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Demand & Supply 1 On Modeling Models may seem very simplistic at times - but many good models are. Proof of pudding is in how well the model stands up to empirical scrutiny. Two pitfalls to avoid: – the fallacy of composition – post hoc ergo propter hoc mistakes positive vs. normative analysis 2 Supply and Demand The supply and demand model is a basic workhorse of economics. We will consider each of its pieces. Then, we will use it to answer some basic questions. Note: When employing supply and demand we are considering perfectly competitive markets. For now that simply means all buyers and sellers are assumed to be price takers. 3 Demand Concepts The demand function for X: XD = f(PX, Ps, Pc, I, T&P, Pop) Where: XD = quantity demanded PX = X’s price Ps = the price of substitutes Pc = the price of complements I=income T&P=tastes and preferences Pop=population in market or market size 4 The Demand Curve (Verbal) The demand curve, a.k.a. demand, describes the relation between a good’s price and the maximum quantity that consumers are willing and able to buy at that price, ceteris paribus. – Ceteris paribus means holding all the other demand function variables constant at some given level. 5 The Demand Curve (Verbal) The Law of Demand states that the relationship between a good’s price and the quantity demanded of that good is negative. Example: when the price of a good falls from 25 to 10, the quantity demanded rises from 15 to 30. This is referred to as a “change in quantity demanded” and in this case an “increase in quantity demanded.” Own-price changes cause movements along a given demand curve. 6 Movements vs. Shifts A movement along the demand curve for X would be caused by a change in Px. A shift of the entire demand curve would be caused by a change in one of the “ceteris paribus” demand variables. – This would be referred to as an increase or decrease in demand. 7 Increase in Demand When demand increases, the quantity demanded by consumers increases at every price. Example: when demand increases, the quantity demanded at a price of 25 rises from 15 to 25. 8 Decrease in Demand When demand decreases, the quantity demanded by consumers falls at every price. Example: when demand decreases, the quantity demanded at a price of 25 falls from 15 to 10. 9 The Demand Curve (Table) The quantity demanded is a declining function of the price, as the table to the right illustrates. Price 0 5 10 15 20 25 30 35 40 Demand Curve Quantity Demanded 40 35 30 25 20 15 10 5 0 10 Increase in Demand When demand increases, the quantity demanded is greater at every price. Price 0 5 10 15 20 25 30 35 40 Demand Curve Original Increased Demand Demand 40 50 35 45 30 40 25 35 20 30 15 25 10 20 5 15 0 10 11 Decrease in Demand When demand decreases, the quantity demanded is lower at every price. Price 0 5 10 15 20 25 30 35 40 Demand Curve Decreased Original Demand Demand 35 40 30 35 25 30 20 25 15 20 10 15 5 10 0 5 0 12 The Demand Curve (Graph) The same demand curve can be represented by a simple graph with a negative slope. Price Demand 25 At price = 25, the quantity demanded = 15. 15 Quantity 13 Change in the Quantity Demanded A change in the quantity demanded is a movement along the demand curve. When price falls to 10, the quantity demanded increases to 30. Price Demand 25 10 15 30 Quantity 14 Increase in Demand An increase in demand is a rightward shift in the entire curve. More is demanded at every price At price = 25, the quantity demanded = 25 after the increase. Price Demand New Demand 25 15 25 Quantity 15 Decrease in Demand A decrease in demand is a leftward shift in the entire curve. Less is demanded at every price At price = 25, the quantity demanded = 10 after the decrease. Price Demand 25 New Demand 10 15 Quantity 16 The Demand Curve (Equation) XD = 40 - P Mathematically, the demand curve is an equation that shows a negative relation between price (P) and quantity (X) for all positive prices and quantities. Beware of the equation and the graph of demand. P 15 = 40 - 25 D 25 15 Q 17 Supply Concepts The supply function for X: XS = g(PX, Pfop, Poc, S&T, N) Where: XS = quantity supplied PX = X’s price Pfop = prices of factors of production Poc = opportunity costs (alternatives in productions) S&T = science and technology N = number of firms in the market 18 The Supply Curve (Verbal) The supply curve, a.k.a. supply, describes the relation between a good’s price and the maximum quantity that producers are willing and able to sell at that price, ceteris paribus. – Ceteris paribus means holding all the other supply function variables constant at some given level. 19 The Supply Curve (Verbal) The Law of Supply states that the relationship between a good’s price and the quantity supplied of the good is positive. Example: when the price of a good falls from 25 to 10, the quantity supplied falls from 31 to 16. This is referred to as a “change in quantity supplied” and in this case an “decrease in quantity supplied.” Own-price changes cause movements along a given supply curve. 20 Movements vs. Shifts A movement along the supply curve for X would be caused by a change in Px. A shift of the entire supply curve would be caused by a change in one of the “ceteris paribus” supply variables. – This would be referred to as an increase or decrease in supply. 21 Increase in Supply When supply increases, the quantity supplied by producers increases at every price. Example: when supply increases, the quantity supplied at a price of 25 rises from 31 to 36. 22 Decrease in Supply When supply decreases, the quantity supplied by producers falls at every price. Example: when supply decreases, the quantity supplied at a price of 25 falls from 31 to 21. 23 The Supply Curve (Table) The quantity supplied is an increasing function of the price, as the table to the right illustrates. Price 0 5 10 15 20 25 30 35 40 Supply Curve Quantity Supplied 6 11 16 21 26 31 36 41 46 24 Increase in Supply When supply increases, the quantity supplied is greater at every price. Price 0 5 10 15 20 25 30 35 40 Supply Curve Original Increased Supply Supply 6 11 11 16 16 21 21 26 26 31 31 36 36 41 41 46 46 51 25 Decrease in Supply When supply decreases, the quantity supplied is lower at every price. Price 0 5 10 15 20 25 30 35 40 Supply Curve Decreased Original Supply Supply 6 1 11 6 16 11 21 16 26 21 31 26 36 31 41 36 46 26 The Supply Curve (Graph) The same supply curve can be represented by a simple graph with a positive slope. Price Supply 25 At price = 25, the quantity supplied = 31. 31 Quantity 27 Change in the Quantity Supplied A change in the quantity supplied is a movement along the supply curve. At price = 10, the quantity supplied = 16. Price Supply 25 10 16 31 Quantity 28 Increase in Supply An increase in supply is a rightward shift in the entire curve. More is supplied at every price At price = 25, the quantity supplied = 36 after the increase. Price Supply 25 New Supply 31 36 Quantity 29 Decrease in Supply A decrease in supply is a leftward shift in the entire curve. Less is supplied at every price At price = 25, the quantity supplied = 21 after the decrease. Price New Supply Supply 25 21 31 Quantity 30 The Supply Curve (Equation) Mathematically, the XS supply curve is an equation that shows a positive relation between price (P) and quantity (X) for all positive prices and quantities. Beware of the equation and the graph of supply. =6+P 31 = 6 + 25 S P 25 31 Q 31 Market Equilibrium (Verbal) The equilibrium price and quantity in a market occur at the price where the quantity demanded equals the quantity supplied. Example: for the demand and supply curves used above, the equilibrium price is 17, where the quantity demanded, 23, equals the quantity supplied, 23. 32 Market Equilibrium (Table) At a price of 17, the quantity demanded is equal to the quantity supplied, as the table to the right illustrates. Price 0 5 10 15 17 20 25 30 35 40 Market Equilibrium Quantity Quantity Demanded Supplied 40 6 35 11 30 16 25 21 23 23 20 26 15 31 10 36 5 41 0 46 33 Market Equilibrium (Equations) The equilibrium price and quantity satisfy both the demand and supply equations simultaneously. To find P*, set XD = XS . – – – – Recall: XD = 40 - P and XS = 6 + P So… (40 - P*) = (6 + P*) 34 = 2P* or P* = 34/2 so... P*=17 To find X*, plug P* into either the demand or supply equation. – X*=23 = 40 - 17 or X*=23 = 6 + 17 34 Market Equilibrium (Graph) The market equilibrium occurs at the intersection of the supply and demand curves. At price = 17, the quantity supplied = quantity demanded = 23. Price Demand Supply 17 23 Quantity 35 Comparative Statics Using the model to make predictions. Something changes in the market. Compare one market equilibrium with another market equilibrium and see what happens to P* and X* Compare two equilibria - compare two static situations - comparative statics! 36 First…demand side changes Demand shifts and the demand variables: – PX - not a shift! (a movement along) – Ps - positively related to demand – PC - negatively related to demand – I - depends: is X normal or inferior? – T&P - positively related to demand – Pop - positively related to demand 37 Increase in Demand An increase in demand is a rightward shift of the entire curve. More is demanded at every price. At price = 25, the quantity demanded = 25 Price Demand New Demand 25 15 25 Quantity 38 Market Equilibrium Increased Demand The increased demand intersects the original supply curve to the right of the original equilibrium. Price Demand New Demand Supply 22 17 Price = 22 and quantity supplied = quantity demanded = 28 23 28 Quantity 39 Summary: Market Equilibrium Increased Demand Increased demand is indicated by a greater quantity demanded at every price. The demand curve shifts right and a movement along the supply curve results. When demand increases: – Equilibrium price increases – Equilibrium quantity increases – Note the movement in the same direction 40 Market Equilibrium Decreased Demand The decreased demand intersects the original supply curve to the left of the original equilibrium. Price = 14.5 and quantity supplied = quantity demanded = 20.5 Price Demand Supply 17 14.5 New Demand 20.5 23 Quantity 41 Summary: Market Equilibrium Decreased Demand Decreased demand is indicated by a smaller quantity demanded at every price. The demand curve shifts left and a movement along the supply curve results. When demand decreases: – Equilibrium price decreases – Equilibrium quantity decreases – Note the movement in the same direction 42 Now…supply side changes Supply shifts and the supply variables: – PX - not a shift! – Pfop - negatively related to supply – Poc - negatively related to supply – S&T - positively related to supply – N - positively related to supply 43 Increase in Supply An increase in supply is a rightward shift of the entire curve. Price Supply 25 More is supplied at every price. At price = 25, the quantity supplied = 36 New Supply 31 36 Quantity 44 Market Equilibrium Increased Supply The increased supply intersects the original demand curve to the right of the original equilibrium. Price Demand Supply 17 14.5 Price = 14.5 and quantity supplied = quantity demanded = 25.5 New Supply 23 25.5 Quantity 45 Summary: Market Equilibrium Increased Supply Increased supply is indicated by a greater quantity supplied at every price. The supply curve shifts right and a movement along the demand curve results. When supply increases: – Equilibrium price decreases – Equilibrium quantity increases – Note the movement in opposite directions 46 Summary: Market Equilibrium Decreased Supply Decreased supply is indicated by a smaller quantity supplied at every price. The supply curve shifts left and a movement along the demand curve results. When supply decreases: – Equilibrium price increases – Equilibrium quantity decreases – Note the movement in opposite directions 47 Examples: Changes in Demand An increase in family income increases the demand for automobiles. An increase in the price of software decreases the demand for computers. An increase in the price of hockey tickets increases the demand for basketball tickets. 48 Automobile Market Increased family income increases the demand for automobiles. New price = P* and new quantity supplied = new quantity demanded = X*. Price Supply of Autos P* P Equilibrium price and quantity both rise. X X* Quantity 49 Computer Market An increase in the price of software decreases the demand for computers. New price = P* and new quantity supplied = new quantity demanded = X*. Price Supply of Computers P P* Equilibrium price and quantity both fall. X* X Quantity 50 Explanation of Computer Example Software is an example of good that is demand “complementary” with computers. When the price of a complementary good (software) rises, the demand for the good itself (computers) decreases. The market moves down the supply curve. 51 Basketball Market An increase in the price of hockey tickets increases the demand for basketball tickets. Price Supply of Basketball P* New price = P* and new quantity supplied = new quantity demanded = X*. Equilibrium price and quantity both rise. P X X* Quantity 52 Explanation of Basketball Example Hockey games are demand “substitutes” for basketball games. When the price of a substitute good (hockey) rises, the demand for the good itself (basketball) increases. The market moves up the supply curve. 53 Examples: Changes in Supply A flood in Bordeaux in September decreases the supply of fine red wine. A decrease in the price of energy increases the supply of steel. An increase in the wage rate for engineers decreases the supply of new microprocessors. 54 Red Wine Market The decreased supply intersects the original demand curve to the left of the original equilibrium. New price = P* and new quantity supplied = quantity demanded = X*. Price P* P Equilibrium price rises and equilibrium quantity falls. X* X Quantity 55 Explanation of Red Wine Example Flood conditions in Bordeaux dilute the grapes and make them unsuitable for fine red wine. Thus, the supply of red wine is reduced because of reduced production at all prices. The market retreats along the demand curve. 56 Steel Market The decreased price of energy increases the supply of steel. Price New price = P* and new quantity supplied = quantity demanded = X*. Equilibrium price falls and equilibrium quantity rises. P P* X X* Quantity 57 Explanation of Steel Example Energy is a factor in the production of steel. When the price of energy falls, it becomes less costly to produce steel. Thus the supply of steel increases at all prices. The market moves down the demand curve. 58 Microprocessor Market The decreased supply intersects the original demand curve to the left of the original equilibrium. Price P* New price = P* and new quantity supplied = quantity demanded = X*. P Equilibrium price rises and equilibrium quantity falls. X* X Quantity 59 Explanation of Microprocessor Example Engineers are a one of the types of labor used to design new microprocessors. When engineers become more expensive, the cost of designing microprocessors rises and supply falls at all prices. The market moves up the demand curve. 60 4 Government interventions Price floors Price ceilings Quantity Quotas Taxes 61 Price floor government established minimum selling price. – floor must be above P* to be binding – examples: supporting milk prices, minimum wage law – government usually thinks the market price is too low for some reason Usually end up with….surpluses 62 Market Surplus Equilibrium is at P = 17 and X = 23. The price floor is 25. At the artificially high price of 25, sellers want to sell 31. But buyers only want to buy 15. Price Demand Supply Surplus = 16 25 17 There is a surplus of 16. 15 23 31 Quantity 63 Price ceiling government established maximum selling price. – must be below P* to be binding – examples: gas price ceilings; apartment rent control – government usually thinks the market price is too high for some reason Usually end up with….shortages 64 Market Shortage Equilibrium is at P = 17 and X = 23. Suppose there is a price ceiling of 10. At the artificially low price of 10, buyers want to buy 30. But sellers only want to sell 16. There is a shortage of 14. Price Demand Supply 17 10 Shortage = 14 16 23 30 Quantity 65 Quantity quota government established maximum number of units sold. – Qq must be below Q* to be binding – example: import restrictions – government thinks too many units are being traded end up with…higher prices and more. 66