1. Principles of Microeconomics 1. Demand and Supply
Akos Lada
July 21st , 2014

2. Assumptions & Models
Assumptions simplify the complex world, make it easier to understand.
Example: To study international trade, assume two countries and two goods.
Unrealistic, but simple to learn and gives useful insights about the real world.
Model: a highly simplified representation of a more complicated reality. Economists use models to study economic issues. 2

3. Some Familiar Models 3

4. Our First Model: The Circular-Flow Diagram
The Circular-Flow Diagram: a visual model of the economy, shows how dollars flow through markets among households and firms
Two types of “actors”:
households
firms
Two markets:
the market for goods and services
the market for “factors of production” 4

5. Factors of Production
Factors of production: the resources the economy uses to produce goods & services, including
labor
land
capital (buildings & machines used in production) 5

6. The Circular-Flow Diagram
Households:
Own the factors of production, sell/rent them to firms for income
Buy and consume goods & services
Firms
Households
Firms:
Buy/hire factors of production, use them to produce goods and services
Sell goods & services
This and the following slide build the Circular-Flow Diagram piece by piece. 6

7. The Circular-Flow Diagram
Revenue
Markets for Goods & Services
Spending
G & S sold
G & S bought
Firms
Households
Wages, rent, profit
Factors of production
Income
Labor, land, capital
In this diagram, the green arrows represent flows of income/payments. The red arrows represent flows of goods & services (including services of the factors of production in the lower half of the diagram).
To keep the graph simple, we have omitted the government, financial system, and foreign sector, as discussed on the next slide.
You may wish to change the order in which the elements appear. To do so, look for “Custom Animation” in your version of PowerPoint.
Markets for Factors of Production 7

8. Demand

9. Question: What are the economic forces behind this news?
Motivating questions
Question: What are the economic forces behind this news?
In the real world, there are relatively few perfectly competitive markets. Most goods come in lots of different varieties – including ice cream, the example in the textbook. And there are many markets in which the number of firms is small enough that some of them have the ability to affect the market price.
For now, though, we look at supply and demand in perfectly competitive markets, for two reasons: First, it’s easier to learn. Understanding perfectly competitive markets makes it a lot easier to learn the more realistic but complicated analysis of imperfectly competitive markets. Second, despite the lack of realism, the perfectly competitive model can teach us a LOT about how the world works, as we will see many times in the chapters that follow. 9

10. Demand
The quantity demanded of any good is the amount of the good that buyers are willing and able to purchase.
Law of demand: the claim that the quantity demanded of a good falls when the price of the good rises, other things equal
Demand comes from the behavior of buyers. 10

11. Quantity of coffees demanded
The Demand Schedule
Demand schedule: a table that shows the relationship between the price of a good and the quantity demanded
Example: Kirk’s demand for (iced) coffee.
Price of coffee
Quantity of coffees demanded
$0.00 16
1.00 14
2.00 12
3.00 10
4.00 8
5.00 6
6.00 4
Notice that Kirk’s preferences obey the Law of Demand. 11

12. Kirk’s Demand Schedule & Curve
Price of Coffees
Quantity of Coffees
Price of coffee
Quantity of coffees demanded
$0.00 16
1.00 14
2.00 12
3.00 10
4.00 8
5.00 6
6.00 4 12

13. Market Demand versus Individual Demand
The quantity demanded in the market is the sum of the quantities demanded by all buyers at each price.
Suppose Kirk and Rebeca are the only two buyers in the Cambridge coffee market. (Qd = quantity demanded)
$0.00
6.00
5.00
4.00
3.00
2.00
1.00
Price 4 6 8 10 12 14 16
Kirk’s Qd 2 3 4 5 6 7 8
Rebeca’s Qd
Market Qd + = 24 + = 21
This example violates the “many buyers” condition of perfect competition. Yet, we are merely trying to show here that, at each price, the quantity demanded in the market is the sum of the quantity demanded by each buyer in the market. This holds whether there are two buyers or two million buyers. But it would be harder to fit data for two million buyers on this slide, so we settle for two. + = 18 + = 6 9 12 15 13

14. The Market Demand Curve for (iced!) coffeeP P
Qd (Market)
$0.00 24
1.00 21
2.00 18
3.00 15
4.00 12
5.00 9
6.00 6 Q 14

15. Demand Curve Shifters
The demand curve shows how price affects quantity demanded, other things being equal.
These “other things” are non-price determinants of demand (i.e., things that determine buyers’ demand for a good, other than the good’s price).
Changes in them shift the D curve… 15

16. Summary: Variables That Influence Buyers
Variable A change in this variable…
Price …causes a movement along the D curve
# of buyers …shifts the D curve
Income …shifts the D curve
Price of related goods …shifts the D curve
Tastes …shifts the D curve
Expectations …shifts the D curve
Students should notice that the only determinant of quantity demanded that causes a movement along the curve is price. Also notice: price is one of the variables measured along the axes of the graph.
Here’s a handy “rule of thumb” to help students remember whether the curve shifts: If the variable causing demand to change is measured on one of the axes, you move along the curve. If the variable that’s causing demand to change is NOT measured on either axis, then the curve shifts.
This rule of thumb works with all curves in economics that involve an X-Y relationship. (I.e., it works for the supply curve, the marginal cost curve, the IS and LM curves, among many others, but it does not apply to curves drawn on time series graphs.) 16

17. Demand Curve Shifters: # of BuyersP Q
Increase in # of buyers increases quantity demanded at each price, shifts D curve to the right.
Suppose the number of buyers increases.
Then, at each P, Qd will increase (by 5 in this example).
Beginning economics students often have trouble understanding the difference between a movement along the curve and a shift in the curve. Here, the animation has been carefully designed to help students see that a shift in the curve results from an increase in quantity at each price.
(A more realistic scenario would involve a non-parallel shift, where the horizontal distance of the shift would be greater for lower prices than higher ones. However, to remain consistent with the textbook, and to keep things simple, this slide shows a parallel shift.) 17

18. Demand Curve Shifters: Income
Increase in income causes increase in quantity demanded at each price, shifts D curve to the right.
If this is the case, we call this product a normal good.
Demand for an inferior good is negatively related to income. An increase in income shifts D curves for inferior goods to the left. 18

19. Demand Curve Shifters: Prices of Related Goods
Two goods are substitutes if an increase in the price of one causes an increase in demand for the other.
Example: pizza and hamburgers. An increase in the price of pizza increases demand for hamburgers, shifting hamburger demand curve to the right.
Other examples: Coke and Pepsi, laptops and desktop computers, CDs and music downloads
If you are willing to spend a couple extra minutes on substitutes and complements, and have a blackboard or whiteboard to draw on, here’s an idea:
Before (or instead of) showing this slide, draw the demand curve for hamburgers. Pick a price, say $5, and draw a horizontal line at that price, extending from the vertical axis through the D curve and continuing to the right. Suppose Q = 1000 when P = $5. Label this on the horizontal axis.
Now ask your students: If pizza becomes more expensive, but price of hamburgers does not change, what would happen to the quantity of hamburgers demanded? Would it remain at 1000, would it increase, or would it decrease? Explain.
Some and perhaps most students will see right away that people will want more hamburgers when the price of pizza rises. After establishing this, note that the increase in the price of pizza caused an increase in the quantity demanded of hamburgers. Then state the term “substitutes” and give the definition.
Before giving the other examples (listed in the 3rd bullet of this slide), do a similar exercise to develop the concept of complements. Finally, give the examples of substitutes and complements from the 3rd bullet point of this and the following slides, but mix up the order and ask students to identify whether each example is complements or substitutes. 19

20. Demand Curve Shifters: Prices of Related Goods
Two goods are complements if an increase in the price of one causes a fall in demand for the other.
Example: computers and software. If price of computers rises, people buy fewer computers, and therefore less software. Software demand curve shifts left.
Other examples: college tuition and textbooks, bagels and cream cheese, eggs and bacon 20

21. Demand Curve Shifters: Tastes
Anything that causes a shift in tastes toward a good will increase demand for that good and shift its D curve to the right.
Anything that causes a shift in tastes away from a good will decrease demand for that good and shift its D curve to the left.
Examples:
The Atkins diet became popular in the ’90s, caused an increase in demand for eggs, shifted the egg demand curve to the right.
The FDA recently issued a new regulation imposing the use of graphic cigarette labels. What is the likely outcome? 21

22. Demand Curve Shifters: Expectations
Expectations affect consumers’ buying decisions.
Examples:
If people expect their incomes to rise, their demand for meals at expensive restaurants may increase now.
If the economy sours and people worry about their future job security, demand for new autos may fall now. 22

23. STUDENTS’ TURN: Demand Curve
Draw a demand curve for music downloads. What happens to it in the following scenarios? Why?
A. The price of iPods falls
B. The price of music downloads falls
C. The price of CDs falls
In each case, there are only three possible answers:
- The curve shifts to the right
- The curve shifts to the left
- The curve does not shift (though there may be a movement along the curve)

24. A. Price of iPods falls Music downloads and iPods are complements.
A fall in price of iPods shifts the demand curve for music downloads to the right.
Price of music down-loads
Quantity of music downloads D1 D2 P1 Q1 Q2
Point out to your students that there are no numbers or units on either axis, and we are using “P1” and “Q1” to represent the initial price and quantity, rather than specific numerical values. Tell them that this is common, because in much economic analysis, the goal is only to see the direction of changes, not specific amounts. (Besides, if we put numbers on this graph, they’d just have been made up, so why bother?)
Also point out the following:
The price of music downloads is the same, but the quantity demanded is now higher. In fact, this is the nature of a shift in a curve: at any given price, the quantity is different than before.

25. B. Price of music downloads falls
The D curve does not shift.
Move down along curve to a point with lower P, higher Q. P1 Q2 P2 D1 Q1
Quantity of music downloads

26. C. Price of CDs falls CDs and music downloads are substitutes.
A fall in price of CDs shifts demand for music downloads to the left.
Price of music down-loads D1 D2 P1 Q1 Q2
Quantity of music downloads

27. 3. Supply

28. Supply
The quantity supplied of any good is the amount that sellers are willing and able to sell.
Law of supply: the claim that the quantity supplied of a good rises when the price of the good rises, other things equal
Supply comes from the behavior of sellers. 28

29. Quantity of coffees supplied
The Supply Schedule
Supply schedule: A table that shows the relationship between the price of a good and the quantity supplied.
Example: Starbucks’ supply of (iced) coffee.
Price of coffees
Quantity of coffees supplied
$0.00
1.00 3
2.00 6
3.00 9
4.00 12
5.00 15
6.00 18
Notice that Starbucks’ supply schedule obeys the Law of Supply. 29

30. Starbucks’ Supply Schedule & CurveP
Price of coffees
Quantity of coffees supplied
$0.00
1.00 3
2.00 6
3.00 9
4.00 12
5.00 15
6.00 18 Q 30

31. Market Supply versus Individual Supply
The quantity supplied in the market is the sum of the quantities supplied by all sellers at each price.
Suppose Starbucks and Peet’s are the only two sellers of iced coffee in this market (Harvard Square). (Qs = quantity supplied)
$0.00
6.00
5.00
4.00
3.00
2.00
1.00
Price 18 15 12 9 6 3
Starbucks 12 10 8 6 4 2
Peet’s
Market Qs + = + = 5 + = 10
Again, the assumption of only two sellers is a clear violation of perfect competition. However, it’s much easier for students to learn how the market supply curve relates to individual supplies in the two-seller case. + = 30 25 20 15 31

32. The Market Supply CurveP Q P
QS (Market)
$0.0
1.00 5
2.00 10
3.00 15
4.00 20
5.00 25
6.00 30 32

33. Supply Curve Shifters
The supply curve shows how price affects quantity supplied, other things being equal.
These “other things” are non-price determinants of supply.
Changes in them shift the S curve…
“Non-price determinants of supply” simply means the things – other than the price of a good – that determine sellers’ supply of the good. 33

34. Summary: Variables that Influence Sellers
Variable A change in this variable…
Price …causes a movement along the S curve
Input Prices …shifts the S curve
Technology …shifts the S curve
# of Sellers …shifts the S curve
Expectations …shifts the S curve 34

35. Supply Curve Shifters: Input Prices
Examples of input prices: wages, prices of raw materials.
A fall in input prices makes production more profitable at each output price, so firms supply a larger quantity at each price, and the S curve shifts to the right.
An increase in input prices produces the opposite effect
In the second bullet point, “output price” just means the price of the good that firms are producing and selling. I have used “output price” here to distinguish it from “input prices.” 35

36. Supply Curve Shifters: Input PricesP Q
Suppose the price of coffee beans falls.
At each price, the quantity of iced coffees supplied will increase (by 5 in this example).
Again, the animation here is carefully designed to help make clear that a shift in the supply curve means that there is a change in the quantity supplied at each possible price. If it seems tedious, you can turn it off.
In any case, be assured that, by the end of this chapter, the animation of curve shifts will be streamlined and simplified. 36

37. Supply Curve Shifters: Technology
Technology determines how much inputs are required to produce a unit of output.
A cost-saving technological improvement has the same effect as a fall in input prices, shifts S curve to the right. 37

38. Supply Curve Shifters: # of Sellers
An increase in the number of sellers increases the quantity supplied at each price,
shifts S curve to the right. 38

39. Supply Curve Shifters: Expectations
Supply Curve Shifters: Expectations
Example:
Events in the Middle East lead to expectations of higher oil prices.
In response, owners of Texas oilfields reduce supply now, save some inventory to sell later at the higher price.
S curve shifts left.
In general, sellers may adjust supply* when their expectations of future prices change. (*If good not perishable) 39

40. STUDENTS’ TURN: Supply Curve
Draw a supply curve for tax return preparation software. What happens to it in each of the following scenarios?
A. Retailers cut the price of the software.
B. A technological advance allows the software to be produced at lower cost.
“Tax return preparation software” means programs like TurboTax by Quicken and TaxCut by H&R Block.

41. A. Fall in price of tax return software
Quantity of tax return software
S curve does not shift.
Move down along the curve to a lower P and lower Q. S1 P1 Q1 Q2 P2

42. B. Fall in cost of producing the software
Price of tax return software
S curve shifts to the right:
at each price, Q increases. S2 S1 P1 Q2 Q1
Quantity of tax return software

43. Supply and Demand TogetherP Q
Equilibrium: P has reached the level where quantity supplied equals quantity demanded S D
We now return to the latte example to illustrate the concepts of equilibrium, shortage and surplus. 43

44. Equilibrium price P Q S D
The price that equates quantity supplied with quantity demanded P Q S D P QD QS $0 24 1 21 5 2 18 10 3 15 4 12 20 9 25 6 30 44

45. Equilibrium quantity P D S Q P QD QS $0 24 1 21 5 2 18 10 3 15 4 12 20
The quantity supplied and quantity demanded at the equilibrium price P Q S D P QD QS $0 24 1 21 5 2 18 10 3 15 4 12 20 9 25 6 30 45

46. Surplus (a.k.a. excess supply):
when quantity supplied is greater than quantity demanded P Q
Example: If P = $5, S D
Surplus
then QD = 9 coffees
and QS = 25 coffees
resulting in a surplus of 16 coffees 46

47. Surplus (a.k.a. excess supply):
when quantity supplied is greater than quantity demanded P Q
Facing a surplus, sellers try to increase sales by cutting price. S D
Surplus
This causes QD to rise
and QS to fall…
…which reduces the surplus. 47

48. Equilibrium Quantity and Price

49. Surplus (a.k.a. excess supply):
when quantity supplied is greater than quantity demanded P Q
Facing a surplus, sellers try to increase sales by cutting price. S D
Surplus
This causes QD to rise and QS to fall.
Prices continue to fall until market reaches equilibrium. 49

50. Shortage (a.k.a. excess demand):
when quantity demanded is greater than quantity supplied P Q
Example: If P = $1, S D
then QD = 21 lattes
and QS = 5 lattes
resulting in a shortage of 16 lattes
Shortage 50

51. Shortage (a.k.a. excess demand):
when quantity demanded is greater than quantity supplied P Q
Facing a shortage, sellers raise the price, S D
causing QD to fall
and QS to rise,
…which reduces the shortage.
Shortage 51

52. Shortage (a.k.a. excess demand):
when quantity demanded is greater than quantity supplied P Q
Facing a shortage, sellers raise the price, S D
causing QD to fall
and QS to rise.
Prices continue to rise until market reaches equilibrium.
Shortage 52

53. Prince Controls
If price is set above market equilibrium --> we have a surplus, or excess supply
If price is set below market equilibrium --> we have a shortage, or excess demand
Price ceiling: legally mandated maximum price
Price floor: legally mandated minimum price