Download Topic 3: Part I Demand and Supply

Econ 103 Topic 3 page 1
Principles in Microeconomics
Topic 3: Part I
Demand and Supply
Text reference: Chapter 3
Chapter 6 pp 144-162
□ Assumptions of the competitive model.
□ Demand:
-Determinants of demand
-Demand curves
-Consumer surplus
-Divisibility
-“Law of demand
-Change in demand
Econ 103 Topic 3 page 2
Principles in Microeconomics
-Changes in the quantity demanded
-Normal and inferior goods
-Complements and substitutes
-Individual demand and market demand
Econ 103 Topic 3 page 3
Principles in Microeconomics
In Topic 2, Person 1 and Person 2 exchanged fish and
mushrooms and increased their well-being with trade.
In real economies, goods are exchanged for money, not other
goods.
►Prices are measured in $s, not fish.
Usually there is more than one buyer and seller.
Typically prices are determined by the interaction of all
buyers and sellers.
This topic analyses the interactions of the buyers and sellers
in the competitive market.
Econ 103 Topic 3 page 4
Principles in Microeconomics
The Competitive Market Model:
Assumptions:
● Many potential buyers of the good being offered
● Each potential buyer is small relative to the overall
market and cannot influence price.
Can buy as much of the good as he or she wants
without affecting price.
● Many potential sellers of the good.
● Each seller is small relative to overall market and
cannot influence price.
Can sell as much or as little without affecting the price.
Econ 103 Topic 3 page 5
Principles in Microeconomics
The model is highly unrealistic for many markets.
However, this will provide a useful base model for analysis.
Potential buyers in a market are known as the demand side.
Potential sellers in a market are known as the supply side.
In competitive markets, demand and supply jointly
determine:
-the quantity of goods that are produced and consumed
-the price at which goods sell for.
Buyers and sellers are both better off as a result of market
trades.
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The measurement of social welfare will allow us to see
this.
Competitive markets will – under certain circumstances,
maximize consumer and producer well-being.
In this sense, we say competitive markets are efficient.
Econ 103 Topic 3 page 7
Principles in Microeconomics
Demand
What determines how much of a given good a potential
buyer is willing to buy?
What are the determinants of demand?
-There are many determinants of demand
-price of the good in question is the most obvious one.
Econ 103 Topic 3 page 8
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Recall from Topic 1 regarding coffee consumption. We were
looking at how much I was willing to pay for coffee one
morning.
Coffee MB of coffee
1
$5
2
$3
3
$1
This is my demand schedule for coffee.
This table contains the information needed to determine
how many coffees I will buy at a given price.
Econ 103 Topic 3 page 9
Principles in Microeconomics
We will represent this information graphically by
drawing my demand curve for coffee.
Demand (D) curve plots the quantities I am willing to buy
at different prices for the good, holding everything else
constant.
The quantity I am willing to buy at a certain price is called
the quantity demanded.
Econ 103 Topic 3 page 10
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Graphical representation of my MB schedule is actually
my demand curve.
We label the horizontal axis Q (quantity).
$
Each point from the MB
schedule is plotted.
5
3
1
Quantity
0
1
2
3
Econ 103 Topic 3 page 11
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Plot each point from the MB
schedule. Then join up points
with “stair-step” line.
That line is the MB curve.
$
5
3
MB curve
1
Quantity
0
1
2
3
Econ 103 Topic 3 page 12
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Recall: in Topic 1, we used this information to see how
much coffee I would buy at a price of $1.25 a cup.
Compare MB of each cup to MC, and buy if MB>MC.
$
If coffee is $1.25, I buy 2 cups.
5
3
P= $1.25=MC of coffee
1
Quantity
0
1
2
3
The same information could be used to see what I would do
at different prices.
Econ 103 Topic 3 page 13
Principles in Microeconomics
Now suppose P=$3.25
The MC > MB only for one cup of coffee, so if P=$3.25, Q=1.
MB curve can be used to tell us what Q we
would buy at any possible price. Which is
just what a demand curve tells us.
$
5
P= $3.25=MC of coffee
3
My MB curve is my demand curve!
1
Quantity
0
1
2
3
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We can use the demand curve diagrams to measure
consumer well-being.
That is, we can measure a consumer’s net benefit (NB)
from a given purchase choice.
We called this ‘happiness profit’ in Topic 1.
Here we will use its formal name “consumer surplus.”
Consumer Surplus is the difference between what a
consumer is willing to pay for a given Q of a good, and
what the consumer actually has to pay for that Q.
Total benefits of consumption minus total costs of
consumption.
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Consumer Surplus
Recall that I am willing to pay $5 for the first cup of coffee.
On the demand curve diagram, that willingness to pay can be
represented by the area under the demand curve, as quantity
goes for 0 to 1.
$
5
first coffee gives me $5 of happiness
3
1
Quantity
0
1
2
3
Econ 103 Topic 3 page 16
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Recall, that I am willing to pay $3 for the second coffee.
On the demand curve diagram, that willingness to pay
can be represented by the area under the demand curve as
quantity goes from 1 to 2.
$
5
3
second coffee gives me $3 of happiness.
Third coffee gives me $1 of happiness.
1
Quantity
0
1
2
3
Econ 103 Topic 3 page 17
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When price =$1.25 and I buy 2 coffees, total happiness
from coffee= $5 + $3 = $8.
$8 = the maximum amount of money I would have been
willing to spend to get those 2 coffees.
$
5
But I didn’t have to spend $8
3
I had to spend $2.50= P*Q.
P=$1.25 = MC of coffee
1
Quantity
0
1
2
3
Econ 103 Topic 3 page 18
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Consumer Surplus: willingness to pay minus actual
cost=$8-$2.50=$5.50.
My $2.50 bought me $8 of happiness.
Consumer surplus = $5.50.
$
5
CS is the area below
the demand curve and
above the price line up
to the quantity bought.
3
P=$1.25 = MC of coffee
1
Quantity
0
1
2
3
Econ 103 Topic 3 page 19
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Consumer surplus can be used to analyze changes in
consumer well-being as market conditions change.
If price increases to $2.50:
When price is $2.50
$
CS= $3.
5
3
P=$2.50
When price is $1.25
CS= $5.50.
P=$1.25 = MC of coffee
1
Quantity
0
1
2
3
CS= $8-$5 = $3
CS can be used to analyze changes I consumer well-being
as market conditions change: $5.50-$3= $2.50 Change in CS.
Econ 103 Topic 3 page 20
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Demand:
Notice the contrast of the “stair-step” demand curve to the
smooth demand curve in chapter 3 of the text.
The difference is due to the assumptions about what we call
the divisibility of goods.
We could allow coffee to be sold in very small fractions of a
millilitre:
Econ 103 Topic 3 page 21
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$
Demand Curve
Quantity
In the limit, we will have so many tiny stairs that effectively
the demand curve becomes perfectly smooth.
Assume the demand curves can be drawn as perfectly smooth.
Econ 103 Topic 3 page 22
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►Often we will also assume the demand curves are linear.
This is not because we think they are, just because it makes
analysis easier.
$
Demand Curve
Quantity
Econ 103 Topic 3 page 23
Principles in Microeconomics
We can still calculate CS and changes in CS as before:
$
-Consumer was WTP (A+B+C) for Q1 units.
-Consumer only had to pay (B+C) for Q1 units.
P1
A
Demand Curve
B
C
Q1
Consumer surplus = area A.
Quantity
Econ 103 Topic 3 page 24
Principles in Microeconomics
If price falls to P2, quantity demanded increases to Q2
$
-Consumer was WTP (A+B+C+E+F) for Q2 units.
-Consumer only had to pay (C+F) for Q2 units.
P1
P2
A
B
Demand Curve
E
-New CS = area (A+B+E)
C
F
Q 1 Q2
Quantity
Econ 103 Topic 3 page 25
Principles in Microeconomics
Law of Demand: the demand curve slopes downward if
marginal benefit falls as consumption rises.
Does not have to be true, however.
There are cases of vertical and horizontal demand curves.
$
Note: if price falls and quantity rises, we
refer to this as a change in quantity
demanded. Implies a movement along
the Demand Curve.
P1
Q 1 Q2
Quantity
Econ 103 Topic 3 page 26
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►So far we have only talked explicitly about one
determinant of demand: the price of the good.
►Other determinants of demand include: consumer income,
prices of related goods, tastes or preferences, expectations
about the future.
►Changes in these things are represented by shifts of the
entire demand curve.
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Econ 103 Topic 3 page 28
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Example: Suppose my income increases.
►holding the price of coffee constant, would I buy or less?
♥It depends on whether coffee is a “normal” or “inferior good
to me.
■If income increases and I buy more of a good: normal.
Or less if income falls.
■If income increases and I buy less of a good: inferior.
Or more if income falls.
Changes in income will shift my demand curve right
increase in demand) or left (decrease in demand).
Econ 103 Topic 3 page 29
Principles in Microeconomics
$
Note: Income increased and coffee is normal for me
P1
-At original income I am willing to buy Q1 at P1.
-At new income I am willing to buy Q2 at P1.
Increase in demand
Q 1 Q2
D 1 D2
Quantity
Willing to buy more than before at any possible price.
The entire demand curve has shifted to the right.
Econ 103 Topic 3 page 30
Principles in Microeconomics
Prices of Related Goods:
The relationship between my demand for coffee and other
prices depends on the relationship between coffee and other
goods.
It depends on whether other goods are substitutes for or
complements to my consumption of coffee.
A substitute is a good I could consume instead of coffee.
►Eg. Tea
A complement is a good I like to consume with coffee.
►Eg. Egg McMuffin
Changes in the price of related goods will also shift my
demand curve left or right.
Econ 103 Topic 3 page 31
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Other Prices: Tea is a substitute and its price falls.
At original price of tea, I am willing to buy Q2 coffees at
price P1.
At a lower price for tea, I am willing to buy just Q1 coffees at
price P1.
$
Willing to buy less than before at any possible price.
P1
Decrease in demand
Q 1 Q2
D 2 D1
Quantity
Econ 103 Topic 3 page 32
Principles in Microeconomics
Tastes/preferences
Obviously how much coffee I am willing to buy depends also
on how I feel about coffee.
Do I like it or not? If so, how much do I like it?
If my tastes change, my demand curve will shift accordingly.
Expectations:
If I think coffee is going to be more (or less) expensive
tomorrow, I might buy more (or less) today.
This would be represented by a shift of the demand curve.
Econ 103 Topic 3 page 33
Principles in Microeconomics
So far we have been looking at one individual’s demand curve.
There are many potential buyers of most goods.
We need to be able to derive market demand curves from individual
demand curves.
Simply add up the quantity demanded at each and every price.
Econ 103 Topic 3 page 34
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Supply:
Determinants of supply, supply curves, producer surplus, the
law of supply, changes in quantity supplied, changes in
supply, individual supply, market supply.
Recall the fish and mushroom example. We will now
represent mushroom in $, not fish. We can convert the MC of
mushrooms into dollar $s.
Assume a competitive environment. There are many sellers
and buyers. No one firm can influence price.
Econ 103 Topic 3 page 35
Principles in Microeconomics
The market price for fish is $10 / fish.
Output per day
Mushrooms
0
+10
10
+10
20
+10
30
+10
40
Fish
15
14
11
6
0
-1
-3
-5
-6
-MC of 1st 10 mushrooms =1/10 Fish =$1.
-MC of 2nd 10 mushrooms = 3/10 fish= $3.
-MC of 3rd 10 mushrooms = 5 /10 fish = $5.
-MC of 4th 10 mushrooms = 6 /10 fish = $6.
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Principles in Microeconomics
We can use the MC information to figure out how many
mushrooms will be produced and sold at different mushroom
prices.
The MC tells us all we need to know about supply decisions.
We will see that the graphical representation of MC schedule
is the producer’s supply curve.
Econ 103 Topic 3 page 37
Principles in Microeconomics
$
6
5
4
3
2
1
0
10
20
30 40
Quantity mushrooms
Plot each point from the MC schedule.
Econ 103 Topic 3 page 38
Principles in Microeconomics
$
6
5
4
3
2
1
0
MC curve
10
20
30 40
Quantity mushrooms
Join up the points with a stair-step line.
That line is the MC curve.
Econ 103 Topic 3 page 39
Principles in Microeconomics
We can use marginal analysis to examine supply decisions.
Simply compare MB and MC of each “step” where here each
step is an increase in output.
$
6
5
4
3
2
1
0
MC curve
10
20
30 40
Econ 103 Topic 3 page 40
Principles in Microeconomics
In a competitive
market, the seller’s
MB is the market
price Pm.
Assume the market price is $4:
$
6
5
4
3
2
1
0
Pm
MC curve is the supply curve
10
20
30 40
If Pm=$4, then MB> MC for quantity up to 20 mushrooms.
Tells us that at Pm=$4, 20 mushrooms will be supplied.
Econ 103 Topic 3 page 41
Principles in Microeconomics
We use supply curve diagrams to measure producer wellbeing.
We can measure a producer’s net benefit from a given sales
choice.
This referred to as producer surplus.
Producer surplus is the difference between the minimum
payment a producer had to receive in order to be willing to
sell a given quantity and the actual payment it received for
that quantity.
A seller needs to at least receive enough $ to cover MC in
order to be willing to sell a given amount.
Econ 103 Topic 3 page 42
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To calculate the minimum payment required for the 20 mushrooms
sold, add up all the MCs.
$
6
5
4
3
2
1
0
Pm
MC curve
10
20
30 40
Quantity of mushrooms
Producer needs at least $40 to be willing
MC of 1st 10 mushroom = $10.
to sell 20 mushrooms.
MC of 2nd 10 mushrooms= $30
Producer actually receives revenue of $80 for selling 20 mushrooms.
}
Q × P = 20 × 4 = $80
Producer surplus is the difference between the two: $80-$40=$40.
Econ 103 Topic 3 page 43
Principles in Microeconomics
Producer surplus can be used to analyze changes in the wellbeing of the producer as market conditions change.
Suppose the market price increased from $4 to $5.50.
PmN
$ 5.50 6
5
4
3
2
1
0
Pm
S curve
10
20
Quantity sold
increases to 30
mushrooms.
30 40 Quantity of mushrooms
Producer surplus also increases.
Econ 103 Topic 3 page 44
Principles in Microeconomics
The minimum payment needed to sell 30 mushrooms:
10+30+50 = $90.
This is the area under the S curve up to Q=30.
Revenue now= $5.50 × 30 = $165
PS=$165-$90=$75.
This is an increase in producer well=being of
$75-$40=$35!
Econ 103 Topic 3 page 45
Principles in Microeconomics
In this example the supply curve is a stair-step function.
Implicitly, we are assuming that mushrooms can only be sold
in 10 unit increments.
We can easily allow for a greater degree of divisibility.
In the limit, if the good is infinitely divisible, we will
have perfectly smooth supply curves.
The supply curve slopes upward or positively if MC is
increasing as production increases.
This is known as the “law of supply.”
Econ 103 Topic 3 page 46
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Movements and Shifts in Supply
$
S If there is a decrease in
price and quantity falls,
this is a change in
quantity supplied, NOT
a decrease in supply.
P1
P2
Q2
Q1
Quantity
A change in quantity supplied is represented by a
movement along the supply curve.
Econ 103 Topic 3 page 47
Principles in Microeconomics
There are other determinants that affect how much of a good
a producer is prepared to sell at each price.
All these other determinants of supply will cause the supply
curve to shift.
Example: Input prices are another determinant of supply.
Wages, raw material costs, etc.
Example: Technology: technological process make resources
relatively more productive in production.
Example: Changes in Expectations: if a producer believes
that market price will be higher in the future, current supply
decisions may change.
Econ 103 Topic 3 page 48
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Example: Number of Producers: Competitive markets are
characterized by many potential sellers. If more suppliers
enter an industry, the market supply function will increase
(shift) to the right.
Econ 103 Topic 3 page 49
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Market Price:
Although in a competitive environment each individual seller
and buyer take price as given and have no influence on price,
collectively, their actions determine price.
Market price is determined by the interaction of supply and
demand.
Equilibrium: defn.: A state of rest or balance due to the
equal action of opposing forces; or equal balance between any
powers, influences, etc.; equality of effect.
‘Forces’, ‘powers’ and ‘influence’ in the competitive markets
are supply and demand.
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Equilibrium is a competitive market is an outcome in which
supply and demand are in “equal balance.”
QD = QS .
Where
►Point where supply and demand cross is the equilibrium
point:
QE
Also known as the equilibrium quantity.
Price $
S
PE
Equilibrium
D
QE
Q
Econ 103 Topic 3 page 51
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How does the market get to the equilibrium point?
In competitive markets, the mechanism is price.
Suppose P > PE :
The market is not in balance;
Price $
not in equilibrium. There is
Excess S
S
P
PE
Equilibrium
a gap between QS and QD
called a surplus or excess
supply. To clear the
excesses, price has to fall.
Too many sellers and too
few buyers put downward
pressure on price. Market
forces put pressure on price
to fall.
D
QE
Q
Econ 103 Topic 3 page 52
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As price falls:
-there is an increase in quantity demanded (movement
along the demand curve; and
-there is a decrease in quantity supplied; a movement
along the supply curve.
The gap between demand
Price $
S
P
PE
Equilibrium
and supply is closed as both
sides of the market adjust to
falling price. There will be
pressure for price to fall as
long as there is excess
supply. Only when price is at
PE there is no further change
in market price.
D
Qs
QE
QD
Q
Econ 103 Topic 3 page 53
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Excess Demand: Suppose P<PE:
QD>QS. There is a gap called a
shortage or excess demand.
Price $
S
There will be upward pressure
on price.
The gap will close from both
sides of the market.
PE
Equilibrium
P
D
Excess demand
Qs
QE
Upward pressure on Price stops
once price reaches PE.
QD
Q
Once a market is in equilibrium, it should stay there until
changes occur in the market condition.
Econ 103 Topic 3 page 54
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Example: suppose consumers’ income increases. In the
market for a normal good what would happen?
Price $
D2
S
D1
PE
Increase in income leads
to an increase in demand:
the demand curve shifts to
the right.
At price PE, the quantity
demanded is greater that
quantity supplied: Qs>QD.
QD
Q
At price PE, quantity supplied is QE.
There is excess demand in the market.
Excess demand puts upward pressure on price.
QE
Econ 103 Topic 3 page 55
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As price rises, the quantity demanded decreases, partially
offsetting the original increase in demand in the market for a
normal good.
Price $
D2
We have a movement
along the new demand
curve D2.
S
D1
PE 2
PE
QE
QE 2
QD
Q
Also, as price increases,
quantity supplied
increases as a movement
along the supply curve.
Excess demand in
eliminated by change on
both sides of the market.
Econ 103 Topic 3 page 56
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Consumer and Producer Surplus
Consumer and producer surplus measure consumer and
producer well-being.
CS+PS is a measure of the net benefit accruing to all
participants in a market.
$
S
PE
CS
PS
D
QE
CS+PS is either “market
surplus” or “private
surplus.”
The text refers to this as
total surplus.
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Market Surplus:
We have seen that we can calculate market surplus by finding
CS and PS and adding them together.
We can also calculate market surplus directly, without
thinking about its’ distribution between consumers and
producer.
We do this by focussing just on the quantity traded in a
market.
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Recall that the:
-demand curve can also be interpreted as the MB curve
and;
-supply curve can also be interpreted as the MC curve.
Area under the demand curve
can be used to calculate total
benefits to consumers;
Equivalent to total WTP.
Total benefits of QE units =
areas A+B
$
MC
S
A
MB
B
QE
D
Q
Area under the supply curve can be used to calculate total cost
of supplying a given quantity: Adding up MCs of each unit.
Cost of supplying QE units = area B.
Econ 103 Topic 3 page 59
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Taking total benefits and subtracting cost of supply leaves
area A.
Area A = market surplus, given QE units..
$
MC
S
A
MB
D
B
QE
Q
We are not thinking at all
about its distribution
between consumers and
producer.
But we do not need to think
about that if all we are
interested in is the overall
amount of market surplus.
We can use market surplus to start thinking about
efficiency in the context of competitive markets.
Econ 103 Topic 3 page 60
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We have only loosely talked about efficiency so far.
A situation is inefficient if we could rearrange things such
that at least someone is better of and no-one is worse off.
To build a more defined and stronger concept of
efficiency in a market context, we will start the process
with market surplus.
Econ 103 Topic 3 page 61
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Key Point: At the competitive market equilibrium, market
surplus is maximized.
Overall net benefits cannot be higher at any quantity not
equal to QE.
$
MC
Consider quantities such the
QL< QE.
►Consumer benefits= A + B.
►Cost of supplying = B
►Market surplus = A
A C
MB
B
Q L QE
Q
Market surplus is C lower at
QL than at QE.
Econ 103 Topic 3 page 62
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Consider a higher amount:
$
MC
A
Consider quantities such the QH
> QE.
►Consumer benefits= A+B+D.
►Cost of supplying = B+D+C
►Market surplus = A-C
C
B
D
Q E QH
MB
Q
Market surplus is C lower at QH
than at QE.
Market surplus is lower at any output where QE ≠ Q.
Market surplus is maximized at QE.