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Introduction to Economics

Module I – Microeconomics


Lectures 2 & 3: Demand and Supply

Salvatore Nunnari
Demand
 Demand Curve
What will influence your decision to eat a slice
of pizza at lunch tomorrow?

Generally speaking, what factors influence the
market demand for pizza slices around Bocconi?

 Determinants of Demand
Ø The demand for a good is influenced by:
o  Price of the good
o  Population size and population growth
o  Consumers’ tastes or preferences
o  Consumers’ income
o  Prices of other products
o  Government taxes or regulations
 Demand Curve
Ø  The demand curve of a good P
(for a single individual or for a
whole market) shows how
much buyers want to buy at
each possible price holding
fixed all other factors.

Ø  Downward sloping: buying the

product less attractive when
price is higher. D

Q
 Shifts and Movement along the
Demand Curve
Ø Change in price of the product causes a
movement along the demand curve
o A change in the quantity demanded

Ø Change in another factor causes the entire

demand curve to shift
o A change in the quantity demanded at any given
price
 Movement along the Demand Curve
P
Ø  Increase in price (P)
from p’ to p’’
à Quantity demanded (Q)
decreases from q’ to q’’ P’’
P’
D

Q’’ Q’ Q
 Demand Shifts
•  Other products’ prices
o  Substitute goods an increase in the price of a substitute
product causes buyers to demand more of the other, all else
equal (examples: Coke and Pepsi; coffee and tea, …)
o  Complement goods: an increase in the price of a
complementary product causes buyers to demand less of
the other, all else equal (examples: printers and printer
cartridges; iPhones and iPhone apps; cars and gasoline; …).
•  Income
o Normal goods: if income increases, demand increases
o Inferior goods: if income increases, demand decreases
(shopping at large discount chains, long-distance buses,
inexpensive food, ….)
 Demand Shifts
Ø Change in prices of P
related products
Ø Substitutes:
Pgood 1 increases
⇒ Dsubstitute shifts
right (increases)

D’
D
Q
 Demand Shifts
P
Ø Change in prices of
related products
Ø Complements:
Pgood 1 increases
⇒ Dcomplement shifts
left (decreases)

D’ D
Q
 Demand Shifts
Ø  Change in income P
(normal good)
Ø  Income (M)
increases ⇒ D shifts
right (increases)

D’
D
Q
 Demand Shifts
P
Ø  Change in income
(inferior good)
Ø  Income (M) increases
⇒ D shifts left
(decreases)
Ø  Examples: shopping
at large discount
chains, long-distance
buses, inexpensive
food, ….

D’ D
Q
 Demand Functions
Ø A product’s demand function is the mathematical
representation of its demand curve:

Quantity Demanded = f (Price, Other Factors)

Ø Can be determined by applying statistical techniques

to historical data
Ø From the demand function we can learn if products
are substitutes or complements, and normal or
inferior (look at signs)
 Demand Function: Example

Ø  Demand for pizza slices affected by: price of pizza, price

of coke, price of arancini(e), students’ income
d
Qpizza = 6 − 2Ppizza + 2.5Parancini − 0.5Pcoke + 0.00055M

Ø  Increases in the prices of corn and butter will decrease

the amount of corn buyers demand
Ø  Increases in the price of potatoes or income (M) will
increase the amount of corn buyers demand
Ø  To draw it, fix price of corn, price of butter and income.
Ø  If we fix M=$30,000; Ppotatoes=$0.5; Pbutter=$4, we have:
d
Qcorn = 15 − 2 Pcorn
 Demand Function: Example
Ø  Demand for pizza slices affected by: price of pizza, price
of coke, price of arancini(e), students’ income
d
Qpizza = 6 − 2Ppizza + 2.5Parancini − 0.5Pcoke + 0.00055M

Ø  Increases in the prices of pizza and coke will decrease the

amount of pizza slices buyers demand
Ø  Increases in the price of arancini or income (M) will
increase the amount of pizza buyers demand
Ø  To draw it, fix price of coke, arancini and income.
Ø  If we fix M = €10,000; Parancini=€2; Pcoke=€3, we have:
d
Qpizza = 15 − 2Ppizza
Plotting a Demand Curve Starting from
a Demand Function
Ø Assume a linear function (= a straight line):
d
Q = a − bP

where a and b are constants; P is a variable
Ø To plot a demand curve, we use inverse demand
function: P=f(Q), P as a function of Q.
d
a Q
P= −
b b
Ø Y-intercept (where X=0): a/b
Ø X-intercept (where Y=0): a

 Demand Curve for Pizza
P
d
Qpizza = 15 − 2Ppizza
(Here: a = 15, b = 2) 7.5

1) Find inverse demand curve
d
Qpizza
Ppizza = 7.5 −
2 D
2) Find Y-intercept
Set Qpizza=0 à Ppizza= 7.5
15
Q
3) Find X-intercept
Set Ppizza=0 à Qpizza = 15
 Shift in Demand Curve for Pizza

What happens to the demand for pizza if

the price of arancini increases from €2 to
€3?
 Shift in Demand Curve for U.S. Corn
P Market (hypothetical)

8.75

7.5 New demand curve is:

d
Qpizza = 17.5 − 2Ppizza
New inverse demand curve is:
d
Qpizza
Ppizza = 8.75 −
2
New Y-intercept is 8.75

D’ New X-intercept is 17.5
D
15 17.5
Q
Supply
 Supply Curve
What influences Roqus decision about how
many pizzas to produce today?

More generally, what factors influence the
market supply for pizza slices around Bocconi?
 Determinants of Supply
Ø Supply of a good is influenced by:
o Price of the good
o Technology
o Prices of inputs – e.g. labor
o Prices of other possible outputs
o Government taxes or regulations
 Supply Curve
Ø  A product’s supply curve (for
an individual seller or for the P
whole market) shows how
much sellers of the product
want to sell at each possible S
price holding fixed all other
factors that affect supply

Ø  Upward sloping: selling the

product is less attractive when
the price is lower.

Q
2-23
Shifts and Movements Along a Supply
Curve
Ø Change in price of the product causes a
movement along the supply curve
o A change in the quantity supplied

Ø Change in another factor causes the entire

supply curve to shift
o A change in quantity supplied for any given price
Movement along the Supply Curve
Ø Change in P
price of the
product ⇒ S
movement
along the
curve

Q
 Supply Shifts: Increase

P
Ø Decrease in prices
of inputs S
Ø Decrease taxes/
regulations S’

Q
 Supply Shifts: Decrease

P
Ø Increase in prices of
inputs S’
S
Ø  increase in taxes/
regulations

Q
 Supply Functions
Ø A product’s supply function is the mathematical
representation of its supply curve:

Quantity Supplied = f (Price, Other Factors)

Ø Can be determined by applying statistical
techniques to historical data
 Supply Function: Example
Ø Supply of pizza affected by: price of pizza, price of
mozzarella, price of arancini
s
Q pizza = 9 + 5Ppizza − 2Pmozzarella − 5Parancini
Ø Increases in the price of diesel fuel (input) and
soybeans (substitute) will decrease the amount of
corn sellers supply
Ø Increases in the price of corn will increase the
amount of corn sellers supply
Ø For example, if we fix Pfuel=$2.5, Psoybean=$8, the
supply function becomes:
s
Qcorn = 5Pcorn − 6
 Supply Function: Example
Ø Supply of pizza affected by: price of pizza, price of
mozzarella, price of arancini
s
Q pizza = 9 + 5Ppizza − 2Pmozzarella − 5Parancini
Ø Increases in the price of mozzarella (input) and
arancini (substitute) will decrease the amount of
pizza sellers supply
Ø Increases in the price of pizza will increase the
amount of pizza sellers supply
Ø For example, if we fix Pmozzarella=€2.5, Parancini=€2,
the supply function becomes:
s
Qpizza = 5Ppizza − 6
 Let’s Plot the Supply Curve
Ø Assume linear function:
Qs = a + bP
Ø To plot a supply curve: use inverse supply
function: P=f(Q), P as a function of Q.
P = Qs/b – a/b
Ø Y-intercept: - a/b
Ø Slope: 1/b

 Supply Curve for Pizza
P
s
Q pizza = 5Ppizza − 6
S
Y-intercept:
Set Qpizza=0 à Ppizza=1.2

Slope: 1/5
1.2

Q
Putting Demand & Supply Together:
Market Equilibrium
 Market Equilibrium
•  (Perfectly competitive) market equilibrium:
o Equilibrium quantity and price
o How do changes in demand and supply affect the
equilibrium quantity and price? How does the
economy react to a shock? (Note: useful to predict
impact of government intervention).
 Market Equilibrium
Ø The equilibrium price is the price at which
the amounts supplied and demanded are equal
Ø Graphically, the price at which the supply and
demand curves intersect:
P
S
Equilibrium
Price

D
Q
 Market Equilibrium

P
Excess supply
⇒ sellers lower S
Excess supply
their prices
⇒ Qs decreases Phigh
and Qd increases
⇒ lower excess
supply, until it D
disappears
Qd Qs Q
 Market Equilibrium
P
Excess demand S
⇒ buyers
increase their bids
⇒ Qs increases
and Qd decreases
⇒ lower excess
demand, until it
disappears Plow Excess
demand D
Qs Qd Q
 Market Equilibrium
P
Qd = Qs
S
Equilibrium

D
Q
 Example
Ø Let’s find the equilibrium price and output in
the market for pizza slices around Bocconi:
d
Q pizza = 15 − 2Ppizza
s
Q pizza = 5Ppizza − 6
 Changes in Market Equilibrium
Ø Changing market conditions alters the market
equilibrium:
o Changes in the determinants of supply (or
demand) other than the product price cause the
supply (or demand) curve to shift
Ø 4 cases: demand increases or decreases, supply
increases or decreases
 Changes in Market Equilibrium
Ø Sometimes supply and demand will both shift
 Changes in Market Equilibrium
Ø Sometimes supply and demand will both shift
Ø Ultimate effect on equilibrium: combination of the
separate effects of changes in demand and supply
Ø Will be able to determine the necessary direction
of price or quantity movement, but not both
Ø Example: If supply and demand both increase,
quantity will increase for sure but what will
happen to the price?
 Changes in Market Equilibrium
Ø Sometimes supply and demand will both shift
Ø Ultimate effect on equilibrium: combination of the
separate effects of changes in demand and supply
Ø Will be able to determine the necessary direction
of price or quantity movement, but not both
Ø Example: If supply and demand both increase,
quantity will increase for sure but what will
happen to the price?
o  Demand increase pushes the price up
o  Supply increase pushes the price down
o  Net effect on price ambiguous, depends on relative size of 2 effects
Increase in Both Demand and Supply

2-46
Effects of Simultaneous Changes in Demand
and Supply

Source of Effect on Effect on Amount

Change Price Bought/Sold
Demand and supply Ambiguous Rises
both increase
Demand and supply Ambiguous Falls
both decrease
Demand increases, Rises Ambiguous
Supply decreases
Demand decreases, Falls Ambiguous
Supply increases

2-47
Elasticity of Demand
 Price Elasticity of Demand
Ø Tells us by how much the quantity demanded of a
product changes when its price changes

Ø Very useful information for firms and governments

 Price Elasticity of Demand
Ø  Definition: the elasticity of the demand with respect to
price equals the percentage change in the quantity
demanded for each 1 percent change change in price.

D
DchangeinQ
0
0
E = P
0 changeinP
0
 Interpreting the Price
Elasticity of Demand
Ø Typically, price elasticity of demand is negative
(because demand falls when price increases)

D
Ø Suppose E = −2
P

Ø This means that, starting from the current price,

the quantity demanded decreases 2% for each
1% increase in price
 Price Elasticity of Demand

•  Goods tend to have more price elastic demand when:

o  They have close substitutes à if price changes, consumers
can easily switch to an alternative product
o  Buyers of the product consider it a luxury
o  Buyers of the product have low income and thus are sensitive
to changes in their expenditures

•  In general, price elasticity varies along demand curve:

o  A 2% increase in price will have a different effect on demand
when the starting price is high than when the starting price is
low
 Categories of Elasticity of Demand
Focus on products with negative elasticity: elasticity ranges between - ∞ and 0.

Ø  ELASTIC: Ed <-1
o  Meaning: 1% rise in price reduces consumption by more than 1%.
o  Examples: cosmetics, unbranded clothing, eating out, luxury goods (poor
consumers), flight tickets (economy class), meat/fish.

Ø  INELASTIC (or RIGID): -1 < Ed≤ 0
o  Meaning: a 1% rise in price reduces consumption by less than 1%
o  Examples: gasoline, electricity, water, bread/rice/milk, luxury goods (wealthy
consumers), flight tickets (business class), espresso (Italian consumers).

Ø  UNIT ELASTIC: Ed = - 1
o  Meaning: a 1% rise in price reduces consumption by 1%.
 Categories of Elasticity of Demand
Extreme cases:

Ø  PERFECTLY ELASTIC: Ed = - ∞ (horizontal D curve)
o  Meaning: a rise in the price of the good induces consumers to stop purchasing it.

Ø  PERFECTLY INELASTIC: < Ed = 0 (vertical D curve)
o  Meaning: a rise in the price of the good won’t affect consumption.

 Elasticity for Linear Demand Curves
For a general linear demand function:

Qd = a - bP

Ed = -b(P0/Q0)
Where
Ø  -b is the slope of the linear demand curve
Ø  P0 and Q0 are the initial price and quantities
 Example
Ø What is the elasticity of the demand curve
d
Q = 15 − 2Ppizza
pizza

at a price of 3.75?

Ø Ed=-B(P/Q):
Ø Q=15-7.5=7.5
Ø Slope=-2
Ø Ed=-2(3.75/7.5)=-1
 Example
Ø What is the elasticity of the demand curve
d
Q = 15 − 2Ppizza
pizza

at a price of 3.75?

Ø Ed = -b(P0/Q0)
Ø Q0= 15- 2P0= 15-2(3.75) = 15-7.5 = 7.5
Ø b = -2 (slope)
Ø Ed = -2 (3.75/7.5) = -1
 Elasticity for Linear Demand Curves
o  Slope is constant along linear demand curve
but (P0/Q0) varies, so elasticity varies along the
demand curve
o  Demand is more elastic at higher prices since P
is larger and Q is smaller
o  Demand is less elastic at lower prices since P is
smaller and Q is larger
o  For this reason, we measure elasticity
separately at each point of the demand curve
Elasticities Along a Linear Demand
Curve
d
Qpizza = 15 − 2Ppizza

Elastic demand

inelastic demand

2-62
 Total Expenditure and Elasticity of Demand

Ø Total expenditure equals PxQ, the product of the

price and the total amount demanded
Ø Elasticity of demand tells us how total expenditure
changes when price increases
Ø TE will increase with a small increase in price when
demand is inelastic and decrease when demand is
elastic
Ø If Ed=-1, then a 1% increase in P will decrease Q by
exactly 1%, leaving TE unchanged.
Ø TE is largest at a price for which elasticity equals -1

2-63
 Price, Elasticity, and Total Expenditure
d
Qcorn = 15 − 2 Pcorn

•  TE increases where demand is inelastic; for prices below $3.75

•  TE falls where demand is elastic
•  TE is largest where Ed = -1; when price = $3.75
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 Income Elasticity of Demand
Ø Measures responsiveness of a product s demand
to changes in consumers income

d %Δ amount demanded ( ΔQ Q )
E =
M =
%Δ income (ΔM / M )
•  EdM may be positive or negative depending on the
good considered and on consumers’ preferences
over the good.

2-65
 Income Elasticity of Demand
Ø Measures responsiveness of a product s demand
to changes in consumers income

d %Δ amount demanded ( ΔQ Q )
E =
M =
%Δ income (ΔM / M )
Ø Normal goods: income elasticity > 0
Ø Inferior goods: income elasticity < 0

2-66
Cross-price Elasticity of Demand
Ø Measures responsiveness of the quantity
demanded to changes in another product s price

d
E =
%Δ amount demanded
=
(ΔQ Q )
P0
%Δ other product' s price (ΔP0 / P0 )

•  EdPo may be positive, negative or equal to zero

depending on the relationship between the two
goods.

2-67
Cross-price Elasticity of Demand
Ø Measures responsiveness of the quantity
demanded to changes in another product s price

d
E =
%Δ amount demanded
=
(ΔQ Q )
P0
%Δ other product' s price (ΔP0 / P0 )

Ø Substitute: cross-price elasticity > 0

Ø Complements: cross-price elasticity < 0

2-68