CHAPTER 2. Demand and Supply

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1 CHAPTER 2 Demand and Supply

2 The Supply_and_demand model A model for understanding the determination of the price of quantity of a good sold on the market Two groups: buyers and sellers

3 Types of Competition The model relies on a high degree of competition Buyers bid against each other and raise the price Sellers bid against each other and lower the price The equilibrium is a point at which all the bidding has been done No one has an incentive to offer higher prices or accept lower prices

4 Types of Competition Perfect competition exits when there are so many buyers and sellers that no single buyer or seller can unilaterally affect the price on the market Imperfect competition exists when a single buyer or seller has the power to influence the price on the market The model applies most accurately when there is perfect competition No market is actually perfectly competitive, but the model framework still provides a good approximation for what is happening much of the time

5 2.1 Demand 2-5 Demand 3 forms 1) Table-Demand Schedule 2) Curve (Graph) 3) Function

6 Table 2-1 The Demand Schedule for Jeans in a Small Market Price of Jeans ($) Quantity of Jeans Sold 0 80, , , , , , , ,

7

8 P= Q

9 2.1 Demand 2-9 Demand A demand curve A graphical representation of the relationship between price and quantity demanded Quantity demanded the amount of a good or serve consumers are willing and able to buy at a given price Law of demand when the price of a good rises(falls), and everything else remain the same, the quantity of the good demanded will fall(rise). everything else remain the same=ceteris paribus= other things equal

10 Changes in Demand 2-10 Demand Price A Increase in demand Decrease in demand B D 2 D 0 D 1 0 Quantity

11 Demand Shifters Price Quantity Average Consumer Income Advertising Expenditure Average Price of Shirts 0 80,000 $ 25,000 $ 50,000 $ ,000 25,000 50, ,000 25,000 50, ,000 25,000 50, ,000 25,000 50, ,000 25,000 50, ,000 25,000 50, ,000 25,000 50, ,000 50,000 20

12 2-12 Demand Demand Shifters Income Normal good Inferior good Prices of related goods Substitute goods Complement goods Advertising and consumer tastes Population Consumer expectations Other factors

13 2-13 Demand The Demand Function The demand function for good X is a mathematical representation describing how many units will be purchased at different prices for good X, different prices of a related good Y, different levels of income, and other factors that affect the demand for good X.

14 2-14 Demand The Linear Demand Function One simple, but useful, representation of a demand function is the linear demand function: QQ dd XX = αα 0 + αα XX PP XX + αα YY PP YY + αα MM MM + αα HH HH, where: QQ dd XX is the number of units of good X demanded; PP XX is the price of good X; PP YY is the price of a related good Y; MM is income; HH is the value of any other variable affecting demand.

15 2-15 Demand The Linear Demand Function in Action Suppose that an economic consultant for X Corp. recently provided the firm s marketing manager with this estimate of the demand function for the firm s product: QQ XX dd = 12,000 3PP XX + 4PP YY 1MM + 2AA XX Question: How many of good X will consumers purchase when PP XX = $200 per unit, PP YY = $15 per unit, MM = $10,000 and AA XX = 2,000? Are goods X and Y substitutes or complements? Is good X a normal or an inferior good? Answer: QQ XX dd = 12, , = 5,460 units. Goods X and Y are substitutes. Good X is an inferior good.

16 2-16 Demand Inverse Demand Function By setting PP YY = $15 and MM = $10,000 and AA = 2,000 the demand function is QQ XX dd = 12,000 3PP XX , ,000 the linear demand function simplifies to QQ XX dd = 6,060 3PP XX Solving this for PP XX in terms of QQ XX dd results in PP XX = 2, QQ XX dd, which is called the inverse demand function. This function is used to construct a market demand curve.

17 2-17 Graphing the Inverse Demand Function in Action Demand Price $2,020 PP XX = 2, QQ XX dd 0 6,060 Quantity

18 2.2 Supply 2-18 Supply Supply curve A graphical representation of the relationship between price and quantity supplied Quantity supplied(qs) The amount of a good that sellers are willing and able to produce and sell Law of supply As the price of a good rises (falls), the quantity supplied of the good rises (falls), holding other factors affecting supply constant.

19 2-19 Change in Supply in Action Supply Price S1 S 0 Decrease in supply B S 2 Increase in supply A 0 Quantity

20 Supply Shifters 2-20 Supply Input prices Technology Number of firms Entry Exit Prices of related goods Substitutes in production Complements in production Taxes Excise tax (levied on each unit of output sold) Ad valorem tax (percentage tax such as sales tax) Producer expectations

21 Substitutes in production Definition: they are two or more goods that can be produced using the same resources. Producing one good prevents sellers from using resources to produce another. EX1: Farmers are faced with the production of substitute crops, such as corn or soybeans. EX2: Automobile companies must choose between the production of four-door sedans or pickup trucks.

22 Complements in production Definition: they are two or more goods that are jointly produced using a given resource. Both goods are simultaneously produced from the same resource. EX1: Cattle ranchers produce both beef and leather from the same cattle resource. EX2: Lumber mills use timber resources to the produce two-by-fours and sawdust.

23 The Supply Function 2-23 Supply The supply function for good X is a mathematical representation describing how many units will be produced at different prices for X, different prices of inputs W, prices of technologically related goods, and other factors that affect the supply for good X.

24 The Linear Supply Function 2-24 Supply One simple, but useful, representation of a supply function is the linear supply function: QQ ss XX = ββ 0 + ββ XX PP XX + ββ WW WW + ββ rr PP rr + ββ HH HH, where: QQ ss XX is the number of units of good X produced; PP XX is the price of good X; WW is the price of an input; PP rr is price of technologically related goods; HH is the value of any other variable affecting supply.

25 The Linear Supply Function 2-25 in Supply Action Your research department estimates that the supply function for televisions sets is given by: QQ ss XX = 2, PP XX 4PP RR 1PP WW a) How many televisions are produced when PP XX = $400, PP RR = $100 per unit, and PP WW = $2,000? Answer: QQ ss XX = 2, ,000 = 800 television sets. b) Substitutes in production

26 Inverse Supply Function 2-26 Supply The inverse supply function PP XX = aa + bbqq XX ss By setting PP WW = $2,000 and PP rr = $100 in QQ XX ss = 2, PP XX ,000 the linear supply function simplifies to QQ XX ss = 3PP XX 400 Solving this for PP XX in terms of QQ XX ss results in PP XX = QQ XX ss, which is called the inverse supply function. This function is used to construct a market supply curve.

27 Market Equilibrium Market Equilibrium 2-27 Competitive market equilibrium Price of a good is determined by the interactions of the market demand and market supply for the good. A price and quantity such that there is no shortage or surplus in the market. Forces that drive market demand and market supply are balanced, and there is no pressure on prices or quantities to change.

28 Market Equilibrium I Market Equilibrium 2-28 Price Surplus Supply PP HH PP ee PP LL Shortage Demand 0 QQ 0 QQ ee QQ 1 Quantity

29 The Demand Function: QQ XX dd = αα 0 + αα XX PP XX + αα YY PP YY + αα MM MM + αα HH HH The Own Demand Function: QQ XX dd = aa bbpp XX The Supply Function: QQ XX ss = ββ 0 + ββ XX PP XX + ββ WW WW + ββ rr PP rr + ββ HH HH The Own Supply Function: QQ XX ss = aa + bbpp XX

30 Market Equilibrium II Consider a market with demand and supply functions, respectively, as QQ dd = 10 2PP and QQ ss = 2 + 2PP A competitive market equilibrium exists at a price, PP ee, such that QQ dd PP ee = QQ ss PP ee. That is, 10 2PP = 2 + 2PP 8 = 4PP PP ee = $2 QQ ee = 10 2 $2 = 6 Or QQ ee = $2 = 6 QQ ee = 6 units

31 2-31 Price Restrictions In a competitive market equilibrium, price and quantity freely adjust to the forces of demand and supply. Sometimes the government restricts how much prices are permitted to rise or fall. Price ceiling (rental control for tenants) New York City s rent control program, which began in 1943, is among the oldest in the country Price floor (minimum wage) 7.25 dollar/hour in TX (Jan. 1 st 2014)

32 2-32 Price Ceiling in Action Consider a market with demand and supply functions, respectively, as QQ dd = 10 2PP and QQ ss = 2 + 2PP Suppose a $1.50 price ceiling is imposed on the market. QQ dd = 10 2 $1.50 = 7 units. QQ ss = 2 + 2($1.50) = 5 units. Since QQ dd > QQ ss a shortage of 7 5 = 2 units exists.

33 2-33 Price Floor in Action Consider a market with demand and supply functions, respectively, as QQ dd = 10 2PP and QQ ss = 2 + 2PP Suppose a $4 price floor is imposed on the market. QQ dd = 10 2 $4 = 2 units QQ ss = 2 + 2($4) = 10 units Since QQ ss > QQ dd a surplus of 10 2 = 8 units exists.

34 2-34 Increase in Demand in Action Comparative Statics Price Demand for Rental Cars Supply $49 $45 Demand 1 Demand Quantity (thousands rented per day)

35 Decrease in Supply in Action Comparative Statics 2-35 Price Supply 1 PP 1 Supply 0 PP 0 Demand 0 QQ 0 QQ 1 Quantity

36 2-36 Decrease in Supply and increase in Demand Price Japan s Sake Market PP 2 C Supply 2 Supply 1 PP 1 B Supply 0 PP 0 A Demand 1 Demand 0 0 QQ 2 QQ 0 QQ 1 Quantity

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