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Chapter Outline
2.1 Markets and Models
2.2 Demand
2.3 Supply
2.4 Market Equilibrium
2.5 Elasticity
2.6 Conclusion
Introduction 2
In this chapter, we introduce the supply and
demand model. We will:
• Describe the basics of supply and demand.
• Use equations and graphs to represent supply
and demand.
• Analyze markets for goods and services using
the supply and demand model.
Markets and Models 2.1
What is a market?
A market is characterized by a specific:
1. Product or service being bought and sold
2. Location
3. Point in time
QD (P , I , Ps , Pc , Pref , n )
Demand 2.2
Many factors influence demand for goods and services.
Is there one factor that stands out?
• Focus on how the price of a good influences the quantity
demanded by consumers.
• Demand curve: Describes the relationship between
quantity of a good that consumers demand and the
good’s price, holding all other factors constant.
Demand 2.2
Figure 2.1 Demand for Tomatoes
Demand 2.2
Consider the market for oranges. We want to map out the quantity (in
pounds) demanded by local consumers at various prices ($/pound)
Price of oranges
($/pound) REMEMBER TO ALWAYS LABEL GRAPHS!
$6
5
At $6, consumers demand no oranges
‒ This is known as the demand choke
4 price.
QS ( P , Costs , n )
Supply 2.3
Figure 2.3 Supply of Tomatoes
Supply 2.3
We can describe the relationship between the quantity of oranges
supplied (in pounds) and the price ($/pound) with a supply
curve.
Price of oranges
($/pound)
5
To reach the equilibrium, prices must fall,
4 leading to a decrease in the quantity
supplied, and an increase in the quantity
3
demanded.
2
‒ The equilibrium is reached where both
quantity demanded and quantity supplied
1 equal 800 pounds at a price of $4 per
D pound.
0 400 800 1,200 1,600 2,000 2,400 Quantity of oranges
(pounds)
Market Equilibrium 2.4
Why markets move toward equilibrium
4
To reach the equilibrium, prices must rise,
leading to a decrease in the quantity
3 demanded, and an increase in the quantity
supplied.
2 ‒ The equilibrium is reached where both
Excess
1
Demand quantity demanded and quantity supplied
D equal 800 pounds at a price of $4 per pound
‒ .
0 400 800 1,200 1,600 2,000 2,400 Quantity of oranges
(pounds)
Market Equilibrium 2.4
Figure 2.6 Why Pe is the Equilibrium Price
In-text
figure it out
The demand and supply for a monthly cell phone plan with
unlimited texts can be represented by
QD = 50 − 0.5P
QS = −25 + P
where P is the monthly price, in dollars.
Price of oranges
($/pound) Prior to the FDA’s discovery, 800 pounds of
S
oranges are sold at $4 per pound.
$6
After the announcement, demand shifts from D1 to
5 D2.
4
The new equilibrium occurs when 400 pounds are
sold at a price of $3 per pound.
3
Following the decrease in demand, we should see
2 a decrease in the quantity of oranges supplied
in response to a falling price.
1 ‒ The equilibrium price falls $1 from $4 to $3.
D2 D1
0 400 800 1,200 1,600 2,000 2,400 Quantity of oranges
(pounds)
Market Equilibrium 2.4
In February, 2011, Brazil won a trade dispute with the U.S.
regarding imported orange juice, finding the U.S. was unfairly
excluding Brazilian suppliers from U.S. markets by use of a tariff.
The result was more orange juice imported from Brazil.
Price of oranges With the tariff, 800 pounds of oranges are sold at
($/pound)
S1 S2 $4 per pound.
Price S1 S2
Demand has relatively steep slope: Shift in
supply results in large change in price and small
change in quantity exchanged.
ΔP
ΔP
Demand has relatively shallow slope: The
same shift in supply results in small change in
D price and large change in quantity exchanged.
D
0 Quantity
ΔQΔQ
Market Equilibrium 2.4
Figure 2.10 Size of Equilibrium Price and Quantity Changes, and the
Slopes of the Demand and Supply Curves
Market Equilibrium 2.4
Sometimes, supply and demand shift simultaneously!
Example:
Hurricane Katrina and the New Orleans housing market
• Katrina destroyed many homes. What happens to supply?
• The hurricane displaced thousands of residents, many of
which have not returned. What happens to demand?
‒ How will these shifts affect the housing market
equilibrium in New Orleans?
Market Equilibrium 2.4
Hurricane Katrina and the New Orleans housing market
Q D
P
E
D
D
P Q
Price of oranges 6
E S 400 1.5
($/pound) 1, 600 (elastic)
5
$6 E S 400 1.67
1, 200 (elastic)
5 4
E S = 400 · =2
800 (elastic)
4
3
3 E S = 400 · =3
400 (elastic)
2 At the bottom of the supply curve,
1 P 2
1 ES S 400
slope Q 0 (perfectly elastic)
0 Quantity
Elasticity 2.5
Income elasticity of demand: Percentage change in quantity
demanded divided by the percentage change in income
%DQ DQ / Q
D D D
E =
D
I =
%DI DI / I
The sign of 𝐸𝐼𝐷 depends on the type of product:
• 𝐸𝐼𝐷 is negative for inferior goods (𝐸𝐼𝐷 < 0).
‒ Consumption decreases with increases in income.
Given data for the equilibrium price and quantity P* and Q*, as well as estimates of the
elasticities of demand and supply ED and ES, we can calculate the parameters c and d for
the supply curve and a and b for the demand curve. (In the case drawn here, c < 0.) The
curves can then be used to analyze the behavior of the market quantitatively.
Reconstructing LINEAR Demand and Supply equations from
equilibrium observations and elasticity estimates
Conclusion 2.6
This chapter has introduced one of the most basic models in
economics: the Supply and Demand model.
Forthcoming chapters:
• Examine the factors of production underlying supply.
• Introduce consumer theory, which underlies market demand.
• Examine situations in which assumptions fail to reflect reality
(e.g., the impact of uncertainty).
D2
b. This represents a change
D1 (or shift) in demand.
Q1 Q2 Quantity of
generators
In-text
figure it out
P1
This represents a change (or shift)
in supply followed by a change in
D the quantity demanded.
Q2 Q1 Quantity of ‒ Both Decrease
asparagus
Additional
figure it out
Therefore, Q D
P 1
ED D 50 0.33333
P Q 150
And, demand is:
Inelastic
Additional
figure it out
P 12 3
At a price of $12, D
Q 1,000 50 (12) 100
Q D P 3
Therefore, E
D
D 50 1.5
P Q 100
And, demand is:
Elastic
Additional
figure it out
50 P 1, 000 50 P
Combining the terms, yields a price of P = $10
%∆𝑸𝐜𝐞𝐫𝐞𝐚𝐥 = −𝟗, when the price of milk rises by 10%, the quantity
demanded of cereal falls by 9%.