Chapter 3 Demand and Supply

Copyright ©2014 Pearson Education, Inc. All rights reserved.3-2 Introduction Over the past 30 years, college tuition and fees have increased significantly. Annual tuition that would have been about $2,000 in the 1980s is now at a level of around $20,000. Textbook prices have experienced a sizable increase as well. Students now typically pay $1,000 a year for books, compared to an annual expense of about $200 in the 1980s. In this chapter you will learn what has caused these prices to rise.

Copyright ©2014 Pearson Education, Inc. All rights reserved.3-3 Learning Objectives Explain the law of demand Discuss the difference between money prices and relative prices Distinguish between changes in demand and changes in quantity demanded

Copyright ©2014 Pearson Education, Inc. All rights reserved.3-4 Learning Objectives (cont'd) Explain the law of supply Distinguish between changes in supply and changes in quantity supplied Understand how supply and demand interact to determine equilibrium price and quantity

Copyright ©2014 Pearson Education, Inc. All rights reserved.3-5 Chapter Outline Demand The Demand Schedule Shifts in Demand The Law of Supply The Supply Schedule Shifts in Supply Putting Demand and Supply Together

Copyright ©2014 Pearson Education, Inc. All rights reserved.3-6 Did You Know That... After truck freight-hauling prices jumped in the early 2010s, rail shipments of freight containers rose by more than 10 percent? Higher truck-transportation prices induced many companies to choose rail transportation as a substitute. By using demand and supply, you can develop a better understanding of why sometimes we observe large increases in the purchase of items such as rail freight services.

Copyright ©2014 Pearson Education, Inc. All rights reserved.3-7 Did You Know That … (cont’d) Market –All of the arrangements that individuals have for exchanging with one another –Examples of markets: Automobile market Health-care market Market for high-speed internet access –One of the most important activities in these markets in the determination of prices.

Copyright ©2014 Pearson Education, Inc. All rights reserved.3-8 Demand A schedule showing how much of a good or service people will purchase at any price during a specified time period, other things being constant

Copyright ©2014 Pearson Education, Inc. All rights reserved.3-9 Demand (cont’d) Law of Demand –A negative, or inverse, relationship between the price of any good or service and the quantity demanded, holding other factors constant (ceteris paribus) When the price of a good goes up, people buy less of it, other things being equal. When the price of a good goes down, people buy more of it, other things being equal.

Copyright ©2014 Pearson Education, Inc. All rights reserved.3-10 Demand (cont’d) What are we holding constant? –Income –Tastes and preferences –Price of other goods –Many other factors

Copyright ©2014 Pearson Education, Inc. All rights reserved.3-11 Demand (cont’d) Relative prices and money prices –Relative Price The price of a commodity in terms of another commodity –Money Price Price we observe today in today’s dollars (absolute, or nominal price)

Copyright ©2014 Pearson Education, Inc. All rights reserved.3-12 Table 3-1 Money Price versus Relative Price

Copyright ©2014 Pearson Education, Inc. All rights reserved.3-13 Example: Why Sales of Electric Cars are Stuck in Low Gear Prices of electric autos exceed prices of hybrid versions by at least 30 percent and prices of gasoline powered versions by 50 percent. The quality-adjusted prices of electric cars are even higher when we take into account the limited range of distance over which they can operate. Beyond a distance of roughly 250 miles, the batteries in electric cars cease to function. This limitation in their usefulness helps explain why sales of electric cars remain a small portion of the overall automobile market.

Copyright ©2014 Pearson Education, Inc. All rights reserved.3-14 The Demand Schedule Demand schedule –Table relating prices to quantities demanded –We must also consider: Time dimension (e.g., per year) Constant-quality units

Copyright ©2014 Pearson Education, Inc. All rights reserved.3-15 The Demand Schedule (cont’d) Demand Curve –A graphical representation of the demand schedule –Negatively sloped line showing the inverse relationship between the price and the quantity demanded (other things being equal)

Copyright ©2014 Pearson Education, Inc. All rights reserved.3-16 Figure 3-1 The Individual Demand Schedule and the Individual Demand Curve, Panel (a)

Copyright ©2014 Pearson Education, Inc. All rights reserved.3-17 Figure 3-1 The Individual Demand Schedule and the Individual Demand Curve, Panel (b)

Copyright ©2014 Pearson Education, Inc. All rights reserved.3-18 The Demand Schedule (cont’d) Individual versus market demand curves Market Demand –The demand of all consumers in the marketplace for a particular good or service –Summation at each price of the quantity demanded by each individual

Copyright ©2014 Pearson Education, Inc. All rights reserved.3-19 Figure 3-2 The Horizontal Summation of Two Demand Curves, Panel (a)

Copyright ©2014 Pearson Education, Inc. All rights reserved.3-20 Figure 3-2 The Horizontal Summation of Two Demand Curves, Panels (b), (c), (d)

Copyright ©2014 Pearson Education, Inc. All rights reserved.3-21 Figure 3-3 The Market Demand Schedule for Magneto Optical Disks, Panel (a)

Copyright ©2014 Pearson Education, Inc. All rights reserved.3-22 Figure 3-3 The Market Demand Schedule for Magneto Optical Disks, Panel (b)

Copyright ©2014 Pearson Education, Inc. All rights reserved.3-23 Shifts in Demand Scenario –Imagine the government gives every registered college student in the United States a magneto optical disk drive. If some factor other than price changes, we can show its effect by moving the entire demand curve, shifting the curve left or right. In this case, there will be an increase in the number of MO disks demanded at each and every possible price.

Copyright ©2014 Pearson Education, Inc. All rights reserved.3-24 Figure 3-4 A Shift in the Demand Curve

Copyright ©2014 Pearson Education, Inc. All rights reserved.3-25 Shifts in Demand (cont’d) Ceteris-Paribus Conditions –Determinants of the relationship between price and quantity that are unchanged along a curve –Changes in these factors cause a curve to shift

Copyright ©2014 Pearson Education, Inc. All rights reserved.3-26 Shifts in Demand (cont’d) Normal Goods –Goods for which demand rises as income rises; most goods are normal goods Inferior Goods –Goods for which demand falls as income rises

Copyright ©2014 Pearson Education, Inc. All rights reserved.3-27 Example: Lower Incomes Boost the Demand for Reconditioned Cellphones U.S. residents who have been out of work or who are classified as discouraged workers are earning much lower incomes than they did a few years ago. Many of these people have purchased reconditioned cellphones, a cheaper alternative to a new phone. This allows us to identify reconditioned cellphones as an inferior good.

Copyright ©2014 Pearson Education, Inc. All rights reserved.3-28 Shifts in Demand (cont’d) Determinants of demand –Income –Tastes and preferences –The prices of related goods Substitutes Complements

Copyright ©2014 Pearson Education, Inc. All rights reserved.3-29 Shifts in Demand (cont'd) Substitutes –Two goods are substitutes when a change in the price of one causes a shift in demand for the other in the same direction as the price change

Copyright ©2014 Pearson Education, Inc. All rights reserved.3-30 Shifts in Demand (cont'd) Complements –Two goods are complements when a change in the price of one causes an opposite shift in the demand curve for the other

Copyright ©2014 Pearson Education, Inc. All rights reserved.3-31 Example: Why Fewer Wine Bottles Have Natural Cork Stoppers Cork bottle stoppers have traditionally been used for wine bottles because wine can “breathe” air through the porous cell structure of natural cork. Since the early 2000s, prices of natural cork bottle stoppers have risen above prices of plastic stoppers, and this translates into higher prices for wine in cork-furnished bottles. In response, consumers have purchased more wine bottled with plastic stoppers.

Copyright ©2014 Pearson Education, Inc. All rights reserved.3-32 Shifts in Demand (cont'd) Determinants of demand –Expectations Future prices Income Product availability –Market size (number of buyers)

Copyright ©2014 Pearson Education, Inc. All rights reserved.3-33 Policy Example: An Expected Uranium Price Implosion Cuts Uranium Demand Following the 2011 earthquake and tsunami in Japan, many countries announced plans to decrease their reliance on nuclear power as a source of energy. This led to an expectation of lower uranium prices in the future. As a consequence, purchases of uranium were delayed, and the uranium price dropped immediately.

Copyright ©2014 Pearson Education, Inc. All rights reserved.3-34 Shifts in Demand (cont'd) Changes in demand versus changes in quantity demanded –Whenever there is a change in a ceteris paribus condition, there will be a change in demand A shift of the entire demand curve to the right or to the left The only thing that can cause the entire curve to move is a change in a determinant other than the good’s own price

Copyright ©2014 Pearson Education, Inc. All rights reserved.3-35 Shifts in Demand (cont'd) Changes in demand versus changes in quantity demanded –A change in a good’s own price leads to a change in quantity demanded (a single point on a demand curve) for any given demand curve A movement along the same demand curve

Copyright ©2014 Pearson Education, Inc. All rights reserved.3-36 Figure 3-5: Movement Along a Given Demand Curve

Copyright ©2014 Pearson Education, Inc. All rights reserved.3-37 The Law of Supply Supply –Schedule showing relationship between price and quantity supplied for a specified time period, other things being equal –The amount of a product or service that firms are willing to sell at alternative prices

Copyright ©2014 Pearson Education, Inc. All rights reserved.3-38 The Law of Supply (cont'd) Law of Supply –The higher the price of a good, the more of that good sellers will make available over a specified time period, other things being equal At higher prices, a larger quantity will generally be supplied than at lower prices, all other things held constant. At lower prices, a smaller quantity will generally be supplied than at higher prices, all other things held constant.

Copyright ©2014 Pearson Education, Inc. All rights reserved.3-39 Example: Steel Producers Reduce Production When the Price of Steel Falls When the market price of steel declined from $660 per ton to below $625 per ton, steel manufacturers responded by cutting back on production. This is consistent with the upward-sloping supply curve of steel.

Copyright ©2014 Pearson Education, Inc. All rights reserved.3-40 The Supply Schedule The supply schedule is a table relating prices to quantity supplied at each price. Supply Curve –A graphical representation of the supply schedule –Positively sloped line (curve) showing the direct relationship between price and quantity supplied, all else being equal

Copyright ©2014 Pearson Education, Inc. All rights reserved.3-41 Figure 3-6 The Individual Producer’s Supply Schedule and Supply Curve for Magnetic Optical Disks, Panel (a)

Copyright ©2014 Pearson Education, Inc. All rights reserved.3-42 Figure 3-6 The Individual Producer’s Supply Schedule and Supply Curve for Magnetic Optical Disks, Panel (b)

Copyright ©2014 Pearson Education, Inc. All rights reserved.3-43 Figure 3-7 Horizontal Summation of Supply Curves, Panel (a)

Copyright ©2014 Pearson Education, Inc. All rights reserved.3-44 Figure 3-7 Horizontal Summation of Supply Curves, Panels (b), (c), (d)

Copyright ©2014 Pearson Education, Inc. All rights reserved.3-45 Figure 3-8 The Market Supply Schedule and the Market Supply Curve for Magnetic Optical Disks, Panel (a)

Copyright ©2014 Pearson Education, Inc. All rights reserved.3-46 Figure 3-8 The Market Supply Schedule and the Market Supply Curve for Magnetic Optical Disks, Panel (b)

Copyright ©2014 Pearson Education, Inc. All rights reserved.3-47 Shifts in Supply Scenario –A new method of manufacturing magnetic optical disks significantly reduces the cost of production. –Producers of MO disks will supply more product at any given price.

Copyright ©2014 Pearson Education, Inc. All rights reserved.3-48 Example: Cotton Price Movements Squeeze and Stretch Clothing Supply Between 2009 and 2010, the price of cotton increased by 55 percent. –Clothing manufacturers responded by reducing the number of cotton garments supplied at any given price. During 2011, cotton prices decreased. –In response, there was an increase in the supply of cotton clothes.

Copyright ©2014 Pearson Education, Inc. All rights reserved.3-49 Figure 3-9 Shifts in the Supply Curve

Copyright ©2014 Pearson Education, Inc. All rights reserved.3-50 Shifts in Supply (cont'd) Determinants of supply –Cost of inputs –Technology and productivity –Taxes and subsidies –Price expectations –Number of firms in industry

Copyright ©2014 Pearson Education, Inc. All rights reserved.3-51 What If... politicians oppose a higher gasoline price yet favor higher fuel taxes? A decrease in the market supply of gasoline results in higher prices. –Members of Congress may then complain that gas prices are “too high”. –Yet, these same elected officials may favor higher fuel taxes. –A tax imposed on gasoline has the same effect as a decrease in supply.

Copyright ©2014 Pearson Education, Inc. All rights reserved.3-52 Example: How Deadly Southern Twisters Pummeled U.S. Poultry Supply Between April 26 and April 28 of 2011, there were 278 tornadoes in the U.S. Many of the twisters hit Alabama, where poultry farmers typically supply about 12 percent of the national poultry market. Damage to chicken-processing plants resulted in a decrease in the number of firms supplying the market.

Copyright ©2014 Pearson Education, Inc. All rights reserved.3-53 Shifts in Supply (cont'd) Changes in supply versus changes in quantity supplied –Whenever there is a change in a ceteris paribus condition, there will be a change in supply A shift of the entire supply curve to the right or to the left The only thing that can cause the entire curve to move is a change in a determinant other than the good’s own price

Copyright ©2014 Pearson Education, Inc. All rights reserved.3-54 Shifts in Supply (cont'd) Changes in supply versus changes in quantity supplied –A change in a good’s own price leads to a change in quantity supplied (a single point on a supply curve) for any given supply curve A movement along the same supply curve

Copyright ©2014 Pearson Education, Inc. All rights reserved.3-55 Putting Demand and Supply Together Putting demand and supply together Equilibrium (Market Clearing) Price –The price that clears the market –The price at which quantity demanded equals quantity supplied –The price where the demand curve intersects the supply curve

Copyright ©2014 Pearson Education, Inc. All rights reserved.3-56 Figure 3-10 Putting Demand and Supply Together, Panel (a)

Copyright ©2014 Pearson Education, Inc. All rights reserved.3-57 Figure 3-10 Putting Demand and Supply Together, Panel (b)

Copyright ©2014 Pearson Education, Inc. All rights reserved.3-58 Putting Demand and Supply Together (cont'd) Equilibrium –The situation when quantity supplied equals quantity demanded at a particular price –There tends to be no movement of the price of the quantity away from this point unless demand or supply changes –Equilibrium is a stable point – any point that is not equilibrium is unstable and will not persist

Copyright ©2014 Pearson Education, Inc. All rights reserved.3-59 Putting Demand and Supply Together (cont'd) The equilibrium price –The price toward which the market price will automatically tend to gravitate, –There is no outcome better than this price for both consumers and producers

Copyright ©2014 Pearson Education, Inc. All rights reserved.3-60 Putting Demand and Supply Together (cont'd) Shortages –The situation when quantity demanded is greater than quantity supplied –Exist at any price below the market clearing price –Shortages and scarcity are not the same thing

Copyright ©2014 Pearson Education, Inc. All rights reserved.3-61 Example: Production Breakdowns Create a Shortage of a Life-Saving Drug Each year, 20,000 new cases of acute lymphoblastic leukemia are diagnosed. –Cytarabine is the drug commonly used to treat this disease. Recently, all of the firms manufacturing this drug experienced problems that slowed or halted production of the drug. A shortage of cytarabine resulted, and the drug was rationed by medical professionals who judged the urgency of need in various individuals.

Copyright ©2014 Pearson Education, Inc. All rights reserved.3-62 Putting Demand and Supply Together (cont'd) Surpluses –The situation when quantity supplied is greater than quantity demanded –Exist at any price above the market clearing price

Copyright ©2014 Pearson Education, Inc. All rights reserved.3-63 Policy Example: Should Shortages in the Ticket Market Be Solved by Scalpers? If you’ve ever tried to get tickets to the big game you know all about “shortages” Since the quantity of tickets is fixed, the price can go pretty high Enter the scalper

Copyright ©2014 Pearson Education, Inc. All rights reserved.3-64 Figure 3-11 Shortages of Super Bowl Tickets

Copyright ©2014 Pearson Education, Inc. All rights reserved.3-65 You Are There … Why the Casket Industry Is on Life Support The CEO of a casket manufacturer described his industry as one that isn’t growing. Falling prices for a substitute good, cremations, are the primary reason. The typical price for a traditional casket burial exceeds $7,200. This compares to $1,300 for the average price of a cremation service. This decreasing price of a lower-priced substitute has caused a decline of the demand for caskets.

Copyright ©2014 Pearson Education, Inc. All rights reserved.3-66 Issues & Applications: Your Higher Education Bills Really Are Increasing What explains the higher prices that students are paying for a college education, as compared to prices 30 years ago? The figure on the following slide displays an index measure of three variables from 1978 to 2010: –1) U.S. college tuition and fees –2) U.S. educational books and supplies –3) The level of consumer prices overall

Copyright ©2014 Pearson Education, Inc. All rights reserved.3-67 Issues & Applications: Your Higher Education Bills Really Are Increasing (cont’d) Figure 3-12 Indexes of Prices for Higher-Education-Related Items and All Goods and Services since 1978

Copyright ©2014 Pearson Education, Inc. All rights reserved.3-68 Issues & Applications: Your Higher Education Bills Really Are Increasing (cont’d) The figure on the preceding slide shows that the money prices of tuition and textbooks have increased substantially since The relative prices of these goods have increased as well. Compared to 1978: –Relative tuition has tripled –Relative textbook prices have doubled The equilibrium prices of these goods and services have increased over the past four decades.

Copyright ©2014 Pearson Education, Inc. All rights reserved.3-69 Summary Discussion of Learning Objectives The law of demand says that prices and quantity demanded are inversely related –At a higher price people buy less, at a lower price people buy more Relative prices must be distinguished from money prices, since people respond to changes in relative prices

Copyright ©2014 Pearson Education, Inc. All rights reserved.3-70 Summary Discussion of Learning Objectives (cont'd) A change in quantity demanded versus a change in demand –A change in quantity demanded is a movement along the same demand curve –A change in demand is a shift of the whole demand curve

Copyright ©2014 Pearson Education, Inc. All rights reserved.3-71 Summary Discussion of Learning Objectives (cont'd) The law of supply states that price and quantity supplied are directly related –Firms offer more at a higher price; firms offer less at a lower price A change in quantity supplied versus a change in supply –A change in quantity supplied is a movement along the same supply curve –A change in supply is a shift of the whole supply curve

Copyright ©2014 Pearson Education, Inc. All rights reserved.3-72 Summary Discussion of Learning Objectives (cont'd) Determining market price and equilibrium quantity –The demand and supply curves intersect at the market clearing, or equilibrium point –Surpluses exist if the price of the good is greater than the market price –Shortages exist when the price of a good is below the market price