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# Demand and Supply FunctionsLecture 2

## Supply and Demand

1. Supply and Demand

• 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
1. 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 ed = -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%

1. 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

2. 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
1. Supply - shows the quantity and price of a good that firms are willing to produce/sell

The Supply Function
• 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
1. Social Welfare – consumers' plus producers' surpluses

• A competitive market maximizes social welfare

Social Welfare-Consumers' plus Producers' Surpluses

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

1. 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

1. Example – U.S. imports petroleum from Kazakhstan

• United States import Q2 – Q1 = T

• U.S. gains petroleum

• Kazakhstan exports Q4 – Q3 = T

• Kazakhstan gains U.S. dollars

Free Trade Between the U.S. and Kazakhstan
1. 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. 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

2. 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. 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