CHAPTER 4: Demand and Supply Analysis

CHAPTER CHECKLIST 1.Distinguish between quantity demanded and demand and explain what determines demand. 2.Distinguish between quantity supplied and supply and explain what determines supply. 3.Explain how demand and supply determine price and quantity in a market and explain the effects of changes in demand and supply. 4.Explain how price ceilings, price floors, and sticky prices cause shortages, surpluses, and unemployment.

LECTURE TOPICS  Demand  Supply  Market Equilibrium  Price Rigidities

MARKETS A market is any arrangement that bring buyers and sellers together.

In this chapter, we study a simple model of a market: a market that has so many buyers, all small relative to the size of the market, and so many sellers, all small relative to the size of the market, that no individual buyer or seller can influence the price by their individual actions. This is called a “perfectly competitive market.” MARKETS

4.1 DEMAND Quantity demanded The amount of a good, service, or resource that people are willing and able to buy during a specified period at a specified price. The quantity demanded is an amount per unit of time. For example, the amount per day or per month. How much people want to buy, given the price.

4.1 DEMAND  The Law of Demand Other things remaining the same, [“ceteris paribus”] If the price of a good rises, the quantity demanded of that good decreases. If the price of a good falls, the quantity demanded of that good increases. I.e., if something becomes more expensive, people want to buy less of it; if it becomes cheaper, people want to buy more of it.

4.1 DEMAND  Demand Schedule and Demand Curve Demand The relationship between the quantity demanded and the price of a good when all other influences on buying plans remain the same. Demand is a list of quantities at different prices and is illustrated by the demand curve. “Demand” means all the amounts people will want to buy at all possible different prices, everything else unchanged; it is the relationship between price and how much people want to buy.

4.1 DEMAND Demand schedule A list of the quantities demanded at each different price when all the other influences on buying plans remain the same. Demand curve A graph of the relationship between the quantity demanded of a good and its price when all other influences on buying plans remain the same; i.e. the graph of the good’s own-price and how much people want to buy at each own-price.

4.1 DEMAND

Economists have their own traditions ….  It is usual to draw graphs with the dependent variable on the y (vertical) axis and the independent variable on the x (horizontal) axis  Economics does it the other way round in demand and supply diagrams -- own-price determines the amount buyers want to buy, but own-price is on the vertical [y] axis.

Why?  Economists started drawing [and publishing in books] supply and demand diagrams in the 19th century, before the standard y = f(x) convention was strongly established  The standard supply and demand diagrams are so firmly established, nobody dares try to change them to conform to what is standard in math, science, and engineering

4.1 DEMAND  Changes in Demand Change in the quantity demanded A change in the quantity of a good that people plan to buy that results from a change in the price of the good. Change in demand A change in the quantities that people plan to buy [at various prices] when any influence other than the own- price of the good changes. In other words, a shift or change in the relationship between the price of the good and how much of it people want to buy.

4.1 DEMAND 1.When demand decreases, the demand curve shifts leftward from D 0 to D 1. 2.When demand increases, the demand curve shifts rightward from D 0 to D 2. When demand changes, the demand curve shifts.

4.1 DEMAND The main influences on buying plans that change demand are: Prices of related goods Income Expectations Number of buyers Preferences

Make a Mnemonic to remember:  Economists use “Y” for income a lot; so  Prices of related goods  Y -- income of [potential] buyers  Number of [potential] buyers  Tastes [preferences] of [potential] buyers  Expectations about the future

4.1 DEMAND Prices of Related Goods Substitute A good that can be consumed in place of another good. For example, apples and oranges. The demand for a good increases, if the price of one of its substitutes rises. The demand for a good decreases, if the price of one of its substitutes falls.

4.1 DEMAND Complement A good that is consumed with another good. For example, ice cream and fudge sauce. The demand for a good increases, if the price of one of its complements falls. The demand for a good decreases, if the price of one of its complements rises.

4.1 DEMAND Income The demand for a normal good increases if income increases. The demand for an inferior good decreases if income increases.

4.1 DEMAND Expectations Expected future income and expected future prices influence demand today. For example, if the price of a computer is expected to fall next month, the demand for computers today decreases. Number of Buyers The greater the number of buyers in a market, the larger is the demand for any good.

4.1 DEMAND Preferences When preferences change, the demand for one item increases and the demand for another item (or items) decreases. Preferences change when: People become better informed, or new information becomes available. New goods become available. Fashions [opinions] shift for some reason. Advertisers succeed in influencing tastes.

4.1 DEMAND  Demand: A Summary

4.2 SUPPLY Quantity supplied The amount of a good, service, or resource that people are willing and able to sell during a specified period at a specified price – how much people want to sell at the given price. The Law of Supply Other things remaining the same, If the price of a good rises, the quantity supplied of that good increases. When price rises, people will want to sell more. If the price of a good falls, the quantity supplied of that good decreases. If the good’s price falls, people will want to sell less.

4.2 SUPPLY  Supply Schedule and Supply Curve Supply The relationship between the quantity supplied of a good and the price of the good when all other influences on selling plans remain the same. Supply is a list of quantities at different prices and is illustrated by the supply curve, just like demand and the demand curve.

4.2 SUPPLY Supply schedule A list of the quantities supplied at each different price when all other influences on selling plans remains the same. Supply curve A graph of the relationship between the quantity supplied and the good’s own-price when all other influences on selling plans remain the same. As with demand, this is the relationship between the amounts sellers will want to sell and the price of the good, other things constant.

4.2 SUPPLY

 Changes in Supply Change in quantity supplied A change in the quantity of a good that suppliers plan to sell that results from a change in the price of the good. Change in supply A change in the quantities that suppliers plan to sell at all different prices when any influence on selling plans other than the own-price of the good changes; i.e. a change in the relationship between own-price and how much sellers want to sell caused by some change in something other than the good’s price.

4.2 SUPPLY 2.When supply increases, the supply curve shifts rightward from S 0 to S 2. 1.When supply decreases, the supply curve shifts leftward from S 0 to S 1. When supply changes, the supply curve shifts. 4.2 SUPPLY

The main influences on selling plans that change supply are: Prices of related goods Prices of resources and other Inputs Expectations Number of sellers Productivity

Things that shift supply..  Prices of inputs used to make the good and of related outputs;  Expectations about future prices  Supplier numbers  Technology

4.2 SUPPLY Prices of Related Goods A change in the price of one good can bring a change in the supply of another good. Substitute in production A good that can be produced in place of another good. For example, a truck and an SUV in an auto factory. The supply of a good increases if the price of one of its substitutes in production falls. The supply a good decreases if the price of one of its substitutes in production rises.

4.2 SUPPLY Complement in production A good that is produced along with another good. For example, straw is a complement in production of wheat. Manufacturing examples are hard to find except in things like metal-refining. The supply of a good increases if the price of one of its complements in production rises. The supply a good decreases if the price of one of its complements in production falls.

4.2 SUPPLY Prices of Resources and Other Inputs Resource and input prices influence the cost of production. And the more it costs to produce a good, the smaller will be supply of that good. Expectations Expectations about future prices influence supply. Expectations of future input prices also influence supply.

4.2 SUPPLY Number of Sellers The greater the number of sellers in a market, the larger is supply. Productivity Productivity is output per unit of input. An increase in productivity lowers costs and increases supply.

4.2 SUPPLY  Supply: A Summary

Supply and Market Structure  Remember, we ONLY talked about markets where there are many suppliers, all small compared to the market  With other market structures, there may not be a ‘supply curve’ in a meaningful sense; ECO 2023 will deal with those cases

4.3 MARKET EQUILIBRIUM Market equilibrium When the quantity demanded equals the quantity supplied—when buyers’ and sellers’ plans are consistent. Equilibrium price The price at which the quantity demanded equals the quantity supplied. Equilibrium quantity The quantity bought and sold at the equilibrium price.

4.3 MARKET EQUILIBRIUM Figure 4.5 shows the equilibrium price and equilibrium quantity. 1. Market equilibrium is at the intersection of the demand curve and the supply curve. 2. The equilibrium price is $1 a bottle. 3. The equilibrium quantity is 10 million bottles a day.

4.3 MARKET EQUILIBRIUM  Price: A Market’s Automatic Regulator Law of market forces When there is a shortage, the price tends to rise. When there is a surplus, the price tends to fall. Surplus or Excess Supply The quantity supplied exceeds the quantity demanded. Shortage or Excess Demand The quantity demanded exceeds the quantity supplied.

4.3 MARKET EQUILIBRIUM Figure 4.6(a) market achieves equilibrium. At $1.50 a bottle: 1. Quantity supplied is 11 bottles. 3. There is a surplus. 4. Price falls until the market is in equilibrium. 2. Quantity demanded is 9 bottles.

4.3 MARKET EQUILIBRIUM Figure 4.6(b) market achieves equilibrium. At 75 cents a bottle: 5. Quantity demanded is 11 bottles. 7. There is a shortage. 8. Price rises until the market is in equilibrium. 6. Quantity supplied is 9 bottles.

4.3 MARKET EQUILIBRIUM Figure 4.7(a) shows the effects of an increase in demand. 1. An increase in demand shifts the demand curve rightward. 2. The price rises to restore market equilibrium. 3. Quantity supplied increases along the supply curve. 4. Equilibrium quantity increases.

4.3 MARKET EQUILIBRIUM Figure 4.7(b) shows the effects of a decrease in demand. 1. A decrease in demand shifts the demand curve leftward. 2. The price falls to restore market equilibrium. 3. Quantity supplied decreases along the supply curve. 4. Equilibrium quantity decreases.

4.3 MARKET EQUILIBRIUM  Effects of Changes in Demand When demand changes: The supply curve does not shift. But there is a change in the quantity supplied – sellers change how much they want to sell, because price changes. Price and quantity change in the same direction as the change in demand.

4.3 MARKET EQUILIBRIUM Figure 4.8(a) shows the effects of an increase in supply. 1. An increase in supply shifts the supply curve rightward. 2. The price falls to restore market equilibrium. 3. Quantity demanded increases along the supply curve. 4. Equilibrium quantity increases.

4.3 MARKET EQUILIBRIUM Figure 4.8(b) shows the effects of a decrease in supply. 1. A decrease in supply shifts the supply curve leftward. 2. The price rises to restore market equilibrium. 3. Quantity demanded decreases along the supply curve. 4. Equilibrium quantity decreases.

4.3 MARKET EQUILIBRIUM  Effects of Changes in Supply When supply changes: The demand curve does not shift. But there is a change in the quantity demanded – buyers change how much they want to buy, because the price changes. Price changes in the same direction as the change in supply. Quantity changes in the opposite direction to the change in supply.

4.3 MARKET EQUILIBRIUM Figure 4.9(a) shows the effects of an increase in both demand and supply. An increase in demand shifts the demand curve rightward and an increase in supply shifts the supply curve rightward. 1. Quantity increases. 2. Price might rise or fall.

4.3 MARKET EQUILIBRIUM Increase in Both Demand and Supply Increases the equilibrium quantity. The change in the equilibrium price is ambiguous because the: Increase in demand raises the price. Increase in supply lowers the price.

4.3 MARKET EQUILIBRIUM Figure 4.9(b) shows the effects of a decrease in both demand and supply. A decrease in demand shifts the demand curve leftward and a decrease in supply shifts the supply curve leftward. 3. Quantity decreases. 4. Price might rise or fall.

4.3 MARKET EQUILIBRIUM Decrease in Both Demand and Supply Decreases the equilibrium quantity. The change in the equilibrium price is ambiguous because the: Decrease in demand lowers the price Decrease in supply raises the price.

4.3 MARKET EQUILIBRIUM Figure 4.10(a) shows the effects of an increase in demand and a decrease in supply. An increase in demand shifts the demand curve rightward, and a decrease in supply shifts the supply curve leftward. 1. Price rises. 2. Quantity might increase, decrease, or not change.

4.3 MARKET EQUILIBRIUM Increase in Demand and Decrease in Supply Raises the equilibrium price. The change in the equilibrium quantity is ambiguous because the: Increase in demand increases the quantity. Decrease in supply decreases the quantity.

4.3 MARKET EQUILIBRIUM Figure 4.10(b) shows the effects of a decrease in demand and an increase in supply. A decrease in demand shifts the demand curve leftward, and an increase in supply shifts the supply curve rightward. 3. Price falls. 2. Quantity might increase, decrease, or not change.

4.3 MARKET EQUILIBRIUM Decrease in Demand and Increase in Supply Lowers the equilibrium price. The change in the equilibrium quantity is ambiguous because the: Decrease in demand decreases the quantity. Increase in supply increases the quantity.

Kinds of Equilibrium

Market Equilibrium  One of the neat things about the market is that the Demand and Supply model shows that market equilibrium is generally stable  I.e., it is like  If the ball moves a little, it will go back where it started; if conditions don’t change, but price is perturbed [moved] a little from equilibrium, it will go back where it started.

4.4 PRICE RIGIDITIES Price adjustments bring market equilibrium. But sometimes prices do not adjust. What happens then? Three reasons why price adjustment might not occur are: Price ceiling Price floor Sticky price

4.4 PRICE RIGIDITIES  Price Ceiling Price Ceiling The highest price at which it is legal to trade a particular good, service, or factor of production. Rent Ceiling A law that makes it illegal for landlords to charge a rent that exceeds a set limit.

Figure 4.11 shows a rental apartment market. 1. Market equilibrium is determined by demand and supply. 2. The equilibrium rent is $550 a month. 3. The equilibrium quantity is 4,000 apartments. 4.4 PRICE RIGIDITIES

Figure 4.12 shows a rental apartment market. The rent ceiling is introduced below the equilibrium rent at $400 a month. The quantity for apartments demanded increases to 6,000. The quantity of apartments supplied decreases to 3,000. There is a shortage of 4,000 apartments. 4.4 PRICE RIDIGITIES

4.4 PRICE RIGIDITIES  Price Floor Price floor The lowest price at which it is legal to trade a particular good, service, or factor of production. Minimum wage law A government regulation that makes hiring labor for less than a specified wage illegal.

Figure 4.13 shows a market for fast food servers. 1. Market equilibrium is determined by demand and supply. 2. The equilibrium wage rate is $5 an hour. 3. The equilibrium quantity is 5,000 servers. 4.4 PRICE RIGIDITIES

Figure 4.14 shows how a minimum wage creates unemployment. The minimum wage rate is set at $7 an hour. 1. The quantity demanded decreases to 3,000 workers. 2. The quantity supplied increases to 7,000 workers. 3. A surplus of workers occurs and 4,000 are unemployed. 4.4 PRICE RIGIDITIES

 Sticky Price In most markets, a law does not restrict the price. But in some markets, either the buyer and seller agree on a price for a fixed period or the seller sets a price that changes infrequently. In these markets, prices adjust slowly and not quickly enough to avoid shortages and surpluses.

Methodology  How to use Demand and Supply:  Identify the Ceteris Paribus variable(s) that changed.  Shift the Demand and/or Supply curve.  Find the new Equilibrium.  Make your prediction.  It will be qualitative – direction of change, not how much.