Theory of Supply and Demand Hall and Lieberman, 3rd edition, Thomson South-Western, Chapter 3

Overview Market (who, what, how) Supply and demand is an economic model Designed to explain how prices are determined in certain types of markets What you will learn in this chapter How the model of supply and demand works and how to use it The law of demand The law of supply The determination of market equilibrium Factors shifting demand or supply curves

Markets In economics, a market is not a place but rather a group of buyers and sellers with the potential to trade with each other Market is defined not by its location but by its participants First step in an economic analysis is to define and characterize the market or collection of markets to analyze Economists think of the economy as a collection of individual markets

How Broadly Should We Define The Market Defining the market often requires economists to group things together Aggregation is the combining of a group of distinct things into a single whole Markets can be defined broadly or narrowly, depending on our purpose How broadly or narrowly markets are defined is one of the most important differences between Macroeconomics and Microeconomics

Defining Macroeconomic Markets Goods and services are aggregated to the highest levels Macro models lump all consumer goods into the single category “consumption goods” Macro models will also analyze all capital goods as one market Macroeconomists take an overall view of the economy without getting bogged down in details

Defining Microeconomic Markets Markets are defined narrowly Focus on models that define much more specific commodities Always involves some aggregation But stops it reaches the highest level of generality that macroeconomics investigates

Buyers and Sellers Buyers and sellers in a market can be Households Business firms Government agencies All three can be both buyers and sellers in the same market, but are not always For purposes of simplification this text will usually follow these guidelines In markets for consumer goods, we’ll view business firms as the only sellers, and households as only buyers In most of our discussions, we’ll be leaving out the “middleman”

Competition in Markets In imperfectly competitive markets, individual buyers or sellers can influence the price of the product In perfectly competitive markets (or just competitive markets), each buyer and seller takes the market price as a given What makes some markets imperfectly competitive and others perfectly competitive? Perfectly competitive markets have many small buyers and sellers Each is a small part of the market, and the product is standardized Imperfectly competitive markets have just a few large buyers and sellers Or else the product of each seller is unique in some way

Using Supply and Demand Supply and demand model is designed to explain how prices are determined in perfectly competitive markets Perfect competition is rare but many markets come reasonably close Perfect competition is a matter of degree rather than an all or nothing characteristic Supply and demand is one of the most versatile and widely used models in the economist’s tool kit (example: laptop computers; orange juice)

Demand A household’s quantity demanded of a good Specific amount household would choose to buy over some time period, given A particular price that must be paid for the good All other constraints on the household Market quantity demanded (or quantity demanded) is the specific amount of a good that all buyers in the market would choose to buy over some time period, given A particular price they must pay for the good All other constraints on households

Quantity Demanded Implies a choice Is hypothetical Stresses price How much households would like to buy when they take into account the opportunity cost of their decisions? Is hypothetical Makes no assumptions about availability of the good How much would households want to buy, at a specific price, given real-world limits on their spending power? Stresses price Price of the good is one variable among many that influences quantity demanded We’ll assume that all other influences on demand are held constant, so we can explore the relationship between price and quantity demanded

The Law of Demand The price of a good rises and everything else remains the same, the quantity of the good demanded will fall The words, “everything else remains the same” are important In the real world many variables change simultaneously However, in order to understand the economy we must first understand each variable separately Thus we assume that, “everything else remains the same,” in order to understand how demand reacts to price Consider an example from our real life: the price of laptop decreases, how is the total number of computer bought changed?

The Demand Schedule Demand schedule Demand V.S. Quantities demanded A list showing the quantity of a good that consumers would choose to purchase at different prices, with all other variables held constant Demand V.S. Quantities demanded - demand is the entire relationship between price and quantity - quantities demanded are specific amount of goods buyers want to buy

The Demand Curve The market demand curve (or just demand curve) shows the relationship between the price of a good and the quantity demanded , holding constant all other variables that influence demand Each point on the curve shows the total buyers would choose to buy at a specific price Law of demand tells us that demand curves virtually always slope downward Emphasize the “other things constant” Emphasize the price influence Exercise and example: - Illustrate the example of maple syrup in the textbook – how to draw the graph? what is the relations? Is it the linear relation?

Figure 1: The Demand Curve Number of Bottles per Month Price per Bottle When the price is $4.00 per bottle, 40,000 bottles are demanded (point A). A $4.00 At $2.00 per bottle, 60,000 bottles are demanded (point B). Maple syrup example Horizontal axis; Vertical axis Points A and B, interpretation Negative relations Move along the curve – price change B 2.00 D 40,000 60,000

“Shifts” vs. “Movements Along” The Demand Curve Move along the demand curve From a change in the price of the good we analyze In maple syrup example, Figure 1 A fall in price would cause a movement to the right along the demand curve (point A to B) See figure 3(a)

Figure 3(a): Movements Along and Shifts of The Demand Curve Quantity Price Price increase moves us leftward along demand curve P2 Price increase moves us rightward along demand curve P1 P3 Q2 Q1 Q3

“Shifts” vs. “Movements Along” The Demand Curve Shift of demand curve a change in other things than price of the good causes a shift in the demand curve itself, for example, income In Figure 2 Demand curve has shifted to the right of the old curve (from Figure 1) as income has risen A change in any variable that affects demand—except for the good’s price—causes the demand curve to shift

Figure 2: A Shift of The Demand Curve Number of Bottles per Month Price per Bottle An increase in income shifts the demand curve for maple syrup from D1 to D2. D2 D1 At each price, more bottles are demanded after the shift B C $2.00 60,000 80,000

“Change in Quantity Demanded” vs. “Change in Demand” Language is important when discussing demand “Quantity demanded” means A particular amount that buyers would choose to buy at a specific price It is a number represented by a single point on a demand curve When a change in the price of a good moves us along a demand curve, it is a change in quantity demand The term demand means The entire relationship between price and quantity demanded—and represented by the entire demand curve When something other than price changes, causing the entire demand curve to shift, it is a change in demand

Income: Factors That Shift The Demand Curve An increase in income has effect of shifting demand for normal goods to the right However, a rise in income shifts demand for inferior goods to the left A rise in income will increase the demand for a normal good, and decrease the demand for an inferior good Normal good and inferior good are defined by the relation between demand and income

Wealth: Factors That Shift The Demand Curve Your wealth—at any point in time—is the total value of everything you own minus the total dollar amount you owe - Example An increase in wealth will Increase demand (shift the curve rightward) for a normal good Decrease demand (shift the curve leftward) for an inferior good

Prices of Related Goods: Factors that Shift the Demand Curve Substitute—good that can be used in place of some other good and that fulfills more or less the same purpose Example A rise in the price of a substitute increases the demand for a good, shifting the demand curve to the right Complement—used together with the good we are interested in A rise in the price of a complement decreases the demand for a good, shifting the demand curve to the left

Other Factors That Shift the Demand Curve Population As the population increases in an area Number of buyers will ordinarily increase Demand for a good will increase Expected Price An expectation that price will rise (fall) in the future shifts the current demand curve rightward (leftward) Tastes Combination of all the personal factors that go into determining how a buyer feels about a good When tastes change toward a good, demand increases, and the demand curve shifts to the right When tastes change away from a good, demand decreases, and the demand curve shifts to the left

Small Summary -- Factors Affecting Demand Income (depends on good’s nature: normal or inferior) Wealth (depends on good’s nature) Prices of substitutes (positively related) Prices of complements (negatively related) Population (positively related) Expected price (positively related) Tastes (positively related)

Figure 3(b): Movements Along and Shifts of The Demand Curve Quantity Price Entire demand curve shifts rightward when: income or wealth ↑ price of substitute ↑ price of complement ↓ population ↑ expected price ↑ tastes shift toward good D2 D1

Figure 3(c): Movements Along and Shifts of The Demand Curve Quantity Price Entire demand curve shifts leftward when: income or wealth ↓ price of substitute ↓ price of complement ↑ population ↓ expected price ↓ tastes shift toward good D1 D2

Supply A firm’s quantity supplied of a good is the specific amount its managers would choose to sell over some time period, given A particular price for the good All other constraints on the firm Market quantity supplied (or quantity supplied) is the specific amount of a good that all sellers in the market would choose to sell over some time period, given All other constraints on firms

Quantity Supplied Implies a choice Is hypothetical Stresses price Quantity that gives firms the highest possible profits when they take account of the constraints presented to them by the real world Is hypothetical Does not make assumptions about firms’ ability to sell the good How much would firms’ managers want to sell, given the price of the good and all other constraints they must consider? Stresses price The price of the good is just one variable among many that influences quantity supplied We’ll assume that all other influences on supply are held constant, so we can explore the relationship between price and quantity supplied

The Law of Supply States that when the price of a good rises and everything else remains the same, the quantity of the good supplied will rise The words, “everything else remains the same” are important In the real world many variables change simultaneously However, in order to understand the economy we must first understand each variable separately We assume “everything else remains the same” in order to understand how supply reacts to price

The Supply Schedule and The Supply Curve Supply schedule—shows quantities of a good or service firms would choose to produce and sell at different prices, with all other variables held constant Supply curve—graphical depiction of a supply schedule Shows quantity of a good or service supplied at various prices, with all other variables held constant

Figure 4: The Supply Curve Number of Bottles per Month Price per Bottle When the price is $2.00 per bottle, 40,000 bottles are supplied (point F). S $4.00 G At $4.00 per bottle, quantity supplied is 60,000 bottles (point G). 2.00 F 40,000 60,000

Shifts vs. Movements Along the Supply Curve A change in the price of a good causes a movement along the supply curve In Figure 4 A rise (fall) in price would cause a rightward (leftward) movement along the supply curve A drop in transportation costs will cause a shift in the supply curve itself In Figure 5 Supply curve has shifted to the right of the old curve (from Figure 4) as transportation costs have dropped A change in any variable that affects supply—except for the good’s price—causes the supply curve to shift

Figure 5: A Shift of The Supply Curve Number of Bottles per Month Price per Bottle A decrease in transportation costs shifts the supply curve for maple syrup from S1 to S2. S1 S2 At each price, more bottles are supplied after the shift $4.00 J G 60,000 80,000

Factors That Shift the Supply Curve Input prices A fall (rise) in the price of an input causes an increase (decrease) in supply, shifting the supply curve to the right (left) Price of Related Goods When the price of an alternate good rises (falls), the supply curve for the good in question shifts leftward (rightward) Technology Cost-saving technological advances increase the supply of a good, shifting the supply curve to the right

Factors That Shift the Supply Curve Number of Firms An increase (decrease) in the number of sellers—with no other changes—shifts the supply curve to the right (left) Expected Price An expectation of a future price increase (decrease) shifts the current supply curve to the left (right)

Factors That Shift the Supply Curve Changes in weather Favorable weather Increases crop yields Causes a rightward shift of the supply curve for that crop Unfavorable weather Destroys crops Shrinks yields Shifts the supply curve leftward Other unfavorable natural events may effect all firms in an area Causing a leftward shift in the supply curve

Figure 6(a): Changes in Supply and in Quantity Supplied Price Price increase moves us rightward along supply curve S P2 P1 Price increase moves us leftward along supply curve P3 Q3 Q1 Q2

Figure 6(b): Changes in Supply and in Quantity Supplied Price Entire supply curve shifts rightward when: price of input ↓ price of alternate good ↓ number of firms ↑ expected price ↑ technological advance favorable weather S1 S2

Figure 6(c): Changes in Supply and in Quantity Supplied Price Entire supply curve shifts rightward when: price of input ↑ price of alternate good ↑ number of firms ↓ expected price ↑ unfavorable weather S2 S1

Summary: Factors That Shift The Supply Curve The short list of shift-variables for supply that we have discussed is far from exhaustive In some cases, even the threat of such events can cause serious effects on production Basic principle is always the same Anything that makes sellers want to sell more or less of a good at any given price will shift supply curve

Equilibrium: Putting Supply and Demand Together When a market is in equilibrium Both price of good and quantity bought and sold have settled into a state of rest The equilibrium price and equilibrium quantity are values for price and quantity in the market but, once achieved, will remain constant Unless and until supply curve or demand curve shifts The equilibrium price and equilibrium quantity can be found on the vertical and horizontal axes, respectively At point where supply and demand curves cross

Figure 7: Market Equilibrium Number of Bottles per Month Price per Bottle 2. causes the price to rise . . . 3. shrinking the excess demand . . . S E 4. until price reaches its equilibrium value of $3.00 . $3.00 H J 1.00 Excess Demand D 25,000 50,000 75,000 1. At a price of $1.00 per bottle an excess demand of 50,000 bottles . . .

Excess Demand Excess demand At a given price, the excess of quantity demanded over quantity supplied Price of the good will rise as buyers compete with each other to get more of the good than is available

Figure 8: Excess Supply and Price Adjustment 1. At a price of $5.00 per bottle an excess supply of 30,000 bottles . . . Number of Bottles per Month Price per Bottle Excess Supply at $5.00 S 3. shrinking the excess supply . . . $5.00 K L 2. causes the price to drop, E 4. until price reaches its equilibrium value of $3.00. 3.00 D 35,000 50,000 65,000

Excess Supply Excess Supply At a given price, the excess of quantity supplied over quantity demanded Price of the good will fall as sellers compete with each other to sell more of the good than buyers want

Solve for Equilibrium Algebraically Suppose that demand is given by the equation , where is quantity demanded, P is the price of the good. Supply is given by where is quantity supplied. What is the equilibrium price and quantity?

Income Rises: What Happens When Things Change Income rises, causing an increase in demand Rightward shift in the demand curve causes rightward movement along the supply curve Equilibrium price and equilibrium quantity both rise Shift of one curve causes a movement along the other curve to new equilibrium point

Figure 9 Number of Bottles of Maple Syrup per Period Price per Bottle 3. to a new equilibrium. 4. Equilibrium price increases 2. moves us along the supply curve . . . S $4.00 F' 1. An increase in demand . . . 3.00 E D2 D1 5. and equilibrium quantity increases too. 50,000 60,000

An Ice Storm Hits: What Happens When Things Change An ice storm causes a decrease in supply Weather is a shift variable for supply curve Any change that shifts the supply curve leftward in a market will increase the equilibrium price And decrease the equilibrium quantity in that market

Figure 10: A Shift of Supply and A New Equilibrium Number of Bottles Price per Bottle S2 S1 $5.00 E' 3.00 E D 35,000 50,000

Using Supply and Demand: The Invasion of Kuwait Why did Iraq’s invasion of Kuwait cause the price of oil to rise? Immediately after the invasion, United States led a worldwide embargo on oil from both Iraq and Kuwait A significant decrease in the oil industry’s productive capacity caused a shift in the supply curve to the left Price of oil increased

Figure 12: The Market For Oil Barrels of Oil Price per Barrel of Oil S2 S1 E' P2 P1 E D Q2 Q1

Using Supply and Demand: The Invasion of Kuwait Why did the price of natural gas rise as well? Oil is a substitute for natural gas Rise in the price of a substitute increases demand for a good Rise in price of oil caused demand curve for natural gas to shift to the right Thus, the price of natural gas rose

Figure 13: The Market For Natural Gas Cubic Feet of Natural Gas Price per Cubic Foot of Natural Gas S F' P4 F P3 D2 D1 Q3 Q4

Figure 11: Changes in the Market for Handheld PCs Millions of Handheld PCs per Quarter Price per Handheld PC 3. moved the market to a new equilibrium. 2. and a decrease in demand . . . 4. Price decreased . . . S2002 S2003 A $500 1. An increase in supply . . . B $400 5. and quantity decreased as well. D2002 D2003 2.45 3.33

Both Curves Shift When just one curve shifts (and we know the direction of the shift) we can determine the direction that both equilibrium price and quantity will move When both curves shift (and we know the direction of the shifts) we can determine the direction for either price or quantity—but not both Direction of the other will depend on which curve shifts by more

The Three Step Process Key Step 1—Characterize the Market Decide which market or markets best suit problem being analyzed and identify decision makers (buyers and sellers) who interact there Key Step 2—Find the Equilibrium Describe conditions necessary for equilibrium in the market, and a method for determining that equilibrium Key Step 3—What Happens When Things Change Explore how events or government polices change market equilibrium

Example: rental apartment quantity demanded quantity supplied 800 30 10 1000 25 14 1200 22 17 1400 19 1600 21 1800 15 Example: problem 4, chapter 3 in textbook. Demand & Supply Diagram Equilibrium P & Q Why $1000 can not be equilibrium? Effects from a tornado destroying some apartments.

Demand for two bedroom rental apartment

Summaries Through the study of the chapter, you will be able to Characterize a market. Use a demand schedule and a demand curve to demonstrate the law of demand. Explain the difference between a change in demand (shift of the curve) and a change in quantity demanded (movement along the curve). List the factors that will lead to a change in demand, and give examples of each. Similar analysis for supply side. Explain how equilibrium price and quantity are determined in a competitive market. Explain what will happen in a competitive market after a shift in the supply curve, the demand curve, or both. Describe the three steps economists take to answer almost any question about the economy.