Part 2 Chapter 3 Economic Principles Lecture 3 notes

Demand and supply:

Demand – relates to how many people want this product. How many demands it.
Supply – relates to the availability to sell or give this product. How much can we
supply of it to a market.

Market – is a group of buyers and sellers of a particular good or service. The buyers
determine the demand for the product, and the sellers determine the supply.
Different markets have different characteristics:
 Some markets are highly organised (stock exchange) while others are less
organised (used cars market).
 Some have many buyers and sellers (i.e. corn) and some have few buyers
and sellers (market for military weapons).

In the model of supply and demand, we assume the market is competitive.

A market is competitive when there is a huge number of buyers and sellers and the
product in question is homogenous ().
 Each buyer and seller have perfect information (no transaction cost, no need
to actively search for each other)
 Each buyer and seller make up only a small fraction of the market.
 No individual buyer or seller can influence the market price or quantity.
 All sellers supply similar products.
 There is freedom of entry and exit to and from the market.
 Everyone takes the market price as given.

The model for supply and demand represent competitive markets very well such as:
 Agriculture • Commodities
 Certain labour markets • Stocks / Bonds

Looking at other markets, i.e. monopoly markets, we need to slightly adjust the
analysis (but the core concepts remain).

Demand:
The demand of a product in a local market (i.e. country) is determined by factors:
 Average income • Preferences
 Price of similar goods • Price of specific sellers’ product
 Quality of product

 The demand curve plots how much ice cream consumers wish to buy for
various prices holding everything else constant.
 When the price of ice cream rises, people will want to buy less ice cream
 This is the law of demand.
 The law of demand states that consumers will buy less of a good when it
becomes more expensive.

 What happens if something other than price changes?

o If this change affects the demand, the relationship between price and
quantity demanded will be different.
o This is what we call a shift in the demand curve. Something external
effects (i.e. news about a product is bad/good, laws, trends)
 What other factors can shift the demand curve?
o Prices of compliments or substitutes.
o Two goods are substitutes if a price increase in one good increases
demand for the other (i.e. beef and chicken).
o Two goods are compliments if a price increase in one good decreases
demand for the other (ice cream and bananas).
 Other factors:
• Tastes / trends • Size of the population
• Expectations of the consumer • Advertising
 The effect of income – income can either shift the demand curve right or left
depending on the type of good. Cheaper/ inferior goods will have a decreased
demand if people get richer, and normal goods (and expensive goods) will
have decreased demand if people get poorer.
It’s proven that in low GDP countries, people tend to have more children. In high
GDP countries people tend to have less children. By the law of demand, this will
categorise children as being inferior goods.

Supply:
What determines how much of a product a firm can produce?
 The cost of inputs (raw material)
 Technology
 How many competitors there are (monopoly, oligopoly, perfect competition)
 The price of the product (produce for less than market price)
 Natural / Social factors

The supply curve plots how much of a product a seller is willing to sell at different
prices holding everything else constant.
When the price of ice cream is really high, sellers will want to make a lot of a product
(because it’s really profitable to do so) and new competitors will enter the market.
When the price is really low, ice cream is not very profitable to make, and many firms
will shut down. The supply curve is upward sloping.
Suppose a quantity supplied of a product for various prices can be described as
below. The market supply curve is just sum of the supply curve of individual firms.
  What happens if the price of a product increases?
o This will represent a movement along the supply curve.

 What happens if something other than the price of a product changes?

o This will represent a shift to the supply curve.
o For example, what happens when the price of milk decreases for a firm
that produces ice cream?

(If milk price decreases, the supply of ice cream will increase (as seen in graph
(outwards shift)) and ultimately the price will decrease)
Equilibrium:
 The willingness to pay meets the willingness to supply. To find the equilibrium
price, we have to add the supply and demand curves together.

(In this graph the equilibrium is at 5 ice creams supplied, and £0.80 paid per
ice cream)

 Why is it a stable point?

Suppose a price of £0.90, which is above the equilibrium point.

Observation:
The suppliers are willing to produce 7 units of ice cream to that price,
While
The buyers / demand is reduced to 3 units of ice cream to that price.
Sellers want to sell 7 units and buyers only want to purchase 3 units. There is
a surplus of 4 units. Firms have unsold inventory and will begin to decrease
their production and lower the price. Therefore, it’s not equilibrium because
it’s not stable. When price is above equilibrium the price will decrease.
  Now suppose the price were £0.60 which is “too low”.

 We have excess demand.

 There are 9 people that wish to buy to this price, but only 1 unit/firm that sells
to this price. There is a shortage equal to 8 units. There will be ques, and the
price will gradually increase until supply is equal to demand.

Once the equilibrium is reached, the market will stay there until some external factor
changes.

The equilibrium can also be found using algebra:

Economist estimate that the demand curve for pork can be approximated by:
Qd=286−20 p
They’ve estimated that the supply curve for pork can be approximated by:
Qs=88+40 p

To find the equilibrium we must find where Qd and Qs are the same, therefore:
Qd=Qs→ 286−20 p=88+ 40 p

198=60 p → p=£ 3.30

Qd=286−20∗3.30 → Qd=220
Or
Qs=88+40∗3.30 →Qs=220
Comparative Statics:
In reality, the equilibrium price and quantity in a market is always changing.
Comparative statics is used to analyse the effects of particular events on the market
equilibrium. We will compare the equilibrium before the event with the equilibrium
after the event.
Looking at oil:
The supply decreases when we produce more oil, and the demand increases when
large countries experience economic growth (for example).
Same goes for currencies:
For countries with freely floating exchange rates, the relative value of the currency is
determined by the forces of supply and demand.
 When foreigners demand a lot of pounds (to buy British goods and assets),
the relative value of the pound increases.
 When British citizens supply a lot of pounds (to buy foreign goods and assets)
the relative value of the pound decreases.

Elasticity – Demand:
 How price and quantity respond to external events depends crucially on how
sensitive supply and demand are to the price.
 The price elasticity of demand is a very important concept to understand.
 Price elasticity of demand is the percentage change in quantity demanded
that results from a percentage change in price.
 If the price increase 1%, by how much will quantity demanded fall?
o If the price elasticity of demand is 2, a 1% increase in price leads to a
2% drop in quantity demanded.
 If price elasticity of demand is more than 1, the good we consider is elastic.
 If price elasticity of demand is between 0 and 1, the good we are considering
is inelastic.
 To calculate the percentage change, we either use the Midpoint Method:

Q 2+Q1
(Q2−Q1)/( )
2
Price Elasticity of D emand=
P 2+ P1
(P2−P1)/( )
2

 Or the other method:

P
∗dQd
Qd
Price Elasticity of Demand =
dP
 What determines the price elasticity of demand?
- Proportion of income devoted to good
- Availability of close substitutes
- Definition of the market (broad vs narrow)
- Time horizon. Most goods are more price elastic in the long run.
However, for certain types of goods known as durable goods, the
reverse is true.
- Necessities vs. luxuries.

 The price elasticity of demand is related to the slope of the demand curve.
 Suppose price increases from £10 to £11 (10% increase)
o If the resulting change in quantity demanded is very large, the price
elasticity of demand is high, and the demand curve will be flat.
o If the resulting change in quantity demanded is very small, the price
elasticity of demand is low, and the demand curve will be steep.
 When the price of a product increases, consumers purchase less. How much
less depends on the elasticity.
 But what about total spending (total expenditure)?
Total Spending=Price∗Quantity
o If a good is price inelastic (less than 1), an increase in price actually
increases the total spending.
- That’s because while fewer units are being purchased, each unit
is sufficiently more expensive, meaning expenditure rises.
Elasticity – Supply:
 Law of supply tells us that producers will respond to a price drop by producing
less, but it does not tell us how much less.
 The degree of sensitivity of producers to a change in price is measured by the
concept of price elasticity of supply.
 The main determinants of the price elasticity of supply are:
o The time periods
o Productive capacity
o The size of the firm/industry
o Mobility of the factors of production
o Ease of storing stock/inventory
 Computing the price elasticity of supply:
P
∗dQs
Qs
Price Elasticity of Supply=
dP
Or
Q 2+Q 1
(Q 2−Q 1)/( )
2
Price Elasticity of Supply=
P 2+ P 1
(P 2−P 1)/( )
2
  If the price elasticity of supply is greater than 1, supply is said to be elastic
(1% increase in price leads to more than 1% increase in supply)
 If the price elasticity of supply is less than 1, supply is said to be inelastic
(1% increase in price leads to less than 1% increase in supply)

 The price elasticity of supply plays an important role in determining how price
changes affect a firm’s revenue.
Total Revenue=Price∗Quantity Supplied
 When the price increases, firms will supply more. Price and quantity sold work
in the same direction to increase a firm’s revenue

Comparative Statics:
 Consider a tax on producers.
 If demand is very elastic, the tax will not have a big impact on the market
price, but it will have a huge effect on quantity.
 If demand is very inelastic, the tax will have a big impact on the market price,
but it will not have a huge effect on quantity.

Demand is elastic: Demand is inelastic:

  Housing prices are very volatile because their supply and demand is highly
inelastic. Good example is the 2008 housing prices.

Elasticity – Application 1
Application to petrol taxes:
 Most governments tax fuel consumption as a way to raise revenue.
 These taxes are also aimed at reducing congestion, smog, and pollution.

Are fuel taxes effective in decreasing fuel consumption in the UK and USA.
 It all comes down to the elasticity of demand.
 The average urban population density in the UK is 10.600 people per square
mile of urban area. In the USA it is 2.900.
 Public transportation is not as developed in USA. 32% of Americans claimed
public transportation was not available at all, vs 4% in the UK.

How do we reduce the consumption of hard drugs.

 Most agree that the consumption of hard drugs is bad for society.
- Social problems
- Higher health care costs
- Lower productivity
 What is the most effective way to reduce drug use?
 The elasticity of demand for these drugs is very because they are addictive.