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Supply and Demand Chapter 4 Demand Demand means the willingness and capacity to pay. Prices are the tools by which the market coordinates individual desires. The Law of Demand Law of demand – there is an inverse relationship between price and quantity demanded. – – Quantity demanded rises as price falls, other things constant. Quantity demanded falls as prices rise, other things constant. The Law of Demand What accounts for the law of demand? Substitution Price too high? Buy something else. The Demand Curve The demand curve is the graphic representation of the law of demand. The demand curve slopes downward and to the right. As the price goes up, the quantity demanded goes down. Price (per unit) A Sample Demand Curve PA A D 0 QA Quantity demanded (per unit of time) Other Things Constant Other things constant places a limitation on the application of the law of demand. – – – All other factors that affect quantity demanded are assumed to remain constant, whether they actually remain constant or not. Called parameters P,Q are called variables Other Things Constant Include changing tastes, prices of other goods, income, even the weather. Shifts Versus Movements Shift: change in underlying parameter Movement along: change in a variable on the axes. Shifts in Demand Versus Movements Along a Demand Curve Quantity demanded refers to a specific amount that will be demand per unit of time at a specific price. Graphically, it refers to a specific point on the demand curve. Shifts in Demand Versus Movements Along a Demand Curve A movement along a demand curve is the graphical representation of the effect of a change in price on the quantity demanded. Shifts in Demand Versus Movements Along a Demand Curve A shift in demand is the graphical representation of the effect of anything other than price on demand. Price (per unit) Change in Quantity Demanded $2 B Change in quantity demanded (a movement along the curve) $1 A D1 0 100 200 Quantity demanded (per unit of time) Price (per unit) Shift in Demand Change in demand (a shift of the curve) $2 $1 B A D0 D1 250 100 200 Quantity demanded (per unit of time) Shift Factors of Demand Shift factors of demand are factors that cause shifts in the demand curve: – – – – – Society's income. The prices of other goods. Tastes. Expectations. Taxes on subsidies to consumers. Income An increase in income will increase demand for normal goods. An increase in income will decrease demand for inferior goods. Price of Other Goods When the price of a substitute good falls, demand falls for the good whose price has not changed. When the price of a complement good falls, demand rises for the good whose price has not changed. Tastes A change in taste will change demand with no change in price. Expectations If you expect your income to rise, you may consume more now. If you expect prices to fall in the future, you may put off purchases today. Taxes and Subsidies Taxes levied on consumers increase the cost of goods to consumers, thereby reducing demand. Subsidies have an opposite effect. The Demand Table The demand table assumes all the following: – – – As price rises, quantity demanded declines. Quantity demanded has a specific time dimension to it. All the products involved are identical in shape, size, quality, etc. The Demand Table The demand table assumes all the following: – The schedule assumes that everything else is held constant. From a Demand Table to a Demand Curve You plot each point in the demand table on a graph and connect the points to derive the demand curve. From a Demand Table to a Demand Curve The demand curve graphically conveys the same information that is on the demand table. From a Demand Table to a Demand Curve The curve represents the maximum price that you will pay for various quantities of a good – you will happily pay less. From a Demand Table to a Demand Curve A Demand Table A B C D E $0.50 1.00 2.00 3.00 4.00 9 8 6 4 2 Price per DVDs (in dollars) Price per DVD rentals cassette demanded per week A Demand Curve $6.00 5.00 4.00 3.50 3.00 E D G 2.00 C 1.00 .50 0 F Demand for DVDs B A 1 2 3 4 5 6 7 8 9 10 11 12 13 Quantity of DVDs demanded (per week) Individual and Market Demand Curves A market demand curve is the horizontal sum of all individual demand curves. – This is determined by adding the individual demand curves of all the demanders. Individual and Market Demand Curves Sellers estimate total market demand for their product which becomes smooth and downward sloping curve. From Individual Demands to a Market Demand Curve A $.0.50 B 1.00 C 1.50 D 2.00 E 2.50 F 3.00 G 3.50 H 4.00 9 8 7 6 5 4 3 2 6 5 4 3 2 1 0 0 (2) Cathy’s demand 1 1 0 0 0 0 0 0 (3) Market demand 16 14 11 9 7 5 3 2 $4.00 Price per cassette (in dollars) (1) (2) (3) Price per Alice’s Bruce’s cassette demand demand G 3.50 F 3.00 E 2.50 D 2.00 C 1.50 B 1.00 0.50 0 A Cathy 2 4 Bruce Alice Market demand 6 8 10 12 14 16 Quantity of cassettes demanded per week McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. The Law of Demand The demand curve is downward sloping for the following reasons: – – At lower prices, existing demanders buy more. At lower prices, new demanders enter the market. Supply Individuals control the factors of production – inputs, or resources, necessary to produce goods. Individuals supply factors of production to intermediaries or firms. Supply The analysis of the supply of produced goods has two parts: – – An analysis of the supply of the factors of production to households and firms. An analysis of why firms transform those factors of production into usable goods and services. The Law of Supply There is a direct relationship between price and quantity supplied. – – Quantity supplied rises as price rises, other things constant. Quantity supplied falls as price falls, other things constant. The Law of Supply The law of supply is accounted for by two factors: – – When prices rise, firms substitute production of one good for another. Assuming firms’ costs are constant, a higher price means higher profits. The Supply Curve The supply curve is the graphic representation of the law of supply. The supply curve slopes upward to the right. The slope tells us that the quantity supplied varies directly – in the same direction – with the price. Price (per unit) A Sample Supply Curve S PA 0 A QA Quantity supplied (per unit of time) Shifts Versus Movements Supply refers to a schedule of quantities a seller is willing to sell per unit of time at various prices, other things constant. Shifts in Supply Versus Movements Along a Supply Curve Quantity supplied refers to a specific amount that will be supplied at a specific price. Shifts in Supply Versus Movements Along a Supply Curve Changes in price causes changes in quantity supplied represented by a movement along a supply curve. Shifts in Supply Versus Movements Along a Supply Curve A movement along a supply curve – the graphic representation of the effect of a change in price on the quantity supplied. Shifts in Supply Versus Movements Along a Supply Curve If the amount supplied is affected by anything other than a change in price, there will be a shift in supply. Shifts in Supply Versus Movements Along a Supply Curve Shift in supply – the graphic representation of the effect of a change in a factor other than price on supply. Shift in Supply S0 Price (per unit) S1 $15 A B Shift in Supply (a shift of the curve) 1,250 1,500 Quantity supplied (per unit of time) Change in Quantity Supplied S Price (per unit) 0 B $15 A Change in quantity supplied (a movement along the curve) 1,250 1,500 Quantity supplied (per unit of time) Shift Factors of Supply Other factors besides price affect how much will be supplied: – – – – Prices of inputs used in the production of a good. Technology. Suppliers’ expectations. Taxes and subsidies. Price of Inputs When costs go up, profits go down, so that the incentive to supply also goes down. If costs go up substantially, the firm may even shut down. Technology Advances in technology reduce the number of inputs needed to produce a given supply of goods. Costs go down, profits go up, leading to increased supply. Expectations If suppliers expect prices to rise in the future, they may store today's supply to reap higher profits later. Taxes and Subsidies When taxes go up, costs go up, and profits go down, leading suppliers to reduce output. When government subsidies go up, costs go down, and profits go up, leading suppliers to increase output. The Supply Table Each supplier follows the law of supply. When price rises, each supplies more, or at least as much as each did at a lower price. From a Supply Table to a Supply Curve To derive a supply curve from a supply table, you plot each point in the supply table on a graph and connect the points. From a Supply Table to a Supply Curve The supply curve represents the set of minimum prices an individual seller will accept for various quantities of a good. From a Supply Table to a Supply Curve Competing suppliers’ entry into the market places a limit on the price any supplier can charge. Individual and Market Supply Curves The market supply curve is derived by horizontally adding the individual supply curves of each supplier. From Individual Supplies to a Market Supply (1) (2) (3) (4) (5) Quantities Price Ann's Barry's Charlie's Market Supplied (per DVD) Supply Supply Supply Supply A B C D E F G H I $0.00 0.50 1.00 1.50 2.00 2.50 3.00 3.50 4.00 0 1 2 3 4 5 6 7 8 0 0 1 2 3 4 5 5 5 0 0 0 0 0 0 0 2 2 0 1 3 5 7 9 11 14 15 From Individual Supplies to a Market Supply $4.00 Charlie Barry Ann Market Supply Price per DVD 3.50 H 3.00 G 2.50 F 2.00 E 1.50 D 1.00 0.50 0 A I C B CA 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 Quantity of DVDs supplied (per week) The Interaction of Supply and Demand The English historian Thomas Carlyle once said: “Teach any parrot the words supply and demand and you’ve got an economist.” Equilibrium Equilibrium is a concept in which opposing dynamic forces cancel each other out. Equilibrium In a free market, the forces of supply and demand interact to determine equilibrium quantity and equilibrium price. Equilibrium Equilibrium price – the price toward which the invisible hand drives the market. Equilibrium quantity – the amount bought and sold at the equilibrium price. What Equilibrium Isn’t Equilibrium isn’t a state of the world, it is a characteristic of a model. Equilibrium isn’t inherently good or bad, it is simply a state in which dynamic pressures offset each other. What Equilibrium Isn’t When the market is not in equilibrium, you get either excess supply or excess demand, and a tendency for price to change. Excess Supply Excess supply – a surplus, the quantity supplied is greater than quantity demanded Prices tend to fall. Excess Demand Excess demand – a shortage, the quantity demanded is greater than quantity supplied Prices tend to rise. Price Adjusts The greater the difference between quantity supplied and quantity demanded, the more pressure there is for prices to rise or fall. Price Adjusts When quantity demanded equals quantity supplied, prices have no tendency to change. The Graphical Interaction of Supply and Demand Price (per DVD) Quantity Supplied Quantity Demanded Surplus (+) Shortage (-) $3.50 7 3 +4 $2.50 5 5 0 $1.50 3 7 -4 The Graphical Interaction of Supply and Demand $5.00 S Excess supply Price per DVD 4.00 3.50 A 3.00 E 2.50 C 2.00 1.50 Excess demand 1.00 1 D 2 3 4 5 6 7 8 9 10 11 12 Quantity of DVDs supplied and demanded The Graphical Interaction of Supply and Demand When price is $3.50 each, quantity supplied equals 7 and quantity demanded equals 3. The excess supply of 4 pushes price down. The Graphical Interaction of Supply and Demand When price is $1.50 each, quantity supplied equals 3 and quantity demanded equals 7. The excess demand of 4 pushes price up. The Graphical Interaction of Supply and Demand When price is $2.50 each, quantity supplied equals 5 and quantity demanded equals 5. There is no excess supply or excess demand, so price will not rise or fall. Political and Social Forces and Equilibrium Political and social forces can push price away from a supply/demand equilibrium. These forces create an equilibrium where quantity supplied won’t equal quantity demanded. Shifts in Supply and Demand Shifts in either supply or demand change equilibrium price and quantity. Increase in Demand An increase in demand creates excess demand at the original equilibrium price. The excess demand pushes price upward until a new higher price and quantity are reached. Increase in Demand S0 B $2.50 Excess demand A 2.25 D0 0 D1 8 9 10 Quantity of DVDs (per week) Decrease in Supply A decrease in supply creates excess demand at the original equilibrium price. The excess demand pushes price upward until a new higher price and lower quantity are reached. Decrease in Supply S1 S0 C $2.50 2.25 B Excess demand A D0 0 8 9 10 Quantity of DVDs (per week) The Limitations Of Supply And Demand Analysis Sometimes supply and demand are interconnected. Other things don't remain constant. The Limitations Of Supply And Demand Analysis All actions have a multitude of ripple and possible feedback effects. The ripple effect is smaller when the goods are a small percentage of the entire economy. The Limitations Of Supply And Demand Analysis The other-things-constant assumption is likely not to hold when the goods represent a large percentage of the entire economy. The Fallacy of Composition The fallacy of composition is the false assumption that what is true for a part will also be true for the whole. The Fallacy of Composition – The fallacy of composition is of central relevance to macroeconomics. In macroeconomics, the other-things-constant assumption, central to microeconomic supply/demand analysis, cannot hold. Supply and Demand End of Chapter 4