Frank & Bernanke 3rd edition, 2007 Ch. 3: Supply and Demand: An Introduction

The Answer: Supply and Demand Why did gasoline prices almost doubled between November 1999 and May 2000 but fell by half by November 2001? Why could you buy the same computer at half price in 2006 than in 2003? Why are prices at the College Bookstore higher than the discount markets?

Markets When in elementary school you traded your baloney sandwich for your best friend’s peanut butter sandwich, you were involved in an exchange. Trade theory discussed in the previous chapter told us that both of you were better off with this exchange. If you offered your baloney sandwich to whoever wanted it for a “fair trade” there formed a market for a single baloney sandwich. For a market to exist, there should be more than one buyer or more than one seller. One seller and many buyers is called monopoly. One buyer and many sellers is called monopsony.

Market Types Many buyers and many sellers with identical products operate in competitive markets. Many buyers and many sellers with differentiated (brand name) products operate in monopolistically competitive markets. Many buyers and a few sellers constitute an oligopoly. Many buyers and a single seller constitute a monopoly.

Demand and Supply The behavior of buyers is captured with the demand curve. The behavior of the sellers is captured with the supply curve. Each individual decision (both by consumers and firms) is ruled by the marginal benefit vs. marginal cost calculation. Opportunity cost determines if one is a buyer or seller (ex: airplane tickets).

Determinants of Demand Price of the product. P up => Q down. Income of the consumers. Y up => Q up. Change in price of substitutes. Ps up => Q up. Change in price of complements. Pc up => Q down. Change in tastes and preferences. T favor the product more => Q up. Expected price in the future. Pe up => Q up.

Drawing the Demand Curve In a two-dimensional space (the page in your notebook, the chalkboard) we can only measure two variables. We will pick “price” and “quantity demanded” as our two variables. As we change the price of the product and look at the change in quantity demanded, we will assume that all the other variables are kept constant.

An Example of Demand

Income Increase

Exercises Show what happens to the demand for Coke when Pepsi price rises. Show what happens to demand for computers when monitor prices increase. Show what happens to demand for Firestone tires after the Federal government accused them of faulty product. Show what happens to teenage demand for cigarettes if originally price is $2 and consumption is 1 million and price goes up to $2.20.

Teenage Smoking $2.20 $2.00 880,000 1 million

Determinants of Supply Price of the product P up => Q up Input prices W up => Q down Technology New technology => Q up Expected price Pe up => Q down

An Example of Supply

Input Price Increase

Exercises Show what happens when new technology is employed. Show what happens when cost of capital increases. Show what happens when new firms enter into the market.

Equilibrium Equilibrium takes place when the quantity supplied into the market exactly matches quantity demanded. If quantity supplied exceeds quantity demanded, there will be unsold quantities. Sellers will lower price to get rid of excess inventory. If quantity demanded exceeds quantity supplied, price will inch up to bring the market into equilibrium.

Price Controls, Price Supports Show the effect of rent control, gas price controls, wage controls. Show the effect of agricultural price supports, export supports.

Disequilibrium and Social Welfare Why does the society (sellers and buyers) are better off when they move toward equilibrium?

Disequilibrium and Social Welfare

Exercises Show what will happen to quantity and price when income rises and technology improves. Show what will happen to quantity and price when the state increases the sales tax. Show what will happen to quantity and price when wages increase and tastes favor the product.

What Is Happening to Farmland Around Hiram? Farmland is being transformed into residential developments. Are we going to be without food? How does the price system allocate the land between residential development and farmland? Why don’t economists worry about the shortage of food?

Social vs. Private Costs Why an action might be smart for one but dumb for all? Subprime debacle How does the market reach optimal welfare when social costs are different than private costs?