The Market Forces of Supply and Demand CHAPTER 4

In this chapter, look for the answers to these questions: What factors affect buyers’ demand for goods? What factors affect sellers’ supply of goods? How do supply and demand determine the price of a good and the quantity sold? How do changes in the factors that affect demand or supply affect the market price and quantity of a good? How do markets allocate resources? 2

MARKETS AND COMPETITION Supply and demand are the two words that economists use most often. Supply and demand are the forces that make market economies work. Modern microeconomics is about supply, demand, and market equilibrium. 2

Markets and Competition A market is a group of buyers and sellers of a particular product. A competitive market is one with many buyers and sellers, each has a negligible effect on price. In a perfectly competitive market: All goods exactly the same Buyers & sellers so numerous that no one can affect market price – each is a “price taker” In this chapter, we assume markets are perfectly competitive. In the real world, there are relatively few perfectly competitive markets. Most goods come in lots of different varieties – including ice cream, the example in the textbook. And there are many markets in which the number of firms is small enough that some of them have the ability to affect the market price. For now, though, we look at supply and demand in perfectly competitive markets, for two reasons: First, it’s easier to learn. Understanding perfectly competitive markets makes it a lot easier to learn the more realistic but complicated analysis of imperfectly competitive markets. Second, despite the lack of realism, the perfectly competitive model can teach us a LOT about how the world works, as we will see many times in the chapters that follow. THE MARKET FORCES OF SUPPLY AND DEMAND 4

Demand The quantity demanded of any good is the amount of the good that buyers are willing and able to purchase. Law of demand: the claim that the quantity demanded of a good falls when the price of the good rises, other things equal Demand comes from the behavior of buyers. THE MARKET FORCES OF SUPPLY AND DEMAND 5

The Demand Curve: The Relationship between Price and Quantity Demanded Demand Schedule The demand schedule is a table that shows the relationship between the price of the good and the quantity demanded. 17

Catherine’s Demand Schedule 17

Figure 1 Catherine’s Demand Schedule and Demand Curve Price of Ice-Cream Cone $3.00 2.50 1. A decrease in price ... 2.00 1.50 1.00 0.50 1 2 3 4 5 6 7 8 9 10 11 12 Quantity of 2. ... increases quantity of cones demanded. Ice-Cream Cones

Market Demand versus Individual Demand Market demand refers to the sum of all individual demands for a particular good or service. Graphically, individual demand curves are summed horizontally to obtain the market demand curve.

The Market Demand Curve When the price is $2.00, Catherine will demand 4 ice-cream cones. When the price is $2.00, Nicholas will demand 3 ice-cream cones. The market demand at $2.00 will be 7 ice-cream cones. + Catherine’s Demand Nicholas’s Demand = Market Demand Price of Ice-Cream Cone Price of Ice-Cream Cone Price of Ice-Cream Cone 2.00 2.00 2.00 1.00 1.00 1.00 7 13 4 8 3 5 Quantity of Ice-Cream Cones Quantity of Ice-Cream Cones Quantity of Ice-Cream Cones When the price is $1.00, Catherine will demand 8 ice-cream cones. When the price is $1.00, Nicholas will demand 5 ice-cream cones. The market demand at $1.00, will be 13 ice-cream cones. The market demand curve is the horizontal sum of the individual demand curves!

Shifts in the Demand Curve Change in Quantity Demanded Movement along the demand curve. Caused by a change in the price of the product. 19

Changes in Quantity Demanded A tax on sellers of ice-cream cones raises the price of ice-cream cones and results in a movement along the demand curve. Price of Ice-Cream Cones B $2.00 A 1.00 D 4 8 Quantity of Ice-Cream Cones

Shifts in the Demand Curve non-price determinants of demand (i.e., things that determine buyers’ demand for a good, other than the good’s price). Changes in them shift the D curve… Consumer income Prices of related goods Tastes Expectations Number of buyers 11

Demand Curve Shifters: number of Buyers Increase in number of buyers increases quantity demanded at each price, shifts D curve to the right. Income is the first demand shifter discussed in this chapter of the textbook. I chose to start with a different one (number of buyers), for the following reason: In discussing the impact of changes in income on the demand curve, the textbook also introduces the concept of normal goods and inferior goods. Students may find it easier to learn about curve shifts if the presentation focuses solely on a curve shift (at least initially) without simultaneously introducing other concepts. If you wish to present the demand shifters in the same order as they appear in the book, simply reorder the slides in this presentation. THE MARKET FORCES OF SUPPLY AND DEMAND 14

Demand Curve Shifters: number of Buyers P Q Suppose the number of buyers increases. Then, at each P, Qd will increase (by 5 in this example). Beginning economics students often have trouble understanding the difference between a movement along the curve and a shift in the curve. Here, the animation has been carefully designed to help students see that a shift in the curve results from an increase in quantity at each price. (A more realistic scenario would involve a non-parallel shift, where the horizontal distance of the shift would be greater for lower prices than higher ones. However, to remain consistent with the textbook, and to keep things simple, this slide shows a parallel shift.) THE MARKET FORCES OF SUPPLY AND DEMAND 15

Demand Curve Shifters: Income Demand for a normal good is positively related to income. Increase in income causes increase in quantity demanded at each price, shifts D curve to the right. (Demand for an inferior good is negatively related to income. An increase in income shifts D curves for inferior goods to the left.) THE MARKET FORCES OF SUPPLY AND DEMAND 16

Consumer Income Normal Good Price of Ice-Cream Cone $3.00 An increase in income... 2.50 Increase in demand 2.00 1.50 1.00 0.50 D2 D1 Quantity of Ice-Cream Cones 1 2 3 4 5 6 7 8 9 10 11 12

Demand Curve Shifters: Prices of Related Goods Two goods are substitutes if an increase in the price of one causes an increase in demand for the other. Example: pizza and hamburgers. An increase in the price of pizza increases demand for hamburgers, shifting hamburger demand curve to the right. Other examples: Coke and Pepsi, laptops and desktop computers, CDs and music downloads THE MARKET FORCES OF SUPPLY AND DEMAND 18

Demand Curve Shifters: Prices of Related Goods Two goods are complements if an increase in the price of one causes a fall in demand for the other. Example: computers and software. If price of computers rises, people buy fewer computers, and therefore less software. Software demand curve shifts left. Other examples: college tuition and textbooks, bagels and cream cheese, eggs and bacon THE MARKET FORCES OF SUPPLY AND DEMAND 19

Demand Curve Shifters: Tastes Anything that causes a shift in tastes toward a good will increase demand for that good and shift its D curve to the right. Example: The Atkins diet became popular in the ’90s, caused an increase in demand for eggs, shifted the egg demand curve to the right. THE MARKET FORCES OF SUPPLY AND DEMAND 20

Demand Curve Shifters: Expectations Expectations affect consumers’ buying decisions. Examples: If people expect their incomes to rise, their demand for meals at expensive restaurants may increase now. If the economy sours and people worry about their future job security, demand for new autos may fall now. THE MARKET FORCES OF SUPPLY AND DEMAND 21

Summary: Variables That Influence Buyers Variable A change in this variable… Price …causes a movement along the D curve # of buyers …shifts the D curve Income …shifts the D curve Price of related goods …shifts the D curve Tastes …shifts the D curve Expectations …shifts the D curve Students should notice that the only determinant of quantity demanded that causes a movement along the curve is price. Also notice: price is one of the variables measured along the axes of the graph. Here’s a handy “rule of thumb” to help students remember whether the curve shifts: If the variable causing demand to change is measured on one of the axes, you move along the curve. If the variable that’s causing demand to change is NOT measured on either axis, then the curve shifts. This rule of thumb works with all curves in economics that involve an X-Y relationship. (I.e., it works for the supply curve, the marginal cost curve, the IS and LM curves, among many others, but it does not apply to curves drawn on time series graphs.) THE MARKET FORCES OF SUPPLY AND DEMAND 22

Supply The quantity supplied of any good is the amount that sellers are willing and able to sell. Law of supply: the claim that the quantity supplied of a good rises when the price of the good rises, other things equal Supply comes from the behavior of sellers. THE MARKET FORCES OF SUPPLY AND DEMAND 23

Quantity of lattes supplied The Supply Schedule Price of lattes Quantity of lattes supplied $0.00 1.00 3 2.00 6 3.00 9 4.00 12 5.00 15 6.00 18 Supply schedule: A table that shows the relationship between the price of a good and the quantity supplied. Example: Starbucks’ supply of lattes. Notice that Starbucks’ supply schedule obeys the Law of Supply. THE MARKET FORCES OF SUPPLY AND DEMAND 24

Starbucks’ Supply Schedule & Curve Price of lattes Quantity of lattes supplied $0.00 1.00 3 2.00 6 3.00 9 4.00 12 5.00 15 6.00 18 P Q THE MARKET FORCES OF SUPPLY AND DEMAND 25

Market Supply versus Individual Supply The quantity supplied in the market is the sum of the quantities supplied by all sellers at each price. Suppose Starbucks and Jitters are the only two sellers in this market. (Qs = quantity supplied) $0.00 6.00 5.00 4.00 3.00 2.00 1.00 Price 18 15 12 9 6 3 Starbucks 12 10 8 6 4 2 Jitters Market Qs + = + = 5 + = 10 Again, the assumption of only two sellers is a clear violation of perfect competition. However, it’s much easier for students to learn how the market supply curve relates to individual supplies in the two-seller case. + = 30 25 20 15 26 26

Supply Curve Shifters The supply curve shows how price affects quantity supplied, other things being equal. These “other things” are non-price determinants of supply. Changes in them shift the S curve… “Non-price determinants of supply” simply means the things – other than the price of a good – that determine sellers’ supply of the good. THE MARKET FORCES OF SUPPLY AND DEMAND 27

Supply Curve Shifters: Input Prices Examples of input prices: wages, prices of raw materials. A fall in input prices makes production more profitable at each output price, so firms supply a larger quantity at each price, and the S curve shifts to the right. In the second bullet point, “output price” just means the price of the good that firms are producing and selling. I have used “output price” here to distinguish it from “input prices.” THE MARKET FORCES OF SUPPLY AND DEMAND 28

Supply Curve Shifters: Input Prices P Q Suppose the price of milk falls. At each price, the quantity of Lattes supplied will increase (by 5 in this example). Again, the animation here is carefully designed to help make clear that a shift in the supply curve means that there is a change in the quantity supplied at each possible price. If it seems tedious, you can turn it off. In any case, be assured that, by the end of this chapter, the animation of curve shifts will be streamlined and simplified. THE MARKET FORCES OF SUPPLY AND DEMAND 29

Supply Curve Shifters: Technology Technology determines how much inputs are required to produce a unit of output. A cost-saving technological improvement has the same effect as a fall in input prices, shifts S curve to the right. THE MARKET FORCES OF SUPPLY AND DEMAND 30

Supply Curve Shifters: Expectations Example: Events in the Middle East lead to expectations of higher oil prices. In response, owners of Texas oilfields reduce supply now, save some inventory to sell later at the higher price. S curve shifts left. In general, sellers may adjust supply* when their expectations of future prices change. (*If good not perishable) THE MARKET FORCES OF SUPPLY AND DEMAND 31

Summary: Variables that Influence Sellers Variable A change in this variable… Price …causes a movement along the S curve Input Prices …shifts the S curve Technology …shifts the S curve # of Sellers …shifts the S curve Expectations …shifts the S curve THE MARKET FORCES OF SUPPLY AND DEMAND 32

Supply and Demand Together P Q Equilibrium: P has reached the level where quantity supplied equals quantity demanded S D We now return to the latte example to illustrate the concepts of equilibrium, shortage and surplus. THE MARKET FORCES OF SUPPLY AND DEMAND 33

Equilibrium price: the price that equates quantity supplied with quantity demanded P Q S D P QD QS $0 24 1 21 5 2 18 10 3 15 4 12 20 9 25 6 30 THE MARKET FORCES OF SUPPLY AND DEMAND 34

Equilibrium quantity: the quantity supplied and quantity demanded at the equilibrium price P Q S D P QD QS $0 24 1 21 5 2 18 10 3 15 4 12 20 9 25 6 30 THE MARKET FORCES OF SUPPLY AND DEMAND 35

Surplus (a.k.a. excess supply): when quantity supplied is greater than quantity demanded P Q Example: If P = $5, S D Surplus then QD = 9 lattes and QS = 25 lattes resulting in a surplus of 16 lattes THE MARKET FORCES OF SUPPLY AND DEMAND 36

Surplus (a.k.a. excess supply): when quantity supplied is greater than quantity demanded P Q Facing a surplus, sellers try to increase sales by cutting price. S D Surplus This causes QD to rise and QS to fall… …which reduces the surplus. THE MARKET FORCES OF SUPPLY AND DEMAND 37

Surplus (a.k.a. excess supply): when quantity supplied is greater than quantity demanded P Q Facing a surplus, sellers try to increase sales by cutting price. S D Surplus This causes QD to rise and QS to fall. Prices continue to fall until market reaches equilibrium. THE MARKET FORCES OF SUPPLY AND DEMAND 38

Shortage (a.k.a. excess demand): when quantity demanded is greater than quantity supplied P Q Example: If P = $1, S D then QD = 21 lattes and QS = 5 lattes resulting in a shortage of 16 lattes Shortage THE MARKET FORCES OF SUPPLY AND DEMAND 39

Shortage (a.k.a. excess demand): when quantity demanded is greater than quantity supplied P Q Facing a shortage, sellers raise the price, S D causing QD to fall and QS to rise, …which reduces the shortage. Shortage THE MARKET FORCES OF SUPPLY AND DEMAND 40

Shortage (a.k.a. excess demand): when quantity demanded is greater than quantity supplied P Q Facing a shortage, sellers raise the price, S D causing QD to fall and QS to rise. Prices continue to rise until market reaches equilibrium. Shortage THE MARKET FORCES OF SUPPLY AND DEMAND 41

Shortage (a.k.a. excess demand): when quantity demanded is greater than quantity supplied P Q Facing a shortage, sellers raise the price, S D causing QD to fall and QS to rise. Prices continue to rise until market reaches equilibrium. Shortage THE MARKET FORCES OF SUPPLY AND DEMAND 42

Three Steps to Analyzing Changes in Equilibrium To determine the effects of any event, 1. Decide whether event shifts S curve, D curve, or both. 2. Decide in which direction curve shifts. 3. Use supply-demand diagram to see how the shift changes eq’m P and Q. Step one requires knowing all of the things that can shift D and S – the non-price determinants of demand and of supply. THE MARKET FORCES OF SUPPLY AND DEMAND 43

Terms for Shift vs. Movement Along Curve Change in supply: a shift in the S curve occurs when a non-price determinant of supply changes (like technology or costs) Change in the quantity supplied: a movement along a fixed S curve occurs when P changes Change in demand: a shift in the D curve occurs when a non-price determinant of demand changes (like income or # of buyers) Change in the quantity demanded: a movement along a fixed D curve “Supply” refers to the position of the supply curve, while “quantity supplied” refers to the specific amount that producers are willing and able to sell. Similarly, “demand” refers to the position of the demand curve, while “quantity demanded” refers to the specific amount that consumers are willing and able to buy. If you’d like to be a rebel, delete this slide and all references to the jargon it contains, and just use the terms “movement along a curve” and “shift in a curve.” Note, however, that this is not the official recommendation of Cengage/South-Western or Dr. Mankiw. If you’d like to cover this slide but make it move more quickly, delete the text next to each second-level bullet (starting with “occurs when”). Instead, give the information to your students verbally or rely on them to read it in the textbook. 44 44

CONCLUSION: How Prices Allocate Resources One of the Ten Principles from Chapter 1: Markets are usually a good way to organize economic activity. In market economies, prices adjust to balance supply and demand. These equilibrium prices are the signals that guide economic decisions and thereby allocate scarce resources. THE MARKET FORCES OF SUPPLY AND DEMAND 45

CHAPTER SUMMARY A competitive market has many buyers and sellers, each of whom has little or no influence on the market price. Economists use the supply and demand model to analyze competitive markets. The downward-sloping demand curve reflects the Law of Demand, which states that the quantity buyers demand of a good depends negatively on the good’s price. 46

CHAPTER SUMMARY Besides price, demand depends on buyers’ incomes, tastes, expectations, the prices of substitutes and complements, and number of buyers. If one of these factors changes, the D curve shifts. The upward-sloping supply curve reflects the Law of Supply, which states that the quantity sellers supply depends positively on the good’s price. Other determinants of supply include input prices, technology, expectations, and the # of sellers. Changes in these factors shift the S curve. 47

CHAPTER SUMMARY The intersection of S and D curves determines the market equilibrium. At the equilibrium price, quantity supplied equals quantity demanded. If the market price is above equilibrium, a surplus results, which causes the price to fall. If the market price is below equilibrium, a shortage results, causing the price to rise. 48

CHAPTER SUMMARY We can use the supply-demand diagram to analyze the effects of any event on a market: First, determine whether the event shifts one or both curves. Second, determine the direction of the shifts. Third, compare the new equilibrium to the initial one. In market economies, prices are the signals that guide economic decisions and allocate scarce resources. 49