Supply and Demand Chapter 3 Copyright © 2010 by the McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin

3-2 The Market How do market mechanisms decide WHAT, HOW, and FOR WHOM to produce? –What determines the price of a good or service? –How does the price of a product affect its production or consumption? –Why do prices and production levels often change?

3-3 Market Participants A good way to start learning how markets work is to see who participates in them –Over 310 million consumers, 25 million firms, and tens of thousands of government agencies participate directly in the U.S. economy –Millions of international buyers and sellers also participate in U.S. markets

3-4 Maximizing Behavior All participants have limited resources and strive to maximize outcomes –Consumers seek to maximize utility –Businesses try to maximize profits through efficient production –Government seeks to maximize general welfare

3-5 Specialization and Exchange We interact in markets because: –Individuals are not capable of producing everything they need or want –We face limits on time, energy, and other resources, so it makes sense to specialize in production and trade for other goods and services

3-6 The Circular Flow Four different groups participate in our economy: –Consumers –Business firms –Government –International participants

3-7 The Two Markets Factor markets: Any place factors of production (e.g., land, labor, capital) are bought and sold Product Markets: Any place finished goods and services are bought and sold

3-8 The Circular Flow International participants Consumers International participants Business Firms Governments Product markets Factor markets Goods and services supplied Factors of production supplied Goods and services demanded Factors of production demanded

3-9 Dollars and Exchange A market exists wherever and whenever an exchange takes place Every market transaction involves an exchange of dollars for goods or resources Money is critical in facilitating market exchanges and the specialization it permits

3-10 Supply and Demand There must be a buyer and a seller in every market transaction –The seller is on the supply side of the market –The buyer is on the demand side

3-11 Supply and Demand Supply: The ability and willingness to sell specific quantities of a good at alternative prices in a given time period, ceteris paribus Demand: The ability and willingness to buy specific quantities of a good at alternative prices in a given time period, ceteris paribus

3-12 Individual Demand Demand exists only if someone is willing and able to pay for a good or service An individual must consider the opportunity cost associated with a purchase, since it involves a tradeoff due to limited resources

3-13 Individual Demand Demand schedule: A table showing quantities of a good a consumer is willing and able to buy at alternative prices in a given time period, ceteris paribus –“Demand” is an expression of consumer buying intentions – of a willingness to buy – not a statement of actual purchases

3-14 The Demand Curve Demand curve: A curve describing quantities of a good a consumer is willing and able to buy at alternative prices in a given time period, ceteris paribus –A graphical illustration of a demand schedule Demand curves are downward sloping

3-15 The Law of Demand Law of Demand: The quantity of a good demanded in a given time period increases as its price falls, ceteris paribus

3-16 Demand Schedule and Curve Quantity PRICE $ A B C D E F G H I

3-17 Determinants of Demand Determinants of market demand include: –Consumer tastes –Consumer income –Availability and prices of other goods –Consumer expectations –Number of buyers in the market

3-18 Types of Other Goods Substitute goods substitute for each other –When the price of good x rises, the demand for good y increases, ceteris paribus Complementary goods are frequently consumed together –When the price of good x rises, the demand for good y falls, ceteris paribus

3-19 Ceteris Paribus Recall that to simplify their models economists focus on only one or two forces at a time and assume nothing else changes Ceteris paribus: The assumption of nothing else changing

3-20 Shifts in Demand A demand curve (schedule) is valid only if its underlying determinants remain constant Determinants of demand can and do change Shift in demand: A change in the quantity demanded at any given price

3-21 Movements vs. Shifts Changes in quantity demanded: Movements along a demand curve in response to changes in price for the good Changes in demand: Shifts of the demand curve due to changes in the determinants of demand, which change the relationship between price and quantity demanded

3-22 Movements vs. Shifts PRICE $ Quantity D1D1 Initial demand d1d1 Movement along curve g1g1 Shift in demand D2D2 Increased demand d2d2

3-23 Market Demand Market demand: Total quantities of a good or service people are willing and able to buy at alternative prices in a given time period –The sum of individual demands, as determined by the number of potential buyers, their respective tastes and incomes, other goods, and expectations

3-24 Construction of the Market Demand Curve Quantity Demanded PriceTom+George+Lisa+Me=Market Demand A B C D E F G H I

= Tom’s demand curve $50 Price + George’s demand curve Lisa’s demand curve My demand curve Construction of the Market Demand Curve Quantity Demanded

3-26 = Construction of the Market Demand Curve A B C D E F G I $ The market demand curve Price Quantity Demanded H

3-27 Supply Market supply: The total quantities of a good that sellers are willing and able to sell at alternative prices in a given time period, ceteris paribus

3-28 Determinants of Supply The determinants of market supply include: –Technology –Factor costs –Other goods –Taxes and subsidies –Expectations –Number of sellers

3-29 Law of Supply Law of Supply: The quantity of a good supplied in a given time period increases as its price increases, ceteris paribus Supply curves are upward-sloping to the right

3-30 Market Supply The market supply curve is just a summary of the supply intentions of all producers. Market supply is an expression of sellers’ intentions – an offer to sell – not a statement of actual sales.

3-31 Market Supply Quantity Supplied By: PriceAnn+Bob+Cory=Market j$ i h g f e d c b10 0 0

3-32 Market Supply Price Quantity Supplied Ann’s supply curve Bob’s supply curve Cory’s supply curve +=+

3-33 Market Supply Price Quantity Supplied = Quantity supplied increases as price rises

3-34 Shifts of Supply A supply curve is valid only if its underlying determinants remain constant Determinants of supply can and do change Shift in supply: A change in the quantity supplied at any given price

3-35 Movements vs. Shifts Changes in quantity supplied: Movements along the supply curve due to changes in price Changes in supply: Shifts in the supply curve due to changes in the determinants of supply –An increase in supply is a rightward shift –A decrease in supply is a leftward shift

3-36 Equilibrium Only one price/quantity combination is compatible with buyer’s and seller’s intentions Equilibrium price: The price at which the quantity of a good demanded equals the quantity supplied in a given time period –Equilibrium occurs at the intersection of the supply and demand curves

3-37 Price Quantity Supplied Quantity Demanded $50148surplus surplus surplus surplus surplus surplus equilibrium shortage47 10 shortage57 Equilibrium Price

3-38 Equilibrium Price Market demand Equilibrium price Market supply $ At the equilibrium price: quantity demanded = quantity supplied Quantity39 Price

3-39 Market Clearing The equilibrium price reflects a compromise between buyers and sellers –Not everyone is happy, as the price is too high for some buyers and too low for some sellers The unique outcome at market equilibrium is efficient

3-40 The Invisible Hand Market mechanism: The use of market prices and sales to signal desired outputs (or resource allocations) Adam Smith characterized this market mechanism as the invisible hand

3-41 Market Surplus Market surplus: The amount by which the quantity supplied exceeds the quantity demanded at a given price – excess supply A market surplus will emerge when the market price is above the equilibrium price

3-42 Market Shortage Market shortage: The amount by which the quantity demanded exceeds the quantity supplied at a given price – excess demand A market shortage will emerge when the market price is below the equilibrium price

3-43 Surplus and Shortage Market demand Market supply $ Quantity39 Price Shortage y x Surplus

3-44 Self-Adjusting Prices Buyers and sellers will change their behavior to overcome a surplus or shortage Only at the equilibrium price will no further adjustments be required

3-45 Surplus and Shortage Market demand Equilibrium price Market supply $ Quantity39 Price Shortage y x Surplus

3-46 Changes in Equilibrium No equilibrium price is permanent Equilibrium price and quantity will change whenever the supply or demand curve shifts –Shifts are due to a change in supply or demand resulting from a change in any of the underlying determinants

3-47 Change in Equilibrium: Demand Shift Quantity Price $ E1E1 Initial demand Market supply New demand E2E2

3-48 Change in Equilibrium: Supply Shift Quantity Price $ E3E3 E1E1 Initial demand Market supply

3-49 Market Outcomes The market mechanism resolves the basic economic questions: –WHAT we produce is determined by equilibriums –HOW we produce is determined by profit seeking behavior and efficient use of resources –FOR WHOM we produce is determined by those willing and able to pay equilibrium prices

3-50 Optimal, Not Perfect Although outcomes of the marketplace are not perfect, they are often optimal – the best possible given our incomes and scarce resources

Supply and Demand End of Chapter 3 Copyright © 2010 by the McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin