Chapter 2 The Basics of Supply and Demand

Topics to Be Discussed n The Market Mechanism n Shifts in Supply and Demand n Short-Run Versus Long-Run n Understanding and Predicting the Effects of Changing Market Conditions

Introduction n Applications of Supply and Demand Analysis Understanding and predicting how world economic conditions affect market price Analyzing the impact of price controls Analyzing the impact of production incentives on price and output Analyzing the impact of taxation, subsidies, and import restrictions on prices and output

The Market Mechanism n Supply Measures how much producers are willing to sell for each price This price-quantity relationship can be shown by the equation:

The Supply and Demand Model Quantity Price ($ per unit) Vertical axis measures price (P) received per unit in dollars Horizontal axis measures quantity (Q) supplied in number of units per time period

The Supply and Demand Model Quantity S The supply curve slopes upward demonstrating that at higher prices firms will increase output Price ($ per unit)

The Market Mechanism n Demand Measures how much consumers are willing to buy for each price per unit. This price-quantity relationship can be shown by the equation:

The Supply and Demand Model Quantity Vertical axis measures price (P) paid per unit in dollars Horizontal axis measures quantity (Q) demanded in number of units per time period Price ($ per unit)

The Supply and Demand Model Quantity D The demand curve slopes downward demonstrating that consumers are willing to buy more at a lower price as the product becomes relatively cheaper and the consumer’s real income increases. Price ($ per unit)

The Supply and Demand Model Quantity Price ($ per unit)

The Supply and Demand Model Quantity D The curves intersect at equilibrium, or market- clearing, price. At P 0 the quantity supplied is equal to the quantity demanded at Q 0. S P0P0 Q0Q0 Price ($ per unit)

The Market Mechanism n Characteristics of the equilibrium price: Q D = Q S No shortage No excess supply No pressure on the price to change

The Supply and Demand Model Quantity D If price is above equilibrium: 1) Price is above the market clearing price 2) Q s > Q d 3) Price falls to the market-clearing price S P0P0 Q0Q0 P1P1 Surplus Price ($ per unit)

Example: The Supply and Demand Model Quantity D Assume the price is P 1, then: 1) Q s : Q 2 > Q d : Q 1 2) Excess supply is Q 1 :Q 2. 3) Producers lower price. 4) Quantity supplied decreases and quantity demanded increases. S Q1Q1 P1P1 Surplus Q2Q2 Price ($ per unit)

Example: The Supply and Demand Model Quantity D S Q0Q0 P0P0 Price ($ per unit)

The Supply and Demand Model Quantity Price ($ per unit D If price is below equilibrium: 1) Price is below the market clearing price 2) Q d > Q s 3) Price rises to the market-clearing price S P0P0 Q0Q0 P2P2 Shortage

Example: The Supply and Demand Model Quantity D S Q1Q1 Q2Q2 P2P2 Assume the price is P 1, then: 1) Q d : Q 2 > Q s : Q 1 2) Shortage is Q 1 :Q 2. 3) Producers raise price. 4) Quantity supplied increases and quantity demanded decreases. Price ($ per unit) Shortage

Example: The Supply and Demand Model Quantity D S Q0Q0 P0P0 Price ($ per unit)

Shifts in Supply and Demand n Equilibrium prices are determined by the relative level of supply and demand. n Supply and demand are determined by particular values of supply and demand determining variables. n Changes in any one or combination of these variables can cause a change in the equilibrium price and/or quantity.

Shifts in Supply and Demand n Non-price Determining Variables of Supply Costs of Production – Labor – Capital – Raw Materials

Shifts in Supply and Demand n Non-price Determining Variables of Demand Income Consumer Tastes Price of Related Goods

Example: The Price of Eggs n The real price of eggs fell 68% from 1970 to n Supply increased due to the increased mechanization of poultry farming and the reduced cost of production. n Demand decreased due to the increasing consumer concern over the health and cholesterol consequences of eating eggs.

Market for Eggs Q (million dozens) P ( 1970 dollars per dozen) D 1970 S 1970 $0.61 5,300

Market for Eggs Q (million dozens) P ( 1970 dollars per dozen) D 1970 S 1970 $0.61 5,300 D 1995

Market for Eggs Q (million dozens) P ( 1970 dollars per dozen) D 1970 S 1970 $0.61 5,300 D 1995 S 1995 $0.24 5,100 Prices fell until a new equilibrium was reached at $0.24 and a quantity of 5,100 million dozen

Example: Upheaval in the World Oil Market n We can predict numerically the impact of a decrease in the supply of OPEC oil. n In 1995: P* = $18/barrel World demand and total supply = 23 bb/yr. OPEC supply = 10 bb/yr. Non-OPEC supply = 13 bb/yr

Example: Upheaval in the World Oil Market n Short-Run Impact of a stoppage Saudi Production equal to 3 bb/yr. Short-run Demand D = P Short-run Competitive Supply S C = P

Example: Upheaval in the World Oil Market n Short-Run Impact of a stoppage Saudi Production equal to 3 bb/yr. Short-run Total Supply--before supply reduction S T = P Short-run Total Supply--after supply reduction S T = P Setting D=S T and solving for P, P = ( )/ ( )=$18

Example: Upheaval in the World Oil Market n New Price After Reduction P = P P = (24.08 – 18.74) = ( )

Quantity (billions barrels/yr) P rice ($ per barrel) 5 D Impact of Saudi Production Cut STST DSCSC Short-Run Effect

Impact of Saudi Production Cut Quantity (billions barrels/yr) P rice ($ per barrel) STST 5 D If Saudi Arabia was to stop producing oil, supply curve shifts to the left by 3 bb/yr and equilibrium price rises to $41/barrel. DS’ T 41 SCSC

Example: Upheaval in the World Oil Market n Long-Run Impact of a stoppage Saudi Production equal to 3 bb/yr.. Long-run Demand D = P Long-run Total Supply S = P

Example: Upheaval in the World Oil Market n New Price is found setting long-run supply equal to long-run demand: P = P P = (32.18 – 14.78) = ( )

Quantity (billions barrels/yr) P rice ($ per barrel) 5 D Impact of Saudi Production Cut STST D SCSC Long-Run Effect

Quantity (billions barrels/yr) P rice ($ per barrel) 5 D Impact of Saudi Production Cut STST D SCSC Due to the elasticity of the long-run supply and demand curves, the long-run effect of a cut in production is much less. S’ T

Summary n Supply-demand analysis is a basic tool of microeconomics. n The market mechanism is the tendency for supply and demand to equilibrate, so that there is neither excess demand nor excess supply

Summary n The responsiveness of supply and demand to changes in price, income, and other variables pertains to a time frame, i.e., long run v. short run. n If we can estimate the supply and demand curves for a particular market, we can calculate the market clearing price.

Summary n Simple numerical analysis can often be done by fitting linear supply and demand curves to data on price and quantity.