Chapter 8 Section 4 P.O.D. 1

Objectives Explain how the equilibrium price is determined Explain how shortages and surpluses affect price Describe how shifts in the equilibrium price occur Discuss how the forces underlying supply and demand affect prices

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.

Equilibrium In the real world demand and supply operate together As Price of a good goes down Quantity Demanded goes up and Supply goes down As Price goes up—QD goes down and Supply goes up

Equilibrium (cont.) Equilibrium Price  Price at which the QD and the QS meet The price of any good or service will find the level at which the QD and the QS are balanced At this price there is enough of the good to satisfy consumers

Surplus: when quantity supplied is greater than quantity demanded P Q 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

Surplus: when quantity supplied is greater than quantity demanded P Q when quantity supplied is greater than quantity demanded P Q Facing a surplus, sellers try to increase sales by cutting the price. S D Surplus This causes QD to rise and QS to fall… …which reduces the surplus.

Surplus: when quantity supplied is greater than quantity demanded P Q when quantity supplied is greater than quantity demanded P Q Facing a surplus, sellers try to increase sales by cutting the price. S D Surplus Falling prices cause QD to rise and QS to fall. Prices continue to fall until market reaches equilibrium.

Surplus At prices above the equilibrium price, suppliers produce more than consumers want to purchase Suppliers end up with large inventories of goods This and other forces put pressure on the price to drop to the equilibrium price When price drops: Producers have less incentive to supply as much as before Consumers begin to purchase greater quantity

Shortage: when quantity demanded is greater than quantity supplied P Q 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

Shortage: when quantity demanded is greater than quantity supplied P Q 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

Shortage: when quantity demanded is greater than quantity supplied P Q 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

Shortages Shortages occur when at the going price the QD is greater than the QS Shortages will put pressure on prices to rise Consumers will reduce their purchases while suppliers increase the quantity they supply

Shifts in Equilibrium Price

Change in Equilibrium Price

Change in Equilibrium Price

Price Ceilings Occurs when the government puts a legal limit on how high the price of a product can be In order for a price ceiling to be effective it must be set BELOW the natural market equilibrium When a price ceiling is set (effectively) a shortage will occur

Price Ceilings

Price Ceilings

Price Floors The lowest legal price a commodity can be sold at Government uses price floors to prevent prices from being too low Most Common Price Floor = Minimum Wage Also often used in agriculture to try to protect farmers For a price floor to be effective it must be set ABOVE the equilibrium price If a price floor is set effectively there will be a surplus

Price Floor

Price Floor

Demand Curve Shifters: # of buyers P Q Suppose the number of buyers increases. Then, at each price, quantity demanded 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.)

Summary: Variables That Affect Demand Variable A change in this variable… Price …causes a movement along the D curve No. 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 doesn’t apply to curves drawn on time series graphs.)

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.

Summary: Variables That Affect Supply Summary: Variables That Affect Supply 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 No. of sellers …shifts the S curve Expectations …shifts the S curve Again, the price is the only determinant of quantity supplied that causes a movement along the curve. A change in any of the other determinants causes the supply curve to shift.

CONCLUSION: How Prices Allocate Resources 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. In the textbook, the conclusion of this chapter offers some very nice elaboration on the second bullet point.