CHAPTER 2

DEMAND AND SUPPLY

ANALYSIS

1
Market Demand
• Demand function
– Quantity of a good all consumers in the market are
willing to buy
• QD = f(P, I,…)
• 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
• QD = f(p)
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

5
Market Demand (cont.)

6
Market Supply
• Supply function
– Quantity of a good supplied by all producers in the
market depends on various factors
• QS = f(P, W,…)
• Supply curve
– Aggregate quantity of a good that producers are
willing to sell at different prices
• QS = f(P)

7
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
8
 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

9
Market Supply (cont.)

10
 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

11
Market Equilibrium (cont.)

12
Market Equilibrium (cont.)
• Excess demand
– Quantity demanded exceeds quantity supplied
• Excess supply
– Quantity supplied exceeds quantity demanded
• Equilibrium
– No excess supply or excess demand
– No pressure for prices to change
• Demand curve or supply curve shift
– Equilibrium shifts as well
13
Market Equilibrium (cont.)

14
Shifts in Demand, Supply Unchanged

15
Shifts in Supply, Demand Unchanged

16
Shifts in Supply and Demand

17
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

18
Market Equilibrium

19
Market Equilibrium (cont.)

20
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

21
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

22
Price Elasticity (cont.)
• Key characteristics
– |εQ,P = 0| = perfectly inelastic
• Quantity demanded is completely insensitive to price
– |εQ,P = ∞| = perfectly elastic demand
• Any increase in price results in quantity demanded
decreasing to zero
• Any decrease in price results in quantity demanded
increasing to infinity

23
Price Elasticity (cont.)

24
Price Elasticity (cont.)

25
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
26
Elasticity – Linear Demand Curve
(cont.)

27
Elasticity – Linear Demand Curve
(cont.)

28
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
29
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
30
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 (+ve)
• ↑income → ↑demand
• Normal goods: consume more as income rises
– εQ,I < 0 (–ve)
• ↑income → ↓demand
• Inferior goods: consume less as income rises
31
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 (+ve) = demand substitutes
– εQi,Pj < 0 (–ve) = demand complements
– εQi,Pj = 0 = irrelevant

32
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)
• Value must be positive
– εQ,P > 1 = Elastic
– εQ,P < 1 = Inelastic
– εQ,P = 1 = Unit elastic

33
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
34
Elasticity – Long-run vs Short-run
(cont.)

35
Elasticity – Long-run vs Short-run
(cont.)

36
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)

37
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

38
Estimating Demand & Supply
(cont.)
Example:

39
Estimating Demand & Supply
(cont.)

40
Impact of Shift on Price

41