1 ka-fu wong university of hong kong supply and demand

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Ka-fu WongUniversity of Hong Kong

Supply and Demand

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Markets and Prices

Why does Ming YAO earn more than Ka-fu WONG (an award winning teacher)?

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Markets and Prices

Why do diamonds cost more than water?

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Markets and Prices

Why do Picasso’s paintings sell for more than Leroy Nieman’s?

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Markets and Prices

Why do QiBaiShi’s (齊白石 ) crabs sell for more than the real ones?

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Markets and Prices

Is it cost of production that determines prices (as Adam Smith thought)?

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Markets and Prices

Or is it willingness to pay that determines prices (as Stanley Jevons thought)?

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Markets and Prices

Alfred Marshall (Principles of Economics, 1890) was the first to explain clearly how both costs and willingness to pay interact to determine market prices.

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Markets and Prices

The market for any good or service consists of all (actual or potential) buyers or sellers of that good or service.

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The market for lobsters

The market for lobsters in Portland, Maine, on July 20, 2004.

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The demand for lobsters

The demand curve is the set of all price-quantity pairs for which buyers are satisfied. ("Satisfied" means being able to buy the amount they want to at any given price.)Price ($/lobster)

Quantity (1000s of lobsters/day)

10

8

6

4

2

01 2 3 4 5

D

D

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Horizontal interpretation of the demand curve

If buyers face a price of $4/lobster, they will wish to purchase 4000 lobsters a day.

Price ($/lobster)


10

8

6

4

2

01 2 3 4 5

D

D

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Vertical interpretation of the demand curve

If buyers are currently buying 4000 lobsters a day, the demand curve tells us that buyers would be willing to pay at most $4 for one additional lobster.Price ($/lobster)


10

8

6

4

2

01 2 3 4 5

D

D

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Demand curves slope downward for two reasons

1. As the good becomes more expensive, people switch to substitutes. (Substitution effect) The Substitution Effect is the change in the quantity

demanded of a good that results because buyers switch to substitutes when the price of the good changes

2. As the good becomes more expensive, people can’t afford to buy as much of it. (Income effect) Income effect is the change in the quantity demanded

of a good that results because a change in the price of a good changes the buyer’s purchasing power

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The supply of lobsters

The supply curve is the set of price-quantity pairs for which sellers are satisfied. ("Satisfied" means being able to sell the amount they want to at any given price.)

Price ($/lobster)


10

8

6

4

2

0

S

S

1 2 3 4 5 6

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Horizontal interpretation of the supply curve

If sellers face a price of $4/lobster, they will wish to sell 2000 lobsters a day.

Price ($/lobster)


10

8

6

4

2

0

S

S

1 2 3 4 5 6

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Vertical interpretation of the supply curve

If sellers are currently selling 2000 lobsters a day, the marginal cost of a lobster is $4.

Price ($/lobster)


10

8

6

4

2

0

S

S

1 2 3 4 5 6

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Supply curves slope upward for one reason

The low-hanging-fruit principle. Harvest the lobsters closest to shore first.

More generally, as we expand the production of any good, we turn first to those whose opportunity costs of producing that good are lowest, and only then to others with higher opportunity costs.

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Market Equilibrium Quantity and Price

Equilibrium occurs at the price-quantity pair for which both buyers and sellers are satisfied.

Price ($/lobster)


10

8

6

4

2

01 2 3 4 5

D

DS

SAt the market equilibrium price of $6 per lobster, buyers and sellers are each able to buy or sell as many lobsters as they wish to.

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Excess supply

A situation in which price exceeds its equilibrium value is called one of excess supply, or surplus.

Price ($/lobster)


10

8

6

4

2

01 2 3 4 5

D

DS

S

excess supply

At $8, there is an excess supply of 2000 lobsters in this market.

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Excess Demand

A situation in which price lies below its equilibrium value is referred to as one of excess demand.

At a price of $4 in this lobster market, there is an excess demand of 2000 lobsters.

Price ($/lobster)


10

8

6

4

2

01 2 3 4 5

D

DS

S

excess demand

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Zero excess supply and demand

Equilibrium occurs at the price-quantity pair for which both buyers and sellers are satisfied.

Price ($/lobster)


10

8

6

4

2

01 2 3 4 5

D

DS

SAt the market equilibrium price of $6, both excess demand and excess supply are exactly zero..

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Example 3.1.

At a price of $2 in this hypothetical lobster market, how much excess demand for lobsters will there be? How much excess supply will there be at a price of $10?

D

D S

S

1 2 3 4 50

2

4

6

8

10

Price ($/lobster)

Quantity(1000 lobsters/day)

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The Trading Locus

When price differs from the equilibrium price, trading in the marketplace will be constrained-- by the behavior of buyers if the price lies above equilibrium, by the behavior of sellers if below.

Price ($/lobster)


10

8

6

4

2

01 2 3 4 5

D

DS

STrading locus

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From disequilibrium to equilibrium

Price ($/lobster)


10

8

6

4

2

01 2 3 4 5

D

DS

SAt prices above equilibrium, sellers are not selling as much as they want to. The impulse of a dissatisfied seller is to reduce his price.

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Price ($/lobster)


10

8

6

4

2

01 2 3 4 5

D

DS

S At prices below the equilibrium value, buyers cannot obtain the quantities they wish to purchase. Some buyers adjust by offering slightly higher prices.

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An extraordinary feature of this equilibrating process is that no one consciously plans or directs it.

The actual steps that consumers and producers must take to move toward equilibrium are often indescribably complex. Suppliers looking to expand their operations,

for example, must choose from a bewilderingly large menu of equipment options.

Buyers, for their part, face literally millions of choices about how to spend their money.

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And yet the adjustment toward equilibrium results more or less automatically from the natural reactions of self-interested individuals facing either surpluses or shortages.

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Example 3.2. Should Collegetown Rents Be Regulated?

Suppose the supply and demand curves for two-bedroom Collegetown rental apartments are as shown.

Monthly Rent ($/apartment)

Quantity (thousands of apartments per month) 0 2

1000

Demand

Supply

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The city council is concerned that many students cannot afford the equilibrium rent of $1000 per month and is considering a regulation forbidding landlords from charging more than $500.

What will be the likely consequences of adopting this regulation?

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Rent Controls Produce Excess Demand in the Housing Market.



1000

Demand

Supply1500

Controlled rent=500

1 3

Excess demand=2000 apartments per month

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Responses to excess demand in a regulated housing market:

finder’s feeskey depositsrequired furniture rentalexcessive damage depositscurtailed maintenanceapartment conversion

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Alternative to helping the poor (students?)

There are much more effective ways to help poor people than to give them apartments and other goods at artificially low prices.

For example, income transfers:

Wage subsidiesPublic service jobs

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Cash on the Table

When a regulation prevents the price of an apartment, or any other good, from reaching its equilibrium level, the total economic surplus (economic benefits less opportunity costs) available for buyers and sellers is diminished.

Mutually beneficial exchanges are always possible when a market is out of equilibrium.

When people have failed to take advantage of all mutually beneficial exchanges, there is "cash on the table."

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Cash on the Table

At a rent of $500 in the rent-control example, there were tenants willing to pay as much as $1500 for an apartment.

Similarly, there were landlords for whom the opportunity cost of supplying an additional apartment was only $500.

The difference— $1000 per apartment— is the additional economic surplus that would accrue to any seller who could rent an additional apartment for the price that tenants would be willing to pay.



1000

Demand

Supply1500

Controlled rent=500

1 3

Excess demand=2000 apartments per month

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Social optimality

The socially optimal quantity of any good is the quantity that maximizes the total economic surplus that results from producing and consuming the good.

Cost-benefit principle keep expanding production of the good as long

as its marginal benefit is at least as great as its marginal cost.

Socially optimal quantity is that level for which the marginal cost and marginal benefit of the good are the same.

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Social optimality

Does the market equilibrium quantity also maximize total economic surplus?

In market equilibrium, the cost to the seller of producing an additional unit of the good is the same as the benefit to the buyer of having an additional unit.

The equilibrium quantity also maximizes total economic surplus if all costs of producing the good are borne directly

by sellers, and if all benefits from the good accrue directly to

buyers.

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Social optimality

At the equilibrium quantity of 2000 apartments/month, the marginal cost to the seller of supplying an additional apartment ($1000) is the same as the benefit to the buyer of the next apartment (also $1000) .



1000

Demand

Supply

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The Equilibrium Principle

A market in equilibrium leaves no unexploited opportunities for individuals, but may not exploit all gains achievable through collective action.

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Examples of price control in Hong Kong?

Rent control Cheung, S.N.S. (1979), “Rent Control and Housing

Reconstruction: The Postwar Experience of Prewar Premises in Hong Kong”, Journal of Law & Economics, 22 (1), pp. 27-53.

Designated LPG pump stations Brokerage fee of trading stock Public housing Taxi fare

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Taxi regulations

Taxi is in excess supply at the regulated taxi fare.Every day, a lot of taxi line up at the airport

for customers. Some of them have to wait several hours for business.

Some offer discount to customers. Number of taxi license is also regulated.

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Taxi Fare

Taxi services

S

D1 (economy in a recession)

D2

(economy in a boom)

Taxi Fare

Regulated fare

Economy in a recession:Excess supply

Economy in a boom:Excess demand

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When market equilibrium is not social optimal

The market equilibrium price and quantity are socially optimal when all relevant production costs are

incurred by sellers, and when all relevant product benefits accrue to

buyers.

Production of some goods entails costs that fall on people other than those who sell the good.

In other cases, some of the benefits of producing a good accrue to persons other than the buyers.

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Goods whose production generates toxic smoke

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Goods whose production generates noise.

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In the market equilibrium for such goods whose production generate pollution, the benefit to buyers of the last good produced is, as before, equal to the cost incurred by sellers to produce that good.

But since producing that good also resulted in the costs of the associated pollution, we know that the full marginal cost of the last unit produced—the seller’s private marginal cost plus the marginal pollution cost borne by others—must be higher than the benefit of the last unit produced.

Social marginal cost = private marginal cost + marginal pollution cost

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So when costs fall on people other than sellers, market equilibrium quantity > socially optimal quantity.

Total economic surplus would be higher if output of the good were lower.

Yet neither sellers nor buyers have any incentive to alter their behavior.

Potentially, some public policy can be implemented to discourage the production of this kind of goods.

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Increases in production of some goods benefit people other than those who buy them.

More apple trees

=> more honeyMore bees => more apples

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But since producing such goods yields benefits in addition to those received by buyers, we know that the full marginal benefit of the last unit produced—the price paid by the marginal buyer plus the benefit received by nonbuyers—must be higher than the marginal cost of the last unit produced.

Market equilibrium results in too little production of goods that generate external benefits.

Social marginal benefit = private marginal benefit + marginal benefit received by nonbuyers

Potentially, some public policy can be implemented to encourage the production of this kind of goods.

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Newspaper story

“Producers raised prices, and the resulting fall in demand caused prices to fall back to their original level.”

True or False?

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“ Change in demand” vs. “Change in the quantity demanded”

Price

Quantity 0

D

D

Increase in demandD'

D'

Price

Quantity

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4

2

0 1 2 3 4 5

D

D

Increase in the quantity demanded

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Newspaper story

“Producers raised prices, and the resulting fall in demand caused prices to fall back to their original level.”

WRONG!! A rise in price causes a fall in the quantity

demanded, not a fall in demand.

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“ Change in supply” vs. “Change in the quantity supplied”

“An increase in supply”: At every price, there is an increase in the quantity supplied.

SPrice

Quantity

S’

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“ Change in supply” vs. “Change in the quantity supplied”

“ An increase in the quantity supplied”: For an upward sloping supply curve, an increase in price leads to an increase in the quantity supplied.

S

1 2 3 4 50

2

4

6

8

10

Price ($/lobster)

Quantity(1000 lobsters/day)

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Impact of an increase in demand

An increase in demand will lead to an increase in both the equilibrium price and the equilibrium quantity.

DD’

S

Q

Price

QuantityQ’

P

P’

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Impact of a decrease in demand

A decrease in demand will lead to a reduction in both the equilibrium price and the equilibrium quantity.

D’D

S

Q’

Price

QuantityQ

P’

P

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Impact of an increase in supply

An increase in supply will lead to a decrease in the equilibrium price and an increase in the equilibrium quantity.

D

S

QQuantity

Q’

P’

P

S’

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Impact of a decrease in supply

A decrease in supply will lead to an increase in the equilibrium price and a reduction in the equilibrium quantity.

D

S’

Q’Quantity

Q

P

P’

S

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Determinants of Demand1. Incomes

For most goods, the quantity demanded at any price will rise with income. Goods that have this property are called normal goods.

P

Q

D0

D1

Income rises, normal good Income falls, normal good

P

Q

D0D

1

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Determinants of Demand1. Incomes

For inferior goods, the quantity demanded at any price will fall with income. Example: Ground beef with high fat content.

Income rises, inferior good

P

Q

D0D

1

Consumers abandon inferior goods in favor of higher quality substitutes (such as leaner grades of meat in the ground beef case) as soon as they can afford to.

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Determinants of Demand2. Tastes

Example: Following the release of Jurassic Park and The Lost World, tastes in children’s toys shifted toward designs involving prehistoric reptiles.

Tastes shift in favor

P

Q

D0

D1

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Determinants of Demand3. Prices of substitutes

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Quantityof tea

Priceof tea

D

P

Q

P’

Q’

S

Price of coffee falls

D’

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Quantityof tea

Priceof tea

D

P

Q

P’

Q’

S

Price of coffee rises

D’

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Determinants of Demand4. Prices of complements

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Quantityof coffee

Price ofcoffee

D

P

Q

P’

Q’

S

Price of cream falls

D’

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Quantityof coffee

Price ofcoffee

D

P

Q

P’

Q’

S

Price of cream rises

D’

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Determinants of DemandA summary

Factors That Cause an Increase (rightward or upward shift) in Demand1. A decrease in the price of complements to

the good or service2. An increase in the price of substitutes for the

good or service3. An increase in income (for a normal good)4. An increased preference by demanders for

the good or service5. An increase in the population of potential

buyers6. An expectation of higher prices in the future

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Determinants of supply1. Technology

Example: A more efficient lobster trap is invented.

Price

Quantity

S'S

A more efficient lobster trap shifts supply to the right

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Determinants of supply2. Factor prices

Example: The price of gasoline rises.

Price

Quantity

S' S

Rising factor prices shift supply to the left.

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Determinants of supply2. Factor prices

Example: Interest rates fall.

Price

Quantity

S'S

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Determinants of supplyA summary

Factors That Cause an Increase (rightward or upward shift) in Supply1. A decrease in the cost of materials, labor, or

other inputs used in the production of the good or service

2. An improvement in technology that reduces the cost of producing the good or service

3. An improvement in the weather, especially for agricultural products

4. An increase in the number of suppliers5. An expectation of lower prices in the future

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Example 3.3

Why do the prices of some goods, like apples, go down during the months of heaviest consumption, while others, like beachfront cottages, go up?

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Example 3.3

The seasonal consumption increase is the result of a supply increase in the case of apples, a demand increase in the case of cottages.

P P

Q Q

DDS

S

D

SS

Q Q

P

P P

P

sw

w

s

ww

s

sw

Q Qw s

Apples Beachfront Cottages

s

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Example 3.4

What will happen to the equilibrium price and quantity in the fresh seafood market if both of the following events occur: a scientific report is issued saying that fish

contains mercury, which is toxic to humans; and

the price of diesel fuel falls significantly?

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Example 3.4

The equilibrium price will go down, but the equilibrium quantity may go either up (right panel) or down (left panel)

P

Q

P

Q

DD'

S S'

DD'

SS'

S'

S

S'S

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More Hong Kong examples

Impact of X on the price and quantity various kinds of meat, and on the price of wine and quantity of wineFishing holiday Avian FluMad-cow disease

The impact of development of genetic modified food

The expansion of HKU on the housing prices in the Western District.

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Example 3.5. Sales Tax

The Hong Kong government is considering to introduce a sales tax. What is the effect of a sales tax to the market equilibrium?

D

S’

Q’Quantity

Q

P

P’

SPrice

Sales tax paid by sellers.

tax

Tax burden?

Tax Revenue?

Buyer’s burdenSeller’s

burden

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Example 3.5. Sales Tax

The Hong Kong government is considering to introduce a sales tax. What is the effect of a sales tax to the market equilibrium?

D’

Q’Quantity

Q

P’

P

SPrice

Sales tax paid by buyers.

tax

D

Tax burden?

Tax Revenue?

Buyer’s burden

Seller’s burden

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Example 3.6

Suppose there is a world-wide frenzy to buy the newly invented robot pets. The robot pets are made in Japan. Before this invention, the exchange rate of Japanese yen per US dollar was 117 yen for each US dollar. Other things being equal, what is more likely to happen to the exchange rate?a. The exchange rate will remain unchanged.b. The exchange rate will rise (say, to 118 yen per US

dollar).c. The exchange rate will fall (say, to 116 yen per US

dollar).d. The exchange rate will be more unpredictable.

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Example 3.6

Suppose there is a world-wide frenzy to buy the newly invented robot pets. The robot pets are made in Japan. Before this invention, the exchange rate of Japanese yen per US dollar was 117 yen for each US dollar. Other things being equal, what is more likely to happen to the exchange rate?

D

S

QUSD

Q’

116

117

S’Yen/USD

The exchange rate will fall (say, to 116 yen per US dollar).

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Example 3.7.

An important determinant of the amount of grains harvested next year by Ethiopian farmers is the amount of seeds planted this year. Given that Western nations have guaranteed to donate five hundred tons of grain next year, this year the Ethiopian farmers will:

A. plant more seeds as the food aid established a minimum price for grain.

B. plant more seeds as the farmers’ confidence is restored.C. plant the same amount of seeds as they would have

without the food aid.D. plant less seeds as consumers demand for grain is

completely price elastic. E. plant less seeds as the price of grain will be lower with the

food aid.

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Example 3.7

Donate five hundred tons of grain next year means that the demand for domestic production of grain will be lowered by the same amount at all prices?

D’

Q’Quantity (tons of grain)

Q

P’

P

SPrice

D

500 tons

Anticipating a lower market equilibrium price next year, farmer would want to supply less quantity next year.

They do so by planting less seeds this year.

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Example 3.7.

An important determinant of the amount of grains harvested next year by Ethiopian farmers is the amount of seeds planted this year. Given that Western nations have guaranteed to donate five hundred tons of grain next year, this year the Ethiopian farmers will:

A. plant more seeds as the food aid established a minimum price for grain.

B. plant more seeds as the farmers’ confidence is restored.C. plant the same amount of seeds as they would have

without the food aid.D. plant less seeds as consumers demand for grain is

completely price elastic. E. plant less seeds as the price of grain will be lower with the

food aid.

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End

1 ka-fu wong university of hong kong supply and demand

Documents

demand slide

market prices

supply of lobsters

price equilibrium

market equilibrium price

set of price

given price

pricequantity pairs