Theory of Supply and Demand

Hall and Lieberman, 3rd edition, Thomson South-Western, Chapter 3

Overview

Market (who, what, how) Supply and demand is an economic model

Designed to explain how prices are determined in certain types of markets

What you will learn in this chapter

How the model of supply and demand works and how to use it The law of demand The law of supply The determination of market equilibrium Factors shifting demand or supply curves

1. 2. 3. 4.

Markets
In economics, a market is not a place but rather a

group of buyers and sellers with the potential to trade with each other
Market is defined not by its location but by its participants First step in an economic analysis is to define and characterize the market or collection of markets to analyze

Economists think of the economy as a collection

of individual markets
3

How Broadly Should We Define The Market

Defining the market often requires economists to

group things together

Aggregation is the combining of a group of distinct things into a single whole

Markets can be defined broadly or narrowly,

depending on our purpose

How broadly or narrowly markets are defined is one of the most important differences between Macroeconomics and Microeconomics

Defining Macroeconomic Markets

Goods and services are aggregated to the

highest levels
Macro models lump all consumer goods into the single category consumption goods Macro models will also analyze all capital goods as one market Macroeconomists take an overall view of the economy without getting bogged down in details
5

Defining Microeconomic Markets

Markets are defined narrowly Focus on models that define much more specific commodities Always involves some aggregation But stops it reaches the highest level of generality that macroeconomics investigates

Buyers and Sellers

Buyers and sellers in a market can be Households Business firms Government agencies
All three can be both buyers and sellers in the same market, but are not always

For purposes of simplification this text will

usually follow these guidelines

In markets for consumer goods, well view business firms as the only sellers, and households as only buyers In most of our discussions, well be leaving out the middleman
7

Using Supply and Demand

Supply and demand model is designed to explain

how prices are determined in perfectly competitive markets

Perfect competition is rare but many markets come reasonably close Perfect competition is a matter of degree rather than an all or nothing characteristic

Supply and demand is one of the most versatile

and widely used models in the economists tool kit

8

Demand
A households quantity demanded of a good Specific amount household would choose to buy over some time period, given
A particular price that must be paid for the good All other constraints on the household

Market quantity demanded (or quantity

demanded) is the specific amount of a good that all buyers in the market would choose to buy over some time period, given
A particular price they must pay for the good All other constraints on households
9

Quantity Demanded
Implies a choice
How much households would like to buy when they take into account the opportunity cost of their decisions?

Is hypothetical
Makes no assumptions about availability of the good How much would households want to buy, at a specific price, given real-world limits on their spending power?

Stresses price
Price of the good is one variable among many that influences quantity demanded Well assume that all other influences on demand are held constant, so we can explore the relationship between price and quantity demanded
10

The Law of Demand

The price of a good rises and everything

else remains the same, the quantity of the good demanded will fall
The words, everything else remains the same are important
In the real world many variables change simultaneously However, in order to understand the economy we must first understand each variable separately Thus we assume that, everything else remains the same, in order to understand how demand reacts to price
11

The Demand Schedule

Demand schedule A list showing the quantity of a good that consumers would choose to purchase at different prices, with all other variables held constant Demand V.S. Quantities demanded
- demand is the entire relationship between price and quantity - quantities demanded are specific amount of goods buyers want to buy
12

The Demand Curve

The market demand curve (or just demand

curve) shows the relationship between the price of a good and the quantity demanded , holding constant all other variables that influence demand
Each point on the curve shows the total buyers would choose to buy at a specific price

Law of demand tells us that demand curves

virtually always slope downward

13

Figure 1: The Demand Curve

Price per Bottle When the price is $4.00 per bottle, 40,000 bottles are demanded (point A). $4.00 A At $2.00 per bottle, 60,000 bottles are demanded (point B).

2.00

40,000

60,000

Number of Bottles per Month

14

Shifts vs. Movements Along The Demand Curve

Move along the demand curve From a change in the price of the good we analyze In maple syrup example, Figure 1
A fall in price would cause a movement to the right along the demand curve (point A to B)

See figure 3(a)

15

Figure 3(a): Movements Along and Shifts of The Demand Curve

Price Price increase moves us leftward along demand curve P2 Price increase moves us rightward along demand curve P1

P3

Q2

Q1

Q3

Quantity
16

Shifts vs. Movements Along The Demand Curve

Shift of demand curve a change in other things than price of the good causes a shift in the demand curve itself, for example, income In Figure 2 Demand curve has shifted to the right of the old curve (from Figure 1) as income has risen A change in any variable that affects demandexcept for the goods pricecauses the demand curve to shift

17

Figure 2: A Shift of The Demand Curve

Price per Bottle An increase in income shifts the demand curve for maple syrup from D1 to D2. At each price, more bottles are demanded after the shift B $2.00 D1 D2 C

60,000

80,000

Number of Bottles per Month

18

Change in Quantity Demanded vs. Change in Demand

Language is important when discussing demand Quantity demanded means
A particular amount that buyers would choose to buy at a specific price It is a number represented by a single point on a demand curve When a change in the price of a good moves us along a demand curve, it is a change in quantity demand

The term demand means

The entire relationship between price and quantity demandedand represented by the entire demand curve When something other than price changes, causing the entire demand curve to shift, it is a change in demand

19

Income: Factors That Shift The Demand Curve

An increase in income has effect of shifting

demand for normal goods to the right

However, a rise in income shifts demand for inferior goods to the left

A rise in income will increase the demand

for a normal good, and decrease the demand for an inferior good Normal good and inferior good are defined by the relation between demand and income
20

Wealth: Factors That Shift The Demand Curve

Your wealthat any point in timeis the

total value of everything you own minus the total dollar amount you owe - Example An increase in wealth will
Increase demand (shift the curve rightward) for a normal good Decrease demand (shift the curve leftward) for an inferior good
21

Prices of Related Goods: Factors that Shift the Demand Curve

Substitutegood that can be used in place of

some other good and that fulfills more or less the same purpose
Example A rise in the price of a substitute increases the demand for a good, shifting the demand curve to the right

Complementused together with the good we are

interested in
Example A rise in the price of a complement decreases the demand for a good, shifting the demand curve to the left
22

Other Factors That Shift the Demand Curve

Population
As the population increases in an area
Number of buyers will ordinarily increase Demand for a good will increase

Expected Price
An expectation that price will rise (fall) in the future shifts the current demand curve rightward (leftward)

Tastes
Combination of all the personal factors that go into determining how a buyer feels about a good When tastes change toward a good, demand increases, and the demand curve shifts to the right When tastes change away from a good, demand decreases, and the demand curve shifts to the left
23

Small Summary -- Factors Affecting Demand

Income (depends on goods nature: normal

or inferior) Wealth (depends on goods nature) Prices of substitutes (positively related) Prices of complements (negatively related) Population (positively related) Expected price (positively related) Tastes (positively related)
24

Figure 3(b): Movements Along and Shifts of The Demand Curve

Price Entire demand curve shifts rightward when: income or wealth price of substitute price of complement population expected price tastes shift toward good

D2
D1 Quantity
25

Figure 3(c): Movements Along and Shifts of The Demand Curve

Price
Entire demand curve shifts leftward when: income or wealth price of substitute price of complement population expected price tastes shift toward good

D1 D2 Quantity
26

Supply
A firms quantity supplied of a good is the specific

amount its managers would choose to sell over some time period, given
A particular price for the good All other constraints on the firm

Market quantity supplied (or quantity supplied) is

the specific amount of a good that all sellers in the market would choose to sell over some time period, given
A particular price for the good All other constraints on firms
27

Quantity Supplied
Implies a choice
Quantity that gives firms the highest possible profits when they take account of the constraints presented to them by the real world

Is hypothetical
Does not make assumptions about firms ability to sell the good How much would firms managers want to sell, given the price of the good and all other constraints they must consider?

Stresses price
The price of the good is just one variable among many that influences quantity supplied Well assume that all other influences on supply are held constant, so we can explore the relationship between price and quantity supplied
28

The Law of Supply

States that when the price of a good rises

and everything else remains the same, the quantity of the good supplied will rise
The words, everything else remains the same are important
In the real world many variables change simultaneously However, in order to understand the economy we must first understand each variable separately We assume everything else remains the same in order to understand how supply reacts to price
29

The Supply Schedule and The Supply Curve

Supply scheduleshows quantities of a

good or service firms would choose to produce and sell at different prices, with all other variables held constant Supply curvegraphical depiction of a supply schedule
Shows quantity of a good or service supplied at various prices, with all other variables held constant
30

Figure 4: The Supply Curve

Price per Bottle
When the price is $2.00 per bottle, 40,000 bottles are supplied (point F).

$4.00

G At $4.00 per bottle, quantity supplied is 60,000 bottles (point G).

2.00

40,000

60,000

Number of Bottles per Month

31

Shifts vs. Movements Along the Supply Curve

A change in the price of a good causes a

movement along the supply curve

In Figure 4
A rise (fall) in price would cause a rightward (leftward) movement along the supply curve

A drop in transportation costs will cause a shift in

the supply curve itself

In Figure 5
Supply curve has shifted to the right of the old curve (from Figure 4) as transportation costs have dropped A change in any variable that affects supplyexcept for the goods pricecauses the supply curve to shift
32

Figure 5: A Shift of The Supply Curve

Price per Bottle A decrease in transportation costs shifts the supply curve for maple syrup from S1 to S2. At each price, more bottles are supplied after the shift $4.00 G J

S1

S2

60,000

80,000

Number of Bottles per Month

33

Factors That Shift the Supply Curve

Input prices A fall (rise) in the price of an input causes an increase (decrease) in supply, shifting the supply curve to the right (left) Price of Related Goods When the price of an alternate good rises (falls), the supply curve for the good in question shifts leftward (rightward) Technology Cost-saving technological advances increase the supply of a good, shifting the supply curve to the right
34

Factors That Shift the Supply Curve

Number of Firms An increase (decrease) in the number of sellerswith no other changesshifts the supply curve to the right (left)
Expected Price An expectation of a future price increase (decrease) shifts the current supply curve to the left (right)
35

Factors That Shift the Supply Curve

Changes in weather Favorable weather
Increases crop yields Causes a rightward shift of the supply curve for that crop

Unfavorable weather
Destroys crops Shrinks yields Shifts the supply curve leftward

Other unfavorable natural events may effect all

firms in an area
Causing a leftward shift in the supply curve
36

Figure 6(a): Changes in Supply and in Quantity Supplied

Price Price increase moves us rightward along supply curve S

P2

P1 P3

Price increase moves us leftward along supply curve

Q3

Q1

Q2

Quantity
37

Figure 6(b): Changes in Supply and in Quantity Supplied

Price Entire supply curve shifts rightward when: price of input price of alternate good number of firms expected price technological advance favorable weather S1 S2

Quantity
38

Figure 6(c): Changes in Supply and in Quantity Supplied

Price Entire supply curve shifts rightward when: price of input price of alternate good number of firms expected price unfavorable weather

S2
S1

Quantity
39

Summary: Factors That Shift The Supply Curve

The short list of shift-variables for supply that we

have discussed is far from exhaustive In some cases, even the threat of such events can cause serious effects on production Basic principle is always the same
Anything that makes sellers want to sell more or less of a good at any given price will shift supply curve

40

Equilibrium: Putting Supply and Demand Together

When a market is in equilibrium Both price of good and quantity bought and sold have settled into a state of rest The equilibrium price and equilibrium quantity are values for price and quantity in the market but, once achieved, will remain constant
Unless and until supply curve or demand curve shifts

The equilibrium price and equilibrium quantity

can be found on the vertical and horizontal axes, respectively

At point where supply and demand curves cross

41

Figure 7: Market Equilibrium

Price per Bottle 2. causes the price to rise . . . 3. shrinking the excess demand . . . S

E
$3.00 H
Excess Demand

4. until price reaches its equilibrium value of $3.00 .

1.00

J D

1. At a price of $1.00 per bottle an excess demand of 50,000 bottles . . .

25,000 50,000 75,000

Number of Bottles per Month

42

Excess Demand
Excess demand At a given price, the excess of quantity demanded over quantity supplied Price of the good will rise as buyers

compete with each other to get more of the good than is available

43

Figure 8: Excess Supply and Price Adjustment

Price per Bottle 1. At a price of $5.00 per bottle an excess supply of 30,000 bottles . . .
Excess Supply at $5.00 S

$5.00 2. causes the price to drop, 3.00

3. shrinking the excess supply . . .

K E

L 4. until price reaches its equilibrium value of $3.00.

D
35,000 50,000 65,000 Number of Bottles per Month
44

Excess Supply
Excess Supply At a given price, the excess of quantity supplied over quantity demanded Price of the good will fall as sellers compete

with each other to sell more of the good than buyers want

45

Solve for Equilibrium Algebraically

Suppose that demand is given by the

equationQ 140 10 P , is quantity demanded, P is the price of the good. Supply is given by Q S 80 5P where Q s is quantity supplied. What is the equilibrium price and quantity?
D

QD where

46

Income Rises: What Happens When Things Change

Income rises, causing an increase in demand Rightward shift in the demand curve causes rightward movement along the supply curve Equilibrium price and equilibrium quantity both rise
Shift of one curve causes a movement along

the other curve to new equilibrium point

47

Figure 9
Price per Bottle
4. Equilibrium price increases

3. to a new equilibrium.
S 2. moves us along the supply curve . . . 1. An increase in demand . . .

$4.00 3.00 E

F'

D2 D1
5. and equilibrium quantity increases too. 50,000 60,000 Number of Bottles of Maple Syrup per Period
48

An Ice Storm Hits: What Happens When Things Change

An ice storm causes a decrease in supply Weather is a shift variable for supply curve
Any change that shifts the supply curve leftward in a market will increase the equilibrium price
And decrease the equilibrium quantity in that market

49

Figure 10: A Shift of Supply and A New Equilibrium

Price per Bottle $5.00 S2 E'

S1

3.00

D 35,000 50,000 Number of Bottles

50

Using Supply and Demand: The Invasion of Kuwait

Why did Iraqs invasion of Kuwait cause the

price of oil to rise?

Immediately after the invasion, United States led a worldwide embargo on oil from both Iraq and Kuwait A significant decrease in the oil industrys productive capacity caused a shift in the supply curve to the left
Price of oil increased
51

Figure 12: The Market For Oil

Price per Barrel of Oil S2 S1 E'

P2
P1 E

D
Q2 Q1 Barrels of Oil
52

Using Supply and Demand: The Invasion of Kuwait

Why did the price of natural gas rise as well? Oil is a substitute for natural gas Rise in the price of a substitute increases demand for a good Rise in price of oil caused demand curve for natural gas to shift to the right
Thus, the price of natural gas rose

53

Figure 13: The Market For Natural Gas

Price per Cubic Foot of Natural Gas S

F' P4
F P3 D1 D2

Q3

Q4

Cubic Feet of Natural Gas

54

Figure 11: Changes in the Market for Handheld PCs

Price per Handheld PC 3. moved the market to a new equilibrium. 2. and a decrease in demand . . . S2002 S2003 1. An increase in supply . . .

4. Price decreased . . .

$500
B

$400
5. and quantity decreased as well. 2.45 3.33 D2002 D2003 Millions of Handheld PCs per Quarter
55

Both Curves Shift

When just one curve shifts (and we know the

direction of the shift) we can determine the direction that both equilibrium price and quantity will move When both curves shift (and we know the direction of the shifts) we can determine the direction for either price or quantitybut not both
Direction of the other will depend on which curve shifts by more
56

The Three Step Process

Key Step 1Characterize the Market Decide which market or markets best suit problem being analyzed and identify decision makers (buyers and sellers) who interact there Key Step 2Find the Equilibrium Describe conditions necessary for equilibrium in the market, and a method for determining that equilibrium Key Step 3What Happens When Things Change Explore how events or government polices change market equilibrium
57

Example: rental apartment

Example: problem 4,

chapter 3 in textbook. Demand & Supply Diagram Equilibrium P & Q Why $1000 can not be equilibrium? Effects from a tornado destroying some apartments.

rent($) 800 1000 1200 1400

quantity demanded 30 25 22 19

quantity supplied 10 14 17 19

1600
1800

17
15

21
22
58

Demand for two bedroom rental apartment

59

Summaries
Through the study of the chapter, you will be able to Characterize a market. Use a demand schedule and a demand curve to demonstrate the law of

demand. Explain the difference between a change in demand (shift of the curve) and a change in quantity demanded (movement along the curve). List the factors that will lead to a change in demand, and give examples of each. Similar analysis for supply side. Explain how equilibrium price and quantity are determined in a competitive market. Explain what will happen in a competitive market after a shift in the supply curve, the demand curve, or both. Describe the three steps economists take to answer almost any question about the economy.
60