1. Demand, Supply and Equilibrium

2. Contents Deriving the Supply Curve Supply and Demand Equilibrium
Effects of Demand and Supply Shifts on Equilibrium
Welfare Properties of Equilibrium
Fighting the Invisible Hand: The Market Fights Back
Copyright© 2006 South-Western/Thomson Learning. All rights reserved.

3. The Invisible Hand
Supply and demand  automatic solution to economic problems
Interference in markets  counterproductive consequences
Invisible hand = in the pursuit of self-interest, individuals promote social well-being

4. Deriving Supply Curve
Recall example with garages from previous lecture
Consider the cost schedule for Al

5. TABLE 1: Al’s Total, Average, and Marginal Costs
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6. FIGURE 1: Marginal Cost Curve50 MC 45 40 35 30
Marginal Cost per Added Garage (thousands $) 25 20 15 10 5 1 2 3 4 5 6 7 8 9 10
Output, Garages per Year
(c) Marginal Cost
Copyright © 2006 South-Western/Thomson Learning. All rights reserved.

7. Supply Curve
Supply curve of a firm is the increasing part of its marginal cost curve
Why only increasing part?
Because when MC decrease with Q, it is optimal to increase output

8. FIGURE 2: Marginal Cost Curve and Supply Curve50 MC 45 40 35
Supply Curve 30
Marginal Cost per Added Garage (thousands $) 25 20 15 10 5 1 2 3 4 5 6 7 8 9 10
Output, Garages per Year
Marginal Cost
Copyright © 2006 South-Western/Thomson Learning. All rights reserved.

9. From Individual to Market Supply
We derived supply of single firm
In every market there are usually many producers
The market supply is a sum of all individual supply curves

10. Supply and Quantity Supplied
Sellers (producers)  supply
Quantity supplied = amount that producers wish to sell at each price
Law of supply = price and the quantity supplied are positively related, all else equal

11. TABLE 2 Supply Schedule for Milk
We will focus on the example of the market for milk
Copyright© 2006 South-Western/Thomson Learning. All rights reserved.

12. Supply and Quantity Supplied
The Supply Schedule and the Supply Curve
Supply Schedule = a table showing the quantity of demand at each price for some good
Supply Curve = graph of a supply schedule
Positive slope

13. FIGURE 3 Supply Curve for Milka
$1.50 S b
1.40 c
1.30 e
Price per Quart
1.20 f
1.10 g
1.00 h
.90 30 40 50 60 70 80 90
Quantity Supplied
in Billions of Quarts per Year
Copyright© 2006 South-Western/Thomson Learning. All rights reserved.

14. Supply and Quantity Supplied
Shifts of the Supply Curve
Movement along a supply curve due to
Changes in price
Shift between supply curves due to
Changes in industry size (entry and exit)
Changes in production technology
Changes in prices of inputs
Changes in prices of related outputs

15. FIGURE 4 Movements along versus Shifts of a Supply CurveS 1 c
$1.30
Price per Quart f
1.10
Movement along from f to c can be a result of a rise in DEMAND for milk – say if health studies show that milk is very healthy, people would buy more of it. This would create incentives for milk producers to raise price of milk. This DOES NOT affect the supply!
A shift in supply of milk can be a result of, say, the fact that government lowered import quotas on foreign milk, so more milk is now available for sale on the market in total
Quantity Supplied
in Billions of Quarts per Year
Copyright© 2006 South-Western/Thomson Learning. All rights reserved.

16. FIGURE 5 Shifts of the Supply Curve2 S S S 1
Price
Price
A right shift in supply of milk can be a result of, say, the fact that government lowered import quotas on foreign milk, so more milk is now available for sale on the market in total, as we said
A left shift can be caused by the fact that the demand for beef suddenly goes up. Then some people would slaughter cows to get beef, which would reduce supply of milk
Quantity
(a)
Quantity
(b)
Copyright© 2006 South-Western/Thomson Learning. All rights reserved.

17. Refresher on Demand Buyers  demand
Quantity demanded = the amount that buyers wish to purchase at each price
Law of demand = price and the quantity of demand are negatively related, all else equal

18. Refresher on Demand The Demand Schedule
Table showing the quantity of demand at each price for some good

19. TABLE 3 Demand Schedule for Milk
Copyright© 2006 South-Western/Thomson Learning. All rights reserved.

20. Demand and Quantity Demanded
The Demand Curve
Graph of a demand schedule
Negative slope

21. FIGURE 6 Demand Curve for Milk
$1.50 B
1.40 C
Price per Quart
1.30 E
1.20 F
1.10 G
1.00 H
.90 45 50 55 60 65 70 75
Quantity Demanded
in Billions of Quarts per Year
Copyright© 2006 South-Western/Thomson Learning. All rights reserved.

22. Demand and Quantity Demanded
Shifts of the Demand Curve
Movement along a demand curve due to
Changes in price
Shift between demand curves due to
Changes in consumers’ incomes
Changes in number of consumers (population)
Changes in consumers’ preferences (tastes)
Changes in prices and availability of related goods

23. FIGURE 7 Movements along a versus Shifts of a Demand Curve1 D C
$1.30
Price per Quart F
Movement along demand curve is usually the result of a shift in supply – let us recall the example when more milk now comes from abroad This shifts supply to the right, so we move along demand
Shift in demand for milk – example of tastes changes due to medical studies
1.10
Quantity Demanded in Billions of Quarts per year
Copyright© 2006 South-Western/Thomson Learning. All rights reserved.

24. Supply and Demand Equilibrium
There is normally one price where quantity of supply = quantity of demand
This price  equilibrium
An equilibrium price on the market is such that at this price quantity demanded is equal to the quantity supplied
So equilibrium is a pair

25. Supply and Demand Equilibrium
Below equilibrium price  shortage
Above equilibrium price  surplus
Surpluses and shortages  changes in price
Changes in price  restoration of equilibrium

26. TABLE 4 Equilibrium Price & Quantity of Milk
Copyright© 2006 South-Western/Thomson Learning. All rights reserved.

27. Supply and Demand Equilibrium
Interaction of supply and demand  equilibrium
A market not in equilibrium  equilibrium
Equilibrium = a state of rest
“Outside events” cause a change of the equilibrium

28. FIGURE 8 Supply-Demand Equilibrium
$1.50
1.40
1.30 E
Price per Quart
1.20
1.10 g G
1.00
Here Aa is a surplus, gG is a shortage. If surplus, demand too small. Then some sellers that don’t sell decide to lower price a bit, so that to attract some consumers that were not buying previously. This pushes price down. In the end, we get to eqm
For shortage, too many are willing to buy, some even wanna pay more than $1, so some sellers decide to raise price, and so on
.90 30 40 50 60 70 80 90
Quantity
in Billions of Quarts per Year
Copyright© 2006 South-Western/Thomson Learning. All rights reserved.

29. Demand Shifts on Supply-Demand Equilibrium
Shifts in Demand
Changes in any of the non-price determinants of demand and/or supply  change of equilibrium
Shifts of the demand curve  change equilibrium price and quantity in the same direction

30. FIGURE 9 The Effects of Shifts of the Demand Curve1 S D S D D 2 T
$1.30
Price per Quart
Price per Quart E E R
1.20
$1.20 L M
1.10
When demand shifts to right both eqm price and qty go up
When demand shifts to left, both go down 60 70 75 45 50 60
Quantity
Quantity
(a)
(b)
Copyright© 2006 South-Western/Thomson Learning. All rights reserved.

31. Supply Shifts and Supply-Demand Equilibrium
Shifts in Supply
Shifts of the supply curve  change in equilibrium price and quantity in opposite directions
Old equilibrium position  new equilibrium position

32. FIGURE 10 Effects of Shifts of the Supply Curve2 D D V S
$1.40 S
Price per Quart
Price per Quart I E E U
$1.20 S 1
1.20 J
1.10
When supply shifts to right eqm price goes down and eqm qty goes up
When supply shifts to left eqm price goes up and eqm qty goes down 60 65 78
37.5 50 60
Quantity
Quantity
(a)
(b)
Copyright© 2006 South-Western/Thomson Learning. All rights reserved.

33. Rule of Thumb When demand curve shifts, we move along the supply curve
When supply curve shifts, we move along the demand curve
Always draw a diagram to make sure you understand what happens

34. Sometimes we cannot say much…
When both supply and demand curve shift, we usually have problems with predicting new equilibium:
Can predict price, not quantity
Or can predict quantity, not price
Because it is the degree of shifts in both curves that determine the final outcome

35. Consumer Surplus
Consumer Surplus is the difference between the maximum amount that the consumer is willing to pay for the product and the price that she actually gets to pay
Graphically it is the area above the equilibrium price and below the market demand line

36. Producer Surplus
Producer Surplus is the difference between the price at which the producer happens to sell the product and her costs (i.e. the smallest amount of money she is willing to accept in exchange for the product she offers)
Graphically it is the area below the equilibrium price and above the market supply line

37. FIGURE 11 Consumer and Producer Surplus
$1.50
1.40 S CS
1.30
Price per Quart
1.20 PS
1.10
1.00
.90 30 40 50 60 70 80 90
Quantity
in Billions of Quarts per Year
Copyright© 2006 South-Western/Thomson Learning. All rights reserved.

38. Some Geometry Refresher
Area of the triangle:
Let us compute these for the example we just had

39. Calculating CS and PS CS: PS: base = 60 − 0 = 60
height = 1.50 − 1.20 = 0.3
Area = 0.5 * 60 * 0.3 = $9 bln
PS:
height = 1.20 − 1.00 = 0.2
Area = 0.5 * 60 * 0.2 = $6 bln

40. Total Surplus and Welfare
Welfare is understood in economics as some measure of well-being of agents
We saw an example – utility of consumer
For market with many agents, natural measure is Total Surplus (TS)
TS = CS + PS
In previous example, TS = = $15 bln

41. Why Market Economy?
We like free market economy because it maximizes Total Surplus
Only those buyers with high willingness to pay buy
Only those sellers with low costs sell
Total Surplus is the biggest possible in this case
This says nothing about equality!

42. Fighting the Invisible Hand: The Market Fights Back
A Can of Worms
Favoritism and corruption
Unenforceability
Limitation of the volume of transactions
Misallocation of resources
Let us see what our model predicts about fighting the invisible hand

43. Welfare Analysis of Policies

44. Benchmark Case
We first analyze the case when the market system works on its own
This is the benchmark case
We will show all other cases decrease TS
Here CS = A + B + C
PS = H + L + G
TS = A + B + C + H + L + G

45. Benchmark Case

46. Price Ceiling Now suppose government introduces price ceiling
Must be below P2, say, P3
What are CS, PS, TS now?
Since at P3 quantity demanded exceeds quantity supplied, there is shortage
So only Q 1 units are sold

47. Price Ceiling

48. Price Ceiling Here CS = A + B + G PS = L TS = A + B + L + G
Notice the blue triangle C + H is now NOT in the TS
This is called Dead Weight Loss (DWL) – measure of inefficiency

49. Fighting the Invisible Hand: The Market Fights Back
Restraining the Market Mechanism: Price Ceilings
Shortages
Black markets with higher prices
Underinvestment
Vested interests that resist change

50. Price Floor Now suppose government introduces price floor
Must be above P2, say, P1
What are CS, PS, TS now?
Since at P1 quantity supplied exceeds quantity demanded, there is surplus
Again only Q1 units are sold

51. Price Floor

52. Price Floor Here CS = A PS = L + B + G TS = A + B + L + G
Notice the blue triangle C + H is now NOT in the TS again
So we again have DWL from interfering with the market mechanism

53. Fighting the Invisible Hand: The Market Fights Back
Restraining the Market Mechanism: Price Floors
Surpluses
Disposal problems
Overinvestment
Vested interests that resist change

54. More Complicated Example
By simply fixing price we make some group better off at the expense of the other group
Total result is negative, however
Maybe government can help?
Suppose again fix price at P1 as a floor, but government buys all the surplus that consumers do not want to buy

55. More Complicated Example
Extra Costs

56. More Complicated Example
Clearly costs of government intervention do not compensate the extra gain for producer
So intervention is in general not a good idea
Later on in the course we will see examples when government intervention is beneficial

57. Tax Policy Analysis
Suppose government wants to introduce a tax on producers
There are many different taxes
We consider the easiest – per-unit sales tax
It means that producers have to pay a fixed amount of money to the government for every unit they have sold

58. Tax Policy Analysis Costs of producers stay the same
So they translate tax into price one-for-one
Suppose the government introduces a sales tax of 10 cents per gallon of milk
This shifts supply curve up
How much equilibrium changes is determined by demand elasticity
However, all tax burden is split between consumer and producer

59. FIGURE 10 Who Pays for a New Tax on Products?M
$1.64 E 1
1.60 S
Price per Gallon
1.54 E Q 2 Q 1 30 50
Millions of Gallons per Year
Copyright© 2006 South-Western/Thomson Learning. All rights reserved.

60. Tax Policy Analysis
Notice that both consumers and producers pay tax, even though government wants to tax producers only
How tax burden is split between consumers and producers?
Depends on price elasticities of supply and demand
Or, more precise, on the relative elasticity

61. A Simple But Powerful Lesson
Self-interested actions of buyers and sellers  laws of supply and demand
Difficult to resist
Interference  counterproductive effects

62. The End
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