1. 9/26/05
Lectures 2 and 3, September 21-September 26, 2004 Demand, Supply, and Equilibrium
Demand
Supply
Elasticities
Market Equilibrium
The Price Mechanism and the “Law” of Supply and Demand
Applications
Questions
Lectures 2 and 3: Demand and Supply

2. 9/26/05
Demand
Price-taking behavior: price as the independent variable, quantity as the dependent variable
What is held constant, what changes?
Why do demand curves slope downward?
Shifts along demand curve vs shifts of demand curve = change in the quantity demanded vs change in demand
Long run vs short run
Market demand as aggregate of individual demand
Price taking behavior: Can we speak of a demand curve if the buyer has control over the price?
Downward slope: income and substitution effects. Catherine is richer as the price of ice cream falls (depending on the proportion of expenditure on ice cream in her budget; and ice cream becomes relatively less expensive than, say, cookies as its price falls.
Long run vs short run: is demand more or less elastic in the long run? Why?
Lectures 2 and 3: Demand and Supply

3. A Demand Schedule

4. A Demand Curve Corresponding to Catherine’s Demand Schedule
9/26/05
Price of
Ice -
Cream Cone
$3.00
2.50
1. A decrease
in price
...
2.00
1.50
1.00
0.50 1 2 3 4 5 6 7 8 9 10 11 12
Quantity of 2.
...
increases quantity
of cones demanded.
Ice -
Cream Cones
Copyright © South -
Western
Lectures 2 and 3: Demand and Supply

5. A Change in the Quantity Demanded
Price of Ice -
Cream
Cones
A change in the price of ice-cream cones leads to movement along the demand curve B
$2.00 A
1.00 D 4 8
Quantity of Ice -
Cream Cones
Copyright © South -
Western

6. Shifts of Demand Curve Price of Ice - Cream Cone Increase in demand
Decrease
in demand
Demand
curve, D 2
Demand
curve, D 1
Demand curve, D 3
Quantity of
Ice -
Cream Cones
Copyright©2003 Southwestern/Thomson Learning

7. Market Demand as the Sum of Individual Demands
Price
Price
$3.00
$2.00
$1.00
Price
Nicholas’s Demand 2 4 8
Quantity
Catherine’s Demand 6 10
$3.00
$2.00
$1.00
$3.00
$2.00
$1.00
Market Demand
Quantity
Quantity 11

8. Price Elasticity of Demand (Supply)
The price elasticity of demand (supply) is the percentage change in the quantity demanded (supplied) divided by the percentage change in the price

9. Price Elasticity, cont’d
Price elasticity measures the responsiveness of quantity to price changes. An elastic demand schedule or curve is one along which a small change in price produces a relatively large change in the quantity demanded. An inelastic demand schedule is one in which the associated quantity change is small. The borderline between elastic and inelastic demand curves is an elasticity equal to 1. An elasticity greater than 1 means that the market value of the good (price x quantity) increases as the quantity increases and the price declines.
Why is this important?

10. Perfectly Inelastic Demand: Elasticity = 0
Price
Demand
100 $5
1. An
increase
in price . . . 4
Quantity
leaves the quantity demanded unchanged.
Copyright©2003 Southwestern/Thomson Learning

11. Inelastic Demand: Elasticity Is Less Than 1
The Price Elasticity of Demand
Inelastic Demand: Elasticity Is Less Than 1
Price
Demand $5 90
1. A 22%
increase
in price . . . 4
100
Quantity
leads to an 11% decrease in quantity demanded.

12. Unit Elastic Demand: Elasticity = 1
The Price Elasticity of Demand
Unit Elastic Demand: Elasticity = 1
Price
Demand $5 80
1. A 22%
increase
in price . . . 4
100
Quantity
leads to a 22% decrease in quantity demanded.
Copyright©2003 Southwestern/Thomson Learning

13. Elastic Demand: Elasticity Is Greater Than 1
The Price Elasticity of Demand
Elastic Demand: Elasticity Is Greater Than 1
Price
Demand $5 50
1. A 22%
increase
in price . . . 4
100
Quantity
leads to a 67% decrease in quantity demanded.

14. Perfectly Elastic Demand: Elasticity Equals Infinity
Price
1. At any price
above $4, quantity
demanded is zero. $4
Demand
2. At exactly $4,
consumers will
buy any quantity.
3. At a price below $4,
quantity demanded is infinite.
Quantity

15. 9/26/05
Supply
Compared with Demand, there are Similarities (mostly) and Differences
Price-taking behavior
Ceteris paribus
Why supply curves slope upward
Shifts along supply curves vs shifts of supply curves
Long run and short run.
Market supply
Price taking behavior: is there a supply curve when sellers control prices? Are businesses content to sit back and passively accept the role of price taker? Agriculture in the US and Europe, IBM and the sale of its pc business to Lenovo.
Long run and short run: are supply curves more elastic in the long run? Why?
Lectures 2 and 3: Demand and Supply

16. A Supply Schedule Price of Ice - Cream Cone $3.00 2.50 1. An increase
in price
...
2.00
1.50
1.00
0.50 1 2 3 4 5 6 7 8 9 10 11 12
Quantity of 2.
...
increases quantity of cones supplied.
Ice -
Cream Cones
Copyright©2003 Southwestern/Thomson Learning

17. Change in Quantity Supplied
Price of Ice - S
Cream
Cone C
$3.00
A rise in the price
of ice cream
cones results in a
movement along A
the supply curve.
1.00
Quantity of
Ice -
Cream 1 5
Cones
Copyright © South -
Western

18. Shifts in the Supply Curve
Price of
Supply curve, S 3
Ice -
Cream
curve,
Supply S 1
Cone
Supply
curve, S 2
Decrease
in supply
Increase
in supply
Quantity of
Ice -
Cream Cones
Copyright©2003 Southwestern/Thomson Learning

19. Market Supply as the Sum of Supply Curves of All Suppliers3 2 1 P 3 2 1 P 3 2 1 Q Q Q

20. The Difference Between Demand and Supply
For individuals there are income effects, but not for firms.
To the extent individuals are demanders and firms suppliers, this translates into a difference between demand and supply.
But there are many important cases where the roles of firms and individuals are reversed, for example, labor supply.

21. Elasticity of Supply How different from elasticity of demand?
Since supply curves generally slope upward, 1 is not a borderline between increasing and decreasing market value.
Both inelastic and elastic supply curves have the property that revenue (P × Q) increases as price goes up.

22. Market Equilibrium
According to the dictionary, equilibrium is “a condition in which all acting influences are canceled by others, resulting in a stable, balanced, or unchanging system.”
In a market, equilibrium refers to equality between demand and supply.

23. Equilibrium of Supply and Demand
Price of
Ice -
Cream
Cone
Supply
Equilibrium
Equilibrium price
$2.00
Equilibrium
quantity 1 2 3 4 5 6 7 8 9 10 11 12 13
Quantity of Ice -
Cream Cones
Copyright©2003 Southwestern/Thomson Learning

24. How an Increase in Demand Affects the Equilibrium
Price of
Ice -
Cream
1. Hot weather increases
the demand for ice cream . . .
Cone D D
Supply
New equilibrium
$2.50 10
resulting
in a higher
price . . .
2.00 7
Initial
equilibrium
Quantity of 3.
. . .
and a higher
quantity sold.
Ice -
Cream Cones
Copyright©2003 Southwestern/Thomson Learning

25. How a Decrease in Supply Affects the Equilibrium
Price of
Ice -
Cream
1. An increase in the
Cone
price of milk reduces
the supply of ice cream. . . S 2 S 1
Demand
New
equilibrium
$2.50 4
resulting
in a higher
price of ice
cream . . .
2.00 7
Initial equilibrium 3.
. . .
and a lower
quantity sold.
Quantity of
Ice
Cream Cones
Copyright©2003 Southwestern/Thomson Learning

26. Equilibrium as Demand = Supply
How does demand = supply ensure that the forces that move things in one direction are just balanced by the forces that move things in another direction?

27. The Law of Supply and Demand
“The price of any good adjusts to bring the quantity supplied and quantity demanded into balance.” (Mankiw, Principles of Economics, 3rd Edition, p 77)

28. Disequilibrium Between Demand and Supply
(a) Excess Supply
Price of
Ice -
Cream
Supply
Cone
Surplus
Demand
$2.50 10 4
2.00 7
Quantity
demanded
Quantity
supplied
Quantity of
Ice -
Cream
Cones
Copyright©2003 Southwestern/Thomson Learning

29. Disequilibrium Between Demand and Supply (cont’d)
(b) Excess Demand
Price of
Ice -
Cream
Supply
Cone
Demand
$2.00 7
$1.50 10 4
Shortage
Quantity
supplied
Quantity
demanded
Quantity of
Ice -
Cream
Cones
Copyright©2003 Southwestern/Thomson Learning

30. Adjustment of Supply and Demand
$4.50
Demand
Price of
Ice -
Cream S1
Cone
Supply A
$2.50
Equilibrium
Equilibrium price
$2.00
$0.75
Equilibrium
quantity 1 2 3 4 5 6 7 8 9 10 11 12 13
Quantity of Ice -
Cream Cones
Copyright©2003 Southwestern/Thomson Learning

31. Adjustment of Supply and Demand
$4.50
Demand
Price of
Ice -
Cream S2
Cone
Supply B A
$2.50
Equilibrium
Equilibrium price
$2.00 C
$0.75
Equilibrium
quantity 1 2 3 4 5 6 7 8 9 10 11 12 13
Quantity of Ice -
Cream Cones
Copyright©2003 Southwestern/Thomson Learning

32. Adjustment of Supply and Demand
$4.50
Demand
Price of
Ice -
Cream S2
Cone
Supply B
$2.50
Equilibrium
Equilibrium price
$2.00 C
$0.75
Equilibrium
quantity D 1 2 3 4 5 6 7 8 9 10 11 12 13
Quantity of Ice -
Cream Cones
Copyright©2003 Southwestern/Thomson Learning

33. Adjustment of Supply and Demand
$4.50
Demand
Price of
Ice -
Cream
Cone
Supply B
$2.50
Equilibrium
Equilibrium price
$2.00 C
$0.75
Equilibrium
quantity 1 2 3 4 5 6 7 8 9 10 11 12 13
Quantity of Ice -
Cream Cones
Copyright©2003 Southwestern/Thomson Learning

34. Adjustment of Supply and Demand
$4.50
Demand
Price of
Ice -
Cream S2 S1
Cone
Supply
$2.50
Equilibrium
Equilibrium price
$2.00
Equilibrium
quantity
$0.75 1 2 3 4 5 6 7 8 9 10 11 12 13
Quantity of Ice -
Cream Cones
Copyright©2003 Southwestern/Thomson Learning

35. Adjustment of Supply and Demand: An Alternative Adjustment Process
$4.50
Demand
Price of S1
Ice -
Cream S2 A
Cone
Supply
$2.50 B
Equilibrium
Equilibrium price
$2.00
$0.75
Equilibrium
quantity 1 2 3 4 5 6 7 8 9 10 11 12 13
Quantity of Ice -
Cream Cones
Copyright©2003 Southwestern/Thomson Learning

36. Adjustment of Supply and Demand
9/26/05
The difference between equilibrium and adjustment to equilibrium.
Why doesn’t the market go immediately to equilibrium? “Rational expectations.”
The “Law of Supply and Demand” focuses attention on the price mechanism as doing the work of adjustment. This becomes especially problematic when we realize that there are many markets adjusting at the same time.
Adjustment of saving and investment as a counterexample to this focus.
The term of art for adjustment to equilibrium is stability of equilibrium, because economists pose the question as “what happens if an equilibrium is disturbed: does the price mechanism bring a market or markets back to equilibrium?”
Lectures 2 and 3: Demand and Supply

37. Saving and Investment Price (interest rate) Supply of Saving P1
Demand for Investment Q1
Quantity of S and I

38. Suppose investment demand decreases from D1 to D2
Price (interest rate)
Supply of Saving P1
Demand for Investment D1 D2 Q1
Quantity of S and I

39. Suppose investment demand decreases from D1 to D2: the Standard Story
Price (interest rate)
Supply of Saving P1
The equilibrium shifts downward along the given saving schedule P2
Demand for Investment D1 D2 Q2 Q1
Quantity of S and I

40. Suppose investment demand decreases from D1 to D2: a Keynesian Story
Price (interest rate)
Supply of Saving P1
The Saving Schedule shifts downward
Demand for Investment D1 S2 S1 D2 Q2 Q1
Quantity of S and I

41. Saving and Investment Supply of Saving Price (interest rate)
Demand for Investment
Quantity of S and I

42. Applications Coffee Rent Control Health Care
Static
Dynamic
Rent Control
Health Care
Where do the distributional and foundational critiques come in?
What assumptions are being made about the distribution of income?
What assumptions are being made about people, particularly about individualism and self interest?

43. How an Increase in Supply Affects the Coffee Market
9/26/05
How an Increase in Supply Affects the Coffee Market
Price of
Demand
Coffee S0
(dollars)
2.00 S1
Initial equilibrium
New
equilibrium .
Go to next one for question about what happens to revenue.
The next one after that answers the question.
1.00
Price of coffee falls from $2 to $1
and a higher
quantity sold.
Quantity of
Coffee
Coffee (billions of kg)
Copyright©2003 Southwestern/Thomson Learning
Lectures 2 and 3: Demand and Supply

44. How an Increase in Supply Affects the Coffee Market
Price of
Demand
Coffee S0
(dollars)
What happens to total revenue received by coffee growers?
2.00 S1
Initial equilibrium
New
equilibrium .
1.00
Price of coffee falls from $2 to $1
and a higher
quantity sold.
Quantity of
Coffee (billions of kg)
Coffee
Copyright©2003 Southwestern/Thomson Learning

45. How an Increase in Supply Affects the Coffee Market
Price of
Demand
Coffee S0
(dollars)
2.00 S1
Revenue falls from $12 billion (= 2.00 × 6) to $7 billion (= 1.00 × 7).
Initial equilibrium
New
equilibrium .
1.00
Price of coffee falls from $2 to $1
and a higher
quantity sold.
Quantity of
Coffee (billions of kg)
Copyright©2003 Southwestern/Thomson Learning

46. Fair Trade as a Solution?
Price of Coffee
Price Floor
Quantity of Coffee

47. Fair Trade as a Solution?
Surplus production
Price of Coffee
Price Floor
Quantity of Coffee

48. Fair Trade as a Solution?
Shift in demand eliminates surplus production
Price of Coffee
Price Floor D1 D0
Quantity of Coffee

49. Rent Control in the Short Run
(supply and demand are inelastic)
Rental
Price of
Apartment
Supply
Demand
Controlled rent
Shortage
Quantity of
Apartments
Copyright©2003 Southwestern/Thomson Learning

50. Rent Control in the Long Run
(supply and demand are elastic)
Rental
Price of
Apartment
Supply
Demand
Controlled rent
Shortage
Quantity of
Apartments
Copyright©2003 Southwestern/Thomson Learning

51. Health Care Demand as the Sum of Catherine’s and Nicholas’s Demands
Price
$3.00
$2.00
$1.00
Market Demand: observe that N is priced out of the market above $2.00
Quantity

52. Market Demand as the Sum of Individual Demands
Price
Price
$3.00
$2.00
$1.00
Price
Nicholas’s Demand
Catherine’s Demand
$3.00
$2.00
$1.00
$3.00
$2.00
$1.00
Market Demand 2 4 6 8 10
Quantity
Quantity
Quantity 11

53. Health Care Demand as the Sum of Catherine’s and Nicholas’s Demands: Effect of a Price Ceiling
$3.00
$2.00
$1.50
$1.00
Market Demand: observe that N is priced out of the market above $2.00. If N is to receive health care at, say, a market price of $1.50, then there will be a shortage of health care.
Shortage
Quantity

54. Some Questions
What are the similarities between markets in ice-cream cones, coffee, apartments, and health care?
What are the differences that make the consequences of price controls or other market interventions different?
Who gains and who loses? Does society gain? What is society?
What about the assumptions of individualism and self interest?