Price theory & applications

Demand , supply & market

equilibrium
 MARKETS
• Includes the interplay among all the relevant
buyers and Sellers involved in the exchange of
something, good, service etc
• Examples: BSE, UB cafeteria, 411
• Markets are important because they represent
mechanism most societies use to facilitate
production, distribution & transactions of all
kinds
 Tools of Analysis
• Equilibrium Analysis
• Optimization
 Overview of Equilibrium Analysis
(price determination)
• In a free Market economy, price of a product/service
is determined by demand & supply situation in that
market
• Market for a product will be at equilibrium when
producers bring to the market exactly what
consumers want to take out of the market at that
price.
• Equilibrium is a market situation where there is no
inherent tendency for change
• The market is at equilibrium when quantity
demanded is equal to quantity supplied
 Demand Side
• Demand for a good refers to the various
quantities of that good per unit of time that
consumers will take off the market at all
possible alternative prices, ceteris paribus
• Quantity that consumers will take off the
market will be affected by a number of
factors
• These factors are referred to as
determinants of demand
 Determinants of Demand
• Price of the good (P)
• Consumers’ tastes & Preferences (T)
• No. of consumers under consideration (Pn)
• Consumers’ income (I)
• Prices of related goods (Pr)
• Credit Availability (Ca)
• Consumers’ expectations regarding future prices
of the product (E)
• Past levels of demand (Qt-1)
• Number of goods available to consumers (R)
• Q = f(P, T, Pn, I, Pr, R, Ca, E, Qt-1)
 Demand schedules & Curves
• Demand theory singles out the relationship between possible
alternative prices of the product & the quantities of it that
consumers will take off the market per time period
• Thus determinants 2 through 9 are held constant
• It conjectures quantity to be inversely related to price (law of
demand)
• Some exceptions may occur in which quantity taken varies
directly with price, but these must be few
• Demand refers to the entire demand schedule or curve
• A demand schedule lists different quantities of commodity
that consumers will take opposite the various prices of the
good per period
• Demand curve is the demand schedule plotted on an
ordinary graph, Q = f(P) or P = f(Q)
 Demand schedule and Curve contd…
• Pd = a – bQd or Qd = a/b – (1/b) Pd
• Qd = 50 – Pd
• The downward slope reflects the law of
demand – people buy more of a product,
service etc, as its price falls. Why?
• Plot the Demand schedule and curve
Demand Schedule (individual)
Price per KG Quantity per week
50 0
45 5
40 10
35 15
30 20
25 25
20 30
15 35
10 40
5 45
0 50

Demand Curve

60
50
Price in Pula

40
30
20
10
0
0 10 20 30 40 50 60
quantity per week

Demand Curve
Demand Schedule (market)
Quantity per week Summary
price per kgThato Tebogo Tshepho Total qty demanded
price per per
kg week
50 0 0 0 0 50
45 5 2 1 8 45
40 10 5 3 18 40
35 15 8 5 28 35
30 20 11 7 38 30
25 25 14 9 48 25
20 30 17 11 58 20
15 35 20 13 68 15
10 40 23 15 78 10
5 45 26 17 88 5
0 50 29 19 98 0

Market denad curve

60
50
Price in pula

40
30
20
10
0
0 20 40 60 80 100 120
quantity per week
 Change in Demand Vs Change in
quantity demanded
Price per kg

Movement along demand curve

Shift in demand curve

Initial demand curve
25 New demand curve

20

0
10 20 Quantity per week
Change in Demand vs Change in qty
demanded
• A movement along a given demand curve
represents a change in quantity demanded
from a change in price of the good itself, ceteris
paribus
• When any of the circumstances held constant
in the definition of demand curve are changed,
the demand curve itself will shift (change in
demand)
– Take for example an increase in wages & salaries
(Income), consumers will be willing to purchase
more at any given price
– The same reasoning applies in the case of No. of
consumers and other determinants
 Determinants of demand
• Consumers’ tastes (preferences) – a change in
consumer tastes that makes the product more
desirable means more of it will be bought at
each price
• No. of buyers – an increase in the number of
buyers in the market increases product
demand
• Income – for most products (normal/superior
goods) , a rise in income causes an increase in
demand. For inferior goods, an increase in
income reduces their demand
 Determinants of demand contd
• Prices of related goods – a change in the price of a
related good may increase or decrease the demand
for a product, depending on whether it is a
substitute or compliment
• Substitute good – is a good that can be used in the
place of another good. An increase in the price of a
substitute increases the demand for the other good.
• Complimentary good – is a good that is used
together with another good. An increase in the price
of a complimentary good reduces demand for the
other.
 Supply side
• Supply of a good is defined as the various quantities
of that good that sellers will place on the market at
all possible prices, ceteris paribus
• Quantities of a good that suppliers will put in the
market will depend on a No. of factors
• Such factors include, Price of the good (P)
• Set of prices of resources used in producing the good
(Pf)
• Range of production techniques available (K)
• Taxes and subsidies (Ts)
• Therefore Qs = f(P, Pf, K, Ts)
 Supply schedule & Curve
• Supply schedule lists different quantities per unit of
time of the good that suppliers are willing to put in
the market, ceteris paribus
• Supply curve is supply schedule plotted on a graph &
is usually upward sloping to the right
• For the supply curve, Pf, Ts and K are held constant,
I.e. Qs = f(P) or Ps = f(Qs)
• Example: Qs = Ps – 10 or Ps = Qs + 10
• From the equation above, derive the supply schedule
and curve (Do it on the board)
• The law of supply states that as price rises the
quantity supplied rises; as price falls quantity
supplied falls. Why?
Supply Schedule

Qty per week Price Per KG

40 50
35 45
30 40
25 35
20 30
15 25
10 20
5 15
0 10

Supply curve for cab service

60
50
price per trip

40
30
20
10
0
0 10 20 30 40 50
trips per day
 Supply schedule & curve
Supply schedule Supply curve
Price/trip trips per week
A 10 0 price/trip
Supply
B 15 5
40 curve
C 20 10
D 25 15
30
E 30 20
F 35 25 20
G 40 30 10
H 45 35
I 50 40 0 10 20 40
30 trips/wk
 Change in Supply vs Change in qty
supplied
• A change in the price of the good will
occasion a movement along the supply
curve, this is change in quantity supplied

S0 S1
A change in any of the factors
held constant will result in a shift
in the entire supply curve from S0
20 b to S1 – change in supply

15 a
10
0 5 10 trips per day
 Change in supply
• If costs of factor input increase, Quantity
supplied at any given price will fall. For
instance we may have Qs=Ps-15 as the new
supply function (Use board)
Price per trip Trips per week
B1 15 0 (5)
C2 20 5 (10)
D3 25 10 (15)
E4 30 15 (20)
F5 35 20 (25)
G6 40 25 (30)
H7 45 30 (35)
I8 50 35 (40)
 Market price Determination
• If the demand & supply curves of any given
good are placed on a single diagram, then
forces that determine its mkt price will be
highlighted
• Demand curve highlights what consumers are
willing to do
• Supply curve shows what sellers are willing to
do
• Consumers’ demand is assumed to be
independent of the activities of suppliers
• Sellers’ supply is assumed to be independent
of consumers’ activities
 Market Price Determination

Supply curve

50 Excess supply
a b
35
e
30
c d
25
10 Excess demand

15 20 25 Quantity per week

 Some explanations
• At a price of P10 (intercept) or lower, the price is
so low that none of the good will be supplied.
• On the demand, at a price of P50 (intercept) or
higher, the price is so high that none of the good
will be consumed.
• For every P1 increase in price, qty consumed fall
by 1 kg per week (slope of demand curve)
• Similarly, for every P1 increase in the price, qty
supplied increases by 1 kg per week (slope of
supply curve)
 Market price determination
• At price of P35, producers will bring 25 kg of
beef/wk to the market
• Consumers will buy only 15 kg of beef/wk
• Suppliers bring to mkt more than consumers can
take off the mkt, there will be surplus (25-15) of 10
• Suppliers will cut prices to dispose off their surpluses
• As price goes down so will be the goods brought to
the market
• On the other hand, as price falls qty taken off the
mkt by consumers will increase
• Eventually price will drop to P30/kg & consumers
will be willing to take exactly the amount that sellers
want to place on the market at that price – This is
equilibrium price
• Assume the starting point was a price of P25 and do
the equilibrium analysis.
 Changes in demand
• What happens to the equilibrium price &
qty exchanged of a good when its
demand changes, say coz of changes in
income? supply

e2
35
e1 b
30
Excess D2
demand D1
0 25
20 30 kg per wk
 Changes in Demand contd..
• Demand curve shifts from D1 to D2
• At the initial price of P30, suppliers supply 20kg/wk,
but consumers are willing & able to buy 30kg/wk
• Consumers will bid against each other, thus pushing
up the price
• But as price increases, consumers will demand less &
less of the beef.
• On the other side producers will produce more beef
as its price rises
• The bidding & increase in qty supplied will continue
until a new equil is reached at e2
 Changes in Supply
• What happens to the equilibrium price &
qty exchanged of a good when its supply
changes, say coz of increases in wage
level? S2
S1
Price per kg

e2
35
30 e1

Excess Demand curve

demand
0 10 15 20 kg per week
 Changes in Demand & supply
• An increase in demand alone leads to an increase in
both equil price & qty (D : P , Q )
• A decrease in demand alone leads to a decrease in
both equil price & qty (D : P , Q )
• An increase in supply alone leads to an increase in
equil qty & fall in equil price (S : P , Q )
• A decrease in supply alone leads to an increase in
equil price & fall in equil qty (S : P , Q )
• What happens if both supply & demand
increase/decrease together?
 Surplus & shortage
• A surplus is an excess of quantity supplied
over quantity demanded. When there is
surplus, sellers cannot sell the quantities they
desire to supply.
• A shortage is an excess of quantity demanded
over quantity supplied. When there is a
shortage buyers cannot purchase the
quantities they desire
• An equilibrium is a situation in which there
are no inherent forces that produce change
 Algebra of Demand-Supply
Analysis
• Qd = 50 – P: demand
• Or Pd = Ps
• Qs = P – 10: supply
• To find Equilibrium we • 50 – Qd = 10 + Qs
equate Demand to • 40 = Qd + Qs, but Qs = Qd =
Supply, I.e Qd = Qs Q*, so
• 50 – P = P – 10 & solve
for P • 40 = 2Q*
• 2P = 60 • Q* = 20
• P* = 30 • Insert Q* into either Ps or
• Insert P* = 30 into either
Qs or Qd to get Q*
Pd to get P*
• Qd=50-30 = 20 = Qs = Q* • P* = Pd =50-20=Ps=30
 Public Policy Issues
• Microeconomic models above can help illuminate
public policy issues
• Price floors – governments intervene in mkts to
raise prices of particular goods or resources,
minimum wage (to protect unskilled labour from
exploitation), sorghum price (to protect incomes
of farmers)
• Price ceilings – to keep prices of certain goods at
less than certain prices, ex. Rent controls, interest
rates, petrol prices, food prices in Zim!
• Do these policies always help their intended
beneficiaries?
 Price ceiling (max. fare)

Supply curve

50

20
e
15
c d
12
10 shortage

15 20 25 trips per day

 Price floor (min. wage)

Supply curve

50 surplus
a b
20
e
15
12
10

15 20 25 Labor hours per day

 The elasticity of demand
• Elasticity is a measure of the responsiveness of
quantity demanded or quantity supplied to one of its
determinants
• Price elasticity of demand measures how much the
quantity demanded responds to a change in price.
• Demand for a good is said to be elastic if the
quantity demanded responds more than
proportionately to changes in the price
• demand is said to be inelastic if the quantity
demanded responds only slightly to changes in the
price
 Price elasticity of demand
• Measures the sensitivity of quantity demanded to changes in
own price.
• Defined as %change in qty demanded resulting from 1%
change in price
– Varies from one point to another along a single demand
curve, i.e., from one price range to another, why?
– Price elasticity for same good may vary from market to
market, why?
• Why should we care about elasticity of demand?
• Why use percentages: absolute changes may bias our
perception of the responsiveness depending on the units
used. Example: P1 change & changes in grams
• Percentages also permit comparison of sensitivities to
changes in prices of different products. Example: response to
P1 change of houses & matches
 Computing price elasticity of demand
Point elasticity – measured at a single point on the curve
Arc elasticity – measured between two points on the curve
percentage change in quantity demanded of product X
price elasticity of demand ( d ) 
percentage change in price of product X
change in quantity demanded of X change in price of X
d  
original quantity demanded of X original price of X

• Problem! A price decrease and increase between two points along a

given demand curve gives different percentage changes (draw
demand curve & elasticity coefficients when moving from A to B &
from B to A)
– Example: a price change from P1 to P2 is 100%, but a change from P2 to P1 is
50%. Similarly, a qty change from 10 to 20 is 100%, but from 20 to 10 is 50%
– Which of these changes should we use in the calculation of elasticity?
– Elasticity should be the same whether price falls or rises
 price elasticity of demand (midpoint
formula)
• This problem is solved by using the midpoint
formula, where

(Q2  Q1 ) /[(Q2  Q1 ) / 2]
d 
( P2  P1 ) /[( P2  P1 ) / 2]
• Examples: when P1 =2, Q1=10; when P2=1,
Q2=40; calculate price elasticity of demand
using midpoint formula.
 Price elasticity & demand curves
• Demand is elastic when the elasticity is greater than 1,
so that quantity moves proportionately more than price.
Example: a 3% decline in price of lunch results in a 5%
increase in the quantity demanded
• Demand is inelastic when the elasticity is less than 1, so
that quantity moves proportionately less than price:
Example: a 3% decline in price of lunch results in a 1%
increase in quantity demanded
• Demand is unit elastic when elasticity equals to 1, so that
quantity moves the same amount proportionately to
price: E.g., a 3% fall in price results in a 3% increase in
quantity demanded
• The flatter the demand curve through a point, the
greater the price elasticity of demand
• The steeper the demand curve through a point, the
smaller the price elasticity of demand
 Price elasticity & demand curves
• For a vertical demand curve, demand is said
to be perfectly inelastic. Quantity demanded
stays the same irrespective of the price
• Demand is perfectly elastic for a horizontal
demand curve. This implies that very small
changes in the price lead to huge changes in
quantity demanded.
 Price elasticity & total revenue test
Price per Cans of Elasticity TR(PxQ) TR test
can (P) coke (Q) coefficient
8 1 8
7 2 5 14 elastic
2.60
6 3 18 elastic
1.57
5 4 20 elastic
4 5 1.00 20 Unit elastic
0.64
3 6 18 inelastic
0.38
2 7 0.20 14 inelastic
1 8 8 inelastic
Price elasticity along linear dd curve
• For linear demand curve,
• Elasticity of demand is
– Greater than 1 above the midpoint of curve
– Less than 1 below the midpoint of the curve
– Equals to 1 at the midpoint of the curve
P
Elasticity & Total revenue
Elasticity>1; A price reduction increases total
8
revenue; a price increase reduces it

Elasticity=1; total revenue is at maximum

4
Elasticity<1; A price reduction reduces total
revenue; a price increase increases it

0 2 4 6 8 Q

16

Q
0 2 4 6 8
 Elasticity & Total revenue
• If total revenue changes in the opposite
direction from price, demand is elastic
• If total revenue changes in the same direction
as price, demand is inelastic
• If total revenue does not change when price
changes, demand is unit elastic
 Price elasticity & total Revenue
elasticity Price Price fall
increase
Elastic Total revenue Total revenue
(>1) falls (why?) increases
Unitary Total revenue Total revenue
(=1) stays the stays the same
same (why?)
Inelastic Total revenue Total revenue falls
(<1) increases (why?)
Determinants of price elasticity of demand
• Substitutability – the larger the number of substitute
goods that are available, the greater the price elasticity
of demand. The more narrowly defined the product, the
larger the number of substitutes & thus more elastic
• Proportion of income – the higher the price of a good
relative to consumers’ incomes, the greater the price
elasticity of demand. Examples:
• Luxuries vs necessities – the more that a good is
considered to be a “luxury” the greater the price
elasticity of demand.
• Time – product demand is more elastic the longer the
time period under consideration. Consumers need time
to adjust to price changes.
 Price elasticity of supply
• Measures sensitivity of quantity supplied to
changes in price
• Defined as % change in qty supplied resulting
from a 1% change in price
•  s = % change in quantity supplied/% change
in price
 s  (Qs / Qs ) /( Ps / Ps )

 s  [Qs /((Qs1  Qs 2 ) / 2)] /[ Ps /(( Ps1  Ps 2 ) / 2)]

 Price elasticity of supply
• Suppose a 2% increase in price of beef results
in a 6% increase in the supply of beef. Calculate
the coefficient of elasticity
•  s =6%/2%=3; supply is elastic
• Go back to the original supply curve & compute
supply elasticity between points C & E. Using
 s  (Qs / Qs ) /( Ps / Ps )
Qs  (Qs 2  Qs1 )  20  10  10; Qs1  10
Ps  ( Ps 2  Ps1 )  30  20  10; Ps1  20
 s  (Qs / Qs1 ) /( Ps / Ps1 )  1010 10 20  2
 Price elasticity of supply
• If we compute the elasticity by moving from
point E to C we get:
 s  (Qs / Qs ) /( Ps / Ps )
Qs  (Qs1  Qs 2 )  10  20  10; Qs 2  20
Ps  ( Ps1  Ps 2 )  20  30  10; Ps 2  30
 s  (Qs / Qs 2 ) /( Ps / Ps 2 )   10 20   10 30  1.5

• But the two should be the same as they

measure elasticity between the same
points!!!!
Price elasticity of supply (midpoint) formula
• From C to E
Qs  (Qs 2  Qs1 )  20  10  10; (Qs1  Qs 2 ) / 2  15
Ps  ( Ps 2  Ps1 )  30  20  10; ( Ps1  Ps 2 ) / 2  25
 s  [Qs /((Qs1  Qs 2 ) / 2)] /[ Ps /(( Ps1  Ps 2 ) / 2)]
 s  [10 / 15)] /[10 /( 25)]  1.66
• From E to C
Qs  (Qs1  Qs 2 )  10  20  10; (Qs 2  Qs1 ) / 2  15
Ps  ( Ps1  Ps 2 )  20  30  10; ( Ps 2  Ps1 ) / 2  25
 s  [Qs /((Qs 2  Qs1 ) / 2)] /[ Ps /(( Ps 2  Ps1 ) / 2)]
 s  [10 / 15)] /[ 10 /( 25)]  1.66
 Price elasticity of supply – the market period
• The degree of price elasticity of supply depends on how
easily & quickly producers can shift resources between
alternative uses.
• The easier & more quickly producers can shift resources
between alternative uses, the greater the price
elasticity of supply.
• In the immediate market period supply is perfectly
inelastic because supplier does’t have time to respond
• The market period is the period that occurs when the
time immediately after a change in market price is too
short for producers to respond with change in quantity
demanded.
 Price elasticity of supply – the short & long run
• The short run is a period of time too short to change
plant capacity but long enough to use fixed plant
more or less intensively.
• The price elasticity of supply is greater than in the
case of immediate market period. i.e., an increase in
demand and hence price results in an increase in
supply.
• The long run is a time period long enough for firms to
adjust their plant sizes & for new firms to enter the
industry. So there is a greater supply response to
change in price.
 Income elasticity of dd
• Measures the sensitivity of the amount consumed
to changes in consumers’ money income at any
point on an Engel curve.
• Defined as % change in qty consumed resulting
from a 1% change in consumers’ money income.
 I  (Q / Q) /( I / I )
percentage change in quantity demanded of product X
 xI ) 
percentage change in money Income
 xI can be ,  or  0
• If  xI  0, the good is normal or superior
• If  xI  0, the good is inferior
• If  xI  1, the good is a luxury
• If 0   xI  1, the good is a necessity
 Cross price elasticity of dd
• Measures responsiveness of qty demanded of
good to changes in price of another good
• Defined as % change in qty demanded of good x
to 1% change in price of good y
 xy  (Qx / Qx ) /( Py / Py )
•If   0 the goods are substitute s
xy
If •  0 the goods are comp lim ents
xy