Chapter 2 Demand and Supply Analysis

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1 Chapter 2 Demad ad Supply Aalysis

2 Outlie 1. Competitive Markets Defiitio Assumptios of the model 2. The Market Demad Curve 3. The Market Supply Curve 4. Competitive Market Equilibrium 5. Elasticity 2

3 Mothly Crude Oil Prices i US dollars 3

4 Oil Market Why do oil price fluctuate? 1. Fall i Demad Weak ecoomic activity Icreased efficiecy Substitute toward other fuels 2. Geopolitical Reasos Middle East tryig to fold market to keep prices low to make it hard for substitutes Wars i middle east 3. Icrease Productio i America Decreased oil imports to become more eergy idepedet 4

5 Competitive Markets Defiitio: Markets were sellers ad buyers are small ad umerous, so they take the market price as give whe they decide how much to buy ad sell. 5

6 Competitive Market Assumptios 1. Fragmeted market: may buyers ad sellers Implies buyers ad sellers are price takers Ø 2. Udifferetiated Products: cosumers perceive the product to be idetical so do t care who they buy it from 3. Perfect Iformatio about price: cosumers kow the price of all sellers 4. Equal Access to Resources: everyoe has Ø access to the same techology ad iputs. Free etry ito the market, so if profitable for ew firms to eter ito the market they will 6

7 Market Demad Market Demad fuctio: Tells us how the quatity of a good demaded by the sum of all cosumers i the market depeds o various factors. Q d = Q(p,p o, I, ) The Demad Curve: Plots the aggregate quatity of a good that cosumers are willig to buy at differet prices, holdig costat other demad drivers such as prices of other goods, cosumer icome, quality. Q d= Q(p) Example Market Demad for Automobiles i the Uited States Q d = P 7

8 Market Demad Example Demad for New Automobiles i the US Price ($1000) Demad curve for automobiles i the Uited States Quatity (millios of automobiles per year) 8

9 Market Demad Note O a graph: P, price, is ALWAYS o vertical axis ad Q o horizotal axis. Whe writig out a demad fuctio: we write demad as Q as a fuctio of P If P is writte as fuctio of Q, it is called the iverse demad. Demad Fuctio: Q d= 100-2P Iverse Demad Fuctio: P=50 - Q d /2 9

10 Market Demad Law of Demad Law of Demad states that the quatity of a good demaded decreases whe the price of this good icreases. Empirical regularity The demad curve shifts whe factors other tha ow price chage If the chage icreases the willigess of cosumers to acquire the good, the demad curve shifts right If the chage decreases the willigess of cosumers to acquire the good, the demad curve shifts left 10

11 Market Demad Some Demad Shifters What are some? Price of related goods (Substitutes / Complemets Icome Number of buyers Tastes Expectatios 11

12 Market Demad Rule A movemet alog the demad curve for a good ca oly be triggered by a chage i the price of that good. We assume everythig else but price is held fixed Ay chage i aother factor that affects the cosumers willigess to pay for the good results i a shift i the demad curve for the good 12

13 Market Supply Market Supply Fuctio: Tells us how the quatity of a good supplied by the sum of all producers i the market depeds o various factors. Q s =Q(p, p o, w, r ) P o = price of other goods, w= wage rate, r=retal rate Market Supply Curve: Plots the aggregate quatity of a good that will be offered for sale at differet prices. Q s =Q(p) Example Market Supply for wheat i Caada Q s =0.15+P 13

14 Market Supply E.g. Supply Curve for Wheat i Caada Price ($/bushel) Supply curve for wheat i Caada i Quatity (billios of bushels per year) 14

15 Market Supply The Law of Supply states that the quatity of a good offered icreases whe the price of this good icreases. Empirical regularity The supply curve shifts whe factors other tha ow price chage If the chage icreases the willigess of producers to offer the good at the same price, the supply curve shifts right If the chage decreases the willigess of producers to offer the good at the same price, the supply curve shifts left 15

16 Market Supply Supply Shifters Price of related products Iput prices Number of sellers Techology Expectatios 16

17 Market Supply Rule A move alog the supply curve for a good ca oly be triggered by a chage i the price of that good. Ay chage i aother factor that affects the producers willigess to sell the good results i a shift i the supply curve for the good. 17

18 Market Supply E.g. Caadia Wheat Supply Curve: Q S = p +.05r Q S = quatity of wheat (billios of bushels) p = price of wheat (dollars per bushel) r = average raifall i wester Caada,May August (iches per moth) Questios: 1.What is the quatity of wheat supplied at price of $2 ad raifall of 3 iches per moth?

19 Market Supply E.g: Caadia Wheat Q S = p +.05r 2. How do you write the supply curve if raifall is 3 iches per moth? Q S = p + 0.5(3) Q S = p As raifall icreases how does it shift the supply curve? (e.g., r = 4 => Q = p + 0.2) To the right 19

20 Market Supply E.g: Caadia Wheat Price ($) r = 0 Q S = p +.05r Supply with o rai 0 Quatity, Billio bushels 20

21 Market Supply E.g: Caadia Wheat Price ($) Supply with o rai r = 0 Q S = p +.05r r = 3 Supply with 3 rai 0.15 Quatity, Billio bushels 21

22 Market Equilibrium Defiitio: A market equilibrium is a price such that, at this price, the quatities demaded ad supplied are the same. Demad ad supply curves itersect at equilibrium 22

23 Competitive Market Equilibrium Price Q s P* = 100 Equilibrium 50 Q d Q* = 100 Quatity 23

24 Market Equilibrium Practice: Fidig Equilibrium Price ad Quatity for Craberries Set-Up: Q d = 500 4p Q S = p p = price of craberries (dollars per barrel) Q = demad or supply i millios of barrels per year Questios: 1.Fid the equilibrium price of craberries? 24

25 Clicker questio What is the P ad Q i equilibrium if the market demad ad supply is like below Q d = 500 4p Q S = p A.Q=100 ad P=50 B.Q=100 ad P=100 C.Q=50 ad P=50 D.Q=50 ad P=100 25

26 Market Equilibrium Practice: Fidig Equilibrium Price ad Quatity for Craberries Step 1: Set supply equal to demad (Q d = Q s ) Step 2:Now solve for P: 500 4p = p 600=6P* P* = $100 Step 3: Plug P* back ito either Q d OR Q s Pluggig ito Q d : 500-4(100)=100 Pluggig ito Q s : (100)=100 Q*=100 26

27 Market Equilibrium Practice: Fidig Equilibrium Price ad Quatity for Craberries Now lets see how to graph supply ad demad Some folks like to rewrite so Q is o the RHS (iverse demad or supply fuctio) Q d = 500 4p OR p = Q d /4 Q S = p OR p = 50 + Q S /2 But, I like to fid the itercepts whe I kow I have a straight lie if Q d =0 p=125, if p=0 Q d =500 If Q S =0 the P=50 27

28 Practice: Fidig Equilibrium Price ad Quatity for Craberries P ($) Price 125 Market Supply: Q S = p P* = 100 Equilibrium 50 Market Demad: Q d = 500 4p Q* = Q (millios of barrels) 28

29 Elasticity ow we will lear about rubber bads well kid of. What is Elasticity? Tells us how much oe variable chages (i percet terms) with a 1 percet chage i a differet variable. The chage ca be a icrease or a decrease. Elasticity, ε #,% = % ()*+,- # % ()*+,-% Examples =.+/0, *4.50, *4 How much quatity demad chages with a icrease i price How much output chages with a decrease i capital How much wages chage with a icrease i labor 29

30 Elasticity Some elasticity get special ames ad attetio Elasticity of Demad (ow price elascity of demad): A measure of the rate of chage i the quatity demaded with respect to price, holdig all other determiats of demad costat.. I other words, it is the percet chage i quatity demad from a 1 percet chage i price. ε 6 /,7= percet chage i quatity percet chage i price Where Q d is a demad fuctio. = % Qd % P 30

31 Elasticity cotiued How do we calculate it? I m ot good at memorizig so I start with the defiitio o the last page ε 6 /,7= % Qd % P ε 6 /,7= Qd /Q P/P ε 6 /,7= Qd Q d P P ε 6 /,7= Qd P ε Q d,p= Qd P P Q d P Q d 31

32 Elasticity: examples %ΔQ d %ΔP = ΔQ Q ΔP / P = Qd P * P Q But we have to kow what this meas explai it i plai Eglish. E.g. elasticity = -2 (imagie it is -2/1) If the price goes up by 1 percet demad will be reduced by 2 percet E.g. elasticity = -0.5 (imagie it is 0.5/1) If the price goes up by 1 percet demad will be reduced by.5 percet percet. 32

33 How do we classify elasticity?.thik rubber bads Whe a oe percet chage i price leads to a greater tha oe-percet chage i quatity demaded, the demad curve is elastic. (e Q, P < -1) I geeral elastic if (e > 1 ) Whe a oe-percet chage i price leads to a less tha oepercet chage i quatity demaded, the demad curve is ielastic. (0 > e Q, P > -1) I geeral ielastic if (e < 1 ) Whe a oe-percet chage i price leads to a exactly oepercet chage i quatity demaded, the demad curve is uit elastic. (e Q, P = -1) I geeral uit elastic if (e = 1 ) 33

34 How Elastic are These Curves? P D 2 Perfectly Ielastic P 1 D 1 Perfectly Elastic Q 2 Q 34

35 Elasticity Estimates: Price Elasticity of Demad for Selected Grocery Products Category Soft Driks Caed Seafood Caed Soup Cookies -1.6 Breakfast Cereal -0.2 Toilet Paper Laudry Deterget Toothpaste Sack Crackers Froze Etrees Paper Towels Dish Deterget Estimated e Q,P Which products is demad elastic ad which is demad ielastic? 35

36 Elasticity Versus Slope Slope: is the ratio of absolute chages i quatity ad price. (= DQ/DP). Measures the absolute chage i quatity demaded (i uits of quatity) due to a oe-uit chage i price. Q d =a-bp a is the itercept, -b is the slope Elasticity: is the ratio of relative (or percetage) chages i quatity ad price. Measure percetage chage i quatity demaded due to oe-percet chage i the price of the good 36

37 Elasticity Versus Slope Why elasticity is more useful? it is uitless so allows us to easily compare across coutries ad goods Uits of quatities will be differet for differet goods. How to compare sow boards to orages. Prices are differet across differet coutries. More difficult to compare Euro to US $ 37

38 What Affects Elasticity? Availability of Substitutes: Demad is more(less) elastic whe there are more(fewer) substitutes for a product. E.g: Demad for all beverages less elastic tha demad for Coca-Cola There are substitute for Coca-Cola, drik Pepsi It is harder to fid a substitute for soda if you love soda. % of Icome Spet o Product Demad is more(less) whe the cosumer s expediture o the product is large(small) Necessity Products The demad is less price elastic whe the product is a ecessity Market Level vs Brad-Level Price Demad teds to be more elastic for a particular brad of a good, tha for the good i geeral 38

39 Liear Demad Slope, choke price, elasticity Geeral Form: Q d = a bp a, b are positive costats p is price Notice that: b is the slope a/b is the choke price: price at which quatity demaded is zero Set Q=0 ad solve for P Solve for iverse demad (itercept): P=a/b-Q d /b 39

40 Liear Demad Curve Slope, choke price, elasticity Elasticity is: e Q,P = (DQ/Dp)(p/Q) defiitio =-b(p/q) Note that: Whe Q=0, elasticity is - Whe p=0, elasticity is 0 so elasticity falls from 0 to - alog the liear demad curve, but slope is costat. 40

41 Elasticity with a Liear Demad Curve P a/b e Q,P = - Elastic regio a/2b e Q,P = -1 Ielastic regio 0 a/2 a e Q,P = 0 Q 41

42 Problem: Determiig Elasticity Liear demad curve if Q d = p, ad p = 30, what is the elasticity of demad w.r.t ow price? e Q,P = (-b)(p)/(q) Q = (30) = 100 e Q,P = (-10)(30)/(100) = -3 "elastic Or use calculus Q d P * P Q d = 10* P = 10* (30) = 3 Why is elasticity egative? demad curve dowward slopig. 42

43 Problem: Determiig Elasticity Costat elasticity demad curve Costat Elasticity F (geeral form): Q d = Ap e e = elasticity of demad ad is egative p = price A = costat Example: If demad ca be expressed as QP = 100, what is the price elasticity of demad? Q=100P -1, so elasticity is -1 43

44 Costat Elasticity Demad Curve Price P Observed price ad quatity Costat elasticity demad curve Liear demad curve 0 Q Quatity 44

45 Importace of Brads Model Price Estimated e Q,P Mazda 323 $5, Nissa Setra Ford Escort Lexus LS400 $5, $5, $27, BMW 735i $37, Demad for idividual models is highly elastic Market-level price elasticity of demad for automobiles -1 to -1.5 Compact automobiles have lots of substitutes Luxury cars have less substitutes Ø Demad for compact cars more elastic tha luxury cars. Example: Price Elasticities of Demad for Automobile Makes,

46 Other Commo Types of Elasticities Other Elasticities -- Elasticity of "X" with respect to "Y": (DX/DY)(Y/X) X ad Y could be aythig Price elasticity of supply: (DQ S /Dp)(p/Q S ) measures curvature of supply curve Icome elasticity of demad:(dq d /DI)(I/Q d ) measures degree of shift of demad curve as icome chages. Cross price elasticity of demad: (DQ d /DP o )(P o /Q d ) measures degree of shift of demad curve whe the price of a substitute chages 46

47 The Cross-Price Elasticity of Cars PRICE Setra Escort LS i Setra Demad Escort LS i Practice Questios: What is the cross price elasticity of demad of the Setra with respect to Escort? If the price of the Escort icreases by 10 %, what will happe to the demad for the Setra? The demad for Setra will icrease by 4.54 % 47

48 Elasticities of Demad for Coke/Pepsi Practice Questio: Elasticity Coke Pepsi Price elasticity of demad Cross-price elasticity of demad Icome elasticity of demad What will happe to the demad for coke if icome icreases by 10%? If icome icreases by 10%, the demad for coke will icrease by 5.8% 48

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