Supply, Demand, and Equilibrium Today: An introduction to supply and demand, and how they relate to equilibrium

Who is very hungry and likes bananas? All the bananas you care to eat for one person (up to however many I have) NOT extra credit, since you get free bananas You are eating bananas at your own risk You are not allowed to share bananas with anyone else Please report to me how many bananas you eat in about 40 minutes

Previously The 7 Core Principles Thinking like an economist Marginal cost and benefit Working with graphs

Today: Markets Supply, demand, and equilibrium What causes shifts in supply and demand? What happens when supply and/or demand shifts?

Central organization versus Markets Central economic organization is rare today Most economic activity today occurs in markets Markets do fail sometimes, but this is the focus of other chapters (e.g. Chapters 8 and 10)

Markets Markets consist of buyers and sellers Assume many buyers and many sellers Fractional amounts of goods can be produced We will talk about supply and demand for most markets Exceptions will be dealt with accordingly as we get to them

Core principle related to demand Cost-benefit analysis Recall energy drinks example Think “reservation price” when you think “willingness to pay” (“WTP”)

Demand Demand states how much of a good that buyers are willing to purchase given each price Demand is typically shown on a graph, but it is occasionally displayed on a table

Demand A fundamental characteristic of demand is that as the price of a good increases, demand typically goes down (all else constant) Recall that WTP for energy drinks decreases as you consume more Thus, each demand curve is downward sloping if we graphed it By convention, quantity is on the horizontal axis and price on the vertical axis

Core principles related to supply Increasing opportunity cost We want to produce at the lowest cost for each additional unit Also called “low-hanging-fruit” principle Incentive principle Businesses will supply less when some units are not profitable Businesses will supply more when producing more could lead to higher profits

Supply Supply states how much of a good that sellers are willing to sell given each price Similar to demand, supply is typically shown on a graph

Supply Low-cost sellers typically enter a market before high-cost sellers Thus, we would expect that the sellers with lowest cost to sell a particular good Supply is then assumed to be upward sloping

Discrete versus continuous Although many products can only be purchased in discrete amounts, we usually assume continuous curves Why? (Come to class to find out) In this class, most common curve used is linear We will typically ignore the “discreteness” problem in supply/demand analysis

Graphing supply and demand

Equilibrium principle Another core principle “No cash on the table”  “stable” Nobody can be made better off by changing her/his decision Does not address potential actions that groups of people can make Later topic, especially with market failure

Equilibrium: 4 units purchased, at a price of 6

Why is a price of 6 equilibrium? To show that 6 is the equilibrium price, we will show that prices above and below are not in equilibrium We will prove by contradiction that this price could not be equilibrium Suppose that a price (P) of 4 is equilibrium

At P = 4: Quantity demanded is 6, quantity supplied is 3.33

When P is 4, people are demanding a quantity that is higher than what is supplied Is this an equilibrium? No, this is not stable Someone can increase their production slightly, and sell at a price of 5 to make more profits

Now suppose that P = 9 is an equilibrium

Quantity supplied is 6 Quantity demanded is 1 This is not stable either Someone not selling their entire stock can sell for P = 7 to make more money

A change in supply versus a movement along the supply curve A change in supply leads to a shift of the entire supply curve A movement along the supply curve can occur when the supply curve does not move Movement occurs when there is a change in price Similar ideas apply for changes in demand versus a movement along demand curves

What causes shifts in demand? Price changes of complements and substitutes Example of complements: baseballs and baseball bats Example of substitutes: two different brands of cola

What causes shifts in demand? Income changes Most goods are normal goods, meaning that when income increases, the demand curve shifts to the right Some goods are inferior, meaning that when income increases, the demand curve shifts to the left Changes in preferences, population, and expected future prices

What is happening here?

The demand curve shifts to the right There is a movement along the supply curve, since supply does not change

What is happening here? Note that at any price, a higher quantity is demanded on curve D2 than on D1 The new equilibrium price (P) and quantity (Q) are higher when demand shifts from D1 to D2

What causes shifts in supply? Anything that changes the cost of production If the cost of production decreases, supply shifts to the right If the cost of production increases, supply shifts to the left A change in number of suppliers Expectations of future prices

What happens when both supply and demand shift? An example: Both supply and demand shift right

Shift in supply… …causes Q to increase and P to decrease Movement from A to B A B

Shift in demand… …causes Q to increase and P to increase Movement from B to C B C

What can we conclusively say about changes in Q and P? Change in supply causes Q to increase and P to decrease Change in demand causes Q to increase and P to increase The only conclusion when both supply and demand shift right is that Q increases

Now that we have talked about supply and demand… …let’s talk about bananas How many bananas did our volunteer eat today? Why not any more? We will talk about what happened here on Monday

Summary The intersection of demand and supply curves determines equilibrium Equilibrium is stable Change in S or D causes the curve to shift A movement along the supply curve can occur when the supply curve does not move Same with demand Both supply and demand can shift, but be careful of your conclusions