Download Changes in Demand

03
Demand, Supply, and Market
Equilibrium
McGraw-Hill/Irwin
Copyright © 2012 by The McGraw-Hill Companies, Inc. All rights reserved.
Markets
• Interaction between buyers and
sellers
• Markets may be:
• Local
• National
• International
• Price is discovered in the interactions
of buyers and sellers
LO1
3-2
Demand
•Demand is a schedule or curve
that shows the various quantities
that consumers are willing and
able to buy at each possible price
during a specific period of time.
LO1
3-3
Law of Demand
• Other things equal, as price falls, the
quantity demanded rises, and as
price rises, the quantity demanded
falls.
• There is an inverse, or negative
relationship between price and Qd.
LO1
3-4
The Demand
Demand Curve
The
Curve
P
6
P Qd
$5 10
4 20
3 35
2 55
Price (per bushel)
5
4
3
2
1
D
1 80
0
10
20
30
40
50
60
70
80
Q
Quantity Demanded (bushels per week)
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3-5
Reasons for Down-sloping Demand
1. This relationship is consistent with
common sense. Price is an obstacle
that keeps consumers from buying.
2. Diminishing marginal utilityconsumers tend to derive less satisfaction
from each extra unit of a good consumed.
Because consumers get less added
satisfaction from additional units
consumed, they will only buy more units if
the price falls.
3. Income effect- as price falls the
purchasing power of money income
increases enabling the buyer to purchase
more of the product than before. A
higher price has the opposite effect.
4. Substitution effect- suggests that at a
lower price buyers have the incentive to
substitute what is now a less expensive
product for other products that are now
relatively more expensive.
On the next slide, we can derive
the market demand curve by
summing the quantity
demanded for each buyer at
each price.
Market Demand
Market Demand for Corn, Three Buyers
Quantity Demanded
Price
per bushel
$5
4
3
2
1
LO1
Total
Qd
per week
Joe
Jen
Jay
10
12
8
30
20
23
17
60
35
39
26
100
55
60
39
154
80
87
54
221
3-11
Changes in Demand
In constructing any demand curve
economists assume that price is the most
important influence on the amount
purchased. But economists know that
other factors can and do affect
purchases. These factors are called
determinants of demand and when they
change, the entire demand curve will
shift position.
Changes in Demand
P
6
Price (per bushel)
5
4
3
2
D2
1
D1
D3
0
2
4
6
8
10
12
14
16
18
Q
Quantity Demanded (bushels per week)
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3-13
Changes in Demand
P
6
Change in Demand
Price (per bushel)
5
Change in Quantity
Demanded
4
3
2
D2
1
D1
D3
0
2
4
6
8
10
12
14
16
18 Q
Quantity Demanded (bushels per week)
LO1
3-14
Determinants of Demand
1.Tastes- represent our likes and
dislikes and are affected by
advertising, fashions, fads, celebrity
endorsements and news reports. A
favorable change in demand will
shift the curve to the right. An
unfavorable change in demand will
shift it to the left.
LO1
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2.Number of Buyers- An increase in the
number of buyers will increase demand,
while a decrease in the number of buyers
will reduce demand. Some factors
influencing the number of buyers
include;
•Changes in communications
•Changes in medicine
•Immigration policies
•Trade agreements
3.Income- For most products a rise in income
causes an increase in demand. Consumers
typically buy more steaks, furniture, and
electronics as income increases. Products
whose demand varies directly with income are
called superior or normal goods. There are
some goods however, that will decrease in
demand as income increases. These are
products like used clothing, retread tires, and
generic brands at the grocery store. Goods
whose demand varies inversely with income
are called inferior goods.
Normal Goods
Inferior Goods
4.Substitutes- are products that can be
used in place of other products. When
the price of one good increases, the
demand for the substitute will also
increase.
5.Complements- are goods that are used
together. When the price of one good
increases, the demand for the
complement will fall. When goods are
unrelated, a change in the price of one
has little or no effect on the demand for
the other good.
6.Consumer expectations- the
expectation of some future event such
as future prices or future income can
affect demand today.
Determinants of Demand
Table 3.1 Determinants of Demand: Factors That Shift the Demand Curve
Determinant
Examples
Change in buyers’ tastes
Physical fitness rises in popularity, increasing the
demand for jogging shoes and bicycles; cell phone
popularity rises, reducing the demand for land-line
phones.
Change in the number of buyers
A decline in the birthrate reduces the demand for
children’s toys.
Change in income
A rise in incomes increases the demand for normal
goods such as restaurant meals, sports tickets, and
necklaces while reducing the demand for inferior
goods such as cabbage, turnips, and inexpensive
wine.
Change in the prices of related
goods
A reduction in airfares reduces the demand for bus
transportation (substitute goods); a decline in the price
of DVD players increases the demand for DVD movies
(complementary goods).
Change in consumer expectations
Inclement weather in South America creates an
expectation of higher future coffee bean prices,
thereby increasing today’s demand for coffee beans.
LO1
3-25
Change in Quantity Demanded
Changes in Quantity demanded- is a
movement along an existing demand
curve from one point to another because
of a change in price and price only. On
figure 3.3 this would be represented as a
movement from point a to b along
demand curve D1, not a shift in the
demand curve.
Supply
Supply is a schedule or curve
showing the various quantities that
firms are willing and able to supply
at each possible price during a
specific period of time.
LO2
3-27
Law of Supply
Law of Supply shows a positive or
direct relationship between price
and quantity supplied. As price rises,
so does quantity supplied and as
price falls, so does quantity supplied.
LO2
3-28
There is an assumption that as
output expands costs tend to rise
so producers need a higher price
to cover the increase in costs. This
is referred to as the low hanging
fruit phenomena. The resulting
supply curve is upward sloping as
in figure 3.4.
The Supply Curve
P
Qs
per
Week
$5
60
4
50
3
35
2
20
1
5
Price (per bushel)
Supply of Corn
Price
per
Bushel
S
5
4
3
2
1
0
10
20
30
40
50
60
70
Q
Quantity supplied (bushels per week)
LO2
3-30
Determinants of Supply
Again, economists assume the most
important factor influencing quantity
supplied is price, but other factors can and do
affect supply and when they do, the supply
curve shifts as in figure 3.5. The key idea is
that costs are a major factor underlying
supply curves. Anything that affects costs will
affect profits and therefore how much
producers are willing to supply.
Changes in Supply
P
$6
S3
S1
Price (per bushel)
5
4
Decrease
in supply
S2
3
2
Increase
in supply
1
0
2
4
6
8
10
12
14
16 Q
Quantity supplied (thousands of bushels per week)
LO2
3-32
Changes in Supply
P
$6
Change in Quantity
S3
Supplied
S1
5
Price (per bushel)
S2
4
3
2
Change in Supply
1
0
2
4
6
8
10
12
14
16 Q
Quantity supplied (thousands of bushels per week)
LO2
3-33
Determinants of Supply
1.Resource prices- Higher resource prices
raise production costs and assuming a
particular product price, squeeze profits.
The reduction in profits reduces the
incentive for firms to supply output. In
contrast, lower resource prices reduce
production costs and increase profits. So
now firms will be willing to supply greater
output at each price.
LO2
3-34
2.Technology- Improvements in
technology enable firms to produce
output with fewer resources. Because
resources are costly, using fewer of them
lowers production costs and increases
supply.
3.Taxes & Subsidies- Businesses treat most
taxes as costs. An increase in sales or
property taxes will increase production costs
and reduce supply. In contrast, subsidies are
taxes in reverse. If the government
subsidizes the production of a good, it in
effect lowers the producers costs and
increases supply.
4.Prices of other goods- Let’s look at
soccer balls and basketballs as an
example. If basketball prices rise because
of the NBA finals, soccer ball producers
may want to switch to producing
basketballs in order to increase profits.
This substitution in production results in
a decline in the supply of soccer balls.
5.Producer expectations- Changes in
expectations about the future price of a
product may affect the producer’s
current willingness to supply that
product. It is difficult, however, to
generalize about how a new expectation
of higher prices affects the present
supply of a product. Ex. Wheat farmers
vs. manufacturing firms.
6.Number of sellers- Other things
equal, the larger the number of
sellers, the greater the market
supply. The fewer the number of
sellers, the smaller the supply.
Determinants of Supply
Table 3.2 Determinants of Supply: Factors That Shift the Supply Curve
Determinant
Examples
Change in resource prices
A decrease in the price of microchips increases the
supply of computers; an increase in the price of crude
oil reduces the supply of gasoline.
Change in technology
The development of more effective wireless
technology increases the supply of cell phones.
Change in taxes and subsidies
An increase in the excise tax on cigarettes reduces the
supply of cigarettes; a decline in subsidies to state
universities reduces the supply of higher education.
Change in prices of other goods
An increase in the price of cucumbers decreases the
supply of watermelons.
Change in producer expectations
An expectation of a substantial rise in future log prices
decreases the supply of logs today.
Change in the number of suppliers
An increase in the number of tattoo parlors increases
the supply of tattoos; the formation of women’s
professional basketball leagues increases the supply
of women’s professional basketball games.
LO2
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Changes in Quantity Supplied
Changes in quantity supplied- is a
movement along the existing supply
curve as a result of a change in price. On
figure 3.5 this is shown as a movement
from point a to b along supply curve S1,
not a shift in the supply curve.
Market Equilibrium
We now bring together supply and demand to
determine how the equilibrium price and
quantity are established using figure 3.6. First
of all this will be a process of trial and error
because the producer, who sets the price,
doesn’t know what the best price is.
Graphically, the equilibrium price is indicated
by the intersection of the supply and demand
curves.
LO3
3-43
If the producer initially sets price above
the equilibrium price, he will know
because a surplus will result. Here he is
not able to sell all the units produced
because consumers don’t want to buy
them (Qs>Qd). To avoid being stuck
with unsold inventory he must lower
the price, and as he does the surplus
will eventually disappear as the market
moves back toward equilibrium.
If the price is below equilibrium, a shortage will
result. Now consumers are buying the product
faster than it can be produced (Qd>Qs). The
producer responds by raising price and again
the market moves back toward equilibrium.
Notice that any surpluses or shortages will only
be temporary. As price falls or rises, they will
disappear and equilibrium will be achieved
where the amount buyers want to buy is exactly
equal to what producers want to sell.
Market Equilibrium
6
6,000 Bushel
Surplus
P
Qd
$5
2,000
4
4,000
3
7,000
2
11,000
1
16,000
Price (per bushel)
5
S
4
3
2
7,000 Bushel
Shortage
1
0
2
4
67
8
10
P
Qs
$5
12,000
4
10,000
3
7,000
2
4,000
1
1,000
D
12
14
16
18
Bushels of Corn (thousands per week)
LO3
3-46
Rationing Functions of Prices
Rationing Function of Prices- The ability of the
competitive forces of supply and demand to
establish a price at which selling and buying
decisions are consistent is called the rationing
function of prices. A competitive market not
only rations goods to consumers but also
allocates society’s resources efficiently.
Remember our MB=MC analysis earlier.
LO3
3-47
Once equilibrium is achieved prices tend
to stay there until something throws it
out of equilibrium. Changes in supply
and/or demand can disrupt the current
equilibrium as seen in figure 3.7. There
are 8 possible scenarios to look at and
you should practice graphing them.
`
ChangesininDemand
Demand
and
Changes
andEquilibrium
Equilibrium
D increase:
P, Q
D decrease:
P, Q
P
P
S
S
D2
D3
D1
0
0
Increase in demand
LO4
D4
Decrease in demand
3-49
Changes
Supply` and
Equilibrium
Changes
in in
Demand
and
Equilibrium
S increase:
P, Q
S decrease:
P, Q
P
P
S1
S4
S2
D
D
0
0
Increase in supply
LO4
S3
Decrease in supply
3-50
Complex Cases
TABLE 3.3 Effects of Changes in Both Supply and Demand
Change in Supply Change in Demand
Effect on
Equilibrium Price
Effect on
Equilibrium
Quantity
1. Increase
Decrease
Decrease
Indeterminate
2. Decrease
Increase
Increase
Indeterminate
3. Increase
Increase
Indeterminate
Increase
4. Decrease
Decrease
Indeterminate
Decrease
LO4
3-51
Government Set Prices
Prices in most markets are free to rise
and fall to their equilibrium levels, no
matter how high or low those levels might
be. However, government sometimes
concludes that supply and demand will
produce prices that are unfairly high for
buyers or unfairly low for sellers. So
government may place legal limits on how
high or low a price may go.
LO5
3-52
Price Ceiling
Price ceiling- sets the maximum legal price
a seller may charge for a product or
service. Examples include gasoline,
wartime rationing, usury laws and rent
controls.
The rationale for imposing ceilings is that it
will enable consumers to obtain some
“essential” good or service that they could
not afford at the equilibrium price.
Figure 3.8 illustrates how the ceiling might
work for gasoline. A rising price of gasoline
would burden low and moderate income
households, which might pressure
government to act. To keep prices down,
the government imposes the ceiling at Pc
@ $3 gallon. In order for the ceiling to be
effective in helping households it must be
placed below the equilibrium. Once the
ceiling is imposed the rationing ability of
the free market is rendered ineffective.
The result is a chronic shortage of gasoline.
The ceiling prevents the usual market
adjustments which bids up price, inducing
more production and rationing some buyers
out of the market. The ceiling then creates
2 related problems.
•How will the available supply of gas be
divided among buyers.
•Black markets, in which gas is illegally
bought and sold at prices above the ceiling
will flourish.
Government Set Prices
P
$3.50 P0
S
ceiling
3.00 PC
D
Shortage
Qs
LO5
Q0
Qd
Q
3-56
Price Floors
Price floors- set the minimum legal price that
can be charged for a good or service. Examples
include agricultural products and minimum
wage.
Price floors above equilibrium prices are
usually invoked when society feels that the
free functioning of the market system has not
provided a sufficient income for certain groups
of resource suppliers or producers.
LO5
3-57
Figure 3.9 illustrates how the floor
might work for farm products, say
wheat.
Imposing the floor will create a surplus
of wheat.
The government may cope with the surplus
in 2 ways.
Restrict the supply using acreage
allotments or increase demand by
researching new uses for the product. These
actions may reduce the difference between
the equilibrium price and the floor price and
that way reduce the size of the surplus.
If this doesn’t work, then the government
must purchase the surplus output at the
floor price and store or dispose of it.
Price floors not only disrupt the rationing ability
of prices but distort resource allocation. Without
the price floor, the $2 equilibrium price of wheat
would cause financial losses and force high-cost
wheat producers to plant other crops or
abandon farming altogether. So society devotes
too many of its scarce resources to wheat
production and too few to producing other, more
valued goods and services. In addition,
consumers pay higher prices because of the
price floor. Taxpayers pay higher taxes to finance
the purchase of the surplus.
Good or Bad Policy?
Key Point: In all these cases, good
intentions lead to bad economic outcomes.
Government controlled prices cause
shortages or surpluses, distort resource
allocation, and produce negative side
effects
Government Set Prices
P
S
Surplus
floor
$3.00 Pf
2.00 P0
D
Q
Qd
LO5
Q0
Qs
3-62