Lecture 3: Demand and Supply Text: Principles of Economics, Chapter 3 AAEC 2305 Shaikh M Rahman Lecture 3: Demand and Supply Text: Principles of Economics, Chapter 3

Learning Objectives Describe how the demand and supply curves summarize the behavior of buyers and sellers in the marketplace. Discuss how the supply and demand curves interact to determine equilibrium price and quantity. Illustrate how shifts in supply and demand curves cause prices and quantities to change Explain and apply the Efficiency Principle and the Equilibrium Principle (also called the “No-Cash-on-the-Table Principle”).

What, How, and For Whom? Every society answers three basic questions

Central Planning versus the Market Decisions by individuals or small groups Agrarian societies Government programs Sets prices and goals for the group Individual influence is limited The Market Buyers and sellers signal wants and costs Resources and goods are allocated accordingly Interaction of supply and demand answer the three basic questions Mixed economies use both the market and central planning

Buyers and Sellers in the Market The market for any good consists of all the buyers and sellers of the good Buyers and sellers jointly determine outcome Buyers and sellers have different motivations Buyers want to benefit from the good The buyer’s reservation price is the highest price an individual is willing to pay for a good Sellers want to make a profit Market price balances two forces Value buyers derive from the good Cost to produce one more unit of the good

Demand Demand for a good refers to the different quantities buyers would purchase at different prices Law of Demand Consumers buy less at higher prices Consumers buy more at lower prices This behavior can be depicted graphically by a downward sloping curve – called the demand curve $4 $2 8 16 Q P D Demand for Pizzas (1000s of slices/day)

Quantity Demanded (cups) Law of Demand When price of a good goes up, people buy less of that good Leads to downward sloping demand curve Price ($/cup) Quantity Demanded (cups) 0.50 5 0.75 4 1.00 3 1.25 2 1.50 1

Demand versus Quantity Demanded Amount of a good consumed at a given price Change in price means a change in quantity demanded Movement along the demand curve Demand A family of numbers that lists the quantity demanded corresponding to each possible price Demand Schedule Demand Curve

Demand Schedule and Demand Curve Demand Schedule - Refers to the demand table that shows quantity demanded at each price Price ($/cup) Quantity Demanded (cups) 0.50 5 0.75 4 1.00 3 1.25 2 1.50 1

Demand Schedule and Demand Curve Demand Curve - Graph illustrating demand - Graphical representation of the demand schedule Price on the vertical axis Quantity demanded on the horizontal axis

Changes in Demand Income Price of related goods Taste Sales Tax Price change does not lead to change in demand Change in anything other than price lead to demand changes - Entire curve shifts Income Price of related goods Substitutes Complements Taste Sales Tax

Changes (Shift) in Demand Fall in Demand Decision made by demanders to buy a smaller quantity at each given price Leftward shift of demand curve Rise in Demand Decision made by demanders to a buy a larger quantity at each given price Rightward shift of demand curve

Changes (Shift) in Demand Price change does not lead to change in demand Factors that lead to demand changes - Entire curve shifts Consumer’s income Consumer’s taste (preference) Price of related goods Substitutes Complements Excise Tax

Market (Aggregate) Demand Aggregate quantity of a good demanded by all consumers in a community (market) at each given price Market Demand reflects the entire market, not one consumer Lower prices bring more buyers into the market Lower prices cause existing buyers to buy more The aggregate or market demand is obtained by the horizontal summation of all individual consumer’s demand curves. Similar to the individual demand curve - Slopes downward

Market (Aggregate) Demand Suppose, there are 10,000 SB coffee consumers in Lubbock Each individual consumer’s demand for SB coffee is the same Price ($/cup) Ind. Quantity (cups) Ag. Quantity (cups) 0.50 5 50,000 0.75 4 40,000 1.00 3 30,000 1.25 2 20,000 1.50 1 10,000

Market Demand The quantity buyers would purchase at each possible price Market Demand curve Negative slope Consumers buy less at higher prices Consumers buy more at lower prices $4 $2 8 16 Q P D Demand for Pizzas (000s of slices/day)

Interpreting the (Market) Demand Curve Horizontal interpretation of demand Given price, how much will buyers buy? Vertical interpretation of demand Given the quantity to be bought, what will the price be? $4 $2 8 16 Q P D Demand for Pizzas (000s of slices/day)

Income and Substitution Effects Buyers buy more at lower prices and buy less at higher prices What happens when price goes up? The substitution effect - Buyers switch to substitutes when price goes up The income effect - Buyers' overall purchasing power goes down What happens when price goes down? The substitution effect - Buyers switch from substitutes The income effect - Buyers' overall purchasing power goes up

Supply Supply of a good refers to the different quantities sellers would sell at different prices Law of Supply Seller sells more at higher prices Seller sells less at lower prices This behavior can be depicted graphically by a upward sloping curve – called the supply curve

Law of Supply When the price of a good goes up, the quantity supplied goes up Leads to a upward sloping supply curve Price ($/cup) Quantity (cups) 0.25 0.50 100 0.75 200 1.00 300 1.25 400 1.50 500

Supply versus Quantity Supplied Amount of a good that suppliers will provide at a given price Changes if the price changes Movement along the curve Supply Family of numbers giving the quantities supplied at each price Change in anything other than price changes supply Shifts the entire curve

Changes (Shift) in Supply Rise in Supply Increase in quantities that supplier will provide at each price Rightward shift of supply Fall in Supply Decrease in quantities that supplier will provide at each price Leftward shift of supply

Changes (Shift) in Supply Price change does not lead to change in supply Factors that lead to supply changes - Entire curve shifts Production costs Improvement in production technology Change in the wage rate Weather condition Excise Tax

Market (Aggregate) Supply Aggregate quantity of a good supplied by all producers in a community (market) at each given price The aggregate or market supply is obtained by the horizontal summation of all individual producer’s supply curves. Similar to the individual producer’s supply curve – Market supply curve slopes upward

Market (Aggregate) Supply Suppose, there are 10 Starbucks (SB) coffee sellers in Lubbock Each individual seller’s supply for SB coffee is the same Price ($/cup) Ind. Quantity (cups) Ag. Quantity (cups) 0.50 1,000 10,000 0.75 2,000 20,000 1.00 3,000 30,000 1.25 4,000 40,000 1.50 5,000 50,000

Interpreting the Market Supply Curve Horizontal interpretation of supply Given price, how much will suppliers offer? Vertical interpretation of supply Given the quantity to be sold, what will the price be?

Market Equilibrium Equilibrium Point – The point where the market demand and supply curves intersect Equilibrium Price – The price at which quantity demanded equals quantity supplied Equilibrium Quantity – the quantity of the good that buyers and sellers exchange at the equilibrium price Actual price and Quantity determined by interactions between demanders (consumers) and suppliers (sellers) Buyers cannot purchase more than sellers willing to sell Sellers cannot sell more than buyers willing to buy Buyers and sellers both are satisfied Able to behave as one wants to, taking market prices as given

Market Equilibrium for SB Coffee Equilibrium price – $1.00 per cup Equilibrium quantity – 30,000 cups per day Price ($/cup) Ag. Quantity Demanded Ag. Quantity Supplied 0.50 50,000 10,000 0.75 40,000 20,000 1.00 30,000 1.25 1.50

Quantity supplied equals quantity demanded AND Market Equilibrium Quantity supplied equals quantity demanded AND Price is on supply and demand curves No tendency to change P or Q Buyers are on their demand curve Sellers are on their supply curve Market for Pizzas P S $3 D Q 12 (000s of slices/day)

Excess Supply and Excess Demand At $4, 16,000 slices supplied and 8,000 slices demanded Excess Demand At $2, 8,000 slices supplied 16,000 slices demanded Market for Pizzas Market for Pizzas P P Surplus S S $4 Shortage $2 D D Q Q 8 16 8 16 (000s of slices/day) (000s of slices/day)

Incentive Principle: Excess Supply at $4 Each supplier has an incentive to decrease the price in order to sell more Lower prices decrease the surplus As price decreases: the quantity offered for sale decreases along the supply curve the quantity demanded increases along the demand curve Market for Pizzas P S $4 $3.50 $3 Equilibrium D Q 8 12 16 (000s of slices/day)

Incentive Principle: Excess Demand at $2 Each supplier has an incentive to increase the price in order to sell more Higher prices decrease the shortage As price increases the quantity offered for sale increases along the supply curve As price increases, the quantity demanded decreases along the demand curve. Market for Pizzas P S $3 Equilibrium $2.50 $2 D Q 8 12 16 (000s of slices/day)

Rent Controls Are Price Ceilings Rent controls set a maximum price that can be charged for a given apartment If the controlled price is below equilibrium, then Quantity demanded increases and Quantity supplied decreases A shortage results Market for NYC Apartments P S $1,600 $800 D Q 1 2 3 (millions of apartments/day)

Changes in the Equilibrium Point The only way that anything can affect the equilibrium price and quantity is by causing a shift in either the supply curve or the demand curve Never look at price and quantity Look at the effect of the change has on demand curve and/or supply curve The factors that shifts the demand and supply curves affect the equilibrium price and quantity

The Effects of Supply and Demand Shifts

Movement along the (market) Demand Curve When price goes up, quantity demanded goes down When price goes down, buyers move to a new, higher quantity demanded A change in quantity demanded results from a change in the price of a good. Demand for Canned Tuna P $2 $1 D Q 8 10 (000s of cans/day) 36

Shift in (Market) Demand If buyers are willing to buy more at each price, then demand has increased Move the entire demand curve to the right Increase in demand If buyers are willing to buy less at each price, then demand has decreased Demand for Canned Tuna P $2 D' D Q 8 10 (000s of cans/day)

Causes of Shifts in Demand Price of complementary goods Tennis courts and tennis balls Price of substitute goods Internet and overnight delivery Income: normal or inferior goods? Preferences Dinosaur toys after Jurassic Park movie Number of buyers in the market Expectations about the future Price changes never cause a shift in demand

Tennis Market If rent for tennis court decreases, demand for tennis balls increases Tennis courts and tennis balls are complements P Q Tennis Court Rentals $7 $10 D (00s rentals/day) 4 11 Tennis Ball Sales P Q $1.00 D (millions of balls/day) 40 58 D' S $1.40

Apartments Near DC Metro If government wages rise, demand for apartments near Metro stations increases Demand increases Price increases Quantity increases Demand for a normal good increases when income increases Demand for an inferior good increases when income decreases Convenient Apartments P D D' S P' P Q Q Q' (units/month) 40

Movement along the (market) Supply Curve Changes in Quantity Supplied When the price of a good changes, move to a new quantity supplied Assumes everything except price is held constant $4 $2 8 16 Q P S Supply of Pizzas (000s of slices/day)

Changes in (Market) Supply Supply increases when sellers are willing to offer more for sale at each possible price Moves the entire supply curve to the right Supply decreases when sellers are willing to offer less for sale at each possible price Moves the entire supply curve to the left $2 8 Q P S Supply of Pizzas (000s of slices/day) S' 9 $2 8 Q P S* Supply of Tuna (000s of cans/day) S 9

Causes of Shifts in Supply A change in the price of an input Fiberglass for skateboards, construction wages A change in technology Desktop publishing and term papers Internet distribution of products (e-commerce) Weather (agricultural commodities and outdoor entertainment) Number of sellers in the market Expectation of future price changes Price changes never cause a shift in supply

Shifts in Supply: Skateboards Costs of production affect the supply of a product Cost of fiberglass for skateboards increases Supply decreases With no change in demand, the price of skateboards increases to $80 and quantity decreases to 800 $80 800 $60 P S Supply of Skateboards 1,000 D S' 600 Q (skateboards/month)

Shift in Supply: Home Construction Cost of labor used to produce houses decreases Supply increases Demand is constant The price of houses decreases to $90,000 per house Quantity increases to 50 $120 40 $90 Q P S' The Market for New Houses 50 D S (houses/month)

Supply and Demand Shifts: Four Rules An increase in demand will lead to an increase in both equilibrium price and quantity P S P' P D' D Q Q' Q

Supply and Demand Shifts: Four Rules An decrease in demand will lead to a decrease in both equilibrium price and quantity P S P P' D D' Q' Q Q 47

Supply and Demand Shifts: Four Rules An increase in supply will lead to a decrease in the equilibrium price and an increase in the equilibrium quantity. P S S' P P' D Q Q' Q 48

Supply and Demand Shifts: Four Rules A decrease in supply will lead to an increase in the equilibrium price and a decrease in the equilibrium quantity. S' P S P' P D Q' Q Q 49

Supply and Demand Both Change: Tortilla Chips Oils used for frying are harmful AND the price of harvesting equipment decreases S S' P Price ($/bag) P' D D' Q' Q Millions of bags per month

Changes in Supply and Demand Increases Decreases P Depends Q Increases P Increases Q Depends P Decreases Q Decreases

Efficiency and Equilibrium Markets communicate information effectively Value buyers place on the product Opportunity cost of producing the product Markets maximize the difference between benefits and costs Market outcomes are the best provided that The market is in equilibrium AND No costs or benefits are shared with the public

Cash on the Table Buyer's surplus: buyer's reservation price minus the market price Seller's surplus: market price minus the seller's reservation price Total surplus = buyer's surplus + seller's surplus Total surplus is buyer's reservation price – seller's reservation price No cash on the table when surplus is maximized No opportunity to gain from additional sales or purchases

Efficiency Principle Socially optimal quantity maximizes the total surplus for the economy from producing and selling a good Economic efficiency -- all goods at their socially optimal level Efficiency Principle: equilibrium price and quantity are efficient if Sellers pay all the costs of production Buyers receive all the benefits of their purchase Efficiency: marginal cost equals marginal benefit Production is efficient if total surplus is maximized

Smart for One, Dumb for All Producers sometimes shift costs to others Pollution is like getting free waste disposal services Total marginal cost = seller's marginal cost plus marginal cost of pollution When costs are shifted, supply is greater than socially optimal Buyers may create benefits for others Marginal benefit is less than the full social benefit Vaccinations, my neighbor's landscaping The demand for these goods is less than socially optimal

Equilibrium Principle Equilibrium Principle: no unexploited opportunities for individuals BUT it may not exploit all gains achievable through collective action Only when the seller pays the full cost of production and the buyer captures the full benefit of the good is the market outcome socially optimal Regulation, taxes and fines, or subsidies can move the market to optimal level

The Algebra of Supply and Demand Chapter 3 Appendix The Algebra of Supply and Demand

From Graphs to Equations … Sample equations P = 16 – 2 Qd is a straight-line demand curve with intercept 16 on the vertical (P) axis and a slope of – 2 P = 4 + 4 Qs is a straight-line supply curve with intercept 4 and a slope of 4

… To Equilibrium P and Q Equilibrium is where P and Q are the same for demand and supply Set the two equations equal to each other (P = P) and solve for Q (Qs = Qd = Q*) 16 – 2 Q* = 4 + 4 Q* 6 Q* = 12 Q* = 2 Use either the supply or demand curve and Q* = 2 to find price P = 16 – 2 Q* P = $12 P = 4 + 4 Q* P = $12