The Law of Supply and Demand

Topic Outline
Demand Supply Elasticity

Consider the following cases:

Making Sales Targets A Public Transportation Problem: Can the daily ridership fluctuations be controlled through a pricing strategy? The Airliners Pricing Problem: How can an airliner fill its plains while maximizing its profit?

Economics and Consumer Demand

Macroeconomics
studies the economic behavior and relationships of an entire society

Microeconomics
examines relationship between individual consumers & producers

Demand

Relationship between the price of a good & the amount people wish to buy.

Factors Affecting Demand

How strong is the need or want? How available is the supply of products and services to satisfy individual needs? What alternative products could satisfy consumer needs?

Law of Demand
When the price of a product is increased, less will be demanded
Demand curve-shows the relationship between price and the quantity demanded

Demand Curve
Shows how much of a good would be purchased, if available, at various alternative prices given: Income Prices of related goods Tastes or preferences Special factors

Amount Supplied
Profit motive Economic resources-natural resources, capital, equipment, and labor Competition

Supply
Relationship between the price of a good & the amount offered on sale.

Supply Curve
Shows how much of a good would be offered for sale at various alternative prices

Cost of production Technology, cost of inputs & other factors

Law of Supply
More will be supplied as prices increase.
Supply curve-graph of the relationship between price and quantity supplied

Market Price
Point where supply and demand for a product are equal
Point where supply and demand curves intersect

Market Price
Self Sustaining Balance of forces

Sometimes prices are sticky

When are markets are competitive,excess demand will pull the prices up whereas excess supply will push it down.

The Long-Run Equilibrium

Price Level Long-run aggregate supply Short-run aggregate supply

Equilibrium price

Natural rate of output

Aggregate demand Quantity of Output

Elasticity the concept

The responsiveness of one variable changes in another
When price rises, what happens to demand? Demand falls BUT! How much does demand fall?

Elasticity the concept

If price rises by 10% - what happens to demand? We know demand will fall By more than 10%? By less than 10%? Elasticity measures the extent to which demand will change

What does it measure really?

The elasticity measure is a ratio between two percentage measures: the percentage change in one variable over the percentage change in another variable

A price elasticity of -6.25 means that for each one percent change in price the quantity demanded will change by 6.25 percent.

Elasticity
4 basic types used: Price elasticity of demand Price elasticity of supply Income elasticity of demand

Cross elasticity

What Determines Elasticity?

Necessities versus luxuries Eating at restaurants Groceries Availability of substitutes Chicken versus beef How much of our income a good takes Salt versus Nike sneakers The passage of time

THE ELASTICITY OF DEMAND

Price elasticity of demand is a measure of how much the quantity demanded of a good responds to a change in the price of that good.

Price elasticity of demand is the percentage change in quantity demanded given a percent change in the price.

Price Elasticity of Demand

The responsiveness of demand to changes in price. Where % change in demand is greater than % change in price elastic Where % change in demand is less than

% change in price - inelastic

The Price Elasticity of Demand

(a) Perfectly Inelastic Demand: Elasticity Equals 0 Price Demand $5

4
1. An increase in price . . .

100

Quantity

2. . . . leaves the quantity demanded unchanged.

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The Price Elasticity of Demand

(b) Inelastic Demand: Elasticity Is Less Than 1

Price

$5 4 1. A 22% increase in price . . . Demand

90

100

Quantity

2. . . . leads to an 11% decrease in quantity demanded.

The Price Elasticity of Demand

(d) Elastic Demand: Elasticity Is Greater Than 1

Price

$5 4 1. A 22% increase in price . . . Demand

50

100

Quantity

2. . . . leads to a 67% decrease in quantity demanded.

Elasticity
The Formula: Ped = % Change in Quantity Demanded ___________________________ % Change in Price

If answer is between 0 and -1: the relationship is inelastic If the answer is between -1 and infinity: the relationship is elastic Note: PED has sign in front of it; because as price rises demand falls and vice-versa (inverse relationship between price and demand)

Elasticity
Price ()

Producer decides to reduce price to increase sales % in Price = - 30% % in Demand = + 300% Ped = - 10 (Elastic) Total Revenue rises Good Move!
D

10 7

Quantity Demanded

20

How Total Revenue Changes When Price Changes: Inelastic Demand

Price An Increase in price from $1 to $3

Price leads to an Increase in total revenue from $100 to $240

$3

Revenue = $240 $1 Revenue = $100 0 100 Demand Quantity 0 80 Demand Quantity

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How Total Revenue Changes When Price Changes: Elastic Demand

Price
An Increase in price from $4 to $5

Price
leads to an decrease in total revenue from $200 to $100

$5
$4 Demand Revenue = $200 Revenue = $100 Demand

50

Quantity

20

Quantity

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Other Elasticity Measures!!!

Recall: Elasticity is a (standard) measure of the degree of sensitivity ( or responsiveness) of one variable to changes in another variable. Income Elasticity: a measure of the degree of sensitivity of demand for a good (or service) to changes in consumers (buyers) income Cross Price Elasticity: a measure of the degree of sensitivity of demand for a good (or service) to changes in the price of another good or service

Elasticity
Income Elasticity of Demand:
The responsiveness of demand to changes in incomes

Normal Good Demand rises as income rises and vice versa Inferior Good Demand falls as income rises and vice versa

Elasticity
Income Elasticity of Demand:
A positive sign denotes a normal good A negative sign denotes an inferior good

Income Elasticity
Goods consumers regard as necessities tend to be income inelastic
Examples include food, fuel, clothing, utilities, and medical services.

Goods consumers regard as luxuries tend to be income elastic.

Examples include sports cars, furs, and expensive foods.

Elasticity
For example: Yed = - 0.6: Good is an inferior good but inelastic a rise in income of 3% would lead to demand falling by 1.8% Yed = + 0.4: Good is a normal good but inelastic a rise in incomes of 3% would lead to demand rising by 1.2% Yed = + 1.6: Good is a normal good and elastic a rise in incomes of 3% would lead to demand rising by 4.8% Yed = - 2.1: Good is an inferior good and elastic a rise in incomes of 3% would lead to a fall in demand of 6.3%

Elasticity
Cross Elasticity: The responsiveness of demand of one good to changes in the price of a related good either a substitute or a complement
Xed = % Qd of good t __________________ % Price of good y

Elasticity
Goods which are complements:
Cross Elasticity will have negative sign (inverse relationship between the two)

Goods which are substitutes:

Cross Elasticity will have a positive sign (positive relationship between the two)

Elasticity
Price Elasticity of Supply:
The responsiveness of supply to changes in price If Pes is inelastic - it will be difficult for suppliers to react swiftly to changes in price If Pes is elastic supply can react quickly to changes in price
Pes =

% Quantity Supplied ____________________

% Price

Determinants of Elasticity
Time period the longer the time under consideration the more elastic a good is likely to be Number and closeness of substitutes the greater the number of substitutes, the more elastic The proportion of income taken up by the product the smaller the proportion the more inelastic Luxury or Necessity - for example, addictive drugs

Importance of Elasticity
Relationship between changes in price and total revenue Importance in determining what goods to tax (tax revenue) Importance in analysing time lags in production Influences the behaviour of a firm

Determinants of Elasticity of Supply

Ability of sellers to change the amount of the good they produce.
Beach-front land is inelastic. Books, cars, or manufactured goods are elastic.

Time period.
Supply is more elastic in the long run

Computing the Price Elasticity of Supply

Percentage change in quantity supplied Price elasticity of supply = Percentage change in price

The Price Elasticity of Supply

(a) Perfectly Inelastic Supply: Elasticity Equals 0 Price Supply $5 4 1. An increase in price . . .

100

Quantity

2. . . . leaves the quantity supplied unchanged.

Copyright2003 Southwestern/Thomson Learning

The Price Elasticity of Supply

(b) Inelastic Supply: Elasticity Is Less Than 1 Price Supply $5 4 1. A 22% increase in price . . .

100

110

Quantity

2. . . . leads to a 10% increase in quantity supplied.

Copyright2003 Southwestern/Thomson Learning

The Price Elasticity of Supply

(c) Unit Elastic Supply: Elasticity Equals 1

Price Supply $5 4 1. A 22% increase in price . . .

100

125

Quantity

2. . . . leads to a 22% increase in quantity supplied.

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The Price Elasticity of Supply

(e) Perfectly Elastic Supply: Elasticity Equals Infinity Price 1. At any price above $4, quantity supplied is infinite. $4 2. At exactly $4, producers will supply any quantity.

Supply

0 3. At a price below $4, quantity supplied is zero.

Quantity

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Summary
The income elasticity of demand measures how much the quantity demanded responds to changes in consumers income. The cross-price elasticity of demand measures how much the quantity demanded of one good responds to the price of another good.

The price elasticity of supply measures how much the quantity supplied responds to changes in the price.

Summary
Price elasticity of demand measures how much the quantity demanded responds to changes in the price. Price elasticity of demand is calculated as the percentage change in quantity demanded divided by the percentage change in price.

Summary
In most markets, supply is more elastic in the long run than in the short run. The price elasticity of supply is calculated as the percentage change in quantity supplied divided by the percentage change in price. The tools of supply and demand can be applied in many different types of markets.

Summary
The income elasticity of demand measures how much the quantity demanded responds to changes in consumers income.

The cross-price elasticity of demand measures how much the quantity demanded of one good responds to the price of another good.

Summary
If a demand curve is elastic, total revenue falls when the price rises. If it is inelastic, total revenue rises as the price rises.

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