Microeconomics

Supply, Demand, and Price

Standard• SSEMI2- The student will explain how the Law of

Demand, the Law of Supply, prices, and profits work to determine production and distribution in a market economy.– Define the Law of Supply and the Law of Demand.– Describe the role of buyers and sellers in determining market

clearing price– Illustrate on a graph how supply and demand determine

equilibrium price and quantity.– Explain how prices serve as incentives in a market economy

• Essential Question: How does quantity demanded and price impact each other?

• 3 Economic Questions– What to produce?– How much to produce?– Who gets what?

Quick Review

• In a market system the interaction of buyers and sellers determines the prices of most goods as well as what quantity of a good will be produced

• Buyers demand goods• Sellers supply goods• Interactions between the groups lead to an

agreement on prices and quantity traded

Supply and Demand Overview

Demand

• Demand- the desire to own something and the ability to pay for it

• The Law of Demand- Consumers buy more a good when its price decreases and less when its price increases

Demand Schedule

Individual Demand Schedule Market Demand SchedulePrice of a slice of

pizzaQuantity

demanded per day

Price of a slice of pizza

Quantity demanded per

day$.50 5 $.50 300

$1.00 4 $1.00 250

$1.50 3 $1.50 200

$2.00 2 $2.00 150

$2.50 1 $2.50 100

$3.00 0 $3.00 50

Demand Schedule- a table that lists the quantity of a good a person will buy at each different price

Market Demand Schedule- a table that lists the quantity of a good all consumers in a market will buy at each different price; allows business owners to predict sales at several different price levels

Demand Graph

• Demand Curve- a graphic representation of a demand schedule– Vertical Axis- labeled with the lowest

possible prices at the bottom and the highest at the top

– Horizontal Axis- lowest quantity at the left and highest quantity at the right

• Demand curves only show the relationship between the price of the good and the quantity purchased; they assume ceteris paribus- Latin phrase that means all other things are held constant

• Demand curves on the graph slopes downward to the right; as price decreases, demand increases

Demand Curve

Market Demand Curve

3.00

2.50

2.00

1.50

1.00

.50

0

0 50 100 150 200 250 300 350Slices of pizza per day

Pric

e pe

r sl

ice

(in

dolla

rs)

Demand

This illustrates our market demand schedule for pizzas from earlier.

Demand Curve

Shifts of the Demand Curve• Changes in Demand

– A demand curve is accurate as long as there are no changes other than price that could affect the consumer’s decision

– When ceteris paribus is dropped and other factors change the entire demand curve shifts• Increase in demand- the curve shifts right• Decrease in demand- the curve shifts left

– A shift if the demand curve means that at every price consumers buy a different quantity than before

What Changes Demand?

• A change in price does NOT cause the demand curve to shift- price changes are already built in

What Changes Demand?

• Recall the definition– Taste (desire)– Income (ability to pay)– Complimentary Items– Substitutes– Expectations

Taste• As we grow up, hear information, learn

more etc our opinions and feelings change

• The way we want, desire, feel or like something is TASTE

Income

• Due to our salary, pay checks, job opportunities we have more or less money to spend.

• This change in Income changes our ability to buy

Complimentary Goods• These items go

together.• For example if the

cost of peanut butter goes way down, we desire more jelly. (if cost goes up we will desire less jelly)

• These items can be exchanged for the other.

• If the cost of peanut butter goes way up, we may buy more pizza for lunch. Pizza can be exchanged for PB and J sandwiches.

Substitutes

Expectations

• What people anticipate will occur in the future

What Changes Demand?

• Remember TICS changes demand!!– Taste (desire)– Income (ability to pay)– Complimentary Items– Substitutes– Expectations

Elasticity of Demand

• Elasticity of Demand- a measure of how consumers react to a change in price– Inelastic- the demand for a good you will

keep buying despite a price increase– Elastic- describes that demand is sensitive to

a change in price

Calculating Elasticity• Remember that the law of demand says

that whenever there is an increase in price, there will be a decrease in demand

• Price range helps to determine the elasticity of a price– Demand for a good at one price may be

elastic but at another price the same good might be inelastic

Calculating Elasticity

Elasticity is calculated by using the following formula:Elasticity of Demand= percentage change in demand of a

good percentage change in the price of

the good

Percentage Change= Original number-New Number X 100 Original Number

Results may be negative, but all negatives are dropped.

Values of Elasticity

• If the elasticity of demand for a good is less than 1, demand is inelastic

• If elasticity is greater than 1, demand is elastic

• If elasticity is equal to 1, demand is unitary elastic

Elasticity• If the price of a pizza

goes up from $1 to $1.50, and the quantity of the pizza fell from 4 to 3.

• The change in price is ____

• The change in quantity demanded is ___

• Is the price of pizza elastic or inelastic?

Factors Affecting Elasticity

• Availability of substitutes- Lack of substitutes makes a good’s demand inelastic; substitutes makes a good’s demand elastic

• Relative importance- how much of your budget you spend on a good will determine its elasticity

• Necessities versus luxuries

Change Over Time

• Consumers often take time to respond to price changes- demand is inelastic for the short term

• Demand for a good becomes elastic as consumer find substitutes

Elasticity and Total Revenue• Total revenue is defined as the amount of

money the company receives by selling its goods

• If a good is elastic, an increase in price may cause a firm’s total revenue to go down

• If a good is inelastic, an increase in price will make up for lower sales

• Firms use elasticity of a good to figure out whether or not it would be helpful or harmful to their revenue to raise the price of a good.

Elasticity and Pricing Policies

Total Revenue and Price

• If Price Increases & total revenue increases= inelastic

• If Price decrease & total revenue decreases= inelastic

• If Price increases & total revenue decreases= elastic

• If Price decreases & total revenue increases= elastic

Are the Following Elastic or Inelastic?

• Salt• New Cars• Pork Chops• European Vacation• Insulin

• Insulin at one of four drug stores in a shopping mall

• Gasoline purchased on day after a 20% price increase

• Gasoline purchased one year after a 20% price increase

Supply• Supply- the amount of goods available; used by

economists to refer to the relationship between price and quantity supplied

• Law of Supply- tendency of suppliers to offer more of a good at a higher price; the higher the price the larger the quantity produced

• Quantity Supplied- the amount a supplier is willing and able to supply at a certain price

• As the price of a good rises, existing firms will produce more in order to earn additional revenue– New firms have an incentive to enter the

market to earn a profit for themselves– If the price falls, some firms produce less and

others might drop out of the market

Supply Continued

Higher Production

• If a firm is earning a profit then an increase in price- ceteris paribus- will increase the firms profits

The Supply Schedule

• Supply Schedule- a chart that lists how much of a good a supplier will offer at different prices

• Market Supply Schedule- a chart that lists how much of a good all suppliers will offer at different prices

• Like demand schedules a change in price is built in the schedule

The Supply Graph

• Supply Curve- a graph of the quantity supplied of a good at different prices– Vertical- price– Horizontal- quantity of the good supplied– Rises from left to right

• Market Supply Curve- a graph of the quantity supplied of a good by all suppliers at different prices

Market Supply Curve

Pric

e (in

dol

lars

)

Output (slices per day)

3.00

2.50

2.00

1.50

1.00

.50

0

0 500 1000 1500 2000 2500 3000 3500

Supply

Supply Curve

What Changes Supply?

• Recall The Definition• Sellers • Technology• Regulations• Input Costs• Productivity• Expectations

Sellers

• Depending on the circumstance there are sometimes more or less sellers based on competition or product availability

Technology• This changes the

manner in which we make our products

• This deals with efficiency

Regulations• Regulation- a

government intervention in a market that affects the production of a good

• Subsidy- a government payment that supports a business or market

• Excise Tax- a tax on the production or sale of a good (ex. Tax on cigarettes)

Input Costs

• This involves the changes that effect the materials, fixed cost and other variable costs it takes to produce the product.

Productivity

• This changes the manner in which we make our products

• This deals with efficiency

• And often focuses on the people and training

Expectations

• What is going to happen…how do businesses prepare for it?

• Ex. Christmas Production

This is why you need to remember

• Sellers• Technology• Regulations• Input Costs• Productivity • Expectations

Supply and Elasticity

• Elasticity of Supply– a measure of the way quantity supplied reacts to a change in price– If elasticity is greater than 1, supply is elastic-

supply is sensitive to change in price– If elasticity is less than 1, supply is inelastic– If elasticity is equal to 1, supply is unitary

elastic

What affects elasticity of supply?

• Time– In the short run, a firm cannot easily change

its output level, so supply is inelastic.– In the long run, firms are more flexible, so

supply can become more elastic

Pric

e pe

r slic

e

Equilibrium Point

Finding Equilibrium

Price of a slice

of pizza

Quantity demanded

Quantity supplied Result

Combined Supply and Demand Schedule

$ .50 300 100

$3.50

$3.00

$2.50

$2.00

$1.50

$1.00

$.50

Slices of pizza per day

050 100 150 200 250 300 350

Supply Demand

The point at which quantity demanded and quantity supplied come together is known as

equilibrium (market clearing price).

$2.00

$2.50

$3.00

150

100

50

250

300

350

Surplus from excess supply

$1.50 200 200 Equilibrium

Equilibrium Price

a

Equ

ilibr

ium

Q

uant

ity

$1.00 250 150

Shortage from excess demand

Combining Supply and Demand

• At Equilibrium the market for a good is stable

• The Equilibrium Price and Quantity can be found where quantity supplied equals quantity demanded or where the two curves cross.

Disequilibrium• Disequilibrium- describes any price or quantity

not at equilibrium; when quantity supplied is not equal to quantity demanded in a market– Excess Demand- when quantity demanded is more

than quantity supplied• Sellers will raise their prices

– Excess Supply- when quantity supplied is more than quantity demanded• Sellers will lower their prices

• Interactions between buyers and sellers will always push the market back towards equilibrium.

Government Intervention

• Price Ceiling- a maximum price that can be legally charged for a good or service– Rent Control- a price control placed on rent

(has occurred in New York City)• What do you think are the problems with rent

control?

Government Regulation

• Price Floor- a minimum price for a good or service– Minimum Wage- minimum price that an

employer can pay a worker for an hour of labor• Minimum Wage can cause a surplus of labor

Shifts in Supply• Understanding a Shift

– Since markets tend to move toward equilibrium, a change in supply will set market forces in motion that lead the market to a new equilibrium price and quantity sold.

• Excess Supply– A surplus is a situation in which quantity supplied is

greater than quantity demanded. If a surplus occurs, producers reduce prices to sell their products. This creates a new market equilibrium.

• A Fall in Supply– The exact opposite will occur when supply is

decreased. As supply decreases, producers will raise prices and demand will decrease.

Shifts in Demand• Excess Demand

– A shortage is a situation in which quantity demanded is greater than quantity supplied.

• Search Costs– Search costs are the financial and opportunity

costs consumers pay when searching for a good or service.

• A Fall in Demand– When demand falls, suppliers respond by

cutting prices, and a new market equilibrium is found.

$800

$600

$400

$200

0

Pric

e

Output (in millions)

Graph A: A Change in Supply

1 2 3 4 5

Analyzing Shifts in Supply and Demand

• Graph A shows how the market finds a new equilibrium when there is an increase in supply.

• Graph B shows how the market finds a new equilibrium when there is an increase in demand.

Original supply

Demand

a

New supply

b

c

Graph B: A Change in Demand

Output (in thousands)

$60

$50

$40

$30

$20

$10

0900800700600500400300200100

Pric

e

Supply

Original demand

a

New demand

c

b

Prices in a Free Market

• Prices help move land, labor, and capital into the hands of producers and finished goods into the hands of buyers.

The Advantages of Prices

• Price as incentive– Prices are a signal that tell a consumer or

producer how to adjust• Prices as signals

– Low Price- buyers purchase more; sellers make less

– High Price- buyers purchase less; sellers make more

The Advantages of Prices

• Flexibility– Prices can be easily increased to solve the

problem of excess demand– Prices can be easily decreased to solve the

problem of excess supply– Supply Shock- a sudden shortage of a good

• Rationing- a system of allocating scarce goods and services using criteria other than price

• Raising prices is the quickest way to solve excess demand

A Wide Choice of Goods

• A benefit of a market-based economy is the diversity of goods and services consumers can buy

• Market economy allows price to allocate resources efficiently

• In a market economy there are incentives to raise prices in return for profit

Wealth of Nations• Wealth of Nations- Written by Adam Smith

in 1776– Businesses prosper by finding out what

people want and then providing it

Market Problems

• Imperfect Competition- there are not enough producers of a good to drive prices down

• Spillover Costs- costs of production that affect people who have no control over how much of a good is produced

• Imperfect Information