1. Copyright 2008 The McGraw-Hill Companies 3-1 3 Demand, Supply, and Market Equilibrium

2. Copyright 2008 The McGraw-Hill Companies 3-2 Chapter Objectives Demand Defined and What Affects It Supply Defined and What Affects It How Supply & Demand Together Determine Market Equilibrium How Changes in Supply and Demand Affect Equilibrium Prices and Quantities Government-Set Prices and their Implications for Surpluses & Shortages

3. Copyright 2008 The McGraw-Hill Companies 3-3 Markets Defined Markets bring together buyers (demanders) and sellers (suppliers) of particular goods and services. They take many forms.Markets bring together buyers (demanders) and sellers (suppliers) of particular goods and services. They take many forms. A market may be local (fish), national (houses), or international (oil) in scope.A market may be local (fish), national (houses), or international (oil) in scope. Some markets are highly personal, face-to-face exchanges (fish); others are impersonal and remote (internet marketing).Some markets are highly personal, face-to-face exchanges (fish); others are impersonal and remote (internet marketing). There are two types of marketsThere are two types of markets –product market (fish) involves goods and services. –resource market (labor market) involves factors of production

4. Copyright 2008 The McGraw-Hill Companies 3-4 Demand Demand Defined Demand is a schedule or a curve that shows the various amounts of a product that consumers are willing and able to buy at each of a series of possible prices during a specified time period. Example look at the following schedule. The schedule shows the relationship between various prices and the quantity a consumer is willing and able to purchase at each of these prices. We say willing an able because willingness is not effective in the market. The table does not tell us which of the 5 prices would exist in the market. This depends on demand and supply. To be meaningful, the demand schedule must have a period of time associated with it, example a day, a week or a month. P54321 QD1020355580

5. Copyright 2008 The McGraw-Hill Companies 3-5 Individual Demand 6 5 4 3 2 1 0 10 20 30 40 50 60 70 80 Quantity Demanded (bushels per week) Price (per bushel) PQdQd $5 4 3 2 1 10 20 35 55 80 Individual Demand P Q D

6. Copyright 2008 The McGraw-Hill Companies 3-6 Law of Demand Law of demand “other things being equal, as price increases, the corresponding quantity demanded falls and as price falls, the quantity demanded rises”. The law of demand can be restated as, “there is an negative or inverse relationship between price and quantity demanded”. Note the “other-things-equal” assumption refers to consumer income, tastes, prices of related goods, and other things besides the price of the product being discussed. Explanation of the law of demand a.Diminishing marginal utility The consumer will derive less satisfaction (utility) form each additional units of the product consumed, e.g., the second “Big Mac” yields less extra satisfaction (or utility) than the first, i.e. consumption is subject to diminishing marginal utility. A consumer will only buy it if its price is less.

7. Copyright 2008 The McGraw-Hill Companies 3-7 b.Income effect A lower price increases the purchasing power of money income, enabling the consumer to buy more at a lower price. A higher price has the opposite effect. c.Substitution effect At a lower price buyers have the incentive to substitute what is now a less expensive product for similar products that are now relatively more expensive. The demand curve A simple graph illustrates the inverse relationship between price and quantity. The downward slope indicates lower quantity (horizontal axis) at higher price (vertical axis) and higher quantity at lower price, reflecting the Law of Demand. Market demand By adding the quantities demanded by all consumers at each of the various prices, we can get from individual demand to market demand (the demand of all consumers in the market).

8. Copyright 2008 The McGraw-Hill Companies 3-8 Determinants of Demand There are several determinants of demand or the “other things,” besides price, which affect demand. A change in one or more of the determinants of demand will cause the demand data and therefore the location of the demand curve to change. A shift in the demand curve is called a change in demandThere are several determinants of demand or the “other things,” besides price, which affect demand. A change in one or more of the determinants of demand will cause the demand data and therefore the location of the demand curve to change. A shift in the demand curve is called a change in demand a.Tastes A favorable change in consumer tastes for a product means that more of it will be demanded at each (current) price. Demand will increase i.e., shifts rightward. Unfavorable change will decrease demand (a shift leftward).A favorable change in consumer tastes for a product means that more of it will be demanded at each (current) price. Demand will increase i.e., shifts rightward. Unfavorable change will decrease demand (a shift leftward). b.Number of buyers An increase in the number of buyers is likely to increase demand; fewer buyers will probably decrease demand.An increase in the number of buyers is likely to increase demand; fewer buyers will probably decrease demand.

9. Copyright 2008 The McGraw-Hill Companies 3-9 c.Income for most products a rise in income causes an increase in demand for superior or normal goods. Less leads to a decrease in demand for normal goods. The rare case of goods whose demand varies inversely with income is called inferior goods, e.g., used cars.for most products a rise in income causes an increase in demand for superior or normal goods. Less leads to a decrease in demand for normal goods. The rare case of goods whose demand varies inversely with income is called inferior goods, e.g., used cars. d.Prices of related goods: A change in the price of related goods may either increase or decrease the demand for a product depending on whether the related good is a substitute or a complement.A change in the price of related goods may either increase or decrease the demand for a product depending on whether the related good is a substitute or a complement. i.Substitutes (can be used in place of another good): if two goods are substitutes, an increase in the price of one will increase the demand for the other (i.e., directly related). ii.Complements (goods that are used together, they are demanded jointly): if the price of a complement increase, the demand for the related good will decline, i.e., there is an inverse relationship between the price of one and the demand for the other.

10. Copyright 2008 The McGraw-Hill Companies 3-10 iii.Unrelated goods (independent goods). A change in the price of one has little or no effect on the demand for the other. e.Consumer expectations A newly formed expectations of higher future prices may cause consumers to buy now in order to beat the anticipated price rises, this will shift the demand rightward, e.g., the real estates market.A newly formed expectations of higher future prices may cause consumers to buy now in order to beat the anticipated price rises, this will shift the demand rightward, e.g., the real estates market. A change in expectations concerning future income may prompt consumers to change their current spending. Demand shifts rightward (in case of expected higher income) or leftward (in case of expected lower income).A change in expectations concerning future income may prompt consumers to change their current spending. Demand shifts rightward (in case of expected higher income) or leftward (in case of expected lower income).

11. Copyright 2008 The McGraw-Hill Companies 3-11 Individual Demand 6 5 4 3 2 1 0 Quantity Demanded (bushels per week) Price (per bushel) PQdQd $5 4 3 2 1 10 20 35 55 80 Individual Demand P Q D1D1 2 4 6 8 10 12 14 16 18 Demand Can Increase or Decrease Increase in Demand Decrease in Demand D2D2 D3D3

12. Copyright 2008 The McGraw-Hill Companies 3-12 Individual Demand 6 5 4 3 2 1 0 Quantity Demanded (bushels per week) Price (per bushel) PQdQd $5 4 3 2 1 10 20 35 55 80 Individual Demand P Q D1D1 2 4 6 8 10 12 14 16 18 Demand Can Increase or Decrease Decrease in Demand D2D2 D3D3 An Increase in Demand Means a shift of the Line A Movement Between Any Two Points on a Demand Curve is Called a Change in Quantity Demanded

13. Copyright 2008 The McGraw-Hill Companies 3-13 A summary of what can cause an increase in demand a.Favorable change in consumer tastes. b.Increase in the number of buyers. c.Rising income if product is a normal good. d.Falling incomes if product is an inferior good. e.Increase in the price of a substitute good. f.Decrease in the price of a complementary good. g.Consumer expectation of higher prices or incomes in the future. A summary of what can cause a decrease in demand. a.Unfavorable change in consumer tastes. b.Decrease in number of buyers. c.Falling income if product is a normal good. d.Rising income if product is an inferior good. e.Decrease in price of a substitute good. f.Increase in price of a complementary good. g.Consumers expectation of lower prices or incomes in the future.

14. Copyright 2008 The McGraw-Hill Companies 3-14 Distinction between a change in quantity demanded and a change in demand 1.A change in demand is a shift of the demand curve. It occurs due to changes in one of the demand determinants. It will shift the whole demand curve to the right (an increase in demand) or to the left (a fall in demand). 2.A change in quantity demanded is a movement from on point to another on a fixed demand schedule. It is caused by price changes.

15. Copyright 2008 The McGraw-Hill Companies 3-15 Supply Supply Defined Supply is a schedule or a curve that shows the various amounts of a product that producers are willing and able to make available for sale at each of a series of possible prices during a specified time period.Supply is a schedule or a curve that shows the various amounts of a product that producers are willing and able to make available for sale at each of a series of possible prices during a specified time period. Law of supply. All else equal, there is a positive or direct relationship between price and quantity supplied. A supply schedule tells us that firms will produce and offer for sale more of their product at a high price that at a low price.All else equal, there is a positive or direct relationship between price and quantity supplied. A supply schedule tells us that firms will produce and offer for sale more of their product at a high price that at a low price.Explanation: 1.Revenue Implications. For a supplier price represents a revenue, which serves as an incentive to produce and sell a product. The higher the price, the greater the incentive and the greater the quantity supplied.

16. Copyright 2008 The McGraw-Hill Companies 3-16 2.Marginal Cost. beyond some quantity of production manufacturers usually encounter increasing marginal cost (the added cast of producing one more unit of output). Certain productive resources (e.g., machinery) cannot be expanded quickly, producers will increase other resources such as labor. As more labor are used the added output will be less, and the marginal cost of successive units rises accordingly. The producer will not produce more costly units unless it receives a higher price for them. The supply curve It shows a direct relationship between the price and quantity supplied. The upward slop of the curve reflects the law of supply – producers offer more of a good or a service or resource for sale as its price rises.It shows a direct relationship between the price and quantity supplied. The upward slop of the curve reflects the law of supply – producers offer more of a good or a service or resource for sale as its price rises.

17. Copyright 2008 The McGraw-Hill Companies 3-17 Individual Supply 6 5 4 3 2 1 0 Quantity Supplied (bushels per week) Price (per bushel) PQsQs $5 4 3 2 1 60 50 35 20 5 IndividualSupply P Q S1S1 10 20 30 40 50 60 70

18. Copyright 2008 The McGraw-Hill Companies 3-18 Market Supply The sum of quantities supplied by each producer at each price. It is obtained by horizontally adding the supply curves of individual producers in the market.The sum of quantities supplied by each producer at each price. It is obtained by horizontally adding the supply curves of individual producers in the market. Determinants of supply A change in any of the supply determinants causes a change in supply and a shift in the supply curve. An increase in supply involves a rightward shift, and a decrease in supply involves a leftward shift.A change in any of the supply determinants causes a change in supply and a shift in the supply curve. An increase in supply involves a rightward shift, and a decrease in supply involves a leftward shift. 1.Resource prices. A higher resource prices raises production costs and squeeze profits. The reduction in profits reduces the incentive to supply output at each product price, supply shifts leftward.A higher resource prices raises production costs and squeeze profits. The reduction in profits reduces the incentive to supply output at each product price, supply shifts leftward. In contrast lower resource prices will reduce production costs and increase profits, causing an increase in supply or rightward shift in the supply curve.In contrast lower resource prices will reduce production costs and increase profits, causing an increase in supply or rightward shift in the supply curve.

19. Copyright 2008 The McGraw-Hill Companies 3-19 2.Technology A technological improvement means more efficient production and lower costs, so an increase in supply or rightward shift in the curve results. 3.Taxes and subsidies A business tax is treated as a cost, so decreases supply; a subsidy lowers cost of production, so increases supply. 4.Prices of related goods If the price of substitute production good rises, producers might shift production toward the higher-priced good (alternative), causing a decrease in supply of the original good.

20. Copyright 2008 The McGraw-Hill Companies 3-20 5.Producer expectations Expectations about the future price of a product can cause producers to increase or decrease current supply.Expectations about the future price of a product can cause producers to increase or decrease current supply. 6.Number of sellers Generally, the larger the number of sellers the greater the supply.Generally, the larger the number of sellers the greater the supply. Changes in quantity supplied and changes in supply Distinction between a change in quantity supplied (due to price changes) and a change or shift in supply (due to change in determinants of supply).Distinction between a change in quantity supplied (due to price changes) and a change or shift in supply (due to change in determinants of supply).

21. Copyright 2008 The McGraw-Hill Companies 3-21 Individual Supply 6 5 4 3 2 1 0 Quantity Supplied (bushels per week) Price (per bushel) PQsQs $5 4 3 2 1 60 50 35 20 5 Individual Supply P Q S1S1 Supply Can Increase or Decrease S2S2 S3S3 2 4 6 8 10 12 14

22. Copyright 2008 The McGraw-Hill Companies 3-22 Individual Supply 6 5 4 3 2 1 0 Quantity Supplied (bushels per week) Price (per bushel) PQsQs $5 4 3 2 1 60 50 35 20 5 Individual Supply P Q S1S1 Supply Can Increase or Decrease S2S2 S3S3 An Increase in Supply Means a shift of the Line A Movement Between Any Two Points on a Supply Curve is Called a Change in Quantity Supplied 2 4 6 8 10 12 14

23. Copyright 2008 The McGraw-Hill Companies 3-23 Market Equilibrium Market Equilibrium: where quantity supplied equals the quantity demanded:Market Equilibrium: where quantity supplied equals the quantity demanded: Equilibrium priceEquilibrium price Equilibrium quantityEquilibrium quantity At prices above this equilibrium, note that there is an excess quantity supplied or surplus.At prices above this equilibrium, note that there is an excess quantity supplied or surplus. At prices below this equilibrium, note that there is an excess quantity demanded or shortage.At prices below this equilibrium, note that there is an excess quantity demanded or shortage. Market clearing or market price is another name for equilibrium price.Market clearing or market price is another name for equilibrium price.

24. Copyright 2008 The McGraw-Hill Companies 3-24 Market Equilibrium 6 5 4 3 2 1 0 2 4 6 8 10 12 14 16 18 Bushels of Corn (thousands per week) Price (per bushel) PQdQd $5 4 3 2 1 2,000 4,000 7,000 11,000 16,000 Market Demand 200 Buyers PQsQs $5 4 3 2 1 12,000 10,000 7,000 4,000 1,000 Market Supply 200 Sellers 200 Buyers & 200 Sellers 7 3 D S 6,000 Bushel Surplus 7,000 Bushel Shortage

25. Copyright 2008 The McGraw-Hill Companies 3-25 Graphically, note that the equilibrium price and quantity are where the supply and demand curves intersect. Note also that it is NOT correct to say supply equals demand!Graphically, note that the equilibrium price and quantity are where the supply and demand curves intersect. Note also that it is NOT correct to say supply equals demand! The rationing function of prices Is the ability of competitive forces of supply and demand to establish a price at which selling and buying decisions are consistent.Is the ability of competitive forces of supply and demand to establish a price at which selling and buying decisions are consistent. Efficient allocation A competitive market forces producers to use the best technology and the right mix of productive resources. The result is productive efficiency: the production of any particular product in the least costly way.A competitive market forces producers to use the best technology and the right mix of productive resources. The result is productive efficiency: the production of any particular product in the least costly way. Competitive markets also produce allocative efficiency: to produce the particular mix of goods and services most valued by the society.Competitive markets also produce allocative efficiency: to produce the particular mix of goods and services most valued by the society.

26. Copyright 2008 The McGraw-Hill Companies 3-26 Changes in Supply and Demand, and Equilibrium Changing demand (with supply held constant). Increase in demand will have effect of increasing equilibrium price and quantityIncrease in demand will have effect of increasing equilibrium price and quantity Decrease in demand will have effect of decreasing equilibrium price and quantityDecrease in demand will have effect of decreasing equilibrium price and quantity Changing supply (with demand held constant). Increase in supply will have effect of decreasing equilibrium price and increasing quantityIncrease in supply will have effect of decreasing equilibrium price and increasing quantity Decrease in supply will have effect of increasing equilibrium price and decreasing quantityDecrease in supply will have effect of increasing equilibrium price and decreasing quantity

27. Copyright 2008 The McGraw-Hill Companies 3-27 Complex cases when both supply and demand shift:when both supply and demand shift: 1.Supply increases and demand decreases, price declines, but the new equilibrium quantity depends on relative sizes of shifts in demand and supply. 2.Supply decreases and demand increases, price rises, but the new equilibrium quantity depends again on relative sizes of shifts in demand and supply. 3.Supply increases and demand increases. If the increase in supply is greater than the increase in demand the price falls and vice versa 4.Supply decreases demand decreases. If the decrease in supply is greater than the decrease in demand, equilibrium price will rise and vice versa.

28. Copyright 2008 The McGraw-Hill Companies 3-28 Application: Government-Set Prices (Ceilings and Floors). Government-set prices prevent the market from reaching the equilibrium price and quantity.Government-set prices prevent the market from reaching the equilibrium price and quantity. A. Price ceilings The maximum legal price a seller may charge, typically placed below equilibrium. Shortages result as quantity demanded exceeds quantity supplied. Examples: Rent controls and gasoline price controlsThe maximum legal price a seller may charge, typically placed below equilibrium. Shortages result as quantity demanded exceeds quantity supplied. Examples: Rent controls and gasoline price controls Rationing problem Since price ceilings does not lead to an equitable distribution of the product, the government must establish some formal system for rationing, e.g., ration couponsSince price ceilings does not lead to an equitable distribution of the product, the government must establish some formal system for rationing, e.g., ration coupons Black Markets Since the demand is greater than supply, buyers will be willing to pay a higher price, which creates a black market where the product is illegally traded in at price above the ceiling price.Since the demand is greater than supply, buyers will be willing to pay a higher price, which creates a black market where the product is illegally traded in at price above the ceiling price.

29. Copyright 2008 The McGraw-Hill Companies 3-29 Price floors. B. Price floors. The minimum legal price a seller may charge, typically placed below equilibrium. Surpluses result as quantity supplied exceeds quantity demanded.The minimum legal price a seller may charge, typically placed below equilibrium. Surpluses result as quantity supplied exceeds quantity demanded. Examples: Minimum wage and farm price supports.Examples: Minimum wage and farm price supports. Note: The minimum wage, for example, will be below equilibrium in some labor markets (large cities as the demand for labor is already high). In that case the price floor has no effect.Note: The minimum wage, for example, will be below equilibrium in some labor markets (large cities as the demand for labor is already high). In that case the price floor has no effect. (Flash film 7)

30. Copyright 2008 The McGraw-Hill Companies 3-30 Government set prices 6 5 4 3 2 1 0 2 4 6 8 10 12 14 16 18 Bushels of Corn (thousands per week) Price (per bushel) 7 3 D S $4 Price Floor 6,000 Bushel Surplus $2 Price Ceiling 7,000 Bushel Shortage

31. Copyright 2008 The McGraw-Hill Companies 3-31 Application: Market Equilibrium Q d = a 1 + b 1 P; a 1 >0, b 1 <0(1) Q s = a 2 + b 2 P; a 2 0 (2) Q d = Q s (3) Equilibrium Condition Solution At equilibrium a 1 + b 1 P = a 2 + b 2 P b 1 P - b 2 P = a 2 - a 1 P* = ( a 2 - a 1 ) ÷ ( b 1 - b 2 )

32. Copyright 2008 The McGraw-Hill Companies 3-32 Example. Given the following information: Q d = 45 - 2 P; a 1 >0, b 1 <0(1) Q s = -15 + 3P; Calculate the equilibrium price and quantity; Solution: At equilibrium: 45-2p = -15 + 3p 5p = 60 P* = 60/5 = 12 Q* = 45 – 2(12) = 21 1.Suppose that the government set a floor price 13, what will happen to the market? 2.Suppose that the government set a ceiling price 10, what will happen to the market?

33. Copyright 2008 The McGraw-Hill Companies 3-33 A Legal Market for Human Organs Waiting List for Transplants Demand for Organs Vertical Supply of Organs Incentive Role of Market and Up-Sloping Supply Increases Quantity Decreases Price Moral Objections Increase the Cost of Health Care Better to Legalize and Regulate? Last Word

34. Copyright 2008 The McGraw-Hill Companies 3-34 A Legal Market for Human Organs Last Word P Q S2S2 S1S1 D1D1 P1P1 P0P0 Q1Q1 Q2Q2 Q3Q3 Supply of Organs Demand for Organs Shortage at Zero Price Q 1 – Q 3 Supply With Price Incentive At Price P 1 the Shortage is Reduced By Q 1 – Q 2

35. Copyright 2008 The McGraw-Hill Companies 3-35 Key Terms Page demand demand schedule law of demand diminishing marginal utility income effect substitution effect demand curve determinants of demand normal goods inferior goods substitute good complementary good change in demand change in quantity demanded supply supply schedule law of supply supply curve determinants of supply change in supply change in quantity supplied equilibrium price equilibrium quantity surplus shortage price ceiling price floor

36. Copyright 2008 The McGraw-Hill Companies 3-36 Next Chapter Preview… The U.S. Economy: Public and Private Sectors