Download PowerPoint

Chapter 8
Supply and Demand: How
Markets Work
Market Exchange
• An enormous amount of activity is
conducted through an interesting human
invention: the market
• In fact, the definition of concepts such as the
GDP of an economy is output that is
produced but exchanged through markets.
• A lot of production takes place outside this
form of organization (consider your home)
Different kinds of markets
• There are ways in which markets differ, but a
very important way is in the number of buyers
and sellers in a market
• Competitive markets consist of many potential
buyers and sellers, each acting independently,
with no one participant having enough power
to dictate terms to any other
Types of Markets
One firm =
2-12 firms
many firms
Monopoly
Oligopoly
Monopolistic
Competition
many, many firms
Perfect
Competition
What happens on a market
• A market exchange is a transfer of title to a
piece of property (a good or a service) to
another party in return for some form of
payment on mutually accepted terms. It is
mostly a voluntary action
• The term market refers to the buying and
selling activities of all those who want to
trade (buy or sell) a particular good or
service
What gets determined on markets
• Markets work to determine two basic
economic outcomes: the price at
which a good or service is exchanged
and the quantity of it that will be
bought and sold.
• Alternative ways to do this?
A demand curve
• A demand curve is a graphical representation of
the buyers' side of the market. It shows how
much of a particular commodity the demanders
of this product will want to purchase at each
possible price, given their taste for the product
and the amount of money they have at their
disposal and other such factors which
determines demand.
• Demand refers to ability to purchase. Not need
or desire.
DEMAND
• Quantity demanded is the amount of a
good that buyers are willing and able to
purchase.
• Law of Demand
– The law of demand states that, other things
equal, the quantity demanded of a good falls
when the price of the good rises.
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.
Demand Schedule
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.
Demand Schedule and Demand Curve
Price of
Ice-Cream Cone
$3.00
2.50
1. A decrease
in price ...
2.00
1.50
1.00
0.50
0 1 2 3 4 5 6 7 8 9 10 11 12 Quantity of
Ice-Cream Cones
2. ... increases quantity
of cones demanded.
Copyright © 2004 South-Western
Market Demand versus Individual
Demand
• Market demand refers to the sum of all individual
demands for a particular good or service.
• Graphically, individual demand curves are summed
horizontally to obtain the market demand curve.
Sum up individual demand curves.
Assume A wants 2 cones at $10 and A wants 1 cone at
$20, B wants 3 @$10 and 2 @ $20. Total market
demand is 5 cones at $10, 3 cones @$20.
• Demand curves are usually downward sloping (why only
usually?)
Shifts in the Demand Curve
• Change in Quantity Demanded
– Movement along the demand curve.
– Caused by a change in the price of the
product.
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
Shifts in the Demand Curve
•
•
•
•
•
Consumer income
Prices of related goods
Tastes
Expectations
Number of buyers
Shifts in the Demand Curve
• Change in Demand
– A shift in the demand curve, either to the left
or right.
– Caused by any change that alters the quantity
demanded at every price.
Figure 3 Shifts in the Demand Curve
Price of
Ice-Cream
Cone
Increase
in demand
Decrease
in demand
Demand
curve, D2
Demand
curve, D1
Demand curve, D3
0
Quantity of
Ice-Cream Cones
Copyright©2003 Southwestern/Thomson Learning
Shifts in the Demand Curve
• Consumer Income
– As income increases the demand for a normal
good will increase.
– As income increases the demand for an
inferior good will decrease.
Price of IceCream Cone
Consumer Income
Normal Good
$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
Consumer Income
Inferior
Good
Price of Mac
and Cheese
$3.00
2.50
An increase
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
Mac and
Cheese
Shifts in the Demand Curve
• 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.
– When a fall in the price of one good increases
the demand for another good, the two goods
are called complements.
Variables That Influence Buyers
Copyright©2004 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 states that, other things
equal, the quantity supplied of a good rises
when the price of the good rises.
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.
Supply Schedule
Supplied
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.
Supply Schedule and Supply Curve
Price of
Ice-Cream
Cone
$3.00
1. An
increase
in price ...
2.50
2.00
1.50
1.00
0.50
0
1 2
3
4
5
6
7
8
9 10 11 12 Quantity of
Ice-Cream Cones
2. ... increases quantity of cones supplied.
Copyright©2003 Southwestern/Thomson Learning
Market Supply versus Individual Supply
• Market supply refers to the sum of all
individual supplies for all sellers of a
particular good or service.
• Graphically, individual supply curves are
summed horizontally to obtain the market
supply curve.
Shifts in the Supply Curve
•
•
•
•
Input prices
Technology
Expectations
Number of sellers
Shifts in the Supply Curve
• Change in Quantity Supplied
– Movement along the supply curve.
– Caused by a change in anything that alters
the quantity supplied at each price.
Perfectly Competitive Firm’s
Supply Curve
• The perfectly competitive firm’s supply curve is
its Marginal Cost Curve.
• Marginal Cost=Cost of Producing one more unit
of a good.
• Why?
• At every point along a market supply curve
– If price>marginal cost, a supplier would produce . If
price< marginal Cost, firm would not produce.
• Thus P=MC in a competitive market.
Change in Quantity Supplied
Price of IceCream
Cone
S
C
$3.00
A rise in the price
of Ice Cream
cones results in a
movement along
the supply curve.
A
1.00
0
1
5
Quantity of
Ice-Cream
Cones
Shifts in the Supply Curve
• Change in Supply
– A shift in the supply curve, either to the left or
right.
– Caused by a change in a determinant other
than price.
Shifts in the Supply Curve
Price of
Ice-Cream
Cone
Supply curve, S3
Decrease
in supply
Supply
curve, S1
Supply
curve, S2
Increase
in supply
0
Quantity of
Ice-Cream Cones
Copyright©2003 Southwestern/Thomson Learning
Variables That Influence Sellers
Copyright©2004 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.
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.
SUPPLY AND DEMAND
TOGETHER
Demand Schedule
Supply Schedule
At $2.00, the quantity demanded
is equal to the quantity supplied!
Figure 8 The Equilibrium of Supply and Demand
Price of
Ice-Cream
Cone
Supply
Equilibrium
Equilibrium price
$2.00
Equilibrium
quantity
0
1
2
3
4
5
6
7
8
Demand
9 10 11 12 13
Quantity of Ice-Cream Cones
Copyright©2003 Southwestern/Thomson Learning
Markets Not in Equilibrium
(a) Excess Supply
Price of
Ice-Cream
Cone
Supply
Surplus
$2.50
2.00
Demand
0
4
Quantity
demanded
7
10
Quantity
supplied
Quantity of
Ice-Cream
Cones
Copyright©2003 Southwestern/Thomson Learning
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.
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.
Markets Not in Equilibrium
(b) Excess Demand
Price of
Ice-Cream
Cone
Supply
$2.00
1.50
Shortage
Demand
0
4
Quantity
supplied
7
10
Quantity of
Quantity
Ice-Cream
demanded
Cones
Copyright©2003 Southwestern/Thomson 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.
Three Steps to Analyzing Changes in
Equilibrium
• Decide whether the event shifts the supply
or demand curve (or both).
• Decide whether the curve(s) shift(s) to the
left or to the right.
• Use the supply-and-demand diagram to
see how the shift affects equilibrium price
and quantity.
How an Increase in Demand Affects the
Equilibrium
Price of
Ice-Cream
Cone
1. Hot weather increases
the demand for Ice Cream
Supply
New equilibrium
$2.50
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©2003 Southwestern/Thomson Learning
How a Decrease in Supply Affects the Equilibrium
Price of
Ice-Cream
Cone
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©2003 Southwestern/Thomson Learning
What Happens to Price and Quantity When Supply
or Demand Shifts?
Copyright©2004 South-Western
Price, Income
and Cross Elasticity
Elasticity – the concept
• The responsiveness of one variable to
changes in another
• When price rises, what happens
to demand?
• Demand falls
• BUT!
• How much does demand fall?
Elasticity – the concept
• If price rises by 10% - what happens to
demand?
• We know demand will fall
• By more than 10%?
• By less than 10%?
• Elasticity measures the extent to which
demand will change
Elasticity
•
•
•
•
•
4 basic types used:
Price elasticity of demand
Price elasticity of supply
Income elasticity of demand
Cross elasticity
Elasticity
• Price Elasticity of Demand
– The responsiveness of demand
to changes in price
– Where % change in demand
is greater than % change in price – elastic
– Where % change in demand is less than %
change in price - inelastic
Elasticity
The Formula:
Ped =
% Change in Quantity Demanded
___________________________
% Change in Price
If answer is between 0 and -1: the relationship is inelastic
If the answer is between -1 and infinity: the relationship is elastic
Note: PED has – sign in front of it; because as price rises
demand falls and vice-versa (inverse relationship between
price and demand)
Elasticity
Price (£)
The demand curve can be a
range of shapes each of which
is associated with a different
relationship between price and
the quantity demanded.
Quantity Demanded
Elasticity
Price
Total
revenue is of
price
x
The importance
elasticity
quantity sold. In this
is the information it
example,
TRthe
= $5
x 100,000
provides on
effect
on
=
$500,000.
total revenue of changes in
price.
This value is represented by
the grey shaded rectangle.
$5
Total Revenue
D
100
Quantity Demanded (000s)
Elasticity
Price
If the firm decides to
decrease price to (say) $3,
the degree of price
elasticity of the demand
curve would determine the
extent of the increase in
demand and the change
therefore in total revenue.
$5
$3
Total Revenue
D
100
140
Quantity Demanded (000s)
Elasticity
Price ($)
Producer decides to lower price to attract sales
% Δ Price = -50%
10
% Δ Quantity Demanded = +20%
Ped = -0.4 (Inelastic)
Total Revenue would fall
5
Not a good move!
D
5 6
Quantity Demanded
Elasticity
Price ($)
10
Producer decides to reduce price to increase sales
% Δ in Price = - 30%
% Δ in Demand = + 300%
Ped = - 10 (Elastic)
Total Revenue rises
Good Move!
7
D
5
Quantity Demanded
20
Elasticity
• If demand is price
elastic:
• Increasing price
would reduce TR
(%Δ Qd > % Δ P)
• Reducing price would
increase TR
(%Δ Qd > % Δ P)
• If demand is price
inelastic:
• Increasing price
would increase TR
(%Δ Qd < % Δ P)
• Reducing price would
reduce TR (%Δ Qd <
% Δ P)
Elasticity
• Income Elasticity of Demand:
– The responsiveness of demand
to changes in incomes
• Normal Good – demand rises
as income rises and vice versa
• Inferior Good – demand falls
as income rises and vice versa
Estimated Price Elasticities of
Demand for Various Goods and
Services
Inelastic
Salt
0.1
Coffee
0.25
Fish (cod) consumed
at home
0.5
Tobacco products,
short-run
0.45
Physician services
0.6
Approximately
Unitary Elasticity
Movies
0.9
Housing, owner
occupied, long-run
1.2
Elastic
Restaurant meals
2.3
Foreign travel, long-run
4.0
Chevrolet automobiles
4.0
Fresh tomatoes
4.6
Elasticity
• Income Elasticity of Demand:
• A positive sign denotes a normal good
• A negative sign denotes an inferior good
Elasticity
• For example:
• Yed = - 0.6: Good is an inferior good but inelastic – a rise in
income of 3% would lead to demand falling
by 1.8%
• Yed = + 0.4: Good is a normal good but inelastic –
a rise in incomes of 3% would lead to demand rising
by 1.2%
• Yed = + 1.6: Good is a normal good and elastic –
a rise in incomes of 3% would lead to demand rising
by 4.8%
• Yed = - 2.1: Good is an inferior good and elastic –
a rise in incomes of 3% would lead to a fall in demand of 6.3%
Determinants of Elasticity
• Time period – the longer the time under consideration
the more elastic a good is likely to be
• Number and closeness of substitutes –
the greater the number of substitutes,
the more elastic
• The proportion of income taken up by the product –
the smaller the proportion the more inelastic
• Luxury or Necessity - for example,
addictive drugs
Importance of Elasticity
• Relationship between changes
in price and total revenue
• Importance in determining
what goods to tax (tax revenue)
• Influences the behaviour of a firm