1. 2. 3. 4. 5.

Competitive Markets Defined Market Demand Market Supply Market Equilibrium Characterizing Demand and Supply: Elasticity

1. Competitive Markets
Definition: 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. as opposed to monopolies and oligopolies (see later) A market is characterized along 3 dimensions: the commodity (what is traded on the market) the geography (where is the market) the time (when does the trade take place)
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2. Market Demand
Definition: the market demand function tells us how the total quantity of a good demanded depends on various factors: Qd = Q(P, Po, I,) Definition: 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,...) Qd = Q(P)
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Example: Qd = 100 - 2P
Convention! Economists always draw the quantity on the X-axis (endogenous variable) and the price on the Y-axis (exogenous variable) Therefore, we often define the inverse demand curve: P = P(Qd)

P = 50 - Qd/2

(draw!)
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Example: The Demand for New Automobiles in US, 90s

Price (thousands of dollars)

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Demand curve for automobiles in the United States

5.3

Quantity (millions of automobiles per year)

The Law of Demand

Definition: The law of demand is the empirical regularity that, all other things being equal, the quantity of a good demanded decreases when the price of this good increases. the demand curve is always downward sloping

Demand curve cte.

P P

Qd Q

Qd1

Qd2

Movement along the demand curve means a change in the own price of the good. If any other factor that affects the demand changes, the demand curve shifts

If the change increases the willingness of consumers to acquire the good, the demand curve shifts to the right (outward shift) If the change decreases the willingness of consumers to acquire the good, the demand curve shifts to the left (inward shift)
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3. Market Supply
Definition: the market supply function tells us how the quantity of a good supplied by the sum of all producers in the market depends on various factors: Qs = Q(P, Po, W,)

Definition: the market supply curve plots the aggregate quantity of a good that will be offered for sale at different prices, holding constant other

supply drivers

Qs = Q(P)
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Inverse supply curve: P = P(Qs) Example: Supply Curve for Wheat in Canada, 90s
Price (dollars per bushel)

Supply curve for wheat in Canada

0 0.15

Quantity (billions of bushels per year)

The Law of Supply

Definition: The law of supply is the empirical regularity that, all other things being equal, the quantity of a good offered increases when the price of this good increases. the supply curve is always upward sloping

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Supply curve cte.

P Qs P Qs1 Qs2

Movement along the supply curve means a change in the own price of the good. If any other factor that affects the supply changes, the supply curve shifts
If the change increases the willingness of producers to offer the good, the supply curve shifts right (outward shift) If the change decreases the willingness of producers to offer the good, the supply curve shifts left (inward shift)
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4. Market Equilibrium
Definition: A market equilibrium is a price such that, at this price, the quantities demanded and supplied are the same.

(Demand and supply curves intersect at equilibrium)

P
Qs

P*
Qd Q* Q 12

 There is no pressure for prices to change and we are in equilibrium. When a change in an exogenous variable causes the demand curve or the supply curve to shift, the equilibrium shifts as well.
P
Qs

P*2 P*1 Qd1 Q*1 Q*2

Qd2
Q 13

Example: the market of Cranberries

Demand: Supply: Qd = 500 4P Qs = 100 + 2P P = 125 Qd /4 P = 50 + Qs/2

P = price of cranberries (dollars per barrel) Q = demand or supply (in millions of barrels per year)

Step 1. Equate demand to supply to calculate the equilibrium price P*

Qd = QS 500 4P* = 100 + 2P* 600 = 6P* P* = 100

Step 2. Plug P* into demand or supply to get equilibrium quantity Q*

Q* = 500 4P* = 500 400 = 100
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Excess Supply and Excess Demand

Definition: If sellers cannot sell as much as they would like at the current price, there is excess supply. Example: Excess Supply in the Market for Cranberries
Price

Market Supply: P = 50 + QS/2

125
Excess Supply

P* = 100

Market Demand: P = 125 - Qd/4 50

Qd Q* QS

Quantity

There is downward pressure on the price until the equilibrium price is reached
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Definition: If buyers cannot buy as much as they would like at the current price, there is excess demand or undersupply.
Price

Market Supply: P = 50 + QS/2 125 P* = 100

Excess Demand

Market Demand: P = 125 - Qd/4

50

QS

Q*

Qd

Quantity

There is upward pressure on the price until the equilibrium price is reached
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5. Characterizing Demand and Supply 1. Price Elasticity of Demand

Definition: The own price elasticity of demand is the percentage change in quantity demanded brought about by a one-percent change in the price of the good.

Q
Q

,P

% change in demand % change in price

,P

( Q d / Q d ) Q d P ( P / P ) P Q d
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 The own price elasticity of demand is always negative (or zero) The price elasticity of demand plays an important role in business decisions: it determines the effect on total revenue due to a price increase Note: Elasticity is not simply equal to slope !
Slope is the ratio of absolute changes in quantity and price, ie, Qd/P. Elasticity is the ratio of relative changes in quantity and price, ie, (Qd/Qd)/(P/P).
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Elastic, Unit Elastic, and Inelastic

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)
d

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)
d

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)
d

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 In general: the price elasticity of demand depends on the P and Q we are measuring it in
Compare 2 functions (take linear demand curves)
P

P2 P1

P
QdB

The flatter the demand curve, the more price elastic the demand
Q
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QdA

Q d A
Q d B

Linear Demand Curve (ex. 1)

Demand: Qd = a bP a, b are positive constants

Inverse demand curve: P = a/b (1/b)Qd b is the slope of the demand function a/b is the choke price (price at which demand is zero) the elasticity is
Q
d

,P

= = = =

(Qd/P)(P/Qd) [((a b(P + P)) (a bP))/P][P/(a bP)] [(a bP bP a + bP)/P][P/(a bP)] [ bP/P][P/(a bP)]
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= bP/(a bP)

Linear Demand graphical representation

P Q,P = -

a/b

Elastic region

Note: the elasticity falls from 0 to along the linear demand curve, but the slope is constant.

a/2b

Q,P

= -1 Inelastic region

Q,P = 0
0 a/2

Q
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Linear demand - numeric example:

Qd = 400 10P
at P = 30 the elasticity is
Q
d

where a = 400 and b = 10

, P 30

= = = = =

b(30)/(a b(30)) (10)(30) / (400 (10)(30)) 300 / (400 300) 300 / 100 3

since Q,P=30 = 3 < 1, the demand at P = 30 is elastic

take P = 20 and P = 10

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Arc versus Point Elasticity

Arc elasticity
step level changes in quantity (Q) and price (P) the formula is Q,P = (Q/P)(P/Q) often quite difficult to calculate calculated elasticity depends on the step level size

Point elasticity

infinitely small changes in quantity (dQ) and price (dP)

the formula is
Q
d

,P

dQ d P dP Q d

See math course!

very easy to calculate, because dQ/dP is the derivative of the demand function Q with respect to the price P calculated elasticity is independent of step level size

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Constant Elasticity Demand Curve (ex. 2)

Demand: Q = a Pb inverse: P a Q
1 b 1 b

where a is a positive constant b is a negative constant

The price elasticity of demand

dQ abPb 1 dP
Qd ,P

dQ P b 1 P abP b b dP Q aP
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equals b, irrespective of the level of P and Q !

Example: A Constant Elasticity versus a Linear Demand Curve

Price

Note: as the price goes up from 0 to : - the elasticity of demand remains constant (Q,P = b)
- the slope of the demand curve goes from - to 0 (dQ/dp = bap(b 1))

0 Q

Observed price and quantity Constant elasticity demand curve Linear demand curve Quantity
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What affects the Price Elasticity of Demand?

Examples of factors that can affect own price elasticity: substitutability switching cost
product differentiation example: demand for all soft drinks is less elastic than demand for Coca-Cola

durability
definition: a durable good provides valuable services over a long time (usually many years) demand for durable goods is relatively elastic in the short run, because consumers and firms can delay purchase
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 The Long run demand versus the short run demand

Definition: the long-run demand curve is the demand that pertains to the period of time in which consumers can fully adjust purchase decisions to changes in price

in general: long run demand is more price elastic than the short run demand curve (more substitution) for durable goods: long run demand is less price elastic than the short run demand curve (necessity) Example: Demand for Commercial Aircraft (a durable good)
Price ($/airplane)
Long run demand curve for commercial airplanes

Short run demand curve for commercial airplanes

Quantity (aircraft/yr)

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2. Other elasticities
General definition of (point) elasticity

The elasticity of X with respect to Y: X ,Y

dX Y dY X

Definition: Price elasticity of supply (dQS/dp)(p/QS) is the effect of a (small) relative change in own price on the relative change in the quantity supplied Definition: Income elasticity of demand (dQd/dI)(I/Qd) is the effect of a (small) relative change in income on the relative change in the quantity demanded
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Definition: Cross-price elasticity of demand (dQd/dp2)(p2/Qd) is the effect of a (small) relative change in the price p2 of a different product on the relative change in the demanded quantity Qd of the original product
demand substitutes: if the price of one increases, the demand for the other increases = cross-price elasticity of demand > 0 demand complements: if the price of one increases, the demand for the other decreases = cross-price elasticity of demand < 0

Example: QD = 90 - 2P - 2PT demand for golf balls (T = titanium) Take P*=12 and PT=10
Q,P = -2 (12/46) = -0.52 demand is price inelastic 30 Q,PT = -2 (10/46) < 0 the goods are demand complements

Example: The Cross-Price Elasticity of Demand for Cars

Nissan Ford Lexus BMW Sentra Escort LS400 735i Sentra -6.528 0.454 Escort 0.078 LS400 0.000 735i 0.000 0.000 0.000 0.000

-6.031 0.001 0.001 0.001

-3.085 0.032 0.093 -3.515

Source: Berry, Levinsohn and Pakes (1995). Automobile Price in Market Equilibrium. Econometrica 63: 841-890.
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Example: Elasticities of Demand for Coke and Pepsi

Elasticity Price elasticity of demand Cross-price elasticity of demand Income elasticity of demand Coke -1.47 0.52 0.58 Pepsi -1.55 0.64 1.38

Source: Gasmi, Laffont and Vuong (1992). Econometric Analysis of Collusive Behavior in a Soft Drink Market. Journal of Economics and Management Strategy 1:278-311.
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1. First example of a simple microeconomic model of supply and demand (two equations and an equilibrium condition) 2. Elasticity as a way of characterizing demand and supply 3. Elasticity changes as market definition changes (commodity, geography, time) 4. Elasticity a very general concept

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