1. Chapter Three The Supply and Demand Model

2. Copyright © by Houghton Mifflin Company, Inc. All rights reserved3 - 2 Demand Demand: Relationship between price of a good AND the quantity people are willing to buy at that price –We usually refer to these as PRICE and QUANTITY DEMANDED –CETERIS PARIBUS: All other things being equal Demand Schedule: A table showing the price and quantity demanded for a certain good, all else being equal Law of Demand: The tendency for the quantity demanded of a good in a market to decline as its price rises Demand Curve: Graph of demand showing the downward- sloping relationship between price and quantity demanded –HINT: Demand starts with D and Down starts with D. Therefore, Demand curves are always Downward-sloping.

3. Copyright © by Houghton Mifflin Company, Inc. All rights reserved3 - 3 Demand Continued Why is the Demand Curve downward sloping? –When price increases, quantity demanded decreases –Price and Quantity Demanded are Negatively or Inversely related –Remember: Ceteris Paribus assumption For example, when talking about bicycles we must assume everything else stays the same (price of parts, price of scooters, etc) so that we can state that when price increases, quantity demanded decreases

4. Copyright © by Houghton Mifflin Company, Inc. All rights reserved3 - 4 Figure 3.1: The Demand Curve – Remembering CETERIS PARIBUS

5. Copyright © by Houghton Mifflin Company, Inc. All rights reserved3 - 5 Shifts in Demand Increase in demand will shift the curve to the right Decrease in demand will shift the curve to the left

6. Copyright © by Houghton Mifflin Company, Inc. All rights reserved3 - 6 Figure 3.2: A Shift in the Demand Curve

7. Copyright © by Houghton Mifflin Company, Inc. All rights reserved3 - 7 Causes of Shifts in the Demand Curve Reasons the demand curve might shift: –Consumers’ Preferences: Changes in people’s tastes will change the amount demanded of a product. Example: Atkins diet led to a decrease in the demand of bread –Consumers’ Information: Changes in information relating to a product will cause the demand curve to shift. Example: In the 60’s, the surgeon general issued a warning that smoking cigarettes was dangerous and the demand for cigarettes decreased.

8. Copyright © by Houghton Mifflin Company, Inc. All rights reserved3 - 8 Causes Continued Consumers’ Incomes: If people’s incomes change, then their purchases of goods change. Example: When a person makes more money, they might go out to eat more often. –Normal good: A good for which demand increases when income rises and vice versa. Example: Luxury cars –Inferior good: A good for which demand increases when income decreases and vice versa. Example: day-old bread

9. Copyright © by Houghton Mifflin Company, Inc. All rights reserved3 - 9 Causes Continued Number of Consumers in the Market: If the number of consumers increases, demand will also increase and vice versa. Example: Baby boomers aging creates a higher demand for nursing homes Consumers’ Expectations of the Future Price: If people expect the price of a good to increase, they will want to buy it before the price increases and vice versa. Example: Waiting for post-Christmas sales to buy clothes

10. Copyright © by Houghton Mifflin Company, Inc. All rights reserved3 - 10 Causes Continued Prices of Closely Related Goods: A decrease in the price of a closely related good will decrease the demand for a good. Example: If the price of scooters decreases dramatically, there will be less demand for bicycles –Substitute: A good that provides some of the same uses or enjoyment as another good. The demand for a good will increase if the price of a substitute for the good rises and vice versa. –Complement: A good that tends to be consumed together with another good. If the demand for a good increases, the demand for its complement also increases. Example: If the demand for coffee increases, the demand for sugar will also increase.

11. Copyright © by Houghton Mifflin Company, Inc. All rights reserved3 - 11 Movements Along versus Shifts of the Demand Curve Important to distinguish when the demand curve shifts and when there is movement along the curve. Movement along the curve happens only when there is a CHANGE IN THE PRICE OF THE GOOD. Example: When the price of bicycles goes up, quantity demanded goes down resulting in another point on the SAME curve, not a shift of the entire curve.

12. Copyright © by Houghton Mifflin Company, Inc. All rights reserved3 - 12 Movements Continued A shift in the curve occurs if there is a change due to ANY SOURCE BUT THE COST. –When the curve shifts, it’s called a change in demand. When we say demand, we are referring to the entire curve. –When we talk about a specific point on the curve, it’s referring to quantity demanded. Need to be able to tell whether an event causes (1) a change in demand or (2) a change in the quantity demanded

13. Copyright © by Houghton Mifflin Company, Inc. All rights reserved3 - 13 Figure 3.3: Shifts versus Movements Along the Demand Curve

14. Copyright © by Houghton Mifflin Company, Inc. All rights reserved3 - 14 Supply Demand refers to consumers’ behavior and supply refers to the behavior of firms. Supply is the relationship between price and quantity supplied. The law of supply says that the higher the price, the higher the quantity supplied and vice versa. Price and Quantity Supplied are positively related.

15. Copyright © by Houghton Mifflin Company, Inc. All rights reserved3 - 15 The Supply Curve The Supply Curve slopes upward because price and quantity supplied are positively related. As price goes up, quantity supplied goes up. Example: As the price of bicycles goes up, there is more incentive to produce more bicycles because the firm will be making more money on each bicycle. Remember, this is assuming ceteris paribus. Example: The cost of making bicycles didn’t go up too.

16. Copyright © by Houghton Mifflin Company, Inc. All rights reserved3 - 16 Figure 3.4: The Supply Curve

17. Copyright © by Houghton Mifflin Company, Inc. All rights reserved3 - 17 Shifts in Supply Just like demand, when there is a decrease in supply, the curve shifts to the left. When there is an increase in supply, the curve shifts to the right. For example, when new technology becomes available that reduces the cost of making computers, there is incentive to make more computers, the supply increases and the entire curve shifts to the right.

18. Copyright © by Houghton Mifflin Company, Inc. All rights reserved3 - 18 Causes for Shifts in the Supply Curve There are several reasons the supply curve may shift –Technology: Technology is considered anything that changes the amount a firm can produce with a give amount of inputs to production. Example: Better technology allows firms to produce computers for less, causing an increase in supply, and a shift to the right. –The Price of Goods Used in Production: If the prices of the inputs to production (raw materials, etc) change, the supply will change. Example: If the price of fertilizer increases, it will be more costly to raise corn, resulting in a decrease in the supply of corn.

19. Copyright © by Houghton Mifflin Company, Inc. All rights reserved3 - 19 Causes Continued The Number of Firms in the Market: If the number of firms in the market increases, then supply will also increase. Example: A lot more cell phone manufacturers in the last 10 years, therefore the supply has increased, shifting the entire curve to the right. Expectations of Future Prices: If firms expect the price of the good they produce to rise in the future, then they will hold off selling at least part of their production until the price rises. Example: Farmers expect prices of wheat to go up because of political unrest in Russia. Therefore, they “hoard” their wheat and supply decreases, resulting in a shift to the left.

20. Copyright © by Houghton Mifflin Company, Inc. All rights reserved3 - 20 Causes Continued Government Taxes, Subsidies, and Regulations: Government has the ability to affect the supply of goods produced by firms. Example: When the government imposes a tax, costs increase for the firm, and supply then decreases. –Subsidies: Payments made to firms to encourage the production of certain goods. Example: Farmers get subsidized to produce certain foods. As they get paid, they can make more resulting in a shift of the curve to the right.

21. Copyright © by Houghton Mifflin Company, Inc. All rights reserved3 - 21 Figure 3.5: A Shift in the Supply Curve

22. Copyright © by Houghton Mifflin Company, Inc. All rights reserved3 - 22 Movements Along Versus Shifts of the Supply Curve A movement along the supply curve occurs when a change in price causes a change in the quantity supplied. A shift of the supply curve occurs if there is a change due to any source except the price. Must be able to distinguish if something causes (1) a change in supply or (2) a change in the quantity supplied.

23. Copyright © by Houghton Mifflin Company, Inc. All rights reserved3 - 23 Figure 3.6: Shifts versus Movements Along the Supply Curve

24. Copyright © by Houghton Mifflin Company, Inc. All rights reserved3 - 24 Figure 3.7: Overview of Supply and Demand

25. Copyright © by Houghton Mifflin Company, Inc. All rights reserved3 - 25 Determination of the Market Price PriceQ DemandQ SupplySh, Sur, EPrice R or F $140181Sh = 17Price Rises $160144Sh = 10Price Rises $180117Sh = 4Price Rises $20099ENo change $220711Sur = 4Price Falls $240513Sur = 8Price Falls $260315Sur = 12Price Falls $280216Sur = 14Price Falls $300117Sur = 16Price Falls

26. Copyright © by Houghton Mifflin Company, Inc. All rights reserved3 - 26 Determination of the Market Price Shortage (Excess Demand): The situation in which the quantity demanded is greater than the quantity supplied. Surplus (Excess Supply): The situation in which the quantity supplied is greater than the quantity demanded. Equilibrium Price: The price at which quantity supplied equals quantity demanded. Equilibrium Quantity: The quantity traded at the equilibrium price. 2 Predictions from the model: (1) The price will be where quantity supplied = quantity demanded (2) Quantity bought and sold in market will be where quantity supplied = quantity demanded

27. Copyright © by Houghton Mifflin Company, Inc. All rights reserved3 - 27 Figure 3.8: Equilibrium Price and Equilibrium Quantity

28. Copyright © by Houghton Mifflin Company, Inc. All rights reserved3 - 28 Figure 3.9: Effects of a Shift in Demand

29. Copyright © by Houghton Mifflin Company, Inc. All rights reserved3 - 29 Figure 3.9: Effects of a Shift in Demand (cont’d)

30. Copyright © by Houghton Mifflin Company, Inc. All rights reserved3 - 30 Figure 3.10: Effects of a Shift in Supply

31. Copyright © by Houghton Mifflin Company, Inc. All rights reserved3 - 31 Figure 3.10: Effects of a Shift in Supply (cont’d)

32. Copyright © by Houghton Mifflin Company, Inc. All rights reserved3 - 32 Effects of Shifts in Demand and Supply Curves ShiftEquilibrium PriceEquilibrium Quantity Increase in Demand Up Decrease in Demand Down Increase in Supply DownUp Decrease in Supply UpDown

33. Copyright © by Houghton Mifflin Company, Inc. All rights reserved3 - 33 Figure 3.11: Peanut Production in the United States

34. Copyright © by Houghton Mifflin Company, Inc. All rights reserved3 - 34 Figure 3.12: Supply and Demand for Peanuts

35. Copyright © by Houghton Mifflin Company, Inc. All rights reserved3 - 35 Figure 3.13: Effects of a Drought in the Southeast

36. Copyright © by Houghton Mifflin Company, Inc. All rights reserved3 - 36 Price Performance Prices’ Three Roles: –Incentives: People chose to eat other foods –Signal: Transmitted information about the effects of the drought in the Southeast all over the country –Distribution of Income: People who buy peanuts and peanut butter had less to spend on other things

37. Copyright © by Houghton Mifflin Company, Inc. All rights reserved3 - 37 A Change in the Foreign Peanut Quota The law limiting the amount of peanuts imported into the United States is called a quota. If the U.S. allows more peanuts in (increasing the quota), supply increases (shifts right), and price goes down.

38. Copyright © by Houghton Mifflin Company, Inc. All rights reserved3 - 38 Figure 3.14: Predicted Effects of an Increase in the Peanut Quota

39. Copyright © by Houghton Mifflin Company, Inc. All rights reserved3 - 39 Interferences with Market Prices Price control: A government law or regulation that sets or limits the price to be charged for a particular good. Price Ceiling: A government price control that sets the maximum allowable price for a good. Rent Control: A government price control that sets the maximum allowable rent on a house or apartment. Price Floor: A government price control that sets the minimum allowable price for a good. Minimum Wage: A wage per hour below which it is illegal to pay workers.

40. Copyright © by Houghton Mifflin Company, Inc. All rights reserved3 - 40 Figure 3.15: Effects of a Maximum Price Law

41. Copyright © by Houghton Mifflin Company, Inc. All rights reserved3 - 41 Figure 3.15: Effects of a Maximum Price Law (cont’d)

42. Copyright © by Houghton Mifflin Company, Inc. All rights reserved3 - 42 Effects of Price Ceilings Persistent Shortages: Bread in Russia (Centrally Planned Economy) Black Markets: Markets in which people buy and sell goods outside the watch of the government and charge whatever price they want (Again, in Centrally Planned Economies) Reduction in Quality of Goods Sold: Lower quality to reduce costs (rent control)

43. Copyright © by Houghton Mifflin Company, Inc. All rights reserved3 - 43 Figure 3.16: Effects of a Minimum Price Law

44. Copyright © by Houghton Mifflin Company, Inc. All rights reserved3 - 44 Figure 3.16: Effects of a Minimum Price Law (cont’d)

45. Copyright © by Houghton Mifflin Company, Inc. All rights reserved3 - 45 Surpluses and Problems of Price Floors Farm Products: Government usually buys surplus, stores it, but buying above equilibrium price costs taxpayers $$$ –As an alternative, the government reduces supply by restricting acreage on crops Minimum Wage: If equilibrium is below minimum, surplus of workers = unemployment Minimum wage would have no effect if equilibrium wage were above minimum wage

46. Copyright © by Houghton Mifflin Company, Inc. All rights reserved3 - 46 Elasticity of Demand and Supply Price Elasticity of demand is a measure of the sensitivity of the quantity demanded of a good to the price of a good. It measures how much quantity demanded changes when the price changes. –Example: When they say elasticity is high, quantity demanded changes a lot when price changes. When they say elasticity is low, quantity demanded changes a little when price changes. –Formula: Percentage change in quantity demanded Percentage change in the price

47. Copyright © by Houghton Mifflin Company, Inc. All rights reserved3 - 47 Price Elasticity of Supply Price elasticity measures how sensitive the quantity supplied is to a change in price. A high price elasticity means that firms raise their production by a large amount if the price increases. A low price elasticity means that firms raise their production only a little if the price increases. Formula = Percentage change in quantity supplied Percentage change in the price