Download Unit 2: Supply and Demand

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