# Topic 2

Price: The Role of Demand and Supply

Law of Demand
 The quantity purchased of a good or

service is inversely related to the price, all other things being equal (ceteris paribus)

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The Law of Demand
Price changes lead Price to qty demanded changing....... Represented by movements along 3 demand curve. 2 Inverse relationship between price and quantity demanded gives rise to a 5 downward- sloping demand curve.

A B
negative slope

DD
15

Quantity/wk

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Quantity Demanded versus Demand  Quantity demanded  The quantities of a good or service that people will purchase at a specific price over a given period of time  Demand  A schedule of the total quantities of a good or service that purchasers will buy at different prices at a given time 4 .

Demand  Individual demand  The quantity of a good or service that an individual or firm stands ready to buy at various prices at a given time  Market demand  The sum of the individual demands in the marketplace 5 .

Demand Schedule and Demand Curve  Demand schedule  A table showing the various quantities of a good or service that will be demanded at various prices  Demand curve  A curve that indicates the number of units of a good or service that consumers will buy at various prices at a given time 6 .

35 1.15 1.50 1.40 1.05 0 1 2 3 4 5 6 7 8 9 10 11 12 13 D 7 Quantity (millions of hours) .55 1.25 1.45 Table 4-1 provides the detail for the demand curve presented here Price per Hour 1.Demand Curve for Internet Time \$1.10 1.20 1.30 1.

Changes in Quantity Demanded and in Demand  Change in quantity demanded  Movement along the demand curve that occurs because the price of the product has changed  Change in demand  A change in the amounts of the product that would be purchased at the same given prices. a shift of the entire demand curve 8 .

55 1.10 1.50 1.35 1.Demand Curves for Internet Time \$1.45 Price per Hour 1.20 1.25 1.05 0 1 2 3 4 5 6 A shift from D to D1 is an increase in demand  more will be purchased at each price A shift from D to D2 is a decrease in demand  less will be purchased at each price D1 D D2 7 8 9 10 11 12 13 9 Quantity (millions of hours) .15 1.30 1.40 1.

Determinants of Demand  Changes in income  Higher incomes  increase in demand  Lower incomes  decrease in demand  Changes in tastes and preferences  Change in consumer expectations 10 .

Determinants of Demand  Changes in the prices of other goods  Substitutes  Increase in the price of substitutes  increase in demand  Complements  Increase in the price of complements  decrease in demand 11 .

Supply  Supply  The total quantities of a good or service that sellers stand ready to sell at different prices at a given time  Individual supply  Quantities offered for sale at various prices at a given time by an individual seller  Market supply  Sum of the individual supply schedules in the marketplace 12 .

Supply  Supply schedule  A table showing the various quantities of a good or service that sellers will offer at various prices at a given time  Supply curve  A line showing the number of units of a good or service that will be offered for sale at different prices at a given time 13 .

because this good has become relatively more profitable to produce. compared to other gds 14 . all things being equal Why? Producers are more willing to sell greater amounts of a good at a higher price .Law of Supply The quantity offered by sellers of a good or service is directly related to price.

Changes in Quantity Supplied and in Supply  Change in the quantity supplied  Movement along the supply curve that occurs because the price of the product has changed  Change in supply  A change in the amount of the product that would be offered for sale at the same given price. a shift of the entire supply curve 15 .

15 1.40 1.05 0 A shift from S to S2 S2 is a decrease in demand  a smaller amount offered for sale at each price S S1 A shift from S to S1 is an increase in demand  a larger amount offered for sale at each price 1 2 3 4 5 6 7 8 9 10 11 12 13 16 Quantity (millions of hours) .10 1.35 1.25 1.30 1.45 Price per Hour 1.55 1.20 1.50 1.Supply Curves for Internet Time \$1.

Determinants of Supply  Changes in the cost of resources  Increase in the cost of resources  decrease in supply  Technology  Improvements  increase in supply  Expectations of future prices(Shift to the right)  Prices of related products 17 .

Expectations of Future Prices If sellers expect price of the good to fall in the future. . they will sell more now before the price actually falls!! Supply increases today.rightward shift 18 ....

Price of related goods Related goods (Supply side of the market) Substitutes in production Require the same resources to produce Complements in production Jointly produced with the same pool of resources Example Rubber bands Rubber erasers Example Beef Leather 19 .

 What impact does this have on the supply of Rubber Bands (RB) ? Price SS Price SS’ SS Supply of RE 20 Quantity Supply of RB Quantity .Price of related goods (substitutes in production)  Assume that the price of Rubber Erasers (RE) has increased.

Price of related goods (complements in production) Assume that the price of beef has increased. What impact does this have on the supply of leather ? Price Price SS SS’ SS 21 Supply of Beef Quantity Quantity Supply of Leather .

Equilibrium Price The price at which the quantity demanded equals the quantity supplied Market Equilibrium A state whereby the forces of market demand and market supply exactly balance each other and there is no tendency for change 22 .

45 1.15 1.55 1.21.20 1.30 1.05 0 1 2 3 4 5 6 7 8 9 10 11 12 13 E At a price of \$1.40 Demand Supply Price per Hour 1. and Market Price for Internet Time \$1.35 1.Demand. Supply.50 1.10 1.25 1. 6 million hours of Internet time will be offered for sale and an equal amount purchased 23 Quantity (millions of hours) .

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Surplus of Internet Time \$1.15 1. sellers will offer to sell at lower prices with the result that more consumers enter the market  price moves toward \$1.20 1.50 1.55 1. 7.8 Supply million hours will be offered for sale but consumers are only willing to purchase 4.40 1.30.05 0 1 25 Demand Surplus E At a price of \$1.45 1.35 1.25 1.2 million hours  Qs > Qd  surplus of Internet hours Rather than hold on to these hours.30 1.10 1.20 9 10 11 12 13 Price per Hour 2 3 4 5 6 7 8 Quantity (millions of hours) .

05 0 1 2 3 4 At a price of \$1.25 1.15 1.20 E Shortage 5 6 7 8 9 10 11 12 13 26 Quantity (millions of hours) .30 1.50 1.20 1.45 1.5 million hours but sellers are willing to offer only 3.Shortage of Internet Time \$1.40 Demand Supply Price per Hour 1. buyers want to buy 8.35 1.10 1.6 million hours  Qd > Q  shortage Some buyers will be willing to pay more with the result that the price will increase and sellers will increase the amount they offer for sale  move toward \$1.55 1.10.

unless demand. supply or both market forces change. there is no tendency for change. 27 . Demand & supply change when there is a change in determinants of demand and/or supply.Changes in Equilibrium Price & Quantity Once equilibrium is attained.

Increase in Demand Price SS P’ P Increase in Pe & Qe DD’ E’ E DD Q Q’ Quantity 28 .

Decrease in Demand Price SS E P P’ E’ Decrease in Pe & Qe DD DD’ Q’ Q 29 Quantity .

Increase in Supply Price E P P’ E’ DD Q 30 SS SS’ Decrease in Pe. Increase in Qe Q’ Quantity .

Decrease in Qe Quantity Q’ 31 Q .Decrease in Supply Price E’ P’ P E DD SS’ SS Increase in Pe.

Change In Both Demand & Supply At The Same Time the effect on only either P or Q can be determined straight away the impact on the other variable cannot be determined . unless given more information on the size of the relative shifts 32 .

What happens when: Demand and supply increase simultaneously? The equilibrium qty will definitely increase. but whether the equilibrium price will increase or decrease depends on how much demand shifts relative to supply 33 .

Increase in Qe Q 34 Q’ Quantity .Three Possible Situations: Demand increases more than supply does Price DD P’ P E’ E DD’ SS SS’ Increase in Pe.

Three Possible Situations: Supply increases more than demand does Price DD P P’ Q 35 DD’ SS SS’ Decrease in Pe. Increase in Qe E E’ Q’ Quantity .

Three Possible Situations: Demand increases by the same amount as supply Price DD’ SS SS’ E E’ No change in Pe. Increase in Qe DD P Q 36 Q’ Quantity .

General Guidelines  An increase in demand relative to supply  higher price  A decrease in demand relative to supply  lower price  An increase in supply relative to demand  lower price  A decrease in supply relative to demand  higher price 37 .

Disequilibrium Due To Government Intervention The government may step in to restrict the free operation of the market and create disequilibrium prices by imposing a PRICE CEILING or PRICE FLOOR 38 .

Price Ceiling A government-mandated maximum price that can be charged for a good or a service below the market equilibrium Producers cannot sell at a price higher than the ceiling price 39 .

40 .. sugar. rent control Price control on necessities eg rice. etc.g. oil.Why Imposed Price Ceiling ? Prevent consumers from being overcharged !!!! E.

000 Quantity (housing units) .000 40.000 30.The Effects of a Price Ceiling on Rental Housing S The effect of the price ceiling on rental housing is to cause a shortage and reduce housing opportunities to those families they are intended to accommodate D Monthly Price (\$) 700 E 500 Shortage 0 41 18.

consumers may have to put up with the deteriorating quality of such housing . Some people are willing to pay more to get some of the good.How Are Consumers Affected By A Price Ceiling? Since there is little incentive to maintain the quality of rent-controlled housing. The shortage caused by the price ceiling forces consumers to spend more time searching for an alternative. These people may end up relying on political connections and paying “coffee money”. 42 . The amount bought and sold with a price ceiling imposed is less than that at market equilibrium.

or min wage to ensure workers a min standard of living 43 . Price floors on agricultural products.Why Imposed Price Floor??? To ensure producers a higher and more stable income eg.

000 115.00 The impact of the price floor is to cause a surplus  the government must then buy and store the surplus that is created by the price floor D 0 44 75.000 Quantity (bushels) .000 100.00 2.The Effects of a Price Floor on Wheat S PF Price per Bushel (\$) Surplus 3.

govt intervention is needed to prevent downward pressure on price Govt often steps in to buy up the surplus..Effects of Price Floors Price floors create surpluses. as part of its support program towards producers 45 ..

What Does The Government Do With The Surplus? Surplus may be distributed to the poor But govt has to ensure that its actions does not lead to falling demand Alternatively. surplus may simply be stored up . wasteful if quality deteriorates over time 46 ....

The amount bought and sold with a price floor imposed is less than that at market equilibrium. 47 .How Are Consumers Affected By A Price Floor? Consumers pay a higher price than at market equilibrium (PF higher than Pe). Consumers pay taxes to cover government support for producers.

Price Elasticity of Demand  A measure of the sensitivity or responsiveness of quantity demanded to a change in price  Formula method  Total revenue method 48 .

Formula Method Price elasticity = percentage change in quantity demanded percentage change in price Q2 −Q1 (Q1 +Q2 )/2 = P2 −P 1 ( P +P2 )/2 1 49 .

000 2.Demand Curve Showing Different Elasticities \$13 12 11 10 9 8 7 6 5 4 3 2 1 0 50 D1 D2 D Price Elastic demand Unit elastic Inelastic demand D D1 1.600 2.400 Quantity/Time .

0  Demand curve D in Figure 4-9 51 .Unit Elastic Demand  Demand that exists when a percentage change in price causes an equal percentage change in quantity demanded  Has an elasticity coefficient equal to 1.

Elastic Demand  Demand that exists when a percentage change in price causes a greater percentage change in quantity demanded  Has an elasticity coefficient greater than 1.0  Demand curve D1 in Figure 4-9 52 .

Inelastic Demand  Demand that exists when a percentage change in price causes a smaller percentage change in quantity demanded  Has an elasticity coefficient less than 1.0 Demand curve D2 in Figure 4-9 53 .

Total Revenue Method
 If price changes but total revenue remains constant,

unit price elasticity of demand exists  If price changes but total revenue moves in the opposite direction, demand is elastic  If price changes and total revenue moves in the same direction, demand is inelastic

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Characteristics Affecting Price Elasticity of Demand
Trend Toward Elastic Demand Luxuries Large expenditures Durable goods Substitute goods Multiple uses

Trend Toward Inelastic Demand Necessities Small expenditures Perishable goods Complementary goods Limited uses

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Three Demand Curves Showing Different Elasticities
(a) P
Perfectly Elastic D1

(b)

(c)

P

D2 Perfectly Inelastic

P
Perfectly Unit Elastic D3

Q/t

Q/t

Q/t

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Demand Curve Showing Different Elasticities \$12 11 10 9 8 7 6 5 4 3 2 1 0 10 57 Price Un it E las tic Elasticity changes along the demand curve from elastic at the top to inelastic at the bottom Ela De stic ma nd 20 30 40 50 60 70 Ine De las ma tic nd 80 90 100 110 120 Quantity/Time .

Other Types of Elasticity  Cross elasticity of demand  Income elasticity of demand  Elasticity of supply 58 .

Cross Elasticity of Demand A measure of the responsiveness of the quantity demanded of one product as a result of a change in the price of another product Cross elasticity of demand = percentage change in the quantity demanded of product B percentage change in the price of product A 59 .

can affect the quantity demanded of the other 60 . if it is substitute or complementary product.Cross Elasticity of Demand  Substitute goods  Functionally equivalent goods  Complementary goods  Goods that are used together  A change in the price of one product.

the greater the cross elasticity 61 .Cross Elasticity of Demand  The coefficient of cross elasticity can be positive or negative  Positive in the case of substitutes  Negative in the case of complements  The larger the coefficient.

Income Elasticity of Demand A measure of the responsiveness of quantity demanded to a change in income Income elasticity of demand = percentage change in quantity percentage change in income 62 .

Income Elasticity of Demand  Normal goods  Positive coefficient  Demand varies in the same direction as income  Inferior goods  Negative coefficient  Demand varies inversely with changes in income 63 .

Elasticity of Supply A measure of responsiveness of quantity supplied to a change in price Price elasticity of supply = percentage change in quantity supplied percentage change in price 64 .

the only impact is an increase in price D1 D P Q 65 Q/t .Time and Elasticity of Supply – Immediate P S P1 Demand increases from D to D1 and because the sellers cannot adjust the quantity supplied on such short notice.

the seller has sufficient time to vary some productive resources  supply becomes more elastic and the quantity supplied increases.Time and Elasticity of Supply – Short Run P S P2 P D1 D Q 66 In the short run. causing the price to fall Q2 Q/t .

the supply curve becomes still more elastic because producers can S vary all productive resources and make use of new technology D1 Q3 Q/t D Q 67 .Time and Elasticity of Supply – Long Run P P3 P Over the long run.

Effects of a Tax on Cigarettes Price per Pack (\$) S + \$1 S Price per Pack (\$) S + \$1 S 5.00 e R e 5.25 5.75 5.00 R D 40 50 48 50 D Quantity (millions of packs) Quantity (millions of packs) 68 Note that the same \$1 tax has a much larger impact on quantity when demand is more elastic than when it is inelastic .