1. Part 2 Markets: Demand, Supply, and Elasticity
What determines the price of a good or service and the quantity bought and sold?
Demand and supply model of a market
This simple model of a market assumes competitive conditions
Distinguish between a demand side and a supply side of the market
Together they determine the equilibrium price and quantity

2. Demand
Demand is the quantity of a good people purchase over a given time
The quantity of a good a person will plan to purchase will depend on:
- Preferences (tastes)
- Price of the good
- Prices of other goods
- Expected future prices
- Income
In the aggregate, demand will also depend on:
- Population and demographics

3. The Law of Demand
Other things remaining the same, the higher the price of a good, the smaller is the quantity demanded
Substitution effect—the effect of the change in relative price
Income effect—the effect of the change in overall purchasing power

4. Demand Function and Demand Curves
Demand function—demand as a function of a number of variables
Demand curve—demand as a function of price, everything else held constant
What is held constant along a demand curve?
Changes in the quantity demanded—movements along the demand curve

5. Changes in Quantity DemandedP
Decrease in quantity
demanded P’ P
Increase in quantity
demanded P” Q’ Q Q” Q
Change in quantity demanded—a movement
along the demand curve

6. Demand Curves Can be linear or non-linear A linear demand curve P
P = a + bQ
Where a is the P
intercept and b is the slope
variable and is negative 20 30 Q
P = /3Q

7. Demand Curves
A demand curve is more usually written with Q as the dependent variable P
Q = a + bP
Where a is the Q intercept and
b is the inverse of the slope
and is negative 20 Q 30
Q = 30 – 3/2P

8. Changes in Demand Shift in a demand curve is a Change in Demand
Change in tastes or preferences
Change in the prices of other goods
- substitutes
- complements
Changes in expected future prices
Changes in income
- normal goods
- inferior goods
Changes in population/demographics

9. An Increase in Demand
An increase in demand—a rightward shift P D’ D Q

10. An Increase in Demand Price of a substitute rises
Price of a complement falls
Expected future price rises
Income rises (normal good) or income falls (inferior good)
Preferences move toward the good
Population increases

11. A Decrease in Demand
A decrease in demand—a leftward shift P D D’ Q

12. A Decrease in Demand Price of a substitute falls
Price of a complement rises
Expected future price falls
Income falls (normal good) or income rises (inferior good)
Preferences move away from the good
Population falls.

13. Supply
Supply is the quantity of a good firms produce over a given time
The firm has to have the resources and technology to produce the good
The firm has to think it can produce the good at a profit (at least in the long run)
Short run and long run supply decisions

14. Supply
The amount of any particular good or service supplied by a firm will depend on:
- The price of the good
- The prices of inputs needed to produce the good
- The available technology
- The available capital (short run)
- Prices of other goods
- Expected future prices
In the aggregate, supply will also depend on:
- The number of firms in the market

15. The Law of Supply
Other things remaining the same, the higher the price of a good, the greater will be the quantity supplied
Higher prices mean it will be profitable to expand production
With rising marginal costs higher prices are required for firms to be willing to increase production

16. Supply Functions and Supply Curves
Supply curve—shape
Supply curves can only be defined for competitive industries (where price is a given to the firm)
What is held constant along a supply curve?
Changes in the quantity supplied—movements along the supply curve

17. Changes in Quantity Supplied
Increase in quantity
supplied P P’
Decrease in quantity supplied Q’ Q Q” Q
Change in quantity supplied—a movement
along the supply curve

18. Supply Curves A linear supply curve:
P = a + bQ where a is the P intercept
And b is the slope which is positive P S
Slope is = 2 10 Q
P = Q

19. Supply Curves
Supply curves are more usually written with Q as the dependent variable: Q = a + bP where a is the Q intercept and b is the inverse of the slope and positive P S
Slope = 2 inverse of
Slope = 1/2 10
Q = -5 + ½ P -5 Q

20. Changes in Supply Shift in a supply curve is a Change in Supply
Change in input prices
Changes in technology
Changes in expected future prices
Change in the scale of the firm
Changes in the number of firms—entry and exit of firms

21. An Increase in Supply An increase in supply—a rightward shift in
the supply curve S S’ P Q

22. An Increase in Supply Price of inputs fall More efficient technology
Expected future price fall
(ie natural resource production)
Firms grow in size
Number of firms in the industry grows

23. A Decrease in Supply P S’ S Q A decrease in supply is a leftward
shift in the supply curve

24. A Decrease in Supply Price of inputs rise
Expected future price rise (natural resources)
Loss of technological knowledge
Firms decline in size
Number of firms in the industry shrinks

25. Market Equilibrium Market equilibrium is where demand = supply
Equilibrium price
Equilibrium quantity
Price adjusts to bring about an equilibrium
If D>S price rises which reduces quantity demanded and increases quantity supplied
If S>D price falls which increases quantity demanded and reduces quantity supplied

26. Market Equilibrium P Surplus- price falls S E P* Shortage- Price risesD Q* Q

27. Market Equilibrium in Equations
Demand curve D = a + bP where a is the Q intercept and b is the inverse of the slope (and negative)
Supply Curve S = c + dP where c is the Q intercept (usually zero or negative) and b the inverse of the slope and positive
In equilibrium D = S
Solve for P* then Q*

28. Market Equilibrium in Equations
Demand curve D = 400 – .5P
Supply Curve S = – P
Solve for P*
400 – .5P* = – P*
600 = 1.5P*
P* = 400
Solve for Q*
Q* = 400 – 200
Q* = 200

29. Market Equilibrium in Equations
Diagram of the equations P
800
S = P
400
D = P Q
-200
200
400

30. Equilibrium Price and Quantity Changes
A change in demand with a given supply curve P S E’ P’ E P D’ D Q Q’ Q
Rightward shift in demand leads to a movement
along the supply curve. P and Q both rise.

31. Equilibrium Price and Quantity Changes
A change in supply with a given demand curve S P S’ E P E’ P’ D Q Q Q’
A rightward shift in supply leads to a
movement along the demand curve. P falls
and Q rises.

32. Equilibrium Price and Quantity Changes
A change in supply and demand
—same directions S P S’ E E’ P D’ D Q Q Q’
A rightward shift in both demand and supply
leads to a higher Q. P may rise, fall, or stay
the same.

33. Equilibrium Price and Quantity Changes
A change in supply and demand
—opposite directions P S E S’ P E’ P’ D D’ Q Q
A rightward shift in supply and a leftward
shift in demand leads to a lower P. Q may rise,
fall, or stay the same.

34. An Example
From Slate Magazine June 2009 in a discussion of a campaign by Chevron to get people to drive less: “All other things being constant, if every gullible soul performed the conservation miracles Chevron proposes, energy consumption would fall, and so would prices. As prices fell the non-gullible would take advantage of the depressed prices to consume more and thus drive the price back up.” Is this right?

35. Elasticity Elasticity is a measure of responsiveness
Many elasticities can be measured: price elasticity of demand, cross price elasticity of demand, income elasticity of demand, and elasticity of supply
Elasticity measures are measures of proportionate responsiveness and are unit free

36. Elasticity General form:
The elasticity of X with respect to Y is given by the % or proportionate change in X divided by the % or proportionate change in Y
EXY = % Δ X / % Δ Y or
EXY= ΔX/X / ΔY/Y or
EXY=ΔX/ΔY • Y/X

37. Price Elasticity of Demand
Elasticity of Demand with respect to the good’s own price
EDxPx= %ΔQ/%ΔP or
EDxPx= ΔQ/Q / ΔP/P or
EDxPx= ΔQ/ΔP • P/Q
For price elasticities of demand the sign is ignored as they are all negative
Elastic demand > 1
Inelastic demand < 1
Unit elastic demand = 1

38. Inelastic and Elastic DemandP
Elasticity = 0 Q P D
Elasticity =  Q P
Elasticity = 1 D Q

39. Price Elasticity of Demand Over an Arc
Px ($)
If measuring price elasticity
of demand over an arc use
the average P and Q 15
12.5 5 10
100 Dx Qx
(Kgs)
100
200
150
EDxPx= 100/150 / 5/12.5 = .66/.4 = 1.66
EDxPx= 100/5 x 12.5/150 = 20 x .083 = 1.66

40. Price Elasticity of Demand at a Point
EDxPx= ΔQ/ΔP • P/Q
ΔQ/ΔP = inverse of the slope of the demand curve P
100
Slope = 2
Inverse of slope = 0.5
Elasticity = 0.5 x 4 = 2 80 D 20 50 Q

41. Price Elasticity Along a Straight Line Demand Curve
EDxPx > 1
Slope = 2/3
Inverse of slope = 1.5
200
EDxPx = 1
100
EDxPx < 1 Q
150
300
EDxPx > 1 Elastic Demand
EDxPx = 1 Unit Elastic Demand
EDxPx < 1 Inelastic Demand

42. Price Elasticity of Demand and Total Revenue
If the price elasticity of demand is > 1, then a reduction in price will increase quantity demanded more than proportionately and TR (P x Q) will increase.
If the price elasticity of demand = 1, then a reduction in price will increase quantity demanded in proportion and TR will be unchanged
If the price elasticity of demand is < 1, then a reduction of price will increase quantity demanded less than proportionately and TR will fall.

43. Price Elasticity of Demand and Total RevenueQ TR
Max TR TR
rising TR
falling Q

44. Factors that Affect Price Elasticity of Demand
The closeness of substitutes
- the more close substitutes the higher the price elasticity of demand
The proportion of income spent on the good
- the higher the proportion of income spent on the good the higher the price elasticity of demand
The time elapsed
- The more time elapsed the more elastic the demand

45. Cross Price Elasticity of Demand
The elasticity of the demand for good X with respect to the price of another good Y
EDxPy= %ΔQX/%ΔPY or
EDxPy= ΔQX/QX / ΔPY/PY or
EDxPy= ΔQX/ΔPY • PY/QX
The sign matters, positive cross price elasticities indicate substitutes, negative cross price elasticities indicate complements

46. Complements and Substitutes
The demand curve for good X shifts
with changes in the price of good Y P
Price of a complement falls
Price of a substitute rises D’
Price of a complement rises
Price of a substitute falls D D” Q

47. Income Elasticity of Demand
The elasticity of demand for good X with respect to income (I)
EDxI= %ΔQX/%ΔI or
EDxI= ΔQX/QX / ΔI/I or
EDxI= ΔQX/ΔI • I/QX
EDxI > 1 normal and income elastic
EDxI < 1 > 0 normal and income inelastic
EDxI <0 inferior good
Necessaries, luxuries and income levels

48. Elasticity of Supply
The elasticity of the supply of good X with respect to its own price
ESxPx= %ΔQS/%ΔP or
ESxPx= ΔQS/QS / ΔP/P or
ESxPx= ΔQS/ΔP • P/QS
Elasticities of supply can range from zero to infinity. Depends on technology, resource substitution, and time frame
All straight line supply curves through the origin will have elasticities of supply = 1

49. Elasticity of Supply P S 50 10 40 100 Q 200 100
ESxPx = 100/10 x 45/150 = 3

50. An Example
Times Colonist editorial concerning BC Ferry fares, July 2009: “Increased fares have resulted in fewer passengers. BC Ferries own figures indicate an 8% rise in fares results in a 2.25% drop in travel. Last year fares rose by 7.3%. Fewer passengers means less revenue for the Corporation and more fare increases. It is the start of a vicious cycle.” Is this correct?