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lecture%20notes%202 - Lecture Note 2 The Basics of Supply...

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Unformatted text preview: Lecture Note 2: The Basics of Supply and Demand Somasree Dasgupta Econ 501.01 Autumn,2007 Competitive markets can be analyzed using the model of supply and demand. The supply curve shows the quantity of a good that producers are willing to sell at a given price, ceteris paribus. The supply curve is given by the equation: Qs = Qs(P). / Pn‘UL S , S Qt @ 9” > Q.“ E The supply curve is upward sloping. This is because the higher the price the more the firms are willing to produce and sell. Other variables that affect supply: examples are cost of raw materials or level of technology. A reduction in the cost of raw materials or technological progress would cause the supply curve to shift outwards. Reduction in the cost of raw materials or technological progress would encourage the existing firms to expand production and enable new firms to enter the market at a given market price. Hence at the given market price, a greater quantity will be supplied and the supply curve shifts to the right. Change in supply refers to shift in the supply curve whereas change in the quantity supplied refers to movements along the supply curve. The demand curve shows how much of a good consumers are willing to buy at a given price, ceteris paribus. The demand curve is given by thePequation : QD= QD(P). Q1 Q9, Q 5 The demand curve is downward sloping. This is because consumers are willing to buy more of a good if its price is lower. Other variables that affect demand: examples are income or prices of related goods ( substitutes or complements). An increase in income would cause the consumers to demand more of a good at a given market price, thereby causing the demand curve to shift to the right. An increase in the price of a complement good would cause the consumers to demand less of the good , thereby shifting the demand curve to the left. An increase in the price of a substitute good would cause the consumers to demand more of the good , thereby shifting the demand curve to the right. Market Equflibriuszhe demand and the supply curves intersect at the equilibrium or the market clearing price and quantity. In the above diagram, the market clears at price Po and quantity Q0, So the market equilibrium is ( P0,Qo). Market mechanism: Tendency in a free market for price to change until the market clears. Suppose initially price is above the market clearing level at P1. At this price,quantity supplied exceeds quantity demanded, that is there is a surplus. To sell this surplus or at least to prevent it from growing, producers will begin to lower the price. As price starts falling, quantity demanded would start increasing and quantity supplied would decrease until the equilibrium price P0 is reached. The opposite would happen if the initial price was below Po ( say, at P2)and there is a shortage. At P2, quantity demanded exceeds quantity supplied and consumers would be unable to purchase all they like. Price would start increasing as consumers tried to outbid one another for existing supplies and producers reacted by increasing price and expanding output. Price would continue to rise till it reaches the equilibrium price P0. Question 1: Consider a market for computers. Suppose there is a technological innovation in V computers. Show graphically how the market equilibrium will be affected. What will happen to the equilibrium price and quantity for computers? Question 2: Consider a market for computers. Suppose there is a technological innovation in computers. Also there is an increase in the income of the consumers of computers. How will the equilibrium price and quantity be affected? In this case, both the demand and the supply curves shift to the right. But without any further information, we cannot say anything about the nature of the change in the equilibrium price and quantity. Price and quantity change will depend on the relative shifts of the two curves and also on the shapes of the curves. Read examples 2.1, 2.2, 2.3 , 2.4 from the book. Elasticities of Supply and Demand: Elasticity measures the sensitivity of one variable to another. It is a number which tells us the percentage change that will occur in one variable in response to a 1% increase in another variable. Price Elasticity of demand: Percentage change in quantity demanded of a good resulting from a 1% increase in its price. E1, = (%AQ)/ (%AP) = (AQ/Q) / ( AP/P) = (P/Q).( AQ/ AP) Price elasticity of demand is usually a negative number. When the price elasticity is greater than 1 in magnitude, we say demand is price elastic. When the price elasticity is less than 1 in magnitude, we say demand is price inelastic. Price elasticity of demand must be measured at a particular point on the demand curve. 3 Question 3: Consider a linear demand curve: Q = 8-2P. What is the price elastbity of demand when P=2 and Q=4? Ans: Ep= -1 Income elasticity of demand: Percentage change in the quantity demanded resulting from a 1% increase in income. Er: (AQ/Q) / ( AI/I) = (I/Q).( AQ/ AI) Cross price elasticity of demand: Percentage change in the quantity demanded of one good resulting from a 1% increase in the price of another. Price elasticity of supply: Percentage change in quantity supplied resulting from a 1% increase in price. Example 2.5: Read from the book ( pages 36 and 37). It is important to understand this problem for the quiz and midterm . Question 4:Derive the linear supply and the demand curves which are consistent with the following: Q* = 7.5 million metric tons per year, P* = $ 0.75 per pound, Es= 1.6, ED: -0.8. Solution 2 Step 1: Specify the general forms of the linear supply and the demand curves: Linear demand curve: Q = a-bP Linear supply curve: Q= c+dP We need to solve for a,b, c,d on the basis of the information provided. Step 2: Price elasticity, whether of supply or of demand,can be written as E = (P/Q).( AQ/ AP) For price elasticity of demand use the demand curve to calculate E and for price elasticity of supply use the supply curve to calculate E. From the demand curve, AQ = (-b)AP Hence, AQ/ AP = -b EDz —b (P*/Q*) .... ..(1) From the supply curve, AQ = (d)AP AQ/ AP = d Es= d(P*/Q*).....(2) Step 3: Plug in values in (1) and (2). We can solve for b and d. —0.8= -b (0.75/7.5)= —0.1b => b= 8 1.6: d (0.75 /7.5) = 0.1d => d= 16 Step 4: In equilibrium, Q* = a-bP* and Q* = c+ dP* must hold simultaneously. Plug in values of P*,Q*, b and d these two equations to solve for a and c. 7.5=a— (8)(0.75)=a-6 =>a=13.5 7.5= c+(16)(0.75) = c+12 =>c= -4.5 So the demand curve is: Q= 13.5 -8P The supply curve is: Q = -4.5 +16P Government Intervention: Price Controls Prong, Q Without price control, equilibrium price and quantity are Po and Q0. With price control, if price cannot be higher than Pmax,the quantity supplied falls to Q1 and the quantity demanded increases to Q2, so that a shortage develops. Producers lose through price control. Some consumers who get the good at lower price are better ofi', others who cannot buy the good at all are worse ofi‘. 5 Practice Questions :Chapter 2 Pindyck and Rubinfeld: Questions for review2Pg 57,Question 2 Pindyck and Rubinfeld: Questions for revieszg 57,Question 3 Hamilton and Suslow, Exercise 5, pg 16 Hamilton and Suslow, Exercise 7,pg 19 Hamilton and Suslow,Exercise 9, pg 21 Hamilton and Suslow, Pg 24, question 20 Hamilton and Suslow: Pg 25,questions 24,25,26 NQMPP’N? ...
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lecture%20notes%202 - Lecture Note 2 The Basics of Supply...

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