MBA 773, Week 2:

Equilibrium Prices
Professor Jesse Davis, Fall 2022
Agenda: Equilibrium Prices
1. Market Clearing
1. Solving for the Equilibrium
2. Shifts in Supply & Demand
3. Activity: Demand for Bagels (Thursday)
2. Elasticity
1. Elasticity & Revenue
2. Drivers of Elasticity
3. Perfectly Elastic/Inelastic
4. Brand v. Market
5. Short-run v. Long-run
3. Microeconomics in the News
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Market clearing, mathematically
We can solve for the equilibrium using our demand/supply equations.

Suppose we’re given the following equations for the natural gas market:

Supply: qs = 2,000,000*(3 - 4plabor + 2p)

Demand: qd = 4,000,000*(7 + 3pcoal – 1.5p)

Initially, you believe that plabor = 12 and pcoal = 16:

qs = 2,000,000*(3 - 4(12) + 2p) = 2,000,000*(-45+ 2p)

qd = 4,000,000*(7 + 3(16) – 1.5p) = 4,000,000*(55 – 1.5p)

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Market clearing, mathematically
Applying our market-clearing conditions (qs = qd):
(Supply) 2,000,000*(-45+ 2p) = 4,000,000*(55 – 1.5p) (Demand)
-45 + 2p = 110 – 3p
5p = 155
p* = 31
We can substitute p* into either the supply or demand equation:
q* = 2,000,000*(-45+ 2p*)
q* = 2,000,000*(-45+2(31))
q* = 34,000,000

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Example: Impact of Shifting Demand
Suppose you are given the following equations for the natural gas
market in North Carolina.

Supply: qs = 2,000,000*(3 - 4plabor + 2p)

Demand: qd = 4,000,000*(7 + 3pcoal – 1.5p)

Suppose that plabor = 12 (as before) but pcoal increases from 16 to 18.
1. Qualitatively, what should happen to p*/q* (relative to before)?
2. What is the new demand equation?
3. What is the new equilibrium price/quantity?

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Example: Impact of Shifting Demand

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Impact of shifting demand, mathematically
Let’s return to the natural gas supply/demand equations from earlier:

Supply: qs = 2,000,000*(3 - 4plabor + 2p)

Demand: qd = 4,000,000*(7 + 3pcoal – 1.5p)

Suppose that plabor = 12 (as before) but pcoal increases from 16 to 18.
1. An increase in the price of coal increases demand; this should lead to an
increase in both the price and quantity!
2. Substituting the new price of coal into our demand equation:

qd = 4,000,000*(7 + 3(18) – 1.5p) = 4,000,000*(61 – 1.5p)

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Impact of shifting demand, mathematically
3. Applying our market-clearing conditions (qs = qd):
(Supply) 2,000,000*(-45+ 2p) = 4,000,000*(61 – 1.5p) (Demand)
-45 + 2p = 122 – 3p
5p = 167
p* = 33.4 > 31
We can substitute p* into either the supply or demand equation:
q* = 2,000,000*(-45+ 2p*)
q* = 2,000,000*(-45+2(33.4))
q* = 43,600,000 > 34,000,000

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Impact of shifting demand
D1
D2
Price

As demand shifts, we move

along the supply curve!

• When demand shifts …

p2
Supply • … price and quantity move
p1
in the same direction.
– Demand unambiguously
affects revenue
q1 q2 Quantity

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Example: Impact of Shifting Supply
Suppose you are given the following equations for the natural gas
market in North Carolina.

Supply: qs = 2,000,000*(3 - 4plabor + 2p)

Demand: qd = 4,000,000*(7 + 3pcoal – 1.5p)

Suppose that plabor = 10 (instead of 12, as before) and pcoal remains 18.
1. Qualitatively, how does the change in plabor affect p*/q*?
2. What is the new supply equation?
3. What is the new equilibrium price/quantity?

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Example: Impact of Shifting Supply

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Impact of shifting supply, mathematically
Let’s return to the natural gas supply/demand equations from earlier:

Supply: qs = 2,000,000*(3 - 4plabor + 2p)

Demand: qd = 4,000,000*(7 + 3pcoal – 1.5p)

Suppose that plabor = 10 (instead of 12, as before) and pcoal remains 18.
1. A decrease in the price of labor increases supply; this should lead to a
decrease in the price but an increase in the quantity!
2. Substituting the new price of labor into our supply equation:

qs = 2,000,000*(3 – 4(10) + 2p) = 2,000,000*(-37 + 2p)

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Impact of shifting supply, mathematically
3. Applying our market-clearing conditions (qs = qd):
(Supply) 2,000,000*(-37+ 2p) = 4,000,000*(61 – 1.5p) (Demand)
-37 + 2p = 122 – 3p
5p = 159
p* = 31.8 < 33.4
We can substitute p* into either the supply or demand equation:
q* = 2,000,000*(-37+ 2p*)
q* = 2,000,000*(-37+2(31.8))
q* = 53,200,000 > 43,600,000

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Impact of shifting supply
Demand
Price

As supply shifts, we move

along the demand curve!

• When supply shifts …

p1 S1
S2 • … price and quantity move
p2
in the opposite direction.
• The impact of a supply shift
on revenue is uncertain
q1 q2 Quantity

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Price elasticity (ε)
• The most common measure of elasticity examines how the quantity
changes with respect to the price.
• For large changes, we can use the arc price elasticity:
∆𝑞
(𝑞2 + 𝑞1 )/2
∆𝑝
(𝑝2 + 𝑝1 )/2
• As the change in price ↓, this becomes the point price elasticity:
𝜕𝑞 This is the derivative of
𝑞 𝑝 𝜕𝑞
𝜀= = ∗ the demand/supply
𝜕𝑝 𝑞 𝜕𝑝
𝑝
function

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Example: price elasticity
• Suppose you are given the following demand/supply equations:
qd = 16 – 2p and qs = -2 + p
I will always
• This implies that:
give you this
∂qd/∂p = -2 and ∂qs/∂p = 1 information
• What are the price elasticities at the equilibrium?
1. Solve for the equilibrium price/quantity:
(Demand) 16 – 2p = -2 + p (Supply)
18 = 3p
6 = p*
q* = 16 – 2p* = 16 – 2(6) = 4

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Example: price elasticity
• Suppose you are given the following demand/supply equations:
qd = 16 – 2p and qs = -2 + p
I will always
• This implies that:
give you this
∂qd/∂p = -2 and ∂qs/∂p = 1 information
• What are the price elasticities at the equilibrium?
2. Substitute into the elasticity formula:
𝑝 𝜕𝑞𝑑 6
𝐸𝑙𝑎𝑠𝑡𝑖𝑐𝑖𝑡𝑦 𝑜𝑓 𝐷𝑒𝑚𝑎𝑛𝑑 𝜀𝑑 = ∗ = ∗ (−2) = −3
𝑞 𝜕𝑝 4
𝑝 𝜕𝑞𝑠 6 Note: even though
𝐸𝑙𝑎𝑠𝑡𝑖𝑐𝑖𝑡𝑦 𝑜𝑓 𝑆𝑢𝑝𝑝𝑙𝑦 𝜀𝑠 = ∗ = ∗ (1) = 1.5 the slope is constant
𝑞 𝜕𝑝 4
the elasticity is NOT
as the price/quantity
pair changes.

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Impact of supply on revenue
Demand
Price

Suppose supply shifts out:

1. The quantity sold increases,
increasing revenue…
2. … but the price at which each
p1 S1 unit is sold decreases, which
S2
p2 lowers revenue

Net impact depends upon the relative

change in price/quantity
q1 q2 Quantity

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Impact of supply on revenue
Demand
Price

Suppose supply shifts out:

1. The quantity sold increases,
increasing revenue…
2. … but the price at which each
p1 S1 unit is sold decreases, which
S2
p2 lowers revenue

Net impact depends upon the relative

change in price/quantity
q1 q2 Quantity

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How responsive is demand?
• When the demand curve is
Price

Demand “flat”, demand is price-

sensitive:

– A small change in the price

p1 S1
S2 is accompanied by a large
p2 change in the quantity
– E.g., a decrease in the price
is dominated by the
increase in the quantity
q1 q2 Quantity

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How responsive is demand?
Demand • When the demand curve is
Price

“steep”, demand is price-

insensitive:

– A large change in the price

S1
S2 leads to a small change in
p1
the quantity
p2
– E.g., a decrease in the price
dominates the increase in
the quantity sold
q1q2 Quantity

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Example: Price Elasticity
Suppose you are given the following demand equation:
qd = 60 – 2p2
This implies that:
∂qd/∂p = -4p

1. What is the price elasticity when p = 1? When p = 4?

2. What happens to revenue as the price rises from p = 1 to p = 2?
And from p = 4 to p = 5?

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Example: Price Elasticity
• Suppose you are given the following demand equation:
qd = 60 – 2p2
• This implies that:
∂qd/∂p = -4p

1. What is the price elasticity when p = 1? When p = 4?

𝑝 𝜕𝑞𝑑 𝑝 −4𝑝2
𝜀𝑑 = ∗ = ∗ (−4𝑝) =
𝑞 𝜕𝑝 60 − 2𝑝2 60 − 2𝑝2
– When p = 1, ε = (-4(1)2)/(60-2(1)2) = -4/58 ≈ -0.07
– When p = 4, ε = (-4(4)2)/(60-2(4)2) = -64/28 ≈ -2.3

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Example: Price Elasticity
• Suppose you are given the following demand equation:
qd = 60 – 2p2
• This implies that:
∂qd/∂p = -4p
2. What happens to revenue as the price rises from p = 1 to p = 2? And from p = 4 to
p = 5? Revenue is p*q = p*(60-2p2)

• p = 1, Revenue = (1)*(60-2(1)2) = (1)*(58) = 58 Increases from

• p = 2, Revenue = (2)*(60-2(2)2) = (2)*(52) = 104 p = 1 to 2

• p = 4, Revenue = (4)*(60-2(4)2) = (4)*(28) = 112 Decreases from

• p = 5, Revenue = (5)*(60-2(5)2) = (5)*(10) = 50 p = 4 to 5

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Example: Price Elasticity
• Suppose you are given the following demand equation:
qd = 60 – 2p2
• This implies that:
∂qd/∂p = -4p
2. What happens to revenue as the price rises from p = 1 to p = 2?
And from p = 4 to p = 5?
– Revenue is p*q = p*(60-2p2)
• p = 1, Revenue = (1)*(60-2(1)2) = (1)*(58) = 58 The quantity barely falls
• p = 2, Revenue = (2)*(60-2(2)2) = (2)*(52) = 104 as we move from p =1 to
p =2 and we can charge a
• p = 4, Revenue = (4)*(60-2(4)2) = (4)*(28) = 112 an extra dollar for the 52
• p = 5, Revenue = (5)*(60-2(5)2) = (5)*(10) = 50 that we still sell.

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Example: Price Elasticity
• Suppose you are given the following demand equation:
qd = 60 – 2p2
• This implies that:
∂qd/∂p = -4p
2. What happens to revenue as the price rises from p = 1 to p = 2?
And from p = 4 to p = 5?
– Revenue is p*q = p*(60-2p2)
• p = 1, Revenue = (1)*(60-2(1)2) = (1)*(58) = 58 The quantity falls quickly
• p = 2, Revenue = (2)*(60-2(2)2) = (2)*(52) = 104 as we move from p =4 to
p =5 and we can charge a
• p = 4, Revenue = (4)*(60-2(4)2) = (4)*(28) = 112 an extra dollar only on the
• p = 5, Revenue = (5)*(60-2(5)2) = (5)*(10) = 50 10 that we still sell.

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Demand elasticity and revenue
If revenue increases when the price decreases, the

1. If ε < -1, revenue falls as the price increases consumer demand is elastic, which implies that the
elasticity of demand must be less than -1.

– The quantity purchased ↓ more quickly than the ↑ in the price.

– We say that demand is “elastic” in this region, i.e., demand is more
price-sensitive (i.e., the curve is “flatter”)
2. If ε = -1, revenue is unchanged for a “small” change in the price
– The ↓ in the quantity purchased exactly offsets the price ↑.
3. If ε > -1, revenue increases as the price increases
– The quantity purchased ↓ less quickly than the ↑ in the price.
– We say that demand is “inelastic” in this region, i.e., demand is less
price-sensitive (i.e., the curve is “steeper”)

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What drives demand elasticity?
Demand becomes more inelastic when the good …
• Has a lack of available substitutes
– If there’s nothing else to purchase which serves the
purpose, you are less likely to change your buying behavior
• Is a small fraction of a consumer’s expenditures
– A 10% change in the price of toothpaste will generate a
different response than a 10% change in rent
• Is a necessity
– Medicine, water, electricity, food staples

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Perfectly elastic/inelastic demand
Perfectly inelastic
Price

• Perfectly inelastic: the same

quantity is demanded at any price

• Perfectly elastic:
p* – At any price above p*
• Consumers demand zero
– At any price below p*
Perfectly elastic • Consumers demand an
infinite amount

Quantity

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Perfectly elastic/inelastic supply
Perfectly inelastic
Price

• Perfectly inelastic: the same

quantity is supplied at any price

• Perfectly elastic:
p* – At any price above p*
• Suppliers produce an infinite
amount

Perfectly elastic – At any price below p*

• Suppliers produce zero

Quantity

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Market-level versus Brand-level
Generally believe that market-level elasticity of demand is lower
than brand-level elasticity of demand. Why?
Demand for gasoline

Price
Price

Demand for Shell gasoline

S2
p1
p2 S1 p1
S1 S2
p2

q1 q2 Quantity q1q2 Quantity

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Long-run versus Short-run
In most cases, elasticity of demand/supply is higher in the long-
run than over the short-run. Why?
Short-run supply

Price
Short-run demand
Price

pn Long-run demand
po pn
po
Long-run supply

ql q s qo Quantity qo qs ql Quantity

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Long-run versus Short-run
• For most goods, it takes consumers time to adjust their buying
habits in response to a change in prices.
– E.g., an increase in the price of electricity doesn’t lead to an
immediate boom in demand for solar panels
• At the same time, it takes suppliers time to modify production in
response to a change in prices
– E.g, even if demand for SUV’s increases, switching production in an
automotive factory takes time, training
• One common exception to this intuition: durable goods
– For example, if the price of a durable good goes up, we may choose
not to buy it today, even though in the long-run, we will eventually do
so, even at the higher price.

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Microeconomics in the News
• “Drivers Endure Near-Record Gas Prices During July 4 Travel”,
7/1/22
• “The World’s Hottest Smartphone Brand Is Chinese – And It Isn’t
Huawei”, 8/23/21
• “Western Wildfires Lift Lumber Prices”, 7/22/21
• “Store Brands Eye a Bigger Share of the Dinner Plate”, 5/22/20
• “Peet’s Coffee Owner Brews $2.2 Billion IPO”, 5/18/20
• “Grocery Delivery Strains to Meet Voracious Demand”, 3/18/20
• “Latest Spin on Laundromats Includes Pastries, Movie Nights and
Maybe Even Karaoke”, 5/28/19

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