Demand, Supply, & Market Equilibrium Chapter 3

Demand A schedule or curve that shows the various amounts of a product that consumers are willing and able to purchase at each of a series of possible prices during a specified period of time A statement of a buyer’s plans, or intentions, with respect to the purchase of a product

Law of Demand Other-Things-Equal Assumption As the Price (P) falls, the Quantity Demanded (Q D ) rises. (P↓ Q D ↑) As the Price (P) rises, the Quantity Demanded (Q D ) falls. (P↑ Q D ↓) Thus, there is an inverse (or negative) relationship between Price and Quantity Demanded.

Law of Demand Common Sense –People do buy more at low prices –Sales!!! Diminishing Marginal Utility –Each additional unit of the product produces less satisfaction (or benefit, or utility) Income Effect –Lower prices increase the purchasing power of a buyer’s income Substitution Effect –Lower prices give buyers the incentive to substitute similar products

Individual Demand Quantity Demanded (bushels per week) Price (per bushel) PQdQd $ Individual Demand P Q D

Determinants of Demand Tastes –Favorable change in consumer tastes (preferences) = More Demanded at each price Number of Buyers –Increase in number of buyers = Increase in Demand Income –Normal (Superior) Goods – Demand Varies Directly with Income –Inferior Goods – Demand Varies Inversely with Income Prices of Related Goods –Substitutes: Used in place of another good Example: Leather vs. Cloth Coats –Complements: Used together with another good Example: Computers & Software –Unrelated Goods: Not related at all Example: Potatoes & Automobiles Consumer Expectations

Determinants of Demand Therefore, an Increase in Demand may be caused by: –A favorable change in consumer tastes/preferences –An increase in the number of buyers –Rising incomes if the product is a normal good –Falling incomes if the product is an inferior good –An increase in the price of a substitute good –A decrease in the price of a complimentary good –A new consumer expectation that either prices or income will be higher in the future

Individual Demand Quantity Demanded (bushels per week) Price (per bushel) PQdQd $ Individual Demand P Q D1D Demand Can Increase or Decrease Increase in Demand Decrease in Demand D2D2 D3D3

Changes in Quantity Demanded Not to be confused with Change in Demand –A shift of the demand curve to the right (increase in demand) or to the left (decrease in demand) –Cause: A change in one or more determinants of demand Change in Quantity Demanded –A movement from one point to another point – from one price/quantity combination to another– on a fixed demand schedule/curve –Cause: An increase or decrease in the price of the product under consideration

Individual Demand Quantity Demanded (bushels per week) Price (per bushel) PQdQd $ Individual Demand P Q D1D Demand Can Increase or Decrease Decrease in Demand D2D2 D3D3 An Increase in Demand Means a Movement of the Line A Movement Between Any Two Points on a Demand Curve is Called a Change in Quantity Demanded

Supply A schedule or curve showing the various amounts of a product that producers are willing and able to make available for sale at each of a series of possible prices during a specific period

Law of Supply As the Price (P) falls, the Quantity Supplied (Q s ) falls. (P↓ Q s ↓) As the Price (P) rises, the Quantity Supplied (Q s ) rises. (P↑ Q s ↑) Thus, there is a direct (or positive) relationship between Price and Quantity Supplied. Remember, the supplier is on the receiving end of the product’s price. Therefore, higher prices don’t pose the same obstacle on the supply side as they do on the demand side.

Individual Supply Quantity Supplied (bushels per week) Price (per bushel) PQsQs $ Individual Supply P Q S1S

Determinants of Supply Resource Prices –Higher Resource Prices raise production costs & squeeze profits –Lower Resource Prices reduce production costs & increase profits Technology –Improvements in technology enable firms to produce units of output with fewer resources Taxes & Subsidies –Businesses treat most taxes as costs. –Increase in sales or property taxes will increase production costs & reduce supply –Subsidies are considered “taxes in reverse” –Thus, lower production costs/increase in supply

Determinants of Supply Prices of other Goods –Substitution in Production –Example: Producing basketballs instead of soccer balls results in a decline in the supply of soccer balls Producer Expectations –Future Prices of Products Number of Sellers in the Market –Other things equal, the larger the number of suppliers, the greater the market supply –As more firms enter the industry, the supply curve shifts to the right –The smaller the number of suppliers, the less the market supply –As more firms leave the industry, the supply curve shifts to the left

Individual Supply Quantity Supplied (bushels per week) Price (per bushel) PQsQs $ Individual Supply P Q S1S1 Supply Can Increase or Decrease S2S2 S3S

Changes in Quantity Supplied Not to be confused with Change in Supply –A change in the schedule & shift of the curve –An increase in supply shifts curve to the right –A decrease in supply shifts curve to the left –Cause: A change in one or more of the determinants of supply Change in Quantity Supplied –A movement from one point to another on a fixed supply curve –Cause: A change in the price of the specific product being considered

Individual Supply Quantity Supplied (bushels per week) Price (per bushel) PQsQs $ Individual Supply P Q S1S1 Supply Can Increase or Decrease S2S2 S3S3 An Increase in Supply Means a Movement of the Line A Movement Between Any Two Points on a Supply Curve is Called a Change in Quantity Supplied

Market Equilibrium Equilibrium Price (P E ) –Market Clearing Price –The price where the intentions of buyers & sellers match –Q D = Q S Equilibrium Quantity –The quantity demanded & supplied at the equilibrium price in a competitive market Competition among buyers & sellers drives the price to equilibrium Surplus: Excess Supply Shortage: Excess Demand

Market Equilibrium Bushels of Corn (thousands per week) Price (per bushel) PQdQd $ ,000 4,000 7,000 11,000 16,000 Market Demand 200 Buyers PQsQs $ ,000 10,000 7,000 4,000 1,000 Market Supply 200 Sellers 200 Buyers & 200 Sellers 7 3 D S $4 Price Floor 6,000 Bushel Surplus $2 Price Ceiling 7,000 Bushel Shortage

Government-Set Prices Price Ceilings –The maximum legal price a seller may charge for a product or service –Prices at or below the ceiling are legal –Prices above are not –Examples: Rent Controls –Sometimes leads to black markets & political pressure to lower prices Price Floors –A minimum price fixed by the government –A price at or above the floor are legal –Prices below are not –Distort resource allocation

Efficient Allocation Productive Efficiency –The production of any particular good in the least costly way Example: Have $100 worth of resources Can produce a bushel of corn using either $5 or $3 of those resources, leaving either $95 or $97 remaining for alternative uses Which is better? Allocative Efficiency –The particular mix of goods & services most highly valued by society (minimum cost production assumed) –Society wants iPods instead of cassette tapes –However, society also wants cell phones –Competitive markets help assign allocative efficiency

Equilibrium Price & Quantity In competitive markets, produces an assignment of resources that is “right” from an economic perspective Demand reflects MB based on utility received Supply reflects MC of producing good Remember: –MB>MC Expand Output –MB<MC Reduce Output –MB=MC Optimal Output

Changes in Supply, Demand, & Equilibrium Changes in Demand –Supply Constant, Demand Increases Raises P E and Q E See pg 57, Figure 3.7 a –Supply Constant, Demand Decreases Reduces P E and Q E See pg 57, Figure 3.7b Changes in Supply –Demand Constant, Supply Increases Reduces P E, Increases Q E See pg 57, Figure 3.7c –Demand Constant, Supply Decreases Increases P E, Reduces Q E See pg 57, Figure 3,7d

Changes in Supply, Demand, & Equilibrium Complex Cases: (See pg. 57, Table 3.7) –Supply ↑ Demand ↓ P E ↓ Q E ? –Supply ↓ Demand ↑ P E ↑ Q E ? –Supply ↑ Demand ↑ P E ? Q E ↑ –Supply ↓ Demand ↓ P E ? Q E ↓