Chapter 4.1
Market Equilibrium
Market Equilibrium
• Market equilibrium is a situation that occurs in
a market when the price is such that quantity
that consumers wish to buy is exactly
balanced by the quantity that firms wish to
supply.
• In a free market, the forces of supply and
demand interact to determine equilibrium
quantity and equilibrium price.
The Interaction of Supply and Demand
• The English historian Thomas Carlyle once
said:
“Teach any parrot the words supply and
demand and you’ve got an economist.”
Equilibrium
• Equilibrium price – the price toward which the
invisible hand drives the market.
• Equilibrium quantity – the amount bought
and sold at the equilibrium price.
What Equilibrium Isn’t
• Equilibrium isn’t a state of the world, it is a
characteristic of a model.
• Equilibrium isn’t inherently good or bad, it is
simply a state in which dynamic pressures
offset each other.
• When the market is not in equilibrium, you
get either excess supply or excess demand,
and a tendency for price to change.
Excess Supply & Excess Demand
• Excess supply – a surplus, the quantity
supplied is greater than quantity demanded
• Prices tend to fall.
• Excess demand – a shortage, the quantity
demanded is greater than quantity supplied
• Prices tend to rise.
Price Adjusts
• The greater the difference between quantity
supplied and quantity demanded, the more
pressure there is for prices to rise or fall.
• When quantity demanded equals quantity
supplied, prices have no tendency to change.
The Graphical Interaction of Supply
and Demand
Price (per
DVD)
Quantity
Supplied
Quantity Surplus (+)
Demanded Shortage (-)
$3.50
7
3
+4
$2.50
5
5
0
$1.50
3
7
-4
The Graphical Interaction of Supply and Demand
$5.00
Excess supply
4.00
Price per DVD
S
3.50
A
3.00
E
2.50
C
2.00
1.50
Excess demand
1.00
1
D
2 3 4 5 6 7 8 9 10 11 12
Quantity of DVDs supplied and demanded
The Graphical Interaction of Supply and Demand
• When price is $3.50 each, quantity supplied
equals 7 and quantity demanded equals 3.
• The excess supply of 4 pushes price
down.
The Graphical Interaction of Supply and Demand
• When price is $1.50 each, quantity supplied
equals 3 and quantity demanded equals 7.
• The excess demand of 4 pushes price
up.
The Graphical Interaction of Supply and Demand
• When price is $2.50 each, quantity supplied
equals 5 and quantity demanded equals 5.
• There is no excess supply or excess
demand, so price will not rise or fall.
Equilibrium (Graph)
Chapter 4.2
Examples of Markets
Examples of Markets
• Labor market – firms demand labor and
employees supply labor.
• From a firms point of view the demand for
labor is a derived demand.
– Firms want labor not for its own sake, but for the
output that it produces.
Unemployment
• A higher wage rate encourages more people
to offer themselves for work.
• Unemployment results when people seeking
work at the going wage cannot find a job.
• underemployment classification includes
those workers who are highly skilled but
working in low skill jobs and part-time workers
who would prefer to be full time.
The Foreign Exchange Market
• The exchange rate is the price at which two
currencies exchange and it can be analyzed
using demand and supply.
Money Market
• Demand for money is associated with the
functions of money set out as a medium of
exchange, store of value, unit of account and
standard of deferred payment.
• Money supply is determined by the central
bank.
Chapter 4.3
Comparative Statics
Comparative statics
• Comparative static analysis – examines the
effect on equilibrium of a change in the
external conditions affecting a market.
Chapter 4.4
Elasticity: the sensitivity of demand
and supply
Elasticity: The demand Sensitivity of
demand and supply
• Elasticity is a measure of the sensitivity of one
variable to change in another variable.
• Price elasticity of demand (PED) is a measure
of the sensitivity of quantity demanded to
change in the price of a good or service.
Income Elasticity of Demand
• Income elasticity of demand (YED) measures the
responsiveness of quantity demanded to changes in
real income.
• YED = %Δ demand / %Δ in income
• Example:
– A rise in consumer real income of 7% leads to an
9.5% rise in demand for pizza deliveries.
– The income elasticity of demand:
= 9.5/ 7 = +1.36 (ELASTIC)
Significance of Income Elasticity of
Demand
• High Income Elasticity
– Demand is sensitive to changes in real incomes
– Demand is therefore cyclical – in an economic
expansion, demand will grow strongly. In a
recession demand may fall
– Can be difficult for businesses to accurately
forecast demand and make capital investment
decisions
Significance of Income Elasticity of
Demand
• Low Income Elasticity
– Demand is more stable during fluctuations in the
economic cycle than high YED
– Over time, the share of consumer spending on
inferior goods and normal necessities tends to
decline
– Long run – businesses need to invest in / focus on
products with a higher income elasticity of
demand if they want to increase total profits
Elasticity – the concept
• The responsiveness of one variable to changes
in another
• When price rises, what happens
to demand?
• Demand falls
• BUT!
• How much does demand fall?
Elasticity – the concept
• If price rises by 10% - what happens to
demand?
• We know demand will fall
• By more than 10%?
• By less than 10%?
• Elasticity measures the extent to which
demand will change
Elasticity
•
•
•
•
•
4 basic types used:
Price elasticity of demand
Price elasticity of supply
Income elasticity of demand
Cross elasticity
Elasticity
• Price Elasticity of Demand
– The responsiveness of demand
to changes in price
– Where % change in demand
is greater than % change in price – elastic
– Where % change in demand is less than % change
in price - inelastic
Elasticity
The Formula:
Ped =
% Change in Quantity Demanded
___________________________
% Change in Price
If answer is between 0 and -1: the relationship is inelastic
If the answer is between -1 and infinity: the relationship is elastic
Note: PED has – sign in front of it; because as price rises
demand falls and vice-versa (inverse relationship between
price and demand)
Elasticity
Price (£)
The demand curve can be a
range of shapes each of which
is associated with a different
relationship between price and
the quantity demanded.
Quantity Demanded
Elasticity
Price
Total
revenue is of
price
x
The importance
elasticity
quantity sold. In this
is the information it
example,
TRthe
= £5
x 100,000
provides on
effect
on
=
£500,000.
total revenue of changes in
price.
This value is represented by
the grey shaded rectangle.
£5
Total Revenue
D
100
Quantity Demanded (000s)
Elasticity
Price
If the firm decides to
decrease price to (say) £3,
the degree of price
elasticity of the demand
curve would determine the
extent of the increase in
demand and the change
therefore in total revenue.
£5
£3
Total Revenue
D
100
140
Quantity Demanded (000s)
Elasticity
Price (£)
Producer decides to lower price to attract sales
% Δ Price = -50%
10
% Δ Quantity Demanded = +20%
Ped = -0.4 (Inelastic)
Total Revenue would fall
5
Not a good move!
D
5 6
Quantity Demanded
Elasticity
Price (£)
10
Producer decides to reduce price to increase sales
% Δ in Price = - 30%
% Δ in Demand = + 300%
Ped = - 10 (Elastic)
Total Revenue rises
Good Move!
7
D
5
Quantity Demanded
20
Elasticity
• If demand is price
elastic:
• Increasing price would
reduce TR (%Δ Qd > % Δ
P)
• Reducing price would
increase TR
(%Δ Qd > % Δ P)
• If demand is price
inelastic:
• Increasing price would
increase TR
(%Δ Qd < % Δ P)
• Reducing price would
reduce TR (%Δ Qd < % Δ
P)
Elasticity
• Income Elasticity of Demand:
– The responsiveness of demand
to changes in incomes
• Normal Good – demand rises
as income rises and vice versa
• Inferior Good – demand falls
as income rises and vice versa
Elasticity
• Income Elasticity of Demand:
• A positive sign denotes a normal good
• A negative sign denotes an inferior good
Elasticity
• Cross Elasticity:
• The responsiveness of demand
of one good to changes in the price of a
related good – either
a substitute or a complement
Xed =
% Δ Qd of good t
__________________
% Δ Price of good y
Elasticity
• Goods which are complements:
– Cross Elasticity will have negative sign (inverse
relationship between the two)
• Goods which are substitutes:
– Cross Elasticity will have a positive sign (positive
relationship between the two)
Elasticity
• Price Elasticity of Supply:
– The responsiveness of supply to changes
in price
– If Pes is inelastic - it will be difficult for suppliers to
react swiftly to changes in price
– If Pes is elastic – supply can react quickly to changes in
price
Pes =
% Δ Quantity Supplied
____________________
% Δ Price
Determinants of Elasticity
• Time period – the longer the time under consideration the
more elastic a good is likely to be
• Number and closeness of substitutes –
the greater the number of substitutes,
the more elastic
• The proportion of income taken up by the product – the
smaller the proportion the more inelastic
• Luxury or Necessity - for example,
addictive drugs
Importance of Elasticity
• Relationship between changes
in price and total revenue
• Importance in determining
what goods to tax (tax revenue)
• Importance in analysing time lags in
production
• Influences the behaviour of a firm