Chapter 3: Where Prices Come From: The Interaction of Demand and Supply 1 of 42 © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. Perfectly competitive market A market in which 1) there are many buyers and sellers, 2) all the products are identical, and 3) there are no barriers to new sellers entering the market. Where Prices Come From: The Interaction of Demand and Supply

Chapter 3: Where Prices Come From: The Interaction of Demand and Supply 2 of 42 © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. Demand schedule A table showing the relationship between the price of a product and the quantity of the product demanded. Quantity demanded The amount of a good or service that a consumer is willing and able to purchase at a given price. Demand curve A curve that shows the relationship between the price of a product and the quantity of the product demanded. Market demand The demand by all the consumers of a given good or service. The Demand Side of the Market Demand Schedules and Demand Curves Learning Objective 3.1

Chapter 3: Where Prices Come From: The Interaction of Demand and Supply 3 of 42 © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. The Demand Side of the Market Learning Objective 3.1 FIGURE 3-1 A Demand Schedule and Demand Curve Demand Schedules and Demand Curves

Chapter 3: Where Prices Come From: The Interaction of Demand and Supply 4 of 42 © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. The Demand Side of the Market Law of demand The rule that, holding everything else constant, when the price of a product falls, the quantity demanded of the product will increase, and when the price of a product rises, the quantity demanded of the product will decrease. Learning Objective 3.1 What Explains the Law of Demand? Substitution effect The change in the quantity demanded of a good that results from a change in price, making the good more or less expensive relative to other goods that are substitutes. Income effect The change in the quantity demanded of a good that results from the effect of a change in the good’s price on consumers’ purchasing power.

Chapter 3: Where Prices Come From: The Interaction of Demand and Supply 5 of 42 © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. The Demand Side of the Market Ceteris paribus (“all else equal”) The requirement that when analyzing the relationship between two variables—such as price and quantity demanded—other variables must be held constant. A shift of a demand curve is an increase or decrease in demand. A movement along a demand curve is an increase or decrease in the quantity demanded. Learning Objective 3.1 Holding Everything Else Constant: The Ceteris Paribus Condition

Chapter 3: Where Prices Come From: The Interaction of Demand and Supply 6 of 42 © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. The Demand Side of the Market Learning Objective 3.1 FIGURE 3-2 Shifting the Demand Curve Holding Everything Else Constant: The Ceteris Paribus Condition

Chapter 3: Where Prices Come From: The Interaction of Demand and Supply 7 of 42 © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. The Demand Side of the Market Learning Objective 3.1 Normal good A good for which the demand increases as income rises and decreases as income falls. Inferior good A good for which the demand increases as income falls and decreases as income rises. Variables That Shift Market Demand Income Many variables other than price can influence market demand.

Chapter 3: Where Prices Come From: The Interaction of Demand and Supply 8 of 42 © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. Variables That Shift Market Demand Learning Objective 3.1 Substitutes Goods and services that can be used for the same purpose. Complements Goods and services that are used together. Price of related goods Consumers can be influenced by an advertising campaign for a product. Tastes Population and demographics Demographics The characteristics of a population with respect to age, race, and gender. Expected Future Prices Consumers choose not only which products to buy but also when to buy them.

Chapter 3: Where Prices Come From: The Interaction of Demand and Supply 9 of 42 © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. The Aging of the Baby Boom Generation Making the Connection What effects will the aging of the baby boom generation have on the economy? Older people have a greater demand for medical care but less demand for cars than do younger people. Aging boomers will also have an effect on the housing market.

Chapter 3: Where Prices Come From: The Interaction of Demand and Supply 10 of 42 © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. The Demand Side of the Market Learning Objective 3.1 Variables That Shift Market Demand TABLE 3-1 Variables That Shift Market Demand Curves

Chapter 3: Where Prices Come From: The Interaction of Demand and Supply 11 of 42 © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. The Demand Side of the Market Learning Objective 3.1 Variables That Shift Market Demand TABLE 3-1 Variables That Shift Market Demand Curves (continued)

Chapter 3: Where Prices Come From: The Interaction of Demand and Supply 12 of 42 © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 12 of 34 Why Supermarkets Need to Understand Substitutes and Complements A supermarket shouldn’t remove a slow-selling soup from its shelves without researching whether shoppers use that soup as a substitute or a complement for another soup. COFFEE FROZEN PIZZA HOT DOGS ICE CREAM POTATO CHIPS REGULAR CEREAL SPAGHETTI SAUCEYOGURT Varieties in Five Chicago Supermarkets Varieties Introduced in a 2-Year Period Varieties Removed in a 2-Year Period

Chapter 3: Where Prices Come From: The Interaction of Demand and Supply 13 of 42 © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. The Demand Side of the Market Learning Objective 3.1 FIGURE 3-3 A Change in Demand versus a Change in the Quantity Demanded A Change in Demand versus a Change in Quantity Demanded

Chapter 3: Where Prices Come From: The Interaction of Demand and Supply 14 of 42 © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. Supply schedule A table that shows the relationship between the price of a product and the quantity of the product supplied. Supply curve A curve that shows the relationship between the price of a product and the quantity of the product supplied. The Supply Side of the Market Learning Objective 3.2 Supply Schedules and Supply Curves Quantity supplied The amount of a good or service that a firm is willing and able to supply at a given price.

Chapter 3: Where Prices Come From: The Interaction of Demand and Supply 15 of 42 © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. The Supply Side of the Market Learning Objective 3.2 Supply Schedules and Supply Curves FIGURE 3-4 Supply Schedule and Supply Curve

Chapter 3: Where Prices Come From: The Interaction of Demand and Supply 16 of 42 © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. The Supply Side of the Market Law of supply The rule that, holding everything else constant, increases in price cause increases in the quantity supplied, and decreases in price cause decreases in the quantity supplied. Learning Objective 3.2 The Law of Supply

Chapter 3: Where Prices Come From: The Interaction of Demand and Supply 17 of 42 © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. The Supply Side of the Market Learning Objective 3.2 FIGURE 3-5 Shifting the Supply Curve The Law of Supply

Chapter 3: Where Prices Come From: The Interaction of Demand and Supply 18 of 42 © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. Variables That Shift Market Supply Prices of Substitutes in Production Alternative products that a firm could produce are called substitutes in production. Number of Firms in the Market A change in the number of firms in the market will change supply. Expected Future Prices If a firm expects that the price of its product will be higher in the future than it is today, it has an incentive to decrease supply now and increase it in the future. Technological change A positive or negative change in the ability of a firm to produce a given level of output with a given quantity of inputs. The following are the most important variables that shift market supply: Prices of Inputs A change in the price of an input—anything used in the production of a good or service—is the most likely factor to cause the supply curve for a product to shift. Technological Change

Chapter 3: Where Prices Come From: The Interaction of Demand and Supply 19 of 42 © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. The Supply Side of the Market Learning Objective 3.2 Variables That Shift Supply TABLE 3-2 Variables That Shift Market Supply Curves

Chapter 3: Where Prices Come From: The Interaction of Demand and Supply 20 of 42 © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. The Supply Side of the Market Learning Objective 3.2 TABLE 3-2 Variables That Shift Market Supply Curves (continued) Variables That Shift Supply

Chapter 3: Where Prices Come From: The Interaction of Demand and Supply 21 of 42 © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. The Supply Side of the Market Learning Objective 3.2 FIGURE 3-6 A Change in Supply versus a Change in the Quantity Supplied A Change in Supply versus a Change in Quantity Supplied

Chapter 3: Where Prices Come From: The Interaction of Demand and Supply 22 of 42 © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. Market Equilibrium: Putting Demand and Supply Together FIGURE 3-7 Market Equilibrium Learning Objective 3.3

Chapter 3: Where Prices Come From: The Interaction of Demand and Supply 23 of 42 © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. Market equilibrium A situation in which quantity demanded equals quantity supplied. Competitive market equilibrium A market equilibrium with many buyers and many sellers. Learning Objective 3.3 Market Equilibrium: Putting Demand and Supply Together

Chapter 3: Where Prices Come From: The Interaction of Demand and Supply 24 of 42 © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. Market Equilibrium: Putting Demand and Supply Together Learning Objective 3.3 Surplus A situation in which the quantity supplied is greater than the quantity demanded. Shortage A situation in which the quantity demanded is greater than the quantity supplied. How Markets Eliminate Surpluses and Shortages

Chapter 3: Where Prices Come From: The Interaction of Demand and Supply 25 of 42 © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. Market Equilibrium: Putting Demand and Supply Together Learning Objective 3.3 FIGURE 3-8 The Effect of Surpluses and Shortages on the Market Price How Markets Eliminate Surpluses and Shortages

Chapter 3: Where Prices Come From: The Interaction of Demand and Supply 26 of 42 © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. Market Equilibrium: Putting Demand and Supply Together Learning Objective 3.3 Demand and Supply Both Count Always keep in mind that it is the interaction of demand and supply that determines the equilibrium price. Neither consumers nor firms can dictate what the equilibrium price will be. No firm can sell anything at any price unless it can find a willing buyer, and no consumer can buy anything at any price without finding a willing seller.

Chapter 3: Where Prices Come From: The Interaction of Demand and Supply 27 of 42 © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. Solved Problem 3-3 Demand and Supply Both Count: A Tale of Two Letters Learning Objective 3.3

Chapter 3: Where Prices Come From: The Interaction of Demand and Supply 28 of 42 © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. The Effect of an Increase in Supply on Equilibrium Figure 3.9 The Effect of Shifts in Supply on Equilibrium 1. As Toshiba enters the market for tablet computers, a larger quantity of tablets will be supplied at every price, so the market supply curve shifts to the right, from S 1 to S 2, which causes a surplus of tablets at the original price, P The equilibrium price falls from P 1 to P The equilibrium quantity rises from Q 1 to Q 2. If a firm enters a market, as Toshiba entered the market for tablet computers when it introduced the Thrive, the equilibrium price will fall, and the equilibrium quantity will rise:

Chapter 3: Where Prices Come From: The Interaction of Demand and Supply 29 of 42 © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. The Falling Price of LCD Televisions Making the Connection Learning Objective 3.4

Chapter 3: Where Prices Come From: The Interaction of Demand and Supply 30 of 42 © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. The Effect of Demand and Supply Shifts on Equilibrium FIGURE 3-10 The Effect of an Increase in Demand on Equilibrium The Effect of Shifts in Demand on Equilibrium Learning Objective 3.4

Chapter 3: Where Prices Come From: The Interaction of Demand and Supply 31 of 42 © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. Shifts in Demand and Supply over Time Figure 3.11 The Effect of Shifts in Demand and Supply over Time In panel (a), demand shifts to the right more than supply, and the equilibrium price rises: 1. Demand shifts to the right more than supply. 2. Equilibrium price rises from P 1 to P 2. In panel (b), supply shifts to the right more than demand, and the equilibrium price falls: 1. Supply shifts to the right more than demand. 2. Equilibrium price falls from P 1 to P 2. Whether the price of a product rises or falls over time depends on whether demand shifts to the right more than supply.

Chapter 3: Where Prices Come From: The Interaction of Demand and Supply 32 of 42 © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. The Effect of Demand and Supply Shifts on Equilibrium TABLE 3-3 How Shifts in Demand and Supply Affect Equilibrium Price (P) and Quantity (Q) The Effect of Shifts in Demand and Supply over Time Learning Objective 3.4 SUPPLY CURVE UNCHANGED SUPPLY CURVE SHIFTS TO THE RIGHT SUPPLY CURVE SHIFTS TO THE LEFT DEMAND CURVE UNCHANGED Q unchanged P unchanged Q increases P decreases Q decreases P increases DEMAND CURVE SHIFTS TO THE RIGHTQ increases P increases Q increases P increases or decreases Q increases or decreases P increases DEMAND CURVE SHIFTS TO THE LEFT Q decreases P decreases Q increases or decreases P decreases Q decreases P decreases or increases

Chapter 3: Where Prices Come From: The Interaction of Demand and Supply 33 of 42 © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. Solved Problem 3-4 High Demand and Low Prices in the Lobster Market? Learning Objective 3.4 Supply and demand for lobster both increase during the summer, but the increase in supply is greater than the increase in demand, therefore, equilibrium price falls.

Chapter 3: Where Prices Come From: The Interaction of Demand and Supply 34 of 42 © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. The Effect of Demand and Supply Shifts on Equilibrium Shifts in a Curve versus Movements along a Curve Learning Objective 3.4 When analyzing markets using demand and supply curves, it is important to remember that when a shift in a demand or supply curve causes a change in equilibrium price, the change in price does not cause a further shift in demand or supply.