Unit Two Demand, Supply, and Market Equilibrium. Markets Markets bring together buyers (demanders) and sellers (suppliers) in search of satisfaction.

Unit Two

Demand, Supply, and Market Equilibrium

Markets• Markets bring together buyers (demanders) and

sellers (suppliers) in search of satisfaction.

• A market can exist anywhere at anytime and be global, national or local. It may be face-to-face or digital. It may involve millions of participants or just two (consumer & producer.)

• Markets work through a process of voluntary exchange and self-interest.

• The law of supply and demand is based on a pure market economy with pure competition (large numbers of independently acting buyers & sellers of standardized products.)

Demand• Demand is a schedule or a curve that

shows the various amounts of a product that consumers are willing and able to purchase at each of a series of possible prices during a specified period of time.

• We say “willing and able” because willingness alone is not effective in the market.

• Consumers must be able as well. They must have the necessary dollars or use of credit.

The Law of DemandThe Law of Demand The The law of demandlaw of demand states that if all else is states that if all else is

equal (equal (ceteris paribusceteris paribus), as price ), as price fallsfalls, the , the quantity demanded quantity demanded risesrises, and as price , and as price risesrises, , the quantity demanded the quantity demanded fallsfalls..

There is a There is a negativenegative or or inverseinverse relationship relationship between the between the priceprice and and quantity demandedquantity demanded (downward slope of the demand curve.) (downward slope of the demand curve.)

The The law of demandlaw of demand is consistent with is consistent with common sensecommon sense. People typically . People typically buy buy moremore of a product at a of a product at a lowlow price than at a price than at a highhigh price. price.

If the If the price changesprice changes, causing a change in , causing a change in the the quantityquantity demandeddemanded, the demand curve , the demand curve does does notnot shift. It simply shift. It simply moves moves upup or or downdown the the originaloriginal demand curve placement. demand curve placement.

The 3 Price Determinants ofQuantity Demand

#1 The Income Effect: indicates that a lower price increases the “purchasing power” of a buyer’s money income (also known as real income.)

If income stays the same and the price level (CPI) increases, then real income or purchasing power goes down, causing a decrease in the quantity demanded (inflation).

If income stays the same and the price level (PL) decreases, then real income or purchasing power goes up, causing an increase in the quantity demanded (deflation or disinflation.)

The 3 Price Determinants ofQuantity Demanded

#2 The Law of Diminishing Marginal Utilities: Every time an individual purchases a unit of a good or service they begin to move towards 100% total satisfaction.

Each additional (marginal) unit purchased moves them closer to total satisfaction, but brings less satisfaction than the previously purchased unit.

Eventually, the market will get to a place where it stops purchasing additional units (greater satisfaction from saving their income than spending it.)

If the market price goes down the market will get to that place where they stop buying additional units later (QD up.) If, the market price goes up, the market will get to that point sooner (QD down.)

The 3 Price Determinants ofQuantity Demanded (QD)

#3 The Substitution Effect: suggests that at a lower price, buyers have the incentive to substitute what is now a less expensive product for similar products that are now relatively more expensive.

The product whose price has fallen is now “a better deal” relative to the other products.

For example, a decline in the price of chicken will increase the QD of chicken, but decrease the “demand” for pork, lamb, beef, fish (substitutes.)

The Demand CurveThe Demand Curve

The The inverseinverse relationship between relationship between priceprice and and quantityquantity demandeddemanded for any product for any product can be represented on a simple graph.can be represented on a simple graph.

QuantityQuantity demandeddemanded (QD) is measured on (QD) is measured on the horizontal axis and price on the vertical the horizontal axis and price on the vertical axis.axis.

The downward slope reflects the The downward slope reflects the inverseinverse or or negativenegative relationship between the relationship between the priceprice and and quantityquantity demandeddemanded. .

NonNon PricePrice Determinants of Determinants of DemandDemand

Economists assume that Economists assume that priceprice is the most is the most important important influenceinfluence on the on the amountamount of of product product purchasedpurchased..

But they know other But they know other nonnon priceprice factors factors can and can and dodo affect affect purchasespurchases..

These factors are known as These factors are known as determinantsdeterminants of demand or “demand of demand or “demand shiftersshifters” (move ” (move the curve right or left.) the curve right or left.)

They are the “They are the “otherother thingsthings equalequal” in the ” in the relationship between relationship between priceprice and and quantityquantity demandeddemanded..

5 5 NonNon PricePrice Determinants Determinantsof Demand (of Demand (ShiftersShifters))

#1#1 Consumers TastesConsumers Tastes: A : A favorablefavorable change in change in consumer consumer tastestastes or or preferencespreferences for a product will for a product will increaseincrease demand at demand at allall prices (The Apple prices (The Apple IPHONE) and cause the demand curve to IPHONE) and cause the demand curve to shiftshift to to the the rightright..

An An unfavorableunfavorable change in consumer change in consumer preferencespreferences will will decreasedecrease demand at demand at allall prices(HP no longer prices(HP no longer making PCs), making PCs), shiftingshifting demand curve to the demand curve to the leftleft..

NewNew productsproducts may have a large may have a large impactimpact on on consumer consumer tastetaste. The introduction of digital . The introduction of digital cameras greatly decreased the demand for film cameras greatly decreased the demand for film cameras.cameras.

5 5 NonNon PricePrice Determinants Determinants of Demand (of Demand (ShiftersShifters))

#2#2 Number of BuyersNumber of Buyers: An : An increaseincrease in the in the numbernumber of of buyersbuyers in the market is likely to in the market is likely to increaseincrease product demand and vice versa. product demand and vice versa.

PopulationPopulation growthgrowth or or declinedecline of various of various geographic regions (geographic regions (urban fleeurban flee) directly ) directly impacts the impacts the demanddemand for for productsproducts at at allall prices.prices.

An An increaseincrease in in buyersbuyers at at allall prices will shift prices will shift the demand curve to the the demand curve to the rightright and a and a decreasedecrease in in buyersbuyers at at allall prices, shift the prices, shift the demand curve to the demand curve to the leftleft..

5 Non Price Determinants 5 Non Price Determinants of Demand (Shifters)of Demand (Shifters)

#3#3 Income:Income: How How incomeincome affects demand affects demand variesvaries depending on the depending on the goodgood or or serviceservice..

ConsumersConsumers typically buy typically buy moremore products products when their when their incomeincome increasesincreases - direct - direct relationship. (But there are exceptions).relationship. (But there are exceptions).

ProductsProducts whose demand varies whose demand varies directlydirectly with money income are called with money income are called normalnormal or or superiorsuperior goods (i.e. name brands). goods (i.e. name brands).

ProductsProducts whose demand varies whose demand varies inverselyinversely with money with money incomeincome are called are called inferiorinferior goods ( i.e. generic brands).goods ( i.e. generic brands).

5 Non Price Determinants 5 Non Price Determinants of Demand (Shifters)of Demand (Shifters)

#4#4 Prices of Related Goods:Prices of Related Goods: A change in the A change in the priceprice of a of a relatedrelated goodgood may either may either increaseincrease or or decreasedecrease the the demanddemand for a product. for a product.

A A substitutesubstitute good is one that can be used good is one that can be used ““inin placeplace ofof”” another good. When another good. When twotwo productsproducts are are substitutessubstitutes, an , an increaseincrease in the in the priceprice of one will of one will increaseincrease the the demanddemand for for the the otherother. Conversely, a . Conversely, a decreasedecrease in the in the priceprice of one will of one will decreasedecrease the the demanddemand for the for the otherother..

ComplementaryComplementary goods are goods are ““usedused togethertogether,”,” they are they are typically demanded typically demanded jointlyjointly. If the . If the priceprice of a complement of a complement goes goes upup, the , the demanddemand for the for the relatedrelated goodgood will will declinedecline. . Conversely, if the Conversely, if the priceprice of a complement of a complement fallsfalls, the , the demanddemand for a for a relatedrelated goodgood will will increaseincrease. .

The vast The vast majoritymajority of goods are of goods are unrelatedunrelated or or independentindependent. .

5 Non Price Determinants 5 Non Price Determinants of Demand (Shifters)of Demand (Shifters)

#5 #5 Consumer Future ExpectationsConsumer Future Expectations: A newly : A newly formed formed expectationexpectation of higher of higher futurefuture prices prices may may cause consumers to cause consumers to buy nowbuy now in order to in order to “beat”“beat” the the anticipatedanticipated price rises price rises, thus , thus increasing increasing current current demanddemand..

Similarly, a Similarly, a change in change in expectationsexpectations concerning concerning futurefuture incomeincome may prompt consumers to change may prompt consumers to change their their currentcurrent spending. Which may either spending. Which may either increaseincrease or or decreasedecrease currentcurrent demanddemand..

Changes in Demand &Quantity Demanded• A change in demand must not be confused

with a change in quantity demanded.• A change in demand is a shift of the

demand curve to the right (increase) or to the left (decrease.) It occurs, because the consumer’s state of mind about purchasing the product has been altered in response to a change in one or more of the determinants of demand.

• In contrast, a change in quantity demanded is a movement from one point to another point. The cause of such a change is an increase or decrease in the price of the product under consideration.

Supply

Supply is a schedule or curve showing the various amounts of a product that producers are willing and able to make available for sale at each of a series of possible prices during a specific period.

Firms may be willing, but not able to produce a product (time lags, resource availability, patent or copyright infringement.)

Law of Supply

The Law of Supply reflects a positive or direct relationship that prevails between price and quantity supplied.

As price rises, the quantity supplied rises; as price falls, the quantity supplied falls.

A supply schedule illustrates that firms will produce and offer for sale more of their product at a high price than at a low price.

Price & the Law of Supply

Price is an obstacle from the standpoint of the consumer, who is on the paying end. But the supplier is on the receiving end of the product’s price. Price represents revenue and therefore serves as an incentive.

The higher the price, the greater the incentive to produce, the greater the willingness to risk, and therefore the greater the quantity supplied (original and potential producers.)

Price and quantity supplied are directly related.

The Supply Curve

As with demand, it is convenient to represent individual supply graphically.

The upward slope of the supply curve reflects the law of supply.

Producers offer more of a good, service, or resource for sale as its price rises.

The relationship between price and quantity supplied is positive, or direct.

Determinants of Supply Determinants of Supply (Shifters)(Shifters)

In constructing a In constructing a supplysupply curvecurve, it is , it is assumed that assumed that priceprice is the most is the most significant influence on the significant influence on the quantityquantity suppliedsupplied of any product. of any product.

But other But other factorsfactors (“other things (“other things equal”) can and do affect equal”) can and do affect supplysupply..

These These factorsfactors oror determinantsdeterminants (other than price,) cause a (other than price,) cause a change in change in supplysupply and and shiftshift the entire the entire supplysupply curvecurve. .

6 Non-Price Determinants of 6 Non-Price Determinants of Supply (Shifters)Supply (Shifters)

#1 #1 Resource Prices:Resource Prices: The prices of the The prices of the resourcesresources or or inputsinputs used in the production process help determine used in the production process help determine the the costscosts of of productionproduction..

HigherHigher resource prices resource prices raiseraise production production costs costs and and reduce profitsreduce profits lessening the lessening the incentiveincentive to take to take risksrisks, , therefore therefore decreasingdecreasing supplysupply (shift the supply curve to (shift the supply curve to the left.) A “the left.) A “Supply Shock”Supply Shock” may substantially drive up may substantially drive up an an inputinput price.price.

In contrast, In contrast, lowerlower resource prices resource prices reducereduce production production costscosts and and increase profitsincrease profits, therefore , therefore increasingincreasing supplysupply (shift to the right.) (shift to the right.)

Cost of a barrel of crude oil is a good example of this Cost of a barrel of crude oil is a good example of this determinant.determinant.

6 Non-Price Determinants of 6 Non-Price Determinants of Supply (Shifters)Supply (Shifters)

#2 #2 Technology:Technology: Improvements in Improvements in technology enable firms to technology enable firms to produceproduce units of units of output output with with fewerfewer resources. resources. 90’s “I.T.” 90’s “I.T.” boom led to substantial increases in boom led to substantial increases in productivityproductivity. .

FewerFewer resources resources equates to a equates to a lowerlower costcost of of productionproduction raising profit and raising profit and increasingincreasing the the supplysupply of the product (shift right.) of the product (shift right.)

RemovingRemoving technology (D.D.T. in 1972) is technology (D.D.T. in 1972) is highly unusual, but would highly unusual, but would increaseincrease the the cost of productioncost of production and and decreasingdecreasing supplysupply (shift left.) (shift left.)

6 6 Non-PriceNon-Price Determinants of Determinants ofSupply (Supply (ShiftersShifters))

#3 #3 TaxesTaxes and and Subsidies:Subsidies: Businesses count Businesses count taxestaxes as as a a costcost of productionof production ((Role of Government ?Role of Government ? ) )

An An increaseincrease in in salessales, , propertyproperty or or corporatecorporate taxes taxes will will increaseincrease production production costscosts and therefore and therefore reducereduce supplysupply..

If the government If the government subsidizessubsidizes the the productionproduction of a of a goodgood (“ (“taxes in reversetaxes in reverse”) it ”) it lowerslowers the producers’ the producers’ costscosts and and increasesincreases supplysupply (shift left). (shift left).

TaxTax cutscuts are a major component of are a major component of expansionary expansionary fiscal policyfiscal policy and are typically adhered to by and are typically adhered to by conservativesconservatives and and supply-siderssupply-siders. .

ReaganomicsReaganomics (81-89) (81-89) lowered tax rateslowered tax rates significantly significantly and the economy and the economy grewgrew by an by an average GDP of 3.4%. average GDP of 3.4%.

Believe excessive tax rates canBelieve excessive tax rates can reducereduce tax tax revenuerevenue. .

6 Non-Price determinants of6 Non-Price determinants ofSupply (Shifters)Supply (Shifters)

#4 #4 PricesPrices of of OtherOther GoodsGoods:: Firms that Firms that produce a particular product can sometimes produce a particular product can sometimes use their use their plantplant to produce to produce alternativealternative goods.goods.

Firms Firms may may shiftshift production to a production to a higherhigher priced goodpriced good to reap to reap greater greater profitsprofits (substitution in production.) (substitution in production.)

Corn production Corn production upup 24% and Soybean 24% and Soybean production production downdown 18%, 18%, “The Ethanol “The Ethanol Effect.”Effect.”

6 Non-Price Determinants of 6 Non-Price Determinants of

Supply (Shifters)Supply (Shifters) #5 #5 Future Price Expectations of ProducersFuture Price Expectations of Producers::

ChangesChanges in expectations about the in expectations about the futurefuture priceprice of a product of a product may affectmay affect the producer’s the producer’s currentcurrent willingnesswillingness to to supplysupply that product. that product.

It is It is difficultdifficult to to generalizegeneralize how future price how future price expectations may impact expectations may impact currentcurrent supplysupply..

If wheat farmers If wheat farmers expectexpect prices to go prices to go upup in the in the near future they may near future they may holdhold backback some of their some of their currentcurrent harvest harvest, , decreasingdecreasing supplysupply..

On the other hand, On the other hand, expectationsexpectations that a that a price will price will increaseincrease on a product may induce firms to on a product may induce firms to addadd another shift of workers or another shift of workers or expandexpand their their production facilities, causing production facilities, causing currentcurrent supply to supply to increaseincrease..

6 Non-Price Determinants of6 Non-Price Determinants ofSupply (Shifters)Supply (Shifters)

#6 Number#6 Number ofof Sellers:Sellers: Other things equal, the Other things equal, the largerlarger the the numbernumber of of supplierssuppliers, the , the greatergreater the the market market supplysupply..

As more firms As more firms enterenter an industry, the an industry, the supplysupply curve curve shifts to the shifts to the rightright..

The The smallersmaller the the number number of of firmsfirms in the industry, in the industry, the the lessless the market the market supplysupply and the curve shifts to and the curve shifts to the the leftleft..

Pure CompetitionPure Competition involves involves numerousnumerous independentindependent firms ( firms (price takersprice takers) while a ) while a monopolymonopoly involves involves oneone firm ( firm (price makerprice maker).).

Many industries are Many industries are oligopoliesoligopolies, where a , where a fewfew major major firms firms dominatedominate the market ( 3 or 4 firms produce the market ( 3 or 4 firms produce 80%).80%).

Difference between Supply & Difference between Supply & “Quantity” Supplied“Quantity” Supplied

Remember, a Remember, a changechange in in supplysupply means a means a change in the schedule and a change in the schedule and a shiftshift of the of the curvecurve (right or left.) (right or left.)

Changes in supplyChanges in supply occur, because of a occur, because of a change in one or more change in one or more non-pricenon-price determinantsdeterminants..

In contrast, a In contrast, a changechange in in quantityquantity suppliedsupplied is a movement from is a movement from oneone point to point to anotheranother on a fixed supply curve.on a fixed supply curve.

An increase or decrease in the An increase or decrease in the quantity quantity suppliedsupplied is caused by a is caused by a change change in the in the priceprice of the specific product being considered.of the specific product being considered.

Market EquilibriumMarket EquilibriumEquilibrium Price & QuantityEquilibrium Price & Quantity The The equilibriumequilibrium priceprice (market-clearing price) is (market-clearing price) is

the price where the price where quantity demandedquantity demanded equalsequals quantity suppliedquantity supplied..

AtAt equilibrium equilibrium, there is neither a , there is neither a shortageshortage nor a nor a surplussurplus, the , the market is market is clearedcleared and everyone is and everyone is satisfiedsatisfied (buyers and sellers.)(buyers and sellers.)

CompetitionCompetition among buyers and among sellers among buyers and among sellers bidsbids (moves) the (moves) the priceprice to the equilibrium price to the equilibrium price ((balance.)balance.)

Non-Price ShiftersNon-Price Shifters in demand or supply in demand or supply (shifts (shifts to the curves) will to the curves) will changechange the the equilibrium priceequilibrium price..

AboveAbove the Equilibrium the Equilibrium PricePrice

At any At any aboveabove-equilibrium price-equilibrium price, quantity , quantity suppliedsupplied exceedsexceeds quantity quantity demandeddemanded and the and the result is a market result is a market surplussurplus..

SurplusesSurpluses drive drive prices downprices down by encouraging by encouraging competing competing sellerssellers to to lower the pricelower the price to attract to attract buyersbuyers to take the to take the surplussurplus off their hands. off their hands.

As the As the price fallsprice falls, the incentive to , the incentive to produce produce decreasesdecreases and the incentive to and the incentive to consumeconsume increasesincreases..

The The market market is always in is always in searchsearch of the of the equilibrium priceequilibrium price..

Below the Equilibrium Below the Equilibrium PricePrice

Any price Any price belowbelow the the equilibriumequilibrium priceprice will will create a create a shortageshortage (quantity demanded (quantity demanded exceeds quantity supplied.)exceeds quantity supplied.)

The market price The market price belowbelow the equilibrium price the equilibrium price discouragesdiscourages sellers from devoting sellers from devoting additionaladditional resourcesresources to to productionproduction and and encouragesencourages consumers to consumers to desiredesire moremore goodsgoods than are than are available.available.

ConsumersConsumers desiring to purchase the good at desiring to purchase the good at belowbelow equilibrium prices will equilibrium prices will competecompete for the for the good and good and drivedrive up the up the price price to equilibrium to equilibrium (helping to eliminate the shortage.)(helping to eliminate the shortage.)

Rationing Functions of PricesThe ability of the competitive forces of “supply and demand” to establish a price at which buying and selling decisions are made is called the “rationing function of prices.” Command or centrally planned economies do not enjoy this “natural market force.” Freely made individual decisions set a market-clearing price. “Laissez-faire” or “let it be.”

Efficient AllocationEfficient AllocationProductiveProductive & & AllocativeAllocative Efficiency EfficiencyA A competitivecompetitive marketmarket not only not only rationsrations goods to goods to consumersconsumers, but also , but also allocatesallocates society’s resources society’s resources efficientlyefficiently to the to the particular product.particular product.CompetitionCompetition among among producersproducers results in results in ““productiveproductive efficiencyefficiency”” (lowest cost of (lowest cost of production) in an attempt to production) in an attempt to minimize minimize costcost (right mix of resources.) (right mix of resources.)Competitive marketsCompetitive markets also produce also produce ““allocativeallocative efficiencyefficiency”” ( (desired mixdesired mix of of goods) in search of the elusive goods) in search of the elusive “dollar “dollar votes”votes” of of consumersconsumers (consumer (consumer sovereignty.)sovereignty.)

Government Manipulation of Market Prices (Price Controls)

• Prices in most markets are free to rise or fall to their equilibrium levels, no matter how high or low those levels might be.

• However, the government sometimes concludes that supply and demand will produce prices that are unfairly high for buyers or unfairly low for sellers.

• The government may place legal limits on how high or low a price or prices may go.

Government Manipulation ofMarket Prices (Price Controls)

• A price ceiling sets the maximum legal price a seller may charge for a good or service.

• A price at or below the ceiling is legal; a price above it is not.

• A price ceiling enables a consumer to obtain “essential” products which they may not be able to afford at the equilibrium price.

• Examples are rent control (over 200 cities) and usury laws (Ohio 25%).

• Price ceilings typically create “black markets” and shortages.

Government Manipulation ofMarket Prices (Price Controls)

• A price floor is a minimum price fixed by the government. A price at or above the price floor is legal; a price below it is not.

• Price floors or “supports” above the equilibrium prices are invoked when it’s believed resource suppliers or producers aren’t receiving sufficient income.

• Supported prices for agricultural products and minimum wages are two examples of price floors.

Government Manipulation ofMarket Prices (Price Controls)

• Possible consequences of price floors include surpluses and the distortion of resource allocation.

• At any price above the equilibrium price, quantity supplied will exceed quantity demanded resulting in an excess of supply or surplus.

• The government may respond to the surplus, by paying producers not to produce or by purchasing the surplus.

• Resources will be allocated to those markets receiving the subsidies created by a price floor (soybeans to corn.)