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Demand, Supply & Market Equilibrium P ECO 2013 Chapter 3 Prof M. Mari Fall 2007 S D Q Demand A relation between the price of a good and the quantity that consumers are willing and able to buy during a given period, other things constant. Willing: you want to buy the product Able: you can afford the buy the product Demand Schedule and Curve Demand curve: a curve showing the relation between the price of a good and quantity demanded during a given period, other things constant. Suppose we are making pizza. Price of Quantity Good Demand ed $3 200 $4 150 $5 100 $6 75 $7 50 Law of Demand States that a quantity of a good demanded during a given period relates inversely to its price, other things constant. Price increases Quantity Demanded decreases Price decreases Quantity demanded increases Creates a downward sloping demand curve Why? Substitution Effect Unlimited wants/scarce resources When the price of a good falls, consumers substitute that good for other goods, which become relatively more expensive. Reverse also holds true Why? Income Effect Money income: is simply the number of dollars received per period Real income: your income measured in terms of what it can buy. A fall in the price of a good increases consumers’ real income making consumers more able to purchase goods; for a normal good, the quantity demanded increases. Demand Curve A curve showing the relation between the price of a good and the quantity demanded. Price $6 $5 Point on the line that matches the schedule Every point on the line matches the schedule. It is a price/quantity demanded that consumers are willing and able to buy. $4 $3 0 50 75 100 150 Demand Quantity 200 Movement Along the Demand Curve Caused by a change in price Only a change in price Move from one point to another on the same graph Called a Change in quantity demanded. Movement along the Demand Curve Price B $6 $5 A Demand 0 75 100 Quantity Demand Individual demand The demand of an individual consumer Market demand Sum of individual demands of all consumers in the market Shifts in the Demand Curve A demand curve isolates the relation between prices of a good and quantities demanded when other factors that could affect demand remain unchanged. Factors called assumptions or determinants Determinants of Demand Changes in consumer income Changes in prices of related goods Changes in consumer expectations Changes in the number or composition of consumers Changes in consumer tastes Changes in determinants Results in changes to the RELATIONSHIP BETWEEN PRICE AND QUANTITY DEMANDED. At each and every price a DIFFERENT quantity is demanded. Results in a shift in the demand curve New curve must be drawn Changes in Demand Increase in demand P At each and every price MORE of the good is Price demanded Shifts to the right Qd1 Qd2 $4 150 $5 A B D2 200 $5 100 150 $6 75 100 D1 100 150 Quantity Causes of Increase in Demand Increase in consumer income Causes consumers to buy more of the product at each and every price. Normal goods Inferior goods Change in consumer income Normal goods A good for which demand increases as consumer income rise Inferior goods A good which demand increases as consumer income falls Changes in Price of Related Goods Substitutes Goods that are not consumed jointly Goods that are related in such a way that an increase in the price of one shifts the demand curve for the other rightward. Increase in price of Coke leads to increase in demand for Pepsi Changes in Price of Related Goods Substitutes Suppose that the price of Coke rises from $1 to $1.50, then the demand for Pepsi will decrease from 75 to 100. $1 D2 D1 75 100 Changes in the price of related goods Complements Goods that are related in a such a way that an increase in the price of one shifts the demand of the other leftward Two goods that are consumed jointly. An decrease in the price of one will increase demand for the other Changes in Price of Related Goods Complements An decrease in the price of DVD players, increases the demand for DVDs Suppose that DVD players decrease in price from $145 to $100, now the demand for DVDs will decrease from 750 at $20 to 900. $20 D2 D 750 900 Changes in Consumer Expectations Such as expectations in Prices and income Affect how consumers spend their money and their demand If product cheaper today than tomorrow, then increase in demand Changes in consumer tastes Consumer preferences likes and dislikes in consumption assumed to be constant along a given demand curve assumed constant along a given demand curve Changes in taste will cause a shift in the demand curve as different quantities are demanded at each and every price. Changes in taste Consumers prefer platform shoes. At $50, demand increases from 100 to 200. $50 D 100 200 D2 Change in the number and composition of consumers The market demand curve is the sum of the individual demand curves. If the number of consumers falls then the sum will be smaller thus shifting the demand curve Changes in Demand Decrease in demand P At each and every price Less of the good is Price demanded Shifts to the Left Qd1 Qd2 $4 150 B $5 D1 110 $5 100 90 $6 75 60 D2 90 100 Quantity Causes of Decrease in Demand Decrease in consumer income Causes consumers to buy less of the product at each and every price. Changes in Price of Related Goods Substitutes Goods that are not consumed jointly Goods that are related in such a way that an increase in the price of one shifts the demand curve for the other rightward. Decrease in price of Coke leads to Decrease in demand for Pepsi Changes in Price of Related Goods Substitutes Suppose that the price of Coke drops from $1 to $0.50, then the demand for Pepsi will decrease from 100 to 75. $1 D D2 75 100 Changes in the price of related goods Complements Goods that are related in a such a way that an increase in the price of one shifts the demand of the other leftward Two goods that are consumed jointly. An increase in the price of one will decrease demand for the other Changes in Price of Related Goods Complements An decrease in the price of DVD players, increases the demand for DVDs Suppose that DVD players increase in price from $100 to $145, now the demand for DVDs will decrease from 900 at $20 to 750. $20 D1 D2 750 900 Changes in Consumer Expectations Such as expectations in Prices and income Affect how consumers spend their money and their demand If product more expensive today than tomorrow, then decrease in demand Changes in consumer tastes Consumer preferences likes and dislikes in consumption assumed to be constant along a given demand curve assumed constant along a given demand curve Changes in taste will cause a shift in the demand curve as different quantities are demanded at each and every price. Change in the number and composition of consumers The market demand curve is the sum of the individual demand curves. If the number of consumers falls then the sum will be smaller thus shifting the demand curve Review of Demand A change in quantity demanded is not a change in demand Change in quantity demanded is caused by a change in price Change in quantity demanded is a movement along the demand curve Change is demand is caused by a change in the determinants Change in demand shifts the demand curve Supply Producer’s side A relation between the price of a good and the quantity that the producers are willing and able to offer for sale during a given period, other things constant. Law of Supply The quantity of a good supplied during a given period is usually directly related to the price of the good Increase in price leads to increase in quantity supplied Decrease in price leads to decrease in quantity supplied. Creates upward sloping supply curve Supply Curve Price Price of Good Quantity Demanded 6 $3 50 $4 75 $5 100 $6 150 $7 200 Supply 5 Quantity Movement along the supply curve A change in price and only in price Causes a movement along the supply curve Called a Change in Quantity Supplied Supply $6 B $4 A 100 150 Supply Individual supply The supply of an individual producer Market supply The sum of individual supplies of all producers in the market Determinants for the Supply Curve Changes in technology Changes in prices of relevant resources Changes in the prices of alternative goods Changes in Producer Expectations Changes in the number of producers Changes in Supply Caused by changes in the determinants to the supply curve Results in changes to the relationship between the price and quantity supplied At each and every price a different quantity is supplied New supply curve - shift in supply Increase in Supply At each and every price more of the good is supplied S1 $6 300 400 S2 Causes of increase in Supply Improvements in Technology Changes in relevant resources Changes in price of alternative goods Decrease in the price of resources Lowers costs If price of alternative good increases, supply of the good increases Changes in producers expectations Changes in technology Technology is the economy’s stock of knowledge about how to combine resources efficiently Changes in Technology Improvements in technology Causes an increase in supply More of the product is available at all prices S1 $6 300 400 S2 Changes in Relevant Resources Decrease in resource prices Increases the supply of the good at each and every price. S1 $6 300 400 S2 Changes in prices of Alternative Goods Alternative goods Other goods that use some or all of the same resources as the good in question Beef and leather. If the price of beef increases, producers will supply more beef thus increasing the supply of leather. Price S1 S2 $6 Q Leather 300 400 Above is the market for the supply of leather Changes in Producers Expectations Expectation of future prices of resources or their own product can cause producers to change what they offer at each individual price Changes in the Number of Producers As the number of producers change so does the supply of the product A decrease in the number of producers will lead to a decrease in supply Decrease in Supply At each and every price LESS of the good is supplied 5 S2 400 600 S1 Causes of Decrease in Supply Backward movement in Technology Changes in relevant resources Changes in price of alternative goods Increase in the price of resources Raises costs If price of alternative good decreases, supply of the good decreases Changes in producers expectations Changes in Relevant Resources $9 S2 500 600 S1 Are those employed in the production of the good in question Increase in price of resources Results in decrease in supply Less of the good is available at all prices Changes in prices of Alternative Goods Alternative goods Other goods that use some or all of the same resources as the good in question Beef and leather. If the price of beef decreases, producers will supply less beef thus decreasing the supply of leather. Price S1 $6 Q Leather 300 400 Above is the market for the supply of leather Producer’s Expectation Nationalization Expropriation Supply Review Change in Quantity Supplied Caused by a change in the price of the product Movement along the supply curve Change in Supply Caused by change in the determinants Results in a shift in the supply curve Market Equilibrium Market Includes all the arrangements used to buy and sell Reduce transaction costs The place where buyers and sellers meet to determine price and quantity Equilibrium At specific price where: Quantity demanded = Quantity supplied Equilibrium price – market clearing price Equilibrium quantity – D=S Equilibrium At specific price where: Quantity demanded Equals Quantity Supplied P S $5 Equilibrium D Q 150 Reaching Equilibrium P Surplus S $6 $5 D 100 150 200 Q If market price is ABOVE equilibrium Qs > QD Economy is at a SURPLUS Market price will fall Reaching Equilibrium If the market price is BELOW the equilibrium price QD > Qs Shortage exists Market price rises to equilibrium P S $5 $4 D Shortage 100 150 200 Q Shifts in Demand Demand increases Equilibrium price increases Equilibrium quantity increases P S $6 $4 B A D1 D 100 150 200 Q Shifts in Demand P S Decrease in demand $6 B $5 A D1 D 100 200 Q decrease in price decrease in equilibrium Shifts in Supply Increase in supply Price S1 S2 $6 $5 Q Leather 300 400 Decrease in equilibrium price Increase in quantity Shifts in Supply Decrease in supply Price increases Quantity decreases Simultaneous Shifts in Supply and Demand The change in equilibrium price and quantity depends on which curve shifts the most. S S1 5 A B 4 D 200 300 D1 Simultaneous Changes Change in Supply Change in Demand Increase Decrease Increase Decrease Increase Increase Effect on Effect on Equilibrium Equilibrium Price Quantity Decrease Indeterminate Increase Indeterminate Indeterminate Increase Decrease Decrease Indeterminate Decrease Government Intervention Government enters the economy Price Setting Subsidies Government payments to reduce the cost of product or to limit production. Price Floors A minimum legal price below which a good or service cannot be sold If above equilibrium causes surplus Surplus S $7 $6 D 100 150 200 Q Price Ceilings P S $5 D Shortage 100 150 200 Q A maximum legal price above which a good or service cannot be sold Below equilibrium price Shortage occurs