Supply and Demand: An Introduction

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MC

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Supply and Demand: An Introduction

How do consumers get the goods and services they want in the right quantities and qualities?

Some goods and services are allocated by the market forces of supply and demand

Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved.

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Supply and Demand: An Introduction

Why do some goods and services have shortages or surpluses and others do not?

Some good and supplies services are regulated by government

Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved.

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What, How, and For Whom? Central Planning Versus the Market

Three Problems All Economic Systems Must Address

What should be produced? How should it be produced? For whom will it be produced?

Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved.

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What, How, and For Whom? Central Planning Versus the Market

Centralized Economic Organizations

Agrarian society Former Soviet Union Cuba North Korea China Bureaucracy

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What, How, and For Whom? Central Planning Versus the Market

A small number of individuals address:

What
Establish

production targets for factories and

farms

How
Plan

how to achieve the goals

For Whom
Distribute

the goods and services

produced

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What, How, and For Whom? Central Planning Versus the Market

Free-Market or Capitalist Economic System

Individual choices determine:

Which

careers to pursue Which products to produce or buy When to start and shut-down a business Who gets what is decided by individual preferences and purchasing power

Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved.

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Buyers and Sellers In Markets

Market

Consists of all buyers and sellers of a good or service

What determines the price of pizza, gasoline, a car wash, or other goods and services?

What do you think?

Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved.

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Buyers and Sellers In Markets

The Demand Curve

A schedule or graph that tells us the quantity of a good that buyers wish to buy at each price

Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved.

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Buyers and Sellers In Markets

A Property of Demand
As price of a good or service goes down the quantity consumers wish to buy will increase Therefore, the demand curve is downwardsloping

Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved.

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The Daily Demand Curve for Pizza in Chicago

Price ($ per slice)

Demand

12

16

Quantity (1000s of slices per day)

Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved.

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Buyers and Sellers In Markets

The Demand Curve

Why do buyers purchase a greater quantity at lower prices and vice-versa?

The

substitution effect The income effect

Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved.

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Buyers and Sellers In Markets

The Substitution Effect

The change in the quantity demanded of a good that results because buyers switch to substitutes when the price of the good changes

Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved.

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Buyers and Sellers In Markets

The Income Effect

The change in the quantity demanded of a good that results because a change in the price of a good changes the buyers purchasing power

Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved.

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Buyers and Sellers In Markets

The Cost-Benefit Principle
The reservation price is the benefit the buyer receives from the good The cost of the good is its market price If the reservation price (benefit) exceeds the market price (cost) the consumer will purchase the good At higher prices, benefit will exceed cost for a smaller quantity than at lower prices

Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved.

Chapter 3 - Supply and Demand: An Introduction

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Buyers and Sellers In Markets

Price ($ per slice)

The buyers reservation price:

4 The largest dollar amount the buyer would be willing to pay for a good

Demand

12

16

Quantity (1000s of slices per day)

Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved.

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Buyers and Sellers In Markets

Horizontal Interpretation
Price ($ per slice)

Price determines quantity demanded

Demand

12

16

Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved.

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Buyers and Sellers In Markets

Vertical Interpretation
Price ($ per slice)

Quantity measures the marginal buyers reservation price

Demand

12

16

Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved.

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Buyers and Sellers In Markets

The Supply Curve

A curve or schedule showing the quantity of a good that sellers wish to sell at each price

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Buyers and Sellers In Markets

Question

Will the opportunity cost of producing additional units of pizza increase or decrease?
Hint:Low-hanging-fruit

principle

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Buyers and Sellers In Markets

The Supply Curve

Sellers must receive a higher price to produce additional units of product to cover the higher opportunity costs of each additional unit

Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved.

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The Daily Supply Curve for Pizza in Chicago

Price ($ per slice)

Supply

12

16

Quantity (1000s of slices per day)

Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved.

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The Daily Supply Curve for Pizza in Chicago

Horizontal Interpretation
Price ($ per slice)

Supply

4 Shows the quantity produced for each price

12

16

Quantity (1000s of slices per day)

Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved.

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The Daily Supply Curve for Pizza in Chicago

Vertical Interpretation
Price ($ per slice)

Supply

4 Shows the marginal cost (reservation price) for producing each additional unit

12

16

Quantity (1000s of slices per day)

Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved.

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The Daily Supply Curve for Pizza in Chicago

Sellers Reservation Price

The smallest dollar amount for which a seller would be willing to sell an additional unit, generally equal to marginal cost

Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved.

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Market Equilibrium

Equilibrium

A system is in equilibrium when there is no tendency for it to change

Occurs in a market when all buyers and sellers are satisfied with their respective quantities at the market price

Market Equilibrium

Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved.

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The Equilibrium Price and Quantity of Pizza In Chicago

Price ($ per slice)

Supply

Equilibrium at $3 Quantity Demanded = Quantity Supplied

Demand
Quantity (1000s of slices per day)

12

16

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Market Equilibrium

Equilibrium Price and Equilibrium Quantity

The values of price and quantity for which quantity supplied and quantity demanded are equal

Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved.

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Market Equilibrium

What Do You Think?

Would buyers prefer a lower price than the equilibrium price? Would sellers prefer a higher price than the equilibrium price?

Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved.

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Excess Supply
Excess supply = 8,000 slices per day
Price ($ per slice)

Supply

Demand
Quantity (1000s of slices per day)

12

16

Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved.

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Excess Demand
Price ($ per slice)

Supply

4 Excess demand = 8,000 slices per day

Demand
Quantity (1000s of slices per day)

16

Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved.

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Points Along the Demand and Supply Curves of a Pizza Market

Demand for pizza Supply of pizza
Price ($/slice) Quantity supplied (1000s of slices/day)

Price ($/slice)

Quantity demanded (1000s of slices/day)

1
2 3 4

8
6 4 2

1
2 3 4

2
4 6 8

Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved.

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Graphing Supply and Demand and Finding the Equilibrium Price and Quantity

Price ($per slice)

Supply

5
4

3 2.50
2

The Equilibrium Price = $2.50 The Equilibrium Quantity = 5

Demand
2 4 5 6 8 10
Quantity (1000s of slices per day)

Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved.

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Market Equilibrium

What Do You Think?

Is the market equilibrium always an ideal outcome for all market participants?

Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved.

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An Unregulated Housing Market

Monthly Rent ($/apartment)

Supply

1,600

What Do You Think? Is $1600 more than some people can afford?

Demand

Quantity (Millions of apartments/day)

Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved.

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Rent Controls
Monthly Rent ($/apartment)

Supply

2,400

1,600

Excess demand = 2 million apartments per month

Controlled = 800

Demand
Quantity (Millions of apartments/day)

Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved.

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Market Equilibrium

Rent Controls Reconsidered

Other consequences of rent controls

Maintenance

will decline and housing quality

will fall Illegal payments Creation of co-ops and conversion to condominiums Reduction in household mobility Discrimination

Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved.

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Market Equilibrium

What do you think?

How can we make housing affordable for poor people without using rent ceilings?

Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved.

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Rent Controls
Monthly Rent ($/apartment)

Supply

1,200 What is the impact of a rent control set at $1,200/month?

800

Demand
Quantity (Millions of apartments/day)

Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved.

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Price Controls In The Pizza Market

Price ($ per slice)

Supply

4
Excess demand = 8,000 slices per day

Price ceiling = 2

Demand
Quantity (1000s of slices per day)

12

16

Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved.

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Market Equilibrium

Pizza Price Controls?

Market responses to a pizza price ceiling

Long

lines Preferential treatment to selected customers Alternative pricing strategies Poorer quality ingredients Black-market pizzas

Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved.

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Predicting and Explaining Changes In Prices and Quantities

Distinguishing Between:

A change in the quantity demanded

A

movement along the demand curve that occurs in response to a change in price shift of the entire demand curve

A change in demand
A

Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved.

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An Increase In Quantity Demanded vs. An Increase In Demand

Price ($/can)

6 5 4 3 2 1

Increase in quantity demanded

D
2 4 6 8 10 12
Quantity (1000s of cans/day)

Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved.

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An Increase In Quantity Demanded vs. An Increase In Demand

Price ($/can)

6 5 4

Increase in demand
3 2

D
1

D
12
Quantity (1000s of cans/day)

Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved.

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Predicting and Explaining Changes In Prices and Quantities

Change in the quantity supplied

A movement along the supply curve that occurs in response to a change in price
A shift of the entire supply curve

Change in supply

Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved.

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An Increase In Quantity Supplied vs. An Increase In Supplied

Price ($/can)

6 5 4 3 2

S
Increase in quantity supplied

S
1
Quantity (1000s of cans/day)

10

Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved.

Chapter 3 - Supply and Demand: An Introduction

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An Increase In Quantity Supplied vs. An Increase In Supplied

Price ($/can)

6 5 4 3 2 1

Increase in supply

S
0 2 4

S
6 8 10
Quantity (1000s of cans/day)

Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved.

Chapter 3 - Supply and Demand: An Introduction

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The Effect on the Market for Tennis Balls of a Decline in Court-Rental Fees
Price ($/ball)

1.40 1.00

D
40 58
Quantity (letters/month)

Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved.

Chapter 3 - Supply and Demand: An Introduction

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Predicting and Explaining Changes In Prices and Quantities

Shifts in Demand

Complements
Two

goods are complements in consumption if an increase (decrease) in the price of one cause a decrease (increase) in the demand for the other

Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved.

Chapter 3 - Supply and Demand: An Introduction

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The Effect on the Market for Overnight Letter Delivery of a Decline in the Price of Internet Access

Price ($/letter)

P P

D
Q Q

Quantity (letters/month)

Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved.

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Predicting and Explaining Changes In Prices and Quantities

Shifts in Demand

Substitutes
Two

goods are substitutes in consumption if an increase (decrease) in the price of one causes an increase (decrease) in the demand for the other

Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved.

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Predicting and Explaining Changes In Prices and Quantities

What do you think?

How will a decline in airfares affect intercity bus fares and the price of hotel rooms in resort communities?

Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved.

Chapter 3 - Supply and Demand: An Introduction

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Predicting and Explaining Changes In Prices and Quantities

Economic Naturalist

When the Federal Government implements a large pay increase for its employees, why do rents for apartments near Washington Metro stations go up relative to rents for apartments located far away from Metro stations?

Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved.

Chapter 3 - Supply and Demand: An Introduction

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The Effect of a Federal Pay Raise on the Rent for Conveniently Located Apartments in Washington D.C.

Rent (dollars per month)

P P D
Conveniently located apartments (units per month)

D Q Q

Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved.

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Predicting and Explaining Changes In Prices and Quantities

Shifts in Demand

Changes In Demand
An

increase (decrease) in the demand for a good will shift the demand curve to the right (left)

Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved.

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Predicting and Explaining Changes In Prices and Quantities

A Change In Income

Normal Good
One

whose demand increases (decreases) when the incomes of buyers increase (decrease)

Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved.

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Predicting and Explaining Changes In Prices and Quantities

A Change In Income

Inferior Good
One

whose demand decreases (increases) when the incomes of buyers increase (decrease)

Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved.

Chapter 3 - Supply and Demand: An Introduction

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The Effect of the Release of Jurassic Park on the Market for Toy Dinosaurs
D = demand after release of movie Price

P P D D Q Q
Toy Dinosaurs (units per month)

Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved.

Chapter 3 - Supply and Demand: An Introduction

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The Effect of a Credible Rumor on the Market for Apple Macintosh Computers
D = demand after rumor of cheaper model soon to be released Price

P P D
Apple Computers (units per month)

D Q Q

Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved.

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The Effect of the Increase in the Population of Potential Buyers

D = demand after increase in population Price

P P D
Housing NY City (units per month)

D Q Q

Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved.

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Predicting and Explaining Changes In Prices and Quantities

Factors that Shift Demand

Price of complements Price of substitutes Income Preferences Population of potential buyers Expectations

Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved.

Chapter 3 - Supply and Demand: An Introduction

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The Effect on the Skateboard Market of an Increase in the Price of Fiberglass

Price ($/skateboard)

S S

80 60

D
800 1000
Quantity (skateboards/month)

Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved.

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Predicting and Explaining Changes In Prices and Quantities

What Do You Think?

Does the increase in the cost of fiberglass have any effect on the demand curve for skateboards?

Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved.

Chapter 3 - Supply and Demand: An Introduction

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The Effect on the Market for New Houses of a Decline in Carpenters Wage Rates

Price ($1000/house)

S S

120 90

D
40 50
Quantity (houses/month)

Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved.

Chapter 3 - Supply and Demand: An Introduction

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The Effect of Technical Change on the Market for the Term Paper Revisions

Price ($/revision)

55

7.50 12 36

Quantity (millions of revisions per year)

Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved.

Chapter 3 - Supply and Demand: An Introduction

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Predicting and Explaining Changes In Prices and Quantities

Factors that Shift Supply

Costs of production Technology Weather Number of suppliers Expectations

Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved.

Chapter 3 - Supply and Demand: An Introduction

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Four Rules Governing the Effects of Supply And Demand Shifts

An increase in demand will lead to an increase in both the equilibrium price and quantity Price

P P

D
Q Q

D
Quantity

Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved.

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Four Rules Governing the Effects of Supply And Demand Shifts

A decrease in demand will lead to a decrease in both the equilibrium price and quantity Price

P P

D
Q Q

D
Quantity

Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved.

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Four Rules Governing the Effects of Supply And Demand Shifts

An increase in supply will lead to a decrease in the equilibrium price and an increase in the equilibrium quantity Price

S S
P P

D
Q Q
Quantity

Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved.

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Four Rules Governing the Effects of Supply And Demand Shifts

An decrease in supply will lead to an increase in the equilibrium price and a decrease in the equilibrium quantity Price

S S

P P

D
Q
Quantity

Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved.

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Predicting and Explaining Changes In Prices and Demand Factors That Cause an Increase (rightward or upward shift) in Demand

1. A decrease in the price of complements to the good or service 2. An increase in the price of substitutes for the good or service 3. An increase in income (for a normal good)

Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved.

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Predicting and Explaining Changes In Prices and Demand Factors That Cause an Increase (rightward or upward shift) in Demand

4. An increased preference by demanders for the good or service 5. An increase in the population of potential buyers 6. An expectation of higher prices in the future

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Predicting and Explaining Changes In Prices and Demand Factors That Cause an Increase (rightward or upward shift) in Supply

1. A decrease in the cost of materials, labor, or other inputs used in the production of the good or service 2. An improvement in technology that reduces the cost of producing the good or service

Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved.

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Predicting and Explaining Changes In Prices and Demand Factors That Cause an Increase (rightward or upward shift) in Supply

3. An improvement in the weather, especially for agricultural products 4. An increase in the number of suppliers 5. An expectation of lower prices in the future

Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved.

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The Effects Of Simultaneous Shifts In Supply And Demand

The Market for Corn Tortilla Chips
Price ($/bag)

S P P

S after reduction in price of corn harvesting equipment D after discovery that oils are harmful to peoples health

D
D Q Q
Millions of bags per month

Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved.

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The Effects Of Simultaneous Shifts In Supply And Demand

The Market for Corn Tortilla Chips
Price ($/bag)

S P S
S after reduction in price of corn harvesting equipment D after discovery that oils are harmful to peoples health

P
D

D
Millions of bags per month

Q Q

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Predicting and Explaining Changes In Prices and Demand

Assume
A vitamin found in corn chips helps protect against cancer and heart diseases Swarm of locusts destroys part of the corn crop

What Do You Think?

What will happen to the equilibrium price and quantity of corn chips?

Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved.

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Predicting and Explaining Changes In Prices and Demand

Economic Naturalist

Why do the prices of some goods, like airline tickets to Europe, go up during the months of heaviest consumption, while others, like sweet corn, go down?

Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved.

Chapter 3 - Supply and Demand: An Introduction

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Seasonal Variation in Air Travel

High Consumption and Prices Due to High Demand Price ($/ticket)

S PS

PW
DW QW QS

DS

1000s of tickets

Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved.

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Seasonal Variation in Corn Markets

Price ($/bushel)

High Consumption and Low Prices due to High Supply

SW

SS

PS PW

QW

QS

Millions of bushels

Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved.

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Markets And Social Welfare

What Do You Think?

When are the prices and quantities determined in market equilibrium socially optimal, in the sense of maximizing total economic surplus?

Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved.

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Markets And Social Welfare

Cash On The Table

Assume:
All

exchange is purely voluntary

If so:
The

buyers reservation price exceeds the sellers reservation price and both the buyer and seller receive an economic surplus

Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved.

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Markets And Social Welfare

Cash On The Table

Buyers surplus
The

difference between the buyers reservation price and the price he or she actually pays

Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved.

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Markets And Social Welfare

Cash On The Table

Sellers surplus
The

difference between the price received by the seller and his or her reservation price

Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved.

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Markets And Social Welfare

Cash On The Table

Total surplus
The

difference between the buyers reservation price and the sellers reservation price

Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved.

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Markets And Social Welfare

Cash On The Table

Economic metaphor for unexploited gains from exchange

Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved.

Chapter 3 - Supply and Demand: An Introduction

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Price Controls In The Pizza Market

Assume: Buyers reservation P = $4 Sellers reservation P = $2 Pizza sells for $3

Price ($ per slice)

4
Buyers surplus: $4 - $3 = $1 Sellers surplus: $3 - $2 = $1 Total surplus: $4 - $2 = $2

D
Quantity (1000s of slices per day)

12

16

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Price Controls In The Pizza Market

Excess demand = $8,000 slices/day

Price ($ per slice)

Assume price controls = $2 Quantity supplied falls to 8,000 Buyers reservation price ($4) is greater than sellers ($2) Both would benefit from additional production There is CASH ON THE TABLE

D
Quantity (1000s of slices per day)

12

16

Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved.

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Socially optimal quantity

The

quantity of a good that results in the maximum possible economic surplus from producing and consuming the good

The socially optimal quantity occurs when MC = MB

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Economic efficiency occurs when all goods and services are produced and consumed at their respective socially optimal levels

Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved.

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The Efficiency Principle

Maximize

the economic surplus Increases the economic pie

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When is the market equilibrium efficient?

When

all cost of producing the good or service are borne directly by the seller When all benefits from the good or service accrue directly to buyers

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Inefficient market equilibrium

When

some costs of production fall on people other than those who sell the good or service

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Example: Pollution
The market is in equilibrium: MC = MB MC however underestimates the cost to society of producing the good Therefore, the market produces more than the efficient amount and there is no incentive for producers and consumers to alter their behavior

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Inefficient market equilibrium

When

some benefits from the good or service accrue to people who did not buy the good or service

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Example: Vaccinations
The

market is in equilibrium: MC = MB MB underestimates the benefits to society of consuming the vaccinations The market produces less than the efficient amount of vaccinations and there is no incentive for producers and consumers to alter their behavior

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In these markets
Buyers

and sellers are behaving rationally Market equilibrium exists There are no unexploited opportunities for individuals Economic surplus is not maximized

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The Equilibrium Principle

A market in equilibrium leaves no unexploited opportunities for individuals, but may not exploit all gains achievable through collective action.

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