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Chapter III
Demand , Supply, and
Equilibrium
The Single Market
J.F. O’Connor
1/19/05
Outline
• Self-sufficiency versus interdependence
• The economic problem and alternative ways
of solving it
• Monetary economy versus barter
• Demand and factors affecting demand
• Supply and factors affecting supply
• Equilibrium in the market
• Social Efficiency of the market equilibrium
• How does the equilibrium change when the
factors affecting demand and supply
change?
• Government intervention in the market:
price floor, price ceiling, tax and subsidy.
Two Contrasting Economies
• Self-sufficiency
(Subsistence):
• Each unit, individual
or family, produces the
goods and services
that it wants.
• Each unit consumes
what it produces.
• Kentucky 1770.
• Interdependent:
• Each unit produces
little if any of the
goods and services
that it wants.
• Each unit consumes
little if any of the
services that it
produces.
• Kentucky 2002
The Economic Problem
• What goods and services will be produced
and who will produce them? (Choice)
• How will the goods and services be
produced? ( Organization)
• For whom will the goods and services be
produced? (Distribution)
• Who makes economic decisions and by
what process? (System)
Solving the Economic Problem
• Not very complicated for the self-sufficient
units in a subsistence economy
• The modern economy, with its
specialization, needs a mechanism to:
a) bring potential buyers and sellers of each
product together
b) coordinate the plans of the specialized
individuals and groups
• A system of markets is one such mechanism
A Modern Market
• Barter economy: goods are exchanged for other
goods.
• Monetary economy: goods are exchanged for
money.
• We have talked about the value of oranges in
terms of apples. We could also value all the other
goods in the economy in terms of apples. Apples
would then be the unit of account. However, we
still have a problem in that we need a medium of
exchange and apples are not too convenient. So
we introduce money.
The Role of Money
•
•
•
•
The unit of account
The medium of exchange
A store of value
The importance of money in the market
process is that it allows one to sell what one
has without having to find a buyer who is
selling what you want to buy.
Two Kinds Of Money
• Currency
• Demand deposits - what is in your checking
account.
• Be careful to distinguish income, wealth,
and money.
A Single Market
• One good, say, ice cream, and two kinds of
people:
– Buyers
– Sellers
• Demand represents the intentions of
buyers.
• Supply represents the intentions of
sellers.
Demand
• Demand gives the relationship between the
quantity of the good that buyers are willing
and able to purchase and the price of the
good, while other factors affecting quantity
demanded are held constant.
• We can represent demand in a table, a
graph, or an equation. Accordingly, we talk
about a demand schedule, curve, or
function.
Factors Affecting Demand
•
•
•
•
•
•
Prices of other goods
Income of buyers
Preferences or tastes of buyers
Number of buyers
Expectations about prices
Advertising ?
Two buyers,
Cath and Nick
Demand Schedules
Price
Cath
0
0.5
1
1.5
2
2.5
3
3.5
Nick
12
10
8
6
4
2
0
Market
7
6
5
4
3
2
1
0
19
16
13
10
7
4
1
0
The market demand
is the sum of the
individual demands
Demand Curve
Market Demand
4
Price
3
2
1
0
0
2
4
6
8
10
Quantiy
12
14
16
18
20
Supply
• Supply is the relationship between the
quantity of the good that sellers are willing
and able to supply and the price of the good,
while other factors affecting quantity
supplied are constant.
• We can represent supply in a table, a graph,
or an equation. Accordingly, we talk about a
supply schedule, curve, or function.
Factors Affecting Supply
•
•
•
•
Input prices
Technology of production
Number of sellers
Expectations
Two sellers,
Ben and
Jerry
Supply Schedules
Price
Ben
0
0.5
1
1.5
2
2.5
3
Jerry
0
0
1
2
3
4
5
Market
0
0
0
2
4
6
8
0
0
1
4
7
10
13
Supply Curve
Market Supply
3.0
2.5
Price
2.0
1.5
1.0
0.5
0.0
0
2
4
6
8
Quantity
10
12
14
Market Equilibrium
• Balancing Demand and Supply.
• The equilibrium price is the price at which
the quantity demanded is equal to the
quantity supplied.
• If you have excess demand or excess supply
the market is not in equilibrium. Why?
• Excess demand (shortage) increases price;
excess supply (surplus) depresses price.
Market Demand and Supply
P ric e
$ / u n it
Q u a n t it y
Dem anded
Q u a n t it y
S u p p lie d
0
0.5
1
1.5
2
2.5
3
3.5
19
16
13
10
7
4
1
0
0
0
1
4
7
10
13
16
Equilibrium
price $2
quantity 7 units
Market Equilibrium
3.5
Supply
3.0
2.5
Price
2.0
1.5
Demand
1.0
0.5
0.0
0
1
2
3
4
5
6
7
8
9
10
11
Quantity
12
13
14
15
16
17
18
19
20
Markets and Social Welfare
• Social optimal quantity of a good
– The quantity that results in the maximum
possible economic surplus.
– The socially optimal quantity will occur
where the marginal cost equals the marginal
benefit.
• Economic efficiency
– Occurs when all goods and services are
produced and consumed at their respective
socially optimal levels.
Markets and Efficiency
• Efficiency Principle:
– Efficiency is an important social goal.
– Everyone can have a larger slice of a larger pie.
• Equilibrium Principle:
– A market in equilibrium leaves no unexploited
opportunities for individuals.
– No “cash on the table” remains.
– All opportunities for profit have been exploited.
• Efficiency occurs when:
– the market-demand curve captures all the marginal
benefits of the good.
– the market-supply curve captures all the marginal
costs of the good.
Terminology
• If the good’s price changes, you have a:
– “change in quantity demanded”
• A movement along the demand curve
– “change in quantity supplied”
• A movement along the supply curve
• If something else changes, you have a:
– “change in demand”
• A shift of the entire demand curve
– change in supply”
• A shift of the entire supply curve
Fig. 4.9
An Increase in the Quantity Demanded Versus
an Increase in Demand
Increase in Demand
• Means the demand curve shifts right
• Caused by factors other than the price of the
good:
– For a normal good, an increase in income
– An increase in the price of a substitute or
a decrease in the price of a complement
– An increase in the number of buyers
– Change in preferences
Increase in Demand
Increase in Demand
3.5
3.0
Supply
2.5
Price
2.0
Demand2
1.5
1.0
0.5
0.0
0
Demand1
1
2
3
4
5
6
7
8
9
10
11
Quantity
12
13
14
15
16
17
18
19
20
Increase in Demand
• Note that demand increases by 6 units but
the new equilibrium quantity is only 3 units
greater than old. Why?
• Note that the increase in demand results in a
movement up the supply curve.
• You should analyze a decrease in demand.
Increase in Supply
• Sellers are willing to supply more units of
the good at each price.
• Major Causes:
– decrease in input prices
– improvement in technology of production
– increase in the number of sellers
Increase in Supply
3.5
3.0
Supply
2.5
Price
2.0
1.5
1.0
0.5
0.0
Demand1
0
1
2
3
4
5
6
7
8
9
10
11
Quantity
12
13
14
15
16
17
18
19
20
Increase in Supply
• Increase in supply results in an increase in
the equilibrium quantity and a decrease in
price.
• Note that the increase in supply results in a
movement down the demand curve.
• You should analyze a decrease in supply
Free Markets and Equilibrium
• Free markets have an automatic tendency to
eliminate excess supply and excess demand.
– Surplus leads producers to decrease the price
– Shortage leads producers to increase the price
Reasons for Government Activity
• Efficiency Concerns:
Imperfect Competition
Externalities
Public goods
• Equity considerations:
Distribution of outcomes
Distribution of endowments
Legislation and Markets
• Market equilibrium does not mean that everyone
has what they want.
– E.G. a poor person may not be able to afford the item at
the equilibrium price.
• Legislators protect consumers by using:
– price ceilings
• A maximum allowable price specified by law
• Price signal is too low, so consumers want too much
• e.g. rent controls, limits on the price of gasoline
• Result in shortages
Legislation and Markets
• Legislators protect producers by using:
– price floors
• A minimum allowable price specified by law
• For example, price supports, minimum wage
• Price signal is too high, so consumers don’t want as
much.
• Result in surpluses
Fig. 4.6
An Unregulated Housing Market
Fig. 4.7
Rent Controls
Economists and the Poor
• Economists realize there are more effective
ways of helping the poor than violating the
free market system.
• Using rent controls or price ceilings results
in inefficiency for everyone.
• Using a direct income transfer to the poor is
a more efficient way to help.
Fig. 4.8
Price Controls in the Hamburger Market
and
Shifts in Supply
• Favorable changes to the producer shift
supply curve rightward.
– lower equilibrium price
– higher equilibrium quantity
• Unfavorable changes to the producer shift
supply leftward.
– higher equilibrium price
– lower equilibrium quantity
Fig. 4.10
The Effect on the Skateboard Market of
an Increase in the Price of Fiberglass
Shifts in Supply
•
•
•
•
Changes in the Cost of Production
Changes in Technology
Changes in Weather
Changes in Expectations
Fig. 4.11
The Effect on the Market for New Houses of a
Decline in Carpenters’ Wage Rates
Fig. 4.12
The Effect of Technical Change on the Market
for Manuscript Revisions
Shifts in Demand
•
•
•
•
•
Complements
Substitutes
Income
Preferences
Demand curve shifts rightward
– higher equilibrium price
– higher equilibrium quantity
• Demand curve shifts leftward
– lower equilibrium price
– lower equilibrium quantity
Fig. 4.13
The Effect on the Market for Tennis Balls of
a Decline in Court Rental Fees
Complements
• Goods that are more valuable when used in
combination--e.g. tennis balls and tennis
courts.
• Two goods are complements in
consumption if an increase in the price of
one causes a leftward shift in the demand
curve for the other.
Substitutes
• Goods that replace each other--e.g. email
messages and overnight letters.
• Two goods are substitutes in consumption if
an increase in the price of one causes a
rightward shift in the demand curve for the
other.
Fig. 4.14
Effect on the Market for Overnight Letter
Delivery of a Decline in the Price of Internet
Access
Income
• Normal good
– One whose demand curve shifts right when the
incomes of buyers increase.
• Inferior good
– One whose demand curves shifts left when the
incomes of buyers increase.
Fig. 4.15
The Effect of a Federal Pay Raise on the
Rent for Conveniently Located Apartments
Simultaneous Shifts
• If, at the same time,
– Demand decreases and Supply increases
• Demand shifts left
– Lower price, lower quantity
• Supply shifts right
– Lower price, higher quantity
• We can predict that price will fall
• But, what happens to quantity?
– We must know the magnitude of the shifts
Fig. 4.16
Four Rules Governing the Effects of
Supply and Demand Shifts
Fig. 4.17
The Effects of Simultaneous Shifts in
Supply and Demand
Fig. 4.18
Seasonal Variation in the Air Travel and Corn
Markets
Economic System
• An economic system is a set of
arrangements for solving the economic
problem.
• Important Features:
– Ownership of resources
– Procedure for making decisions
– Objectives of decision makers
Alternative Systems
• Pure Capitalism
Private ownership
Decentralized
decision making
• Cooperative System
Communal ownership
Democratic decision
making
• Communal Command
Communal ownership
Centralized decision
making
• Mixed Systems
Democratic capitalism
Democratic socialism
Mixed Open Economy
• Consumer sovereignty
• Substantial private ownership and private
enterprise production.
• Substantial use of markets to guide resource
allocation.
• Substantial government activity
• Significant international trade