Supply and Demand 3 Slides By: Solina Lindahl

After studying this chapter you should be able to describe: the nature and purposes of markets. the nature of demand, demand curves, and the law of demand. the determinants of demand. the difference between a change in demand and a change in quantity demanded.

After studying this chapter you should be able to describe (cont.): the nature of supply, supply curves, and the law of supply. the determinants of supply. the difference between a change in supply and a change in quantity supplied. market equilibrium price and output. and predict how price and output will change given changes to supply and demand in the market. impacts of government intervention in markets.

Markets Models of supply and demand are the foundation of economic theory. Market: institution that brings buyers and sellers together Examples: lemonade stand, eBay, NY Stock Exchange

The Price System Prices send signals in free-market economies: To buyers What to buy? How much? To sellers What to sell? How much? What method of production to use? The Price System: market economies use prices to allocate resources, goods and services.

Demand Demand: the maximum amount of a product that buyers are willing and able to purchase over some time period at various prices (ceteris paribus)

The Demand Curve D Price Quantity $100 80 5 60 10 40 15 20 Price ($) 80 5 60 10 40 15 20 $80 $60 Price ($) $40 $20 5 10 15 20 Quantity (computer games)

Law of Demand Law of Demand: Holding all other relevant factors constant, price and quantity demanded are negatively related Consumer incomes can afford more goods when prices are lower.

Market Demand Curves Market demand: horizontal summation of all individual demand curves Horizontal summation: Market demand and supply curves are found by adding together how many units of the product will be purchased/supplied at each price.

Market Demand Curve Betty’s Demand Curve Abe’s Demand Curve + =

Determinants of Demand In drawing a demand curve, we hold other factors constant: these are called Determinants of Demand Tastes and Preferences Income Prices of related goods Number of buyers Future expectations

Tastes and Preferences Demand will increase for products that “come into fashion” (and vice versa) Examples: Soymilk, organic produce, “fair trade” coffee, skinny pants, acai berries

Income Normal goods: demand increases as incomes rise. Inferior goods: demand decreases as incomes rise. Examples of inferior goods: Bus travel, fast food Other?

Prices of Related Goods Substitute goods are those used in place of one another (depending on their relative prices) Examples: Margarine brands An increase in the price of Brand A will increase the demand for Brand B

Prices of Related Goods Gas price increases are bad for SUV sales Complement goods are those typically consumed together Examples: Gas and SUVs If the price of a complement decreases, the demand for the original good increases (and vice versa)

The Number of Buyers As more consumers enter a market, demand increases As average life spans are extended, demand for pharmaceuticals increases. 3 17

Future Expectations A change in consumers’ expectations about: Future Prices A good’s availability Their own incomes Will affect demand curves 2009: gun sales increased as NRA members worried that Obama would enact tougher gun control laws

Changes in Demand A “change in demand” is NOT the same as a “change in quantity demanded.” A change in demand: Occurs when one or more of the determinants of demand changes, shown as a shift in the entire demand curve.

Changes in Demand vs. Changes in Quantity Demanded Change in Demand Change in Quantity Demanded 80 80 Price ($) Price ($) D1 40 D0 D0 20 40 20 40 Quantity (computer games) Quantity (computer games)

Who’s Who Alfred Marshall (1842-1924) Father of modern Supply and Demand Was J.M. Keynes’ teacher Developed key ideas: Price elasticity of demand Consumer and producer surplus

Supply Supply: the maximum amount of a product that producers are willing and able to sell over some time period at various prices (ceteris paribus) 3- 22

The Supply Curve S Price Quantity $20 10 40 20 60 30 80 100 50 $100 Price Quantity $20 10 40 20 60 30 80 100 50 $80 $60 Price ($) $40 $20 10 20 30 40 50 Quantity (computer games)

Law of Supply Price and Quantity Supplied are positively related Producers want to maximize their profits so usually offer more for sale when prices rise e.g., production of corn increases as ethanol demand pushes prices for corn higher (and thus profits!)

Market Supply Curves Market supply: horizontal summation of all individual supply curves e.g., if there are 100 producers of doghouses, each of whom makes 5 doghouses when P=$50, then market supply = 500

Determinants of Supply In drawing a supply curve, we hold other factors constant: Production Technology Costs of Resources Prices of Other Commodities Future Expectations Number of Sellers Taxes and Subsidies

Production Technology Supply will increase for products when technology improves Examples: Computers, gaming systems, laser hair removal, flat screen TVs. 3- 27

Costs of Resources Example: if corn prices decrease, the supply of corn tortillas increases Supply will increase if the costs of resources used decrease (and vice versa)

Prices of Other Commodities Producers have the ability to produce other goods An increase in the profitability of small cars will decrease the supply of SUVs 3- 29

Future Expectations A change in producers’ expectations about profitability will affect supply curves Windmill production increases as producers expect sales and profitability to increase. 3- 30

Number of Sellers As more producers enter a market, supply increases (and vice versa) As more firms enter the solar installation market, the number of solar installations available for sale increases

Taxes and Subsidies Seems like a good thing to tax…. Or not: The Omnibus Budget Reconciliation Act of 1990 applied a 10% federal luxury tax to the retail sale of luxury goods such as pleasure boats with a sales price above the $100,000. Expected tax revenue? $9 billion. Reality? Sales of boats down 52.7%; Net loss of 30,000 jobs; The federal government paid out > $7 million more in unemployment benefits to those workers than it collected in luxury tax revenues. The federal luxury tax was repealed in 1993. Estimates from the Marine Retailers Association of America and The CPA Journal “Luxury Tax” by Elda DiRe, October 1991. Taxes and subsidies affect profits and therefore supply. A 10% yacht tax reduced the supply of yachts 53% in the early 1990s. 3- 32

Cotton Supply When the U.S. decreases its cotton subsidies, U.S. cotton supply decreases

Changes in Supply A “change in supply” is NOT the same as a “change in quantity supplied.” A change in supply: Occurs when one or more of the determinants of supply changes, shown as a shift in the entire supply curve.

Changes in Supply vs. Changes in Quantity Supplied Change in Supply Change in Quantity Supplied S0 S0 S1 80 80 40 Price ($) Price ($) 40 20 20 40 Quantity (computer games) Quantity (computer games)

Market Equilibrium Equilibrium: When Qs=Qd at a certain price Equilibrium price: the price that results when Qs=Qd Equilibrium Quantity: the output that results where Supply = Demand

How Markets Find Equilibrium When Price Is Too High Energy Drinks At P = $5.00: Surplus forces producers to drop price….Price will fall, people will buy more and Qd = Qs S . . $5.00 4.00 3.00 2.00 1.00 D Q 5 10 15 20 25 At a price of $5.00, a SURPLUS of 10 energy drinks exists

How Markets Find Equilibrium When Price Is Too Low Energy Drinks At P = $3.00: Shortage allows producers to raise price….Price will rise, people will buy less and Qd = Qs S $5.00 4.00 . . 3.00 2.00 1.00 D Q 5 10 15 20 25 At a price of $3.00, a SHORTAGE of 10 energy drinks exists

How Markets Find Equilibrium When Price is Too High Energy Drinks At P = $5.00: Qs = 25, Qd = 15 S . $5.00 4.00 Price will fall to equilibrium ($4.00) and Qd will rise to 20, Qs will fall to 20 and Qd = Qs 3.00 2.00 1.00 D Q 5 10 15 20 25 At a price of $5.00, a SURPLUS of 10 energy drinks (25-15) exists… suppliers are left with stock on the shelves, so they take action to get the surplus sold and raise revenue.

How Markets Find Equilibrium When Price is Too Low Energy Drinks At P = $3.00: Qs = 15, Qd = 25 S $5.00 Price will rise to equilibrium ($4.00): Qd will fall to 20, Qs will rise to 20 and Qd = Qs 4.00 . . 3.00 2.00 1.00 D Q 5 10 15 20 25 At a price of $3.00, a SHORTAGE of 10 energy drinks (25-15) exists… buyers compete with each other for purchases, so sellers see their chance to raise price and revenue

Equilibrium and Shifts of the Demand Curve Price of energy drinks An increase in demand S Q1 P1 Causes the equilibrium to change to a higher P and Q D1 P0 Figure Caption: Figure 3-14: Equilibrium and Shifts of the Demand Curve The original equilibrium in the market for coffee is at E1, at the intersection of the supply curve and the original demand curve, D1. A rise in the price of tea, a substitute, shifts the demand curve rightward to D2. A shortage exists at the original price, P1, causing both the price and quantity supplied to rise, a movement along the supply curve. A new equilibrium is reached at E2, with a higher equilibrium price, P2, and a higher equilibrium quantity, Q2. When demand for a good or service increases, the equilibrium price and the equilibrium quantity of the good or service both rise. Note to the instructor: An example from sports: The recent successes of Red Socks (Boston’s Baseball Team) caused an increase in demand for the tickets of Red Socks games. In 10 years, global warming may increase the demand for land in parts of the world earlier considered “too cold”. Question for Class Discussion: Coffee and tea are substitutes: if the price of tea rises (falls), the demand for coffee will increase (decrease). But how does the price of tea affect the market for coffee? D0 Q0 Quantity of energy drinks

Equilibrium and Shifts of the Demand Curve Price of energy drinks A decrease in demand D1 S Causes the equilibrium to change to a lower P and Q P0 Q1 P1 Figure Caption: Figure 3-14: Equilibrium and Shifts of the Demand Curve The original equilibrium in the market for coffee is at E1, at the intersection of the supply curve and the original demand curve, D1. A rise in the price of tea, a substitute, shifts the demand curve rightward to D2. A shortage exists at the original price, P1, causing both the price and quantity supplied to rise, a movement along the supply curve. A new equilibrium is reached at E2, with a higher equilibrium price, P2, and a higher equilibrium quantity, Q2. When demand for a good or service increases, the equilibrium price and the equilibrium quantity of the good or service both rise. Note to the instructor: An example from sports: The recent successes of Red Socks (Boston’s Baseball Team) caused an increase in demand for the tickets of Red Socks games. In 10 years, global warming may increase the demand for land in parts of the world earlier considered “too cold”. Question for Class Discussion: Coffee and tea are substitutes: if the price of tea rises (falls), the demand for coffee will increase (decrease). But how does the price of tea affect the market for coffee? D0 Q0 Quantity of energy drinks

Equilibrium and Shifts of the Supply Curve Price of energy drinks An increase in supply S0 S1 P0 Causes the equilibrium to change to a lower P and higher Q Q1 P1 Figure Caption: Figure 3-14: Equilibrium and Shifts of the Demand Curve The original equilibrium in the market for coffee is at E1, at the intersection of the supply curve and the original demand curve, D1. A rise in the price of tea, a substitute, shifts the demand curve rightward to D2. A shortage exists at the original price, P1, causing both the price and quantity supplied to rise, a movement along the supply curve. A new equilibrium is reached at E2, with a higher equilibrium price, P2, and a higher equilibrium quantity, Q2. When demand for a good or service increases, the equilibrium price and the equilibrium quantity of the good or service both rise. Note to the instructor: An example from sports: The recent successes of Red Socks (Boston’s Baseball Team) caused an increase in demand for the tickets of Red Socks games. In 10 years, global warming may increase the demand for land in parts of the world earlier considered “too cold”. Question for Class Discussion: Coffee and tea are substitutes: if the price of tea rises (falls), the demand for coffee will increase (decrease). But how does the price of tea affect the market for coffee? D0 Q0 Quantity of energy drinks

Equilibrium and Shifts of the Supply Curve Price of energy drinks A decrease in supply S1 S0 Q1 P1 Causes the equilibrium to change to a higher P and lower Q Q0 P0 Figure Caption: Figure 3-14: Equilibrium and Shifts of the Demand Curve The original equilibrium in the market for coffee is at E1, at the intersection of the supply curve and the original demand curve, D1. A rise in the price of tea, a substitute, shifts the demand curve rightward to D2. A shortage exists at the original price, P1, causing both the price and quantity supplied to rise, a movement along the supply curve. A new equilibrium is reached at E2, with a higher equilibrium price, P2, and a higher equilibrium quantity, Q2. When demand for a good or service increases, the equilibrium price and the equilibrium quantity of the good or service both rise. Note to the instructor: An example from sports: The recent successes of Red Socks (Boston’s Baseball Team) caused an increase in demand for the tickets of Red Socks games. In 10 years, global warming may increase the demand for land in parts of the world earlier considered “too cold”. Question for Class Discussion: Coffee and tea are substitutes: if the price of tea rises (falls), the demand for coffee will increase (decrease). But how does the price of tea affect the market for coffee? D0 Quantity of energy drinks

When Both Curves Shift Predicting the outcome is more tricky, but can be done if you know which curves shifts further. 3- 45

Review of Shifts

Price Ceilings S0 A price ceiling is a government-set maximum price that can be charged for a product or service. Price ceilings lead to shortages. Price Pe Pc Q3 Q4 D0 Shortage Quantity

Price Floors Surplus A price floor is a government-set minimum price that can be charged for a product or service. Price floors lead to surpluses. S0 P1 Price Pe D0 Q1 Q2 Quantity

Key Concepts Markets Supply Price System Law of Supply Demand Supply curve Law of Demand Determinants of Supply Demand Curve Change in Supply Horizontal summation Change in quantity Supplied Determinants of Demand Equilibrium Normal good Equilibrium price Inferior good Equilibrium quantity Substitute goods Surplus Complementary goods Shortage Change in Demand Price ceiling Change in quantity Demanded Price floor

Demand Which of the following is NOT a determinant of demand for orange juice? Level of consumer incomes Price of apple juice, a substitute good Medical research that reports new benefits from drinking orange juice Level of government subsidies to orange farmers

Which of the following will cause an increase in the demand for autos? Price of car tires increase because of a Malaysian rubber shortage Concrete steel reinforcing rods are replaced by aluminum along the Atlantic coast to prevent rusting Gasoline prices drop by 50% when OPEC nations increase production McDonald’s increases its hamburger production in response to consumer trends

If the cost of wood falls, what will happen in the violin market? Equilibrium Price and Quantity both fall Equilibrium Price and Quantity both rise Equilibrium Price falls and Quantity rises Equilibrium Price rises and Quantity falls

If garden gnomes regain widespread popularity, what will happen? Equilibrium Price and Quantity both fall Equilibrium Price and Quantity both rise Equilibrium Price falls and Quantity rises Equilibrium Price rises and Quantity falls

If the price of MP3s drops substantially, what happens in the market for CDs? Equilibrium Price and Quantity both fall Equilibrium Price and Quantity both rise Equilibrium Price falls and Quantity rises Equilibrium Price rises and Quantity falls