LECTURE 1

BASIC CONCEPTS:

DEMAND, SUPPLY,
AND
EQUILIBRIUM

By Dr. Donald J. Liu for the International Food Policy Research Institute
DEMAND
 Market Demand Curve

 A market demand curve is

defined as
P
 the alternative quantities
of a good
Demand Curve
 that all consumers in a
particular market

 are willing and able to

buy as price varies,
Qd
 holding all other factors
constant.
Change in Quantity Demanded
(Movement Along a Demand Curve)

Qd  f ( P holding cons tan t other factors)

P A movement along a demand

curve occurs when own price
changes, holding constant
Demand Curve other factors.

What are the other

factors that we are
holding constant?
Qd
 Other Factors Affecting Demand

 The factors holding constant are:

 the prices of other goods including substitutes and

complements (PO),

 aggregate consumer money income (M),

 consumer population (POP), and

 noneconomic factors including social, physiological,

psychological, and demographic factors unique to the
consumers in the market (SPPD).

Qd  f ( P PO, M , POP , SPPD)

 Change in Demand
(Shift in the Position of the Demand Curve)

 It is important to distinguish between:

 a movement along a demand curve (change in quantity

demanded) and

 a shift in the position of the demand curve (change in

demand).

 A movement along a demand curve occurs when own price

changes, holding constant PO, M, POP, and SPPD.

 A shift in the demand curve occurs when we change one of

those factors being held constant.
 Shift in Demand: Population (POP)

With an increase in POP,

the demand curve shifts
to the right. P

With the demand curve

shifting to the right, the
quantity demanded
increases for all prices. $3

Factors that lead Qd

consumers to change 20 30
demand quantities at the
same price are referred to
as demand shifters.
 Demand Shifter: Noneconomic Factor
(SPPD)

Consider the consumption

trend of moving away from
foods that are perceived to P
be high in fat and
cholesterol content.

This can be thought of as a

change in one component $3
of the SPPD.

As a result of this change Qd

in the dietary habit of 20 30
consumers, the demand
for red meat has shifted
to the left.
 Demand Shifter: Price of Other Good (PO)
How about an increase in one of the prices of other goods?

Well, it depends!

With an increase in the price of a substitute, the demand curve

shifts to the right.

As the price of pork Pbeef

increases, consumers
demand more beef even
though the price of beef
does not change.
$3
This is because beef is now
relatively more inexpensive
compared to pork. Qbeef
20 30
 On the other hand, with an increase in the price of a
complement, the demand curve shifts to the left.

 As the price of bread increases,

the demand for bread decreases.
Pbutter
 Hence the demand for butter
decreases even though the
price of butter stays the same.

$3
This is because butter is, in
general, complementary to
bread. Qbutter
20 30
 Demand Shifter: Money Income (M)
How about an increase in income?

Again, it depends!

In most cases, an increase in income shifts the demand

curve to the right.

P
 This is consistent with the
idea that as income increases
people buy more of the
products.
$3
 In this case, the good is
called a normal good.
Qd
20 30
 A few commodities such as dry beans and potato
are called inferior goods.

 As income increases consumers

tend to buy less of the inferior
P
goods as they can now afford
more expensive normal goods.

 That is, an increase in

income shifts the demand $3
curve for an inferior good to
the left.
Qd
20 30
 Slope of a Demand Curve
P
rise Demand Curve
slope 
run P

From the definition, the  Qd

slope of a demand curve is Qd
the change in price divided
by change in quantity
demanded:
slope of demand curve
P
 < or = 0
Qd
 P
Measuring Responsiveness Demand Curve
It is often of useful to have a
measure of how "responsive" P
demand is to some change in
own price.  Qd
Qd
Qd
That is: Re sponsive 
P
Now the first idea that springs to mind is to use the inverse of
the slope of a demand curve as a measure of responsiveness.

After all, the definition of the slope of demand curve

slope of a demand curve is
the change in price divided P
by change in quantity 
demanded: Qd
 slope of demand curve P
P Demand Curve

Qd
P
So, the inverse of the slope of a  Qd
demand curve looks like a measure of
responsiveness. Qd

Well, it is a measure of responsiveness - but it has problems.

In particular, the slope of a demand curve depends on the

units in which we measure price and quantity.
For example, if we measure demand in gallons rather than in
quarts, the slope becomes four times bigger, and hence,
1/slope becomes four times smaller.
It is convenient to consider a unit-free measure of
responsiveness. Economists have chosen to use a measure
known as elasticity.
elasticity
 The Own-Price
Elasticity of Demand Q d , P  
The own-price elasticity of demand,  , is defined as the
percent change in quantity demanded divided by the
percent change in own price.

A 10 percent increase in price is the same percentage

increase whether the price is measured in American
dollars or English pounds.

Thus, measuring increases in percentage terms keeps

the definition of elasticity unit-free.

 Qd 5%
0.5%
%  in Qd Qd  Qd P
   
%  in P P P Qd
10% 1%
P
 A convenient way to think of an own-price elasticity of
demand is as the percentage change in quantity demanded
corresponding to a one percentage change in own price,
holding other factors constant.

%  in Qd
   %  in Q d associated with 1%  in P
%  in p

30%  in Qd
   6%  in Q d associated with 1%  in P
5%  in p
 Own-Price Elastic VS.
Inelastic

 = - 0.5 A 1% increase in the price of the good will cause

a 0.5% reduction in the demand quantity.
  0.5 Good 1

 = - 1.5 A 1% increase in the price of the good will cause

a 1.5% reduction in the demand quantity.
  15
. Good 2

Which of the two goods is more own-price elastic?

Good 2 is more own-price elastic. The absolute

value of its own price elasticity is larger than that
pertains to good 1.
 Own-Price Elastic VS. Inelastic

 = - 0.5 A 1% increase in the price of the good will cause

a 0.5% reduction in the demand quantity.
  0.5 This good is own-price inelastic.

 = - 1.5 A 1% increase in the price of the good will cause

a 1.5% reduction in the demand quantity.
  15
.
This good is own-price elastic.

 = - 1.0 A 1% increase in the price of the good will cause

a 1% reduction in the demand quantity.
  10
. The elasticity is unitary.
  Qd
Qd
Computing Own-Price Elasticity  
P
P

 Qd
Qd  Qd P
   *
P P Qd
P 1
1 P slope
 *  0
Slope of the demand curve Qd

The own-price elasticity of demand can be

expressed as the product of the inverse of the
slope of the demand curve and the ratio of own
price to quantity.
  Qd P 1 P
  *  *
P Qd Slope of the demand curve Qd

 Notice that the flatter the demand curve, the larger in

absolute value is  (that is, the more price elastic is the
demand).

 The flatter the demand curve, the smaller in absolute

value is the slope, P (e.g., - 2, instead of - 4).
,
Qd
 Hence, the flatter the demand curve, the larger in
absolute value is the inverse of the slope, Qd ,
(e.g., - 0.5, instead of - 0.25). P

 Hence
 The flatter the demand curve, the more price elastic
is the demand.

P P

flatter steeper

Qd Qd

The flatter the demand Hence, the flatter the

curve, the more room demand curve, the more
there is for the quantity responsive is the quantity
to adjustment. to a price change.
  Qd P 1 P
  *  *
P Qd Slope of the demand curve Qd

P elasticity = - infinity P elasticity = - 0

slope = - 0 slope = - infinity

Perfectly Elastic Perfectly Inelastic

Qd Qd

The flatter the demand curve, the more price elastic is the demand.
  Qd P 1 P
  *  *
P Qd Slope of the demand curve Qd

Own price elasticity is defined

for a point on the demand P
curve and, in general, the
elasticity coefficient varies
along the demand curve.

For example, consider a linear

demand curve:
Qd

Along the curve, the slope stays the same, but P and
Qd change as we move along the demand curve.

Hence, the elasticity coefficient changes as we move

along the demand curve.
 Evaluating Price Elasticity at a Sample
Point

Since the elasticity coefficient varies along a demand curve,

It is not technically correct to say that the demand for a
commodity is own-price elastic or inelastic.

That is, demand is price elastic or inelastic only

within some range of the data.

In making empirical computations, a common procedure is

to evaluate the price elasticity of demand at the mean of the
data.

 Qd P where P and Qd are the

  * price and quantity evaluated at
P Qd the mean of the data.
 In-Class Exercise 1-a

Consider the following demand equation for beef products:

Q beef  0.01  0.5 Pbeef  0.03 Ppork  0.01Pchicken  0.04 M  0.01SPPD
The sample means of the variables are:
Q beef  2, Pbeef  3,
Ppork  5, Pchicken  4, M  20, SPPD  250

Write down the formula for own price elasticity of demand for beef.

Compute the own price elasticity of demand for beef (evaluating at

the sample means). Is the demand own price elastic or inelastic?

Suppose the price of beef is projected to decrease by 2% next

month, what would be the percentage change in Qbeef (demand)?
SUPPLY
 Factors Determining Supply
 What are the factors determining supply quantity?

 It depends on the output price (P).

 It depends on the input prices (PI).

 It depends on the price of alternative output (PO).

 This is the opportunity costs of not producing other

commodities.

 It also depends on such noneconomic factors as

capacity, technology, and weather that firms face (CAP).

Qs  f ( P, PI , PO, CAP )
 Supply Curve

A supply curve is the relationship between

quantity supplied for a good (Qs) and its price (P),
holding constant other factors.

The factors which we are holding

constant include: input prices (PI), Supply
prices of alternative outputs (PO), Shifters
and noneconomic factors (CAP).

Qs  f ( P PI , PO, CAP )
 Change in Quantity Supplied
(Movement Along a Supply Curve)

P
Supply Curve
Notice that the supply
curve has a positive
P"
slope. P
P'
slope of supply curve
P  Qs Qs
 0 Qs Qs
Qs
' "

That is, as price

increases, the quantity
supplied moves up
Qs  f ( P PI , PO, CAP )
along the supply curve.
 Change in Supply
(Shift in the Position of the Supply Curve)

 It is important to distinguish between:

 a movement along a supply curve (change in quantity

supplied) and

 a shift in the position of the supply curve (change in

supply).

 A movement along a supply curve occurs when output

price changes, holding constant PI, PO, and CAP.

 A shift in the supply curve occurs when we change one of

those factors being held constant.
 Shift in Supply: Input Prices (PI)

With a decrease in input

prices, the supply curve P
shifts to the right.

With the supply curve

shifting to the right, the
quantity supplied increases $3
for all levels of output price.

Factors that lead 20 30 Qs

producers to change
supply quantities at the
same price are referred to
as supply shifters.
 Shift in Supply: Alternative Output
Prices (PO)

With a decrease in alternative P

output prices, the supply curve for
the commodity in question shifts
to the right.

For example, a decrease in

sorghum price means that the $3
land and labor used in sorghum
production will now be less
profitable than if used in wheat
production. 20 30 Qs

Hence, a decrease in sorghum

price shifts the supply curve of
wheat to the right.
 Shift in Supply: Technology (CAP)

P
An improvement in
technology is defined as
something that enables firms
to produce more output with
the same quantity of inputs as $3
previously.

Thus, with improved 20 30 Qs

technology, the supply curve
shifts to the right.
 The Own Price Elasticity of Supply
 Qs, p

The price elasticity of supply, Qs , p , is defined to be the
percent change in quantity supplied divided by the percent
change in the output price.

%  in Qs  Qs P
 Qs , P   slope of supply curve
%  in P P Qs P
 0
P Qs

1 P  Qs
 P
slope of supply curve Qs
Supply Curve
 0 Qs
 %  in Qs  Qs P
 Q s, P  
%  in P P Qs

1 P

slope of supply curve Qs

A convenient way to think of a price elasticity of supply is

as the percentage change in quantity supplied
corresponding to a one percentage change in output price,
holding other factors constant.
  Qs P 1 P
Q  
s, P
P Qs slope of supply curve Qs

 Notice that the flatter the supply curve, the larger is  Qs , p

(that is, the more price elastic is the supply).

 The flatter the supply curve, the smaller is the slope, P ,

Qs
(e.g., 2, instead of 4).

 Hence, the flatter the supply curve, the larger is the

inverse of the slope, Qs , (e.g., 0.5, instead of 0.25).
P

 Hence
 The flatter the supply curve, the more price elastic
is the supply.

P P
steeper
flatter

Qs Qs

The flatter the supply Hence, the flatter the

curve, the more room supply curve, the more
there is for the quantity responsive is the quantity
to adjustment. to a price change.
  Qs P 1 P
Q  
s, P
P Qs slope of supply curve Qs

P elasticity = infinity P elasticity = 0

slope = 0 slope = infinity

Perfectly Elastic Perfectly Inelastic

Qd Qd

The flatter the supply curve, the more price elastic is the supply.
 Own Price Elastic VS.
Inelastic

 = 0.5 A 1% increase in the output price will cause a

0.5% increase in the supply quantity.
The supply is own price inelastic.

 = 1.5 A 1% increase in the output price will cause a

1.5% increase in the supply quantity.

The supply is own price elastic.

 In-Class Exercise 1-b
Consider the following supply equation for beef products:
Q beef  1231
.  0.2 Pbeef  0.08 Ppork  0.007 Pbeans  0.005 Pcorn  0.02CAP
The sample means of the variables are:
Q beef  2, Pbeef  3,
Ppork  5, Pbeans  3, Pcorn  2, CAP  250

Write down the formula for own price elasticity of supply of beef.

Compute the own price elasticity of supply of beef (evaluating at the

sample means). Is the supply own price elastic or inelastic?

Suppose the price of beef is projected to decrease by 2% next

month, what would be the percentage change in Qbeef (supply)?
EQUILIBRIUM
 Price Determination

 Now, we examine how the

equilibrium price is determined.
P
 Equilibrium implies "equal," Supply
"balanced," and "stable."

 The concept of equilibrium P*

price is simply the price at
which quantity demanded Demand
equals quantity supplied. Qd, Qs
Q*
 Thus, the intersection point of
the demand and supply curves
indicates the equilibrium price.
 P
Supply
Disequilibrium P'
excess supply

P*
 In a perfectly competitive market,
Demand
prices other than the equilibrium
price cannot be sustained. Qd, Qs
Q*

Some or all producers will

Or May be we can
 At prices above the equilibrium
price, we have a situation called begin to offer their products at
export the excess
excess supply. a lower price.

supplies
 to a
This is because the quantity The lower price discourages
foreign market!
that consumers are willing to some supply and encourages
buy is less than the quantity additional demand.
producers are willing to sell.
The process continues until
price is driven down to P*, at
which point Qd = Qs.
 P
Supply
Disequilibrium
P*
 On the other hand, at prices P' excess demand Demand
below the equilibrium price, we
have a situation called excess Qd, Qs
Q*
demand.

Or May be we can
 This is because the quantity
The higher price discourages
some demand and encourages
satisfy the excess
that consumers are willing to
buy is more than the quantity
additional supply.
demand through
producers are willing to sell. The process continues until
imports from a price is driven driven to P*, at
which point Qd = Qs.
foreign
In this market!
case, consumers
will begin bidding up the
Accordingly, only the equilibrium
price.
price can be sustained.
 In-Class Exercise 1-c (i)
Consider the following demand equation for beef products:
Q dbeef  0.01  0.5 Pbeef  0.03 Ppork  0.01Pchicken  0.04 M  0.01SPPD

Consider the following supply equation for beef products:

Q sbeef  1231
.  0.2 Pbeef  0.08 Ppork  0.007 Pbeans  0.005 Pcorn  0.02CAP

Forecasts are obtained for the demand and supply shifters:

+ 0.03 (5) + 0.01 (4) + 0.04 (20) + 0.01 (250) = + 3.49

- 0.08 (5) - 0.007 (3) - 0.005 (2) + 0.02 (30) = + 0.169

effect of demand shifters effect of supply shifters

In-Class Exercise 1-c (ii)
Consider the following demand equation for beef products:
Q dbeef  0.01  0.5 Pbeef  +0.03 Ppork  0.01Pchicken  0.04 M  0.01SPPD
3.49

Consider the following supply equation for beef products:

Q sbeef  1231
.  0.2 Pbeef  0+.080.169
Ppork  0.007 Pbeans  0.005 Pcorn  0.02CAP

The demand equation can be written as: What would

happen to the
Q dbeef  350
.  0.5 Pbeef demand
equation if
there is an
The supply equation can be written as: increase in
consumer
Q sbeef  140
.  0.2 Pbeef income?
 In-Class Exercise 1-c (iii)
The demand equation is: The supply equation is:
Q dbeef  350
.  0.5 Pbeef Q sbeef  140
.  0.2 Pbeef

P
Supply

P*

Demand
Qd, Qs
Q*

Graphically solve for the equilibrium price and quantity.

Algebraically solve for the equilibrium price and quantity.

Work Space for In-Class Exercise 1-c (i)
The demand equation is: The supply equation is:
Q dbeef  350
.  0.5 Pbeef Q sbeef  140
.  0.2 Pbeef

The equilibrium condition is:

Q dbeef  Q sbeef

3.50 - 0.5 Pbeef = 1.40 + 0.2 Pbeef

Pbeef = 3

Qdbeef = 3.5 - 0.5 (3) =2

Qsbeef = 1.4 + 0.2 (3) =2
 Work Space for In-Class Exercise 1-c (ii)

The demand equation is:

Q dbeef  350
.  0.5 Pbeef

If Pbeef = 0, then Qdbeef = 3.5 (P,Q) = (0, 3.5)

If Qdbeef = 0, then Pbeef = 7 (P,Q) = (7, 0)

The supply equation is:

Q sbeef  140
.  0.2 Pbeef

If Pbeef = 0, then Qsbeef = 1.4 (P,Q) = (0, 1.4)

If Qsbeef = 0, then Pbeef = -7 (P,Q) = (-7, 0)
 Work Space for In-Class Exercise 1-c (iii)

The demand equation is: P

Q dbeef  350
.  0.5 Pbeef
7
(P,Q) = (0, 3.5)
(P,Q) = (7, 0)
1.4 3.5
Q
The supply equation is:
Q sbeef  140
.  0.2 Pbeef

(P,Q) = (0, 1.4) -7

(P,Q) = (-7, 0)
 END OF
LECTURE 1