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Chapter 3 The Supply and Demand Model Introduction • The supply and demand model can explain the following: Why are ticket scalpers for Final Four seats (or any sold-out sporting event) able to sell tickets for as much as $5000? Why do gasoline prices go up or down very easily? Why do rose prices rise significantly on Valentine’s Day? Demand • Demand – a relationship between price and the quantity demanded, all other things equal. • Price – the amount of money or other goods that one must pay to obtain a particular good. • Quantity Demanded – the quantity of a good that people want to buy at a given price during a specific time period. Demand Demand Schedule: a tabular representation of demand. The information it contains describes the quantity of a good that a buyer is willing to purchase at different prices. The Demand Curve Demand Curve: a graph of demand showing the downward-sloping relationship between price and quantity demanded. Figure 1: The Demand Curve The Law of Demand • Law of Demand: the tendency for the quantity demanded of a good to decline as its price rises. • Note: For a demand curve to be consistent with the Law of Demand, the demand curve must be downward sloping. The Law of Demand According to the law of demand, a lower price will result in an increase in the quantity of the good that consumers are willing to buy, holding all else constant. Figure 1: The Demand Curve A lower price Leads to a higher quantity demanded Shifts in Demand Changes in the following can cause the demand curve to shift to the left or to the right: Consumers’ Preferences Consumers’ Information Consumers’ Income Number of Consumers in the Market Consumers’ Expectations of Future Prices Prices of Closely Related Goods a) Substitutes b) Complements Figure 2: A Shift in the Demand Curve Figure 2: A Shift in the Demand Curve Consumers’ Preferences Changes in consumers’ preferences or tastes for a product (relative to another product) will change the amount of they purchase at a given price. Example: • After September 11, 2001, more consumers were afraid to fly, resulting in a decrease in the demand for air travel. The demand for gasoline increased, as people chose to drive more to different destinations. Consumers’ Information New information available to consumers can result in a change in the quantity that consumers buy of a good, even though the price does not change. Examples: a) Car owners bought fewer Firestone tires once they learned of the mass recall of Firestone tires. b) Demand for Krispy Kreme doughnuts declined when people got information that eating fewer carbohydrates can facilitate weight loss (e.g., as in the Atkins diet). Consumers’ Incomes Normal Goods – goods for which demand increases when the consumers’ income rises and decreases when consumers’ income falls. Examples: a) Jewelry b) Luxury cars Consumers’ Incomes Inferior Goods – goods for which demand decreases when the consumers’ income rises and increases when consumers’ income falls. Examples: a) Instant noodles b) Bus tickets Number of Consumers in the Market More consumers in the market will likely result in a larger demand for the good or service, while fewer consumers will likely result in a smaller demand for the good or service. Example: The demand for electricity in your city increases as the population increases. Consumers’ Expectations of Future Prices Expectations of higher future prices will increase demand now. Expectations of lower future prices will decrease demand now. Example: Expectations of higher prices of gasoline in the future tend to make individuals fill up now. Prices of Closely Related Goods Substitute – a good that has many of the same characteristics as and can be used in place of another good. Examples: a) Coke is a substitute for Pepsi. b) Riding a car is a substitute for taking the bus. c) Downloading music is a substitute for buying music CDs. Prices of Closely Related Goods Complement – a good that is consumed or used together with another good. Examples: a) Gasoline is a complement to SUVs. b) Cream is a complement to coffee. Prices of Closely Related Goods If two goods are complements, then an increase in the price of one good will result in a decrease in the demand for the other good. If two goods are substitutes, then an increase in the price of one good will result in an increase in the demand for the other good. Figure 3: Shifts of versus Movements Along the Demand Curve Supply • Supply – a relationship between price and the quantity supplied, all other things equal. • Quantity Supplied – the quantity of a good that sellers want to sell at a given price during a specific time period. Supply Supply Schedule: a tabular representation of the supply curve. The Supply Curve Supply Curve: the graph of supply showing the upward relationship between price and quantity supplied. Figure 4: The Supply Curve The Law of Supply Law of Supply – the tendency for the quantity supplied of a good in a market to increase as its price rises. The Law of Supply According to the law of supply, a higher price will result in an increase in the quantity of the good that sellers are willing to sell, holding all else constant. A higher price Leads to a higher quantity supplied Figure 4: The Supply Curve Shifts in Supply Changes in the following can cause the supply curve to shift to the left or to the right: a) Technology b) Weather conditions c) Prices of inputs used in production d) Number of firms in the market e) Expected future selling price f) Government taxes, subsidies, and regulations Technology Anything that changes the amount that a firm can produce with a given amount of inputs can be considered a change in technology. Improvements in technology will correspond to an increase in supply. Example: Innovations that decrease the time it takes to produce cars Weather Conditions Droughts, earthquakes, and hurricanes affect how much of certain goods can be produced. Examples: a) An unusually cold winter in 2006 decreased citrus production in California. b) Hurricanes Katrina and Rita decreased oil production in Louisiana and Texas. The Price of Inputs Used in Production More expensive inputs (raw materials, land, and capital) increase the cost of production of goods and services, and may force the firm to sell less at a given price. Example: Higher steel prices in 2002 decreased the production of household appliances. The Number of Firms in the Market If the number of firms in the market increases, the supply curve shifts to the right. If the number of firms in the market decreases, the supply curve shifts to the left. Expectations of Future Prices Expectations of lower selling prices in the future will increase the supply today as firms decide to sell less in the future when prices are lower. Similarly, expectations of higher selling prices in the future will decrease the supply today as firms decide to sell more in the future when prices are higher. Government Taxes, Subsidies, and Regulations An increases in taxes (payments by firms to the government) or a decrease in subsidies (payment by the government to firms) will decrease supply. A decrease in taxes or an increase in the subsidies will increase supply. Government Taxes, Subsidies, and Regulations Regulations – government policies or rules that control the firm’s behavior. These regulations can affect the firm’s cost of production and thereby affect supply. Example: • Government requirements that food vendors pass sanitary inspection will reduce the number of vendors and decrease supply. Shifts versus Movement Movement Along the Supply Curve – occurs when a change in the quantity supplied of a good is brought along by a change in its price. A Shift in the Supply Curve – occurs when a change is brought along by any source other than the price. Figure 6: Shifts of versus Movements Figure 7: Overview of Supply and Demand Market Equilibrium Shortage (excess demand) – a situation in which the quantity demanded is greater than the quantity supplied. This occurs when the price in the market is below the equilibrium price. Surplus (excess supply) – a situation in which the quantity supplied is greater than the quantity demanded. This occurs when the current price in the market is above the equilibrium price. Market Equilibrium Equilibrium Price – the price at which the quantity that sellers are willing to sell equals the quantity that consumers are willing to purchase. Equilibrium Quantity – the quantity traded at the equilibrium price. Market Equilibrium – the situation where the price equals the equilibrium price and the quantity traded equals the equilibrium quantity. Finding the Equilibrium with a Supply and Demand Diagram If the price is below the equilibrium, a shortage occurs, causing the price to increase until the price reaches equilibrium. If the price is above the equilibrium, a surplus occurs, causing the price to decrease until the price reaches equilibrium. Figure 8: Equilibrium Price and Equilibrium Quantity Figure 8: Equilibrium Price and Equilibrium Quantity Effects of an Increase in Demand An increase in demand will shift the demand curve to the right, resulting in a higher equilibrium price and quantity. Figure 9(a): Effects of a Shift in Demand Effects of a Decrease in Demand A decrease in demand will shift the demand curve to the left, resulting in a lower equilibrium price and quantity. Figure 9(b): Effects of a Shift in Demand Effects of an Increase in Supply An increase in supply will shift the supply curve to the right, resulting in a lower equilibrium price and a higher equilibrium quantity. Figure 10(a): Effects of a Shift in Supply Effects of a Decrease in Supply A decrease in supply will shift the supply curve to the left, resulting in a higher equilibrium price and a lower equilibrium quantity. Figure 10(b): Effects of a Shift in Supply Using Supply and Demand to Analyze Real-World Issues Figure 11: Combined Effect of a Simultaneous Increase in Demand and Decrease in Supply of Gasoline Figure 12: Predicted Effects of Energy Policy Key Terms • • • • • • • • • • • demand price quantity demanded demand schedule law of demand demand curve normal good inferior good substitute complement supply • • • • • • • • • quantity supplied supply schedule law of supply supply curve shortage (excess demand) surplus (excess supply) equilibrium price equilibrium quantity market equilibrium