CHAPTER 2 SUPPLY AND DEMAND

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DEFINITIONS Supply and Demand: the name of the most important model in all economics Price: the amount of money that must be paid for a unit of output Market: any mechanism by which buyers and sellers exchange goods or services Output: the good or service and/or the amount of it sold

DEFINITIONS (CONTINUED) Consumers: those people in a market who are wanting to exchange money for goods or services Producers: those people in a market who are wanting to exchange goods or services for money Equilibrium Price: the price at which no consumers wish they could have purchased more goods at that price; no producers wish that they could have sold more Equilibrium Quantity: the amount of output exchanged at the equilibrium price

QUANTITY DEMANDED AND QUANTITY SUPPLIED Quantity demanded: how much consumers are willing and able to buy at a particular price during a particular period of time Quantity supplied: how much firms are willing and able to sell at a particular price during a particular period of time

CETERIS PARIBUS As I talked about before economists use models to focus on what is most important Models typically hold other variables constant to examine the effect of other variables. For example in looking at the supply and demand for peanut butter we typically hold the price of jelly constant We sometimes use the Latin phrase ceteris paribus which means “holding other things equal” to identify this case.

DEMAND AND SUPPLY Demand is the relationship between price and quantity demanded, ceteris paribus. Supply is the relationship between price and quantity supplied, ceteris paribus.

FIGURING OUT THE DEMAND CURVE There are really two different parts to it which are similar One is the “extensive margin” that is who buys the good The second is the “intensive margin” or how much of the good each person buys Guell focuses on the intensive margin, but I want to start with the extensive as I think it is easier to think about

EXTENSIVE MARGIN Think about something like an ipad where there is really no reason to buy more than one Suppose there are 5 people in the economy and this is what they are willing to pay: NameWTP Jim$200 Jackie$400 Bill$600 Sally$800 Lisa$1000

DEMAND CURVE So what does demand look like: At $1200 I sell no ipads At $1000 I sell to Lisa only At $800 I sell 2 At $600 I sell 3 At $400 I sell 4 And at $200 I sell5 PricePrice ipads

INTENSIVE DEMAND Now suppose it is just one worker say me I like to go to basketball games (either pro or college) Suppose the seats are all the same, how many games would I go to? At $200 per seat I would probably go to a game At $50 per seat I would probably go to like 4 games a year At $25 I would go to like 15 At $5 I would go to like 20 At $0 I would go to like 20 Thus demand slopes down for me-the larger the price the fewer games I would go to Demand in the economy picks up both the intensive and extensive margin

THE LAW OF DEMAND The relationship between price and quantity demanded is a negative or inverse one. This occurs both on the extensive and intensive margin There are 3 reasons to expect it on the intensive margin

The Substitution Effect moves people toward the good that is now cheaper or away from the good that is now more expensive If the price of Mobil gas goes up I buy more Amoco

The Real Balances Effect When a price increases it decreases your buying power causing you to buy less. If I live in New York and am spending almost all of my money on rent, if rent doubles I have to move into cheaper place because I can’t afford my current place any more

The Law of Diminishing Marginal Utility The amount of additional happiness that you get from an additional unit of consumption falls with each additional unit. This is what was really going on with my basketball tickets-I like going but I get tired of it if I go to two many games Pretty much any good we can think of has this characteristic

Put it all together and we are pretty confident that demand curves slope down P Q p q

DETERMINANTS OF DEMAND Taste Income Normal Goods Inferior Goods Price of Other Goods Complement Substitute Population of Potential Buyers Expected Price Excise Taxes Subsidies

MOVEMENTS IN THE DEMAND CURVE DeterminantResult of an increase in the determinant Result of a decrease in the determinant TasteD shifts rightD shifts left Income-Normal GoodD shifts rightD shifts left Income-Inferior GoodD shifts leftD shifts right Price of Other Goods-ComplementD shifts leftD shifts right Price of Other Goods-SubstituteD shifts rightD shifts left Population of Potential BuyersD shifts rightD shifts left Expected Future PriceD shifts rightD shifts left Excise TaxesD shifts leftD shifts right SubsidiesD shifts rightD shifts left

P Times Eating Out Example: Demand for Eating Out When Income Falls p q1q2 At a given price people eat out less

P Ketchup Example: Demand for ketchup when the price of beef falls p q2q1 At a given price the People want more Ketchup

A PITFALL: CONFUSING MOVEMENT ALONG VS. SHIFTS IN DEMAND Price changes cause movements along a demand curve. Other factors will cause shifts in demand. These are not the same The “Quantity Demanded” can change either because the price change or because the demand curve changed

P Q Two ways that Quantity Demanded can Increase:

SUPPLY Supply is more complicated and harder to think about than demand (at least for me) In demand for an ipad a person buys an ipad and brings it home In supply for an ipad you have to design it, buy all the components, build it, ship it, sell it in the store The Law of Supply is the statement that there is a positive relationship between price and quantity supplied. If I am trying to sell something, the higher is the price the more I will want to sell

WHY DOES THE LAW OF SUPPLY MAKE SENSE? Because of Increasing Marginal Costs firms require higher prices to produce more output. Because many firms produce more than one good, an increase in the price of good A makes it (at the margin) more profitable so resources are diverted from good B to produce more of good A (think about the PPF)

THE SUPPLY SCHEDULE PriceIndividual Q s Q S for 10 firms $ $ $1.001,00010,000 $1.502,00020,000 $2.003,00030,000 $2.504,00040,000

THE SUPPLY CURVE P Q (in thousands) $2.50 $2.00 $1.50 $1.00 $ Supply

MOVEMENTS IN THE SUPPLY CURVE DeterminantResult of an increase in the determinant Result of a decrease in the determinant Price of InputsS shifts leftS shifts right TechnologyS shifts rightS shifts left Price of Other Potential OutputsS shifts leftS shifts right Number of SellersS shifts rightS shifts left Expected Future PriceS shifts leftS shifts right Excise TaxesS shifts leftS shifts right SubsidiesS shifts rightS shifts left

NUMBER OF SELLERS GOES UP P Q (in thousands) $2.50 $2.00 $1.50 $1.00 $ At a given price supply will increase

PRICE OF AN INPUT GOES UP P Q (in thousands) $2.50 $2.00 $1.50 $1.00 $ At a given price supply will decrease

MARKET EQUILIBRIUM A competitive market is in equilibrium when price has moved to a level at which quantity demand equals quantity supplied of that good. Competitive markets have many buyers and sellers and none is large enough to individually affect the price. Why do markets reach an equilibrium? If prices are too high, there is excess supply (a surplus) and firms will lower prices. If prices are too low, there is excess demand (a shortage) and firms will raise prices.

A COMBINED SUPPLY AND DEMAND SCHEDULE PriceQDQD QSQS ShortageSurplus $0.0050,0000 $0.5040,0000 $1.0030,00010,00020,000 $1.5020,000 $2.0010,00030,00020,000 $ ,000

THE SUPPLY AND DEMAND MODEL P Q (in thousands) $2.50 $2.00 $1.50 $1.00 $ Supply Demand Equilibrium

WHAT IF PRICE TOO HIGH? P Q (in thousands) $2.50 $2.00 $1.50 $1.00 $ Supply Demand Surplus

WHAT IF PRICE TOO LOW? P Q (in thousands) $2.50 $2.00 $1.50 $1.00 $ Supply Demand Shortage

WHAT IF PRICE OF A SUBSTITUTE INCREASES? New Demand New Equilibrium P Q/t $2.50 $2.00 $1.50 $1.00 $ Demand Supply Old Equilibrium

PricesQuantities Demand Increases Increase

WHAT IF GOOD GETS BAD REVIEWS? New Demand New Equilibrium P Q/t $2.50 $2.00 $1.50 $1.00 $ Demand Supply Old Equilibrium

PricesQuantities Demand Increases Increase Demand Decreases Decrease

TECHNOLOGY IMPROVES P Q/t $2.50 $2.00 $1.50 $1.00 $ Demand Supply Old Equilibrium New Equilibrium New Supply

PricesQuantities Demand Increases Increase Demand Decreases Decrease Supply IncreasesFallIncreases

AN INCREASE IN COST OF AN INPUT P Q/t $2.50 $2.00 $1.50 $1.00 $ Demand Supply Old Equilibrium New Equilibrium New Supply

PricesQuantities Demand Increases Increase Demand Decreases Decrease Supply IncreasesDecreaseIncrease Supply FallsIncreaseDecrease

WHY THE NEW EQUILIBRIUM? If there is a change in supply or demand then without a change in the price of the good, there will be a shortage or a surplus. Suppose the cost of an input increased-firms would no longer be willing to sell at the same price They raise prices As a result consumers purchase less

AN INCREASE IN COST OF AN INPUT P Q/t $2.50 $2.00 $1.50 $1.00 $ Demand Supply New Supply shortage As a result of the shortage, employers can raise prices to new equilibrium where shortage goes away