CHAPTER 2

DEMAND AND SUPPLY

ANALYSIS

Market Demand
Demand function
Quantity of a good all consumers in the market are
willing to buy

Demand curve
Aggregate quantity of a good that consumers are
willing to buy at different prices, holding constant
other demand drivers such as prices of other
goods, consumer income, quality
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Market Demand (cont.)

Derived demand
Demand for a good that is derived from the
production and sale of other goods
E.g. demand for sugar is derived from demand for soft
drink

Direct demand
Demand for a good that comes from the desire of
buyers to directly consume the good itself
E.g. rice is purchased by brokers, who then sell it to
retailers, who then resell it to final consumer
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Market Demand (cont.)

Law of demand
Quantity of a good demanded decreases when the
price of this good increases
Holding all other factors that affect demand constant

Demand curve rule

A move along the demand curve for a good can
only be triggered by a change in own price
Any change in another factor that affects the consumers
willingness to pay for the good results in a shift in the
demand curve for the good
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Market Demand (cont.)

Demand curve shifts
When factors other than own price change
If the change increases the willingness of
consumers to acquire the good
Demand curve shifts right

If the change decreases the willingness of

consumers to acquire the good
Demand curve shifts left

Market Demand (cont.)

Market Demand (cont.)

Market Supply
Supply function
Quantity of a good supplied by all producers in the
market depends on various factors

Supply curve
Aggregate quantity of a good that producers are
willing to sell at different prices

Market Supply (cont.)

Law of supply
Quantity of a good offered increases when the
price of this good increases

Supply curve rule

A move along the supply curve for a good can
only be triggered by a change in the price of that
good
Any change in another factor that affects the producers
willingness to offer for the good results in a shift in the
supply curve for the good
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Market Supply (cont.)

Supply curve shift
When factors other than own price change
If the change increases the willingness of
producers to offer the good at the same price
Supply curve shifts right

If the change decreases the willingness of

producers to offer the good at the same price
Supply curve shifts left

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Market Supply (cont.)

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Market Supply (cont.)

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Market Equilibrium
Market Equilibrium
A price such that, at this price, the quantities
demanded and supplied are the same.
A point at which there is no tendency for the
market price to change as long as exogenous
variables remain unchanged.

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Market Equilibrium (cont.)

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Market Equilibrium (cont.)

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Market Equilibrium (cont.)

Excess demand
A situation in which the quantity demanded at a
given price exceeds the quantity supplied

Excess supply
A situation in which the quantity supplied at a
given price exceeds the quantity demanded

No excess supply or excess demand

No pressure for prices to change (i.e. equilibrium)

When demand curve or the supply curve shift

Equilibrium shifts as well
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Market Equilibrium (cont.)

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Shifts in Demand, Supply Unchanged

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Shifts in Supply, Demand Unchanged

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Shifts in Supply and Demand

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Basics Laws of Supply & Demand

Increase in demand + unchanged supply
Higher price and larger quantity

Decrease in supply + unchanged demand

Higher price and smaller quantity

Decrease in demand + unchanged supply

Lower price and smaller quantity

Increase in supply + unchanged demand

Lower price and larger quantity
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Market Equilibrium

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Market Equilibrium (cont.)

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Price Elasticity
Price elasticity of demand
Percentage change in quantity demanded brought
about by a one-percent change in the price of the
good
Q,P = %Q / %P = Q / P (P / Q)
Elasticity is not slope
Slope is the ratio of absolute changes in quantity and
price.
Elasticity is the ratio of relative (or percentage)
changes in quantity and price
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Price Elasticity (cont.)

Key characteristics
|Q,P > 1| = elastic
One percent change in price leads to a greater than onepercent change in quantity demanded

|0 < Q,P < 1| = inelastic

One percent change in price leads to a less than onepercent change in quantity demanded

|Q,P = 1| = unit elastic

One percent change in price leads to an exactly onepercent change in quantity demanded
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Price Elasticity (cont.)

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Price Elasticity (cont.)

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Elasticity Linear Demand Curve

Linear demand curve
Q = a bp
a and b are positive constants, p is price, b is the slope

Inverse demand curve

P = a/b (1/b)Q
a/b is the choke price

Q,P = (Q/P)(P/Q) = -b(P/Q)

Elasticity falls from 0 to - along the linear
demand curve, but slope is constant
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Elasticity Linear Demand Curve

(cont.)

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Elasticity Linear Demand Curve

(cont.)
Linear Demand Curve:
Qd = a -bP
Q,P = (Q/ P)(P/Q) = -b(P/Q)

Price

Constant Elasticity Demand

Curve:
Qd = aP-b
Q,P = -b

Observed price and quantity

Constant elasticity demand curve
Linear demand curve

Quantity
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Elasticity Linear Demand Curve

(cont.)

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Price Elasticity and Total Revenue

Total Revenue (TR) = P*Q
When P Q and when P Q

Demand is elastic
Fall in Q > Rise in P
P TR

Demand is inelastic
Fall in Q < Rise in P
P TR

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Determinants of Price Elasticity

Availability of substitutes
More substitutes more price elastic
Goods which have price inelastic at the market level,
like cigarettes, is highly price elastic at the brand level

Buyers budget
Large expenditure more price elastic

Necessities vs luxuries
Necessities less price elastic

Time Horizon
Long-run more price elastic

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Income Elasticity of Demand

Income elasticity of demand
Ratio of the percentage change of quantity
demanded to the percentage change of income
Q,I = %Q / %I = Q / I (I / Q)
Q,I > 0
income demand
Normal goods: consume more as income rises

Q,I < 0
income demand
Inferior goods: consume less as income rises
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Cross-Price Elasticity of Demand

Cross-price elasticity of demand
Ratio of the percentage change of the quantity of
one good demanded with respect to the percentage
change in the price of another good
Qi,Pj = %Qi / %Pj = Qi / Pj (Pj / Qi)
Qi,Pj > 0 = demand substitutes
Qi,Pj < 0 = demand complements
Qi,Pj = 0 = irrelevant

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Price Elasticity of Supply

Price elasticity of supply
Percentage change in quantity supplied for each
percent change in price
Q,P = %Q / %P = Q / P (P / Q)
Q,P > 0 = Elastic
Q,P < 0 = Inelastic
Q,P = 0 = Unit elastic

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Elasticity Long-run vs Short-run

Long-run demand/supply curves
Consumers/sellers can fully adjust their
purchase/supply decisions to changes in price

Short-run demand/supply curves

Consumers/sellers cannot fully adjust their
purchase/supply decisions to changes in price

Example:
Consumer substitute solar for gas
Producer build new plant
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Elasticity Long-run vs Short-run

(cont.)

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Elasticity Long-run vs Short-run

(cont.)

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Estimating Demand & Supply

Demand estimation
Estimating demand from own price elasticity and
equilibrium price and quantity
Choose a general shape for functions
Q = a - bp
Estimating parameters of demand using elasticity
and equilibrium information
Q,P = Q / P (P / Q)

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Estimating Demand & Supply

(cont.)
Demand and supply estimation from past shifts
A shift in the supply curve reveals the slope of the
demand curve
We can identify the slope of demand by a shift in supply

A shift in the demand curve reveals the slope of

the supply curve
We can identify the slope of supply by a shift in demand

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Estimating Demand & Supply

(cont.)
Example:

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Estimating Demand & Supply

(cont.)

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Impact of Shift on Price

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