1. McGraw-Hill/Irwin © 2009 The McGraw-Hill Companies, All Rights Reserved Lecture 3 Supply and Demand Required Text: Franks and Bernanke – Chapter 3

2. 3-2LO 3- All Learning Objectives: Understand how 1.Demand curves show buyers' market behaviors. 2.Supply curves show sellers' market behaviors. 3.Supply and demand determine equilibrium price and quantity. 4.Shifts in supply and demand change equilibrium outcomes. 5.The Efficiency Principle says growth makes it possible for each person to have more. 6.The Equilibrium Principle says market equilibrium leaves no unexploited opportunities for individuals.

3. 3-3LO 3- All What, How, and For Whom?  Every society answers three basic questions

4. 3-4LO 3 - All Central Planning v. Market Central Planning  Decisions by individuals or small groups  Agrarian societies  Government programs  Sets prices and goals for the group  Individual influence is limited The Market  Buyers and sellers signal wants and costs  Resources and goods are allocated accordingly  Interaction of supply and demand answer the three basic questions Mixed economies use both the market and central planning

5. 3-5LO 3- All Buyers and Sellers in the Market  Buyers and sellers have different motivations  Buyers want to benefit from consuming the good  Sellers want to make a profit  Market: people who buy and sell the good  Buyers and sellers jointly determine outcome  Market price balances two forces  Value buyers derive from the good  Cost to produce one more unit of the good

6. 3-6LO 3- All Law of Demand  When price of a good goes up, people buy less of that good  Leads to downward sloping demand curve Price ($/cup) Quantity Demanded (cups) 0.505 0.754 1.003 1.252 1.501

7. 3-7LO 3- All Demand versus Quantity Demanded  Quantity Demanded  Amount of a good consumed at a given price  Change in price means a change in quantity demanded  Movement along the demand curve  Demand  A family of numbers that lists the quantity demanded corresponding to each possible price  Demand Schedule  Demand Curve

8. 3-8LO 3- All Demand Schedule and Demand Curve  Demand Schedule - Refers to the demand table that shows quantity demanded at each price  Demand Curve - Graph illustrating demand - Graphical representation of the demand schedule  Price on the vertical axis  Quantity demanded on the horizontal axis

9. 3-9LO 3- All Changes in Demand  Price change does not lead to change in demand  Change in anything other than price lead to demand changes - Entire curve shifts  Income  Price of related goods  Substitutes  Complements  Taste  Sales Tax

10. 3-10LO 3- All Shift in Demand  Fall in Demand  Decision made by demanders to buy a smaller quantity at each given price  Leftward shift of demand curve  Rise in Demand  Decision made by demanders to a buy a larger quantity at each given price  Rightward shift of demand curve

11. 3-11LO 3- All Market (Aggregate) Demand  Aggregate quantity of a good demanded by all consumers in a community (market) at each given price  The aggregate or market demand is obtained by the horizontal summation of all individual consumer’s demand curves.  Similar to the individual demand curve - Slopes downward

12. 3-12LO 3- All Market (Aggregate) Demand  Suppose, there are 10,000 SB coffee consumers in Lubbock  Each individual consumer’s demand for SB coffee is the same Price ($/cup) Ind. Quantity (cups) Ag. Quantity (cups) 0.50550,000 0.75440,000 1.00330,000 1.25220,000 1.50110,000

13. 3-13LO 3 - 1 Market Demand  The quantity buyers would purchase at each possible price  Market Demand curve  Negative slope  Consumers buy less at higher prices  Consumers buy more at lower prices $4 $2 8 16 Q P D Demand for Pizzas (000s of slices/day)

14. 3-14LO 3 - 1 (Market) Demand Slopes Downward  Buyers value goods differently  Reservation price: the highest price an individual is willing to pay for a good  Market Demand reflects the entire market, not one consumer  Lower prices bring more buyers into the market  Lower prices cause existing buyers to buy more

15. 3-15LO 3 - 1 Income and Substitution Effects  Buyers buy more at lower prices and buy less at higher prices  What happens when price goes up?  The substitution effect: Buyers switch to substitutes when price goes up  The income effect: Buyers' overall purchasing power goes down  What happens when price goes down?  The substitution effect -  The income effect -

16. 3-16LO 3 - 1 Interpreting the (Market) Demand Curve  Horizontal interpretation of demand  Given price, how much will buyers buy? $4 $2 8 16 Q P D Demand for Pizzas (000s of slices/day)

17. 3-17LO 3 - 1 Interpreting the (Market) Demand Curve  Vertical interpretation of demand  Given the quantity to be bought, what will the price be? $4 $2 8 16 Q P D Demand for Pizzas (000s of slices/day)

18. 3-18LO 3- All Law of Supply  When the price of a good goes up, the quantity supplied goes up  Leads to a upward sloping supply curve Price ($)Quantity (cups) 0.250 0.50100 0.75200 1.00300 1.25400 1.50500

19. 3-19LO 3- All Supply versus Quantity Supplied  Quantity Supplied  Amount of a good that suppliers will provide at a given price  Changes if the price changes  Movement along the curve  Supply  Family of numbers giving the quantities supplied at each price  Change in anything other than price changes supply  Shifts the entire curve

20. 3-20LO 3- All Changes in Supply  Rise in Supply  Increase in quantities that supplier will provide at each price  Rightward shift of supply  Fall in Supply  Decrease in quantities that supplier will provide at each price  Leftward shift of supply

21. 3-21LO 3- All Changes in Supply  Price change does not lead to change in supply  Factors that lead to supply changes - Entire curve shifts  Production costs  Improvement in production technology  Change in the wage rate  Excise Tax

22. 3-22LO 3- All Market (Aggregate) Supply  Aggregate quantity of a good supplied by all producers in a community (market) at each given price  The aggregate or market supply is obtained by the horizontal summation of all individual producer’s supply curves.  Similar to the individual producer’s supply curve – Market supply curve slopes upward

23. 3-23LO 3- All Market (Aggregate) Supply  Suppose, there are 10 SB coffee sellers in Lubbock  Each individual seller’s supply for SB coffee is the same Price ($/cup) Ind. Quantity (cups) Ag. Quantity (cups) 0.501,00010,000 0.752,00020,000 1.003,00030,000 1.254,00040,000 1.505,00050,000

24. 3-24LO 3 - 2 The (Market) Supply Curve  The quantity of a good that sellers offer at each price  If the price is less than opportunity cost, offer more  Opportunity cost differs among sellers due to  Technology ■ Different costs such as rent  Skills ■ Expectations  Higher prices, larger quantities  Low-Hanging Fruit Principle

25. 3-25LO 3 - 2 Interpreting the (Market) Supply Curve  Horizontal interpretation of supply  Given price, how much will suppliers offer? $4 $2 8 16 Q P S Supply of Pizzas (000s of slices/day)

26. 3-26LO 3 - 2 Interpreting the (Market) Supply Curve  Vertical interpretation of supply  Given the quantity to be sold, what will the price be? $4 $2 8 16 Q P S Supply of Pizzas (000s of slices/day)

27. 3-27LO 3- All Market Equilibrium  Actual price and Quantity determined by interactions between demanders (consumers) and suppliers (sellers)  Demanders cannot purchase more than suppliers willing to sell  Suppliers cannot sell more than demanders willing to buy

28. 3-28LO 3- All Equilibrium Point  Point where the market demand and supply curves intersect  Price at which quantity demanded equals quantity supplied  Demanders and suppliers are satisfied  Able to behave as one wants to, taking market prices as given

29. 3-29LO 3- All Market Equilibrium for SB Coffee  Equilibrium price – $1.00 per cup  Equilibrium quantity – 30,000 cups per day Price ($/cup) Ag. Quantity Demanded Ag. Quantity Supplied 0.5050,00010,000 0.7540,00020,000 1.0030,000 1.2520,00040,000 1.5010,00050,000

30. 3-30LO 3 - 3 Market Equilibrium  Quantity supplied equals quantity demanded AND  Price is on supply and demand curves  No tendency to change P or Q  Buyers are on their demand curve  Sellers are on their supply curve 12 Q P S Market for Pizzas (000s of slices/day) D $3

31. 3-31LO 3 - 3 Excess Supply and Excess Demand Excess Supply  At $4, 16,000 slices supplied and 8,000 slices demanded Excess Demand  At $2, 8,000 slices supplied 16,000 slices demanded $4 8 16 Q P S Market for Pizzas (000s of slices/day) D $2 8 16 Q P S Market for Pizzas (000s of slices/day) D Surplus Shortage

32. 3-32LO 3 - 3 Incentive Principle: Excess Supply at $4  Each supplier has an incentive to decrease the price in order to sell more  Lower prices decrease the surplus  As price decreases:  the quantity offered for sale decreases along the supply curve  the quantity demanded increases along the demand curve $4 816 Q P S Market for Pizzas (000s of slices/day) D $3.50 $3 12 Equilibrium

33. 3-33LO 3 - 3 Incentive Principle: Excess Demand at $2  Each supplier has an incentive to increase the price in order to sell more  Higher prices decrease the shortage  As price increases  the quantity offered for sale increases along the supply curve  As price increases, the quantity demanded decreases along the demand curve. $2.50 $2 816 Q P S Market for Pizzas (000s of slices/day) D $3 12 Equilibrium

34. 3-34LO 3 - 3 Rent Controls Are Price Ceilings  Rent controls set a maximum price that can be charged for a given apartment  If the controlled price is below equilibrium, then  Quantity demanded increases and  Quantity supplied decreases  A shortage results 2 Q P S Market for NYC Apartments (millions of apartments/day) D $1,600 $800 31

35. 3-35LO 3- All Changes in the Equilibrium Point  The only way that anything can affect the equilibrium price and quantity is by causing a shift in either the supply curve or the demand curve  Never look at price and quantity  Look at the effect of the change has on demand curve and/or supply curve  The factors that shifts the demand and supply curves affect the equilibrium price and quantity

36. 3-36 © The McGraw-Hill Companies, Inc., 2009 McGraw-Hill/Irwin The Effects of Supply and Demand Shifts

37. 3-37LO 3 - 3 Movement along the (market) Demand Curve  When price goes up, quantity demanded goes down  When price goes down, buyers move to a new, higher quantity demanded  A change in quantity demanded results from a change in the price of a good. $2 $1 810 Q P D Demand for Canned Tuna (000s of cans/day)

38. 3-38LO 3 - 4 Shift in (Market) Demand  If buyers are willing to buy more at each price, then demand has increased  Move the entire demand curve to the right  Increase in demand  If buyers are willing to buy less at each price, then demand has decreased $2 810 Q P D Demand for Canned Tuna (000s of cans/day) D'

39. 3-39LO 3 - 4 Causes of Shifts in Demand  Price of complementary goods  Tennis courts and tennis balls  Price of substitute goods  Internet and overnight delivery  Income: normal or inferior goods?  Preferences  Dinosaur toys after Jurassic Park movie  Number of buyers in the market  Expectations about the future Price changes never cause a shift in demand

40. 3-40LO 3 - 4 Tennis Market  If rent for tennis court decreases, demand for tennis balls increases  Tennis courts and tennis balls are complements P Q Tennis Court Rentals $7 $10 D (00s rentals/day) 411 $1.40 Tennis Ball Sales P Q $1.00 D (millions of balls/day) 40 58 D' S

41. 3-41LO 3 - 4 Apartments Near DC Metro  If government wages rise, demand for apartments near Metro stations increases  Demand increases  Price increases  Quantity increases  Demand for a normal good increases when income increases  Demand for an inferior good increases when income decreases Convenient Apartments P Q (units/month) D'DS P P' Q Q'

42. 3-42LO 3 - 4 Movement along the (market) Supply Curve Changes in Quantity Supplied  When the price of a good changes, move to a new quantity supplied  Assumes everything except price is held constant $4 $2 8 16 Q P S Supply of Pizzas (000s of slices/day)

43. 3-43LO 3 - 4 Changes in (Market) Supply  Supply increases when sellers are willing to offer more for sale at each possible price  Moves the entire supply curve to the right  Supply decreases when sellers are willing to offer less for sale at each possible price  Moves the entire supply curve to the left $2 8 Q P S Supply of Pizzas (000s of slices/day) S' 9 $2 8 Q P S* Supply of Tuna (000s of cans/day) S 9

44. 3-44LO 3 - 4 Causes of Shifts in Supply  A change in the price of an input  Fiberglass for skateboards, construction wages  A change in technology  Desktop publishing and term papers  Internet distribution of products (e-commerce)  Weather (agricultural commodities and outdoor entertainment)  Number of sellers in the market  Expectation of future price changes Price changes never cause a shift in supply

45. 3-45LO 3- All Shifts in Supply: Skateboards  Costs of production affect the supply of a product  Cost of fiberglass for skateboards increases  Supply decreases  With no change in demand, the price of skateboards increases to $80 and quantity decreases to 800 (skateboards/month) $80 800 $60 P S Supply of Skateboards 1,000 D S' 600 Q

46. 3-46LO 3 - 1 Shift in Supply: Home Construction  Cost of labor used to produce houses decreases  Supply increases  Demand is constant  The price of houses decreases to $90,000 per house  Quantity increases to 50 $120 40 $90 Q P S'S' The Market for New Houses 50 D S (houses/month)

47. 3-47LO 3 - 4 Supply and Demand Shifts: Four Rules An increase in demand will lead to an increase in both equilibrium price and quantity Q P D D'D' S Q'Q P P'

48. 3-48LO 3 - 4 Supply and Demand Shifts: Four Rules An decrease in demand will lead to a decrease in both equilibrium price and quantity Q P D D'D' S Q'Q P P'

49. 3-49LO 3 - 4 Supply and Demand Shifts: Four Rules An increase in supply will lead to a decrease in the equilibrium price and an increase in the equilibrium quantity. Q P D S Q'Q P P' S'S'

50. 3-50LO 3 - 4 Supply and Demand Shifts: Four Rules An decrease in supply will lead to an increase in the equilibrium price and a decrease in the equilibrium quantity. Q P D S Q'Q P P' S'S'

51. 3-51LO 3 - 4 Supply and Demand Both Change: Tortilla Chips  Oils used for frying are harmful AND the price of harvesting equipment decreases Price ($/bag) Millions of bags per month P Q S D P' Q' D' S'

52. 3-52LO 3 - 4 Changes in Supply and Demand Supply DemandIncreasesDecreases Increases PDepends QIncreases PIncreases QDepends Decreases PDecreases QDepends PDepends QDecreases

53. 3-53LO 3 - 5 Efficiency and Equilibrium  Markets communicate information effectively  Value buyers place on the product  Opportunity cost of producing the product  Markets maximize the difference between benefits and costs  Market outcomes are the best provided that  The market is in equilibrium AND  No costs or benefits are shared with the public

54. 3-54LO 3 - 5 Cash on the Table  Buyer's surplus: buyer's reservation price minus the market price  Seller's surplus: market price minus the seller's reservation price  Total surplus = buyer's surplus + seller's surplus  Total surplus is buyer's reservation price – seller's reservation price  No cash on the table when surplus is maximized  No opportunity to gain from additional sales or purchases

55. 3-55LO 3 - 5 Efficiency Principle  Socially optimal quantity maximizes the total surplus for the economy from producing and selling a good  Economic efficiency -- all goods at their socially optimal level  Efficiency Principle: equilibrium price and quantity are efficient if  Sellers pay all the costs of production  Buyers receive all the benefits of their purchase  Efficiency: marginal cost equals marginal benefit  Production is efficient if total surplus is maximized

56. 3-56LO 3 - 5 Smart for One, Dumb for All  Producers sometimes shift costs to others  Pollution is like getting free waste disposal services  Total marginal cost = seller's marginal cost plus marginal cost of pollution  When costs are shifted, supply is greater than socially optimal  Buyers may create benefits for others  Marginal benefit is less than the full social benefit  Vaccinations, my neighbor's landscaping  The demand for these goods is less than socially optimal

57. 3-57LO 3 - 6 Equilibrium Principle  Equilibrium Principle: no unexploited opportunities for individuals  BUT it may not exploit all gains achievable through collective action  Only when the seller pays the full cost of production and the buyer captures the full benefit of the good is the market outcome socially optimal  Regulation, taxes and fines, or subsidies can move the market to optimal level

58. 3-58LO 3- All Supply and Demand Efficiency Principle Equilibrium Principle Efficiency Principle Equilibrium Principle  Changes Equilibrium Price and Quantity Demand  Changes Supply  Changes

59. McGraw-Hill/Irwin © 2009 The McGraw-Hill Companies, All Rights Reserved Chapter 3 Appendix The Algebra of Supply and Demand

60. 3-60LO 3 - 3 From Graphs to Equations …  Sample equations P = 16 – 2 Q d is a straight-line demand curve with intercept 16 on the vertical (P) axis and a slope of – 2 P = 4 + 4 Q s is a straight-line supply curve with intercept 4 and a slope of 4

61. 3-61LO 3 - 3 … To Equilibrium P and Q  Equilibrium is where P and Q are the same for demand and supply  Set the two equations equal to each other (P = P) and solve for Q (Q s = Q d = Q * ) 16 – 2 Q * = 4 + 4 Q * 6 Q * = 12 Q * = 2  Use either the supply or demand curve and Q * = 2 to find price P = 16 – 2 Q * P = $12 P = 4 + 4 Q * P = $12