1. Chapter 3 Supply and Demand

2. Supply and Demand Supply and demand is an economic model
Designed to explain how prices are determined in certain types of markets
What you will learn in this chapter
How the model of supply and demand works and how to use it
Strengths and limitations of model
Lieberman & Hall; Introduction to Economics, 2005

3. Markets
Specific location where buying and selling takes place, such as
Supermarket or a flea market
In economics, a market is not a place but rather
A group of buyers and sellers with the potential to trade with each other
Economists think of the economy as a collection of individual markets
First step in an economic analysis is to define and characterize the market or collection of markets to analyze
Lieberman & Hall; Introduction to Economics, 2005

4. How Broadly Should We Define the Market
Defining the market often requires economists to group things together
Aggregation is the combining of a group of distinct things into a single whole
Markets can be defined broadly or narrowly, depending on our purpose
How broadly or narrowly markets are defined is one of the most important differences between Macroeconomics and Microeconomics
Lieberman & Hall; Introduction to Economics, 2005

5. Defining Macroeconomic Markets
Goods and services are aggregated to the highest levels
Macro models lump all consumer goods into the single category “consumption goods”
Macro models will also analyze all capital goods as one market
Macroeconomists take an overall view of the economy without getting bogged down in details
Lieberman & Hall; Introduction to Economics, 2005

6. Defining Microeconomic Markets
Markets are defined narrowly
Focus on models that define much more specific commodities
Always involves some aggregation
Stops short of the broad levels of generality that macroeconomics investigates
Lieberman & Hall; Introduction to Economics, 2005

7. Buyers and Sellers Buyers and sellers in a market can be
Households
Business firms
Government agencies
All three can be both buyers and sellers in the same market, but are not always
For purposes of simplification this text will usually follow these guidelines
In markets for consumer goods, we’ll view business firms as the only sellers, and households as only buyers
In most of our discussions, we’ll be leaving out the “middleman”
Lieberman & Hall; Introduction to Economics, 2005

8. Competition in Markets
In imperfectly competitive markets, individual buyers or sellers can influence the price of the product
In perfectly competitive markets (or just competitive markets), each buyer and seller takes the market price as a given
What makes some markets imperfectly competitive and others perfectly competitive?
Perfectly competitive markets have many small buyers and sellers
Each is a small part of the market, and the product is standardized
Imperfectly competitive markets have just a few large buyers and sellers
Or else the product of each seller is unique in some way
Lieberman & Hall; Introduction to Economics, 2005

9. Using Supply and Demand
Supply and demand model is designed to explain how prices are determined in perfectly competitive markets
Perfect competition is rare but many markets come reasonably close
Perfect competition is a matter of degree rather than an all or nothing characteristic
Supply and demand is one of the most versatile and widely used models in the economist’s tool kit
Lieberman & Hall; Introduction to Economics, 2005

10. Demand A household’s quantity demanded of a good
Specific amount household would choose to buy over some time period, given
A particular price that must be paid for the good
All other constraints on the household
Market quantity demanded (or quantity demanded) is the specific amount of a good that all buyers in the market would choose to buy over some time period, given
A particular price they must pay for the good
All other constraints on households
Lieberman & Hall; Introduction to Economics, 2005

11. Quantity Demanded Implies a choice Is hypothetical Stresses price
How much households would like to buy when they take into account the opportunity cost of their decisions?
Is hypothetical
Makes no assumptions about availability of the good
How much would households want to buy, at a specific price, given real-world limits on their spending power?
Stresses price
Price of the good is one variable among many that influences quantity demanded
We’ll assume that all other influences on demand are held constant, so we can explore the relationship between price and quantity demanded
Lieberman & Hall; Introduction to Economics, 2005

12. The Law of Demand
States that when the price of a good rises and everything else remains the same, the quantity of the good demanded will fall
The words, “everything else remains the same” are important
In the real world many variables change simultaneously
However, in order to understand the economy we must first understand each variable separately
Thus we assume that, “everything else remains the same,” in order to understand how demand reacts to price
Lieberman & Hall; Introduction to Economics, 2005

13. The Demand Schedule and the Demand Curve
A list showing the quantity of a good that consumers would choose to purchase at different prices, with all other variables held constant
The market demand curve (or just demand curve) shows the relationship between the price of a good and the quantity demanded , holding constant all other variables that influence demand
Each point on the curve shows the total buyers would choose to buy at a specific price
Law of demand tells us that demand curves virtually always slope downward
Lieberman & Hall; Introduction to Economics, 2005

14. Figure 1: The Demand Curve
Price per Bottle
When the price is $4.00 per bottle, 40,000 bottles are demanded (point A). A
$4.00
At $2.00 per bottle, 60,000 bottles are demanded (point B). B
2.00 D
40,000
60,000
Number of Bottles per Month
Lieberman & Hall; Introduction to Economics, 2005

15. Shifts vs. Movements along the Demand Curve
A change in the price of a good causes a movement along the demand curve
In Figure 1
A fall (rise) in price would cause a movement to the right (left) along the demand curve
A change in income causes a shift in the demand curve itself
In Figure 2
Demand curve has shifted to the right of the old curve (from Figure 1) as income has risen
A change in any variable that affects demand—except for the good’s price—causes the demand curve to shift
Lieberman & Hall; Introduction to Economics, 2005

16. Figure 2: A Shift of the Demand Curve
An increase in income shifts the demand curve for maple syrup from D1 to D2. At each price, more bottles are demanded after the shift.
Price per Bottle B C
$2.00 D1 D2
60,000
80,000
Number of Bottles per Month
Lieberman & Hall; Introduction to Economics, 2005

17. Dangerous Curves: “Change in Quantity Demanded” vs. “Change in Demand”
Language is important when discussing demand
“Quantity demanded” means
A particular amount that buyers would choose to buy at a specific price
It is a number represented by a single point on a demand curve
When a change in the price of a good moves us along a demand curve, it is a change in quantity demand
The term demand means
The entire relationship between price and quantity demanded—and represented by the entire demand curve
When something other than price changes, causing the entire demand curve to shift, it is a change in demand
Lieberman & Hall; Introduction to Economics, 2005

18. Income: Factors That Shift the Demand Curve
An increase in income has effect of shifting demand for normal goods to the right
However, a rise in income shifts demand for inferior goods to the left
A rise in income will increase the demand for a normal good, and decrease the demand for an inferior good
Lieberman & Hall; Introduction to Economics, 2005

19. Wealth: Factors that Shift the Demand Curve
Your wealth—at any point in time—is the total value of everything you own minus the total dollar amount you owe
An increase in wealth will
Increase demand (shift the curve rightward) for a normal good
Decrease demand (shift the curve leftward) for an inferior good
Lieberman & Hall; Introduction to Economics, 2005

20. Prices of Related Goods: Factors that Shift the Demand Curve
Substitute—good that can be used in place of some other good and that fulfills more or less the same purpose
A rise in the price of a substitute increases the demand for a good, shifting the demand curve to the right
Complement—used together with the good we are interested in
A rise in the price of a complement decreases the demand for a good, shifting the demand curve to the left
Lieberman & Hall; Introduction to Economics, 2005

21. Other Factors that Shift the Demand Curve
Population
As the population increases in an area
Number of buyers will ordinarily increase
Demand for a good will increase
Expected Price
An expectation that price will rise (fall) in the future shifts the current demand curve rightward (leftward)
Tastes
Combination of all the personal factors that go into determining how a buyer feels about a good
When tastes change toward a good, demand increases, and the demand curve shifts to the right
When tastes change away from a good, demand decreases, and the demand curve shifts to the left
Lieberman & Hall; Introduction to Economics, 2005

22. Figure 3(a): Movements Along and Shifts of the Demand Curve
Quantity
Price
Price increase moves us leftward along demand curve P2
Price increase moves us rightward along demand curve P1 P3
Lieberman & Hall; Introduction to Economics, 2005 Q2 Q1 Q3

23. Figure 3(b): Movements Along and Shifts of the Demand Curve
Quantity
Price
Entire demand curve shifts rightward when:
income or wealth ↑
price of substitute ↑
price of complement ↓
population ↑
expected price ↑
tastes shift toward good D2 D1
Lieberman & Hall; Introduction to Economics, 2005

24. Figure 3(c): Movements Along and Shifts of the Demand Curve
Quantity
Price
Entire demand curve shifts leftward when:
income or wealth ↓
price of substitute ↓
price of complement ↑
population ↓
expected price ↓
tastes shift toward good D1 D2
Lieberman & Hall; Introduction to Economics, 2005

25. Supply
A firm’s quantity supplied of a good is the specific amount its managers would choose to sell over some time period, given
A particular price for the good
All other constraints on the firm
Market quantity supplied (or quantity supplied) is the specific amount of a good that all sellers in the market would choose to sell over some time period, given
All other constraints on firms
Lieberman & Hall; Introduction to Economics, 2005

26. Quantity Supplied Implies a choice Is hypothetical Stresses price
Quantity that gives firms the highest possible profits when they take account of the constraints presented to them by the real world
Is hypothetical
Does not make assumptions about firms’ ability to sell the good
How much would firms’ managers want to sell, given the price of the good and all other constraints they must consider?
Stresses price
The price of the good is just one variable among many that influences quantity supplied
We’ll assume that all other influences on supply are held constant, so we can explore the relationship between price and quantity supplied
Lieberman & Hall; Introduction to Economics, 2005

27. The Law of Supply
States that when the price of a good rises and everything else remains the same, the quantity of the good supplied will rise
The words, “everything else remains the same” are important
In the real world many variables change simultaneously
However, in order to understand the economy we must first understand each variable separately
We assume “everything else remains the same” in order to understand how supply reacts to price
Lieberman & Hall; Introduction to Economics, 2005

28. The Supply Schedule and The Supply Curve
Supply schedule—shows quantities of a good or service firms would choose to produce and sell at different prices, with all other variables held constant
Supply curve—graphical depiction of a supply schedule
Shows quantity of a good or service supplied at various prices, with all other variables held constant
Lieberman & Hall; Introduction to Economics, 2005

29. Figure 4: The Supply Curve
Number of Bottles per Month
Price per Bottle
When the price is $2.00 per bottle, 40,000 bottles are supplied (point F). S
$4.00 G
At $4.00 per bottle, quantity supplied is 60,000 bottles (point G).
2.00 F
40,000
60,000
Lieberman & Hall; Introduction to Economics, 2005

30. Shifts vs. Movements along the Supply Curve
A change in the price of a good causes a movement along the supply curve
In Figure 4
A rise (fall) in price would cause a rightward (leftward) movement along the supply curve
A drop in transportation costs will cause a shift in the supply curve itself
In Figure 5
Supply curve has shifted to the right of the old curve (from Figure 4) as transportation costs have dropped
A change in any variable that affects supply—except for the good’s price—causes the supply curve to shift
Lieberman & Hall; Introduction to Economics, 2005

31. Figure 5: A Shift of the Supply Curve
Number of Bottles per Month
Price per Bottle
A decrease in transportation costs shifts the supply curve for maple syrup from S1 to S2. S1 S2
At each price, more bottles are supplied after the shift
$4.00 J G
60,000
80,000
Lieberman & Hall; Introduction to Economics, 2005

32. Factors that Shift the Supply Curve
Input prices
A fall (rise) in the price of an input causes an increase (decrease) in supply, shifting the supply curve to the right (left)
Price of Related Goods
When the price of an alternate good rises (falls), the supply curve for the good in question shifts rightward (leftward)
Technology
Cost-saving technological advances increase the supply of a good, shifting the supply curve to the right
Lieberman & Hall; Introduction to Economics, 2005

33. Factors that Shift the Supply Curve
Number of firms
An increase (decrease) in the number of sellers—with no other changes—shifts the supply curve to the right (left)
Expected price
An expectation of a future price increase (decrease) shifts the current supply curve to the left (right)
Lieberman & Hall; Introduction to Economics, 2005

34. Factors that Shift the Supply Curve
Changes in weather
Favorable weather
Increases crop yields
Causes a rightward shift of the supply curve for that crop
Unfavorable weather
Destroys crops
Shrinks yields
Shifts the supply curve leftward
Other unfavorable natural events may effect all firms in an area
Causing a leftward shift in the supply curve
Lieberman & Hall; Introduction to Economics, 2005

35. Figure 6(a): Changes in Supply and in Quantity Supplied
Price
Price increase moves us rightward along supply curve S P2 P1
Price increase moves us leftward along supply curve P3 Q3 Q1 Q2
Lieberman & Hall; Introduction to Economics, 2005

36. Figure 6(b): Changes in Supply and in Quantity Supplied
Price
Entire supply curve shifts rightward when:
price of input ↓
price of alternate good ↓
number of firms ↑
expected price ↑
technological advance
favorable weather S1 S2
Lieberman & Hall; Introduction to Economics, 2005

37. Figure 6(c): Changes in Supply and in Quantity Supplied
Price
Entire supply curve shifts rightward when:
price of input ↑
price of alternate good ↑
number of firms ↓
expected price ↑
unfavorable weather S2 S1
Lieberman & Hall; Introduction to Economics, 2005

38. In Summary: Factors that Shift the Supply Curve
The short list of shift-variables for supply that we have discussed is far from exhaustive
In some cases, even the threat of such events can cause serious effects on production
Basic principle is always the same
Anything that makes sellers want to sell more or less of a good at any given price will shift supply curve
Lieberman & Hall; Introduction to Economics, 2005

39. Equilibrium: Putting Supply and Demand Together
When a market is in equilibrium
Both price of good and quantity bought and sold have settled into a state of rest
The equilibrium price and equilibrium quantity are values for price and quantity in the market but, once achieved, will remain constant
Unless and until supply curve or demand curve shifts
The equilibrium price and equilibrium quantity can be found on the vertical and horizontal axes, respectively
At point where supply and demand curves cross
Lieberman & Hall; Introduction to Economics, 2005

40. Figure 7: Market Equilibrium
Number of Bottles per Month
Price per Bottle
2. causes the price to rise . . .
3. shrinking the excess demand . . . S E
4. until price reaches its equilibrium value of $3.00 .
$3.00 H J
1.00
Excess Demand D
25,000
50,000
75,000
1. At a price of $1.00 per bottle an excess demand of 50,000 bottles . . .
Lieberman & Hall; Introduction to Economics, 2005

41. Excess Demand: Putting Supply and Demand Together
At a given price, the excess of quantity demanded over quantity supplied
Price of the good will rise as buyers compete with each other to get more of the good than is available
Lieberman & Hall; Introduction to Economics, 2005

42. Figure 8: Excess Supply and Price Adjustment
1. At a price of $5.00 per bottle an excess supply of 30,000 bottles . . .
Number of Bottles per Month
Price per Bottle
Excess Supply at $5.00 S
3. shrinking the excess supply . . .
$5.00 K L
2. causes the price to drop, E
4. until price reaches its equilibrium value of $3.00.
3.00 D
35,000
50,000
65,000
Lieberman & Hall; Introduction to Economics, 2005

43. Excess Supply: Putting Supply and Demand Together
At a given price, the excess of quantity supplied over quantity demanded
Price of the good will fall as sellers compete with each other to sell more of the good than buyers want
Lieberman & Hall; Introduction to Economics, 2005

44. Income Rises: What Happens When Things Change
Income rises, causing an increase in demand
Rightward shift in the demand curve causes rightward movement along the supply curve
Equilibrium price and equilibrium quantity both rise
Shift of one curve causes a movement along the other curve to new equilibrium point
Lieberman & Hall; Introduction to Economics, 2005

45. Figure 9: A Shift in Demand and a New Equilibrium
Number of Bottles of Maple Syrup per Period
Price per Bottle
3. to a new equilibrium.
4. Equilibrium price increases
2. moves us along the supply curve . . . S
$4.00 F'
1. An increase in demand . . .
3.00 E D2 D1
5. and equilibrium quantity increases too.
50,000
60,000
Lieberman & Hall; Introduction to Economics, 2005

46. An Ice Storm Hits: What Happens When Things Change
An ice storm causes a decrease in supply
Weather is a shift variable for supply curve
Any change that shifts the supply curve leftward in a market will increase the equilibrium price
And decrease the equilibrium quantity in that market
Lieberman & Hall; Introduction to Economics, 2005

47. Figure 10: A Shift of Supply and a New Equilibrium
Number of Bottles
Price per Bottle S2 S1
$5.00 E'
3.00 E D
35,000
50,000
Lieberman & Hall; Introduction to Economics, 2005

48. Figure 11: Changes in the Market for Handheld PCs
Millions of Handheld PCs per Quarter
Price per Handheld PC
3. moved the market to a new equilibrium.
2. and a decrease in demand . . .
4. Price decreased . . .
S2002
S2003 A
$500
1. An increase in supply . . . B
$400
5. and quantity decreased as well.
D2002
D2003
2.45
3.33
Lieberman & Hall; Introduction to Economics, 2005

49. Both Curves Shift
When just one curve shifts (and we know the direction of the shift) we can determine the direction that both equilibrium price and quantity will move
When both curves shift (and we know the direction of the shifts) we can determine the direction for either price or quantity—but not both
Direction of the other will depend on which curve shifts by more
Lieberman & Hall; Introduction to Economics, 2005

50. The Principle of Markets and Equilibrium
The supply-and-demand model is just one example of a more general approach
To identify a market and examine its equilibrium
Basic Principle #4: Markets and Equilibrium
To understand how the economy behaves, economists organize the world into separate markets and then examine the equilibrium in each of those markets
This approach helps us predict important changes in the economy and prepare for them
And it helps us predict important changes in the economy our social goals and avoid policies that are likely to backfire
Lieberman & Hall; Introduction to Economics, 2005

51. Price Ceilings
Government-imposed maximum price that prevents the price of a good from rising above a certain level in a market
Short side of the Market
Smaller of quantity supplied and quantity demanded at a particular price
When quantity supplied and quantity demanded differ, short side of market will prevail
Price ceiling creates a shortage and increases the time and trouble required to buy the good
While the price decreases, the opportunity cost may rise
Black Market
A market created by unintended consequences of government intervention
Goods are sold illegally at a price above the legal ceiling
Lieberman & Hall; Introduction to Economics, 2005

52. Figure 12: A Price Ceiling in the Market for Maple Syrup
5. With a black market, the lower quantity sells for a higher price than initially.
Number of Bottles of Maple Syrup per Period
Price per Bottle
3. and decreases quantity supplied.
4. The result is a shortage – the distance between R and V. S T
$4.00 E
3.00 R V
2. increases quantity demanded
2.00 D
40,000
50,000
60,000
1. A price ceiling lower than the equilibrium price . . .
Lieberman & Hall; Introduction to Economics, 2005

53. Price Floors
Government imposed minimum amount below which price is not permitted to fall
Price floors for agricultural goods are commonly called price support programs
When sellers produce more of the good than buyers want at the price floor
Remaining goods become a surplus that no one wants at the imposed price
Government responds by maintaining price floors
Uses taxpayer dollars to buy up entire excess supply of the good in question
Prevents excess supply from doing what it would ordinarily do
Drive price down to its equilibrium value
Lieberman & Hall; Introduction to Economics, 2005

54. The Principle of Policy Tradeoffs
In our discussion of government intervention in markets, you may have noticed something interesting
A policy designed to help us achieve one goal causes us to compromise on some other goal
In fact, as you will see throughout this text, there are virtually always tradeoffs involved in government policy making
For this reason, we consider government policy tradeoffs to be one of the basic principles of economics
Lieberman & Hall; Introduction to Economics, 2005

55. The Principle of Policy Tradeoffs
Basic Principle #5: Policy Tradeoffs
Government policy is constrained by the reactions of private decision makers
As a result, policy makers face tradeoffs
Making progress toward one goal often requires some sacrifice of another goal
Economics is famous for making the public aware of policy tradeoffs
Lieberman & Hall; Introduction to Economics, 2005

56. Supply and Demand and Normative Economics
Supply and demand offers us important lessons about the economy
The lessons are both positive
Telling us what will happen when there is a change in a market
And normative
Suggesting what sorts of polices we should or should not pursue
Most economists believe that the mechanism of supply and demand is an effective way to allocate resources
Why do economists feel this way?
Answering this question requires a more thorough understanding of the economy than we can provide after just three chapters of this book
However, when you finish your introductory study of economics, you will know why economists treat supply and demand with such respect
Lieberman & Hall; Introduction to Economics, 2005

57. Using Supply and Demand: The Invasion of Kuwait
Why did Iraq’s invasion of Kuwait cause the price of oil to rise?
Immediately after the invasion, United States led a worldwide embargo on oil from both Iraq and Kuwait
A significant decrease in the oil industry’s productive capacity caused a shift in the supply curve to the left
Price of oil increased
Lieberman & Hall; Introduction to Economics, 2005

58. Figure 13: The Market For Oil
Barrels of Oil
Price per Barrel of Oil S2 S1 E' P2 P1 E D Q2 Q1
Lieberman & Hall; Introduction to Economics, 2005

59. Using Supply and Demand: The Invasion of Kuwait
Why did the price of natural gas rise as well?
Oil is a substitute for natural gas
Rise in the price of a substitute increases demand for a good
Rise in price of oil caused demand curve for natural gas to shift to the right
Thus, the price of natural gas rose
Lieberman & Hall; Introduction to Economics, 2005

60. Figure 14: The Market For Natural Gas
Cubic Feet of Natural Gas
Price per Cubic Foot of Natural
Gas S F' P4 F P3 D2 D1 Q3 Q4
Lieberman & Hall; Introduction to Economics, 2005