Download Supply and Demand Theory

Lecture V: Demand And Supply
I. Introduction
-- Recall that the price is the primary allocation mechanism in most economies.
-- There are two factors in a market for a commodity that determine the price level:
1. DEMAND –
and
2. SUPPLY –
II. Demand
A. Definition
Quantity Demanded: the amount of a good that households want to consume
given their income and all prices in a given time period, this is the amount people
want to buy
B. Demand Schedule – shows the relationship between the price level and the quantity
demanded
Ex: Sum all demand in the US at that price
Price of corn per bushel in dollars (P)
Millions of bushels of corn sold per year
7
0
6
10
5
20
4
30
3
40
2
50
1
60
0
70
C. Graph of the demand schedule
P
$7
height shows the most someone is willing to pay
this is viewed while holding all other things
constant
Demand Curve (D)
Q
70
- it is also assumed that the quality in this market is homogeneous (the same)
D. Law of Demand – As the price of a good increases, the quantity demanded falls,
holding all else constant (ceteris paribus)
Ceteris Paribus - holding all else constant
Relative Prices – the price of a good compared to the price of other goods
Q: Why is the demand curve downward sloping??
III. Supply – thinking like a producer
Households provide inputs to firms through the factor markets
A. Quantity Supplied – the amount of a commodity that a firm plans to sell given the
time period and other prices
They may wish to sell as much as possible, but this is how much they produce and are
actually prepared to sell and put on the market
B. Supply Schedule – shows the relationship between price and supply
Price of corn per bushel in dollars (P)
0
1
2
3
4
5
6
7
Millions of bushels of corn supplied per year (Q)
0
10
20
30
40
50
60
70
C. Graph of the Supply schedule
P
$7
Supply Curve (S)
this is viewed while holding all other things
constant
Q
70
D. The Law of Supply – as the price for which a good can be sold increases, the
quantity of that good that is supplied will increase, other things held constant
IV Market Equilibrium
Illustrating Equilibrium –
A. Graphically
Bringing Supply and Demand Together – to determine market price
P
Supply Curve (S)
PE
Demand Curve (D)
Q
QE
PE and QE are the equilibrium price and quantity
Equilibrium – in the market is where quantity supplied and quantity demanded are equal
B. Algebraically
Suppose we know the linear equation for the supply and demand curves:
Supply: P = 2 +2Q
Demand: P = 32 – 3Q
Can be solve for equilibrium algebraically:
Supply = Demand or P = P
Q* = 6
P* = $14
C. Numerically
Demand Schedule
Supply Schedule
QD
10
8
5
2
P
0.50
0.75
0.90
1.25
Where is equilibrium in this market?
P
0.50
0.75
0.90
1.25
QS
1
3
5
8
At P = 0.90, QD = QS = 5
PE = 0.90
QE = 5
V. Disequilibrium in the market
A. Excess supply (surplus)
(excess supply)
P
surplus
Supply Curve (S)
P*
PE
Demand Curve (D)
Q
QD*
At P* , QS > QD
QE
QS*
Excess supply puts downward pressure on the price
As the price falls, quantity demanded rises and quantity supplied falls to bring us to equilibrium
B. Excess demand (shortage)
P
Supply Curve (S)
Excess demand - shortage
PE
P*
Demand Curve (D)
Q
QD*
At P* , QS < QD
QE
QS*
Excess demand puts upward pressure on the price
As suppliers put upward pressure on price, quantity demand falls and quantity supplied increases
C. The Dynamic Laws of Supply and Demand
First dynamic law of supply and demand:
When quantity demanded is greater than quantity supplied, prices tend to rise (QS < QD)
When quantity supplied is greater than quantity demanded, prices tend to fall (QS > QD)
Second dynamic law of supply and demand
The larger the difference between quantity supplied and quantity demanded, the greater
the pressure for price to rise if there is excess demand and to fall if there is excess
supply
Third dynamic law of supply and demand
If quantity supplied and quantity demanded are equal the price does not tend to change
VI. Changes in Demand and Quantity Demanded
1. A change in quantity demanded – a movement along a demand curve caused by a
change in the price level.
2. A change in demand – a shift of the entire demand curve due to a change in one of
the determinants of demand.
a. an increase in demand:
at each price level more is demanded
b. a decrease in demand:
at each price level less is demanded
P
(a)
P
Q
(b)
Q
VII. Determinants of Demand (Shift Factors of Demand)
When stating the Law of Demand we say “ all other things constant.” These
determinants of demand are the factors that we are holding constant. They determine the
position of the demand curve so if the change, the demand curve shifts.
A. Price of related goods
1. Substitutes:
-- as Psub rises, demand for own good rises
-- as Psub falls, demand for own good falls
P
(a)
P
(b)
S
S
D
Q
D
Q
2. Complement Goods – a commodity consumed jointly with some other
commodity
-- shoes and shoestrings, peanut butter and jelly, tapes and tape players, cars and gasoline
-- As Pcomp rises, demand for own good falls
-- As Pcomp falls, demand for own good rises
Suppose that the price of gasoline rises: What happens in the market for cars?
B. Average Household Income
The effect of income on demand depends on the type of good
1. normal good – as income increases, demand rises (other things constant)
example: the demand for houses when income increases
2. inferior goods – as income increases, demand decreases (other things
constant)
potatoes, mac and cheese, used clothing, bus rides
P
(a)
P
(b)
S
S
D
Q
D
Q
C. Expected future price levels
If prices are expected to be higher in the future, we buy more now. (increase in
current demand)
If prices are expected to be lower in the future, we buy less now. (decrease in
current demand)
D. Population
If the buying population increases, demand increases and visa versa.
E. Preferences (tastes)
Fashions, fads, seasons, advertising – platform shoes, bell bottoms, …
VI. Changes in Supply and Quantity Supplied
1. A change in quantity supplied – a movement along a supply curve caused by a change in the
price level.
2. A change in supply – a shift of the entire supply curve due to a change in one of the
determinants of supply.
a. an increase in supply:
at each price level more is supplied
b. a decrease in supply:
at each price level less is supplied
P
(a)
P
Q
(b)
Q
VII. Determinants of Supply (Shift Factors of Supply)
A. Price of the factors of production
As the prices of inputs in production increase, supply decreases
As the prices of inputs in production decrease, supply increases
P
(a)
P
(b)
S
S
D
Q
D
Q
B. Changes in Technology
As technology increase, costs of production fall causing supply to increase
(we do not consider the decline of technology, because this rarely if ever occurs)
C. Prices of goods related in production
1. Substitutes in production – goods that may be produced using many of the
same inputs so one can be produced as easily as the other, and switching
production involves a relatively low cost.
P
(1)
P
(2)
S
S
D
Q
D
Q
2. Complements in Production: Two goods that are easily produced in unison, one is
typically a bi-product of the other’s productive process.
D. The number of firms producing and selling the good
E. Expectations about future prices, weather, etc.
F. Taxes and Subsidies
A tax on some aspect of production can increase the cost of the factors of production
and decrease supply
G. Natural disasters
X. Comparative Statics Analysis
Examining how PE and QE change when one or both s & D curves shift
What happens if one curve shifts?
“
“
“ both curves shift?