 P2=P1+T=2.20  Elastic D P2-T=0.90 1 4 Thousands of pencils Instructor Notes: 1) A sales tax of 20 cents a dose shifts the supply curve to S + tax. 2) The price rises to $2.20 a dose, but the quantity bought does not change. 3) Buyers pay the entire tax. The more inelastic D, the more buyer pays: P2 = P1 + T Buyer burden: P2 - P1 = (P1 + T) - P1 = T Seller burden: P1 - (P2 - T) = P1 - (P1 + T - T) = 0 The more elastic D, the more seller pays: P2 = P1 Buyer burden: P2 - P1 = P1 - P1 = 0 Seller burden: P1 - (P2 - T) = P1 - (P1 - T) = T 46

Excise Tax and the Supply Bottles of spring water P2-T=45 P1=P2=50 100  Inelastic S Seller pays entire tax Price Thousands of pounds of send for computer chips P1=10 3 5 Price  Elastic S S + tax Buyer pays entire tax P2=P1+T=11 D D Instructor Notes: 1) With a sales tax of 5 cents a bottle, the price remains at 50 cents a bottle. 2) The number of bottles bought remains the same, but the price received by the seller decreases to 45 cents a bottle. 3) The spring produces 100,000 bottles of water per week regardless of the price. 4) Buyers will buy the 100,000 bottles only if the price is 50 cents. 5) The seller pays the entire tax. The more inelastic S, the more seller pays: P2 = P1 The more elastic S, the more buyer pays: P2 = P1 + T 52

The Ad Valorem Tax (% of Value) Price ($/CD player) 130 Consumer surplus S(1 + tax) S Buyer pays (with tax) $10 tax P2 - P1 Buyer tax burden P2=105 Price before tax Tax Revenue Deadweight loss P1=100 P2-T=95 P1 - (P2 - T) Seller tax burden Seller receives (without tax) Instructor Notes: A deadweight loss also arises, which is shown by the gray area. Producer surplus 75 D D 0 1 2 3 4 5 6 7 8 9 10 Quantity (thousands of CD players per week) 62

Static Effects of a Tariff Sus P Pt PW Tt PIt G CIt Dus QSt Mt QDt QSW MW QDW Loss of Consumer Surplus = Tt + PIt + G + CIt Transfer to Producer Surplus = Tt Government Revenues from Tariff = G Dead Weight Loss due to Tariff = PIt + CIt Production Inefficiencies = PIt Consumption Inefficiencies = CIt

Static Effects of a Quota Sus Sus + Quota P0 PQ PW Tq PIq W CIq Dus QSq Quota QDq QSW MW QDW Loss of Consumer Surplus = Tq + PIq + W + CIq Transfer to Producer Surplus = Tq Windfall to Importer = W Dead Weight Loss due to Quota = PIq + CIq Production Inefficiencies = PIq Consumption Inefficiencies = CIq