Supply and Demand Slides by John Pamela Hall

Supply and Demand • Supply and demand is an economic model – Designed to explain how prices are determined in certain types of markets • What you will learn in this chapter – How the model of supply and demand works and how to use it – Strengths and limitations of model 2

Markets • Specific location where buying and selling takes place, such as – Supermarket or a flea market • In economics, a market is not a place but rather – A group of buyers and sellers with the potential to trade with each other • Economists think of the economy as a collection of individual markets • First step in an economic analysis is to define and characterize the market or collection of markets to analyze 3

How Broadly Should We Define The Market • Defining the market often requires economists to group things together – Aggregation is the combining of a group of distinct things into a single whole • Markets can be defined broadly or narrowly, depending on our purpose – How broadly or narrowly markets are defined is one of the most important differences between Macroeconomics and Microeconomics 4

Defining Macroeconomic Markets • Goods and services are aggregated to the highest levels – Macro models lump all consumer goods into the single category “consumption goods” – Macro models will also analyze all capital goods as one market – Macroeconomists take an overall view of the economy without getting bogged down in details 5

Defining Microeconomic Markets • Markets are defined narrowly – Focus on models that define much more specific commodities • Always involves some aggregation – Stops short of the broad levels of generality that macroeconomics investigates 6

Buyers and Sellers • Buyers and sellers in a market can be – Households – Business firms – Government agencies • All three can be both buyers and sellers in the same market, but are not always • For purposes of simplification this text will usually follow these guidelines – In markets for consumer goods, we’ll view business firms as the only sellers, and households as only buyers – In most of our discussions, we’ll be leaving out the “middleman” 7

Competition in Markets • In imperfectly competitive markets, individual buyers or sellers can influence the price of the product • In perfectly competitive markets (or just competitive markets), each buyer and seller takes the market price as a given • What makes some markets imperfectly competitive and others perfectly competitive? – Perfectly competitive markets have many small buyers and sellers • Each is a small part of the market, and the product is standardized – Imperfectly competitive markets have just a few large buyers and sellers • Or else the product of each seller is unique in some way 8

Using Supply and Demand • Supply and demand model is designed to explain how prices are determined in perfectly competitive markets – Perfect competition is rare but many markets come reasonably close – Perfect competition is a matter of degree rather than an all or nothing characteristic • Supply and demand is one of the most versatile and widely used models in the economist’s tool kit 9

Demand • A household’s quantity demanded of a good – Specific amount household would choose to buy over some time period, given • A particular price that must be paid for the good • All other constraints on the household • Market quantity demanded (or quantity demanded) is the specific amount of a good that all buyers in the market would choose to buy over some time period, given – A particular price they must pay for the good – All other constraints on households 10

Quantity Demanded • Implies a choice – How much households would like to buy when they take into account the opportunity cost of their decisions? • Is hypothetical – Makes no assumptions about availability of the good – How much would households want to buy, at a specific price, given real-world limits on their spending power? • Stresses price – Price of the good is one variable among many that influences quantity demanded – We’ll assume that all other influences on demand are held constant, so we can explore the relationship between price and quantity demanded 11

The Law of Demand • States that when the price of a good rises and everything else remains the same, the quantity of the good demanded will fall – The words, “everything else remains the same” are important • In the real world many variables change simultaneously • However, in order to understand the economy we must first understand each variable separately • Thus we assume that, “everything else remains the same, ” in order to understand how demand reacts to price 12

The Demand Schedule and The Demand Curve • Demand schedule – A list showing the quantity of a good that consumers would choose to purchase at different prices, with all other variables held constant • The market demand curve (or just demand curve) shows the relationship between the price of a good and the quantity demanded , holding constant all other variables that influence demand – Each point on the curve shows the total buyers would choose to buy at a specific price • Law of demand tells us that demand curves virtually always slope downward 13

Figure 1: The Demand Curve Price per Bottle When the price is $4. 00 per bottle, 40, 000 bottles are demanded (point A). $4. 00 A B 2. 00 At $2. 00 per bottle, 60, 000 bottles are demanded (point B). D 40, 000 60, 000 Number of Bottles per Month 14

Shifts vs. Movements Along The Demand Curve • A change in the price of a good causes a movement along the demand curve • In Figure 1 – A fall (rise) in price would cause a movement to the right (left) along the demand curve • A change in income causes a shift in the demand curve itself • In Figure 2 – Demand curve has shifted to the right of the old curve (from Figure 1) as income has risen – A change in any variable that affects demand—except for the good’s price—causes the demand curve to shift 15

Figure 2: A Shift of The Demand Curve Price per Bottle An increase in income shifts the demand curve for maple syrup from D 1 to D 2. At each price, more bottles are demanded after the shift $2. 00 B 60, 000 C D 1 D 2 80, 000 Number of Bottles per Month 16

Dangerous Curves: “Change in Quantity Demanded” vs. “Change in Demand” • Language is important when discussing demand – “Quantity demanded” means • A particular amount that buyers would choose to buy at a specific price • It is a number represented by a single point on a demand curve • When a change in the price of a good moves us along a demand curve, it is a change in quantity demand – The term demand means • The entire relationship between price and quantity demanded— and represented by the entire demand curve • When something other than price changes, causing the entire demand curve to shift, it is a change in demand 17

Income: Factors That Shift The Demand Curve • An increase in income has effect of shifting demand for normal goods to the right – However, a rise in income shifts demand for inferior goods to the left • A rise in income will increase the demand for a normal good, and decrease the demand for an inferior good 18

Wealth: Factors That Shift The Demand Curve • Your wealth—at any point in time—is the total value of everything you own minus the total dollar amount you owe • An increase in wealth will – Increase demand (shift the curve rightward) for a normal good – Decrease demand (shift the curve leftward) for an inferior good 19

Prices of Related Goods: Factors that Shift the Demand Curve • Substitute—good that can be used in place of some other good and that fulfills more or less the same purpose – A rise in the price of a substitute increases the demand for a good, shifting the demand curve to the right • Complement—used together with the good we are interested in – A rise in the price of a complement decreases the demand for a good, shifting the demand curve to the left 20

Other Factors That Shift the Demand Curve • Population – As the population increases in an area • Number of buyers will ordinarily increase • Demand for a good will increase • Expected Price – An expectation that price will rise (fall) in the future shifts the current demand curve rightward (leftward) • Tastes – Combination of all the personal factors that go into determining how a buyer feels about a good – When tastes change toward a good, demand increases, and the demand curve shifts to the right – When tastes change away from a good, demand decreases, and the demand curve shifts to the left 21

Figure 3(a): Movements Along and Shifts of The Demand Curve Price increase moves us leftward along demand curve P 2 Price increase moves us rightward along demand curve P 1 P 3 Q 2 Q 1 Q 3 Quantity 22

Figure 3(b): Movements Along and Shifts of The Demand Curve Price Entire demand curve shifts rightward when: • income or wealth ↑ • price of substitute ↑ • price of complement ↓ • population ↑ • expected price ↑ • tastes shift toward good D 2 D 1 Quantity 23

Figure 3(c): Movements Along and Shifts of The Demand Curve Price Entire demand curve shifts leftward when: • income or wealth ↓ • price of substitute ↓ • price of complement ↑ • population ↓ • expected price ↓ • tastes shift toward good D 1 D 2 Quantity 24

Supply • A firm’s quantity supplied of a good is the specific amount its managers would choose to sell over some time period, given – A particular price for the good – All other constraints on the firm • Market quantity supplied (or quantity supplied) is the specific amount of a good that all sellers in the market would choose to sell over some time period, given – A particular price for the good – All other constraints on firms 25

Quantity Supplied • Implies a choice – Quantity that gives firms the highest possible profits when they take account of the constraints presented to them by the real world • Is hypothetical – Does not make assumptions about firms’ ability to sell the good – How much would firms’ managers want to sell, given the price of the good and all other constraints they must consider? • Stresses price – The price of the good is just one variable among many that influences quantity supplied – We’ll assume that all other influences on supply are held constant, so we can explore the relationship between price and quantity supplied 26

The Law of Supply • States that when the price of a good rises and everything else remains the same, the quantity of the good supplied will rise – The words, “everything else remains the same” are important • In the real world many variables change simultaneously • However, in order to understand the economy we must first understand each variable separately • We assume “everything else remains the same” in order to understand how supply reacts to price 27

The Supply Schedule and The Supply Curve • Supply schedule—shows quantities of a good or service firms would choose to produce and sell at different prices, with all other variables held constant • Supply curve—graphical depiction of a supply schedule – Shows quantity of a good or service supplied at various prices, with all other variables held constant 28

Figure 4: The Supply Curve Price per Bottle When the price is $2. 00 per bottle, 40, 000 bottles are supplied (point F). $4. 00 2. 00 S G At $4. 00 per bottle, quantity supplied is 60, 000 bottles (point G). F 40, 000 60, 000 Number of Bottles per Month 29

Shifts vs. Movements Along the Supply Curve • A change in the price of a good causes a movement along the supply curve – In Figure 4 • A rise (fall) in price would cause a rightward (leftward) movement along the supply curve • A drop in transportation costs will cause a shift in the supply curve itself – In Figure 5 • Supply curve has shifted to the right of the old curve (from Figure 4) as transportation costs have dropped • A change in any variable that affects supply—except for the good’s price—causes the supply curve to shift 30

Figure 5: A Shift of The Supply Curve Price per Bottle A decrease in transportation costs shifts the supply curve for maple syrup from S 1 to S 2. S 1 S 2 At each price, more bottles are supplied after the shift $4. 00 G 60, 000 J 80, 000 Number of Bottles per Month 31

Factors That Shift the Supply Curve • Input prices – A fall (rise) in the price of an input causes an increase (decrease) in supply, shifting the supply curve to the right (left) • Price of Related Goods – When the price of an alternate good rises (falls), the supply curve for the good in question shifts rightward (leftward) • Technology – Cost-saving technological advances increase the supply of a good, shifting the supply curve to the right 32

Factors That Shift the Supply Curve • Number of Firms – An increase (decrease) in the number of sellers —with no other changes—shifts the supply curve to the right (left) • Expected Price – An expectation of a future price increase (decrease) shifts the current supply curve to the left (right) 33

Factors That Shift the Supply Curve • Changes in weather – Favorable weather • Increases crop yields • Causes a rightward shift of the supply curve for that crop – Unfavorable weather • Destroys crops • Shrinks yields • Shifts the supply curve leftward • Other unfavorable natural events may effect all firms in an area – Causing a leftward shift in the supply curve 34

Figure 6(a): Changes in Supply and in Quantity Supplied Price S Price increase moves us rightward along supply curve P 2 P 1 Price increase moves us leftward along supply curve P 3 Q 1 Q 2 Quantity 35

Figure 6(b): Changes in Supply and in Quantity Supplied Price Entire supply curve shifts rightward when: • price of input ↓ • price of alternate good ↓ • number of firms ↑ • expected price ↑ • technological advance • favorable weather S 1 S 2 Quantity 36

Figure 6(c): Changes in Supply and in Quantity Supplied Price Entire supply curve shifts rightward when: • price of input ↑ • price of alternate good ↑ • number of firms ↓ • expected price ↑ • unfavorable weather S 2 S 1 Quantity 37

In Summary: Factors That Shift The Supply Curve • The short list of shift-variables for supply that we have discussed is far from exhaustive • In some cases, even the threat of such events can cause serious effects on production • Basic principle is always the same – Anything that makes sellers want to sell more or less of a good at any given price will shift supply curve 38

Equilibrium: Putting Supply and Demand Together • When a market is in equilibrium – Both price of good and quantity bought and sold have settled into a state of rest – The equilibrium price and equilibrium quantity are values for price and quantity in the market but, once achieved, will remain constant • Unless and until supply curve or demand curve shifts • The equilibrium price and equilibrium quantity can be found on the vertical and horizontal axes, respectively – At point where supply and demand curves cross 39

Figure 7: Market Equilibrium Price per Bottle 2. causes the price to rise. . . 3. shrinking the excess demand. . . S E $3. 00 1. At a price of $1. 00 per bottle an excess demand of 50, 000 bottles. . . H Excess Demand 4. until price reaches its equilibrium value of $3. 00. J 25, 000 50, 000 75, 000 D Number of Bottles per Month 40

Excess Demand: Putting Supply and Demand Together • Excess demand – At a given price, the excess of quantity demanded over quantity supplied • Price of the good will rise as buyers compete with each other to get more of the good than is available 41

Figure 8: Excess Supply and Price Adjustment Price per Bottle 1. At a price of $5. 00 per bottle an excess supply of 30, 000 bottles. . . Excess Supply at $5. 00 S $5. 00 2. causes the price to drop, 3. 00 3. shrinking the excess supply. . . L K E 4. until price reaches its equilibrium value of $3. 00. D 35, 000 50, 000 65, 000 Number of Bottles per Month 42

Excess Supply: Putting Supply and Demand Together • Excess Supply – At a given price, the excess of quantity supplied over quantity demanded • Price of the good will fall as sellers compete with each other to sell more of the good than buyers want 43

Income Rises: What Happens When Things Change • Income rises, causing an increase in demand – Rightward shift in the demand curve causes rightward movement along the supply curve – Equilibrium price and equilibrium quantity both rise • Shift of one curve causes a movement along the other curve to new equilibrium point 44

Figure 9 Price per Bottle 4. Equilibrium price increases 3. to a new equilibrium. S F' $4. 00 3. 00 2. moves us along the supply curve. . . E 1. An increase in demand. . . D 2 D 1 5. and equilibrium quantity increases too. 50, 000 60, 000 Number of Bottles of Maple Syrup per Period 45

An Ice Storm Hits: What Happens When Things Change • An ice storm causes a decrease in supply – Weather is a shift variable for supply curve • Any change that shifts the supply curve leftward in a market will increase the equilibrium price – And decrease the equilibrium quantity in that market 46

Figure 10: A Shift of Supply and A New Equilibrium Price per Bottle $5. 00 3. 00 S 2 S 1 E' E D 35, 000 50, 000 Number of Bottles 47

Figure 11: Changes in the Market for Handheld PCs Price per Handheld PC 3. moved the market to a new equilibrium. 2. and a decrease in demand. . . 4. Price decreased. . . A $500 B $400 S 2002 S 2003 1. An increase in supply. . . D 2002 5. and quantity decreased as well. D 2003 2. 45 3. 33 Millions of Handheld PCs per Quarter 48

Both Curves Shift • When just one curve shifts (and we know the direction of the shift) we can determine the direction that both equilibrium price and quantity will move • When both curves shift (and we know the direction of the shifts) we can determine the direction for either price or quantity—but not both – Direction of the other will depend on which curve shifts by more 49

The Three Step Process • Key Step 1—Characterize the Market – Decide which market or markets best suit problem being analyzed and identify decision makers (buyers and sellers) who interact there • Key Step 2—Find the Equilibrium – Describe conditions necessary for equilibrium in the market, and a method for determining that equilibrium • Key Step 3—What Happens When Things Change – Explore how events or government polices change market equilibrium 50

Using Supply and Demand: The Invasion of Kuwait • Why did Iraq’s invasion of Kuwait cause the price of oil to rise? – Immediately after the invasion, United States led a worldwide embargo on oil from both Iraq and Kuwait – A significant decrease in the oil industry’s productive capacity caused a shift in the supply curve to the left • Price of oil increased 51

Figure 12: The Market For Oil Price per Barrel of Oil S 2 S 1 E' P 2 E P 1 D Q 2 Q 1 Barrels of Oil 52

Using Supply and Demand: The Invasion of Kuwait • Why did the price of natural gas rise as well? – Oil is a substitute for natural gas – Rise in the price of a substitute increases demand for a good – Rise in price of oil caused demand curve for natural gas to shift to the right • Thus, the price of natural gas rose 53

Figure 13: The Market For Natural Gas Price per Cubic Foot of Natural Gas S F' P 4 P 3 F D 2 D 1 Q 3 Q 4 Cubic Feet of Natural Gas 54