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