Part 2

Markets: Demand,
Supply, and Elasticity
What determines the price of a good
or service and the quantity bought
and sold?
Demand and supply model of a
market
This simple model of a market
assumes competitive conditions
Distinguish between a demand side
and a supply side of the market
Together they determine the
equilibrium price and quantity

Demand
Demand is the quantity of a good
people purchase over a given time
The quantity of a good a person will
plan to purchase will depend on:
- Preferences (tastes)
- Price of the good
- Prices of other goods
- Expected future prices
- Income
In the aggregate, demand will also
depend on:
- Population and demographics

The Law of Demand

Other things remaining the
same, the higher the price of a
good, the smaller is the quantity
demanded
Substitution effectthe effect
of the change in relative price
Income effectthe effect of the
change in overall purchasing
power

Demand Function and

Demand Curves
Demand functiondemand as a
function of a number of
variables
Demand curvedemand as a
function of price, everything
else held constant
What is held constant along a
demand curve?
Changes in the quantity
demandedmovements along
the demand curve

Changes in Quantity
Demanded
P
Decrease in quantity
demanded

P
P

Increase in quantity
demanded

P
Q

Change in quantity demandeda movement

along the demand curve

Demand Curves
Can be linear or non-linear
A linear demand curve
P
20

P = a + bQ
Where a is the P
intercept and b is the slope
variable and is negative

30
P = 20 - 2/3Q

Demand Curves
A demand curve is more usually
written with Q as the dependent
variable
P
20

Q = a + bP
Where a is the Q intercept and
b is the inverse of the slope
and is negative

Q
30
Q = 30 3/2P

Changes in Demand
Shift in a demand curve is a Change
in Demand
Change in tastes or preferences
Change in the prices of other goods
- substitutes
- complements
Changes in expected future prices
Changes in income
- normal goods
- inferior goods
Changes in population/demographics

An Increase in Demand
An increase in demanda
rightward shift
P

D
D

An Increase in Demand

Price of a substitute rises

Price of a complement falls
Expected future price rises
Income rises (normal good) or
income falls (inferior good)
Preferences move toward the
good
Population increases

A Decrease in Demand
A decrease in demanda
leftward shift
P

D
D

A Decrease in Demand

Price of a substitute falls

Price of a complement rises
Expected future price falls
Income falls (normal good) or
income rises (inferior good)
Preferences move away from
the good
Population falls.

Supply
Supply is the quantity of a good
firms produce over a given time
The firm has to have the
resources and technology to
produce the good
The firm has to think it can
produce the good at a profit (at
least in the long run)
Short run and long run supply
decisions

Supply
The amount of any particular good
or service supplied by a firm will
depend on:
- The price of the good
- The prices of inputs needed to
produce the good
- The available technology
- The available capital (short run)
- Prices of other goods
- Expected future prices
In the aggregate, supply will also
depend on:
- The number of firms in the market

The Law of Supply

Other things remaining the
same, the higher the price of a
good, the greater will be the
quantity supplied
Higher prices mean it will be
profitable to expand production
With rising marginal costs
higher prices are required for
firms to be willing to increase
production

Supply Functions and

Supply Curves
Supply function
Supply curveshape
Supply curves can only be
defined for competitive
industries (where price is a
given to the firm)
What is held constant along a
supply curve?
Changes in the quantity
suppliedmovements along the
supply curve

Changes in Quantity
Supplied
P
S

Increase in quantity
supplied

P
P

Decrease in quantity supplied

Q

Change in quantity supplieda movement

along the supply curve

Supply Curves
A linear supply curve:
P = a + bQ where a is the P intercept
And b is the slope which is positive
P

Slope is = 2
10
Q
P = 10 + 2Q

Supply Curves
Supply curves are more usually
written with Q as the dependent
variable: Q = a + bP where a is the Q
intercept and b is the inverse of the
slope and positive
P

S
Slope = 2 inverse of
Slope = 1/2

10

-5

Q = -5 + P
0

Changes in Supply
Shift in a supply curve is a
Change in Supply
Change in input prices
Changes in technology
Changes in expected future
prices
Change in the scale of the firm
Changes in the number of firms
entry and exit of firms

An Increase in Supply
An increase in supplya rightward shift in
the supply curve
P

An Increase in Supply
Price of inputs fall
More efficient technology
Expected future price fall
(ie natural resource production)
Firms grow in size
Number of firms in the industry
grows

A Decrease in Supply
P

S
S

Q
A decrease in supply is a leftward
shift in the supply curve

A Decrease in Supply
Price of inputs rise
Expected future price rise
(natural resources)
Loss of technological
knowledge
Firms decline in size
Number of firms in the industry
shrinks

Market Equilibrium
Market equilibrium is where demand
= supply
Equilibrium price
Equilibrium quantity
Price adjusts to bring about an
equilibrium
If D>S price rises which reduces
quantity demanded and increases
quantity supplied
If S>D price falls which increases
quantity demanded and reduces
quantity supplied

Market Equilibrium
P

Surplusprice falls

E
P*

ShortagePrice rises
Q*

D
Q

Market Equilibrium
in Equations
Demand curve D = a + bP
where a is the Q intercept and b
is the inverse of the slope (and
negative)
Supply Curve S = c + dP where
c is the Q intercept (usually zero
or negative) and b the inverse of
the slope and positive
In equilibrium D = S
Solve for P* then Q*

Market Equilibrium
in Equations

Demand curve D = 400 .5P

Supply Curve S = 200 + 1P
Solve for P*
400 .5P* = 200 + 1P*
600 = 1.5P*
P* = 400
Solve for Q*
Q* = 400 200
Q* = 200

Market Equilibrium in
Equations
Diagram of the equations
P
800
S = -200 + 1P
400

D = 400 - .5P
-200

200

400

Equilibrium Price and

Quantity Changes
A change in demand with a given supply curve
P

S
E

P
P

E
D
D

Q
Q
Q
Rightward shift in demand leads to a movement
along the supply curve. P and Q both rise.

Equilibrium Price and

Quantity Changes
A change in supply with a given demand curve
S

P
P

E
E

P
D
Q

A rightward shift in supply leads to a

movement along the demand curve. P falls
and Q rises.

Equilibrium Price and

Quantity Changes
A change in supply and demand
same directions
S

P
P

S
E
D
D

A rightward shift in both demand and supply

leads to a higher Q. P may rise, fall, or stay
the same.

Equilibrium Price and

Quantity Changes
A change in supply and demand
opposite directions
P
P

D
D

A rightward shift in supply and a leftward

shift in demand leads to a lower P. Q may rise,
fall, or stay the same.

An Example
From Slate Magazine June 2009
in a discussion of a campaign by
Chevron to get people to drive
less: All other things being
constant, if every gullible soul
performed the conservation
miracles Chevron proposes,
energy consumption would fall,
and so would prices. As prices
fell the non-gullible would take
advantage of the depressed prices
to consume more and thus drive
the price back up. Is this right?

Elasticity
Elasticity is a measure of
responsiveness
Many elasticities can be
measured: price elasticity of
demand, cross price elasticity of
demand, income elasticity of
demand, and elasticity of supply
Elasticity measures are
measures of proportionate
responsiveness and are unit free

Elasticity
General form:
The elasticity of X with respect
to Y is given by the % or
proportionate change in X
divided by the % or
proportionate change in Y
EXY = % X / % Y or
EXY= X/X / Y/Y or
EXY=X/Y Y/X

Price Elasticity of
Demand
Elasticity of Demand with respect to
the goods own price
EDxPx= %Q/%P or
EDxPx= Q/Q / P/P or
EDxPx= Q/P P/Q
For price elasticities of demand the
sign is ignored as they are all
negative
Elastic demand > 1
Inelastic demand < 1
Unit elastic demand = 1

Inelastic and Elastic

Demand
P

D
Elasticity = 0

P
D
Elasticity =
Q
P
Elasticity = 1
D

Price Elasticity of
Demand Over an Arc
Px ($)

15
12.5
10

If measuring price elasticity

of demand over an arc use
the average P and Q
5
100
100

Dx
200

150

EDxPx= 100/150 / 5/12.5 = .66/.4 = 1.66

EDxPx= 100/5 x 12.5/150 = 20 x .083 = 1.66

Qx
(Kgs)

Price Elasticity of
Demand at a Point
EDxPx= Q/P P/Q
Q/P = inverse of the slope of
the demand curve
P
100
Slope = 2
Inverse of slope = 0.5
Elasticity = 0.5 x 4 = 2

80

D
20

50

Price Elasticity Along a

Straight Line Demand
Curve
P
200

100

Slope = 2/3
Inverse of slope = 1.5

EDxPx > 1

EDxPx = 1
EDxPx < 1
150
EDxPx > 1 Elastic Demand
EDxPx = 1 Unit Elastic Demand
EDxPx < 1 Inelastic Demand

300

Price Elasticity of
Demand and Total
Revenue
If the price elasticity of demand is >
1, then a reduction in price will
increase quantity demanded more
than proportionately and TR (P x Q)
will increase.
If the price elasticity of demand = 1,
then a reduction in price will
increase quantity demanded in
proportion and TR will be
unchanged
If the price elasticity of demand is <
1, then a reduction of price will
increase quantity demanded less than
proportionately and TR will fall.

Price Elasticity of
Demand and Total
Revenue
P
E>1
E=1
E<1
D
Q
TR

Max TR

TR
rising

TR
falling
Q

Factors that Affect Price

Elasticity of Demand
The closeness of substitutes
- the more close substitutes the
higher the price elasticity of demand
The proportion of income spent on
the good
- the higher the proportion of income
spent on the good the higher the
price elasticity of demand
The time elapsed
- The more time elapsed the more
elastic the demand

Cross Price Elasticity of

Demand
The elasticity of the demand for
good X with respect to the price
of another good Y
EDxPy= %QX/%PY or
EDxPy= QX/QX / PY/PY or
EDxPy= QX/PY PY/QX
The sign matters, positive cross
price elasticities indicate
substitutes, negative cross price
elasticities indicate
complements

Complements and
Substitutes
The demand curve for good X shifts
with changes in the price of good Y
P
Price of a complement falls
Price of a substitute rises
D

Price of a complement rises

Price of a substitute falls

D
D
Q

Income Elasticity of
Demand
The elasticity of demand for good X
with respect to income (I)
EDxI= %QX/%I or
EDxI= QX/QX / I/I or
EDxI= QX/I I/QX
EDxI > 1 normal and income elastic
EDxI < 1 > 0 normal and income inelastic
EDxI <0 inferior good
Necessaries, luxuries and income levels

Elasticity of Supply
The elasticity of the supply of good X
with respect to its own price
ESxPx= %QS/%P or
ESxPx= QS/QS / P/P or
ESxPx= QS/P P/QS
Elasticities of supply can range from zero
to infinity. Depends on technology,
resource substitution, and time frame
All straight line supply curves through
the origin will have elasticities of supply
=1

Elasticity of Supply
P

50
10
40
100

100

200

ESxPx = 100/10 x 45/150 = 3

An Example
Times Colonist editorial
concerning BC Ferry fares, July
2009: Increased fares have
resulted in fewer passengers.
BC Ferries own figures indicate
an 8% rise in fares results in a
2.25% drop in travel. Last year
fares rose by 7.3%. Fewer
passengers means less revenue
for the Corporation and more
fare increases. It is the start of a
vicious cycle. Is this correct?