The Basics of Supply and Demand

1. CHAPTER 2

The Basics of Supply and
Demand

2. The supply curve: the positive relationship between the quantity of a good that producers are willing to sell and the price of

the good.
Price
Supply
Variables that effect the supply curve:
1. Costs of raw materials
P
P’
Supply’
2. Production costs
3. Interest charges
Q
Q’
Quantity

3. The Demand Curve: Negative relationship between the quantity of a good that consumers are willing to buy and the price of a

good
Price
Variables that effect demand curve:
1. Income
2. Prices of related goods
A
3. Tastes, Culture, Mentality
4. Weather, season
B Demand’
Demand
Q1
Q2
Quantity
5. Expectations

4. The market mechanism: tendency in a free market for price to change until the market clears

Price
Supply
Surplus=excess supply
Surplus
Shortage= excess demand
Market clearing=equilibrium
Market clearing
Shortage
Demand
Quantity

5. Elasticities of supply and demand: elasticity measures the sensitivity of one variable to another

Price elasticity of demand: measures the sensitivity of Qd to price changes
Ep=% change in Qd /% change in P
or
P/Qd multiplied by change in Qd / change in P
IF Ep>1 price elastic, close substitutes
IF Ep<1 price inelastic, no close substitutes

6. Price Elasticity of Demand

Price
Price
Demand
Demand
Quantity
Infinitely elastic demand
Quantity
Completely inelastic demand

7. Income Elasticity of Demand:

This is percentage change in the Qd resulting from
1% increase in income
or
Measures sensitivity of Qd to changes in income
Income elasticity formula = I/Qd multiplied by change in Qd/change in
Income

8. Cross price Elasticity:

This is the percentage change in Qd for a good that results from a 1% increase
in the price of another related product. Example:
Substitutes: pepsi or coca cola
Complements: software and hardware
Formula: Elasticity of Ppepsi and Qcola= Pp/Qc * change in Qc / change in Pp

9. Point Elasticity:

This is price elasticity at a particular point on the demand curve
Formula: P/Q * 1/slope
Arc Elasticity:
Price elasticity calculated over a range of prices
Formula: change in Qd/change in P * average P/average Qd

10. Short Run versus Long Run Elasticities

Demand: durables, nondurables
Example:
Nondurables: Gasoline, coffee, hamburger, e.t.c.
If the price of gasoline sharply increases in the short run motorists will drive
less, but in the long run they will shift to smaller, fuel-efficient cars. So, for
nondurables demand is more elastic in the long run.
Durables: Frige, automobile, TV, e.t.c.
If Pcars wil increase sharply in the short run people will not buy car, they will
wait, but in the long run they should wear out old cars, so Qd for cars will
increase but not so much. As a conclusion, for durables demand is more
elastic in the short run.

11. Income Elasticities in the short run and in the long run

IE is more elastic in the short run for durables, because people try to realise
dream when they become richer.
IE is more elastic in the long run for nondurables, because changing consumers
confidence takes time.

12. Price Elacticity of Supply: shows sensitivity of supply by 1% change in price

Supply: Primary Supply, Secondary Supply
Price elasticity of supply is generally more elastic in the long run, but
especially primary supply is more elastic in the long run because of capacity
constraints.
Capacity constraints: expand capital, hiring professionals, building factory,
etc.
Price elasticity of supply of secondary raw materials is more elastic in the
short run, but its costly because of some procedures like, melting,
refablicating scrap metal to convert it into new supply

13. Understanding and predicting the effects of changing market conditions

Demand:Qd=a-bP Qd= Qs
Supply: Qs=c+dP
Step1:
In Elasticity formula delta Q /delta P part is fixed for linear curves so, for
demand it is –b, for supply it is d
Ed=-b*(P/Q) for demand
Es= d*(P/Q) for supply
Step2:
Q=7,5 mln metric tons p/year
P=$0,75p/pound
Es=1,6
Ed=-0,8
FIND a,b,c,d,?

14. Example:

Demand depends on income, so we can write like:
Qd=a-bP+fI
I is aggregate income
I=1,0
Ei=1,3
derivative part of the elasticity formula is fixed and it is f
FIND f?
Ei=f*I/Qd 1,3=f*1,0/7,5
f=(1,3*7,5)/1,0=9,75
b=8
f=9,75
a=?
a= 3,75
Find a? Qd=a-bP+fI 7,5=a-8*0,75+9,75*1,0

15. Effects of government intervention – Price controls

Price
Supply
P1
P2(price ceiling)
shortage
Demand
Quantity