Supply and Demand Intertwined Chapter 3 Supply and Demand Intertwined McGraw-Hill/Irwin Copyright © 2009 by The McGraw-Hill Companies, Inc. All Rights Reserved.

Learning Objectives How do supply and demand determine prices? What is equilibrium? What is surplus? What is shortage? What is the effect of a change in demand? What is the effect of a change in supply?

When Supply and Demand Intersect At $0.45: Consumers want 12,000 apples. Firms want to produce 12,000 apples. Quantity demanded = Quantity supplied. Supply and demand intersect. = Equilibrium $P .45 Quantity demanded at 0.45 Supply Quantity supplied at 0.45 Demand 12,000 Quantity of Apples

Surplus At $0.70: Consumers want 10,000 apples. Firms want to produce 14,600 apples. Quantity supplied > quantity demanded = Surplus. Price will fall. Quantity demanded at 0.70 $P .70 Supply Quantity supplied at 0.70 Demand 10,000 14,600 Quantity of Apples

Shortage At $0.25: Firms want to produce 9,000 apples. Consumers want 15,000 apples. Quantity supplied < quantity demanded = Shortage. Price will rise. $P .25 Quantity supplied at 0.25 Supply Quantity demanded at 0.25 Demand 9,000 15,000 Quantity of Apples

Equilibrium A market at equilibrium is stable unless disturbed by shift of supply or demand curves. A market not at equilibrium moves towards equilibrium with change in price.

Equilibrium quantity sold Price Demand Supply Price above equilibrium = Surplus. Fall in price Equilibrium price Equilibrium Price below equilibrium = Shortage. Rise in price Equilibrium quantity sold Quantity

Do You Know? When does a surplus arise? When price is above equilibrium where quantity supplied exceeds quantity demanded. When does a shortage arise? When price is below equilibrium where quantity demanded exceeds quantity supplied.

Moving Towards New Equilibrium An increase in supply: A new equilibrium at a lower price and a higher quantity. Price Old equilibrium Old Supply New Supply New equilibrium Demand Quantity

Moving Towards New Equilibrium An increase in demand: A new equilibrium at a lower price and a higher quantity. New equilibrium Price Supply Old equilibrium New Demand Old Demand Quantity

Moving Towards New Equilibrium A decrease in supply: A new equilibrium at a higher price and a lower quantity. Price New equilibrium New Supply Old Supply Old equilibrium Demand Quantity

Moving Towards New Equilibrium A decrease in demand: A new equilibrium at a higher price and a lower quantity. Old equilibrium Price Supply New equilibrium Old Demand New Demand Quantity

Market Forces in a Fictional Tale In anticipation of the blockade… Increase in demand for food and hence its price. Smuggler transports food rather than luxury goods. After the blockade… With higher food prices, the smuggler is willing to take the risk of shipping food. After government control over food prices… No incentive for the smuggler to ship food.

Invisible Hand Invisible hand of the market pushes self-interested people to act for the good of society. “It is not from the benevolence of the butcher, the brewer or the baker, that we expect our dinner, but from their regard to their own interest.”

Markets in Times of Crisis Pets destroy wheat crop. Increase in demand for a substitute, i.e. fish. Increase in price of fish. Fishermen catch more fish. New equilibrium Price $7 $4 Supply Old equilibrium Demand after Demand before 600 800 Quantity of fish

Markets in Times of Crisis War in the Middle East reduces supply of oil. Price of oil rises. Higher price causes people to use less oil. Market offers the best solution among all the alternatives. $Price New equilibrium Supply after Supply before 150 Old equilibrium 70 Demand Quantity of oil

Markets in Times of Crisis Hurricane damage affects the supply and demand for bottled water. Decrease in supply Increase in demand How will it affect new equilibrium price? How will it affect new equilibrium quantity? Only one can be determined, the other is ambiguous.

Hurricane Damage Increase in demand > Decrease in supply. Higher price Higher quantity Increase in demand < Decrease in supply. Higher price Lower quantity Price Demand after Price Supply after Demand before Supply after Demand before Demand after Supply before Supply before Quantity of bottled water Quantity of bottled water

Markets in Times of Crisis Price gouging: Increase in price as a result of market reaction to increase in demand or decrease in supply. It provides incentive to firms to sell more. It provides incentive to consumers to conserve the good short in supply.

Diamonds vs. Water Why do markets place higher value on diamonds than on precious water? Water is in much greater supply than diamonds. Water Supply Water demand Diamond demand Price Diamond supply Diamond Equilibrium Water Equilibrium Quantity

Diamonds vs. Water A good’s price is influenced by its marginal value to consumers. Marginal value = additional benefit received from the last unit of the good consumed. Consumers receive less marginal value from a good the more they have of it. At the equilibrium in market for water, so much water is consumed that marginal value is very low.

Market for Developable Land Government passes anti-development law: Decrease in supply of developable land. Higher price and lower quantity of traded developable land. Price New Equilibrium Supply after Supply before Old Equilibrium Demand Quantity of developable land

Market for Newly Built Homes Increase in price of developable land increases cost of production. Decrease in supply of newly built homes. Higher price and lower quantity sold of newly built homes. Price New Equilibrium after higher land prices New Supply Old Supply Old Equilibrium before higher land prices Demand Quantity of newly built homes sold

Market for Previously Occupied Homes Newly built and previously occupied homes are substitutes. Higher price of newly built homes: Increase in demand for previously occupied homes Higher price and higher quantity sold of previously occupied homes New Equilibrium before higher prices of new homes Price Old Equilibrium before higher prices of new homes Supply New Demand Old Demand Quantity sold of previously built homes

Do You Know? Do markets move to new equilibrium instantaneously? No. It takes time. How long depends on the type of market. It can be from a few seconds to a few months. What are some examples of forces that disturb market equilibrium? Any changes that effect demand or supply disturb market equilibrium, e.g., change in input prices, future expectations, change in price of substitutes, innovations.

Do You Know? What is Adam Smith’s Invisible Hand? Market forces guide self-interested people as if by an invisible hand to act for the good of society. How does marginal value relate to the price of water? A good’s price is influenced by its marginal value to consumers. The marginal value of water is very low since lots of water is consumed.

Summary Equilibrium = When quantity demanded meets quantity supplied. Surplus = When quantity supplied exceeds quantity demanded. Shortage = When quantity demanded exceeds quantity supplied. A market not at equilibrium moves towards equilibrium with change in price.

Summary A good’s price is determined by intersection of demand and supply. A change in demand or supply shifts the market to a new equilibrium. Market forces offer the best solution to any changes in the society.

By how much does quantity change when there is a change in price? Coming Up By how much does quantity change when there is a change in price?