Chapter 4 SUPPLY AND DEMAND

Today’s lecture will: Introduce the law of demand and draw a demand curve. Explain the importance of substitution to the laws of supply and demand. Distinguish between a change in demand (shift in the curve) and a change in quantity demanded (movement along the demand curve). Explain the law of supply and construct a supply curve.

Today’s lecture will: Distinguish between a change in supply (shift in the curve) and a change in quantity supplied (movement along the supply curve). Explain how the laws of supply and demand interact to bring about equilibrium. Show the effect of shifts in demand and supply on equilibrium price and quantity. Explore the limitations of demand and supply analysis.

The Law of Demand Law of demand – there is an inverse relationship between price and quantity demanded. Other things equal: Quantity demanded rises as price falls Quantity demanded falls as price rises Law of demand is based on the fact that people substitute for goods whose price increases.

The Demand Curve The demand curve is the graphic representation of the law of demand. The demand curve slopes downward and to the right. B QB PB PA A Price (per unit) D QA Quantity demanded (per unit of time)

Quantity Demanded Versus Demand Change in quantity demanded Change in demand B 100 $2 $2 Price (per 50 miles) Price (per 50 miles) B A A $1 $1 D0 D1 D1 200 175 200 Cars (per mile each hour) Cars (per mile each hour)

Shift Factors of Demand Shift factors of demand are factors that cause changes in demand (shifts in the demand curve). Society’s Income Prices of Other Goods Tastes Expectations Taxes and Subsidies

From a Demand Table to a Demand Curve $6.00 A Demand Curve 5.00 Price per DVD DVD rentals demanded per week E 4.00 Price per DVDs (in dollars) 3.50 G D 3.00 A B C D E $0.50 1.00 2.00 3.00 4.00 9 8 6 4 2 Demand for DVDs C 2.00 B F 1.00 A .50 1 2 3 4 5 6 7 8 9 10 11 12 13 Quantity of DVDs demanded (per week)

Individual and Market Demand Curves $4.00 Alice Price per DVD Alice’s demand Bruce’s demand Carmen’s demand Market demand A C E F G + + + = 3.50 Bruce Market demand 3.00 A B C D E F G H $.0.50 1.00 1.50 2.00 2.50 3.00 3.50 4.00 9 8 7 6 5 4 3 2 6 5 4 3 2 1 1 16 14 11 9 7 5 3 2 2.50 D Price per DVD (in dollars) 2.00 1.50 B 1.00 Carmen 0.50 2 4 6 8 10 12 14 16 Quantity of DVDs demanded per week

The Law of Supply There is a direct relationship between price and quantity supplied. Other things constant: Quantity supplied rises as price rises. Quantity supplied falls as price falls. The law of supply occurs because: When prices rise, firms substitute production of one good for another. Assuming firms’ costs are constant, a higher price means higher profits.

The Supply Curve The supply curve is the graphic representation of the law of supply. The supply curve slopes upward to the right because quantity supplied varies directly with price. S B PB Price (per unit) A PA QA QB Quantity supplied (per unit of time)

Quantity Supplied Versus Supply Movement along Supply Curve S1 C $80 Price (per barrel) S0 B A $50 Shift in Supply 4.1 4.3 4.6 Barrels per day (millions)

Shift Factors of Supply Price of Inputs Technology Expectations Taxes and Subsidies

Individual and Market Supply Price (per DVD) Ann + Barry + Charlie = Charlie Barry Ann A B C D E F G H I $0.00 0.50 1.00 1.50 2.00 2.50 3.00 3.50 4.00 Market Supply 1 2 3 4 5 6 7 8 1 2 3 4 5 2 1 3 5 7 9 11 14 15 $4.00 3.50 3.00 2.50 2.00 1.50 1.00 0.50 I H G F E D C CA B A 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 Quantity of DVDs supplied (per week)

Equilibrium Equilibrium is a concept in which opposing forces cancel each other out. In a free market, the forces of supply and demand interact to determine: Equilibrium price – the price toward which the invisible hand drives the market. Equilibrium quantity – the amount bought and sold at the equilibrium price.

Quantity of DVDs supplied and demanded (per week) Equilibrium $5.00 S Price (per DVD) QS QD Surplus(+) Shortage (-) $3.50 7 3 +4 $2.50 5 $1.50 -4 Excess supply 4.00 3.50 3.00 Price per DVD 2.50 E 2.00 1.50 Excess demand D 1.00 1 2 3 4 5 6 7 8 Quantity of DVDs supplied and demanded (per week)

Shifts in Supply and Demand Shifts in either supply or demand change equilibrium price. An increase in demand or a decrease in supply: Creates excess demand at the original equilibrium price. Excess demand increases price until a new higher equilibrium price and quantity are reached.

Quantity of DVDs (per week) Increase in Demand S0 B Excess demand $2.50 Price (per DVDs) A C 2.25 D0 D1 8 9 10 Quantity of DVDs (per week)

Quantity of DVDs (per week) Decrease in Supply S1 S0 C $2.50 Price (per DVDs) B Excess demand 2.25 A D0 8 9 10 Quantity of DVDs (per week)

Limitations of Supply and Demand Analysis Sometimes supply and demand are interconnected. The other things constant assumption is likely not to hold when the goods represent a large percentage of the entire economy. The fallacy of composition is the false assumption that what is true for a part will also be true for the whole.

Summary The law of demand states that the quantity demanded rises as price falls, other things constant. The law of supply states that the quantity supplied rises as price rises, other things constant. The laws of demand and supply hold true because people can substitute.

Summary A change in quantity demanded (supplied), caused only by a change in the good’s own price, is a movement along the demand (supply) curve. A change in demand (supply) is a shift of the entire demand (supply) curve. Factors that affect supply and demand other than price are called shift factors.

Summary Shift Factors of Demand Shift Factors of Supply Income Price of Inputs Prices of Other Goods Technology Tastes Expectations Taxes and Subsidies on Producers Taxes and Subsidies on Consumers

Summary A market demand (supply) curve is the horizontal sum of all individual demand (supply) curves. When quantity demanded equals quantity supplied at equilibrium, prices have no tendency to change. When quantity demanded > quantity supplied, prices tend to rise. When quantity supplied > quantity demanded, prices tend to fall.

Summary When the demand curve shifts to the right (left), equilibrium price rises (declines) and equilibrium quantity rises (falls). When the supply curve shifts to the right (left), equilibrium price declines (rises) and equilibrium quantity rises (falls).

Given the following demand and supply of pizza: Price Quantity Quantity per Pizza Supplied Demanded $8 200 60 7 150 80 6 100 100 5 50 120 4 0 140 Review Question 4-1 What is the equilibrium price and quantity? Equilibrium price is $6 and equilibrium quantity is 100 pizzas. Review Question 4-2 If the price is $7, is there a shortage or surplus? How much is the shortage or surplus? Explain how the market will return to equilibrium. At a price of $7, there is a surplus of 150 - 80 = 70 pizzas. Producers will reduce the price in order to sell the surplus. As price decreases, quantity demanded increases until the surplus is eliminated at the equilibrium price of $6. Review Question 4-1 What is the equilibrium price and quantity? Equilibrium price is $6 and equilibrium quantity is 100 pizzas. Review Question 4-2 If the price is $7, is there a shortage or surplus? How much is the shortage or surplus? Explain how the market will return to equilibrium. At a price of $7, there is a surplus of 150 - 80 = 70 pizzas. Producers will reduce the price in order to sell the surplus. As price decreases, quantity demanded increases until the surplus is eliminated at the equilibrium price of $6.