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Chapter 4 SUPPLY AND DEMAND McGraw-Hill/Irwin Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reserved. 4-2 Today’s lecture will: • Introduce the law of demand and draw a • • • demand curve. Explain the importance of substitution to the laws of supply and demand. Distinguish between a change in demand (shift in the curve) and a change in quantity demanded (movement along the demand curve). Explain the law of supply and construct a supply curve. McGraw-Hill/Irwin Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reserved. 4-3 Today’s lecture will: • • • • Distinguish between a change in supply (shift in the curve) and a change in quantity supplied (movement along the supply curve). Explain how the laws of supply and demand interact to bring about equilibrium. Show the effect of shifts in demand and supply on equilibrium price and quantity. Explore the limitations of demand and supply analysis. McGraw-Hill/Irwin Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reserved. 4-4 The Law of Demand • Law of demand – there is an inverse • relationship between price and quantity demanded. Other things equal: Quantity demanded rises as price falls Quantity demanded falls as price rises • Law of demand is based on the fact that people substitute for goods whose price increases. McGraw-Hill/Irwin Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reserved. 4-5 The Demand Curve • The demand curve is the graphic representation of the law of demand. The demand curve slopes downward and to the right. PB Price (per unit) • B A PA D 0 QB QA Quantity demanded (per unit of time) McGraw-Hill/Irwin Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reserved. 4-6 Change in quantity demanded $2 B A $1 0 Price (per 50 miles) Price (per 50 miles) Quantity Demanded Versus Demand Change in demand $2 B $1 D0 D1 100 175 200 Cars (per mile each hour) McGraw-Hill/Irwin A D1 200 Cars (per mile each hour) Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reserved. 4-7 Shift Factors of Demand • Shift factors of demand are factors • • • • • that cause changes in demand (shifts in the demand curve). Society’s Income Prices of Other Goods Tastes Expectations Taxes and Subsidies McGraw-Hill/Irwin Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reserved. 4-8 A Demand Table Price per DVD A B C D E $0.50 1.00 2.00 3.00 4.00 McGraw-Hill/Irwin DVD rentals demanded per week 9 8 6 4 2 Price per DVDs (in dollars) From a Demand Table to a Demand Curve $6.00 A Demand Curve 5.00 4.00 3.50 3.00 2.00 1.00 .50 0 E D G Demand for DVDs C F B A 1 2 3 4 5 6 7 8 9 10 111213 Quantity of DVDs demanded (per week) Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reserved. 4-9 Individual and Market Demand Curves Price per + Alice’s Bruce’s Carmen’s Market DVD demand + demand+ demand = demand A $.0.50 B 1.00 C 1.50 D 2.00 E 2.50 F 3.00 G 3.50 H 4.00 9 8 7 6 5 4 3 2 6 5 4 3 2 1 0 0 1 1 0 0 0 0 0 0 16 14 11 9 7 5 3 2 Price per DVD (in dollars) $4.00 3.50 3.00 2.50 2.00 1.50 G F Market demand E D C B 1.00 0.50 0 A Carmen BruceAlice 2 4 6 8 10 12 14 16 Quantity of DVDs demanded per week McGraw-Hill/Irwin Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reserved. 4-10 The Law of Supply • • • There is a direct relationship between price and quantity supplied. Other things constant: Quantity supplied rises as price rises. Quantity supplied falls as price falls. The law of supply occurs because: When prices rise, firms substitute production of one good for another. Assuming firms’ costs are constant, a higher price means higher profits. McGraw-Hill/Irwin Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reserved. 4-11 • • The supply curve is the graphic representation of the law of supply. The supply curve slopes upward to the right because quantity supplied varies directly with price. McGraw-Hill/Irwin Price (per unit) The Supply Curve S B PB PA 0 A QA QB Quantity supplied (per unit of time) Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reserved. 4-12 Price (per barrel) Quantity Supplied Versus Supply Movement along Supply Curve S1 C $80 $50 S0 B A Shift in Supply 4.1 4.3 4.6 Barrels per day (millions) McGraw-Hill/Irwin Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reserved. 4-13 Shift Factors of Supply • Price of Inputs • Technology • Expectations • Taxes and Subsidies McGraw-Hill/Irwin Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reserved. 4-14 Individual and Market Supply Market Price Ann + Barry + Charlie = supply (per DVD) A B C D E F G H I $0.00 0.50 1.00 1.50 2.00 2.50 3.00 3.50 4.00 0 1 2 3 4 5 6 7 8 0 0 1 2 3 4 5 5 5 0 0 0 0 0 0 0 2 2 0 $4.00 1 3.50 3 5 3.00 7 2.50 9 2.00 11 1.50 14 15 1.00 Charlie Barry 0.50 0 A1 Ann Market Supply I H G F E D C B CA 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 Quantity of DVDs supplied (per week) McGraw-Hill/Irwin Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reserved. 4-15 Equilibrium • Equilibrium is a concept in which • opposing forces cancel each other out. In a free market, the forces of supply and demand interact to determine: Equilibrium price – the price toward which the invisible hand drives the market. Equilibrium quantity – the amount bought and sold at the equilibrium price. McGraw-Hill/Irwin Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reserved. 4-16 Equilibrium Price (per DVD) QS $3.50 7 QD 3 Surplus(+) Shortage (-) +4 $2.50 5 5 0 $1.50 3 7 -4 Price per DVD $5.00 Excess supply 4.00 S 3.50 3.00 E 2.50 2.00 1.50 Excess demand 1.00 1 2 3 4 5 6 7 D 8 Quantity of DVDs supplied and demanded (per week) McGraw-Hill/Irwin Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reserved. 4-17 Shifts in Supply and Demand • Shifts in either supply or demand • change equilibrium price. An increase in demand or a decrease in supply: Creates excess demand at the original equilibrium price. Excess demand increases price until a new higher equilibrium price and quantity are reached. McGraw-Hill/Irwin Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reserved. 4-18 Increase in Demand S0 B $2.50 Excess demand A C 2.25 D0 0 McGraw-Hill/Irwin D1 8 9 10 Quantity of DVDs (per week) Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reserved. 4-19 Decrease in Supply S1 S0 C $2.50 2.25 B A Excess demand D0 0 McGraw-Hill/Irwin 8 9 10 Quantity of DVDs (per week) Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reserved. 4-20 Limitations of Supply and Demand Analysis • Sometimes supply and demand are • • interconnected. The other things constant assumption is likely not to hold when the goods represent a large percentage of the entire economy. The fallacy of composition is the false assumption that what is true for a part will also be true for the whole. McGraw-Hill/Irwin Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reserved. 4-21 Summary • The law of demand states that the • • quantity demanded rises as price falls, other things constant. The law of supply states that the quantity supplied rises as price rises, other things constant. The laws of demand and supply hold true because people can substitute. McGraw-Hill/Irwin Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reserved. 4-22 Summary • A change in quantity demanded • • (supplied), caused only by a change in the good’s own price, is a movement along the demand (supply) curve. A change in demand (supply) is a shift of the entire demand (supply) curve. Factors that affect supply and demand other than price are called shift factors. McGraw-Hill/Irwin Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reserved. 4-23 Summary Shift Factors of Demand Shift Factors of Supply Income Price of Inputs Prices of Other Goods Technology Tastes Expectations Expectations Taxes and Subsidies on Producers Taxes and Subsidies on Consumers McGraw-Hill/Irwin Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reserved. 4-24 Summary • • • • A market demand (supply) curve is the horizontal sum of all individual demand (supply) curves. When quantity demanded equals quantity supplied at equilibrium, prices have no tendency to change. When quantity demanded > quantity supplied, prices tend to rise. When quantity supplied > quantity demanded, prices tend to fall. McGraw-Hill/Irwin Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reserved. 4-25 Summary • When the demand curve shifts to the • right (left), equilibrium price rises (declines) and equilibrium quantity rises (falls). When the supply curve shifts to the right (left), equilibrium price declines (rises) and equilibrium quantity rises (falls). McGraw-Hill/Irwin Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reserved. 4-26 Given the following demand and supply of pizza: Price per Pizza Quantity Supplied Quantity Demanded $8 200 60 7 150 80 6 100 100 5 50 120 4 0 140 Review Question 4-1 What is the equilibrium price and quantity? Equilibrium price is $6 and equilibrium quantity is 100 pizzas. Review Question 4-2 If the price is $7, is there a shortage or surplus? How much is the shortage or surplus? Explain how the market will return to equilibrium. At a price of $7, there is a surplus of 150 - 80 = 70 pizzas. Producers will reduce the price in order to sell the surplus. As price decreases, quantity demanded increases until the surplus is eliminated at the equilibrium price of $6. McGraw-Hill/Irwin Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reserved.