1. Demand and Supply

2. 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.

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

4. 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)

5. 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

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

7. Supply Curve Law of Supply (ceteris paribus)
Amounts of a good produced at alternative prices
Inverse supply: minimum price to produce given amounts
Law of Supply (ceteris paribus)
Upward supply due to substitution effect
Quantity
Price S
Price
Quantity IS

8. 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)

9. 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 A 10 5 10

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

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

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

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

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

15. 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

16. 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
Price Floors
The minimum legal price that can be charged.
Minimum wage
Agricultural price supports

17. 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

18. Full Economic Price
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:  $5 = $15
Non-pecuniary price per gallon: $15/15 = $1
Full economic price of a gallon of gasoline: $1 + $1 = $2

19. Cost of purchasing excess supply
Impact of a Price Floor
Price
Quantity S D P* Q*
Surplus PF Qd Qs
Cost of purchasing excess supply

20. 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 = ?.

21. The Excise Tax 130 S + tax S P2=105 P1=100 P2-T=95 75 D D
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
Quantity (thousands of CD players per week) 62

22. 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
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

23. 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

24. 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
Quantity (thousands of CD players per week) 62

25. Demand and Revenue Demand Function Q = 70,000 – 100P
Inverse Demand Function P = 700 – .01Q
Total Revenue TR = P * Q = 700Q – .01Q2
Average Revenue AR = TR / Q = 700 – .01Q = P
Marginal Revenue MR = dTR / dQ = 700 – .02Q
For linear demand MR has the same intercept and twice the slope of AR
ARC Marginal Revenue Arc MR = TR / Q = (TR2-TR1) / (Q2-Q1) MR
P or AR