3 DEMAND AND SUPPLY CHAPTER Dr. Gomis-Porqueras ECO 680

Demand, Supply and Markets The terms supply and demand refer to the behavior of people . . . as they interact with one another in markets. Buyers determine demand and Sellers determine supply. A market is a group of buyers and sellers of a particular good or service. The market price of a good or service is determined by both the supply and demand for it.

Markets and Prices A market is any arrangement that enables buyers and sellers to get information and do business with each other. A competitive market is a market that has many buyers and many sellers so no single buyer or seller can influence the price. The money price of a good is the amount of money needed to buy it. The relative price of a good—the ratio of its money price to the money price of the next best alternative good—is its opportunity cost. Before you jump into the demand-supply model, be sure that your students understand that a price in economics is relative price and that a relative price is an opportunity cost. Also spend some class time ensuring that they appreciate the key lessons of Chapter 2: a) Prosperity comes from specialization and exchange. b) Specialization and exchange requires the social institutions of property rights and markets. c) We must understand how markets work. You might like to explain that the most competitive markets are explicitly organized as auctions. An interesting market to describe is that at Aalsmeer in Holland, which handles a large percentage of the world’s fresh cut flowers. Roses grown in Columbia are flown to Amsterdam, auctioned at Aalsmeer, and are in vases in New York, London, and Tokyo all in less than a day. If you have an Internet connection in your classroom, you can participate in a simulation of an auction of flowers. Here is the URL (which you can also click on at the Parkin Web site) http://www.batky-howell.com/~jb/auction/daauction.cgi.

Demand If you demand something, then you: Want it, Can afford it, and Have made a definite plan to buy it. Wants are the unlimited desires or wishes people have for goods and services. Demand reflects a decision about which wants to satisfy. The quantity demanded of a good or service is the amount that consumers plan to buy during a particular time period, and at a particular price.

Demand What Determines Buying Plans? The amount of any particular good or service that consumers plan to buy is influenced by 1. The price of the good, 2. The prices of other goods, 3. Expected future prices, 4. Income, 5. Population, and 6. Preferences.

Demand The Law of Demand The law of demand states: Other things remaining the same, the higher the price of a good, the smaller is the quantity demanded. The law of demand results from a substitution effect an income effect Estimating the demand for Coke (or bottled water) in the classroom. Of the hundreds of classroom experiments that are available today, very few are worth the time they take to conduct. The classic demand-revealing experiment is one of the most productive and worthwhile ones. Bring to class two bottles of ice-cold, ready-to-drink Coke, bottled water, or sports drink. (If your class is very large, bring six bottles). Tell the students that you have these drinks and ask them to indicate if they would like one. Most hands will go up and you are now ready to make two points: 1. The students have just revealed a want but not a demand. 2. You don’t have enough bottles to satisfy their wants, so you need an allocation mechanism. Ask the students to suggest some allocation mechanisms. You might get suggestions such as: give them to the oldest, the youngest, the tallest, the shortest, the first-to-the-front-of-the-class. For each one, point out the difficulty/inefficiency/inequity. If no one suggests selling them to the highest bidder, tell the class that you are indeed going to do just that. Tell them that this auction is real. The winner will get the drink and will pay. Now ask for a show of hands of those who have some cash and can afford to buy a drink. Explain that these indicate an ability to buy but not a definite plan to buy. Continues on next (hidden) slide notes page.

Demand Substitution effect—when the relative price (opportunity cost) of a good or service rises, people seek substitutes for it, so the quantity demanded decreases. Income effect—when the price of a good or service rises relative to income, people cannot afford all the things they previously bought, so the quantity demanded decreases.

Demand Demand Curve and Demand Schedule A demand curve shows the relationship between the quantity demanded of a good and its price when all other influences on consumers’ planned purchases remain the same.

Demand Figure 3.1 shows a demand curve for recordable compact discs (CD-Rs). A rise in the price, other things remaining the same, brings a decrease in the quantity demanded and a movement along the demand curve.

Demand A demand curve is also a willingness-and-ability-to-pay curve. The smaller the quantity available, the higher is the price that someone is willing to pay for another unit. Willingness to pay measures marginal benefit.

Demand A Change in Demand When any factor that influences buying plans other than the price of the good changes, there is a change in demand for that good. The quantity of the good that people plan to buy changes at each and every price, so there is a new demand curve. When demand increases, the quantity that people plan to buy increases at each and every price so the demand curve shifts rightward. When demand decreases, the quantity that people plan to buy decreases at each and every price so the demand curve shifts leftward.

Demand Factors that change demand: Prices of related goods A substitute is a good that can be used in place of another good. A complement is a good that is used in conjunction with another good. When the price of substitute for CD-Rs rises or when the price of a complement for CD-Rs falls, the demand for CD-Rs increases.

Demand Figure 3.2 shows the shift in the demand curve for CD-Rs when the price of CD burner falls. Because a CD burner is a complement of a CD-R, the demand for CD-Rs increases.

Demand Expected future prices If the price of a good is expected to rise in the future, current demand increases and the demand curve shifts rightward. Income When income increases, consumers buy more of most goods and the demand curve shifts rightward. A normal good is one for which demand increases as income increases. An inferior good is a good for which demand decreases as income increases.

Demand Population The larger the population, the greater is the demand for all goods. Preferences People with the same income have different demands if they have different preferences.

Demand A Change in the Quantity Demanded Versus a Change in Demand Figure 3.3 illustrates the distinction between a change in demand and a change in the quantity demanded.

Demand When the price of the good changes and everything else remains the same, there is a change in the quantity demanded and a movement along the demand curve.

Demand When one of the other factors that influence buying plans changes, there is a change in demand and a shift of the demand curve.

Supply If a firm supplies a good or service, then the firm: Has the resources and the technology to produce it, Can profit form producing it, and Has made a definite plan to produce and sell it. Resources and technology determine what it is possible to produce. Supply reflects a decision about which technologically feasible items to produce. The quantity supplied of a good or service is the amount that producers plan to sell during a given time period at a particular price.

Supply What Determines Selling Plans? The amount of any particular good or service that a firm plans to supply is influenced by 1. The price of the good, 2. The prices of resources needed to produce it, 3. The prices of related goods produced, 4. Expected future prices, 5. The number of suppliers, and 6. Available technology.

Supply The Law of Supply The law of supply states: Other things remaining the same, the higher the price of a good, the greater is the quantity supplied. The law of supply results from the general tendency for the marginal cost of producing a good or service to increase as the quantity produced increases. Producers are willing to supply only if they at least cover their marginal cost of production. Estimating the supply of Coke (or bottled water) in the classroom. (It is best to do this next classroom activity on a different day from the demand experiment.) Tell the students that you would like a Coke (or other drink) that is available from a machine somewhere near the classroom and you want someone to get it for you. You are going to continue teaching while the student is out of the room and you will be giving hints about what is on the next test. Ask the students to raise their hand if they are willing to fetch one can of Coke if you pay $5.00. Write down the number. Lower the price you’ve willing to pay in $1 increments until the number of students willing to fetch you the drink begins to decrease. Keep track of the numbers. Lower the price you’re willing to pay in 25¢ increments until you get close to only having one student willing to fetch you the drink. Keep track of the numbers. Lower the price in smaller increments if necessary until just one student is willing to fetch you a drink. Continues on next (hidden) slide notes page.

Supply Supply Curve and Supply Schedule The supply curve shows the relationship between the quantity supplied of a good and its price when all other influences on producers’ planned sales remain the same.

Supply A rise in the price, other things remaining the same, brings an increase in the quantity supplied and a movement along the supply curve. Why do you have point A starting at 0.50 rather than 0?

Supply A supply curve is also a minimum-supply-price curve. The greater the quantity produced, the higher is the price that a firm must offered to be willing to produce that quantity.

Supply A Change in Supply When any factor that influences selling plans other than the price of the good changes, there is a change in supply of that good. The quantity of the good that producers plan to sell changes at each and every price, so there is a new supply curve. When supply increases, the quantity that producers plan to sell increases at each and every price so the supply curve shifts rightward. When supply decreases, the quantity that producers plan to sell decreases at each and every price so the supply curve shifts leftward.

Supply Factors that change supply: Prices of productive resources If the price of resource used to produce a good rises, the minimum price that a supplier is willing to accept for producing each quantity of that good rises. So a rise in the price of productive resources decreases supply and shifts the supply curve leftward.

Supply Prices of related goods produced A substitute in production for a good is another good that can be produced using the same resources. Goods are compliments in production if they must be produced together. The supply of a good increases and its supply curve shifts rightward if the price of a substitute in production falls or if the price of a complement in production rises.

Supply Expected future prices If the price of a good is expected to fall in the future, current supply increases and the supply curve shifts rightward. The number of suppliers The larger the number of suppliers of a good, the greater is the supply of the good. An increase in the number of suppliers shifts the supply curve rightward.

Supply Technology Advances in technology create new products and lower the cost of producing existing products, so they increase supply and shift the supply curve rightward.

Supply Figure 3.5 shows how an advance in the technology for producing recordable CDs increases the supply of CD-Rs and shifts the supply curve for CD-Rs rightward.

Supply When one of the other factors that influence selling plans changes, there is a change in supply and a shift of the supply curve.

Some Ancient History and Some Economics According to Roman legend, a series of prophecies by god Apollo were written down in nine books and interpreted by the Sibyl of Cumae. Around 500 B.C. the Sibyl gave Tarquinius Superbus a chance to buy the books for a price payable in gold. He refused. According to myth, the Sibyl burned three of the books and offered the king the remaining six for the original price she had asked for the nine. He refused again; she burned three more books and offered him the remaining three at the same price she had asked for all nine. This time he paid her.

Some Ancient History and Some Economics Why would he do that? How can his behavior be seen as consistent with the theory of consumer demand? By reducing the number of books in existence, the Sibyl made it clear to him that the remaining ones were now scarcer. She changed the quality of the product in the king’s mind, which induced him to pay a price three times higher per book than he would have paid if he had bought the books at the original price.

Some Ancient History and Some Economics Questions: Are there other examples where sellers destroy some of their product in order to enhance the value of what remains by so much as to increase their total revenue? Why don’t we see very many other sellers behaving like the Sibyl and trying to convince people how valuable their product is by throwing some of it away?

Some Ancient History and Some Economics Answers: Sometimes firms will diminish the quality of their good in order to establish a low quality goods market. The firm may then be able to sell goods to two types of customers and increase total revenue. We don’t see many sellers behaving like the Sibyl because most sellers are more patient than the Sibyl. The sellers are willing to wait for a person to be willing to buy the product. The sellers may also be afraid that the potential customer will not offer anything for the remaining product.

Market Equilibrium Equilibrium is a situation in which opposing forces balance each other. Equilibrium in a market occurs when the price balances the plans of buyers and sellers. The equilibrium price is the price at which the quantity demanded equals the quantity supplied. The equilibrium quantity is the quantity bought and sold at the equilibrium price. Price regulates buying and selling plans. Price adjusts when plans don’t match. The magic of market equilibrium and the forces that bring it about and keep the market there need to be demonstrated with the basic diagram, with intuition, and, if you’ve got the time, with hard evidence in the form of further class activity. You might want to begin with the demand curve experiment and explain that in that market, the supply was fixed (vertical supply curve) at the quantity of bottles that you brought to class. The equilibrium occurred where the market demand curve (demand by the students) intersected your supply curve. Then you might use the supply curve experiment and explain that in that market, demand was fixed (vertical demand curve) at the quantity that you had decided to buy. The equilibrium occurred where the market supply curve (supply by the students) intersected your demand curve. Point out that the trades you made in your little economy made buyers and sellers better off. If you want to devote a class to equilibrium and the gains from trade in a market, you might want to run a double oral auction. There are lots of descriptions of these and one of the best is at Marcelo Clerici-Arias’s Web site at Stanford University—http://www.stanford.edu/~marcelo/index.html?Teaching/Docs/Experiments/Auction/auction.htm~mainFrame

Market Equilibrium Price as a Regulator Figure 3.7 illustrates the equilibrium price and equilibrium quantity in the market for CD-Rs. If the price of a disc is $2, the quantity supplied exceeds the quantity demanded and there is a surplus of discs.

Market Equilibrium If the price of a disc is $1, the quantity demanded exceeds the quantity supplied and there is a shortage of discs. If the price of a disc is $1.50, the quantity demanded equals the quantity supplied and there is neither a shortage nor a surplus of discs.

Market Equilibrium Because the price rises if it is below equilibrium, falls if it is above equilibrium, and remains constant if it is at the equilibrium, the price is pulled toward the equilibrium and remains there until some event changes the equilibrium.

Predicting Changes in Price and Quantity A Change in Demand Figure 3.8 shows the effect of a change in demand. An increase in demand shifts the demand curve rightward and creates a shortage at the original price. The whole chapter builds up to this section, which now brings all the elements of demand, supply, and equilibrium together to make predictions. Students are remarkably ready to guess the consequences of some event that changes either demand or supply or both. They must be encouraged to work out the answer and draw the diagram. Explain that the way to answer any question that seeks a prediction about the effects of some events on a market has five steps. Walk them through the steps and have one or two students work some examples in front of the class. The five steps are: 1.Draw a demand-supply diagram and label the axes with the price and quantity of the good or service in question. 2. Think about the events that you are told occur and decide whether they change demand, supply, both demand and supply, or neither demand nor supply. 3. Do the events that change demand or supply bring an increase or a decrease? 4. Draw the new demand curve and supply curve on the diagram. Be sure to shift the curves in the correct direction—leftward for decrease and rightward for increase. (Lots of students want to move the curves upward for increase and downward for decrease—works ok for demand but exactly wrong for supply. Emphasize the left-right shift.) 5. Find the new equilibrium and compare it with the original one. Walk them through the steps and have one or two students work some examples in front of the class. It is critical at this stage to return to the distinction between a change in demand (supply) and a change in the quantity demanded (supplied). You can now use these distinctions to describe the effects of events that change market outcomes. At this point, the students know enough for it to be worthwhile emphasizing the magic of the market’s ability to coordinate plans and reallocate resources. The price rises and the quantity supplied increases.

Predicting Changes in Price and Quantity A Change in Supply Figure 3.9 shows the effect of a change in supply. An increase in supply shifts the supply curve rightward and creates a surplus at the original price. The price falls and the quantity demanded increases.

Predicting Changes in Price and Quantity A Change in Both Demand and Supply A change both demand and supply changes the equilibrium price and the equilibrium quantity but we need to know the relative magnitudes of the changes to predict some of the consequences.

Predicting Changes in Price and Quantity Figure 3.10 shows the effects of a change in both demand and supply in the same direction. An increase in both demand and supply increases the equilibrium quantity but has an uncertain effect on the equilibrium price.

Predicting Changes in Price and Quantity Figure 3.11 shows the effects of a change in both demand and supply when they change in opposite directions. An increase in supply and a decrease in demand lowers the equilibrium price but has an uncertain effect on the equilibrium quantity.

Different Types of Markets

How do markets work?