© 2009 South-Western, a part of Cengage Learning, all rights reserved C H A P T E R The Market Forces of Supply and Demand E conomics P R I N C I P L E S O F N. Gregory Mankiw

In this chapter, look for the answers to these questions:  What factors affect buyers’ demand for goods?  What factors affect sellers’ supply of goods?  How do supply and demand determine the price of a good and the quantity sold?  How do changes in the factors that affect demand or supply affect the market price and quantity of a good?  How do markets allocate resources? 1

THE MARKET FORCES OF SUPPLY AND DEMAND 2 Demand  The quantity demanded of any good is the amount of the good that buyers are willing and able to purchase.  Law of demand: the claim that the quantity demanded of a good falls when the price of the good rises, other things equal

THE MARKET FORCES OF SUPPLY AND DEMAND 3 P Q The Market Demand Curve for Lattes P Q d (Market) $

THE MARKET FORCES OF SUPPLY AND DEMAND 4 Demand Curve Shifters  The demand curve shows how price affects quantity demanded, other things being equal.  These “other things” are non-price determinants of demand (i.e., things that determine buyers’ demand for a good, other than the good’s price).  Changes in them shift the D curve… P Q

THE MARKET FORCES OF SUPPLY AND DEMAND 5 Summary: Variables That Influence Buyers VariableA change in this variable… Price…causes a movement along the D curve # of buyers…shifts the D curve Income…shifts the D curve Price of related goods…shifts the D curve Tastes…shifts the D curve Expectations…shifts the D curve

A. The price of iPods falls B. The price of music downloads falls C. The price of CDs falls A C T I V E L E A R N I N G 1 Demand Curve 6 Draw a demand curve for music downloads. What happens to it in each of the following scenarios? Why?

THE MARKET FORCES OF SUPPLY AND DEMAND 7 Supply  The quantity supplied of any good is the amount that sellers are willing and able to sell.  Law of supply: the claim that the quantity supplied of a good rises when the price of the good rises, other things equal

THE MARKET FORCES OF SUPPLY AND DEMAND 8 P Q The Market Supply Curve P Q S (Market) $

THE MARKET FORCES OF SUPPLY AND DEMAND 9 Supply Curve Shifters  The supply curve shows how price affects quantity supplied, other things being equal.  These “other things” are non-price determinants of supply.  Changes in them shift the S curve… P Q

THE MARKET FORCES OF SUPPLY AND DEMAND 10 Summary: Variables that Influence Sellers VariableA change in this variable… Price…causes a movement along the S curve Input Prices…shifts the S curve Technology…shifts the S curve # of Sellers…shifts the S curve Expectations…shifts the S curve

A C T I V E L E A R N I N G 2 Supply Curve 11 Draw a supply curve for tax return preparation software. What happens to it in each of the following scenarios? A. Retailers cut the price of the software. B. A technological advance allows the software to be produced at lower cost. C. Professional tax return preparers raise the price of the services they provide.

THE MARKET FORCES OF SUPPLY AND DEMAND 12 P Q Supply and Demand Together D S Equilibrium: P has reached the level where quantity supplied equals quantity demanded

THE MARKET FORCES OF SUPPLY AND DEMAND 13 P Q D S Surplus (a.k.a. excess supply): when quantity supplied is greater than quantity demanded Surplus Example: If P = $5, then Q D = 9 lattes and Q S = 25 lattes resulting in a surplus of 16 lattes

THE MARKET FORCES OF SUPPLY AND DEMAND 14 P Q D S Surplus (a.k.a. excess supply): when quantity supplied is greater than quantity demanded Facing a surplus, sellers try to increase sales by cutting price. This causes Q D to rise Surplus …which reduces the surplus. and Q S to fall…

THE MARKET FORCES OF SUPPLY AND DEMAND 15 P Q D S Surplus (a.k.a. excess supply): when quantity supplied is greater than quantity demanded Facing a surplus, sellers try to increase sales by cutting price. This causes Q D to rise and Q S to fall. Surplus Prices continue to fall until market reaches equilibrium.

THE MARKET FORCES OF SUPPLY AND DEMAND 16 STEP 1: S curve shifts because event affects cost of production. D curve does not shift, because production technology is not one of the factors that affect demand. STEP 2: S shifts right because event reduces cost, makes production more profitable at any given price. EXAMPLE 2: A Shift in Supply P Q D1D1 S1S1 P1P1 Q1Q1 S2S2 P2P2 Q2Q2 EVENT: New technology reduces cost of producing hybrid cars. STEP 3: The shift causes price to fall and quantity to rise.

THE MARKET FORCES OF SUPPLY AND DEMAND 17 EXAMPLE 3: A Shift in Both Supply and Demand P Q D1D1 S1S1 P1P1 Q1Q1 S2S2 D2D2 P2P2 Q2Q2 EVENTS: price of gas rises AND new technology reduces production costs STEP 1: Both curves shift. STEP 2: Both shift to the right. STEP 3: Q rises, but effect on P is ambiguous: If demand increases more than supply, P rises.

18 EXAMPLE 3: A Shift in Both Supply and Demand STEP 3, cont. P Q D1D1 S1S1 P1P1 Q1Q1 S2S2 D2D2 P2P2 Q2Q2 EVENTS: price of gas rises AND new technology reduces production costs But if supply increases more than demand, P falls.

19 Elasticity  Basic idea: Elasticity measures how much one variable responds to changes in another variable.  One type of elasticity measures how much demand for your websites will fall if you raise your price.  Price elasticity of demand measures how much Q d responds to a change in P.  Price elasticity of supply measures how much Q s responds to a change in P.

20 Price Elasticity of Demand Price elasticity of demand equals P Q D Q2Q2 P2P2 P1P1 Q1Q1 P rises by 10% Q falls by 15% 15% 10% = 1.5 Price elasticity of demand = Percentage change in Q d Percentage change in P Example:

21 The Determinants of Price Elasticity: A Summary The price elasticity of demand depends on:  the extent to which close substitutes are available  whether the good is a necessity or a luxury  how broadly or narrowly the good is defined  the time horizon – elasticity is higher in the long run than the short run The price elasticity of demand depends on:  the extent to which close substitutes are available  whether the good is a necessity or a luxury  how broadly or narrowly the good is defined  the time horizon – elasticity is higher in the long run than the short run

ELASTICITY AND ITS APPLICATION 22 Q2Q2 Price Elasticity of Supply Price elasticity of supply equals P Q S P2P2 Q1Q1 P1P1 P rises by 8% Q rises by 16% 16% 8% = 2.0 Price elasticity of supply = Percentage change in Q s Percentage change in P Example:

ELASTICITY AND ITS APPLICATION 23 The Determinants of Supply Elasticity  The more easily sellers can change the quantity they produce, the greater the price elasticity of supply.  Example: Supply of beachfront property is harder to vary and thus less elastic than supply of new cars.  For many goods, price elasticity of supply is greater in the long run than in the short run, because firms can build new factories, or new firms may be able to enter the market.

24 The Variety of Curves  The price elasticity of demand/supply is closely related to the slope of the demand/supply curve.  Rule of thumb: The flatter the curve, the bigger the elasticity. The steeper the curve, the smaller the elasticity.

25 APPLICATION: Does Drug Interdiction Increase or Decrease Drug-Related Crime?  One side effect of illegal drug use is crime: Users often turn to crime to finance their habit.  We examine two policies designed to reduce illegal drug use and see what effects they have on drug-related crime.  For simplicity, we assume the total dollar value of drug-related crime equals total expenditure on drugs.  Demand for illegal drugs is inelastic, due to addiction issues.

ELASTICITY AND ITS APPLICATION 26 D1D1 Policy 1: Interdiction Price of Drugs Quantity of Drugs S1S1 S2S2 P1P1 Q1Q1 P2P2 Q2Q2 Interdiction reduces the supply of drugs. Since demand for drugs is inelastic, P rises propor- tionally more than Q falls. Result: an increase in total spending on drugs, and in drug-related crime new value of drug- related crime initial value of drug-related crime

27 Policy 2: Education Price of Drugs Quantity of Drugs D1D1 S P1P1 Q1Q1 D2D2 P2P2 Q2Q2 Education reduces the demand for drugs. P and Q fall. Result: A decrease in total spending on drugs, and in drug-related crime. initial value of drug-related crime new value of drug- related crime