Chapter 4: DEMAND & Supply
Demand First!
What do we mean by (Consumer) Demand?
Demand Curve
◦Graph depicting the relationship between the price
of a certain commodity and the amount of it that
consumers are willing and able to purchase at that
given price.
◦Graphic representation of a demand schedule.
Price of
Ice-cream cone
Quantity of
Cones demanded
$0.00
0.50
1.00
1.50
2.00
2.50
3.00
12 cones
10
8
6
4
2
0
Price of
Ice-Cream
Cones
$3.00
1. A decrease
in price . . .
2.50
2.00
2. . . . increases quantity
of cones demanded.
1.50
1.00
Demand curve
0.50
0
1 2 3 4 5 6 7 8 9 10 11 12
Quantity of Ice-Cream Cones
The demand schedule is a table that shows the quantity demanded at each price.
The demand curve, which graphs the demand schedule, illustrates how the quantity
demanded of the good changes as its price varies. Because a lower price increases
the quantity demanded, the demand curve slopes downward.
3
Different Types of Demand Curves: Linear and Non-Linear
Qty D = a – b*Price
Log(Qty D) = a – b*Price
Shape of Demand Curve – depends on consumer’s response to price changes.
If always constant -> linear. If it varies with price changes -> non-linear
4
Different Types of Demand Curves:
Individual and Market Demand Curves
Market Demand Curve = Sum of Individual Demand Curves for the Product
Market
Demand
Market
Demand
What Role Does Demand Play in Market
Behavior/Analysis?
Demand curves are used to estimate behaviors in competitive
markets,
Combined with supply curves they can be used to estimate the
equilibrium price (the price at which sellers together are willing to
sell the same amount as buyers together are willing to buy, also
known as market clearing price) and the equilibrium quantity (the
amount of that good or service that will be produced and bought
without surplus/excess supply or shortage/excess demand) of that
market.[
Demand/Supply and Market Equilibrium
How People Make Decisions
Principle 3: Rational people think at the margin
Rational people
◦ Systematically & purposefully do the best they can to achieve
their objectives
What are Marginal changes
◦ Small incremental adjustments to a plan of action
Rational decision maker – take action only if
◦ Marginal (additional) benefits > Marginal (additional) costs
◦ Or if value of consuming next unit > market price
8
From the Demand Side
First Law of Demand
◦ What Does Law Of Demand Mean?
◦ all other factors being equal, as the price of a
good or service increases, consumer quantity
demanded for the good will decrease and vice
versa.
Investopedia explains Law Of Demand...
◦ summarizes the effect price changes on
consumer behavior. For example, a consumer will
purchase more pizzas if the price of pizza falls.
The opposite is true if the price of pizza
increases.
◦ http://www.investopedia.com/terms/l/lawofdem
and.asp
A Demand Example
Price
Individual's Demand Curve
Qty Demanded
$10.00
1
$9.00
2
$8.00
3
$7.00
4
$6.00
5
$5.00
6
$4.00
7
$3.00
8
$2.00
9
$1.00
10
Price per unit
$12.00
$10.00
$8.00
$6.00
Price
$4.00
$2.00
$0.00
1
2
3
4
5
6
7
Quantity Demanded
8
9
10
Computing Marginal Value
Price
Qty Demanded
$10.00
1
$9.00
2
$8.00
3
$7.00
4
$6.00
5
$5.00
6
$4.00
7
$3.00
8
$2.00
9
$1.00
10
Total and Marginal Value
Price
Qty Demanded
Amt Paid
Marginal Value
Total Value
Price x Qty Dem
$10.00
1
$10.00
$10.00
$10.00
$9.00
2
$18.00
$9.00
$19.00
$8.00
3
$24.00
$8.00
$27.00
$7.00
4
$28.00
$7.00
$34.00
$6.00
5
$30.00
$6.00
$40.00
$5.00
6
$30.00
$5.00
$45.00
$4.00
7
$28.00
$4.00
$49.00
$3.00
8
$24.00
$3.00
$52.00
$2.00
9
$18.00
$2.00
$54.00
$1.00
10
$10.00
$1.00
$55.00
Area under Demand
Difference in
TV(3)-TV(2)
MV is also equal
to price paid
Consumer’s Marginal Value
Some basic definitions
◦ Total Willingness-to-pay: “value in use”
◦ How much would you be willing to pay for x units of the good than go
entirely without?
◦ Equals the area under the demand curve up to x units
Individual's Demand Curve
WTP for 4 units
Price per unit
$12.00
$10.00
$8.00
$6.00
Price
$4.00
$2.00
$0.00
1
2
3
4
5
6
7
Quantity Demanded
8
9
10
In Graphic Terms
Note: (again) price = marginal value
Consumer is willing to buy up to P = MV
Dollars
Price, Total & Marginal Use Value
$12.00
$10.00
$8.00
$60.00
$50.00
$40.00
$6.00
$4.00
$2.00
$0.00
$30.00
$20.00
$10.00
$0.00
1
2
3
4
5
6
7
8
Quantity Demanded
9 10
Price
Marginal Value
Total Value
Why Do People Buy Things?
1. Because they are better off buying the good
◦
Value in consumption/use > price paid = opportunity cost of spending it
on next best alternative
2. How much better off?
◦
Difference between the maximum amount you would be willing to pay
for each unit of the good
◦
Minus the amount you have to give up (i.e., what you have to pay to get it)
Economists call this difference “Consumer Surplus”
CS = MaxWTP(Q*) – Price x Q*
Max WTP(0:Q*) = MV(1) + MV(2) + …. + MV(Q*)
◦
15
Area under the demand curve up to the last unit purchased (Q*)
Calculating Consumer Surplus
Consumer surplus is the
difference between the total
amount that consumers are
willing and able to pay for a
good or service (indicated by
the demand curve) and the total
amount that they actually do
pay (i.e. the market price).
Rational decision maker – takes action
only if
Marginal benefits > Marginal costs
From Chapter1
Ten principles of economics
How People Make Decisions
1: People Face Trade-offs
2: The Cost of Something Is What You Give Up to Get It
3: Rational People Think at the Margin
4: People Respond to Incentives
17
Ceteris Paribus
What’s it mean?
Ceteris paribus or caeteris paribus is a Latin phrase meaning "with other things the same" or
"other things being equal or held constant".
What are we “holding constant” when we “draw” the an individual’s demand curve?
◦ Major factors (80/20 rule) that affect a consumer’s demand for a good
◦
◦
◦
◦
◦
◦
Individual’s Income
Price of Substitutes for the goods
Price of Complements (goods consumed/used with the good being studied)
Future Price of the good
Product Quality
Individual’s Taste and Preferences
◦ And if we are modelling market demand (all customers)
◦ All of the above + number of people in the market (and how much they buy at each price)
Table 4.1
Factors That Shift the Demand Curve
Appendix
Graphs of Two Variables
Taking into Account More Than Two Variables on a Graph
FIGURE 1A-5
Showing Three
Variables on a Graph
Shift of the Entire Curve
Shift out/right of the Demand Curve
◦ WTP increases for all Qd
Shift in/left of the Demand Curve
◦ WTP decreases for all levels of Qd
Shift out/right
Increase in Demand
Shift in/left
Decrease in Demand D
2
EXHIBIT 3.3
Income as a Determinant of Demand
3-22
Factors That Can Shift Demand
Income
◦ Normal good
◦ As income rises, quantity demanded increases at a given price -> Demand curve shifts out
◦ Superior good – percent of budget spent on good increases more than percent increase in income
◦ Demand curve shift is very large
◦ Inferior good
◦ As income rises, quantity demanded decreases at a given price
◦ Demand curve shifts in
Factors That Can Shift Demand
Substitutes
◦ Goods that are similar to the “good in question” (or being analyzed)
◦ E.g., Pepsi/Coke
Shifts in Demand Curve
◦ If price of substitute increases, then demand for “GIQ” shifts out as it
becomes relatively less expensive
◦ If price of substitute decreases, then demand for “GIQ” shifts in as it becomes
relatively more expensive
◦ “closer” the substitute -> more demand curve shifts (i.e., greater cross-price
elasticity)
◦ For substitutes: relative price matters!
Factors That Can Shift Demand
Complements
◦ Goods that are “jointly consumed” with “GIQ”, e.g. coffee & cream
Demand Curve shifts
◦ Price of complement increases, then demand for “GIQ” shifts in as total cost
of consumption has increased
◦ Price of complement decreases, then demand for “GIQ” shifts out as total
cost of consumption has decreased
◦ For complements: total cost of consumption matters!
Factors That Can Shift Demand
Product Quality
◦ Better or improved product quality increases (relative) demand
◦ Demand curve shifts out
Future price (hedge market) of the good
◦ If the price is expected to go up in the future -> increases current demand (shift out/right)
◦ Cheaper to consume today and stockpile
◦ If the price is expected to decrease in the future -> decrease current demand (shift in/left)
◦ Wait to buy (christmas/after christmas sales)
Taste and Preferences
◦ Always assumed constant unless you have empirical proof (new MRI imaging)
Factor that Affects the ONLY Aggregate Market
Demand Curve
As the population/number of buyers (Nb) increases -> Market Demand curve shifts outward
Market Demand:
Maybe a little bit different
Market Demand may be kinked as new buyers enter at different price points
When it’s only Tom – Tom’s D is the market
Harry joins the Market
Dick joins
Table 4.1
Factors That Shift the Demand Curve
Key Assumptions
Demand Curve
For a given (individual’s) demand curve
◦ These factors are held constant (ceteris paribus):
◦ Price of:
◦ substitutes,
◦ complements,
◦ future price of the good
◦ income,
◦ quality, and
◦ taste and preferences
And for a market demand curve:
◦ number of buyers (Nb)
Only price and quantity demanded are allowed to vary
EXHIBIT 3.4
Distinguishing Change in Demand from Change in Quantity Demanded
3-31
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