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Week 3: Demand & supply & elasticities

This week covers the most important material in microeconomics – it explains how competitive markets work and how markets respond to changes in the factors determining the intentions of buyers and sellers.

It is simple material but it takes practise to good good at using the theory.

Demand describes the intentions of buyers in a market for a good. In this model competitive buyers – who purchase such a small part of a market’s output that they do not influence price (they are price-takers) – have their behaviour described by a demand function or demand curve which relates intended levels of purchases to given prices. This curve is drawn as a downward-sloping function (it obeys the ‘law of demand’) with price measured on the vertical axis and purchases on the horizontal axis. It can be defined for individual consumers or for all consumers in a market – in the latter case it is the market demand curve.

The demand curve traces out quantities demanded at different prices.

Changing the own-price of a good shifts consumers along their demand curve. Changes in the price of substitute or complement goods (cross price changes), changes in income and changes in tastes shift the whole demand curve since they will alter the scale of purchases at different prices.

  • An increase in the price of a substitute good shifts demand for a good to the right.
  • An increase in the price of a complement good shifts demand left.
  • An increase in income shifts demand for a normal good right and for an inferior good left.

Supply describes the intentions of sellers (and specifically firms) in a market. Competitive firms – who produce such a small part of a market’s output that they do not influence price (they are also price takers) – have their behaviour determined by a supply function or supply curve which relates intended levels of sales to given prices. This is drawn as a positively-sloped function (it obeys the ‘law of supply’) . It can be defined for individual firms or all firms in a market – in the latter case it is the market supply curve.

The supply curve traces out quantities supplied at different prices.

Changes in the price of a good shift firms along their supply curves. Changes in the prices firms must pay for inputs they use (for example changed wages or interest costs), technological improvements and even for agricultural firms unexpected changes in the weather will shift the whole supply curve since they change quantities supplied at different prices.

  • An increase in an input price shifts the supply curve leftward.
  • A technological improvement that reduces production costs shifts supply right.
  • An unexpected favourable change in the weather shifts agricultural supply curves right.

The demand-supply model developed is incomplete since we have not explained price. (If you are mathematically minded we have, as yet, market demand explained by price, market supply explained by price but there are three different ‘variables’ here but only two relationships).

The model can be closed by supposing an equilibrium condition that:

demand = supply.

In some markets this might be motivated by supposing that if demand exceeded supply (excess demand) firms would expect shortages to develop and would have incentives to raise price. If supply exceeded demand (excess supply) firms would expect surpluses and cut prices. Hence the only situation where firms do not have incentives to change their behavior – such a situation might be poetically described as an equilibrium) is where demand=supply.

In some markets an excess supply might not cause prices to fall. For example in labour markets even though there is an excess supply of labour (there is unemployment) wages often do not fall because institutions such as trade unions or particular contracting arrangements prevent this from happening. But in many other markets it is a more reasonable assumption.

Intuitively an equilbrium price is a price where the decisions of intending purchasers are consistent with the decisions of intending vendors – where demand = supply.

Graphically the equilibrium price occurs at the intersection of supply and demand curves.

We can examine the comparative statics of markets by drawing a supply demand curve diagram and by examining how a change in an exogenous variable (income, cross price, tastes, input costs, technology, the weather) affects the endogenous variables of a supply-demand model (quantity demanded, quantity supplied, price). To do this:

  • Identify whether demand or supply is influenced by the change.
  • Determine the direction of the demand or supply shift.
  • Draw a graph of the change to determine what happens.

I’ll give two examples in the market for PC’s (which I will assume to be competitive) to illustrate the approach:

1. An increase in the price of software. Software is a complement in consumption to PC consumption so an increase cost of software should reduce the demand for PCs – shift the demand for PCs to the left. It won’t have any effect on the supply of computers that have no software loaded. If demand shifts left the number of PCs sold will fall as will the equilibrium price of PCs.

2. A technological innovation that reduces further the cost of a PC production. This change will not affect demand but will shift supply right. This will mean more PCs are sold at a lower price.

This is an extremely useful qualitative calculus that you can use to work out the direction of changes in various factors influencing markets. But without specific information about supply and demands it is impossible to come up with precise numerical estimates of the extent of changes.

One way that the sensitivity of demands and supplies to price can be visually assessed is by means of the slopes of the respective demand and supply curves. If demand cuirves have a steep negative slope then quantities demanded will change a lot when price changes a little. Similarly if the supply curve has a steep positive slope then quantities supplied change a lot when supply changes a little.

Unfortunately the slopes of supply and demand curves depend on the units used to measure prices and quantities. For example the slope of a demand curve measures:

change in demand demanded/change in price.

Thus if I alter the way I measure price from using dollars to cents I reduce slope by a factor of 1/100. If quantities demanded shift from being measured in kilograms to tonnes then slope falls by 1/1000.

A way around this is to use the elasticity idea. This week elasticity is only developed for demand although it is a general idea used in many contexts. The elasticity of demand is defined as:

  • % change in demand/% change in quantity, or
  • relative change in demand/relative change in quantity, or
  • slope*(price/quantity).

Thus if demand rises by 20% when price falls by 5% elasticity is -4. With elasticity information we can be much more definite in determine comparative static outcomes in markets. We will illustrate this idea in subsequent weeks.

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