Chapter 02- Micro-the basic of Supply and Demand

Chapter 2: the basic of Supply and Demand

The supply curve, labeled S in the figure, shows how the quantity of a good offered for sale
changes as the price of the good changes. The supply curve is upward sloping: The higher
the price, the more firms are able and willing to produce and sell.

If production costs fall, firms can produce the same quantity at a lower price or a larger
quantity at the same price. The supply curve then shifts to the right (from S to S’).

The quantity that producers are willing to sell depends not only on the price they receive
but also on their production costs, including wages, interest charges, and the costs of raw
materials.

When production costs decrease, output increases no matter what the market price
happens to be.
The entire supply curve thus shifts to the right. Economists often use the phrase change
in supply to refer to shifts in the supply curve,while reserving the phrase change in the
quantity supplied to apply to movements along the supply curve.

The Demand Curve

The demand curve, labeled D, shows how the quantity of a good demanded by
consumers depends on
its price. The demand curve is downward sloping; holding other things equal,
consumers will want to purchase more of a good as its price goes down.

The quantity demanded may also depend on other variables, such as income, the
weather, and the prices of other goods. For most products, the quantity demanded
increases when income rises.

A higher income level shifts the demand curve to the right (from D to D’).

Shifting the Demand Curve

If the market price were held constant, we would expect to see an increase in the
quantity demanded as a result of consumers’ higher incomes. Because this increase
would occur no matter what the market price, the result would be a shift to the right of
the entire demand curve.

●  substitutes Two goods for which an increase in the price of one leads to an increase
in the quantity demanded of the other.

●  complements Two goods for which an increase in the price of one leads to a decrease
in the quantity demanded of the other.

THE MARKET MECHANISM

●  equilibrium (or market clearing) price
Price that equates the quantity supplied to the quantity demanded.
●  market mechanism: Tendency in a free market for price to change until the market

clears.

When Can We Use the Supply-Demand Model?

We are assuming that at any given price, a given quantity will be produced and sold.

This assumption makes sense only if a market is at least roughly competitive.

By this we mean that both sellers and buyers should have little market power—i.e.,
little ability individually to affect the market price. Suppose that supply were controlled
by a single producer.

If the demand curve shifts in a particular way, it may be in the monopolist’s interest to
keep the quantity fixed but change the price, or to keep the price fixed and change the
quantity.

For example

From 1970 to 2007, the real (constant-dollar) price of eggs fell by 49 percent, while the
real price of a college education rose by 105 percent.

The mechanization of poultry farms sharply reduced the cost of producing eggs, shifting
the supply curve downward. The demand curve for eggs shifted to the left as a more health-
conscious population tended to avoid egg.

As for college, increases in the costs of equipping and maintaining modern classrooms,
laboratories, and libraries, along with increases in faculty salaries, pushed the supply
curve up.
The demand curve shifted to the right as a larger percentage of a growing number of
high school graduates decided that a college education was essential.

Over the past two decades, the wages of skilled high-income workers have grown
substantially, while the wages of unskilled low-income workers have fallen slightly.

From 1978 to 2005, people in the top 20 percent of the income distribution experienced
an increase in their average real pretax household income of 50 percent, while those in
the bottom 20 percent saw their average real pretax income increase by only 6 percent.

While the supply of skilled workers has grown slowly, the demand has risen dramatically,
pushing wages up

ELASTICITIES OF SUPPLY AND DEMAND.

The price elasticity of demand depends not only on the slope of the demand curve but
also on the price and quantity.

The elasticity, therefore, varies along the curve as price and quantity change. Slope is
constant for this linear demand curve.

Near the top, because price is high and quantity is small, the elasticity is large in magnitude.

The elasticity becomes smaller as we move down the curve.

●infinitely elastic demand Principle that consumers will buy as much of a good as they
can get at a single price, but for any higher price the quantity demanded drops to zero,
while for any
lower price the quantity demanded increases without limit.

In the short run, an increase in price has only a small effect on the quantity of gasoline
demanded. Motorists may drive less, but they will not change the kinds of cars they are
driving overnight.

In the longer run, however, because they will shift to smaller and more fuel-efficient cars,
the effect of the price increase will be larger. Demand, therefore, is more elastic in the long
run than in the short run.

(b) Automobiles: Short-Run and Long-Run Demand Curves

The opposite is true for automobile demand. If price increases, consumers initially defer buying new cars; thus annual quantity demanded falls sharply.

In the longer run, however, old cars wear out and must be replaced; thus annual quantity demanded picks up.

Demand, therefore, is less elastic in the long run than in the short run.

Income Elasticities

Income elasticities also differ from the short run to the long run.

For most goods and services—foods, beverages, fuel, entertainment, etc.— the income
elasticity of demand is larger in the long run than in the short run.

For a durable good, the opposite is true. The short-run income elasticity of demand will
be much larger than the long-run elasticity.

Annual growth rates are compared for GDP and investment in durable equipment.

Because the short-run GDP elasticity of demand is larger than the long-run elasticity for
long-lived capital equipment, changes in investment in equipment magnify changes in GDP.
Thus capital goods industries are considered “cyclical.”

Annual growth rates are compared for GDP, consumer expenditures on durable goods
(automobiles, appliances, furniture, etc.), and consumer expenditures on nondurable goods
(food, clothing, services, etc.).

Because the stock of durables is large compared with annual demand, short-run demand
elasticities are larger than long-run elasticities. Like capital equipment, industries that
produce consumer durables are “cyclical” (i.e., changes in GDP are magnified). This is not
true for producers of nondurables.

Fitting Linear Supply and Demand Curves to Data

Linear supply and demand  curves provide a convenient tool for analysis.

Given data for the equilibrium price and quantity P* and Q*, as well as estimates of the
elasticities of demand and supply ED and ES, we can calculate the parameters c and d for
the supply curve and a and b for the demand curve. (In the case drawn here, c < 0.) The
curves can then be used to analyze the behavior of the market quantitatively.

Effects of Price Controls

Without price controls, the market clears at the equilibrium price and quantity P0 and Q0.

If price is regulated to be no higher than Pmax, the quantity supplied falls to Q1, the quantity
demanded increases to Q2, and a shortage develops.