Chapter 3: Demand & Supply Demand Supply Market Equilibrium Examples Price ceiling/floor.

Chapter 3: Demand & SupplyChapter 3: Demand & Supply

• Demand

• Supply

• Market Equilibrium

• Examples

• Price ceiling/floor

Build a modelBuild a model

• buyers

• sellers

• & their interaction

Use the modelUse the model

• to predict

• the impact of changes

• to explain

• changes that occur

DemandDemand

• behavior of buyers

• relationship between• quantity demanded of a good• price• holding other factors constant

quantity demanded (Qd)quantity demanded (Qd)

• amount of good or service

• unit of measure• per unit of time• “2 bottles of water per day”

Law of DemandLaw of Demand

If the price of a good

then the Qd

holding other things constant!!!

Why?Why?

• higher price makes you feel poorer

• income effect• higher price on one good,

substitute other goods.• substitution effect

Example: bottles of water per dayExample: bottles of water per day

Describe demand in 2 ways:

• Demand schedule• a list of Qd

at each price• Demand curve

• a graph of demand schedule

Demand ScheduleDemand Schedule

P QdPrice = $/bottle

Qd = bottles/day

$2.00 0$1.50 1

$1.00 2$.50 3

0 1 2 3 4

P

Qd

2

1.5

1

.5

Demand curveDemand curve

P

Qd

0 1 2 3 4

2

1.5

1

.5D

• individual demand

• demand curve for 1 buyer

• market demand**

• demand curve for all buyers

• add up individual Qd for each price

Changes in DemandChanges in Demand

• recall our assumption

• hold other things constant• allow only price to change

• but what if other factors do change?• change in demand• shift to a new demand curve

increase in demandincrease in demand

• increase in Qd at every price

• demand curve shifts to the right

P

Qd0 1 2 3 4

2

1.5

1

.5 DD’

decrease in demanddecrease in demand

• decrease in Qd at every price

• demand curve shifts to the left

P

Qd

DD’’

Factors affecting demandFactors affecting demand

• income

• prices of related goods

• buyer expectations

• # of buyers

• preferences

incomeincome

• for normal goods,an increase in income will increase demand

• examples:CDs, bottled water,eating out,

• for inferior goods,

an increase in income will

decrease the demand• examples:

ramen noodles,

check-cashing service

Prices of related goodsPrices of related goods

• what are related goods?

• substitutes

e.g. Snapple, Coke• complements

goods consumed with water

e.g. pretzels

substitutessubstitutes

• if price of Snapple rises,

• people switch to water• increase in demand for water

• if price of Snapple falls,• people switch from water

to Snapple• decrease in demand for water

complementscomplements

• if price of pretzels rises

• eat fewer pretzels,

so drink less water,• demand for water falls

buyer expectationsbuyer expectations

• buyers can expect change in

• future income• future prices

and act to change demand today

• expect price of water to rise next month,

• buy a case today,• increase demand today

# of buyers# of buyers

• size of population

• demographics• age• gender• race

• if there are more buyers

• increase market demand for water• could be due to

more people overall

more people who like water

preferencespreferences

• what do we want to buy?• change in our likes/dislikes

• acid washed jeans?• tattoos?

• change in technology• 5 1/4” floppies?• DVDs?

• if drinking more water

beneficial to health,

• increase in demand for bottled water

Important!!Important!!

• Change in demand-- occurs when other factors change-- shift to a new demand curve

• change in demand• NOT caused by change in price of

the good

• Change in quantity demanded-- occurs when prices change

-- movement along existing demand curve

Change in QdChange in Qd

P

Qd

D

Change in DemandChange in Demand

P

Qd

DD

SupplySupply

• behavior of sellers

• relationship between• quantity supplied of a good• price• holding other factors constant

Law of SupplyLaw of Supply

If the price of a good

then the Qs

holding other things constant!!!

Why?Why?

• Holding costs constant

• higher price means higher profit margin

Supply ScheduleSupply Schedule

P QsPrice = $/bottleQs = bottles/day

$2.00 3$1.50 2

$1.00 1$.50 0

0 1 2 3 4

P

Qs

2

1.5

1

.5

S

Supply curveSupply curve

P

Qs0 1 2 3 4

2

1.5

1

.5

• Individual supply

• supply curve for 1 supply

• market supply**

• supply curve for all sellers

• add up individual Qs for each price

Changes in SupplyChanges in Supply

• if other factors do change,

• change in supply• shift to a new supply curve

increase in supplyincrease in supply

• increase in Qs at every price

• supply curve shifts to the right

P

Qs

S

S’

decrease in supplydecrease in supply

• decrease in Qs at every price

• supply curve shifts to the left

P

Qs

S

S’’

Factors affecting supplyFactors affecting supply

• Cost of inputs

• prices of related goods

• seller expectations

• # of seller

• productivity

Cost of inputsCost of inputs

• As input prices get higher,

supply decreases• example: increase in cost of

• bottles• labor• electricity

Prices of related goodsPrices of related goods

• Substitutes in production

• a good that can be made instead

of bottled water

e.g. bottled tea• If price of bottled tea increases,

switch to tea production,

supply of bottled water falls

• Complements in production

• good that is produced with other good

e.g. Beef & leather• if price of beef rises,

Qs of beef rises,

& supply of leather rises

Seller expectationsSeller expectations

• Expect input prices to rise in future

• increase supply today• expect price of good to rise in future

• decrease supply today

# of sellers# of sellers

• As more sellers supply good,

• market supply increases

ProductivityProductivity

• Amount of output per unit of input• bottles of water per hour of labor

• Increase in productivity lowers cost• increases supply

• what makes productivity increase?• Technology• human capital

Important!!Important!!

• Change in supply-- occurs when other factors change-- shift to a new supply curve

(right or left)• change in supply

-- NOT caused by change in price ofthe good

• Change in quantity supplied-- occurs when prices change

-- movement along existing supply curve

Change in QsChange in Qs

P

Qs

S

P

Qs

S

S’’

Change in SupplyChange in Supply

Market EquilibriumMarket Equilibrium

• What will be the price of bottled water?

• Price at which Qs = Qd

-- equilibrium price

-- equilibrium quantities

Market for Bottled WaterMarket for Bottled WaterP

(millions bottles per day)

Q

D

S

$10

10

Equilibrium

Why is this an equilibrium?Why is this an equilibrium?

• If Qs > Qd

• surplus• price falls until Qs = Qd

• If Qs < Qd• shortage• price rises until Qs = Qd

Changes in equilibriumChanges in equilibrium

• If supply and/or demand changes

(shifts left or right),

then equilibrium will change too.

Example 1Example 1

• Market for bottled water

• price of plastic bottles rises• what happens to equilibrium?

Which curve is affected?Which curve is affected?

• buyers or sellers?

• Supply curve• bottles are an input

Increase or decrease in supply?Increase or decrease in supply?

• Increase in cost of input

• supply decreases• shift LEFT

P

(millions bottles per day)

S

Q

D

$10

10

S’

Equilibrium:

P

Q

notenote

• Change in supply causes

change in equilibrium price

BUT• Change in price does NOT cause a

change in supply

Example 2Example 2

• Market for bottled water

• sugar is found to be harmful to health

• what happens to equilibrium?

Which curve is affected?Which curve is affected?

• Demand curve

• health concerns increase

preferences for water

Increase or decrease in demand?Increase or decrease in demand?

• Increase in preference for water

• demand increases• shift RIGHT

P

(millions bottles per day)

S

Q

D

$10

10

D’

Equilibrium:

P

Q

Example 3Example 3

• Market for bottled water

• incomes fall &

sellers expect utilities to rise

Which curve is affected?Which curve is affected?

• Demand curve

• income falls• Supply curve

• seller expectations change• expect costs to rise

Increase or decrease?Increase or decrease?

• Demand decreases (left)

• income falls &

bottled water is normal good• Supply increases (right)

• make more water today before

costs go up

P

(millions bottles per day)

S

Q

DD’

Equilibrium:

P

Q ?

S’

Example 4: Leather sandalsExample 4: Leather sandals

Market for leather sandals

A. Mad cow disease

-- must destroy 20% of herds

• what happens to equilibrium

P

Q

S

D

S’

Supply decreases

Q decreases

P increases

B.B.

PETA

• campaign against leather products• what happens to equilibrium?

P

Q

S

DD’

demand decreases

Q decreases

P decreases

Example 5: Natural Gas PricesExample 5: Natural Gas Prices

• Winter 2000-2001

prices increased over 100%

• why?

3 possible causes:

1. Supply decreases

or

2. Demand increases

or

3. both

P

Q

S

D

S’

Decrease in Supply

Why would S fall?Why would S fall?

• regulation

-- tougher to drill

-- increase costs• hot summer (2000)

-- depletes inventories

P

Q

S

D

D’

Increase in Demand

Why would D rise?

• booming economy (2000)• EPA rules

-- fewer coal plants, more gas plants

• cold winter

Why did P rise?Why did P rise?

• both falling supply & rising demand

-- but demand was most important

Price ceilingPrice ceiling

• gov’t regulation sets maximum price

• example: rent control in NYC• what happens?

Rent

Q

S

D

$2500

500

$1200

250 750

rent ceiling = $1200

Rent

Q

S

D

$2500

500

$1200

250 750

Qd = 750 units

Qs = 250 units

at P = $1200:

SHORTAGE

who gets housing?who gets housing?

• those willing to pay more

• bogus fees:“key money”• those who look harder

• loss of time• those who get lucky

• Monica on Friends

ResultResult

• Price does not ration scarce good

• too few apt. units• lost resources in searching• price ceiling is inefficient

Why have rent control?Why have rent control?

• intended to help make housing affordable

• secondary effect• shortage• run-down buildings• rent-controlled apts. go to the

“connected”

B. Price floors.

• The minimum legal price a seller may charge, typically placed below equilibrium.

• Surpluses result as quantity supplied exceeds quantity demanded.

• Examples: Minimum wage, farm price supports

Note: The federal minimum wage, for example, will be below equilibrium in some labor markets (large cities). In that case the price floor has no effect.

Application: Government-Set Prices (Ceilings and Floors)

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 controls

Price ceilingPrice ceiling

• gov’t regulation sets maximum price

• example: rent control in NYC• what happens?

Rent

Q

S

D

$2500

500

$1200

250 750

rent ceiling = $1200

Rent

Q

S

D

$2500

500

$1200

250 750

Qd = 750 units

Qs = 250 units

at P = $1200:

SHORTAGE

who gets housing?who gets housing?

• those willing to pay more

• bogus fees:“key money”• those who look harder

• loss of time• those who get lucky

• Monica on Friends

ResultResult

• Price does not ration scarce good

• too few apt. units• lost resources in searching• price ceiling is inefficient

Why have rent control?Why have rent control?

• intended to help make housing affordable

• secondary effect• shortage• run-down buildings• rent-controlled apts. go to the

“connected”

Application: Government-Set Prices (Ceilings and Floors)

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 controls

B. Price floors.

• The minimum legal price a seller may charge, typically placed above equilibrium.

• Surpluses result as quantity supplied exceeds quantity demanded.

• Examples: Minimum wage, farm price supports

Note: The federal minimum wage, for example, will be below equilibrium in some labor markets (large cities). In that case the price floor has no effect.

Straight-Line Equations:Straight-Line Equations:     Slope-Intercept Form     Slope-Intercept Form

• y = mx + b

This is called the slope-intercept form because "m" is the slope and "b" gives the y-intercep

Find the equation of the straight line that has slope Find the equation of the straight line that has slope mm = 4 = 4 and passes through the point (–1, –6). and passes through the point (–1, –6).

• y = mx + b(–6) = (4)(–1) + b–6 = –4 + b–2 = b

• Then the line equation must be "y = 4x – 2".

Find the equation of the line that passes through the points (–2, 4) Find the equation of the line that passes through the points (–2, 4) and (1, 2) and (1, 2)

. if I have two points on a straight line, I can always find the slope                      

if I use the point (1, 2), I get:y = mx + b2 = (– 2/3)(1) + b2 = – 2/3 + b2 + 2/3 = b6/3 + 2/3 = bb = 8/3y = (– 2/3)x + 8/3

y

x

0 1 2 3 4

2

1.5

1

.5

Qd

5

3

2

1

4

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