Chapter 3 Demand, Supply and the Market ©McGraw-Hill Companies, 2010

©McGraw-Hill Companies, 2010 Key terms Market: a set of arrangements by which buyers and sellers are in contact to exchange goods or services Demand: the quantity of a good buyers wish to purchase at each conceivable price Supply: the quantity of a good sellers wish to sell at each conceivable price Equilibrium price: price at which quantity supplied = quantity demanded ©McGraw-Hill Companies, 2010

©McGraw-Hill Companies, 2010 The demand curve shows the relation between price and quantity demanded holding other things constant Price Other things include: The price of related goods Consumer incomes Consumer preferences D Quantity ©McGraw-Hill Companies, 2010

©McGraw-Hill Companies, 2010 The supply curve shows the relation between price and quantity demanded holding other things constant S Price Other things include: Technology Input costs Government regulations Quantity ©McGraw-Hill Companies, 2010

©McGraw-Hill Companies, 2010 Market equilibrium S Market equilibrium is at E0 where quantity demanded equals quantity supplied with price P0 and quantity Q0 P0 is the equilibrium price. Price E0 P0 D Q0 Quantity ©McGraw-Hill Companies, 2010

A shift in demand D0 S D1 Q1 P1 Q0 P0 S If the price of a substitute good decreases ... less will be demanded at each price. Price D0 S The demand curve shifts from D0D0 to D1D1. D1 Q1 P1 E0 Q0 P0 E1 See Sections 3-4 and 3-5 in the main text. If price stayed at P0 there would be excess supply. So the market moves to a new equilibrium at E1. S Quantity 6

A shift in supply S1 S1 S0 D Q1 P1 E2 P0 E0 D Q0 Suppose safety The supply curve shifts to S1S1 Suppose safety regulations are tightened, increasing producers’ costs S0 D Price Q1 P1 E2 So the market moves to a new equilibrium at E2 P0 E0 If price stayed at P0 there would be excess demand See Sections 3-6 and 3-7 in the main text. D Q0 Quantity 7

Two ways in which demand may increase (1) Price (1) A movement along the demand curve from A to B represents consumer reaction to a price change could follow a supply shift A P0 B P1 Q1 See Activity Box 3 in the main text. D Q0 Quantity 8

Two ways in which demand may increase (2) (2) A movement of the demand curve from D0 to D1 leads to an increase in demand at each price e.g., at P0 quantity demanded increases from Q0 to Q2: at P1 quantity demanded increases from Q1 to Q3 Price C D1 F Q2 Q3 P0 A P1 B See Activity Box 3 in the main text. D0 Q0 Q1 Quantity 9

A market in disequilibrium Price S Suppose a disastrous harvest moves the supply curve to SS. Government may try to protect the poor, setting a price ceiling at P1, which is below P0, the equilibrium price level. The result is excess demand. D P2 E P0 A B P1 excess demand You may wish to point out that: 1 Supply is actually reduced as a result of this policy; 2 There is a possible long-run effect on resource allocation arising because the incentives for producers are poor with prices held artificially low; 3 A price ceiling at P2 would be ineffective/irrelevant, given that the market could reach its equilibrium level. See Section 3-8 in the main text. D S RATIONING is needed to cope with the resulting excess demand. QS Q0 QD Quantity 10

Price and quantity changes In practice, we cannot plot ex ante demand curves and supply curves. So we use historical data and the supposition that the observed values are equilibrium ones. Since other things are often not constant, some detective work is required. This is where our theory comes in useful. See Box 3-4 in main text. 11

What, how and for whom The market: decides how much of a good should be produced by finding the price at which the quantity demanded equals the quantity supplied tells us for whom the goods are produced those consumers willing to pay the equilibrium price determines what goods are being produced there may be goods for which no consumer is prepared to pay a price at which firms would be willing to supply See Section 3-9 in the main text. 12

Consumer & producer surplus For a single consumer, the consumer surplus is the difference between the maximum price that she is willing to pay for a given amount of a good or service and the price she actually pays. The producer surplus for sellers is the amount that sellers benefit by selling at a market price that is higher than they would be willing to sell for. Price Consumer surplus S P * Producer surplus D Q* Quantity ©McGraw-Hill Companies, 2010