Chapter 3 Supply Demand and the Market Process

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Chapter 3 Supply, Demand, and the Market Process Slides to Accompany “Economics: Public and Private Choice 9 th ed. ” James Gwartney, Richard Stroup, and Russell Sobel Next page Copyright (c) 2000 by Harcourt Inc. All rights reserved.

Law of Demand n Law of Demand: There is an inverse relationship between the price of a good and the quantity consumers are willing to purchase. As price of a good rises, consumers buy less. u The availability of substitutes --goods that do similar functions -- explains this negative relationship. u Jump to first page Copyright (c) 2000 by Harcourt Inc. All rights reserved.

Market Demand Schedule n n n A market demand schedule is a table that shows the quantity of a good people will demand at varying prices. Consider the market for cellular phones. A market demand schedule lays out the amount of cell phones that are demanded in the market for a spectrum of prices. We can graph these points (price and the respective demand) to make a demand curve for cell phones. Jump to first page Copyright (c) 2000 by Harcourt Inc. All rights reserved.

Market Demand Schedule Price (monthly bill) 140 Millions of Cell Phone (monthly bill) Subscribers Cell Phone Price $123 $107 $ 92 $ 79 $ 73 $ 63 $ 56 2. 1 3. 5 5. 3 7. 6 11. 0 16. 0 24. 1 120 100 80 Demand 60 5 10 15 20 25 30 Quantity (of Cell Phone Subscribers) Jump to first page Copyright (c) 2000 by Harcourt Inc. All rights reserved.

Market Demand Schedule Price (monthly bill) 140 • Notice how the law of demand is reflected by the shape of the demand curve. • As the price of a good rises … • . . . consumers buy less. 120 100 80 Demand 60 5 10 15 20 25 30 Quantity (of Cell Phone Subscribers) Jump to first page Copyright (c) 2000 by Harcourt Inc. All rights reserved.

Market Demand Schedule Price (monthly bill) 140 120 • The height of the demand curve at any quantity shows the maximum price that 100 consumers are willing to pay for that additional unit. 80 • Here, for the 11 th unit. . . • . . . consumers are only willing to pay up to $73 for it. 60 • While they would be willing to pay up to $92 for the 5. 3 (millionth) unit. Demand 5 10 15 20 25 30 Quantity (of Cell Phone Subscribers) Jump to first page Copyright (c) 2000 by Harcourt Inc. All rights reserved.

Consumer Surplus n Consumer Surplus - the area below the demand curve but above the actual price paid. u n Consumer surplus is the difference between the amount consumers are willing to pay and the amount they have to pay for a good. Lower market prices will increase consumer surplus. Jump to first page Copyright (c) 2000 by Harcourt Inc. All rights reserved.

Consumer Surplus • Lets consider the market for Price (monthly bill) cellular phones again. This time we will assume that the demand 140 for cell phones is more linear and that the market price is $100. 120 • If the market price is $100, then the 25 th unit will not sell because those who demand it are 100 only willing to pay $60 for cellular phone service. 80 • At $100, the 15 th unit will sell because those who demand it are 60 willing to pay up to $100 for cellular phone service. • At $100, the 10 th unit will sell because those who demand it are willing to pay up to $120 for cellular phone service. Market Price = $100 Demand 5 Jump to first page 10 15 20 25 30 Quantity (of Cell Phone Subscribers) Copyright (c) 2000 by Harcourt Inc. All rights reserved.

Consumer Surplus Price (monthly bill) • For all those goods under 15 units, people are willing to pay more than $100 for service. • The area, represented by the distance above the actual price paid and below the demand curve, is called consumer surplus. • This area represents the net gains to buyers from market exchange. 140 120 Market Price = $100 80 Demand 60 5 10 15 20 25 30 Quantity (of Cell Phone Subscribers) Jump to first page Copyright (c) 2000 by Harcourt Inc. All rights reserved.

Elastic and Inelastic Demand Curves n Elastic demand - quantity demanded is sensitive to small price changes. u n Easy to substitute away from good. Inelastic demand - quantity demanded is not sensitive to price changes. u Difficult to substitute away from good. Jump to first page Copyright (c) 2000 by Harcourt Inc. All rights reserved.

Elastic and Inelastic • If the market price for Demand Curves gasoline was to rise from $1. 25 to $2. 00, the quantity demanded in the market decreases insignificantly (from 8 to 7 units). • If the market price for tacos rises from $1. 25 to $2. 00, the quantity demanded in the market decreases significantly (from 8 to 1 unit). • Taco demand is highly sensitive to price changes and can be described as elastic; gasoline demand is relatively insensitive to price changes and can be described as inelastic. 2. 00 Gasoli ne 1. 25 1 2 3 4 5 6 7 8 9 10 2. 00 Tacos 1. 25 1 2 3 4 5 6 7 8 9 10 Jump to first page Copyright (c) 2000 by Harcourt Inc. All rights reserved.

Changes in Demand Quantity Demanded n n Change in Demand - shift in entire demand curve. Change in Quantity Demanded movement along the same demand curve in response to a price change. Jump to first page Copyright (c) 2000 by Harcourt Inc. All rights reserved.

Change in Demand Price (dollars) • If CDs cost $15 each, the CD demand curve D 1 shows that 10 units would be demanded. • If the price of CDs changed to $7. 50, the quantity demanded for CDs would increase to 20 units. • If, somehow, the preferences for CDs changed then the demand for CDs may change. • Here we will assume that consumer income increases, increasing demand for CDs at all price levels. At $15 15 units are now demanded. 25 20 15 10 5 D 1 5 10 15 20 D 2 25 30 Quantity (of Compact Disks per yr) Jump to first page Copyright (c) 2000 by Harcourt Inc. All rights reserved.

Demand Curve Shifters n n n Changes in Consumer Income Change in the Number of Consumers Change in Price of Related Good Changes in Expectations Demographic Changes in Consumer Tastes and Preferences Jump to first page Copyright (c) 2000 by Harcourt Inc. All rights reserved.

Questions for Thought: 1. Which of the following do you think would lead to an increase in the current demand for beef: (a) higher pork prices, (b) higher incomes, (c) higher prices of feed grains used to feed cows, (d) good weather conditions leading to a bumper (very good) corn crop, (e) an increase in the price of beef? 2. What is being held constant when a demand curve for a specific product (like shoes or apples, for example) is constructed? Explain why the demand curve for a product slopes downward and to the right. Jump to first page Copyright (c) 2000 by Harcourt Inc. All rights reserved.

Producers n n Opportunity Cost of Production - the sum of the producer’s cost of employing each resource required to produce the good. Firms will not stay in business for long unless they are able to cover the cost of all resources employed, including the opportunity cost of those owned by the firm. Jump to first page Copyright (c) 2000 by Harcourt Inc. All rights reserved.

Role of Profits and Losses n n n Profit occurs when revenues are greater than cost. Firms supplying goods for which consumers are willing to pay more than the opportunity cost of resources used will make a profit. Firms making a profit will expand those with a loss will contract. Jump to first page Copyright (c) 2000 by Harcourt Inc. All rights reserved.

Law of Supply n Law of Supply - there is a positive relationship between the price of a product and the amount of it that will be supplied. u As the price of a product rises, producers will be willing to supply more. Jump to first page Copyright (c) 2000 by Harcourt Inc. All rights reserved.

Market Supply Schedule Price (monthly bill) Supply 140 Quantity of Cell Phones Supplied (monthly bill) Cell Phone Price $ 60 $ 73 $ 80 $ 91 $107 $120 $135 5. 0 11. 0 15. 1 18. 2 21. 0 22. 5 24. 1 120 100 80 60 5 10 15 20 25 30 Quantity (of Cell Phone Subscribers) Jump to first page Copyright (c) 2000 by Harcourt Inc. All rights reserved.

Market Supply Schedule Price (monthly bill) Supply 140 • Notice how the law of supply is reflected by the shape of the supply curve. • As the price of a good rises … • . . . producers supply more. 120 100 80 60 5 10 15 20 25 30 Quantity (of Cell Phone Subscribers) Jump to first page Copyright (c) 2000 by Harcourt Inc. All rights reserved.

Market Supply Schedule Price (monthly bill) 140 • The height of the supply curve at any quantity shows the minimum price necessary 120 to induce producers to supply that next unit to market. 100 • Here, for the 11 th unit. . . • . . . producers require $73 to 80 induce them to supply it. • The height of the supply curve at any quantity also 60 shows the opportunity cost of producing that next unit of the good. Supply 5 10 15 20 25 30 Quantity (of Cell Phone Subscribers) Jump to first page Copyright (c) 2000 by Harcourt Inc. All rights reserved.

Producer Surplus • Lets consider the market for Price Supply (monthly bill) cellular phones again. This time 140 we will assume that the supply for cell phones is more linear and that the market price is $100. 120 • If the market price is $100, then the 25 th unit will not be 100 produced because the cost of supplying it exceeds the market price of $140. 80 • At $100, the 15 th unit will be produced because those who 60 supply it are willing to do so for at least $100. • At $100, the 10 th unit will be produced because those who supply it are willing to do so for at least $80. Market Price = $100 5 Jump to first page 10 15 20 25 30 Quantity (of Cell Phone Subscribers) Copyright (c) 2000 by Harcourt Inc. All rights reserved.

Producer Surplus Price Supply (monthly bill) • For market outputs of less then 15 units, producers are willing to supply the good for $100. • The area represented by the distance above the supply curve but below the actual sales price is called producer surplus. • This area is the difference between the minimum amount required to induce producers to supply a good and the amount they actually receive. 140 120 Market Price = $100 80 60 5 10 15 20 25 30 Quantity (of Cell Phone Subscribers) Jump to first page Copyright (c) 2000 by Harcourt Inc. All rights reserved.

Elastic and Inelastic Supply Curves n n Elastic supply- quantity supplied is sensitive to small price changes. Inelastic supply - quantity supplied is not sensitive to price changes. Jump to first page Copyright (c) 2000 by Harcourt Inc. All rights reserved.

Elastic and Inelastic • If the market price for Supply Curves motor oil was to rise from $1. 25 to $2. 00, the quantity supplied in the market increases insignificantly (from 7 to 8 units). • If the market price for burgers rises from $1. 25 to $2. 00, the quantity supplied in the market increases substantially (from 1 to 8 units). • Burger supply is highly sensitive to price changes and can be described as elastic; motor oil supply is relatively insensitive to price changes and can be described as inelastic. 2. 00 1. 25 1 2 3 4 5 6 7 8 9 10 Jump to first page Copyright (c) 2000 by Harcourt Inc. All rights reserved.

Short Run and Long Run n Short Run - Firms don’t have enough time to change plant size. u n Supply tends to be inelastic in the short run. Long Run - Firms have enough time to change plant size. u Supply tends to be much more elastic in the long run. Jump to first page Copyright (c) 2000 by Harcourt Inc. All rights reserved.

Changes in Supply and Quantity Supplied n n Change in Supply - shift in entire supply curve. Change in Quantity Supplied movement along the same supply curve in response to a price change. Jump to first page Copyright (c) 2000 by Harcourt Inc. All rights reserved.

Change in Supply Price (dollars) • If the market price for gas is $1. 50 a gallon, the gasoline supply curve S 1 shows that 20 units would be supplied. • If the market price of gas changed to $. 75, the quantity supplied of gasoline would decrease to 10 units. • If, somehow, the opportunity costs for gas manufacturers changed then the supply of gas may change. • Here we will assume that the cost of crude oil (an input in gasoline) increases, decreasing the supply of gas at all price levels. Now at $1. 50, 15 units of gasoline are supplied. S 2 The Market for Gasoline 2. 50 2. 00 S 1 1. 50 1. 00. 50 5 10 15 20 25 30 Quantity (Millions of Gal of Gas) Jump to first page Copyright (c) 2000 by Harcourt Inc. All rights reserved.

Supply Curve Shifters n n Changes in Resource Prices Change in Technology Elements of Nature and Political Disruptions Changes in Taxes Jump to first page Copyright (c) 2000 by Harcourt Inc. All rights reserved.

Questions for Thought: 1. What are profits and losses? What must a firm do in order to make profit? 2. Define consumer and producer surplus. What is meant by economic efficiency and how does it relate to consumer and producer surplus? Jump to first page Copyright (c) 2000 by Harcourt Inc. All rights reserved.

Market Equilibrium • This table and graph indicate the demand supply conditions for oversized playing cards. • Equilibrium will occur where the quantity demanded equals the quantity supplied. If the price in the market exceeds the equilibrium level, market forces will guide it to equilibrium. • A price of $12 in this market will result in. . . quantity demanded of 450 and quantity supplied of 600. . . resulting in excess supply. • With an excess supply present, there will be downward pressure on price to clear the market. Demand 13 12 11 10 9 8 7 Supply 350 400 450 500 550 600 650 > Excess Supply Downward Quantity Supplied = 600 Quantity Demanded = 450 Jump to first page Copyright (c) 2000 by Harcourt Inc. All rights reserved.

Market Equilibrium Demand • A price of $8 in this market will result in. . . quantity supplied of 500 and quantity demanded of 650. . . resulting in excess demand. • With an excess demand present, there will be upward pressure on price to clear the market. 13 12 11 10 9 8 7 Supply 350 400 450 500 550 600 650 > < Excess Supply Downward Excess Upward Demand Jump to first page Quantity Supplied = 500 Quantity Demanded = 650 Copyright (c) 2000 by Harcourt Inc. All rights reserved.

Market Equilibrium Demand • A price of $10 in this market will result in. . . quantity supplied of 550 and quantity demanded of 550. . . resulting in a balance. • With a balance present, there will be an equilibrium and the market will clear. 13 12 11 10 9 8 7 Supply 350 400 450 500 550 600 650 > = < Excess Supply Downward Balance Equilibrium Excess Upward Demand Jump to first page Quantity Supplied = 550 Quantity Demanded = 550 Copyright (c) 2000 by Harcourt Inc. All rights reserved.

Market Equilibrium Demand • At every price above market equilibrium there is excess supply and there will be downward pressure on the price level. • At every price below market equilibrium there is excess demand there will be upward pressure on the price level. • It is at equilibrium that prices will rest. 13 12 11 10 9 8 7 excess supply Equilibrium Price Supply excess demand 350 400 450 500 550 600 650 > = < Excess Supply Downward Balance Equilibrium Excess Upward Demand Jump to first page Copyright (c) 2000 by Harcourt Inc. All rights reserved.

Net Gains to Buyers and Sellers • Returning to the market for cell Price Supply (monthly bill) phones, if the market price is driven 140 to equilibrium through market pressures to exist where supply equals demand, then the market 120 equilibrium in the cell phone market should be driven to $100 per month. • If the area above the market price and below the demand curve is called consumer surplus. . . • . . . and the area above the supply curve but below the market price is called producer surplus. . . • . . . Then the combined area represented in the graph to the right represents the net gains to buyers and sellers. It is here that all potential gains from production and exchange are realized. Market Equilibrium Price = $100 80 Demand 60 5 10 15 20 25 30 Quantity (of Cell Phone Subscribers) Jump to first page Copyright (c) 2000 by Harcourt Inc. All rights reserved.

Effects of a Change in Demand n n If Demand decreases, the equilibrium price and quantity will fall. If Demand increases, the equilibrium price and quantity will rise. Jump to first page Copyright (c) 2000 by Harcourt Inc. All rights reserved.

• Consider the market for eggs. Market Adjustment to an Increase in Demand Price ($ per doz) • Prior to Easter season, the market for eggs produces an equilibrium 1. 40 where Supply equals Demand 1 at a market price of $. 80 and 1. 20 output of Q 1. • When the Easter season arrives, the demand by consumers for eggs 1. 00 increases from Demand 1 to Demand 2. What happens to the equilibrium price and output level? . 80 • At $. 80 a dozen the quantity demanded exceeds the quantity supplied. There is upward. 60 pressure on price inducing the existing suppliers to increase their quantity supplied to Q 2, pushing the equilibrium price up to $1. 00. • What happens to equilibrium price and output after the Easter season? Jump to first page Supply ` Demand 2 Demand 1 Q 2 Quantity (million doz eggs per week) Copyright (c) 2000 by Harcourt Inc. All rights reserved.

Effects of a Change in Supply n n If Supply decreases, the equilibrium price will rise and the equilibrium quantity will fall. If Supply increases, the equilibrium price will fall and the equilibrium quantity will rise. Jump to first page Copyright (c) 2000 by Harcourt Inc. All rights reserved.

• Consider the market for romaine lettuce. • Prior to a season of adverse weather affecting the yield of the market, an equilibrium exists where Supply equals Demand 1 with a market price of $1. 80 and output of Q 1. • When the season of adverse weather arrives the supply of romaine lettuce falls, decreasing the supply from supply 1 to supply 2. What happens to the equilibrium price and output level? • At $1. 80 a head the quantity demanded exceeds the quantity supplied. There is upward pressure on price inducing the existing consumers to decrease their quantity demanded to Q 2, drawing up the equilibrium price to $2. 00. • What happens to equilibrium price and output when the weather returns to normal? Market Adjustment to a Decrease in Supply Price ($ per head) Supply 2 2. 40 2. 20 2. 00 Supply 1 ` 1. 80 1. 60 Demand 1 Q 2 Q 1 Quantity (million heads lettuce per week) Jump to first page Copyright (c) 2000 by Harcourt Inc. All rights reserved.

Time and the Adjustment Process n With the passage of time, the market adjustments of both producers and consumers will be more complete. u Both demand supply are more elastic in the long run than in the short run. Jump to first page Copyright (c) 2000 by Harcourt Inc. All rights reserved.

• Consider the market for laptop computers. • We begin in the short run in equilibrium at output level Q 1 and price level P 1. • When the demand for laptops unexpectedly increases from demand 1 to demand 2, suppliers do there best to increase product in the market, pushing the price level upward to P 2. What happens to the equilibrium price and output in the long run, after suppliers have a chance to change their capacity? • With time suppliers expand output pivoting the supply curve to its long run representation. The new equilibrium is where demand equals supply. The result, a further increase in equilibrium output, to Q 3, and a reduction in the equilibrium price to P 3. Time and Adjustment to Increase in Demand Supply. SR Price Supply. LR P 2 P 3 ` Demand 2 P 1 Demand 1 Q 2 Q 3 Jump to first page Quantity Copyright (c) 2000 by Harcourt Inc. All rights reserved.

Invisible Hand n Invisible hand- the tendency of market prices to direct individuals pursuing their own interest into productive activities that also promote the economic well-being of society. Jump to first page Copyright (c) 2000 by Harcourt Inc. All rights reserved.

Communicating Information n n Product prices communicate up-to-date information about the consumers’ valuation of additional units of each commodity. Without the information provided by market price it would be impossible for decision-makers to determine how intensely a good was desired relative to its opportunity cost. Jump to first page Copyright (c) 2000 by Harcourt Inc. All rights reserved.

Coordinating Actions of Market Participants n n Price changes bring the decisions of buyers and sellers into harmony. Price changes create profits and losses which change production levels for various products. Jump to first page Copyright (c) 2000 by Harcourt Inc. All rights reserved.

Qualifications n The efficiency of market organization is dependent upon: The presence of competitive markets. u Well-defined and enforced private property rights. u Jump to first page Copyright (c) 2000 by Harcourt Inc. All rights reserved.

Questions for Thought: 1. A drought during the summer of 1988 sharply reduced the 1988 output of wheat, corn, soybeans, and hay. Indicate the expected impact of the drought on the following: a. Prices of feed grains and hay during the summer of ‘ 88. b. Price of cattle during the fall of ‘ 88. (Hint: What has happened to the opportunity cost of maintaining cattle during the upcoming winter? ) c. Price of cattle during the summer and fall of ‘ 89. 2. What is the “invisible hand” principle? Does it indicate that “good intentions” are necessary if one’s actions are going to be beneficial to others? Jump to first page Copyright (c) 2000 by Harcourt Inc. All rights reserved.