Markets, Demand (D), Supply (S), and Market Prices

Objectives: Upon completion of this unit, you should understand and be able to answer these key questions: 1. What are the basic decision-making units in the economy? 2. What are the relationships between these basic units? How does a circular flow diagram illustrate these relationships? 3. What do we mean by ‘quantity demanded?’ What influences quantity demanded on the part of households? 4. What is the demand schedule for a product? What are the main features of a demand curve? What is the law of demand and how is it illustrated by demand curves? 5. What can change the demand for a product? How does the demand curve react to changes in demand? What do we mean by normal goods? Inferior goods? Complementary goods? Substitute goods? 6. What is the law of supply? What influences the quantity supplied of a good? What are the features of a supply curve? How do supply curves illustrate the law of supply? What factors can cause the supply of a product to change and how are these changes reflected in the supply curve? 7. What is the equilibrium price for a product? What do we mean by a shortage? A surplus? 8. How do changes in the supply or demand for a product affect its equilibrium price and quantity?

Key Concepts 1. Circular flow model and markets 2. Demand (D) a.D schedule, D curve, movement along D curve, law of D b.Factors affecting D, shift of D curve c.Individual and market D d.Types of goods (normal, inferior, substitutes, complements) 3. Supply (S) a.S schedule, S curve, movement along S curve, law of S b.Factors affecting S, shift of S curve c.Individual and market S 4. Market interaction of S&D a. Disequilibrium (excess demand, excess supply) b. Equilibrium & equilibrium changes (due to shifts in D and/or S) c. Market and non market alternatives for allocating goods/services d. Price ceilings, price floors, taxes

Circular Flow Model This is a diagram that shows how 1) funds and 2) tangible items/services are exchanged between households and business firms. It simplifies the description of an ‘economy down to two types of markets (input and output) and two types of decision makers (consumers and firms).

Question Suppose a cold winter shifts the D curve for oil to the right, while an oil-worker strike shifts the S curve of oil to the left. Will there be a shortage of oil in the market?

Question Many high school students in California are currently unable to get into one of the main public California universities (e.g. USC, UCLA) even though they are excellent students. What is the most logical economic explanation for this?

Question Your instructor often advises students to buy roses for their “valentine” the week before Valentine’s Day. Why?

Some S & D Managerial Implications 1.Understand how P’s are determined in order to anticipate P changes and capitalize with strategies related to: - buying - selling - producing - managing inventories - staffing - contracting 2.Understand how consumers and producers are likely to respond or be motivated by P changes (i.e. how economic activities are coordinated) in order to anticipate and capitalize on those expected responses.

Quote of the Day “In this world, there are two ways to get rich: #1. Produce something valuable and sell it to others. #2. Steal from those who are successful at pursuing the first strategy.” N. Gregory Mankiw Fortune (June 12, 2000)

D Schedule =a table showing the quantities (physical amount or units) of an item a buyer (or buyers) are willing to buy at different prices, ceteris paribus

Law of D  D curves are downward sloping  ΔP and ΔQ d are in ‘opposite’ directions

Product “Dimensions” The economic concept of Demand pertains to a specific item where the following dimensions are specified: 1. The form (quality/type) 2. The location 3. The time

D Curve Types 1. One consumer 2. One firm (i.e. its customers) 3. One market (i.e. all buyers in the market)

On a typical day, literally millions of hamburgers are purchased by individuals in the U.S. What factors influence the willingness and ability of these consumers to buy hamburgers? Question

Factors That Affect D for X 1.P X = P of that product (or item) (note ΔP could be caused by Δ supply) 2.P and/or availability of another item (e.g. Y) a.Substitutes (  P Y   D for X) b.Complements (  P Y   D for X) 3.Income (I) a.Inferior (  I   D for X) b.Normal (  I   D for X) 4.Type of Item a.Luxury b.Necessity

Factors That Affect D for X 5. Buyer concerns or expectations a. Safety b. Health c. Cost 6. Advertising 7. Tastes and preferences 8. No. of buyers or alternative uses 9. Govt. policy (e.g. tax) 10. Seasonality 11. Interest rates 12. Profitability of an input – derived demand

Change in “Quantity Demanded” of X (Due to ΔP X = ΔP of THAT product) A B PXPX D0D0 Q A to B: Increase in quantity demanded

Change in “Demand” for X (Due to Δ other than ΔP of THAT product) D 0 to D 1 : Increase in Demand PXPX Q D1D D0D0

Graphical Impacts of D (for X) Factor s 1. ΔP X  movement along the D curve for X (often called “Δ in quantity demanded”) 2. Δ any other factor  shift of the D curve for X (called “Δ in demand”) Shift to right   D

S Schedule =a table showing the quantities (physical amount or units) of an item a seller (or sellers) are willing to sell at different prices, ceteris paribus.

S Curve =a graph of a S schedule, normally with price (P) units on the vertical axis. P S Q

Law of S  S curves are upward sloping  ΔP and ΔQ S are in the “same” direction

In a typical year recently, U.S. farmers produce 9-11 billion bushels of corn. What factors influence the willingness and ability of these producers to produce corn? Question

Factors that Affect S of X 1. P X = P of that product or item (note ΔP could be caused ΔD) 2. P or profitability of an alternative production item (e.g. Y) (  P Y   S of X) 3. P or cost of an input (e.g. Z) (P Z   S of X) 4. Taxes 5. Interest rates

Factors that Affect S of X 6. Gov’t policies/regulations 7. Technology 8. Producer expectations 9. Weather 10. Number of producers

Graphical Impacts of S (of X) Factor Δs 1. ΔP X  movement along the S curve for X (Often called ‘Δ quantity supplied”) 2. Δ any other factor  shift of the S curve for X (often called “Δ in supply”) Shift to right   S

Change in “Quantity Supplied” of X (Due to ΔP = ΔP of THAT product) Q PXPX S0S0 B A

Change in Supply of X (Due to Δ other thanΔP of THAT product) PXPX Q S0S0 S1S1

What happens if a market price is either above or below the equilibrium value? Question

Equilibrium Price = Price for which Q D = Q S P * *300 D (P=4-.01Q) ← equilibrium point S (P=0+.01Q)

Disequilibrium price  Prices for Q d ≠ Q S P Q D (P=4-.01Q) Excess D Excess S S (P=0+.01Q)

Solving for Equilibrium P Mathematically 1. Set S equation for P = D equation for P, and solve for equilibrium Q 2. Plug equilibrium Q back into either the S equation or the D equation and solve for equilibrium P Example: S equation: P = Q D equation: P = Q  1).01Q = Q .02Q = 4  Q = 200  2) P = Q  P = (200)  P = 2.00

Econ Quote of the Day Teach a parrot the terms ‘supply and demand’ and you’ve got an economist. - Thomas Carlyle

In markets, people pursue their own self interests by responding to price incentives. Adam Smith (Wealth of Nations, 1776) noted it’s almost as if individuals are being led by an ‘invisible hand’, and this self-regulating behavior actually promotes the best interests of society as a whole. Invisible Hand

The Role of Market Prices (i.e. markets): To ration or allocate goods and services (and resources) (solving the basic production problems of what, how, and for whom in the process).

Equilibrium Changes Over Time P PP QQQ T1T1 T3T3 T2T2 S1S1 S2S2 S3S3 D1D1 D2D2 D3D3

Comparative Statics Analysis Change one D factor that shifts the D curve: – Results in a change in P that results in a movement along a given S curve Change one S factor that shifts the S curve: – Results in a change in P that results in a movement along a given D curve

Equilibrium Changes CasePQ 1.  D  2.  D  3.  S  4.  S  5.  D,  S ?  6.  D,  S  ? 7.  D,  S  ? 8.  D,  S ? 

P Rationing Example #1 S curve shifts to left (or D curve shifts to right)  Excess demand (i.e. shortage) exists at original price  Market P will rise to ration lower supply

Graph of Equilibrium Change, Case #1 (  D X )  Shift of D curve for X to right caused by ΔD factor other than ΔP X causes ΔP X which causes ΔQ S (movement along S curve) PXPX P2P2 P1P1 S1S1 D2D2 D1D1 QXQX

Graph of Equilibrium Change Case #6 (  D X,  S X ) PXPX P2P2 P1P1 D1D1 D2D2 S2S2 S1S1 QXQX

Graph of Equilibrium Change Case #4 (  S X ) Shift of S curve of X to left caused by ΔS factor other than ΔP X causes ΔP X which causes ΔQ d (movement along D curve) PXPX QXQX D1D1 S2S2 S1S1 P1P1 P2P2

Favorite Trading Rules “The reaction of the market to news is more important than the news itself.” “People who buy headlines end up selling newspapers.” “Facts are priceless – opinions are worthless.” Rich Felthaus, Refco, July 2004

Question Do the laws of S and D work to determine the price of an item if there is only ONE unit of that item to be sold?

P Rationing Example #2 Extremely limited supply (e.g. Q S = 1)  P is D determined  P will rise until there is only 1 willing buyer

“Buy land. They’ve stopped making it.” (Mark Twain) P S Q (land)

P Rationing Example #3 (resources) Suppose the demand for a product increases.  More profits to produce that product  Profits encourage firms to buy more capital, labor, etc.  Input prices influence what specific resources are used

Question Should the state of Iowa put a ‘cap’ on college tuition increases to make a University education more affordable to everyone?

P Constraint Example #1 – P Ceiling P Ceiling = max P sellers can charge (below equilibrium P) usually set by Gov’t Examples:gasoline (1970s), interest rates, rental rates, ATM fees Arguments for:P gouging is bad, not ‘fair’ or right to charge ‘exorbitant’ Ps, everyone should be able to buy necessities at ‘reasonable’ prices

P Constraint Example #1 – P Ceiling (cont’d) Problem: Excess D still exists  need to implement alternative rationing mechanisms such as: 1. Queuing  waiting in line 2. Favored customers  let sellers decide 3. Issuing ration tickets or coupons

“Hidden” costs or problems with non- P rationing mechanisms 1. Queuing: cost of waiting in line 2. Favored customers: bribes, hidden ‘service’ charges 3. Ration coupons: often end up being bought/sold legally or illegally (black market) 4. General: discourages both producers and consumers from making needed S and/or D adjustments

P Constraint Example #2 – P Floor P floor = min. P buyers must pay (above equilibrium P) Examples: minimum wage, ag P supports Arguments for: needed to keep producers in business, to generate ‘fair’ income levels Problem: excess S will be created (  e.g. surplus production, unemployment, etc.)

P Constraint Example #3 – Import Fee Fee = tax on imports Impacts:  P to U.S. consumers   Q d in U.S.  Q S in U.S.  Q of imports  Gov’t revenue

P Constraint example #4 (per unit tax on buyers) To buy Q 1 initially, buyers willing to pay P w/o. After tax, buyers willing to pay P w to keep the same total cost per unit. => Tax causes D curve to shift left (or down by amt of t) $ P w/o PwPw Q1Q1 t D 2 (w/tax) D 1 (w/o tax) Q

Question Is there any product or service you currently buy that you consider to be a ‘really good’ deal for the money?

Consumer Surplus Amount willing to pay (value) - Amount have to pay (cost) ___________________________ =consumer surplus

Consumer Surplus (graphically) P a D Q Q1Q1 Cost CS P1P1 = area under the D curve and above the price line = CS = ½ Q 1 (a-P 1 )

Producer Surplus Amount paid to sellers - Amount willing to sell for (cost) __________________________ =producer surplus

Producer Surplus (graphically) P S Q a Cost PS p1p1 = area above the S curve and under the price line = PS = ½ Q 1 (P 1 – a) Q1Q1

Economic Impacts of Deviations Away from Equilibrium CS=consumer surplus +PS=producer surplus __________________________________ =NSW (net social welfare)

Market Equilibrium & NSW P CS PS S D Q QeQe PePe NSW = net social welfare = PS + CS Max NSW  P = P e

NSW Impacts:  Q &  P ΔNSW=Δ net social welfare =ΔPS + ΔCS =(a-c) + (-a-b) =-c-b =net welfare loss (deadweight loss) P Q a PS b c S D CS P2P2 PePe Q2Q2 Q1Q1