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Demand, Supply and Equilibrium Contents ● Deriving the Supply Curve ● Supply and Demand Equilibrium ● Effects of Demand and Supply Shifts on Equilibrium ● Welfare Properties of Equilibrium ● Fighting the Invisible Hand: The Market Fights Back Copyright© 2006 South-Western/Thomson Learning. All rights reserved. The Invisible Hand ● Supply and demand automatic solution to economic problems ● Interference in markets counterproductive consequences ● Invisible hand = in the pursuit of selfinterest, individuals promote social wellbeing Copyright© 2006 South-Western/Thomson Learning. All rights reserved. Deriving Supply Curve ● Recall example with garages from previous lecture ● Consider the cost schedule for Al Copyright© 2006 South-Western/Thomson Learning. All rights reserved. 1: Al’s Total, Average, and Marginal Costs TABLE Copyright © South-Western/Thomson 2006 South-Western/Thomson Learning. rightsreserved. reserved. Copyright© 2006 Learning. AllAll rights Marginal Cost per Added Garage (thousands $) FIGURE 1: Marginal Cost Curve 50 MC 45 40 35 30 25 20 15 10 5 0 1 2 3 4 5 6 7 8 Output, Garages per Year (c) Marginal Cost 9 10 Copyright © South-Western/Thomson 2006 South-Western/Thomson Learning. rightsreserved. reserved. Copyright© 2006 Learning. AllAll rights Supply Curve ● Supply curve of a firm is the increasing part of its marginal cost curve ● Why only increasing part? ♦ Because when MC decrease with Q, it is optimal to increase output Copyright© 2006 South-Western/Thomson Learning. All rights reserved. 2: Marginal Cost Curve and Supply Curve Marginal Cost per Added Garage (thousands $) FIGURE 50 MC 45 40 35 Supply Curve 30 25 20 15 10 5 0 1 2 3 4 5 6 7 8 Output, Garages per Year Marginal Cost 9 10 Copyright © South-Western/Thomson 2006 South-Western/Thomson Learning. rightsreserved. reserved. Copyright© 2006 Learning. AllAll rights From Individual to Market Supply ● We derived supply of single firm ● In every market there are usually many producers ● The market supply is a sum of all individual supply curves Copyright© 2006 South-Western/Thomson Learning. All rights reserved. Supply and Quantity Supplied ● Sellers (producers) supply ● Quantity supplied = amount that producers wish to sell at each price ● Law of supply = price and the quantity supplied are positively related, all else equal Copyright© 2006 South-Western/Thomson Learning. All rights reserved. 2 Supply Schedule for Milk TABLE Copyright© 2006 South-Western/Thomson Learning. All rights reserved. Supply and Quantity Supplied ● The Supply Schedule and the Supply Curve ♦ Supply Schedule = a table showing the quantity of demand at each price for some good ♦ Supply Curve = graph of a supply schedule ■Positive slope Copyright© 2006 South-Western/Thomson Learning. All rights reserved. 3 Supply Curve for Milk FIGURE a $1.50 S b Price per Quart 1.40 c 1.30 e 1.20 f 1.10 g 1.00 h .90 0 S 30 40 50 60 70 80 90 Quantity Supplied in Billions of Quarts per Year Copyright© 2006 South-Western/Thomson Learning. All rights reserved. Supply and Quantity Supplied ● Shifts of the Supply Curve ♦ Movement along a supply curve due to ■Changes in price ♦ Shift between supply curves due to ■Changes in industry size (entry and exit) ■Changes in production technology ■Changes in prices of inputs ■Changes in prices of related outputs Copyright© 2006 South-Western/Thomson Learning. All rights reserved. 4 Movements along versus Shifts of a Supply Curve FIGURE S0 Price per Quart S1 c $1.30 f 1.10 S0 S1 Quantity Supplied in Billions of Quarts per Year Copyright© 2006 South-Western/Thomson Learning. All rights reserved. 5 Shifts of the Supply Curve FIGURE S2 S0 Price S1 S0 Price S0 S2 S1 S0 Quantity (a) Quantity (b) Copyright© 2006 South-Western/Thomson Learning. All rights reserved. Refresher on Demand ● Buyers demand ● Quantity demanded = the amount that buyers wish to purchase at each price ● Law of demand = price and the quantity of demand are negatively related, all else equal Copyright© 2006 South-Western/Thomson Learning. All rights reserved. Refresher on Demand ● The Demand Schedule ♦ Table showing the quantity of demand at each price for some good Copyright© 2006 South-Western/Thomson Learning. All rights reserved. 3 Demand Schedule for Milk TABLE Copyright© 2006 South-Western/Thomson Learning. All rights reserved. Demand and Quantity Demanded ● The Demand Curve ♦ Graph of a demand schedule ♦ Negative slope Copyright© 2006 South-Western/Thomson Learning. All rights reserved. FIGURE 6 Demand Curve for Milk Price per Quart D $1.50 A B 1.40 C 1.30 E 1.20 F 1.10 G 1.00 H .90 D 0 45 50 55 60 65 70 75 Quantity Demanded in Billions of Quarts per Year Copyright© 2006 South-Western/Thomson Learning. All rights reserved. Demand and Quantity Demanded ● Shifts of the Demand Curve ♦ Movement along a demand curve due to ■Changes in price ♦ Shift between demand curves due to ■Changes in consumers’ incomes ■Changes in number of consumers (population) ■Changes in consumers’ preferences (tastes) ■Changes in prices and availability of related goods Copyright© 2006 South-Western/Thomson Learning. All rights reserved. 7 Movements along a versus Shifts of a Demand Curve FIGURE D1 Price per Quart D0 $1.30 1.10 C F D1 D0 Quantity Demanded in Billions of Quarts per year Copyright© 2006 South-Western/Thomson Learning. All rights reserved. Supply and Demand Equilibrium ● There is normally one price where quantity of supply = quantity of demand ● This price equilibrium ● An equilibrium price on the market is such that at this price quantity demanded is equal to the quantity supplied * * ● So equilibrium is a pair P ,Q Copyright© 2006 South-Western/Thomson Learning. All rights reserved. Supply and Demand Equilibrium ● Below equilibrium price shortage ● Above equilibrium price surplus ● Surpluses and shortages changes in price ● Changes in price restoration of equilibrium Copyright© 2006 South-Western/Thomson Learning. All rights reserved. 4 Equilibrium Price & Quantity of Milk TABLE Copyright© 2006 South-Western/Thomson Learning. All rights reserved. Supply and Demand Equilibrium ● Interaction of supply and demand equilibrium ● A market not in equilibrium equilibrium ● Equilibrium = a state of rest ● “Outside events” cause a change of the equilibrium Copyright© 2006 South-Western/Thomson Learning. All rights reserved. 8 Supply-Demand Equilibrium FIGURE D a A $1.50 S Price per Quart 1.40 1.30 E 1.20 1.10 g G 1.00 .90 0 D S 30 40 50 60 70 80 90 Quantity in Billions of Quarts per Year Copyright© 2006 South-Western/Thomson Learning. All rights reserved. Demand Shifts on SupplyDemand Equilibrium ● Shifts in Demand ♦ Changes in any of the non-price determinants of demand and/or supply change of equilibrium ♦ Shifts of the demand curve change equilibrium price and quantity in the same direction Copyright© 2006 South-Western/Thomson Learning. All rights reserved. 9 The Effects of Shifts of the Demand Curve FIGURE D1 S T $1.30 E 1.20 D0 Price per Quart Price per Quart D0 R S D2 E $1.20 L M 1.10 D1 D0 S 60 70 75 Quantity (a) D0 S D2 45 50 60 Quantity (b) Copyright© 2006 South-Western/Thomson Learning. All rights reserved. Supply Shifts and SupplyDemand Equilibrium ● Shifts in Supply ♦ Shifts of the supply curve change in equilibrium price and quantity in opposite directions ♦ Old equilibrium position new equilibrium position Copyright© 2006 South-Western/Thomson Learning. All rights reserved. 10 Effects of Shifts of the Supply Curve FIGURE S2 D S0 E I $1.20 J 1.10 S1 V Price per Quart Price per Quart D $1.40 S0 E U 1.20 S2 S0 S0 S1 D 60 Quantity (a) 65 D 78 37.5 50 60 Quantity (b) Copyright© 2006 South-Western/Thomson Learning. All rights reserved. Rule of Thumb ● When demand curve shifts, we move along the supply curve ● When supply curve shifts, we move along the demand curve ● Always draw a diagram to make sure you understand what happens Copyright© 2006 South-Western/Thomson Learning. All rights reserved. Sometimes we cannot say much… ● When both supply and demand curve shift, we usually have problems with predicting new equilibium: ♦ Can predict price, not quantity ♦ Or can predict quantity, not price ● Because it is the degree of shifts in both curves that determine the final outcome Copyright© 2006 South-Western/Thomson Learning. All rights reserved. Consumer Surplus ● Consumer Surplus is the difference between the maximum amount that the consumer is willing to pay for the product and the price that she actually gets to pay ● Graphically it is the area above the equilibrium price and below the market demand line Copyright© 2006 South-Western/Thomson Learning. All rights reserved. Producer Surplus ● Producer Surplus is the difference between the price at which the producer happens to sell the product and her costs (i.e. the smallest amount of money she is willing to accept in exchange for the product she offers) ● Graphically it is the area below the equilibrium price and above the market supply line Copyright© 2006 South-Western/Thomson Learning. All rights reserved. 11 Consumer and Producer Surplus FIGURE $1.50 D Price per Quart 1.40 1.30 S CS 1.20 1.10 PS 1.00 .90 0 30 40 50 60 70 80 90 Quantity in Billions of Quarts per Year Copyright© 2006 South-Western/Thomson Learning. All rights reserved. Some Geometry Refresher ● Area of the triangle: 1 S base height 2 ● Let us compute these for the example we just had Copyright© 2006 South-Western/Thomson Learning. All rights reserved. Calculating CS and PS ● CS: ♦ base = 60 − 0 = 60 ♦ height = 1.50 − 1.20 = 0.3 ♦ Area = 0.5 * 60 * 0.3 = $9 bln ● PS: ♦ base = 60 − 0 = 60 ♦ height = 1.20 − 1.00 = 0.2 ♦ Area = 0.5 * 60 * 0.2 = $6 bln Copyright© 2006 South-Western/Thomson Learning. All rights reserved. Total Surplus and Welfare ● Welfare is understood in economics as some measure of well-being of agents ♦ We saw an example – utility of consumer ● For market with many agents, natural measure is Total Surplus (TS) ● TS = CS + PS ● In previous example, TS = 9 + 6 = $15 bln Copyright© 2006 South-Western/Thomson Learning. All rights reserved. Why Market Economy? ● We like free market economy because it maximizes Total Surplus ● Only those buyers with high willingness to pay buy ● Only those sellers with low costs sell ● Total Surplus is the biggest possible in this case ● This says nothing about equality! Copyright© 2006 South-Western/Thomson Learning. All rights reserved. Fighting the Invisible Hand: The Market Fights Back ● A Can of Worms ♦ Favoritism and corruption ♦ Unenforceability ♦ Limitation of the volume of transactions ♦ Misallocation of resources ● Let us see what our model predicts about fighting the invisible hand Copyright© 2006 South-Western/Thomson Learning. All rights reserved. Welfare Analysis of Policies Copyright© 2006 South-Western/Thomson Learning. All rights reserved. Benchmark Case ● We first analyze the case when the market system works on its own ● This is the benchmark case ● We will show all other cases decrease TS ● Here CS = A + B + C ● PS = H + L + G ● TS = A + B + C + H + L + G Copyright© 2006 South-Western/Thomson Learning. All rights reserved. Benchmark Case Copyright© 2006 South-Western/Thomson Learning. All rights reserved. Price Ceiling ● Now suppose government introduces price ceiling ● Must be below P2, say, P3 ● What are CS, PS, TS now? ● Since at P3 quantity demanded exceeds quantity supplied, there is shortage ● So only Q 1 units are sold Copyright© 2006 South-Western/Thomson Learning. All rights reserved. Price Ceiling Copyright© 2006 South-Western/Thomson Learning. All rights reserved. Price Ceiling ● Here CS = A + B + G ● PS = L ● TS = A + B + L + G ● Notice the blue triangle C + H is now NOT in the TS ● This is called Dead Weight Loss (DWL) – measure of inefficiency Copyright© 2006 South-Western/Thomson Learning. All rights reserved. Fighting the Invisible Hand: The Market Fights Back ● Restraining the Market Mechanism: Price Ceilings ♦ Shortages ♦ Black markets with higher prices ♦ Underinvestment ♦ Vested interests that resist change Copyright© 2006 South-Western/Thomson Learning. All rights reserved. Price Floor ● Now suppose government introduces price floor ● Must be above P2, say, P1 ● What are CS, PS, TS now? ● Since at P1 quantity supplied exceeds quantity demanded, there is surplus ● Again only Q1 units are sold Copyright© 2006 South-Western/Thomson Learning. All rights reserved. Price Floor Copyright© 2006 South-Western/Thomson Learning. All rights reserved. Price Floor ● Here CS = A ● PS = L + B + G ● TS = A + B + L + G ● Notice the blue triangle C + H is now NOT in the TS again ● So we again have DWL from interfering with the market mechanism Copyright© 2006 South-Western/Thomson Learning. All rights reserved. Fighting the Invisible Hand: The Market Fights Back ● Restraining the Market Mechanism: Price Floors ♦ Surpluses ♦ Disposal problems ♦ Overinvestment ♦ Vested interests that resist change Copyright© 2006 South-Western/Thomson Learning. All rights reserved. More Complicated Example ● By simply fixing price we make some group better off at the expense of the other group ● Total result is negative, however ● Maybe government can help? ● Suppose again fix price at P1 as a floor, but government buys all the surplus that consumers do not want to buy Copyright© 2006 South-Western/Thomson Learning. All rights reserved. More Complicated Example Extra Costs Copyright© 2006 South-Western/Thomson Learning. All rights reserved. More Complicated Example ● Clearly costs of government intervention do not compensate the extra gain for producer ● So intervention is in general not a good idea ● Later on in the course we will see examples when government intervention is beneficial Copyright© 2006 South-Western/Thomson Learning. All rights reserved. Tax Policy Analysis ● Suppose government wants to introduce a tax on producers ● There are many different taxes ● We consider the easiest – per-unit sales tax ● It means that producers have to pay a fixed amount of money to the government for every unit they have sold Copyright© 2006 South-Western/Thomson Learning. All rights reserved. Tax Policy Analysis ● Costs of producers stay the same ● So they translate tax into price one-for-one ♦ Suppose the government introduces a sales tax of 10 cents per gallon of milk ♦ This shifts supply curve up ♦ How much equilibrium changes is determined by demand elasticity ● However, all tax burden is split between consumer and producer Copyright© 2006 South-Western/Thomson Learning. All rights reserved. 10 Who Pays for a New Tax on Products? FIGURE Price per Gallon D S1 M $1.64 E1 1.60 S0 1.54 S1 E0 D S0 Q2 Q1 30 50 Millions of Gallons per Year Copyright© 2006 South-Western/Thomson Learning. All rights reserved. Tax Policy Analysis ● Notice that both consumers and producers pay tax, even though government wants to tax producers only ● How tax burden is split between consumers and producers? ♦ Depends on price elasticities of supply and demand ♦ Or, more precise, on the relative elasticity Copyright© 2006 South-Western/Thomson Learning. All rights reserved. A Simple But Powerful Lesson ● Self-interested actions of buyers and sellers laws of supply and demand ● Difficult to resist ● Interference counterproductive effects Copyright© 2006 South-Western/Thomson Learning. All rights reserved. The End Copyright© 2006 South-Western/Thomson Learning. All rights reserved.