Economic Analysis for Management

Lecture 3

IME, IIT Kanpur

Demand and suppy recap

▶ Basic structure of a demand curve and a suppply curve

▶ Why they are called inverse curves
▶ Movement along the curve and shift of the curves
▶ Substitutes and complements
The Market Mechanism

▶ The Market mechanism works through interaction of supply and

demand curves.
▶ The intersecting point is called the equilibrium.
▶ In a ‘free market’, there is a ‘tendency’ of the market price to
change until the market clears, i.e., the market is in equilibrium.
▶ Market may not be in equilibrium always. And a market may not
clear quickly, when conditions change suddently (stock market is
one example, that clears quickly).
▶ At the equilibrium point, the quantity supplied and quantity
demanded are equal.
▶ Is the equilibrium a stable equilibrium? In other words, why does
the market tend to clear?
Supply and Demand equilibrium

Source: Microeconomics 8e, by Pindyck and Rubinfeld

When does this model work best?

▶ The assumption is that at any given price, a certain quantity will

be produced. And sold.
▶ This assumption works well in a competitive market, when
buyers and sellers cannot individually affect the market, when
the buyers and sellers have little market power.
▶ In a market where there is only one buyer, or seller, this
assumption does not work.
▶ Suppose demand increases. A monopolist will increase
production iff the new profit is higher than old profit. It will have
the option of increasing the price instead.
Changes in Market equilibrium - I
When the supply curve shifts to the right, the market clears at a lower
price P3 and a larger quantity Q3 .

Source: Microeconomics 8e, by Pindyck and Rubinfeld

Changes in Market equilibrium - II
When the demand curve shifts to the right, the market clears at a
higher price P3 and a larger quantity Q3 .

Source: Microeconomics 8e, by Pindyck and Rubinfeld

Changes in Market equilibrium - III
Supply and demand curves shift over time as market conditions
change.
In this example, rightward shifts of the supply and demand curves
lead to a slightly higher price and a much larger quantity.
In general, changes in price and quantity depend on the amount by
which each curve shifts and the shape of each curve.

Source: Microeconomics 8e, by Pindyck and Rubinfeld

Question

Use supply and demand curves to illustrate how each of the following
events would affect the price of butter and the quantity of butter
bought and sold: (a) an increase in the price of margarine; (b) an
increase in the price of milk; (c) a decrease in average income levels.
The Concept of Elasticity

▶ Often, we want to know how much the quantity supplied or

demanded will rise or fall due to rise in price (or some other
variable, such as income).
▶ We use elasticities to measure these.
▶ An elasticity measures the sensitivity of one variable to another.
▶ Specifically, it is a number that tells us the percentage change
that will occur in one variable in response to a 1-percent increase
in another variable.
▶ Example: Price elasticity of demand (or just price elasticity),
Income elasticity of demand, tax elasticity, etc.
Price elasticity of demand
▶ We write the price elasticity of demand, Ep as:
Ep = (%∆Q)/(%∆P),
where %∆Q means “percentage change in quantity demanded”
and %∆P means “percentage change in price.”
Price elasticity of demand
▶ We write the price elasticity of demand, Ep as:
Ep = (%∆Q)/(%∆P),
where %∆Q means “percentage change in quantity demanded”
and %∆P means “percentage change in price.”
▶ Now, the percentage change in a variable is the change in the
variable divided by the original level of the variable.
▶ Therefore, the price elasticity of demand can be written as:
∆Q/Q ∆Q P
Ep = ∆P/P = ∆P Q
Price elasticity of demand
▶ We write the price elasticity of demand, Ep as:
Ep = (%∆Q)/(%∆P),
where %∆Q means “percentage change in quantity demanded”
and %∆P means “percentage change in price.”
▶ Now, the percentage change in a variable is the change in the
variable divided by the original level of the variable.
▶ Therefore, the price elasticity of demand can be written as:
∆Q/Q ∆Q P
Ep = ∆P/P = ∆P Q

▶ Note that price elasticity of demand is generally a negative

number. Why?
Price elasticity of demand
▶ We write the price elasticity of demand, Ep as:
Ep = (%∆Q)/(%∆P),
where %∆Q means “percentage change in quantity demanded”
and %∆P means “percentage change in price.”
▶ Now, the percentage change in a variable is the change in the
variable divided by the original level of the variable.
▶ Therefore, the price elasticity of demand can be written as:
∆Q/Q ∆Q P
Ep = ∆P/P = ∆P Q

▶ Note that price elasticity of demand is generally a negative

number. Why?
▶ The higher the absolute value of price elasticity for a good, the
more price elastic the good is.
▶ Price elasticity can vary across goods.
▶ And also can vary across people for the same good.
Why elasticity?

We could have expressed the change in demand due to price rise

simply by dividing the change in quantity demanded by the rise in
price.
Then why is the concept of elasticity necessary?
Why elasticity?

We could have expressed the change in demand due to price rise

simply by dividing the change in quantity demanded by the rise in
price.
Then why is the concept of elasticity necessary?

Two reasons: 1. Unitless, and 2. comparable

Mercedes: 1000 cars sell a year, each 5 million rupees. Price goes
up to 6 million rupees, demand falls to 800.
∆Q/∆P = −200/1, 000, 000 units/rupees.
Why elasticity?

We could have expressed the change in demand due to price rise

simply by dividing the change in quantity demanded by the rise in
price.
Then why is the concept of elasticity necessary?

Two reasons: 1. Unitless, and 2. comparable

Mercedes: 1000 cars sell a year, each 5 million rupees. Price goes
up to 6 million rupees, demand falls to 800.
∆Q/∆P = −200/1, 000, 000 units/rupees.
Cotton: 10,000,000 kg sold in a year, Rs. 100 per kg. Price goes up
to 110, demand falls to 9,000,000 kg. ∆Q/∆P = −1, 000, 000/10
kg/rupees.
Linear demand curve

▶ Recall the expression for elasticity. It has two components, ratio

of change in quantity and price, and the ratio of the price and
quantity.
▶ So, price elasticity of demand depends upon slope of the
demand curve.
▶ Further, at various points within a demand curve, the elasticity
will have different values.
▶ Example: Q = 8 − 2P. Therefore, dQ dP = −2.
▶ Price elasticity of demand for this particular demand curve is
P
given by: −2 Q . It is not constant.
▶ The absolute value decreases as we move down along this
curve.
Diagram
Diagram

Source: Microeconomics 8e, by Pindyck and Rubinfeld

Infinitely elastic demand
▶ Principle that consumers will buy as much of a good as they can get at
a single price, but for any higher price the quantity demanded drops to
zero, while for any lower price the quantity demanded increases
without limit.
▶ Example: A horizontal demand curve. P = constant.
▶ ∆Q/∆P is infinite. So, price elasticity of demand is infinite as well.
Completely inelastic demand

▶ Principle that consumers will buy a fixed quantity of a good regardless

of its price.
▶ Example: A vertical demand curve. Q = constant.
▶ ∆Q/∆P is zero. So, price elasticity of demand is zero as well.
Question

Suppose the demand for natural gas is perfectly inelastic. What

would be the effect, if any, of natural gas price controls?