topic 2: supply and demand - dartmouth collegeecon01ab/f02-topic2.pdf · topic 2: supply and demand...

DARTMOUTH COLLEGE, DEPARTMENT OF ECONOMICS ECONOMICS 1

Andreas Bentz page 1

Dartmouth College, Department of Economics: Economics 1, Fall 02Dartmouth College, Department of Economics: Economics 1, Fall 02Dartmouth College, Department of Economics: Economics 1, Fall 02

Topic 2: Supply and DemandTopic 2: Supply and Demand

Economics 1, Fall 2002Andreas Bentz

Based Primarily on Frank Chapters 2, 4


Supply and Demand: EquilibriumSupply and Demand: Equilibrium

Example: The Market for Apartments



3

The (Market) Demand CurveThe (Market) Demand Curve

Demand curve for one bedroom apartments:

The demand curvefor a good tells ushow much of thatgood is demandedat each price.

D

price (100s of $)

10

8

6

4

2

0

0 1 2 3 4 5 quantity (100s)

4

The Demand Curve, contdThe Demand Curve, contd

A downward-sloping demand curve tells usthat:

The higher the price, the less the demand for thegood.

Why? As price increases, fewer potential buyers can

afford to buy the good (income/wealth effect).

As price increases, some potential buyerssubstitute other goods (substitution effect).

We can write the (inverse) demand curve asp(q). Then we know that dp / dq < 0.



5

The (Industry) Supply CurveThe (Industry) Supply Curve

The supply curve fora good tells us howmuch of that good issupplied at eachprice.

S

price (100s of $)

10

8

6

4

2

0

0 1 2 3 4 5 quantity (100s)

Supply curve for one bedroom apartments:

6

The Supply Curve, contdThe Supply Curve, contd

An upward-sloping supply curve tells us that: The higher the price, the greater the supply for the

good.

Why? Typically: the more you produce, the greater the

production cost for each additional unit. In order tobe willing to supply more, you therefore need to beable to charge a higher price for each unit. (Theprice must cover the production cost.)



7

EquilibriumEquilibrium

In equilibrium,prices are such thatthe quantitydemanded equalsthe quantitysupplied.

D

S

price (100s of $)

10

8

6

4

2

0

0 1 2 3 4 5 quantity (100s)

Equilibrium in the market for apartments:

8

D

S

Excess Supply / Excess DemandExcess Supply / Excess Demand

excess supply: theamount by whichquantity suppliedexceeds quantitydemanded

excess demand: theamount by whichquantity demandedexceeds quantitysupplied

price (100s of $)

10

8

6

4

2

0

0 1 2 3 4 5 quantity (100s)



9

D

S

Price Ceiling (Rent Control)Price Ceiling (Rent Control)

The price ceilingcauses excessdemand: somepotential buyerswho would want topay more than theceiling cannotobtain the good(rationing).

price (100s of $)

10

8

6

4

2

0

0 1 2 3 4 5 quantity (100s)

Price ceiling at $400:

10

D

S

Price FloorPrice Floor

The price floorcauses excesssupply: somepotential supplierswho would want tosupply at a lowerprice cannot sellthe good.

price (100s of $)

10

8

6

4

2

0

0 1 2 3 4 5 quantity (100s)

Price floor at $800:



11

D

S

Welfare Properties of EquilibriumWelfare Properties of Equilibrium

Equilibrium has nice welfare properties:

Example: Prices arefixed at $400, so 200apartments are rented.

Now suppose somebuyer offered $700 forone more apartment. Aseller should be happyto provide one moreapartment (since thecost of providing thatapartment is $400).

price (100s of $)

10

8

6

4

2

0

0 1 2 3 4 5 quantity (100s)

12

PricesPrices

Prices serve two important functions: Rationing function:

We live in a world of scarcity. If all goods were free, howcould we ration peoples unlimited wants?

Allocative function: Since we live in a world of scarcity, we need to allocate

the available resources so that:

those who value goods most highly obtain them;

those goods that are most wanted are being produced(suppose there is excess demand in one market: firmswould have an incentive to expand production in thatmarket, because supernormal profits can be made).




Using Supply and DemandUsing Supply and Demand

Changes in DemandChanges in SupplyApplication: Taxes

Elasticity

14

Changes in DemandChanges in Demand

What shifts the demand curve? (Alternatively:What causes a rise (fall) in the quantitydemanded at every price?)

Changes in income/wealth: as consumersincome/wealth increases, they will want to buymore of a good at each price.

Prices of substitutes/complements: complements (e.g. coffee and cream): if the price of coffee

rises, your demand for cream will fall;

substitutes (e.g. coffee and tea): if the price of coffee rises,your demand for tea will increase.

etc.



15

Changes in SupplyChanges in Supply

What shifts the supply curve? (Alternatively:What causes a rise (fall) in the quantitysupplied at every price?)

Technology: better technology reduces cost ofproduction.

Factor prices: higher factor prices (e.g. cost oflabor) means higher cost of production.

Number of suppliers (e.g. computer manufacturers)

etc.

16

Demand v. Quantity DemandedDemand v. Quantity Demanded

Distinguish between: a change in demand (the entire demand curve shifts), and

a change in the quantity demanded (a movement along thedemand curve).

price

quantity

D

S

Example: consumersexpect a future price rise

price

quantity

Example: good weatherbefore harvest

S

D

S

D



17

Supply v. Quantity SuppliedSupply v. Quantity Supplied

Similarly

Distinguish between: a change in supply (the entire supply curve shifts),

and

a change in the quantity supplied (a movementalong the supply curve).

18

Using Supply and DemandUsing Supply and Demand

Example: Why do airfares increase in summer?

price

quantity

D

S

Example (a): carriers canexpand capacity

price

quantity

D

S

Example (b): carrierscannot expand capacity

D D

Think about your own example with a fall in demand!



19

Using Supply and Demand, contdUsing Supply and Demand, contd

price

quantity

D

Example (b): demand forgas is (relatively) inelastic

S

Sprice

quantity

D

S

Example (a): demand forgas is (relatively) elastic

S

Example: What happened during the oil price shock?

Think about your own example with a supply increase!


Application: TaxesApplication: Taxes

Producer/Consumer Taxes(Economic) Tax Incidence



21

TaxesTaxes

Suppose a tax of T is levied on each unit soldby the producer.

price

quantity

S

Supply curve shifts up bythe amount T.

S

T

In order to cover cost, theproducer needs to charge Tmore for each unit sold.

price

quantity

Tax incidence: who bearsthe tax?

S

S

D

But some of the cost T of thetax is borne by consumers.

22

Taxes, contdTaxes, contd

In order to buy the samequantity as before, the pricehas to fall by T.

But some of the cost T of thetax is borne by producers.

price

quantity

Demand curve shifts downby the amount T.

DD

T

price

quantity

Tax incidence: who bearsthe tax?

DD

S

Suppose a tax of T is levied on each unitbought by the buyer.



23

Tax IncidenceTax Incidence

Who bears the tax depends on the elasticitiesof supply and demand. Example: demand.

price

quantity

Example (a): Relativelyelastic demand curve

S

S

D

Tax borne largely byproducers.

Tax borne largely byconsumers.

price

quantity

Example (b): Relativelyinelastic demand curve

S

S

D

24

Tax Incidence, contdTax Incidence, contd

price

quantity

Example (a): Relativelyelastic supply curve

S

S

D

Tax borne largely byconsumers.

Tax borne largely byproducers.

price

quantity

Example (b): Relativelyinelastic supply curve

S

S

D

Who bears the tax depends on the elasticitiesof supply and demand. Example: supply.



25

Tax Incidence, contdTax Incidence, contd

Similarly, supply and demand elasticitiesdetermine the incidence of a tax levied onconsumers.

Workout: Try this at home!


ElasticityElasticity

Price Elasticity of DemandCross-Price Elasticity of Demand

Income Elasticity of Demand



27

Price Elasticity of DemandPrice Elasticity of Demand

The price elasticity of demand measures theresponsiveness of demand for a good withrespect to changes in the price of that good.

Definition: The price elasticity of demand is thepercentage change in the quantity demandedthat results from a 1 percent change in price.

Precisely, it is:

or, rewritten:

pp

qq

/

/=

q

p

dp

dq =q

p

p

q =

q

p

dq

dp

= /1

pp

qq=

/

/

28

Price Elasticity of Demand, contdPrice Elasticity of Demand, contd

says that:

The price elasticity of demand at some point on thedemand curve is

the inverse of the slope of the (inverse) demand curve,

times the ratio of price to quantity at that point on thedemand curve.

Implications: the price elasticity of demand is (probably) different at every point on the demand

curve;

nonpositive.

q

p

dq

dp

= /1



29


We call demand (at some point) elastic, if the quantitydemanded is relatively responsive to changes in price.

Definition: demand is elastic whenever < -1.

We call demand (at some point) inelastic, if thequantity demanded is relatively unresponsive tochanges in price.

Definition: demand is inelastic whenever -1 < < 0.

We call demand (at some point) unit elastic, if thequantity demanded changes proportionately tochanges in price.

Definition: demand is unit elastic whenever = -1.

30


Perfectly elastic demand( = -)

Perfectly inelasticdemand ( = 0)

Demand curve with slopedp/dq = 0

D

price

quantity

Demand curve with slopedp/dq =

D

price

quantity

Two extreme cases:



31

Using Price Elasticity of DemandUsing Price Elasticity of Demand

Example: Suppose you know that the priceelasticity of demand for pizza at Thayer is -2.

That is, every 1% increase in price results in a 2%reduction in the quantity demanded.

Currently, 100 slices of pizza are sold, at$1.75 each. So revenue from pizza is $175.

If the price of pizza increased to $2.10, wouldtotal revenue increase or decrease?

32

Using Price Elasticity, contdUsing Price Elasticity, contd

An increase from $1.75 to $2.10 is an increaseof 20%.

Since the elasticity is -2, we know that demand willfall by 40%.

Only 60 slices of pizza will be sold after theprice increase.

60 slices of pizza at $2.10 each create revenue of$126, which is less than $175.

Total revenue would decrease.



33

Buzz GroupBuzz Group

What effect does a 20% increase in price haveon total revenue from pizza if the priceelasticity of demand were -0.5?

34

Cross-Price Elasticity of DemandCross-Price Elasticity of Demand

We have already seen that prices of othergoods may influence demand for a good.

Example: If tea and coffee are substitutes, anincrease in the price of coffee will increase yourdemand for tea.

The cross-price elasticity of demand measuresthe responsiveness of demand for a good withrespect to changes in the price of some othergood.



35

Cross-Price Elasticity, contdCross-Price Elasticity, contd

Definition: The cross-price elasticity of demandis the percentage change in the quantitydemanded of one good that results from a 1percent change in price of some other good.

Precisely, for two goods, x and y, it is:

yy

xxxy pp

qq

/

/=

36


We can now be specific about substitutes andcomplements:

Two goods, x and y, are substitutes if anincrease in price of good y increases demandfor good x.

Definition: x and y are substitutes if xy > 0.

Two goods, x and y, are complements if anincrease in price of good y decreases demandfor good x.

Definition: x and y are complements if xy < 0.



37


38

Income Elasticity of DemandIncome Elasticity of Demand

We have also seen that changes inincome/wealth may have an effect on thequantity demanded of some good.

Example: As your income/wealth rises, you canafford to buy more of everything.

The income elasticity of demand measures theresponsiveness of demand for a good withrespect to changes in a consumersincome/wealth.



39

Income Elasticity, contdIncome Elasticity, contd

Definition: The income elasticity of demand isthe percentage change in the quantitydemanded of some good that results from a 1percent change in a consumersincome/wealth.

Precisely, it is:

(where m is income/wealth).

mm

qq

/

/=

40


Income elasticity of demand is usually positive(normal goods).

But there are goods of which you want to buyless as your income increases (inferior goods).



41


We can now be specific about which goodsare necessities and which are luxuries:

A good is a necessity if quantity demanded isrelatively unresponsive to changes inincome/wealth.

Definition: a good is a necessity if 0 < < 1.

A good is a luxury if quantity demanded isrelatively responsive to changes inincome/wealth.

Definition: a good is a luxury if > 1.

topic 2: supply and demand - dartmouth collegeecon01ab/f02-topic2.pdf · topic 2: supply and demand...

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