Download Chapter 3 - Supply and Demand

Chapter 3
Supply and Demand
INTRODUCTION TO ECONOMICS 2e / LIEBERMAN & HALL
CHAPTER 3 / SUPPLY AND DEMAND
©2005, South-Western/Thomson Learning
Slides by John F. Hall
Animations by Anthony Zambelli
Supply and Demand
 Supply
and demand is an economic
model
 Designed to explain how prices are
determined in certain types of markets
 What
you will learn in this chapter
 How the model of supply and demand
works and how to use it
 Strengths and limitations of model
Lieberman & Hall; Introduction to Economics, 2005
2
Markets


Specific location where buying and selling takes
place, such as
 Supermarket or a flea market
In economics, a market is not a place but rather
 A group of buyers and sellers with the potential to trade
with each other


Economists think of the economy as a collection of
individual markets
First step in an economic analysis is to define and
characterize the market or collection of markets to
analyze
Lieberman & Hall; Introduction to Economics, 2005
3
How Broadly Should We Define the
Market

Defining the market often requires
economists to group things together
 Aggregation is the combining of a group of
distinct things into a single whole

Markets can be defined broadly or narrowly,
depending on our purpose
 How broadly or narrowly markets are defined is
one of the most important differences between
Macroeconomics and Microeconomics
Lieberman & Hall; Introduction to Economics, 2005
4
Defining Macroeconomic Markets

Goods and services are aggregated to the
highest levels
 Macro models lump all consumer goods into the
single category “consumption goods”
 Macro models will also analyze all capital goods
as one market
 Macroeconomists take an overall view of the
economy without getting bogged down in details
Lieberman & Hall; Introduction to Economics, 2005
5
Defining Microeconomic Markets

Markets are defined narrowly
 Focus on models that define much more specific
commodities

Always involves some aggregation
 Stops short of the broad levels of generality that
macroeconomics investigates
Lieberman & Hall; Introduction to Economics, 2005
6
Buyers and Sellers



Buyers and sellers in a market can be
 Households
 Business firms
 Government agencies
All three can be both buyers and sellers in the
same market, but are not always
For purposes of simplification this text will usually
follow these guidelines
 In markets for consumer goods, we’ll view business firms
as the only sellers, and households as only buyers
 In most of our discussions, we’ll be leaving out the
“middleman”
Lieberman & Hall; Introduction to Economics, 2005
7
Competition in Markets



In imperfectly competitive markets, individual buyers or
sellers can influence the price of the product
In perfectly competitive markets (or just competitive
markets), each buyer and seller takes the market price as a
given
What makes some markets imperfectly competitive and
others perfectly competitive?
 Perfectly competitive markets have many small buyers and sellers
• Each is a small part of the market, and the product is standardized
 Imperfectly competitive markets have just a few large buyers and
sellers
• Or else the product of each seller is unique in some way
Lieberman & Hall; Introduction to Economics, 2005
8
Using Supply and Demand

Supply and demand model is designed to
explain how prices are determined in
perfectly competitive markets
 Perfect competition is rare but many markets
come reasonably close
 Perfect competition is a matter of degree rather
than an all or nothing characteristic

Supply and demand is one of the most
versatile and widely used models in the
economist’s tool kit
Lieberman & Hall; Introduction to Economics, 2005
9
Demand

A household’s quantity demanded of a good
 Specific amount household would choose to buy over
some time period, given
• A particular price that must be paid for the good
• All other constraints on the household

Market quantity demanded (or quantity demanded)
is the specific amount of a good that all buyers in
the market would choose to buy over some time
period, given
 A particular price they must pay for the good
 All other constraints on households
Lieberman & Hall; Introduction to Economics, 2005
10
Quantity Demanded

Implies a choice
 How much households would like to buy when they take into account
the opportunity cost of their decisions?

Is hypothetical
 Makes no assumptions about availability of the good
 How much would households want to buy, at a specific price, given
real-world limits on their spending power?

Stresses price
 Price of the good is one variable among many that influences
quantity demanded
 We’ll assume that all other influences on demand are held constant,
so we can explore the relationship between price and quantity
demanded
Lieberman & Hall; Introduction to Economics, 2005
11
The Law of Demand

States that when the price of a good rises and
everything else remains the same, the quantity of
the good demanded will fall
 The words, “everything else remains the same” are
important
• In the real world many variables change simultaneously
• However, in order to understand the economy we must first
understand each variable separately
• Thus we assume that, “everything else remains the same,” in
order to understand how demand reacts to price
Lieberman & Hall; Introduction to Economics, 2005
12
The Demand Schedule and the
Demand Curve

Demand schedule
 A list showing the quantity of a good that consumers
would choose to purchase at different prices, with all
other variables held constant

The market demand curve (or just demand curve)
shows the relationship between the price of a good
and the quantity demanded , holding constant all
other variables that influence demand
 Each point on the curve shows the total buyers would
choose to buy at a specific price

Law of demand tells us that demand curves
virtually always slope downward
Lieberman & Hall; Introduction to Economics, 2005
13
Figure 1: The Demand Curve
Price per
Bottle
$4.00
A
When the price is $4.00
per bottle, 40,000
bottles are demanded
(point A).
B
2.00
At $2.00 per bottle,
60,000 bottles are
demanded (point B).
D
40,000
Lieberman & Hall; Introduction to Economics, 2005
60,000
Number of Bottles
per Month
14
Shifts vs. Movements along the
Demand Curve


A change in the price of a good causes a
movement along the demand curve
In Figure 1
 A fall (rise) in price would cause a movement to the right
(left) along the demand curve


A change in income causes a shift in the demand
curve itself
In Figure 2
 Demand curve has shifted to the right of the old curve

(from Figure 1) as income has risen
A change in any variable that affects demand—except for
the good’s price—causes the demand curve to shift
Lieberman & Hall; Introduction to Economics, 2005
15
Figure 2: A Shift of the Demand Curve
An increase in income
shifts the demand curve
for maple syrup from D1
to D2. At each price, more
bottles are demanded
after the shift.
Price per
Bottle
B
C
$2.00
60,000
Lieberman & Hall; Introduction to Economics, 2005
D1
D2
80,000
Number of Bottles
per Month
16
Dangerous Curves: “Change in Quantity
Demanded” vs. “Change in Demand”

Language is important when discussing demand
 “Quantity demanded” means
• A particular amount that buyers would choose to buy at a specific
price
• It is a number represented by a single point on a demand curve
• When a change in the price of a good moves us along a demand
curve, it is a change in quantity demand
 The term demand means
• The entire relationship between price and quantity demanded—
and represented by the entire demand curve
• When something other than price changes, causing the entire
demand curve to shift, it is a change in demand
Lieberman & Hall; Introduction to Economics, 2005
17
Income: Factors That Shift the
Demand Curve

An increase in income has effect of shifting
demand for normal goods to the right
 However, a rise in income shifts demand for
inferior goods to the left

A rise in income will increase the demand for
a normal good, and decrease the demand for
an inferior good
Lieberman & Hall; Introduction to Economics, 2005
18
Wealth: Factors that Shift the Demand
Curve
Your wealth—at any point in time—is the
total value of everything you own minus the
total dollar amount you owe
 An increase in wealth will
 Increase demand (shift the curve rightward) for a

normal good
 Decrease demand (shift the curve leftward) for
an inferior good
Lieberman & Hall; Introduction to Economics, 2005
19
Prices of Related Goods: Factors that
Shift the Demand Curve

Substitute—good that can be used in place
of some other good and that fulfills more or
less the same purpose
 A rise in the price of a substitute increases the
demand for a good, shifting the demand curve to
the right

Complement—used together with the good
we are interested in
 A rise in the price of a complement decreases
the demand for a good, shifting the demand
curve to the left
Lieberman & Hall; Introduction to Economics, 2005
20
Other Factors that Shift the Demand
Curve

Population
 As the population increases in an area
• Number of buyers will ordinarily increase
• Demand for a good will increase

Expected Price
 An expectation that price will rise (fall) in the future shifts the current
demand curve rightward (leftward)

Tastes
 Combination of all the personal factors that go into determining how
a buyer feels about a good
 When tastes change toward a good, demand increases, and the
demand curve shifts to the right
 When tastes change away from a good, demand decreases, and the
demand curve shifts to the left
Lieberman & Hall; Introduction to Economics, 2005
21
Figure 3(a): Movements Along and
Shifts of the Demand Curve
Price
Price increase moves us
leftward along demand
curve
P2
Price increase moves us
rightward along demand
curve
P1
P3
Q2
Lieberman & Hall; Introduction to Economics, 2005
Q1
Q3
Quantity
22
Figure 3(b): Movements Along and
Shifts of the Demand Curve
Price
Entire demand curve shifts
rightward when:
• income or wealth ↑
• price of substitute ↑
• price of complement ↓
• population ↑
• expected price ↑
• tastes shift toward good
D2
D1
Quantity
Lieberman & Hall; Introduction to Economics, 2005
23
Figure 3(c): Movements Along and
Shifts of the Demand Curve
Price
Entire demand curve shifts
leftward when:
• income or wealth ↓
• price of substitute ↓
• price of complement ↑
• population ↓
• expected price ↓
• tastes shift toward good
D1
D2
Quantity
Lieberman & Hall; Introduction to Economics, 2005
24
Supply


A firm’s quantity supplied of a good is the specific
amount its managers would choose to sell over
some time period, given
 A particular price for the good
 All other constraints on the firm
Market quantity supplied (or quantity supplied) is
the specific amount of a good that all sellers in the
market would choose to sell over some time period,
given
 A particular price for the good
 All other constraints on firms
Lieberman & Hall; Introduction to Economics, 2005
25
Quantity Supplied

Implies a choice
 Quantity that gives firms the highest possible profits when they take
account of the constraints presented to them by the real world

Is hypothetical
 Does not make assumptions about firms’ ability to sell the good
 How much would firms’ managers want to sell, given the price of the
good and all other constraints they must consider?

Stresses price
 The price of the good is just one variable among many that
influences quantity supplied
 We’ll assume that all other influences on supply are held constant,
so we can explore the relationship between price and quantity
supplied
Lieberman & Hall; Introduction to Economics, 2005
26
The Law of Supply

States that when the price of a good rises
and everything else remains the same, the
quantity of the good supplied will rise
 The words, “everything else remains the same”
are important
• In the real world many variables change
•
•
simultaneously
However, in order to understand the economy we
must first understand each variable separately
We assume “everything else remains the same” in
order to understand how supply reacts to price
Lieberman & Hall; Introduction to Economics, 2005
27
The Supply Schedule and The
Supply Curve
Supply schedule—shows quantities of a
good or service firms would choose to
produce and sell at different prices, with all
other variables held constant
 Supply curve—graphical depiction of a
supply schedule
 Shows quantity of a good or service supplied at

various prices, with all other variables held
constant
Lieberman & Hall; Introduction to Economics, 2005
28
Figure 4: The Supply Curve
Price per
Bottle
When the price is $2.00
per bottle, 40,000 bottles
are supplied (point F).
$4.00
2.00
G
At $4.00 per bottle,
quantity supplied is
60,000 bottles (point G).
F
40,000
Lieberman & Hall; Introduction to Economics, 2005
S
60,000
Number of Bottles
per Month
29
Shifts vs. Movements along the
Supply Curve

A change in the price of a good causes a
movement along the supply curve
 In Figure 4
• A rise (fall) in price would cause a rightward (leftward) movement
along the supply curve

A drop in transportation costs will cause a shift in
the supply curve itself
 In Figure 5
• Supply curve has shifted to the right of the old curve (from Figure
4) as transportation costs have dropped
• A change in any variable that affects supply—except for the
good’s price—causes the supply curve to shift
Lieberman & Hall; Introduction to Economics, 2005
30
Figure 5: A Shift of the Supply Curve
Price per
Bottle
A decrease in transportation
costs shifts the supply curve for
maple syrup from S1 to S2.
S1
S2
At each price, more bottles
are supplied after the shift
$4.00
G
60,000
Lieberman & Hall; Introduction to Economics, 2005
J
80,000
Number of Bottles
per Month
31
Factors that Shift the Supply Curve

Input prices
 A fall (rise) in the price of an input causes an increase
(decrease) in supply, shifting the supply curve to the right
(left)

Price of Related Goods
 When the price of an alternate good rises (falls), the
supply curve for the good in question shifts rightward
(leftward)

Technology
 Cost-saving technological advances increase the supply
of a good, shifting the supply curve to the right
Lieberman & Hall; Introduction to Economics, 2005
32
Factors that Shift the Supply Curve

Number of firms
 An increase (decrease) in the number of
sellers—with no other changes—shifts the
supply curve to the right (left)

Expected price
 An expectation of a future price increase
(decrease) shifts the current supply curve to the
left (right)
Lieberman & Hall; Introduction to Economics, 2005
33
Factors that Shift the Supply Curve

Changes in weather
 Favorable weather


• Increases crop yields
• Causes a rightward shift of the supply curve for that crop
Unfavorable weather
• Destroys crops
• Shrinks yields
• Shifts the supply curve leftward
Other unfavorable natural events may effect all
firms in an area
 Causing a leftward shift in the supply curve
Lieberman & Hall; Introduction to Economics, 2005
34
Figure 6(a): Changes in Supply and
in Quantity Supplied
Price
S
Price increase moves
us rightward along
supply curve
P2
P1
Price increase moves
us leftward along
supply curve
P3
Q3
Lieberman & Hall; Introduction to Economics, 2005
Q1
Q2
Quantity
35
Figure 6(b): Changes in Supply and
in Quantity Supplied
Price
Entire supply curve shifts
rightward when:
• price of input ↓
• price of alternate good ↓
• number of firms ↑
• expected price ↑
• technological advance
• favorable weather
Lieberman & Hall; Introduction to Economics, 2005
S1
S2
Quantity36
Figure 6(c): Changes in Supply and
in Quantity Supplied
Price
Entire supply curve shifts
rightward when:
• price of input ↑
• price of alternate good ↑
• number of firms ↓
• expected price ↑
• unfavorable weather
Lieberman & Hall; Introduction to Economics, 2005
S2
S1
Quantity37
In Summary: Factors that Shift the
Supply Curve
The short list of shift-variables for supply that
we have discussed is far from exhaustive
 In some cases, even the threat of such
events can cause serious effects on
production
 Basic principle is always the same
 Anything that makes sellers want to sell more or

less of a good at any given price will shift supply
curve
Lieberman & Hall; Introduction to Economics, 2005
38
Equilibrium: Putting Supply and
Demand Together

When a market is in equilibrium
 Both price of good and quantity bought and sold have


settled into a state of rest
The equilibrium price and equilibrium quantity are values
for price and quantity in the market but, once achieved,
will remain constant
• Unless and until supply curve or demand curve shifts
The equilibrium price and equilibrium quantity can
be found on the vertical and horizontal axes,
respectively
 At point where supply and demand curves cross
Lieberman & Hall; Introduction to Economics, 2005
39
Figure 7: Market Equilibrium
Price per
Bottle
2. causes the price
to rise . . .
3. shrinking the
excess demand . . .
S
E
$3.00
1.00
H
4. until price reaches its
equilibrium value of $3.00
.
J
Excess Demand
D
1. At a price of $1.00 per
bottle an excess demand
of 50,000 bottles . . .
Lieberman & Hall; Introduction to Economics, 2005
25,000 50,000 75,000
Number of Bottles
per Month
40
Excess Demand: Putting Supply and
Demand Together
 Excess
demand
 At a given price, the excess of quantity
demanded over quantity supplied
 Price
of the good will rise as buyers
compete with each other to get more of
the good than is available
Lieberman & Hall; Introduction to Economics, 2005
41
Figure 8: Excess Supply and Price
Adjustment
Price per
Bottle
1. At a price of $5.00 per
bottle an excess supply
of 30,000 bottles . . .
Excess Supply at $5.00 S
$5.00
2. causes the
price to drop,
3.00
3. shrinking the
excess supply . . .
L
K
E
4. until price reaches its
equilibrium value of
$3.00.
D
35,000 50,000 65,000
Lieberman & Hall; Introduction to Economics, 2005
Number of Bottles
per Month
42
Excess Supply: Putting Supply and
Demand Together

Excess Supply
 At a given price, the excess of quantity supplied
over quantity demanded

Price of the good will fall as sellers compete
with each other to sell more of the good than
buyers want
Lieberman & Hall; Introduction to Economics, 2005
43
Income Rises: What Happens When
Things Change

Income rises, causing an increase in demand
 Rightward shift in the demand curve causes
rightward movement along the supply curve
 Equilibrium price and equilibrium quantity both
rise

Shift of one curve causes a movement along
the other curve to new equilibrium point
Lieberman & Hall; Introduction to Economics, 2005
44
Figure 9: A Shift in Demand and a
New Equilibrium
Price per
Bottle
4. Equilibrium
price
increases
3. to a new
equilibrium.
S
$4.00
3.00
2. moves us along
the supply
curve . . .
F'
E
1. An increase in
demand . . .
D2
D1
5. and equilibrium quantity
increases too.
Lieberman & Hall; Introduction to Economics, 2005
50,000 60,000
Number of Bottles of
Maple Syrup per Period
45
An Ice Storm Hits: What Happens
When Things Change

An ice storm causes a decrease in supply
 Weather is a shift variable for supply curve
• Any change that shifts the supply curve leftward in a
market will increase the equilibrium price

And decrease the equilibrium quantity in that market
Lieberman & Hall; Introduction to Economics, 2005
46
Figure 10: A Shift of Supply and a New
Equilibrium
Price per
Bottle
$5.00
3.00
S2
S1
E'
E
D
35,000 50,000
Lieberman & Hall; Introduction to Economics, 2005
Number of Bottles
47
Figure 11: Changes in the Market for
Handheld PCs
Price per
Handheld
PC
3. moved the market to
a new equilibrium.
2. and a decrease
in demand . . .
4. Price
decreased . . .
A
$500
B
S2002
S2003
1. An increase in
supply . . .
$400
D2002
5. and quantity
decreased as well.
D2003
2.45 3.33
Lieberman & Hall; Introduction to Economics, 2005
Millions of Handheld PCs
per Quarter
48
Both Curves Shift
When just one curve shifts (and we know the
direction of the shift) we can determine the
direction that both equilibrium price and
quantity will move
 When both curves shift (and we know the
direction of the shifts) we can determine the
direction for either price or quantity—but not
both
 Direction of the other will depend on which curve

shifts by more
Lieberman & Hall; Introduction to Economics, 2005
49
The Principle of Markets and
Equilibrium


The supply-and-demand model is just one example
of a more general approach
 To identify a market and examine its equilibrium
Basic Principle #4: Markets and Equilibrium
 To understand how the economy behaves, economists
organize the world into separate markets and then
examine the equilibrium in each of those markets

This approach helps us predict important changes
in the economy and prepare for them
 And it helps us predict important changes in the economy
our social goals and avoid policies that are likely to
backfire
Lieberman & Hall; Introduction to Economics, 2005
50
Price Ceilings


Government-imposed maximum price that prevents the
price of a good from rising above a certain level in a market
Short side of the Market
 Smaller of quantity supplied and quantity demanded at a particular
price
 When quantity supplied and quantity demanded differ, short side of
market will prevail


Price ceiling creates a shortage and increases the time and
trouble required to buy the good
 While the price decreases, the opportunity cost may rise
Black Market
 A market created by unintended consequences of government
intervention
• Goods are sold illegally at a price above the legal ceiling
Lieberman & Hall; Introduction to Economics, 2005
51
Figure 12: A Price Ceiling in the Market
for Maple Syrup
5. With a black market, the
lower quantity sells for a
higher price than initially.
Price per
Bottle
3. and decreases
quantity supplied.
4. The result is a shortage
– the distance between
S
R and V.
T
$4.00
3.00
R
2.00
E
V
2. increases quantity
demanded
D
40,000 50,000 60,000
1. A price ceiling lower than
the equilibrium price . . .
Lieberman & Hall; Introduction to Economics, 2005
Number of Bottles of
Maple Syrup per Period
52
Price Floors

Government imposed minimum amount below which price is
not permitted to fall
 Price floors for agricultural goods are commonly called price support
programs

When sellers produce more of the good than buyers want at
the price floor
 Remaining goods become a surplus that no one wants at the
imposed price

Government responds by maintaining price floors
 Uses taxpayer dollars to buy up entire excess supply of the good in
question
 Prevents excess supply from doing what it would ordinarily do
• Drive price down to its equilibrium value
Lieberman & Hall; Introduction to Economics, 2005
53
The Principle of Policy Tradeoffs

In our discussion of government intervention in
markets, you may have noticed something
interesting
 A policy designed to help us achieve one goal causes us
to compromise on some other goal

In fact, as you will see throughout this text, there
are virtually always tradeoffs involved in
government policy making
 For this reason, we consider government policy tradeoffs
to be one of the basic principles of economics
Lieberman & Hall; Introduction to Economics, 2005
54
The Principle of Policy Tradeoffs

Basic Principle #5: Policy Tradeoffs
 Government policy is constrained by the
reactions of private decision makers
 As a result, policy makers face tradeoffs
• Making progress toward one goal often requires some
sacrifice of another goal

Economics is famous for making the public
aware of policy tradeoffs
Lieberman & Hall; Introduction to Economics, 2005
55
Supply and Demand and Normative
Economics

Supply and demand offers us important lessons about the
economy
 The lessons are both positive
• Telling us what will happen when there is a change in a market
 And normative
• Suggesting what sorts of polices we should or should not pursue


Most economists believe that the mechanism of supply and
demand is an effective way to allocate resources
Why do economists feel this way?
 Answering this question requires a more thorough understanding of
the economy than we can provide after just three chapters of this
book
• However, when you finish your introductory study of economics, you will
know why economists treat supply and demand with such respect
Lieberman & Hall; Introduction to Economics, 2005
56
Using Supply and Demand: The
Invasion of Kuwait

Why did Iraq’s invasion of Kuwait cause the
price of oil to rise?
 Immediately after the invasion, United States led
a worldwide embargo on oil from both Iraq and
Kuwait
 A significant decrease in the oil industry’s
productive capacity caused a shift in the supply
curve to the left
• Price of oil increased
Lieberman & Hall; Introduction to Economics, 2005
57
Figure 13: The Market For Oil
Price per
Barrel of Oil
S2
S1
E'
P2
E
P1
D
Q2
Lieberman & Hall; Introduction to Economics, 2005
Q1
Barrels of Oil
58
Using Supply and Demand: The
Invasion of Kuwait
 Why
did the price of natural gas rise as
well?
 Oil is a substitute for natural gas
 Rise in the price of a substitute increases
demand for a good
 Rise in price of oil caused demand curve
for natural gas to shift to the right
• Thus, the price of natural gas rose
Lieberman & Hall; Introduction to Economics, 2005
59
Figure 14: The Market For Natural Gas
Price per Cubic
Foot of Natural
Gas
S
F'
P4
F
D2
P3
D1
Q3
Lieberman & Hall; Introduction to Economics, 2005
Q4
Cubic Feet of
Natural Gas
60