CHAPTER 3 Demand, supply and the market ©McGraw-Hill Education, 2014

Market : a set of arrangements by which buyers and sellers are in contact to exchange goods or services Demand : the quantity of a good buyers wish to purchase at each conceivable price Supply : the quantity of a good sellers wish to sell at each conceivable price Equilibrium price : price at which quantity supplied = quantity demanded. Key concepts in the study of markets ©McGraw-Hill Education, 2014

Quantity Price S The supply curve shows the relation between price and quantity demanded holding other things constant Other things include: Technology Input costs Government regulations Business expectations ©McGraw-Hill Education, 2014

Market equilibrium Quantity Price Market equilibrium is at E 0 where quantity demanded equals quantity supplied. The equilibrium price is P 0 and quantity Q 0 S E0E0 P0P0 Q0Q0 D ©McGraw-Hill Education, 2014

Behind the demand curve It is important to distinguish between movements (or shifts) in the demand curve and movements along the demand curve. Movements along the demand curve result from changes in the price of the good itself. ©McGraw-Hill Education, 2014

Movements along the demand curve A P0P0 Q0Q0 Quantity Price D B P1P1 Q1Q1 A movement along the demand curve from A to B occurs when price falls Here all other determinants of demand remain constant. ©McGraw-Hill Education, 2014

Behind the demand curve Movements (or shifts) in the demand curves are caused by  Changes in the price of related goods – either substitutes or complements  Changes in consumer incomes  Changes in tastes  Expectations over future price changes. ©McGraw-Hill Education, 2014

Income changes and demand The influence of changes in income on demand depends on whether the good is  a normal good or  an inferior good. ©McGraw-Hill Education, 2014

B A C F Q2Q2 Q3Q3 Movements of or shifts in the demand curve P0P0 Q0Q0 Q1Q1 Quantity Price P1P1 A movement (or shift) of the demand curve from D 0 to D 1 leads to an increase in demand at each and every price e.g., at P 0 quantity demanded increases from Q 0 to Q 2 : at P 1 quantity demanded increases from Q 1 to Q 3 ©McGraw-Hill Education, 2014

E0E0 Q0Q0 P0P0 A shift in demand E1E1 Price Quantity If the price of a substitute good decreases, then less will be demanded at each price. D0D0 D0D0 The demand curve shifts from D 0 D 0 to D 1 D 1. D1D1 D1D1 Q1Q1 P1P1 If price stayed at P 0 the resultant glut would put downward pressure on the price. Demand would rise and supply fall until equilibrium is restored at E 1. ©McGraw-Hill Education, 2014

Behind the supply curve (1) It is important to distinguish between movements (or shifts) in the supply curve and movements along the supply curve. Movements along the supply curve result from changes in the price of the good itself. ©McGraw-Hill Education, 2014

Behind the supply curve (2) Movements (or shifts) in the supply curves are caused by  Changes in technology  Changes in input costs  Changes in government regulations  Business expectations ©McGraw-Hill Education, 2014

A shift in supply D Q0Q0 P0P0 E0E0 Price Quantity Suppose safety regulations are tightened, increasing producers’ costs S0S0 S0S0 The supply curve shifts to S 1 S 1 If price stayed at P 0, then there would be excess demand and upward pressure on price. Q1Q1 P1P1 E2E2 Demand would fall and supply increase until market equilibrium is restored. S1S1 D ©McGraw-Hill Education, 2014

Consumer and producer surplus(1) The difference between what a consumer is willing to pay for a good and the price actually paid is a measure of the consumer’s surplus. Total consumer surplus in a market is the sum of all the surpluses enjoyed by all consumers. ©McGraw-Hill Education, 2014

Consumer and producer surplus (2) The difference between the price at which a firm would be willing to supply a good and the price actually received by the firm is a measure of its producer surplus. Total producer surplus in a market is the sum of all the surpluses enjoyed by all producers. ©McGraw-Hill Education, 2014

Consumer and producer surplus (3) Quantity Price P * Q* Consumer surplus Producer surplus For a single consumer, the consumer surplus is the difference between the maximum price that she is willing to pay for a given amount of a good or service and the price she actually pays. The producer surplus for sellers is the amount that sellers benefit by selling at a market price that is higher than they would be willing to sell for. ©McGraw-Hill Education, 2014

Consumer and producer surplus and the gains from trade The economic surplus in a market (sum of consumer and producer surplus) is a measure of the benefits firms and consumers derive from trade. It is maximized at the equilibrium price. Only at this price are all the benefits from exchange exhausted. ©McGraw-Hill Education, 2014

What, how and for whom The market: – decides how much of a good should be produced by finding the price at which the quantity demanded equals the quantity supplied – tells us for whom the goods are produced those consumers willing to pay the equilibrium price – determines what goods are being produced there may be goods for which no consumer is prepared to pay a price at which firms would be willing to supply ©McGraw-Hill Education, 2014

excess demand QSQS Q0Q0 QDQD Quantity Free markets and price controls: a market in disequilibrium Price P0P0 S P1P1 E AB P2P2 S Suppose a disastrous harvest moves the supply curve to SS. The resulting market clearing or equilibrium price is P 0. Government may try to protect the poor, setting a price ceiling at P 1. The result is excess demand. RATIONING is needed to cope with the resulting excess demand. ©McGraw-Hill Education, 2014

Free markets and price controls: a market in disequilibrium Minimum wages are an example of a price floor and can result in unemployment. Rent caps are an example of a price ceiling and can result in shortages in rental markets. ©McGraw-Hill Education, 2014

Exploring the mathematics of demand and supply (1) The demand equation: Q D =a - bP (1) where Q D denotes the quantity demanded, P the price while a and b are two positive constants. The supply equation: Q S =c + dP (2) where Q S s the quantity supplied, while c and d are two constants. We assume that the constant d is positive. ©McGraw-Hill Education, 2014

Exploring the mathematics of demand and supply (2) Market equilibrium is where quantity demanded equals quantity supplied: Q D = Q S P * is the equilibrium price that equates quantity demanded and quantity supplied. ©McGraw-Hill Education, 2014

Uncovering demand and supply curves It is important to understand that demand and supply curves are not physical objects that can be seen or touched. Rather they are relationships revealed through the appropriate use of statistical analyses undertaken by skilled econometricians. ©McGraw-Hill Education, 2014

Uncovering supply and demand We cannot plot ex ante demand curves and supply curves So we use historical data and the supposition that the observed values are equilibrium ones Since other things are often not constant, careful use of statistical techniques is required to isolate the parameters of a demand or supply curve. ©McGraw-Hill Education, 2014

Concluding comments (1) Demand is the quantity that buyers wish to buy at each price. Supply is the quantity of a good sellers wish to sell at each price. The market clears, or is in equilibrium, when the price equates the quantity supplied and the quantity demanded, and there are no shortages or surpluses. An increase in the price of a substitute good (or decrease in the price of a complementary good) will raise the quantity demanded at each price. ©McGraw-Hill Education, 2014

Concluding comments (2) The consumer surplus is measured by the area below the market demand and above the equilibrium price. The producer surplus is measured by the area above the market supply and below the equilibrium price. To be effective, a price ceiling must be imposed below the free market equilibrium price. An effective price floor must be imposed above the free market equilibrium price. ©McGraw-Hill Education, 2014