1 1 Lesson Overview BA 210 Lesson I.4 Demand and Supply Chapter 3 Demand and Supply What is a demand curve? Movements along a demand curve verses shifts What causes demand shifts? Substitution and income effects What is a supply curve? Movements along a supply curve verses shifts What causes supply shifts? What is a competitive market? Competitive market equilibrium Price moving to equilibrium Controversy: Government Bailouts Summary Review Questions

2 2 When there are many competing buyers of the same commodity, buyers cannot bargain over the price. A demand schedule for a commodity shows how much of a good buyers will want to buy at different prices Price of coffee beans (per pound) Quantity of coffee beans demanded (billions of pounds) $2.00 Demand Schedule for Coffee Beans What is a demand curve?

3 3 A demand curve is a graph of the demand schedule; it shows how much of a good consumers want to buy at any given price and, alternatively, it shows how much a consumer is willing to pay for each unit of a good. (The curve below is interpolated from 7 demand points.) $ Price of coffee bean (per gallon) Quantity of coffee beans (billions of pounds) Demand curve, D As price rises, the quantity demanded falls BA 210 Lesson I.4 Demand and Supply What is a demand curve?

4 4 An increase in the population and other factors generate an increase in demand – a rise in the quantity demanded at any given price.An increase in the population and other factors generate an increase in demand – a rise in the quantity demanded at any given price. This is represented by the two demand schedules – one showing demand in 2004, before the rise in population, the other showing demand in 2008, after the rise in population.This is represented by the two demand schedules – one showing demand in 2004, before the rise in population, the other showing demand in 2008, after the rise in population. Demand Schedules for Coffee Beans Price of coffee beans (per pound) Quantity of coffee beans demanded (billions of pounds) in 2004in 2008 $ $ $ $ $ $ $ Movements along a demand curve verses shifts

5 5 A shift of the demand curve is a change in the quantity demanded at any given price, represented by the change of the original demand curve to a new position, denoted by a new demand curve. Price of coffee beans (per gallon) $ D 1 D 2 Demand curve in 2008 Demand curve in 2004 Quantity of coffee beans (billions of pounds) BA 210 Lesson I.4 Demand and Supply Movements along a demand curve verses shifts

$ D 1 D 2 AC B A shift of the demand curve… … is not the same thing as a movement along the demand curve Price of coffee beans (per gallon) Quantity of coffee beans (billions of pounds) A movement along the demand curve is a change in the quantity demanded of a good that is the result of a change in that good’s price. BA 210 Lesson I.4 Demand and Supply Movements along a demand curve verses shifts

7 7 Read demand horizontally. A “decrease in demand”, means a leftward shift of the demand curve: at any given price, consumers demand a smaller quantity than before. (D1  D3) Price Quantity D 3 D 1 D 2 Increase in demand Decrease in demand BA 210 Lesson I.4 Demand and Supply Movements along a demand curve verses shifts

8 8 What causes demand shifts? Changes in IncomeChanges in Income n Normal Goods: When a rise in income increases the demand for a good - the normal case - we say that the good is a normal good. Rich people eat lobster. Other normal goods? n Inferior Goods: When a rise in income decreases the demand for a good, it is an inferior good. Poor people eat Raman Noodles. Other inferior goods? Changes in TastesChanges in Tastes Changes in ExpectationsChanges in Expectations BA 210 Lesson I.4 Demand and Supply What causes demand shifts?

9 9 Demand Shifts from Changes in the Prices of Other Goods When the price of Good X changes, the demand for Good Y responds in two steps: n The Substitution Effect: Substitutes: Goods X and Y are substitutes if an increase in the price of one of the goods makes consumers more willing to buy the other good. Complements: Goods X and Y are complements if an increase in the price of one good makes people less willing to buy the other good. n The Income Effect: An increase in the price of Good X decreases each consumer’s power to purchase goods. That decrease in purchasing power has the same effect as a decrease in income: People are less willing to buy good Y if good Y is a normal good. People are more willing to buy good Y if good Y is an inferior good. BA 210 Lesson I.4 Demand and Supply Substitution and Income Effects

10 Changes in the Prices of Other Goods For example, when the price of gas increases, the demand for cars decreases in two steps: n The Substitution Effect: Gas and cars are complements because they are consumed together, so an increase in the price of gas makes people less willing to buy cars, meaning the demand for cars decreases. n The Income Effect: An increase in the price of gas decreases each consumer’s power to purchase goods. Since cars are a normal good (rich households have more cars than poor households), that decrease in purchasing power makes people less willing to buy cars, meaning the demand for cars decreases further. BA 210 Lesson I.4 Demand and Supply Substitution and Income Effects

11 Changes in the Prices of Other Goods The Gross Effect is the substitution effect plus the income effect. When the price of Good X changes, the demand for Good Y responds with the gross effect: n Substitutes: Goods X and Y are gross substitutes if an increase in the price of one of the goods makes consumers more willing to buy the other good. n Complements: Goods X and Y are gross complements if an increase in the price of one good makes people less willing to buy the other good. (When Paul Krugman says “substitutes”, he really means gross substitutes because there is both a substitution effect and an income effect when prices change. Likewise, when Paul Krugman says “complements”, he means gross complements.) BA 210 Lesson I.4 Demand and Supply Substitution and Income Effects

12 Sometimes gross substitution is the same as substitution For example, when the price of apples increases, the demand for oranges responds in two steps: n The Substitution Effect: Apples and oranges are substitutes because they are consumed as alternatives, so an increase in the price of apples makes people more willing to buy oranges, meaning the demand for oranges increases. n The Income Effect: An increase in the price of apples decreases consumers’ power to purchase goods, but that decrease is small since consumers do not spend much on apples. n Apples and oranges are thus “gross substitutes” and “substitutes”. BA 210 Lesson I.4 Demand and Supply Substitution and Income Effects

13 Sometimes gross substitution is different than substitution For example, when tuition at Pepperdine increases, the demand for oranges responds in two steps: n The Substitution Effect: Pepperdine and oranges are not significantly substitutes nor complements because they are not significantly consumed together or as alternatives. n The Income Effect: An increase in tuition at Pepperdine decreases consumers’ power to purchase goods. Since oranges are a normal good (rich households buy more oranges than poor households), that decrease in purchasing power makes people less willing to buy oranges, meaning the demand for oranges decrease. n Apples and oranges are thus “gross complements” but not “complements”. BA 210 Lesson I.4 Demand and Supply Substitution and Income Effects

14 When there are many competing sellers of the same commodity, sellers cannot bargain over the price. A supply schedule shows how much of a good would be supplied at different prices. Alternatively, a supply schedule shows the minimum price it would take per unit for suppliers to supply a particular quantity of a good. Supply Schedule for Coffee Beans Price of coffee beans (per pound) Quantity of coffee beans supplied (billions of pounds) $ What is a supply curve?

15 Quantity of coffee beans (billions of pounds) Price of coffee beans (per pound) $ As price rises, the quantity supplied rises. A supply curve graphs how much of a good people are willing to sell at any given price. (The curve below is interpolated from 7 supply points.) Supply curve, S BA 210 Lesson I.4 Demand and Supply What is a supply curve?

16 The entry of Vietnam into the coffee bean business generated an increase in supply—a rise in the quantity supplied at any given price. This event is represented by the two supply schedules—one showing supply before Vietnam’s entry, the other showing supply after Vietnam came in. Supply Schedule for Coffee Beans Price of coffee beans (per pound) Quantity of beans supplied (billions of pounds) Before entryAfter entry $ $ $ $ $ $ $ Movements along a supply curve verses shifts

17 A shift of the supply curve is a change in the quantity supplied of a good at any given price $ S 1 S 2 Price of coffee beans (per pound) Quantity of coffee beans (billions of pounds) … is not the same thing as a shift of the supply curve A movement along the supply curve… BA 210 Lesson I.4 Demand and Supply Movements along a supply curve verses shifts

18 A movement along the supply curve is a change in the quantity supplied of a good that is the result of a change in that good’s price $ S 1 S 2 A C B Price of coffee beans (per pound) Quantity of coffee beans (billions of pounds) … is not the same thing as a shift of the supply curve A movement along the supply curve… BA 210 Lesson I.4 Demand and Supply Movements along a supply curve verses shifts

19 Read supply horizontally. Any “increase in supply” means a rightward shift of the supply curve: at any given price, there is an increase in the quantity supplied. (S1  S2) S 3 S 1 S 2 Price Quantity Decrease in supply Increase in supply BA 210 Lesson I.4 Demand and Supply Movements along a supply curve verses shifts

20 Changes in input prices n An input is a good that is used to produce another good. Changes in the prices of related goods that could have been sold Changes in technology Changes in expectations about future prices Changes in the number of producers BA 210 Lesson I.4 Demand and Supply What causes supply shifts?

21 A competitive market: n Many competing buyers and sellers n Same commodity (physical good or service) The demand and supply model explains a competitive market. Five key elements: n Demand curve n Supply curve n Demand and supply curve shifts n Market equilibrium n Changes in the market equilibrium BA 210 Lesson I.4 Demand and Supply What is a competitive market?

22 The market demand curve is the horizontal sum of the individual demand curves of all consumers in that market. D Darla D Dino $ D Market (a) Darla’s Individual Demand Curve (b) Dino’s Individual Demand Curve (c) Market Demand Curve Price of coffee beans (per pound) Quantity of coffee beans (pounds) BA 210 Lesson I.4 Demand and Supply Competitive market equilibrium

23 The market supply curve is the horizontal sum of the individual supply curves of all firms in that market. S Figueroa S Bien Pho $ S Market (a) Mr. Figueroa’s Individual Supply Curve (b) Mr. Bien Pho’s Individual Supply Curve (c) Market Supply Curve Price of coffee beans (per pound) Quantity of coffee beans (pounds) BA 210 Lesson I.4 Demand and Supply Competitive market equilibrium

24 Equilibrium in a competitive market: when the quantity demanded of a good equals the quantity supplied of that good. The price at which this takes place is the equilibrium price, or market-clearing price): n Every buyer finds a seller and vice versa. n The quantity of the good bought and sold at that price is the equilibrium quantity. BA 210 Lesson I.4 Demand and Supply Competitive market equilibrium

25 Market equilibrium occurs at point E, where the supply curve and the demand curve intersect. Price of coffee beans (per pound) Quantity of coffee beans (billions of pounds) $ Supply Demand E Equilibrium Equilibrium price Equilibrium quantity BA 210 Lesson I.4 Demand and Supply Competitive market equilibrium

26 If the price were higher than in a competitive equilibrium, there is a surplus of a good when the quantity supplied exceeds the quantity demanded. Suppliers then decrease price from $1.50 to compete for buyers $ Supply Demand E Surplus Quantity demanded Quantity supplied Price of coffee beans (per pound) Quantity of coffee beans (billions of pounds) BA 210 Lesson I.4 Demand and Supply Price moving to equilibrium

$ Supply Demand E Shortage Quantity demanded Quantity supplied Price of coffee beans (per pound) Quantity of coffee beans (billions of pounds) If the price were higher than in a competitive equilibrium, there is a shortage of a good when the quantity demanded exceeds the quantity supplied. Suppliers then increase price from $0.75 to increase profit. BA 210 Lesson I.4 Demand and Supply Price moving to equilibrium

28 Q 2 Q 1 P 2 P 1 D 2 Supply D 1 E 2 E 1 Price of coffee beans Quantity of coffee beans Price rises Quantity rises An increase in demand… … leads to a movement along the supply curve due to a higher equilibrium price and higher equilibrium quantity BA 210 Lesson I.4 Demand and Supply Price moving to equilibrium

29 P 2 P 1 Q 1 Q 2 Demand E 1 S 1 S 2 E 2 Price of coffee beans Quantity of coffee beans Price rises Quantity falls A decrease in supply… … leads to a movement along the demand curve due to a higher equilibrium price and lower equilibrium quantity BA 210 Lesson I.4 Demand and Supply Price moving to equilibrium

30 Two opposing forces determining the equilibrium quantity. The increase in demand dominates the decrease in supply. Quantity of coffee Q 2 Q 1 P 2 P 1 S 2 D 2 D 1 S 1 E 1 E 2 Simultaneous demand and supply shifts. One possible outcome: Price Rises, Quantity Rises Small decrease in supply Large increase in demand BA 210 Lesson I.4 Demand and Supply Price moving to equilibrium Price of coffee

31 Simultaneous demand and supply shifts. Another possible outcome: Price Rises, Quantity Falls Q 1 Q 2 P 2 P 1 S 2 D 2 D 1 S 1 E 1 E 2 Price of coffee Quantity of coffee Large decrease in supply Small increase in demand BA 210 Lesson I.4 Demand and Supply Price moving to equilibrium Two opposing forces determining the equilibrium quantity. The increase in demand is dominated by the decrease in supply.

32 Controversy: Government Bailouts BA 210 Lesson I.3 Trade Controversy: Government Bailouts

33 BA 210 Lesson I.3 Trade A bailout is an act of giving capital to a company in danger of failing in an attempt to save it from bankruptcy, insolvency, or total liquidation and ruin. A bailout could be seen as a necessity in order to prevent greater, socioeconomic failures: For example, the US government assumes transportation to be the backbone of America's general economic fluency, which maintains the nation's geopolitical power. As such, it is the policy of the US government to protect the biggest American companies responsible for transportation—airliners, petrol companies, etc—from failure through subsidies and low-interest loans. These companies, among others, are deemed “too big to fail” because their goods and services are considered by the government to be constant universal necessities in maintaining the nation's welfare and often, indirectly, its security. Controversy: Government Bailouts

34 BA 210 Lesson I.3 Trade Question: Consider the policy of the US government to protect American airlines from failure through subsidies and low-interest loans. What would happen to the largest American airlines (Southwest, American, Delta, United, U.S. Airways, Northwest, Continental, …) if they are all currently failing to make profits and if the US government changed its policy and did nothing? Would the entire industry fail? Controversy: Government Bailouts

35 BA 210 Lesson I.3 Trade Answer: Eventually, without profits, airlines would start dropping out of the industry (though bankruptcy, insolvency, or total liquidation). But as some airlines drop out, the total supply of air travel decreases, which raises price. And as prices raise, profits raise. This process would increase until airlines no longer fail to make sufficient profits to stay in business. In particular, the entire industry does not fail without government bailouts. Controversy: Government Bailouts

36 P 2 P 1 Q 1 Q 2 Demand E 1 S 1 S 2 E 2 Price of air travel Quantity of air travel Price rises Quantity falls A decrease in supply… … leads to a movement along the demand curve due to a higher equilibrium price and lower equilibrium quantity BA 210 Lesson I.4 Demand and Supply Controversy: Government Bailouts

37 Summary 1.A demand schedule exists when there are many competing buyers of the same commodity. The demand schedule shows the quantity demanded at each price and is represented graphically by a demand curve. The law of demand says that demand curves slope downward. 2.A movement along the demand curve occurs when a price change leads to a change in the quantity demanded. When economists talk of increasing or decreasing demand, they mean shifts of the demand curve—a change in the quantity demanded at any given price. BA 210 Lesson I.4 Demand and SupplySummary

38 Summary 3.There are five main factors that shift the demand curve: A change in the prices of related goods A change in the prices of related goods A change in income A change in income A change in tastes A change in tastes A change in expectations A change in expectations A change in the number of consumers A change in the number of consumers 4.A supply schedule exists when there are many competing sellers of the same commodity. The supply schedule shows the quantity supplied at each price and is represented graphically by a supply curve. Supply curves usually slope upward. BA 210 Lesson I.4 Demand and SupplySummary

39 Summary 5.A movement along the supply curve occurs when a price change leads to a change in the quantity supplied. When economists talk of increasing or decreasing supply, they mean shifts of the supply curve—a change in the quantity supplied at any given price. 6.There are five main factors that shift the supply curve: A change in input prices A change in the prices of related goods and services A change in technology A change in expectations A change in the number of producers BA 210 Lesson I.4 Demand and SupplySummary

40 Summary 7.The supply and demand model illustrates how a competitive market works. 8.The market demand curve for a good or service is the horizontal sum of the individual demand curves of all consumers in the market. 9.The market supply curve for a good or service is the horizontal sum of the individual supply curves of all producers in the market. BA 210 Lesson I.4 Demand and SupplySummary

41 Summary 10.An increase in demand increases both the equilibrium price and the equilibrium quantity; a decrease in demand has the opposite effect. An increase in supply reduces the equilibrium price and increases the equilibrium quantity; a decrease in supply has the opposite effect. 11.Shifts of the demand curve and the supply curve can happen simultaneously. BA 210 Lesson I.4 Demand and SupplySummary

42 Review Questions BA 210 Lesson I.4 Demand and Supply Review Questions  You should try to answer some of the following questions before the next class.  You will not turn in your answers, but students may request to discuss their answers to begin the next class.  Your upcoming Exam 1 and cumulative Final Exam will contain some similar questions, so you should eventually consider every review question before taking your exams.

43 Review Questions BA 210 Lesson I.4 Demand and Supply Follow the link for review questions for Lesson I.4 that practices these skills: Describe when demand or supply increases (shifts right) or decreases (shifts left). Describe when demand or supply increases (shifts right) or decreases (shifts left). Identify a competitive equilibrium of demand and supply. Identify a competitive equilibrium of demand and supply. Describe the equilibrium shifts when demand or supply increases or decreases. Describe the equilibrium shifts when demand or supply increases or decreases. Describe how prices or gross substitutes or gross complements shift demand. Describe how prices or gross substitutes or gross complements shift demand. Describe how input costs or production costs shift supply. Describe how input costs or production costs shift supply. Aggregate individual demand into market demand. Aggregate individual demand into market demand. Describe how effective price ceilings cause shortages. Describe how effective price ceilings cause shortages. Compute some special demand curves and some special supply curves from verbal descriptions. Compute some special demand curves and some special supply curves from verbal descriptions.

44 End of Lesson I.4 BA 210 Introduction to Microeconomics BA 210 Lesson I.4 Demand and Supply