1. Chapter 4.1
Market Equilibrium

2. Market Equilibrium
Market equilibrium is a situation that occurs in a market when the price is such that quantity that consumers wish to buy is exactly balanced by the quantity that firms wish to supply.
In a free market, the forces of supply and demand interact to determine equilibrium quantity and equilibrium price.

3. The Interaction of Supply and Demand
The English historian Thomas Carlyle once said:
“Teach any parrot the words supply and demand and you’ve got an economist.”

4. Equilibrium
Equilibrium price – the price toward which the invisible hand drives the market.
Equilibrium quantity – the amount bought and sold at the equilibrium price.

5. What Equilibrium Isn’t
Equilibrium isn’t a state of the world, it is a characteristic of a model.
Equilibrium isn’t inherently good or bad, it is simply a state in which dynamic pressures offset each other.
When the market is not in equilibrium, you get either excess supply or excess demand, and a tendency for price to change.

6. Excess Supply & Excess Demand
Excess supply – a surplus, the quantity supplied is greater than quantity demanded
Prices tend to fall.
Excess demand – a shortage, the quantity demanded is greater than quantity supplied
Prices tend to rise.

7. Price Adjusts
The greater the difference between quantity supplied and quantity demanded, the more pressure there is for prices to rise or fall.
When quantity demanded equals quantity supplied, prices have no tendency to change.

8. The Graphical Interaction of Supply and Demand

9. The Graphical Interaction of Supply and Demand
$5.00 S
4.00
Excess supply
3.50 A
3.00
Price per DVD
2.50 E C
2.00
1.50
Excess demand D
1.00 1 2 3 4 5 6 7 8 9 10 11 12
Quantity of DVDs supplied and demanded

10. The Graphical Interaction of Supply and Demand
When price is $3.50 each, quantity supplied equals 7 and quantity demanded equals 3.
The excess supply of 4 pushes price down.

11. The Graphical Interaction of Supply and Demand
When price is $1.50 each, quantity supplied equals 3 and quantity demanded equals 7.
The excess demand of 4 pushes price up.

12. The Graphical Interaction of Supply and Demand
When price is $2.50 each, quantity supplied equals 5 and quantity demanded equals 5.
There is no excess supply or excess demand, so price will not rise or fall.

13. Equilibrium (Graph)

14. Chapter 4.2
Examples of Markets

15. Examples of Markets
Labor market – firms demand labor and employees supply labor.
From a firms point of view the demand for labor is a derived demand.
Firms want labor not for its own sake, but for the output that it produces.

16. Unemployment
A higher wage rate encourages more people to offer themselves for work.
Unemployment results when people seeking work at the going wage cannot find a job.
underemployment classification includes those workers who are highly skilled but working in low skill jobs and part-time workers who would prefer to be full time.

17. The Foreign Exchange Market
The exchange rate is the price at which two currencies exchange and it can be analyzed using demand and supply.

18. Money Market
Demand for money is associated with the functions of money set out as a medium of exchange, store of value, unit of account and standard of deferred payment.
Money supply is determined by the central bank.

19. Chapter 4.3
Comparative Statics

20. Comparative statics
Comparative static analysis – examines the effect on equilibrium of a change in the external conditions affecting a market.

21. Elasticity: the sensitivity of demand and supply
Chapter 4.4
Elasticity: the sensitivity of demand and supply

22. Elasticity: The demand Sensitivity of demand and supply
Elasticity is a measure of the sensitivity of one variable to change in another variable.
Price elasticity of demand (PED) is a measure of the sensitivity of quantity demanded to change in the price of a good or service.

23. Income Elasticity of Demand
Income elasticity of demand (YED) measures the responsiveness of quantity demanded to changes in real income.
YED = %Δ demand / %Δ in income
Example:
A rise in consumer real income of 7% leads to an 9.5% rise in demand for pizza deliveries.
The income elasticity of demand:
= 9.5/ 7 = (ELASTIC)

24. Significance of Income Elasticity of Demand
High Income Elasticity
Demand is sensitive to changes in real incomes
Demand is therefore cyclical – in an economic expansion, demand will grow strongly. In a recession demand may fall
Can be difficult for businesses to accurately forecast demand and make capital investment decisions

25. Significance of Income Elasticity of Demand
Low Income Elasticity
Demand is more stable during fluctuations in the economic cycle than high YED
Over time, the share of consumer spending on inferior goods and normal necessities tends to decline
Long run – businesses need to invest in / focus on products with a higher income elasticity of demand if they want to increase total profits

26. 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?

27. 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

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

29. Elasticity Price Elasticity of Demand
The 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

30. Elasticity The Formula: % Change in Quantity Demanded
___________________________
Ped =
% 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
Note: PED has – sign in front of it; because as price rises
demand falls and vice-versa (inverse relationship between
price and demand)

31. Elasticity Price (£) Quantity Demanded
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

32. Elasticity Total Revenue Price £5 D 100 Quantity Demanded (000s)
Total revenue is price x quantity sold. In this example, TR = £5 x 100,000 = £500,000.
This value is represented by the grey shaded rectangle.
The importance of elasticity is the information it provides on the effect on total revenue of changes in price. £5
Total Revenue D
100
Quantity Demanded (000s)

33. Elasticity Total Revenue D Price £5 £3 100 140
If the firm decides to decrease price to (say) £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. £5 £3
Total Revenue D
100
140
Quantity Demanded (000s)

34. Elasticity % Δ Price = -50% % Δ Quantity Demanded = +20%
Producer decides to lower price to attract sales 10
% Δ Price = -50%
% Δ Quantity Demanded = +20%
Ped = -0.4 (Inelastic)
Total Revenue would fall 5
Not a good move! D 5 6
Quantity Demanded

35. Elasticity Producer decides to reduce price to increase sales
% Δ in Price = - 30%
% Δ in Demand = + 300%
Ped = - 10 (Elastic)
Total Revenue rises 10
Good Move! 7 D 5 20
Quantity Demanded

36. Elasticity If demand is price elastic:
Increasing price would reduce TR (%Δ Qd > % Δ P)
Reducing price would increase TR
(%Δ Qd > % Δ P)
If demand is price inelastic:
Increasing price would increase TR
(%Δ Qd < % Δ P)
Reducing price would reduce TR (%Δ Qd < % Δ P)

37. Elasticity Income Elasticity of Demand:
The 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

38. Elasticity Income Elasticity of Demand:
A positive sign denotes a normal good
A negative sign denotes an inferior good

39. 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
% Δ Qd of good t
__________________
Xed =
% Δ Price of good y

40. Elasticity Goods which are complements: Goods which are substitutes:
Cross Elasticity will have negative sign (inverse relationship between the two)
Goods which are substitutes:
Cross Elasticity will have a positive sign (positive relationship between the two)

41. Elasticity Price Elasticity of Supply:
The responsiveness of supply to changes in price
If Pes is inelastic - it will be difficult for suppliers to react swiftly to changes in price
If Pes is elastic – supply can react quickly to changes in price
% Δ Quantity Supplied
____________________
Pes =
% Δ Price

42. 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

43. 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
This slide also has an automatic response with ten second gaps in between each point. At this stage we have tried to keep things as simple as possible but to introduce issues that will be dealt with later in the course.