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Chapter 3 Demand, Supply, and the Market Process 7 Learning Goals 1) Investigate and describe consumer behavior 2) Distinguish a change in demand from a change in quantity demanded 3) Investigate and describe firm behavior 4) Distinguish a change in supply from a change in quantity supplied 5) Build a market model and illustrate how equilibrium is reached 6) Demonstrate how markets respond to changes in demand and supply 7) Recognize how prices and the invisible hand principle create market order Consumer Choice and the Law of Demand Let’s watch someone go shopping: Clicker question next Q3.1 When you go to the store, what is the most important factor that determines what you buy and how much you buy? a) b) c) d) e) f) g) h) i) Quality Preferences Income Price of the good Price of other, similar goods Expectations Popularity of the good Convenience Advertising Relationships: The Law of Demand: The inverse relationship between price and quantity demanded; when price rises, quantity demanded falls Quantity demanded is a number; it’s how many units of a good you bought Ways to express Law of Demand: 1. Words (see notes you just wrote) Ways to express Law of Demand: 1. Words (see notes you just wrote) 2. Table (Demand Schedule) Cell phone service price Cell phone subscribers (monthly bill) (millions) $ 143 $ 92 $ 73 $ 58 $ 46 $ 41 2.1 7.6 16.0 33.7 55.3 69.2 Ways to express Law of Demand: 1. Words (see notes you just wrote) 2. Table 3. Math equation P = 10 – Q Q = f (Px, Py, M) Q = ln Px + ln Py + ln M Ways to express Law of Demand: 1. 2. 3. 4. Words (see notes you just wrote) Table Math equation Picture We usually draw a picture of this relationship Graph: Why is the demand curve downward sloping? Class Activity: Economics Is Everywhere 6.6 Today is a great day in economic research. A study of mine, written jointly with a former colleague, has been accepted for publication in a leading scholarly journal. Both he and I are very happy about it. For a professor, getting recognition for your ideas is always very gratifying and, in my profession, publication outlets form a clear hierarchy, with this one near the top. This outlet had previously published thirteen papers by my ex-colleague, but none of mine. The marginal utility of the fourteenth paper published in that journal must be less than the marginal utility of the first. If we are both rational and have the same preferences, then I should be much happier about having this study accepted for publication than he is. Q: I have had many scholarly papers published over my thirty-eight-year career in economics, many of them in others of the very top scholarly journals in the field. What’s special about this one? Why is the demand curve downward sloping? Demonstration: Diminishing Marginal Utility – The marginal benefit you receive from an item falls as you gain more of the item – The only way to get you to buy more is to lower the price Demonstration of diminishing marginal utility: Class Activity: Imagine you’re a participant. Describe the way your stomach feels as you eat the first marshmallow versus the 20th one. How do consumers react to price changes? (1) When the price of one good falls, people substitute away from relatively more expensive goods to the relatively cheaper goods Called the substitution effect (2) When the price of one good falls, real consumer income rises so people buy more (it’s like getting a raise) Called the income effect Both of these also cause the demand curve to be downward sloping Clicker Question next Q3.2 (PMA) Consumers buy less of a good as its price increases because a) b) c) d) e) f) production costs have risen. substitute goods are now relatively cheaper. substitute goods are now relatively more expensive. the income of consumers has effectively risen. the income of consumers has effectively decreased. the higher price will make the good more valuable to each consumer. The demand curve represents your willingness to pay (your maximum price), not how much you actually paid Video: What if the actual price is lower than your willingness to pay? In economics, we call this difference consumer surplus (CS) Graphically, CS is the area below demand, out to quantity, and down to price Graph of CS: Clicker question next Q3.3 Which of the following best explains the source of consumer surplus for good A? a) b) c) d) Many consumers pay prices that are greater than the market price of good A. Many consumers would be willing to pay more than the market price for good A. Many consumers think the market price of good A is greater than its cost. Many consumers think the demand for good A is elastic. Changes in Demand Versus Changes in Quantity Demanded Class Activity: List at least 3 factors besides price that influence how much and what you buy. Video: Hudsucker Proxy Extra credit clicker question next (2 points for correct, 0 for incorrect) Q3.4 What was the original price and the lowest price for the Hula Hoop? a) b) c) d) Original = $1.79; Lowest = free Original = $1.79; Lowest = 2 for 25¢ Original = $1.59; Lowest = 49¢ Original = $1.49; Lowest = 39¢ Demand is the relationship between two variables: price and quantity demanded Changes: (1) When price changes, quantity demanded changes but demand does NOT change – This is movement along a demand curve (2) When something else changes, demand changes (i.e., the relationship changes) – This is movement of the entire curve Typical “something else” changes: Income Number of consumers Prices of related goods (substitutes and complements) Expectations Demographics Tastes and preferences Another way to think about the difference between demand and quantity demanded Why is the consumer buying more (or less)? If price is the reason, then quantity demanded changes; move along the demand curve If any variable besides price is the reason, then demand changes; shift the demand curve Graphs: 2 Clicker questions next Q3.5 When economists say the demand for a product has increased, they mean the Q3.5 When economists say the demand for a product has increased, they mean the a) demand curve has shifted to the right. b) price of the product has fallen, and consequently, consumers are buying more of it. c) cost of producing the product has risen. d) amount of the product that consumers are willing to purchase at various prices has decreased. Q3.6 When economists say the quantity demanded of a product has decreased, they mean the Q3.6 When economists say the quantity demanded of a product has decreased, they mean the a) demand curve has shifted to the left. b) demand curve has shifted to the right. c) price of the product has fallen, and consequently, consumers are buying more of it. d) price of the product has risen, and consequently, consumers are buying less of it. The price for one good can be intimately tied to demand for another good (1) Substitute goods-used in place of each other An increase (decrease) in price for the first good will increase (decrease) demand for the second good (1) Substitute goods Example: (A)__________, (B)__________ If the price of (A)_________ rose, the (demand/quantity demanded) of (A)____________ would (rise/fall) and consumers would purchase (more/less) (A)_______________. The (demand/quantity demanded) for (B)____________ would (rise/fall), causing the demand curve to shift (right/left). Graphs: Video about substitutes: (2) Complement goods-usually consumed at the same time An increase (decrease) in price for the first good will decrease (increase) demand for the second good (2) Complement goods Example: (A)__________, (B)__________ If the price of (A)_____________ rose, the (demand/quantity demanded) of (A)_____________ would (rise/fall) and consumers would purchase (more/less) (A)________________. The (demand/quantity demanded) for (B)_____________ would (rise/fall), causing the demand curve to shift (right/left). Graphs: 2 Clicker questions next Q3.7 If air travel and bus travel are substitutes, a) an increase in the price of bus travel will decrease the demand for air travel. b) a decrease in the price of bus travel will decrease the demand for air travel. c) an increase in the price of bus travel will generally have no effect on the demand for air travel. d) an increase in the price of bus travel will shift the demand curve for air travel to the left. Q3.8 If coffee and cream are complements, an increase in the price of coffee will cause a) b) c) d) the demand for cream to increase. the demand for cream to fall. the demand for coffee to fall. no change in the demand for cream; only quantity demanded would be affected. Producer Choice and the Law of Supply Goal: Explain and Predict Firm Behavior The Law of Supply: – The positive relationship between price and quantity supplied; when price rises, quantity supplied rises – Quantity supplied is a number; it’s how many units of a good you made Ways to express Law of Supply: 1. Words (see notes you just wrote) Ways to express Law of Supply: 1. Words (see notes you just wrote) 2. Table Cell phone service price (monthly bill) $ $ $ $ $ $ 60 73 80 91 107 120 Cell phone service supplied to market (millions) 5.0 11.0 15.1 18.2 21.0 22.5 Ways to express Law of Supply: 1. Words (see notes you just wrote) 2. Table 3. Math equation P=5+q Q = f (Px, P inputs, Tech) Q = ln Px + ln P inputs + P tech Ways to express Law of Supply: 1. 2. 3. 4. Words (see notes you just wrote) Table Math equation Picture We usually draw a picture of this relationship Graph: Why is the supply curve upward sloping? At a higher price, a product is usually more profitable so a firm has a stronger incentive to make more. Clicker question next Q3.9 According to the law of supply, a) producers are willing to supply larger amounts of a good as its price increases. b) a direct relationship exists between the price of a good and the amount buyers choose to buy. c) an inverse relationship exists between the price of a good and the amount buyers wish to buy. d) an inverse relationship exists between the price of a good and the amount producers supply. What if the actual price is higher than your minimum price? In economics, we call this difference producer surplus (PS) Graphically, PS is the area above supply, out to quantity, and up to price Graph of PS: Video: Pretty Woman Class Activity: Economics Is Everywhere 6.15 In the movie Pretty Woman, Richard Gere and Julia Roberts are bargaining over the price of her “services” for a week. They settle on a price of $3,000. She informs him that she would have stayed for $2,000; implicitly, she obtains a producer surplus of $1,000, the excess of what she receives over the lowest price for which she would have provided the services. Richard Gere then goes on to say that he would have paid her $4,000. He is getting $1,000 in consumer surplus- the price he has to pay is $1,000 less than the highest amount he was willing to pay. Q: What is the consumer surplus if Richard Gere had been willing to pay only $3,500? Would the movie have been made if he had been willing to pay only $2,500? Changes in Supply Versus Changes in Quantity Supplied Price is not the only factor that determines how much a firm makes Changes: (1) When price changes, quantity supplied changes but supply does NOT change – This is movement along a supply curve (2) When something else changes, supply changes (i.e., the relationship changes) – This is movement of the entire curve Typical “something else” changes: Resource prices Technology Nature Political Taxes Another way to think about the difference between supply and quantity supplied Why is the firm producing more (or less)? If price is the reason, then quantity supplied changes; move along the supply curve If any variable besides price is the reason, then supply changes; shift the supply curve Graphs: 2 Clicker questions next Q3.10 When economists say the supply of a product has increased, they mean the Q3.10 When economists say the supply of a product has increased, they mean the a) price of the product has risen, and consequently, suppliers are producing more of it. b) supply curve has shifted to the left. c) amount of the product that consumers are willing to purchase at various prices has increased. d) supply curve has shifted to the right. Q3.11 When economists say the quantity supplied of a product has decreased, they mean the a) supply curve has shifted to the left. b) supply curve has shifted to the right. c) price of the product has risen, and consequently, suppliers are producing more of it. d) price of the product has fallen, and consequently, suppliers are producing less of it. Class Activity: Economics Is Everywhere 2.15 Even gangsters’ supply curves slope upward. In his book But He Was Good to His Mother (Jerusalem: Gefen, 2000), Robert Rockaway reports that an associate of Big Jack, a New York gangster in the early twentieth century, stated to police that Big Jack had the following price list for his services: slash on the cheek with knife, $1 to $5; shot in leg, $1 to $25; shot in arm, $5 to $25; throwing a bomb, $5 to $50, murder, $10 to $100. Clearly, the prices are higher for the more difficult tasks; and the range of prices for a particular criminal act probably reflects the ease of access to the target. Perhaps a shot in the leg costs less than one in the arm because hitting a person in the leg without causing further damage is easier than hitting someone in the arm. Q: Draw a supply curve for criminal activities. Then show how it would shift if unemployment were low and there were many good legitimate jobs. Then show how the curve would shift if jobs were scarce. Clicker question next Q3.12 How will an increase in lumber prices influence the home construction market? a) The demand for newly constructed homes will increase. b) The demand for newly constructed homes will decrease. c) The supply of newly constructed homes will increase. d) The supply of newly constructed homes will decrease. How Market Prices are Determined: Supply and Demand Interact Graph: Key points: – (1) Excess supply and excess demand are NOT unique points – (2) Equilibrium IS a unique point Class Activity: Economics Is Everywhere 3.8 If free to do so, markets tend toward an equilibrium where supply equals demand. That’s even true for the market for dating, as shown in the 1960s No. 1 hit song, “Surf City,” by Jan and Dean. They sing, “We’re going to Surf City; gonna have some fun…Two girls for every boy.” Two girls for every boy is not an equilibrium- it is a disequilibrium situation. There is a shortage of boys and a surplus of girls. Jan and Dean are going to Surf City, having been attracted by the surplus of girls. Their arrival there will reduce the size of the surplus of girls and also reduce the shortage of boys. If enough other boys follow their lead, the market for dates in Surf City will be in equilibrium- the shortage and surplus will have been removed by the action of the market as people respond to the shortage of boys by “going to Surf City.” If free to do so, markets tend toward an equilibrium where supply equals demand. That’s even true for the market for dating, as shown in the 1960s No. 1 hit song, “Surf City,” by Jan and Dean. They sing, “We’re going to Surf City; gonna have some fun…Two girls for every boy.” Two girls for every boy is not an equilibrium- it is a disequilibrium situation. There is a shortage of boys and a surplus of girls. Jan and Dean are going to Surf City, having been attracted by the surplus of girls. Their arrival there will reduce the size of the surplus of girls and also reduce the shortage of boys. If enough other boys follow their lead, the market for dates in Surf City will be in equilibrium- the shortage and surplus will have been removed by the action of the market as people respond to the shortage of boys by “going to Surf City.” Q: If you have ever been to a mixer or a singles bar where there is an excess of members of one sex, why did the excess arise? How long do you think the “market” at Surf City will take to reach equilibrium? 2 Clicker questions next Q3.13 On the following graph, how much is excess supply (surplus)? a) b) c) d) e) 150 50 100 125 75 Q3.13 On the following graph, how much is excess supply (surplus)? a) b) c) d) e) 150 50 100 125 75 Q3.14 On the following graph, how much is excess demand (shortage)? a) b) c) d) 50 75 100 125 Q3.14 On the following graph, how much is excess demand (shortage)? a) b) c) d) 50 75 100 125 How Markets Respond to Changes in Supply and Demand This is called supply and demand analysis You don’t have to use graphs but it’s helpful Use this 3 step procedure: – (1) Identify the change – (2) Determine if Supply or Demand is affected and how – (3) Draw and read graph (or reason through the change) Only allow one variable to change at a time. Example: Part of Doak Campbell Stadium is destroyed by locusts – (1) Fewer seats will be available – (2) Supply is affected, will decrease – (3) Shift supply left and find new equilibrium Graph: Class Activity: Economics Is Everywhere 3.3 There have been stories all over the Web and on television in the last few weeks about the lowcarbohydrate food craze- people following weight-loss diets that involve sharp reductions in the intake of carbohydrates. One story on Yahoo said, “Food companies rush to take advantage of carbohydrate crunch.” This is a good description of behavior in a market where the demand curve has shifted to the right. The demand shift is due to people’s new belief that these diets will enable them to lose weight. To meet the shift in demand- and seeing a chance to make additional profits- food companies are happy to produce more lowcarbohydrate foods. They are happy to increase the amount supplied in response to the shift in demand. Q: What does this change in consumer behavior do to the equilibrium price of low-carbohydrate foods? 2 Clicker Questions Next Q3.15 If the demand for a good decreased, what would be the effect on the equilibrium price and quantity? Q3.15 If the demand for a good decreased, what would be the effect on the equilibrium price and quantity? a) Price would increase and quantity would decrease. b) Price would decrease and quantity would decrease. c) Price would increase and quantity would increase. d) Price would decrease and quantity would increase. Q3.16 If Georgia experiences a late frost that damages the peach crop, we should expect the a) supply curve for peaches to shift to the right and the price of peaches to fall. b) supply curve for peaches to shift to the left and the price of peaches to rise. c) demand curve for peaches to shift to the left and the price of peaches to fall. d) demand curve for peaches to shift to the right and the price of peaches to rise. “Homework” assignment Graph (or reason through) the following scenarios: 1) Increase in demand 2) Decrease in demand 3) Increase in supply 4) Decrease in supply The magnitude of the shift doesn’t matter What if supply and demand shift at the same time? Suppose supply and demand both decrease Talk with a neighbor for this question Clicker question next Q3.17 If there is a simultaneously an increase in demand and an increase in supply, we would expect Q3.17 (PMA) If there is a simultaneously an increase in demand and an increase in supply, we would expect a) An increase in equilibrium price and an increase in equilibrium quantity. b) A decrease in equilibrium price and an increase in equilibrium quantity. c) An increase in equilibrium price and a decrease in equilibrium quantity. d) A decrease in equilibrium price and a decrease in equilibrium quantity. “Homework” assignment Graph (or reason through) the following scenarios: 1) Increase in demand, increase in supply 2) Increase in demand, decrease in supply 3) Decrease in demand, increase in supply 4) Decrease in demand, decrease in supply For each one, you will have 3 scenarios: a) Demand shift greater than supply shift b) Demand shift less than supply shift c) Demand shift equal to supply shift Class Activity: Name one good you purchased recently. Identify at least 5 different people that were involved in that product so that you could buy it. Video: Invisible Hand Principle Adam Smith- An Inquiry into the Nature and Causes of the Wealth of Nations Invisible Hand Principle Adam Smith- An Inquiry into the Nature and Causes of the Wealth of Nations Personal self-interest directed by market prices is a powerful force promoting economic progress “Every individual is continually exerting himself to find out the most advantageous employment for whatever [income] he can command. It is his own advantage, indeed, and not that of the society which he has in view. But the study of his own advantage naturally, or rather necessarily, leads him to prefer that employment which is most advantageous to society…He intends only his own gain, and he is in this, as in many other cases, led by an invisible hand to promote an end which was not part of his intention. By pursuing his own interest he frequently promotes that of the society more effectually than when he really intends to promote it.” Many outcomes are the result of human action but not human design Examples: Who invented the English language? Seating in HCB Early roads and pathways Clicker question next Q3.18 Which of the following is a major implication of the invisible hand concept? a) b) c) d) When directed by competitive market prices, the actions of self-interested individuals will tend to promote overall economic prosperity. Prosperity cannot be achieved unless the selfish nature of people can be changed. Competition is harmful to the health of an economy because it results in wasteful duplication. Government-operated firms tend to have higher efficiency and lower costs than private sector firms. 7 Learning Goals 1) Investigate and describe consumer behavior 2) Distinguish a change in demand from a change in quantity demanded 3) Investigate and describe firm behavior 4) Distinguish a change in supply from a change in quantity supplied 5) Build a market model and illustrate how equilibrium is reached 6) Demonstrate how markets respond to changes in demand and supply 7) Recognize how prices and the invisible hand principle create market order