Chapter 4

Chapter 4Demand, Supply, and Markets

The Law of Demand Law of Demand: the inverse ( or

negative) relationship between the price of a good and the quantity consumers are willing to purchase, other things held constant (ceteris paribus). As the price of a good rises, consumers

buy less.

The Law of Demand The demand curve allows you to find

the quantity demanded by a buyer at different selling prices by moving along the curve

The Substitution Effect of a Price Change What explains this “Law of Demand?”

Lower Price= Greater Amount Consumer… Why?

Substitution effect: The consumer will substitute a cheaper good for a more expensive good.

The Income Effect of a Price Change Income Effect: A fall in the price of the

good increases the consumers purchasing power. The consumer can now buy more with NO

change in their income level.

The Demand Schedule and Demand Curve Demand: a curve or schedule

showing the various quantities of a product consumers are willing to purchase at possible prices during a specific period of time, other things held constant. Demand is the quantity consumers are

both willing and able to buy at each possible price.

Market Demand Schedule A demand schedule is simply a table

listing the various quantities of something consumers are willing to purchase prices Example of the demand schedule

Example of a Market Schedule Demand of Hula Hoops

Price (in Dollars) Quantity Demanded (Hula Hoops)

$10.00 0

8.00 10

6.00 20

4.00 30

2.00 40

The Demand Curve Using the Schedule The demand curve is the plots of this

table Example of demand curve using the

demand schedule

Demand Curve of Hula HoopsPrice of

the Hula

Hoops (measured in

dollars)

Quantity Demanded of Hula Hoops

Market Demand The transition from the individual to the

market demand curve is done by totaling or summing the individual demand schedules (this is known as the horizontal summation of demand). Example of horizontal summation

Horizontal Summation of Demand

+

= Market Demand of Hula Hoops

Market Demand of Hula Hoops The market demand of hula hoops, is

the horizontal summation of the two individuals demand for hula hoops (i.e. the summation of quantity demanded at each individual price).

Market Demand of Hula Hoops

Price (measured in dollars)

Quantity Demanded of Hula Hoops

Changes in demand vs. changes in quantity demanded A movement along the curve- CHANGES

IN PRICE ONLY Changes in quantity demanded

Example of movement

Movement along the CurveA movement from $8 to

$6 represents an increase in quantity

demanded

A movement from $8 to $10 represents an decrease in

quantity demanded

The distinction between changes in Quantity Demanded and Changes in Demand

Remember that price and quantity variables in our model are subject to the ceteris paribus assumption (other things held constant). IT IS VERY IMPORTANT TO REMEMBER

THE FOLLOWING: If you are dealing with price of the item it

is a movement along the curve, a change in quantity demanded not DEMAND, NO SHIFT!!!!!!

Shifts of the Demand Curve:1) Changes in consumer income

Normal goods Inferior goods

2) Changes in the price of a related good Substitutes Complements

3) Changes in expectations- prices, income, or availability of goods.

4) Changes in the number of consumers in the market

5) Changes in consumer tastes and preferences

Examples Income

Normal goods: direct relationship Inferior goods: inverse relationship

Changes in Demand Most of us would consider steak to be a

normal good. Since, steak is a more expensive meat as income increases then more consumption of steak should occur.

Thus, when consumer income increases, the demand for steak increases.

Normal Good

D1

D2

Inferior Goods However, we could argue that Ramon

Noodles would be an inferior good, meaning as income increases then the demand for Ramon Noodles would decline.

Thus, when income increases, then the demand of Ramon Noodles will decrease. This would be a leftward shift of the

demand curve

Examples Related goods

Substitute good: if the price of the substitutable good decreases, then demand decreases for the good of interest

Complementary good: if the price of the complement good increases, then demand decreases for the good of interest.

Substitute goods Let’s assume that Pepsi and Coke are

substitute goods for one another. If the price of Pepsi increases, then what

happens to the demand of Coke? The demand for Coke will increase,

because now consumers will substitute Coke for Pepsi

Graph of CokePrice

(measured in dollars)

Quantity Demanded of Coke (in

millions)

D1

D2

Complementary Goods Complementary goods are goods that

we buy together, I think it is safe to say that peanut butter and jelly are bought together.

Thus, what would happen to the demand of jelly, if the price of peanut butter increased? The demand for jelly would decrease.

This is a leftward shift of the demand curve

Demand for Jelly

D1D2

Supply Supply indicates how much producers

are willing and able to offer for sale per period at each possible price, other things held constant.

Law of Supply There is a direct (positive) relationship

between the price of a good or service and the amount of it that suppliers are willing to produce. Example of the supply curve When price increases, then the amount

supplied will increase. Why are sellers willing to sell more at a

higher price? Does this make sense?

Market Supply Again, it is the horizontal summation of

the quantity produced by the sellers Example of Horizontal Summation

Changes in Supply VS. Changes in Quantity Supplies Increase or decrease in the price of the

good is a movement along the curve This is a change in “quantity supplied”

Example here

Shifts of the Supply Curve1) Changes in Technology2) Changes in the Prices of Relevant

resources Inputs into production.

3) Changes in the Price of Alternative Goods Other goods that the producer could

produce

4) Changes in Producer Expectations5) Changes in the Number of Producers

Markets A market is any arrangement in which

buyers and sellers interact to determine the price and quantity of goods and services exchanged. Markets reduce transaction costs

Market Equilibrium The market is where the buyers and

sellers come together Equilibrium is no conflict between

demand and supply Quantity supplied= Quantity demand Example of the equilibrium

This is the theory of how the price system operates and it is the cornerstone of microeconomic analysis

Equilibrium in the Pizza Market

Millions of pizzas per Week

Price per

pizza

Quantity

Demanded

Quantity

Supplied

Surplus or

Shortage Effect on Price

$15

12

9

6

3

8

14

20

26

32

28

24

20

16

12

Surplus of 20

Surplus of 10

Equilibrium

Shortage of 10

Shortage of 20

Falls

Falls

Remains the same

Rises

Rises

(a) Market schedules

Equilibrium in the Pizza Market(b) Market curves

S

24201614

Millions of pizzas per week

26 0

9

6

3

12

Pric

e pe

r pi

zza

$15

D

c

Shortage

SurplusMarket equilibrium occurs at:Price where QD=QS; Point c

Above the equilibrium price:QS>QD; Surplus; Downward pressure on P

Below the equilibrium price:QD>QS; Shortage; Upward pressure on P

Economic Efficiency When a market reaches equilibrium, all

the gains from trade between the buyer and seller have been fully realized and Economic efficiency is met

Prices and Market order Prices communicate information to

decision makers Prices coordinate the actions of the

market participants Prices motivate economic players

Invisible Hand Principle The tendency of market forces to

channel the actions of self-interest individuals into activities that promote the general betterment of society

The key to economic progress

What is this all about Price System?? What is that?

Shifts of the Demand Curve

Increase in demand Rightward shift of D curve Shortage; Upward pressure on P QD decreases; Qs increase New equilibrium: Increase in P and Q

Decrease in demand Surplus; Downward pressure on P New equilibrium: Decrease in P and Q

Effects of an Increase in DemandS

2420

Millions of pizzas per week

30 0

9

$12

Pric

e pe

r pi

zza

D

c

D’

g

Increase in demand:Rightward shift to D’At P=$9: QD>QS; shortageUpward pressure on PQD decreasesQS increases

New equilibrium gHigher PHigher Q

Exhibit 6

Shifts in the Supply Curve

Increase in supply Rightward shift of S curve Surplus; Downward pressure on P QD increases; QS decreases New equilibrium:

P decreases; Q increases

Decrease in supply New equilibrium:

P increase; Q decreases

Effects of an Increase in Supply

Increase in supply:Rightward shift to S’At P=$9: QS>QD; surplusDownward pressure on PQD increasesQS decreases

New equilibrium dHigher QLower P

Exhibit 7

S

2620

Millions of pizzas per week

30 0

$9

6Pric

e pe

r pi

zza

D

c S’

d

Simultaneous Shifts of D and S curves

Both S and D increase; Q increases D shifts more: P increases S shifts more: P decreases

Both S and D decrease: Q decreases D shifts more: P decreases S Shifts more: P increases

Indeterminate Effect of an Increase in Both Demand and Supply

Exhibit 8

S

p’

p

Pric

e

D

S’

a

D’

b

Q’QUnits per period

0

(a) Shift of D dominatesS

p’’

p

Pric

e

D

S’’

a

D’’

c

Q’’QUnits per period

0

(b) Shift of S dominates

Disequilibrium Surplus

Downward pressure on P

Shortage Upward pressure on P

Disequilibrium Temporary, or Result of government

intervention Price floors Price ceilings

Disequilibrium Price Floors

Set above equilibrium P Minimum selling P Surplus Distort markets Reduce economic

welfare

Disequilibrium Price Ceilings

Set below the equilibrium P Maximum selling P Shortage Distort markets Reduce economic welfare

Price Floors and Price Ceilings

Exhibit 11

S

D

(a) Price floor for milk (b) Price ceiling for rent

$2.50

1.90

Pri

ce p

er g

allo

n

1914Millions of gallons per month

0 24

S

D

$1,000

600

Mon

thly

ren

tal p

rice

5040Thousands of rental units per month 0 60

Surplus

Shortage

No effect if price floor is

set at or below equilibrium P

No effect if price ceiling is

set at or above equilibrium P