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Unit 2: Supply and Demand Now that you have been introduced to basic economic concepts, we can move on to discuss a fundamental economic model that is associated with a market economy: Supply and Demand. Before we learn about supply and demand, like all economic models, it is important to understand the basic assumptions of the model. Most importantly, this model assumes a perfectly competitive market. Basically, this means that there are many buyers and sellers. The significance of this assumption is that no person who buys the good or service, and no business that sells the good or service has any impact on the price of the product. Economists would say that everyone involved is a price taker, because of the level of competition removes any control over price. Let’s start: What does the model do for us? At its essence, the supply and demand model allows us to analyze how prices and the quantity in the market are determined by both buyers and sellers. We start by looking at buyers and sellers as separate actors in the market for a particular good or service. Let’s say we want to analyze the market for concert tickets. We will start by looking at the buyers in the market for concert tickets. Let’s first look at the impact of price on buyers desire to purchase the concert tickets. In general, we can make the assumption that at higher prices consumers will want to purchase less of an item, and at lower prices consumers will purchase more of an item. (This may not always be the case, but remember that ceteris paribus thing!) This inverse relationship is known as the law of demand, which states that: An increase in prices leads to a decrease in the quantity demanded And A decrease in prices leads to a decrease in the quantity demanded Why is there an inverse relationship between prices and quantity demanded? Even though this probably makes perfect sense to you, it is important to understand why there is an inverse relationship between prices and quantity demanded for buyers. This relationship can be explained by understanding the concept of diminishing marginal utility. First you should know what these words mean to economists. Utility means satisfaction. In this case, we should ask what level of satisfaction you would receive from the concert tickets. If you only receive a little satisfaction, you will not be willing to pay a high price for the tickets, because you might receive more satisfaction from something else. (Remember that we have limited resources and we are forced to make choices!) If you receive a lot of satisfaction from the tickets, you will be willing to pay more. Marginal refers to incremental change. So we look at each additional unit of a good. How much satisfaction would you receive by seeing the same concert 2 or 3 or 4 times. Diminishing means decreasing. If we put them all together we get: Diminishing Marginal Utility is the concept that with each additional unit of a good, people receive increased overall satisfaction, but at a decreasing rate. In this case, the first concert ticket would probably bring you a lot of satisfaction. If you purchase a second ticket you will still feel satisfied, increasing your total satisfaction, but the ticket did not bring as much satisfaction as the first. The third ticket will bring you more satisfaction, but not as much satisfaction as the first two. Now remember how this relates to demand: Your first ticket would bring you more satisfaction, so you would pay more for it. Your second and third tickets would provide less satisfaction, so the price you would be willing to pay would decrease-So as the price increases the quantity demanded decreases, and as the price decreases the quantity demanded increases. Let’s see how the law of demand works with numbers. Assume that concert tickets are very cheap at $10 a ticket, and at that price, 1000 people are willing and able to purchase the tickets. If the price of the tickets were to increase to $50 a ticket, 500 people are willing and able to purchase the tickets. If the ticket prices were $100 a ticket, only 100 people would be willing and able to purchase the tickets. Let’s put these numbers into a chart: Price of tickets $10 $50 $100 Quantity demanded 1000 500 100 This listing of the relationship between the price of a good or service and the quantity demanded of the good or service is referred to as the Demand Schedule If we plot the schedule on a graph it would look like this: The Market for Concert Tickets P $100 $50 $10 D 0 100 500 1000 Q Here are a few things you MUST remember: 1. 2. 3. 4. 5. 6. You must label the market at the top. In this case it is the market for Concert Tickets P represents price and it is always on the vertical axis Q represents quantity and it is always on the horizontal axis D stands for Demand The line plotting the demand schedule is referred to as the demand curve. Also, you must always place a 0 in the corner. (Economists are crazy picky about these things!) So the demand curve represents the demand schedule and demonstrates the inverse relationship between prices and the quantity demanded. It is important that your vocabulary is correct here. The numbers on the horizontal axis refer to the quantity demanded. It is also important that you realize that changes in price lead to slides along the demand curve, and changes in quantity demanded (If the price of tickets changes from $100 to $10 we would slide from point A to Point B) That is how demand is represented in this model. Now we will move onto shifts in demand. Shifts in Demand So we have learned that the demand curve represents the relationship between changes in price and the quantity demanded of a good or service. Up to now we have only considered price as a variable that affects quantity demanded. Now we will look at the Determinants of Demand. The Determinants of Demand change the quantity demanded of each good or service at any given price. For example there may be some change that could lead more or less people to demand concert tickets if the price of tickets were $50. The determinants of demand include: The price of substitutes The price of complementary goods Population Income Tastes and preferences Expectations of future prices Expectations about the economy Price of Substitutes: Substitutes can be thought of as replacements for a particular good or service. Using concert tickets as an example-a substitute might be to go to the movies. How does this affect demand? If the price of the movies decreases, people are less likely to demand concert tickets. If the price of the movies increases, people are more likely to go to a concert. So: A decrease in the price of a substitute leads to a decrease in demand And An increase in the price of a substitute leads to an increase in demand Price of Complementary Goods: A Complementary Good is something that is bought along with an item. If you go to the concert you may buy food and drinks. If the cost of food and drinks increases, you may be less likely to want to go to a concert. If the price of food and drinks decreases, you may be more likely to go to a concert. So: A decrease in the price of a complement leads to an increase in demand And An increase in the price of a complement leads to a decrease in demand. Population: If the population or the number of buyers increases there will be an increase in demand. If the population decreases there will be a decrease in demand. The more people there are, the greater the demand for concerts. Income: If the income of buyers increases, there will be an increase in demand. If the income of buyers decreases there will be a decrease in demand. If people have more money, they will buy more concert tickets. Tastes and Preferences: Peoples’ opinions about goods and services can change. If people begin to like something more, they will demand more. If people like something less they will demand less. Sometimes advertising can have a big influence on tastes and preferences. If an artist has a new album that has been aggressively advertised and they have recently won music awards, people will more likely want to attend their concert. Expectations of Future Prices: If people believe that the price of concert tickets is going to increase in the future, they will demand more concert tickets now. If people believe that prices will go down, they will postpone buying, and the demand for the product now will decrease. Expectations about the Economy: If people believe that the economy is going to get worse, they get worried about their economic security and they will demand less. If people believe the economy is going to improve demand will increase. How do we show the changes in the determinants of demand with the demand curve? If a determinant changes, you shift the demand curve either up and to the right or down and to the left. If the change leads to an increase in demand, the demand curve shifts to the right Let’s look at our previous graph Let’s assume that overall income in the economy has increased. Because of this, the number of tickets demanded at $50 will increase from 500 to 750. There would also be similar increases at the $100 and $10 prices.( At every price the quantity demanded would increase) This would lead to an outward shift of the demand curve from the original demand curve (labeled D1) to the new demand curve (labeled D2). The Market for Concert Tickets P $100 $50 D2 $10 D1 0 100 500 $750 1000 Q Now let’s look at a decrease in demand: If a change in a determinant leads to a decrease in demand, the curve will shift in to the left. The Market for Concert Tickets P $100 $50 $10 D2 0 100 200 500 1000 D1 Q Let’s assume that a concert for another artist was just scheduled on the same day as the concert we have been discussing. Also assume that the price of the new concert is significantly cheaper than the first concert. All else being equal (e.g. people may receive the same utility form seeing either concert), people will demand less tickets for the first concert. This change will lead to a decrease in demand. This means that at any given price people will demand less of a particular good or service. This is shown in the graph above by shifting the demand curve from D1 to D2. Now, if we look at the quantity demanded for tickets at $50 we can see that it has decreased from 500 to 200. Elasticity: One more thing you have to know about the demand curve. The concept of elasticity pertains to the level of responsiveness demand has to price changes. For example, if there is an increase in the price of a lifesaving drug, people would still demand the drug. The price really doesn’t matter that much. In contrast, if there is an increase in the price of a good with many possible substitutes, such as different types of breakfast foods, people would demand less of the good. Elasticity measures the level of responsiveness to the price change and allows us to categorize the impact. If price change has a significant impact on demand, we consider it elastic. If price change does not have a significant impact on demand, we consider it inelastic. Basically: If demand is sensitive to price change, demand for the item is considered elastic. If demand is insensitive to price change, demand for the item is considered inelastic. Note: We can also determine the elasticity of supply as well. We have a formula to determine whether something is elastic or inelastic. Here it is: The percentage change in the quantity demanded / The percentage change in price If the answer is more than 1 = elastic If the answer is less than 1= inelastic If the answer is 1= unitary elastic We can also show elasticity with the demand curve: A. In graph A You can see that the slope of the line is relatively steep. This indicates that a change in price will not have a significant impact the quantity demanded. This indicates an inelastic demand curve P D 0 Q Note: Even though we look at the slope of the line, we are not calculating the slope of the line (rise over run) remember that we are looking at the percentage changes instead. B. P In graph B you can see that the slope of the line is relatively flat. This indicates that a change in price will have a significant impact the quantity demanded. This indicates an elastic demand curve D 0 Q For a lesson on calculating elasticity, go to the following link: Elasticity What Determines the Elasticity of Demand? Substitutes Percentage of a person’s total budget Amount of time to adjust to a price change If there are many substitutes for a good or a service the demand is more elastic- a person can buy something else. If there are few or no substitutes the demand is less elastic- if there are fewer choices, people will be less impacted by price. If a good or service is relatively inexpensive, a change in price probably would not have a large impact on demand- in this case, demand would be inelastic. If a good or service is expensive and it takes up a lot of a person’s budget, changes in price have more of an impact on whether or not a person buys the product-in this case, demand would be elastic. When there is a change in price it takes time for people to change their purchasing habits. So shortly after a price change, demand is inelastic. Overtime, demand becomes elastic. Now let’s look at supply. First- remember that supply represents the actions of sellers, and sellers act differently than buyers: Sellers respond differently than buyers to changes in prices. This brings us to the Law of Supply An increase in price leads to an increase in the quantity supplied And A decrease in price leads to a decrease in the quantity supplied Back to our concert tickets: If the price of tickets to a particular concert increases, sellers have more incentive to sell tickets, and they will then supply more. If the price of tickets decreases, the ticket agency will probably choose to sell less tickets to our concert. They can probably make more money selling tickets to another event, so they will decrease their supply of tickets. We can show this by using a supply schedule like this one: Price of tickets $10 $50 $100 Quantity Supplied 100 500 1000 And, just like the demand schedule, we can plot these points and construct a supply curve. The Market for Concert Tickets P S $100 $50 $10 0 100 500 1000 Q So, the supply curve has a positive slope. But, one thing that it has in common with the demand curve is that changes in price lead to a slide along the curve and changes in the quantity supplied. What Shifts Supply? Just like demand, there are non- price determinants that shift the supply curve. They include: The prices of inputs Technology # of sellers Expectations of future prices Input prices Inputs are the products that go into the production of a good or service. If the price of an input increases, it will be more costly to produce the good or service which would provide a disincentive for companies to provide the product at any given price. If the price of gas increases, and it now costs more to transport the musicians, instruments and staging, the number of available concerts would decrease. But, if the price of gasoline decreases, the cost of the concert for the supplier would decrease, and there would be an incentive for the supplier to provide more concerts. So a decrease in the price of inputs leads to an increase in supply. Improved technology In this case, we consider technology to be the methods we use to produce a good or service. If we can purchase a ticket, by clicking a button on the computer, it would be more efficient for the seller of the concert tickets tan if they had to provide a ticket window in one section of a city. With the increased technology of using the computer, the supplier will supply more tickets. # of sellers This is pretty straight forward. If there are more sellers, there will be more tickets. If there are less sellers, there will be less tickets. Expectations of future prices If prices are expected to increase in the future, sellers will decrease supply in anticipation of increasing prices. If prices are expected to decrease in the future, sellers will increase supply now to take advantage of higher prices. If sellers of the tickets believe that ticket prices in the future will increase, they will hold back supply now. If the prices are expected to go down, they will supply more tickets now. Let’s see how this looks on a graph: The Market for Concert Tickets P S1 $100 S2 $50 $10 0 500 750 1000 100 Q If there is an increase in supply (Maybe because of a lower input price like a decrease in the cost of fuel for tour buses.), the supply curve will shift to the right from S1 to S2. This shift represents an increase in supply at every given price. In the example above 500 tickets would be supplied at $50. After the shift in supply, 750 tickets will be supplied at $50 The Market for Concert Tickets S2 P S1 $100 $50 $10 0 100 250 500 1000 Q If there is a decrease in supply (Maybe due to an increase in the price of fuel), the supply curve will shift to the left form S1 to S2. This shift represents a decrease in supply at any given price. Instead of 500 tickets being supplied at $50, the supply decreased to 250. Now let’s put supply and demand together We do this to demonstrate how changes in supply and demand affect the price and quantity of a good or service. The Market for Concert Tickets P S $50 D 0 500 Q This graph shows us where the sellers and buyers come to an agreement. Both the buyers and sellers agree that at $50 sellers will supply 500 tickets and buyers will buy 500 tickets. The point at which supply and demand intersect point is called equilibrium. To understand the forces that lead to equilibrium go to the following link: Equilibrium- Surplus and Shortage Below is a generic supply and demand curve. Notice the equilibrium point on the vertical axis is labeled P (for price) and the equilibrium point on the horizontal axis is labeled Q (for Quantity). The Market for X P S P2 P1 P3 D2 D3 0 Q1 Q2 D1 Q Now we can show a shift in demand. If there is an increase in demand the curve will shift out from D1 to D2. This will increase price from P1 to P2 and increase quantity form Q1 to Q2. If there is a decrease in demand the curve will shift in from D1 to D2. This will decrease the price from P1 to P3 and decrease the quantity from Q1 to Q3 . The Market for X S3 P S1 S2 P3 P1 P2iugiuqsgPPPPPPPPPPPPPPP P2 D 0 Q3 Q1 Q2 Q Next we can shift supply. If supply increases from S1 to S2, the price decreases from P1 to P2 and the quantity increases from Q1 to Q2. If the supply decreases from S1 to S3, the price increases from P1 to P3 and the quantity decreases from Q1 to Q3. There you go- Supply and Demand. Be sure to remember: The law for each What causes slides and shifts How slides and shifts impact price and quantity. Quiz on Supply and Demand: Quiz Supply and Demand