Microeconomics: 33001

Booth School of Business

Winter 2011
Professor Matthew J. Notowidigdo

Week One Class Outline

• Goals:
o Understand supply and demand curves
o Understand market equilibrium
o Understand elasticity
o Understand consumer surplus
• Demand Curves
o What are they?
o How do we draw them?
o Shifting demand curves
o Movement along demand curves
o Equations for demand curves
• Supply Curves
o What are they?
o How do we draw them?
o Shifting supply curves
o Movement along supply curves
o Equations for supply curves
• Market Equilibrium
o How to calculate it
o What happens when the curves move?
• Elasticity
o What is it?
o Calculating
 Arc Elasticity
 Point Elasticity
o Using elasticity to make pricing decisions
• Consumer Surplus: Definition

1
 Introduction to Supply and Demand

Textbook Reference: Perloff, chapters 1 and 2

I. What is microeconomics?

Microeconomics is the study of how scarce resources are allocated to satisfy competing ends in a
market economy.

Three key concepts:

• SCARCITY: the economy only has a limited amount of resources. If resources weren’t
scarce, allocating them would not be a problem.
• CHOICE: if allocation were done by government fiat, economics would have nothing to say.
Economics is the study of how individuals and firms make choices in an environment of
limited resources.
• MARKET: the market is what determines the allocation of goods in the economy.

II. Introduction to DEMAND

A DEMAND FUNCTION maps out the quantity of a good that will be bought at each price.
• Quantity demanded falls as prices rise, so the demand curve slopes DOWNWARD.
• An INDIVIDUAL DEMAND FUNCTION maps out the quantity of a good that an
individual would buy at each price.
• A MARKET DEMAND FUNCTION maps out the total quantity of a good that would be
bought in a market at each price. It is the horizontal sum of the individual demand functions.

Changes in tastes, income, and the price of other goods SHIFT the demand function. That is,
when tastes, income or the price of other goods changes, the amount of the good that the
consumer is willing to buy at each price changes.

Examples:
• The price of coffee beans increased so much due to the bad weather in Brazil that worldwide
coffee bean consumption is down 10% this year. (This describes movement along the
demand curve for coffee beans)
• The price of coffee beans increased so much due to the bad weather in Brazil that
consumption of tea is up 5% this year. (Describes a shift of the demand curve for tea)
• Income in the North Side of Chicago has risen 10% relative to the U.S. in the last 5 years.
Because of this, coffee consumption on the North Side of Chicago has increased 20%.
(Describes a shift of the demand curve for prepared coffee)

The change in the price of another good can shift the demand curve either inwards or outwards:
• Two goods are SUBSTITUTES if, when the price of good A rises, the demand for good B
increases (shifts outward).
• Two goods are COMPLEMENTS if, when the price of good A rises, demand for good B
decreases (shifts inward).

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III. Introduction to SUPPLY

A SUPPLY FUNCTION expresses the relationship between the total quantity supplied and the
price received by suppliers.

• Quantity supplied typically INCREASES when price increases. We will talk about a key
exception to this rule later in the course.
• A firm’s supply function maps out the quantity of a good that a firm will produce at each
price.
• A MARKET SUPPLY FUNCTION maps out the total quantity of a good that will be
produced in a market at each price. It is the horizontal sum of the firm supply functions.

Changes in the state of technology and the price of inputs will shift the supply function. When
the supply function shifts outward, producers are willing to produce more of the good at each
price.

It is important to be able to distinguish shifts in the supply curve from movement along the
supply curve. Examples:
• The market price of coffee beans has increased a lot, so the acreage devoted to coffee beans
in Columbia has doubled. (Describes a movement along the supply curve for coffee beans)
• The market price of coffee beans has increased a lot and is expected to remain high
indefinitely. Several coffee shops scheduled to open on the North Side have delayed
opening. (Describes a shift of the supply curve for prepared coffee, which uses coffee beans
as a major input)
• The advent of the high-speed, high-volume espresso machines has fueled the proliferation of
coffee shops. (Describes a shift of the supply curve for prepared coffee due to technological
change)

IV. Market Equilibrium

• A market equilibrium exists when the quantity demanded equals the quantity supplied.
• At the equilibrium price, the amount that producers want to produce equals the amount that
buyers want to buy.
• At any other price, there is a discrepancy between the amount demanded and the amount
supplied.

When the market demand function or the market supply function SHIFTS, the market
equilibrium changes. Prices will adjust to generate a new equilibrium in which supply and
demand are once again in balance.

Example:
Suppose that the market for gourmet prepared coffee in the city of Chicago is in equilibrium.
Now, suppose that there is bad weather in Brazil, and the price of coffee beans on the world
market rises. The supply curve for gourmet prepared coffee shifts inward.

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 The Price Elasticity of Demand and Supply

Textbook Reference: Perloff, chapter 3.

I. Price Elasticity of Demand

(NOTE: Sometimes you will just see the term “elasticity of demand”; unless clearly stated
otherwise, you can assume that this refers to the price elasticity of demand)

The arc price elasticity of demand is the average percentage change in the quantity demanded
divided by the average percentage change in price.
∆Q
(Q1 + Q2 ) / 2
ε ARC =
∆P
( P1 + P2 ) / 2

As the price changes get smaller and smaller, the arc price elasticity of demand approaches the
point price elasticity of demand:
∂QP
ε=
∂PQ
∂Q
where gives the derivative of the demand function with respect to price.
∂P

NOTE: In this course, you should always use the arc price elasticity formula whenever you are
either (1) computing the elasticity between two points or (2) using a given elasticity to compute a
change in prices for a given change in quantities (or compute a change in quantities for a given
change in prices). You should use the point price elasticity formula to compute the elasticity at a
given point when you are given a linear demand curve.

• When price elasticity of demand is high, then the demand curve is relatively flat. A small
change in price changes the quantity demanded a lot.
• When the price elasticity of demand is low, then the demand curve is relatively steep. A
small change in price changes quantity demanded very little.
• Note that the arc elasticity is always negative. When P goes up, Q goes down, so ∆Q/∆P is
always negative [and ∂ Q / ∂ P is always negative].
• The price elasticity of demand is NOT equal to the slope of the demand curve. The slope of a
linear demand curve is constant. A $1 change in price always changes quantity demanded by
the same amount. When we look at elasticities, however, we care about the percentage
change in quantity due to a percentage change in price. Using percentage measure allows us
to compare the elasticity of demand for cars to the elasticity of demand for toothbrushes,
even though their prices are on very different scales. The price elasticity of demand along a
linear demand curve is not constant.

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Three cases of price elasticity of demand:
1. If the elasticity is less than -1, then we say the demand curve is PRICE-ELASTIC. A one
percent change in price changes quantity by more than 1%. When the price elasticity is
less than -1, a 1% increase in price reduces total revenue, while a 1% decrease in price
raises total revenue.
2. If the value of the arc price elasticity is equal to -1, the demand has UNITARY
ELASTICITY. In this case, a small price change does not change total revenue.
3. If the value of the price elasticity is between -1 and 0, then the demand curve is PRICE-
INELASTIC. This means that total revenue changes in the same direction as the price
change. A decrease in price decreases total revenue.

Where does the price elasticity of demand come from?

• One possibility: you might expect that the demand is more inelastic if the average consumer
spends a small fraction of her income on the product. For example, you really haggle when
you go in to buy a car (e.g., you visit multiple dealerships; you play them off each other;
etc.). You just don’t do that for a cup of coffee.
• The demand elasticity is also substantially affected by how many close substitutes are there
for the good.

II. Price Elasticity of Supply

The price elasticity of supply measures the responsiveness of the quantity supplied to a price
change. The arc price elasticity of supply formula is identical to the arc price elasticity of
demand formula:
∆Q
(Q + Q2 ) / 2
ε ARC = 1
∆P
( P1 + P2 ) / 2

Similarly, the point price elasticity of supply formula is identical to the point price elasticity of
demand formula:
∂QP
ε=
∂PQ
∂Q
where, in this case, gives the derivative of the SUPPLY function with respect to price.
∂P

In general, we think that supply is more elastic in the LONG-RUN than in the SHORT-RUN due
to fixed factors. While this is typically the case for supply curves, it is also possible that demand
curves are more elastic in the long-run than in the short-run. For example, the demand for
gasoline may be significantly more elastic in the long-run, after consumers have time to adjust
fuel economy of vehicles, invest in energy-saving appliances at home, etc. In the short run all of
these durable goods are fixed, so the typical consumer will be very price inelastic with respect to
gasoline.

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III. Consumer Surplus

Consumer surplus is the difference between the maximum amount that a consumer is willing to
pay to consume a given quantity of a good, and the actual amount paid to consume the quantity
of the good.

If the market demand is downward sloping, some individuals will get the good for less than they
are willing to pay. The difference is the consumer surplus. In this course, we will calculate
consumer surplus as the area under the demand curve above the price. With linear demand
curves and constant prices, this area is a triangle.

This is shown graphically below:

Note that the flatter the demand curve, the less “area” in the shaded triangle. In other words, the
more ELASTIC the demand curve, the smaller the amount of consumer surplus.