Chapter 2 - Demand and supply analysis. This chapter presents the following content: Motivation – U.S. corn markets, competitive markets defined, the market demand curve, the market supply curve, equilibrium, characterizing demand and supply – elasticity, back of the envelope techniques.
Chapter 2 Copyright (c)2014 John Demand and Supply Analysis 1 Motivation – U.S corn markets Competitive Markets Defined The Market Demand Curve The Market Supply Curve Equilibrium Characterizing Demand and Supply – Elasticity Back of the Envelope Techniques Chapter Two Copyright (c)2014 John Chapter Two Overview Motivations Example: U.S Corn Market Historical price: $2.00 per bushel fell below $2.00 per 20042005: Prices bushel rose above $5.00 per 20062008: Prices bushel 20082009: Prices fell to $3.90 per bushel Why prices vary so much? Changes in Supply and Demand conditions affects pattern of prices Chapter Two Copyright (c)2014 John 20032004: Prices rose to $3.00 per bushel Motivations Example: U.S Corn Market 2002-2003 • • 2004-2005 • • Unexpectedly large U.S corn crops 2006-2008 • • • • Decrease in supply due to drought in the corngrowing states Changes in U.S government policy Bubble years Increase in production costs due to oil price increases and rains and flooding wiped out corn crop 2008-2009 • • Weather conditions back to normal Economic Crisis Chapter Two Copyright (c)2014 John • Defined: Competitive Markets are those with sellers and buyers that are small and numerous enough that they take the market price as given when they decide how much to buy and sell Chapter Two Copyright (c)2014 John Competitive Markets Defined: The Market Demand Function tells us that the quantity of a good all consumers in the market are willing to buy is a function of various factors Chapter Two Copyright (c)2014 John The Market Demand Function Market Demand Derived Demand • • The part of demand for a good that is derived from the production and sale of other goods Direct Demand • The part of demand for a good that comes from the desire of buyers to directly consume the good itself Chapter Two Copyright (c)2014 John • Defined: The Market Demand Curve plots the 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 Chapter Two Copyright (c)2014 John The Market Demand Curve Defined: The Law of Demand states that the quantity of a good demanded decreases when the price of this good increases Chapter Two Copyright (c)2014 John The Law of Demand Demand Curve Rule A move along the demand 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 consumers’ willingness to pay for the good results in a shift in the demand curve for the good Chapter Two 10 Copyright (c)2014 John Defined: Price Elasticity • • Slope is the ratio of absolute changes in quantity and price (= Q/ P) Elasticity is the ratio of relative (or percentage) changes in quantity and price Chapter Two 28 Copyright (c)2014 John Elasticity is not slope Price Elasticity Key Characteristics: • • When a one percent change in price leads to a greater than one-percent change in quantity demanded, the demand curve is elastic ( Q,P < -1) When a one-percent change in price leads to a less than one-percent change in quantity demanded, the demand curve is inelastic (0 > Q,P > -1) When a one-percent change in price leads to an exactly one-percent change in quantity demanded, the demand curve is unit elastic ( Q,P = -1) Chapter Two 29 Copyright (c)2014 John • Elasticity – Linear Demand Curve Where: • a and b are positive constants • p is price • b is the slope • a/b is the choke price Re-writing, we have: P = a/b – (1/b)P Elasticity is: εQ,P = (ΔQ/ ΔP)(P/Q) = -b(P/Q) Elasticity falls from to slope is constant along the linear demand curve, but Example: Calculate elasticity when P = 30 and Qd = 400 – 10P Answer: εQ,P = -3 “elastic” Chapter Two 30 Copyright (c)2014 John Qd = a – bP Elasticity – Linear Demand Curve P a/b Q,P = - a/2b • Q,P = -1 Inelastic region Q,P = 0 Q a a/2 Chapter Two 31 Copyright (c)2014 John Elastic region Constant Elasticity vs Linear Demand Curv Price P • Observed price and quantity Constant elasticity demand curve Linear demand curve Q Quantity Chapter Two 32 Copyright (c)2014 John Linear Demand Curve: Qd = a -bP εQ,P = (ΔQ/ ΔP)(P/Q) = -b(P/Q) Constant Elasticity Demand Curve: Qd = aP-b εQ,P = -b 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 Demand is inelastic • Fall in Q < Rise in P Chapter Two TR falls TR falls 33 Copyright (c)2014 John • Determinants of Price Elasticity of Demand Availability of Substitutes – – • Necessities versus Luxuries – • Necessities → less price elastic Importance in Buyer’s Budget – • More substitutes → more price elastic Goods which have price inelastic at the market level, like cigarettes, can be highly price elastic at the brand level Copyright (c)2014 John • More important → more price elastic Time Horizon – Long-run → more price elastic Chapter Two 34 Elasticity in the Longrun versus the Short run • • • Long-run demand curve – demand curve when consumers can fully adjust their purchase decisions to changes in price Short-run demand curve – demand curve when consumers can fully adjust their purchase decisions to changes in price Long-run supply curve – supply curve when sellers can fully adjust their supply decisions to changes in price Short-run supply curve – supply curve when sellers can 35 Chapter Two fully adjust their supply decisions to changes in price Copyright (c)2014 John • Defined: The Durable Good is a good that provides valuable services over a long time (usually many years) Demand for non-durables is less elastic in the short run when consumers can only partially adapt their behavior Demand for durables is more elastic in the short run because consumers can delay purchase Chapter Two 36 Copyright (c)2014 John Durable Goods Copyright (c)2014 John Other Elasticities Chapter Two 37 Source: Gasmi, Laffont and Vuong, "Econometric Analysis of Collusive Behavior in a Soft Drink Market," Journal of Economics and Management Strategy (Summer, 1992) 278-311 Chapter Two 38 Copyright (c)2014 John Elasticities & the Cola Wars Estimating Elasticity Chapter Two 39 Copyright (c)2014 John Estimating Demand & Supply Estimating Demand & Supply U.S. Boilers 1990 Chapter Two 40 Copyright (c)2014 John Example: Estimating Demand & Supply We can “identify” the slope of supply by a shift in demand We can “identify” the slope of demand by a shift in supply This technique only works if one or the other of the curves stays constant Chapter Two 41 Copyright (c)2014 John From Past Shifts • Market Demand Function and Curve • Market Supply Function and Curve • Equilibrium • Measures of Elasticity • Back-of-the-Envelope Calculations Chapter Two Copyright (c)2014 John Chapter Two Main Points 42 ... Copyright (c )20 14 John 20 03? ?20 04: Prices rose to $3.00 per bushel Motivations Example: U.S Corn Market 20 0 2- 2003 • • 20 04 -2 0 05 • • Unexpectedly large U.S corn crops 20 06 -2 0 08 • • • • Decrease... = -3 “elastic” Chapter Two 30 Copyright (c )20 14 John Qd = a – bP Elasticity – Linear Demand Curve P a/b Q,P = - a/2b • Q,P = -1 Inelastic region Q,P = 0 Q a a /2 Chapter Two 31 Copyright (c )20 14... Envelope Techniques Chapter Two Copyright (c )20 14 John Chapter Two Overview Motivations Example: U.S Corn Market Historical price: $2. 00 per bushel fell below $2. 00 per 20 04? ?20 05: Prices bushel