1

Demand Side
3

1. Demand Side
Given information about the quantity demanded at different prices (demand schedule) we can draw the demand curve. price
Demand Schedule of pizzas
$5.00

CHAPTER 03: SUPPLY & DEMAND

Micro Recitation Torsten Jochem

Price $5.00 $3.00 $1.00

Quantity 100 500 1,000

$3.00

$1.00

DEMAND quantity 100 500 1,000

Chap 3: Supply & Demand

2 4

Demand Side
1. Demand Side
The Law of Demand
Ceteris paribus, as the price of a good/service falls, demand for it increases; hence, we have a downwardssloping demand curve. Why?
1. Substitution Effect: A price change also changes the relative price toward other substitutes. The demand for substitutes may go up/down as a result of a price increase/decrease. E.g.: If a gyro goes down in price by $1, its relative price to subs goes down shifting demand from subs over to gyros. 2. Income Effect: More income leads to higher quantity demanded (if the good is normal; forthcoming).

Outline
1. Demand 2. Supply 3. Market Equilibrium

Concepts: Demand schedule/curve, Supply schedule/curve, Equilibrium, Substitution Effect, Income Effect, Ordinary Good, Giffen Good, Substitute, Complement, Normal Good, Inferior Good, Source for Demand shifts, Sources for Supply shifts, Law of Demand, Law of Supply, ceteris paribus, Surplus, Shortfall

Demand Side
5 7

Demand Side
1. Demand Side
Good Relationships
Substitutes: Goods that can be used for same purpose
E.g., gyro for subs, bus tickets for gas, email for snail mail,

1. Demand Side
Responsiveness to price changes
(i) An Ordinary Good: As price increases, demand decreases. price
$5.00

Complements: Goods that go with one another

E.g., car with gas, frozen food with fridges,

$3.00

$1.00

DEMAND quantity 100 500 1,000

Demand Side
6 8

Demand Side
1. Demand Side
Good types
Responsiveness to income changes (i) A Normal Good: As income increases, consumption of the good increases (e.g., clothes). (ii) An Inferior Good: As income increases, consumption of the good decreases (e.g., potatoes as the poor peoples staple is replaced with more meat as income goes up).

1. Demand Side
Responsiveness to price changes
(ii) A Giffen Good: As price increases, consumption of the good increases, thereby violating the Law of Demand!
I.e., upwards sloping demand curve for Giffen goods! (RARE!) E.g., rice in China: rice as a poor persons stable is a necessity. If price of rice increases, substituting away not possible; better food is crowded out and more rice needs to be consumed for survival. (Jensen & Miller, AER 2008) Similar notion: Veblen Good (=luxurious good, such as Rolex) where its value is derived from the price level. (The higher the price of a Rolex, the more prestigious.)

Demand Side
9 11

Supply Side
2. Supply Side
Reasons for Increase in Demand (=Demand curve shifting to the right)

1. Demand Side
Shift in Demand
price $5.00 D1 $3.00 D2 $1.00 quantity 100 500 1,000

Given information about the quantity supplied at different prices (supply schedule) we can draw the supply curve.
price $5.00 SUPPLY

Increase in 1. Income (and good is normal) 2. Taste 3. Population 4. Expected future prices 5. Price of related good a. Price of substitute goes up b. Price of complement goes down

Demand Schedule of pizzas Price $5.00 $3.00 $1.00 Quantity 1,000 500 100
100 500 1,000 $1.00 quantity $3.00

Demand Side
10 12

Supply Side
2. Supply Side
Reasons for Decrease in Demand (=Demand curve shifting to the left)

1. Demand Side
Shift in Demand
price $5.00 D1

The Law of Supply

Ceteris paribus, as the price of a good/service increases, supply for it increases; hence, we have an upwards-sloping supply curve. Why?
As the price of a good increases, there are more firms who are willing (and are capable) to produce it at that price.

$3.00

Increase in 1. Income (and good is inferior) 2. Price of related good: a. Price of substitute goes down b. Price of complement goes up
D2 quantity

$1.00

100

500

1,000

Supply Side
13 15

Market Equilibrium
3. Market Equilibrium
The Equilibrium (price) is where Supply = Demand
Reasons for Increase in Supply (=Supply curve shifting to the right)
price S2

2. Supply Side
Shift in Supply
price S1 $5.00

$3.00

1. 2. 3. 4.

$1.00

Decrease in input prices Improvement in Technology Increase in # of firms Price of related goods a. Price of substitute goes down b. Price of complement goes up

Pizza Market Price $5.00 $3.00 $1.00 Quantity demanded 100 500 1,000 Quantity supplied 1,000 500 100

$5.00

SUPPLY

$3.00

$1.00

DEMAND quantity 100 500 1,000

quantity 100 500 1,000

Energy drinks: If price of sodas goes down, producing sodas gets less profitable. Companies (Pepsi Co,etc. ) will shift production from sodas to energy drinks.

Supply Side
14 16

Market Equilibrium
3. Market Equilibrium: Surplus
Reasons for Decrease in Supply (=Supply curve shifting to the left) 1. Increase in input prices 2. Decrease in # of firms 3. Price of related goods a. Price of substitute goes up b. Price of complement goes down 4. Expected future prices higher
quantity

2. Supply Side
Shift in Supply
price $5.00 S1 S2

At a higher price level we would have more production than there is demand: surplus / excess supply. full inventories firms cut prices demand picks up & firms reduce output.

surplus at $5.00
price $5.00 SUPPLY

$3.00

$3.00

$1.00

$1.00

DEMAND quantity 100 500 1,000

100

500

1,000

Expected future prices: if a firm believes that future prices are higher, it may sell less and increase inventories in anticipation of rising prices for the good.

Market Equilibrium
17 19

Market Equilibrium
3. Market Equilibrium:
Example: (positive) Taste shock
price price SUPPLY

3. Market Equilibrium: Shortfall

At a lower price level we would have less production than there is demand: shortfall / excess demand. as more demand than goods available firms increase prices for those goods available demand reduces and supply increases.

$5.00

$3.00

1. Positive Taste shock 2. Demand increases from D1 D2 3. New equilibrium at ($3.50 / 600 units)`

SUPPLY $3.50 $3.00

$1.00

DEMAND D2

shortfall at $1.00
100 500 1,000

D1 quantity 500 600 quantity

Caveat
18

Easy to confuse:
Change in Quantity supplied (green) vs. Change in Supply (blue)
price S1 S2

quantity

Likewise:
Change in Quantity demanded vs. Change in Demand