Lecture 3 Supply and Demand
• Market
• The law of demand, shifts vs. movements along
the demand curve, factors that shift the demand
curve
• The law of supply, shifts vs. movements along the
supply curve, factors that shift the supply curve
• Equilibrium: putting demand and supply together
• What happens when demand curve or supply
curve shifts?
1
Supply and Demand
• Supply and demand is an economic model
– Designed to explain how prices are determined
in certain types of markets
• The price of a good or service is what must
be given in exchange for the good. Price
measures the scarcity. Prices provide our
economy with incentives to use scarce
resources efficiently.
2
Markets
• Specific location where buying and selling takes
place, such as
– Supermarket or a flea market
• In economics, a market is not a place but rather
– A group of buyers and sellers with the potential to trade
with each other
• Economists think of the economy as a collection
of individual markets
• First step in an economic analysis is to define and
characterize the market or collection of markets to
analyze, Markets can be defined broadly or
narrowly, depending on our purpose.
3
Buyers and Sellers
• Buyers and sellers in a market can be
– Households
– Business firms
– Government agencies
• All three can be both buyers and sellers in the same
market, but are not always
• For purposes of simplification this text will usually follow
these guidelines
– In markets for consumer goods, we’ll view business firms as the
only sellers, and households as only buyers
– In most of our discussions, we’ll be leaving out the “middleman”
4
Competition in Markets
– Perfectly competitive markets have many small
buyers and sellers, e.g., farmer’s market, big
city hot dog market
• Each is a small part of the market, and the product is
standardized, and each buyer and seller takes the
market price as a given
– Imperfectly competitive markets have just a few
large buyers and sellers, e.g., local electricity
company
• The product of each seller is unique in some way,
each buyer or seller has some influence over the
price.
5
Using Supply and Demand
• Supply and demand model is designed to explain
how prices are determined in perfectly competitive
markets
– Perfect competition is rare but many markets come
reasonably close
– Perfect competition is a matter of degree rather than an
all or nothing characteristic
• Supply and demand is one of the most versatile
and widely used models in the economist’s tool kit
6
Demand
• A household’s quantity demanded of a good
– Specific amount household would choose to buy over
some time period, given
• A particular price that must be paid for the good
• All other constraints on the household
• Market quantity demanded (or quantity demanded)
is the specific amount of a good that all buyers in
the market would choose to buy over some time
period, given
– A particular price they must pay for the good
– All other constraints on households
7
Quantity Demanded
• Implies a choice
– How much households would like to buy when they take into
account the opportunity cost of their decisions?
• Is hypothetical
– Makes no assumptions about availability of the good
– How much would households want to buy, at a specific price, given
real-world limits on their spending power?
• Stresses price
– Price of the good is one variable among many that influences
quantity demanded
– We’ll assume that all other influences on demand are held constant,
so we can explore the relationship between price and quantity
demanded
8
The Law of Demand
• States that when the price of a good rises and
everything else remains the same, the quantity of
the good demanded will fall (e.g., air travel,
magazines, education, etc)
– The words, “everything else remains the same” are
important
• In the real world many variables change simultaneously
• However, in order to understand the economy we must first
understand each variable separately
• Thus we assume that, “everything else remains the same,” in
order to understand how demand reacts to price
9
The Demand Schedule and The
Demand Curve
• Demand schedule
– A list showing the quantity of a good that consumers would choose
to purchase at different prices, with all other variables held
constant
• The market demand curve (or just demand curve) shows
the relationship between the price of a good and the
quantity demanded , holding constant all other variables
that influence demand
– Each point on the curve shows the total buyers would choose to
buy at a specific price
• Law of demand tells us that demand curves virtually
always slope downward
10
Demand Schedule for Maple Syrup in U.S.A.
Price
(per bottle)
Quantity Demanded
(Bottles per Month)
$1.00
75,000
2.00
60,000
3.00
50,000
4.00
40,000
5.00
35,000
11
Figure 1: The Demand Curve
Price per
Bottle
When the price is $4.00
per bottle, 40,000 bottles
are demanded (point A).
$4.00
A
B
2.00
At $2.00 per bottle,
60,000 bottles are
demanded (point B).
D
40,000
60,000
Number of Bottles
per Month
12
Shifts vs. Movements Along The
Demand Curve
• A change in the price of a good causes a movement along
the demand curve
• In Figure 1
– A fall (rise) in price would cause a movement to the right (left)
along the demand curve
• A change in income causes a shift in the demand curve
itself (Figure1, assume annual average U.S. household
income $40,000; Figure, change from $40-$50,000 )
• In Figure 2
– Demand curve has shifted to the right of the old curve (from Figure
1) as income has risen
– A change in any variable that affects demand—except for the
good’s price—causes the demand curve to shift
13
Figure 2: A Shift of The Demand
Curve
Price per
Bottle
An increase in income
shifts the demand curve for
maple syrup from D1 to D2.
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
14
Dangerous Curves: “Change in Quantity
Demanded” vs. “Change in Demand”
• Language is important when discussing demand
– “Quantity demanded” means
• A particular amount that buyers would choose to buy at a
specific price
• It is a number represented by a single point on a demand curve
• When a change in the price of a good moves us along a
demand curve, it is a change in quantity demand
– The term demand means
• The entire relationship between price and quantity demanded—
and represented by the entire demand curve
• When something other than price changes, causing the entire
demand curve to shift, it is a change in demand
15
Income: Factors That Shift The
Demand Curve
• An increase in income has effect of shifting
demand for normal goods to the right
– However, a rise in income shifts demand for
inferior goods to the left
– Examples: housing, automobiles, health club
memberships, etc.
• A rise in income will increase the demand
for a normal good, and decrease the
demand for an inferior good (e.g. instant
noodles).
16
Wealth: Factors That Shift The
Demand Curve
• Your wealth—at any point in time—is the
total value of everything you own minus the
total dollar amount you owe
• An increase in wealth will
– Increase demand (shift the curve rightward) for
a normal good
– Decrease demand (shift the curve leftward) for
an inferior good
17
Prices of Related Goods: Factors
that Shift the Demand Curve
• Substitute—good that can be used in place of
some other good and that fulfills more or less the
same purpose, e.g., different types of meat
– A rise in the price of a substitute increases the demand
for a good, shifting the demand curve to the right
• Complement—used together with the good we are
interested in, e.g., pancake mix and maple syrup
– A rise in the price of a complement decreases the
demand for a good, shifting the demand curve to the
left
18
Other Factors That Shift the Demand
Curve
• Population
– As the population increases in an area
• Number of buyers will ordinarily increase
• Demand for a good will increase
• Expected Price
– An expectation that price will rise (fall) in the future shifts the
current demand curve rightward (leftward)
• Tastes
– Combination of all the personal factors that go into determining
how a buyer feels about a good
– When tastes change toward a good, demand increases, and the
demand curve shifts to the right
– When tastes change away from a good, demand decreases, and
the demand curve shifts to the left
19
Figure 3(a): Movements Along and
Shifts of The Demand Curve
Price
Price increase moves us
leftward along demand
curve
P2
Price increase moves us
rightward along demand
curve
P1
P3
Q2
Q1
Q3
Quantity
20
Figure 3(b): Movements Along and
Shifts of The Demand Curve
Price
Entire demand curve shifts
rightward when:
• income or wealth ↑
• price of substitute ↑
• price of complement ↓
• population ↑
• expected price ↑
• tastes shift toward good
D2
D1
Quantity
21
Figure 3(c): Movements Along and
Shifts of The Demand Curve
Price
Entire demand curve shifts
leftward when:
• income or wealth ↓
• price of substitute ↓
• price of complement ↑
• population ↓
• expected price ↓
• tastes shift toward good
D1
D2
Quantity
22
Supply
• A firm’s quantity supplied of a good is the specific
amount its managers would choose to sell over
some time period, given
– A particular price for the good
– All other constraints on the firm
• Market quantity supplied (or quantity supplied) is
the specific amount of a good that all sellers in the
market would choose to sell over some time
period, given
– A particular price for the good
– All other constraints on firms
23
Quantity Supplied
• Implies a choice
– Quantity that gives firms the highest possible profits when they
take account of the constraints presented to them by the real world
• Is hypothetical
– Does not make assumptions about firms’ ability to sell the good
– How much would firms’ managers want to sell, given the price of
the good and all other constraints they must consider?
• Stresses price
– The price of the good is just one variable among many that
influences quantity supplied
– We’ll assume that all other influences on supply are held constant,
so we can explore the relationship between price and quantity
supplied
24
The Law of Supply
• States that when the price of a good rises
and everything else remains the same, the
quantity of the good supplied will rise
– The words, “everything else remains the same”
are important
• In the real world many variables change
simultaneously
• However, in order to understand the economy we
must first understand each variable separately
• We assume “everything else remains the same” in
order to understand how supply reacts to price
25
The Supply Schedule and The
Supply Curve
• Supply schedule—shows quantities of a
good or service firms would choose to
produce and sell at different prices, with all
other variables held constant
• Supply curve—graphical depiction of a
supply schedule
– Shows quantity of a good or service supplied at
various prices, with all other variables held
constant
26
Figure 4: The Supply Curve
Price per
Bottle
When the price is $2.00
per bottle, 40,000 bottles
are supplied (point F).
$4.00
2.00
S
G
At $4.00 per bottle,
quantity supplied is
60,000 bottles (point G).
F
40,000
60,000
Number of Bottles
per Month
27
Shifts vs. Movements Along the
Supply Curve
• A change in the price of a good causes a
movement along the supply curve
– In Figure 4
• A rise (fall) in price would cause a rightward (leftward)
movement along the supply curve
• A drop in transportation costs will cause a shift in
the supply curve itself
– In Figure 5
• Supply curve has shifted to the right of the old curve (from
Figure 4) as transportation costs have dropped
• A change in any variable that affects supply—except for the
good’s price—causes the supply curve to shift
28
Figure 5: A Shift of The Supply
Curve
Price per
Bottle
A decrease in transportation
costs shifts the supply curve for
maple syrup from S1 to S2.
S1
S2
At each price, more bottles
are supplied after the shift
$4.00
G
60,000
J
80,000
Number of Bottles
per Month
29
Factors That Shift the Supply Curve
• Input prices
– A fall (rise) in the price of an input causes an increase
(decrease) in supply, shifting the supply curve to the
right (left)
• Price of Related Goods
– When the price of an alternate good rises (falls), the
supply curve for the good in question shifts rightward
(leftward)
• Technology
– Cost-saving technological advances increase the
supply of a good, shifting the supply curve to the right
30
Factors That Shift the Supply Curve
• Number of Firms
– An increase (decrease) in the number of
sellers—with no other changes—shifts the
supply curve to the right (left)
• Expected Price
– An expectation of a future price increase
(decrease) shifts the current supply curve to the
left (right)
31
Factors That Shift the Supply Curve
• Changes in weather
– Favorable weather
• Increases crop yields
• Causes a rightward shift of the supply curve for that crop
– Unfavorable weather
• Destroys crops
• Shrinks yields
• Shifts the supply curve leftward
• Other unfavorable natural events may effect all
firms in an area
– Causing a leftward shift in the supply curve
32
Figure 6(a): Changes in Supply and
in Quantity Supplied
Price
S
Price increase moves
us rightward along
supply curve
P2
P1
Price increase moves
us leftward along
supply curve
P3
Q3
Q1
Q2
Quantity
33
Figure 6(b): Changes in Supply and
in Quantity Supplied
Price
Entire supply curve shifts
rightward when:
• price of input ↓
• price of alternate good ↓
• number of firms ↑
• expected price ↑
• technological advance
• favorable weather
S1
S2
Quantity
34
Figure 6(c): Changes in Supply and
in Quantity Supplied
Price
Entire supply curve shifts
rightward when:
• price of input ↑
• price of alternate good ↑
• number of firms ↓
• expected price ↑
• unfavorable weather
S2
S1
Quantity
35
In Summary: Factors That Shift The
Supply Curve
• The short list of shift-variables for supply that we
have discussed is far from exhaustive
• In some cases, even the threat of such events can
cause serious effects on production
• Basic principle is always the same
– Anything that makes sellers want to sell more or less of
a good at any given price will shift supply curve
36
Equilibrium: Putting Supply and
Demand Together
• When a market is in equilibrium
– Both price of good and quantity bought and sold have
settled into a state of rest
– The equilibrium price and equilibrium quantity are
values for price and quantity in the market but, once
achieved, will remain constant
• Unless and until supply curve or demand curve shifts
• The equilibrium price and equilibrium quantity can
be found on the vertical and horizontal axes,
respectively
– At point where supply and demand curves cross
37
Figure 7: Market Equilibrium
Price per
Bottle
2. causes the price
to rise . . .
3. shrinking the
excess demand . . .
S
E
$3.00
1.00
H
4. until price reaches its
equilibrium value of $3.00
.
J
Excess Demand
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
38
Excess Demand: Putting Supply
and Demand Together
• Excess demand
– At a given price, the excess of quantity
demanded over quantity supplied
• Price of the good will rise as buyers
compete with each other to get more of the
good than is available
39
Figure 8: Excess Supply and Price
Adjustment
Price per
Bottle
1. At a price of $5.00 per
bottle an excess supply
of 30,000 bottles . . .
Excess Supply at $5.00 S
$5.00
2. causes the
price to drop,
3.00
3. shrinking the
excess supply . . .
L
K
E
4. until price reaches its
equilibrium value of
$3.00.
D
35,000 50,000 65,000
Number of Bottles
per Month
40
Excess Supply: Putting Supply and
Demand Together
• Excess Supply
– At a given price, the excess of quantity supplied
over quantity demanded
• Price of the good will fall as sellers compete
with each other to sell more of the good
than buyers want
41
Income Rises: What Happens When
Things Change
• Income rises, causing an increase in
demand
– Rightward shift in the demand curve causes
rightward movement along the supply curve
– Equilibrium price and equilibrium quantity both
rise
• Shift of one curve causes a movement
along the other curve to new equilibrium
point
42
Figure 9
Price per
Bottle
4. Equilibrium
price
increases
3. to a new
equilibrium.
S
$4.00
3.00
2. moves us along
the supply
curve . . .
F'
E
1. An increase in
demand . . .
D2
D1
5. and equilibrium quantity
increases too.
50,000 60,000
Number of Bottles of
Maple Syrup per Period
43
An Ice Storm Hits: What Happens When
Things Change
• An ice storm causes a decrease in supply
– Weather is a shift variable for supply curve
• Any change that shifts the supply curve leftward in a
market will increase the equilibrium price
– And decrease the equilibrium quantity in that market
44
Figure 10: 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
45
Figure 11: Changes in the Market
for Handheld PCs
Price per
Handheld
PC
3. moved the market to
a new equilibrium.
2. and a decrease
in demand . . .
4. Price
decreased . . .
A
$500
B
S2002
S2003
1. An increase in
supply . . .
$400
D2002
5. and quantity
decreased as well.
D2003
2.45 3.33
Millions of Handheld PCs
per Quarter
46
Both Curves Shift
• When just one curve shifts (and we know the
direction of the shift) we can determine the
direction that both equilibrium price and quantity
will move
• When both curves shift (and we know the
direction of the shifts) we can determine the
direction for either price or quantity—but not both
– Direction of the other will depend on which curve shifts
by more
47
The Three Step Process
• Key Step 1—Characterize the Market
– Decide which market or markets best suit problem
being analyzed and identify decision makers (buyers
and sellers) who interact there
• Key Step 2—Find the Equilibrium
– Describe conditions necessary for equilibrium in the
market, and a method for determining that equilibrium
• Key Step 3—What Happens When Things
Change
– Explore how events or government polices change
market equilibrium
48
Using Supply and Demand: The
Invasion of Kuwait
• Why did Iraq’s invasion of Kuwait cause the
price of oil to rise?
– Immediately after the invasion, United States
led a worldwide embargo on oil from both Iraq
and Kuwait
– A significant decrease in the oil industry’s
productive capacity caused a shift in the supply
curve to the left
• Price of oil increased
49
Figure 12: The Market For Oil
Price per
Barrel of Oil
S2
S1
E'
P2
E
P1
D
Q2
Q1
Barrels of Oil
50
Using Supply and Demand: The
Invasion of Kuwait
• Why did the price of natural gas rise as well?
– Oil is a substitute for natural gas
– Rise in the price of a substitute increases
demand for a good
– Rise in price of oil caused demand curve for
natural gas to shift to the right
• Thus, the price of natural gas rose
51
Figure 13: The Market For Natural
Gas
Price per Cubic
Foot of Natural
Gas
S
F'
P4
F
D2
P3
D1
Q3
Q4
Cubic Feet of
Natural Gas
52