Supply and Demand

1. Supply and Demand Unit 1 Reading: KW Chapter 3,5,26

3. Learning Outcomes Students should be able to • Use supply and demand curve analysis to analyze the qualitative effects of shocks to a market. • Use demand and supply schedules to identify the quantitative equilibrium in a market. • Calculate the price elasticity of supply and demand from a supply schedule. • Calculate the revenue effect of a price change given elasticity. • Explain the determinants of income and price elasticities as well as other events that shift supply and demand curve. • Describe the equilibrium in the loanable funds market.

4. Gas prices at record high Prices of Oil and Gasoline continue to climb! What happens if Iranian oil is taken offline?

5. August 25, 2005 Rising Price of Oil Pushes S.&P. to Negative Territory By ERIC DASH Oil prices climbed to another record yesterday, driving stocks lower and leaving the Standard & Poor's 500-stock index down for the year. All three major market gauges closed lower yesterday; the S.&. P.'s loss meant that for the first time since July 7, all three were in negative territory for the year. "Once oil decided that it was going to move higher and stay higher, that just took the starch out of any buyers in the stock market," said Joseph Liro, the chief equity strategist at Stone & McCarthy, an economic research firm in Princeton. "Oil is just the biggest single depressant on the market except for the oil stocks."

6. Wall Street slides as oil prices climb Strong manufacturing report keeps losses in check Updated: 7:14 a.m. ET May 26, 2005 NEW YORK - Stocks moved lower Wednesday, as oil prices hovered near 51 dollars per barrel and investors adjusted their portfolios after the market’s recent rally. The higher oil prices overshadowed a strong report on manufacturing orders.

7. To think about commodity prices, economists first think about the theory of competitive markets • Competitive Markets have many buyers and many sellers who compete without barriers preventing rivals from entering or leaving the market. • Participants in competitive markets are price takers, agents who behave as if their own behavior has no effect on market prices.

8. Law of Demand:There is always an inverse relationship between the price of a good and the quantity that consumers would like to purchase. Reason: • Consumers have limited income. • The price that consumers will pay for an extra good will be no greater than the extra benefit that they receive from it. • People face diminishing returns from consuming any given good. • Each extra good consumed generates less marginal benefit than the good before • Consumers will be willing to pay less for each extra good than they were willing to pay for the good before.

9. Representations of Demand Curves • A demand curve is a price schedule which might be represented in three ways • Table • Graph • Algebraic Equation

10. Representation of a Hypothetical Oil Demand Schedule QD = 39214.5 ∙P-.061

11. Notes on Derivation of Oil Demand Curve • Guess convenient function Q = A∙P-ε • Get estimate of ε[JCB Cooper, OPEC Review 2003 estimates (short-run) price elasticity of demand of -.061 in US] • Use data to calculate A2005. [In 2005, average price of oil was US$56.5 per barrel (St. Louis Fed). Observed demand for oil was 30660 million barrels (USA Today).] • Calculate A = Q/P-ε: 39214.5 = 30660 /56.5-.061

12. Law of Supply: There is a positive relationship between the price of a good and the quantity producers bring to the market. • In a competitive market place, producers are willing to sell an extra good as long as the price is at least as large of the extra cost of producing it (marginal cost). • Producers have decreasing returns to production and therefore increasing costs. To induce them to produce greater amounts, they must be compensated for these increasing costs with higher prices.

13. Why do supply curves slope up? • Firms will only increase supply because their costs as production increases. • Producing extra goods generates increasing costs because some inputs are fixed and the flexible factors of production will have diminishing returns. • Example: A busy McDonalds can sell more burgers by adding more McWorkers, but effectiveness of workers is limited by amount of Cash registers, Ovens, and ultimately Space.

14. Representation of a Hypothetical Oil Supply Schedule QS = 26091∙P.04

15. Notes on Derivation of Oil Supply Curve • Guess convenient function QS = B∙Pε • Get estimate of ε[Recent OECD study estimates (short-run) price elasticity of supply of .04.] • Use data to calculate B2005. Calculate B = Q/Pε: B = 26091.0 = 30660 /56.5.04 Note: The demand shifter, A, contains all of the factors that determine demand that do not depend on price. Likewise, B, contains all the factors that shift supply other than price.

16. Equilibrium • Equilibrium in the competitive market occurs when the price is set at a level (P*) such that the amount that consumers want to buy is equal to the amount that sellers want to sell (Q*). Excess SupplyIf P were above equilibrium, sellers would want to sell more goods than buyers would want to buy. Competition between sellers would force prices down. Excess DemandIf P were below equilibrium, customers would want to buy more goods than people would want to sell. Competition between buyers would force prices up.

17. Competitive Market Equilibrium(Geometry) P D S P* Q* Q

18. Excess Supply P D S P* Q* Q

19. Excess Demand P D S P* Q* Q

20. Market Equilibrium(Spreadsheet) When price is below 55, demand is greater than supply When price is above 60, supply is greater than demand Equilibrium price is between 55 and 60

21. Market Equilibrium(Algebra) =

22. Elasticity: The Concept • How strong is the effect of a change in price on the change in quantity supplied or quantity demand. • If the price effect is strong, we say the supply/demand schedule is elastic. • If the price effect is weak, we say it is inelastic. Strict definition to come

23. Shifting Curves/Changing Equilibrium • Changes in equilibrium result from shifts in either the demand or supply schedule. We think of shifts in the curves as changes in supply or demand that are caused by factors other than changes in the price of the good. • Shifts in the demand curve lead to movements along the supply curve resulting in changes in prices and quantities that move in the same direction. • Shifts in the supply curve lead to movements along the demand curve resulting in changes in prices and quantities that move in different directions.

24. What shifts a demand curve? • Changes in consumer preferences • Changes in consumer income • Changes in the prices of other goods.

25. Hypothetical Demand Shift • Consider that there is an increase in consumer income sufficiently large that oil demand would increase by 5% if the price level stayed the same. This event will increase the demand for oil at any given price level. Demand schedule shifts out/up. • Equilibrium price and quantity rise. • At the old price level, there is a situation of excess demand. As consumers, scramble to get more oil, producers are able to raise prices. • Higher prices induce i) some cutbacks in oil use; and ii) some additional production until supply is equal to demand.

26. A Shift in the Demand Curve: A parallel increase in the demand schedule at every price point.Equilibrium Effect: Movement along the supply curve P S Shift in the demand curve P** D′ P* D Q* Q** Q

27. A shift in the demand schedule(Spreadsheet) A 5% shift in the demand schedule If price stayed constant, demand for oil would increase 5%. But to get producers to produce more, price must go up which will have a counter-veiling effect on demand. . New price level between 90 and 95, output increases by about 2%.

28. A shift in the demand curve (Algebra) • A 5% shift out in the demand curve is a 5% increase in the demand shifter A. A′ = 1.05∙A • We can calculate the % change in quantity and price simply by knowing the parameters and along with the size of the demand shift.

29. Shifts in Supply Curves • Supply curves represent the extra cost of producing a good which increases in the number of goods produced. But other factors may affect cost besides scale. • Cost Shifters • Changes in resource prices • Changes in Technology • Nature and Political Disruptions • Changes in Taxes on Producers

30. A Shift in the Supply Curve is a Movement along the Demand curve-Price and Quantity Move in opposite Directions P D S S′ P** P* Q** Q* Q

31. Equilibrium Effects of an Decrease in Supply • When there is some disruption, oil companies produce less at any given price. Supply schedule shifts in/up. • Equilibrium price rises/Equilibrium quantity falls. • At the current price level, there is a situation of excess demand. As consumers, scramble to get more oil, producers are able to raise prices. • Higher prices induce i) some cutbacks in oil use; and ii) some additional production from other sources; until supply is equal to demand.

32. Negative Supply Shock • Negative supply shock like embargo on Iranian oil would raise prices and reduce quantity of oil available. • But how much?

34. Elasticities Quantitative Measurement

35. Measuring the Impact of Price on Quantity Demanded • A natural way of measuring impact of a price change is to measure the change in quantity demanded relative in size to the change in prices. • This measure is the inverse of the SLOPE of the demand curve which is constant when the demand curve is linear (as often depicted in textbooks)

36. Economists often prefer elasticity to slope in real world • Economists typically do not measure the price impact using slope for 2 reasons. • Slope as a measure is not unit free, so price impacts are not comparable across types of goods or currency. • Empirical demand curves tend not to have constant slope or constant elasticity, but constant elasticity functions are a better approximation.

37. Elasticity:The % impact on quantity demanded of a 1% change in price • Economists prefer to measure price impacts in terms of elasticity since it is unit free (everything is measured in percentages) and a better match for empirical demand schedules.

38. How do you calculate a % change? • Standard measure of a percentage difference. Example: Rainfall in HK in 2005 is 3214.5mm In 2004, rainfall in HK it was 1738.6mm. What if it goes back in 2006 Q: In % terms, how much greater was rainfall in 2005 relative to 2004? Q: In % terms, how much less is rainfall in 2006, than in 2005?

39. Midpoint Method • If you want to calculate a % difference between two points which is the same regardless of which you designate as the reference point (denominator), you can use the average of the two points as the reference point. • The % difference in rainfall between 2004 and 2005 was 59.6%

40. Slope and Elasticity of Oil Demand

41. A shift in the supply schedule(Spreadsheet) A 4.9% shift in the supply schedule • At the new supply curve there is excess demand for oil. • Excess demand will induce additional supply and cut back in demand. • New price level between 90 and 95, output decreases by about 3%.

42. A shift in the supply curve (Algebra) • A 4.9% decrease reduces the supply shifter B. B′ = .951∙B. • We can calculate the % change in quantity and price simply by knowing the parameters along with the %-size of the supply shift.

43. What determines price elasticity? Availability of Substitutes • A price increase will lead to a shift away from the use of a product and toward other products. • Elasticity will be stronger the more readily available are substitutes for a good. • Particular brand of goods may have more elastic demand than broader category. Dairy Farm Milk may have better substitutes than Milk. • Some necessity goods like medicines may have no good substitutes and be demand inelastic. Frivolous goods might easily be foregone.

44. Elasticities Extreme P Perfectly Inelastic Demand (Insulin) D Perfectly Elastic Demand (Clear Pepsi) D Q

45. Comparisons of Demand Price Elasticities • Oil has very inelastic demand. • Estimate of elasticity of demand for oil in the US is -.061 J.C.B. Cooper, OPEC Review, 2003) • Price Elasticities of Other Goods

46. A demand curve is classified as INELASTIC if the elasticity is between 0 and -1 Unit elasticity (elasticity equal to -1) is the cutoff point A demand curve is classified as ELASTIC if the elasticity is less than -1

47. Elasticity and Revenues • The revenues generated by a firm along any point of the demand schedule are equal to the product of quantity demanded and price R = P∙QD • Raising prices has two counter-veiling effects: • a direct positive impact on revenues because each good sold generates more revenue. • a negative indirect impact because fewer goods will be sold. • Which is stronger?

48. Effect of price change on revenues • Changes in revenues are approximately %R ≈ %P+%Q • Divide through by %P to get the total impact

49. If the price elasticity of demand is • exactly UNITY, a price rise has no effect on total revenue • ELASTIC, a price rise will decrease revenues. • INELASTIC elastic, a price rise will increase revenues.