DARTMOUTH COLLEGE, DEPARTMENT OF ECONOMICS

ECONOMICS 1

Dartmouth College, Department of Economics: Economics 1, Fall 02

Topic 2: Supply and Demand

Economics 1, Fall 2002 Andreas Bentz Based Primarily on Frank Chapters 2, 4

Dartmouth College, Department of Economics: Economics 1, Fall 02

Supply and Demand: Equilibrium

Example: The Market for Apartments

Andreas Bentz

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DARTMOUTH COLLEGE, DEPARTMENT OF ECONOMICS

ECONOMICS 1

The (Market) Demand Curve

Demand curve for one bedroom apartments:
price (100s of $) 10 8 6 4 2 D 0 0 1 2 3 4 5 quantity (100s)
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The demand curve for a good tells us how much of that good is demanded at each price.

The Demand Curve, contd

A downward-sloping demand curve tells us that:

The higher the price, the less the demand for the good. As price increases, fewer potential buyers can afford to buy the good (income/wealth effect). As price increases, some potential buyers substitute other goods (substitution effect).

Why?

We can write the (inverse) demand curve as p(q). Then we know that dp / dq < 0.
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Andreas Bentz

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DARTMOUTH COLLEGE, DEPARTMENT OF ECONOMICS

ECONOMICS 1

The (Industry) Supply Curve

Supply curve for one bedroom apartments:
price (100s of $) S 10 8 6 4 2 0 0 1 2 3 4 5 quantity (100s)
5

The supply curve for a good tells us how much of that good is supplied at each price.

The Supply Curve, contd

An upward-sloping supply curve tells us that:

The higher the price, the greater the supply for the good. Typically: the more you produce, the greater the production cost for each additional unit. In order to be willing to supply more, you therefore need to be able to charge a higher price for each unit. (The price must cover the production cost.)

Why?

Andreas Bentz

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DARTMOUTH COLLEGE, DEPARTMENT OF ECONOMICS

ECONOMICS 1

Equilibrium
Equilibrium in the market for apartments:
price (100s of $) S 10 8 6 4 2 D 0 0 1 2 3 4 5 quantity (100s)
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In equilibrium, prices are such that the quantity demanded equals the quantity supplied.

Excess Supply / Excess Demand

price (100s of $) S 10 8 6 4 2 D 0 0 1 2 3 4 5 quantity (100s)
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excess supply: the amount by which quantity supplied exceeds quantity demanded excess demand: the amount by which quantity demanded exceeds quantity supplied

Andreas Bentz

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DARTMOUTH COLLEGE, DEPARTMENT OF ECONOMICS

ECONOMICS 1

Price Ceiling (Rent Control)

Price ceiling at $400:
price (100s of $) S 10 8 6 4 2 D 0 0 1 2 3 4 5 quantity (100s)
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The price ceiling causes excess demand: some potential buyers who would want to pay more than the ceiling cannot obtain the good (rationing).

Price Floor
Price floor at $800:
price (100s of $) S 10 8 6 4 2 D 0 0 1 2 3 4 5 quantity (100s)
10

The price floor causes excess supply: some potential suppliers who would want to supply at a lower price cannot sell the good.

Andreas Bentz

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DARTMOUTH COLLEGE, DEPARTMENT OF ECONOMICS

ECONOMICS 1

Welfare Properties of Equilibrium

Equilibrium has nice welfare properties:
price (100s of $) S 10 8 6 4 2 D 0 0 1 2 3 4 5

Example: Prices are fixed at $400, so 200 apartments are rented. Now suppose some buyer offered $700 for one more apartment. A seller should be happy to provide one more apartment (since the cost of providing that apartment is $400).
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quantity (100s)

Prices
Prices serve two important functions:

Rationing function:

We live in a world of scarcity. If all goods were free, how could we ration peoples unlimited wants? Since we live in a world of scarcity, we need to allocate the available resources so that: those who value goods most highly obtain them; those goods that are most wanted are being produced (suppose there is excess demand in one market: firms would have an incentive to expand production in that market, because supernormal profits can be made).
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Allocative function:

Andreas Bentz

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DARTMOUTH COLLEGE, DEPARTMENT OF ECONOMICS

ECONOMICS 1

Dartmouth College, Department of Economics: Economics 1, Fall 02

Using Supply and Demand

Changes in Demand Changes in Supply Application: Taxes Elasticity

Changes in Demand
What shifts the demand curve? (Alternatively: What causes a rise (fall) in the quantity demanded at every price?)

Changes in income/wealth: as consumers income/wealth increases, they will want to buy more of a good at each price. Prices of substitutes/complements:

complements (e.g. coffee and cream): if the price of coffee rises, your demand for cream will fall; substitutes (e.g. coffee and tea): if the price of coffee rises, your demand for tea will increase.
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etc.

Andreas Bentz

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DARTMOUTH COLLEGE, DEPARTMENT OF ECONOMICS

ECONOMICS 1

Changes in Supply
What shifts the supply curve? (Alternatively: What causes a rise (fall) in the quantity supplied at every price?)

Technology: better technology reduces cost of production. Factor prices: higher factor prices (e.g. cost of labor) means higher cost of production. Number of suppliers (e.g. computer manufacturers) etc.

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Demand v. Quantity Demanded

Distinguish between:

a change in demand (the entire demand curve shifts), and a change in the quantity demanded (a movement along the demand curve).
Example: consumers expect a future price rise price S Example: good weather before harvest price S S

D quantity

D quantity
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Andreas Bentz

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DARTMOUTH COLLEGE, DEPARTMENT OF ECONOMICS

ECONOMICS 1

Supply v. Quantity Supplied

Similarly Distinguish between:

a change in supply (the entire supply curve shifts), and a change in the quantity supplied (a movement along the supply curve).

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Using Supply and Demand

Example: Why do airfares increase in summer?
Example (a): carriers can expand capacity price S Example (b): carriers cannot expand capacity price S

D quantity

D quantity

Think about your own example with a fall in demand!

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Andreas Bentz

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DARTMOUTH COLLEGE, DEPARTMENT OF ECONOMICS

ECONOMICS 1

Using Supply and Demand, contd

Example: What happened during the oil price shock?
Example (a): demand for gas is (relatively) elastic price S S Example (b): demand for gas is (relatively) inelastic price S S

D quantity

D quantity

Think about your own example with a supply increase!

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Dartmouth College, Department of Economics: Economics 1, Fall 02

Application: Taxes
Producer/Consumer Taxes (Economic) Tax Incidence

Andreas Bentz

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DARTMOUTH COLLEGE, DEPARTMENT OF ECONOMICS

ECONOMICS 1

Taxes
Suppose a tax of T is levied on each unit sold by the producer.
Supply curve shifts up by the amount T. price S S Tax incidence: who bears the tax? price S S

T
quantity

D quantity

In order to cover cost, the producer needs to charge T more for each unit sold.

But some of the cost T of the tax is borne by consumers.

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Taxes, contd
Suppose a tax of T is levied on each unit bought by the buyer.
Demand curve shifts down by the amount T. price Tax incidence: who bears the tax? price S

D quantity

D quantity

In order to buy the same quantity as before, the price has to fall by T.

But some of the cost T of the tax is borne by producers.

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Andreas Bentz

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DARTMOUTH COLLEGE, DEPARTMENT OF ECONOMICS

ECONOMICS 1

Tax Incidence
Who bears the tax depends on the elasticities of supply and demand. Example: demand.
Example (a): Relatively elastic demand curve price S S D D Example (b): Relatively inelastic demand curve price S S

quantity

quantity

Tax borne largely by producers.

Tax borne largely by consumers.

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Tax Incidence, contd

Who bears the tax depends on the elasticities of supply and demand. Example: supply.
Example (a): Relatively elastic supply curve price S S D quantity D quantity Example (b): Relatively inelastic supply curve price S S

Tax borne largely by consumers.

Tax borne largely by producers.

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Andreas Bentz

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DARTMOUTH COLLEGE, DEPARTMENT OF ECONOMICS

ECONOMICS 1

Tax Incidence, contd

Similarly, supply and demand elasticities determine the incidence of a tax levied on consumers. Workout: Try this at home!

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Dartmouth College, Department of Economics: Economics 1, Fall 02

Elasticity
Price Elasticity of Demand Cross-Price Elasticity of Demand Income Elasticity of Demand

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DARTMOUTH COLLEGE, DEPARTMENT OF ECONOMICS

ECONOMICS 1

Price Elasticity of Demand

The price elasticity of demand measures the responsiveness of demand for a good with respect to changes in the price of that good. Definition: The price elasticity of demand is the percentage change in the quantity demanded that results from a 1 percent change in price.
Precisely, it is: = q / q p / p

q / q q p dq p dp p = = = 1/ or, rewritten: = p / p p q dp q dq q
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Price Elasticity of Demand, contd

dp p says that: = 1/ dq q

The price elasticity of demand at some point on the demand curve is

the inverse of the slope of the (inverse) demand curve, times the ratio of price to quantity at that point on the demand curve.

Implications: the price elasticity of demand is

(probably) different at every point on the demand curve; nonpositive.

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Andreas Bentz

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DARTMOUTH COLLEGE, DEPARTMENT OF ECONOMICS

ECONOMICS 1

Price Elasticity of Demand, contd

We call demand (at some point) elastic, if the quantity demanded is relatively responsive to changes in price.

Definition: demand is elastic whenever < -1.

We call demand (at some point) inelastic, if the quantity demanded is relatively unresponsive to changes in price.

Definition: demand is inelastic whenever -1 < < 0.

We call demand (at some point) unit elastic, if the quantity demanded changes proportionately to changes in price.

Definition: demand is unit elastic whenever = -1.

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Price Elasticity of Demand, contd

Two extreme cases:
Perfectly elastic demand ( = -)
Demand curve with slope dp/dq = 0 price

Perfectly inelastic demand ( = 0)

Demand curve with slope dp/dq = price D

quantity

quantity
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Andreas Bentz

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DARTMOUTH COLLEGE, DEPARTMENT OF ECONOMICS

ECONOMICS 1

Using Price Elasticity of Demand

Example: Suppose you know that the price elasticity of demand for pizza at Thayer is -2.

That is, every 1% increase in price results in a 2% reduction in the quantity demanded.

Currently, 100 slices of pizza are sold, at $1.75 each. So revenue from pizza is $175. If the price of pizza increased to $2.10, would total revenue increase or decrease?
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Using Price Elasticity, contd

An increase from $1.75 to $2.10 is an increase of 20%.

Since the elasticity is -2, we know that demand will fall by 40%.

Only 60 slices of pizza will be sold after the price increase.

60 slices of pizza at $2.10 each create revenue of $126, which is less than $175.

Total revenue would decrease.

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Andreas Bentz

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DARTMOUTH COLLEGE, DEPARTMENT OF ECONOMICS

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Buzz Group
What effect does a 20% increase in price have on total revenue from pizza if the price elasticity of demand were -0.5?

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Cross-Price Elasticity of Demand

We have already seen that prices of other goods may influence demand for a good.

Example: If tea and coffee are substitutes, an increase in the price of coffee will increase your demand for tea.

The cross-price elasticity of demand measures the responsiveness of demand for a good with respect to changes in the price of some other good.

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Andreas Bentz

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DARTMOUTH COLLEGE, DEPARTMENT OF ECONOMICS

ECONOMICS 1

Cross-Price Elasticity, contd

Definition: The cross-price elasticity of demand is the percentage change in the quantity demanded of one good that results from a 1 percent change in price of some other good. Precisely, for two goods, x and y, it is:
xy = q x / q x py / py

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Cross-Price Elasticity, contd

We can now be specific about substitutes and complements: Two goods, x and y, are substitutes if an increase in price of good y increases demand for good x.

Definition: x and y are substitutes if xy > 0.

Two goods, x and y, are complements if an increase in price of good y decreases demand for good x.

Definition: x and y are complements if xy < 0.

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DARTMOUTH COLLEGE, DEPARTMENT OF ECONOMICS

ECONOMICS 1

Cross-Price Elasticity, contd

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Income Elasticity of Demand

We have also seen that changes in income/wealth may have an effect on the quantity demanded of some good.

Example: As your income/wealth rises, you can afford to buy more of everything.

The income elasticity of demand measures the responsiveness of demand for a good with respect to changes in a consumers income/wealth.
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Andreas Bentz

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DARTMOUTH COLLEGE, DEPARTMENT OF ECONOMICS

ECONOMICS 1

Income Elasticity, contd

Definition: The income elasticity of demand is the percentage change in the quantity demanded of some good that results from a 1 percent change in a consumers income/wealth. Precisely, it is: q / q = m / m (where m is income/wealth).
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Income Elasticity, contd

Income elasticity of demand is usually positive (normal goods). But there are goods of which you want to buy less as your income increases (inferior goods).

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DARTMOUTH COLLEGE, DEPARTMENT OF ECONOMICS

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Income Elasticity, contd

We can now be specific about which goods are necessities and which are luxuries: A good is a necessity if quantity demanded is relatively unresponsive to changes in income/wealth.

Definition: a good is a necessity if 0 < < 1.

A good is a luxury if quantity demanded is relatively responsive to changes in income/wealth.

Definition: a good is a luxury if > 1.

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