Chapter 3 Notes

3 Demand, Supply, and Market Equilibrium

Chapter Objectives Demand Defined and What Affects It Supply Defined and What Affects It How Supply & Demand Together Determine Market Equilibrium How Changes in Supply and Demand Affect Equilibrium Prices and Quantities Government-Set Prices and their Implications for Surpluses & Shortages

Demand Demand Defined Demand Schedule Law of Demand Demand Curve Diminishing Marginal Utility Income Effect Substitution Effect Demand Curve Market Demand 3.1 3.2 3.3 3.4

What is demand? Demand – the desire to have a good or service and the ability to pay for it. The 2 factors of desire and ability are both necessary Ex. I have the desire to go on a European vacation, but I can not afford it. Therefore, I do not possess demand for it.

Demand Defined Expressed on a schedule or curve that shows the various amounts of a product that consumers are willing and able to purchase at each of a series of possible prices during a specified period of time Show quantities of a product that will be purchased at various psb prices, other things equal

Demand Schedule Table showing how much of a product an individual is willing & able to buy @ each price in the market. Market demand schedule – table showing how much all consumers are willing to buy @ each price

Law of Demand Inverse relationship between price and quantity demanded States that when price increases, quantity demanded decreases When P. dec., QD. inc. Ppl buy less at higher prices, more at lower prices

Explanations of the Law of Demand Why the inverse relationship b/w P and QD? 1. Common sense—think about it! 2. Diminishing marginal utility – marginal benefit from using each additional unit of a product during a given period will decline. Ex. You get more satisfaction from the first glass of lemonade than the second, third, fourth…and are therefore not willing to pay as much for each additional unit

Explanations of the Law of Demand 3. Income and substitution effects income effect – change in the amount that consumers will buy b/c the purchasing power of their income changes, although income itself doesn’t change. Ex. You go to the store to buy ground beef, it is on sale, you feel wealthier and buy more.

Explanations of the Law of Demand 2. substitution effect – change in the amount that people will buy b.c they substitute goods instead. Ex. You go to the store to buy ground beef but you see ground turkey is on sale for ½ the price so you buy that instead.

Demand Curve Graph showing how much of a product an individual will buy @ each price Graphic representation of demand schedule and law of demand Slopes downward from left to right Market demand curve – graph showing data from market demand schedule Price on Y-axis, Quantity on X-axis See p.45 Figure 3.1

Individual Demand Individual Demand P Qd $5 4 3 2 1 10 20 35 55 80 P 6 5 4 3 2 1 10 20 30 40 50 60 70 80 Quantity Demanded (bushels per week) Price (per bushel) Individual Demand P Qd $5 4 3 2 1 10 20 35 55 80 D Q

Change in Quantity Demanded -change in the amt. of a product consumers will buy b/c of a change in price Shown by a movement along the demand curve

Individual Demand Determinants of Demand Tastes Number of Buyers Income Normal Goods Inferior Goods Price of Related Goods Substitute Good Complementary Good Unrelated Goods Consumer Expectations

Change in Demand Something prompts consumers to buy different amounts @ every price Represented by shifts of the demand curve Inc. in demand – curve shifts right Dec. in demand – curve shifts left Influenced by 6 factors

Factor 1: Income If consumer income inc., demand inc. If income dec., demand dec. Ex. a factory closes, ppl lose jobs, income falls and demand dec.

2 types of goods: Normal goods – goods for which demand inc. as income inc. Ex. most goods such as TVs, steaks, IPODS, etc… Inferior goods - goods for which demand dec. as income inc. Ex. Generics, Ramen noodles, etc…

Factor 2: Market Size # of consumers, population changes, seasonal tourist trends If market size inc., demand inc.

Factor 3: Consumer tastes Advertising, trends, styles, popularity, celebrity endorsements If consumer tastes inc., demand inc.

Factor 4: Consumer Expectations Refers to expectations of future prices If consumers expect a future price inc., current demand inc.

Factor 5: Substitute Goods g/s that can be used in place of each other Ex. Coke and Pepsi, wireless phones and traditional phones If demand for substitute inc., demand for original item dec.

Factor 6: Complements Goods used together so a rise in the demand for one inc. as the demand for another inc. Ex. digital cameras and photo printers, cars and gas

Individual Demand Demand Can Increase or Decrease Individual Demand P 6 5 4 3 2 1 Individual Demand P Qd Increase in Demand $5 4 3 2 1 10 20 35 55 80 Price (per bushel) D2 Decrease in Demand D1 D3 Q 2 4 6 8 10 12 14 16 18 Quantity Demanded (bushels per week)

Demand Curve is Called a Change in Quantity Individual Demand Demand Can Increase or Decrease An Increase in Demand Means a Movement of the Line P 6 5 4 3 2 1 Individual Demand A Movement Between Any Two Points on a Demand Curve is Called a Change in Quantity Demanded P Qd $5 4 3 2 1 10 20 35 55 80 Price (per bushel) D2 Decrease in Demand D1 D3 Q 2 4 6 8 10 12 14 16 18 Quantity Demanded (bushels per week)

Supply Supply Defined Supply Schedule Law of Supply Supply Curve Revenue Implications Marginal Cost Supply Curve Market Supply

What is supply? Willingness and ability of producers to offer a g/s for sale Expressed as a schedule or curve showing the various amounts of a product that producers are willing and able to sell at each of a series of psb prices during a specified period Producer = anyone who is willing to provide a g/s Ex. worker, company, farmers, etc… Profit motivates producers to inc. supply

Law of Supply Direct (positive) relationship between P and QSS When P. inc., QS inc. When P. dec., QS dec.

Supply Schedule Table showing how much of a g/s an individual producer is willing and able to sell @ each P. Market supply schedule – lists how much of a g/s all producers will sell @ each P. See p.51 Figure 3.4

Supply Curve Supply schedule data in graphic form Shows law of supply in graph form Slopes upward from left to right Market supply curve – market supply schedule in graph form See p.102 Figure 3.4

Individual Supply Individual Supply P Qs $5 4 3 2 1 60 50 35 20 5 P S1 Individual Supply S1 P Qs $5 4 3 2 1 60 50 35 20 5 Price (per bushel) 10 20 30 40 50 60 70 Q Quantity Supplied (bushels per week)

What Factors Affect Supply? Changes in quantity supplied – inc. or dec. in the amount of a g/s that producers are willing to sell b/c of a change in P. -shown by movement to different points along the S. curve

Individual Supply Resource Prices Technology Taxes and Subsidies Determinants of Supply Resource Prices Technology Taxes and Subsidies Prices of Other Goods Producer Expectations Number of Sellers

Changes in Supply Occur when a change in the marketplace causes producers to sell different amounts @ every price. Inc. in S, curve shifts right Dec. in S, curve shifts left 6 Factors influence supply

Factor 1: Input Costs Price of resources used to make products Ex. Cost of nuts used to make candy bars Input costs inc., Supply dec.

Labor Productivity Amt of a g/s a person can produce in a given time Ex. More skilled & educated workers, labor strike Inc. productivity, Supply inc.

Factor 2: Government Action Excise tax – taxes production/sale of certain goods Tax inc., Supply dec. Subsidy – gov. payment for part of production cost Subsidy inc., supply inc. Regulation – rules/laws controlling business beh. (Ex. Pollution, worker safety) New regulation, Supply dec.

Factor 3: Technology Applying science & innovation to production Ex. Robots on assembly line, computers, etc… Inc. in technology, Supply inc.

Factor 4: Prices of Other Goods Substitution in production that may occur when higher prices of other goods a seller produces entice the producer to switch production to those other goods in order to increase profits. See example on page 52.

Factor 5: Producer Expectations If producers expect a future P. inc, they will withhold current supply.

Factor 6: # of Producers More producers of a product, Supply inc. Ex. Fast food restaurants, auto manufacturers

Individual Supply Supply Can Increase or Decrease Individual Supply P 6 5 4 3 2 1 S3 Individual Supply S1 S2 P Qs $5 4 3 2 1 60 50 35 20 5 Price (per bushel) 2 4 6 8 10 12 14 Q Quantity Supplied (bushels per week)

Supply Curve is Called a Change in Quantity Individual Supply Supply Can Increase or Decrease A Movement Between Any Two Points on a Supply Curve is Called a Change in Quantity Supplied P 6 5 4 3 2 1 S3 Individual Supply S1 S2 P Qs $5 4 3 2 1 60 50 35 20 5 Price (per bushel) An Increase in Supply Means a Movement of the Line 2 4 6 8 10 12 14 Q Quantity Supplied (bushels per week)

Market Equilibrium Equilibrium Price Equilibrium Quantity Surplus 3.1 Equilibrium Price Equilibrium Quantity Surplus Shortage Rationing Function of Prices

Seeking Equilibrium: Demand and Supply Market equilibrium – situation in which the quantity demanded for a service is equal to the quantity supplied Two curves intersect at point of market equilibrium. Equilibrium price(market-clearing price) – price at which QS = QD; equilibrium quantity can also be determined

Reaching the Equilibrium Price Trial and error may be necessary for the market to arrive at equilibrium. Market may have a surplus: QS>QD Market may have a shortage: QD>QS

Surpluses and Shortages Surpluses happen when prices are too high relative to demand (excess supply) With surplus, prices tend to fall; producers cut back production Shortages happen when prices are too low relative to demand (excess demand) With shortage, prices rise; producers increase quantity supplied

Market Equilibrium 200 Buyers & 200 Sellers P Qd P Qs Market Demand Supply 200 Sellers 6 5 4 3 2 1 6,000 Bushel Surplus S P Qd P Qs $5 4 3 2 1 2,000 4,000 7,000 11,000 16,000 $5 4 3 2 1 12,000 10,000 7,000 4,000 1,000 $4 Price Floor Price (per bushel) 3 $2 Price Ceiling 7,000 Bushel Shortage D 2 4 6 8 10 12 14 16 18 7 Bushels of Corn (thousands per week)

Rationing Function of Prices Ability of the forces of S and D to establish a P at which selling and buying decisions are consistent At equilibrium, there is no shortage and no surplus

Efficient Allocation Competitive market also allocate societies’ resources efficiently Results in productive efficiency – production of any particular good in the least costly way Also results in allocative efficiency – the particular mix of G&S most highly valued by society, assuming minimum-cost production. Demand essentially reflects the MB of a good, while supply reflects MC of producing a good. At the intersection of the S and D curves, MB=MC, resulting in allocative efficiency!

Market Equilibrium Changes in S and D affect Equilibrium Changes in Equilibrium Efficient Allocation Productive Efficiency Allocative Efficiency

Market Equilibrium ? ? ? ? Supply Increase; Demand Decrease Price Quantity Supply Increase; Demand Decrease Supply Decrease; Demand Increase Supply Increase; Demand Increase Supply Decrease; Demand Decrease ? ? ? ?

Government-Set Prices Price Ceilings on Gasoline Rationing Problem Black Markets Rent Controls Price Floors on Wheat Optimal Allocation of Resources 3.2

Intervention in the Price System: At times the government or other entity will interfere in the price system to keep prices from going too high. Price Ceiling – legal max. price a seller may charge for a product -set below equilibrium price, so a shortage results Ex. Rent control – legal price ceilings on rent, leads to housing shortages Ex. gasoline –See p.58

Rationing Resources and Products In periods of national emergency, the gov. may distribute products or resources Rationing – way of allocating products using factors other than price -occurred in U.S. during WWII May lead to black market – illegal buying and selling of products

Price Floors Gov. decides to intervene in the price system in order to increase income to certain producers Price Floor –legal minimum price buyers may pay for a product Ex. Minimum wage or price floor on wheat – See p.59

A Legal Market for Human Organs Last Word Waiting List for Transplants Demand for Organs Vertical Supply of Organs Incentive Role of Market and Up-Sloping Supply Increases Quantity Decreases Price Moral Objections Increase the Cost of Health Care Better to Legalize and Regulate?

A Legal Market for Human Organs Last Word Supply With Price Incentive S1 S2 P Supply of Organs Demand for Organs Shortage at Zero Price Q1 – Q3 P1 At Price P1 the Shortage is Reduced By Q1 – Q2 D1 P0 Q1 Q2 Q3 Q