Modern Principles: Microeconomics Tyler Cowen and Alex Tabarrok Copyright © 2010 Worth Publishers Modern Principles: Microeconomics Cowen/Tabarrok Chapter 2 Supply and Demand

Slide 2 of 55 Introduction The model of supply and demand is one of the most important tools in economics. The model is a simple presentation of exchange that captures the behavior of both buyers and sellers.

Slide 3 of 55 The Demand Curve for Oil Demand represents the behavior of buyers. A Demand Curve is a function that shows the quantity demanded at different prices.  The Quantity Demanded is the quantity that buyers are willing and able to purchase at a particular price.

Slide 4 of 55 The Demand Curve for Oil The Law of Demand indicates an inverse relationship between price and quantity demanded.  When price rises, all else equal, quantity demanded falls.  When price falls, all else equal, quantity demanded rises. Demand curves consistent with the law of demand are downward sloping.

Slide 5 of 55 Demand Curves The Demand Curve for Oil is a Function Showing the Quantity of Oil Demanded at Different Prices Price of Oil per Barrel Quantity of Oil (MBD) $55 $5 $ Demand Price Quantity Demanded $55 5 $2025 $550

Slide 6 of 55 Demand Curves Demand curves can be read in two ways:  Horizontally: How much buyers are willing and able to purchase at a given price.  Vertically: The maximum price for which buyers are willing to pay for a given quantity. Demand curves thus reveal the quantity demanded at a given price or the maximum willingness to pay for a given quantity.

Slide 7 of 55 The Demand Curve for Oil Horizontal Reading Price of Oil per Barrel Quantity of Oil (MBD) Start End $55 $5 $ Demand

Slide 8 of 55 The Demand Curve for Oil Vertical Reading Price of Oil per Barrel Quantity of Oil (MBD) End Start $55 $5 $ Demand

Slide 9 of 55 Demand Curves Why is the demand curve downward sloping?  A good is not equally valuable in all of its uses. At a high price, a good is consumed in only its highest valued use. At a low price, a good is also consumed in its lower valued uses.  The value of a good’s use will depend on the availability of substitutes.

Slide 10 of 55 The Demand Curve for Oil Price of Oil per Barrel Quantity of Oil (MBD) When the price of oil is high, oil will only be used in higher valued uses. As the price falls, oil will also be used in lower valued uses $ $ Demand Higher Valued Uses of Oil Lower Valued Uses of Oil

Slide 11 of 55 Consumer Surplus Consumer Surplus is the consumer’s gain from exchange, or the difference between the maximum price a consumer is willing to pay for a given quantity and the market price. Total consumer surplus is the sum of consumer surplus of all buyers. Graphically, total consumer surplus is measured by the area below the demand curve and above the price.

Slide 12 of 55 Consumer Surplus Total Consumer Surplus at a Price of $20 ½(80-20)x90 = $2,700 Area of Triangle Height Base ½(Base x Height) Joe’s Consumer Surplus The President’s Consumer Surplus Demand Price of Oil per Barrel Quantity of Oil (MBD) Consumer Surplus is the Area beneath the Demand Curve and above the Price

Slide 13 of 55 What Shifts the Demand Curve? The demand curve  An increase in demand means that quantity demanded at a given price increases, or the maximum willingness to pay for a given quantity rises. Graphically, an increase in demand shifts the demand curve outwards, up, and to the right.  A decrease in demand means that quantity demanded at a given price decreases, or the maximum willingness to pay for a given quantity falls. Graphically, a decrease in demand shifts the demand curve inwards, down, and to the left.

Slide 14 of 55 Change in Demand Price per Unit Quantity An Increase in Demand $50 80 New Demand $25 Old Demand 70 Greater Quantity Demanded at the Same Price Greater Willingness to Pay for the Same Quantity

Slide 15 of 55 Change in Demand $50 80 Old Demand Curve $25 70 New Demand Curve Less Quantity Demanded at the Same Price Lower Willingness to Pay for the Same Quantity Price per Unit Quantity A Decrease in Demand

Slide 16 of 55 Important Demand Shifters 1.Income 2.Population 3.Price of Substitutes 4.Price of Complements 5.Expectations 6.Tastes

Slide 17 of 55 Important Demand Shifters - Income 1.The effect of changes in income on demand depends on the nature of the good in question.  A Normal Good is a good for which demand increases (decreases) when income increases (decreases).  An Inferior Good is a good for which demand decreases (increases) when income increases (decreases).

Slide 18 of 55 Important Demand Shifters - Population 2.As the population of an economy changes, the number of buyers of a particular good also changes, directly influencing its demand.  More buyers of a good increases its demand.  Fewer buyers of a good decreases its demand.

Slide 19 of 55 Important Demand Shifters - Price of Substitutes 3.Two goods are Substitutes if a decrease (increase) in the price of one good leads to a decrease (increase) in demand for the other good.

Slide 20 of 55 Important Demand Shifters - Price of Complements 4.Two goods are Complements if a decrease (increase) in the price of one good leads to an increase (decrease) in the demand for the other.

Slide 21 of 55 Important Demand Shifters - Expectations 5.The expectation of a higher (lower) price for a good in the future increases (decreases) current demand for the good.  Consumers will adjust their current spending in anticipation of the direction of future prices in order to obtain the lowest possible price.

Slide 22 of 55 Important Demand Shifters - Tastes 6.Tastes and preferences are subjective and will vary among consumers.  Some issues like seasonal changes or fads, however, will have rather predictable effects on demand.

Slide 23 of 55 What Shifts the Demand Curve? A change in quantity demanded is NOT the same as a change in demand.  Quantity demanded changes only when the price of a good changes.  Graphically, a change in quantity demanded is represented by a movement along a fixed demand curve.  Demand changes only when a non-price factor (demand shifter) changes.  Graphically, a change in demand is represented by a shift in the entire demand curve.

Slide 24 of 55  Economic growth in India is raising the incomes of Indian workers. What do you predict will happen to the demand for automobiles? What about the demand for charcoal bricks for home heating?  As the price of oil rises, what do you predict will happen to the demand for mopeds?

Slide 25 of 55 The Supply Curve for Oil Supply represents the behavior of sellers. A Supply Curve is a function that shows the quantity supplied at different prices.  The Quantity Supplied is the quantity that producers are willing and able to sell at a particular price.

Slide 26 of 55 The Supply Curve for Oil The Law of Supply indicates a direct relationship between price and quantity supplied.  When price rises, all else equal, quantity supplied rises.  When price falls, all else equal, quantity supplied falls. Supply curves consistent with the law of supply are upward sloping.

Slide 27 of 55 Supply Curves The Supply Curve for Oil is a Function Showing the Quantity of Oil Supplied at Different Prices Quantity of Oil (MBD) Price of Oil per Barrel Supply Curve for Oil $5 $20 $55 Price Quantity Supplied $5550 $2030 $510

Slide 28 of 55 Supply Curves Supply curves can be read in two ways:  Horizontally: How much suppliers are willing and able to sell at a given price.  Vertically: The minimum price for which suppliers are willing to sell a given quantity. Supply curves, thus, reveal the quantity supplied at a given price, or the minimum price at which suppliers will sell a given quantity.

Slide 29 of 55 The Supply Curve for Oil Start End Horizontal Reading Quantity of Oil (MBD) Price of Oil per Barrel Supply Curve for Oil $5 $20 $55

Slide 30 of 55 Supply Curves Vertical Reading Quantity of Oil (MBD) Price of Oil per Barrel Supply Curve for Oil $5 $20 $55 End Start

Slide 31 of 55 Supply Curves Why is the supply curve upward sloping?  The cost of producing a good is not equal across all suppliers. At a low price, a good is produced and sold only by the lowest cost suppliers. At a high price, a good is also produced and sold by higher cost suppliers.

Slide 32 of 55 The Supply Curve for Oil Supply Quantity of Oil (MBD) Price of Oil per Barrel The Supply Curve for Oil $60 $40 $ Oil Shale Profitable Here Low Cost Oil Higher Cost Oil

Slide 33 of 55 Producer Surplus Producer Surplus is the producer’s gain from exchange, or the difference between the market price and the minimum price at which producers would be willing to sell a given quantity. Total producer surplus is the sum of the producer surplus of each seller. Graphically, total producer surplus is measured by the area above the supply curve and below the price.

Slide 34 of 55 Total Producer Surplus at a Price of $40 Producer Surplus $40 $20 $ Supply Curve 2080 Producer Surplus is the Area Above the Supply Curve and Below the Price Quantity of Oil (MBD) Price of Oil per Barrel

Slide 35 of 55 Important Supply Shifters Changes in Supply  An increase in supply means that quantity supplied at a given price increases, or the minimum willingness to sell for a given quantity falls. Graphically, an increase in supply shifts the supply curve down and to the right.  A decrease in supply means that quantity supplied at a given price decreases, or the minimum willingness to sell a given quantity rises. Graphically, a decrease in supply shifts the supply curve up and to the left.  Changes in supply are inversely related to the costs of production.

Slide 36 of 55 Change in Supply Old Supply$50 20 Lower Costs Increase Supply Quantity of Oil (MBD) Price of Oil per Barrel New Supply $10 80 Greater Quantity Supplied at the Same Price Willing to Sell Same Quantity at Lower Prices

Slide 37 of 55 Change in Supply Quantity of Oil (MBD) Higher Costs Decrease Supply Price of Oil per Barrel 2080 Old Supply $50 $10 New Supply Smaller Quantity Supplied at the Same Price Higher Price Needed to Sell Same Quantity

Slide 38 of 55 Important Supply Shifters 1.Technological Innovations 2.Input Prices 3.Taxes and Subsidies 4.Expectations 5.Entry or Exit of Producers 6.Changes in Opportunity Costs

Slide 39 of 55 Important Supply Shifters - Technological Innovations 1.A technological innovation makes sellers willing to supply a greater quantity at a given price, or the new technology allows producers to sell a given quantity at a lower price.  A technological innovation lowers costs and increases supply.

Slide 40 of 55 Important Supply Shifters - Input Prices 2.A decrease (increase) in the price of an input makes sellers willing to supply a greater (lesser) quantity at a given price, or the lower (higher) input price allows producers to sell a given quantity at a lower (higher) price.  A decrease (increase) in the price of an input lowers (raises) costs and increases (decreases) supply.

Slide 41 of 55 Important Supply Shifters - Taxes and Subsidies 3.A tax on output makes sellers willing to supply a lesser quantity at a given price, or the tax forces producers to sell a given quantity at a higher price.  A tax on output raises costs and decreases supply. A subsidy on production makes sellers willing to supply a greater quantity at a given price, or the subsidy allows producers to sell a given quantity at a lower price.  A subsidy on production lowers costs and increases supply.

Slide 42 of 55 Important Supply Shifters - Taxes and Subsidies $10 Supply With $10 Tax $10 $50 Supply Without Tax $40 60 Quantity of Oil (MBD) Price of Oil per Barrel With a $10 Tax Suppliers Require a $10 Higher Price to Sell the Same Quantity

Slide 43 of 55 Important Supply Shifters - Expectations 4.The expectation of a higher (lower) price for a good in the future decreases (increases) current supply of the good.  Sellers will adjust their current offerings in anticipation of the direction of future prices in order to obtain the highest possible price.

Slide 44 of 55 Important Supply Shifters - Expectations Expectations Can Shift the Supply Curve Quantity Price per Unit Supply Today Supply Today with Expectation of Future Price Increase Into Storage

Slide 45 of 55 Important Supply Shifters - Entry or Exit of Producers 5.As producers enter and exit the market, the number of sellers of a particular good changes, directly influencing supply.  Entry implies more sellers in the market increasing supply.  Exit implies fewer sellers in the market decreasing supply.

Slide 46 of 55 Important Supply Shifters - Entry or Exit of Producers Domestic Supply Domestic Supply Plus Canadian Imports Price Quantity Entry Increases Supply Greater Quantity Supplied at the Same Price Lower Price for the Same Quantity Supplied

Slide 47 of 55 Important Supply Shifters - Changes in Opportunity Costs 6.Inputs used in production have opportunity costs, and sellers will choose to employ those inputs in the production of the highest priced finished goods.  Sellers will supply less (more) of a good if the price of an alternate good using the same inputs rises (falls).

Slide 48 of 55 Important Supply Shifters – Changes in Opportunity Costs $5 Supply with Low Opportunity Costs 2,800 Higher (Opportunity) Costs Reduce Supply Quantity of Soybeans (Millions of Bushels) Price per Unit 2,000 $7 Supply with High Opportunity Costs Smaller Quantity Supplied at the Same Price Higher Price Required to Sell the Same Quantity

Slide 49 of 55 What Shifts the Supply Curve? A change in quantity supplied is NOT the same as a change in supply.  Quantity supplied changes only when the price of a good changes.  Graphically, a change in quantity supplied is represented by a movement along a fixed supply curve.  Supply changes only when a non-price factor changes.  Graphically, a change in supply is represented by a shift in the entire supply curve.

Slide 50 of 55  Technological innovations in chip making have driven down the costs of producing computers. What happens to the supply curve for computers? Why?  The U.S. government subsidizes making ethanol as a fuel made from corn. What effect does the subsidy have on the supply curve for ethanol?

Slide 51 of 55 Demand represents the behavior of buyers. A demand curve is a function that shows the quantity demanded at different prices. Demand curves are downward sloping. Consumer Surplus is the consumer’s gain from exchange, or the difference between the maximum price a consumer is willing to pay for a given quantity and the market price. Graphically, total consumer surplus is measured by the area below the demand curve and above the price.

Slide 52 of 55 An increase in demand shifts the demand curve upward, out, and to the right. A decrease in demand shifts the demand curve inward, down, and to the left. Important Demand Shifters 1.Income 2.Population 3.Price of Substitutes 4.Price of Complements 5.Expectations 6.Tastes

Slide 53 of 55 Supply represents the behavior of sellers. A supply curve is a function that shows the quantity supplied at different prices. Supply curves are upward sloping. Producer Surplus is the producer’s gain from exchange, or the difference between the market price and the minimum price at which producers would be willing to sell a given quantity. Graphically, total producer surplus is measured by the area above the supply curve and below the price.

Slide 54 of 55 An increase in supply shifts the supply curve down and to the right. A decrease in supply shifts the supply curve up and to the left. Important Supply Shifters 1.Technological Innovations 2.Input Prices 3.Taxes and Subsidies 4.Expectations 5.Entry or Exit of Producers 6.Changes in Opportunity Costs