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

Who is hungry in the front row? All the bananas you care to eat for one person (up to however many I have) 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

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 10 and 12)

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

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) 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

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 In this class, most common curve used is linear We will typically ignore the “discreteness” problem in supply/demand analysis

Supply and Demand

Equilibrium When you think of equilibrium, think “stable” Stability comes from nobody having an incentive to change their decisions, given the decisions of others

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 3.3

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 is 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 shifted 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 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 Friday

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 Both supply and demand can shift, but be careful of your conclusions