Chapter 3
Supply and Demand
ECONOMICS: Principles and Applications, 4e
HALL & LIEBERMAN, © 2008 Thomson South-Western
Markets
• Market
– A group of buyers and sellers with the
potential to trade with each other
– Can be defined broadly or narrowly
• Macroeconomics
• Microeconomics
• The economy
– A collection of individual markets
2
Markets
• Macroeconomic Markets
– All capital goods - one market
– All consumer goods - “consumption
goods”
– Overall view of the economy
• Microeconomic Markets
– Narrowly defined
– Models - specific commodities
3
Product and Resource Markets
• Product market
– Goods and services
– Firms – suppliers
– Households – buyers
• Resource market
– Resources
– Firms – buyers
– Households – suppliers
4
Product and Resource Markets
• Figure 1 The Circular Flow Model
Flow of goods and resources
•Resource market
- Households sell resources
- Firms buy resources to
produce goods and services
•Product Market
- Firms sell goods and
services to households
Money flows
- Firms – pay the resource
owners
- Households – receive
income for resources (to buy
goods and services )
5
Competition in Markets
• Imperfectly competitive markets
– Buyers/sellers can influence the price
– A few large buyers or sellers
– Product differentiation
• Perfectly competitive markets (or just
competitive markets)
– Buyers/sellers take the market price
– Many small buyers and sellers
– Standardized product
6
Using Supply and Demand
• Supply and demand model
– Designed to explain how prices are
determined in perfectly competitive
markets
• Perfect competition
– Rare in the real world
– Many markets are close to perfect
competition
• To analyze a market, we need both,
Supply and Demand
7
Demand – Quantity Demanded
• Quantity demanded
• amount of a good
• all buyers in a market would choose to buy
• during a period of time
• given their constraints
– Implies a Choice
• Households choose to buy – considering the
opportunity cost of their decisions
8
Demand – Quantity Demanded
• Quantity demanded
– Is Hypothetical
• quantity the households are able to
purchase
• given the price
• real-world constraints
– Depends on Price
• assume other things constant
• explore the relationship between price and
quantity demanded
9
The Law of Demand
• When the price of a good rises and
everything else remains the same, the
quantity of the good demanded will fall
• Ceteris paribus assumption
• many variables change simultaneously
• understand each variable separately
– we assume “everything else remains the
same”
• understand how demand reacts to price
10
Demand Schedule and Demand Curve
• Demand schedule
– list of different quantities demanded at
different prices, ceteris paribus
• Demand curve
– relationship between the price of a good
and the quantity demanded, ceteris
paribus
11
The Demand Curve
• Each point on the demand curve
– total quantity that buyers would choose
to buy at a specific price
• Graphical depiction of a demand
schedule
• Slopes downward
– Law of Demand
12
The Demand Curve
• Figure 2 The Demand Curve – movement along the demand curve
Price per
Bottle
When the price is $4.00
per bottle, 40,000 bottles
are demanded
$4.00
A
B
2.00
At $2.00 per bottle,
60,000 bottles are
demanded
D
40,000
60,000
Number of Bottles per
Month
13
Movements Along the Demand Curve
• a change in the price of a good causes a
movement along the demand curve,
ceteris paribus.
• In Figure 2
– a fall in price - move rightward along the
demand curve (from A to B)
– a rise in price - move leftward along the
demand curve (from B to A).
14
Shifts of the Demand Curve
• a change in any variable that affects
demand—except for the good’s price—
causes the demand curve to shift.
– An increase in quantity at any price
• The demand curve shifts rightward (increase
in demand)
– A decrease in quantity at any price
• The demand curve shifts leftward (decrease
in demand)
15
The Demand Curve
• Figure 3 A Shift of the Demand Curve
An increase in income
shifts the demand curve
for maple syrup from D1 to D2
Price per
Bottle
At each price, more bottles
are demanded after the shift
B
C
$2.00
60,000
D1
D2
80,000
Number of Bottles
per Month
16
Change in Quantity Demanded
• “Quantity demanded”
– A particular amount
• buyers would choose to buy at a specific
price
– One point on a demand curve
• Change in quantity demanded
– A movement along a demand curve in
response to a change in price
17
Change in Demand
• “Demand”
– Relationship between price and quantity
demanded
– Represented by the entire demand curve
• Change in demand
– Shift of the demand curve
– From changes in something other than
price
18
Factors that Shift the Demand Curve
1. Income
– Normal Good
•
People demand more as the income rises
– Inferior Good
•
•
People demand less as the income rises
A rise in income will
– increase the demand for a normal good
– decrease the demand for an inferior
good
19
Factors that Shift the Demand Curve
2. Wealth
– Total value of everything you own
minus the total dollar amount you owe
– Measured at a point in time
•
An increase in wealth will
– increase demand (shift rightward) for a
normal good
– decrease demand (shift leftward) for an
inferior good
20
Factors that Shift the Demand Curve
3. Prices of Related Goods
• Substitutes
– can be used in place of some other
good
– fulfills more or less the same purpose
•
A rise in the price of a substitute will:
– increase the demand for a good (shift
the demand curve to the right)
21
Factors that Shift the Demand Curve
3. Prices of Related Goods
• Complements
– used together with the good we are
interested in
•
A rise in the price of a complement will
– decrease the demand for a good (shifts
the demand curve to the left)
22
Factors that Shift the Demand Curve
4. Population
– An increase in population will
•
•
increase the number of buyers
increase the demand (rightward shift)
5. Expected Price
– An expected rise in price shifts the
demand curve rightward (increase)
– An expected fall in price shifts the
demand curve leftward (decrease)
23
Factors that Shift the Demand Curve
6. Tastes/Preferences
– tastes change toward a good
•
demand increases (demand curve shifts
right)
– tastes change away from a good
•
demand decreases (demand curve shifts
left)
24
The Demand Curve
• Figure 4 The Demand Curve – A summary
a) Price ↓
Move rightward along
the demand curve
P
P
b) Price ↑
Move leftward along
the demand curve
B
A
P2
P1
B
P2
A
P1
D
D
Q1
Q2
Q
Q2
Q1
Q
25
The Demand Curve
• Figure 4 The Demand Curve – A summary
c) The Demand curve
shifts rightward
P
D2
D1
Income or wealth ↑
Price of substitute↑
Price of complement ↓
Population ↑
Expected price ↑
Tastes shift toward good
Q
26
The Demand Curve
• Figure 4 The Demand Curve – A summary
P
d) The Demand curve
shifts leftward
D1
D2
Income or wealth ↓
Price of substitute ↓
Price of complement ↑
Population ↓
Expected price ↓
Tastes shift away from good
Q
27
Supply – Quantity Supplied
• Quantity supplied
• number of units of a good
• all sellers in the market would choose to sell
• over some time period
• given their constraints
– Implies a choice
• the quantity that firms choose to sell
• maximizing profit
• given their constraints
28
Supply – Quantity Supplied
• Quantity supplied
– Is Hypothetical
• quantity firms would sell
• given the price of the good
• and all other constraints
– Depends on the price
• assume other things constant
• explore the relationship between price and
quantity supplied
29
The Law of Supply
• When the price of a good rises, and
everything else remains the same, the
quantity of the good supplied will rise
• Ceteris paribus assumption
• many variables change simultaneously
• we must understand each variable
separately
– we assume “everything else remains the
same”
• understand how supply reacts to price
30
Supply Schedule and Supply Curve
• Supply schedule
• list of different quantities supplied at different
prices, ceteris paribus
• Supply curve
– relationship between the price of a good
and the quantity supplied, with all other
variables held constant
– Each point on the curve
• total quantity that sellers would choose to
sell at a specific price
– Slopes upward - Law of Supply
31
The Supply Curve
• Figure 5 The Supply Curve – movement along the supply curve
Price per
Bottle
When the price is $2.00
per bottle, 40,000 bottles
are supplied
$4.00
2.00
S
G
At $4.00 per bottle,
quantity supplied is
60,000 bottles
F
40,000
60,000
Number of Bottles
per Month
32
Movements Along the Supply Curve
• a change in the price of a good causes a
movement along the supply curve,
ceteris paribus
• In Figure 5
– a rise in price - move rightward along the
demand curve (from F to G)
– a fall in price - move leftward along the
demand curve (from G to F)
33
Shifts of the Supply Curve
• a change in any variable that affects
supply—except for the good’s price—
causes the supply curve to shift.
– Sell a greater quantity at any price
• The supply curve shifts rightward (increase
in supply)
– Sell a smaller quantity at any price
• The supply curve shifts leftward (decrease in
supply)
34
Shifts of the Supply Curve
• Figure 6 A Shift of the Supply Curve
Price per
Bottle
$4.00
A decrease in transportation
costs shifts the supply curve
for maple syrup from S1 to S2.
At each price, more bottles are
supplied after the shift.
S1
G
60,000
S2
J
80,000
Number of Bottles
per Month
35
Factors that Shift the Supply Curve
1. Input Prices
– A fall in the price of an input
•
•
lower cost of production
increase in supply (rightward shift)
2. Price of Alternatives
– Other goods that a firm could produce
– A rise in the price for an alternative
•
decrease in supply (leftward shift)
36
Factors that Shift the Supply Curve
3. Technology
– technological advances
•
increase the supply of a good
4. Number of Firms
– An increase in the number of sellers
•
increase supply
5. Expected price
– An expected rise in price
•
decrease the current supply (leftward shift)
37
Factors that Shift the Supply Curve
6. Changes in Weather/Other Natural
Events
– Favorable weather
•
•
increases crop yields
increases the supply (rightward shift)
– Unfavorable weather
•
•
destroys crops, shrinks yields,
decreases the supply (leftward shift)
38
The Supply Curve
• Figure 7 The Supply Curve – A summary
P
a) Price ↓
Move leftward along
the supply curve
A
P1
P2
P
S
S
B
P2
P1
B
Q2 Q1
b) Price ↑
Move rightward along
the supply curve
A
Q
Q1
Q2
Q
39
The Supply Curve
• Figure 7 The Supply Curve – A summary
P
c) The Supply curve
shifts rightward
S1
S2
Price of input ↓
Price of alternatives ↓
Number of firms ↑
Expected price ↓
Technological advance
Favorable weather
Q
40
The Supply Curve
• Figure 7 The Supply Curve – A summary
P
d) The Supply curve
shifts leftward
S2
S1
Price of input ↑
Price of alternatives ↑
Number of firms ↓
Expected price ↑
Unfavorable weather
Q
41
Supply and Demand
• Equilibrium
– both P and Q have settled into a state of
rest
• Equilibrium price and quantity
– once achieved - remain constant
– until either the demand curve or supply
curve shifts
42
Excess Demand
• the amount by which quantity demanded
exceeds quantity supplied - at a given
price
– Buyers compete with each other to get
more of the good than is available
– The price will rise
– Equilibrium is reached
43
Excess Demand
• Figure 8 Excess Demand Causes Price to Rise
Price per
Bottle
2. causes the price
to rise . . .
S
E
$3.00
1.00
H
3. shrinking the excess
demand until price
reaches its equilibrium
value of $3.00
Excess Demand
J
D
1. At a price of $1.00 per
Bottle, an excess demand
of 50,000 bottles . . .
25,000 50,000 75,000
Number of Bottles
per Month
44
Excess Supply
• the amount by which quantity supplied
exceeds quantity demanded - at a given
price
– Sellers compete with each other to sell
more than buyers want
– The price will fall
– Equilibrium is reached
45
Excess Supply
• Figure 9 Excess Supply Causes Price to Fall
Price per
Bottle
1. At a price of $5.00 per
bottle an excess supply
of 30,000 bottles . . .
3. shrinking the
excess supply . . .
S
Excess Supply
$5.00
L
K
3.00
E
4. until price reaches
its equilibrium
value of $3.00
D
2. causes the price
to drop…
35,000
50,000
65,000 Number of Bottles
per Month
46
What Happens When Things Change
• Income rises
• normal good
• the demand increases (rightward shift of
the demand curve)
– Rightward movement along the supply
curve
– Equilibrium price rises
– Equilibrium quantity rises
47
Income rises, causing an increase in D
• Figure 10 A Shift in Demand and a New Equilibrium
Price per
Bottle
4. equilibrium
price increases
3. to a new
equilibrium
S
$4.00
3.00
2. moves us along
the supply curve…
E'
E
1. An increase
in demand . . .
D2
D1
5. equilibrium quantity
increases too
50,000 60,000
Number of Bottles of
Maple Syrup per Period
48
What Happens When Things Change
• An Ice Storm Hits
– Weather changes will shift the supply
curve
• decrease in supply (the supply curve
shifts leftward)
– Equilibrium price rises
– Equilibrium quantity falls
49
Bad weather hits, decreasing the S
• Figure 11 A Shift of Supply and a New Equilibrium
Price per
Bottle
$5.00
3.00
S2
S1
E'
E
D
35,000 50,000
Number of Bottles
50
Both Curves Shift
• Just one curve shifts (D or S)
– we can determine the direction that
BOTH equilibrium price AND quantity will
move
• Both curves shift (D and S)
– we can determine the direction that
EITHER equilibrium price OR equilibrium
quantity will move
– direction of the other – which curve shifts
by more
51
Income rises and Bad weather hits
• Figure 12 A Shift in Both Curves and a New Equilibrium
Price per
Bottle
$6.00
3.00
S2
S1
E'
E
D2
D1
Number of Bottles
52
The Three Step Process
• Step 1—Characterize the Market
• markets - problem analyzed
• identify the decision makers
• Step 2—Find the Equilibrium
• conditions for equilibrium
• method - determine equilibrium
• Step 3—What Happens When Things
Change
• how events/government polices change
market equilibrium
53
Avian Flu in Early 2006
• In Europe
– people were buying substantially less
chicken
• In the United States
– people were buying more chicken
• Use the three step process
54
Avian Flu in Early 2006
• Figure 13 The European Market for Chicken
Price per
pound
S2006
S2005
A
$0.42
B
0.14
D2005
D2006
Q2
Q1
Quantity of Chicken
55
Avian Flu in Early 2006
• Figure 14 The U.S. Market for Chicken
Price per
pound
S2005
S2006
A
$0.42
B
0.14
D2006
D2005
Q1
Q2
Quantity of Chicken
56