Chapter 3 Supply, Demand, and the Market Process

7 Learning Goals 1) 1)Investigate and describe consumer behavior 2) 2)Distinguish a change in demand from a change in quantity demanded 3) 3)Investigate and describe firm behavior 4) 4)Distinguish a change in supply from a change in quantity supplied 5) 5)Build a market model and illustrate how equilibrium is reached 6) 6)Demonstrate how markets respond to changes in demand and supply 7) 7)Recognize how prices and the invisible hand principle create market order

Consumer Choice and the Law of Demand

The Law of Demand: The inverse relationship between price and quantity demanded; when price rises, quantity demanded falls Quantity demanded is a number; it’s how many units of a good you bought

Picture of this relationship:

Why is the demand curve downward sloping? Diminishing Marginal Utility –The marginal benefit you receive from an item falls as you gain more of the item –The only way to get you to buy more is to lower the price

How do consumers react to price changes? (1) When the price of one good falls, people substitute away from relatively more expensive goods to the relatively cheaper goods Called the substitution effect (2) When the price of one good falls, real consumer income rises so people buy more (it’s like getting a raise) Called the income effect Both of these also cause the demand curve to be downward sloping

The demand curve represents your willingness to pay (your maximum price), not how much you actually paid

What if the actual price is lower than your willingness to pay? In economics, we call this difference consumer surplus (CS) Graphically, CS is the area below demand, out to quantity, and down to price

Graph of CS:

Changes in Demand Versus Changes in Quantity Demanded

Demand is the relationship between two variables: price and quantity demanded Changes: (1) When price changes, quantity demanded changes but demand does NOT change –This is movement along a demand curve (2) When something else changes, demand changes (i.e., the relationship changes) –This is movement of the entire curve

Another way to think about the difference between demand and quantity demanded Why is the consumer buying more (or less)? If price is the reason, then quantity demanded changes; move along the demand curve If any variable besides price is the reason, then demand changes; shift the demand curve

Graphs:

The price and demand for one good can be intimately tied to demand for another good (1) Substitute goods-used in place of each other An increase (decrease) in demand for the first good will decrease (increase) demand for the second good An increase (decrease) in price for the first good will increase (decrease) demand for the second good

(1) Substitute goods Example: (A)__________, (B)__________ If consumers’ preferences changed so that they wanted more (A)______________, the (demand/quantity demanded) for (A)_______________ would (rise/fall), causing the demand curve to shift (right/left) and they would purchase (more/less) (A)_______________. The (demand/quantity demanded) for (B)____________ would (rise/fall), causing the demand curve to shift (right/left).

(1) Substitute goods Example: (A)__________, (B)__________ If the price of (A)_________ rose, the (demand/quantity demanded) of (A)____________ would (rise/fall) and consumers would purchase (more/less) (A)_______________. The (demand/quantity demanded) for (B)____________ would (rise/fall), causing the demand curve to shift (right/left).

Graphs:

(2) Complement goods-usually consumed at the same time An increase (decrease) in demand for the first good will increase (decrease) demand for the second good An increase (decrease) in price for the first good will decrease (increase) demand for the second good

(2) Complement goods Example: (A)__________, (B)__________ If consumers’ preferences changed so that they wanted more (A)______________, the (demand/quantity demanded) for (A)______________ would (rise/fall), causing the demand curve to shift (right/left) and they would purchase (more/less) (A)_______________. The (demand/quantity demanded) for (B)_____________ would (rise/fall), causing the demand curve to shift (right/left).

(2) Complement goods Example: (A)__________, (B)__________ If the price of (A)_____________ rose, the (demand/quantity demanded) of (A)_____________ would (rise/fall) and consumers would purchase (more/less) (A)________________. The (demand/quantity demanded) for (B)_____________ would (rise/fall), causing the demand curve to shift (right/left).

Graphs:

Producer Choice and the Law of Supply

Goal: Explain and Predict Firm Behavior The Law of Supply: –The positive relationship between price and quantity supplied; when price rises, quantity supplied rises –Quantity supplied is a number; it’s how many units of a good you made

Graph:

Why is the supply curve upward sloping? At a higher price, a product is usually more profitable so a firm has a stronger incentive to make more.

What if the actual price is higher than your minimum price? In economics, we call this difference producer surplus (PS) Graphically, PS is the area above supply, out to quantity, and up to price

Graph of PS:

Changes in Supply Versus Changes in Quantity Supplied

Price is not the only factor that determines how much a firm makes Changes: (1) When price changes, quantity supplied changes but supply does NOT change –This is movement along a supply curve (2) When something else changes, supply changes (i.e., the relationship changes) –This is movement of the entire curve

Another way to think about the difference between supply and quantity supplied Why is the firm producing more (or less)? If price is the reason, then quantity supplied changes; move along the supply curve If any variable besides price is the reason, then supply changes; shift the supply curve

Graphs:

How Market Prices are Determined: Supply and Demand Interact

Graph:

Key points: –(1) Excess supply and excess demand are NOT unique points –(2) Equilibrium IS a unique point

How Markets Respond to Changes in Supply and Demand

This is called supply and demand analysis You don’t have to use graphs but it’s helpful Use this 3 step procedure: –(1) Identify the change –(2) Determine if Supply or Demand is affected and how –(3) Draw and read graph (or reason through the change)

Graph:

What if supply and demand shift at the same time? Suppose supply and demand both increase

Graphs:

Invisible Hand Principle Adam Smith- An Inquiry into the Nature and Causes of the Wealth of Nations Personal self-interest directed by market prices is a powerful force promoting economic progress

“Every individual is continually exerting himself to find out the most advantageous employment for whatever [income] he can command. It is his own advantage, indeed, and not that of the society which he has in view. But the study of his own advantage naturally, or rather necessarily, leads him to prefer that employment which is most advantageous to society…He intends only his own gain, and he is in this, as in many other cases, led by an invisible hand to promote an end which was not part of his intention. By pursuing his own interest he frequently promotes that of the society more effectually than when he really intends to promote it.” “Every individual is continually exerting himself to find out the most advantageous employment for whatever [income] he can command. It is his own advantage, indeed, and not that of the society which he has in view. But the study of his own advantage naturally, or rather necessarily, leads him to prefer that employment which is most advantageous to society…He intends only his own gain, and he is in this, as in many other cases, led by an invisible hand to promote an end which was not part of his intention. By pursuing his own interest he frequently promotes that of the society more effectually than when he really intends to promote it.”

Many outcomes are the result of human action but not human design