The Market Forces of Supply and Demand

The Market Forces of Supply and Demand

Overview • Demand supply are the most fundamental and powerful of all economic tools. • Supply and demand are the forces that make market economies work.

Markets • A market is a group of buyers and sellers of a particular good or service. • The terms supply and demand refer to the behavior of people as they interact in markets.

Demand • Quantity demanded: The amount of a good that buyers are willing and able to purchase at each and every price, all else equal. • Law of Demand – The law of demand states that, other things equal, the quantity demanded of a good falls when the price of the good rises.

The Demand Curve • The demand curve is a graph of the relationship between the price of a good and the quantity demanded. • The demand curve illustrates the maximum quantity of a good that consumers are willing and able to purchase at each and every price, all else equal. • The law of demand implies demand curves slope down, all else equal.

Why Are Demand Curves Downward Sloping? • Substitution Effect: When the price of a good rises, consumers purchase less of that good and more of similar goods that are now relatively less expensive. • The Income Effect: When the price of a good rises, a consumers real income falls, making them less able to purchase all goods. • Real Income: Income measured in terms of the goods that income can purchase.

Two Ways to Illustrate Demand 1. Demand Schedule: weekly coffee sales Price per pound Quantity Demanded $2 300 lbs $4 260 lbs $6 220 lbs $8 180 lbs $10 140 lbs $12 100 lbs

2. Demand Curve P 12 10 8 6 4 2 D 100 140 180 220 260 300 Q (lbs)

Market Demand versus Individual Demand • Market demand refers to the sum of all individual demands for a particular good or service. • Graphically, individual demand curves are summed horizontally to obtain the market demand curve.

Market Demand for Starbuck’s Coffee Daily Demand by Market Participants Price Eric Jenn Mark $1. 00 Cynthia Total 6 3 3 2 14 $1. 20 5 2 2 1 10 $1. 40 4 2 1 1 8 $1. 60 3 1 1 0 5 $1. 80 3 1 0 0 4

Constructing Market Demand Using Demand Curves (The Case of Two Market Participants) P P $1. 8 1 1 D 1 3 6 Eric Dm D 2 Q 1 3 Q Jenn 4 9 Market Q

Factors that Shift the Demand Curve • Income • Prices of Related Goods: • Substitutes: Goods that are interchangeable. – If goods A and B are substitutes, and the price of good B rises, the demand for good A will rise. • Complements: Goods that go together – If goods A and B are complements and the price of good B rises, the demand for good A will fall. • Tastes and Preferences • Population and Demographics • Expected Future Prices

Shifts Versus Movements Along the Demand Curve • If any determinant of demand other than a good’s own price changes, the demand curve must shift. • Changes in the price of a good result in a movement along the demand curve. • A change in price results in a change in quantity demanded. A change in any other factor results in a change in demand.

Changes in Quantity Demanded Price A change in price results in a movement along the demand curve P 2 P 1 Demand Q 2 Q 1 Quantity

Increase in Income Price An increase in income shifts the demand curve to the right P 1 D 2 D 1 Q 2 Quantity

Factors That Influence Demand Copyright© 2004 South-Western

Supply • Quantity supplied: The amount of a good that sellers are willing and able to sell at each and every price, all else equal. • Law of Supply – The law of supply states that, other things equal, the quantity supplied of a good rises when the price of the good rises.

The Supply Curve • The supply curve is the graph of the relationship between the price of a good and the quantity supplied. • The supply curve illustrates the maximum quantity of a good that sellers are willing and able to produce at each and every price, all else equal. • The law of supply implies supply curves slope up.

Why Are Supply Curves Upward Sloping? • Profit Effect: All else equal, an increase in the price of a good provides suppliers with a profit incentive to increase production. • If input costs don’t change, and the price of a product increases, profits per unit will increase.

Two Ways to Illustrate Supply 1. Supply Schedule: Weekly Coffee Production Price per unit Quantity Supplied $2 100 lbs $4 140 lbs $6 180 lbs $8 220 lbs $10 260 lbs $12 300 lbs

2. Supply Curve P S 12 10 8 6 4 2 100 140 180 220 260 300 Q (lbs)

Market Supply versus Individual Supply • Market supply refers to the sum of all individual supplies for all sellers of a particular good or service. • Graphically, individual supply curves are summed horizontally to obtain the market supply curve.

Factors that Shift the Supply Curve • Input Prices (wages, cost of raw materials) – Increases in input costs shifts supply curve left • Technology – Advancements in technology shifts supply curve right • Prices of Substitutes in Production – If the price of a substitute in production falls, the supply curve shifts right • Number of Sellers – Increases in the number of sellers shifts supply curve right • Expected Future Prices – If prices are expected to be higher in the future, supply shifts left

Change in Quantity Supplied Price Supply P 2 A change in price results in a movement along the supply curve P 1 Q 2 Quantity

Shifts in the Supply Curve • If any determinant of supply other than a good’s own price changes, the supply curve must shift. • Changes in the price of a good result in a movement along the supply curve. • A change in price results in a change in quantity supplied. A change in any other factor results in a change in supply.

An Increase in Input Costs Price S 2 An increase in input costs shifts the supply curve to the left S 1 P 1 Q 2 Q 1 Quantity

The Effect of an Advancement in Technology Price S 1 An advancement in technology shifts the supply curve to the right S 2 P 1 Q 2 Quantity Copyright© 2003 Southwestern/Thomson Learning

Variables That Influence Supply Copyright© 2004 South-Western

Market Equilibrium • The interaction of supply and demand create a market. • Supply and demand jointly determine prices and quantities so that markets achieve equilibrium. • Equilibrium: a state in which there are no forces acting to change the current quantity or price. A state of balance. • Equilibrium occurs where quantity supplied equals quantity demanded.

Market Equilibrium Price A market is in equilibrium when quantity supplied equals quantity demanded. P 1 Supply Equilibrium Demand Q 1 Quantity

Markets Not in Equilibrium: Price Above Equilibrium Price Rental Rate Excess Supply Surplus $1, 000 $800 Demand 60 Quantity demanded 80 100 Quantity supplied Quantity of Apartments (in thousands) Copyright© 2003 Southwestern/Thomson Learning

Surplus: Excess Supply When the current price is above equilibrium price, quantity supplied is greater than quantity demanded. • There is excess supply or a surplus. • Suppliers will lower the price to increase sales, thereby moving toward equilibrium.

Markets Not in Equilibrium: Price Below Equilibrium Price Rental Rate Excess Demand Supply $800 $600 Shortage Demand 0 60 Quantity supplied 80 100 Quantity demanded Quantity of Apartments (in thousands) Copyright© 2003 Southwestern/Thomson Learning

Shortage: Excess Demand When price is below equilibrium price, quantity demanded is greater than quantity supplied. • There is excess demand or a shortage. • Suppliers will raise the price due to too many buyers chasing too few goods, thereby moving toward equilibrium.

Three Steps to Analyzing Changes in Equilibrium • Decide whether the event shifts the supply or demand curve (or both). • Decide whether the curve(s) shift(s) to the left or to the right. • Use the supply-and-demand diagram to see how the shift affects equilibrium price and quantity.

A Decrease in Demand: The Market for CD’s Price of CD’s Introduction of a low cost substitute (internet music downloading). S 1 Initial equilibrium $19 $13 new equilibrium D 1 D 2 0 7 10 Quantity of CD’s (millions) Copyright© 2003 Southwestern/Thomson Learning

A Decrease in Supply: The Market for Gasoline Price of Gasoline 1. An increase in the S 2 price of oil S 1 $2. 00 New equilibrium Initial equilibrium 1. 50 2. . resulting in a higher price of gasoline D 1 0 60 80 3. . and a lower quantity sold. Quantity of Gasoline (millions of gallons)

What Happens When Supply and Demand Both Shift? Price of Gasoline S 2 2. 50 1. 50 S 1 A decrease in supply and an increase in demand, results in an increase in price and an ambiguous change in quantity Initial equilibrium D 2 D 1 0 80 Quantity of Gasoline (millions of gallons)

Example: The Market for Personal Computers • During the 1990’s the demand for personal computers increased substantially. At the same time, the price of personal computers fell. • What could explain the simultaneous rise in demand decline in price?

The Market for Personal Computers Price of PC’s S 1 An increase in demand accompanied by an even greater increase in supply will result in an increase in equilibrium quantity and a decrease in equilibrium price. S 2 P 1 P 2 D 1 0 Q 1 Q 2 Quantity of PC’s

What Happens to Price and Quantity When Supply or Demand Shifts? Copyright© 2004 South-Western

Applications of Supply and Demand Analysis • The Market for Sports Utility Vehicles • The War on Drugs

The Market for Sports Utility Vehicles

The Market for Sports Utility Vehicles

SUV’s • Because SUV’s are classified as light trucks, they are not subject to the same clean air regulations as cars: – SUV’s are permitted to emit 29% to 47% more carbon monoxide (CO) and 75% to 175% more nitrogen oxides (NOx) than passenger cars.

SUV’s Make/Model Gas Mileage tons of CO 2 Ford Excursion 13 mpg 134 Jeep Grand Cherokee 18 mpg 96 Ford Taurus 23 mpg 74 Honda Civic HX 36 mpg 48 Honda Insight 65 mpg 23 Toyota Prius 60 mpg 23

Vehicle Emissions • Hydrocarbons: contribute to the formation of ground-level ozone. Can cause eye irritation, coughing, wheezing, and shortness of breath and can lead to permanent lung damage. • Nitrogen oxides (NOx): contribute to the formation of ozone and acid rain. • Carbon monoxide: colorless, odorless, deadly gas. Reduces flow of oxygen in the bloodstream, impairs mental functions and visual perception.

The Market For SUV’s Policy Issue: Suppose the government wanted to provide an incentive for individuals to buy fewer SUV’s and more fuel efficient/low emissions vehicles. Policy Options: • .

A Per-Unit Tax Imposed on SUV Producers Price of SUV’s A per-unit tax imposed on SUV’s manufactures: an increase in input costs S 2 S 1 New equilibrium P 2 Initial equilibrium P 1 D 1 0 Q 2 Q 1 Quantity of SUV’s

An Increase in Gasoline Taxes Price of SUV’s Increase in the price of gas: a complement good. S 1 Initial equilibrium P 1 P 2 new equilibrium D 1 D 2 Q 1 Quantity of SUV’s

A Per-Unit Subsidy to Producers of Fuel Efficient Cars. Part 1: The Effect on the Market for Cars Price of Cars A per-unit subsidy paid to the manufactures of fuel efficient cars: a decrease in input costs S 1 S 2 Initial equilibrium P 1 P 2 D 1 0 Q 1 Q 2 Quantity of Cars

A Per-Unit Subsidy to Producers of Fuel Efficient Cars. Part 2: The Effect on the Market for SUV’s Price of SUV’s … decrease in the price of cars: a substitute good. S 1 Initial equilibrium P 1 P 2 new equilibrium D 1 D 2 0 Q 2 Q 1 Quantity of SUV’s

The War on Drugs

The War on Drugs • Commentary on the War on Drugs • Background: Excerpts from Frontline Special on Drug Wars. • The war on drugs started shortly after Nixon was elected President in 1968. • Research suggests there is a strong connection between drug use, drug prices, and criminal activity. When drug prices rise, criminal activity also tends to rise.

The War on Drugs • Administrations since Nixon have taken various stances. Decriminalization of certain drugs, like marijuana, was seriously considered under the Carter administration. • Efforts to halt the flow of illegal drugs have long depended on work outside the United States. This involves the eradication of crops and the interdiction of shipments in international waters. During the 1980 s and 1990’s, these efforts increased in response to a flood of cocaine, primarily from Colombia.

The War on Drugs • Despite a 30 -year effort, the eradication of the illegal drug trade has proven to be nearly impossible. • At the heart of the difficulty is the amount of money involved. It has evolved into a $300 to $400 billion multinational business. • Americans alone spend $58 billion a year on narcotics. • The U. S. government currently spends about $42 billion to fight drugs.

The War on Drugs • Current Policy: • Stiff penalties for drug dealers • Eradication of drug related crops • • • Alternative Policies: . .

Current Policy: Stiff Penalties for Drug Dealers and Eradication of Drug Related Crops Price The reduction in supply causes price to rise and quantity to fall. Unfortunately, higher prices may lead to greater crime. S 2 Both policies are designed to reduce the supply of illegal drugs: New equilibrium P 2 S 1 Initial equilibrium P 1 D 1 0 Q 2 Q 1 Quantity

Legalize Drugs Price S 1 Legalizing drugs would most likely increase both demand supply. However, supply is likely to increase more than demand, causing quantity to rise and price to fall. S 2 P 1 New equilibrium P 2 D 1 0 Q 1 Q 2 Quantity

Stiff Penalties for Drug Users Stiffer penalties for drug use would reduce the demand for drugs. As a result, the equilibrium price and quantity of drugs would fall. Price S 1 P 1 Initial equilibrium P 2 new equilibrium D 1 D 2 0 Q 2 Q 1 Quantity

Drug Awareness Education Price Programs aimed at informing individuals about the harmful effects of drugs are designed to change tastes and preferences for drug use. S 1 Initial equilibrium P 1 P 2 new equilibrium D 1 D 2 Q 1 Quantity