Demand, Supply and Equilibrium

Contents Deriving the Supply Curve Supply and Demand Equilibrium Effects of Demand and Supply Shifts on Equilibrium Welfare Properties of Equilibrium Fighting the Invisible Hand: The Market Fights Back Copyright© 2006 South-Western/Thomson Learning. All rights reserved.

The Invisible Hand Supply and demand  automatic solution to economic problems Interference in markets  counterproductive consequences Invisible hand = in the pursuit of self-interest, individuals promote social well-being

Deriving Supply Curve Recall example with garages from previous lecture Consider the cost schedule for Al

TABLE 1: Al’s Total, Average, and Marginal Costs Copyright © 2006 South-Western/Thomson Learning. All rights reserved.

FIGURE 1: Marginal Cost Curve 50 MC 45 40 35 30 Marginal Cost per Added Garage (thousands $) 25 20 15 10 5 1 2 3 4 5 6 7 8 9 10 Output, Garages per Year (c) Marginal Cost Copyright © 2006 South-Western/Thomson Learning. All rights reserved.

Supply Curve Supply curve of a firm is the increasing part of its marginal cost curve Why only increasing part? Because when MC decrease with Q, it is optimal to increase output

FIGURE 2: Marginal Cost Curve and Supply Curve 50 MC 45 40 35 Supply Curve 30 Marginal Cost per Added Garage (thousands $) 25 20 15 10 5 1 2 3 4 5 6 7 8 9 10 Output, Garages per Year Marginal Cost Copyright © 2006 South-Western/Thomson Learning. All rights reserved.

From Individual to Market Supply We derived supply of single firm In every market there are usually many producers The market supply is a sum of all individual supply curves

Supply and Quantity Supplied Sellers (producers)  supply Quantity supplied = amount that producers wish to sell at each price Law of supply = price and the quantity supplied are positively related, all else equal

TABLE 2 Supply Schedule for Milk We will focus on the example of the market for milk Copyright© 2006 South-Western/Thomson Learning. All rights reserved.

Supply and Quantity Supplied The Supply Schedule and the Supply Curve Supply Schedule = a table showing the quantity of demand at each price for some good Supply Curve = graph of a supply schedule Positive slope

FIGURE 3 Supply Curve for Milk a $1.50 S b 1.40 c 1.30 e Price per Quart 1.20 f 1.10 g 1.00 h .90 30 40 50 60 70 80 90 Quantity Supplied in Billions of Quarts per Year Copyright© 2006 South-Western/Thomson Learning. All rights reserved.

Supply and Quantity Supplied Shifts of the Supply Curve Movement along a supply curve due to Changes in price Shift between supply curves due to Changes in industry size (entry and exit) Changes in production technology Changes in prices of inputs Changes in prices of related outputs

FIGURE 4 Movements along versus Shifts of a Supply Curve S 1 c $1.30 Price per Quart f 1.10 Movement along from f to c can be a result of a rise in DEMAND for milk – say if health studies show that milk is very healthy, people would buy more of it. This would create incentives for milk producers to raise price of milk. This DOES NOT affect the supply! A shift in supply of milk can be a result of, say, the fact that government lowered import quotas on foreign milk, so more milk is now available for sale on the market in total Quantity Supplied in Billions of Quarts per Year Copyright© 2006 South-Western/Thomson Learning. All rights reserved.

FIGURE 5 Shifts of the Supply Curve 2 S S S 1 Price Price A right shift in supply of milk can be a result of, say, the fact that government lowered import quotas on foreign milk, so more milk is now available for sale on the market in total, as we said A left shift can be caused by the fact that the demand for beef suddenly goes up. Then some people would slaughter cows to get beef, which would reduce supply of milk Quantity (a) Quantity (b) Copyright© 2006 South-Western/Thomson Learning. All rights reserved.

Refresher on Demand Buyers  demand Quantity demanded = the amount that buyers wish to purchase at each price Law of demand = price and the quantity of demand are negatively related, all else equal

Refresher on Demand The Demand Schedule Table showing the quantity of demand at each price for some good

TABLE 3 Demand Schedule for Milk Copyright© 2006 South-Western/Thomson Learning. All rights reserved.

Demand and Quantity Demanded The Demand Curve Graph of a demand schedule Negative slope

FIGURE 6 Demand Curve for Milk $1.50 B 1.40 C Price per Quart 1.30 E 1.20 F 1.10 G 1.00 H .90 45 50 55 60 65 70 75 Quantity Demanded in Billions of Quarts per Year Copyright© 2006 South-Western/Thomson Learning. All rights reserved.

Demand and Quantity Demanded Shifts of the Demand Curve Movement along a demand curve due to Changes in price Shift between demand curves due to Changes in consumers’ incomes Changes in number of consumers (population) Changes in consumers’ preferences (tastes) Changes in prices and availability of related goods

FIGURE 7 Movements along a versus Shifts of a Demand Curve 1 D C $1.30 Price per Quart F Movement along demand curve is usually the result of a shift in supply – let us recall the example when more milk now comes from abroad This shifts supply to the right, so we move along demand Shift in demand for milk – example of tastes changes due to medical studies 1.10 Quantity Demanded in Billions of Quarts per year Copyright© 2006 South-Western/Thomson Learning. All rights reserved.

Supply and Demand Equilibrium There is normally one price where quantity of supply = quantity of demand This price  equilibrium An equilibrium price on the market is such that at this price quantity demanded is equal to the quantity supplied So equilibrium is a pair

Supply and Demand Equilibrium Below equilibrium price  shortage Above equilibrium price  surplus Surpluses and shortages  changes in price Changes in price  restoration of equilibrium

TABLE 4 Equilibrium Price & Quantity of Milk Copyright© 2006 South-Western/Thomson Learning. All rights reserved.

Supply and Demand Equilibrium Interaction of supply and demand  equilibrium A market not in equilibrium  equilibrium Equilibrium = a state of rest “Outside events” cause a change of the equilibrium

FIGURE 8 Supply-Demand Equilibrium $1.50 1.40 1.30 E Price per Quart 1.20 1.10 g G 1.00 Here Aa is a surplus, gG is a shortage. If surplus, demand too small. Then some sellers that don’t sell decide to lower price a bit, so that to attract some consumers that were not buying previously. This pushes price down. In the end, we get to eqm For shortage, too many are willing to buy, some even wanna pay more than $1, so some sellers decide to raise price, and so on .90 30 40 50 60 70 80 90 Quantity in Billions of Quarts per Year Copyright© 2006 South-Western/Thomson Learning. All rights reserved.

Demand Shifts on Supply-Demand Equilibrium Shifts in Demand Changes in any of the non-price determinants of demand and/or supply  change of equilibrium Shifts of the demand curve  change equilibrium price and quantity in the same direction

FIGURE 9 The Effects of Shifts of the Demand Curve 1 S D S D D 2 T $1.30 Price per Quart Price per Quart E E R 1.20 $1.20 L M 1.10 When demand shifts to right both eqm price and qty go up When demand shifts to left, both go down 60 70 75 45 50 60 Quantity Quantity (a) (b) Copyright© 2006 South-Western/Thomson Learning. All rights reserved.

Supply Shifts and Supply-Demand Equilibrium Shifts in Supply Shifts of the supply curve  change in equilibrium price and quantity in opposite directions Old equilibrium position  new equilibrium position

FIGURE 10 Effects of Shifts of the Supply Curve 2 D D V S $1.40 S Price per Quart Price per Quart I E E U $1.20 S 1 1.20 J 1.10 When supply shifts to right eqm price goes down and eqm qty goes up When supply shifts to left eqm price goes up and eqm qty goes down 60 65 78 37.5 50 60 Quantity Quantity (a) (b) Copyright© 2006 South-Western/Thomson Learning. All rights reserved.

Rule of Thumb When demand curve shifts, we move along the supply curve When supply curve shifts, we move along the demand curve Always draw a diagram to make sure you understand what happens

Sometimes we cannot say much… When both supply and demand curve shift, we usually have problems with predicting new equilibium: Can predict price, not quantity Or can predict quantity, not price Because it is the degree of shifts in both curves that determine the final outcome

Consumer Surplus Consumer Surplus is the difference between the maximum amount that the consumer is willing to pay for the product and the price that she actually gets to pay Graphically it is the area above the equilibrium price and below the market demand line

Producer Surplus Producer Surplus is the difference between the price at which the producer happens to sell the product and her costs (i.e. the smallest amount of money she is willing to accept in exchange for the product she offers) Graphically it is the area below the equilibrium price and above the market supply line

FIGURE 11 Consumer and Producer Surplus $1.50 1.40 S CS 1.30 Price per Quart 1.20 PS 1.10 1.00 .90 30 40 50 60 70 80 90 Quantity in Billions of Quarts per Year Copyright© 2006 South-Western/Thomson Learning. All rights reserved.

Some Geometry Refresher Area of the triangle: Let us compute these for the example we just had

Calculating CS and PS CS: PS: base = 60 − 0 = 60 height = 1.50 − 1.20 = 0.3 Area = 0.5 * 60 * 0.3 = $9 bln PS: height = 1.20 − 1.00 = 0.2 Area = 0.5 * 60 * 0.2 = $6 bln

Total Surplus and Welfare Welfare is understood in economics as some measure of well-being of agents We saw an example – utility of consumer For market with many agents, natural measure is Total Surplus (TS) TS = CS + PS In previous example, TS = 9 + 6 = $15 bln

Why Market Economy? We like free market economy because it maximizes Total Surplus Only those buyers with high willingness to pay buy Only those sellers with low costs sell Total Surplus is the biggest possible in this case This says nothing about equality!

Fighting the Invisible Hand: The Market Fights Back A Can of Worms Favoritism and corruption Unenforceability Limitation of the volume of transactions Misallocation of resources Let us see what our model predicts about fighting the invisible hand

Welfare Analysis of Policies

Benchmark Case We first analyze the case when the market system works on its own This is the benchmark case We will show all other cases decrease TS Here CS = A + B + C PS = H + L + G TS = A + B + C + H + L + G

Benchmark Case

Price Ceiling Now suppose government introduces price ceiling Must be below P2, say, P3 What are CS, PS, TS now? Since at P3 quantity demanded exceeds quantity supplied, there is shortage So only Q 1 units are sold

Price Ceiling

Price Ceiling Here CS = A + B + G PS = L TS = A + B + L + G Notice the blue triangle C + H is now NOT in the TS This is called Dead Weight Loss (DWL) – measure of inefficiency

Fighting the Invisible Hand: The Market Fights Back Restraining the Market Mechanism: Price Ceilings Shortages Black markets with higher prices Underinvestment Vested interests that resist change

Price Floor Now suppose government introduces price floor Must be above P2, say, P1 What are CS, PS, TS now? Since at P1 quantity supplied exceeds quantity demanded, there is surplus Again only Q1 units are sold

Price Floor

Price Floor Here CS = A PS = L + B + G TS = A + B + L + G Notice the blue triangle C + H is now NOT in the TS again So we again have DWL from interfering with the market mechanism

Fighting the Invisible Hand: The Market Fights Back Restraining the Market Mechanism: Price Floors Surpluses Disposal problems Overinvestment Vested interests that resist change

More Complicated Example By simply fixing price we make some group better off at the expense of the other group Total result is negative, however Maybe government can help? Suppose again fix price at P1 as a floor, but government buys all the surplus that consumers do not want to buy

More Complicated Example Extra Costs

More Complicated Example Clearly costs of government intervention do not compensate the extra gain for producer So intervention is in general not a good idea Later on in the course we will see examples when government intervention is beneficial

Tax Policy Analysis Suppose government wants to introduce a tax on producers There are many different taxes We consider the easiest – per-unit sales tax It means that producers have to pay a fixed amount of money to the government for every unit they have sold

Tax Policy Analysis Costs of producers stay the same So they translate tax into price one-for-one Suppose the government introduces a sales tax of 10 cents per gallon of milk This shifts supply curve up How much equilibrium changes is determined by demand elasticity However, all tax burden is split between consumer and producer

FIGURE 10 Who Pays for a New Tax on Products? M $1.64 E 1 1.60 S Price per Gallon 1.54 E Q 2 Q 1 30 50 Millions of Gallons per Year Copyright© 2006 South-Western/Thomson Learning. All rights reserved.

Tax Policy Analysis Notice that both consumers and producers pay tax, even though government wants to tax producers only How tax burden is split between consumers and producers? Depends on price elasticities of supply and demand Or, more precise, on the relative elasticity

A Simple But Powerful Lesson Self-interested actions of buyers and sellers  laws of supply and demand Difficult to resist Interference  counterproductive effects

The End ???