SUPPLY & DEMAND

Chapter 3

The market for any good or service consists of all buyers and sellers of that good.

As economists, typically represent a basic market in the form of supply and demand.

Examining a Market

Assumptions.

The model of Demand and Supply assumes that we are analyzing a perfectly competitive market.

Perfectly Competitive Market. A market that meets the conditions of 1. Many buyers and sellers2. All firms sell identical products and 3. No barriers to new firms entering the

market.

Demand

Demand Schedule — a table showing the total quantity of a goof(or service) that buyers wish to buy at each price

Demand curve—a graph showing the

total quantity of a good (or service) that buyers wish to buy at each price.

Quantity demanded — The amount of a good or service that a consumer is willing and able to purchase at a given price.

Market demand — The demand by all the consumers of a given good or service

The Law of Demand.

States that “all else equal” (ceteris paribus), when the price of a product falls, the quantity demanded of the product will increase, and when the price of a product rises, the quantity demanded of the product will decrease.

The ceteris paribus Condition Ceteris paribus (“all else equal”)

condition.Ceteris paribus is the Latin word for all

else equal. It is the requirement that when

analyzing the relationship between two variables- such as price and qty demanded – other variables be held constant.

Why is the demand curve downward sloping?

A demand curve is downward sloping from left to right because of the inverse relationship b/w price and quantity demanded.

This is why consumers consume more of a commodity at lower price.

Other reasons include the income and Substitution effects.

A Change in Demand Vs a Change in Quantity Demanded. A change in quantity demanded is a

movement along the demand curve that occurs in response to a change in the price of the product in question ONLY.

A change in demand is a shift of the entire demand curve.

A shift occurs if there is a change in one of the shifter variables, other than the price of the product, that affects the willingness of consumers to buy the product.

Shifts in Demand Curves:

1. Change in the price of a complement.2. Change in the price of a substitute.3. Change in consumer income.4. Change in preferences of demanders of the good.5. Change in the population of potential buyers.6. An expectation of future prices.

Complements—Goods and services that are used together. Eg. Cars and gas, coffee and sugar, shoe and socks.

two goods are complements in consumption if an increase in the price of one causes a leftward (inward) shift in the demand curve for the other.

1. Change in the Price of a Complement

Coffee and Sugar

P of Coffee

Coffee Market

Sugar Market

Substitutes— Goods and services that can be used for the same purpose. Eg. Coke and Pepsi,..

two goods are substitutes in consumption if an increase in the price of one causes a rightward (outward) shift in the demand curve for the other.

2. Change in the Price of a Substitute

Coke and Pepsi

P of Coke

Coke Market

Pepsi Market

3. Change in Consumer Income

Normal good—a normal good is a good for which the demand increases as income rises and decreases as income falls.

For a normal good, the demand curve shifts rightward (outward) when the incomes’ of buyers increase.

Income - Normal Good

Inferior good—an inferior good is a good for which the demand increases as income falls and decreases as income rises.

For an inferior good, the demand curve shifts leftward (inward) when the incomes’ of buyers increase.

Income - Inferior Good

4. Changes in the Preferences of Demanders for the Good If preferences shift away from a good,

the demand curve for the good will shift downward.

5. Change in the Population of Potential Buyers.

Increases in population generally shift outward the demand curves for most goods.

Population

6. An Expectation of Higher Future Prices.

Higher expected prices will shift outward the demand curve for a good.

Expected Price

Supply

Supply curve—a graph showing the total quantity of a good (or service) that sellers wish to sell at each price.

Why is the supply curve upward sloping?

This shape of the supply curve reflects the reality that the number of firms willing to supply that commodity increases as the market price increases.

The only thing we allow to change along a given supply curve is the price of the good itself. If anything else changes, the entire supply curve shifts.

The law of Supply

It states that, holding all else constant, increases in price cause increases in the quantity supplied, and decreases in price cause decreases in the quantity supplied.

Quantity Supplied: The amount of a good or service that a firm is willing and able to supply at a given price.

A change in quantity supplied is a movement along the supply curve that occurs in response to a change in price.

A change in supply is a shift of the entire supply curve.

A change in supply has taken place if, at the same price, a different quantity is supplied.

Shifts in Supply Curves:

1) Changes 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 production of the good or service.

3) A change in the weather (especially for agricultural products).

4) A change in the number of producers (suppliers).

5) An expectation of lower future prices.

1. Changes in Input Costs

Changes in the cost of materials, labor, or other inputs used in the production of the good or service.

Cost of a Production Input

2. Technology

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

Technology

3. Weather

A change in the weather (especially for agricultural products).

Better Weather

4. Change in the Number of Producers

As the number of firms within a given market changes, the available supply of the goods or services produced by those firms will also fluctuate.

Number of Producers

5. Change in Future ExpectationsAn expectation of future prices will influence the firm’s behavior today regarding available supply of goods

Expected Price

Supply = Demand

Market equilibrium occurs when all buyers and sellers are satisfied with their respective quantities at the market price. At equilibrium, QD=QS.

QD = QS

Excess Supply

A situation where QS > QD.Surplus: A situation in which the quantity

supplied is greater than the quantity demanded.

Excess Demand

A situation where QD > QS.Shortage: A situation in which the quantity

demanded is greater than the quantity supplied.

Demand and Supply both Count:A Tale of Two letters.

Which letter is likely to be worth more: one written by Abraham Lincoln or one written by his assassin, John Booth ? Lincoln is one of the greatest presidents, and many people collect anything written by him. The demand for letters written by Lincoln would be much greater than letters by Booth.

Booth letters sold for $31,050 and Lincoln sold for only $21,850.

Shifts in Supply and Demand Curves:1. D2. D3. S4. S5. D and S6. D and S7. D and S 8. D and S

D

D

S

S

The effect of shift in Demand and Supply over time. Whenever only demand or only supply

shifts, we can easily predict the effect on equilibrium price and quantity. But what happens if both shift ?

Eg. In many markets demand curve shifts to the right over time as population increases. The supply curve also often shifts to the right as new firms enter the market.

Whether the equilibrium price in a market rises or falls over time depends on whether demand shifts to the right more than does supply.

D and S

D and S

D and S

D and S

Summary

No Change in S

An Increase in S

A Decrease in S

No Change in D P same, Q same P down, Q up P up, Q down

An Increase in D P up, Q up P ambiguous, Q up

P up, Q ambiguous

A Decrease in D P down, Q down P down, Q ambiguous

P ambiguous, Q down

Market Friction 1: Price Floor Price floor—A price floor specifics a

minimum legal price below which goods cannot be sold.

Minimum Wage

Price ceiling—A price ceiling specifies the highest price that firms may legally charge.

Market Friction 2: Price Ceiling

Rent Control

Market Example 1: Energy Prices Due to relatively high unemployment

over the last few years, the demand curve for energy has shifted inward.

Market Example 2: Market for Bank Loans

Supply of bank loans: Banks

Demand for bank loans: Households and business firms

Price of bank loans = interest rate on bank loans

Market for Bank Loans

Credit Crunch

In a credit crunch banks greatly reduce their lending. As a result, the supply curve for bank loans shifts inward.

Credit Crunch

Market for bank loans.

Credit Crunch

Fewer loans are granted at a higher interest rate.

Practice Question

Suppose the supply of a good is given by the equation P = 200 + QS and the demand for the good is given by the equation P = 500 - QD/2, where quantity is measured in

millions of units and P is measured in dollars per unit.  

What is the equilibrium quantity in this market?

What is the equilibrium price in this market?

Graph?