1 Chapter 3 (not so briefly) An Introduction to Supply and Demand What is a market? Where do prices come from? What happens if prices are set “too.

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Chapter 3 (not so briefly)Chapter 3 (not so briefly)

An Introduction to Supply and DemandWhat is a market?Where do prices come from?What happens if prices are set “too high”?What happens if prices are set “too low”?Do markets really achieve equilibrium?

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QuestionsQuestions

All economies must answer the following questions:What should be produced?How should it be produced?For whom will it be produced?

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Central PlanningCentral PlanningAgrarian societyFormer Soviet UnionCuba, North KoreaChinaBureaucracy

A small number of individuals address these concerns:Establish production targets for factories and farmsPlan how to achieve the goalsDistribute the goods and services produced

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Market ForcesMarket ForcesFree marketCapitalist economies

Individuals decide for themselvesWhich careers to pursueWhich products to produce or buyWhen to start businessesWho gets what is decided by individual

preferences and purchasing power

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MarketsMarkets

A market for any good consists of all buyers and sellers of that goodIncludes individuals who either do sell or

might sell = suppliers (usually firms)Includes individuals who either do buy or

might buy = demanders (usually people)

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PricesPricesWhy are some goods cheap and others

expensive?Through most of history, individuals had no ideaMost thought that it was because of the cost of

productionOthers thought only of the value people received

from consumption

Answer: both supply and demand determine prices

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SupplySupply

Shows the quantity of a good or service that sellers wish to sell at each priceOn a graph = supply curveIn a schedule = supply schedule

Positive relationship between P and QS

As price rises, a higher quantity can be sold because more opportunity costs can be covered

Application of the “low-hanging fruit principle”Reflects the rising marginal costs of producing

additional units

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Supply ScheduleSupply Schedule

Price Quantity Supplied

$4 16

$3 12

$2 8

$1 4

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Supply Curve - Fig. 4.1Daily Supply Curve of Hamburgers in

Greenwich Village

Supply Curve - Fig. 4.1Daily Supply Curve of Hamburgers in

Greenwich Village

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DemandDemandShows the total quantity of a good or service

that buyers wish to buy at each priceOn a graph = demand curveIn a schedule = demand schedule

Inverse relationship between P and QD

As price rises, consumers want fewer itemsPeople switch to substitutesPeople cannot afford as much

At higher quantities, consumers are willing to pay less (application of the principle of diminishing marginal utility/benefit)

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Demand ScheduleDemand Schedule

Price Quantity Demanded

$4 8

$3 12

$2 16

$1 20

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Demand Curve - Fig. 4.2Daily Demand Curve for Hamburgers

Demand Curve - Fig. 4.2Daily Demand Curve for Hamburgers

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Market EquilibriumMarket Equilibrium

When all buyers and sellers are satisfied with their respective quantities at the market priceThere is a stable, balanced, unchanging situationThe supply and demand curves intersectThis results in the equilibrium price

The price the good sells for

This results in the equilibrium quantityThe quantity that will be sold

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Market Equilibrium - Fig. 4.3The Equilibrium Price and Quantity of

Hamburgers in Greenwich Village

Market Equilibrium - Fig. 4.3The Equilibrium Price and Quantity of

Hamburgers in Greenwich Village

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Do markets really exist in equilibrium?

Do markets really exist in equilibrium?

What would be evidence that a particular market is in equilibrium? Stable pricesStable quantities

Can you name a good for which price has not changed in a long time?

Can you name a good for which price changes daily?

Can you name a good for which price changes every second?

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Does equilibrium mean all wants are satisfied ?

Does equilibrium mean all wants are satisfied ?

Market equilibrium does not mean that everyone has what they wantE.G. a poor person may not be able to

afford the item at the equilibrium price

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DisequilibriumDisequilibriumExcess supply

Market SurplusPrice is higher than equilibrium priceSellers are dissatisfied

Excess demandMarket ShortagePrice is lower than equilibrium priceBuyers are dissatisfied

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Fig. 4.4 Excess Supply

Fig. 4.4 Excess Supply

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Fig. 4.5Excess Demand

Fig. 4.5Excess Demand

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Free Markets and Equilibrium

Free Markets and Equilibrium

Free markets have an automatic tendency to eliminate excess supply and excess demandA market surplus serves as a signal to

sellers that price is too high and therefore leads producers to decrease the price

A market shortage serves as a signal to sellers that price is too low and therefore leads producers to increase the price

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Legislation and MarketsLegislation and MarketsLegislators protect producers and

consumers by using price controlsPrice ceilingsPrice floors

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Price controlsPrice controls

price ceilings – intended to help consumers A maximum allowable price specified by law

because the true equilibrium price was deemed “too high”

Price ceiling price < P* so now consumers want too much

e.g. rent controls, limits on the price of gasolineResult in permanent shortages

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Price ControlsPrice Controls

price floors – intended to help producersA minimum allowable price specified by

lawFor example, agricultural price supports,

minimum wagesPrice floor price is > P* so now sellers

want to sell moreResult in surpluses

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Fig. 4.6An Unregulated Housing Market

Fig. 4.6An Unregulated Housing Market

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Fig. 4.7Rent Controls

Fig. 4.7Rent Controls

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Markets and Social WelfareMarkets and Social WelfareSocial optimal quantity of a good

The quantity that results in the maximum possible economic surplus (net gains)

The socially optimal quantity will occur where the marginal cost equals the marginal benefit

Economic efficiencyOccurs when all goods and services are

produced and consumed at their respective socially optimal levels

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Markets and EfficiencyMarkets and EfficiencyEfficiency Principle

Efficiency is an important social goalEveryone can have a larger slice of a larger pie

Equilibrium PrincipleA market in equilibrium leaves no unexploited

opportunities for individualsNo “cash on the table” remainsAll opportunities for profit have been exploited

Efficiency occurs whenthe market-demand curve captures all the marginal

benefits of the goodthe market-supply curve captures all the marginal costs

of the good

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TerminologyTerminology

If the good’s price changes, you have a“change in quantity demanded”

A movement along the demand curve “change in quantity supplied”

A movement along the supply curve

If something else changes, you have a“change in demand”

A shift of the entire demand curvechange in supply”

A shift of the entire supply curve

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Fig. 4.9An Increase in the Quantity Demanded

Versus an Increase in Demand

Fig. 4.9An Increase in the Quantity Demanded

Versus an Increase in Demand

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Shifts in SupplyShifts in Supply

Favorable changes to the producer shift supply curve rightwardlower equilibrium pricehigher equilibrium quantity

Unfavorable changes to the producer shift supply leftwardhigher equilibrium pricelower equilibrium quantity

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Fig. 4.10The Effect on the Skateboard Market of an Increase in the Price of Fiberglass

Fig. 4.10The Effect on the Skateboard Market of an Increase in the Price of Fiberglass

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Shifts in SupplyShifts in Supply

Changes in the Cost of ProductionChanges in TechnologyChanges in WeatherChanges in Expectations

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An Increase in SupplyAn Increase in SupplySequence of events:

1. Conditions become more favorable to firms. Eg: lower cost of inputs

2. Firms now can earn higher per-unit profits at any price, so they wish to sell more units at all prices.

3. Firms increase Qs for all Prices = shift right in the supply curve (along demand).

4. Shift results in lower P* and higher Q*

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Fig. 4.11The Effect on the Market for New Houses of a Decline in Carpenters’ Wage Rates

Fig. 4.11The Effect on the Market for New Houses of a Decline in Carpenters’ Wage Rates

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Fig. 4.12The Effect of Technical Change on the

Market for Manuscript Revisions

Fig. 4.12The Effect of Technical Change on the

Market for Manuscript Revisions

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Shifts in DemandShifts in DemandComplementsSubstitutesIncomePreferencesDemand curve shifts rightward

higher equilibrium pricehigher equilibrium quantity

Demand curve shifts leftwardlower equilibrium pricelower equilibrium quantity

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An Increase in DemandAn Increase in DemandSequence of events:1. Conditions change such that consumers

want more units at any price. Egs: lower price of complement good, higher price of a substitute, higher income, …

2. Higher Qd at all prices means rightward shift in the demand curve

3. Demand shifts right (along supply) resulting in higher P* and Q*

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Fig. 4.13The Effect on the Market for Tennis

Balls of a Decline in Court Rental Fees

Fig. 4.13The Effect on the Market for Tennis

Balls of a Decline in Court Rental Fees

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ComplementsComplements

Goods that are more valuable when used in combination--e.g. tennis balls and tennis courts

Two goods are complements in consumption if an increase in the price of one causes a leftward shift in the demand curve for the other

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SubstitutesSubstitutes

Goods that replace each other--e.g. email messages and overnight letters

Two goods are substitutes in consumption if an increase in the price of one causes a rightward shift in the demand curve for the other

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Fig. 4.14Effect on the Market for Overnight Letter

Delivery of a Decline in the Price of Internet Access

Fig. 4.14Effect on the Market for Overnight Letter

Delivery of a Decline in the Price of Internet Access

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IncomeIncome

Normal goodOne whose demand curve shifts right

when the incomes of buyers increase

Inferior goodOne whose demand curves shifts left when

the incomes of buyers increase

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Fig. 4.15The Effect of a Federal Pay Raise on the

Rent for Conveniently Located Apartments

Fig. 4.15The Effect of a Federal Pay Raise on the

Rent for Conveniently Located Apartments

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Simultaneous ShiftsSimultaneous ShiftsIf, at the same time,

Demand decreases and Supply increases

Demand shifts leftLower price, lower quantity

Supply shifts rightLower price, higher quantity

We can predict that price will fallBut, what happens to quantity?

We must know the magnitude of the shifts

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Fig. 4.17 The Effects of Simultaneous Shifts in

Supply and Demand

Fig. 4.17 The Effects of Simultaneous Shifts in

Supply and Demand

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Naturalist QuestionNaturalist QuestionWhy did you pay $60 for a Christmas tree in

2000 which only cost $40 in 1999? Assume: Inflation was not 50% The number of Christmas trees sold year to year in

the United States is fairly stable. It takes six to eight years to grow a tree to the right

size for Christmas trees. There are over 15,000 Christmas tree farms in the

US Recall: there were significant forest fires in the

northwest in 2000