3 Supply And Demand

Theory of Supply and Demand

2

Overview Market (who, what, how) Supply and demand is an economic model

– Designed to explain how prices are determined in certain types of markets

1. The law of demand2. The law of supply3. The determination of market equilibrium4. Factors shifting demand or supply curves

3

Markets

In economics, a market is not a place but rather a group of buyers and sellers with the potential to trade with each other – Market is defined not by its location but by its

participants– First step in an economic analysis is to define and

characterize the market or collection of markets to analyze

Economists think of the economy as a collection of individual markets

4

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

5

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

6

Defining Microeconomic Markets

Markets are defined narrowly– Focus on models that define much more

specific commodities

7

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 we 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”

8

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

9

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

10

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

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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

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The Law of Demand

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

13

The Demand Schedule

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

Demand V.S. Quantities demanded - demand is the entire relationship between price and quantity

- quantities demanded are specific amount of goods buyers want to buy

14

The Demand Curve

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

15

Figure 1: The Demand Curve

Number of Bottles per Month

Price per Bottle

A

B

Rs4.00

2.00

D

40,000 60,000

At Rs2.00 per bottle, 60,000 bottles are demanded (point B).

When the price is Rs4.00 per bottle, 40,000 bottles are demanded (point A).

16

“Shifts” vs. “Movements Along” The Demand Curve

Move along the demand curve– From a change in the price of the good we analyze

In maple syrup example, Figure 1– A fall in price would cause a movement to the right along the

demand curve (point A to B)

See figure 3(a)

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Figure 3(a): Movements Along and Shifts of The Demand Curve

Quantity

Price

P2

Q2 Q1 Q3

P1

P3

Price increase moves us leftward along demand curve

Price increase moves us rightward along demand curve

18

“Shifts” vs. “Movements Along” The Demand Curve

Shift of demand curve– a change in other things than price of the good causes a

shift in the demand curve itself, for example, income 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

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Figure 2: A Shift of The Demand Curve

B CRs2.00

60,000 80,000

D1D2

An increase in income shifts the demand curve for maple syrup from D1 to D2.


Price per Bottle

At each price, more bottles are demanded after the shift

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“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

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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 leftA rise in income will increase the demand

for a normal good, and decrease the demand for an inferior good

Normal good and inferior good are defined by the relation between demand and income

22

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

- ExampleAn increase in wealth will

– Increase demand (shift the curve rightward) for a normal good

– Decrease demand (shift the curve leftward) for an inferior good

23

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– Example– 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– Example– A rise in the price of a complement decreases the demand

for a good, shifting the demand curve to the left

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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

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Small Summary-- Factors Affecting Demand

Income (depends on good’s nature: normal or inferior)

Wealth (depends on good’s nature)Prices of substitutes (positively related) Prices of complements (negatively related)Population (positively related)Expected price (positively related)Tastes (positively related)

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Figure 3(b): Movements Along and Shifts of The Demand Curve

Quantity

Price

D2

D1

Entire demand curve shifts rightward when:• income or wealth ↑• price of substitute ↑• price of complement ↓• population ↑• expected price ↑• tastes shift toward good

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Figure 3(c): Movements Along and Shifts of The Demand Curve

Quantity

Price

D1

D2

Entire demand curve shifts leftward when:• income or wealth ↓• price of substitute ↓• price of complement ↑• population ↓• expected price ↓• tastes shift toward good

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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

29

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

30

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

31

The Supply Schedule and The Supply CurveSupply 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

32

Figure 4: The Supply Curve

F

G

2.00

S

40,000 60,000

Rs4.00

At Rs4.00 per bottle, quantity supplied is 60,000 bottles (point G).

When the price is Rs2.00 per bottle, 40,000 bottles are supplied (point F).


Price per Bottle

33

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

34

Figure 5: A Shift of The Supply Curve

S2

GJ

S1

60,000

Rs4.00

80,000

A decrease in transportation costs shifts the supply curve for maple syrup from S1 to S2.


Price per Bottle

At each price, more bottles are supplied after the shift

35

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 leftward (rightward)

Technology– Cost-saving technological advances increase the supply

of a good, shifting the supply curve to the right

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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)

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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

38

Figure 6(a): Changes in Supply and in Quantity Supplied

P2

Q3 Q1 Q2

P1

P3

Quantity

Price Price increase moves us rightward along supply curve

S

Price increase moves us leftward along supply curve

39

Figure 6(b): Changes in Supply and in Quantity Supplied

Quantity

Price

S2

S1Entire supply curve shifts rightward when:• price of input ↓• price of alternate good ↓• number of firms ↑• expected price ↑• technological advance• favorable weather

40

Figure 6(c): Changes in Supply and in Quantity Supplied

Quantity

Price

S1

S2Entire supply curve shifts rightward when:• price of input ↑• price of alternate good ↑• number of firms ↓• expected price ↑• unfavorable weather

41

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

42

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

43

Figure 7: Market Equilibrium

E

HJ1.00

Rs3.00

D

S

50,000 75,00025,000

Excess Demand

4. until price reaches its equilibrium value of Rs3.00 .

2. causes the price to rise . . .

3. shrinking the excess demand . . .

1. At a price of Rs1.00 per bottle an excess demand of 50,000 bottles . . .


Price per Bottle

44

Excess Demand

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

45

Figure 8: Excess Supply and Price Adjustment

3. shrinking the excess supply . . .

K L

E3.00

D

S

Rs5.00

50,00035,000 65,000

Excess Supply at Rs5.00

2. causes the price to drop,

4. until price reaches its equilibrium value of Rs3.00.


Price per Bottle

1. At a price of Rs5.00 per bottle an excess supply of 30,000 bottles . . .

46

Excess Supply

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

47

Solve for Equilibrium Algebraically

Suppose that demand is given by the equation , where is quantity demanded, P is the price of the good. Supply is given by where is quantity supplied.

What is the equilibrium price and quantity?

PQD 10140

PQS 580

DQ

sQ

48

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

49

Figure 9

1. An increase in demand . . .E

F'

3.00

D1

D2

S

Rs4.00

50,000 60,000

3. to a new equilibrium.

5. and equilibrium quantity increases too.

2. moves us along the supply curve . . .

Number of Bottles of Maple Syrup per Period

Price per Bottle

4. Equilibrium price increases

50

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

51

Figure 10: A Shift of Supply and A New Equilibrium

E'

E3.00

D

Rs5.00

50,00035,000

S2 S1

Number of Bottles

Price per Bottle

52

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

53

Figure 12: The Market For Oil

P2

D

E'

P1E

Q2 Q1

S2

S1

Barrels of Oil

Price per Barrel of Oil

54

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

55

Figure 13: The Market For Natural Gas

Cubic Feet of Natural Gas

Price per Cubic Foot of Natural

Gas

P4

P3

F

Q3 Q4

S

D2

F'

D1

56

Figure 11: Changes in the Market for Handheld PCs

1. An increase in supply . . .

2. and a decrease in demand . . .

5. and quantity decreased as well.

A

BRs400

D2003

S2002

S2003

D2002

Rs500

2.45 3.33 Millions of Handheld PCs per Quarter

Price per Handheld

PC

4. Price decreased . . .

3. moved the market to a new equilibrium.

57

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

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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

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Example: rental apartment

Example: problem 4, chapter 3 in textbook.

Demand & Supply Diagram Equilibrium P & Q Why Rs1000 can not be

equilibrium? Effects from a tornado

destroying some apartments.

rent(Rs)quantity demanded

quantity supplied

800 30 10

1000 25 14

1200 22 17

1400 19 19

1600 17 21

1800 15 22

60

Demand for two bedroom rental apartment

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Summaries Through the study of the chapter, you will be able to Characterize a market. Use a demand schedule and a demand curve to demonstrate the law of

demand. Explain the difference between a change in demand (shift of the

curve) and a change in quantity demanded (movement along the curve).

List the factors that will lead to a change in demand, and give examples of each.

Similar analysis for supply side. Explain how equilibrium price and quantity are determined in a

competitive market. Explain what will happen in a competitive market after a shift in the

supply curve, the demand curve, or both. Describe the three steps economists take to answer almost any

question about the economy.