CHAPTER 4 1 Supply Demand and Market Equilibrium

The Model of Supply and Demand u The purpose of the model of supply and demand is to predict changes in market quantity and price based on changes in supply and demand conditions. u The supply and demand model is used to explain how a perfectly competitive market operates. © 2001 Prentice Hall Business Publishing Economics: Principles and Tools, 2/e O’Sullivan & Sheffrin 2

Market Demand u Market demand shows how much of a particular product are consumers willing to buy during a particular time period, all else being equal. © 2001 Prentice Hall Business Publishing Economics: Principles and Tools, 2/e O’Sullivan & Sheffrin 3

The Determinants of Demand The main determinants of demand include: u The price of the product u Consumer income u The price of related goods—substitutes and complements u The number of consumers u Consumer preferences—tastes and advertising u Consumer expectations about future prices © 2001 Prentice Hall Business Publishing Economics: Principles and Tools, 2/e O’Sullivan & Sheffrin 4

The Individual Demand Curve u The individual demand curve shows the relationship between the price of a good and the quantity that a single consumer is willing to buy, or quantity demanded. © 2001 Prentice Hall Business Publishing Economics: Principles and Tools, 2/e O’Sullivan & Sheffrin 5

The Individual Demand Curve and The Law of Demand u The negative slope of the individual demand curve reflects the law of demand. u Law of Demand: The higher the price, the smaller the quantity demanded, ceteris paribus. Demand schedule © 2001 Prentice Hall Business Publishing Economics: Principles and Tools, 2/e Individual Demand Curve O’Sullivan & Sheffrin 6

The “Ceteris Paribus” Assumption u To obtain various points on the individual demand curve for pizzas we assume that only the price of pizzas changes, while other determinants of the demand for pizzas (income, tastes and preferences, the price of related goods, etc. ) remain constant, or ceteris paribus. © 2001 Prentice Hall Business Publishing Economics: Principles and Tools, 2/e O’Sullivan & Sheffrin 7

A Change in Quantity Demanded u A change in quantity demanded is caused by a change in the price of the good, which causes a movement along the demand curve. © 2001 Prentice Hall Business Publishing Economics: Principles and Tools, 2/e O’Sullivan & Sheffrin 8

Income and Substitution Effects u The reason why the slope of the individual demand curve is negative, involves the substitution and income effects. © 2001 Prentice Hall Business Publishing Economics: Principles and Tools, 2/e O’Sullivan & Sheffrin 9

The Substitution Effect u The substitution effect describes a change in consumption resulting from a change in the price of one good relative to the price of other goods. u The lower the price of a good, the smaller the sacrifice associated with consumption of a good. © 2001 Prentice Hall Business Publishing Economics: Principles and Tools, 2/e O’Sullivan & Sheffrin 10

The Income Effect u The income effect describes the change in consumption resulting from an increase in the consumer’s real income, or the income in terms of the goods the money can buy. l Real income is the consumer’s income measured in terms of the goods it can buy. © 2001 Prentice Hall Business Publishing Economics: Principles and Tools, 2/e O’Sullivan & Sheffrin 11

From Individual to Market Demand u Market demand is the sum of the quantities demanded by all consumers in the market, or the sum of individual demand curves. © 2001 Prentice Hall Business Publishing Economics: Principles and Tools, 2/e O’Sullivan & Sheffrin 12

From Individual to Market Demand © 2001 Prentice Hall Business Publishing Economics: Principles and

The Market Demand Curve and The Law of Demand u Since the slope of the individual demand curve is negative, it follows that the slope of the market demand curve is also negative, reflecting the law of demand. Market Demand Market demand schedule © 2001 Prentice Hall Business Publishing Economics: Principles and Tools, 2/e O’Sullivan & Sheffrin 14

Market Supply u The supply curve shows the relationship between price and the quantity that producers are willing to sell during a particular time period, all else being equal. © 2001 Prentice Hall Business Publishing Economics: Principles and Tools, 2/e O’Sullivan & Sheffrin 15

The Determinants of Supply The main determinants of supply include: u The price of the product u The cost of inputs u The state of production technology u The number of producers u Producer expectations about future prices u Taxes or subsidies from the government © 2001 Prentice Hall Business Publishing Economics: Principles and Tools, 2/e O’Sullivan & Sheffrin 16

The Marginal Principle and the Output Decision u The decision to produce a given quantity of output is based on the marginal principle. Marginal PRINCIPLE Increase the level of an activity if its marginal benefit exceeds its marginal cost, but reduce the level if the marginal cost exceeds the marginal benefit. If possible, pick the level at which the marginal benefit equals the marginal cost. © 2001 Prentice Hall Business Publishing Economics: Principles and Tools, 2/e O’Sullivan & Sheffrin 17

The Marginal Principle and the Output Decision u u The optimal quantity of output is the one that satisfies the marginal principle—where marginal cost equals marginal benefit. As price rises, marginal benefit intersects marginal cost at a higher output level. © 2001 Prentice Hall Business Publishing Economics: Principles and Tools, 2/e O’Sullivan & Sheffrin 18

Individual Supply and the Law of Supply u The individual supply curve shows the relationship between the price and the quantity supplied by a single firm, ceteris paribus. u The positive slope of the curve reflects the law of supply. © 2001 Prentice Hall Business Publishing Economics: Principles and Tools, 2/e O’Sullivan & Sheffrin 19

Individual Supply and the Law of Supply u Law of Supply: The higher the price, the larger the quantity supplied, ceteris paribus. © 2001 Prentice Hall Business Publishing Economics: Principles and Tools, 2/e O’Sullivan & Sheffrin 20

Individual Supply to Market Supply u The market supply curve for a particular good shows the relationship between the price of the good and the quantity that all producers together are willing to sell, ceteris paribus. © 2001 Prentice Hall Business Publishing Economics: Principles and Tools, 2/e O’Sullivan & Sheffrin 21