Chapter 3 Demand and Supply

Learning Objectives Describe the relationship between price and quantity demanded, and distinguish between changes in demand and changes in quantity demanded. Describe the relationship between price and quantity supplied, and distinguish between changes in supply and changes in quantity supplied. Outline the forces that cause supply and demand to lead to an equilibrium price. Copyright © 2005 Pearson Addison-Wesley. All rights reserved.

Demand Your demand for any good or service is how much you are willing to purchase at various prices during a specified time period. If the price is right, you will make an exchange—you will give up funds in exchange for the good or service that somebody is willing to sell you. Copyright © 2005 Pearson Addison-Wesley. All rights reserved.

The Law of Demand At higher prices, consumers tend to purchase less of any good or service than at lower prices, all other things remaining the same. Copyright © 2005 Pearson Addison-Wesley. All rights reserved.

Behind the Law of Demand There are two basic reasons why the quantity demanded is inversely related to the price of a good or service. One has to do with how price changes affect your ability to buy goods and service, the other has to do with your desire to substitute among goods and services. Copyright © 2005 Pearson Addison-Wesley. All rights reserved.

The Real Income Effect If the price of a good or service that you normally buy goes up, your ability to buy the same quantities of everything you are buying has been reduced. Your real income has fallen. Therefore, you normally buy less of the higher-priced good. Copyright © 2005 Pearson Addison-Wesley. All rights reserved.

The Substitution Effect When the price of one item goes up, and the prices of other items in your budget do not, you generally attempt to substitute away from the more expensive item in favor of the less expensive item. This is the called the substitution effect. Copyright © 2005 Pearson Addison-Wesley. All rights reserved.

Relative Prices The relative price of any good or service is its price in terms of other goods and services. The price that you pay in dollars and cents today for any good or service is called its money price, or nominal price. Copyright © 2005 Pearson Addison-Wesley. All rights reserved.

Figure 3-1(a): The Individual Demand Schedule Copyright © 2005 Pearson Addison-Wesley. All rights reserved.

The Individual Demand Curve If you plot a simple graph with the number of rewritable CDs per year on the bottom and the price of rewritable CDs on the left side, you end up with the following demand curve—in Panel (b), Figure 3-1. Copyright © 2005 Pearson Addison-Wesley. All rights reserved.

Figure 3-1(b): The Individual Demand Curve Copyright © 2005 Pearson Addison-Wesley. All rights reserved.

Market Demand To go from an individual demand curve to a demand curve for the entire market, you have to add together all the demands of individual buyers. When we refer to the entire market demand, we are looking at all actual and potential buyers of a particular good or service. Copyright © 2005 Pearson Addison-Wesley. All rights reserved.

Change in Quantity Demanded A quantity demanded is the specific quantity consumers are willing to buy at a specific price, represented by a single point on a demand curve. When price changes, quantity demanded changes according to the law of demand, and there will be a movement from one point to another point along the same demand curve. Copyright © 2005 Pearson Addison-Wesley. All rights reserved.

Change in Demand Demand refers to a schedule of planned rates of purchase, and depends on many non-price determinants. Whenever there is a change in a non-price determinant, there will be a change in demand—a shift in the entire demand curve. Copyright © 2005 Pearson Addison-Wesley. All rights reserved.

Determinants of Demand Many factors determine the demand for different goods and services. Any change in the most important determinants of demand will change, or shift, the demand curve. They are: tastes or preferences, population, income, and prices of related goods. Copyright © 2005 Pearson Addison-Wesley. All rights reserved.

Determinants of Demand (cont.) Tastes or preferences—any time tastes or preferences for a good or service change, the demand curve will change, too. Population—The size of the market is important. As population increases, the demand for most goods and services increases. Income—Typically, as incomes rise, the demand for most goods and services increases. Copyright © 2005 Pearson Addison-Wesley. All rights reserved.

Determinants of Demand (cont.) Prices of Related Goods—When the price of a substitute rises, the demand for the other good or service rises, too. Sometimes goods are used together with other goods. They are called complements. If the price of a complement goes up, the demand for the other good or service decreases. Copyright © 2005 Pearson Addison-Wesley. All rights reserved.

Figure 3-1(b): The Individual Demand Curve Copyright © 2005 Pearson Addison-Wesley. All rights reserved. 3-18

The Law of Supply To understand how suppliers or producers of goods and services react to price changes, consider the law of supply: As the price of a good or service goes up, producers of that good or service generally provide larger quantities, all other things being constant. Copyright © 2005 Pearson Addison-Wesley. All rights reserved.

Figure 3-3(a): The Market Supply Schedule Copyright © 2005 Pearson Addison-Wesley. All rights reserved.

The Supply Curve If you take the price-quantity combinations in panel (a) of Figure 3-6 and plot them on a graph, the result is panel (b)—in the next exhibit. This is an upward-sloping supply curve showing the positive relationship between price and quantity supplied. Copyright © 2005 Pearson Addison-Wesley. All rights reserved.

Figure 3-3(b): The Market Supply Curve Copyright © 2005 Pearson Addison-Wesley. All rights reserved.

Determinants of Supply Price of inputs used to produce a good or service—If one or more input prices fall, producers will produce more of a good or service. That is to say, if a production cost falls because an input price falls, shifting the supply curve to the right, more of the final product will be produced at each and every price. Copyright © 2005 Pearson Addison-Wesley. All rights reserved.

Determinants of Supply (cont.) Technology and Productivity—Supply curves are drawn by assuming a given technology. When available production techniques improve, the supply curve will shift to the right—it will increase. Taxes—If taxes rise on a particular item, this becomes effectively an increase in production cost. That will reduce the quantity supplied at each and every price of the final product. Copyright © 2005 Pearson Addison-Wesley. All rights reserved.

Determinants of Supply (cont) Number of Firms in the Industry—In the short run, when firms can only change the number of employees they use, the number of firms in the industry is constant. In the long run, the number of firms (or the size of some existing firms) may change. If the number of firms increases, the supply curve will shift outward to the right. Copyright © 2005 Pearson Addison-Wesley. All rights reserved.

Changes in Supply versus Changes in Quantity Supplied A change in the price of the good leads to a change in the quantity supplied, other things being constant. This is a movement on the curve. The only thing that can cause a change in the entire supply curve—change in supply—is a change in a determinant other than price. Copyright © 2005 Pearson Addison-Wesley. All rights reserved.

Figure 3-7: Putting Demand and Supply Together Copyright © 2005 Pearson Addison-Wesley. All rights reserved.

Equilibrium: Putting Demand and Supply Together (cont.) At a price of $3, both the quantity supplied and the quantity demanded per year are 6 million. Hence, $3 is called the market clearing price. Another term for that price is the equilibrium price, the price at which there is no tendency for change. Copyright © 2005 Pearson Addison-Wesley. All rights reserved.

Equilibrium: Putting Demand and Supply Together (cont.) At equilibrium there is neither excess quantity demanded (shortage) nor excess quantity supplied (surplus). The synchronization of decisions by buyers and sellers that creates a situation of equilibrium is called the rationing function of prices. Copyright © 2005 Pearson Addison-Wesley. All rights reserved.

Other Forms of Rationing Alternative ways of rationing, other than the price system, are: first come, first serve; political power; physical force; lottery; rationing by coupons; and rationing by waiting in line. Copyright © 2005 Pearson Addison-Wesley. All rights reserved.

Key Terms and Concepts complements demand curve demand schedule equilibrium price law of demand law of supply market clearing price money price nominal price rationing function of prices real income effect relative price shortage substitution effect supply schedule supply curve surplus Copyright © 2005 Pearson Addison-Wesley. All rights reserved.