1. SUPPLY AND DEMAND: AN INTRODUCTION Chapter 3 in Frank and Bernanke

2. Purpose of Lecture Review price formation in markets and market equilibrium through interaction of supply and demand curves Central Planning vs. Markets Demand Curve Supply Curve Market Equilibrium 3 Steps to Analyzing Changes in Equilibrium

3. Central Planning vs. Markets How to organize economic activities in societies? Two basic options:  1. Central planning  2. Markets

4. Central Planning  Major economic decisions made centrally, by individual or small group of individuals, on behalf of a larger group  The case for most of history with clans, tribes, extended families, empires  Centralized Economic Organizations Agrarian society Former Soviet Union Cuba, North Korea China Bureaucracy

5. Markets  Production and distribution decisions left to individuals interacting in private markets  Market or capitalist economies Mixed economies Social control over markets  Decentralized decision-making by individuals  Coordination of decisions through markets  Prices from the different markets signal information and the individual choices to coordinate this decentralized behavior

6. Market  A market consists of all buyers and sellers of a good or service  Buyers as a group determine demand for the product  Sellers as a group determine the supply of the product Competitive Market  Market in which there are many buyers and many sellers, so that each has a negligible impact on the market price

7. Conservation and Management of Resources and Environment by Principle of Central Planning or Markets  Command-and-control regulations vs. market-based  Analogous to central planning vs. markets  Market-Based  Give decentralized decision-making by economic agents involved  Economic agents more likely to face full social costs of their decisions  Give positive economic incentives  Command-and-Control  Sometimes necessary

8. Demand Quantity demanded  The amount of a good that buyers are willing and able to purchase Law of Demand  Quantity demanded is inversely related to price, all other things equal (held constant) As price rises, quantity demanded falls As price falls, quantity demanded rises

9. Demand Schedule  Table showing the quantity of a good that buyers wish to buy at each price Price of Good ($/kg) Quantity of Good (kg) ---------------------------- -------------------------------- 0 10 1 9 2 8 3 7

10. Demand Curve Graph of the relationship between the price of a good and the quantity demanded Figure 3.1

11. Demand Curve Figure 3.1 81216 The buyers reservation price: The highest price the buyer would be willing to pay for a good 4 2 3

12. Demand Horizontal Interpretation Price determines quantity demanded Price ($ per slice) 4 2 3 81216 Demand Price ($/unit) Quantity (# units per time period) Price determines quantity demanded Price determines quantity demanded

13. Demand Vertical Interpretation Quantity measures the marginal buyer’s reservation price Price ($ per slice) 4 2 3 81216 Demand Quantity measures the marginal buyer’s reservation price Quantity measures the marginal buyer’s reservation price Price ($/unit) Quantity (# units per time period)

14. Distinguish Between  A change in the quantity demanded A movement along the demand curve that occurs in response to a change in price  A change in demand A shift of the entire demand curve Caused by change in factors of demand that are otherwise held constant when examine price- quantity demanded relationship

15. Movements Along The Demand Curve  Changes in the price of the good or service lead to movements along the demand curve Price ($/kg) P 0 P 1 Q 0 Q 1 Quantity demanded (kg per time period)

16. Shifts in the Demand Curve Price ($/kg) D 1 D 0 D 2 Quantity demanded ($/kg) Increase in demand Decrease in demand

17. An Increase in the Quantity Demanded versus an Increase in Demand Figure 3.10

18. Variables That Can Shift Demand Curve  Income Normal good  A good for which, other things equal, an increase in income leads to an increase in demand Inferior good  A good for which, other things equal, an increase in income leads to a decrease in demand The Income Effect  The change in the quantity demanded of a good that results because a change in the price of a good changes the buyer’s purchasing power

19. Variables That Shift Demand, Cont’d.  Prices of Related Goods Substitutes  Two goods for which an increase in the price of one leads to an increase in the demand for the other.  Substitutes are often pairs of goods that are used in place of each other, such as coffee and tea. Complements  Two goods for which an increase in the price of one leads to a decrease in the demand for the other.  Complements are often pairs of goods that are used together, such as gasoline and automobiles.

20. Variables That Shift Demand, Cont’d.  Prices of Related Goods, Cont’d. The Substitution Effect  The change in the quantity demanded of a good that results because buyers switch to substitutes when the price of the good changes

21. Variables That Shift Demand, Cont’d. Tastes and Preferences  Most obvious determinant of consumer demand Expectations  Expectations about future may affect consumer demand for a good or service today Number of Buyers  The more buyers of a good or service, the greater the market demand.

22. Variables That Influence Buyers VariableA Change in This Variable … PriceRepresents a movement along the demand curve IncomeShifts the demand curve Prices of related goodsShifts the demand curve Tastes and preferences Shifts the demand curve ExpectationsShifts the demand curve Number of buyers (Population) Shifts the demand curve

23. Supply Quantity supplied  The amount of a good or service that sellers are willing and able to sell Law of Supply  Quantity demanded is positively related to price, all other things equal (held constant) As price rises, quantity supplied rises As price falls, quantity supplied rises

24. Supply Schedule  A table that shows the relationship between the price of a good and the quantity supplied Price of Good ($/kg) Quantity of Good (kg) ---------------------------- -------------------------------- 1 7 2 8 3 9 4 10 5 11

25. Supply Curve A graph of the relationship between the price of a good and the quantity supplied Figure 3.2

26. Seller’s Reservation Price  The smallest dollar amount for which a seller would be willing to sell an additional unit  Generally equal to marginal cost Quantity Price Supply Reservation price for 10 th unit 105 Reservation price for 5 th unit

27. Supply Price ($ per slice) 4 2 3 81216 Supply Horizontal Interpretation Shows the quantity produced for each price Price ($/unit) Quantity (# units per time period)

28. Supply Price ($ per slice) Quantity (1000s of slices per day) 4 2 3 81216 Supply Vertical Interpretation Shows the marginal cost (reservation price) for producing each additional unit Quantity (# units per time period) Price ($/unit)

29. Movements Along The Supply Curve  Changes in the price of the good or service lead to movements along the supply curve Price ($/kg) P 1 P 0 Q 0 Q 1 Quantity supplied ($/kg)

30. Shifts in the Supply Curve Price ($/kg) S 1 S 0 S 2 Quantity supplied (kg) Increase in supply Decrease in supply

31. Variables That Can Shift The Supply Curve  Input Prices Increase in price of an input raises costs and makes production less profitable, thereby lowering supply (and shifting supply curve in) Decrease in price of an input lowers costs and makes production more profitable, thereby increasing supply (and shifting supply curve out)  Technology Technical progress lowers costs and makes production more profitable, thereby increasing supply (and shifting supply curve out)  Expectations  Number of Sellers

32. Variables That Influence Sellers VariableA Change in This Variable … PriceRepresents a movement along the supply curve Input pricesShifts the supply curve TechnologyShifts the supply curve ExpectationsShifts the supply curve Number of buyersShifts the supply curve

33. Market Equilibrium: Supply and Demand Together Price ($/kg) S D Quantity (kg/time period) Equilibrium price Equilibrium quantity Equilibrium: Quantity Demand = Quantity Supplied

34.  Market Equilibrium Point where supply and demand curves intersect Situation in which the price has reached the level where quantity supplied equals quantity demanded  Market Equilibrium Price Price at intersection called market equilibrium price oSometimes called market clearing price Price that balances quantity supplied and quantity demanded Supply price equals demand price  Market Equilibrium Quantity Quantity supplied and quantity demanded at the equilibrium price

35. Surplus or Excess Supply  Excess quantity supplied at given price  Suppliers unable to sell all they want at the going price  Sellers respond by cutting their prices  Falling prices, in turn, increase quantity demanded and decrease quantity supplied  Prices continue to fall until the market reaches equilibrium

36. Excess Supply or Surplus  Situation in which quantity supplied is greater than the quantity demanded at given price Price ($/kg) Supply Demand Quantity (kg/time period) Excess Supply Quantity demanded Quantity supplied Equilibrium Quantity Equilibrium Price

37. Excess Demand or Shortage  Situation in which quantity demanded is greater than the quantity supplied at given price Price ($/kg) Supply Demand Quantity (kg/time period) Excess Demand Quantity demanded Quantity supplied Equilibrium Price Equilibrium Quantity

38. Shortage or Excess Demand  Excess quantity demanded at given price  Buyers unable to purchase all they want at the going price Too many buyers chasing too few goods  Buyers respond by bidding up their prices  Sellers respond to shortage by raising their prices  As price rises, quantity demanded falls, quantity supplied rises  Prices continue to rise until the market reaches equilibrium

39. Rent Controls  Example of excess demand in market

40. An Unregulated Housing Market Figure 3.7

41. Excess Demand: Rent Controls Figure 3.8

42. Example: The Effect of Minimum Wage Legislation on Employment

43. The Effect of Minimum Wage Legislation on Employment Figure 13.5

44. Law of Supply and Demand  Price of any good adjusts to bring the quantity supplied and quantity demanded for that good into balance

45. Three Steps to Analyzing Changes in Equilibrium 1. Decide whether the event changes supply or demand (or perhaps both) 2. Decide in which direction the supply or demand curve shifts 3. Use the supply-and-demand diagram to see how the shift changes the equilibrium price and quantity

46. Increase in Demand Price ($/kg) Supply D 1 D 0 Quantity (kg) 1. Increase in demand … 2…result in a higher price… 3…and a higher quantity sold. Initial equilibrium New equilibrium

47. Example of Shift in Demand and Complement Goods  Complements Decrease in price of one causes a rightward shift in demand curve for other  Tennis courts and tennis balls are complements  Decline in court-rental fees shifts demand curve for tennis balls rightward from D to D’

48. The Effect on the Market for Tennis Balls of a Decline in Court Rentals Fees Figure 3.11

49. The Short-Run Effect of Demand Shifts in Two Markets Figure 8.9

50. The Effect of an Increase in the Demand for Computer Programmers Figure 13.2

51. Decrease in Supply Price ($/kg) S 1 S 0 Demand Quantity (kg) Initial equilibrium New equilibrium 1. An increase in an input price reduces the supply… 2…resulting in a higher price… 3…and a lower quantity sold

52. Technical Change Shifts Supply Curve Example of Technical Change  Vessel electronics on fishing boats  Effect on short-run supply of fish and price of fish  Short-run because take resource stock as given  Not long-run supply curve that is in steady- state equilibrium in resource stock

53. Technical Change: Vessel Electronics S 0 Initial Supply of Fish S 1 Subsequent Supply of Fish D P0P0 P1P1 Q0Q0 Price ($/unit) Q1Q1 Quantity/time period

54. Increase in Demand and Increase in Supply Price ($/unit) S 1 S 0 D 1 D 0 Quantity (# units/time period) Initial equilibrium New equilibrium P0P0 P1P1 Q0Q0 Q1Q1 Large increase in demand Small increase in supply

55. Increase in Demand and Decrease in Supply Price ($/kg) S 1 S 0 D 0 D 1 Quantity (kg/time period) Q0Q0 Q1Q1 P0P0 P1P1 New equilibrium Initial equilibrium Increase in demand Decrease in supply

56. The Effects of Simultaneous Shifts in Supply and Demand Figure 3.18

57. Four Rules Governing the Effects of Supply and Demand Shifts Figure 3.17

58. What Happens to Price and Quantity When Supply or Demand Shifts? No Change in Supply An Increase in Supply A Decrease in Supply No Change in Demand P sameP downP up Q sameQ upQ down An Increase in Demand P upP ambiguousP up Q up Q ambiguous A Decrease in Demand P down P ambiguous Q downQ ambiguousQ down