Perfectly competitive markets comprise large numbers of buyers and sellers.

The transactions
of any individual buyer or seller are so small in comparison to the overall volume of the good
or service traded in the market that each buyer or seller “takes” the market price as given
when making purchase or production decisions. For this reason, the model of perfect
competition is often cited as a model of price-taking behavior.

A market can be characterized along three dimensions: commodity—the product bought and
sold, geography—the location in which purchases are being made and time—the period of
time during which transactions are occurring.

Market demand curve shows us the quantity of goods that consumers are willing to buy at
different prices. Part of the demand derived demand - demand for a good that is derived
from the production and sale of other goods. Another part of the demand is direct demand -
demand for a good that comes from the desire of buyers to directly consume the good itself.
The demand curve tells us the highest price that the “market will bear” for a given quantity
or supply of output. Other factors besides price affect the quantity of a good demanded. The
prices of related goods, consumer incomes, consumer tastes, and advertising are among the
factors that we expect would influence the demand for a typical product. However, the
demand curve focuses only on the relationship between the price of the good and the
quantity of the good demanded. When we draw the demand curve, we imagine that all other
factors that affect the quantity demanded are fixed. The inverse relationship between price
and quantity demanded, holding all other factors that influence demand fixed, is called the
law of demand.

Problem 1: Sketching a Demand Curve

Suppose the demand for new automobiles in the United States is described by the equation

Qd =5.3−0.1 P
where Qd is the number of new automobiles demanded per year (in millions) when P is the
average price of an automobile (in thousands of dollars). (At this point, don’t worry about the
meaning of the constants in equations for demand or supply curves—in this case, 5.3 and
−0.1.)

Problem

(a) What is the quantity of automobiles demanded per year when the average price of an
automobile is $15,000? When it is $25,000? When it is $35,000?
(b) Sketch the demand curve for automobiles. Does this demand curve obey the law of
demand?

Solution

(a) To find the yearly demand for automobiles, given the average price per car, use
equation (2.1):

Average Price per Car (P) Using Equation (2.1) Quantity Demanded (Qd )
d
$15,000 Q = 5.3 − 0.1(15) = 3.8 3.8 million cars
d
$25,000 Q = 5.3 − 0.1(25) = 2.8 2.8 million cars
d
$35,000 Q = 5.3 − 0.1(35) = 1.8 1.8 million cars

(b) The downward slope of the demand curve in Figure tells us that as the price of
automobiles goes up, consumers demand fewer automobiles.

Market supply curve shows us the total quantity of goods that their suppliers are willing to
sell at different prices. The supply curve slopes upward, indicating that at higher prices,
suppliers of corn are willing to offer more corn for sale than at lower prices. The positive
relationship between price and quantity supplied is known as the law of supply.
As with demand, other factors besides price affect the quantity of a good that producers will
supply to the market. For example, the prices of factors of production—resources such as
labor and raw materials that are used to produce the good—will affect the quantity of the
good that sellers are willing to supply. When we draw a supply curve we imagine that all
these other factors that affect the quantity supplied are held fixed.

Problem 2: Sketching a Supply Curve

Suppose the yearly supply of wheat in Canada is described by the equation

s
Q =0.15+ P
where Qs is the quantity of wheat produced in Canada per year (in billions of bushels) when
P is the average price of wheat (in dollars per bushel).

Problem

(a) What is the quantity of wheat supplied per year when the average price of wheat is $2 per
bushel? When the price is $3? When the price is $4?

(b) Sketch the supply curve for wheat. Does it obey the law of supply?

Solution

(a) To find the yearly supply of wheat, given the average price per bushel, use equation (2.2):

Average Price per Bushel(P) Using Equation  Quantity Supplied (Q s )

s
$2 Q = 0.15 + 2 = 2.15 2.15 billion bushels
s
$3 Q = 0.15 + 3 = 3.15 3.15 billion bushels
s
$4 Q = 0.15 + 4 = 4.15 4.15 billion bushels

(b) The fact that the supply curve in Figure 2.4 slopes upward indicates that the law of supply
holds.
At the point, the market is in equilibrium if the quantity demanded equals the quantity
supplied, so the market clears. an equilibrium is a point at which there is no tendency for the
market price to change as long as exogenous variables (e.g., rainfall, national income) remain
unchanged. At any price other than the equilibrium price, pressures exist for the price to
change. if the price of product is more than equilibrium price, there is excess supply—the
quantity supplied at that price exceeds the quantity demanded. The fact that suppliers of
product cannot sell as much as they would like creates pressure for the price to go down. As
the price falls, the quantity demanded goes up, the quantity supplied goes down, and the
market moves toward the equilibrium price. If the price of product is less than equilibrium
price, there is excess demand—the quantity demanded at that price exceeds the quantity
supplied. Buyers of product cannot procure as much product as they would like, and so there
is pressure for the price to rise. As the price rises, the quantity supplied also rises, the
quantity demanded falls, and the market moves toward the equilibrium price.

Problem 3: Calculating Equilibrium Price and Quantity

Suppose the market demand curve for cranberries is given by the equation Qd =500−4 P ,
while the market  supply curve for cranberries (when P ≥ 50) is described by the equation
Qs =−100+2 P , where P is the price of cranberries expressed in dollars per barrel, and
quantity (Qd or Q s ) is in thousands of barrels per year.

Problem

At what price and quantity is the market for cranberries in equilibrium? Show this
equilibrium graphically.

Solution

At equilibrium, the quantity supplied equals the quantity demanded, and we can use this
relationship to solve for P: Q d = Qs , or 500 − 4P = −100 + 2P, which implies P = 100. Thus, the
equilibrium price is $100 per barrel. We can then find the equilibrium quantity by
substituting the equilibrium price into the equation for either the demand curve or the
supply curve:

Q d =500−4 ( 100 ) =100

Q s =−100+2 ( 100 )=100

Thus, the equilibrium quantity is 100,000 barrels per year.

To do a comparative statics analysis of the market equilibrium, you first must determine how
a particular exogenous variable affects demand or supply or both. You then represent
changes in that variable by a shift in the demand curve, in the supply curve, or in both. By
going through comparative statics analyses for a decrease in demand and an increase in
supply, we can derive the four basic laws of supply and demand:

1. Increase in demand + unchanged supply curve = higher equilibrium price and larger
equilibrium quantity.

2. Decrease in supply + unchanged demand curve = higher equilibrium price and smaller
equilibrium quantity.

3. Decrease in demand + unchanged supply curve = lower equilibrium price and smaller
equilibrium quantity.

4. Increase in supply + unchanged demand curve = lower equilibrium price and larger
equilibrium quantity.

Problem 3: Comparative Statics on the Market Equilibrium

Suppose that the U.S. demand for aluminum is given by the equation Qd =500−50 P+10 I
where P is the price of aluminum expressed in dollars per kilogram and I is the average
income per person in the United States (in thousands of dollars per year). Average income is
an important determinant of the demand for automobiles and other products that use
aluminum, and hence is a determinant of the demand for aluminum itself. Further suppose
that the U.S. supply of aluminum (when P ≥ 8) is given by the equation Qs =−400+50 P . In
both the demand and supply functions, quantity is measured in millions of kilograms of
aluminum per year.

Problem

(a) What is the market equilibrium price of aluminum when I = 10 (i.e., $10,000 per year)?

(b) What happens to the demand curve if average income per person is only $5,000 per year
(i.e., I = 5 rather than I = 10). Calculate the impact of this demand shift on the market
equilibrium price and quantity and then sketch the supply curve and the demand curves
(when I = 10 and when I = 5) to illustrate this impact.

Solution

(a) We substitute I = 10 into the demand equation to get the demand curve for aluminum:
d d s
Q =600−50 P .We then equate Q to Q to find the equilibrium price: 600 − 50P = −400
+50P, which implies P = 10. The equilibrium price is thus $10 per kilogram. The equilibrium
quantity is Q = 600 − 50(10), or Q = 100. Thus, the equilibrium quantity is 100 million
kilograms per year.

(b) The change in I creates a new demand curve that we find by substituting I = 5 into the
demand equation shown

above: Qd =550−50 P . As before, we equate

Qd to Q s to find the equilibrium price: 550 − 50P = −400 + 50P, which implies P = 9.5. The
equilibrium price thus decreases from $10.00 per kilogram to $9.50 per kilogram. The
equilibrium quantity is Q = 550 − 50(9.50), or Q = 75. Thus, the equilibrium quantity
decreases from 100 million kilograms per year to 75 million kilograms.

The increase in demand tends to push the equilibrium quantity upward, while the decrease
in supply tends to push the equilibrium quantity downward. The net impact on the
equilibrium quantity would depend on the magnitude of those shifts, as well as the shapes of
the demand and supply curves themselves.
The price elasticity of demand measures the sensitivity of the quantity demanded to price.
The price elasticity of demand (denoted by ϵ Q , P ) is the percentage change in quantity
demanded (Q) brought about by a 1 percent change in price (P), which means that,
percentage change∈quantity
ϵ Q, P=
percentage change∈ price

If ΔQ is the change in quantity and ΔP is the change in price, then

∆Q
percentage change ∈quantity= ∗100 %
Q

and
∆P
percentage change ∈ price= ∗100 %
P

Thus, the price elasticity of demand is

∆Q
∗100 %
Q
ϵ Q, P=
∆P
∗100 %
P

or
∆Q P
ϵ Q, P=
∆P Q

As illustrated by this example, the value of ϵ Q , P must always be negative, reflecting the fact
that demand curves slope downward because of the inverse relationship of price and
quantity: When price increases, quantity decreases, and vice versa. The following table
shows how economists classify the possible range of values for ϵ Q , P :

Value of ϵ Q , P Classification Meaning

Quantity demanded is
0 Perfectly inelastic demand completely insensitive to
price.
Quantity demanded is
between 0 and −1 Inelastic demand relatively insensitive to
price.
Percentage increase in
quantity demanded is equal
-1 Unitary elastic demand
to percentage decrease in
price.
between −1 and −∞ Elastic demand Quantity demanded is
 relatively sensitive to price.
Any increase in price results
in quantity demanded
decreasing to zero, and any
−∞ Perfectly elastic demand
decrease in price results in
quantity demanded
increasing to infinity

Problem 3: Price Elasticity of Demand

Suppose price is initially $5.00, and the corresponding quantity demanded is 1,000 units.
Suppose, too, that if the price rises to $5.75, the quantity demanded will fall to 800 units.

Problem

What is the price elasticity of demand over this region of the demand curve? Is demand
elastic or inelastic?

Solution

In this case, ΔP = 5.75 − 5 = $0.75, and ΔQ = 800 − 1,000 = −200, so,

∆ Q P −200 $ 5
ϵ Q, P= = =−1.33
∆ p Q $ 0.75 1000

Thus, over the range of prices between $5.00 and $5.75, quantity demanded falls at a rate of
1.33 percent for every 1 percent increase in price. Because the price elasticity of demand is
between −1 and −∞, demand is elastic over this price range (i.e., quantity demanded is
relatively sensitive to price).

A commonly used form of the demand curve is the linear demand curve, represented by the
equation Q = a − b P, where a and b are positive constants. In this equation, the constant a
embodies the effects of all the factors (e.g., income, prices of other goods) other than price
that affect demand for the good. The coefficient b reflects how the price of the good affects
the quantity demanded. Any downward-sloping demand curve has a corresponding inverse
demand curve that expresses price as a function of quantity. We can find the inverse demand
curve by taking the equation for the demand curve and solving it for P in terms of Q. The
inverse demand curve for the linear demand curve is given by
a 1
P= − Q
b b
The term a/b is called the choke price. This is the price at which the quantity demanded falls
to 0.14

The price elasticity of demand for the linear demand curve is given by the formula
∆Q P P
ϵ Q, P= =−b
∆p Q Q

This formula tells us that for a linear demand curve, the price elasticity of demand varies as
we move along the curve. Between the choke price a/b (where Q = 0) and a price of a/2b at
the midpoint M of the demand curve, the price elasticity of demand is between −∞ and −1.
This is known as the elastic region of the demand curve. For prices between a/2b and 0, the
price elasticity of demand is between −1 and 0. This is the inelastic region of the demand
curve.

Equation highlights the difference between the slope of the demand curve, −b, and the price
elasticity of demand, −b(P/Q). The slope measures the absolute change in quantity demanded
(in units of quantity) brought about by a one-unit change in price. By contrast, the price
elasticity of demand measures the percentage change in quantity demanded brought about
by a 1 percent change in price.

Another commonly used demand curve is the constant elasticity demand curve,

given by the general formula: Q = aP-b, where a and b are positive constants. For the

constant elasticity demand curve, the price elasticity is always equal to the exponent −b.

Problem 4: Elasticities along Special Demand Curves

Problem
−1
(a) Suppose a constant elasticity demand curve is given by the formula Q=200−P 2 . What is
the price elasticity of demand?

(b) Suppose a linear demand curve is given by the formula Q = 400 − 10P. What is the price
elasticity of demand at P = 30? At P = 10?

Solution

(a) Since this is a constant elasticity demand curve, the price elasticity of demand is equal to
−1/2 everywhere along the demand curve.

(b) For this linear demand curve, we can find the price elasticity of demand by using
equation
P
ϵ Q , P =−b . Since b = 10 and Q = 400 − 10P, when P = 30,
Q

ϵ Q , P =−10
( 30
)
400−10 ( 30 )
=−3

and when P = 10,

ϵ Q , P =−10
( 400−10
10
( 10 ) )
=−0.33

Note that demand is elastic at P = 30, but it is inelastic at P = 10 (in other words, P = 30 is in
the elastic region of the demand curve, while P = 10 is in the inelastic region).

To see why a business might care about the price elasticity of demand, let’s consider how an
increase in price might affect a business’s total revenue, that is, the selling price times the
quantity of product it sells, or PQ. If the demand is elastic (the quantity demanded is
relatively sensitive to price), the quantity reduction will outweigh the benefit of the higher
price, and total revenue will fall. If the demand is inelastic (the quantity demanded is
relatively insensitive to price), the quantity reduction will not be too severe, and total
revenue will go up.

Here are some factors that determine a product’s price elasticity of demand—the extent to
which demand is relatively sensitive or insensitive to price.

• Demand tends to be more price elastic when there are good substitutes for a product (or,
alternatively, demand tends to be less price elastic when the product has few or not very
satisfactory substitutes).

• Demand tends to be more price elastic when a consumer’s expenditure on the product is
large (either in absolute terms or as a fraction of total expenditures).

• Demand tends to be less price elastic when the product is seen by consumers as being a
necessity.

The distinction between market-level and brand-level elasticities reflects the impact of
substitution possibilities on the degree to which consumers are sensitive to price. If a firm
expects its rivals to quickly match its price change, then the market-level elasticity will
provide the appropriate measure of how the demand for the firm’s product is likely to change
with price. If, by contrast, a firm expects its rivals not to match its price change (or to do so
only after a long time lag), then the brand-level elasticity is appropriate. Brand-level price
elasticities of demand are more negative than market-level price elasticities of demand
because consumers have greater substitution possibilities when only one firm raises its price.

Two of the more common elasticities in addition to the price elasticity of demand are the
income elasticity of demand and the cross-price elasticity of demand. The income elasticity
of demand is the ratio of the percentage change of quantity demanded to the percentage
change of income, holding price and all other determinants of demand constant:
∆Q
∗100 %
Q
ϵ Q, I =
∆I
∗100 %
I

or, after rearranging terms,

∆Q I
ϵ Q, I =
∆I Q

The cross-price elasticity of demand - The ratio of the percentage change of the quantity of
one good demanded with respect to the percentage change in the price of another good - for
good i with respect to the price of good j is the ratio of the percentage change of the quantity
of good i demanded to the percentage change of the price of good j :
∆Qi
∗100 %
Qi
ϵQ P =
i j
∆ Pj
∗100 %
Pj

or, after rearranging terms,

∆ Q i Pi
ϵQ P = i j
∆ P j Qj

where P j denotes the initial price of good j and Qi denotes the initial quantity of good i
demanded.

Cross-price elasticity can be positive or negative. If ϵ Q P >0 , a higher price for good j
i j

increases the quantity of good i demanded. In this case, goods i and j are demand substitutes.

If ϵ Q P <0 , a higher price for good j decreases the quantity of good i demanded. In this case,
i j

goods i and j are demand complements.

The price elasticity of supply measures the sensitivity of quantity supplied Qs to price. The
price elasticity of supply—denoted by ϵ Q , P—tells us the percentage change in quantity
s

supplied for each percent change in price:

∆ Qs
∗100 %
Qs ∆ Qs P
ϵ Q, I = =
∆P ∆ P Qs
∗100 %
P
This formula applies to both the firm level and the market level. The firm-level price
elasticity of supply tells us the sensitivity of an individual firm’s supply to price, while the
market-level price elasticity of supply tells us the sensitivity of market supply to price.

It is useful to distinguish between the long-run demand curve for a product—the demand
curve that pertains to the period of time in which consumers can fully adjust their purchase
decisions to changes in price–and the short-run demand curve—the demand curve that
pertains to the period of time in which consumers cannot fully adjust their purchasing
decisions to changes in price. The long-run demand curve is “flatter” than the short-run
demand curve.

Similarly, firms sometimes cannot fully adjust their supply decisions in response to changes
in price. The increase in the quantity supplied as a result of the price increase will thus be
greater in the long run than in the short run. The long-run supply curve—the supply curve
that pertains to the period of time in which sellers can fully adjust their supply decisions in
response to changes in price, and the short-run supply curve—the supply curve that pertains
to the period of time in which sellers cannot fully adjust their supply decisions in response to
a change in price. The long-run supply curve is flatter than the short-run supply curve.

For certain goods, long-run market demand can be less elastic than short-run demand. This is
particularly likely to be true for goods such as automobiles or airplanes— durable goods—
that provide valuable services over many years.

Analysts often lack the resources to collect enough data for a sophisticated statistical analysis,
so they need some techniques that allow them, in a conceptually correct way, to infer the
shape or the equation of a demand curve from fragmentary information about prices,
quantities, and elasticities. These techniques are called back-of-the-envelope calculations
because they are simple enough to do on the back of an envelope.

The approach to fitting a linear demand curve to quantity, price, and elasticity data proceeds
as follows. Suppose Q* and P* are the known values of quantity and price in this market, and
ϵ Q , P is the estimated value of the price elasticity of demand. Recall the formula for the price
elasticity of demand for a linear demand function.
P¿
ϵ Q , P =−b ¿
Q
Solving equation for b yields
Q¿
b=−ϵ Q , P ¿
P
To solve for the intercept a, we note that Q* and P* must be on the demand curve. Thus, it
must be that Q* = a − bP*, or a = Q* + bP*.

Substituting the expression in equation for b gives

¿
(
a=Q + −ϵ Q ,P
Q¿ ¿
P
¿ P )
Then, by canceling P* and factoring out Q*, we get
¿
a=( 1−ϵ Q , P ) Q

Taken together, equations provide a set of formulas for generating the equation of a linear
demand curve.