demand, supply and elasticity

7/29/2019 Demand, Supply and Elasticity

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DEMAND, SUPPLY ANDELASTICITY


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Overview

I. Market Demand

Curve

The Demand Function Determinants of Demand

Consumer Surplus

II. Market Supply

Curve The Supply Function

Supply Shifters

Producer Surplus

III. Market Equilibrium

IV. Price Restrictions

V. Comparative Statics


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Market Demand Curve

Shows the amount of a good that will be

purchased at alternative prices.

Law of Demand

The demand curve is downward sloping.

Quantity

D

Price


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Determinants of Demand

Income

Prices of substitutes

Prices of complements

Advertising

Population

Consumer expectations


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The Demand Function

An equation representing the demand curve

Qxd = f(Px ,PY , M, H,)

Qxd = quantity demand of good X.

Px = price of good X.

PY = price of a substitute good Y.

M = income.

H = any other variable affecting demand


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Change in Quantity

DemandedPrice

Quantity

D0

4 7

10

6

A

A to B: Increase in quantity

demanded

B


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Change in Demand

Price

Quantity

D0

D1

6

7

D0 to D1: Increase inDemand

13


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Market Supply Curve

The supply curve shows the amount of a good

that will be produced at different prices.

Law of Supply

The supply curve is upward sloping

Price

Quantity

S0


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Supply Shifters

Input prices

Technology or government regulations

Number of firms

Substitutes in production

Taxes

Producer expectations


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The Supply Function

An equation representing the supply curve:

QxS = f(Px ,PR ,W, H,)

QxS = quantity supplied of good X.

Px = price of good X.

PR = price of a related good

W = price of inputs (e.g., wages)

H = other variable affecting supply


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Change in Quantity Supplied

Price

Quantity

S0

20

10

B

A

5 10

A to B: Increase in quantity supplied


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Change in Supply

Price

Quantity

S0

S1

8

5 7

S0

to S1

: Increase in

supply

6


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Market Equilibrium

Balancing supply and demand

QxS = Qx

d

Steady-state


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If price is too low

Price

Quantity

S

D

5

6 12

Shortage

12 - 6 = 6

6

7


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If price is too high

Price

Quantity

S

D

9

14

Surplus

14 - 6 =8

6

8

8

7


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Price Restrictions

Price Ceilings

The maximum legal price that can be charged

Price Floors

The minimum legal price that can be charged.


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Impact of a Price Ceiling

Price

Quantity

S

D

P*

Q*

Ceiling

Price

Q s

PF

Shortage

Q d


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Impact of a Price Floor

Price

Quantity

S

D

P*

Q* Q

S

Q

d

Surplus

PF


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Summary

Use supply and demand analysis to

clarify the big picture (the general impact of a

current event on equilibrium prices and

quantities) organize an action plan (needed changes in

production, inventories, raw materials, human

resources, marketing plans, etc.)


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PRICE, INCOME

AND CROSSELASTICITY


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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?


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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


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Elasticity

4 basic types used:

Price elasticity of demand

Price elasticity of supply

Income elasticity of demand

Cross elasticity


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Elasticity

Price Elasticity of Demand

The responsiveness of demand

to changes in price

Where % change in demandis greater than % change in priceelastic

Where % change in demand is less than %

change in price - inelastic


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Elasticity

The Formula:

Ped =% Change in Quantity Demanded___________________________

% 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

PED has sign in front of it; because as price risesdemand falls and vice-versa (inverse relationship betweenprice and demand)


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Elasticity

Price (Rs.)

Quantity Demanded

The demand curve can be arange of shapes each of whichis associated with a differentrelationship between price andthe quantity demanded.


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Elasticity

Price

Quantity Demanded (000s)

D

The importance of elasticityis the information itprovides on the effect ontotal revenue of changes inprice.

Rs.5

100

Total revenue is price xquantity sold. In thisexample, TR = Rs.5 x100,000 = Rs.500,000.

This value is represented bythe grey shaded rectangle.

Total Revenue


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ElasticityPrice

Quantity Demanded (000s)

D

If the firm decides todecrease price to (say)Rs.3, the degree of priceelasticity of the demandcurve would determine theextent of the increase indemand and the change

therefore in total revenue.Rs.5

100

Rs.3

140

TotalRevenue


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Elasticity

Price (Rs.)

Quantity Demanded

10

D

5

5

6

% Price = -50%

% Quantity Demanded = +20%

Ped = -0.4 (Inelastic)

Total Revenue would fall

Producer decides to lower price to attract sales


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Elasticity

Price (Rs.)

Quantity Demanded

D

10

5 20

Producer decides to reduce price to increase sales

7

% in Price = - 30%

% in Demand = + 300%

Ped = - 10 (Elastic)Total Revenue rises


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Elasticity

If demand is priceelastic:

Increasing price

would reduce TR(% Qd > % P)

Reducing pricewould increase TR

(% Qd > % P)

If demand is priceinelastic:

Increasing price

would increase TR(% Qd < % P)

Reducing pricewould reduce TR

(% Qd < % P)


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Elasticity

Income Elasticity of Demand:


to changes in incomes

Normal Good demand risesas income rises and vice versa

Inferior Good demand falls

as income rises and vice versa


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Elasticity

Income Elasticity of Demand:

A positive sign denotes a normal good

A negative sign denotes an inferior good


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Elasticity

For example:

Yed = - 0.6: Good is an inferior good but inelastic a rise inincome of 3% would lead to demand fallingby 1.8%

Yed = + 0.4: Good is a normal good but inelastic

a rise in incomes of 3% would lead to demand risingby 1.2%

Yed = + 1.6: Good is a normal good and elastica rise in incomes of 3% would lead to demand risingby 4.8%

Yed = - 2.1: Good is an inferior good and elastica rise in incomes of 3% would lead to a fall in demand of 6.3%


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Elasticity

Cross Elasticity:


of one good to changes in the price of arelated good either

a substitute or a complement

Xed =

% Qd of good t__________________

% Price of good y


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Elasticity

Goods which are complements:

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)


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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

Pes =

% Quantity Supplied____________________

% Price


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Determinants of Elasticity

Time period the longer the time under considerationthe more elastic a good is likely to be

Number and closeness of substitutesthe 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


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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

demand, supply and elasticity

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