# Copyright 2012 Worth Publishers

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Copyright 2012 Worth Publishers
Supply and Demand Copyright 2012 Worth Publishers

Total consumer surplus Total producer surplus Normal good
Demand curve Supply curve Quantity demanded Quantity supplied Consumer surplus Producer surplus Total consumer surplus Total producer surplus Normal good Inferior good For applications, click here Substitutes Complements Inside and Outside the Classroom Activities The best way for students to get comfortable with shifting supply and demand curves is to practice. Once your lecture is over, spend some time asking them to shift supply and demand curves in their notebooks in response to situations you present them with. Here are some examples to get you started: What would happen (or did happen): To the demand for Cleveland Cavaliers tickets if LeBron James was traded To the supply of houses if lumber became more expensive To the demand for televisions if computers broadcast more video of live events To the demand for CD players when iTunes was released To the supply of sneakers if companies had to hire more expensive U.S. labor instead of less expensive foreign labor To the supply of automobiles if the government subsidizes production To the demand for Celtics merchandise after they won the NBA finals To the supply of automobiles if GM goes out of business To the demand for McDonald’s hamburgers if a Wendy’s opens up next door To the supply of new flat screen televisions if the economy is expected to be in a prolonged recession. To Try it! questions

Demand Demand represents the behavior of buyers.
A Demand Curve shows the quantity demanded at different prices. The Quantity Demanded: the quantity that buyers are willing (and able) to purchase at a particular price.

Law of Demand Price and Quantity Demanded are negatively related

The Demand Curve for Oil
Price of Oil per Barrel Quantity of Oil (MBD) Demand Price Quantity Demanded \$55 5 \$20 25 \$5 50 \$55 5 \$20 25 \$5 50

Reading Demand Curves Demand curves can be read in two ways:
Horizontally: How much buyers are willing and able to purchase at a certain price. Vertically: The highest price buyers are willing to pay for a certain quantity.

Intuition of the Demand Curve
When the price is high, oil will only be used in the high value products. If the price falls, oil will also be used in lower value products. Price of Oil per Barrel Higher Valued Uses of Oil Lower Valued Uses of Oil \$120 20 \$20 120 Demand Quantity of Oil (MBD)

Consumer Surplus Consumer Surplus is the consumer’s gain from exchange, the difference between the highest price a consumer will pay at a given quantity and the actual market price. Total consumer surplus is the sum of consumer surplus of all buyers.

Your roommate just bought an iPad for \$600
Your roommate just bought an iPad for \$600. She would have been willing to pay \$1,000 for a machine that could make her life so much more worthwhile. How much consumer surplus does your roommate enjoy from the iPad? \$600 \$400 \$1600 \$1400 To next Try it!

Consumer Surplus Price of Oil per Barrel Quantity of Oil (MBD)
Consumer Surplus is the Area beneath the Demand Curve and above the Price Total Consumer Surplus at a Price of \$20 ½(80-20)x90 = \$2,700 Area of Triangle Height Base ½(Base x Height) 80 20 90 Joe’s Consumer Surplus The President’s Consumer Surplus Demand Teaching Tip:You can easily personalize consumer surplus. Look for a student with a Coke, coffee, or water. Ask them how much they paid for it. Then ask if that was the maximum they would have paid or if the store had been charging a little more would they still have bought it. They likely will admit they still would have bought it.Then ask what is the maximum price they would have paid before walking away without buying. Calculate their consumer surplus from the transaction and relate this to how it would be measured on a demand diagram.

If the price is \$2010, what is the consumer surplus? \$3,588,000
\$1,794,000 \$6,000,000 \$3,000,000 To next Try it!

What Shifts the Demand Curve?
An “increase in demand” means that consumers buy more at every price level, (or consumers are willing to pay more for each quantity.) On the graph: the demand curve shifts outwards, up, and to the right.

What Shifts the Demand Curve?
A “decrease in demand” means that consumers buy less at every price level, (or they reduce the price they’re willing to pay for a given quantity.) On the graph: the demand curve shifts inwards, down, and to the left.

A Decrease in Demand Price per Unit Quantity \$50 80 \$25 70
Old Demand Curve \$25 70 Lower Willingness to Pay for the Same Quantity Less Quantity Demanded at the Same Price New Demand Curve

An Increase in Demand Price per Unit Quantity
Greater Quantity Demanded at the Same Price Greater Willingness to Pay for the Same Quantity \$50 \$25 New Demand Curve Old Demand Curve 70 80

Important Demand Shifters:
Income Population Price of Substitutes Price of Complements Expectations Tastes

Important Demand Shifters: Income
The effect of changes in income on demand depends on the nature of the good in question. A Normal Good: demand increases when income increases (and vice versa). An Inferior Good: demand decreases when income increases (and vice versa) Teaching Tip: Ask the students what things they currently purchase but plan to stop buying once they graduate and get a full-time job. You’re likely to get lots of examples of inferior goods.

increases; increases; increases increases; increases; decreases
When the price of petroleum goes up, the demand for natural gas ______, the demand for coal ______, and the demand for solar power ______. increases; increases; increases increases; increases; decreases decreases; decreases; increases decreases; decreases; decreases To next Try it!

Important Demand Shifters: Population
As the population of an economy changes, the # of buyers of a particular good also changes, (thereby changing its demand.) What happens to the demand for diapers in Russia as birth rates drop?

Important Demand Shifters: Price of Substitutes
Two goods are Substitutes if a decrease in the price of one leads to a decrease in demand for the other (or vice versa). - What happens to the demand for travel in Hawaii if the (perceived) safety cost of traveling to Mexico increases?

Important Demand Shifters: Price of Complements
Two goods are Complements if a decrease in the price of one good leads to an increase in the demand for the other (or vice versa). What happens to the demand for Sport Utility Vehicles when gasoline gets more expensive? Teaching Tip: Demand shifts for complements and substitutes are often a subject that students believe they understand while you are demonstrating examples, but then struggle with when they have to solve problems for themselves.After covering complements and substitutes in class it’s often a good idea to pose a couple of questions to students and ask them to draw the demand shifts in their own notes. Give them a few questions and a few minutes to solve them. Then go over the answers. It’s an easy way for students to get immediate feedback on whether they’ve really understood what you were teaching or whether they were just following along.

Price of Complements Consumers often have to buy goods together. An increase in price of gasoline will decrease the demand for SUVs

Important Demand Shifters: Expectations

Important Demand Shifters: Tastes
Tastes and preferences are subjective and will vary among consumers. Seasonal changes or fads have predictable effects on demand. What happens to demand for boots in October? To carbohydrates during the Atkins diet fad? Or to Acai berries after newly perceived health benefits? Instructor Notes: There are tons of examples here, and students may need a few to get the hang of it. The Atkins diet craze influenced the types of food people ate. Consumers switched away from carbohydrates and started eating more red meat. Of course, when Dr. Atkins passed from a heart attack, dieters began to rethink their food choices and started consuming less red meat. Advertising tries to influence tastes and preferences. Students will easily recognize this. A good exercise would be to talk about both good and bad television commercials.

What Shifts the Demand Curve?
A “change in quantity demanded” is NOT the same as a “change in demand.” “Quantity demanded” changes only when the price of a good changes. It is a movement along a fixed demand curve. “Demand” changes only when a non-price factor (demand shifter) changes. It is a shift in the entire demand curve. Students have a real problem with this distinction. It is important to stress that the two changes are caused by different things and have different effects on the model. When supply and demand are brought together in Chapter 3, students might understand this better. That is, they will recognize that that a change in supply causes price to change which in turn causes quantity demanded to change. It is tempting to try to bring in that logic here, but it is recommended to wait until that chapter. A “change in Quantity Demanded” A “change in Demand”

When the price of a good increases the quantity demanded ______
When the price of a good increases the quantity demanded ______. When the price of a good decreases the quantity demanded ______. rises; rises rises; falls falls; rises falls; falls To next Try it!

What made this oil field happen?
Supply What made this oil field happen?

Supply Supply represents the behavior of sellers.
A Supply Curve shows the quantity supplied at different prices. The Quantity Supplied is the quantity that producers are willing and able to sell at a particular price.

The Supply Curve for Oil
Quantity of Oil (MBD) Price of Oil per Barrel The Supply Curve for Oil Supply Curve for Oil 50 30 10 \$5 \$20 \$55 Price Quantity Supplied

Reading Supply Curves Supply curves can be read in two ways:
Horizontally: How much suppliers are willing and able to sell at a certain price. Vertically: The minimum price for which suppliers are willing to sell a certain quantity.

Supply Curves Why is the supply curve upward sloping?
The cost of producing a good is not equal across all suppliers. At a low price, a good is produced and sold only by the lowest cost suppliers. At a high price, a good is also produced and sold by higher cost suppliers. Instructor Notes:

The Supply Curve for Oil
Quantity of Oil (MBD) Price of Oil per Barrel 60 40 20 \$60 \$40 \$20 80 100 The Supply Curve for Oil Supply Oil Shale Profitable Here Higher Cost Oil The Supply Curve for Oil As the price of oil rises, it becomes profitable to extract oil from more costly sources. Thus, as the price of oil rises the quantity of oil supplied increases. Low Cost Oil: Saudi Arabia High Cost Oil: Oil Shale Low cost oil producers in Saudi Arabia are willing to sell their oil at low prices while high cost U.S. oil producers require a higher price to sell their oil. Low Cost Oil

Furthermore… Does sex have a “price?” See this blog post for a discussion about changes in supply and demand for sex.

Producer Surplus Producer Surplus is the producer’s gain from exchange
the difference between the market price and the minimum price at which producers would be willing to sell a certain quantity. Total producer surplus is the sum of the producer surplus of each seller. Graphically, total producer surplus is measured by the area above the supply curve and below the price. A simple lemonade stand may be a good example here. Imagine neighborhood children and their lemonade stand. It only costs them 5 cents to make a cup of lemonade, but they receive a quarter for each cup. They have gained 20 cents from the trade. That is their producer surplus.

Producer Surplus \$40 \$20 \$60 60 40 Supply Curve 20 80
Producer Surplus is the Area Above the Supply Curve and Below the Price Quantity of Oil (MBD) Price of Oil per Barrel \$40 \$20 \$60 60 40 Supply Curve 20 80 Total Producer Surplus at a Price of \$40 Producer Surplus Is the Area above the Supply Curve and below the Price Total producer surplus is the sum of the producer surplus of each seller, the area above the supply curve and below the price.

Using the following diagram, calculate total producer surplus if the price of oil is \$50 per barrel.
\$45 \$1,350 \$2,700 To next Try it!

Lower Costs Increase Supply
Change in Supply Lower Costs Increase Supply Quantity of Oil (MBD) Price of Oil per Barrel Old Supply \$50 20 Greater Quantity Supplied at the Same Price New Supply \$10 Instructor Notes: Figure 2.11: Shifting the Supply Curve (A) A decrease in costs shifts the supply curve down and to the right. Willing to Sell Same Quantity at Lower Prices 80

Higher Costs Decrease Supply
Change in Supply New Supply Higher Costs Decrease Supply Quantity of Oil (MBD) Price of Oil per Barrel Old Supply 20 Smaller Quantity Supplied at the Same Price \$10 Higher Price Needed to Sell Same Quantity Instructor Notes: Figure 2.11: Shifting the Supply Curve (A) A decrease in costs shifts the supply curve down and to the right. 80

Important Supply Shifters
Technological Innovations Input Prices Taxes and Subsidies Expectations Entry or Exit of Producers Changes in Opportunity Costs Instructor Notes:

Important Supply Shifters: Technological Innovations
A technological innovation makes sellers willing to offer more at a given price, or sell a their quantity at a lower price. A technological innovation lowers costs and increases supply. Instructor Notes: There are lots of examples here. The main point is the connection between technology and costs. From The Western Farm Press, “New Module-Building Cotton Picker Unveiled” November 4, 2006: “… “The Case IH Module Express design started as a collaboration with growers and ginners — a lot of people in the industry have contributed to the development of this machine,” he [Trent A. Haggard] said. “We've changed for the better the way cotton will be handled from picker to gin.” The biggest change — aside from becoming accustomed to the sight of a 16-foot-long “half” module coming out of the back of the picker — is in the number of people involved in the harvesting. “The first question I'm always asked is, ‘Can I get rid of my boll buggy and separate module builder?’” says Haggard. “With the Module Express 625 picker, it's one man, one machine for cotton harvest and module building, so you reduce your equipment and labor investment dramatically.” How much you save depends on your operation. [Jimmy] Hargett has said he believes you can save 10 to 12 workers in a typical harvesting operation. When he was testing two Module Express 625 pickers in 2005, he did it with five workers — two picker operators, two men in a truck putting tarps on the modules and one man driving a tractor with a Bush Hog. Hargett ran four of the new pickers in 2006. If you operate 12 pickers, 12 boll buggies and 12 module builders as Kenneth Hood and his brothers, Howard, Curtis and Cary have done in the past, “then you've just reduced your work force by 24 men,” says Kenneth. “Not only do you save money, but it's difficult to find those extra 24 people in our area these days.” Producers may also gain efficiency from other sources, according to Haggard. The Module Express 625 picks at about the same pace as a traditional six-row picker, but it builds the module at the same time it's picking. It also takes less time to unload a 10,000-pound module than to empty 10,000 pounds of cotton from a conventional basket.”

Production Technology
Supply will increase for products when technology improves Examples: Computers, gaming systems, laser hair removal, flat screen TVs.

Important Supply Shifters: Input Prices
A decrease in the price of an input (all else equal) increases profits and encourages more supply (and vice versa) What will happen to the amount of new businesses if the government reduces the fees and red tape associated with new business licenses? What happens if the fees rise? It is important for students to note that producers of finished goods are demanders for inputs used to make those finished goods. It might be a good idea to pick a product that students are familiar with, say a car or a truck, and ask them what is used in its production. Students should see pretty quickly that the prices of these inputs affect the cost of producing the finished and good and ultimately the supply.

Important Supply Shifters: Taxes and Subsidies
A tax on output reduces profit and makes sellers less willing to supply at a given price, unless they can effectively raise the price without losing any sales. (for now, assume they cannot) A tax on output raises costs and decreases supply. Graph the effect on supply of a new cigarette tax in your notes. Instructor Notes: Governments often place taxes on business to raise revenue for spending projects. From the 2007 Montana Tax Code: “ License tax on producers of gypsum and cement. Every person engaged in or carrying on the business in the state of producing or manufacturing cement, gypsum, gypsum plaster, stucco, wallboard, land plaster, or other products of cement or gypsum must pay to the department of revenue for the use of the state a license tax for engaging in and carrying on such business in the state in an amount equal to the following sums:      (1) for each ton of cement produced or manufactured by such person or used by such person in the manufacture or production of any of the articles or products hereinabove enumerated, 22 cents;      (2) for each ton of gypsum produced or manufactured by such person or used by such person in the manufacture or production of any of the articles or products hereinabove named, 5 cents.” These numbers may seem small, but they add up and represent a direct cost to the firm. Governments often give subsidies to producers to make them more competitive with cheaper foreign producers. From The Independent, January 7, 2007: “Producers of one of the most expensive foods on earth, the truffle, are campaigning for a European Union subsidy. French truffles are fetching up to €800 a killogram - or £260 a pound - this winter in village markets in the south of France. Producers have asked the European Commission to give them a subsidy to plant more "truffle trees" - the varieties of oak that promote the growth of the much-prized underground fungi, which are sniffed out by dogs and pigs. … Only about 20 tons are expected to come to market in the south of France this winter. If nothing is done, the truffle producers say, the European market will be overwhelmed by an influx of cheaper, and less powerfully tasting, Chinese truffles.”

Important Supply Shifters: Taxes and Subsidies
A subsidy on production makes sellers willing to supply a greater quantity at a given price, or the subsidy allows producers to sell a given quantity at a lower price. A subsidy on production lowers costs and increases supply. Graph the effect on supply of a new subsidy to fast food producers aimed at helping them market and sell overseas.

Taxes and Subsidies Seems like a good thing to tax…. Or not: The Omnibus Budget Reconciliation Act of 1990 applied a 10% federal luxury tax to the retail sale of luxury goods such as pleasure boats with a sales price above the \$100,000. Expected tax revenue? \$9 billion. Reality? Sales of boats down 52.7%; Net loss of 30,000 jobs; The federal government paid out > \$7 million more in unemployment benefits to those workers than it collected in luxury tax revenues. The federal luxury tax was repealed in 1993. Estimates from the Marine Retailers Association of America and The CPA Journal “Luxury Tax” by Elda DiRe, October 1991. Taxes and subsidies affect profits and therefore supply. A 10% yacht tax reduced the supply of yachts 53% in the early 1990s.

Cotton Supply When the U.S. decreases its cotton subsidies, U.S. cotton supply decreases

Important Supply Shifters: Taxes and Subsidies
Quantity of Oil (MBD) Price of Oil per Barrel With a \$10 Tax Suppliers Require a \$10 Higher Price to Sell the Same Quantity \$10 Supply With \$10 Tax \$50 Supply Without Tax \$40 60 Instructor Notes: Figure 2.12: A Tax on Industry Output Shifts the Supply Curve Up by the Amount of the Tax When suppliers pay no tax, they are willing to supply 60 MBD of oil for a price of \$40 per barrel. If they must pay a tax of \$10 per barrel, they will be willing to supply 60 MBD for \$10 more, or \$50 a barrel. Thus a tax shifts the supply curve up by the amount of the tax. A subsidy to suppliers would have the opposite effect and would shift the supply curve down by the amount of the subsidy.

Important Supply Shifters: Expectations
The expectation of a higher price for a good in the future decreases current supply of the good – if they can store the good- (and vice versa). Sellers will adjust their current offerings in anticipation of the direction of future prices in order to obtain the highest possible price. Instructor Notes: Like on the demand side, this one often gives students some trouble (probably more so). It is important to stress that this price-supply relationship is at different points in time. Sellers will accelerate current production for sale if they think prices will fall in the future and will delay current production if they think prices will rise in the future. From The Wall Street Journal, “We Can Lower Oil Prices Now” by Martin Feldstein, July 1, 2008: “… Unlike perishable agricultural products, oil can be stored in the ground. So when will an owner of oil reduce production or increase inventories instead of selling his oil and converting the proceeds into investible cash? A simplified answer is that he will keep the oil in the ground if its price is expected to rise faster than the interest rate that could be earned on the money obtained from selling the oil. The actual price of oil may rise faster or slower than is expected, but the decision to sell (or hold) the oil depends on the expected price rise.”

Future Expectations A change in producers’ expectations about profitability will affect supply curves Windmill production increases as producers expect sales and profitability to increase.

Important Supply Shifters: Expectations
Expectations Can Shift the Supply Curve Quantity Price per Unit Supply Today with Expectation of Future Price Increase Into Storage Supply Today Instructor Notes Figure 2.13: Expectations Can Shifts the Supply Curve If sellers expect a higher price in the future, today’s supply curve will shift to the left as producers store some of the good for future sales.

Important Supply Shifters: Entry or Exit of Producers
As producers enter and exit the market, the overall supply changes. Entry implies more sellers in the market increasing supply. Exit implies fewer sellers in the market decreasing supply. What will happen to the supply for Marijuana in California if the drug is legalized for general use? Instructor Notes:

Number of Producers As more producers enter a market, supply increases (and vice versa) As more firms enter the solar installation market, the number of solar installations available for sale increases

Important Supply Shifters: Entry or Exit of Producers
Price Quantity Entry Increases Supply Greater Quantity Supplied at the Same Price Lower Price for the Same Quantity Supplied Domestic Supply Domestic Supply Plus Canadian Imports Instructor Notes: Figure 2.14: Entry Increases Supply The entry of lower-cost producers increases supply, thus shifting the supply curve to the right and down. Passage of the North American Free Trade Agreement (NAFTA) in 1992 allowed the free flow of Canadian lumber into the U.S. market thereby increasing the number of sellers and the supply of lumber in the U.S. Restrictions on foreign competitors within the domestic market place would decrease the number of sellers and, thus, the market supply.

Important Supply Shifters: Changes in Opportunity Costs
Inputs used in production have opportunity costs. Sellers will choose to use those inputs where the profit is the highest Sellers will supply less of a good if the price of an alternate good using the same inputs rises (and vice versa). Sellers always chase the highest profit goods. Instructor Notes: Students will have a good bit of difficulty grasping this one. Remind them that all activities involve an opportunity cost. From the Associated Press, August : “Last year, high corn prices helped fuel a switch from cotton acreage in Louisiana. This year, high soybean and rice prices “contributed to the all-time low in cotton acreage planted in the state,” said Nathan Crisp, director of Louisiana’s branch of the National Agricultural Statistics Service.”

Changes in Opportunity Costs
Producers have the ability to produce other goods An increase in the profitability of small cars will decrease the supply of SUVs 3- 58

Important Supply Shifters: Changes in Opportunity Costs
Higher (Opportunity) Costs Reduce Supply- Rising Wheat Prices Reduce Soybean Supply Quantity of Soybeans (Millions of Bushels) Price per Unit Smaller Quantity Supplied at the Same Price Higher Price Required to Sell the Same Quantity 2,000 \$7 Supply with High Opportunity Costs \$5 Supply with Low Opportunity Costs 2,800 Instructor Notes: Figure 2.15: Higher (Opportunity) Costs Reduce Supply An increase in the price of wheat increases the opportunity cost of growing soybeans, which shifts the supply curve of soybeans up and to the left.

What Shifts the Supply Curve?
A “change in quantity supplied” is NOT the same as a “change in supply.” “Quantity supplied” changes only when the price of a good changes. It is a movement along a fixed supply curve. “Supply” changes only when a non-price factor changes. It is a shift in the entire supply curve. Instructor Notes: Students have a real problem with this distinction. It is important to stress that the two changes are caused by different things and have different effects on the model. When supply and demand are brought together in Chapter 3, students might understand this better. That is, they will recognize that that a change in demand causes price to change which in turn causes quantity supplied to change. It is tempting to try to bring in that logic here, but it is recommended to wait until that chapter. A “change in Quantity Supplied” A “change in Supply”

Market Price of Marijuana
Explain using the concepts of supply, demand, and transport costs (including in this case smuggling costs) the pattern of prices you see here

The market price of the product is \$20 per unit
The market price of the product is \$20 per unit. Calculate the dollar amount of consumer surplus being earned in this market. \$120,000 \$60,000 \$100,000 \$80,000 Back to