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2 SUPPLY AND DEMAND I: HOW MARKETS WORK The Market Forces of Supply and Demand Copyright © 2011 Cengage Learning 4 Brief Outline of Today’s Lecture • What is a market? • Types of markets • From perfectly competitive to monopoly • Perfectly competitive markets • Definition, demand, supply, equilibrium, changes in equilibrium • Prices as signals guiding economic decisions. • Smith’s invisible hand. Copyright © 2011 Cengage Learning Supply and Demand • Supply and demand are the two words that economists use most often. • Supply and demand are the forces that make market economies work. • Modern microeconomics is about supply, demand, and market equilibrium. Copyright © 2011 Cengage Learning MARKETS AND COMPETITION • A market is a group of buyers and sellers of a particular good or service. • The terms supply and demand refer to the behaviour of people . . . as they interact with one another in markets. Copyright © 2011 Cengage Learning MARKETS AND COMPETITION • Buyers determine demand. • Sellers determine supply. Copyright © 2011 Cengage Learning Competition: Perfect and Otherwise • Perfect Competition • Products are the same • Numerous buyers and sellers so that each has no influence over price • Buyers and Sellers are price takers • A competitive market is a market in which there are many buyers and sellers so that each has a negligible impact on the market price. Copyright © 2011 Cengage Learning Competition: Perfect and Otherwise • Monopoly • One seller, and seller controls price • Oligopoly • Few sellers • Not always aggressive competition • Monopolistic Competition • Many sellers • Slightly differentiated products • Each seller may set price for its own product Copyright © 2011 Cengage Learning DEMAND • Quantity demanded is the amount of a good that buyers are willing and able to purchase. • Law of Demand • The law of demand is the claim that, other things equal, the quantity demanded of a good falls when the price of the good rises. Copyright © 2011 Cengage Learning The Demand Curve: The Relationship between Price and Quantity Demanded • Demand Schedule • The demand schedule is a table that shows the relationship between the price of the good and the quantity demanded. Copyright © 2011 Cengage Learning Sabine’s Demand Schedule Copyright © 2011 Cengage Learning The Demand Curve: The Relationship between Price and Quantity Demanded • Demand Curve • The demand curve is a graph of the relationship between the price of a good and the quantity demanded. Copyright © 2011 Cengage Learning Figure 1 Sabine’s Demand Schedule and Demand Curve Copyright©2011 South-Western Market Demand versus Individual Demand • Market demand refers to the sum of all individual demands for a particular good or service. • Individual demand: how? • Preferences → utility functions → optimal choice • Graphically, individual demand curves are summed horizontally to obtain the market demand curve. Copyright © 2011 Cengage Learning Figure 2 Market Demand as the Sum of Individual Demands Copyright Copyright © 2011 © 2011 Cengage Cengage Learning Learning Change in Quantity Demanded • Movement along the demand curve. • Caused by a change in the price of the product. • For instance through the introduction of a tax. Copyright © 2011 Cengage Learning Changes in Quantity Demanded Price of IceCream Cones B €2.00 A tax that raises the price of ice-cream cones results in a movement along the demand curve. A €1.00 D 0 4 8 Quantity of Ice-Cream Cones Copyright © 2011 Cengage Learning Shifts in the Demand Curve • A shift in the demand curve, either to the left or right. • Caused by any change (other than price) that alters the quantity demanded at every price. Copyright © 2011 Cengage Learning Figure 3 Shifts in the Demand Curve Price of Ice-Cream Cones Increase in demand Decrease in demand Demand curve, D2 Demand curve, D1 Demand curve, D3 0 Quantity of Ice-Cream Cones Copyright©2011 South-Western Shifts in the Demand Curve … … are caused by changes in: • • • • • Consumer income Prices of related goods Tastes Expectations (e.g., future income, future prices) Number of buyers Copyright © 2011 Cengage Learning Shifts in the Demand Curve … • … through a change in consumer income • As income increases (other things equal) the demand for a normal good will increase. • Examples: clothing, food, etc. • As income increases (other things equal) the demand for an inferior good will decrease. • Examples: bus rides, second-hand TV sets, etc. • Don’t confuse “inferior goods” with “bads” (things you would not pay for). • Examples: garbage, pollution, etc. Copyright © 2011 Cengage Learning Consumer Income Normal Good Price of IceCream Cones € 3.00 An increase in income... 2.50 Increase in demand 2.00 1.50 1.00 0.50 D1 0 1 2 3 4 5 6 7 8 9 10 11 12 D2 Quantity of Ice-Cream Cones Copyright © 2011 Cengage Learning Consumer Income Inferior Good Price of IceCream Cones € 3.00 2.50 A decrease in income... 2.00 Decrease in demand 1.50 1.00 0.50 D2 0 1 D1 2 3 4 5 6 7 8 9 10 11 12 Quantity of Ice-Cream Cones Copyright © 2011 Cengage Learning Shifts in the Demand Curve … • … through a change in prices of related goods • When a fall in the price of one good reduces the demand for another good, the two goods are called substitutes. • Examples: apples and oranges, margarine and butter, tea and coffee, etc. • When a fall in the price of one good increases the demand for another good, the two goods are called complements. • Examples: coffee and sugar, printers and ink cartridges, DVD players and DVDs, etc. Copyright © 2011 Cengage Learning Table 1 Variables That Influence Buyers Copyright©2010 South-Western SUPPLY • Quantity supplied is the amount of a good that sellers are willing and able to sell. • Law of Supply • The law of supply is the claim that, other things equal, the quantity supplied of a good rises when the price of the good rises. Copyright © 2011 Cengage Learning The Supply Curve: The Relationship between Price and Quantity Supplied • Supply Schedule • The supply schedule is a table that shows the relationship between the price of the good and the quantity supplied. Copyright © 2011 Cengage Learning Häagen’s Supply Schedule Copyright © 2011 Cengage Learning The Supply Curve: The Relationship between Price and Quantity Supplied • Supply Curve • The supply curve is the graph of the relationship between the price of a good and the quantity supplied. Copyright © 2011 Cengage Learning Figure 5 Häagen’s Supply Schedule and Supply Curve Copyright©2010 South-Western Market Supply versus Individual Supply • Market supply refers to the sum of all individual supplies for all sellers of a particular good or service. • Individual supply: how? • technology → profit functions → optimal choice • Graphically, individual supply curves are summed horizontally to obtain the market supply curve. Copyright © 2011 Cengage Learning Figure 6 Market Supply as the Sum of Individual Supplies Copyright Copyrigt©2010 Copyright © 2011 © 2011 Cengage Cengage Cengage Learning Learning Change in Quantity Supplied • Movement along the supply curve. • Caused by a change in the price of the product. Copyright © 2011 Cengage Learning Change in Quantity Supplied Price of IceCream Cones S C €3.00 €1.00 0 A rise in the price of ice cream cones results in a movement along the supply curve. A 1 5 Quantity of Ice-Cream Cones Copyright © 2011 Cengage Learning Shifts in the Supply Curve • A shift in the supply curve, either to the left or right. • Caused by a change in a determinant other than price. Copyright © 2011 Cengage Learning Figure 7 Shifts in the Supply Curve Price of Ice-Cream Cones Supply curve, S3 Decrease in supply Supply curve, S1 Supply curve, S2 Increase in supply 0 Quantity of Ice-Cream Cones Copyright©2011 South-Western Shifts in the Supply Curve … … are caused by changes in: • • • • Input prices Technology Expectations Number of sellers Copyright © 2011 Cengage Learning Table 2 Variables That Influence Sellers Copyright©2011 South-Western SUPPLY AND DEMAND TOGETHER • Equilibrium refers to a situation in which the price has reached the level where quantity supplied equals quantity demanded • such that there is no downward or upward pressure on price. Copyright © 2011 Cengage Learning SUPPLY AND DEMAND TOGETHER • Equilibrium Price • The price that balances quantity supplied and quantity demanded. • On a graph, it is the price at which the supply and demand curves intersect. • Equilibrium Quantity • The quantity supplied and the quantity demanded at the equilibrium price. • On a graph it is the quantity at which the supply and demand curves intersect. Copyright © 2011 Cengage Learning Figure 8 The Equilibrium of Supply and Demand Price of Ice-Cream Cones Supply € 2.00 Equilibrium Equilibrium price Equilibrium quantity 0 1 2 3 4 5 6 7 8 Demand 9 10 11 12 13 Quantity of Ice-Cream Cones Copyright©2011 South-Western Figure 9 Markets Not in Equilibrium (a) Excess Supply Price of Ice-Cream Cones Supply Surplus € 2.50 2.00 Demand 0 4 Quantity demanded 7 10 Quantity supplied Quantity of Ice-Cream Cones Copyright©2011 South-Western Equilibrium • Surplus • When price > equilibrium price, then quantity supplied > quantity demanded. • There is excess supply or a surplus. • Suppliers will lower the price to increase sales, thereby moving toward equilibrium. Copyright © 2011 Cengage Learning Figure 9 Markets Not in Equilibrium (b) Excess Demand Price of Ice-Cream Cones Supply € 2.00 1.50 Shortage Demand 0 4 Quantity supplied 7 10 Quantity of Quantity Ice-Cream demanded Cones Copyright©2011 South-Western Equilibrium • Shortage • When price < equilibrium price, then quantity demanded > the quantity supplied. • There is excess demand or a shortage. • Suppliers will raise the price due to too many buyers chasing too few goods, thereby moving toward equilibrium. Copyright © 2011 Cengage Learning Equilibrium • Law of supply and demand • The claim that the price of any good adjusts to bring the quantity supplied and the quantity demanded for that good into balance. Copyright © 2011 Cengage Learning Changes in Equilibrium • How do markets respond to changes in supply and demand? → Change in the market equilibrium • Assume market is initially in equilibrium (P1*, Q1*). • Then, some event shifts the demand or supply curve (or both). • Market will changes to a new equilibrium (P2*, Q2*). Copyright © 2011 Cengage Learning Three Steps to Analyzing Changes in Equilibrium 1. Decide whether the event shifts the supply or demand curve (or both). 2. Decide whether the curve(s) shift(s) to the left or to the right. 3. Use the supply and demand diagram to see how the shift affects equilibrium price and quantity. Copyright © 2011 Cengage Learning Figure 10 How an Increase in Demand Affects the Equilibrium Price of Ice-Cream Cones 1. Hot weather increases the demand for ice cream . . . Supply € 2.50 New equilibrium 2.00 2. . . . resulting in a higher price . . . Initial equilibrium D D 0 7 3. . . . and a higher quantity sold. 10 Quantity of Ice-Cream Cones Copyright©2011 South-Western Figure 11 How a Decrease in Supply Affects the Equilibrium Price of Ice-Cream Cones S2 1. An increase in the price of sugar reduces the supply of ice cream. . . S1 New equilibrium € 2.50 Initial equilibrium 2.00 2. . . . resulting in a higher price of ice cream . . . Demand 0 4 7 3. . . . and a lower quantity sold. Quantity of Ice-Cream Cones Copyright©2011 South-Western Figure 12 A Shift in Both Supply and Demand (i) (1) Copyright © 2011 Cengage Learning Copyright © 2011 Cengage Learning Figure 12 A Shift in Both Supply and Demand (i) (2) Copyright © 2011 Cengage Learning Copyright © 2011 Cengage Learning Figure 13 A Shift in Both Supply and Demand (ii) (1) Copyright © 2011 Cengage Learning Copyright © 2011 Cengage Learning Figure 13 A Shift in Both Supply and Demand (ii) (2) Copyright © 2011 Cengage Learning Copyright © 2011 Cengage Learning Figure 13 A Shift in Both Supply and Demand (ii) (3) Copyright © 2011 Cengage Learning Copyright © 2011 Cengage Learning Table 4 What Happens to Price and Quantity When Supply or Demand Shifts? Copyright©2011 South-Western Some maths (1) The demand equation: QD = a - bP (1) where QD denotes the quantity demanded, P the price while a and b are two positive constants. The supply equation: QS = c + dP (2) where QS s the quantity supplied, while c and d are two constants. We assume that the constant d is positive. Copyright © 2011 Cengage Learning Some maths (2) Market equilibrium is where quantity demanded equals quantity supplied: QD = QS a bP c dP bP dP a c P(b d ) a c P* Q * Q D ( P * ) QS ( P * ) ac bd ad bc bd P* is the equilibrium price that equates quantity demanded and quantity supplied. Copyright © 2011 Cengage Learning What, how and for whom? • The market: • decides how much of a good should be produced • by finding the price at which the quantity demanded equals the quantity supplied • tells us for whom the goods are produced • those consumers willing to pay the equilibrium price • determines what goods are being produced • there may be goods for which no consumer is prepared to pay a price at which firms would be willing to supply Copyright © 2011 Cengage Learning The Invisible Hand Invisible hand: • the tendency of market prices to direct individuals pursuing their own self interests into productive activities that also promote the economic well-being of society. • This direction, provided by markets, is a key to economic progress. Copyright © 2011 Cengage Learning The Invisible Hand “Every individual is continually exerting himself to find out the most advantageous employment for whatever capital [income] he can command. It is his own advantage, indeed, and not that of the society which he has in view. But the study of his own advantage naturally, or rather necessarily, leads him to prefer that employment which is most advantageous to society. . . . He intends only his own gain, and he is in this, as in many other cases, led by an invisible hand to promote an end which was not part of his intention.” – Adam Smith, The Wealth of Nations (1776) Copyright © 2011 Cengage Learning Prices Prices: Coordinating Actions of Market Participants • Price changes coordinate the choices of buyers and sellers and bring them into harmony. • Price changes create profits and losses which change production levels for products. • Example: • Suppose, consumers develop an increased taste for rice and rice products. • This increases demand, pushing the price up. • Increased price provides incentives to producers to produce more rice. • Thus it is the price of rice that signals our wants and desires. Copyright © 2011 Cengage Learning Markets Markets: Motivating Economic Participants • Suppliers have an incentive to produce efficiently (at a low cost). • Entrepreneurs have an incentive to both innovate and produce goods that are highly valued relative to cost. • Resource owners have an incentive both to develop and supply resources that producers value highly. Copyright © 2011 Cengage Learning Summary • Economists use the model of supply and demand to analyze competitive markets. • In a competitive market, there are many buyers and sellers, each of whom has little or no influence on the market price. Copyright © 2011 Cengage Learning Summary • The demand curve shows how the quantity of a good depends upon the price. • According to the law of demand, as the price of a good falls, the quantity demanded rises. Therefore, the demand curve slopes downward. • In addition to price, other determinants of how much consumers want to buy include income, the prices of complements and substitutes, tastes, expectations, and the number of buyers. • If one of these factors changes, the demand curve shifts. Copyright © 2011 Cengage Learning Summary • The supply curve shows how the quantity of a good supplied depends upon the price. • According to the law of supply, as the price of a good rises, the quantity supplied rises. Therefore, the supply curve slopes upward. • In addition to price, other determinants of how much producers want to sell include input prices, technology, expectations, and the number of sellers. • If one of these factors changes, the supply curve shifts. Copyright © 2011 Cengage Learning Summary • Market equilibrium is determined by the intersection of the supply and demand curves. • At the equilibrium price, the quantity demanded equals the quantity supplied. • The behaviour of buyers and sellers naturally drives markets toward their equilibrium. Copyright © 2011 Cengage Learning Summary • To analyze how any event influences a market, we use the supply and demand diagram to examine how the even affects the equilibrium price and quantity. • In market economies, prices are the signals that guide economic decisions and thereby allocate resources. Copyright © 2011 Cengage Learning