Chapter Two Supply and Demand Chapter 1

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Chapter Two Supply and Demand

Chapter 1 Concepts and Related Concepts § Definition of Economics § Microeconomics versus Macroeconomics § Positive versus Normative Economics § Mainstream Neoclassical Economics © 2009 Pearson Addison-Wesley. All rights reserved. 2 -2

Chapter 2 Outline 1. 2. 3. 4. 5. 6. Demand. Supply. Market Equilibrium. Shocking the Equilibrium. Effects of Government Interventions. When to Use the Supply-and. Demand Model. © 2009 Pearson Addison-Wesley. All rights reserved. 2 -3

Demand: determinants of demand. § The following factors determine the demand for a good: w Price of the good w Tastes w Information w Prices of related goods Complements and substitutes w Income w Government rules and regulations w Other © 2009 Pearson Addison-Wesley. All rights reserved. 2 -4

Demand: the demand curve § Quantity demanded - the amount of a good that consumers are willing to buy at a given price, holding constant the other factors that influence purchases. § Demand curve - the quantity demanded at each possible price, holding constant the other factors that influence purchases © 2009 Pearson Addison-Wesley. All rights reserved. 2 -5

p, $ per kg Figure 2. 1 A Demand Curve 14. 30 Demand curve for pork, D 1 Law of Demand consumers demand more of a good the lower its price, holding constant all other factors that influence consumption 4. 30 3. 30 2. 30 0 200 220 240 286 Q, Million kg of pork per year © 2009 Pearson Addison-Wesley. All rights reserved. 2 -6

p, $ per kg Figure 2. 2 A Shift of the Demand Curve Effect of a 60¢ increase in the price of beef 3. 30 D 2 D 1 0 176 © 2009 Pearson Addison-Wesley. All rights reserved. 220 232 Q, Million kg of pork per year 2 -7

The Demand Function § The processed pork demand function is: Q = D(p, pb, pc, Y) w where Q is the quantity of pork demanded (millions of kg) w p is the price of pork (dollars per kg) w pb is the price of beef (dollars per kg) w pc is the price of chicken (dollars per kg) w Y is the income of consumers (thousand dollars) © 2009 Pearson Addison-Wesley. All rights reserved. 2 -8

From the Demand Function to the Demand Curve § Estimated demand function for pork: Q = 171− 20 p + 20 pb + 3 pc + 2 Y § Using the values pb = 4, pc = 3. 33 and Y = 12. 5, we have (direct demand) Q = 286− 20 p w which is the linear demand function for pork. © 2009 Pearson Addison-Wesley. All rights reserved. 2 -9

From the Demand Function to the Demand Curve p, $ per kg Q = 286− 20 p 14. 30 If. Ifpp= = 0, then by If p increases In general, $3. 30 If p decreases $1 (to Demand curve for pork, D by $1 DQ = -20 Dp 286 $4. 30) Qthen, (to = then, Q =$2. 30) then, 220 Q = 200 Q = 240 1 4. 30 3. 30 2. 30 0 200 220 240 286 Q, Million kg of pork per year Demand curve or inverse demand P = (286/20) – (1/20)Q © 2009 Pearson Addison-Wesley. All rights reserved. 2 -10

Terminology § Demand function w The quantity demanded as a function of the important independent variables § Direct demand w The quantity demanded as solely a function of price given the values of the independent variables § Demand curve w The inverse of direct demand w The values of the independent variables are given © 2009 Pearson Addison-Wesley. All rights reserved. 2 -17

The price of beef increases from $4. 00 to $5. 50. § Given Q = 171 – 20 p + 20 pb + 3 pc + 2 Y § How does the demand curve shift and what is the magnitude of the shift? w ∆Q/ ∆pb= 20 w ∆Q = 20 ∆pb = 20*1. 50 = 30 § ∆Q is equal to the horizontal shift in the demand curve © 2007 Pearson Addison-Wesley. All rights reserved. 2– 18

p, $ per kg A Shift of the Demand Curve Effect of a $1. 50 increase in the price of beef 3. 30 D 2 D 1 0 176 © 2009 Pearson Addison-Wesley. All rights reserved. 220 250 Q, Million kg of pork per year 2 -19

Supply: determinants of supply. § The following factors determine the supply for a good: w Price of the good w Costs w Government rules and regulations © 2009 Pearson Addison-Wesley. All rights reserved. 2 -25

Supply: the demand curve § Quantity supplied - the amount of a good that firms want to sell at a given price, holding constant other factors that influence firms’ supply decisions, such as costs and government actions § Supply curve - the quantity supplied at each possible price, holding constant the other factors that influence firms’ supply decisions © 2009 Pearson Addison-Wesley. All rights reserved. 2 -26

p, $ per kg Figure 2. 3 A Supply Curve An increase in the price… Supply curve, S 1 5. 30 3. 30 causes a movement along the curve…. 0 176 220 and a decrease in the quantity supplied…. © 2009 Pearson Addison-Wesley. All rights reserved. 300 Q, Million kg of po per year rk 2 -27

p, $ per kg Figure 2. 4 A Shift of a Supply Curve A $0. 25 increase in the price of hogs…. . shifts the supply curve to the left S 2 S 1 3. 30 reducing the quantity supplied at the previous price. 0 176 205 © 2009 Pearson Addison-Wesley. All rights reserved. 220 Q, Million kg of po rk per year 2 -28

The Supply Function § The processed pork supply function is: Q = S(p, ph) w where Q is the quantity of pork supplied w p is the price of pork (dollars per kg) w ph is the price of a hog (dollars per kg) © 2009 Pearson Addison-Wesley. All rights reserved. 2 -29

From the Supply Function to the Supply Curve § Estimated demand function for pork: Q = 178 + 40 p− 60 ph § Using the values ph = $1. 50 per kg Q = 88 + 40 p. § What happens to the quantity supplied if the price of processed pork increases by Δp = p 2−p 1? © 2009 Pearson Addison-Wesley. All rights reserved. 2 -30

Solved Problem 2. 2 § How does a quota set by the United States on foreign steel imports of Q affect the total American supply curve for steel given the domestic supply, Sd in panel a of the graph, and foreign supply, Sf in panel b? © 2009 Pearson Addison-Wesley. All rights reserved. 2 -33

Market Equilibrium § Equilibrium - a situation in which no one wants to change his or her behavior. w excess demand the amount by which the quantity demanded exceeds the quantity supplied at a specified price. w excess supply the amount by which the quantity supplied is greater than the quantity demanded at a specified price © 2009 Pearson Addison-Wesley. All rights reserved. 2 -35

p, $ per kg Figure 2. 6 Market Equilibrium At a price above equilibrium…. Excess supply = Market equilibrium point!39 S 3. 95 e 3. 30 2. 65 Excess demand = 39 At a price below equilibrium…. 0 176 D is below the quantity supplied demanded 194 207 the quantity demanded…. the supplied…. © 2009 Pearson Addison-Wesley. All rights reserved. 220 233 246 Q, Million kg of pork per year 2 -36

Using Math to Determine the Equilibrium § Demand: Qd = 286 − 20 p § Supply: Qs = 88 + 40 p § Equilibrium: Qd = Q s 286 − 20 p = 88 + 40 p 60 p = 198 P = $3. 30 Q = 286 – 20(3. 3) = 220 © 2009 Pearson Addison-Wesley. All rights reserved. 2 -37

Equilibrium: Practice Problem § The demand function for a good is Q = a−bp, and the supply function is Q = c + ep, where a, b, c, and e are positive constants. Solve for the equilibrium price and quantity in terms of these four constants. © 2009 Pearson Addison-Wesley. All rights reserved. 2 -38

Shocking the Equilibrium The equilibrium changes only if a shock occurs that shifts the demand curve or the supply curve. These curves shift if one of the variables we were holding constant changes. © 2009 Pearson Addison-Wesley. All rights reserved. 2 -40

Figure 2. 7 a Equilibrium Effects of a Shift of a Demand Curve p, $ per kg A $0. 60 increase in the price of beef shifts the demand outward e 2 3. 50 3. 30 S Which puts an upward pressure in the price to a new equilibrium. D 2 e 1 D 1 At the original price there is now an excess demand…. Excess demand = 12 0 176 220 228 232 Q, Million kg of pork per year © 2009 Pearson Addison-Wesley. All rights reserved. 2 -41

p, $ per kg Figure 2. 7 b Equilibrium Effects of a Shift of a Supply Curve A $0. 25 increase in the price of hogs shifts the supply curve to the left Which puts an upward pressure in the price to a new equilibrium. S 2 S 1 e 2 3. 55 3. 30 e 1 D At the original price there is now an excess demand…. Excess demand = 15 0 176 205 215 220 Q, Million kg of pork per year © 2009 Pearson Addison-Wesley. All rights reserved. 2 -42

Solved Problem 2. 3 § Mathematically, how does the equilibrium price of pork vary as the price of hogs changes if the variables that affect demand are held constant at their typical values? © 2009 Pearson Addison-Wesley. All rights reserved. 2 -43

Solved Problem 2. 3: Solution 1. Solve for the equilibrium price of pork in terms of the price of hogs. Qd = 286− 20 p Qs = 178 + 40 p− 60 ph 286− 20 p = 178 + 40 p− 60 ph 60 p = 108 + 60 ph p = 1. 8 + ph 2. Show the equilibrium price of pork varies with the price of hogs. w Since Δp = Δph, any increase in the price of hogs causes an equal increase in the price of processed pork. © 2009 Pearson Addison-Wesley. All rights reserved. 2 -44

Solved Problem 2. 4 – Mad Cow Disease § There is an outbreak of mad cow disease in the U. S. Japan bans imports of U. S. beef § In the first few weeks after the U. S. ban, the quantity of beef sold in Japan fell substantially, and the price rose. In contrast, three weeks after the first discovery, the U. S. price in January 2004 fell by about 15% and the quantity sold increased by 43% over the last week in October 2003. Use supply-and-demand diagrams to explain why these events occurred. © 2009 Pearson Addison-Wesley. All rights reserved. 2 -45

p, Price of r ice per pound Figure 2. 8 A Ban on Rice Imports Raises the Price in Japan – S (ban) p 2 A ban on rice imports shifts the total supply of rice in Japan… S (no ban) e 2 p 1 which causes the equilibrium to change and the price to increase. e 1 D Q 2 © 2009 Pearson Addison-Wesley. All rights reserved. Q 1 Q, Tons of rice per year 2 -47

Solved Problem 2. 5 § What is the effect of a United States quota on steel on the equilibrium in the U. S. steel market? Hint: The answer depends on whether the quota binds (is low enough to affect the equilibrium). © 2009 Pearson Addison-Wesley. All rights reserved. 2 -49

p, $ per gallon Figure 2. 9 Price Ceiling on Gasoline Supply shifts to the left…. S 1 S 2 but gas stations must continue to charge a price of P 1…. . e 1 – p 1 = p 1 p Price ceiling D which creates an excess demand. Q 1= Q d Qs Excess demand © 2009 Pearson Addison-Wesley. All rights reserved. Q, Gallons of gasoline per month 2 -52

Demand Shifts (Supply Constant) 2 -55

Supply Shifts (Demand Constant) 2 -56

Simultaneous Shifts § When demand & supply shift simultaneously w Can predict either the direction in which price changes or the direction in which quantity changes, but not both w The change in equilibrium price or quantity is said to be indeterminate when the direction of change depends on the relative magnitudes by which demand & supply shift 2 -57

Simultaneous Shifts: ( D, S) P S S’ S’’ B P’ P P’’ A • • • C D’ D Q Q Q’ Q’’ Price may rise or fall; Quantity rises 2 -58

Simultaneous Shifts: ( D, S) P S S’ S’’ A • P B P’ • • C P’’ D D’ Q Q’’ Price falls; Quantity may rise or fall 2 -59

Simultaneous Shifts: ( D, S) P S’’ S’ P’’ • C S B • P’ A • P D’ D Q Q’’ Q Q’ Price rises; Quantity may rise or fall 2 -60

Simultaneous Shifts: ( D, S) P S’’ P P’ • C S’ S A • B • D D’ Q’ Q Price may rise or fall; Quantity falls 2 -61 Q

Why Supply Need Not Equal Demand § The quantity that firms want to sell and the quantity that consumers want to buy at a given price need not equal the actual quantity that is bought and sold. w Example: price ceiling. © 2009 Pearson Addison-Wesley. All rights reserved. 2 -62

Perfectly competitive markets § Everyone is a price taker. § Firms sell identical products. § Everyone has full information about the price and quality of goods. § Costs of trading are low. © 2009 Pearson Addison-Wesley. All rights reserved. 2 -63