1. Prepared by: Jamal Husein C H A P T E R 2 © 2005 Prentice Hall Business PublishingSurvey of Economics, 2/eO’Sullivan & Sheffrin Supply, Demand, and Market Equilibrium

2. 2 © 2005 Prentice Hall Business PublishingSurvey of Economics, 2/eO’Sullivan & Sheffrin The Model of Supply and Demand perfectly competitive market operates  The supply and demand model is used to explain how a perfectly competitive market operates.  The purpose of the model of supply and demand is to predict changes in market quantity and price based on changes in supply and demand conditions.

3. 3 © 2005 Prentice Hall Business PublishingSurvey of Economics, 2/eO’Sullivan & Sheffrin The Demand Curve  Market demand shows how much of a particular product are consumers willing to buy during a particular time period, all else being equal.

4. 4 © 2005 Prentice Hall Business PublishingSurvey of Economics, 2/eO’Sullivan & Sheffrin Variables Affecting Demand The main determinants of demand include include :  The price of the product  Consumer income  The price of related goods—substitutes and complements  The number of consumers  Consumer preferences—tastes and advertising  Consumer expectations about future prices

5. 5 © 2005 Prentice Hall Business PublishingSurvey of Economics, 2/eO’Sullivan & Sheffrin The Individual Demand Curve  The individual demand curve shows the relationship between the price of a good and the quantity that a single consumer is willing to buy, or quantity demanded.

6. 6 © 2005 Prentice Hall Business PublishingSurvey of Economics, 2/eO’Sullivan & Sheffrin The Individual Demand Curve and The Law of Demand  The negative slope of the individual demand curve reflects the law of demand. Demand schedule Individual Demand Curve  Law of Demand:  Law of Demand: The higher the price, the smaller the quantity demanded, ceteris paribus.

7. 7 © 2005 Prentice Hall Business PublishingSurvey of Economics, 2/eO’Sullivan & Sheffrin The “Ceteris Paribus” Assumption  To obtain various points on the individual demand curve for pizzas we assume that only the price of pizzas changes, while other determinants of the demand for pizzas (income, tastes and preferences, the price of related goods, etc.) remain constant, or ceteris paribus.

8. 8 © 2005 Prentice Hall Business PublishingSurvey of Economics, 2/eO’Sullivan & Sheffrin A Change in Quantity Demanded  A change in quantity demanded  A change in quantity demanded is caused by a change in the price of the good, which causes a movement along the demand curve.

9. 9 © 2005 Prentice Hall Business PublishingSurvey of Economics, 2/eO’Sullivan & Sheffrin Income and Substitution Effect substitution effect  The substitution effect describes a change in consumption resulting from a change in the price of one good relative to the price of other goods.  The lower the price of a good, the smaller the sacrifice associated with consumption of a good. negative  The reason why the slope of the individual demand curve is negative, involves the substitution and income effects.

10. 10 © 2005 Prentice Hall Business PublishingSurvey of Economics, 2/eO’Sullivan & Sheffrin The Income Effect income effect real income  The income effect describes the change in consumption resulting from an increase in the consumer’s real income, or the income in terms of the goods the money can buy. Real income is the consumer’s income measured in terms of the goods it can buy.

11. 11 © 2005 Prentice Hall Business PublishingSurvey of Economics, 2/eO’Sullivan & Sheffrin From Individual to Market Demand  Market Demand Curve  Market Demand Curve: A curve showing the relationship between price and quantity demanded by all consumers together, ceteris paribus.  Market demand is the sum of the quantities demanded by all consumers in the market, or the sum of individual demand curves.

12. 12 © 2005 Prentice Hall Business PublishingSurvey of Economics, 2/eO’Sullivan & Sheffrin From Individual to Market Demand

13. 13 © 2005 Prentice Hall Business PublishingSurvey of Economics, 2/eO’Sullivan & Sheffrin The Market Demand Curve and The Law of Demand  Since the slope of the individual demand curve is negative, it follows that the slope of the market demand curve is also negative, reflecting the law of demand. Market demand schedule Market Demand

14. 14 © 2005 Prentice Hall Business PublishingSurvey of Economics, 2/eO’Sullivan & Sheffrin Market Supply supply curve  The supply curve shows the relationship between price and the quantity that producers are willing to sell during a particular time period, all else being equal.

15. 15 © 2005 Prentice Hall Business PublishingSurvey of Economics, 2/eO’Sullivan & Sheffrin Variables Affecting Supply The main determinants of supply include:  The price of the product  The cost of inputs  The state of production technology  The number of producers  Producer expectations about future prices  Taxes or subsidies from the government

16. 16 © 2005 Prentice Hall Business PublishingSurvey of Economics, 2/eO’Sullivan & Sheffrin The Marginal Principle and the Output Decision  The decision to produce a given quantity of output is based on the marginal principle. Marginal PRINCIPLE Increase the level of an activity if its marginal benefit exceeds its marginal cost, but reduce the level if the marginal cost exceeds the marginal benefit. If possible, pick the level at which the marginal benefit equals the marginal cost.

17. 17 © 2005 Prentice Hall Business PublishingSurvey of Economics, 2/eO’Sullivan & Sheffrin The Marginal Principle and the Output Decision  The optimal quantity of output is the one that satisfies the marginal principle—where marginal cost equals marginal benefit.  As price rises, marginal benefit intersects marginal cost at a higher output level.

18. 18 © 2005 Prentice Hall Business PublishingSurvey of Economics, 2/eO’Sullivan & Sheffrin Individual Supply and the Law of Supply law of supply  The positive slope of the curve reflects the law of supply.  Supply schedule  Supply schedule is a table of numbers that shows the relationship between price and quantity supplied, ceteris paribus. individual supply curve  The individual supply curve shows the relationship between the price and the quantity supplied by a single firm, ceteris paribus.

19. 19 © 2005 Prentice Hall Business PublishingSurvey of Economics, 2/eO’Sullivan & Sheffrin Individual Supply and the Law of Supply  Law of Supply:  Law of Supply: The higher the price, the larger the quantity supplied, ceteris paribus.

20. 20 © 2005 Prentice Hall Business PublishingSurvey of Economics, 2/eO’Sullivan & Sheffrin Individual Supply to Market Supply market supply  The market supply curve for a particular good shows the relationship between the price of the good and the quantity that all producers together are willing to sell, ceteris paribus.

21. 21 © 2005 Prentice Hall Business PublishingSurvey of Economics, 2/eO’Sullivan & Sheffrin Individual Supply to Market Supply

22. 22 © 2005 Prentice Hall Business PublishingSurvey of Economics, 2/eO’Sullivan & Sheffrin Market Supply and the Law of Supply law of supply  The market supply curve is positively sloped, reflecting the law of supply. The higher the price, the larger the quantity supplied, ceteris paribus. Supply schedule Supply Curve

23. 23 © 2005 Prentice Hall Business PublishingSurvey of Economics, 2/eO’Sullivan & Sheffrin Market Equilibrium  Market equilibrium  Market equilibrium is a situation in which, at the current market price, quantity supplied equals quantity demanded.  When the market is in equilibrium, there is no tendency for the price to increase or decrease.

24. 24 © 2005 Prentice Hall Business PublishingSurvey of Economics, 2/eO’Sullivan & Sheffrin Shortage: excess quantity demanded  Excess Demand (Shortage) :  Excess Demand (Shortage) : A situation in which consumers are willing to buy more than producers are willing to sell. It occurs when market price is lower than equilibrium price.  An increase in the Price  An increase in the Price eliminates the shortage by changing both quantity demanded and quantity supplied until the original equilibrium is established

25. 25 © 2005 Prentice Hall Business PublishingSurvey of Economics, 2/eO’Sullivan & Sheffrin Surplus: excess quantity supplied  Excess Supply (Surplus):  Excess Supply (Surplus): A situation in which producers are willing to sell more than consumers are willing to buy. It occurs when market price is above equilibrium price.  A decrease in the Price  A decrease in the Price eliminates excess supply by changing both quantity demanded and quantity supplied until the original equilibrium is established

26. 26 © 2005 Prentice Hall Business PublishingSurvey of Economics, 2/eO’Sullivan & Sheffrin Equilibrium and Disequilibria

27. 27 © 2005 Prentice Hall Business PublishingSurvey of Economics, 2/eO’Sullivan & Sheffrin A Change in Demand increase in demand  An increase in demand (rightward shift) results in higher quantity demanded at each price level.  A change in demand  A change in demand is a change in the amount of a good demanded resulting from a change in something other than the price of the good, which causes a shift of the entire demand curve.

28. 28 © 2005 Prentice Hall Business PublishingSurvey of Economics, 2/eO’Sullivan & Sheffrin Shifting the Demand Curve  Changes in determinants  Changes in determinants of demand other than price cause the demand curve to shift.  A rightward leftward  A rightward shift shows an increase in demand and a leftward shift a decrease in demand.

29. 29 © 2005 Prentice Hall Business PublishingSurvey of Economics, 2/eO’Sullivan & Sheffrin Causes of an Increase in Demand  An increase in income (normal goods) and a decrease in income (inferior goods)  An increase in the price of a substitute good  A decrease in price of a complementary good  Higher preference for the good in question  Favorable advertising  An increase in the number of consumers (population)  An expectation of higher future prices

30. 30 © 2005 Prentice Hall Business PublishingSurvey of Economics, 2/eO’Sullivan & Sheffrin Market Effects of A Change in Demand Supply Price Supply D2D2 D2D2D2D2 D3D3D3D3 30 30 8 8 D3D3D3D3 Thousands of Pizzas per month Price An Increase in Demand A Decrease in Demand 10 4048 Thousands of Pizzas per month 12 20

31. 31 © 2005 Prentice Hall Business PublishingSurvey of Economics, 2/eO’Sullivan & Sheffrin Causes of a Decrease in Demand  A decrease in income (normal goods) or an increase in income (inferior goods)  A decrease in the price of a substitute good  An increase in the price of a complementary good  Less preference for the good in question  An expectation of lower future prices  A decrease in the number of consumers

32. 32 © 2005 Prentice Hall Business PublishingSurvey of Economics, 2/eO’Sullivan & Sheffrin Normal Versus Inferior Goods normal good  A normal good is a good for which the demand increases as real income rises. inferior good  An inferior good is a good for which demand decreases as real income rises.  For normal goods, the law of demand makes sense because the substitution and income effects reinforce each other. Lower prices result in higher quantity demanded.

33. 33 © 2005 Prentice Hall Business PublishingSurvey of Economics, 2/eO’Sullivan & Sheffrin Normal and Inferior Goods inferior goods  For inferior goods, the substitution and income effects conflict with each other, blurring the law of demand. substitution effect  The substitution effect tends to increase consumption while the income effect tends to decrease it. The law of demand is correct only as long as the substitution effect outweighs the income effect.

34. 34 © 2005 Prentice Hall Business PublishingSurvey of Economics, 2/eO’Sullivan & Sheffrin A Change in Quantity Supplied quantity supplied  A change in quantity supplied is caused by a change in the price of the good, which causes a movement along the supply curve.

35. 35 © 2005 Prentice Hall Business PublishingSurvey of Economics, 2/eO’Sullivan & Sheffrin A Change in Supply change in supply  A change in supply is caused by a change in something other than the price of the good, which causes a shift of the entire supply curve. increase in supply  An increase in supply results in higher quantity supplied at each price level.

36. 36 © 2005 Prentice Hall Business PublishingSurvey of Economics, 2/eO’Sullivan & Sheffrin Shifting the Supply Curve  Changes in determinants of supply other than price cause the supply curve to shift. rightward increase leftward decrease  A rightward shift shows an increase in supply and a leftward shift a decrease in supply.

37. 37 © 2005 Prentice Hall Business PublishingSurvey of Economics, 2/eO’Sullivan & Sheffrin Causes of an Increase in Supply  A decrease in the cost of inputs  A technological improvement that decreases cost of production  Lower future prices than anticipated  Subsidies  An increase in the number of producers (firms)

38. 38 © 2005 Prentice Hall Business PublishingSurvey of Economics, 2/eO’Sullivan & Sheffrin Causes of a Decrease in Supply  An increase in the cost of inputs  A loss of technology  A decrease in the number of producers (firms)  Higher future prices than anticipated  Higher taxes imposed on the producers of the good in question

39. 39 © 2005 Prentice Hall Business PublishingSurvey of Economics, 2/eO’Sullivan & Sheffrin Market Effects of Simultaneous Changes in Supply and Demand  When the magnitude of an increase in demand is smaller than the magnitude of an increase in supply, equilibrium quantity increases and market price decreases.

40. 40 © 2005 Prentice Hall Business PublishingSurvey of Economics, 2/eO’Sullivan & Sheffrin Market Effects of A Change in Supply Price S2S2S2S2 D S1S1 30 36 8 P*Price ($) An increase in Supply A decrease in Supply 10 1423 S2S2S2S2 D 30 8 S3S3S3S3 45 6

41. 41 © 2005 Prentice Hall Business PublishingSurvey of Economics, 2/eO’Sullivan & Sheffrin Market Effects of Simultaneous Changes in Supply and Demand  When the magnitude of an increase in demand is larger than the magnitude of an increase in supply, equilibrium quantity increases and market price increases.

42. 42 © 2005 Prentice Hall Business PublishingSurvey of Economics, 2/eO’Sullivan & Sheffrin Applications of Supply and Demand Market Effects of an Increase in Demand An increase in demand causes a shortage at the original price. To eliminate the shortage, price increases from $0.60 to $0.70.

43. 43 © 2005 Prentice Hall Business PublishingSurvey of Economics, 2/eO’Sullivan & Sheffrin Applications of Supply and Demand Market Effects of an Antismoking Campaign A decrease in the demand for cigarettes would result in lower cigarette prices produced and sold, at a lower price.

44. 44 © 2005 Prentice Hall Business PublishingSurvey of Economics, 2/eO’Sullivan & Sheffrin Applications of Supply and Demand Effects of Technological Innovations on the Market for Personal Computers Technological innovations decrease production costs, shifting the supply curve to the right.

45. 45 © 2005 Prentice Hall Business PublishingSurvey of Economics, 2/eO’Sullivan & Sheffrin Applications of Supply and Demand Effects of Bad Weather on the Coffee Market Bad weather decreases the supply of coffee beans, shifting the supply curve to the left. Price increases and quantity exchanged decreases.

46. 46 © 2005 Prentice Hall Business PublishingSurvey of Economics, 2/eO’Sullivan & Sheffrin Market Equilibrium, The Invisible Hand, and Efficiency  The “invisible hand” describes how the actions of individual buyers and sellers, each acting on their own self interest, leads to a market equilibrium.  But, does this market equilibrium promote the social interest, or could society do better?

47. 47 © 2005 Prentice Hall Business PublishingSurvey of Economics, 2/eO’Sullivan & Sheffrin Market Equilibrium, The Invisible Hand, and Efficiency  Four conditions must be met in order to promote the social interest: 1.Buyers and sellers must have enough information to make informed decisions. 2.The market must be perfectly competitive.

48. 48 © 2005 Prentice Hall Business PublishingSurvey of Economics, 2/eO’Sullivan & Sheffrin  Four conditions must be met in order to promote the social interest: 3.There must be no spillover benefits. 4.There must be no spillover costs. Market Equilibrium, The Invisible Hand, and Efficiency