Chapter 2: Theory of Demand & Supply PDF

CHAPTER TWO THEORY OF DEMAND & SUPPLY AND ELASTICITY  Co pyr igh t Topic 2 200 Mc...

CHAPTER TWO THEORY OF DEMAND & SUPPLY AND ELASTICITY  Co pyr igh t Topic 2 200 Mc 4 Gra w- Hil Demand and Supply Au l stra lia 2012 Pty Ltd PP Ts Teach a parrot to say t/a demand and supply Mi and you have made an cro eco economist. no mic s 7/e 2 by Jac  Demand Quantity Demanded – the amount(number) of a good that a consumer is willing and able to purchase at the given price in a given period of time. Demand –consumers willingness and ability to purchase goods and services at various prices in a specific period of time., holding all else constant. 3  Cont… The relationship between price and quantity demanded can be seen using demand schedule, demand curve, demand function. Demand Schedule – a table that shows the relationship between quantity demanded and price ,ceteris paribus Demand Curve – a graph that shows the relationship between quantity demanded and price ,ceteris paribus Demand Function – a mathematical expression that shows the relationship between quantity demanded and price, ceteris paribus Law of Demand – All else equal, as price falls the quantity demanded rises and vice versa. 4 Cont… 5 Market Demand Versus Individual Demand Curve Individual Demand Curve – is a curve that represents the price quantity combination of a particular good for a single buyer Market Demand Curve – is a curve that represents the price quantity combination of a particular good for all buyer 6  Cont… Individual and market demand schedule 7  Cont… Individual and market demand curve Exercise: If there are 1000 identical buyers in the market, each with a demand function of Qdx=8-Px, then what is the market demand function? 8  Determinants of Demand 1. Price of product itself 2. Income 3. Price of Related Goods a. Substitute Goods b. Complementary Goods 4. Tastes and Preferences 5. Expectations 6. Number of buyers 9  Changes in Quantity Demand vs. Changes in Demand Changes in Quantity Demand –is represented by a movement a long a given demand curve =>This is caused by the change in the price of the good Changes in Demand–is represented by a shift of the demand curve =>This is caused by the change in the determinants of demand other than price of the product 10  Cont… 1. Income Normal Good – the higher your income the more you consume Examples: Sports Tickets, Cars, and Luxury Goods ↑Income => consume more at each P =>↑D Inferior Good – as income rises you consume less Examples: Shiro wot, Cabbage ↑Income => consume other products => ↓ D 11  Cont… 2. Price of Related Goods Substitute Goods – two goods in which a consumer will consume one good or the other Examples: Pepsi or Coke, Rent Movie or Go to Theater ↑Price of Pepsi => drink less Pepsi => purchase more Coke => ↑D 12  Cont… Complementary Goods – two goods consumed together Examples: gasoil and car, DVD Player and Movie, sugar and tea ↑Price of sugar => consume less tea => consume less sugar and tea => ↓D 13  Cont… 3. Tastes / Preference New tastes for the product => Consume more => ↑D 4. Expectations ↑Price tomorrow => buy today instead of tomorrow => ↑D 5. Number of buyers ↑number of buyers => More of the good is consumed => ↑D 14  Supply Quantity Supplied – the amount(number) of a good that a producer is willing and able to offer at each price level in a given period of time. Supply –producers willingness and ability to provide goods and services at different prices in a specific period of time., holding all else constant. 15  Cont… The relationship between price and quantity supplied can be seen using supply schedule, supply curve, supply function. Supply Schedule – a table that shows the relationship between quantity supplied and price ,ceteris paribus Supply Curve – a graph that shows the relationship between quantity supplied and price ,ceteris paribus Supply Function – a mathematical expression that shows the relationship between quantity supplied and price,ceteris paribus Law of Supply – All else equal, as price falls the quantity supplies falls and vice versa 16  Cont… Supply schedule and curve 17 Market Supply Versus Individual Supply Curve Individual Supply Curve – is a curve that represents the price quantity combination of a particular good for a single seller Market Supply Curve – is a curve that represents the price quantity combination of a particular good for all sellers 18  Cont… Individual and market supply schedule 19  Cont… Individual and market supply curve 20  Changes in Quantity Supply vs. Changes in Supply Changes in Quantity Supply –is represented by a movement a long a given Supply curve =>This is caused by the change in the price of the good Changes in Supply–is represented by a shift of the Supply curve =>This is caused by the change in the determinants of Supply other than price of the product 21  Determinants of Supply 1. Price of the product itself 2. Cost of Production a. Prices of required inputs b. Technologies used in production 2. Price of Related Products 3. Taxes and Subsidies 4. Sellers Expectation 5. Number of sellers 6. Weather condition 22  Cont… 1. Cost of Production a. Prices of required inputs ↑Price of labor =>hire less people =>produce less at current P =>↓S b. Technologies used in production New technology => produce output for less => higher profit on output => produce more at current P => ↑S 23  Cont… 2. Price of Related Products Examples: wheat Vs teff, leather Jacket Vs leather shoe ↑Price of leather Jacket => produce less leather shoe => Produce more leather Jacket => ↓S of leather shoe 3. Number of sellers ↑number of sellers => More of the good is produced => ↑S 4. Expectations ↑Price tomorrow => Sell tomorrow instead of today => ↓S 24  Cont… 5. Taxes and subsidies ↑ tax => Less of the good is produced => ↓S ↑subsidy => more of the good is produced ↑S 6. Weather condition(Agricultural Products)  Good Vs bad weather condition Good Weather condition => ↑ production of the good => ↑S 25  Market Equilibrium Market Equilibrium – occurs at a point at which the supply and demand curves intersect. => occurs when there is no incentive for prices to change (a steady state). This occurs when QS = QD The price at which these two curves cross is called the equilibrium price The quantity at which these two curves cross is called the equilibrium quantity 26  Cont… Market equilibrium 27  Cont… Exercise 1: From statistical studies, we know that for 1981 the supply curve for wheat was approximately as follows: Supply: QS = 1800 + 240P Where price is measured in dollars per bushel and quantities are in millions of bushels per year. These studies also indicate that in 1981 the demand curve for wheat was Demand: QD = 3550 – 266P Find the market clearing price and equilibrium quantity of wheat for the year1981. 28  Cont… Shortage (Excess Demand) – a shortage occurs when the quantity demanded is greater than the quantity supplied at a particular price. Surplus (Excess Supply) – a surplus occurs when the quantity demanded is less than the quantity supplied at a particular price. 29  Cont… Figure for shortage and surplus 30 Effects of changes in demand and supply in equilibrium price and equilibrium quantity Events that affect demand or supply (or both) will alter the equilibrium price and quantity. Let’s see for the following conditions; a. Change in demand keeping supply constant b. Change in supply keeping demand constant c. Simultaneous change in demand and supply a. Change in demand keeping supply constant I. when demand increases Demand curve shifts to the right Equilibrium point changes Equilibrium price and quantity increases p Do D1 So F P1 E P0 Q  II. when demand decreases Demand curve shifts to the left Equilibrium point changes Equilibrium price and quantity decreases p D1 Do So E P0 F P1 Q b. Change in supply keeping demand constant I. when supply increases Supply curve shifts to the right/outward Equilibrium price decreases but quantity increases So P S1 E P0 P1 F D0 Q0 Q1 Q  II. when supply decreases Supply curve shifts to the left/inward Equilibrium price increases but quantity decreases S1 P S0 B P1 P0 A D0 Q1 Q0 Q c. Change in both demand and supply I. When demand increases and supply decreases When DD↑ ↑P* and Q* ↑ When SS ↓ ↑P* and Q* ↓ ___________________________ P* ,but Q* remains indeterminate  Cont… II. When demand decreases and supply increases When DD ↓ ↑P* and Q* ↓ When SS↑ ↓ P* and Q* ↑ ___________________________ P* ,but Q* remains indeterminate  Cont… III. When both demand and supply increase When DD ↑ ↑P* and Q* ↑ When SS↑ ↓ P* and Q* ↑ ___________________________ P* remains indeterminate, Q* IV. When both demand and supply decrease When DD ↓ ↓ P* and Q* ↓ When SS ↓ ↑ P* and Q* ↓ ___________________________ P* remains indeterminate, Q*  Elasticity Of Demand and Supply Elasticity refers to responsiveness 1. Price Elasticity of Demand - measures how responsive consumers react to price change Price elasticity of demand = Percentage change in quantity demanded Percentage change in price ED = %ΔQ %ΔP Point price elasticity of demand ED = ΔQ. P ΔP Q Arc price elasticity of demand ED = ΔQ. P+P’ ΔP Q+Q’ 39  Cont… Elasticity expresses a relationship between two amounts => The percent change in quantity demanded => The percent change in price The law of demand states that price and quantity demanded are inversely related, => the change in price and the change in quantity demanded have opposite signs => the price elasticity of demand has a negative sign Referring a negative number gets cumbersome, the price elasticity of demand is represented as an absolute value => positive 40 number Categories of Elasticity of Demand 1. Inelastic:  Elasticity is between 0 and 1.0  The percent change in quantity demanded is smaller than the percent change in price,  Quantity demanded is relatively unresponsive to a change in price 2.unit-elastic :  elasticity with an absolute value of 1.0  If the percent change in quantity demanded equals the percent change in price 41  Cont… 3.Elastic:  price elasticity has an absolute value exceeding 1.0  The percent change in quantity demanded exceeds the percent change in price 4. Perfectly inelastic  demand curve is vertical  regardless of the price, the quantity demanded stays the same  price elasticity of demand approaches zero 5. Perfectly elastic demand  price elasticity of demand approaches infinity  the demand curve becomes horizontal  reflecting the fact that very small changes in the price lead to huge changes in the quantity demanded 42 43  Elasticity and Total Revenue Price elasticity can indicate the effect of a price change on total revenue Total revenue (TR) is the price (p) multiplied by the quantity demanded (q) at that price TR = p x q 44  Cont… Relation between Elasticity and Total Revenue When demand is elastic,  percent increase in quantity demanded≧ percent decrease in price  Total revenue increases When demand is unit elastic,  percent increase in quantity demanded= percent decrease in price  Total revenue remains unchanged When demand is inelastic,  percent increase in quantity demanded ≦the percent decrease in price  Total revenue decreases 45  Cont… 2. Income Elasticity of Demand Measures the percent change in demand divided by the percent change in income EI = ΔQ. I ΔI Q Categories of Income Elasticity of Demand  Goods with income elasticity less than zero are called inferior goods => demand declines when income increases Normal goods have income elasticity greater than zero => demand increases when income increases  Normal goods with income elasticity greater than zero but less than 1 are called income inelastic goods(necessary goods) => demand increases not as much as income does  Goods with income elasticity greater than 1 are called income elastic(luxury goods) => demand increases more than does income does 46  Cont… 3. Cross price elasticity of demand Measures the percent change in demand of a good divided by the percent change in price of an other good. EX = ΔQX. PY ΔPY QX Categories of cross price Elasticity of Demand  Goods with cross price elasticity less than zero are called complementary goods=> demand of a good declines when price of another good increases  Goods with cross price elasticity greater than zero are called subistute goods=> demand of a good increases when price of another good increases  Goods with cross price elasticity equals to zero are called unrelated goods=> demand of a good doesn’t change when 47 price of another good increases  Cont… 4. Price elasticity of supply Measures how responsive producers are to a price change Price elasticity of supply = Percentage change in quantity supplied Percentage change in price Es = %ΔQs %ΔP Point price elasticity of supply Es = ΔQs. P ΔP Qs Arc price elasticity of supply Es = ΔQs. P+P’ ΔP Qs+Qs’ 48  Categories of Supply Elasticity The terminology for supply elasticity is the same as for demand elasticity  If supply elasticity is less than 1.0, supply is inelastic  If it equals 1.0, supply is unit elastic  If it exceeds 1.0, supply is elastic  If it approaches to infinity, supply is Perfectly elastic  If it approaches to Zero, supply is Perfectly inelastic Exercise 2: Plot the graphs of perfectly inelastic and perfectly elastic supply curves. Exercise 3: Find the price elasticity of demand and supply of wheat for the year 1981 at the equilibrium price and quantity. Exercise 4:If demand function is given by P=50-0.1Q. Find the unit elastic point 49