Micro MegaGuide- Chapter 2 Complete

8/10/2019 Micro MegaGuide- Chapter 2 Complete

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Chapter 2Supply and Demand

This chapter outlines the basics of the supply and demand model. We first introduce the concept of the

demand curve, which embodies consumers desires for goods,and then move on to the supply

curve, which embodies producers willingness to make those goods available.

Standard approach to Economics is to simplify a problem until it becomes manageable.

Market is defined by

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Specific product being bought and sold

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A particular location

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Point in time

Often times we use more broadly defined markets

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Pros: more interest, more data to analyze

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Cons: makes the assumptions of the supply and demand model less likely to hold

Key Assumptions of the Supply and Demand Model(later we will examine how changing the models assumptions

influence its predictions in market outcomes)

1.

Restrict Focus to Supply and Demand in a Single Market

o Ignore the possibility that changes in the market were studying might have spillover

effects on other markets.

2.

All Goods Bought and Sold are Identical

o Treat groups of goods as though they are identical (differences in Automobiles)

o Commodities- (products traded in markets in which consumer view different

varieties of the good as essentially interchangeable) best reflect this assumption

Examples of commodities: wheat, soybeans, crude oil, nails, gold

3.

All Goods Sold in the Market Sell for the Same Price, and Everyone Has the Same Information

o Implies that there are no special deals for particular buyers and no quantity

discounts

4.

There are Many Producers and Consumers in the Market

o Assumption that no particular consumer or producer has a noticeable impact on

anything that occurs in the market and the price level in particular.

Factors that Influence Demand

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Price

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Number of Consumers

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Consumer Income and Wealth

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Consumer Tastes

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Prices of other goods-

o

SubstituteA good that can be used in place of another

Supply-the combined amount of a

good that all the producers in a

market are willing to sell

Demand- The combined amount of a

good that all consumers are willing to


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Inverse Demand CurveA demand curve written in the form of price as a function of quantity

demanded

Demand Choke PriceThe price at which no consumer is willing to buy a good and quantity demanded

is zero; the vertical intercept of the inverse demand curve.

Shifts in Demand Curves-

Change in Quantity DemandedA movement along the demand curve that occurs as a result of a

change in the goods price.

Change in demandA shift of the demand curve caused by a change in the determinant of demand

other than the goods own price.


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Graphical Representation of the Supply Curve

Supply Curve - The relationship between the quantities supplied of a good and the goods price, holding

all other factors constant.

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Sloped upwardholding everything else equal, produces are willing to supply more of a

good as price rises.

Mathematical Representation of the Supply Curve

Q= 200P200

Inverse Supply CurveA supply curve written in the form of price as a function of quantity supplied.

Supply Choke PriceThe price at which no firm is willing to produce a good and quantity supplied is

zero; the vertical intercept of the inverse supply curve.

Q- Quantity supplied (pounds of

tomatoes)

P- Price (Dollars per pound)


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Shift in the Supply Curve

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When one of the other (nonprice) factors that affect supply changes, the change affects the

quantity of a good that suppliers want to sell at every price.

Change in Quantity SuppliedMovement along the supply curve that occurs as a result of a change in

the goods price.

Change in Supply- A shift of the entire supply curve caused by a change in a determinant of supply other

than the goods price.

Prices roles in both the demand and supply sides of a market mean that prices can adjust freely to make

the quantity demanded by consumers equal to the quantity supplied by producers. When this

happens, we have a market in which everyone who wants to buy at the current price can do so, and

everyone who wants to sell at the current market price can do so as well.


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Market Equilibrium

Market Equilibrium- The point at which the quantity demanded by consumers exactly equals the

quantity supplied by producers.

Equilibrium PriceThe only price at which quantity supplied equals quantity demanded.

Mathematics of Market Equilibrium

To find the equilibrium quantity Qe, we plug this value ofPeback into the equation for eitherthedemand or supply curve, because both quantity demanded and quantity supplied will be the same atthe equilibrium price:

Qe= 1,000 200Pe= 1,000 200(3)= 1,000 600 =400

A simple trick will ensure that you have the right answer, and it takes only a few seconds. Take the

equilibrium price that you obtain and plug it into boththe demand and supply curves (you should get

the same answer).


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Why Markets Move toward Equilibrium

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If the current price is higher than the equilibrium price, there will be excess supply. If the

price is lower, there will be excess demand.

Excess Supply

SurplusThe amount by which quantity supplied exceeds quantity demanded when market price is

higher than equilibrium price.

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Quantity Supplied at High PriceQuantity Demanded at High Price

Excess Demand

ShortageThe amount by which quantity demanded exceeds quantity supplied when market price is

lower than the equilibrium price.

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Quantity Demanded at Low PriceQuantity Demanded at Low Price


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Shifts in Demand

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Solve numerically by equating the new demand curve with the old supply curve.

Q2= 500 200(1.75)= 150


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Shifts in Supply

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To calculate numerically equate the new supply curve and the old demand curve.


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What determines the size of price and quantity changes?

Size of Shift

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The larger the shift, larger the change in equilibrium price or quantity.

Slopes of the Curves-

If the demand curve shifts, then the slope of the supply curve determines whether the shift leads to a

relatively large equilibrium price change and a relatively small equilibrium quantity change, or vice

versa. If the supply curve shifts, its the slope of the demand curve that matters.


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Changes in Market Equilibrium When both Curves Shit

As a general rule, when both curves shift at the same time, we will know with certaintythe

direction of change of either the equilibrium price or quantity, but never both.


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Elasticity

Steeper curves mean that price changes are correlated with relatively small quantity changes. When

demand curves are steep, this implies that consumers are not very price-sensitive and wont change

their quantity demanded much in response to price changes. Similarly, steep supply curves mean that

producers quantities supplied are not particularly sensitive to price changes.Flatter demand or supplycurves, on the other hand, imply that price changes are associated with large quantity changes. Markets

with flat demand curves have consumers whose quantities demanded change a lot as price

varies. Markets with flat supply curves will see big movements in quantity supplied as prices change.

ElasticityThe ratio of the percentage change in one value to the percentage change in another

Price Elasticity of DemandThe percentage change in quantity demanded resulting from a 1% change

in price.

Slope and Elasticity are NOT the same

- Using elasticities to express responsiveness avoids these tricky issues, because

everything is expressed in relative percentage changes. That eliminates the units

problem (a 10% change is a 10% change regardless of what units the thing changing

is measured in) and makes magnitudes comparable across markets.

Price elasticity of demand = (% change in quantity demanded)/(% change in price)

Price elasticity of supply = (% change in quantity supplied)/(% change in price)

Price Elasticity of DemandAlways Negative (Non positive)can be thought of as the

percentage change in quantity demanded for a 1% price increase.

Price Elasticity of SupplyAlways Positive (Non Negative)can be thought of as the

percentage change in quantity supply in response to a 1% price increase.


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Markets with Large-magnitude price elasticities of demand

- Markets where consumers have a lot of ability to substitute toward or away from

the good in question

o Example: Apples in a supermarketpeople can just purchase other fruits

Markets with less price- responsive demand

- Circus candy

Markets with large price elasticities of supplywhere quantity supplied is sensitive to price

differences.

- Where it is easy to vary their amount of production as price changes

o Example: SoftwareNew CDs can easily be made or download provided.

Markets with low price elasticities of supply have quantities supplied that are fairly

unresponsive to change in price.

- Superbowl seating- even if the price increases a lot they cant just go and add more

seats.

The availability of substitutes is one of the key determinants of the price elasticity of demand.

In the long run (over a larger time horizon) the magnitude of the elasticity for a demand for a

product is larger than the elasticity of demand over the short term.

The same logic holds for producers and supply elasticities. The longer the horizon, the more scope

they have to adjust output to price changes.

For these reasons, the price elasticities of demand and supply for most products are larger in

magnitude (i.e., more negative for demand and more positive for supply) in the long run than in the

short run.

Elastic A price elasticity with and absolute value greater than 1.

Inelastic A price elasticity with an absolute value equal to 1.

Unit Elastic Aprice elasticity with an absolute value equal to 1.

Perfectly Inelastic A price elastic that is equal to zero there is no change in quantity demanded

or supplied or any change in price.

Perfectly Elastic A price elasticity that is infinite; any change in price leads to an infinite change

in quantity demanded or supplied.


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Elasticities and Linear Demand and Supply Curves

The price elasticity of demand changes from to zero as we move down and to the right along a

linear demand curve.


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Therefore, the price elasticity of supply wont drop to zero.(Because supply wont intercept the x-

axis)

Because the price elasticity of supply equals (1/slope) (P/Q), such supply curves approach becoming

unit elastic at high prices and quantities supplied, but never quite get there. Also, becauseP/Q never

falls to zero, the only way a supply curve can have an elasticity of zero is if its inverse slope is zerothat

is, if it is vertical.


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Perfect Inelasticityprice elasticity = 0.

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A perfectly inelastic demand curve is vertical.

o A vertical demand curve indicates that the quantity demanded by consumers is

completely unchanged regardless of price.

o Any change in price will induce a 0% change in quantity demanded.

ExamplesDiabetics for insulinno substitutes

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Any shift in market supply will only change the market equilibrium price, not the quantity.

Perfect ElasticityPrice elasticity is infinite

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Small price change from above to below a horizontal supply curve would shift producers

quantity supplied from infinite to zero.

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Shift in the Demand or Shifts in the Supply curve, only change the equilibrium quantity and

not the price.

If demand is inelastic, then the percentage drop in quantity (the numerator) will be smaller than the

percentage increase in price (the denominator). This means the direct effect of price outweighs the

quantity effect, and expenditures rise.


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If demand is elastic (the elasticity is greater than 1 in absolute value) on the other hand, then the

percentage drop in quantity (the numerator) will be larger than the percentage increase in price (the

denominator). In this case, the indirect effect of the price increase is larger than the direct effect, and

total expenditures fall.

For unit elastic demand (an elasticity of 1),the percentage increase in price exactly equals the

percentage decrease in quantity demanded, so expenditure doesnt change.

Income Elasticity of DemandThe percentage change in quantity demanded associated with a 1%

change in consumer income.

Inferior GoodA good for which quantity demanded rises when income rises.

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Goods with an income elasticity that is negative

Normal Good- A good for which quantity demanded rises when income rises

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Goods with a positive income elasticity

Luxury GoodA good with an income elasticity greater than 1.


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Cross-Price Elasticity of DemandThe percentage change in the quantity demanded of one good

associated with a % change in the price of another good.

When a good has a positive cross-price elasticity with another good, that means consumers demand a

higher quantity of it when the other goods price rises.In other words, the good is a substitute for the

other good.

When a good has a negative cross-price elasticity with another good, consumers demand less of it when

the other goods price increases.This indicates that the goods are complements. Complements tend to

be goods that are consumed together.

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Micro MegaGuide- Chapter 2 Complete