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Price Theory

Lecture 2: Supply & Demand
I
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The explanation works by looking at two different
groups – buyers and sellers – and asking how they interact
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Types of Competition

The supply-and-demand model relies on a high degree of competition, meaning that there
are enough buyers and sellers in the market for bidding to take place
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The equilibrium is a point at which all the bidding has been done;
nobody has an incentive to offer higher prices or accept lower prices
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Imperfect competition exists
when a single buyer or seller has the power to influence the price on the market
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This is an abstraction, because no market is actually perfectly competitive,
but the supply-and-demand framework still provides a good approximation for what is
happening much of the time
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The Concept of Demand

Used in the vernacular to mean almost any kind of wish or desire or need
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Quantity demanded (Qd) is the total amount of a good that buyers would choose to
purchase under given conditions
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We could talk about the relationship between quantity demanded and any one of these
things
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The Law of Demand states that when the price of a good rises, and everything else
remains the same, the quantity of the good demanded will fall
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In this context, it means that income, wealth, prices of other
goods, population, and preferences all remain fixed
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Lots of things tend to
change at once
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The whole point
is to try to discover the effects of something without being confused or distracted
by other things
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But by and large the law seems to hold
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Please note that this is different from the book’s definition of normal
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It is a curve or line, each point of which is a priceQd pair
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Changes in demand or shifts in demand occur when one of the determinants of demand
other than price changes
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”
The demand curve’s current position depend on those other things being equal, so when
they change, so does the demand curve’s position
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The price of a substitute good drops
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2
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This implies a rightward shift
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Incomes increase
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4
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This could cause a shift in either direction, depending on
how preferences change
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Remember that quantity demanded is a specific
amount associated with a specific price
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“Change in quantity demanded” means a movement along the demand curve
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IV
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Again, economists think of it differently
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Quantity supplied (Qs) is the total amount of a good that sellers would choose to produce
and sell under given conditions
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When we talk about Supply, we’re talking about the relationship between quantity
supplied and the price of the good, while holding everything else constant
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” In short,
↑P → ↑Qs
A Supply Curve is a graphical representation of the relationship between price and
quantity supplied (ceteris paribus)
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That point shows the amount of the good sellers would choose to sell at that price
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Examples:
1
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This would cause a leftward shift the
supply curve
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A rise in the price of an alternative good that could be provided with the same
resources
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3
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This leads to a rightward shift of supply
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Analogous to the demand versus quantity demanded
distinction
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“Change in supply” refers to a shift of the supply curve, caused by something other than a
change in price
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Constructing the Market

Putting demand and supply together, we can find an equilibrium where the supply and
demand curve cross
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The equilibrium must satisfy the market-clearing condition,
which is Qd = Qs
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1Qd and P = 5 +
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In equilibrium,
Qd = Qs, so we have a system of equations
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1Q = 5 +
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15Q
Q* = 100
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1(100) = 10
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If price is below P*, at PL, then we have Qd > Qs
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” The quantity that actually occurs will be Qs
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If price is below P*, at PH, then we have Qs > Qd
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” The suppliers will start competing against each other for customers by
lowering the price
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This is implied by the requirement of voluntarism
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Price Controls

Price floors and price ceilings are government mandated prices that attempt to control the
price of a good or service
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To have any effect, it must be imposed below the market price
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What effect do we predict? As with any below-equilibrium price in the example
above, we expect to get a shortage
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Using the short-side rule, we discover that rent control actually reduces the
amount of housing made available to the public
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From the demand curve, we can see that consumers would be willing to pay a
very high price (much higher than the price ceiling or even the market price) for
the reduced quantity (Qs) available
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N
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: If the price ceiling is imposed above the market price, it has no effect
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To have any effect, it must be set above the market price
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These are imposed, usually, because farm lobbies have convinced the legislature
that they are not earning enough to stay in business
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And
for many years, that’s exactly what the U
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had
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Note: If the price floor is imposed below the market price, it has no effect
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An effective price ceiling
is below the market price, while an effective price floor is above it
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)
VII
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This could be caused by many things: an
increase in income, higher price of substitute, lower price of complements, etc
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[↑P*, ↑Q*]

P
S
P2
P1
D1

D2
Q

Q1 Q2

Example: Consider the market for rental housing, and suppose that a new factory
or industry opens up in the city, attracting more residents
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Note: The price of
housing does go up, but not by as much as you might think, because the change in
demand induces suppliers to bring more housing to market
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A leftward shift of demand would reverse the effects: a fall in both price and quantity
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Now consider a rightward shift of supply (caused by lower factor price, better
technology, or whatever)
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[↓P*, ↑Q*
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The lower price of steel leads to a rightshift in the supply of cars,
so the price of cars falls and the quantity rises
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Now, what happens if both demand and supply both shift at once? In general, the two
changes have reinforcing effects on either price or quantity, and offsetting effects on the
other
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Incredible improvements in technology, as
well as the entry of many new firms into the industry, have increased supply
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The increase in demand tends to increase both P and Q
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So both effects tend to raise quantity
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Observation of the computer industry
shows that prices have actually fallen, so we can conclude that supply shifts have
been relatively more important than demand shifts in this market
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A possible complication: Much technological change has been in the form of
higher quality, and consumers shift demand from lower quality to higher quality
machines
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The price of a new, cutting edge computer has stayed about the same
over time, at about $2000
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(This example may not be totally accurate
historically, but it demonstrates the point
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Meanwhile,
demand has increased because jobs for educated people have become increasingly
attractive relative to other jobs
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The decrease in supply tends to raise P while lowering Q
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But they
work in opposite directions on Q
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When analyzing situations where both supply and demand shift at once, don’t let yourself
be fooled by your graph
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But we know that one variable will experience an offsetting effect
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(Take the computer example above
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) Unless you are
provided with additional information about the size of the shifts, you can only make a
prediction about one variable
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Welfare Analysis
Aside from our positive observations about the effects of price controls (and other
policies), we can also do welfare analysis, which is a means of showing who gains and
who loses from these policies
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Definition of Consumer Surplus: the extra (or excess) value individuals receive from
consuming a good over what they pay for it
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The CS is above the price paid, below the demand curve, and
to the left of the quantity purchased
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Or, the dollar valued benefits to sellers
from all trade in a market
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S

PS
P

Q

Definition of Total Surplus: CS + PS
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Welfare analysis for a price ceiling
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The CS
extends further down, but not as far right, compared to the free market
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The transfer is
the portion of CS that used to be in PS, between the equilibrium price and the price
ceiling
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CS
DWL

S

P*
Pc
PS

Qc

Q*

D

Dead-weight loss (DWL) is the reduction in the total surplus that results from a policy
that prevents mutually beneficial trades from occurring
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The transfer is the portion of the total surplus that moves from CS to PS, or from PS to
CS, when a policy such as a price control displaces the market outcome
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In efficiency terms, the move from free market to the price-controlled market was not a
Pareto improvement
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But
the free market is Kaldor-Hicks superior to the price-controlled market, because the total
wealth is larger
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Note: The transfer is totally irrelevant from a (K-H) efficiency
perspective, because it remains in the total
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One thing this analysis leaves out is the effect of waiting, bribes, rental agency fees, and
other means of rationing the reduced quantity of the good
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Welfare analysis for a price floor
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But this time, there is a
transfer from the CS to the PS
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Some of the producers gain, if they are the
producers who get the privilege of selling the reduced quantity
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Overall, since the price floor produces both winners
and losers, the price floor regime and the free market are Pareto-incomparable
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IX
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It's not
enough to say, for instance, that a rise in price leads to a fall in quantity demanded (the
Law of Demand); we want to know how much quantity changes in response to price
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A flatter
demand curve represents a greater degree of responsiveness (for a supply or demand
curve), as shown in the above graphs: the flatter demand curve produces a larger change
in quantity for the same change in price
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The extremes are
easy to remember: A perfectly elastic demand curve is horizontal, because an infinitely
small change in price corresponds to an infinitely large change in quantity; the graph
looks like the letter E for elastic
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But using the slope can be misleading, because it doesn't tell us the significance of the
quantities
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That would not surprise us for gumballs, but it would certainly surprise us
for televisions
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This is why we use elasticity
instead of just the slope
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That is,
Ed = |%∆Qd/%∆P|
How do you find the percentage change in something? You find out how much it
changed, and divide by the initial value
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The change is $100, so the percentage change is $100/$400
=
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N
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: The percentage change depends on the direction you're going
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2
or down 20%
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When calculating the percentage change in a variable, instead of
dividing by the original point, they divide by the average of the two endpoints
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]
Thus, we can also write
Ed = |(∆Qd/Qd)/(∆P/P)|
Now, we can rearrange this like so:
Ed = |(∆Qd/∆P) × (P/Qd)|
Look at the first term, change in Q over change in P
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I say “basically” because when we talk about the slope of a line, we usually
measure the rise (vertical distance) over the run (horizontal distance)
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So actually, the slope is change in P
over change in Q
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If we use m to stand for
the slope, we have:
Ed = |(1/m) × (P/Qd)|
This is the easiest formula to use when you have a straight line for a demand curve
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1Qd
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1
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1)(40/100)| = 4
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1)(30/200)| = 1
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Notice that the elasticity is not the same at every point on a line
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” With arc
elasticity, you are finding the elasticity over a section of the demand curve
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” Point
elasticity tells you the elasticity at a single point – specifically, at the (P, Qd) point you
plug in
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We have the following definitions:
When Ed > 1, we say the curve is elastic at that point
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When Ed = 1, we say the curve is unit elastic at that point
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If you don’t take
the absolute value, you’ll get a negative elasticity, which means that the demand curve is
downward sloping
...
]
In general, any demand curve will have one point that is unit elastic, which means that a
one percent change in price corresponds to a one percent change in quantity
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We can find the unit elastic point by setting
Ed = 1
|(-1/
...
1Q)/Q| = 1
(50 -
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1
50 -
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1Q
50 =
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The price elasticity of supply is almost identical to the price elasticity of demand, except
using a different curve
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Since the supply curve is upward sloping, the
sign will be positive instead of negative
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Tax Incidence

So why is elasticity important? Many reasons, but here is one: it determines the
distribution of the burden of taxes
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Consider the following statements:
"If we raise the tax on cigarettes, tobacco companies will just pass the tax on to
consumers
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"The Social Security tax is divided between the employer and the employee
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"
This statement implies that the government can decide how the burden of the tax
will be distributed
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Consumers do not bear the
entire burden of a tax in most cases, but neither can the government decide who pays how
much
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The key to understanding tax incidence is to realize that a sales tax (in fact, almost any
kind of tax) is not a tax on a person -- it's a tax on a transaction
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It doesn't really matter who sends the check to the
government
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Suppose that you were previously willing to sell a pack of cigarettes for any price higher
than $2
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But with a $1 tax added to your costs, you're not willing to sell for anything
less than $3
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It’s like your cost of production has gone up by $1 per pack
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Consider the
following graph to see the result:

Stax
S
Pc
P*
Pp

D
Qt

Q*

The vertical distance between S and Stax is the amount of the tax ($1 in our example)
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But do the producers receive that price? No, they must receive a price that is $1
lower, at Pp
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The burden is distributed between the two of groups
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It is the triangle between the old S
and D, and between Qt and Q*
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But the gains from
trade from selling these units, while positive, is not large enough to cover the tax, so the
trades don't take place
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It depends on the elasticity of supply
and demand
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Then we get a picture like the one below
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Another way of thinking about this is in terms of CS and PS
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But
when demand is inelastic and supply is elastic, the CS is reduced by more and the PS is
reduced by less
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The general result is
that when demand is more elastic than supply, producers bear the larger burden, and
when supply is more elastic than demand, consumers bear the larger burden
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In the case of cigarettes, do you think the demand is
relatively elastic or relatively inelastic? Given the addictive quality of cigarettes, it seems
like demand is probably inelastic
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In the case of the Social Security tax, do you think
the supply of labor is relatively elastic or relatively inelastic? It's probably fairly inelastic
(people need to have their jobs, and almost all legal jobs are taxed), so the suppliers (i
...
,
the employees) probably bear most of the burden

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