1. Supply and Demand Key issues demand supply market equilibrium shocking the equilibrium effects of government interventions when to use supply and demand model Today's questions What is the effect of a ban on foreign imports of rice into Japan on the supply of rice to the Japanese market? What is the effect of a price control (ceiling)? What is the effect of instituting usury laws? Could the Immigration Reform and Control Act create a labor shortage for farmers? Will the mad cow crisis lower beef prices in the United States? 1. 2. 3. 4. 5. 1

2. What is the most important thing you know about economics? many people reply supply equals demand this statement summarizes a simple, yet powerful model Supply and demand model most widely-used economic model testable (like all good theories) describes how consumers and suppliers interact in a market to determine quantity of a good sold and its price To use supply and demand model you need to determine buyers' behavior sellers' behavior how they interact know where to use the model: in competitive markets 2

3. Quantity demanded is the amount of a good or service that consumers want to buy at a given price, holding constant other factors that affect demand What determines demand? tastes price of this good prices of other goods income information (cholesterol) government actions other factors: nicotine,... Demand curve shows quantity demanded—largest quantity that consumers are willing to buy—at each price, holding constant other factors that affect purchases note: quantity demanded of a good or service can exceed quantity sold (or vice versa) strange demand curve convention: price is on the vertical axis 3

4. Figure 2.1 Demand Curve for Canadian Processed Pork p, $ per kg 14.30 4.30 3.30 2.30 0200 220 240286 Q, Million kg of pork per year Effect of price changes movement along the demand curve demand curve is a concise summary of the answer to the question: what happens to the quantity demanded as the price changes, holding all other factors constant? Law of demand demand curves slope down a drop in price results in an increase in quantity demanded (holding other factors constant) one of the most important empirical finding in economics 4 Demand curve for pork, D 1

5. Demand effects of other factors change in any factor other than the price of the good causes a shift of the demand curve (not a movement along the demand curve) this shift of the demand curve is a trick to avoid drawing 3D diagrams Effect on pork demand of a rise in price of beef beef is a substitute for pork at a given price of pork, a rise in the price of beef causes some people to switch from beef to pork Figure 2.2 A Shift of the Pork Demand Curve p, $ per kg 3.30 D 2D 2 0 176220232 Q, Million kg of pork per year 5 Effect of a 60¢ increase in the price of beef DD1DD1

6. Summary change in the price of a good causes a movement along a demand curve change in any other factor besides the price causes a shift of the demand curve Variable definitions Q = quantity of pork demanded (million kg per year) p = price of pork ($ per kg) p b = price of beef ($ per kg) p c = price of chicken ($ per kg) Y = income of consumers (thousand $) Demand function general function Q = D(p, p b, p c, Y) specific (linear) pork demand function Q = 171 - 20p + 20p b + 3p c + 2Y 6

7. Hold other factors constant D 1 (Figure 2.1) holds p b, p c, and Y at their typical values: p b = $4 per kg p c = $3 1/3 per kg Y = $12.5 thousand Q = 171 – 20p + 20p b + 3p c + 2Y = 171 – 20p + (20 x 4) + (3 x 3 1/3) + (2 x 12.5) = 286 – 20p Figure 2.1 Demand Curve for Canadian Processed Pork p, $ per kg 14.30 4.30 3.30 2.30 0200 220 240286 Q, Million kg of pork per year Plotting demand function: Intercept Q = 286 – 20p constant term, 286, is the quantity demanded if price is zero Q = 286 - (20 x 0) = 286 D 1 hits quantity axis at 286 (price = 0) 7 Demand curve for pork, D 1

8. Plotting demand function: Slope Q = 286 – 20p number on price, 20, is rate at which quantity changes as price changes Q = Q 2 - Q 1 = D(p 2 ) – D(p 1 ) = (286 – 20p 2 ) - (286 – 20p 1 ) = -20(p 2 – p 1 ) = -20 p p = $1 Q = -20 p = -20 million kg per year Slope of pork demand curve p/ Q = [the "rise"]/[the "run"] = [$1 per kg]/[-20 million kg per year] = -$0.05 per million kg per year negative sign is consistent with Law of Demand Calculus Q = 286 – 20p differentiate: dQ dp 20 8

9. Summing demand curves total demand is sum of demand for all consumers suppose there are 2 consumers with demand curves: Q 1 = D 1 (p) Q 2 = D 2 (p) total quantity demanded = horizontal sum of quantity each consumer demands at each given price: Q = Q 1 + Q 2 = D 1 (p) + D 2 (p) Application Aggregating the Demand for Cling Peaches p, $ per ton 275 183 0 Q = 4Q = 18 Q = 2250 fc Q, Tons of peaches per 10,000 people per year Quantity supplied is the amount of a good or service that firms want to sell at a given price, holding constant other factors that affect supply 9 Demand forfruit Total demand Demand for canned peaches cocktail

10. Supply is a function of price costs of production government rules and regulations technology… Supply curve increase in price of pork causes a movement along the supply curve (holding fixed other variables that affect supply) supply curve is a concise summary of answer to the question: what happens to the quantity supplied as the price changes holding all other factors constant? Figure 2.3 Supply Curve of Canadian Processed Pork p, $ per kg 5.30 Supply curve, S 1 3.30 0 176220300 Q, Million kg of pork per year 10

11. Effect of price on supply supply curve for pork is upward sloping thus, increase in the price of pork movement along the supply curve, resulting in larger quantity of pork supplied There is no "Law of Supply" market supply curve may be upward sloping, vertical, horizontal, or downward sloping Supply effects of other variables shift in a variable other than price of pork causes the entire supply curve to shift 11

12. Figure 2.4 A Shift of Pork Supply Curve p, $ per kg S 1S 1 3.30 0 176205220 Q, Million kg of pork per year Summary change in price of pork causes a movement along the supply curve when costs, government rules, or other variables that affect supply change, the supply curve shifts General supply function Q = S(p, p h ), Q = the quantity of processed pork supplied (million kg per year) p = price of processed pork ($ per kg) p h = price of a hog ($ per kg) 12 Effect of a 25¢ increase in the price of hogs S 2

13. Specific linear pork supply function Q = 178 + 40p - 60p h, holding p h fixed at its average value of $1.50 per the supply function is Q = 88 + 40pQ = 88 + 40p Movement along the supply curve supply function: Q = 88 + 40p if price of processed pork increases by p = p 2 - p 1 then Q = 40 p Calculus Q = 88 + 44p differentiate: dQ dp 44 13

14. Summing supply curves total supply curve horizontal summation of individual supply curves shows total quantity produced by all suppliers at each possible price Total Supply: The Sum of Domestic and Foreign Supply (a) Japanese Domestic Supply(b) Foreign Supply(c) Total Supply p, Price ce on rice ton per ton ) p *p *p*p*p *p * ppp Q *dQ *d Q * f Q, Tons per year f Q * = Q * + Q * d f Q, Tons per year d Solved problem What is the effect of a ban on foreign imports of rice into Japan on the supply curve of rice to the Japanese market? (suppose that domestic and foreign supply curves of rice in Japan are linear, upward sloping curves with the same intercept and different slopes) 14 S (no ban p, P S f (no ban) per p, Pri S d per t

15. Restatement of problem in most of our problems we are asked to determine how a change in a variable or policy affects one or more variables what changes: foreign rice may no longer be imported which affects foreign supply and total Japanese supply curve Answer 1. s how what the ban does to the foreign supply: ban prevents imports new foreign supply curve, S f, lies on the vertical axis 2. compare the new and original foreign supply curves: at prices above the price where foreign supplier originally supplied quantity, the new foreign supply curve lies to left of original one Answer (continued) 3. s how what happens to new total supply: new total supply curve is the horizontal sum of the Japanese supply curve, S d, and foreign supply curve, S f. Thus, new total supply curve is identical to domestic supply curve 4. compare new and original total supply curves: at any price above the price where any quantity was originally supplied by foreign suppliers, the new total supply curve lies to the left of the original one 15

16. Figure 2.5 Total Supply: The Sum of Domestic and Foreign Supply (a) Japanese Domestic Supply(b) Foreign Supply(c) Total Supply p, Price ce on rice ton per ton ) p *p *p*p*p *p * ppp Q *dQ *d Q * f Q, Tons per year f Q = Q * Q * = Q * + Q * d d f Q, Tons per year d Quota next figure shows the effect of a (nonzero) quota on the supply curve of rice (a) U.S. Domestic Supply(b) Foreign Supply(c) Total Supply rice ton p, Price per ton ice ton SfSf p*p*p*p*p*p* ppp Q Q * Q + Q Q * + Q Q *+ Q * d Q, Tons per year d f Q, Tons per year f d f d f d f Q, Tons per year 16 SSSS p, Pr per S d S f p, P per S (ban) S (no ban p, Pri S d per t p, P S f (ban) S f (no ban) per

17. Supply and demand: Market equilibrium supply and demand curves determine market price and quantity unless price is set so that consumers want to buy exactly as much as suppliers want to sell, some party will be frustrated when neither buyers nor sellers are disappointed, market is in equilibrium: no one wants to change his or her behavior Equilibrium equilibrium price: price where consumers can buy as much as they want sellers can sell as much as they want equilibrium quantity:quantity bought and sold at the equilibrium price Figure 2.6 Pork Market Equilibrium p, $ per kg Excess supply = 39 3.95 3.30 2.65 0 176194207220233246 Q, Million kg of pork per year 17 Excess SDSD e Excess demand= 39

18. Determine equilibrium price find price, p, that equates equilibrium demand and supply quantity: Q d = Q s = Q, equilibrium quantity: Q d = 286 - 20p (demand function) Q s = 88 + 40p (supply function) Q d = 286 - 20p = 88 + 40p = Q s 286 - 88 = 40p + 20p 198 = 60p 3.30 = p Determine equilibrium quantity substitute equilibrium price, p = $3.30, into demand function or supply function to determine equilibrium quantity: Q d = 286 – (20 x 3.30) = 88 + (40 x 3.30) = Q s = 220 = Q Invisible hand at nonequilibrium price, consumers or firms change their behavior (market forces) driving price to equilibrium level 18

19. Market forces drive market to equilibrium at prices < equilibrium level: excess demand (amount by which quantity demanded exceeds quantity supplied at the specified price) at price > equilibrium level: excess supply equilibrium price is market clearing price: no excess demand or excess supply Figure 2.6 Pork Market Equilibrium p, $ per kg Excess supply = 39 3.95 3.30 2.65 0 176194207220233246 Q, Million kg of pork per year Shocking the equilibrium once an equilibrium is achieved, it can persist indefinitely because no one applies pressure to change the price equilibrium changes only if demand curve shifts supply curve shifts government intervenes 19 Excess SDSD e Excess demand= 39

20. Figure 2.7a Effects of a Shift of the Pork Demand Curve (a) Effect of a 60¢ Increase in the Price of Beef p, $ per kg S 3.50 3.30 1 1 0 176220 228 232 Excess demand = 12 Q, Million kg of pork per year Figure 2.7b Effects of a Shift of the Pork Demand Curve (b) Effect of a 25¢ Increase in the Price of Hogs p, $ per kg e2e2 3.55 3.30 1 0 176205215 220 Excess demand = 15 Q, Million kg of pork per year Government policies ceiling price price controls usury laws rent control floor price: minimum wage quotas (restriction on supply) taxes and tariffs (tax on imports only) 20 S2S 1S2S 1 eDeD e2e2 e D2DD2D

21. Zimbabwe price controls October 2001 during a presidential campaign, Zimbabwe’s government imposed price controls on many basic commodities foods (about a third of citizens’ daily consumption) soap cement controls led to shortages thriving black or parallel market developed black market prices 2 to 3 x controlled prices Zimbabwe: Cement cement manufacturers stopped accepting new orders when price controls were imposed dealers quickly shifted existing supplies to the parallel market lack of cement crippled the construction industry by May 2002, the government nearly doubled control price of cement in an effort to induce firms to resume selling cement Zimbabwe: Food sugar is significantly cheaper than in surrounding regions smuggling to other countries Zimbabwe suffered from sugar shortage supermarkets have no maize-meal, sugar, and cooking oil on many days bakers scaled back operation--they have only half as much flour as before controls because of shortages, many people may starve 21

22. Solved problem: Minimum wage What is the effect of a minimum wage on a labor market? restatement: what changes is that government sets a minimum wage, w*, that must be paid affects equilibrium wage, equilibrium hours worked Minimum Wage w, wage w* w H dH d HsHs H, Hours worked H Excess supply: Unemployment Supply need not equal demand price ceilings or price floors quantity supplied does not necessarily equal quantity demanded quantity supplied = amount firms want to sell at a given price, holding constant other factors that affect supply quantity demanded = amount consumers want to buy at a given price, holding constant other factors 22 S Minimum wage e D

23. Permanent excess demand or supply quantity demanded and quantity supplied at a given price need not equal actual quantity that is bought and sold: can get persistent excess demand (price ceiling) can get persistent excess supply (price floor) Supply equals demand if someone insists that "demand must equal supply," they must be defining demand and supply as the actual quantities sold we define quantities supplied and demanded in terms of peoples' wants thus, statement that "supply equals demand" is a theory, not merely a definition When to use supply and demand model many buyers and sellers firms sell identical goods firms are price takers no uncertainty: everyone has full information about price and quality of goods low transaction costs: buyers and sellers can trade easily 23

24. When supply and demand model is inappropriate only a few sellers (auto manufacturers) buyers and sellers are uncertain about the market equilibrium (concert music business) consumers know much less than sellers about quality or price (used cars) high transaction costs (art work) Use supply and demand model in agricultural markets financial labor construction services wholesale retail 1 Demand curve summary demand curve: relationship between quantity demanded and price, fixing other factors Law of Demand: demand curves slope down change in price causes a movement along the demand curve change in income, tastes, or another factor other than price, causes a shift of the demand curve total demand curve = horizontal sum of individuals’ demand curves 24

25. 2 Supply curves supply curve: relationship between quantity supplied and price, holding constant other factors market supply curve need not slope up but frequently does change in price causes a movement along the supply curve shift in the price of an input or government regulations cause a shift of the supply curve total supply curve = horizontal sum of individual firms’ supply curves 3 Market equilibrium intersection of demand and supply curves determines market equilibrium price and quantity market force drive the price and quantity to the equilibrium levels if they are initially too low or too high 4 Shocks change in an underlying factor other than price that causes a shift of the supply curve or the demand curve, alters the equilibrium 25

26. 5 Effects of government intervention government policies, such as price controls, can cause the quantity supplied to be greater or less than the quantity demanded, so that there are persistent shortages or excesses 6 When to use supply and demand model supply and demand model is applicable only in competitive markets competitive markets: homogeneous goods, many buyers and sellers (price takers) 26