1. 10/15/2015 1 Demand, Supply, and Market Equilibrium Chapter 3

2. In this chapter, you will learn: 1. What demand is and what affects it. 2. What supply is and what affects it. 3. How supply & demand together determine market equilibrium. 4. How changes in supply & demand affect equilibrium prices & quantities. 5. What government-set prices are and how they can cause product surpluses & shortages. 10/15/2015 2

3. Markets Consist of large numbers of independently acting buyers & sellers of standardized products Consist of large numbers of independently acting buyers & sellers of standardized products These are highly competitive markets These are highly competitive markets All such markets involve demand, supply, price, and quantity All such markets involve demand, supply, price, and quantity 10/15/2015 3

4. 4 Demand A schedule or curve that shows the various amounts of a product that consumers are willing & able to buy at all prices during a specific period of time A schedule or curve that shows the various amounts of a product that consumers are willing & able to buy at all prices during a specific period of time Can be easily shown in table form (Demand schedule) Can be easily shown in table form (Demand schedule) Table shows relationship between price and quantity demanded at each price Table shows relationship between price and quantity demanded at each price Table does not tell us which price will exist in the market…depends on interaction of demand and supply Table does not tell us which price will exist in the market…depends on interaction of demand and supply

5. Law of demand Fundamental characteristic: Other things equal, as price falls, the quantity demanded rises Fundamental characteristic: Other things equal, as price falls, the quantity demanded rises As price rises, quantity demanded falls As price rises, quantity demanded falls In short, negative or inverse relationship between price and quantity demanded (Law of Demand) In short, negative or inverse relationship between price and quantity demanded (Law of Demand) 10/15/2015 5

6. Why Inverse Relationship? People ordinarily do buy more of a product at a lower price (common sense) People ordinarily do buy more of a product at a lower price (common sense) In any specific time period, each buyer of a product will derive less satisfaction (or benefit, or utility) for each successive unit of the product consumed (diminishing marginal utility) In any specific time period, each buyer of a product will derive less satisfaction (or benefit, or utility) for each successive unit of the product consumed (diminishing marginal utility) Income & substitution effects Income & substitution effects Lower price – increases purchasing power of a buyer’s money income, enabling the buyer to purchase more Lower price – increases purchasing power of a buyer’s money income, enabling the buyer to purchase more At a lower price, buyers have the incentive to substitute what is now less expensive product for similar products that are now more expensive At a lower price, buyers have the incentive to substitute what is now less expensive product for similar products that are now more expensive 10/15/2015 6

7. Demand curve (Fig. 3.1) Quantity demanded on horizontal axis Quantity demanded on horizontal axis Price on vertical axis Price on vertical axis Downslope reflects the law of demand Downslope reflects the law of demand People buy more of a product, service, or resource as its price falls. (inverse or negative relationship) People buy more of a product, service, or resource as its price falls. (inverse or negative relationship) 10/15/2015 7

8. Market demand By adding the quantities demanded by all consumers at each price, we can calculate the market demand (Fig. 3.2) By adding the quantities demanded by all consumers at each price, we can calculate the market demand (Fig. 3.2) Price is most important influence on demand Price is most important influence on demand Determinants of demand Determinants of demand When determinants change, the demand curve will shift to the right or left When determinants change, the demand curve will shift to the right or left Consumers’ tastes (preferences), # of buyers, consumers’ income, prices of related goods, consumer expectations Consumers’ tastes (preferences), # of buyers, consumers’ income, prices of related goods, consumer expectations 10/15/2015 8

9. Change in Demand Change in demand schedule or curve is called a “change in demand” Change in demand schedule or curve is called a “change in demand” Increase in demand = rightward shift of curve Increase in demand = rightward shift of curve Decrease in demand = leftward shift of curve Decrease in demand = leftward shift of curve 10/15/2015 9

10. Increase in Demand may be caused by: Favorable change in consumer taste Favorable change in consumer taste Increase in # of buyers Increase in # of buyers Rising income if product is normal good Rising income if product is normal good Falling income if product is inferior good Falling income if product is inferior good An increase in price of a substitute good A decrease in price of a complementary good New expectation that either prices or income will be higher in future Reverse these for decrease in demand 10/15/2015 10

11. Changes in Qty. Demanded Movement from one point to another point on a fixed demand curve Movement from one point to another point on a fixed demand curve Cause of such a change is an increase or decrease in the price of the product under consideration Cause of such a change is an increase or decrease in the price of the product under consideration 10/15/2015 11

12. 10/15/2015 12 Supply (3.2) Schedule or curve showing various amounts of a product that producers are willing & able to make available for sale at all prices during a period of time Schedule or curve showing various amounts of a product that producers are willing & able to make available for sale at all prices during a period of time Supply schedule – shows quantities of a product that will be supplied at various prices Supply schedule – shows quantities of a product that will be supplied at various prices Law of supply – positive or direct relationship that prevails between price & quantity supplied…as price rises, quantity supplied rises too Law of supply – positive or direct relationship that prevails between price & quantity supplied…as price rises, quantity supplied rises too Higher prices represent more revenue to the producer which increases their incentives to produce Higher prices represent more revenue to the producer which increases their incentives to produce

13. Supply curve Upward slope of the curve reflects the law of supply Upward slope of the curve reflects the law of supply Producers offer more of a good, service, or resource for sale as its price rises Producers offer more of a good, service, or resource for sale as its price rises Relationship is positive or direct Relationship is positive or direct 10/15/2015 13

14. Market supply We sum the quantities supplied by each producer at each price. We sum the quantities supplied by each producer at each price. Price – vertical axis Price – vertical axis Quantity supplied – horizontal axis Quantity supplied – horizontal axis 10/15/2015 14

15. 10/15/2015 15 Determinants of supply Price is most significant influence on quantity supplied of any product Price is most significant influence on quantity supplied of any product Other factors can and do affect supply Other factors can and do affect supply A change in supply will shift the entire supply curve A change in supply will shift the entire supply curve A shift to the right increases supply A shift to the right increases supply A shift to the left decreases supply A shift to the left decreases supply

16. Basic Determinants of Supply Resource prices Resource prices Technology Technology Taxes & subsidies Taxes & subsidies Prices of other goods Prices of other goods Producer expectations Producer expectations # of sellers # of sellers 10/15/2015 16

17. Changes in Quantity Supplied Movement from one point to another on a fixed supply curve Movement from one point to another on a fixed supply curve Cause of such a movement is a change in the price of the specific product being considered Cause of such a movement is a change in the price of the specific product being considered 10/15/2015 17

18. 10/15/2015 18 Market equilibrium (3.3) Only price where the intentions of buyers & sellers match Only price where the intentions of buyers & sellers match No shortage or surplus & equilibrium No shortage or surplus & equilibrium Competition among buyers & among sellers drives the price to equilibrium Competition among buyers & among sellers drives the price to equilibrium

19. Surplus Above equilibrium (supply>demand) Above equilibrium (supply>demand) Encourages sellers to offer more but discourages many consumers from buying it Encourages sellers to offer more but discourages many consumers from buying it Surpluses drive prices down to equilibrium Surpluses drive prices down to equilibrium 10/15/2015 19

20. Shortage Below equilibrium (demand>supply) Below equilibrium (demand>supply) Discourages sellers from devoting resources to the product Discourages sellers from devoting resources to the product Consumers desire more of the product at the lower price Consumers desire more of the product at the lower price 10/15/2015 20

21. 10/15/2015 21 Efficient allocation Competition among producers forces them to use the best technology & right mix of productive resources Competition among producers forces them to use the best technology & right mix of productive resources Otherwise, their costs will be too high relative to the market price …unprofitable Otherwise, their costs will be too high relative to the market price …unprofitable Productive efficiency Productive efficiency Production of a good in the least costly way Production of a good in the least costly way Allocative efficiency Allocative efficiency Producing the mix of goods & services most wanted by society Producing the mix of goods & services most wanted by society

22. 10/15/2015 22 Changes in demand (show graphically) Supply stays constant but demand increases Supply stays constant but demand increases Increase in both price & quantity Increase in both price & quantity Decrease in demand Decrease in demand Decreases both price & quantity Decreases both price & quantity Changes in Supply Changes in Supply Demand is constant Demand is constant Increase in supply lowers price & increases quantity Increase in supply lowers price & increases quantity Decrease in supply increases price & lowers quantity Decrease in supply increases price & lowers quantity

23. Complex Cases (show graphically) Supply increase; demand decrease Supply increase; demand decrease Supply decrease; demand increase Supply decrease; demand increase Supply increase; demand increase Supply increase; demand increase Supply decrease; demand decrease Supply decrease; demand decrease 10/15/2015 23

24. 10/15/2015 24 Government-set prices Sometimes government concludes that supply & demand will produce prices that are unfairly high for buyers or unfairly low to sellers Sometimes government concludes that supply & demand will produce prices that are unfairly high for buyers or unfairly low to sellers Government may place legal limits on how high or low a price may go Government may place legal limits on how high or low a price may go Is that a good idea? Is that a good idea?

25. Price ceiling Maximum legal price a seller may charge for a product or service Maximum legal price a seller may charge for a product or service A price at or below the ceiling is legal; a price above is not A price at or below the ceiling is legal; a price above is not Rationale: enable consumers to obtain an “essential” good or service that they couldn’t afford at equilibrium Rationale: enable consumers to obtain an “essential” good or service that they couldn’t afford at equilibrium Example: Rent Control Example: Rent Control Maximum price for rent that can be charged for housing Maximum price for rent that can be charged for housing Ceilings result in a shortage which leads to illegal black markets Ceilings result in a shortage which leads to illegal black markets Product or service sold above the ceiling to meet the excess demand created by the ceiling Product or service sold above the ceiling to meet the excess demand created by the ceiling 10/15/2015 25

26. Price floor Minimum price fixed by the government Minimum price fixed by the government A price at or above the price floor is legal A price at or above the price floor is legal Price floors are invoked when the market economy does not provide sufficient income for certain groups of resource suppliers or producers Price floors are invoked when the market economy does not provide sufficient income for certain groups of resource suppliers or producers Creates a surplus of the product or service. Creates a surplus of the product or service. Examples: Examples: Minimum wage Minimum wage Target price for agricultural products Target price for agricultural products 10/15/2015 26