Professional Documents
Culture Documents
Market Equilibrium
P
$6.00 $5.00 $4.00 $3.00 $2.00 $1.00 $0.00 0 5 10 15 20 25 30 35
2
Equilibrium: P has reached the level where quantity supplied equals quantity demanded
Equilibrium Price: The price that equates quantity supplied with quantity demanded (Max WTP = Min WTA)
P
$6.00 $5.00 $4.00 $3.00 $2.00 $1.00 $0.00 0 5 10 15 20 25 30 35
3
P $0 1 2 3 4 5
QD 24 21 18 15 12 9 6
QS 0 5 10 15 20 25 30
Equilibrium quantity: The quantity supplied and quantity demanded at the equilibrium price
P
$6.00 $5.00 $4.00 $3.00 $2.00 $1.00 $0.00 0 5 10 15 20 25 30 35
4
P $0 1 2 3 4 5
QD 24 21 18 15 12 9 6
QS 0 5 10 15 20 25 30
Surplus
Surplus
Facing a surplus, sellers try to increase sales by cutting price. This causes QD to rise and QS to fall which reduces the surplus. Q
Surplus
Facing a surplus, sellers try to increase sales by cutting price. This causes QD to rise and QS to fall. Prices continue to fall until market reaches equilibrium. Q
Shortage (excess demand): when quantity demanded is greater than quantity supplied
P
$6.00 $5.00 $4.00 $3.00 $2.00 $1.00 $0.00 0 5
Shortage
10 15 20 25 30 35
Shortage (excess demand): when quantity demanded is greater than quantity supplied
P
$6.00 $5.00 $4.00 $3.00 $2.00 $1.00 $0.00 0 5 10 15 20 25 30 35
9
Facing a shortage, sellers raise the price, causing QD to fall and QS to rise, which reduces the shortage.
Shortage
Shortage (excess demand): when quantity demanded is greater than quantity supplied
P
$6.00 $5.00 $4.00 $3.00 $2.00 $1.00 $0.00 0 5 10 15 20 25 30 35
10
Facing a shortage, sellers raise the price, causing QD to fall and QS to rise. Prices continue to rise until market reaches equilibrium.
Shortage
EXAMPLES
11
Demand Curve
Draw a demand curve for music downloads. What happens to it in each of the following scenarios? Why?
A. The price of iPods falls B. The price of music downloads falls C. The price of CDs falls
12
Music downloads and iPods are complements. A fall in price of iPods shifts the demand curve for music downloads to the right.
D1 Q1 Q2 D2
Quantity of music downloads
13
P1
The D curve does not shift. Move down along curve to a point with lower P, higher Q.
P1 P2 D1 Q1 Q2
CDs and music downloads are substitutes. A fall in price of CDs shifts demand for music downloads to the left.
D2 Q2 Q1 D1
Quantity of music downloads
15
P1
Supply Curve
Draw a supply curve for tax return preparation software. What happens to it in each of the following scenarios?
A. Retailers cut the price of the software. B. A technological advance allows the software to be produced at lower cost. C. Professional tax return preparers raise the price of the services they provide.
16
S1
S curve does not shift. Move down along the curve to a lower P and lower Q.
P1 P2
Q2 Q1
S1
S2
P1
Q1
Q2
S1
This shifts the demand curve for tax preparation software, not the supply curve.
D curve, or both.
2. Decide in which direction curve shifts. 3. Use supply-demand diagram to see
P1
P S1 P2
D curve shifts because P1 STEP 2: price of gas affects demand for D shifts right hybrids. because high gas price STEP 3: S curvehybrids does not shift, makes more The shift causes an increase because price of gas attractive relative to in price and quantity of does not affect cost of other cars. hybrid cars. producing hybrids.
D1 Q1 Q2
D2 Q
D1 Q1 Q2
D2 Q
P S1 S2
S curve shifts because P1 STEP 2: event affects cost of production. P2 S shifts right D curve event does not shift, because reduces STEP 3: production because cost, The shift causes price technology is not of makes productionone more to fall and quantity to the factors that affect profitable at any given rise. demand. price.
D1 Q1 Q2 Q
P S1 P2 P1 S2
Q rises, but effect on P is ambiguous: If demand increases more than supply, P rises.
25
D1 Q1 Q2
D2 Q
P S1 S2
P1 P2 D1 Q1 Q2 D2 Q
A fall in the price of CDs Sellers of music downloads negotiate a reduction in the royalties they must pay for each song they sell. Events A and B both occur.
D2 Q2 Q1
D1
1. S curve shifts (Royalties are part of 2. S shifts right sellers costs) P1 3. P falls, P2 Q rises.
D1 Q1 Q2
Slide 29 a1 The royalties that sellers must pay the artists are part of sellers costs of production. Typically, this royalty is a fixed amount each time one of the artists songs is downloaded. Event B, therefore, describes a reduction in sellers costs of production. Sellers of music downloads negotiate a reduction in the royalties they must pay for each song they sell. This event causes a fall in costs of production for sellers of music downloads. Hence, the S curve shifts to the right.
arnab, 7/7/2013
A Problem
In Rolling Stone magazine, several fans and rock stars, including Pearl Jam, were bemoaning the high price of concert tickets. One superstar argued, It just isnt worth $75 to see me play. No one should have to pay that much to go to a concert. Assume this star sold out arenas around the country at an average ticket price of $75. a) b) How would you evaluate the arguments that ticket prices are too high? Suppose that due to this star s protests, ticket prices were lowered to $50. In what sense is this price too low? Draw a diagram using supply and demand curves to support your argument. Suppose Pearl Jam really wanted to bring down ticket prices. Since the band controls the supply of its services, what do you recommend they do? Explain using a supply and demand diagram. Suppose the bands next CD was a total flop. Do you think they would still have to worry about ticket prices being too high? Why or why not? Draw a supply and demand diagram to support your argument. Suppose the group announced their next tour was going to be their last. What effect would this likely have on the demand for and price of tickets? Illustrate with a supply and demand diagram.
31
c)
d)
e)
A Funny Exercise
Explain the story told by this image with the help of Demand Supply Tools..
32
\ Q d = f P d = a - bP d .(1)
An inverse demand function or price function is \ P d = f -1 Q d = a - bQ d .(1.1)
( )
( )
a 1 where, a = and b = b b
\ Q s = f P s = c + dP s ....(2)
An inverse supply function is
( )
( )
\ a - bQ = c + dQ
e
a -c Q = b+d
e
a -c and , P = a - b b+d
e
Since, Price cannot be negative a f c Alternatively, you can obtain the equilibrium price and quantity just by equating equations (1) and (2)
34
Example
Demand is given by QD = 620 - 10P and supply is given by QS = 100 + 3P. What is the price and quantity when the market is in equilibrium? Answer: In equilibrium, QD = QS, 620 - 10P = 100 + 3P So, the equilibrium Price is 40 And the equilibrium quantity is 220.
35
a3
The objective of Demand supply analysis is to find a price at which the market is clear. We know it is the equilibrium price. Other than Market clearing explanation of equilibrium price what else can you say about this price? In the simplest manner, equilibrium price can be defined as the market value of a product or service and at this value the willingness to accept (WTA) of the sellers matches with willingness to pay (WTP) of the buyers. Now the question is why does equilibrium price differ across different markets? It was thought by the economists, that intrinsic use value of a commodity is the reason for this difference . However, the concepts of production cost and scarcity value better explain this difference. It should be noted that scarcity is also responsible for increasing the production cost. The following examples help you to 36 understand this concept:
37
Suggested Readings
Shuttlecock Production in Uluberia, West Bengal (http://articles.economictimes.indiatimes.com/2012-1228/news/36036532_1_shuttlecocks-duck-feathers-badmintonplayers) Discovery of Jojoba Beans caused a collapse of Whale Oil Lubricant Price ( MMH, Chapter 2, Page 29) Depreciation of Rupee and Impact on Product Market (The article sent through e-mail) Atkins Diet and Demand for Egg (The article sent through e-mail)
38
Elasticity
Basic idea: Elasticity measures how much one variable responds to changes in another variable. One type of elasticity measures how much demand for your websites will fall if you raise your price. Definition: Elasticity is a numerical measure of the responsiveness of Qd or Qs to one of its determinants.
39
Percentage change in P
40
Percentage change in P
P P rises by 10% P2 P1 D Q2 Q falls by 15%
41
Example:
Price elasticity of demand equals 15% 10%
= 1.5
Q1
Percentage change in P
P P2 P1 D Q2 Q1 Q
Along a D curve, P and Q move in opposite directions, which would make price elasticity negative. We will drop the minus sign and report all price elasticities as positive numbers.
42
43
45
The Determinants of Price Elasticity The price elasticity of demand depends on:
the extent to which close substitutes are available whether the good is a necessity or a luxury how broadly or narrowly the good is defined the time horizon elasticity is higher in the long run than the short run
48
To millions of diabetics, insulin is a necessity. A rise in its price would cause little or no decrease in demand. A cruise is a luxury. If the price rises, some people will forego it. Lesson: Price elasticity is higher for luxuries than for necessities.
The prices of both of these goods rise by 20%. For which good does Qd drop the most? Why? Breakfast cereal has close substitutes (e.g., pancakes, Eggo waffles, leftover pizza), so buyers can easily switch if the price rises. Sunscreen has no close substitutes, so consumers would probably not buy much less if its price rises. Lesson: Price elasticity is higher when close substitutes are available.
EXAMPLE 4: Car Fuel in the Short Run vs. Car Fuel in the Long Run
The price of petrol rises 20%. Does Qd drop more in the short run or the long run? Why? Theres not much people can do in the short run, other than ride the bus or carpool. In the long run, people can buy smaller cars or live closer to where they work. Lesson: Price elasticity is higher in the long run than the short run.
53
a4
=
D
0% 10%
=0
Q1 Q changes by 0%
54
Slide 54 a4 If Q doesnt change, then the percentage change in Q equals zero, and thus elasticity equals zero. It is hard to think of a good for which the price elasticity of demand is literally zero. Take insulin, for example. A sufficiently large price increase would probably reduce demand for insulin a little, particularly among people with very low incomes and no health insurance. However, if elasticity is very close to zero, then the demand curve is almost vertical. In such cases, the convenience of modeling demand as perfectly inelastic probably outweighs the cost of being slightly inaccurate.
arnab, 7/12/2013
Inelastic demand
Price elasticity = of demand
a5
% change in Q % change in P
P P1 P2 P falls by 10%
<1
D curve: relatively steep Consumers price sensitivity: relatively low Elasticity: <1
55
Slide 55 a5 An example: Student demand for textbooks that their professors have required for their courses. Here, its a little more clear that elasticity would be small, but not zero. At a high enough price, some students will not buy their books, but instead will share with a friend, or try to find them in the library, or just take copious notes in class. Another example: Gasoline in the short run.
arnab, 7/12/2013
10% 10%
=1
Q1
Q2
Q rises by 10%
56
Elastic demand
Price elasticity = of demand
a6
% change in Q % change in P
P P1 P2 P falls by 10%
>1
D curve: relatively flat Consumers price sensitivity: relatively high Elasticity: >1
Q1
Q2
Slide 57 a6 A good example here would be breakfast cereal, or nearly anything with readily available substitutes. An elastic demand curve is flatter than a unit elastic demand curve (which itself is flatter than an inelastic demand curve).
arnab, 7/12/2013
a7
P changes by 0%
Q1
Q2 Q changes by any %
58
Slide 58 a7 Heres a good real-world example of a perfectly elastic demand curve, which foreshadows an upcoming chapter on firms in competitive markets. Suppose you run a small family farm in Jodhpur. Your main crop is Bazra. The demand curve in this market is downward-sloping, and the market demand and supply curves determine the price of Bazra. Suppose that price is Rs. 50/Kg. Now consider the demand curve facing you, the individual Bazra farmer. If you charge a price of Rs.50, you can sell as much or as little as you want. If you charge a price even just a little higher than Rs. 50, demand for YOUR Bazra will fall to zero: Buyers would not be willing to pay you more than Rs.50 when they could get the same Bazra elsewhere for Rs. 50. Similarly, if you drop your price below Rs. 50, then demand for YOUR Bazra will become enormous (not literally infinite, but almost infinite): if other Bazra farmers are charging Rs.50 and you charge less, then EVERY buyer will want to buy Bazra from you. Why is the demand curve facing an individual producer perfectly elastic? Recall that elasticity is greater when lots of close substitutes are available. In this case, you are selling a product that has many perfect substitutes: the wheat sold by every other farmer is a perfect substitute for the wheat you sell.
arnab, 7/12/2013
Problem
Use the following information to calculate the price elasticity of demand for hotel rooms: if P = $70, Qd = 5000 if P = $90, Qd = 3000
59
Answers
Use midpoint method to calculate % change in Qd (5000 3000)/4000 = 50% % change in P ($90 $70)/$80 = 25% The price elasticity of demand equals 50% = 2.0 25%
60
A scenario
You design websites for local businesses. You charge $200 per website, and currently sell 12 websites per month. Your costs are rising (including the opportunity cost of your time), so you consider raising the price to $250. The law of demand says that you wont sell as many websites if you raise your price. How many fewer websites? How much will your revenue fall, or might it increase?
61
a8
Continuing our scenario, if you raise your price from $200 to $250, would your revenue rise or fall? Revenue = P x Q A price increase has two effects on revenue: Higher P means more revenue on each unit you sell. But you sell fewer units (lower Q), due to Law of Demand. Which of these two effects is bigger? It depends on the price elasticity of demand.
62
Slide 62 a8 It should be clear that making the best possible decision would require information about the likely effects of the price increase on revenue. That is why elasticity is so helpful, as we will now see.
arnab, 7/12/2013
Revenue = P x Q
The fall in revenue from lower Q is greater than the increase in revenue from higher P, so revenue falls.
63
$250 $200
If demand is inelastic, then price elast. of demand < 1 % change in Q < % change in P
The fall in revenue from lower Q is smaller than the increase in revenue from higher P, so revenue rises. In our example, suppose that Q only falls to 10 (instead of 8) when you raise your price to $250.
65
$250 $200
D Q
10
12
Problem
A. Pharmacies raise the price of insulin by 10%. Does total expenditure on insulin rise or fall? B. As a result of a fare war, the price of a luxury cruise falls 20%. Does luxury cruise companies total revenue rise or fall?
67
Answers
A. Pharmacies raise the price of insulin by 10%. Does
total expenditure on insulin rise or fall? Expenditure = P x Q Since demand is inelastic, Q will fall less than 10%, so expenditure rises.
68
Answers
B. As a result of a fare war, the price of a luxury cruise
falls 20%. Does luxury cruise companies total revenue rise or fall? Revenue = P x Q The fall in P reduces revenue, but Q increases, which increases revenue. Which effect is bigger? Since demand is elastic, Q will increase more than 20%, so revenue rises.
69
Hence, for normal goods, income elasticity > 0. For inferior goods, income elasticity < 0.
70