Unit 2

Supply and Demand: the one-page sheet

2.1 Demand

Demand shows how much buyers want at each price. By the law of demand, a higher price lowers the quantity demanded, because of the substitution and income effects and diminishing marginal utility. A change in the good's own price moves buyers along the curve; a change in tastes, income, the prices of substitutes or complements, expectations or the number of buyers shifts the whole curve. Market demand adds every buyer's quantity at each price.

Law of demand: other things equal, a higher price means a smaller quantity demanded. The curve slopes down.
It slopes down because of the substitution effect, the income effect and diminishing marginal utility.
A change in the good's own price is a movement along the curve: a change in quantity demanded.
A change in a determinant shifts the whole curve: tastes, income (normal or inferior), prices of substitutes and complements, expectations, the number of buyers.
Market demand is the horizontal sum of every buyer's quantity at each price.

the good is cheaper than its substitutes and buyers' money goes further the quantity demanded rises buyers move down along the same demand curve; the curve does not shift

demand: Demand: the quantities of a good buyers are willing and able to buy at each price, shown as a downward-sloping demand curve. The quantity demanded is the amount at one particular price.
law of demand: The law of demand: other things equal, when a good's price rises the quantity demanded falls, and when it falls the quantity demanded rises.
income effect: Income effect: a lower price makes buyers' income go further, so they can buy more. Substitution effect: a lower price makes the good cheaper than its substitutes, so buyers switch toward it.
market demand: Market demand: the sum of every individual buyer's quantity demanded at each price (a horizontal sum of the individual demand curves).
determinants of demand: Determinants of demand: the changes other than the good's own price that shift demand: tastes, income (a normal good's demand rises with income, an inferior good's falls), prices of substitutes and complements, expectations and the number of buyers.

2.2 Supply

Supply shows how much sellers offer at each price. By the law of supply, a higher price raises the quantity supplied, because a higher price covers the rising cost of producing more. A change in the good's own price moves sellers along the curve; a change in input prices, technology, the prices of other goods the seller could make, taxes or subsidies, expectations or the number of sellers shifts the whole curve. Market supply adds every seller's quantity at each price.

Law of supply: other things equal, a higher price means a larger quantity supplied. The curve slopes up.
A change in the good's own price is a movement along the curve: a change in quantity supplied.
A change in a determinant shifts the whole curve: input prices, technology, the prices of other goods the seller could make, taxes and subsidies, expectations, the number of sellers.
A shift left is a decrease in supply (less at each price); a shift right is an increase.
Market supply is the horizontal sum of every seller's quantity at each price.

each unit sells for more sellers offer more: the quantity supplied rises sellers move up along the same supply curve; the curve does not shift

supply: Supply: the quantities of a good sellers are willing and able to offer at each price, shown as an upward-sloping supply curve. The quantity supplied is the amount offered at one particular price.
law of supply: The law of supply: other things equal, when a good's price rises the quantity supplied rises, and when it falls the quantity supplied falls.
market supply: Market supply: the sum of every individual seller's quantity supplied at each price (a horizontal sum of the individual supply curves).
determinants of supply: Determinants of supply: the changes other than the good's own price that shift supply: input prices, technology, the prices of other goods the seller could produce, taxes and subsidies, expectations and the number of sellers.

2.3 Price Elasticity of Demand

Price elasticity of demand measures how strongly the quantity demanded responds to a price change: the percent change in quantity over the percent change in price, read as an absolute value. Above 1 demand is elastic, below 1 inelastic, at 1 unit elastic. The total revenue test follows: with elastic demand a price rise lowers total revenue, with inelastic demand it raises it. Close substitutes, a large budget share and more time to adjust make demand more elastic.

Price elasticity of demand = percent change in quantity demanded divided by percent change in price. Read the absolute value.
Greater than 1: elastic. Less than 1: inelastic. Exactly 1: unit elastic. Zero: perfectly inelastic (vertical). Infinite: perfectly elastic (horizontal).
Total revenue test: elastic demand, price and TR move opposite; inelastic demand, they move together; unit elastic, TR does not change.
Along a straight-line demand curve the slope is constant but elasticity is not: elastic at the top, unit elastic at the midpoint, inelastic at the bottom.
Demand is more elastic with close substitutes, a large budget share, a narrowly defined good and more time to adjust.

buyers switch away when its price rises the quantity demanded falls by a larger percent than the price rose: demand is elastic the lost sales outweigh the higher price, so total revenue falls

price elasticity of demand: Price elasticity of demand: the percent change in quantity demanded divided by the percent change in price, read as an absolute value. Elastic if greater than 1, inelastic if less than 1, unit elastic if 1; perfectly inelastic demand is vertical and perfectly elastic demand is horizontal.
total revenue: Total revenue (TR): price times quantity sold. The total revenue test: with elastic demand, price and TR move in opposite directions; with inelastic demand they move together; with unit elastic demand TR does not change.
midpoint method: Midpoint method: a way to compute elasticity that divides each change by the average of the starting and ending values, so the answer is the same for a rise or a fall in price. One accepted route, not the only one.
determinants of elasticity: Determinants of price elasticity of demand: the availability of close substitutes, whether the good is a necessity or a luxury, its share of the buyer's budget, how narrowly the good is defined, and how much time buyers have to adjust.

2.4 Price Elasticity of Supply

The price elasticity of supply is the percent change in quantity supplied divided by the percent change in price. Above 1 supply is elastic, below 1 inelastic; a vertical supply curve is perfectly inelastic and a horizontal one perfectly elastic. Supply is more elastic when sellers have spare capacity, easy access to inputs, goods they can store and more time to adjust. The more elastic supply is, the more a rise in demand shows up as more output rather than a higher price.

Price elasticity of supply = percent change in quantity supplied divided by percent change in price. It is positive.
Same benchmarks as demand: greater than 1 elastic, less than 1 inelastic, 1 unit elastic; vertical supply is perfectly inelastic, horizontal supply perfectly elastic.
Supply is more elastic with spare capacity, inputs that are easy to buy, goods that can be stored, and more time to adjust.
Perishable goods and fixed capacity (seats, land) make supply inelastic.

they can add output quickly a price rise brings a large percent rise in quantity supplied: supply is elastic a rise in demand raises quantity a lot and the price only a little

price elasticity of supply: Price elasticity of supply: the percent change in quantity supplied divided by the percent change in price (positive). Elastic supply (greater than 1) responds strongly; inelastic supply (less than 1) responds weakly; a vertical supply curve is perfectly inelastic.

2.5 Other Elasticities

Income elasticity of demand divides the percent change in quantity demanded by the percent change in income; cross-price elasticity divides the percent change in quantity demanded of one good by the percent change in the price of another. Unlike price elasticity of demand, both keep their sign. A positive income elasticity marks a normal good and a negative one an inferior good. A positive cross-price elasticity marks substitutes, a negative one complements, and one near zero unrelated goods.

Income elasticity of demand = percent change in quantity demanded divided by percent change in income. Keep the sign.
Positive: normal good (above 1, demand grows faster than income). Negative: inferior good.
Cross-price elasticity of demand = percent change in quantity demanded of X divided by percent change in the price of Y. Keep the sign.
Positive: substitutes. Negative: complements. Near zero: unrelated.
Elasticity can be measured for any determinant of demand; each is a percent change in quantity over a percent change in the cause.

coffee drinkers look for a cheaper drink the quantity of tea demanded rises at each tea price the cross-price elasticity is positive: the goods are substitutes

income elasticity of demand: Income elasticity of demand: the percent change in quantity demanded divided by the percent change in income. Positive for a normal good (above 1 when demand grows faster than income), negative for an inferior good.
cross-price elasticity of demand: Cross-price elasticity of demand: the percent change in quantity demanded of one good divided by the percent change in the price of another. Positive for substitutes, negative for complements, near zero for unrelated goods.

2.6 Market Equilibrium and Consumer and Producer Surplus

A market is in equilibrium at the price where quantity demanded equals quantity supplied. Consumer surplus is the gain to buyers, the area under demand above the price; producer surplus is the gain to sellers, the area above supply below the price; both run out to the quantity traded. Their sum, total surplus, is largest at the competitive equilibrium, and prices act as signals that move resources to where buyers value them most.

Market equilibrium: the price where quantity demanded equals quantity supplied, where the curves cross. Mark PE and QE on the axes.
Consumer surplus (CS): what buyers would pay minus what they pay. The area under demand, above the price, out to the quantity traded.
Producer surplus (PS): the price minus the least sellers would accept. The area above supply, below the price, out to the quantity traded.
Total surplus = CS + PS. In a competitive market with no other problems, it is largest at equilibrium.
For straight lines, each surplus is a triangle: $\tfrac{1}{2} \times$ base $\times$ height.

it is worth more to the buyer than it costs the seller to supply buyers and sellers keep trading units up to where the curves cross total surplus (consumer plus producer surplus) is as large as it can be

market equilibrium: Market equilibrium: the price and quantity at which quantity demanded equals quantity supplied, where the demand and supply curves cross. The market clears at the equilibrium price.
consumer surplus: Consumer surplus (CS): the difference between what buyers are willing to pay and what they actually pay, summed over the units bought. On a graph, the area under demand and above the price, out to the quantity traded.
producer surplus: Producer surplus (PS): the difference between the price sellers receive and the least they would accept, summed over the units sold. On a graph, the area above supply and below the price, out to the quantity traded.
total surplus: Total surplus: consumer surplus plus producer surplus, the total gain from trade in a market. In a competitive market it is largest at the equilibrium quantity.

2.7 Market Disequilibrium and Changes in Equilibrium

At any price other than equilibrium the market is in disequilibrium: below it a shortage pushes the price up, above it a surplus pushes it down, until quantity demanded equals quantity supplied. When one curve shifts, the equilibrium moves along the other: demand shifts move price and quantity together, supply shifts move them apart. When both shift, one change is certain and the other is indeterminate. Each shift also changes consumer, producer and total surplus, and elasticities decide how much of the change is in price.

Below equilibrium: a shortage, quantity demanded minus quantity supplied, pushes the price up. Above it: a surplus, quantity supplied minus quantity demanded, pushes the price down.
One shift: demand moves price and quantity the same way; supply moves them opposite ways.
Two shifts at once (simultaneous shifts): one of price or quantity is indeterminate unless you know which shift is larger.
A shift changes consumer, producer and total surplus; recompute each triangle at the new equilibrium.
The more inelastic the curve that does not shift, the more the change shows up in price rather than quantity.

at the old price, quantity demanded exceeds quantity supplied: a shortage the price rises quantity supplied rises along supply and quantity demanded falls along the new demand curve a new equilibrium with a higher price and a larger quantity

shortage: Shortage (excess demand): at a price below equilibrium, the amount by which quantity demanded exceeds quantity supplied. It pushes the price up.
surplus (of a good): Surplus of a good (excess supply): at a price above equilibrium, the amount by which quantity supplied exceeds quantity demanded. It pushes the price down. Not the same as consumer or producer surplus.
simultaneous shifts: Simultaneous shifts: demand and supply shifting at the same time. The change both shifts agree on is certain; the other is indeterminate, meaning it depends on which shift is larger.

2.8 The Effects of Government Intervention in Markets

Price ceilings, price floors, quotas, taxes and subsidies change the price signals and the quantity traded. A binding ceiling (below equilibrium) causes a shortage; a binding floor (above it) a surplus; in both, fewer units are traded. A per-unit tax shifts supply up, raises the price buyers pay, lowers the price sellers keep and raises revenue equal to the tax times the new quantity; a subsidy does the reverse at a cost of the subsidy times the new quantity. In a market that was efficient, each of these creates a deadweight loss, and the burden of a tax falls more on the less elastic side.

Price ceiling (maximum) binds below equilibrium: a shortage, and only Qs is traded. Price floor (minimum) binds above equilibrium: a surplus, and only Qd is traded.
A per-unit tax shifts supply up by the tax: buyers pay more, sellers keep less, quantity falls. Revenue = tax × the new quantity.
A per-unit subsidy shifts supply down: buyers pay less, sellers get more, quantity rises. Cost = subsidy × the new quantity, the whole rectangle.
Deadweight loss: total surplus lost on units not traded (or traded past the equilibrium), the triangle between demand and supply.
Tax incidence: the less elastic side of the market bears more of the tax, whoever hands it to the government. A quota cuts quantity and raises the price.

supply shifts up (left) by the amount of the tax buyers pay a higher price, sellers keep a lower one, and fewer units are traded the surplus on the units no longer traded is lost: a deadweight loss the government collects the tax times the new quantity, paid partly by each side

price ceiling: Price ceiling: a legal maximum price. It binds only below the equilibrium price, where it causes a shortage and only the quantity supplied at the ceiling is traded. Rent control is an example.
price floor: Price floor: a legal minimum price. It binds only above the equilibrium price, where it causes a surplus and only the quantity demanded at the floor is traded.
deadweight loss: Deadweight loss (DWL): the total surplus lost when the quantity traded differs from the efficient equilibrium quantity. On a graph, the triangle between demand and supply from the quantity traded to the equilibrium quantity.
per-unit tax: Per-unit (excise) tax: a fixed amount per unit sold. Collected from sellers, it shifts supply up by the tax; tax revenue is the tax times the quantity sold after the tax.
tax incidence: Tax incidence: how the burden of a tax is shared between buyers (the rise in the price they pay) and sellers (the fall in the price they keep). The less elastic side bears more, whoever hands the tax to the government.
per-unit subsidy: Per-unit subsidy: a payment from the government for each unit sold. It shifts supply down by the subsidy; buyers pay less, sellers receive more, and the cost to the government is the subsidy times the new, larger quantity.
quantity control: Quantity control (quota): a legal limit on the quantity of a good that can be sold. A binding quota holds the quantity below equilibrium, which raises the price and creates a deadweight loss.

2.9 International Trade and Public Policy

When a small country opens to trade, its price moves to the world price. If the world price is lower, it imports the gap between quantity demanded and domestic quantity supplied; consumers gain more than producers lose. If it is higher, the country exports and producers gain more than consumers lose. Either way total surplus rises. A tariff raises the domestic price, increases domestic output, cuts imports, raises revenue equal to the tariff times the remaining imports, and creates two deadweight loss triangles. An import quota has the same effect on quantities and price without the tariff revenue.

A small country takes the world price as given. Below its own price: it imports (Qd minus Qs at the world price). Above: it exports (Qs minus Qd).
Importing: consumers gain, domestic producers lose, total surplus rises. Exporting: producers gain, consumers lose, total surplus rises.
A tariff raises the domestic price by the tariff: domestic output rises, imports fall, consumers lose. Tariff revenue = tariff × imports after the tariff.
A tariff's deadweight loss is two triangles: costly domestic production and buying given up.
An import quota limits imports directly: the price rises as with a tariff, but the government collects no tariff revenue. (Quotas are not graphed in this course.)

the domestic price falls to the world price domestic buyers want more and domestic firms supply less; imports fill the gap domestic firms supply more, buyers want less, so imports fall the government collects revenue on the remaining imports and two triangles of surplus are lost

world price: World price: the price of a good on the world market. A small country that opens to free trade takes it as given, so its domestic price moves to the world price.
imports: Imports: goods bought from other countries. At a world price below the domestic price, imports equal domestic quantity demanded minus domestic quantity supplied. Exports are the reverse: at a world price above the domestic price, quantity supplied minus quantity demanded.
tariff: Tariff: a tax on imports, per unit. It raises the domestic price by the tariff, raises domestic output, cuts imports and creates deadweight loss. Tariff revenue is the tariff times the imports after the tariff.
import quota: Import quota: a legal limit on the quantity of a good that can be imported. It raises the domestic price and lowers imports as a tariff does, but raises no tariff revenue.