Chapter2_2018.pdf
- 1. Chapter 2 Demand and Supply Analysis
- 2. Outline 1. Competitive Markets § Definition § Assumptions of the model 2. The Market Demand Curve 3. The Market Supply Curve 4. Competitive Market Equilibrium 5. Elasticity 2
- 3. Monthly Crude Oil Prices in US dollars 3
- 4. Oil Market Why do oil price fluctuate? 1. Fall in Demand § Weak economic activity § Increased efficiency § Substitute toward other fuels 2. Geopolitical Reasons § Middle East trying to fold market to keep prices low to make it hard for substitutes § Wars in middle east 3. Increase Production in America § Decreased oil imports to become more “energy independent” 4
- 5. Competitive Markets 5 Definition: Markets were sellers and buyers are small and numerous, so they take the market price as given when they decide how much to buy and sell.
- 6. Competitive Market Assumptions 1. Fragmented market: many buyers and sellers Ø Implies buyers and sellers are price takers 2. Undifferentiated Products: consumers perceive the product to be identical so don’t care who they buy it from 3. Perfect Information about price: consumers know the price of all sellers 4. Equal Access to Resources: everyone has access to the same technology and inputs. Ø Free entry into the market, so if profitable for new firms to enter into the market they will 6
- 7. Market Demand n Market Demand function: Tells us how the quantity of a good demanded by the sum of all consumers in the market depends on various factors. § Qd =Q(p,po, I,…) n The Demand Curve: Plots the aggregate quantity of a good that consumers are willing to buy at different prices, holding constant other demand drivers such as prices of other goods, consumer income, quality. § Qd=Q(p) n Example – Market Demand for Automobiles in the United States Qd=5.3-0.1P 7
- 8. Market Demand – Example Demand for New Automobiles in the US 8 0 Quantity (millions of automobiles per year) Price ($1000) Demand curve for automobiles in the United States 53 5.3 40 2
- 9. Market Demand Note n On a graph: § P, price, is ALWAYS on vertical axis and Q on horizontal axis. n When writing out a demand function: § we write demand as Q as a function of P… If P is written as function of Q, it is called the inverse demand. § Demand Function: Qd=100-2P n Inverse Demand Function: P=50 - Qd/2 9
- 10. Market Demand Law of Demand n Law of Demand states that the quantity of a good demanded decreases when the price of this good increases. § Empirical regularity n The demand curve shifts when factors other than own price change… § If the change increases the willingness of consumers to acquire the good, the demand curve shifts right § If the change decreases the willingness of consumers to acquire the good, the demand curve shifts left 10
- 11. Market Demand Some Demand Shifters – What are some? n Price of related goods (Substitutes / Complements n Income n Number of buyers n Tastes n Expectations 11
- 12. Market Demand Rule n A movement along the demand curve for a good can only be triggered by a change in the price of that good. § We assume everything else but price is held fixed n Any change in another factor that affects the consumers’ willingness to pay for the good results in a shift in the demand curve for the good 12
- 13. Market Supply Market Supply Function: Tells us how the quantity of a good supplied by the sum of all producers in the market depends on various factors. Qs=Q(p, po, w, r …) Po = price of other goods, w= wage rate, r=rental rate Market Supply Curve: Plots the aggregate quantity of a good that will be offered for sale at different prices. Qs=Q(p) Example – Market Supply for wheat in Canada Qs=0.15+P 13
- 14. Market Supply E.g. Supply Curve for Wheat in Canada 14 0 Quantity (billions of bushels per year) Price ($/bushel) Supply curve for wheat in Canada in 2015 0.15
- 15. Market Supply n The Law of Supply states that the quantity of a good offered increases when the price of this good increases. § Empirical regularity n The supply curve shifts when factors other than own price change… § If the change increases the willingness of producers to offer the good at the same price, the supply curve shifts right § If the change decreases the willingness of producers to offer the good at the same price, the supply curve shifts left 15
- 16. Market Supply Supply Shifters n Price of related products n Input prices n Number of sellers n Technology n Expectations 16
- 17. Market Supply Rule n A move along the supply curve for a good can only be triggered by a change in the price of that good. n Any change in another factor that affects the producers’ willingness to sell the good results in a shift in the supply curve for the good. 17
- 18. Market Supply E.g. Canadian Wheat Supply Curve: QS = p + .05r n QS = quantity of wheat (billions of bushels) n p = price of wheat (dollars per bushel) n r = average rainfall in western Canada,May – August (inches per month) Questions: 1.What is the quantity of wheat supplied at price of $2 and rainfall of 3 inches per month? § 2.15 18
- 19. Market Supply E.g: Canadian Wheat QS = p + .05r 2. How do you write the supply curve if rainfall is 3 inches per month? QS = p + 0.5(3) QS = p + 0.15 3. As rainfall increases how does it shift the supply curve? (e.g., r = 4 => Q = p + 0.2) § To the right 19
- 20. Market Supply E.g: Canadian Wheat 20 Price ($) Quantity, Billion bushels 0 r = 0 Supply with no rain QS = p + .05r
- 21. Market Supply E.g: Canadian Wheat 21 Price ($) Quantity, Billion bushels 0 r = 0 r = 3 .15 Supply with no rain Supply with 3” rain QS = p + .05r
- 22. Market Equilibrium Definition: A market equilibrium is a price such that, at this price, the quantities demanded and supplied are the same. Demand and supply curves intersect at equilibrium 22
- 23. 23 Competitive Market Equilibrium Price Quantity 50 Price Quantity Q* = 100 P* = 100 Equilibrium Qs Qd
- 24. Market Equilibrium Practice: Finding Equilibrium Price and Quantity for Cranberries Set-Up: Qd = 500 – 4p QS = -100 + 2p n p = price of cranberries (dollars per barrel) n Q = demand or supply in millions of barrels per year Questions: 1.Find the equilibrium price of cranberries? 24
- 25. Clicker question What is the P and Q in equilibrium if the market demand and supply is like below Qd = 500 – 4p QS = -100 + 2p A.Q=100 and P=50 B.Q=100 and P=100 C.Q=50 and P=50 D.Q=50 and P=100 25
- 26. Market Equilibrium Practice: Finding Equilibrium Price and Quantity for Cranberries n Step 1: Set supply equal to demand (Qd = Qs ) 500 – 4p = -100 + 2p n Step 2:Now solve for P: 600=6P* P* = $100 n Step 3: Plug P* back into either Qd OR Qs § Plugging into Qd: 500-4(100)=100 § Plugging into Qs: -100+2(100)=100 § Q*=100 26
- 27. Market Equilibrium Practice: Finding Equilibrium Price and Quantity for Cranberries Now lets see how to graph supply and demand n Some folks like to rewrite so Q is on the RHS (inverse demand or supply function) Qd = 500 – 4p OR p = 125 - Qd/4 QS = -100 + 2p OR p = 50 + QS/2 n But, I like to find the intercepts when I know I have a straight line … § if Qd =0 p=125, if p=0 Qd =500 § If QS =0 then P=50 27
- 28. 28 Practice: Finding Equilibrium Price and Quantity for Cranberries Price Q (millions of barrels) Market Supply: QS = -100 + 2p 50 P ($) Market Demand: Qd = 500 – 4p 125 Q* = 100 P* = 100 Equilibrium 500
- 29. Elasticity – now we will learn about rubber bands well kind of …. What is Elasticity? n Tells us how much one variable changes (in percent terms) with a 1 percent change in a different variable. The change can be an increase or a decrease. n Elasticity, 𝜖#,%= % ()*+,- # % ()*+,-% = .+/0,-+012 3*4 .50,-+012 3*4 n Examples § How much quantity demand changes with an increase in price § How much output changes with a decrease in capital § How much wages change with an increase in labor 29
- 30. Elasticity Some elasticity get special names and attention Elasticity of Demand (own price elascity of demand): A measure of the rate of change in the quantity demanded with respect to price, holding all other determinants of demand constant.. In other words, it is the percent change in quantity demand from a 1 percent change in price. Where Qd is a demand function. 30 𝜖6/ ,7= 𝑝𝑒𝑟𝑐𝑒𝑛𝑡 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑞𝑢𝑎𝑛𝑡𝑖𝑡𝑦 𝑝𝑒𝑟𝑐𝑒𝑛𝑡 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑝𝑟𝑖𝑐𝑒 = % △ 𝑄𝑑 % △ 𝑃
- 31. Elasticity continued n How do we calculate it? I’m not good at memorizing so I start with the definition on the last page 𝝐𝑸𝒅 ,𝑷= 𝝏𝑸𝒅 𝝏𝑷 𝑷 𝑸𝒅 31 𝜖6/ ,7= % △ 𝑄𝑑 % △ 𝑃 𝜖6/ ,7= △ 𝑄𝑑/𝑄 △ 𝑃/P 𝜖6/ ,7= △ 𝑄𝑑 △ 𝑃 𝑃 𝑄𝑑
- 32. Elasticity: examples But we have to know what this means – explain it in plain English. n E.g. elasticity = -2 (imagine it is -2/1) § If the price goes up by 1 percent demand will be reduced by 2 percent n E.g. elasticity = -0.5 (imagine it is 0.5/1) § If the price goes up by 1 percent demand will be reduced by .5 percent percent. 32 %ΔQd %ΔP = ΔQ Q ΔP / P = ∂Qd ∂P * P Q
- 33. How do we classify elasticity? ….think rubber bands n When a one percent change in price leads to a greater than one-percent change in quantity demanded, the demand curve is elastic. (eQ,P < -1) § In general elastic if (e > |1|) n When a one-percent change in price leads to a less than one- percent change in quantity demanded, the demand curve is inelastic. (0 > eQ,P > -1) § In general inelastic if (e < |1|) n When a one-percent change in price leads to an exactly one- percent change in quantity demanded, the demand curve is unit elastic. (eQ,P = -1) § In general unit elastic if (e = |1|) 33
- 34. How Elastic are These Curves? 34 P Q D1 D2 Perfectly Elastic Perfectly Inelastic P1 Q2
- 35. Elasticity Estimates: Price Elasticity of Demand for Selected Grocery Products 35 Category Estimated eQ,P Soft Drinks -3.18 Canned Seafood -1.79 Canned Soup -1.62 Cookies -1.6 Breakfast Cereal -0.2 Toilet Paper -2.42 Laundry Detergent -1.58 Toothpaste -0.45 Snack Crackers -0.86 Frozen Entrees -0.77 Paper Towels -0.05 Dish Detergent -0.74 Which products is demand elastic and which is demand inelastic?
- 36. Elasticity Versus Slope n Slope: is the ratio of absolute changes in quantity and price. (= DQ/DP). § Measures the absolute change in quantity demanded (in units of quantity) due to a one-unit change in price. § Qd=a-bP § a is the intercept, -b is the slope n Elasticity: is the ratio of relative (or percentage) changes in quantity and price. § Measure percentage change in quantity demanded due to one-percent change in the price of the good 36
- 37. Elasticity Versus Slope n Why elasticity is more useful? § it is unitless so allows us to easily compare across countries and goods § Units of quantities will be different for different goods. How to compare snow boards to oranges. § Prices are different across different countries. More difficult to compare Euro to US $ 37
- 38. What Affects Elasticity? n Availability of Substitutes: § Demand is more(less) elastic when there are more(fewer) substitutes for a product. § E.g: Demand for all beverages less elastic than demand for Coca-Cola § There are substitute for Coca-Cola, drink Pepsi § It is harder to find a substitute for soda if you love soda. n % of Income Spent on Product § Demand is more(less) when the consumer’s expenditure on the product is large(small) n Necessity Products § The demand is less price elastic when the product is a necessity n Market Level vs Brand-Level Price § Demand tends to be more elastic for a particular brand of a good, than for the good in general 38
- 39. Linear Demand Slope, choke price, elasticity General Form: Qd = a – bp n a, b are positive constants n p is price Notice that: nb is the slope n a/b is the choke price: price at which quantity demanded is zero n Set Q=0 and solve for P n Solve for inverse demand (intercept): P=a/b-Qd/b 39
- 40. Linear Demand Curve Slope, choke price, elasticity n Elasticity is: eQ,P = (DQ/Dp)(p/Q) …definition… =-b(p/Q) Note that: §When Q=0, elasticity is -¥ §When p=0, elasticity is 0 §so…elasticity falls from 0 to -¥ along the linear demand curve, but slope is constant. 40
- 41. 41 0 P Q a/2 a a/2b a/b • eQ,P = -1 Inelastic region Elastic region eQ,P = -¥ eQ,P = 0 Elasticity with a Linear Demand Curve
- 42. Problem: Determining Elasticity Linear demand curve if Qd = 400 – 10p, and p = 30, what is the elasticity of demand w.r.t own price? eQ,P = (-b)(P)/(Q) Q = 400 – 10 (30) = 100 eQ,P = (-10)(30)/(100) = -3 "elastic” Or use calculus n Why is elasticity negative? § demand curve downward sloping. 42 ∂Qd ∂P * P Qd = −10 * 30 400 −10P = −10 * 30 400 −10(30) = −3
- 43. Problem: Determining Elasticity Constant elasticity demand curve Constant Elasticity Fn (general form): Qd = Ape n e = elasticity of demand and is negative n p = price n A = constant Example: If demand can be expressed as QP = 100, what is the price elasticity of demand? nQ=100P-1 , so elasticity is -1 43
- 44. 44 Quantity Price 0 Q P • Observed price and quantity Constant elasticity demand curve Linear demand curve Constant Elasticity Demand Curve
- 45. Importance of Brands 45 Model Price Estimated eQ,P Mazda 323 $5,039 -6.358 Nissan Sentra $5,661 -6.528 Ford Escort $5,663 -6.031 Lexus LS400 $27,544 -3.085 BMW 735i $37,490 -3.515 Example: Price Elasticities of Demand for Automobile Makes, 1990. • Demand for individual models is highly elastic • Market-level price elasticity of demand for automobiles -1 to -1.5 • Compact automobiles have lots of substitutes Luxury cars have less substitutes Ø Demand for compact cars more elastic than luxury cars.
- 46. Other Common Types of Elasticities n Other Elasticities -- Elasticity of "X" with respect to "Y": (DX/DY)(Y/X) § X and Y could be anything n Price elasticity of supply: (DQS/Dp)(p/QS) § measures curvature of supply curve n Income elasticity of demand:(DQd/DI)(I/Qd) § measures degree of shift of demand curve as income changes. n Cross price elasticity of demand: (DQd/DPo)(Po/Qd) § measures degree of shift of demand curve when the price of a substitute changes 46
- 47. The Cross-Price Elasticity of Cars Practice Questions: n What is the cross price elasticity of demand of the Sentra with respect to Escort? § 0.454 n If the price of the Escort increases by 10 %, what will happen to the demand for the Sentra? § The demand for Sentra will increase by 4.54 % 47 PRICE Sentra Escort LS400 735i Demand Sentra -6.528 0.454 0.000 0.000 Escort 0.078 -6.031 0.001 0.000 LS400 0.000 0.001 -3.085 0.032 735i 0.000 0.001 0.093 -3.515
- 48. Elasticities of Demand for Coke/Pepsi Practice Question: n What will happen to the demand for coke if income increases by 10%? § If income increases by 10%, the demand for coke will increase by 5.8% 48 Elasticity Coke Pepsi Price elasticity of demand -1.47 -1.55 Cross-price elasticity of demand 0.52 0.64 Income elasticity of demand 0.58 1.38