McGraw-Hill/Irwin Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved. DEMAND AND SUPPLY DEMAND AND SUPPLY Chapter 4

McGraw-Hill/Irwin Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved. 4-2 Today’s lecture will: Introduce the law of demand and draw a demand curve. Explain the importance of substitution in the laws of supply and demand. Distinguish between a change in demand (shift in the curve) and a change in quantity demanded (movement along the demand curve). Explain the law of supply and construct a supply curve.

McGraw-Hill/Irwin Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved. 4-3 Today’s lecture will: Distinguish between a change in supply (shift in the curve) and a change in quantity supplied (movement along the supply curve). Explain how the laws of supply and demand interact to bring about equilibrium. Show the effect of shifts in demand and supply on equilibrium price and quantity. Explore the limitations of demand and supply analysis.

McGraw-Hill/Irwin Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved. 4-4 The Law of Demand Law of demand – there is an inverse relationship between price and quantity demanded. Other things equal:  Quantity demanded rises as price falls  Quantity demanded falls as price rises Law of demand is based on the fact that people substitute for goods whose price increases.

McGraw-Hill/Irwin Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved. 4-5 The Demand Curve The demand curve is the graphic representation of the law of demand. The demand curve slopes downward and to the right. As price goes up, the quantity demanded goes down. D Price (per unit) 0 Quantity demanded (per unit of time) PAPA QAQA A B QBQB PBPB

McGraw-Hill/Irwin Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved. 4-6 Other Things Constant Other things constant places a limitation on the application of the law of demand. All other factors, such as changing tastes, prices of other goods, income, and even the weather, are assumed to remain constant, whether they actually remain constant or not.

McGraw-Hill/Irwin Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved. 4-7 Quantity Demanded Versus Demand Quantity demanded refers to a specific amount that will be demanded per unit of time at a specific price. Quantity demanded refers to a specific point on the demand curve. A change in quantity demanded, caused only by a change in the price of the good itself, is shown by a movement along a demand curve.

McGraw-Hill/Irwin Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved. 4-8 Quantity Demanded Versus Demand Demand refers to a schedule of quantities of a good that will be bought per unit of time at various prices, other things constant. It refers to the entire demand curve. A change in demand, caused by anything other than the good’s own price, is shown by a shift in the demand curve.

McGraw-Hill/Irwin Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved. 4-9 B 100 $2 Quantity Demanded Versus Demand D1D1 Change in quantity demanded 0 Price (per 50 miles) Quantity demanded (per unit of time) $1 200 A Price (per 50 miles) Quantity demanded (per unit of time) D0D0 D1D1 $2 $1 100 B A Change in demand 200

McGraw-Hill/Irwin Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved Shift Factors of Demand Shift factors of demand are factors that cause changes in demand (shifts in the demand curve). Society’s Income  An increase in income will increase demand for normal goods.  An increase in income will decrease demand for inferior goods.

McGraw-Hill/Irwin Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved Shift Factors of Demand Prices of Other Goods  When the price of a substitute good falls, demand falls for the good whose price has not changed.  When the price of a complement good falls, demand rises for the good whose price has not changed. Tastes  A change in taste will change demand with no change in price.

McGraw-Hill/Irwin Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved Shift Factors of Demand Expectations  If you expect your income to rise, you may consume more now.  If you expect prices to fall in the future, you may put off purchases today. Taxes and Subsidies  Taxes increase the cost of goods, thereby reducing demand.  Subsidies have an opposite effect.

McGraw-Hill/Irwin Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved The Demand Table The demand table assumes:  As price rises, quantity demanded declines.  Quantity demanded has a specific time dimension to it.  All the products involved are identical in shape, size, quality, etc.  Everything else is constant.

McGraw-Hill/Irwin Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved From a Demand Table to a Demand Curve Price per DVDs (in dollars) A Demand Curve Quantity of DVDs demanded (per week) $ E D C B F A A Demand Table ABCDEABCDE $ Price per cassette DVD rentals demanded per week Demand for DVDs G

McGraw-Hill/Irwin Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved Individual and Market Demand Curves Price per cassette $ Alice’s demand Market demand ABCDEFGHABCDEFGH Cathy Bruce Alice D A C E F G Quantity of cassettes demanded per week 2 $ Price per cassette (in dollars) B + Bruce’s demand Cathy’s demand ++=

McGraw-Hill/Irwin Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved The Law of Supply There is a direct relationship between price and quantity supplied. Other things constant:  Quantity supplied rises as price rises.  Quantity supplied falls as price falls. The law of supply occurs because:  When prices rise, firms substitute production of one good for another.  Assuming firms’ costs are constant, a higher price means higher profits.

McGraw-Hill/Irwin Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved The Supply Curve The supply curve is the graphic representation of the law of supply. The supply curve slopes upward to the right because quantity supplied varies directly with price. As price increases, the quantity supplied increases. Quantity supplied (per unit of time) 0 Price (per unit) S A PAPA QAQA B PBPB QBQB

McGraw-Hill/Irwin Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved Quantity Supplied Versus Supply Quantity supplied refers to a specific amount that will be supplied at a specific price. Quantity supplied refers to a specific point on the supply curve. A change in quantity supplied, caused only by a change in the price of the good itself, is shown by a movement along the supply curve.

McGraw-Hill/Irwin Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved Quantity Supplied Versus Supply Supply refers to a schedule of quantities a seller is willing to sell per unit of time at various prices, other things constant. Supply refers to the whole supply curve. A change in supply, caused by anything other than the good’s price, is shown by a shift in the supply curve.

McGraw-Hill/Irwin Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved Quantity Supplied Versus Supply Price (per barrel) Barrels per year (millions) S0S0 Change in Supply S1S1 $15 AB Change in quantity supplied Price (per barrel) Barrels per year (millions) S0S0 $15 A B $36

McGraw-Hill/Irwin Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved Shift Factors of Supply Shift factors of supply are factors that cause changes in supply (shifts in the supply curve). Price of Inputs  When costs go up, profits go down, so that the incentive to supply also goes down. Technology  Advances in technology reduce the number of inputs needed to produce a given supply of goods, decreasing costs, increasing profits, leading to increased supply.

McGraw-Hill/Irwin Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved Shift Factors of Supply Expectations  If suppliers expect prices to rise in the future, they may store today’s supply to sell later, decreasing supply now. Taxes and Subsidies  When taxes increase, costs go up, and profits go down, causing a decrease in supply.  When subsidies increase, costs decrease, and profits increase, leading to an increase in supply.

McGraw-Hill/Irwin Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved Individual and Market Supply Price (per DVD) ABCDEFGHIABCDEFGHI $ Ann Market supply CharlieBarry ++= Quantity of DVDs supplied (per week) $ Charlie Barry Ann 0 I H G F E D C B A Market Supply CACA

McGraw-Hill/Irwin Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved. 4-24Equilibrium Equilibrium is a concept in which opposing forces cancel each other out. In a free market, the forces of supply and demand interact to determine:  Equilibrium price – the price toward which the invisible hand drives the market.  Equilibrium quantity – the amount bought and sold at the equilibrium price.

McGraw-Hill/Irwin Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved. 4-25Equilibrium When the market is not in equilibrium, there is either excess demand or excess supply. Excess supply – a surplus, the quantity supplied is greater than the quantity demanded, and prices fall. Excess demand – a shortage, the quantity demanded is greater than the quantity supplied, and prices rise. When quantity demanded equals quantity supplied, prices have no tendency to change.

McGraw-Hill/Irwin Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved. 4-26Equilibrium Price (per DVD) QSQS QDQD Surplus(+) Shortage (-) $ $ $ A Price per DVD $ S D Quantity of DVDs supplied and demanded (per week) C Excess demand Excess supply E 78

McGraw-Hill/Irwin Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved Shifts in Supply and Demand Shifts in either supply or demand change equilibrium price. An increase in demand or a decrease in supply:  Creates excess demand at the original equilibrium price.  Excess demand increases price until a new higher equilibrium price and quantity are reached.

McGraw-Hill/Irwin Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved Increase in Demand Price (per DVDs) A S0S0 Quantity of DVDs (per week) $ D0D0 D1D1 B Excess demand

McGraw-Hill/Irwin Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved B Excess demand A Price (per DVDs) Quantity of DVDs (per week) $ D0D0 S0S0 C S1S1 Decrease in Supply

McGraw-Hill/Irwin Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved Limitations of Supply and Demand Analysis Sometimes supply and demand are interconnected. The other things constant assumption is likely not to hold when the goods represent a large percentage of the entire economy. The fallacy of composition is the false assumption that what is true for a part will also be true for the whole.

McGraw-Hill/Irwin Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved. 4-31Summary The law of demand states that the quantity demanded rises as price falls, other things constant. The law of supply states that the quantity supplied rises as price rises, other things constant. The laws of demand and supply hold true because people can substitute.

McGraw-Hill/Irwin Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved. 4-32Summary A change in quantity demanded (supplied), caused only by a change in the good’s own price, is a movement along the demand (supply) curve. A change in demand (supply) is a shift of the entire demand (supply) curve. Factors that affect supply and demand other than price are called shift factors.

McGraw-Hill/Irwin Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved. 4-33Summary Shift Factors of DemandShift Factors of Supply IncomePrice of Inputs Prices of Other GoodsTechnology TastesExpectations Taxes and Subsidies on Producers Taxes and Subsidies on Consumers

McGraw-Hill/Irwin Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved. 4-34Summary A market demand (supply) curve is the horizontal sum of all individual demand (supply) curves. When quantity demanded equals quantity supplied at equilibrium, prices have no tendency to change. When quantity demanded > quantity supplied, prices tend to rise. When quantity supplied > quantity demanded, prices tend to fall.

McGraw-Hill/Irwin Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved. 4-35Summary When the demand curve shifts to the right (left), equilibrium price rises (declines) and equilibrium quantity rises (falls). When the supply curve shifts to the right (left), equilibrium price declines (rises) and equilibrium quantity rises (falls).

McGraw-Hill/Irwin Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved Given the following demand and supply of pizza: Price Quantity Quantity per PizzaSuppliedDemanded $ Review Question 4-1 What is the equilibrium price and quantity? Review Question 4-2 If the price is $7, is there a shortage or surplus? How much is the shortage or surplus? Explain how the market will return to equilibrium. Equilibrium price is $6 and equilibrium quantity is 100 pizzas. At a price of $7, there is a surplus of = 70 pizzas. Producers will reduce the price in order to sell the surplus. As price decreases, quantity demanded increases until the surplus is eliminated at the equilibrium price of $6.