GECON 200: Lecture 4
Where Prices Come From: The Interaction of Demand and Supply
(Chapter 3), Public Goods and Market Failure (Handout)
The Demand Side of the Market
Perfectly Competitive Market A market that meets the
conditions of (1) many buyers and sellers, (2) all
firms selling identical products, and (3) no barriers to
new firms entering the market.
3.1 LEARNING OBJECTIVE
Discuss the variables that
influence demand.
The Demand Side of the Market
Demand schedule A table showing the relationship between the
price of a product and the quantity of the product demanded.
Quantity demanded The amount of a good or service that a
consumer is willing and able to purchase at a given price.
Demand curve A curve that shows the relationship between the
price of a product and the quantity of the product demanded.
Market demand The demand by all the consumers of a given
good or service.
The Demand Side of the Market
Demand Schedules and Demand Curves
FIGURE 3-1
A Demand Schedule and
Demand Curve
As the price changes,
consumers change the quantity
of energy drinks they are willing
to buy. We can show this as a
demand schedule in a table or as
a demand curve on a graph.
The table and graph both show
that as the price of energy drinks
falls, the quantity demanded
rises.
When the price of energy drinks
is $3.00, consumers buy 60
million cans per day. When the
price drops to $2.50, consumers
buy 70 million cans.
Therefore, the demand curve for
energy drinks is downward
sloping.
The Demand Side of the Market
Law of demand The rule that, holding everything else
constant, 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.
A shift of a demand curve is an increase or a decrease
in demand. A movement along a demand curve is an
increase or a decrease in the quantity demanded
What Explains the Law of Demand?
Substitution effect The change in the quantity
demanded of a good that results from a change in
price, making the good more or less expensive
relative to other goods that are substitutes.
Income effect The change in the quantity demanded of
a good that results from the effect of a change in the
good’s price on consumers’ purchasing power.
Holding Everything Else Constant: The
Ceteris Paribus Condition
Ceteris paribus (“all else equal”) condition The
requirement that when analyzing the relationship
between two variables—such as price and quantity
demanded—other variables must be held constant.
Ceteris paribus also applies to supply curves and nearly
all economic analysis to some degree.
.
Buyers and Sellers In Markets
• The Cost-Benefit Principle
– The reservation price is the benefit the buyer receives
from the good
– The cost of the good is its market price
– If the reservation price (benefit) exceeds the market price
(cost) the consumer will purchase the good
– At higher prices, benefit will exceed cost for a smaller
quantity than at lower prices
The Demand Side of the Market
Holding Everything Else Constant: The Ceteris Paribus Condition
FIGURE 3-2
Shifting the
Demand Curve
When consumers increase
the quantity of a product
they want to buy at a given
price, the market demand
curve shifts to the right, from
D1 to D2.
When consumers decrease
the quantity of a product
they want to buy at any
given price, the demand
curve shifts to the left, from
D1 to D3.
Buyers and Sellers In Markets
Horizontal Interpretation
Price
($ per slice)
Price determines quantity
demanded
4
3
2
Demand
8
12
16
Quantity
(1000s of slices per day)
Buyers and Sellers In Markets
Vertical Interpretation
Price
($ per slice)
Quantity measures the
marginal buyer’s
reservation price
4
3
2
Demand
8
12
16
Quantity
(1000s of slices per day)
The Demand Side of the Market
Variables That Shift Market Demand
Many variables other than price can influence market demand.
Income
Normal good A good for which the demand increases as income rises and
decreases as income falls.
Inferior good A good for which the demand increases as income falls and
decreases as income rises.
Prices of related goods
Substitutes Goods and services that can be used for the same purpose.
Complements Goods and services that are used together.
The Demand Side of the Market
Variables That Shift Market Demand
Tastes
Consumers can be influenced by an advertising campaign for a product.
Population and demographics
Demographics The characteristics of a population with respect to age, race,
and gender.
Expected future prices
Consumers choose not only which products to buy but also when to buy
them.
Making
the
Are Big Macs an Inferior Good?
Connection
Big Macs seem to fit the
economic definition of an
inferior good because demand
increased as income fell. But
remember that inferior goods are
not necessarily of low quality,
they are just goods for which
consumers increase their
demand as their incomes fall.
McDonald’s restaurants experienced
increased sales during 2008 and 2009,
despite the recession.
YOUR TURN: Test your understanding by doing related problem 1.8 at the end of
this chapter.
Making
the
The Aging of the Baby Boom Generation
Connection
What effects will the aging of the baby boom generation have on the
economy?
Older people have a greater demand for medical care than do younger
people.
Aging boomers will also have an effect on the housing market.
YOUR TURN: Test your understanding by doing related problem 1.9 at the end of
this chapter.
The Demand Side of the Market
TABLE 3-1
Variables That Shift Market Demand Curves
The Demand Side of the Market
TABLE 3-1
Variables That Shift Market Demand Curves
The Demand Side of the Market
TABLE 3-1
Variables That Shift Market Demand Curves
The Demand Side of the Market
TABLE 3-1
Variables That Shift Market Demand Curves
The Demand Side of the Market
A Change in Demand versus a Change in Quantity Demanded
FIGURE 3-3
A Change in Demand versus a
Change in Quantity Demanded
If the price of digital music players
falls from $3.00 to $2.50, the result will
be a movement along the demand
curve from point A to point B—an
increase in quantity demanded from
60 million to 70 million.
If consumers’ incomes increase, or if
another factor changes that makes
consumers want more of the product
at every price, the demand curve will
shift to the right—an increase in
demand. In this case, the increase in
demand from D1 to D2 causes the
quantity of energy drinks demanded
at a price of $3.00 to increase from 60
million cans at point A to 80 million
cans at point C.
Predicting and Explaining Changes In Prices
and Quantities
• Distinguishing Between:
– A change in the quantity demanded
• A movement along the demand curve that occurs in response to a
change in price
– A change in demand
• A shift of the entire demand curve
Making
the
Connection
Red Bull and the Future Demand for Energy Drinks
It is important for managers to
accurately forecast the demand
for their products because it
helps them determine how much
of a good to produce.
Will Red Bull continue to
grow its share of the
energy drink market?
YOUR TURN: Test your understanding by doing related problem 1.11 at the end
of this chapter.
The Supply Side of the Market
Quantity supplied The amount of a good or service that a
firm is willing and able to supply at a given price.
Supply schedule A table that shows the relationship
between the price of a product and the quantity of the
product supplied.
Market supply The total supply by all the producers of a
given good or service.
Buyers and Sellers In Markets
Supply curve A curve that shows the relationship between
the price of a product and the quantity of the product
supplied.
– Sellers must receive a higher price to produce additional
units of product to cover the higher opportunity costs of
each additional unit
– Suppliers of goods are not (necessarily) gouging customers
when they raise prices.
– Do you leave money on the table?
The Supply Side of the Market
Supply Schedules and Supply Curves
FIGURE 3-4
A Supply Schedule and Supply Curve
As the price changes, Red Bull, Monster
Energy, Rockstar, and the other firms
producing energy drinks change the
quantity they are willing to supply. We can
show this as a supply schedule in a table
or as a supply curve on a graph.
The supply schedule and supply curve
both show that as the price of energy
drinks rises, firms will increase the
quantity they supply.
At a price of $2.50 per can, firms will
supply 90 million cans. At a price of $3.00,
firms will supply 100 million cans.
3.2 Learning Objective
Discuss the variables that
influence supply.
The Supply Side of the Market
Law of supply The rule that, holding everything else
constant, increases in price cause increases in the
quantity supplied, and decreases in price cause
decreases in the quantity supplied.
The Daily Supply
Curve for Pizza in Chicago
Horizontal Interpretation
Price
($ per slice)
Supply
4
Shows the
quantity produced
for each price
3
2
8
12
16
Quantity
(1000s of slices per day)
The Daily Supply
Curve for Pizza in Chicago
Vertical Interpretation
Price
($ per slice)
Supply
4
Shows the marginal
cost (reservation
price) for producing
each additional unit
3
2
8
12
16
Quantity
(1000s of slices per day)
The Supply Side of the Market
FIGURE 3-5
Shifting the Supply Curve
When firms increase the
quantity of a product they want
to sell at a given price, the
supply curve shifts to the
right.
The shift from S1 to S3
represents an increase in
supply.
When firms decrease the
quantity of a product they want
to sell at a given price, the
supply curve shifts to the left.
The shift from S1 to S2
represents a decrease in
supply.
The Supply Side of the Market
Variables That Shift Market Supply
The following are the most important variables that shift market
supply:
• Prices of inputs
• Technological change A positive or negative change in the
ability of a firm to produce a given level of output with a given
quantity of inputs.
• Prices of substitutes in production
• Number of firms in the market
• Expected future prices
The Supply Side of the Market
TABLE 3-2
Variables That Shift Market Supply Curves
The Supply Side of the Market
TABLE 3-2
Variables That Shift Market Supply Curves (continued)
The Supply Side of the Market
TABLE 3-2
Variables That Shift Market Supply Curves (continued)
The Supply Side of the Market
A Change in Supply versus a Change in Quantity Supplied
FIGURE 3-6
A Change in Supply versus a
Change in Quantity Supplied
If the price of energy drinks rises from
$2.00 to $2.50 per can, the result will
be a movement up the supply curve
from point A to point B—an increase in
quantity supplied by Red Bull, Monster
Energy, Rockstar, and the other firms
from 80 million to 90 million cans.
If the price of an input decreases or
another factor changes that makes
sellers supply more of the product at
every price, the supply curve will shift
to the right—an increase in supply.
In this case, the increase in supply
from S1 to S2 causes the quantity of
energy drinks supplied at a price of
$2.50 to increase from 90 million cans
at point B to 110 million cans at point
C.
Market Equilibrium: Putting Demand
and Supply Together
FIGURE 3-7
Market Equilibrium
Where the demand curve crosses
the supply curve determines
market equilibrium.
In this case, the demand curve for
energy drinks crosses the supply
curve at a price of $2.00 and a
quantity of 80 million cans.
Only at this point is the quantity of
energy drinks consumers are
willing to buy equal to the quantity
that Red Bull, Monster Energy,
Rockstar, and the other firms are
willing to sell: The quantity
demanded is equal to the quantity
supplied.
3.3 Learning Objective
Use a graph to illustrate
market equilibrium.
Predicting and Explaining Changes In Prices
and Quantities
• Change in the quantity supplied
– A movement along the supply curve that occurs in
response to a change in price
• Change in supply
– A shift of the entire supply curve
Market Equilibrium: Putting Demand
and Supply Together
Market equilibrium A situation in which quantity
demanded equals quantity supplied.
Competitive market equilibrium A market equilibrium
with many buyers and many sellers.
Market Equilibrium: Putting Demand
and Supply Together
Surplus A situation in which the quantity supplied is
greater than the quantity demanded.
Shortage A situation in which the quantity demanded
is greater than the quantity supplied.
Market Equilibrium: Putting Demand
and Supply Together
FIGURE 3-8
The Effect of Surpluses and
Shortages on the Market
Price
When the market price is above equilibrium,
there will be a surplus. In the figure, a price
of $2.50 for energy drinks results in 90
million cans being supplied but only 70
million cans being demanded, or a surplus
of 20 million. As Red Bull, Monster Energy,
Rockstar, and the other firms cut the price
to dispose of the surplus, the price will fall
to the equilibrium of $2.00.
When the market price is below equilibrium,
there will be a shortage. A price of $1.00
results in 100 million cans being demanded
but only 60 million cans being supplied, or a
shortage of 40 million cans. As consumers
who are unable to buy energy drinks offer to
pay higher prices, the price will rise to the
equilibrium of $2.00.
Excess Supply
Excess supply = 8,000 slices per day
Price
($ per slice)
Supply
4
3
2
Demand
8
12
16
Quantity
(1000s of slices per day)
Excess Demand
Price
($ per slice)
Supply
4
Excess demand = 8,000
slices per day
3
2
Demand
8
16
Quantity
(1000s of slices per day)
Market Equilibrium: Putting Demand
and Supply Together
Demand and Supply Both Count
Keep in mind that the interaction of demand and
supply determines the equilibrium price.
Neither consumers nor firms can dictate what the
equilibrium price will be.
No firm can sell anything at any price unless it can find
a willing buyer, and no consumer can buy anything at
any price without finding a willing seller.
3-3
Solved
Problem
Demand and Supply Both
Count: A Tale of Two Letters
Both demand and supply
count when determining
market price.
The demand for Lincoln’s
letters is much greater
than the demand for
Booth’s letters,
but the supply of Booth’s
letters is very small.
Historians believe that
only eight letters written
by Booth exist today.
YOUR TURN: For more practice, do related problems 3.4 and 3.5 at the end of
this chapter.
The Effect of Demand and Supply
Shifts on Equilibrium
FIGURE 3-9
The Effect of an Increase in
Supply on Equilibrium
If a firm enters a market, as Coca-Cola
entered the market for energy drinks
when it launched Full Throttle, the
equilibrium price will fall, and the
equilibrium quantity will rise:
1. As Coca-Cola enters the market for
energy drinks, a larger quantity of
energy drinks will be supplied at every
price, so the market supply curve
shifts to the right, from S1 to S2, which
causes a surplus of cans at the
original price, P1.
2. The equilibrium price falls from P1 to
P2.
3. The equilibrium quantity rises from Q1
to Q2.
3.4 Learning Objective
Use demand and supply
graphs to predict changes
in prices and quantities.
Making
the
The Falling Price of LCD Televisions
Connection
An increase in supply drove the price of a typical large LCD television
from $4,000 in fall 2004 to $1,000 at the end of 2008, increasing the
quantity demanded worldwide from 8 million to 105 million.
YOUR TURN: Test your understanding by doing related problem 4.7 at the end of
this chapter.
The Effect of Demand and Supply
Shifts on Equilibrium
FIGURE 3-10
The Effect of an Increase in
Demand on Equilibrium
Increases in income will cause the
equilibrium price and quantity to rise:
1. Because energy drinks are a
normal good, as income
grows, the quantity demanded
increases at every price, and
the market demand curve
shifts to the right, from D1 to
D2, which causes a shortage of
energy drinks at the original
price, P1.
2. The equilibrium price rises
from P1 to P2.
3. The equilibrium quantity rises
from Q1 to Q2.
The Effect of Demand and Supply
Shifts on Equilibrium
FIGURE 3-11
Shifts in Demand and Supply over Time
In panel (a), demand shifts to the right more than
supply, and the equilibrium price rises:
In panel (b), supply shifts to the right more than
demand, and the equilibrium price falls:
1. Demand shifts to the right more than supply.
2. Equilibrium price rises from P1 to P2.
1. Supply shifts to the right more than demand.
2. Equilibrium price falls from P1 to P2.
The Effect of Demand and Supply
Shifts on Equilibrium
TABLE 3-3
How Shifts in Demand and Supply Affect
Equilibrium Price (P) and Quantity (Q)
DEMAND CURVE
UNCHANGED
DEMAND CURVE
SHIFTS TO THE RIGHT
DEMAND CURVE
SHIFTS TO THE LEFT
SUPPLY CURVE
UNCHANGED
SUPPLY CURVE
SHIFTS TO THE RIGHT
SUPPLY CURVE SHIFTS
TO THE LEFT
Q unchanged
P unchanged
Q increases
P decreases
Q decreases
P increases
Q increases
P increases
Q increases
P increases or
decreases
Q increases or
decreases
P increases
Q increases or
decreases
P decreases
Q decreases
P increases or
decreases
Q decreases
P decreases
3-4
Solved
Problem
High Demand and Low Prices
in the Lobster Market?
Supply and demand for lobster
both increase during the summer,
but the increase in supply is
greater than the increase in
demand, therefore, equilibrium
price falls.
YOUR TURN: For more practice, do related problems 4.5 and 4.6 at the end of
this chapter.
The Effect of Demand and Supply
Shifts on Equilibrium
Shifts in a Curve versus Movements along a Curve
When analyzing markets using demand and supply curves, it is important to remember
that when a shift in a demand or supply curve causes a change in equilibrium price, the
change in price does not cause a further shift in demand or supply.
Don’t Let This Happen to YOU!
Remember: A Change in a Good’s Price Does Not Cause the Demand or Supply
Curve to Shift
YOUR TURN: Test your understanding by doing related problems 4.13 and 4.14
at the end of this chapter.
AN INSIDE
LOOK
>> How Does Advertising Help Red Bull
Increase Demand for Its Energy Drink?
Advertising may cause an increase in the demand for Red Bull.
Predicting and Explaining Changes In Prices
and Demand
• Assume
– A vitamin found in corn chips helps protect against cancer
and heart diseases
– Swarm of locusts destroys part of the corn crop
• What Do You Think?
– What will happen to the equilibrium price and quantity of
corn chips?
Predicting and Explaining Changes In Prices
and Demand
• Economic Naturalist
– Why do the prices of some goods, like airline tickets to
Europe, go up during the months of heaviest consumption,
while others, like sweet corn, go down?
Seasonal Variation in Air Travel
High Consumption and Prices Due to High Demand
Price
($/ticket)
S
PS
PW
DS
DW
QW
QS
1000s of
tickets
Seasonal Variation in Corn Markets
Price
($/bushel)
High Consumption and Low Prices due to High Supply
SW
SS
PS
PW
D
QW
QS
Millions of
bushels
Markets And Social Welfare
• Smart For One, Dumb For All
– Socially optimal quantity
• The quantity of a good that results in the maximum possible
economic surplus from producing and consuming the good
– Private cost The cost borne by the producer of a service.
– Private benefit The benefit received by the consumer of a
good or service.
– Social cost The total cost of producing a good, including
both the private cost and any external cost.
– Social benefit The total benefit from consuming a good,
including both the private benefit and any external
benefit.
Externalities
• Externality A benefit or cost that affects someone who is not
directly involved in the production or consumption of the
good or service.
• Externalities arise when there is a difference between the
private cost of production and the social cost, or the private
benefit from consumption and the social benefit
• Positive externality When the social benefit exceeds the
private benefit of consumption.
• Negative externality When the social cost exceeds the private
cost of consumption.
Markets And Social Welfare
• The socially optimal quantity occurs when “social
MC” = “social MB”
– Economic efficiency occurs when all goods and services
are produced and consumed at their respective socially
optimal levels
• The Efficiency Principle
• Maximize the economic surplus
• Increases the economic pie
Markets And Social Welfare
• When is the market equilibrium efficient?
• When all cost of producing the good or service are borne directly by the
seller
• When all benefits from the good or service accrue directly to buyers
• Inefficient market equilibrium
• When some costs of production fall on people other than those who sell
the good or service
• Market failure Situations in which the market fails to produce
the efficient level of output
• Example: Pollution
– The market is in equilibrium: MC = MB
– MC however underestimates the cost to society of producing the good
– Therefore, the market produces more than the efficient amount and
there is no incentive for producers and consumers to alter their
behavior
Markets And Social Welfare
• Inefficient market equilibrium
• When some benefits from the good or service accrue to people who did
not buy the good or service
– In these markets
•
•
•
•
Buyers and sellers are behaving rationally
Market equilibrium exists
There are no unexploited opportunities for individuals
Economic surplus is not maximized
• Example: Vaccinations
• The market is in equilibrium: MC = MB
• MB underestimates the benefits to society of consuming the vaccinations
• The market produces less than the efficient amount of vaccinations and
there is no incentive for producers and consumers to alter their behavior
Solutions to Externalities
• The government can help provide solutions in the case
of a market failure
– Taxation for private consumers to “internalize” the social cost.
– The government can provide goods in the case of public goods
• Public goods Goods which are nonrival and nonexcludable.
– e.g., National defense, lighthouses.
– Rival One person’s consumption diminishes another’s ability to consume
that good.
– Excludable When consumption of a good can be prevented.
– Free riding Benefitting from a good without paying for it.
• Sometimes hard to define if a good is public or not.
• Common resource A good that is rival but nonexcludable
– e.g., fish in a river, space in a park or quad.
Coase Theorem
• Coase Theorem The argument of economist Ronald
Coase that if transactions costs are low, private
bargaining will result in an efficient solution to the
problem of externalities.