Theory of Supply and Demand
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- Market equilibrium
- The market equilibrium is where the supply and demand curves cross
- The market clearing price is the price (y-coordinate) at which the market equilibrium occurs
- Determinants of supply and demand
These cause an increase in demand (shift demand curive to the right):
- Positive change in preference (e.g. successful ads)
- increase in the price of substitute, or decrease in price of complements
- increase in income if we have a normal good, or a decrease in income if we have an inferior good
- increase in # of buyers
- future expectations of higher income, higher prices, shortgages
- lower taxes or higher subsidies
- regulations that promotes use
These cause an increase in supply (shift supply curive to the right):
- decrease in input costs (material, wage, etc.)
- decrease in the price of a substitute in production or increase in the price of a joint product
- better technology
- increase in # of sellers
- future expectations of lower prices
- lower taxes or higher subsidies
- regulations that lessens restrictions
- Price and quantity controls
- Elasticity
Elasticity measures the responsiveness of demand to price changes (more precise definition below)
The increase of these cause an increase in elasticity (increases the value {$e$} defined below):
- number of close subsititues
- proportion of income spent on the good
- time available to respond to the price changes
- lack of importance (more non-essential -> more elasticity)
- Price, income, and cross-price elasticities of demand
- Price elastisticity of demand:
{$e = $}(percentage change in quantity demanded) / (percentage change in price)
{$ = $}(Change in quantity divided by average quantity) / (Change in price divided by average price)
{$ = $}((1 / (Slope of Demand Curve)) multiplied by ((Average Price)/(Average Quantity))
If {$e < 1$}: Demand is inelastic. If {$e > 1$}: Demand is elastic.
Steeper demand curve is less elastic than a flatter demand curve
Demand curve is vertical => price has no bearing on the quantity demanded => elasticity = 0
Demand curve is horizontal => any change of price results in 0 quantity demanded => elasticity = infinite
Demand curve is usual (having nonzero, finite slope) => At the midpoint the elasticity is 1; below that we have smaller {$P/Q$} so {$e<1$} and demand is inelastic; above that we have elastic demand.
- Income elasticity = (percentage change in amount bought) divided by (percentage change in income)
If income elasticity < 0: Inferior good; if income elasticity > 0: Normal good.
- Cross-Price Elasticity = (percentage change in amount of A bought) divided by (percentage change in price of B)
If cross-price elasticity < 0: Complement goods; if cross-price elasticity > 0: A and B are substitutes of each other.
- Price elasticity of supply
Price elastisticity of supply:
{$e = $}(percentage change in quantity supplied) / (percentage change in price)
- Consumer surplus, producer surplus, and market efficiency
- Consumers' surplus is the difference between the value in use of an item and its value in exchange. It's the difference between the maximum a person is willing to pay for a good and the actual amount that he does pay. Graphically it's the area bounded by the y axis, under the demand curve, and the equilibrium price.
- Producers' surplus is the difference between the actual price and the minimum that the producer is willing to sell for. Graphically it's the area bounded by the y axis, above the supply curve, and the equilibrium price.
- Tax incidence and deadweight loss
Tax imposed on consumer means demand falls => demand curve shifts down => this divides the two regions previously (consumer surplus and producer surplus) into 4: a area of tax revenue, sandwiched by the new consumer and producer surplus, and a deadweight loss that is lost to everyone (consumer, producer, tax collector).