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1Module Supply and Demand: Introduction and Demand 5KRUGMAN'SMACROECONOMICS for AP*Margaret Ray and David Anderson
2What you will learn in this Module: What a competitive market is and how it is described by the supply and demand modelWhat the demand curve isThe difference between movements along the demand curve and changes in demandThe factors that shift the demand curve
3I. Supply and Demand: A Model of a Competitive Market A. Competitive Market- A market is an institution or mechanism which brings together buyers (demanders) and sellers (suppliers) of particular goods and services.B. Supply and Demand ModeliStart with a definition of a market:A market is an institution or mechanism which brings together buyers (demanders) and sellers (suppliers) of particular goods and services.1. A market may be local, national, or international in scope.2. Some markets are highly personal with face‑to‑face exchanges and flexible prices (a garage sale or estate auction) while others are impersonal and remote (global market for oil or coffee beans).3. This chapter concerns competitive markets with a large number of independent buyers and sellers.4. Each of these buyers and sellers are so small that they cannot affect the price of the product.Stress to the students that the assumption of competitive markets just simplifies the analysis. Much information can be gained by looking at demand and supply in a competitive market, and in later chapters of a microeconomics textbook, students would study markets that are not competitive.
4II. The Demand CurveDemand schedule- shows how much of a product consumers are willing and able to buy at each of a series of possible prices during a specified time period.B. Law of Demand-1. Other things being equal, as the price increases, the corresponding quantity demanded falls.2. Restated, there is an inverse relationship between price and quantity demanded.C. Demand curve- The demand schedule graphedD. Quantity demanded- a point on the lineA. Demand Schedule and CurveDemand is a schedule that shows how much of a product consumers are willing and able to buy at each of a series of possible prices during a specified time period.The demand schedule shows that when the price is high, the quantity of sodas demanded is low. This relationship is known as the Law of Demand.Law of demand is a fundamental characteristic of demand behavior.1. Other things being equal, as the price increases, the corresponding quantity demanded falls.2. Restated, there is an inverse relationship between price and quantity demanded.3. Note the “other things being equal” assumption which refers to a handful of other factors that affect our demand for a good. These will be covered shortly.
6III. Understanding Shifts of the Demand Curve Increase = right- At any price, consumers wish to buy more.Decrease = left- At any price, consumers wish to buy less.B. M.E.R.I.T. shifts demand1. market size (number of consumers)2. expectations3. related prices (complements, substitutes)4. income (normal, inferior)5. tastesThere are several “shifters” of demand or the “other things,” besides price, which affect demand.Changes in a shifter cause changes in demand.If demand has increased, it has shifted to the right. At any price, consumers wish to buy more.If demand has decreased, it has shifted to the left. At any price, consumers with to buy less.1. Prices of related goodsi. Substitute goods (those that can be used in place of each other):Price of substitute and demand for the other good are directly related. If the price of Nike shoes rises, the demand for New Balance shoes should shift to the right.ii. Complementary goods (those that are used together like tennis balls and rackets):When goods are complementary, there is an inverse relationship between the price of one and the demand for the other. If the price of tennis rackets rises, demand for tennis balls will shift to the left.2. Incomei. Normal goodsMore income leads to an increase in demand; less leads to decrease in demand for most goods and services. Steak is a normal good. So are textbooks, running shoes, and iPods.ii. Inferior goodsFor a few goods, more income leads to a decrease in demand. City bus tickets are inferior goods. So are second-hand clothing and store-brand food items.3. TastesA favorable change in tastes leads to an increase in demand; an unfavorable change to a decrease.EX. Demand for a sport team’s apparel increases when the team is winning.4. ExpectationsConsumers have expectations about future prices, product availability, and income, and these expectations can shift demand.EX. If I expect the price of gas to decrease next week, my demand for gas will decrease this week. I will wait for the price to fall.Ex. If I take a new job and expect my salary to rise next month, I may increase my demand for a new suit today.5. Number of buyers—the more buyers lead to an increase in demand; fewer buyers lead to decrease. EX. Demand for prescription drugs has increased, as the population has grown older.Ex. Demand for infant formula would decrease if families had fewer babies.
7Module Supply and Demand: Supply and Equilibrium 6KRUGMAN'SMACROECONOMICS for AP*Margaret Ray and David Anderson
8What you will learn in this Module: What the supply curve isThe difference between movements along the supply curve and changes in supplyThe factors that shift the supply curveHow supply and demand curves determine a market's equilibrium price and equilibrium quantityIn the case of a shortage or surplus, how price moves the market back to equilibrium
9The Supply Schedule and the Supply Curve Supply schedule- shows amounts of a product a producer is willing and able to produce and sell at each of a series of possible prices during a specified time period.Supply Curve- a graphical representation of the supply scheduleQuantity supplied- a point on the supply curveD. Law of Supply1. All else equal, as the price rises, quantity supplied rises.2. Restated: There is a direct relationship between price and quantity supplied.Supply is a schedule, which shows amounts of a product a producer is willing and able to produce and sell at each of a series of possible prices during a specified time period.The schedule shows what quantities will be offered at various prices or what price will be required to induce various quantities to be offered.The supply schedule shows that when the price is high, the quantity of sodas supplied is high. This relationship is known as the Law of Supply.The Law of supply is believed to hold true for most products.1. All else equal, as the price rises, quantity supplied rises.2. Restated: There is a direct relationship between price and quantity supplied.3. Note the “all else equal” assumption refers to a handful of other factors that affect the supply of a good. These will be covered shortly.
11Understanding Shifts of the Supply Curve Increase = right, At any price, firms wish to produce more.decrease = left, At any price, firms with to produce less.T.R.I.C.E. shifts supply1. Technology2. Related prices (complements in production, substitutes in production)3. Input prices4. Competition (number of producers)5. ExpectationsThere are several “shifters” of supply or the “other things,” besides price, which affect supply.Changes in a shifter cause changes in supply.If supply has increased, it has shifted to the right. At any price, firms wish to produce more.If supply has decreased, it has shifted to the left. At any price, firms with to produce less.1. Input (Resource) pricesA rise in an input price will cause a decrease in supply or leftward shift in supply curve; a decrease in an input price will cause an increase in supply or rightward shift in the supply curve. An increase in the price of fertilizer would cause a decrease in supply of corn.2. Prices of related goods or servicesIf the price of a substitute production good rises, producers might shift production toward the higher priced good causing a decrease in supply of the original good. An increase in the price of soybeans may cause a farmer to decrease the supply of corn.3. TechnologyA technological improvement means more efficient production and lower costs, so an increase in supply or rightward shift in the curve results. Genetically improved seeds will increase supply of corn.4. ExpectationsExpectations about the future price of a product can cause producers to increase or decrease current supply.Expectations of higher corn prices (next month) may cause farmers to decrease supply to the market today.5. Number of sellersGenerally, the larger the number of sellers the greater the supply.
12III. Supply, Demand, and Equilibrium Equilibrium- No individual would be better off doing something differentEquilibrium price- price where supply meets demandEquilibrium quantity- quantity where supply meets demandMarket-clearing price- Equilibrium price. It clears the market. All sellers have buyers, all buyers have sellersOne way to think about equilibrium is like a stopped pendulum. Once a pendulum has started, it should continue to swing back and forth, never stopping. If you stop it, it will never restart the swinging. That’s equilibrium in the market. There are no changes in price, quantity demand, or quantity supply.Think stability.
14IV. Why Does the Market Price Fall If It Is Above the Equilibrium Price? A. Surplus- When supply is greater than demandB. Producer's Incentive is to lower the price and clear the marketAsk the students what happens to the price of many items (like sweaters) right after Christmas. Most will agree that there are widespread “after Christmas” sales on clothes, electronics, and even cars.Why?Because the store has too many items that went unsold prior to Christmas. In other words, they have a surplus of sweaters, and the best way to get rid of a surplus of sweaters, is to lower the price.Surplus = Qs – Qd
15V. Why Does the Market Price Rise If It is Below the Equilibrium Price? A. Shortage- When quantity demanded exceeds quantity suppliedB. Consumer's Incentive- pay more and get it first, raising the price to the market clearing priceImagine an auction where there is only one thing up for sale (like a valuable painting) and many people who wish to buy it.What happens? The auctioneer begins to raise the price and the number of bidders begins to fall. Eventually all but one bidder has been eliminated because the price got so high that all others dropped out.When you have a shortage of something, the best way to eliminate the shortage is to increase the price.Shortage = Qd – Qs
16Module Supply and Demand: Changes in Equilibrium 7KRUGMAN'SMACROECONOMICS for AP*Margaret Ray and David Anderson
17What you will learn in this Module: How equilibrium price and quantity are affected when there is a change in either supply or demandHow equilibrium price and quantity are affected when there is a simultaneous change in both supply and demand
18I. Shifting DemandNote: When a demand curve shifts, students will find it easy to locate the new intersection and label it as the new equilibrium price and quantity. It’s important to stress how the market adjusts from original, to new, equilibrium points.There are three important components that students must identify for the AP exam.What shifter is at work in the market?What curve is shifting and in what direction?What happens to equilibrium price and quantity?Pick an example that resonates with the class, or ask them to suggest example goods and/or services.Example 1: tickets to a concert for a popular musician or band. As the band has more success, and gets more popular with fans, what happens to the price of a concert ticket?Draw the market for concert tickets to this band. Identify the original price as Pe and quantity of Qe. Now analyze the three important components for this scenario.Stronger tastes and preferences.Demand shifts to the right.Price and quantity both increase. But why?Show the rightward shift of the demand curve. At the original price of Pe, there is a now a shortage of tickets. When there is a shortage, the price must rise. The equilibrium quantity moves upward along the stationary supply curve to the intersection of supply and the new demand curve.A. When demand increases, the equilibrium price and quantity both increase
19Shifting Demand Continued Example 2: During a recession, people buy fewer new cars and trucks. What happens to the price of a new car or truck?Draw the market for new autos. Identify the original price as Pe and quantity of Qe. Now analyze the three important components for this scenario.Lower income during a recession.Demand shifts to the left for normal goods.Price and quantity both decrease. But why?Show the leftward shift of the demand curve. At the original price of Pe, there is a now a surplus of autos. When there is a surplus, the price must fall. The equilibrium quantity moves downward along the stationary supply curve to the intersection of supply and the new demand curve.B. When demand decreases, the equilibrium price and quantity both decrease
20II. Shifting SupplyNote: Stress to the students that when we say that supply has increased, it has increased horizontally (more supply equals more quantity), not vertically.Example 1: Cotton is an important raw material in the making of clothes like denim jeans. If the global price of cotton rises, what happens to the price of jeans?Draw the market for jeans. Identify the original price as Pe and quantity of Qe. Now analyze the three important components for this scenario.An input price has increased (cotton).Supply of jeans shifts to the left.Price increases and quantity decreases. But why?Show the leftward shift of the supply curve. At the original price of Pe, there is a now a shortage of jeans. When there is a shortage, the price must rise. The equilibrium quantity moves upward along the stationary demand curve to the intersection of demand and the new supply curve.A. When supply decreases, the equilibrium price increases and the equilibrium quantity decreases
21Shifting Supply Cont.Example 2: Production technology has greatly improved in agriculture, producing more corn on the same amount of land. How has the better technology affected the price of corn?Draw the market for corn. Identify the original price as Pe and quantity of Qe. Now analyze the three important components for this scenario.Better technology.Supply of corn shifts to the right.Price decreases and quantity increases. But why?Show the rightward shift of the supply curve. At the original price of Pe, there is a now a surplus of corn. When there is a surplus, the price must fall. The equilibrium quantity moves downward along the stationary demand curve to the intersection of demand and the new supply curve.B. When supply increases, the equilibrium price decreases and the equilibrium quantity increases
22III. Simultaneous Shifts of Supply and Demand Note: there are four possible scenarios. The instructor should decide, depending upon the comfort level of the class, whether it is necessary to cover all four.Here is a summary of what we can, and cannot, predict when there is both a demand and a supply shift.Demand and Supply move in opposite directions.When demand increases and supply decreases, the equilibrium price rises but the change in the equilibrium quantity is ambiguous.Example: an increase in the demand for wheat combined with a decrease in the supply of wheat would result in a definite increase in the market price, but an indeterminate change in quantity.A. When demand increases and supply decreases the equilibrium price definitely increases, but quantity is ambiguous
23Simultaneous Shifts of Supply and Demand When demand decreases and supply increases, the equilibrium price falls but the change in the equilibrium quantity is ambiguousA decrease in the demand for rap music coupled with an increase in rap artists would have the effect of reducing the market price but would have an indeterminate effect on the quantity of rap music produced.B. When demand decreases and supply increases the equilibrium price definitely decreases, but quantity is ambiguous
24Simultaneous Shifts of Supply and Demand Demand and Supply move in the same direction.When both demand and supply increase, the equilibrium quantity increases but the change in equilibrium price is ambiguous.Example 2: The recent Winter Olympics has increased the popularity of snowboarding and more companies have begun producing snowboards. How will these events affect the market for snowboards?Demand shift:Tastes and preferences are stronger for snowboarding.This shifts demand for snowboards to the right.Price and quantity of snowboards both increase.Supply shift:More suppliers are producing snowboards.Supply of snowboards shifts to the right.Price decreases, and quantity increases.Both shifts generate an increase in the quantity, so we can certainly predict a higher equilibrium quantity of snowboards. However the change in price depends on which of the two shifts is stronger.Note: many students will assume that there will be no change in the equilibrium price. Stress to the students that this is just one of three possible outcomes for price.C. When demand and supply increase, the change in equilibrium price is ambiguous, but equilibrium quantity definitely increases
25Simultaneous Shifts of Supply and Demand When both demand and supply decrease, the equilibrium quantity decreases but the change in equilibrium price is ambiguous.Example: a decrease in the demand for disco music combined with a decrease in disco artists would result in a definite decrease in the quantity of disco produced, but would have an indeterminate effect on the price of the music.D. When demand and supply decrease, the change in equilibrium price is ambiguous, but equilibrium quantity definitely decreases
26Module Supply and Demand: Price Controls (Ceilings and Floors) 8KRUGMAN'SMACROECONOMICS for AP*Margaret Ray and David Anderson
27What you will learn in this Module: The meaning of price controls, one way government intervenes in marketsHow price controls can create problems and make a market inefficientWhy economists are often deeply skeptical of attempts to intervene in marketsWho benefits and who loses from price controls, and why they are used despite their well-known problems
28I. Why Governments Control Prices Sometimes the efficient outcome in the market is judged as unfair to some groups, usually those that are disadvantaged (poor) and struggling to begin with.How will we deal with this?A price control is a legal restriction on how high or low a market price may go.Price controls are enacted by governments in response to political pressures from buyers and sellers.Sometimes the efficient outcome in the market is judged as unfair to some groups, usually those that are disadvantaged (poor) and struggling to begin with.How will we deal with this?A price control is a legal restriction on how high or low a market price may go.Price controls are enacted by governments in response to political pressures from buyers and sellers.
29II. Price Ceilings Oil Prices in1970s California electricity Legal maximum priceIf Pe is considered “too high”, then a price ceiling must be set below the equilibrium price.A price ceiling set above the equilibrium price has no effect or non binding.ExamplesOil Prices in1970sCalifornia electricityNew York City apartmentsA price ceiling is a maximum price sellers are allowed to charge for a good.Who would want such a thing? Consumers.Note: Ask the students what goods/services they consider to be unfairly expensive.You will often get responses like “gasoline” or “college tuition”.You might use one of these examples to show students the impacts of a price ceiling on the market for this good.If Pe is considered “too high”, then a price ceiling must be set below the equilibrium price. A price ceiling set above the equilibrium price has no effect.Or you could go through an example of a common good that is very unlikely to be the target of a price control.
30Modeling a Price Ceiling Shortage at Pc = Qd - QsIf the Pc=$2, Qd =5.75 and Qs = 4 so there is a shortage of almost 2 tacos.Is this so bad? Aren’t consumers helped by this lower price? Yes, if you are among the lucky 4 who get tacos!
31III. How a Price Ceiling Causes Inefficiency Inefficient Allocation to ConsumersWasted ResourcesInefficiently Low QualityBlack Markets-goods and services bought and sold illegallyPeople who want the good badly and are willing to pay a high price don’t get it, and those who care relatively little about the good and are only willing to pay a low price do get it.Suppose Stan was our sixth potential consumer. He would not have paid $5 for a taco before the price control, but maybe now he is one of the lucky ones that gets a taco at $3.Julia was our second potential customer who would have paid $8 for a taco, but can’t find one now.One way to define inefficiency: A market or an economy is inefficient if there are missed opportunities: Some people could be made better off without making other people worse off.This is inefficient, because Stan can sell a taco to Julia for $7 and both win.This is exactly the reallocation that improves someone without harming another.People spend money and expend effort in order to deal with the shortages caused by the price ceiling.Time spent looking for scarce tacos has an opportunity cost. You could be working, having some leisure, etc. These missed opportunities create more inefficiency to the price control.Sellers offer low-quality goods at Pc, even though buyers would prefer a higher quality at a higher price.Taco suppliers may cut corners on food safety because that costs money. Maybe we get more tacos that make us sickA black market is a market in which goods or services are bought and sold illegally—either because it is illegal to sell them at all or because the prices charged are legally prohibited by a price ceiling.
32So Why Are There Price Ceilings? Price ceilings are enacted because1. They do benefit some consumers. Consumers may have the political clout to persuade government that the equilibrium price is taking advantage of them. This is a normative argument.2. When they have been in effect for a long time, buyers may not have a realistic idea of what would happen without them.3. Government officials often do not understand supply and demand analysis.Benefit some- consumers may have political clout and persuade government officials that equilibrium is too high. (normative)Uncertainty- we’ve always had themLack of understanding
33IV. Price Floors Legal minimum price If Pe is considered “too low”, a price floor is set above the equilibrium price.A price floor set below the equilibrium price has no effect or non-bindingExamplesAgricultural productsMinimum wageA price floor is a legal minimum price buyers are required to pay for a good.The minimum wage is a legal floor on the wage rate, which is the market price of labor.If Pe is considered “too low”, a price floor is set above the equilibrium price. A price floor set below the equilibrium price has no effect.
34Modeling a Price Floor . Surplus at Pf Price floors lead to excess supply; the quantity supplied is greater than quantity demanded.
35V. How a Price Floor Causes Inefficiency Inefficiently Low QuantityInefficient Allocation of Sales Among SellersWasted ResourcesInefficiently High QualityIllegal Activity- Black market for labor1. Surplus at PfPrice floors lead to excess supply; the quantity supplied is greater than quantity demanded.2. Inefficiently low quantity:Since a price floor raises the price of a good to consumers, quantity demanded falls, so the quantity bought and sold falls, creating a loss to society.3. Inefficient allocation of sales among sellers:Those who would be willing to sell the good at the lowest price are not always those who actually manage to sell it.Suppose Susan isn’t a very efficient taco vendor and couldn’t sell tacos at a price of $5, but can at $7. She is lucky enough to get one of the few buyers.Juan is very efficient and could sell at $4, but is unlucky and doesn’t get a buyer at $7.The price floor has just enabled a less efficient seller to make a sale, and might force an efficient seller out of the market.4. Wasted resources.Government price floors set about the equilibrium price cause surpluses which the government may be required to buy and destroy.Minimum wages result in fewer jobs available and so would-be workers waste time searching for a job.What do we do with the surplus tacos?Maybe they go to waste, even if the government purchases them.5. Goods of inefficiently high quality:Sellers offer high-quality goods at a high price, even though buyers would prefer a lower quality at a lower price.The high price may induce taco suppliers to provide extravagantly expensive ingredients that would be unprofitable at the lower market price.Taco consumers would probably just rather have a low-priced taco without the fancy bells and whistles.If they were really wanting expensive ingredients, their preferences would have been reflected in a stronger demand curve to begin with and the market price would have been $6 or higher.6. Illegal activity.Bribery of sellers or government officials.Examples of working for less than minimum wage (off the books) because there is a surplus of labor willing to work.Minimum wage laws are an example of price floors. Relatively high minimum wages in Europe lead to higher levels of unemployment and black markets in labor. In contrast, the minimum wage in the United States is set closer to the equilibrium wage, and labor is relatively more productive in the United States.
36So Why Are There Price Floors? Benefit some Producers may have the political clout to persuade government that the equilibrium price is unfairly low. This is a normative argument.-DisregardLack of understandingPrice floors are enacted because:They do benefit some producers. Producers may have the political clout to persuade government that the equilibrium price is unfairly low. This is a normative argument.Price floors create a persistent surplus of the good.Inefficiencies arising from the persistent surplus come in the form of inefficiently low quantity, inefficient allocation of sales among sellers, wasted resources, and an inefficiently high level of quality offered by suppliers.There is also the temptation to engage in illegal activity, particularly bribery and corruption of government officials.
37Module Supply and Demand: Quantity Controls 9KRUGMAN'SMACROECONOMICS for AP*Margaret Ray and David Anderson
38What you will learn in this Module: The meaning of quantity controls, another way government intervenes in marketsHow quantity controls create problems and can make a market inefficientWho benefits and who loses from quantity controls, and why they are used despite their well-known problems
39I. Controlling Quantities Quantity Control or Quota-an upper limit on the quantity of some good that can be bought or sold.Licenses/PermitsExamples: Fishing, PollutionIn addition to controlling prices, the government can also decide that the equilibrium quantity is, for some reason, too high.So government determines a:quantity control, or quota: an upper limit on the quantity of some good that can be bought or sold.The total amount of the good that can be legally transacted is the quota limit.Questions for the students:Why would we want to limit the quantity of a good that can be bought or sold?Can you think of any production that is limited?Who would benefit from this?
40The Anatomy of Quantity Controls A quota is set, a license is given (or auctioned) to producers.A license gives its owner the right to supply the good.Note: Excellent examples of quota limits are fishing limits. The instructor might provide the students with an article about depleted ocean fisheries or fishing seasons that have been completely closed to protect the stock of a species (i.e., salmon, swordfish, lobster,…).
41II. The Anatomy of Quantity Controls Demand Price-Price consumers will pay for that quantitySupply Price- Price suppliers will charge for that quantityWedge or Quota Rent-The difference between Demand Price and Supply Price.Earnings that accrue to the license-holder for ownership of the right to sell the good.It is equal to the market price of the license when the licenses are traded.We can also think of the quota rent as the opportunity cost the holder of the license bears for not renting out his license to another producer.The demand price Pd: the price at which consumers will demand that quantity.The supply price Ps: the price at which producers will supply that quantity.A quantity control, or quota, drives a wedge between the demand price and the supply price of a good.Suppose at the quota of 40:Demand Price = $80Supply Price = $50If buyers are willing to pay $80, but sellers can produce at cost $50, each owner of a license to fish salmon earns the difference of $30. And this is the amount that any salmon boat would pay to have a license.quota rent: The difference between the demand and supply priceThe earnings that accrue to the license-holder from ownership of the right to sell the good.It is equal to the market price of the license when the licenses are traded.We can also think of the quota rent as the opportunity cost the holder of the license bears for not renting out his license to another producer.
42III. The Cost of Quantity Controls 1. Inefficiency: in the form of mutually beneficial transactions that don’t occur.Anytime the demand price at a given quantity is not equal to the supply price at that quantity, there will be missed opportunities.2. Incentives for illegal activities.Suppliers know that additional units could be supplied and buyers could be found. This kind of overproduction would violate the quota.In the salmon example, this is illegal fishing, or poaching.InefficiencyDeadweight LossIllegal Activity