Chapter 3 Supply and Demand 2012 The

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Learning Objectives: Understand 1. How the demand curve summarizes the behavior of buyers in the marketplace. 2. How the supply curve summarizes the behavior of sellers in the marketplace. 3. How the supply and demand curves interact to determine the equilibrium price and quantity. 4. How shifts in supply and demand curves cause prices and quantities to change. 5. The relationship between individual demand supply curves with market demand supply curves. © 2012 The Mc. Graw-Hill Companies, All Rights Reserved 2

What, How, and For Whom? n Every society answers three basic questions WHAT § Which goods will be produced? § How much of each? HOW § Which technology? § Which resources are used? FOR § How are outputs distributed? § Need? WHOM § Income? © 2012 The Mc. Graw-Hill Companies, All Rights Reserved 3

Central Planning v. Market Central Planning § Decisions by individuals or small groups § Agrarian societies § Government programs Ø Sets prices and goals for the group § Individual influence is limited The Market Ø Buyers and sellers signal wants and costs § Resources and goods are allocated accordingly Ø Interaction of supply and demand answer the three basic questions Mixed economies use both the market and central planning © 2012 The Mc. Graw-Hill Companies, All Rights Reserved 4

Buyers and Sellers in the Market n Buyers and sellers have different motivations Ø Buyers want to benefit from the good Ø Sellers want to make a profit n Market = souk ØA § “place” where buyers and sellers meet Largest market is the internet Ø Buyers and sellers jointly determine outcome n Market price balances two forces Ø Value buyers derive from the good Ø Cost to produce one more unit of the good © 2012 The Mc. Graw-Hill Companies, All Rights Reserved 5

Demand n The quantity buyers would purchase at each possible price to pay at each possible price P Ø Willingness $4 n Demand curve Ø Negative slope § Consumers buy less at higher prices § Consumers buy more at lower prices $2 © 2012 The Mc. Graw-Hill Companies, All Rights Reserved D 8 16 Q 6

Demand Slopes Downward n Substitution Effect Ø As pizza becomes more expensive, a consumer may switch to other foods that substitute for pizza n Income Effect ØA higher price lowers the purchasing power of a consumer, resulting in reduced consumption n Demand reflects the entire market, not one consumer Ø Lower prices bring more buyers into the market Ø Lower prices cause existing buyers to buy more © 2012 The Mc. Graw-Hill Companies, All Rights Reserved 9

Law of Demand n What does the cost-benefit principle say? Ø Buy the good if the benefits > costs § § Benefit is reflected in the buyer’s reservation price (the highest price an individual is willing to pay for a good) Cost of the good is the actual price paid (determined by the market) n Buyers value goods differently Ø When the price increases it satisfies the cost-benefit test for fewer buyers demand slopes downward n Inverse relationship between the price of a good and the quantity buyers are willing to purchase in a defined time period, ceteris paribus (all else remains the same) © 2012 The Mc. Graw-Hill Companies, All Rights Reserved 10

The Supply Curve n The quantity of a good that sellers offer at each price Ø The supply curve reflects the willingness to sell § The supplier is willing to sell if the price covers the opportunity cost n Opportunity cost differs among sellers due to Ø Technology Ø Skills ■ ■ Different costs such as rent Expectations n Higher prices, larger quantities Ø Low-Hanging Fruit Principle © 2012 The Mc. Graw-Hill Companies, All Rights Reserved 13

Interpreting the Supply Curve Ø Vertical interpretation of supply § Given the quantity to be sold, what will the price be? Ø The seller’s reservation price is the marginal cost of producing that good • It is the smallest dollar amount for which she would not be worse off if she sold an additional unit. P S $4 $2 8 16 Q © 2012 The Mc. Graw-Hill Companies, All Rights Reserved 15

Market Equilibrium § Quantity supplied equals quantity demanded AND § Price is on supply and demand curves § No tendency to change P or Q § Buyers are on their demand curve § Sellers are on their supply curve P S $3 © 2012 The Mc. Graw-Hill Companies, All Rights Reserved D 12 Q 17

Excess Supply and Excess Demand Excess Supply Ø At $4, 16 units are supplied and 8 units are demanded P Excess Demand Ø At $2, 8 units are supplied and 16 units are demanded P Surplus S S $4 Shortage $2 D 8 16 D Q © 2012 The Mc. Graw-Hill Companies, All Rights Reserved 8 16 Q 18

Incentive Principle: Excess Supply at $4 Each supplier has an incentive to decrease the price in order to sell more Ø Lower prices decrease the surplus Ø As price decreases: § the quantity offered for sale decreases along the supply curve § the quantity demanded increases along the demand curve Ø P S $4 $3. 50 $3 © 2012 The Mc. Graw-Hill Companies, All Rights Reserved Equilibrium D 8 12 16 Q 19

Incentive Principle: Excess Demand at $2 Each supplier has an incentive to increase the price in order to sell more Ø Higher prices decrease the shortage Ø As price increases § the quantity offered for sale increases along the supply curve § As price increases, the quantity demanded decreases along the demand curve. Ø P S $3 $2. 50 $2 Equilibrium D 8 12 16 Q © 2012 The Mc. Graw-Hill Companies, All Rights Reserved 20

Equilibrium n Markets communicate information effectively Ø Value buyers place on the product Ø Opportunity cost of producing the product n Markets maximize the difference between benefits and costs n Market outcomes are the best provided that Ø The market is in equilibrium AND Ø No costs or benefits are shared with the public © 2012 The Mc. Graw-Hill Companies, All Rights Reserved 21

Market Equilibrium n Equilibrium = a price and a quantity n The market equilibrium is stable Ø If we move away from it, market forces will take us back to it! n What if the equilibrium price was perceived as too high? n What if the equilibrium price was perceived as too low? © 2012 The Mc. Graw-Hill Companies, All Rights Reserved 22

Rent Controls Are Price Ceilings Equilibrium price perceived as too high set a price ceiling § Legal maximum price Ø Common example: Rent § Rent controls set a maximum price that can be charged for a given apartment § Consequences: • Shortages • Illegal markets • Less maintenance • Discrimination Ø Market for Cairo Apartments P S $1, 600 $800 D 1 2 3 Q (millions of apartments/day) © 2012 The Mc. Graw-Hill Companies, All Rights Reserved 23

Minimum Wage as Price Floor Equilibrium price perceived as too low set a price floor § Legal minimum price Ø Common example: Min Wage § Price floors set a minimum wage that can be offered for labor § Consequences: • Unemployment - SL > D L • Black markets Ø Labor Market W SL $12 $10 DL 1 2 3 Q (millions of unskilled labor) © 2012 The Mc. Graw-Hill Companies, All Rights Reserved 24

Movement along the Demand Curve § When price goes up, quantity demanded goes down § When price goes down, buyers move to a new, higher quantity demanded § A change in quantity demanded results from a change in the price of a good movement along the curve Demand for Canned Tuna P $2 $1 D 8 10 Q (000 s of cans/day) © 2012 The Mc. Graw-Hill Companies, All Rights Reserved 25

Shift in Demand § If buyers are willing to buy more at each price, then demand has increased § Move the entire demand curve to the right § Increase in demand § If buyers are willing to buy less at each price, then demand has decreased Demand for Canned Tuna P $2 D 8 10 D' Q (000 s of cans/day) © 2012 The Mc. Graw-Hill Companies, All Rights Reserved 26

Causes of Shifts in Demand n Price of complementary goods Ø Tennis courts and tennis balls n Price of substitute goods Ø Internet (email) and overnight delivery (letters) n Income: normal or inferior goods? n Preferences Ø Dinosaur toys after Jurassic Park movie n Number of buyers in the market n Expectations about the future Price changes never cause a shift in demand © 2012 The Mc. Graw-Hill Companies, All Rights Reserved 27

Tennis Market Ø If rent for tennis court decreases, demand for tennis balls increases § P Tennis courts and tennis balls are complements Tennis Court Rentals P Tennis Ball Sales S $10 $1. 40 $1. 00 $7 D' D D 4 11 Q (00 s rentals/day) © 2012 The Mc. Graw-Hill Companies, All Rights Reserved 40 58 Q (millions of balls/day) 28

Internet and Overnight Delivery Ø If price for internet connection decreases, demand for overnight letter delivery decreases § P Internet (emails) and letters delivery are substitutes Internet Connection P Overnight Letter Delivery S $10 $1. 40 $1. 00 $7 D D D' 4 11 Q (00 s connection/month) © 2012 The Mc. Graw-Hill Companies, All Rights Reserved 40 58 Q (Letter per month) 29

Conveniently Located Apartments n If government wages rise, demand for apartments near Metro stations increases § Demand increases • Price increases • Quantity increases n Demand for a normal good increases when income increases § Demand for an inferior good increases when income decreases Convenient Apartments P D D' S P' P Q Q' (units/month) Q © 2012 The Mc. Graw-Hill Companies, All Rights Reserved 30

Changes in Quantity Supplied § When the price of a good changes, move to a new quantity supplied § Assumes everything except price is held constant (ceteris paribus) P Supply of Pizzas S $4 $2 8 16 Q (000 s of slices/day) © 2012 The Mc. Graw-Hill Companies, All Rights Reserved 31

Changes in Supply § Supply increases when sellers are willing to offer more for sale at each possible price § Moves the entire supply curve to the right § Supply decreases when sellers are willing to offer less for sale at each possible price § Moves the entire supply curve to the left Supply of Pizzas P S Supply of Tuna P S* S S' $2 $2 8 9 Q (000 s of slices/day) © 2012 The Mc. Graw-Hill Companies, All Rights Reserved 8 9 Q (000 s of cans/day) 32

Causes of Shifts in Supply n A change in the price of an input Ø Fiberglass for skateboards, construction wages n A change in technology Ø Desktop publishing and term papers Ø Internet distribution of products (e-commerce) n Weather (agricultural commodities and outdoor entertainment) n Number of sellers in the market n Expectation of future price changes Price changes never cause a shift in supply © 2012 The Mc. Graw-Hill Companies, All Rights Reserved 33

Shifts in Supply: Skateboards n Costs of production affect the supply of a product n Cost of fiberglass for skateboards increases Ø Supply decreases n With no change in demand, the price of skateboards increases to $80 and quantity decreases to 800 Supply of Skateboards P S' $80 $60 © 2012 The Mc. Graw-Hill Companies, All Rights Reserved S D 600 800 1, 000 Q (skateboards/month) 34

Shift in Supply: Home Construction n Cost of labor used to produce houses decreases Ø Supply increases n Demand is constant n. The price of houses decreases to $90, 000 per house n Quantity increases to 50 The Market for New Houses P S $120 $90 © 2012 The Mc. Graw-Hill Companies, All Rights Reserved S' D 40 50 Q (houses/month) 35

Supply and Demand Shifts: Four Rules An increase in demand will lead to an increase in both equilibrium price and quantity P S P' P D' D Q Q' © 2012 The Mc. Graw-Hill Companies, All Rights Reserved Q 36

Supply and Demand Shifts: Four Rules An decrease in demand will lead to a decrease in both equilibrium price and quantity P S P P' D D' Q' Q © 2012 The Mc. Graw-Hill Companies, All Rights Reserved Q 37

Supply and Demand Shifts: Four Rules An increase in supply will lead to a decrease in the equilibrium price and an increase in the equilibrium quantity. P S S' P P' D Q Q' © 2012 The Mc. Graw-Hill Companies, All Rights Reserved Q 38

Supply and Demand Shifts: Four Rules An decrease in supply will lead to an increase in the equilibrium price and a decrease in the equilibrium quantity. S' P S P' P D Q' Q © 2012 The Mc. Graw-Hill Companies, All Rights Reserved Q 39

Supply and Demand Both Change: Carrot Halwa Market Ghee for frying halwa is harmful AND the price of carrot harvesting equipment decreases Price ($/kg) S S' P P' D D' Q' Q Millions of kg per month © 2012 The Mc. Graw-Hill Companies, All Rights Reserved 40

Changes in Supply and Demand Supply Demand Increases Decreases Increases P Q Ambiguous Increases P Q Increases Ambiguous Decreases P Q Decreases Ambiguous P Q Ambiguous Decreases © 2012 The Mc. Graw-Hill Companies, All Rights Reserved 41

Economic Naturalist n Why do the prices of some goods, like airline tickets to Europe, go up during the months of heaviest consumption, while others, like sweet corn, go down? n Airline ticket prices go up because demand increases. n Sweet corn prices go down because supply increases. © 2012 The Mc. Graw-Hill Companies, All Rights Reserved 42

Chapter 3 Appendix The Algebra of Supply and Demand

From Graphs to Equations … n Sample equations P = 16 – 2 Qd is a straight-line demand curve with intercept 16 on the vertical (P) axis and a slope of – 2 P = 4 + 4 Qs is a straight-line supply curve with intercept 4 and a slope of 4 © 2012 The Mc. Graw-Hill Companies, All Rights Reserved 44

… To Equilibrium P and Q n Equilibrium is where P and Q are the same for demand supply Ø Set the two equations equal to each other (P = P) and solve for Q (Qs = Qd = Q*) 16 – 2 Q* = 4 + 4 Q* 6 Q* = 12 Q* = 2 n Use either the supply or demand curve and Q* = 2 to find price P = 16 – 2 Q* P = $12 P = 4 + 4 Q* P = $12 © 2012 The Mc. Graw-Hill Companies, All Rights Reserved 45