Demand, Supply and Price TheoryWEEK 2

Recap What is opportunity Cost?

Why are incentives important to policy makers?

Why isn’t trade amongst countries a game with winners and losers?

Why is productivity important?

What is the relationship between Marginal Benefit and Marginal Cost

The Scientific Method Economics is a Science

Economists devise theories, collect data and analyze it

Scientific economists make positive statements

Identify the problem

Develop a model based on simplified

assumptions

Collect data and test models

“In questions of science, the authority of a thousand is not worth the humble reasoning of a single individual.” ― Galileo Galilei

“Everything must be taken into account. If the fact will not fit the theory---let the theory go.” ― Agatha Christie

Three Economic Models The Circular Flow Diagram

The production possibilities frontier

Market equilibrium

The Circular flow diagram

“A visual model of the economy that shows how money flows through markets amongst households and firms”

Production Possibilities Frontier A graph that shows the combinations of output that the economy can possibly produce given the available factors of production and the available production technology.

Example◦ Economy can produce 300 shirts or 100 cakes◦ Producing at the PPF causes the market to be “efficient”◦ It is easy to see trade offs and opportunity costs◦ Opportunity Cost = the slope of the PPF Line

Slope = Change in Y/ Change in X◦ 300-0/100/0 = 3

Markets and Competition What happens

◦ To the price of petrol when war breaks out in Iran◦ To the price of mangoes when farmers have an abundant year◦ To the number of tourists when the tsunami hit Sri-Lanka

All of the above show the workings of Supply and Demand

Supply and Demand are the forces that make market economies work. ◦ They determine the following

◦ Quantity of Goods produced◦ Price of which goods are sold

Markets do very weird things because it reacts to how people behave, and sometimes people are a little screwy.

Alan Greenspan

What is a Market? A group of buyers and sellers of a particular good or service.

Characteristics of markets◦ Organized markets ◦ Less Organized markets.

A competitive market is a market which has many buyers and sellers so that each has a negligible impact on price.

For today’s class we will assume that markets are perfectly competitive.◦ The goods offered for sale are exactly the same so that no single buyer or

seller has influence over price.

Demand Quantity Demanded – the amount of a good that buyers are willing and are able to pay.

Market Demand – the sum of all individual demand for a particular good or service

Law of DemandThe claim that other things equal the quantity

Demanded of a good falls when the price of The good increases.

Teach a parrot the terms 'supply and demand' and you've got an economist.

Thomas Carlyle

Demand

Price Quantity Demanded

0 6

50 5

100 4

150 3

200 2

250 1

300 0

Shifts in the demand curveDemand curves can shift• To the RIGHT (A)• To the LEFT (B)

Shifts to the right means demand hasincreasedShift to the left means demand has decreased

Variables that cause Demand Curves to shift

Income

Prices of Related goods

Tastes

Expectations

Number of Buyers

Income Normal goods

◦ A good for which other things equal an increase in income leads to an increase in demand

Inferior Good◦ A good for which other things equal an increase in income leads to a

decrease in demand.

Price of Related Goods Substitutes

◦ Two goods for which an increase in price of one leads to an increase in demand for the price of the other

Complements◦ Two goods for which an increase in the price of one leads to a decrease in

demand for the other.

Supply Quantity Supplied

◦ The amount of a good that sellers are willing and able to sell.

Law of SupplyThe claim that other things equal the quantity Supplied of a good increase when the price of

The good increases.

Supply

Price of cone

Quantity Supplied

0 0

50 0

100 1

150 2

200 3

250 4

300 5

Shifts in the Supply Curve

• Shifts to the right increase supply• Shifts to the left decrease supply

Variables that cause the supply curve to shift

Input Prices◦ Costs of inputs. If they increase production decreases, if they decrease

production will increase

Technology◦ Machinery increases productivity

Expectation

Number of Sellers

Market Equilibrium

Equilibrium – A situation which the market price has reached the level at which quantity supplied equals the quantity demanded.

◦ Equilibrium price – the price that balances Qd and Qs◦ Equilibrium quantity – the quantity that balances Pd and Ps

Law of Supply and DemandThe claim that the price of any good adjusts to bring

the Qd and the Qs for the good into balance.

Surplus and Shortage Surplus – A situation where Qs is greater than Qd

Shortage – A situation where Qd is greater than Qs

No change in Supply

An increase in supply

Decrease in supply

No change in demand

P.Q No change P downQ up

P upQ down

Increase in Demand

P up Q up

P ambiguousQ up

P is upQ ambiguous

Decrease in demand

P downQ down

P downQ ambiguous

P ambiguousQ down

Elasticity of Supply and Demand

We use absolute numbers even though Qd is negatively related to its price.

|Ped|= Q/ P△ △

= 20/10 = 2

Price Elasticity of

Demand

Different Types of Demand

Perfectly Inelastic Demand

Inelastic Demand

Unitary Elastic Demand

Elastic Demand

Perfectly Elastic Demand

Determinants of Price Elasticity

Sustainability

Nature of the Product

Proportion of Income

Definition of Market

The Possibility of new purchases

Time Horizons

Addiction

Complementary goods

Price expectations

Income Elasticity of Demand

A measure of how much the quantity demanded for a good responds to a change in consumers income.

(Ey) Negative elasticity

◦ Ey>0 – D decreases as I increases

Zero Income Elasticity◦ Ey=0 – D does not change as I rises of falls

Income Inelastic Demand◦ 0<Ey<1 – D rises at a smaller proportion than I

Unit Income Elasticity◦ Ey=1 – D rises exactly the same proportion as I

Income elastic demand◦ 1<Ey<∞ - D rises at a greater proportion than income

The Cross Price Elasticity of Demand

The measure of how much the quantity demanded of one good responds to a change in the price of another good.

Price Elasticity of Supply

Es = Q/Q △ = Q△ x P △P/P P Q△

Determinants of Elasticity of Supply

Time

Excess Supply or Unsold Stock

Factor Mobility

Natural Constraints

Risk Taking