supply and elasticity

SUPPLY

Definition of supply

Supply is the amount of a particular product or service that a firm would be willing and able to offer for sale at a particular price during a given period of time.

Law of Supply

The higher the price the higher is the quantity supplied and vice versa.

An increase in price will lead to an increase in quantity supplied, and the lower price will lead to a decrease in quantity supply.

Supply schedule:

Price Quantity $0.00 0 0.50 0 1.00 1 1.50 2 2.00 3 2.50 4 3.00 5

Supply Curve

$3.002.502.00

1.501.00

0.50

21 3 4 5 6 7 8 9 10

12

11

Price of Ice-Cream Cone

Quantity of Ice-Cream Cones

0

Price Quantity $0.00 0 0.50 0 1.00 1 1.50 2 2.00 3 2.50 4 3.00 5

Determinants of supply

Price of the good itself Number of sellers Technology Resource Prices Taxes and subsidies Expectations of producers Prices of other goods the firm could produce

Supply function:

Qs = f( Px, Pn, Ns, Cost, Tech., W, G)

Distinction between changes in quantity supplied and changes in supply

Changes in quantity supplied

A movement along the supply curve due to the changes in the price of the good itself. Quantity

S

P1

P2

Q1 Q2

a

b

Changes in supply

The shifts of the supply curve to the left or right due to the changes in the non-price determinants of supply

Price

Quantity

S1 S2

Q1 Q2

P0 c d

Price and output determination:(Market Structure)

What is the equilibrium price?

The price towards which the economy tends’

The price where the quantity demanded equal to quantity supplied.

Equilibrium price and quantity

Equilibrium Price The price that balances supply and demand. On

a graph, it is the price at which the supply and demand curves intersect.

Equilibrium Quantity The quantity that balances supply and demand.

On a graph it is the quantity at which the supply and demand curves intersect.

Price Quantity $0.00 0 0.50 0 1.00 1 1.50 4 2.00 7 2.50 10 3.00 13

Price Quantity $0.00 19 0.50 16 1.00 13 1.50 10 2.00 7 2.50 4 3.00 1

Demand Schedule

Supply Schedule

At $2.00, the quantity demanded is equal to the quantity supplied!

Supply

Demand

Price of Ice-Cream Cone

Quantity of Ice-Cream Cones

Equilibrium of Supply and Demand

21 3 4 5 6 7 8 9 10

12

11

0

$3.002.502.00

1.501.00

0.50

Price of Ice-Cream Cone

Quantity of Ice-Cream Cones

21 3 4 5 6 7 8 9 10

12110

$3.002.50

2.00

1.501.00

0.50

Supply

Demand

Surplus

Surplus:

When the price is above the equilibrium price, the quantity supplied exceeds the quantity demanded. There is excess supply or a surplus. Suppliers will lower the price to increase sales, thereby moving toward equilibrium

Excess Demand

Quantity ofIce-Cream Cones

Price ofIce-Cream

Cone

$2.00

0 1 2 3 4 5 6 7 8 9 10 11 12 13

Supply

Demand

$1.50

Shortage

Shortage:

When the price is below the equilibrium price, the quantity demanded exceeds the quantity supplied. There is excess demand or a shortage. Suppliers will raise the price due to too many buyers chasing too few goods, thereby moving toward equilibrium.

$90

$60

$30

1,000 2,000 3,000 4,000

D

S

The Supply & Demand for Tennis Shoes

Q

$90

$60

$30

1,000 2,000 3,000 4,000

D

S

The Supply & Demand for Tennis Shoes

Q

Surplus

Shortage

What causes a change in market equilibrium?

A change in demand

A change in supply

What can cause a shift in a demand curve?

a. Number of buyers in the market

b. Tastes and preferences

c. Income

d. Expectations of consumers

e. Prices of related goods

Three Steps To Analyzing Changes in Equilibrium Decide whether the curve(s) shift(s) to the

left or to the right. Decide whether the event shifts the supply

or demand curve (or both). Examine how the shift affects equilibrium

price and quantity.

$600

$300

4 8 12 16

D1

The Effects of Shift in Demand on Market Equilibrium

D2

Shortage

$900S

P

Q

$10

10 20 30 40D2

S

D1

Surplus

$20

The Effects of Shift in Demand on Market Equilibrium

Increase in Demand

Increase in Equilibrium

Price

Increase in Quantity Supplied

Decrease in Supply

Increase in Equilibrium

Price

Decrease in Quantity

Demanded

7. ELASTICITY OF DEMAND

Definition:Elasticity means responsiveness or sensitivity. Therefore elasticity of demand means the responsiveness of demand due to the changes of the factors that influence demand.

Types of Elasticity:

Price elasticity of demand Cross elasticity of demand Income elasticity of demand Price elasticity of supply

i. Price Elasticity of Demand (Ep)

Ep measures the responsiveness of the quantity demanded due to the change in its price.

Ep tries to measure how much does demand has decreased when price increased

Calculating price elasticity of demand;Formula:

Ep = - % ∆ in Qd for product X % ∆ in P of product X

= - % ∆ in Q % ∆ in P

= - ∆ Q x P0

∆ P Q0

= - (Q1 – Q0) x P0

(P1 – P0) Q0

Example:

Price(RM) Quantity Demanded

2.00 10

3.00 5

Calculate the price elasticity of demand when price increases from RM2.00 to RM3.00.

Formula:

Ep = - ∆ Q x P0

∆ P Q0

= - (Q1 – Q0) x P0

(P1 – P0) Q0

= - (5 – 10) x 2 (3 – 2) 10

= 1

Degrees of Price Elasticity of Demand

Elastic demand (Ep > 1)

Percentage change in quantity demanded is greater then the percentage change in price.

%Δ Q > %Δ P P

Q

D

D

ii. Inelastic demand (Ep < 1)

Percentage change in quantity is less than the percentage change in price.

%Δ Q < %Δ P

P

Q

D

D

iii. Unitary elastic (Ep = 1)

Percentage change in quantity demanded is equal to the percentage change in price.

%Δ Q = %Δ P

D

P

X

iv. Perfectly Elastic (Ep = ∞)

Percentage change in quantity demanded is infinite in relation to the percentage change in price.P

Q

DP0

v. Perfectly Inelastic (Ep = 0 )

Quantity demanded does not change as the price changes. P

QQ0

D

P1

P2

Determinants of Price Elasticity of Demand Availability of substitutes

Normally, the larger the number of substitutes available, the greater the elasticity of demand for a product. When substitutes are not readily available, the elasticity of demand is likely to be less.

Relative importance of the goods in the budget

If the goods take a large portion of an individuals budget, the demand tends to be elastic. Examples are cars, electrical appliances and other luxury goods. Therefore a small increase in the price of the goods will have a very large effect on the demand for the goods.

The amount of time available to adjust to the price change (Time dimension)

In the short run, demand is less elastic. In the long run demand is likely to be more elastic simply because consumers can make adjustment and fine other substitutes.

The importance of goods – necessity or luxury

The demand for necessity such as rice is inelastic, great increase in price will not reduce the demand for rice very much. On the other hand the demand for luxury goods or less important goods are elastic.

Income level

Those with higher income are less sensitive to price changes, therefore their demand is inelastic. Whereas those from lower income group are sensitive to price changes and their demand is more elastic.

Habits

If goods consume becomes habits, the demand for the particular goods are inelastic. Example is demand for cigarette by smokers.

Relationship between price elasticity of demand and total revenue (TR)

TR = price x quantity TR increases or decreases when there is price changes

depend on the price elasticity of demand.

i. If demand is elastic, to increase TR, price should be decreased.

ii. If demand is inelastic, to increase TR, price should be increased.

iii. If demand is unitary elastic, change in price would not affect and change in TR.

Cross Elasticity of Demand (Ec)

Ec measures the responsiveness of quantity demanded for one product to a change in the price of another product.

Qx = f(Py)

Two possibilities:Ec = +ve - an increase in Py would increase the demand for

good x, goods x and y are substitutes

Ec = -ve - an increae in Py would reduce the demand for

good x, goods x and y are complementary goods.

Formula:

Ec = % ∆ in Qx

% ∆ in Py

= ∆ Qx x Py0

∆ Py Qx0

= (Qx1 – Qx0) x Py0

(Py1 – Py0) Qx0

Example:Price of Y Quantity x Quantity Y

RM10 60 15RM18 40 25RM25 20 30

Calculate the cross elasticity of demand for good x when the price of y increases from RM18 to RM25

Answer:Formula :

= ∆ Qx x Py0

∆ Py Qx0

= (Qx1 – Qx0) x Py0

(Py1 – Py0) Qx0

= 30 - 25 x 1825 - 18 25

= 0.51

Conclusion;If Ec is positive, goods x and y are substitutes

Income Elasticity of Demand (Ey)

Ey measures the responsiveness of quantity demanded to a change in income.

Three possibilities:i. If Ey is positive = normal goods -

Ey >1 - luxury Ey ≤ 1 – necessity

ii. If Ey is negative = inferior goodsiii. If Ey is zero = essential goods

Formula:

Ey = % ∆ in Q

% ∆ in Y

= ∆ Q x Y

∆ Y Q

= (Q1 – Q0) x Y0

(Y1 – Y0) Q0

Example:Income Qty A Qty B Qty C 100 10 20 20 120 15 20 18 150 17 20 14

Calculate the income elasticity of demand for goods A, B and C when income increases from RM120 to RM150.

Good A:

Ey = (QA1 – QA0) x Y0

(Y1 – Y0) QA0

= (17 – 15) x 120 (150 – 120) 15

= 0.53

Since Ey is positive and < 1, good A is a necessity

Good B:

Ey = (QB1 – QB0) x Y0

(Y1 – Y0) QB0

= (20 – 20) x 120 (150 – 120) 20

= 0 (Good B is inferior good)

Good C:Ey = (QC1 – QC0) x Y0

(Y1 – Y0) QC0

= (14 – 15) x 120 (150 – 120) 15

= - 0.27

Good C is an inferior good

Price Elasticity of Supply

Measure “The responsiveness of quantity supplied to a change in price.“

Elasticity of supply can be determined by comparing the % change in quantity supplied with the % change in the price of the product. I

Types of Price Elasticity of Supply

Elastic Supply ( fairly elastic)

% change in quantity supplied is greater than % change in price.

Es =% Δ QS > % Δ P

S

P

Q

2. Inelastic Supply (fairly inelastic)

% change in quantity supplied is less than % change in price.

Es =% Δ QS > % Δ P Q

PS

Unitary Elastic

% change in quantity supplied is equal to the % change in price

Es =% Δ QS > % Δ PQ

S1S2

Perfectly Inelastic

% change in quantity supplied is zero despite the change in the price.

SP

Perfectly Elastic

% change in quantity supplied is infinitely large compared to the % change in price.

Q

P

SP0

mathematical formula

Es = % change in quantity supplied% change in price

= % Δ QS

% Δ P= Δ QS x P0 Δ P Q0

= Q1 - Q0 x P0P1 - P0 Q0

When the price of cars in RM 20,000 each the supply is 1000 units per month. When price increase to RM 30,000 each, the supply is 1200 units per month.Therefore, the elasticity of supply of cars is :-

= % Δ QS % Δ P = Δ QS x P0 Δ P Q0

= Q1 - Q0 x P0 P1 - P0 Q0

= 0.4

Factors Influencing Elasticity of Supply1. TIME

In the short run, supply would be inelastic, it is not possible to increase supply immediately in response to change in price. However, in the long run, supply would be more responsive to price changes, i.e. is more elastic. In the long run sellers or producers can fully adjust their supply to the change in prices.

2. NATURE OF THE GOODIf it takes too long to produce a product, supply is fairly inelastic. Otherwise supply will be elastic. For example, the supply of agricultural product (primary products) is fairly inelastic whereas the supply of manufactured goods (secondary products) is fairly elastic.

3. COST AND FEASIBILITY OF STORAGEIf the change in supply requires only a small change in production costs, most likely supply will be elastic. However if the change in supply involves a major change in costs supply tends to be inelastic.Goods that are too costly to be stored will have a low elasticity of supply.

4. SUBSTITUTABILITY OF FACTORS OR INPUTS USEDIf land, labor and capital can produce one commodity and these factors can be readily switched to produce another good, then supply of the factors is elastic.But if the production of its output require very specialized inputs, supply tends to be more elastic.

5.PERISHABILITY

If the product is a easily perishable, especially agricultural product, then the supply would be inelastic. Such products would not be sensitive to price changes, for example, vegetables. Hence, an increase in price will not bring about a distinctive change or rise in the quantity supplied.

Theory of Consumer Behavior

The theory of consumer behavior uses indifference curves and budget line to explain the conditions of consumers equilibrium or how consumer maximize utility

Assumptions:

A rational consumer will try to dispose of all his or her income in a manner to maximize his or her utility

Consumer knows his or her preferences and decides his or her consumption based on them.

Consumers preference are consistent

Consumer react to prices and react by reconciling their wants with their budget.

Indifference curve Indifference

curve is a locus of various combinations of two goods which yields the same or equal satisfaction.

Product Y

Product X0

A

B

C

Indifference Curve Properties of Indifference curve:

i. downward sloping – explains the tradeoff between the two goods for the

consumer to be equally satisfied.

ii. The further they are from the origin, the higher the utility level the represent.

iii. They do not intersect each other

Map of Indiference curves Product Y

Product X

IC1IC2

IC3

Budget Line

Budget line shows the alternative combinations of two goods which can be purchased with a given money income based on the prices of the gods.

Budget Line:

Given : Money income = RM100,

Px = 20 Py = 25

Slope of budget line: = Price of X

Price of Y

Y

X

4

5

Consumer equilibrium:

Consumer will be in equilibrium if the indifference curve is tangent to the budget line. IC2

Y

X0

e

a

b IC1