Managerial Economics

BEPP 250
Market Equilibrium
Elasticity
Comparative Statics
Today’s Plan

Equilibrium and elasticity:

• Market equilibrium is the intersection of the supply and demand curves.

1. Market Equilibrium • This explains how prices are determined.

• Elasticity is the best way to measure how sensitive supply and demand
2. Elasticity are to changes in prices.

• Comparative statics is the analysis of how prices change with

3. Comparative Statics fundamentals.

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Overview
Supply and Demand

• Today we will learn the supply and demand model, which is one of the most
important models in economics.
• The point of supply and demand is to explain how prices, production, and
consumption are determined in a competitive market.
• We will take it to the next level compared to introductory econ: how do
fundamentals change the equilibrium, and what determines different behavior in
different markets.
• Examples: Why do oil prices vary so much, whereas the price of pizza is relatively
stable? What determines Uber’s surge pricing?

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A brief history of oil prices

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A brief history of oil prices

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Theory and solved problems
The Supply and Demand Model

• Supply function S(p) is the quantity supplied at any given price.

• Demand function D(p) is the quantity demanded at any given price.

Market equilibrium

Market equilibrium is a pair (𝑝∗ , 𝑞 ∗ ) where supply

equals demand so that

∗* ∗* *∗
𝐷D(
𝑝 p )== 𝑆S(𝑝p ) ==q𝑞

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Graph
p
S

D
q
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 Graph
p
S

*
p

D
*
q
q 10
 Why equilibrium?
PRICE TOO HIGH PRICE TOO LOW PRICE JUST RIGHT
p p
p
More is supplied than
demanded

$5

$4
$3

Less is supplied
than demanded
qd qS q qS qd q qd = qS q

At p = $5, producers want to sell more than At p = $3, consumers want to buy more than
At p = $4, the quantity demanded equals the
consumers will take producers will sell
quantity supplied
Lowering price helps producers steal scarce Raising price helps producers avoid
No clear force pushing the price
consumers from their competitors shortages and make more profit

Equilibrium is where demand=supply 11

Exam Style Problem: Oil

• Consider the world market for oil.

• Quantities in bn barrels.
• Prices in USD / barrel.

Find the equilibrium (i.e., predict what will happen).

𝑝
𝐷 = 5.5 −
200
𝑝
𝑆 = 4.5 +
200
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Solution
350

𝐷=𝑆
𝑝
300

→ 5.5 −
200
250

𝑝
= 4.5 +
200

200
p

𝑝 150

→ =1
100 100

→ 𝑝∗ = 100 50

∗ ∗
→ 𝑞 = 𝐷(𝑝 ) = 5 0
0 1 2 3 4 5 6 7
q
Comparative Statics

Examples:
Comparative Statics

Comparative statics is the analysis of how • What happens to oil prices if there is a war
the market equilibrium changes if between Iran and Israel? What if there is better
fundamentals change.
shale oil technology in the US?
• What happens to Uber prices when it rains?
There are three ways of doing comparative statics:
• Graphically
• Intuition
• Mathematically.

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Exam Style Problem: Shocks in the Oil Market

• What happens if East Asian growth increases oil demand by 1 billion barrels per
year (a 20% increase)?
• This is similar to what happened in the 2000s commodity boom.
• Will the equilibrium quantity increase by more or less than 20%? What about
price?
• Solve the problem with the same supply curve. p𝑝
𝐷D== 6.5 −
−
200
p𝑝
𝑆S = 4.5 +
+
200
200 15
Method 1: Graphical Solution

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Method 1: Graphical Solution
p
S

p*

D
q
q* 17
Method 1: Graphical Solution
p
S

p**

**
q
q
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Method 2: Intuition

Graphical analysis says that “prices increase” and “quantities increase, but by less
than 20%”.
We can also figure that out by thinking about the economics:
• Demand increases by 20%.
• There is not enough supply so prices increase.
• The price increase raises the quantity supplied and dampens the quantity
demanded until we get to equilibrium.
• Quantities increase, but by less than 20%.

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Practice Slide

Fill in What Happens if… p

S
• Demand increases?
• Demand decreases?
• Supply increases?
• Supply and demand increase? p*

D
q
q*
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Method 3: Solving the Model
Method 3: Solving the Model
350

𝐷=𝑆
𝑝 300

→ 6.5 −
200 250

𝑝
= 4.5 + 200

200 p

𝑝 150

→ =2
100 100

→ 𝑝∗ = 200 50

∗ ∗
→ 𝑞 = 𝐷(𝑝 ) = 5.5 0
0 1 2 3 4 5 6 7
q

D S D' S'
Elasticities and Comparative Statics

• We found that a 20% increase in demand increases prices by 100%! This large
price response is surprising, but very similar to events in the history of the oil
market: commodities boom, 1973 embargo, etc.
• The reason why prices vary so much is that both the supply and the demand for
oil respond very little to price changes. So a big price change is needed to
reequilibrate the market, and hence we get a lot of price volatility with small
shocks.
• Supply and demand curves that are not very responsive to price are called
“inelastic”. We will study this concept next, as it matters for many issues beyond
comparative statics.

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Motivation for Elasticity

Famous Consulting Case

Famous consulting case: Yankee stadium is considering raising ticket prices by 10%—Should they?
What is the benefit and what is the cost?

• More generally, when producers raise price, how do they expect their customers
to react?
• But also…if demand suddenly rises, what will it take for producers to provide more
goods? A big price increase or a small one?
• How do we compare the sensitivity of demand in markets with different sizes, and
prices of different magnitudes. A $1 price increase for laptops is very different
from a $1 price increase for beer.
• Key idea in elasticities: look at percentage changes.
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Price Elasticity of Demand

Price Elasticity of Demand

The elasticity of demand is how many percent demand changes given a 1% increase in price.

Price
Formula:

𝑑 𝐷
dD ⁄
/D𝐷 𝑑𝐷
dD p𝑝 𝑃!

𝜀 ε== dp / p ==dp ⋅ D
5 𝑃"

𝑑 𝑝⁄𝑝 𝑑𝑝 𝐷 Demand

𝑄! 𝑄" Quantity
• Mathematically, the elasticity is calculated with a derivative.
• But in practice we can get a good approximation with small changes dD and dp.

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Elasticity of Supply

Price Elasticity of Supply

The elasticity of supply is how many percent supply changes given a 1% increase in price.

Formula:
𝑑dS𝑆/⁄S𝑆 dS𝑑𝑆p 𝑝
𝜂 η== == ⋅ '
𝑑dp𝑝/⁄p𝑝 dp𝑑𝑝S 𝑆
• Strictly speaking, demand elasticities are typically negative while supply
elasticities are positive (because with a price increase consumers buy less and
producers supply more).
• But typically we ignore the sign of elasticities as long as it is not confusing.
You will never lose points in the exam by having the wrong sign.
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Exam Style Problem: Calculate Elasticity in the Oil Example

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Exam Style Problem: Calculate Elasticity in the Oil Example

• The elasticities in the original equilibrium were:

𝑑𝐷p 𝑝 1 100
dD 1 100
ε𝜀 == 5= = =5 0.1 = 0.1
𝑑𝑝D 𝐷200 200
dp 5 5
𝑑𝑆p 𝑝 1 100
dS 1 100
η𝜂 == 5= = =5 0.1 = 0.1
𝑑𝑝S 𝑆200 200
dp 5 5
• In practice, the short-run elasticities of demand and supply of oil are very small,
around 0.1. This is why there are enormous price swings with small changes in
quantity as in the 1970s oil shock.

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Concepts
Ranges of Price Elasticity
0 -1

Inelastic Demand Elastic Demand

Quantity does not change a lot with a Quantity changes a lot with a
change in price change in price

Examples Examples
• Pharmaceuticals • Commodities
• Cigarettes for smokers • Cigarettes for potential smokers
• Gasoline in the short run • Gasoline in the long run

What impacts elasticity in general?

• Time: demand tends to be more inelastic in the short run, in long run you substitute
• Specificity: demand tends to be more elastic for more specific categories
• Market Definition: your product demand can be more or less elastic depending on how the market is defined.

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Special Cases

• Infinite elasticity • Zero Elasticity

• (aka Perfectly Elastic) • (aka perfectly inelastic)
• Flat Curve • Steep Curve

D
D
Other Elasticities

Elasticity of any variable x with respect to any other variable z

The elasticity of x with respect to z is how many percent x changes given a 1% increase in z.

dx 𝑑𝑥
z 𝑧
Formula:

ε𝜀x,z!,#
= =⋅ '
dz 𝑑𝑧
x 𝑥
• The most common example is the derivative of demand for a good (trucks) with
respect to the price of another good (gasoline).
• This is called a cross-price elasticity. Whereas the standard elasticity of demand
for a good with respect to its own price is called own-price elasticity.

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Cross Price Elasticity: Examples

Own-Price Elasticity Always negative (law of demand).

Cross-Price Elasticity Can be positive or negative.

Cross-Price Examples:
Elasticity of demand for… … w.r.t price of… …. Positive or negative?

• Coffee • Tea • Positive Substitute goods have

• iPhone • Galaxy S5 • Positive positive cross-price
• Margarine • Butter • Positive elasticities.
….
• Pencils • Erasers • Negative Complementary goods
• Wine • Cheese • Negative have negative cross-price
• DVDs • DVD Players • Negative elasticities.

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Key point: Demand Elasticity Varies with Slope

What happens to Elasticity as the slope of a demand curve changes?

Rotate a demand curve around a point:
"# $
Recall: 𝜀 = "$
⋅%
! #$
We’re holding " fixed, but #! gets smaller as the
Price

line becomes steeper.

• We think of flatter demand curves as being
𝑃 “more elastic” (think: quantity changes a lot
compared to price)
• We think of steeper demand curves as being
“more inelastic” (think: big changes in price
produce small changes in quantity, holding P
and Q fixed)
Quantity
𝑄
Lecture Summary

• The supply and demand model.

1. Market Equilibrium • Market equilibrium.

• We learned the three ways of doing comparative statics analysis:

2. Comparative Statics graphically, intuition, and math.

• What are elasticities. Own elasticities, cross elasticities, properties of

3. Elasticity elasticities.
• Importance of elasticities for comparative statics.

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