Economics THIRD EDITION By John B Taylor Stanford

Chapter 3 The Supply and Demand Model Copyright © 2001 by Houghton Mifflin Company.

Overview The supply and demand model is fundamental to economics. Supply and demand are discussed as representing the interests of sellers and buyers, respectively. Next, supply and demand curves are shown. Shifts of the curves compared to movements along the curves are discussed. The model is then used to show the determination of price. The causes of shortages and surpluses are explained. Finally, market interference is discussed within the issues of price ceiling and price floors. Copyright © 2001 by Houghton Mifflin Company. All rights reserved. 3

Teaching Objectives 1. Develop the demand curve. Differentiate between changes in demand changes in quantity demanded. 2. Develop the supply curve. Differentiate between changes in supply and changes in quantity supplied. List the factors that shift the supply curve. 3. Show the interaction of supply and demand determines the equilibrium price. Copyright © 2001 by Houghton Mifflin Company. All rights reserved. 4

Teaching Objectives (Cont. ) 4. Use supply and demand analysis to explain things students are interested in. 5. Show price controls interfere with the market and create surpluses or shortages. 6. Discuss how shifts in the demand and/or the supply curve will change the equilibrium price. Shift curves simultaneously. Again, the "shifts" versus "movements along" distinction is very important but difficult for some students. Copyright © 2001 by Houghton Mifflin Company. All rights reserved. 5

Demand 1 a. Demand is a relation between the price of a good or service and the quantity of that good or service consumers are willing to buy at that price per unit of time, ceteris paribus. Demand curves relate price and quantity demanded Copyright © 2001 by Houghton Mifflin Company. All rights reserved. 6

Demand 1 b. The law of demand states that price and quantity demanded are negatively related. Price is the independent variable and quantity demanded is the dependent variable. Price determines quantity. Copyright © 2001 by Houghton Mifflin Company. All rights reserved. 7

Figure 3. 1 The Demand Curve Copyright © 2001 by Houghton Mifflin Company. All

Demand 1 c. Demand is shown graphically by the demand curve – see Figure 3. 1. We relate the negative slope to the inverse relationship in the law of demand. 1 d. Price affects quantity because changes in price create an incentive to substitute. Copyright © 2001 by Houghton Mifflin Company. All rights reserved. 9

Shifts in the Demand Curve 1 e. Demand curves shift around, indicating changes in other variables. A shift is called a change in demand. See Figure 3. 2. 1 e. 1. The main determinants of demand are consumer preferences, information, income, price expectations, population, and the prices of related goods. Copyright © 2001 by Houghton Mifflin Company. All rights reserved. 10

Figure 3. 2 A Shift in the Demand Curve Copyright © 2001 by Houghton

Shifts versus movements 1 e. 2. It is important to distinguish between shifts of the demand curve and movements along the demand curve. Use Figure 3. 3. Note: Changes in a variable not identified on the vertical axis shift the function, whereas changes in the listed variable cause movement along the given function. Copyright © 2001 by Houghton Mifflin Company. All rights reserved. 12

Figure 3. 3 Shifts versus Movements Along the Demand Curve Copyright © 2001 by

2. Supply 2 a. Supply is a relation between the price of a good or service and the quantity of the good or service a supplier is willing to sell at that price, ceteris paribus. 2 b. The law of supply states that price and quantity supplied are positively related. This is shown in Table 3. 2. Copyright © 2001 by Houghton Mifflin Company. All rights reserved. 14

Figure 3. 4 The Supply Curve Copyright © 2001 by Houghton Mifflin Company. All

Supply 2 c. As with demand, price creates an incentive to increase the quantity supplied as price increases. Again, price is the independent variable and quantity supplied is the dependent variable. Relate this to the issue of causality discussed earlier. Figure 3. 4 gives the supply curve The positive slope is due to the positive relationship in the law of supply. Copyright © 2001 by Houghton Mifflin Company. All rights reserved. 16

Shifts in Supply Curve 2 d. Supply curves shift around, indicating changes in other variables. See Figure 3. 5. A shift is called a change in supply. 2 d. 1. The principal determinants of supply are the state of technology, the price of inputs, price expectations, the number of sellers, and other things that affect costs such as taxes, subsidies, and regulations. Copyright © 2001 by Houghton Mifflin Company. All rights reserved. 17

Figure 3. 5 A Shift in the Supply Curve Copyright © 2001 by Houghton

Shifts versus Movements • 2 e. Figure 3. 6 to shows the difference between movements along the supply curve and shifts in it. • Movements are due to changes in non-price determinants of supply while movements are due to price changes (variable on the vertical axis). Copyright © 2001 by Houghton Mifflin Company. All rights reserved. 19

Figure 3. 6 Shifts versus Movements Along the Supply Curve Copyright © 2001 by

Figure 3. 7 Overview of Supply and Demand Copyright © 2001 by Houghton Mifflin

3. Market Equilibrium: Combining Supply and Demand • 3 a. The model of supply and demand is used to explain the determination of market price. Use Table 3. 3 and Figure 3. 7. 3 b. Price adjusts to differences in quantity demanded and quantity supplied. A shortage indicates a willingness on the part of consumers to pay sellers higher prices. A surplus indicates a willingness on the part of sellers to lower prices. 3 c. Price reaches equilibrium when quantity demanded equals quantity supplied, ceteris paribus. Copyright © 2001 by Houghton Mifflin Company. All rights reserved. 22

Figure 3. 8 Equilibrium Price and Equilibrium Quantity Copyright © 2001 by Houghton Mifflin

Equilibrium Note: Price adjustment represents movements along the curves and not shifts of the curves. 3 d. Shifts in the demand and/or the supply curve may result in a price adjustment. Figures 3. 8 and 3. 9 will be useful. Copyright © 2001 by Houghton Mifflin Company. All rights reserved. 24

4. Using the Supply and Demand Model: A Case Study • 4 a. Figures 3. 11, 3. 12, and 3. 13 show the effects of shifts in the demand supply of peanuts on the price of peanuts. This example shows the confusion between movements along the demand curve and shifts in the demand curve. See Figure 3. 10. Copyright © 2001 by Houghton Mifflin Company. All rights reserved. 25

Figure 3. 9 Effects of a Shift in Demand Copyright © 2001 by Houghton

Figure 3. 10 Effects of a Shift in Supply Copyright © 2001 by Houghton

5. Interference with Market Prices • 5 a. One form of government interference with the market process is the use of price controls. Price ceilings keep prices from rising, whereas price floors keep prices from falling. 5 b. Price ceilings are always associated with shortages because the ceiling keeps the price from rising to equilibrium. Thus, the quantity demanded always exceeds the quantity supplied. Rent controls are a classic example. Black markets usually develop. Use Figure 3. 14. 5 c. Price floors are associated with surpluses. Use Figure 3. 15. Governments must purchase the surplus to support the price. Copyright © 2001 by Houghton Mifflin Company. All rights reserved. 28