1 Demand & Supply

2 On Modeling u Models may seem very simplistic at times - but many good models are. u Proof of pudding is in how well the model stands up to empirical scrutiny. u Two pitfalls to avoid: –the fallacy of composition –post hoc ergo propter hoc mistakes u positive vs. normative analysis

3 Supply and Demand u The supply and demand model is a basic workhorse of economics. u We will consider each of its pieces. u Then, we will use it to answer some basic questions. u Note: When employing supply and demand we are considering perfectly competitive markets. For now that simply means all buyers and sellers are assumed to be price takers.

4 Demand Concepts u The demand function for X: X D = f(P X, P s, P c, I, T&P, Pop) Where: X D = quantity demanded P X = X’s price P s = the price of substitutes P c = the price of complements I=income T&P=tastes and preferences Pop=population in market or market size

5 The Demand Curve (Verbal) u The demand curve, a.k.a. demand, describes the relation between a good’s price and the maximum quantity that consumers are willing and able to buy at that price, ceteris paribus. –Ceteris paribus means holding all the other demand function variables constant at some given level.

6 The Demand Curve (Verbal) u The Law of Demand states that the relationship between a good’s price and the quantity demanded of that good is negative. u Example: when the price of a good falls from 25 to 10, the quantity demanded rises from 15 to 30. u This is referred to as a “change in quantity demanded” and in this case an “increase in quantity demanded.” u Own-price changes cause movements along a given demand curve.

7 Movements vs. Shifts u A movement along the demand curve for X would be caused by a change in P x. u A shift of the entire demand curve would be caused by a change in one of the “ceteris paribus” demand variables. –This would be referred to as an increase or decrease in demand.

8 Increase in Demand u When demand increases, the quantity demanded by consumers increases at every price. u Example: when demand increases, the quantity demanded at a price of 25 rises from 15 to 25.

9 Decrease in Demand u When demand decreases, the quantity demanded by consumers falls at every price. u Example: when demand decreases, the quantity demanded at a price of 25 falls from 15 to 10.

10 The Demand Curve (Table) u The quantity demanded is a declining function of the price, as the table to the right illustrates.

11 Increase in Demand u When demand increases, the quantity demanded is greater at every price.

12 Decrease in Demand u When demand decreases, the quantity demanded is lower at every price.

13 The Demand Curve (Graph) u The same demand curve can be represented by a simple graph with a negative slope. Price Quantity Demand u At price = 25, the quantity demanded = 15.

14 Change in the Quantity Demanded u A change in the quantity demanded is a movement along the demand curve. Price Demand Quantity u When price falls to 10, the quantity demanded increases to 30.

15 Price Demand Quantity Increase in Demand u An increase in demand is a rightward shift in the entire curve New Demand u More is demanded at every price u At price = 25, the quantity demanded = 25 after the increase.

16 Price Demand Quantity Decrease in Demand u A decrease in demand is a leftward shift in the entire curve. u Less is demanded at every price New Demand u At price = 25, the quantity demanded = 10 after the decrease.

17 The Demand Curve (Equation) u Mathematically, the demand curve is an equation that shows a negative relation between price (P) and quantity (X) for all positive prices and quantities. u Beware of the equation and the graph of demand. X D = 40 - P15 = P D Q

18 Supply Concepts u The supply function for X: X S = g(P X, P fop, P oc, S&T, N) Where: X S = quantity supplied P X = X’s price P fop = prices of factors of production P oc = opportunity costs (alternatives in productions) S&T = science and technology N = number of firms in the market

19 The Supply Curve (Verbal) u The supply curve, a.k.a. supply, describes the relation between a good’s price and the maximum quantity that producers are willing and able to sell at that price, ceteris paribus. –Ceteris paribus means holding all the other supply function variables constant at some given level.

20 The Supply Curve (Verbal) u The Law of Supply states that the relationship between a good’s price and the quantity supplied of the good is positive. u Example: when the price of a good falls from 25 to 10, the quantity supplied falls from 31 to 16. u This is referred to as a “change in quantity supplied” and in this case an “decrease in quantity supplied.” u Own-price changes cause movements along a given supply curve.

21 Movements vs. Shifts u A movement along the supply curve for X would be caused by a change in P x. u A shift of the entire supply curve would be caused by a change in one of the “ceteris paribus” supply variables. –This would be referred to as an increase or decrease in supply.

22 Increase in Supply u When supply increases, the quantity supplied by producers increases at every price. u Example: when supply increases, the quantity supplied at a price of 25 rises from 31 to 36.

23 Decrease in Supply u When supply decreases, the quantity supplied by producers falls at every price. u Example: when supply decreases, the quantity supplied at a price of 25 falls from 31 to 21.

24 The Supply Curve (Table) u The quantity supplied is an increasing function of the price, as the table to the right illustrates.

25 Increase in Supply u When supply increases, the quantity supplied is greater at every price.

26 Decrease in Supply u When supply decreases, the quantity supplied is lower at every price.

27 Price Quantity The Supply Curve (Graph) u The same supply curve can be represented by a simple graph with a positive slope Supply u At price = 25, the quantity supplied = 31.

28 Price Quantity Supply Change in the Quantity Supplied u A change in the quantity supplied is a movement along the supply curve u At price = 10, the quantity supplied = 16.

29 Price Quantity Supply Increase in Supply u An increase in supply is a rightward shift in the entire curve. u More is supplied at every price New Supply u At price = 25, the quantity supplied = 36 after the increase.

30 Decrease in Supply u A decrease in supply is a leftward shift in the entire curve. u Less is supplied at every price u At price = 25, the quantity supplied = 21 after the decrease. Price 25 Quantity Supply 21 New Supply 31

The Supply Curve (Equation) u Mathematically, the supply curve is an equation that shows a positive relation between price (P) and quantity (X) for all positive prices and quantities. u Beware of the equation and the graph of supply. X S = 6 + P31 = P Q S 25 31

32 Market Equilibrium (Verbal) u The equilibrium price and quantity in a market occur at the price where the quantity demanded equals the quantity supplied. u Example: for the demand and supply curves used above, the equilibrium price is 17, where the quantity demanded, 23, equals the quantity supplied, 23.

33 Market Equilibrium (Table) u At a price of 17, the quantity demanded is equal to the quantity supplied, as the table to the right illustrates.

34 Market Equilibrium (Equations) u The equilibrium price and quantity satisfy both the demand and supply equations simultaneously. u To find P*, set X D = X S. –Recall: X D = 40 - P and X S = 6 + P –So… (40 - P*) = (6 + P*) –34 = 2P* or P* = 34/2 so... P*=17 –To find X*, plug P* into either the demand or supply equation. –X*=23 = or X*=23 =

35 Market Equilibrium (Graph) u The market equilibrium occurs at the intersection of the supply and demand curves. u At price = 17, the quantity supplied = quantity demanded = 23. Price Supply Quantity Demand

36 Comparative Statics u Using the model to make predictions. u Something changes in the market. u Compare one market equilibrium with another market equilibrium and see what happens to P* and X* u Compare two equilibria - compare two static situations - comparative statics!

37 First…demand side changes u Demand shifts and the demand variables: –P X - not a shift! (a movement along) –P s - positively related to demand –P C - negatively related to demand –I - depends: is X normal or inferior? –T&P - positively related to demand –Pop - positively related to demand

38 Price Quantity Demand Increase in Demand u An increase in demand is a rightward shift of the entire curve New Demand u More is demanded at every price. u At price = 25, the quantity demanded = 25

39 Market Equilibrium Increased Demand u The increased demand intersects the original supply curve to the right of the original equilibrium. Price Supply Quantity Demand New Demand u Price = 22 and quantity supplied = quantity demanded = 28

40 Summary: Market Equilibrium Increased Demand u Increased demand is indicated by a greater quantity demanded at every price. u The demand curve shifts right and a movement along the supply curve results. u When demand increases: –Equilibrium price increases –Equilibrium quantity increases –Note the movement in the same direction

41 Market Equilibrium Decreased Demand u The decreased demand intersects the original supply curve to the left of the original equilibrium. Price Supply Quantity Demand New Demand u Price = 14.5 and quantity supplied = quantity demanded = 20.5

42 Summary: Market Equilibrium Decreased Demand u Decreased demand is indicated by a smaller quantity demanded at every price. u The demand curve shifts left and a movement along the supply curve results. u When demand decreases: –Equilibrium price decreases –Equilibrium quantity decreases –Note the movement in the same direction

43 Now…supply side changes u Supply shifts and the supply variables: –P X - not a shift! –P fop - negatively related to supply –P oc - negatively related to supply –S&T - positively related to supply –N - positively related to supply

44 Price Quantity Supply Increase in Supply u An increase in supply is a rightward shift of the entire curve New Supply u More is supplied at every price. u At price = 25, the quantity supplied = 36

45 Market Equilibrium Increased Supply u The increased supply intersects the original demand curve to the right of the original equilibrium. Price Supply Quantity Demand New Supply u Price = 14.5 and quantity supplied = quantity demanded = 25.5

46 Summary: Market Equilibrium Increased Supply u Increased supply is indicated by a greater quantity supplied at every price. u The supply curve shifts right and a movement along the demand curve results. u When supply increases: –Equilibrium price decreases –Equilibrium quantity increases –Note the movement in opposite directions

47 Summary: Market Equilibrium Decreased Supply u Decreased supply is indicated by a smaller quantity supplied at every price. u The supply curve shifts left and a movement along the demand curve results. u When supply decreases: –Equilibrium price increases –Equilibrium quantity decreases –Note the movement in opposite directions

48 Examples: Changes in Demand u An increase in family income increases the demand for automobiles. u An increase in the price of software decreases the demand for computers. u An increase in the price of hockey tickets increases the demand for basketball tickets.

49 Automobile Market u Increased family income increases the demand for automobiles. Price P X Supply of Autos Quantity Old Demand for Autos P* X* New Demand for Autos u New price = P* and new quantity supplied = new quantity demanded = X*. u Equilibrium price and quantity both rise.

50 Computer Market u An increase in the price of software decreases the demand for computers. Price P X Supply of Computers Quantity Old Demand for Computers New Demand for Computers P* X* u New price = P* and new quantity supplied = new quantity demanded = X*. u Equilibrium price and quantity both fall.

51 Explanation of Computer Example u Software is an example of good that is demand “complementary” with computers. When the price of a complementary good (software) rises, the demand for the good itself (computers) decreases. u The market moves down the supply curve.

52 Basketball Market u An increase in the price of hockey tickets increases the demand for basketball tickets. Price P X Supply of Basketball Quantity Old Demand for Basketball P* X* New Demand for Basketball u New price = P* and new quantity supplied = new quantity demanded = X*. u Equilibrium price and quantity both rise.

53 Explanation of Basketball Example u Hockey games are demand “substitutes” for basketball games. When the price of a substitute good (hockey) rises, the demand for the good itself (basketball) increases. u The market moves up the supply curve.

54 Examples: Changes in Supply u A flood in Bordeaux in September decreases the supply of fine red wine. u A decrease in the price of energy increases the supply of steel. u An increase in the wage rate for engineers decreases the supply of new microprocessors.

55 Red Wine Market u The decreased supply intersects the original demand curve to the left of the original equilibrium. Price P X Old Supply of Red Wine Quantity Demand for Red Wine New Supply of Red Wine P* X* u New price = P* and new quantity supplied = quantity demanded = X*. u Equilibrium price rises and equilibrium quantity falls.

56 Explanation of Red Wine Example u Flood conditions in Bordeaux dilute the grapes and make them unsuitable for fine red wine. Thus, the supply of red wine is reduced because of reduced production at all prices. u The market retreats along the demand curve.

57 Steel Market u The decreased price of energy increases the supply of steel. Price P X Old Supply of Steel Quantity Demand for Steel New Supply of Steel P* X* u New price = P* and new quantity supplied = quantity demanded = X*. u Equilibrium price falls and equilibrium quantity rises.

58 Explanation of Steel Example u Energy is a factor in the production of steel. When the price of energy falls, it becomes less costly to produce steel. Thus the supply of steel increases at all prices. u The market moves down the demand curve.

59 Microprocessor Market u The decreased supply intersects the original demand curve to the left of the original equilibrium. Price P X Old Supply Quantity Demand for Microprocessors New Supply P* X* u New price = P* and new quantity supplied = quantity demanded = X*. u Equilibrium price rises and equilibrium quantity falls.

60 Explanation of Microprocessor Example u Engineers are a one of the types of labor used to design new microprocessors. When engineers become more expensive, the cost of designing microprocessors rises and supply falls at all prices. u The market moves up the demand curve.

61 4 Government interventions u Price floors u Price ceilings u Quantity Quotas u Taxes

62 Price floor u government established minimum selling price. –floor must be above P* to be binding –examples: supporting milk prices, minimum wage law –government usually thinks the market price is too low for some reason u Usually end up with….surpluses

63 Price Supply Quantity Demand Market Surplus u Equilibrium is at P = 17 and X = Surplus = 16 u The price floor is 25. u At the artificially high price of 25, sellers want to sell 31. u There is a surplus of 16. u But buyers only want to buy 15.

64 Price ceiling u government established maximum selling price. –must be below P* to be binding –examples: gas price ceilings; apartment rent control –government usually thinks the market price is too high for some reason u Usually end up with….shortages

65 Price Supply Quantity Demand Shortage = 14 Market Shortage u Equilibrium is at P = 17 and X = u Suppose there is a price ceiling of 10. u At the artificially low price of 10, buyers want to buy 30. u There is a shortage of 14. u But sellers only want to sell 16.

66 Quantity quota u government established maximum number of units sold. –Q q must be below Q* to be binding –example: import restrictions –government thinks too many units are being traded u end up with…higher prices and more.