Chapter-5. Supply and Demand-- Introduction

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1 Chapter-5 Supply and Demand-- Introduction There is a famous saying that "learned economist" is the one who always answers "supply and demand" in response to every question. It is true that the "theory of supply and demand" is a central part of economics. It is widely applicable, and is a model of the way economists try to think most problems through, even when the theory of supply and demand is not applicable. When people's actions are based on self-interest, they respond to incentives, i.e. to costs and benefits. When the costs of an activity are raised or the benefits reduced, people do less of the activity. Economists have found that they can use this simple idea of action, based on costs and benefits, to construct a model (or theory) which explains how many markets work. This model-- the model of supply and demand-- is perhaps the most basic of the models economists use to explain the world around us. Given the model's importance in the way modern economists think, it is surprising that one does not find the model in the writings of Adam Smith, David Ricardo, Thomas Malthus, or John Stuart Mill, though all of these pioneers in economics used the words "supply" and "demand" frequently. The modern supply and demand model did not appear until 1890 when Alfred Marshall published his Principles of Economics. This group of readings explores economic terms and concepts that follow directly from supply and demand curves, and which are important building blocks for other groups of readings. It begins with the concept of elasticity which measures how people respond to changes. An elasticity computation can be used whenever a measurable change in something causes a measurable change in behavior. We will discuss the most commonly used elasticity measures like price elasticity of supply and demand, income elasticity, and cross-price elasticity. We will then see how value can be represented on a demand-curve graph. We will also discuss the concept of marginal-- examining how marginal, total and average revenue are related. Finally, we will discuss that elasticity and marginal revenue are related by means of a simple equation.

2 Why does someone like Michael Jordan make more money per season than the rest of his team combined? Why are diamonds expensive? Why do heart surgeons make more money than sanitation workers? You probably guessed it right-- due to supply and demand. We will look at supply and demand and how they interact in the marketplace to determine the prices we pay for the goods and services we purchase. Broadly, the learning objectives of this section are as follows: 1. To define demand, supply, inferior good, normal good, substitute, complement, law of demand, price taker, price searcher, and market-clearing price. 2. To distinguish between changes in demand and changes in quantity demanded. 3. To distinguish between changes in supply and changes in quantity supplied. 4. To predict how changes in factors such as income, prices of substitutes, prices of inputs etc. affect the supply and demand curves and equilibrium quantity and price. 5. To explain why we can treat the demand curve as positions of buyer equilibrium and the supply curve as positions of seller equilibrium. 6. To compute price elasticities of supply and demand when the curves are given in the form of a table. 7. To explain what is meant by when one says demand is elastic or inelastic. 8. To define income and cross-price elasticity, and explain what they measure. 9. To compute marginal revenue when total revenue is given, and vice versa. 10. To compute average revenue when total revenue is given, and vice versa. 11. To explain why marginal revenue is the slope of the total revenue curve. 12. To recognize the area that represents total revenue on a demand or supply graph. The following slides will be the basis of our discussions in the following lessons: Slide 1 Pricing is an extent decision Profit = Revenue - Cost Definition: Demand Curves are functions that relate the price of a product to the quantity demanded by consumers. Demand Curves help us make decisions to increase profits by modeling revenue» Particularly MR» Should I sell another unit?

3 Slide 2 Aggregate Demand Aggregate Demand: Each consumer wants one unit. To construct demand, sort by value. Pric Revenu Marginal e Q uantity e Revenue Price Aggregate Demand Q u a n ti ty Discussion: W hy do aggregate demand curves slope downward?» Role of heterogeneity?» How to estim ate? Slide 3 Pricing Tradeoff Lower price sell m ore, but earn less on each unit sold Higher price sell less, but earn more on each unit sold Tradeoff created by downward sloping demand Slide 4 Marginal Analysis Marginal analysis finds the right solution to the pricing tradeoff.» Also requires less information. Definition: The marginal revenue (MR) is the change in total revenue with an extra unit. Proposition: If MR > 0, then total revenue will increase if you sell one more unit. Proposition: If MR > MC, then total profits will increase if you sell one more unit. Proposition: Profits are max. when MR = MC

4 Slide 5 Elasticity of Demand M otivation: Price elasticity is used to do marginal analysis. Definition: Price elasticity = (%change in quantity demanded) (%change in price)» If e is less than one, demand is said to be inelastic.» If e is greater than one, demand is said to be elastic.» If e = 1, dem and is said to be unitary elastic. Slide 6 Other Elasticities Definition: Income elasticity = (%change in quantity demanded) (%change in income)» Inferior (neg.) vs. norm al (pos.) Definition: Cross-price elasticity of good one with respect to the price of good two = (%change in quantity of good one) (% change in price of good two)» Substitute (pos.) vs. complement (neg.) Definition: Advertising elasticity = (%change in quantity) (%change in advertising) Slide 7 Describing demand with price elasticity First law of demand: e < 0 (price goes up, quantity goes down).» Discussion: Do all demand curves slope downward? Second law of demand: in the long run, e increases.» Discussion: Give an example of the second law of demand.

5 Slide 8 Describing demand (contd.) Third law of demand: As price increases, demand curves become more price elastic, and e increases.» Discussion: Give an example of the third law of demand. HFCS Price Sugar Price HFCS Demand HFCS Quantity Slide 9 Estimating Elasticities Definition: Arc (price) elasticity = [(q1 - q2)/(q1+ q2)] [(p1 - p2)/(p1 + p2)].» Discussion: Price changes from $10 to $8, quantity changes from 1 to 2. Discussion: On a promotion week for Vlasic, the price of the Vlasic pickles drops by 25% and quantity increases by 300%. Slide 10 Estimating Elasticities (contd.) 3-Liter Coke Promotion» Instituted to meet Wal-Mart Promotion Product Initial Final % change elas. Price/bottleQ 3-liter % P of 3-liter $1.79 $ % Price/bottleQ 2-liter % 4.86 P of 3-liter $1.79 $ % Price/litre Q liters % P liters $0.52 $ %

6 Slide 11 Quick and Dirty Estimators Linear Demand Curve Formula, e = p/(p max -p) Discussion: How high would the price of the brand have to go before you would switch to another brand of running shoes? Discussion: How high would the price of all running shoes have to go before you should switch to a different type of shoe? Slide 12 Market Share Formula Proposition: The individual brand demand elasticity is approximately equal to the industry elasticity divided by the brand share.» Discussion: Suppose that the elasticity of demand for running shoes is 0.4, and the market share of a Saucony brand running shoe is 20%. What is the price elasticity of demand for Saucony running shoes? Proposition: Demand for aggregate categories is less elastic than demand for the individual brands in aggregate. Slide 13 Using Elasticities for Prediction Discussion: The income elasticity of demand for WSJ is Real income grew by 3.5% in the United States.» Estimate WSJ demand Discussion: The 1998 real per-capita median income in Arizona is $30,863; and in Colorado is $40,706» Estimate difference between per capita consumption in Colorado and in Arizona.

7 Slide 14 Elasticity and Revenue Approximate relationship» % Rev. = % P + % Q» =% P(1+ % Q/% P)» =% P(1+ e)» =% Price(1 - e ) Discussion: In 1980, Marion Barry, Mayor of the District of Columbia, raised the sales tax on gasoline sold in the District by 6%. Slide 15 Elasticity and MR Proposition: MR = P(1-1/ e )» If e > 1, MR > 0.» If e < 1, MR < 0. Discussion: If demand for Nike sneakers is inelastic, should Nike raise or lower price? Discussion: If demand for Nike sneakers is elastic, should Nike raise or lower price? Slide 16 Elasticity and Pricing MR > MC is equivalent to» P(1-1/ e ) > MC» P > MC/(1-1/ e )» (P - MC)/P>1/ e Discussion: Elas. = 2, p = $10 mc = $8, should you raise price? Discussion: Mark-up of 3 liter Coke is 2.7%. Should you raise price?

8 Slide 17 Elasticity and pricing (contd.) Discussion: Sales people MR > 0 vs. marketing MR > MC. Discussion: The Kentucky legislature allows only one race track to be open at a time.

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