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Chapter 3: Supply and Demand With limited resources and various needs of human being, – Every year, how many acres of wheat should be planted ? How many cars should be made? And how many houses should be built? – Who should decide what and how much to produce? Government or the free ‘market’? • Government controlled distribution of scarce resources – Rationing coupons (stamps) of almost everything in P.R.China before 1980 – Rationing of gasoline in 1973 oil crisis in Netherlands – Rent control in New York City and Los Angeles • Market force driven allocation of scarce resources 1 What is A Market? • A market is a structure where buyers meet sellers to exchange any type of goods, services, and information. – Buyers create demand for a good; – Sellers create supply of a good; – How the price of a good is determined? • Cost • Value • Interaction between supply and demand 2 The Demand Curve • A demand curve shows the quantity demanded for a good at a certain level of price. • A demand curve is downward sloping. Demand for Pizzas P $4 $2 D 8 16 (1000s of slices/day) Q – Substitution effect – Income effect – Marginal buyer’s reservation price 3 The Supply Curve • A supply curve shows the quantity supplied of a good at a certain level of price. • A supply curve is upward sloping Supply of Pizzas P S $4 $2 8 16 (1000s of slices/day) Q - As the output of a good increases, the opportunity cost of producing the good increases. Therefore, the price to be charged will also increase. - Marginal seller’s reservation price 4 Market Equilibrium Market for Pizzas P Surplus S $4 $3 Equilibrium $2 Deficit 8 12 16 (1000s of slices/day) D Q • A market is in equilibrium when a price equates quantity demanded and quantity supplied (market clearing price). • At a free market, any deviation from equilibrium tends to automatically revert back to equilibrium. - Excess supply - Excess demand 5 An Example: Rent Control Market for NYC Apartments P S • A price ceiling is a maximum price specified by law. • If the price ceiling is under the equilibrium price, a shortage of apartments results. $1,600 $800 D 1 2 3 Q (millions of apartments/day) 6 Movements of Demand Curve • When the price of a good changes, its quantity demanded changes, which happens along the demand curve – changes in quantity demanded. • When any factor other than the price of a good changes, the change shifts the whole demand curve – a change in demand. Demand for Canned Tuna P $2 D 8 10 D' Q (1000s of cans/day) 7 Shifts in Demand What could shift a demand curve? – – – – – – Price of complementary goods; Price of substitute goods; Income: normal or inferior goods; Preference; Population of potential buyers; Expectations on future price changes. 8 Movements of Supply Curve • Movements along the supply curve; • Shifts of supply curve - Price of an input; Technological changes; Weather; Number of potential sellers; Expectations on future price changes Convenient Apartments P S S’ P P’ D Q Q’ (units/month) 9 Changes in Supply and Demand • Demand changes while supply remains the same Demand Equilibrium Price Equilibrium Quantity Increase Increase Increase Decrease Decrease Decrease • Supply changes while demand remains the same Supply Equilibrium Price Equilibrium Quantity Increase Decrease Increase Decrease Increase Decrease 10 Changes in Supply and Demand Supply Demand Increases Decreases Increases P Q Depends Increases P Q Increases Depends Decreases P Q Decreases Depends P Q Depends Decreases 11 Efficiency and Equilibrium • Does the fact that a market automatically reach its equilibrium also guarantee the achievement of economic efficiency – all goods at their socially optimal levels? – Only if the benefits to buyers and/or the costs to sellers are not shared by others. (Efficiency Principle) – Buyers and sellers are only concerned about their own marginal benefit and marginal cost. – If the production of a good creates benefits or costs to other groups, the market equilibrium would not achieve economic efficiency. 12 Efficiency and Equilibrium • Producers sometimes shift costs to others – Pollution is like getting free waste disposal services – Total marginal cost = seller's marginal cost plus marginal cost of pollution – When costs are shifted, supply is greater than socially optimal • Buyers may create benefits for others – Marginal benefit is less than the full social benefit – Vaccinations, my neighbor's landscaping – The demand for these goods is less than socially optimal 13