DocumentS2

The Market Forces of Demand and Supply:The Market Forces of Demand and Supply:

The Consumer BehaviorThe Consumer Behavior

Markets and Competition

• Supply and demand are the two words that economists use most often.

• Supply and demand are the forces that make market economies work.

• Modern microeconomics is about supply, demand, and market equilibrium.

• A market is a group of buyers and sellers of a particular good or service.

• The terms supply and demand refer to the behavior of people . . . as they interact with one another in markets.

What is a Market?

What is a Market?Market: A place or service that enables buyers and sellers to

exchange goods and services and that exchange determines the prices of goods and services.

• Buyers determine demand.• Sellers determine supply.

Example: A. Product Markets: Market for goods and servicesB .Financial Market: Market for finance

– Money Market– Stock Market– Bond Market

C. Factor Market : Market for resources/input– Land Market– Labor Market

D. Foreign Exchange Market: Market for foreign exchange

5

What are the Types of Market? A) Black Market: Illegal Exchange ex. Buying and

selling illegal drugs and counterfeitUnderground Market: unreported or unrecorded transactions or exchange of goods and services, whether legal or illegal.

B) Regulated Market: Prices are fixedUnregulated Market: Prices are determined by demand and supply.

C) Organized market: Ex stock ExchangeLoosely organized: ex. Market for bicycles

Competitive Markets• A competitive market is a market in which there are many buyers and

sellers so that each has a negligible impact on the market price.

• Competition: Perfect and Otherwise – Perfect Competition

• Products are the same• Numerous buyers and sellers so that each has no influence over

price• Buyers and Sellers are price takers

– Monopoly• One seller, and seller controls price

– Oligopoly• Few sellers• Not always aggressive competition

– Monopolistic Competition• Many sellers• Slightly differentiated products• Each seller may set price for its own product

Goods Markets:Demand and Supply of Goods

8

Demand • Demand means the willingness and capacity to have it.

– Need: Necessity to have it either by option or compulsion

– Price is a tool by which the market coordinates individual desires.

• Demand for a product means the amount of a product that people are willing and capacity to purchase at each possible price during a given period of time.

– Price is a tool by which the market coordinates individual desires.

• The Quantity demand is the amount of a product that people are willing and able to purchase at one, specific price.

9

The Law of Demand

• Law of demand – there is an inverse relationship between price and quantity demanded assuming other things held constant(ceteris paribus)– Quantity demanded rises as price falls, other things constant.– Quantity demanded falls as prices rise, other things constant.

• Other things constant places a limitation on the application of the law of demand.– All other factors that affect quantity demanded are assumed

to remain constant, whether they actually remain constant or not.

– These factors may include changing tastes, prices of other goods, income, even the weather.

Two Reasons for Law of Demand1. Income Effect2. Substitution Effect

10

Components of Demand: The Income Effect

• Income Effect: The change in quantity demanded that occurs when the purchasing power of income is altered as a result of price changes.

• Ex: When the price of a commodity falls , a consumer can purchase more of a commodity with given money income( i.e his /her real income increases)

• A change in the real value of income:– will have a direct effect on quantity demanded if a good is normal.– will have an inverse effect on quantity demanded if a good is inferior.

( Hotdogs. Bread etc.)

• The income effect is consistent with the law of demand only if agood is normal.

11

Components of Demand: The Substitution Effect

• Substitution Effect: When the price of a good falls, the quantity demanded of the commodity by the individual increases because the individual substitutes in consumption of commodity X for other commodities.

• Assuming that real income is constant:

– If the relative price of a good rises, then consumers will try to substitute away from the good. Less will be purchased.

– If the relative price of a good falls, then consumers will try to substitute away from other goods. More will be purchased.

• The substitution effect is consistent with the law of demand.

12

Price

per D

VDs (

in do

llars)

A Demand Curve

Quantity of DVDs demanded (per week)1 2 3 4 5 6 7 8 9 10 11 12 13

$6.00

5.00

4.00

3.00

2.00

1.00 .50

0

3.50E

D

C

BFA

From a Demand Table to a Demand Curve

Price per cassette

ABCDE

A Demand Table

DVD rentals demanded per

week

$0.501.002.003.004.00

98642

Demand for DVDs

G

The demand table assumes other things remaining the sameThe demand curve is the graphic representation of the law of demand

•You plot each point in the demand table on a graph and connect the points to derive the demand curve.

13

Ex. Demand Schedule and Demand Curve for DVDs

14

2. Market Demand Function

QDx=quantity demanded of commodity X

Px=price per unit of commodity X

N=number of consumers on the market

I=consumer income

PY=price of related (substitute or complementary) commodity

T=consumer tastes

QDX = f(PX, N, I, PY, T)

1. Individual Consumer’s Demand

QdX =quantity demanded of commodity X by an individual per time period

PX =price per unit of commodity X

I =consumer’s income

PY =Price of related (substitute or complementary) commodity

T =tastes of the consumer

QdX = f(PX, I, PY, T)

Types of Demand

Qdxi=f(Pxi)Qdx=f(P)

15

How to Derive Market Demand Curves• A market demand curve is the horizontal sum of all individual

demand curves.– This is determined by adding the individual demand curves

of all the demanders.

• Sellers estimate total market demand for their product which becomes smooth and downward sloping curve.

Limitations of Law of Demand ( market)– Bandwagon Effect: People some times demand a

commodity because others are purchasing it.

– Snob (Veblen) Effect: Opposite to bandwagon effect, People some times demand less of a commodity because others are purchasing more of it

16

From Individual Demands to a Market Demand Curve

(1)Price per cassette

$.0.501.001.502.002.503.003.504.00

(2)Alice’s

demand

(3)Bruce’s demand

(2)Cathy’s demand

(3)Market

demand

98765432

65432100

11000000

16141197532

ABCDEFGH Cathy Bruce Alice

D

A

C

EF

G

Quantity of cassettes demanded per week2

$4.00 3.503.002.502.001.501.000.50

0

Price

per c

asse

tte (in

dolla

rs)

4 6 8 10 12 14 16

B

Market demand

17

D

Pric

e (p

er u

nit)

0Quantity demanded (per unit of time)

PA

QA

A

A Sample Demand Curve

18

Demand Faced by a FirmDepends Upon1. Size of the market or industry demand for a commodity2. Form in which industry is organized3. Number of firms in the industry4. Type of Goods

– Durable Goods ( TV, Car, Refrigerator)• Provide a stream of services over time• Demand is volatile

– Nondurable Goods and Services• Direct demand, less volatile

– Producers’ Goods• Used in the production of other goods, they are the inputs

for other firms.• Demand is derived from demand for final goods or services• This is called as derived demand

19

Perfect Competition• Perfect Competition is a market structure

characterized by:

– Many large firms, so large that no one firm has the ability to affect the market.

– These firms are price takers—they have to go along with the market price.

– Identical products, the products are identical, generic products.

– Easy entry into the industry.

– The demand curve is perceived by each firm to be horizontal.

– Ex. Same type of wheat produced in Indian by large farmers

– Firm’s demand curve is horizontal, industry Demand curve is downward sloping

20

Monopoly• Monopoly is a market structure in

which there is just one firm, and entry by other firms is not possible.

– There are no close substitutes.

– The firm has the power to set the price, but still sets an optimal price to maximize profit. If the monopolist sets the price too high, revenue will decline. The firm is a price maker.

– The firm’s demand curve is the market demand curve, and it is downward sloping.

• Ex. Local telephone, electricity, Public transport system etc.

21

Monopolistic Competition• Monopolistic competition is a market

structure in which there are many firms selling differentiated products.

• Monopolistic Competition is characterized by:

– A large number of firms– Easy entry(There are few barriers to

entry)– Differentiated products, because

each firm’s product is slightly different, each firm is kind of a mini-monopoly—the only producer of that specific product.

– This allows the firm to be a price maker.

– The firm’s demand curve is downward sloping and depending on the differentiation of the firm’s product, it may be fairly inelastic. Or flat

– Ex. Gaosline stations and barber shop, CDs, movies, computer games, restaurants,

22

Oligopoloy• Oligopoly is a market structure in which

there are a few interdependent firms.• Oligopoly is characterized by:

– Few firms—more than one, but few enough so each firm alone can affect the market.

– Entry is more difficult, but can occur.

• There are often significant barriers to entry.

– The firms are interdependent—each is affected by what others do.

– The demand curve is downward sloping for each firm.

Ex. Homogeneous product: Cement, Steel, Chemicals,Differentiated Product: automobiles, Cigarettes, soft drinks,

23

Duopoly:• A duopoly is an oligopoly with only two Sellers of similar products. It is the simplest

type of oligopoly.• Price competition is severe lead to price war.• Each react to the other.

– The duopolies may agree on a monopoly outcome.• Collusion

– An agreement among firms in a market about quantities to produce or prices to charge.

• Cartel– A group of firms acting in unisonThe Demand Curve Slopes downward from left to rightEx. Prisoners dilemma

24

Four Basic Market Types

25

Assumption of Law of Demand: Ceterius paribus

26

Assumption of Law of Demand: Other Things Constant

• Other things constant places a limitation on the application of the law of demand.

– All other factors that affect quantity demanded are assumed to remain constant, whether they actually remain constant or not.

– These factors may include changing tastes, prices of other goods, income, even the weather.

27

Changes in Quantity Demanded

D1

Change in quantity demanded(a movement along the curve)

B

0

Pric

e (p

er u

nit)

Quantity demanded (per unit of time)100

$2

$1

200

A

Change in Quantity Demanded -movement along the same demand curve in response to a price change.

28

D0

D1

Change in Demand

Pric

e (p

er u

nit)

Quantity demanded (per unit of time)100

$2

$1

200

B A

Change in demand(a shift of the curve)

250

•Change in Demand - shift in entire demand curve in response to a change in a determinant of demand (a ceteris paribus variable)A shift /change in demand is the graphical representation of the effect of anything other than price on demand.

29

Ex. Change in Demand vs. Change in the Quantity Demanded

30

Determinants and Shift Factors of Demand

TastesTastes

Taxes on subsidiesto consumers

Taxes on subsidiesto consumers

Number of buyers Number of buyers ExpectationsExpectations

Prices of related goodsPrices of related goods

Society’sIncome

Society’sIncome

•Shift factors of demand are factors that cause shifts in the demand curve:

31

The Income

• The demand for any goods and services depends upon income. The higher the income the higher the quantity demanded.

• A change in the real value of income – will have a direct effect on quantity demanded if a good is

normal. So an increase in income will increase demand for normal goods.

– will have an inverse effect on quantity demanded if a good is inferior. Exc. Corn, bread. So an increase in income will decrease demand for inferior goods.

• The income effect is consistent with the law of demand only if agood is normal.

32

Prices of Related Goods: The Substitution: • Assuming that real income is constant:

– If the relative price of a good rises, then consumers will try to substitute away from the good. Less will be purchased.

– If the relative price of a good falls, then consumers will try to substitute away from other goods. More will be purchased.

• The substitution effect is consistent with the law of demand.

• When the price of a substitute good falls, demand falls for the good whose price has not changed. Ex. BMW and Accura

• When the price of a complement good falls, demand rises for the good whose price has not changed. Ex. Car and Petrol

33

Tastes and Expectations and Number of buyers

a) A change in taste will change demand with no change in price.

b) If you expect your income to rise, you may consume more now.

If you expect prices to fall in the future, you may put off purchases today.

c) Number of Buyers: Higher the number of buyers, greater the demand for the product

34

QdX = f(PX, I, PY, T)∆QdX/∆PX < 0

∆QdX/∆I > 0 if a good is normal

∆QdX/∆I < 0 if a good is inferior

∆QdX/∆PY > 0 if X and Y are substitutes

∆QdX/∆PY < 0 if X and Y are complements

An increase in income will increase demand for normal goods.

An increase in income will decrease demand for inferior goods.

When the price of a substitute good falls, demand falls for the good whose price has not changed.

When the price of a complement good falls, demand rises for the good whose price has not changed.

Shift Factors of Demand: Mathematical Expression

35

Factors Affecting Demand for a commodity(Internal vs External Factors)

Product life-cycle management

Planned price changes

Changes in the sales force

Resource constraints

Marketing and sales promotion

Advertising

Product substitution

IncomePrices of SubstitutesPrices of ComplementsExpectations,Changing customer Tastes and preferencesRandom fluctuationSeasonalityCompetition New customersPlans of major customersGovernment policiesRegulatory concernsEconomic conditions/cyclesEnvironmental issuesWeather conditionsGlobal and local trends

Supply of Goods and Services

37

Supply

• Goods and Services are supplied by Firms (also households)

• The analysis of the supply of produced goods has two parts:

– An analysis of the supply of the factors of production to households and firms.

– An analysis of why firms transform those factors of production into usable goods and services.

38


• Supply refers to a schedule of quantities a seller is willing to sell per unit of time at various prices, other things constant.

• Quantity supplied is the amount of a good that sellers are willing and able to sell at a given price at a point of time.

• Law of Supply– The law of supply states that, other things equal, the

quantity supplied of a good rises when the price of the good rises.

– Direct relationship between price and quantity supplied.• Quantity supplied rises as price rises, other things

constant.• Quantity supplied falls as price falls, other things

constant

39

The Law of Supply• The law of supply is accounted for by two factors:

–When prices rise, firms substitute production of one good for another.–Assuming firms’ costs are constant, a higher price means higher profits.

The Supply Curve• The supply curve is the graphic representation of the law of

supply.• The supply curve slopes upward to the right.• The slope tells us that the quantity supplied varies directly – in

the same direction – with the price.


40

S

A

Quantity supplied (per unit of time)0

Pric

e (p

er u

nit)

PA

QA

A Sample Supply CurveThe Supply Schedule

The supply schedule is a table that shows the relationship between the price of the good and the quantity supplied.

41

Ex: Supply Curve DVDs

42

From Individual Supplies to a Market Supply

Quantities Supplied

ABCDEFGHI

(1)Price

(per DVD)

(2)Ann's

Supply

(5)MarketSupply

(4)Charlie'sSupply

$0.000.501.001.502.002.503.003.504.00

012345678

001234555

000000022

013579111415

(3)Barry's Supply

•The market supply curve is derived by horizontally adding the individual supply curves of each supplier.

43

1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16

From Individual Supplies to a Market Supply

Pric

e pe

r DV

DCharlie Barry Ann

Quantity of DVDs supplied (per week)

$4.003.50 3.00 2.50 2.00 1.50 1.00 0.50

0

IH

G

F

ED

C

BA

Market Supply

CA

44

Change in quantity supplied (a movement along the curve)

Change in Quantity Supplied

Pric

e (p

er u

nit)

Quantity supplied (per unit of time)

S0

$15 A

1,250 1,500

B

A movement along a supply curve – the graphic representation of the effect of a change in price on the quantity supplied.

If the amount supplied is affected by anything other than a change in price, there will be a shift in supply.

45

Change/Shift in Supply

Pric

e (p

er u

nit)

Quantity supplied (per unit of time)

S0

Shift in Supply(a shift of the curve)

S1

$15 A B

1,250 1,500

Shift in supply – the graphic representation of the effect of a change in a factor other than price on supply.

46

Decrease in Supply Increase in Supply

47

Factors that Shifts Supply Curve

Prices of RelatedGoods and Services

Number Of

Producers

ExpectationsOf

Producers

TechnologyAnd

Productivity

Resource/Input Prices

Supply

•Other factors besides price affect how much will be supplied:

48

• Price of Inputs (Resource Prices)– When costs go up, profits go down, so that the incentive to supply also

goes down.

• Technology– Advances in technology reduce the number of inputs needed to produce

a given supply of goods.– Costs go down, profits go up, leading to increased supply.

• Expectations– If suppliers expect prices to rise in the future, they may store today's

supply to reap higher profits later.

• Numbers of Suppliers– As more people decide to supply a good the market supply increases

(Rightward Shift).

Factors that Shifts Supply Curve

49

Change in Supply vs. Change in the Quantity Supplied

Equilibrium between Supply and Demand

Supply and Demand Together• Equilibrium is a concept in which opposing dynamic forces cancel

each other out.

• Demand and Supply Equilibrium refers to a situation in which the price has reached the level where quantity supplied equals quantity demanded.

• Equilibrium Price– The price that balances quantity supplied and quantity

demanded. – On a graph, it is the price at which the supply and demand

curves intersect.• Equilibrium Quantity

– The quantity supplied and the quantity demanded at the equilibrium price.

– On a graph it is the quantity at which the supply and demand curves intersect.

52

Supply and Demand not Together

• When the market is not in equilibrium, you get either excess supply or excess demand, and a tendency for price to change.

• Excess supply – a surplus, the quantity supplied is greater than quantity demanded– Prices tend to fall.

• Excess demand – a shortage, the quantity demanded is greater than quantity supplied– Prices tend to rise.

• The greater the difference between quantity supplied and quantity demanded, the more pressure there is for prices to riseor fall.

• When quantity demanded equals quantity supplied, prices have no tendency to change.

53

The Graphical Interaction of Supply and Demand

Price (per DVD)

Quantity Supplied

Quantity Demanded

Surplus (+) Shortage (-)

$3.50 7 3 +4

$2.50 5 5 0

$1.50 3 7 -4

54

A

The Graphical Interaction of Supply and Demand

Pric

e pe

r DV

D

$5.00

4.00

3.50

3.00

2.50

2.00

1.50

1.00

S

D

Quantity of DVDs supplied and demanded

C

Excess demand

1 2 3 4 5 6 7 8 9 10 11 12

Excess supply

E

55

Equilibrium (Graph)

56

Shifts in Supply and Demand

• Shifts in either supply or demand change equilibrium price and quantity.

57

Pric

e (p

e r D

VD

s)

A

S0

Quantity of DVDs (per week)

$2.50

2.25

0 98 10

Excess demand

D1

Increase in Demand

D0

B

•An increase in demand creates excess demand at the original equilibrium price.•The excess demand pushes price upward until a new higher price and quantity are reached.

58

The Effects of a Shift of the Demand Curve

59

A

Decrease in Supply

Pric

e (p

e r D

VD

s)

Quantity of DVDs (per week)

$2.50

2.25

0 98 10

D0

S1S0

C

B Excess demand

•A decrease in supply creates excess demand at the original equilibrium price.•The excess demand pushes price upward until a new higher price and lower quantity are reached.

60

The Limitations Of Supply and Demand Analysis

• Sometimes supply and demand are interconnected.

• Other things don't remain constant. The other-things-constant assumption is likely not to hold when the goods represent a large percentage of the entire economy.

• All actions have a multitude of ripple and possible feedback effects. The ripple effect is smaller when the goods are a small percentage of the entire economy.

61

Elasticity

62

The Concept of Elasticity

• Elasticity is a measure of the degree of responsiveness of one variable to another.

– The greater the elasticity, the greater the responsiveness.

• Types:– Price Elasticity of Demand– Income Elasticity of Demand– Cross Elasticity of Demand

63

1. Price Elasticity and Its sign

• The price elasticity of demand is the percentage change in quantity demanded divided by the percentage change in price

• According to the law of demand, whenever the price rises, the quantity demanded falls. Thus the price elasticity of demand is always negative.

• Because it is always negative, economists usually state the value without the sign.

• Price elasticity of demand and supply gives the exact quantity response to a change in price.

price in change Percentage demanded quantity in change Percentage=ED

)PP(PP

)QQ(QQ

P%Q% E

2121

12

2121

12

+−+−

=∆∆

=

64

Defining elasticities

1) Demand is Inelastic if E<1– or When price elasticity

is between zero and -1 we say demand is inelastic.

2) Demand is Elastic if E>1– or When price elasticity

is between -1 and -infinity, we say demand is elastic.

2) Unitary Elastic if E=1or When price elasticity is -1, we say demand is unit elastic.

65

a. Price Elasticity: Calculating Elasticity at a Point

66.5.33.

42248

)35(35

)2028(2028

21

21

A ===

+−

+−

=atE

Pric

e

Quantity

$10 9 8 7 6 5 4 3 2 1

C

BA

24 402820

To calculate elasticity at a point determine a range around that point and calculate the arc elasticity.

66.5.33.

2416

244*

452420

A ==−

=−−

=atE

66

b. Arc Elasticity : Calculating Elasticity of Demand Between Two Points

27.126.33.

23612

4

)2026(2026

)1014(1410

E

21

21

D =−

=

−

=

+−+−

=Pric

e

Quantity of software (in hundred thousands)

$26242220181614

0

Demand

B

A

10 12 14

Cmidpoint

Elasticity of demand between A and B:

)PP(PP

)QQ(QQ

P%Q% E

2121

12

2121

12

+−+−

=∆∆

=

67

c. The Price Elasticity of Demand Along a Straight-line Demand Curve

68

Demand Curve: Shapes and Elasticity

Perfectly Elastic Demand Curve: The demand curve is horizontal, any change in price can and will cause consumers to change their consumption.

Perfectly Inelastic Demand Curve: The demand curve is vertical, the quantity demanded is totally unresponsive to the price. Changes in price have no effect on consumer demand.

69

Determinants of Price Elasticity of Demand

• The degree to which the price elasticity of demand is inelastic or elastic depends on:– How many substitutes there are – The importance of the product in the consumer’s total budget– The time period under consideration

Demand for a commodity will be more elastic if:

• It has many close substitutes• It is narrowly defined• More time is available to adjust to a price change

Demand for a commodity will be less elastic if:

• It has few substitutes• It is broadly defined• Less time is available to adjust to a price change

70

2. Income Elasticity of Demand

2 1 2 1

2 1 2 1I

Q Q I IEI I Q Q− +

= ⋅− +

Linear Function

a. Point Definition//I

Q Q Q IEI I I Q

∆ ∆= = ⋅

∆ ∆

3IIE aQ

= ⋅

b. Arc Definition

Normal Goods EI>0

Inferior Goods EI<0

71

2. Income Elasticity of Demand

(i) Normal goods are those whose consumption increases with an increase in income. So Normal Goods EI>0,

Normal goods are divided into luxuries and necessities.a. Luxuries are goods that have an income elasticity greater than one.

Typical elasticities are 1.5 to 2.0.Their percentage increase indemand is greater than the percentage increase in income.

b) Necessity has an income elasticity less than 1. Typical income elasticities are 0.4 or 0.5.

The consumption of a necessity rises by a smaller proportion than the rise in income.

(ii) Inferior goods are those whose consumption decreases when income increases. So Inferior Goods EI<0

72

Calculating Income Elasticity

P0

D0 D1

P0

20 Quantity26

Shift due to 20% rise in

income

3.12026

20)2026(

20)-(26

E 21

income ==+

=

73

3. Cross-Price Elasticity of Demand

2 1 2 1

2 1 2 1

X X Y YXY

Y Y X X

Q Q P PEP P Q Q

− += ⋅

− +

Linear Function

a. Point Definition//

X X X YX Y

Y Y Y X

Q Q Q PEP P P Q

∆ ∆= = ⋅

∆ ∆

4Y

X YX

PE aQ

= ⋅

b. Arc Definition

Substitutes Goods EXY>0

Complements Goods EXY<0

• Cross-price elasticity of demand – the percentage change in quantity demand divided by the percentage change in the price ofanother good.

good related a priceofin change Percentage demandquantity in change Percentage

=E Price-Cross

74

Calculating Cross-Price Elasticity

D0

P0

D1

P0

104Quantity of Beef

108

Shift due to 33% rise in price of pork

12.33.

038.33.

)104108(104)-(108

E 21

cross ==+

=

75

The Use of Price Elasticity of Demand

Why Elasticity matters?

77

Elasticity, Total Revenue, Marginal Revenue and Demand

• The elasticity of demand tells suppliers how their total revenue will change if their price changes.

• Total Revenue equals total quantity sold multiplied by price of good.

• TR=P×Q

• Marginal Revenue equals the change in total revenue due to change in output

• MR=∆TR/ ∆ Q

78

Elasticity, Total Revenue, Marginal Revenue and Demand

• If ED is elastic (ED > 1), a rise in price lowers total revenue.

• If ED is inelastic (ED < 1), a rise in price increases total revenue.

– Price and total revenue move in opposite directions.

• If ED is unit elastic (ED = 1), a rise in price leaves total revenue unchanged.

– Price and total revenue move in the same direction.

79

Elasticity and Total Revenue

A

Unit Elastic Demand: E = 1TR constant

C

0 6

Pric

e

Quantity

$10

8

6

4

2

1 2 3 4 5 7 8 9

B

E Lost revenue

FGained revenue

TRE= $4x6=$24TRF= $6x4=$24

80


A

Pric

e

Inelastic Demand: E < 1

Quantity

$10

8

6

4

2

0 1 2 3 4 5 6 7 8 9

TR rises if price increases

CH

G

Lost revenue

Gained revenue

TRG = $1 x 9 = $9

TRH = $2 x 8 = $16

B

81

C

B


A

Pric

eElastic Demand: E > 1

Quantity

$10

8

6

4

2

0 1 2 3 4 5 6 7 8 9

TR falls if price increases.KJ

Lost revenue

Gained revenue

TRJ = $8 x 2 = $16TRK = $9 x 1 = $9

82

Let the demand function isQ= 600-100PSo, MR= 6- Q/50

With elastic demand – a rise in price lowers total revenue.

With inelastic demand – a rise in price increases total revenue.

Total Revenue Along a Demand Curve:Example

83

84

With elastic demand – a rise in price lowers total revenue.With inelastic demand – a rise in price increases total revenue.

85

Example: Using Elasticities inManagerial Decision Making

A firm with the demand function defined below expects a 5% increase in income (M) during the coming year. If the firm cannot change its rate of production, what price should it charge?

• Demand: Q = – 3P + 100M– P = Current Real Price = 1,000– M = Current Income = 40

86

Solution

• Elasticities– Q = Current rate of production = 1,000– P = Price = - 3(1,000/1,000) = - 3– I = Income = 100(40/1,000) = 4

• Price– %∆Q = - 3%∆P + 4%∆I– 0 = -3%∆P+ (4)(5) so %∆P = 20/3 = 6.67%– P = (1 + 0.0667)(1,000) = 1,066.67

87

The Elasticity Of Supply

• Price elasticity of supply is a measure of how much the quantity supplied of a good responds to a change in the price of that good.

• Price elasticity of supply is the percentage change in quantity supplied resulting from a percentage change in price.

88

The Price Elasticity of Supply(a) Perfectly Inelastic Supply: Elasticity Equals 0

$5

4

Supply

Quantity1000

1. Anincreasein price . . .

2. . . . leaves the quantity supplied unchanged.

Price

89

The Price Elasticity of Supply(b) Inelastic Supply: Elasticity Is Less Than 1

110

$5

100

4

Quantity0

1. A 22%increasein price . . .

Price

2. . . . leads to a 10% increase in quantity supplied.

Supply

90

The Price Elasticity of Supply(c) Unit Elastic Supply: Elasticity Equals 1

125

$5

100

4

Quantity0

Price



Supply

(If SUPPLY is unit elastic and linear, it will begin at the origin.)

91

The Price Elasticity of Supply(d) Elastic Supply: Elasticity Is Greater Than 1

Quantity0

Price



4

100

$5

200

Supply

92

The Price Elasticity of Supply(e) Perfectly Elastic Supply: Elasticity Equals Infinity

Quantity0

Price

$4 Supply

3. At a price below $4,quantity supplied is zero.

2. At exactly $4,producers willsupply any quantity.

1. At any priceabove $4, quantitysupplied is infinite.

93

The Price Elasticity of Supply and Its Determinants

• Ability of sellers to change the amount of the good they produce.– Beach-front land is inelastic.– Books, cars, or manufactured goods are

elastic.• Time period

– Supply is more elastic in the long run.

94

Computing the Price Elasticity of Supply

• The price elasticity of supply is computed as the percentage change in the quantity supplied divided by the percentage change in price.

Price elasticity of supply =

Percentage change in quantity supplied

Percentage change in price

95

Three Applications Of Supply, Demand, And Elasticity

• Can good news for farming be bad news for farmers?

• What happens to wheat farmers and the market for wheat when university agronomists discover a new wheat hybrid that is more productive than existing varieties?

96

Can Good News for Farming Be Bad News for Farmers?

• Examine whether the supply or demand curve shifts.

• Determine the direction of the shift of the curve.

• Use the supply-and-demand diagram to see how the market equilibrium changes.

97

An Increase in Supply in the Market for Wheat

Quantity ofWheat

0

Price ofWheat

3. . . . and a proportionately smallerincrease in quantity sold. As a result,revenue falls from $300 to $220.

Demand

S1 S2

2. . . . leadsto a large fallin price . . .

1. When demand is inelastic,an increase in supply . . .

2

110

$3

100

98

Compute the Price Elasticity of Demand When There Is a Change in Supply

ED =

−+−

+

=−

≈ −

100 110100 110 2300 2 00

300 2 00 2

0 0950 4

0 24

( ) /. .

( . . ) /

..

.

Demand is inelastic.

99

Why Did OPEC Fail to Keep the Price of Oil High?

• Supply and Demand can behave differently in the short run and the long run– In the short run, both supply and demand for

oil are relatively inelastic– But in the long run, both are elastic

• Production outside of OPEC• More conservation by consumers

100

Does Drug Interdiction Increase or Decrease Drug-Related Crime?

• Drug interdiction impacts sellers rather than buyers.– Demand is unchanged.– Equilibrium price rises although quantity falls.

• Drug education impacts the buyers rather than sellers.– Demand is shifted.– Equilibrium price and quantity are lowered.

101

Price of Drugs

Quantity of Drugs

Price of Drugs

Quantity of Drugs

Drug Interdiction Drug Education

D2D1

D1

S2

S1S1

The demand for illegal drugs is inelastic.

Interdiction shifts the supply, while education shifts the demand.In each case, the change in price is the same. But in one market the price goes up.

And in the other it goes down.The changes in quantities (and TR) are remarkable.

It is amazing how useful knowledge of elasticities can be!

Policies to Reduce the Use of Illegal Drugs

102

Cases: Handout

• The demand for Big Macs

• The demand for sweet potatoes in US

• Income, Price and Cross elasticties in real World

103

Thank You All

104

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