1. c h a p t e r three © 2006 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien—1 st ed. Prepared by: Fernando & Yvonn Quijano Where Prices Come From: The Interaction of Demand and Supply

2. © 2006 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien—1 st ed. CHAPTER 3: Where Prices Come From:The Interaction of Demand and Supply 2 of 34 After studying this chapter, you should be able to: Discuss the variables that influence demand. Discuss the variables that influence supply. Use a graph to illustrate market equilibrium. Use demand and supply graphs to predict changes in prices and quantities. Carly Fiorina How Hewlett-Packard Manages the Demand for Printers LEARNING OBJECTIVES … Because of the importance of printers to Hewlett-Packard, the company devotes significant resources to monitoring and forecasting consumer demand. 1 2 3 4

3. © 2006 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien—1 st ed. CHAPTER 3: Where Prices Come From:The Interaction of Demand and Supply 3 of 34 The Demand Side of the Market The Demand of an Individual Buyer LEARNING OBJECTIVE 1 Quantity demanded The quantity of a good or service that a consumer is willing to purchase at a given price. 3 - 1 Plotting a Price-Quantity Combination on a Graph At a price of $125 per printer, Kate, the purchasing manager for the Prudential Insurance Company, will be willing to buy 5 printers in the next month.

4. © 2006 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien—1 st ed. CHAPTER 3: Where Prices Come From:The Interaction of Demand and Supply 4 of 34 The Demand Side of the Market Demand schedule A table showing the relationship between the price of a product and the quantity of the product demanded. Demand curve A curve that shows the relationship between the price of a product and the quantity of the product demanded. Demand Schedules and Demand Curves 3 - 2 Kate’s Demand Schedule and Demand Curve

5. © 2006 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien—1 st ed. CHAPTER 3: Where Prices Come From:The Interaction of Demand and Supply 5 of 34 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. 3 - 3 Deriving the Market Demand Curve from Individual Demand Curves

6. © 2006 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien—1 st ed. CHAPTER 3: Where Prices Come From:The Interaction of Demand and Supply 6 of 34 The Demand Side of the Market The Law of Demand The Law of Demand 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. What Explains the Law of Demand? 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. 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 consumer purchasing power.

7. © 2006 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien—1 st ed. CHAPTER 3: Where Prices Come From:The Interaction of Demand and Supply 7 of 34 The Demand Side of the Market Holding Everything Else Constant: The Ceteris Paribus Condition Ceteris paribus (“all else equal”) The requirement that when analyzing the relationship between two variables—such as price and quantity demanded—other variables must be held constant.

8. © 2006 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien—1 st ed. CHAPTER 3: Where Prices Come From:The Interaction of Demand and Supply 8 of 34 The Demand Side of the Market  Price of related goods Substitutes Goods and services that can be used for the same purpose. Complements Goods that are used together.  Income Normal good A good for which the demand increases as income rises and decreases as income falls. Inferior good A good for which the demand increases as income falls, and decreases as income rises.  Tastes  Population and demographics Demographics The characteristics of a population with respect to age, race, and gender.  Expected future prices Variables That Shift Market Demand 3 - 4 Shifting the Demand Curve

9. © 2006 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien—1 st ed. CHAPTER 3: Where Prices Come From:The Interaction of Demand and Supply 9 of 34 Why Supermarkets Need to Understand Substitutes and Complements 3 - 1 A supermarket shouldn’t remove a slow-selling soup from its shelves without researching whether shoppers use that soup as a substitute or a complement for another soup. COFFEE FROZEN PIZZA HOT DOGS ICE CREAM POTATO CHIPS REGULAR CEREAL SPAGHETTI SAUCEYOGURT Varieties in Five Chicago Supermarkets 391337128421285242194288 Varieties Introduced in a 2-Year Period 113109471299311470107 Varieties Removed in a 2-Year Period 135863211877753651

10. © 2006 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien—1 st ed. CHAPTER 3: Where Prices Come From:The Interaction of Demand and Supply 10 of 34 Companies Respond to a Growing Hispanic Population 3 - 2 Firms are responding to the tastes of a growing Hispanic population. Some Home Depot stores, for example, include signs in both English and Spanish.

11. © 2006 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien—1 st ed. CHAPTER 3: Where Prices Come From:The Interaction of Demand and Supply 11 of 34 The Demand Side of the Market Variables That Shift Market Demand Variables That Shift Market Demand Curves 3 - 1

12. © 2006 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien—1 st ed. CHAPTER 3: Where Prices Come From:The Interaction of Demand and Supply 12 of 34 The Demand Side of the Market Variables That Shift Market Demand Variables That Shift Market Demand Curves 3 - 1 (continued)

13. © 2006 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien—1 st ed. CHAPTER 3: Where Prices Come From:The Interaction of Demand and Supply 13 of 34 The Demand Side of the Market A Change in Demand versus a Change in Quantity Demanded 3 - 5 A Change in Demand versus a Change in the Quantity Demanded

14. © 2006 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien—1 st ed. CHAPTER 3: Where Prices Come From:The Interaction of Demand and Supply 14 of 34 Estimating the Demand for Printers at Hewlett- Packard 3 - 3 Inaccurate forecasts in 2001 caused Hewlett-Packard to produce more printers than they could sell.

15. © 2006 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien—1 st ed. CHAPTER 3: Where Prices Come From:The Interaction of Demand and Supply 15 of 34 The Supply Side of the Market Quantity supplied The quantity of a good or service that a firm is willing to supply at a given price. LEARNING OBJECTIVE 2 Supply schedule A table that shows the relationship between the price of a product and the quantity of the product supplied. Supply curve A curve that shows the relationship between the price of a product and the quantity of the product demanded. Supply Schedules and Supply Curves

16. © 2006 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien—1 st ed. CHAPTER 3: Where Prices Come From:The Interaction of Demand and Supply 16 of 34 The Supply Side of the Market 3 - 6 Hewlett-Packard’s Supply Schedule and Supply Curve

17. © 2006 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien—1 st ed. CHAPTER 3: Where Prices Come From:The Interaction of Demand and Supply 17 of 34 The Supply Side of the Market Individual Supply and Market Supply 3 - 7 Deriving the Market Supply Curve from the Individual Supply Curves

18. © 2006 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien—1 st ed. CHAPTER 3: Where Prices Come From:The Interaction of Demand and Supply 18 of 34 The Supply Side of the Market The Law of Supply Law of supply Holding everything else constant, increases in price cause increases in the quantity supplied, and decreases in price cause decreases in the quantity supplied.

19. © 2006 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien—1 st ed. CHAPTER 3: Where Prices Come From:The Interaction of Demand and Supply 19 of 34 The Supply Side of the Market  Price of inputs  Technological change A positive or negative change in the ability of a firm to produce a given level of output with a given amount of inputs.  Prices of substitutes in production  Expected future prices  Number of firms in the market Variables That Shift Supply 3 - 8 Shifting the Supply Curve

20. © 2006 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien—1 st ed. CHAPTER 3: Where Prices Come From:The Interaction of Demand and Supply 20 of 34 The Supply Side of the Market Variables That Shift Supply Variables That Shift Market Supply Curves 3 - 2

21. © 2006 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien—1 st ed. CHAPTER 3: Where Prices Come From:The Interaction of Demand and Supply 21 of 34 The Supply Side of the Market Variables That Shift Supply Variables That Shift Market Supply Curves 3 - 2 (continued)

22. © 2006 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien—1 st ed. CHAPTER 3: Where Prices Come From:The Interaction of Demand and Supply 22 of 34 The Difference between a Change in Supply versus a Change in the Quantity Supplied The Supply Side of the Market A Change in Supply versus a Change in Quantity Supplied 3 - 9

23. © 2006 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien—1 st ed. CHAPTER 3: Where Prices Come From:The Interaction of Demand and Supply 23 of 34 Market Equilibrium: Putting Demand and Supply Together LEARNING OBJECTIVE 3 Market equilibrium A situation where quantity demanded equals quantity supplied. Competitive market equilibrium A market equilibrium with many buyers and many sellers. 3 - 10 Market Equilibrium

24. © 2006 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien—1 st ed. CHAPTER 3: Where Prices Come From:The Interaction of Demand and Supply 24 of 34 Market Equilibrium: Putting Demand and Supply Together How Markets Eliminate Surpluses and Shortages 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. 3 - 11 The Effect of Surpluses and Shortages on the Market Price

25. © 2006 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien—1 st ed. CHAPTER 3: Where Prices Come From:The Interaction of Demand and Supply 25 of 34 Demand and Supply Both Count: A Tale of Two Letters 3 - 1 LEARNING OBJECTIVE 3 Although the demand for Lincoln’s letters is greater than Booth’s, the supply of Booth’s letters is much smaller, which explains why the equilibrium price for Booth’s letters is higher.

26. © 2006 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien—1 st ed. CHAPTER 3: Where Prices Come From:The Interaction of Demand and Supply 26 of 34 LEARNING OBJECTIVE 4 The Effect of Shifts in Supply on Equilibrium 3 - 12 The Effect of a Decrease in Supply on Equilibrium The Effect of Demand and Supply Shifts on Equilibrium

27. © 2006 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien—1 st ed. CHAPTER 3: Where Prices Come From:The Interaction of Demand and Supply 27 of 34 The Falling Price of Large Flat-Screen Televisions Corning’s breakthrough spurred the manufacture of LCD televisions in Taiwan, South Korea, and Japan, and an eventual decline in price. 3 - 4

28. © 2006 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien—1 st ed. CHAPTER 3: Where Prices Come From:The Interaction of Demand and Supply 28 of 34 The Effect of Shifts in Demand on Equilibrium 3 - 13 The Effect of an Increase in Demand on Equilibrium The Effect of Demand and Supply Shifts on Equilibrium

29. © 2006 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien—1 st ed. CHAPTER 3: Where Prices Come From:The Interaction of Demand and Supply 29 of 34 The Effect of Shifts in Both Demand and Supply 3 - 14 Shifts in Demand and Supply over Time The Effect of Demand and Supply Shifts on Equilibrium

30. © 2006 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien—1 st ed. CHAPTER 3: Where Prices Come From:The Interaction of Demand and Supply 30 of 34 The Effect of Shifts in Both Demand and Supply 3 - 13 The Demand for Chicken Has Increased More Than the Supply The Effect of Demand and Supply Shifts on Equilibrium

31. © 2006 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien—1 st ed. CHAPTER 3: Where Prices Come From:The Interaction of Demand and Supply 31 of 34 High Demand and Low Prices in the Lobster Market? 3 - 2 LEARNING OBJECTIVE 4 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.

32. © 2006 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien—1 st ed. CHAPTER 3: Where Prices Come From:The Interaction of Demand and Supply 32 of 34 Remember: A Change in a Good’s Price Does Not Cause the Demand or Supply Curve to Shift. The second shift, from D 2 to D 3, does not occur. After an increase in demand, from D 1 to D 2, the higher resulting price does not lead to a leftward shift of the demand curve to D 3.

33. © 2006 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien—1 st ed. CHAPTER 3: Where Prices Come From:The Interaction of Demand and Supply 33 of 34 Picking a Big Fight with Dell, H-P Cuts PC Profits Razor-Thin

34. © 2006 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien—1 st ed. CHAPTER 3: Where Prices Come From:The Interaction of Demand and Supply 34 of 34 Ceteris paribus (“all else equal”) 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 Quantity demanded Quantity supplied Shortage Substitutes Substitution effect Supply curve Supply schedule Surplus Technological change