U2: Supply and Demand

2.1 Demand

● Demand is downwards sloping:

● Important: When demand increases or decreases, it does not shift up or down; rather, it moves to the left if it decreases and to the right if it increases. Always use arrows to point towards the direction of the shift.

Relation

● Price and quantity demanded are inversely related

○ Substitution effect: when the price of a good decreases, consumers substitute this good for goods that are relatively more expensive than this cheaper good. When the price of a good increases, people will substitute less expensive goods.

○ Law of Diminishing Marginal Utility: states that all else equal, as consumption increases the marginal utility for each additional unit decreases.

○ Income effect: how much one’s income is actually worth depends on the price of goods). When the price of a good falls, consumers experience an increase in purchasing power.

■ Normal goods: buy more when receive higher income

● (ex. computers)

■ Inferior goods: buy less when receive higher income

● (ex. cup noodles)

● Law of Demand: a decrease in the price of goods causes an increase in the quantity demanded or an increase in price causes a decrease in the quantity demanded

Changes in Demand

● Changes in Demand can be a result of:

○ Change in income - when the good is a normal good, demand increases when income increases. If the good is inferior, as income increases, demand decreases

○ Change in the price of substitute goods - if the price of good X decreases, the demand for good Y decreases OR if the price of good X increases, the demand for good Y increases, then good X and good Y are called substitutes.

○ Change in the price of complementary goods (goods that are used together) - if the price of good X decreases as the demand for good Y increases, then they are complements.

○ Change in the number of buyers - if the number of buyers increases, demand for goods increase

○ Change in Expectations - if people expect the price of goods to increase, demand will increase now.

○ Change in Styles/Tastes - as style changes over time, so does demand for goods/services

● Buyers determine demand

● Demand Curves Slope Downward

○ Diminishing Marginal Utility: as a consumer purchases more of a good/service, the additional satisfaction falls for each additional unit.

■ Marginal Utility: The extra satisfaction received from consuming an additional unit of a good or service.

2.2 Supply

● Supply is upwards sloping:

Relation

○ Price and quantity supplied are directly related

○ When supply increases or decreases, it does not shift up or down; rather, it moves to the left if it decreases and to the right if it increases. Always use arrows to point towards the direction of the shift.

○ Market supply curve is upward sloping because when the price that a good is being sold at is higher, producers want to produce more → creates more supply

■ Inverse is true: if price that something’s being sold at is low, producers want to produce less of it

○ Profit Motive: when market prices rise following an increase in demand, it becomes more profitable for businesses to increase output

○ Production & Costs: when output expands, a firm’s production costs begin to rise requiring a higher price to cover these extra costs of production

○ New Entrants: higher prices may create an incentive for new business to enter the market leading to an increase in supply.

● Law of Supply: as prices increase, the quantity supplied increases. Price does not affect supply, it affects the quantity supplied.

Changes in Supply

● Changes in Supply can be a result of:

○ Changes in the cost of production - if the cost of producing goods increases, supply will decrease. If it gets cheaper to produce goods, supply will increase.

○ Changes in technology - if technology makes it cheaper to produce goods/service, supply will increase. It relates to productivity: if workers get more productive, the supply of

goods will increase.

○ Change in the number of producers - an increase in the number of producers would increase the supply of goods/service.

○ Change in expectations - if producers expect the price to increase in the future, they will supply less now.

2.3 Price Elasticity of Demand

● Price Elasticity of Demand: - the measure of how responsive the quantity demanded is to changes in price.

ed = (%ΔQd)/(%ΔP)

● ED > 1 = Relatively Price Elastic

● ED < 1 = Relatively Price Inelastic

● ED = 1 = Price Unit Elastic

● ED = 0 = Perfectly Price Inelastic

● ED = ∞ = Perfectly Price Elastic

○ Inelastic Demand - quantity demanded doesn’t respond strongly to changes in price

○ Elastic Demand - quantity demanded responds strongly to changes in price

■ explaining that the percentage change in quantity supplied exceeds the percentage change in price

■ demand is more elastic if there are more substitute goods. A monopolist has no close substitutes so it is likely the least elastic demand.

○ Unit Elastic - quantity demanded changes by the same % as the price changes

○ Perfectly Price Elastic - quantity demanded changes infinitely with any change in price

○ Perfectly Price Inelastic - quantity demanded doesn’t change with price changes

Determinants

○ Availability of Close Substitutes - if there are many substitutes, demand is elastic

○ Necessities vs Luxuries - if the good/service is considered a luxury, the demand will be more elastic

○ % of Budget - the larger the percentage of your total budget, the more elastic demand will be.

○ Time - the longer consumers have to adjust to a price change, the more elastic the demand will be

● Demand is more elastic at lower quantities (higher prices) and more inelastic at high quantities (lower prices)

● Midpoint Formula

Total Revenue Test (Price X Quantity)

○ If P increases and Total Revenue increases, Demand is Inelastic

○ If P decreases and Total Revenue decreases, Demand is Inelastic

○ If P increases and Total Revenue decreases, Demand is Elastic

○ If P decreases and Total Revenue increases, Demand is Elastic

2.4 Price Elasticity of Supply

● Responsiveness of quantity supplied to price changes

es = (%ΔQs)/(%ΔP)

Determinants

○ Ease and Speed of Getting New Products into the Marketplace

○ Time - the longer producers have to adjust to prices changes the more elastic the supply is)

■ “market-period” → firms care unable to respond to price change → inelastic

■ short-run → firms can only increase production with existing factories → elastic

■ long-run → firms can expand or reduce factory capacity → highly elastic

Rules

● must be positive since higher prices = larger quantities supplied

○ ES = 0 means you are perfectly inelastic

○ ES < 1 means you are relatively inelastic

○ ES = 1 means you are unit elastic

○ ES > 1 means you are relatively elastic

○ ES = ∞ means you are perfectly elastic

2.5 Other Elasticities

● Quantity of a good demanded or supplied is not just dependent on price, so other elasticities can be measured for other factors beyond price as well. A measure of how much the quantity demanded of one good responds to a change in the price of another good

Cross-Price Elasticity of Demand

● Between Goods A and B = (% change in quantity of A demanded)/(% change in price of B)

○ Measures how much the demand of a certain good can be affected by price of a related good (when the goods are complements or substitutes)

■ If the cross-price elasticity of demand is positive, the goods are substitutes

■ If it’s a very large number, they are strong substitutes

● If the number is only slightly above 0, they are weak substitutes

○ If the cross-price elasticity of demand is negative, the goods are complements

■ If it’s a very negative number, they are strong complements

■ If the number is only slightly below 0, they are weak complements

Income Elasticity of Demand

● (% change in quantity demanded)/(% change in income)

● Measures how changes in income affect demand for a good

● If the income elasticity of demand is positive, the good is a normal good (a good in which quantity demanded for that good increases with increased income)

● If the income elasticity of demand is positive, the good is an inferior good (a good in which the quantity demanded for that good decreases with increased income)

2.6 Market Equilibrium and Consumer and Producer Surplus

● Equilibrium: Where supply and demand intersect gives you the equilibrium price and quantity

● Consumer Surplus: the difference between the buyer’s willingness to pay (height of the demand curve) and the price they do pay. 

● Producer Surplus: the difference between the revenue earned for each unit (Q) and its marginal cost of production

Deadweight Loss (DWL)

● Loss of efficiency when the optimal quantity (equilibrium) is not being produced.

○ Loss of total (consumer + producer) surplus.

○ Occurs anytime you move away from equilibrium due to government interference or externalities.

○ Found in the following graphs:

■ Monopoly (the result of setting price above MC)

■ Tax Graphs

■ Price Ceiling/Price Floor

■ Positive/Negative Externalities

2.7 Market Disequilibrium and Changes in Equilibrium

● Shortage: occurs when price is lower than equilibrium

Price Ceiling

○ Quantity demanded > Quantity supplied

○ Usually due to a Price Ceiling: a legal maximum on the price at which a good can be sold (ex. rent control)

■ Must be set below equilibrium price for the price ceiling to be binding

■ Floor High, Ceiling Low

○ A binding price ceiling will increase consumer surplus

○ If the supply is inelastic and a binding price ceiling is imposed, no DWL is resulted since the quantity supplied does not change after the imposition of the price ceiling.

○ What to do: Raise Price and Increase Quantity

Surplus

○ Occurs when price is higher than equilibrium

○ Quantity supplied > Quantity demanded

○ Usually due to a Price Floor: a legal minimum on the price at which a good can be sold (ex. minimum wage)

■ Must be set above equilibrium price for the price floor to be binding

■ Will create surplus - Quantity Demanded is < than Quantity Supplied

■ Floor High, Ceiling Low

○ What to do: Lower Price and (2) Reduce Quantity

Double Shift Rule

○ If two curves shift at once, either price or quantity will be indeterminate, you will know the other one.

2.8 The Effects of Government Intervention in Markets

Quantity Controls

● Quota: quantity control saying only x amount can be bought or sold

● License: gives owner right to supply good/service

● Demand price: price at which given quantity is demanded

● Supply price: price at which given quantity is supplied

● Transactions

○ Transactions of good/service

○ Transaction of license

● Wedge: quota drives wedge between demand price and quantity transacted

○ Vertical distance between A and B

2.9 International Trade and Public Policy

● If the world price of a good is lower than the domestic price, the country will import the good.

● If the world price of a good is higher than the domestic price, the country will export the good.

● Protectionism: the government’s use of embargoes, tariffs, quotas, and other restrictions to protect domestic producers from foreign competition.

● Embargoes: A law that hurts trade with other countries.

Tariffs

● A tax on an import.

○ Economic Effects of tariffs:

■ Consumers pay higher prices and consume less

■ Consumer surplus has been lost

■ Domestic producers increase output

■ Declining imports

■ Tariff Revenue

■ Inefficiency

● Quotas: A limit on the quantity of a good that may be imported in a given time period.

● Tariffs & Quotas have similar economic effects

○ Both hurt consumers with artificially high prices and lower consumer surplus

○ Both protect inefficient domestic producers at the expense of efficient foreign firms, creating DWL

○ Both reallocate economic resources toward inefficient producers

○ Difference: tariffs collect revenue for the government, while quotas do not