Demand and Supply Functions
Lecture 2

Supply and Demand

1. Supply and Demand
   • Modified to include trade
   • Gains and losses from international trade
   • Welfare effects
2. Demand - shows the quantity and price of a good, which consumers are willing to buy
   • Consumers max. utility relative to their limited income
   • Law of Demand – as market price increases, quantity demanded decreases

The Demand Function

3. Characteristics
   • Assumes competitive market – many buyers in market
   • Price Elasticity of Demand – how sensitive consumers are to changes in the market price
     • Has no units
       • Can compare apples to oranges
       • Expressed as a percentage
     • Inelastic demand – consumers are not sensitive to price changes

An Inelastic Demand Function

• • • • • Elasticity lies between 0 and -1
        • Examples
          • Cigarettes
          • Gasoline
          • Alcohol
          • If cigarettes are e _d = -0.5; if the market price increases by 1%, then quantity demanded falls by 0.5%
      • Elastic demand – consumers are sensitive to price changes

An Elastic Demand Function

• • • • • Elasticity lies between -1 and negative infinity
        • Examples – many products
        • Private education, ed = -4.0; if the market price increases by 1%, then quantity demanded falls by 4%

4. Demand curves shifts
   1. Price of other products
      • Substitute goods
      • Complement goods
   2. Income
      • Normal goods – consumers buy more as their income increases; most products
      • Inferior goods – consumers buy less as their income increases
   3. Taste and preferences
5. Consumers' surplus – the area below the demand curve but above the actual price paid
   • Measure of social welfare
   • An aggregate benefit to all consumers in the market
   • Example
     • The market price of coffee is $1.50 and consumers buy 15 (million) pounds of coffee.
     • I place a $2.50 value on this soda, but bought it for $1.50
     • I received a benefit of $1.00

Consumer Surplus

• • • If the market price of the soda decreases to $0.50, consumers' surplus increases!
    • Social welfare increases

Change in Consumer Surplus when Price Decreases

6. Supply - shows the quantity and price of a good that firms are willing to produce/sell

The Supply Function

1. • Producers produce if P >= MC
     • P is market price
       • Gain in revenue for selling one more unit
       • Determined by consumers
     • MC is marginal cost
       • Change in cost as production increases by one more unit
       • Does not include fixed costs
   • Profits
     • Competitive firm maximize profits when P = MC, which equals zero in the long run
     • Assume competitive market; many firms in market
     • Firms earning profits (P > MC)
       • Firms enter the market
       • Industry expands
       • Marginal costs increase, while market price decreases
     • Firms earning losses (P < MC)
       • Firms exit the industry
       • Industry contracts
       • Market price increases, while marginal costs decrease
   • Elasticity – applied to supply function
   • Supply shifts
     1. Input cost
        • Labor
        • Materials
        • Resources and energy
     2. Technology
     3. Taxes and regulations
   • Producers' surplus – the area above the supply curve but below the actual sales price
     • Measure of social welfare
     • An aggregate benefit to all producers in the market
     • Producers' surplus is total fixed costs + profits
     • Example - market price is $1.50. If a firm can produce the product for $0.50, then it earns profits

Producer Surplus

7. Social Welfare – consumers' plus producers' surpluses
   • No international trade
   • A competitive market maximizes social welfare

Social Welfare-Consumers' plus Producers' Surpluses

International Trade

1. Excess Demand (ED) function –
   • Above market price, ED = 0
   • Below market price, ED = Quantity demanded – quantity supplied

Derivation of an Excess Demand (ED) Function

• • Note – Domestic industry declines, while domestic consumers benefit
  • Money flows out of the country

2. Excess Supply (ES) function
   • Above market price, ES = Quantity supplied – quantity demanded
   • Below market price, ES = 0

Derivation of an Excess Supply (ES) Function

• • Note – Export industry expands, while foreign consumers are harmed
  • Money flows into the country

3. Example – U.S. imports petroleum from Kazakhstan
   • United States import Q ₂ – Q ₁ = T
     • U.S. gains petroleum
   • Kazakhstan exports Q ₄ – Q ₃ = T
     • Kazakhstan gains U.S. dollars

Free Trade Between the U.S. and Kazakhstan

4. Welfare effects
   1. Autarky - countries do not engage in trade
      • Consumers' surplus is c
      • Producers' surplus is a + e
      • Total social welfare is a + c + e

The Welfare Effects of Free Trade

1. 2. Country imports s product
      • Consumers' surplus is c + a + b + d
      • Producers' surplus is e
      • Total social welfare is a + b + c + d + e
      • Gains for trade = a + b + c + d + e - (a + c + e) = b + d
   3. Autarky for exporting country
      • Consumers' surplus is m + j + k
      • Producers' surplus is p + q
      • Total social welfare is m + j + k + p + q

The Welfare Effects of Free Trade

1. 4. Country exports a product
      • Consumers' surplus = m
      • Producers' surplus = p + q + j + k + n
      • Social welfare = m + p + q + j + k + n
      • Gains in trade = m + p + q + j + k + n - (m + j + k + p + q) = n
   5. Gains more from trade
      • Exporting nation gains n
      • Importing nation gains b + d
      • Compare n to b + d
      • Note - both the domestic industry for importing country and foreign consumers for exporting country are harmed from trade