ECON 351x: Microeconomics for

Business

Chapter 5.1: Market Equilibrium

M. Safarzadeh
FBE Department
Chapter 5.1: Market Equilibrium
Market Analysis
Market: A Place where demand and supply meet or trade takes place.

Demand: Represents consumer response to prices. Demand Curve shows quantities that a
consumer is willing and able to buy at different prices.

Note that, demand shows quantities that consumer is willing to buy at different prices, not
the quantities that consumer actually buys.

Demand for a good can be expressed as Q = f(P). In a simple linear form, the function is
Q = a – bP, where b is the slope of the demand curve.
Chapter 5.1: Market Equilibrium
Distinction Between Demand & Quantity Demanded:
Quantity demanded changes if price changes.
Demand changes due to changes in demand shifters.
Chapter 5.1: Market Equilibrium
Demand Shifters: Income, Price of related goods (substitutes & compliments), taste,
populations, expected prices, and else.
Chapter 5.1: Market Equilibrium
Supply: Quantities that a producer is willing and able to supply at different prices.

Supply function Q = f(P), or in linear form Q = a + bP.

Chapter 5.1: Market Equilibrium
Distinction Between Supply & Quantity Supplied: Quantity supplied changes due to price
change.
Supply changes due to changes in supply shifters.
Supply Shifters: Technology, Price of Inputs, Sales Tax, expected prices, and else.
Chapter 5.1: Market Equilibrium
Market: Demand and Supply meet.
Chapter 5.1: Market Equilibrium
Effect of Increase in Income (A Demand Shifter):

Demand: + , Supply: No Change, Qe & Pe: +

Chapter 5.1: Market Equilibrium
Effect of Increase in Oil Prices (A Supply Shock):

Demand: No Change, Supply: -, Pe: +, Qe: -

Chapter 5.1: Market Equilibrium
Joint Effect of Income & Oil Price Increase:

Demand +, Supply -, Qe ?, Pe +
Chapter 5.1: Market Equilibrium
Practice on Market Analysis - Questions
1. COVID-19 has caused a major drop in income in US. Analyze the effect of COVID-19 on
housing market using demand and supply. Show what will be the effect on demand for
housing, supply of housing, price and quantity.
2. Due to COVID pandemic and the shut-down of the economy price of lumber and cement
has decreased. What is the effect of the event on housing market?
3. What are the joint effect of items 1 and 2 on housing market?
4. There is expectations of lower housing prices in the housing market. Do a market analysis
showing what will happen to demand, supply, housing prices and houses sold.
5. Economic principle is against government intervention in markets. What are the
exceptions to the economic principle. What are the arguments for government
interventions?
Chapter 5.1: Market Equilibrium
Practice on Market Analysis - Answers
1. Demand -, Supply 0, Price -, Quantity -.
2. Demand 0, Supply +, Price -, Quantity +.
3. Demand -, Supply +, Price -, Quantity ?.
4. Demand -, Supply +, Price -, Quantity +.
5. Government intervention always result in deadweight loss or social cost. The only arguments
for interventions are:
a) Externalities, which are the side effects of businesses. Favorable externalities (education)
should be subsidized by government and unfavorable externalities (pollution) should be taxed.
b) Asymmetry of information, where the information buyer and seller have are in favor of
one side. Example is stock market, where individual investors don’t have as much information as
institutional players in the market.
Chapter 5.1: Market Equilibrium

Elasticity is one of the most applied and widely used concepts in economics.

Price elasticity of demand is a measure of response of quantity demanded to a change in

price. It is defined as percentage change in quantity over percentage change in price
ep = %Q / % P
Being the ratio of two numbers, |ep| has to be either less than one, more than one, or equal
to one.
If ep< 1, demand for good is said to be inelastic. A change in price will have less than
proportional impact on quantity demanded. These are necessity goods, such as gasoline,
medicine, and food.
Chapter 5.1: Market Equilibrium
If ep > 1, demand for good is said to be elastic. A change in price will have more than
proportional impact on quantity demanded. Goods like cruise on a luxury ocean-liner, a
vacation in Europe, or fancy ties and shirts.
If ep = 1, the good is said to be unit elastic. A change in price will have proportional impact on
quantity demanded. More of daily common goods.
Price Elasticity and Total Revenue
Every business is concerned with revenue. Businesses try to take advantage of every
occasion, such as new year, Christmas, change in seasons, and others to increase the
revenue. Total revenue (TR) is equal to price (P) times quantity (Q), TR = P.Q. Raising price
does not mean an increase in TR. Decreasing price also does not mean an increase in TR.
What explains the outcome of total revenue in response to a price change is the price
elasticity of demand or ep.
Chapter 5.1: Market Equilibrium
If a good is inelastic, ep < 1 (necessities), an increase in price will increase TR and a decrease in
price will decrease TR. This explains the behavior of oil industry and why that industry tries
to raise gasoline and other oil products prices with any excuse.
If a good is elastic ep > 1 (luxury), an increase in price will decrease TR and a decrease in price
will increase TR. This explains why sellers of luxury items in Macy’s, Nordstrom and others
have all those sales going on at any excuse.
If a good is unit elastic, ep = 1, a decrease or increase in price will have no effect on TR.

Calculating Elasticity: Given a change in price, price elasticity can be calculated by finding %
Q = 100(Q2 - Q1)/Q1, % P = 100(P2 - P1)/P1, and ep = % Q / % P.
This formulation of elasticity is called point price elasticity.
Chapter 5.1: Market Equilibrium
If Q and P in the denominator of the the %Q and %P were average quantity, (Q2+Q1)/2 and
average price, (P2+P1)/2 rather than the initial values of Q1 and P1 respectively, the
formulation is called mid-point or arc price elasticity.
In practice, the price elasticity for a good is estimated using the historical data on price and
quantity, estimating the demand relation using regression, and finding the elasticity. For
example, if demand for a good is estimated as Q = a – bP, the price elasticity at a point on
demand (Po, Qo) is ep = bPo/Qo.
However, if Q and P of the demand model were expressed in natural logarithm, lnQ = o - lnP,
then ep = .
Elasticity and Slope of Demand Curve
Price elasticity is not the same as the slope of demand curve.
For a linear demand curve price elasticity changes along the demand line.
Chapter 5.1: Market Equilibrium
Linear Demand and Elasticity

For a linear demand, price elasticity

equals one on the mid-point of
demand, greater than one or elastic
above the mid point, and less than
one or inelastic below the mid point.
Chapter 5.1: Market Equilibrium
Some Extreme Cases of Elasticity
Perfectly Inelastic Demand: The case of a very necessity good such as an urgent surgery for
a patient. Demand in this case will be a vertical line as in the graph below.
Chapter 5.1: Market Equilibrium
Perfectly Elastic Demand: This is the case where a small change in price will have extreme
impact on quantity. Demand in this case will be a horizontal line.
Chapter 5.1: Market Equilibrium
Determinants of Price Elasticity
What makes demand for a good more elastic or inelastic?
Necessity and Need: Need and necessity make demand for a good more inelastic. Goods
that can easily be given up will have less inelastic demand.

Having Good Substitutes: Having a good substitute will make the demand for the less
inelastic. Even though food items, in general, are inelastic, demand for hamburgers in a
neighborhood that has many food stands will be less inelastic.

Time: Time makes demand for goods more elastic. A cigarette smoker’s demand for
cigarettes is inelastic. However, as time passes, the person may kick out the habit of
smoking and demand for cigarette becomes less inelastic.
Chapter 5.1: Market Equilibrium
Portion of Income Spent on the Good: Demand for larger items in an individuals’ budget
are more elastic than demand for smaller items. A 10% or 20% discount on price of
toothpick will not make you to buy more toothpicks, but a small discount on a car that
you like will most likely make you to change your mind and buy the car.
Income Elasticity of Demand
One important determinant of demand is income. As income increase we buy more of
normal goods and less of inferior goods. Income elasticity of demand ey is defined as
percent change in quantity (%  Q) over percent change in income (% Y),
ey = %Q / %Y
ey may be negative or positive. A negative ey implies that the good is an inferior good. A
positive ey implies that the good is a normal good.
Chapter 5.1: Market Equilibrium
As well, as income increase people generally spend the extra income not on necessity goods
such as housing, food, or transportation, but on luxury or fun goods. Therefore, necessity
goods usually have an income elasticity of less than one and luxury and fun items have an
income elasticity of greater than one.

Cross Price Elasticity of Demand

Cross price elasticity of demand (ex) is defined as percent change in quantity demanded of
good i to percent change in price of its related good j (complement or substitute). That is,
ex = %Qi / %Pj

A positive ex means that two goods are substitute for each other.
A negative ex means that two goods are complement of each other.
Chapter 5.1: Market Equilibrium
Elasticity of Supply
Elasticity of supply shows responsiveness of supply to changes in price. It is defined as,
es = %Q / %P

Like demand, if es < 1, supply is price inelastic. These are goods such as the farm products
where supply can hardly respond to increase in prices. Some manufacturing goods are price
elastic in supply, with es > 1.

Other Uses of Elasticity: Burden of Taxes

Who pays the Sales Taxes? Sales taxes are generally charged on producers. Producers,
however, transfer as much of it as is possible to consumers.
Chapter 5.1: Market Equilibrium
What portion of a sales tax is transferred to consumers is a matter of price elasticity of
demand for the goods. For an inelastic or necessity good, naturally, a larger portion of the tax
can be transferred to consumers. For elastic or luxury goods, however, transfer of a large
portion of tax will hurt the sales and the revenue of the producers.
Elasticity of Supply
Like demand, price elasticity of of supply can be measured at any point on the supply curve.
Its is defined as:
ep = %Q / %P

Obviously, for some product supply is price elastic. Many manufacturing goods have elastic
supply. However, most of the agricultural products have price-inelastic supply.
Chapter 5.1: Market Equilibrium

Effect of Government Interventions in Markets: Markets perform best when government

does not intervene in markets. Two forms of interventions are Price Ceiling and Price Floor.

Price Ceiling: When government sets the price below the market price.
Example: Rent Control.

Price Floor: When government sets the price above the market price.
Example: Subsidy to Farmers or dairy products.
Chapter 5.1: Market Equilibrium

ICP: Elasticity

Practice:
Answer the following questions using the elasticity concept:
1. Why do coffee growers’ associations in the coffee producing countries destroy part of
the annual coffee crop?
[Link] do the association of potato growers feed part of the annual potato crop to cattle?
[Link] does a freeze in Florida benefits citrus growers in California?
[Link] elasticity of a product is .80. The producer raises the price by 2%. What will be the
change in quantity demanded?
Chapter 5.1: Market Equilibrium
ICP: Elasticity
Practice - Continued:
Answer the following questions using the elasticity concept:
5. A producer raises the price of its product from $20.00 to 24.00. The price increase
reduces quantity demanded from 450 units a day to 420 units. a. What is the
price elasticity of demand? b. Was the price increase a right business decision? Will
revenue increase or decrease? c. What will happen to profit of the firm?
6. Demand for a product is given as : Q = 100 – 2P. What is the price elasticity when the
price of the product is $20?
7. Demand and supply for a product are estimated to be Q = 100 – 2P and Q = .5P. Find
the equilibrium price, equilibrium quantity, price elasticity of demand and price elasticity
of supply at the equilibrium point. Comment on elasticities of demand and supply.