Chapter 3 Supply and Demand 3-1 Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved.

Chapter Objectives Define and explain demand in a product or service market Define and explain supply Determine the equilibrium point in the market for a specific good, given data on supply and demand at different price levels 3-2 Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved.

Chapter Objectives Understand what causes shifts in demand and supply Understand how price ceilings cause shortages Understand how price floors cause surpluses 3-3 Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved.

The schedule of quantities of a good or service that people are willing and able to buy at different prices –Sometimes a schedule is also called a table Demand Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved. 3-4

Hypothetical Daily Demand for Coach Seats on Round- trip Weekly Flights Between Denver and Chicago Table 1 Price QD $500 1, , , , , , , , , Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved.

Hypothetical Daily Demand for Coach Seats on Round- trip Weekly Flights Between Denver and Chicago Table 1 Price QD $500 1, , , , , , , , , Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved.

Hypothetical Daily Demand for Coach Seats on Round- trip Weekly Flights Between Denver and Chicago Table 1 Price QD $500 1, , , , , , , , , Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved.

Hypothetical Daily Demand for Coach Seats on Round- trip Weekly Flights Between Denver and Chicago Table 1 Price QD $500 1, , , , , , , , , Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved.

Hypothetical Daily Demand for Coach Seats on Round- trip Weekly Flights Between Denver and Chicago Table 1 Price QD $500 1, , , , , , , , , Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved.

Hypothetical Daily Demand for Coach Seats on Round- trip Weekly Flights Between Denver and Chicago Table 1 Price QD $500 1, , , , , , , , , Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved.

Hypothetical Daily Demand for Coach Seats on Round- trip Weekly Flights Between Denver and Chicago Table 1 Price QD $500 1, , , , , , , , , Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved.

Hypothetical Daily Demand for Coach Seats on Round- trip Weekly Flights Between Denver and Chicago Table 1 Price QD $500 1, , , , , , , , , Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved.

Hypothetical Daily Demand for Coach Seats on Round- trip Weekly Flights Between Denver and Chicago Table 1 Price QD $500 1, , , , , , , , , Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved.

Hypothetical Daily Demand for Coach Seats on Round- trip Weekly Flights Between Denver and Chicago Table 1 Price QD $500 1, , , , , , , , , Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved.

Table 1 Price QD $500 1, , , , , , , , , Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved. Table 1 is the Demand Schedule Figure 1 is the Graph of the Demand Schedule Figure 1 The line is the Demand Curve

Table 1 Price QD $500 1, , , , , , , , , Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved. Figure 1 Price and Quantity Demanded are inversely related Quantity Demanded is a point on the Demand Curve

Table 1 Price QD $500 1, , , , , , , , , Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved. Figure 1 Remember, Demand is the entire schedule or the entire curve Quantity Demanded is a point on the Demand Curve

Supply Is the “schedule” of quantities of a good or service that people are willing to sell at different prices 3-18 Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved.

3-19 Price QS $500 62,000 $450 59,000 $400 54,000 $350 48,000 $300 40,000 $250 30,000 $200 16,000 $150 7,000 $100 2,000 Supply is the entire schedule or the entire curve

Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved Price QS $500 62,000 $450 59,000 $400 54,000 $350 48,000 $300 40,000 $250 30,000 $200 16,000 $150 7,000 $100 2,000 Quantity Supplied is a point on the curve

Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved Price QS QD $500 62,000 1,000 $450 59,000 3,000 $400 54,000 7,000 $350 48,000 12,000 $300 40,000 19,000 $250 30,000 30,000 $200 16,000 45,000 $150 7,000 57,000 $100 2,000 67,000 Demand and Supply Curves Equilibrium price is the price where QD = QS We can find equilibrium price and quantity by seeing where the supply and demand curves cross

Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved Price QS QD $500 62,000 1,000 $450 59,000 3,000 $400 54,000 7,000 $350 48,000 12,000 $300 40,000 19,000 $250 30,000 30,000 $200 16,000 45,000 $150 7,000 57,000 $100 2,000 67,000 Demand and Supply Curves Equilibrium price = EP Market price = MP MP > EP there is a surplus Surpluses and Shortages 54,000-7,000 = 47,000

Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved Price QS QD $500 62,000 1,000 $450 59,000 3,000 $400 54,000 7,000 $350 48,000 12,000 $300 40,000 19,000 $250 30,000 30,000 $200 16,000 45,000 $150 7,000 57,000 $100 2,000 67,000 Demand and Supply Curves Equilibrium price = EP Market price = MP Surpluses and Shortages 54,000-7,000 = 47,000 A surplus would force sellers to lower their prices. Eventually, prices would fall back to the equilibrium price

Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved Price QS QD $500 62,000 1,000 $450 59,000 3,000 $400 54,000 7,000 $350 48,000 12,000 $300 40,000 19,000 $250 30,000 30,000 $200 16,000 45,000 $150 7,000 57,000 $100 2,000 67,000 Demand and Supply Curves Equilibrium price = EP Market price = MP Surpluses and Shortages 57,000-7,000 = 50,000 MP < EP here is a shortage

Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved Price QS QD $500 62,000 1,000 $450 59,000 3,000 $400 54,000 7,000 $350 48,000 12,000 $300 40,000 19,000 $250 30,000 30,000 $200 16,000 45,000 $150 7,000 57,000 $100 2,000 67,000 Demand and Supply Curves Equilibrium price = EP Market price = MP Surpluses and Shortages 57,000-7,000 = 50,000 A shortage would allow sellers to raise their prices. As prices increased people would buy less. Eventually, prices would move back to the equilibrium price

Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved Price QS QD $500 62,000 1,000 $450 59,000 3,000 $400 54,000 7,000 $350 48,000 12,000 $300 40,000 19,000 $250 30,000 30,000 $200 16,000 45,000 $150 7,000 57,000 $100 2,000 67,000 Demand and Supply Curves Surpluses and Shortages We can see that the forces of demand and supply work together to establish an equilibrium price at which there are no shortages or surpluses

Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved Table 4 Price QD 1 QD 2 $500 1,000 12, ,000 15, ,000 21, ,000 30, ,000 40, ,000 55, ,000 63, ,000 75, ,000 88,000 The schedule changes from QD 1 to QD 2 The demand curve shifts to the right from D 1 to D 2 This is an increase in demand

Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved Table 4 Price QD 1 QD 2 $500 1,000 12, ,000 15, ,000 21, ,000 30, ,000 40, ,000 55, ,000 63, ,000 75, ,000 88,000 The schedule changes from QD 2 to QD 1 The demand curve shifts to the left from D 2 to D 1 This is a decrease in demand

Price Quantity (in thousands) S D Shifts in Supply and Demand If the schedule changes the Supply curve shifts Supply decreases... the curve shifts to the left S 3-29 Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved.

Price Quantity (in thousands) S D Shifts in Supply and Demand If the schedule changes the Supply curve shifts Supply increases... the curve shifts to the right S Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved. 3-30

Price Quantity (in thousands) S1S1 D Shifts in Supply and Demand If the Supply curve is S 1 what is the equilibrium price and quantity? The equilibrium price is approximately 262 or 263 S2S2 The equilibrium quantity is approximately 35, Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved.

Price Quantity (in thousands) S1S1 D Shifts in Supply and Demand If the Supply curve changes to S 2 what is the new equilibrium price and quantity? The new equilibrium price is approximately 325 S2S2 The new equilibrium quantity is approximately 26, Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved.

Price Quantity (in thousands) S1S1 D Shifts in Supply and Demand Is a shift from S 1 to S 2 an increase or decrease in Supply? A decrease S2S2 Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved. 3-33

3-34 Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved. Price Floors and Ceilings The price can go no lower than the floor. A price floor creates a permanent surplus The surplus is the amount by which the quantity supplied is greater than the quantity demanded

3-35 Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved. Price Floors and Ceilings The price can go no higher than the ceiling. A price ceiling creates a permanent shortage The shortage is the amount by which the quantity demanded is greater than the quantity supplied

Applications of Supply and Demand Interest rates are set by –Supply and demand Wage rates are set by –Supply and demand Rents are determined by –Supply and demand The prices of nearly all goods are determined by –Supply and demand The prices of nearly all services are determined by –Supply and demand 3-36 Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved.

3-37 Hypothetical Demand for and Supply of Loanable Funds We can see that $600 billion is lent (or borrowed) at an interest rate of 6 percent What would happen if the supply of loanable funds increased?

Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved Hypothetical Demand for and Supply of Loanable Funds The interest rate would decrease to 4 percent and the amount of money borrowed would increase to $800 billion

Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved Hypothetical Demand for and Supply of Loanable Funds If the demand for loanable funds rises to D 2 the interest rate would rise to 9 percent and the amount of money borrowed would rise to $700 billion

Last Word Government sometimes interferes with the free operation of the markets by –Imposing prices floors and price ceilings –This creates the problems of shortages and surpluses The government may also ensure the smooth operation of the markets by protecting property rights, guaranteeing enforcement of legal contracts, and issuing a supply of money that buyers and sellers readily accept –Property rights are essential to a free and prosperous nation While governmental interference with the market system can have adverse affects, the government does have a substantial supportive role to play in a market economy Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved.

Current Issue: High Gas Prices Hurricane Katrina –Temporarily shut down off shore wells –Briefly put 10% of our refineries out of commission –Result – a sudden drop in oil supply –The government took a “hands” off approach –Gasoline prices rose sharply – duh? –People could buy all they wanted at sharply increased prices with no wait at the pumps Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved. 3-41

The Alternative to High Gas Prices In 1970 and 1979 Middle east countries curtailed oil shipments to the United States Resulted in reduced oil supply Government’s solution – restrict purchases and hold down prices The result – long gas lines in many parts of the country People paid less but waited much longer to purchase gas at moderately higher prices (sometimes one to two hours) Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved. 3-42

Summation Gasoline Supply Decreases Short Run –Prices Rise –Many people cut back on their driving Long Run –People buy more gas efficient cars –Higher prices encourage greater exploration for oil –Higher prices encourage the development of alternative energy sources Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved. 3-43

Summation Government Restricts Purchases and Holds Down Price Increases Short Run –Prices may rise moderately –People cut back on their driving very little if any –Significant waits at the gas pumps occur Long Run –People have little incentive to buy more gas efficient cars –Lower prices discourage greater exploration for oil –Higher prices discourage the development of alternative energy sources Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved. 3-44

Closing Comments Most economists probably believe price ceilings do more harm than good in the long run Most people probably think in the short run and want government to do something about higher prices Government probably is inclined to get involved Corporate greed probably can and will influence government actions The result... who knows? But past history indicates it probably won’t be good for the consumer Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved. 3-45