Unit 2 Supply and Demand Demand The interaction of supply and demand creates the market price

Section 1: Understanding Demand Demand is the desire, ability and willingness to pay for something. Demand represents the buyers in a market

The Law of Demand 1. When a good’s price is low, consumers will buy more 2. When a good’s price is high, consumers will buy less The law of demand is the result of two interacting behaviors:

The Substitution Effect When people react to a price change by buying less of that good and more of other goods Example -

The Income Effect The change in consumption from a change in real income. At $3.80/gallon you cannot afford to buy as much gas as you would at $3.00/gallon

The Income Effect (cont) Normal Good – people buy more if their income increases example - Inferior Good – people buy more if their income decreases example - Giffen Good – an inferior good with no close substitutes; as its price increases, so does quantity demanded Veblen Good – a luxury good whose quantity demand increases as price increases, conspicuous consumption

Demand Schedule 1. A table that lists the quantities that will be purchased at various prices 2. Schedules can be for an individual or a given population Demand for PriceQty

Demand Curve A graph representation of a demand schedule Used to predict how people will change their buying habits when price rises or falls Can change easily depending on related variables

Shifts in the Demand Curve Remember, a change in price only causes a change in quantity demand, not a change in demand

Changes in Demand A change (shift) in demand is when at the same price, quantity demanded rises or falls.

What causes a change in demand? There are at least six reasons why demand can change 1. Income – when income changes, people demand more or different types of goods

2. Consumer Expectations If people expect the price of something to increase in the future, demand will increase now Opposite is also true

4. Changes in Taste, Preferences Fads can increase demand temporarily Bandwagon effect – “everybody else…” Preferences can also show long term changes Ex: More low fat food

3. Change in Population More people want more stuff! Opposite is also true

5. Change in price of complement - If the price of a good increases, demand for its complement decreases - opposite is also true

(what causes…cont) 6. Change in price of a substitute If the price of a good increases, demand for its substitute increases Opposite is also true

The Supply Curve Supply is the amount of goods and services that producers are willing to produce at given prices The Law of Supply – as prices increase, producers are willing to supply a greater quantity of a good or service Supply and price are positively related

Explanation for the Law of supply: 1. Higher Production The expectations of higher prices is an incentive for more companies to produce more 2. Market Entry When prices and profits are high in a market, that is an incentive for other businesses to enter the market

The Supply Schedule A supply schedule is a chart showing the quantities that will be supplied at various prices A change in quantity supplied occurs when the price changes and producers change the amount they will produce WageHours Supplied $0 $7 $10

Changes in Supply Just as there are factors that cause the demand curve to change… There are also several factors that cause the supply curve to change As with demand, right is an increase, left is a decrease

Input Costs 1. Change in the cost of factors of production – higher costs decrease supply 2. Technology – new technology increases supply

Government 3. Subsidies – a government payment that supports a business or market Subsidies increase the supply curve 4. Taxes & Regulations –Taxes & Regs. decrease the supply curve

Other Factors 5. Future Expectations of prices – if producers expect prices to increase, they will decrease supply now 6. Number of suppliers – more producers increases supply

Review We have the supply curve, the demand curve and factors that shift the curves These can be used to predict the price and quantity at which a good is bought or sold

Equlibrium The intersection of S and D is the equilibrium. The price at this point is the equilibrium price and the quantity is the equilibrium quantity

If supply or demand shifts, the market is in disequilbrium If qty demand is greater than qty supplied, a shortage results Prices will rise and qty supplied will increases until the market is in equilibrium If qty supplied is greater than qty demanded, a surplus results Prices will decrease and qty supplied will decrease until the market is in equilibrium

Price Controls In a few cases, market forces do not determine prices Governments have some power to set prices There are two types of price controls

1. Price Ceiling Government imposed price below the equilibrium point, therefore creating a shortage The maximum legal price that can be charged – “price caps” Ex: rent controls in large cities, Medicare or Medicaid payments by the government

Rent Control P* - equilibrium price P – Price Ceiling Pf – Q* - Equilibrium quantity Qd – Quantity demanded Qs – Quantity Supplied Qd – Qs = amount of shortage

Problems with Price Ceilings Inefficient Allocation to consumers Wasted Resources Search costs increase (Price Pf), high “security deposits” Lower Quality Landlords cut maintenance or abandon buildings Black Markets Bribes,

2. Price Floor The minimum legal price that can be charged – “price supports” This price is above the equilibrium point, therefore creating a surplus Ex: agricultural price supports, minimum wage

Minimum Wage W* - Equilibrium wage Wmin – minimum wage L* - equilibrium qty of workers Ls – number of people willing to work LD – number of people hired Ls-Ld=# people unemployed

Quantity Controls The government seeks to limit not the price, but the quantity of an item

Effects of Price Ceiling Overproduction Inflationary effects in related markets

Elasticity of Demand Elasticity is how much a price change affects the quantity demanded Elastic: a small change in price will cause a large change in quantity demanded Inelastic: a change in price will cause little change in quantity demanded

Factors Affecting Elasticity 1. Availability of Substitutes – the fewer substitutes an item has, the greater its inelasticity 2. Necessity v. Luxury – if its considered a necessity, then the greater its inelasticity

3. Percentage of income- if an item uses a large portion of your income, it is more likely to be elastic. If Coke is priced at $1.00 & $1.09 at two stores, you probably won’t care. But, if a car you’re interested in varies from $18,000 to $19,800 (10%) you might care. 4. Change over Time - a good is more elastic if the purchase can be delayed. In emergencies, people are more likely to pay higher prices

Elasticity on the Demand Curve Steep line = inelastic Shallow line = elastic Vertical line = perfectly inelastic

Calculating Elasticity Demand Elasticity is the slope of the demand curve If the % change in quantity > % change in price, demand is elastic If the % change in quantity< % change in price, demand is inelastic If the % change in quantity = % change in price, demand is unit elastic Demand Elasticity = Percentage Change in Quantity Demanded Percentage Change in Price

Price Effect v. Quantity Effect

Total Revenue and Elasticity Total Revenue = Price x Qty A rise in price means less qty demand If an item is elastic, and prices rise, total revenue will decrease If an item is inelastic, and prices rise, total revenue increase Why?

Change in Price Total Revenue Up Inelastic Down Inelastic UpDownElastic DownUpElastic Up/Down=Unit Elastic

Elasticity of Supply The quantity reaction of the producers to a price change An inelastic supply means that producers cannot quickly increase or decrease production if price increases An elastic supply means that producers can quickly increase or decrease production if the price increases Real world examples of perfectly elastic and inelastic supply are easier to find than for demand Examples?

Factors that determine supply elasticity Availability of inputs Time required for production