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Chapter Two Notes

by: Jon Kinne

Chapter Two Notes ECON 302

Jon Kinne

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These are extensive notes over the second chapter
Microeconomic Analysis
Ellis Scharfenaker
Class Notes
supply, demand, market equilibrium, elasticity, Economics, analysis
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This 6 page Class Notes was uploaded by Jon Kinne on Tuesday August 30, 2016. The Class Notes belongs to ECON 302 at University of Missouri - Kansas City taught by Ellis Scharfenaker in Fall 2016. Since its upload, it has received 6 views. For similar materials see Microeconomic Analysis in Economics at University of Missouri - Kansas City.


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Date Created: 08/30/16
CHAPTER 2: Supply and Demand 2.1 Markets and Models Modern economists are very complex. The supply and demand model represents the economist’s best attempt to capture many of the key elements of real-world markets in a simple enough way to be easily analyzed. What is a Market? In the strictest sense, a market is defined by the specific product being bought and sold, a particular location, and a point in time. In principle, the buyers in a market should be able to find the sellers in the market, and vice versa, although it might take some work to make that connection. In practice, the kinds of markets we talk about tend to be much more broadly defined than these examples. They might be broader in terms of the product, location, or the time period. Key Assumptions of the Supply and Demand Model 1) We restrict our focus to supply and demand in a single market 2) All goods bought and sold in the market are identical 3) All goods sold in the market sell for the same prince and everyone has the same information about prices, the quality of the goods being sold, etc. 4) There are many buyers and sellers in the market 2.2 Demand Factors That Influence Demand PRICE THE NUMBER OF CONSUMERS CONSUMER TASTES PRICE OF OTHER GOODS Demand Curves Graphical Representation of the Demand Curve The demand curve slopes downward: Holding everything else equal, consumers are willing to buy less of a good as price rises. A demand curve is drawn with the assumption that there is no change in any of the other factors – such as consumers’ incomes, tastes, or the prices of other goods – that might also affect how much of a good consumers buy. Mathematical Representation of the Demand Curve Q = 1000 – 200P Where Q is the quantity demanded (in pounds) and P is the price (in dollars per pound). Because of the odd condition in Econ of plotting price on the vertical axis and quantity on the horizontal axis, and because it is easier to work with in certain contexts, economists often write demand curve equations in the form of the price as a function of quantity. This approach results in an inverse demand curve. It simply rearranges the demand curve to put price in terms of quantity instead. Q = 1000 – 200p 200P + Q = 1000 200P = 1000 – Q P = 5 – 0.005Q Shifts in Demand Curves Changes in quantity demanded happen when a change in a good’s price creates movement along a given demand curve. Changes in demand happen when a good’s entire demand curve shifts. Why is Price Treated Differently from the Other Factors That Affect Demand? 1) Price is typically one of the most important factors that influence demand 2) Prices can usually be changed frequently and easily 3) Of all the factors that influence demand, price is the only one that also exerts a large, direct influence on the other side of the market – on the quantity of the good that producers are willing to supply. 2.3 Supply Factors That Influence Supply PRICE SUPPLIERS’ COSTS OF PRODUCTION THE NUMBER OF SELLERS SELLERS’ OUTSIDE OPTIONS Supply Curves Graphical Representation of the Supply Curve The supply curve slopes upward: holding everything else equal, producers are willing to supply more of a good as price rises. Mathematical Representation of the Supply Curve Q = 200P – 200 Where Q is the quantity supplied and P is the price. Inverse Supply Curve Q = 200P – 200 200P = Q + 200 P = .005Q + 1 Shifts in the Supply Curve When one of the other (nonprice) factors that affect supply changes, the change affects the quantity of goods that suppliers want to sell at every price. IE: it shifts the whole curve, not just the point on the curve. Why Is Price Also Treated Differently for Supply? Price is the critical element that ties together the two sides of a market. Price’s roles in both the demand and the supply sides of a market mean that prices can adjust freely to make the quantity demanded by consumers equal to the quantity supplied by producers. 2.4 Market Equilibrium The true power of the demand and supply model emerges when we combine the curves. Both relate quantities and prices, so we can draw them on the same graph, with price on the vertical axis and quantity of the horizontal axis. The point where the supply and demand curves meet is the market equilibrium. The Mathematics of Equilibrium QD = QS 1000 – 200P = 200P – 200 1200 = 400P P(e) = 3 In this example, when the price is $3 per pound, the market is at equilibrium. Why Markets Move Toward Equilibrium EXCESS SUPPLY Surplus If the price in the market is high, producers produce more of that good wanting to sell at this high price, but not all producers can find willing buyers willing to buy at that price. EXCESS DEMAND Shortage Buyers want a lot of goods if they are cheap, but not many producers will deliver them at such a low price. At the low price, the QD is greater than the QS. ADJUSTING TO EQUILIBRIUM In the real world an equilibrium can by mysterious. In our stylized model, we’re acting as if all the producers and consumers gather in one spot and report to a sort of auctioneer how much they want to produce or consume at each price. The Effects of Demand/Supply Shifts When demand shifts, so does the market equilibrium. Just like with Supply. What Determines the Size of Price and Quantity Changes? Size of the Shift Slope of the Curves Changes in Market Equilibrium When Both Curves Shift 2.5 Elasticity An elasticity relates the percentage change in one value to the percentage change in another. So, for example, when we talk about the sensitivity of consumers’ quantity demanded to price, we refer to the price elasticity of demand: the percentage change in quantity demanded resulting from a given percentage change in quantity demanded resulting from a given percentage change in price. Slope and Elasticity Are Not the Same The slope relates a change in one level Price to another level Quantity. Two problems with just using slopes to measure price responsiveness: 1) Slopes depend completely on the units of measurement we choose. 2) You can’t compare them across different products. Using elasticities to express responsiveness avoids these issues, because everything is expressed in relative percentage changes. That eliminates the units problem and makes magnitudes comparable across markets. The Price Elasticities of Demand and Supply Price Elasticity of Demand = (% change in QD) / (% change in P) Price Elasticity of Supply = (% change in QS) / (% change in P) Price Elasticities and Price Responsiveness For price elasticity of demand, the change in quantity will have the opposite sign as the price change, and the elasticity will be negative. But its magnitude will be large if consumers are very responsive to price changes. For price elasticity of supply, the change in quantity will have the same sign as the price change, and the elasticity will be negative. But its magnitude will be large if consumers are very responsive to price changes. Elasticity of a Linear Supply Curve Because the slope of the curve is constant, the changes in elasticity along the curve are driven by the price-to-quantity ratio. Perfectly Inelastic Supply and Demand The formula relating elasticities to slope sheds some light on demand and supply curves look like in two special but often discussed cases: perfectly inelastic and perfectly elastic demand and supply. Perfect Inelasticity A linear demand curve with a slope of - would drive the price elasticity of demand to zero due to the inverse relationship between elasticity and slope. A vertical supply curve indicates perfectly inelastic supply and no response of quantity supplied to price differences. Perfect Elasticity This will be the case for linear demand or supply curves that have slopes of zero – those that are horizontal. The Price Elasticity of Demand, Expenditures, and Revenue Expenditures rise with prices if demand is inelastic, but decrease with prices if demand is elastic. Total expenditure = Total revenue = P x Q Income Elasticity of Demand The income elasticity of demand is the ratio of the percentage change in quantity demanded to the corresponding percentage change in consumer income (I): E I %change in QD / %change in Income = Change in QD / Change in Income x (Income/QD) Goods that have and income elasticity that is negative, meaning consumers buy less as income rises, are called inferior goods. Goods with positive income elasticities are call normal goods. The subcategory of normal goods with income elasticities above 1 is sometimes called luxury goods. Cross-Price Elasticity of Demand The ratio of the % change in one good’s (X) QD to the % change in price of another good Y. ED = (%change in QD / %change in P ) XY X Y To avoid confusion, sometimes the price elasticities discussed above, which are concerned with the % change in QD to the % change in the price of the same good, are referred to as own- price elasticities of demand.


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