Chapter 4: DEMAND & Supply

Demand First! What do we mean by (Consumer) Demand? Demand Curve ◦Graph depicting the relationship between the price of a certain commodity and the amount of it that consumers are willing and able to purchase at that given price.Graphcommodity ◦Graphic representation of a demand schedule.

Demand curve A Demand Schedule and a Demand Curve 3 The demand schedule is a table that shows the quantity demanded at each price. The demand curve, which graphs the demand schedule, illustrates how the quantity demanded of the good changes as its price varies. Because a lower price increases the quantity demanded, the demand curve slopes downward. Price of Ice-cream cone Quantity of Cones demanded $ cones Quantity of Ice-Cream Cones $ Price of Ice-Cream Cones 1. A decrease in price increases quantity of cones demanded.

Different Types of Demand Curves: Linear and Non-Linear 4 Shape of Demand Curve – depends on consumer’s response to price changes. If always constant -> linear. If it varies with price changes -> non-linear Qty D = a – b*PriceLog(Qty D) = a – b*Price

Different Types of Demand Curves: Individual and Market Demand Curves Market Demand Curve = Sum of Individual Demand Curves for the Product Market Demand

What Role Does Demand Play in Market Behavior/Analysis? Demand curves are used to estimate behaviors in competitive markets,competitive markets Combined with supply curves they can be used to estimate the equilibrium price (the price at which sellers together are willing to sell the same amount as buyers together are willing to buy, also known as market clearing price) and the equilibrium quantity (the amount of that good or service that will be produced and bought without surplus/excess supply or shortage/excess demand) of that market. [supply curves equilibrium pricemarket clearing [

Demand/Supply and Market Equilibrium

How People Make Decisions Principle 3: Rational people think at the margin Rational people ◦Systematically & purposefully do the best they can to achieve their objectives What are Marginal changes ◦Small incremental adjustments to a plan of action Rational decision maker – take action only if ◦Marginal (additional) benefits > Marginal (additional) costs ◦Or if value of consuming next unit > market price 8

From the Demand Side First Law of Demand ◦What Does Law Of Demand Mean? ◦all other factors being equal, as the price of a good or service increases, consumer quantity demanded for the good will decrease and vice versa. Investopedia explains Law Of Demand... ◦summarizes the effect price changes on consumer behavior. For example, a consumer will purchase more pizzas if the price of pizza falls. The opposite is true if the price of pizza increases. ◦ and.asp

A Demand Example PriceQty Demanded $ $9.002 $8.003 $7.004 $6.005 $5.006 $4.007 $3.008 $2.009 $1.0010

Computing Marginal Value PriceQty Demanded $ $9.002 $8.003 $7.004 $6.005 $5.006 $4.007 $3.008 $2.009 $1.0010

Total and Marginal Value PriceQty DemandedAmt PaidMarginal ValueTotal Value $ $9.002$18.00$9.00$19.00 $8.003$24.00$8.00$27.00 $7.004$28.00$7.00$34.00 $6.005$30.00$6.00$40.00 $5.006$30.00$5.00$45.00 $4.007$28.00$4.00$49.00 $3.008$24.00$3.00$52.00 $2.009$18.00$2.00$54.00 $1.0010$10.00$1.00$55.00 Price x Qty Dem Area under Demand Difference in TV(3)-TV(2) MV is also equal to price paid

Consumer’s Marginal Value Some basic definitions ◦Total Willingness-to-pay: “value in use” ◦How much would you be willing to pay for x units of the good than go entirely without? ◦Equals the area under the demand curve up to x units WTP for 4 units

In Graphic Terms Note: (again) price = marginal value Consumer is willing to buy up to P = MV

Why Do People Buy Things? 1.Because they are better off buying the good ◦Value in consumption/use > price paid = opportunity cost of spending it on next best alternative 2.How much better off? ◦Difference between the maximum amount you would be willing to pay for each unit of the good ◦Minus the amount you have to give up (i.e., what you have to pay to get it) Economists call this difference “Consumer Surplus” CS = MaxWTP(Q*) – Price x Q* Max WTP(0:Q*) = MV(1) + MV(2) + …. + MV(Q*) ◦Area under the demand curve up to the last unit purchased (Q*) 15

Calculating Consumer Surplus Consumer surplus is the difference between the total amount that consumers are willing and able to pay for a good or service (indicated by the demand curve) and the total amount that they actually do pay (i.e. the market price). Rational decision maker – takes action only if Marginal benefits > Marginal costs

Ten principles of economics From Chapter1 How People Make Decisions 1: People Face Trade-offs 2: The Cost of Something Is What You Give Up to Get It 3: Rational People Think at the Margin 4: People Respond to Incentives 17

Ceteris Paribus What’s it mean? Ceteris paribus or caeteris paribus is a Latin phrase meaning "with other things the same" or "other things being equal or held constant".Latin What are we “holding constant” when we “draw” the an individual’s demand curve? ◦Major factors (80/20 rule) that affect a consumer’s demand for a good ◦Individual’s Income ◦Price of Substitutes for the goods ◦Price of Complements (goods consumed/used with the good being studied) ◦Future Price of the good ◦Product Quality ◦Individual’s Taste and Preferences ◦And if we are modelling market demand (all customers) ◦All of the above + number of people in the market (and how much they buy at each price)

Table 4.1 Factors That Shift the Demand Curve

Appendix FIGURE 1A-5 Showing Three Variables on a Graph Graphs of Two Variables Taking into Account More Than Two Variables on a Graph

Shift of the Entire Curve Shift out/right of the Demand Curve ◦WTP increases for all Q d Shift in/left of the Demand Curve ◦WTP decreases for all levels of Q d Shift out/right Shift in/left D2D2 Increase in Demand Decrease in Demand

EXHIBIT 3.3 Income as a Determinant of Demand 3-22

Factors That Can Shift Demand Income ◦Normal good ◦As income rises, quantity demanded increases at a given price -> Demand curve shifts out ◦Superior good – percent of budget spent on good increases more than percent increase in income ◦Demand curve shift is very large ◦Inferior good ◦As income rises, quantity demanded decreases at a given price ◦Demand curve shifts in

Factors That Can Shift Demand Substitutes ◦Goods that are similar to the “good in question” (or being analyzed) ◦E.g., Pepsi/Coke Shifts in Demand Curve ◦If price of substitute increases, then demand for “GIQ” shifts out as it becomes relatively less expensive ◦If price of substitute decreases, then demand for “GIQ” shifts in as it becomes relatively more expensive ◦“closer” the substitute -> more demand curve shifts (i.e., greater cross-price elasticity) ◦For substitutes: relative price matters!

Factors That Can Shift Demand Complements ◦Goods that are “jointly consumed” with “GIQ”, e.g. coffee & cream Demand Curve shifts ◦Price of complement increases, then demand for “GIQ” shifts in as total cost of consumption has increased ◦Price of complement decreases, then demand for “GIQ” shifts out as total cost of consumption has decreased ◦For complements: total cost of consumption matters!

Factors That Can Shift Demand Product Quality ◦Better or improved product quality increases (relative) demand ◦Demand curve shifts out Future price (hedge market) of the good ◦If the price is expected to go up in the future -> increases current demand (shift out/right) ◦Cheaper to consume today and stockpile ◦If the price is expected to decrease in the future -> decrease current demand (shift in/left) ◦Wait to buy (christmas/after christmas sales) Taste and Preferences ◦Always assumed constant unless you have empirical proof (new MRI imaging)

Factor that Affects the ONLY Aggregate Market Demand Curve As the population/number of buyers (Nb) increases -> Market Demand curve shifts outward

Market Demand: Maybe a little bit different Market Demand may be kinked as new buyers enter at different price points When it’s only Tom – Tom’s D is the market Harry joins the Market Dick joins

Table 4.1 Factors That Shift the Demand Curve

Key Assumptions Demand Curve For a given (individual’s) demand curve ◦These factors are held constant (ceteris paribus): ◦Price of: ◦substitutes, ◦complements, ◦future price of the good ◦income, ◦quality, and ◦taste and preferences And for a market demand curve: ◦number of buyers (Nb) Only price and quantity demanded are allowed to vary

EXHIBIT 3.4 Distinguishing Change in Demand from Change in Quantity Demanded 3-31

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