Demand and Supply

The Power of Trade Voluntary versus involuntary exchange An intuitive approach to gains in trade Using an economic model to demonstrate the gains from trade

Voluntary Exchange All parties to a voluntary exchange must be made better off Allow for specialization and division of labor Increase interdependence Promote cooperation rather than conflict

An intuitive Approach to Gains From Trade Self-sufficiency Pros: independence Cons: loss of efficiency, variety in consumption and production Trade with Yakima? Trade with other states? Trade with other nations?

History of Trade Tribal to feudal times Adam Smith (1776) and David Ricardo (1817) The costs of not trading (e.g. lamb example) Distribution impacts: consumers win but some producers and workers lose The cost of protectionism

Markets: The power of Demand and Supply Competitive Markets identical or homogeneous goods many sellers and buyers perfect Information free entry and exit Non-Competitive Markets Monopoly – one seller Oligopoly – few sellers Monopolistically Competitive – differentiated products

Demand The demand curve Price and the quantity demanded Rational behavior Utility maximization MB=MC Boxes example Law of Demand – as the price of a product falls, ceteris paribus (all other things equal), the quantity demanded of the good will rise Law of Diminishing Marginal Utility – Jelly bean example Income and substitution effects Substitution effect – consumers will substitute the now relatively cheaper good for other now relatively more expensive goods Income effect – a decrease in any price, ceteris paribus, increases the purchasing power of the consumer’s income leading. Therefore, consumer will purchase more of a normal good.

Demand schedule – is a table of the various prices and the quantities that a consumer will demand at those prices. Individual demand curve – is a graph relating price and quantity demanded for a consumer. Market demand curve – is a graph reflecting the sum of individual consumer demands in a market.

Catherine’s Demand Schedule 17

Figure 1 Catherine’s Demand Schedule and Demand Curve Price of Ice-Cream Cone $3.00 2.50 1. A decrease in price ... 2.00 1.50 1.00 0.50 1 2 3 4 5 6 7 8 9 10 11 12 Quantity of 2. ... increases quantity of cones demanded. Ice-Cream Cones Copyright © 2004 South-Western

The demand function – lists all of the determinants of demand and includes: Price of the Good - law of demand Price of related goods Complements – as the Pc goes up QD of the good goes down Substitutes - as the Ps goes up QD of the good goes up Income – normal vs. inferior goods Number of Buyers Tastes Expectations – future prices, shortages, other conditions QD =F ( P(-), PR (Pc(-), Ps(+)) ,I (normal (+), inferior(-)), N(+), T(+), E)

Movement along and shifts of the demand curve Movement – only change in the price of the good Shifts – changes in any determinant but the prices of the good Curve versus function Schedules Graphs

Figure 3 Shifts in the Demand Curve Price of Ice-Cream Cone Increase in demand Decrease in demand Demand curve, D 2 Demand curve, D 1 Demand curve, D 3 Quantity of Ice-Cream Cones Copyright©2003 Southwestern/Thomson Learning

Supply Price and the quantity supplied Supply schedule Rational behavior an the profit motive Law of diminishing returns Supply schedule Individual supply curve Market supply curve

Ben’s Supply Schedule 29

Figure 5 Ben’s Supply Schedule and Supply Curve Price of Ice-Cream Cone $3.00 2.50 1. An increase in price ... 2.00 1.50 1.00 0.50 1 2 3 4 5 6 7 8 9 10 11 12 Quantity of Ice-Cream Cones 2. ... increases quantity of cones supplied. Copyright©2003 Southwestern/Thomson Learning

The supply function QS =F ( P, I, N, E, T) Price of the Good Input prices technology number of sellers expectations QS =F ( P, I, N, E, T)

Figure 7 Shifts in the Supply Curve Price of Supply curve, S 3 Ice-Cream curve, Supply S 1 Cone Supply curve, S 2 Decrease in supply Increase in supply Quantity of Ice-Cream Cones Copyright©2003 Southwestern/Thomson Learning

Market Equilibrium Equilibrium price and quantity = market clearing price and quantity Disequilibrium prices and quantities Shortage Surplus Comparative static analysis: changes in equilibrium prices and quantities Shifts in curves versus movement along revisited Changes in demand and supply

Figure 8 The Equilibrium of Supply and Demand Price of Ice-Cream Cone Supply Demand Equilibrium Equilibrium price $2.00 Equilibrium quantity 1 2 3 4 5 6 7 8 9 10 11 12 13 Quantity of Ice-Cream Cones Copyright©2003 Southwestern/Thomson Learning

Figure 9 Markets Not in Equilibrium (a) Excess Supply Price of Ice-Cream Supply Cone Surplus Demand $2.50 10 4 2.00 7 Quantity of Quantity demanded Quantity supplied Ice-Cream Cones Copyright©2003 Southwestern/Thomson Learning

Figure 8 The Equilibrium of Supply and Demand Price of Ice-Cream Cone Supply Demand Equilibrium Equilibrium price $2.00 Equilibrium quantity 1 2 3 4 5 6 7 8 9 10 11 12 13 Quantity of Ice-Cream Cones Copyright©2003 Southwestern/Thomson Learning

Figure 9 Markets Not in Equilibrium (a) Excess Supply Price of Ice-Cream Supply Cone Surplus Demand $2.50 10 4 2.00 7 Quantity of Quantity demanded Quantity supplied Ice-Cream Cones Copyright©2003 Southwestern/Thomson Learning

Figure 9 Markets Not in Equilibrium (b) Excess Demand Price of Ice-Cream Supply Cone Demand $2.00 7 1.50 10 4 Shortage Quantity of Quantity supplied Quantity demanded Ice-Cream Cones Copyright©2003 Southwestern/Thomson Learning

Figure 10 How an Increase in Demand Affects the Equilibrium Price of Ice-Cream 1. Hot weather increases the demand for ice cream . . . Cone D D Supply New equilibrium $2.50 10 2. . . . resulting in a higher price . . . 2.00 7 Initial equilibrium Quantity of 3. . . . and a higher quantity sold. Ice-Cream Cones Copyright©2003 Southwestern/Thomson Learning

Figure 11 How a Decrease in Supply Affects the Equilibrium Price of 1. An increase in the price of sugar reduces the supply of ice cream. . . Ice-Cream Cone S2 S1 Demand New equilibrium $2.50 4 2. . . . resulting in a higher price of ice cream . . . Initial equilibrium 2.00 7 Quantity of 3. . . . and a lower quantity sold. Ice-Cream Cones Copyright©2003 Southwestern/Thomson Learning

The Invisible Hand Economic Agents are motivated by self-interest consumers by utility maximization Producers by profit maximization Market prices as signals for resource allocation and coordinate consumer and producer behavior Market or the Price System and Efficiency

Demand and Supply Applications Market for Water Market for Gas Shortages and Surplus Price Controls Price ceilings Price floors