Supply and Demand Chapter 04 McGraw-Hill/Irwin Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved.

4-2 Learning Objectives  In this chapter you’ll learn how to: 1. Define and explain demand in a product or service market. 2. Define and explain supply. 3. Determine the equilibrium point in the market for a specific good, given data on supply and demand at different price levels. 4. Explain what causes shifts in demand and supply. 5. Explain how price ceilings cause shortages. 6. Explain how price floors cause surpluses. 7. Apply supply and demand analysis to real-world problems.

4-3 Demand  Is 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 shows how much quantity of a good or service can be sold at different prices.  People pay for goods or services according to how many benefits those goods or services will yield.  Generally less quantity will be demanded as prices increase since people will find relatively less expensive substitutes to provide similar levels of benefits.

4-4 Demand Schedule and Curve Table 1 Price QD $500 1, , , , , , , , ,000 To graph, plot one set of points at a time. Begin with P = $500 and Q = 1,000

4-5 Supply  Is the schedule of quantities of a good or service that people are willing to sell at different prices.  In general, the higher the price, the more of a good or service individuals are willing to supply. As price increases so does quantity provided.  This happens because different producers face different opportunity costs and as the price increases or decreases, producing a good or service becomes more or less attractive to producers at the margin.

4-6 Supply Schedule and Curve To graph, plot one set of points at a time. Begin with P = $100 and Q = 2,000

4-7 Equilibrium  Equilibrium price is the price at which quantity demanded equals quantity supplied or Q D = Q S.  A surplus occurs when the market price is above equilibrium price.  A shortage occurs when the market price is below equilibrium price.

4-8 A Picture of Equilibrium  Equilibrium occurs at the point where supply crosses demand.  If price were higher than equilibrium, more producers would want to produce goods or services than consumers would want to consume. Q S > Q D  If the price were lower, more consumers would want to consume goods or services than producers would want to produce. Q D > Q S

4-9 Shifts in Demand  A change in the price of a good or service moves us along a given demand schedule/curve. Movement up or down the same curve.  A change in the demand schedule results in a shift of the demand schedule/curve. If consumer preferences change for whatever reason, that will shift the demand curve either outward or inward depending upon the nature of the change.

4-10 Demand Curve Shifts Outward  When a demand curve shifts outward, people are willing to buy more goods or services at each possible price.  Preferences (willingness) or income (ability to pay) can change.  If perceived benefits increase, people will pay more.  If more people want to fly to visit family at Thanksgiving than at other times, we expect an outward shift.  D 1 shifts to the right to D 2.

4-11 Demand Curve Shifts Inward  When a demand curve shifts inward, people are willing to buy fewer goods at previous prices.  Preferences or ability to pay may change.  If there is a severe economic downturn and fewer people are taking business trips, we would expect an inward shift of the demand curve.  On the graph on the right, a recession would also lead to a lower demand in a product like a video game.

4-12 Questions for Thought and Discussion  Why do markets show that people demand fewer goods at higher prices?  What would happen to demand for the various services and products under the following scenarios? Will the curve shift and in which direction? Oprah Winfrey expresses concern about mad cow disease and beef. What happens to the demand for hamburgers? The National Institutes of Health releases a study that shows Vitamin D reduces the probability of getting cancer. What happens to demand for Vitamin D? The manufacturers of Frisbees discover a new, less expensive polymer to make Frisbees. What happens to the demand for Frisbees?

4-13 Shifts in Supply  Changes in the demand schedule (consumer behavior) or changes in price move us along an existing supply schedule.  Changes in the cost of factors of production or increases in productivity shift the supply curve.

4-14 Supply Shift Outward  When a supply curve shifts outward, businesses are willing to supply the same amount that they did before the shift at lower price levels.  Improvements in technology, lower resource costs, or higher factor productivity can result in this sort of shift.  If the price of jet fuel decreases, this would result in an outward shift in the supply curve of airline flights.  S 1 shifts to the right to S 2.

4-15 Supply Curve Shift Inward  When a supply curve shifts inward, businesses will only supply what they did before the shift at higher prices.  As costs change for businesses, opportunity costs change.  If the cost of jet fuel rises, that would shift the supply curve for airline flights inward to the left.  On the graph on the right, an increase in costs of grapes would lead to a lower supply of bottles of wine.

4-16 Shift in Demand and Equilibrium  If there are shifts in demand or supply, a new equilibrium point will be found on the basis of new perceived benefits or changes in costs.  In this instance, a demand- driven increase for the new iPhone pushes price up and the quantity of subscriptions up.

4-17 Shift in Supply and Equilibrium  If there are shifts in demand or supply, a new equilibrium point will be found on the basis of new perceived benefits or changes in costs.  In this instance, there is a shift in supply.  What happens to equilibrium price and quantity?

4-18 Questions for Thought and Discussion  Why is equilibrium thought to be efficient?  What happens if price is not at an equilibrium point?  What do prices represent to producers and consumers?

4-19 Government and the Market  The government may ensure the smooth operation of the markets by protecting property rights, guaranteeing enforcement of legal contracts, and issuing a supply of money (currency) that buyers and sellers readily accept.  Government sometimes changes market outcomes by Imposing prices floors and price ceilings. This may create problems of shortages and surpluses.  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.

4-20 Price Floors  Sometimes producers feel the price they are getting for their product is too low.  They may lobby the government to put in a price floor.  A price floor results in a surplus being supplied at the higher price.  Suppliers end up supplying more than consumers want to buy.  Examples: wheat and corn prices; federal minimum wage. How do you think price floors for agricultural commodities would impact the market for these commodities?

4-21 Price Ceilings  Sometimes buyers do not like the price they need to pay for a good or service.  Buyers may lobby government to put a price cap on what sellers can charge.  Classic example: rent - controlled apartments.  When rent control is in place producers can not charge a price above the ceiling.

4-22 Rent Control: The Institution People Love to Hate  People who live in rent-controlled properties get their apartments at bargain prices.  People looking for apartments will have a harder time finding them and will have to put up with more inconveniences in the housing market because rent control reduces the incentives of business people to provide quality housing options.  Rent control can misallocate a scarce resource (housing) to people who value the resource less than market value.  From a policy standpoint, who is helped or hurt by rent control? Why does the local government have this policy in some U.S. cities?

4-23 Application of Supply and Demand: Interest Rate Determination  Interest rates are also set by supply and demand.  It is the market for loanable funds.  Suppliers are banks, mortgage companies, credit unions, etc.  Demanders are homeowners and businesses, for example.  In the graph on the right, what is the equilibrium interest rate? How much money is lent/borrowed?

4-24 Application of Supply and Demand: Shifts in Interest Rates What would happen to the interest rate and funds lent/borrowed when supply increases? When demand increases?

4-25 Further Applications of Supply and Demand: Questions for Thought and Discussion  Should parking be free at your school?  Would a parking fee eliminate the shortage?  If the price of gasoline increased to $8 a gallon, would you cut back on your driving?  Explain how prices are a signal to producers about consumer preferences.

4-26 Gasoline Markets and Price: Hurricane Katrina Case Study  On Labor Day weekend of 2005, Hurricane Katrina: Temporarily shut down off-shore wells in the Gulf of Mexico. 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. People could buy all they wanted at sharply increased prices with no wait at the pumps.  What happened after the BP oil spill caused by the explosion of the Deep Water Horizon oil rig in the Gulf of Mexico in April of 2010?

4-27 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.

4-28 Questions for Thought and Discussion  How is equilibrium price affected by changes in demand? By changes in supply?  If you were a landlord, would you be against rent control?  Do corporations have incentives to lobby the government for price floors or ceilings?  Practical Application: Urban highways are usually congested during morning and evening commuting times. Using supply and demand analysis, what simple step could be taken to greatly reduce congestion?