Chapter Two Supply and Demand

Chapter 1 Concepts and Related Concepts  Definition of Economics  Microeconomics versus Macroeconomics  Positive versus Normative Economics  Mainstream Neoclassical Economics © 2009 Pearson Addison-Wesley. All rights reserved. 2-2

© 2009 Pearson Addison-Wesley. All rights reserved. 2-3 Chapter 2 Outline 1.Demand. 2.Supply. 3.Market Equilibrium. 4.Shocking the Equilibrium. 5.Effects of Government Interventions. 6.When to Use the Supply-and- Demand Model.

© 2009 Pearson Addison-Wesley. All rights reserved. 2-4 Demand: determinants of demand.  The following factors determine the demand for a good:  Price of the good  Tastes  Information  Prices of related goods  Complements and substitutes  Income  Government rules and regulations  Other

© 2009 Pearson Addison-Wesley. All rights reserved. 2-5 Demand: the demand curve  Quantity demanded - the amount of a good that consumers are willing to buy at a given price, holding constant the other factors that influence purchases.  Demand curve - the quantity demanded at each possible price, holding constant the other factors that influence purchases

© 2009 Pearson Addison-Wesley. All rights reserved. 2-6 Figure 2.1 A Demand Curve Law of Demand consumers demand more of a good the lower its price, holding constant all other factors that influence consumption p, $ per kg Demand curve for pork, D Q, Million kg of pork per year

© 2009 Pearson Addison-Wesley. All rights reserved. 2-7 Figure 2.2 A Shift of the Demand Curve p, $ per kg Effect of a 60¢ increase in the price of beef D1D1 D2D2 232 Q, Million kg of pork per year

© 2009 Pearson Addison-Wesley. All rights reserved. 2-8 The Demand Function  The processed pork demand function is: Q = D(p, p b, p c, Y)  where Q is the quantity of pork demanded (millions of kg)  p is the price of pork (dollars per kg)  p b is the price of beef (dollars per kg)  p c is the price of chicken (dollars per kg)  Y is the income of consumers (thousand dollars)

© 2009 Pearson Addison-Wesley. All rights reserved. 2-9 From the Demand Function to the Demand Curve  Estimated demand function for pork: Q = 171−20p + 20p b + 3p c + 2Y  Using the values p b = 4, p c = 3.33 and Y = 12.5, we have (direct demand) Q = 286−20p  which is the linear demand function for pork.

© 2009 Pearson Addison-Wesley. All rights reserved From the Demand Function to the Demand Curve If p = 0, then Q = 286 p, $ per kg Demand curvefor pork,D Q, Million kg of pork peryear Q = 286−20p If p increases by $1 (to $4.30) then, Q = 200 If p decreases by $1 (to $2.30) then, Q = 240 In general,  Q = -20  p If p = $3.30 then, Q = 220 Demand curve or inverse demand P = (286/20) – (1/20)Q

© 2009 Pearson Addison-Wesley. All rights reserved Solved Problem 2.1  How much would the price have to fall for consumers to be willing to buy 1 million more kg of pork per year?

© 2009 Pearson Addison-Wesley. All rights reserved Solved Problem 2.1: Answer Express the price that consumers are willing to pay as a function of quantity. Q = 286−20p 20p = Q p = − 0.05Q ∆p = -.05∆Q

© 2009 Pearson Addison-Wesley. All rights reserved From the Demand Function to the Demand Curve p, $ per kg Demand curvefor pork,D Q, Million kg of pork peryear Q = 286−20p p = − 0.05Q

© 2009 Pearson Addison-Wesley. All rights reserved Solved Problem 2.1: Answer 2.Use the inverse demand curve to determine how much the price must change for consumers to buy 1 million more kg of pork per year. Δp = (14.30 − 0.05Q2) − (14.30 − 0.05Q1) = –0.05(Q2 − Q1) = –0.05ΔQ.  The change in quantity is Δ Q = Q2 − Q1 = (Q1 + 1)−Q1 = 1, so the change in price is Δ p = –0.05.

Demand Function © 2007 Pearson Addison-Wesley. All rights reserved. 2–15

Inverse Demand Function (Demand Curve)  How much consumers are willing to buy as a function of price © 2007 Pearson Addison-Wesley. All rights reserved. 2–16

Terminology  Demand function  The quantity demanded as a function of the important independent variables  Direct demand  The quantity demanded as solely a function of price given the values of the independent variables  Demand curve  The inverse of direct demand  The values of the independent variables are given © 2009 Pearson Addison-Wesley. All rights reserved. 2-17

The price of beef increases from $4.00 to $5.50.  Given Q = 171 – 20p + 20p b + 3 p c + 2Y  How does the demand curve shift and what is the magnitude of the shift?  ∆Q/ ∆p b = 20  ∆Q = 20 ∆p b = 20*1.50 = 30  ∆Q is equal to the horizontal shift in the demand curve © 2007 Pearson Addison-Wesley. All rights reserved. 2–18

© 2009 Pearson Addison-Wesley. All rights reserved A Shift of the Demand Curve p, $ per kg Effect of a $1.50 increase in the price of beef D1D1 D2D2 250 Q, Million kg of pork per year

The price of beef increases from $4.00 to $5.50. © 2009 Pearson Addison-Wesley. All rights reserved What is the equation for the new demand curve?

Market Demand © 2007 Pearson Addison-Wesley. All rights reserved. 2–21 Market Demand is the horizontal sum of the individual demand curves

© 2009 Pearson Addison-Wesley. All rights reserved Application: Aggregating the Demand for Broadband Service

Horizontally summing demand curves © 2007 Pearson Addison-Wesley. All rights reserved. 2–23

Market Demand © 2009 Pearson Addison-Wesley. All rights reserved. 2-24

© 2009 Pearson Addison-Wesley. All rights reserved Supply: determinants of supply.  The following factors determine the supply for a good:  Price of the good  Costs  Government rules and regulations

© 2009 Pearson Addison-Wesley. All rights reserved Supply: the demand curve  Quantity supplied - the amount of a good that firms want to sell at a given price, holding constant other factors that influence firms’ supply decisions, such as costs and government actions  Supply curve - the quantity supplied at each possible price, holding constant the other factors that influence firms’ supply decisions

© 2009 Pearson Addison-Wesley. All rights reserved Figure 2.3 A Supply Curve p, $ per kg Supply curve,S Q, Million kg of pork peryear An increase in the price… causes a movement along the curve…. and a decrease in the quantity supplied….

© 2009 Pearson Addison-Wesley. All rights reserved Figure 2.4 A Shift of a Supply Curve p, $ per kg S 1 S2S2 220 Q, Million kg of pork peryear A $0.25 increase in the price of hogs….. shifts the supply curve to the left reducing the quantity supplied at the previous price.

© 2009 Pearson Addison-Wesley. All rights reserved The Supply Function  The processed pork supply function is: Q = S(p, p h )  where Q is the quantity of pork supplied  p is the price of pork (dollars per kg)  p h is the price of a hog (dollars per kg)

© 2009 Pearson Addison-Wesley. All rights reserved From the Supply Function to the Supply Curve  Estimated demand function for pork: Q = p−60p h  Using the values p h = $1.50 per kg Q = p.  What happens to the quantity supplied if the price of processed pork increases by Δp = p2−p1?

Supply Function © 2007 Pearson Addison-Wesley. All rights reserved. 2–31

© 2009 Pearson Addison-Wesley. All rights reserved Figure 2.5 Total Supply: The Sum of Domestic and Foreign Supply

© 2009 Pearson Addison-Wesley. All rights reserved Solved Problem 2.2  How does a quota set by the United States on foreign steel imports of Q affect the total American supply curve for steel given the domestic supply, S d in panel a of the graph, and foreign supply, S f in panel b?

© 2009 Pearson Addison-Wesley. All rights reserved Solved Problem 2.2

© 2009 Pearson Addison-Wesley. All rights reserved Market Equilibrium  Equilibrium - a situation in which no one wants to change his or her behavior.  excess demand the amount by which the quantity demanded exceeds the quantity supplied at a specified price.  excess supply the amount by which the quantity supplied is greater than the quantity demanded at a specified price

© 2009 Pearson Addison-Wesley. All rights reserved Figure 2.6 Market Equilibrium p, $ per kg D S e Q, Million kg of pork peryear Excess supply = 39 Excess demand = 39 Market equilibrium point! At a price below equilibrium…. the quantity supplied…. is below the quantity demanded At a price above equilibrium…. the quantity demanded…. is below the quantity supplied

© 2009 Pearson Addison-Wesley. All rights reserved Using Math to Determine the Equilibrium  Demand: Q d = 286 − 20p  Supply: Q s = p  Equilibrium: Q d = Q s 286 − 20p = p 60p = 198 P = $3.30 Q = 286 – 20(3.3) = 220

© 2009 Pearson Addison-Wesley. All rights reserved Equilibrium: Practice Problem  The demand function for a good is Q = a−bp, and the supply function is Q = c + ep, where a, b, c, and e are positive constants. Solve for the equilibrium price and quantity in terms of these four constants.

Market Equilibrium © 2007 Pearson Addison-Wesley. All rights reserved. 2–39

© 2009 Pearson Addison-Wesley. All rights reserved Shocking the Equilibrium The equilibrium changes only if a shock occurs that shifts the demand curve or the supply curve. These curves shift if one of the variables we were holding constant changes.

© 2009 Pearson Addison-Wesley. All rights reserved Figure 2.7a Equilibrium Effects of a Shift of a Demand Curve D 1 D2D2 S Q, Million kg of pork per year Excess demand = e2e2 e 1 p, $ per kg A $0.60 increase in the price of beef shifts the demand outward At the original price there is now an excess demand…. Which puts an upward pressure in the price to a new equilibrium.

© 2009 Pearson Addison-Wesley. All rights reserved Figure 2.7b Equilibrium Effects of a Shift of a Supply Curve S 1 S2S2 Q, Million kg of pork per year e 1 e2e2 D p, $ per kg Excess demand = 15 A $0.25 increase in the price of hogs shifts the supply curve to the left At the original price there is now an excess demand…. Which puts an upward pressure in the price to a new equilibrium.

© 2009 Pearson Addison-Wesley. All rights reserved Solved Problem 2.3  Mathematically, how does the equilibrium price of pork vary as the price of hogs changes if the variables that affect demand are held constant at their typical values?

© 2009 Pearson Addison-Wesley. All rights reserved Solved Problem 2.3: Solution 1.Solve for the equilibrium price of pork in terms of the price of hogs. Qd = 286−20p Qs = p−60p h 286−20p = p−60p h 60p = p h p = p h 2.Show how the equilibrium price of pork varies with the price of hogs.  Since Δp = Δp h, any increase in the price of hogs causes an equal increase in the price of processed pork.

© 2009 Pearson Addison-Wesley. All rights reserved Solved Problem 2.4 – Mad Cow Disease  There is an outbreak of mad cow disease in the U.S. Japan bans imports of U.S. beef  In the first few weeks after the U.S. ban, the quantity of beef sold in Japan fell substantially, and the price rose. In contrast, three weeks after the first discovery, the U.S. price in January 2004 fell by about 15% and the quantity sold increased by 43% over the last week in October Use supply-and-demand diagrams to explain why these events occurred.

© 2009 Pearson Addison-Wesley. All rights reserved Figure 2.5 Total Supply: The Sum of Domestic and Foreign Supply

© 2009 Pearson Addison-Wesley. All rights reserved Figure 2.8 A Ban on Rice Imports Raises the Price in Japan p, P r ice of r ice per pound Q2Q2 Q 1 S (no ban) D Q,Tons ofrice peryear p2p2 e2e2 e 1 p 1 S (ban) – A ban on rice imports shifts the total supply of rice in Japan… which causes the equilibrium to change and the price to increase.

© 2009 Pearson Addison-Wesley. All rights reserved Solved Problem 2.4 Decrease in supply Increase in supply and decrease in demand

© 2009 Pearson Addison-Wesley. All rights reserved Solved Problem 2.5  What is the effect of a United States quota on steel on the equilibrium in the U.S. steel market? Hint: The answer depends on whether the quota binds (is low enough to affect the equilibrium).

© 2009 Pearson Addison-Wesley. All rights reserved Solved Problem 2.2

© 2009 Pearson Addison-Wesley. All rights reserved Solved Problem 2.5

© 2009 Pearson Addison-Wesley. All rights reserved Figure 2.9 Price Ceiling on Gasoline p, $ per gallon QsQs Q 1 = Q d Price ceiling S 1 D S2S2 Q, Gallons of gasoline per month Excess demand e 1 p1p1 = p – Supply shifts to the left…. p1p1 but gas stations must continue to charge a price of P 1 ….. which creates an excess demand.

© 2009 Pearson Addison-Wesley. All rights reserved Figure 2.10 Minimum Wage

Solve for Excess Demand or Supply  Simply insert price into demand and supply functions © 2009 Pearson Addison-Wesley. All rights reserved. 2-54

2-55 Demand Shifts (Supply Constant)

2-56 Supply Shifts (Demand Constant)

2-57 Simultaneous Shifts  When demand & supply shift simultaneously  Can predict either the direction in which price changes or the direction in which quantity changes, but not both  The change in equilibrium price or quantity is said to be indeterminate when the direction of change depends on the relative magnitudes by which demand & supply shift

2-58 S D’ S’’ S’ D Simultaneous Shifts: (  D,  S) Q Price may rise or fall; Quantity rises P A Q P B P’ Q’ Q’’ C P’’

2-59 D Simultaneous Shifts: (  D,  S) S D’ S’’ S’ Q Price falls; Quantity may rise or fall P A Q P B P’ Q’ Q’’ C P’’

2-60 S’’ Simultaneous Shifts: (  D,  S) D S D’ S’ Q Price rises; Quantity may rise or fall P A Q P B P’ Q’ Q’’ C P’’

2-61 Simultaneous Shifts: (  D,  S) S’’ D S D’ S’ Q Price may rise or fall; Quantity falls P A Q P B P’ Q’ Q’’ C P’’

© 2009 Pearson Addison-Wesley. All rights reserved Why Supply Need Not Equal Demand  The quantity that firms want to sell and the quantity that consumers want to buy at a given price need not equal the actual quantity that is bought and sold.  Example: price ceiling.

© 2009 Pearson Addison-Wesley. All rights reserved Perfectly competitive markets  Everyone is a price taker.  Firms sell identical products.  Everyone has full information about the price and quality of goods.  Costs of trading are low.

© 2009 Pearson Addison-Wesley. All rights reserved Figure 2A.1 Regression