McGraw-Hill/Irwin ©2008 The McGraw-Hill Companies, All Rights Reserved Supply and Demand Chapter 3

2 3 – Supply and Demand 1 – Market Participants & the Circular Flow Model 2 – Demand 3 – Supply 4 – Equilibrium & Market Outcomes

3 1 – Market Participants & the Circular Flow Model

4 Markets Markets exist whenever/wherever an economic exchange takes place: goods/services (in product markets), or… resources (in factor markets).

5 Specialization and Exchange Markets allow specialization for efficiency.

6 Maximizing Behavior in the Market Place Consumers: strive to maximize their utility (satisfaction) given limited resources. Businesses: strive to maximize profits by using resources efficiently in producing goods. Government: strives to maximize the general welfare of society. These basic goals explain most market activity.

7 The Circular Flow Model A model of the market system. Four different groups participate in our economy: Consumers Business firms Government Foreigners

8 The Circular Flow (pg. 44) International participants Consumers International participants Business Firms Governments Product markets Factor markets Goods and services supplied Factors of production supplied Goods and services demanded Factors of production demanded

9 Supply and Demand Every market transaction must have: a buyer (demand), and … a seller (supply). LO1

10 2 – Demand

11 Demand Demand: the ability and willingness to buy specific quantities of a good… at alternative prices… in a given time period, … (ceteris paribus.) *** Quantity demanded is a FUNCTION of price. *** LO1

12 Demand Schedule and Curve (pg. 47) (tutoring, hours) Quantity PRICE $ A B C D E F G H I LO1

13 Demand The law of demand: -the quantity of a good demanded is inversely related to its price … (…in a given time period…) (…ceteris paribus). LO1

14 Demand Demand, technically: an expression of consumer buying intentions – a willingness and ability to buy - not a statement of actual purchases. But… Informally we measure demand by sales. LO1

15 Market Demand Market demand: the total quantities of a good or service people are willing and able to buy at alternative prices (in a given time period, ceteris paribus). It is the sum of individual demands. LO1

16 Construction of the Market Demand Curve (pg. 52) ++= Tom’s demand curve $50 Price + George’s demand curve Lisa’s demand curve My demand curve LO1

17 Construction of the Market Demand Curve (pg. 52) A B C D E F G I $ The market demand curve Price Quantity Demanded H = LO1

18 Hang on … …Now it starts getting tricky:

19 Ceteris Paribus Ceteris paribus … …the assumption that nothing else is changing. But what if something else does change…? LO2

20 Shifts in Demand (pg. 50) Various factors (determinants) can shift the entire curve (relationship).

21 Shifts in Demand (pg. 50) This changes the quantity demanded at all prices.

22 Shifts in Demand (pg. 50) (It rewrites the function between price and quantity demanded.)

23 Shifts in Demand (pg. 50) Decrease in demand = shift to the left. Increase in demand = shift to the right.

24 Rightward Shifts in Demand An increase in demand = the demand curve shifts to the right. A decrease in demand = the demand curve shifts to the left. LO3

25 Determinants of Demand Determinants of market demand include: Tastes — desire for this (and other) goods. Income — of the consumer. Number of buyers. Other goods — their availability and price. Expectations — for income, prices, tastes, etc. LO3

26 Determinants of Demand Tastes — desire for this (and other) goods: Taste/Desire ↑ = Demand ↑ (shift right). Taste/Desire ↓ = Demand ↓ (shift left). LO3

27 Tastes — desire for this (and other) goods

28 Determinants of Demand Income — of the consumer: Income ↑ = Demand ↑ (shift right). Income ↓ = Demand ↓ (shift left). LO3

29 Income — of the consumer:

30 Determinants of Demand Number of buyers: # of buyers ↑ = Demand ↑ (shift right). # of buyers ↓ = Demand ↓ (shift left). LO3

31 Number of buyers: The Baby Boom

32 Determinants of Demand Other goods — their availability and price: 1. Substitute goods: Can be used in place of each other. LO3

33 Determinants of Demand 1. Substitute goods: Price of substitute good ↑ = Demand ↑ (shift right). Price of substitute good ↓ = Demand ↓ (shift left). LO3

34 Determinants of Demand 1. Complimentary goods: Price of complimentary good ↑ = Demand ↓ (shift left). Price of complimentary good ↓ = Demand ↑ (shift right). LO3

35 Determinants of Demand Other goods — their availability and price: 2. Complimentary goods: Are used together. LO3

36 Determinants of Demand Expectations — for income, prices, tastes, etc.: The expectation that something is going to happen generally has the same effect on demand as that thing actually happening. LO3

37 Expectations

38 Determinants of Demand Determinants of market demand include: Tastes — desire for this and other goods. Income — of the consumer. Number of buyers. Other goods — their availability and price. Expectations — for income, prices, tastes. LO3

39 Pizza and Politics Political analysts have observed that demand for pizza in the White House shifts to the right whenever a political crisis erupted. LO3

40 Movements vs. Shifts Changes in quantity demanded: movements on a demand curve, … in response to price changes for that good. The curve does not shift. Changes in demand: demand curve shifts, due to: changes in tastes, income, other goods, or expectations. LO3

41 Movements vs. Shifts PRICE $ Quantity D 1 = initial demand d1d1 Movement along curve g1g1 Shift in demand D2D2 increased demand d2d2 LO3

42 3 – Supply

43 Market Supply (pg. 54) LO1

44 Supply Supply: the ability and willingness to SELL (produce) specific quantities of a good… at alternative prices… in a given time period… (ceteris paribus). LO1

45 Supply Market supply: the total quantities of a good that all sellers combined are willing and able to sell at alternative prices… (in a given time period, ceteris paribus). LO1

46 Market Supply (pg. 54) LO1

47 Market Supply (pg. 54) LO1

48 Market Supply (pg. 54) LO1

49 The Law of Supply The law of supply: -the quantity of a good supplied is directly related to its price … (…in a given time period…) (…ceteris paribus).

50 Market Supply Technically… Market supply is an expression of sellers’ intentions – an offer to sell – not a statement of actual sales.*** LO1

51 Determinants of Supply The determinants of market supply: Factor (resource) costs Technology Number of sellers Other goods*** Taxes, subsidies, & regulation Expectations LO3

52 Shifts of Supply Changes in the quantity supplied — movements along the supply curve in response to a change in price. Changes in supply — shifts of the whole supply curve. LO3

53 Shifts of Supply Increase in supply — shift to the right. Decrease in supply — shift to the left. LO3

54 Determinants of Supply The determinants of market supply: LO3

55 Determinants of Supply Factor (resource) costs: Costs ↓ = Supply ↑ Costs ↑ = Supply ↓ LO3

56 Factor costs

57 Determinants of Supply Technology New Tech = Costs ↓ LO3 = Supply ↑

58 New Technology

59 Determinants of Supply The determinants of market supply: Factor (resource) costs Technology Number of sellers Other goods*** Taxes, subsidies, & regulation Expectations LO3

60 Determinants of Supply Number of sellers: Number of sellers ↑ = Supply ↑ Number of sellers ↓ = Supply ↓ LO3

61 Number of Sellers “China Brilliance produces a Chinese car that (gulp) looks good” by John Neff (RSS feed) on Feb 23rd 2006 at 12:30PMJohn NeffRSS feed

62 Determinants of Supply Other goods: 1.Producer Substitutes: 2.Producer Compliments: LO3

63 Producer Substitutes

64 Determinants of Supply 1.Producer Substitutes: -Price of pro. sub. ↑ = Supply ↓ -Price of pro. sub. ↓ = Supply ↑ LO3

65 Producer Compliments

66 Determinants of Supply 2. Producer Compliments: -Price of pro. Comp. ↑ = Supply ↑ -Price of pro. Comp. ↓ = Supply ↓ LO3

67 Determinants of Supply Taxes, subsidies, & regulation: Taxes & regulation = higher costs Subsidies = lower cost LO3

68 Taxes, Subsidies, & Regulation:

69 Determinants of Supply Producer expectations (esp. for profit): Can drive supply ↑ or ↓ LO3

70 Determinants of Supply The determinants of market supply: Technology Factor (resource) costs Other goods*** Number of sellers Taxes, subsidies, & regulation*** Expectations LO3

71 4 – Equilibrium & Market Outcomes

72 Equilibrium Price LO2

73 Equilibrium (pg. 56) Markets naturally work toward equilibrium. Market demand Equilibrium price & quantity Market supply $ Quantity39 Price Shortage y x Surplus LO2

74 Equilibrium (pg. 56) Equilibrium price (“market clearing price”) : quantity demanded = quantity supplied. The unique outcome at market equilibrium is efficient. LO2

75 Equilibrium Price Market demand Equilibrium price Market supply $ At equilibrium price, quantity demanded equals quantity supplied Quantity39 Price LO2

76 Market Clearing The equilibrium price: reflects a compromise between buyers and sellers. Not everyone is happy with the prevailing equilibrium price or quantity. The unique outcome at market equilibrium is efficient. LO2

77 Surplus and Shortage (pg. 56) Market surplus: emerges when the market price is above the equilibrium price. (excess supply). Market shortage: emerges when the market price is below the equilibrium price. (excess demand). LO2

78 Price Floors & Ceilings Price FLOOR: Minimum price set by law. Creates an artificial surplus if set above the market clearing price. No effect if set below market equilibrium. LO2

79 Price Floors & Ceilings (pg. 56) Price FLOOR: LO2

80 Price Floors & Ceilings Price FLOOR: Minimum price set by law. Creates an artificial surplus if set above the market clearing price. No effect if set below market equilibrium. Price CEILING: Maximum price set by law. Creates an artificial shortage if set below the market clearing price. No effect if set above market equilibrium. LO2

81 Surplus and Shortage (pg. 56) Price CEILING: LO2

82 Surplus and Shortage Market demand Market supply $ Quantity39 Price Shortage y x Surplus LO2

83 Equilibrium Price Market demand Equilibrium price Market supply $ At equilibrium price, quantity demanded equals quantity supplied Quantity39 Price LO2

84 Surplus and Shortage Market demand Market supply $ Quantity39 Price Shortage y x Surplus LO2

85 Self-Adjusting Prices Buyers and sellers will change their behavior to overcome a surplus or shortage. Only at the equilibrium price will no further adjustments be required. LO2

86 The Invisible Hand The market mechanism is the use of market prices and sales to signal desired outputs (or resource allocations). Adam Smith characterized this market mechanism as the invisible hand. LO2

87 Changes in Equilibrium No equilibrium price is permanent. The equilibrium price will change whenever supply or demand shifts. i.e., when the determinants of supply and demand change. LO3

88 Changes in Equilibrium Demand Shift (pg. 59) Quantity Price $ E1E1 Initial demand Market supply New demand E2E2 LO3

89 Changes in Equilibrium Supply Shift (pg. 59) Quantity Price $ E3E3 E1E1 Initial demand Market supply LO3

90 Market Outcomes The market mechanism resolves the basic economic questions of… what, … how, and … for whom.

91 Market Outcomes WHAT we produce is determined by the equilibrium of the markets. HOW we produce is determined by profit seeking behavior and using resources efficiently. FOR WHOM we produce is determined by those willing and able to pay the equilibrium price.

92 Optimal, Not Perfect Although the outcomes of the marketplace are not perfect, they are often optimal. Not everyone is happy with market outcomes, but... …we are given the opportunity to maximize our own satisfaction under the existing circumstances.

McGraw-Hill/Irwin ©2008 The McGraw-Hill Companies, All Rights Reserved Supply and Demand End of Chapter 3