CHAPTER 2

DEMAND AND SUPPLY

ANALYSIS

1

Market Demand

• Demand function

– Quantity of a good all consumers in the market are

willing to buy

• Demand curve

– 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

2

Market Demand (cont.)

• Derived demand

– Demand for a good that is derived from the

production and sale of other goods

• E.g. demand for sugar is derived from demand for soft

drink

• Direct demand

– Demand for a good that comes from the desire of

buyers to directly consume the good itself

• E.g. rice is purchased by brokers, who then sell it to

retailers, who then resell it to final consumer

3

Market Demand (cont.)

• Law of demand

– Quantity of a good demanded decreases when the

price of this good increases

• Holding all other factors that affect demand constant

• Demand curve rule

– A move along the demand curve for a good can

only be triggered by a change in own price

• 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

4

Market Demand (cont.)

• Demand curve shifts

– When factors other than own price change

– If the change increases the willingness of

consumers to acquire the good

• Demand curve shifts right

– If the change decreases the willingness of

consumers to acquire the good

• Demand curve shifts left

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Market Demand (cont.)

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Market Demand (cont.)

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Market Supply

• Supply function

– Quantity of a good supplied by all producers in the

market depends on various factors

• Supply curve

– Aggregate quantity of a good that producers are

willing to sell at different prices

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Market Supply (cont.)

• Law of supply

– Quantity of a good offered increases when the

price of this good increases

• Supply curve rule

– A move along the supply curve for a good can

only be triggered by a change in the price of that

good

• Any change in another factor that affects the producers’

willingness to offer for the good results in a shift in the

supply curve for the good

9

Market Supply (cont.)

• Supply curve shift

– When factors other than own price change

– If the change increases the willingness of

producers to offer the good at the same price

• Supply curve shifts right

– If the change decreases the willingness of

producers to offer the good at the same price

• Supply curve shifts left

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Market Supply (cont.)

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Market Supply (cont.)

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Market Equilibrium

• Market Equilibrium

– A price such that, at this price, the quantities

demanded and supplied are the same.

– A point at which there is no tendency for the

market price to change as long as exogenous

variables remain unchanged.

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Market Equilibrium (cont.)

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Market Equilibrium (cont.)

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Market Equilibrium (cont.)

• Excess demand

– A situation in which the quantity demanded at a given price exceeds the quantity supplied

• Excess supply

– A situation in which the quantity supplied at a given price exceeds the quantity demanded

• No excess supply or excess demand

– No pressure for prices to change (i.e. equilibrium)

• When demand curve or the supply curve shift

– Equilibrium shifts as well

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Market Equilibrium (cont.)

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Shifts in Demand, Supply Unchanged

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Shifts in Supply, Demand Unchanged

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Shifts in Supply and Demand

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Basics Laws of Supply & Demand

• Increase in demand + unchanged supply

– Higher price and larger quantity

• Decrease in supply + unchanged demand

– Higher price and smaller quantity

• Decrease in demand + unchanged supply

– Lower price and smaller quantity

• Increase in supply + unchanged demand

– Lower price and larger quantity

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Market Equilibrium

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Market Equilibrium (cont.)

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Price Elasticity

• Price elasticity of demand

– Percentage change in quantity demanded brought

about by a one-percent change in the price of the

good

εQ,P = %∆Q / %∆P = ∆Q / ∆P (P / Q)

– Elasticity is not slope

• Slope is the ratio of absolute changes in quantity and

price.

• Elasticity is the ratio of relative (or percentage)

changes in quantity and price

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Price Elasticity (cont.)

• Key characteristics

– |εQ,P > 1| = elastic

• One percent change in price leads to a greater than one-

percent change in quantity demanded

– |0 < εQ,P < 1| = inelastic

• One percent change in price leads to a less than one-

percent change in quantity demanded

– |εQ,P = 1| = unit elastic

• One percent change in price leads to an exactly one-

percent change in quantity demanded

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Price Elasticity (cont.)

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Price Elasticity (cont.)

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Elasticity – Linear Demand Curve

• Linear demand curve

– Q = a – bp

• a and b are positive constants, p is price, b is the slope

• Inverse demand curve

– P = a/b – (1/b)Q

• a/b is the choke price

• εQ,P = (ΔQ/ΔP)(P/Q) = -b(P/Q)

– Elasticity falls from 0 to -∞ along the linear

demand curve, but slope is constant

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Elasticity – Linear Demand Curve

(cont.)

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Elasticity – Linear Demand Curve

(cont.)

30 30

Quantity

Price

0 Q

P • Observed price and quantity

Constant elasticity demand curve

Linear demand curve

Linear Demand Curve:

Qd = a -bP

εQ,P = (ΔQ/ ΔP)(P/Q) = -b(P/Q)

Constant Elasticity Demand

Curve:

Qd = aP-b

εQ,P = -b

Elasticity – Linear Demand Curve

(cont.)

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Price Elasticity and Total Revenue

• Total Revenue (TR) = P*Q

– When P↑ Q↓ and when P↓ Q↑

• Demand is elastic

– Fall in Q > Rise in P

• ↓P → ↑TR

• Demand is inelastic

– Fall in Q < Rise in P

• ↑P → ↑TR

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Determinants of Price Elasticity

• Availability of substitutes

– More substitutes → more price elastic

• Goods which have price inelastic at the market level,

like cigarettes, is highly price elastic at the brand level

• Buyer’s budget

– Large expenditure → more price elastic

• Necessities vs luxuries

– Necessities → less price elastic

• Time Horizon

– Long-run → more price elastic

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Income Elasticity of Demand

• Income elasticity of demand

– Ratio of the percentage change of quantity

demanded to the percentage change of income

εQ,I = %∆Q / %∆I = ∆Q / ∆I (I / Q)

– εQ,I > 0

• ↑income → ↑demand

• Normal goods: consume more as income rises

– εQ,I < 0

• ↑income → ↓demand

• Inferior goods: consume less as income rises

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Cross-Price Elasticity of Demand

• Cross-price elasticity of demand

– Ratio of the percentage change of the quantity of

one good demanded with respect to the percentage

change in the price of another good

εQi,Pj = %∆Qi / %∆Pj = ∆Qi / ∆Pj (Pj / Qi)

– εQi,Pj > 0 = demand substitutes

– εQi,Pj < 0 = demand complements

– εQi,Pj = 0 = irrelevant

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Price Elasticity of Supply

• Price elasticity of supply

– Percentage change in quantity supplied for each

percent change in price

εQ,P = %∆Q / %∆P = ∆Q / ∆P (P / Q)

– εQ,P > 0 = Elastic

– εQ,P < 0 = Inelastic

– εQ,P = 0 = Unit elastic

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Elasticity – Long-run vs Short-run

• Long-run demand/supply curves

– Consumers/sellers can fully adjust their

purchase/supply decisions to changes in price

• Short-run demand/supply curves

– Consumers/sellers cannot fully adjust their

purchase/supply decisions to changes in price

• Example:

– Consumer substitute solar for gas

– Producer build new plant

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Elasticity – Long-run vs Short-run

(cont.)

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Elasticity – Long-run vs Short-run

(cont.)

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Estimating Demand & Supply

• Demand estimation

– Estimating demand from own price elasticity and

equilibrium price and quantity

– Choose a general shape for functions

Q = a - bp

– Estimating parameters of demand using elasticity

and equilibrium information

εQ,P = ∆Q / ∆P (P / Q)

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Estimating Demand & Supply

(cont.)

• Demand and supply estimation from past shifts

– A shift in the supply curve reveals the slope of the

demand curve

• We can identify the slope of demand by a shift in supply

– A shift in the demand curve reveals the slope of

the supply curve

• We can identify the slope of supply by a shift in demand

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Estimating Demand & Supply

(cont.)

Example:

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Estimating Demand & Supply

(cont.)

Impact of Shift on Price

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