1. Macroeconomics ECON 2302 May 2011 Marilyn Spencer, Ph.D. Professor of Economics Chapter 3

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3. CHAPTER 3 Where Prices Come From: The Interaction of Demand and Supply The intense competition among firms selling energy drinks is a striking example of how the market responds to changes in consumer tastes.

4. 3.1The Demand Side of the Market Discuss the variables that influence demand. 3.2The Supply Side of the Market Discuss the variables that influence supply. 3.3Market Equilibrium: Putting Demand and Supply Together Use a graph to illustrate market equilibrium. 3.4The Effect of Demand and Supply Shifts on Equilibrium Use demand and supply graphs to predict changes in prices and quantities Chapter Outline and Learning Objectives Where Prices Come From: Interaction of Demand & Supply CHAPTER 3

5. Perfectly Competitive Market A market that meets the conditions of: 1.Many buyers and sellers, 2.All firms selling identical products 3.No barriers to new firms entering the market 4.Low cost information Where Prices Come From: The Interaction of Demand and Supply

6. ÜDemand schedule A table showing the relationship between the price of a product and the quantity of the product demanded. ÜQuantity demanded The amount of a well defined good or service that a consumer is willing and able to purchase at a given price, during some given time period. ÜDemand curve A curve that shows the relationship between the price of a well defined product and the quantity of the product demanded, during some given time period. ÜMarket demand The demand by all the consumers of a given good or service. The Demand Side of the Market Demand Schedules and Demand Curves: Discuss the variables that influence demand. 3.1 LEARNING OBJECTIVE

7. FIGURE 3-1 A Demand Schedule and Demand Curve As price changes, consumers change the quantity of energy drinks they are willing to buy. We can show this as a demand schedule in a table or as a demand curve on a graph. They both show that as the price of energy drinks falls, the quantity demanded rises. When the price is $3.00, consumers buy 60 million cans/day. When the price drops to $2.50, consumers buy 70 million cans. Therefore, the demand curve for energy drinks is downward sloping. The Demand Side of the Market: Demand Schedules and Demand Curves

8. 4 Law of demand The rule that, holding everything else constant, when the price of a product falls, the quantity demanded of the product will increase, and when the price of a product rises, the quantity demanded of the product will decrease. The Demand Side of the Market: The Law of Demand

9. The Demand Side of the Market Individual Demand and Market Demand Market demand The demand for a product by all the consumers in a given geographical area. Deriving the Market Demand Curve from Individual Demand Curves

10. 4 Substitution effect The change in the quantity demanded of a good that results from a change in price, making the good more or less expensive relative to other goods that are substitutes. 4 Income effect The change in the quantity demanded of a good that results from the effect of a change in the good’s price on consumers’ purchasing power. The Demand Side of the Market: What Explains the Law of Demand?

11. 4 Ceteris paribus (“all else equal”) condition The requirement that when analyzing the relationship between two variables—such as price and quantity demanded— other variables must be held constant. 4 A shift of a demand curve is an increase or a decrease in demand. A movement along a demand curve is an increase or a decrease in the quantity demanded. The Demand Side of the Market: Holding Everything Else Constant: The Ceteris Paribus Condition

12. FIGURE 3-2 Shifting the Demand Curve When consumers increase the quantity of a product they want to buy at a given price, the market demand curve shifts to the right, from D 1 to D 2. When consumers decrease the quantity of a product they want to buy at a given price, the demand curve shifts to the left, from D 1 to D 3. The Demand Side of the Market: Holding Everything Else Constant: The Ceteris Paribus Condition

13. ÜNormal good A good for which the demand increases as income rises and decreases as income falls. ÜInferior good A good for which the demand increases as income falls and decreases as income rises. 1. Income Many variables other than price can influence market demand. The Demand Side of the Market: Variables That Shift Market Demand

14. Are Big Macs an Inferior Good? McDonald’s restaurants experienced increased sales during 2008 and 2009, despite the recession. Making the Connection Big Macs seem to fit the economic definition of an inferior good because demand increased as income fell. But remember that inferior goods are not necessarily of low quality, they are just goods for which consumers increase their demand as their incomes fall.

15. ÜSubstitutes Goods and services that can be used for the same purpose. ÜComplements Goods and services that are used together. 2. Prices of related goods Consumers can be influenced by an advertising campaign for a product. And our tastes can also change because of new interests, new friends, and new decisions over time. 3. Tastes The Demand Side of the Market: Variables That Shift Market Demand, cont.

16. Demographics The characteristics of a population with respect to age, race, and gender. 4. Size of the population and demographics 5. Expected future prices Consumers choose not only which products to buy but also when to buy them. The Demand Side of the Market: Variables That Shift Market Demand

17. The Aging of the Baby Boom Generation Making the Connection  Older people have a greater D for medical care than do younger people.  Aging boomers will also have an effect on the housing market.  What other effects will the aging of the baby boom generation have on the economy?

18. TABLE 3-1 Variables That Shift Market Demand Curves The Demand Side of the Market: Variables That Shift Market Demand

19. TABLE 3-1 Variables That Shift Market Demand Curves The Demand Side of the Market: Variables That Shift Market Demand

20. TABLE 3-1 Variables That Shift Market Demand Curves The Demand Side of the Market: Variables That Shift Market Demand

21. TABLE 3-1 Variables That Shift Market Demand Curves The Demand Side of the Market: Variables That Shift Market Demand

22. FIGURE 3-3 A Change in Demand versus a Change in Quantity Demanded If the price of energy drinks falls from $3 to $2.50, the result will be a movement along the D curve from point A to point B - an increase in quantity demanded from 60 M cans to 70 M cans. If consumers’ incomes increase, or if another factor changes that makes consumers want more of the product at every price, the D curve will shift to the right—an increase in demand. The Demand Side of the Market: A Change in Demand versus a Change in Quantity Demanded In this case, the increase in demand from D 1 to D 2 causes the quantity of energy drinks demanded at a price of $3 to increase from 60 M cans at point A to 80 M cans at point C.

23. Red Bull and the Future Demand for Energy Drinks Making the Connection Will Red Bull continue to grow its share of the energy drink market? It is important for managers to accurately forecast the demand for their products because it helps them determine how much of a good to produce.

24. ÜSupply schedule A table that shows the relationship between the price of a well defined product and the quantity of the product supplied, in some given time period. ÜSupply curve A curve that shows the relationship between the price of a well defined product and the quantity of the product supplied, in some given time period. The Supply Side of the Market Supply Schedules and Supply Curves Quantity supplied The amount of a well defined good or service that a firm is willing and able to supply at a given price, within some given time period. Discuss the variables that influence supply. 3.2 Learning Objective

25. The Supply Side of the Market: Supply Schedules and Supply Curves FIGURE 3-4 A Supply Schedule and Supply Curve As the P changes, the makers of Red Bull, Monster Energy, Rockstar, and the firms producing energy drinks change the Q they are willing to supply. We can show this as a supply schedule in a table or as a supply curve on a graph. They both show that as the P of energy drinks rises, firms will increase the Q they supply. At a P of $2.50 per can, firms will supply 90 M cans. At a P of $3, firms will supply 100 M cans.

26. 4 Law of supply The rule that, holding everything else constant, increases in price cause increases in the quantity supplied, and decreases in price cause decreases in the quantity supplied. The Supply Side of the Market: The Law of Supply

27. The Supply Side of the Market Individual Supply and Market Supply 3 - 7 Deriving the Market Supply Curve from the Individual Supply Curves

28. FIGURE 3-5 Shifting the Supply Curve When firms increase the Q of a product they want to sell at a given P, the S curve shifts to the right. The shift from S 1 to S 3 represents an increase in supply. When firms decrease the Q of a product they want to sell at a given P, the supply curve shifts to the left. The shift from S 1 to S 2 represents a decrease in supply. The Supply Side of the Market: The Law of Supply

29. 3.Prices of substitutes in production 4.Number of firms in the market 5.Expected future prices & other changes in expectations Technological change A positive or negative change in the ability of a firm to produce a given level of output with a given quantity of inputs. The following are the most important variables that shift market supply: 1.Prices of inputs 2.Technological change/change in productivity The Supply Side of the Market: Variables That Shift Market Supply

30. TABLE 3-2 Variables That Shift Market Supply Curves The Supply Side of the Market: Variables That Shift Market Supply

31. TABLE 3-2 Variables That Shift Market Supply Curves (continued) The Supply Side of the Market: Variables That Shift Market Supply

32. TABLE 3-2 Variables That Shift Market Supply Curves (continued) The Supply Side of the Market: Variables That Shift Market Supply

33. FIGURE 3-6 Change in Supply v. Change in Quantity Supplied If the P of energy drinks rises from $2 to $2.50/can, the result will be a movement up the S curve from point A to point B - an increase in quantity supplied by Red Bull, Monster Energy, Rockstar, and others from 80 M to 90 M cans. If the P of an input decreases, or another factor changes that makes sellers supply more of the product at every price, the S curve will shift to the right - an increase in supply. The Supply Side of the Market: Change in Supply v. Change in Quantity Supplied The increase in supply, S 1 to S 2, causes Q of energy drinks supplied at a P of $2.50 to increase from 90 M cans at point B to 110 M cans at point C.

34. Market Equilibrium: Putting Demand & Supply Together FIGURE 3-7 Market Equilibrium Where the D curve crosses the S curve determines market equilibrium. In this case, the D curve for energy drinks crosses the S curve at a P of $2 and a Q of 80 M cans/day. Only at this point is the Q of energy drinks consumers are willing to buy equal to the Q that Red Bull, Monster Energy, Rockstar, and the other firms are willing to sell: Use a graph to illustrate market equilibrium. 3.3 Learning Objective The quantity demanded is equal to the quantity supplied.

35. 4 Market equilibrium A situation in which quantity demanded equals quantity supplied. 4 Competitive market equilibrium A market equilibrium with many buyers and many sellers. Market Equilibrium: Putting D & S Together

36. Surplus A situation in which the quantity supplied is greater than the quantity demanded. Shortage A situation in which the quantity demanded is greater than the quantity supplied. How Markets Eliminate Surpluses and Shortages Market Equilibrium: Putting D & S Together

37. FIGURE 3-8 The Effect of Surpluses and Shortages on the Market Price How Markets Eliminate Surpluses and Shortages When the market P > equilibrium, there will be a surplus. In the figure, a price of $2.50 for energy drinks results in 90 M cans supplied but only 70 M cans demanded, for a surplus of 20 M. As Red Bull, Monster Energy, Rockstar, and the others cut the P to dispose of the surplus, the P will fall to the equilibrium of $2. When the market P < equilibrium, there will be a shortage. P of $1 results in 100 M cans demanded but only 60 M cans supplied, for a shortage of 40 M cans. As consumers who are unable to buy energy drinks offer to pay higher prices, the P will rise to the equilibrium of $2. Market Equilibrium: Putting D & S Together

38. Demand and Supply Both Count Keep in mind that the interaction of demand and supply determines the equilibrium price. Neither consumers nor firms can dictate what the equilibrium price will be. No firm can sell anything at any price unless it can find a willing buyer, and no consumer can buy anything at any price without finding a willing seller. Market Equilibrium: Putting D & S Together

39. Solved Problem 3-3 Demand and Supply Both Count: A Tale of Two Letters Both D and S count when determining market P. The D for Lincoln’s letters is much greater than the D for Booth’s letters, but the S of Booth’s letters is very small. Historians believe that only 8 letters written by Booth exist today.

40. The Effect of Demand and Supply Shifts on Equilibrium: Increase in Supply FIGURE 3-9 The Effect of an Increase in Supply on Equilibrium 1.As Coca-Cola enters the market for energy drinks, a larger Q of energy drinks will be supplied at every P, so the market S curve shifts to the right, from S 1 to S 2, which causes a surplus of cans at the original price, P 1. If a firm enters a market, as Coca- Cola entered the market for energy drinks when it launched Full Throttle, the equilibrium price will fall, and the equilibrium quantity will rise: Use demand and supply graphs to predict changes in prices and quantities. 3.4 Learning Objective 2.The equilibrium P falls from P1 to P2. 3.The equilibrium Q rises from Q1 to Q2.

41. The Falling Price of LCD Televisions Making the Connection An increase in S drove the P of a typical large LCD television from $4,000 in fall 2004 to $1,000 at the end of 2008, increasing the quantity demanded worldwide from 8 million to 105 million.

42. FIGURE 3-10 The Effect of an Increase in Demand on Equilibrium Increases in income cause equilibrium P & Q to rise: 1.Because energy drinks are normal, as income grows, the Q demanded increases at every P, and the market D curve shifts right, from D 1 to D 2, causing a shortage at the original price, P 1. The Effect of Demand and Supply Shifts on Equilibrium: Increase in Demand 2.The equilibrium P rises from P1 to P2. 3.The equilibrium Q rises from Q1 to Q2.

43. FIGURE 3-11 Shifts in Demand and Supply over Time In panel (a), D shifts to the right more than S, and the equilibrium price rises: 1. Demand shifts to the right more than supply. 2. Equilibrium price rises from P 1 to P 2. In panel (b), S shifts to the right more than D, and the equilibrium price falls: 1. Supply shifts to the right more than demand. 2. Equilibrium price falls from P 1 to P 2. The Effect of Demand and Supply Shifts on Equilibrium: The Effect of Shifts in D and S over Time

44. TABLE 3-3 How Shifts in Demand and Supply Affect Equilibrium Price (P) and Quantity (Q) SUPPLY CURVE UNCHANGED SUPPLY CURVE SHIFTS TO THE RIGHT SUPPLY CURVE SHIFTS TO THE LEFT DEMAND CURVE UNCHANGED Q unchanged P unchanged Q increases P decreases Q decreases P increases DEMAND CURVE SHIFTS TO THE RIGHT Q increases P increases Q increases P increases or decreases Q increases or decreases P increases DEMAND CURVE SHIFTS TO THE LEFT Q decreases P decreases Q increases or decreases P decreases Q decreases P increases or decreases The Effect of Demand and Supply Shifts on Equilibrium: The Effect of Shifts in D and S

45. Solved Problem 3-4 High Demand and Low Prices in the Lobster Market? Supply and demand for lobster both increase during the summer, but the increase in supply is greater than the increase in demand; therefore, equilibrium price falls.

46. Effect of D and S Shifts on Equilibrium Shifts in a Curve versus Movements along a Curve Don’t Let This Happen to YOU! Remember: A Change in a Good’s Price Does Not Cause the Demand or Supply Curve to Shift! Use demand and supply graphs to predict changes in prices and quantities. 3.4 Learning Objective When analyzing markets using D and S curves, remember that when a shift in a D or S curve causes a change in equilibrium P, the change in P does not cause a further shift in D or S.

47. How Does Advertising Help Red Bull Increase Demand for Its Energy Drink? AN INSIDE LOOK >> Advertising may cause an increase in the demand for Red Bull.

48. Ceteris paribus (“all else equal”) condition Competitive market equilibrium Complements Demand curve Demand schedule Demographics Income effect Inferior good Law of demand Law of supply Market demand Market equilibrium Normal good Perfectly competitive market Quantity demanded Quantity supplied Shortage Substitutes Substitution effect Supply curve Supply schedule Surplus Technological change KEY TERMS

49. Reality check to have been completed before we begin Ch. 4:  Pre-read Ch. 4, including: ÜReview Questions (not in text):  Consumer surplus is used as a measure of a consumer’s net benefit from purchasing a good or service. Explain why consumer surplus is a measure of net benefit.  Why would economists use a term like “deadweight loss” to describe the impact on consumer and producer surplus from a price control?” ÜProblems and Applications:  3 rd ed., p. 130, 4A.5, 4A.6, 4A.7 & 4A.8; (2 nd ed., p. 134, 4A.5, 4A.6, 4A.7 & 4A.8; 1 st edition: 1-4 on p. 129).