Chapter 3 Supply and Demand ECONOMICS: Principles and Applications, 4e HALL & LIEBERMAN, © 2008 Thomson South-Western

2 Markets Market –A group of buyers and sellers with the potential to trade with each other –Can be defined broadly or narrowly Macroeconomics Microeconomics The economy –A collection of individual markets

3 Markets Macroeconomic Markets –All capital goods - one market –All consumer goods - “consumption goods” –Overall view of the economy Microeconomic Markets –Narrowly defined –Models - specific commodities

4 Product and Resource Markets Product market –Goods and services –Firms – suppliers –Households – buyers Resource market –Resources –Firms – buyers –Households – suppliers

5 Product and Resource Markets Figure 1 The Circular Flow Model Flow of goods and resources Resource market - Households sell resources - Firms buy resources to produce goods and services Product Market - Firms sell goods and services to households Money flows - Firms – pay the resource owners - Households – receive income for resources (to buy goods and services )

6 Competition in Markets Imperfectly competitive markets –Buyers/sellers can influence the price –A few large buyers or sellers –Product differentiation Perfectly competitive markets (or just competitive markets) –Buyers/sellers take the market price –Many small buyers and sellers –Standardized product

7 Using Supply and Demand Supply and demand model –Designed to explain how prices are determined in perfectly competitive markets Perfect competition –Rare in the real world –Many markets are close to perfect competition To analyze a market, we need both, Supply and Demand

8 Demand – Quantity Demanded Quantity demanded amount of a good all buyers in a market would choose to buy during a period of time given their constraints –Implies a Choice Households choose to buy – considering the opportunity cost of their decisions

9 Demand – Quantity Demanded Quantity demanded –Is Hypothetical quantity the households are able to purchase given the price real-world constraints –Depends on Price assume other things constant explore the relationship between price and quantity demanded

10 The Law of Demand When the price of a good rises and everything else remains the same, the quantity of the good demanded will fall Ceteris paribus assumption many variables change simultaneously understand each variable separately –we assume “everything else remains the same” understand how demand reacts to price

11 Demand Schedule and Demand Curve Demand schedule –list of different quantities demanded at different prices, ceteris paribus Demand curve –relationship between the price of a good and the quantity demanded, ceteris paribus

12 The Demand Curve Each point on the demand curve –total quantity that buyers would choose to buy at a specific price Graphical depiction of a demand schedule Slopes downward –Law of Demand

13 The Demand Curve Number of Bottles per Month Price per Bottle A B $ D 40,00060,000 Figure 2 The Demand Curve – movement along the demand curve When the price is $4.00 per bottle, 40,000 bottles are demanded At $2.00 per bottle, 60,000 bottles are demanded

14 Movements Along the Demand Curve a change in the price of a good causes a movement along the demand curve, ceteris paribus. In Figure 2 –a fall in price - move rightward along the demand curve (from A to B) –a rise in price - move leftward along the demand curve (from B to A).

15 Shifts of the Demand Curve a change in any variable that affects demand—except for the good’s price— causes the demand curve to shift. –An increase in quantity at any price The demand curve shifts rightward (increase in demand) –A decrease in quantity at any price The demand curve shifts leftward (decrease in demand)

16 The Demand Curve BC $ ,00080,000 D1D1 D2D2 Number of Bottles per Month Price per Bottle Figure 3 A Shift of the Demand Curve An increase in income shifts the demand curve for maple syrup from D1 to D2 At each price, more bottles are demanded after the shift

17 Change in Quantity Demanded “Quantity demanded” –A particular amount buyers would choose to buy at a specific price –One point on a demand curve Change in quantity demanded –A movement along a demand curve in response to a change in price

18 Change in Demand “Demand” –Relationship between price and quantity demanded –Represented by the entire demand curve Change in demand –Shift of the demand curve –From changes in something other than price

19 Factors that Shift the Demand Curve 1.Income –Normal Good People demand more as the income rises –Inferior Good People demand less as the income rises A rise in income will –increase the demand for a normal good –decrease the demand for an inferior good

20 Factors that Shift the Demand Curve 2.Wealth –Total value of everything you own minus the total dollar amount you owe –Measured at a point in time An increase in wealth will –increase demand (shift rightward) for a normal good –decrease demand (shift leftward) for an inferior good

21 Factors that Shift the Demand Curve 3.Prices of Related Goods Substitutes –can be used in place of some other good –fulfills more or less the same purpose A rise in the price of a substitute will: –increase the demand for a good (shift the demand curve to the right)

22 Factors that Shift the Demand Curve 3.Prices of Related Goods Complements –used together with the good we are interested in A rise in the price of a complement will –decrease the demand for a good (shifts the demand curve to the left)

23 Factors that Shift the Demand Curve 4.Population –An increase in population will increase the number of buyers increase the demand (rightward shift) 5.Expected Price –An expected rise in price shifts the demand curve rightward (increase) –An expected fall in price shifts the demand curve leftward (decrease)

24 Factors that Shift the Demand Curve 6.Tastes/Preferences –tastes change toward a good demand increases (demand curve shifts right) –tastes change away from a good demand decreases (demand curve shifts left)

25 The Demand Curve Figure 4 The Demand Curve – A summary Q P P1P1 A B P2P2 Q1Q1 Q2Q2 Q P P2P2 B A P1P1 Q2Q2 Q1Q1 a)Price ↓ Move rightward along the demand curve b)Price ↑ Move leftward along the demand curve D D

26 The Demand Curve Figure 4 The Demand Curve – A summary Q P Income or wealth ↑ Price of substitute↑ Price of complement ↓ Population ↑ Expected price ↑ Tastes shift toward good D1D1 D2D2 c)The Demand curve shifts rightward

27 The Demand Curve Figure 4 The Demand Curve – A summary Q P d)The Demand curve shifts leftward D2D2 D1D1 Income or wealth ↓ Price of substitute ↓ Price of complement ↑ Population ↓ Expected price ↓ Tastes shift away from good

28 Supply – Quantity Supplied Quantity supplied number of units of a good all sellers in the market would choose to sell over some time period given their constraints –Implies a choice the quantity that firms choose to sell maximizing profit given their constraints

29 Supply – Quantity Supplied Quantity supplied –Is Hypothetical quantity firms would sell given the price of the good and all other constraints –Depends on the price assume other things constant explore the relationship between price and quantity supplied

30 The Law of Supply When the price of a good rises, and everything else remains the same, the quantity of the good supplied will rise Ceteris paribus assumption many variables change simultaneously we must understand each variable separately –we assume “everything else remains the same” understand how supply reacts to price

31 Supply Schedule and Supply Curve Supply schedule list of different quantities supplied at different prices, ceteris paribus Supply curve –relationship between the price of a good and the quantity supplied, with all other variables held constant –Each point on the curve total quantity that sellers would choose to sell at a specific price –Slopes upward - Law of Supply

32 The Supply Curve F G 2.00 S 40,00060,000 $4.00 Number of Bottles per Month Price per Bottle Figure 5 The Supply Curve – movement along the supply curve When the price is $2.00 per bottle, 40,000 bottles are supplied At $4.00 per bottle, quantity supplied is 60,000 bottles

33 Movements Along the Supply Curve a change in the price of a good causes a movement along the supply curve, ceteris paribus In Figure 5 –a rise in price - move rightward along the demand curve (from F to G) –a fall in price - move leftward along the demand curve (from G to F)

34 Shifts of the Supply Curve a change in any variable that affects supply—except for the good’s price— causes the supply curve to shift. –Sell a greater quantity at any price The supply curve shifts rightward (increase in supply) –Sell a smaller quantity at any price The supply curve shifts leftward (decrease in supply)

35 Shifts of the Supply Curve S2S2 G J S1S1 60,000 $ ,000 Number of Bottles per Month Price per Bottle Figure 6 A Shift of the Supply Curve A decrease in transportation costs shifts the supply curve for maple syrup from S 1 to S 2. At each price, more bottles are supplied after the shift.

36 Factors that Shift the Supply Curve 1.Input Prices –A fall in the price of an input lower cost of production increase in supply (rightward shift) 2.Price of Alternatives –Other goods that a firm could produce –A rise in the price for an alternative decrease in supply (leftward shift)

37 Factors that Shift the Supply Curve 3.Technology –technological advances increase the supply of a good 4.Number of Firms –An increase in the number of sellers increase supply 5.Expected price –An expected rise in price decrease the current supply (leftward shift)

38 Factors that Shift the Supply Curve 6.Changes in Weather/Other Natural Events –Favorable weather increases crop yields increases the supply (rightward shift) –Unfavorable weather destroys crops, shrinks yields, decreases the supply (leftward shift)

39 The Supply Curve Figure 7 The Supply Curve – A summary Q P P1P1 A B P2P2 Q1Q1 Q2Q2 Q P P2P2 B A P1P1 Q2Q2 Q1Q1 a)Price ↓ Move leftward along the supply curve b)Price ↑ Move rightward along the supply curve SS

40 The Supply Curve Figure 7 The Supply Curve – A summary c)The Supply curve shifts rightward Q PS1S1 S2S2 Price of input ↓ Price of alternatives ↓ Number of firms ↑ Expected price ↓ Technological advance Favorable weather

41 The Supply Curve Figure 7 The Supply Curve – A summary d) The Supply curve shifts leftward Q P S2S2 S1S1 Price of input ↑ Price of alternatives ↑ Number of firms ↓ Expected price ↑ Unfavorable weather

42 Supply and Demand Equilibrium –both P and Q have settled into a state of rest Equilibrium price and quantity –once achieved - remain constant –until either the demand curve or supply curve shifts

43 Excess Demand the amount by which quantity demanded exceeds quantity supplied - at a given price –Buyers compete with each other to get more of the good than is available –The price will rise –Equilibrium is reached

44 Excess Demand E H J 1.00 $3.00 D S 50,00075,00025,000 Number of Bottles per Month Price per Bottle Figure 8 Excess Demand Causes Price to Rise Excess Demand 1. At a price of $1.00 per Bottle, an excess demand of 50,000 bottles causes the price to rise shrinking the excess demand until price reaches its equilibrium value of $3.00

45 Excess Supply the amount by which quantity supplied exceeds quantity demanded - at a given price –Sellers compete with each other to sell more than buyers want –The price will fall –Equilibrium is reached

46 Excess Supply K L E 3.00 D S $ ,00035,00065,000 Excess Supply Number of Bottles per Month Price per Bottle Figure 9 Excess Supply Causes Price to Fall 1. At a price of $5.00 per bottle an excess supply of 30,000 bottles causes the price to drop… 3. shrinking the excess supply until price reaches its equilibrium value of $3.00

47 What Happens When Things Change Income rises normal good the demand increases (rightward shift of the demand curve) –Rightward movement along the supply curve –Equilibrium price rises –Equilibrium quantity rises

48 Income rises, causing an increase in D E E' 3.00 D1D1 D2D2 S $ ,00060,000 Number of Bottles of Maple Syrup per Period Price per Bottle Figure 10 A Shift in Demand and a New Equilibrium 1. An increase in demand moves us along the supply curve… 3. to a new equilibrium 4. equilibrium price increases 5. equilibrium quantity increases too

49 What Happens When Things Change An Ice Storm Hits –Weather changes will shift the supply curve decrease in supply (the supply curve shifts leftward) –Equilibrium price rises –Equilibrium quantity falls

50 Bad weather hits, decreasing the S E' E3.00 D $ ,00035,000 S2S2 S1S1 Number of Bottles Price per Bottle Figure 11 A Shift of Supply and a New Equilibrium

51 Both Curves Shift Just one curve shifts (D or S) –we can determine the direction that BOTH equilibrium price AND quantity will move Both curves shift (D and S) –we can determine the direction that EITHER equilibrium price OR equilibrium quantity will move –direction of the other – which curve shifts by more

52 Income rises and Bad weather hits E' E3.00 D1D1 $6.00 S2S2 S1S1 Number of Bottles Price per Bottle Figure 12 A Shift in Both Curves and a New Equilibrium D2D2

53 The Three Step Process Step 1—Characterize the Market markets - problem analyzed identify the decision makers Step 2—Find the Equilibrium conditions for equilibrium method - determine equilibrium Step 3—What Happens When Things Change how events/government polices change market equilibrium

54 Avian Flu in Early 2006 In Europe – people were buying substantially less chicken In the United States – people were buying more chicken Use the three step process

55 Avian Flu in Early 2006 Figure 13 The European Market for Chicken B A 0.14 D 2005 $0.42 Q1Q1 Q2Q2 S 2006 S 2005 Quantity of Chicken Price per pound D 2006

56 Avian Flu in Early 2006 Figure 14 The U.S. Market for Chicken B A 0.14 D 2006 $0.42 Q1Q1 Q2Q2 S 2005 S 2006 Quantity of Chicken Price per pound D 2005