TOPIC 2: DEMAND AND

SUPPLY ANALYSIS
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T2: DEMAND AND SUPPLY ANALYSIS
Markets
• A market is the place (not necessarily physical)
where services and goods are exchanged

• 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 (we will relax
this at the end of the course)
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T2: DEMAND AND SUPPLY ANALYSIS
Demand
The market demand function shows the
aggregate quantity (derived or direct) 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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T2: DEMAND AND SUPPLY ANALYSIS
Demand
• The demand curve shifts when factors other
than own price change
• If the change increases the willingness of
consumers to acquire the good, the demand
curve shifts right
• If the change decreases the willingness of
consumers to acquire the good, the demand
curve shifts left
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T2: DEMAND AND SUPPLY ANALYSIS
Demand
• We always graph P on vertical
axis and Q on horizontal axis, but
we write demand as Q as a
function of P
• If P is written as function of Q, it
is called the inverse demand
𝑑
• Normal form: 𝑄 = 100 − 2𝑃
𝑄𝑑
• Inverse form: 𝑃 = 50 −
2
• Markets defined by commodity,
geography, time
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T2: DEMAND AND SUPPLY ANALYSIS
Supply
• The market supply curve shows the aggregate
quantity of a good that producers are willing to
sell at different prices

QS=Q(P)

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T2: DEMAND AND SUPPLY ANALYSIS
Supply
• The Law of Supply states that the
quantity of a good offered
increases when the price of this
good increases
• A move along the supply curve
for a good can only be triggered
by a change in the price of that
good
• Any change in another factor
that affects the producers’
willingness to offer for the good
results in a shift in the supply
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curve for the good
7
T2: DEMAND AND SUPPLY ANALYSIS
Supply
• The supply curve shifts when factors other than
own price change
• If the change increases the willingness of
producers to offer the good at the same price,
the supply curve shifts right
• If the change decreases the willingness of
producers to offer the good at the same price,
the supply curve shifts left

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T2: DEMAND AND SUPPLY ANALYSIS
Equilibrium
• A point such that, at its
price, the quantities
demanded and supplied are
the same
• A point at which there is no
tendency for the market
price to change as long as
exogenous variables remain
unchanged
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 Equilibrium
• Example:
• Qd = 500 – 4P
Qs = -100 + 2P
• P = price of cranberries
• Q= demand for cranberries
• The equilibrium price of
cranberries is calculated by
equating demand to supply
• 500 – 4P = -100 + 2P
• Q* = 100

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T2: DEMAND AND SUPPLY ANALYSIS
Equilibrium
• Excess demand: a situation in
which the quantity
demanded at a given price
exceeds the quantity supplied
• Excess supply: a situation in
which the quantity supplied
at a given price exceeds the
quantity demanded.

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T2: DEMAND AND SUPPLY ANALYSIS
Equilibrium
• If there is no excess supply or
excess demand, there is no
pressure for prices to change
and thus there is equilibrium
• When a change in an
exogenous variable causes
the demand curve or the
supply curve to shift, the
equilibrium shifts as well

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T2: DEMAND AND SUPPLY ANALYSIS
Shifts

• Demand increases:
• P Q
• Demand decreases:
• P Q 

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T2: DEMAND AND SUPPLY ANALYSIS
Shifts

• Supply increases:
• P  Q
• Supply decreases:
•P  Q 

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T2: DEMAND AND SUPPLY ANALYSIS
Shifts

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T2: DEMAND AND SUPPLY ANALYSIS
Exercises
2. Use supply and demand curves to illustrate the
impact of the following events on the market for coffee:
a) The price of tea goes up by 100 percent.
b) A study is released that links consumption of caffeine
to the incidence of cancer.
c) A frost kills half of the Colombian coffee bean crop.
d) The price of styrofoam coffee cups goes up by
300 percent.

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T2: DEMAND AND SUPPLY ANALYSIS
Exercises
3. Suppose we observe that the price of soybeans
goes up, while the quantity of soybeans sold goes
up as well. Use supply and demand curves to
illustrate two possible explanations for this
pattern of price and quantity changes.

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T2: DEMAND AND SUPPLY ANALYSIS
Exercises
2.3. The demand and supply curves for coffee are
given by Qd = 600 − 2P and Qs = 300 + 4P.
a) Plot the supply and demand curves on a graph
and show where the equilibrium occurs.
b) Using algebra, determine the market
equilibrium price and quantity of coffee

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T2: DEMAND AND SUPPLY ANALYSIS
Elasticity
• Consider a function y = f(x).

• How does the dependent variable (y) change when the independent
variable increases by one unit?

• This question is related to the sensitivity with which the dependent

variable changes to increases in the independent variable.

• We have learned before that the answer to this question was

obtained with the derivative of the function: For each unit that the
variable x increases from a value x0, the variable y changes in f'(x0)
units.

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T2: DEMAND AND SUPPLY ANALYSIS
Elasticity
• However: This definition of the derivative depends on the units of measurement
of both the independent variable and the dependent variable.

• For example, consider an individual's demand function for gasoline, q = q(p).

- If we express the price in euros or dollars, the function that represents the
individual's behavior is different and, therefore, so is the derivative.
- If we express the quantity in liters or gallons, the function that represents the
individual's behavior is different and, therefore, so is the derivative.

• That is, we see that by changing the units of measurement, the derivative
changes (although the individual's behavior is the same). That is, by taking some
units of measurement or others, we would obtain that the "sensitivity" that the
quantity demanded has to changes in price is one or the other very different.
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T2: DEMAND AND SUPPLY ANALYSIS
Elasticity
• The price elasticity of demand is the percentage
change in quantity demanded brought about by a
one-percent change in the price of the good
Δ𝑄
ൗ𝑄 Δ𝑄
𝜀𝑄,𝑃 = = ൗΔ𝑃 𝑃Τ = 𝑄′(𝑃) 𝑃Τ
Δ𝑃ൗ 𝑄 𝑄
𝑃
Note that 1% is always the same increase and does
not depend on the units of measurement. Therefore
the elasticity would be the same.
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T2: DEMAND AND SUPPLY ANALYSIS
Elasticity
• 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 (or >1 with  in absolute value)
• If Q,P = -∞ (or =∞ with  in absolute value) it is perfectly elastic
• 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 (or 0<<1 with  in absolute value)
• If Q,P = 0 (or =0 with  in absolute value) it is perfectly inelastic
• 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 (or =1 with  in absolute value)
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T2: DEMAND AND SUPPLY ANALYSIS
Elasticity
In a linear curve:
Δ𝑄
• 𝜀𝑄,𝑃 = ൗΔ𝑃 𝑃Τ𝑄 = −𝑏 𝑃Τ𝑄
• Elasticity falls from 0 to - along
the linear demand curve, but
slope is constant
• Example: calculate elasticity
when P = 30 and
Qd = 400 – 10P
• Answer: εQ,P = -3 “elastic”
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T2: DEMAND AND SUPPLY ANALYSIS
Elasticity
• Linear demand curve:
• 𝑄𝑑 = 𝑎 − 𝑏𝑃
Δ𝑄
• 𝜀𝑄,𝑃 = ൗΔ𝑃 𝑃Τ
𝑄 =
− 𝑏 𝑃Τ𝑄
• Constant elasticity
demand curve:
• 𝑄𝑑 = 𝑎𝑃−𝑏
• 𝜀𝑄,𝑃 = −𝑏
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T2: DEMAND AND SUPPLY ANALYSIS
Elasticity
Elasticity and revenue relationship:
• Total revenue (TR) = P*Q
• When P Q and when P Q
• Demand is elastic
• Fall in Q > Rise in P  TR falls
• Demand is inelastic
• Fall in Q < Rise in P  TR increases
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T2: DEMAND AND SUPPLY ANALYSIS
Elasticity
Determinants of elasticity:
• Availability of substitutes
• More substitutes → more price elastic
• Goods which have price inelastic at the market level, like
cigarettes, can be highly price elastic at the brand level
• Necessities versus luxuries
• Necessities → less price elastic
• Importance in buyer’s budget
• More important → more price elastic
• Time horizon
• Long-run → more price elastic

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T2: DEMAND AND SUPPLY ANALYSIS
Elasticity
• Long-run demand curve – demand curve when
consumers can fully adjust their purchase decisions to
changes in price
• Short-run demand curve – demand curve when
consumers cannot fully adjust their purchase decisions to
changes in price
• Long-run supply curve – supply curve when sellers can
fully adjust their supply decisions to changes in price
• Short-run supply curve – supply curve when sellers
cannot fully adjust their supply decisions to changes in
price
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T2: DEMAND AND SUPPLY ANALYSIS
Elasticity
• A durable good is a good that provides valuable
services over a long time (usually many years, like
cars)
• Demand for non-durables is less elastic in the short
run when consumers can only partially adapt their
behavior (you need it now)
• Demand for durables is more elastic in the short run
because consumers can delay purchase (you can
continue with what you have a bit more)
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T2: DEMAND AND SUPPLY ANALYSIS
Other elasticities
• Income elasticity of demand
• The ratio of the percentage change of quantity demanded
to the percentage change of income, holding price and all
other determinants of demand constant
• Cross-price elasticity of demand
• The ratio of the percentage change of the quantity of one
good demanded with respect to the percentage change in
the price of another good
• Price elasticity of supply
• The percentage change in quantity supplied for each
percent change in price, holding all other determinants of
supply constant
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T2: DEMAND AND SUPPLY ANALYSIS
Example
• Cola wars:

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T2: DEMAND AND SUPPLY ANALYSIS
Example
• Suppose demand is linear: 𝑄𝑑 = 𝑎 − 𝑏𝑃
• Hence, elasticity is 𝜀𝑄,𝑃 = −𝑏𝑃ൗ𝑄
• If we have data on ε, Q, and P, we can calculate b from
elasticity equation and then calculate a by substituting into
demand
• Per capita consumption is 70 pounds – price 70¢ per pound
• 𝜀𝑄,𝑃 = −0.55
𝑄Τ
• Therefore 𝜀 = ൗ𝑄  𝑏 = −𝜀
− 𝑏𝑃 𝑃 = − −.55 70Τ
0.7 =
55
• 𝑎 = 𝑄𝑑 + 𝑏𝑃 = 108.5
• 𝑄𝑑 = 108.5 − 55𝑃
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T2: DEMAND AND SUPPLY ANALYSIS
Exercises
6. Explain why we might expect the price
elasticity of demand for speedboats to be more
negative than the price elasticity of demand for
light bulb

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T2: DEMAND AND SUPPLY ANALYSIS
Exercises
2.2. Suppose the demand curve in a particular
market is given by Q = 5 − 0.5P.
a) Plot this curve in a graph.
b) At what price will demand be unitary elastic?

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T2: DEMAND AND SUPPLY ANALYSIS
Exercises
2.6. Granny’s Restaurant sells apple pies. Granny knows that
the demand curve for her pies does not shift over time, but
she wants to learn more about that demand. She has tested
the market for her pies by charging different prices. When
she charges $4 per pie, she sells 30 pies per week. When she
charges $5, she sells 24 pies per week. If she charges $4.50,
she sells 27 apple pies per week.
a) With these data draw a graph of the linear demand curve
for Granny’s apple pies. What is the linear demand function
of pies?
b) Find the price elasticity of demand at each of the three
prices.
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