Download Chapter 3

Macroeconomics
ECON 2302
May 2011
Marilyn Spencer, Ph.D.
Professor of Economics
Chapter 3
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CHAPTER
3 Where Prices Come From:
The Interaction of Demand and Supply
The intense competition
among firms selling energy
drinks is a striking example of
how the market responds to
changes in consumer tastes.
CHAPTER
3
Where Prices Come From: Interaction of
Demand & Supply
Chapter Outline and Learning Objectives
3.1 The Demand Side of the Market
Discuss the variables that influence demand.
3.2 The Supply Side of the Market
Discuss the variables that influence supply.
3.3 Market Equilibrium: Putting Demand and Supply
Together
Use a graph to illustrate market equilibrium.
3.4 The Effect of Demand and Supply Shifts on
Equilibrium
Use demand and supply graphs to predict changes in
prices and quantities
Where Prices Come From:
The Interaction of Demand and Supply
Perfectly Competitive Market A market that meets the
conditions of:
1. Many buyers and sellers,
2. All firms selling identical products
3. No barriers to new firms entering the market
4. Low cost information
3.1 LEARNING OBJECTIVE
Discuss the variables that influence
demand.
The Demand Side of the Market
Demand Schedules and Demand Curves:
Demand schedule A table showing the relationship
between the price of a product and the quantity of the product
demanded.
Quantity demanded The amount of a well defined good or
service that a consumer is willing and able to purchase at a
given price, during some given time period.
Demand curve A curve that shows the relationship
between the price of a well defined product and the quantity of
the product demanded, during some given time period.
Market demand The demand by all the consumers of a
given good or service.
The Demand Side of the Market: Demand
Schedules and Demand Curves
FIGURE 3-1 A Demand Schedule and Demand Curve
As price changes, consumers
change the quantity of
energy drinks they are
willing to buy. We can show
this as a demand schedule in
a table or as a demand curve
on a graph.
They both show that as the
price of energy drinks falls,
the quantity demanded rises.
When the price is $3.00,
consumers buy 60 million
cans/day. When the price
drops to $2.50, consumers
buy 70 million cans.
Therefore, the demand curve
for energy drinks is
downward sloping.
The Demand Side of the Market:
The Law of Demand
Law of demand The rule that, holding everything else
constant, when the price of a product falls, the quantity
demanded of the product will increase, and when the price
of a product rises, the quantity demanded of the product
will decrease.
The Demand Side of the Market
Individual Demand and Market Demand
Deriving the Market Demand
Curve from Individual Demand
Curves
Market demand The
demand for a product
by all the consumers in
a given geographical
area.
The Demand Side of the Market:
What Explains the Law of Demand?
Substitution effect The change in the quantity demanded
of a good that results from a change in price, making the
good more or less expensive relative to other goods that are
substitutes.
Income effect The change in the quantity demanded of a
good that results from the effect of a change in the good’s
price on consumers’ purchasing power.
The Demand Side of the Market:
Holding Everything Else Constant:
The Ceteris Paribus Condition
Ceteris paribus (“all else equal”) condition The
requirement that when analyzing the relationship between
two variables—such as price and quantity demanded—
other variables must be held constant.
A shift of a demand curve is an increase or a decrease in
demand. A movement along a demand curve is an increase
or a decrease in the quantity demanded.
The Demand Side of the Market:
Holding Everything Else Constant:
The Ceteris Paribus Condition
FIGURE 3-2
Shifting the
Demand Curve
When consumers
increase the quantity of a
product they want to buy
at a given price, the
market demand curve
shifts to the right, from
D1 to D2.
When consumers
decrease the quantity of a
product they want to buy
at a given price, the
demand curve shifts to
the left, from D1 to D3.
The Demand Side of the Market:
Variables That Shift Market Demand
Many variables other than price can influence market demand.
1.
Income
Normal good A good for which the demand increases
as income rises and decreases as income falls.
Inferior good A good for which the demand increases
as income falls and decreases as income rises.
Making
the
Are Big Macs an Inferior Good?
Connection
Big Macs seem to fit the
economic definition of an
inferior good because
demand increased as income
fell. But remember that
inferior goods are not
necessarily of low quality,
they are just goods for
which consumers increase
their demand as their
incomes fall.
McDonald’s restaurants experienced
increased sales during 2008 and 2009,
despite the recession.
The Demand Side of the Market:
Variables That Shift Market Demand, cont.
2.
Prices of related goods
Substitutes Goods and services that can be used
for the same purpose.
Complements Goods and services that are used
together.
3.
Tastes
Consumers can be influenced by an advertising
campaign for a product. And our tastes can also change
because of new interests, new friends, and new
decisions over time.
The Demand Side of the Market:
Variables That Shift Market Demand
4.
Size of the population and demographics
Demographics The characteristics of a population
with respect to age, race, and gender.
5.
Expected future prices
Consumers choose not only which products to buy
but also when to buy them.
Making
The Aging of the
Connection Baby Boom Generation
the
Older people have a greater D for medical care than do younger people.
Aging boomers will also have an effect on the housing market.
What other effects will the aging of the baby boom generation have on
the economy?
The Demand Side of the Market:
Variables That Shift Market Demand
TABLE 3-1 Variables That Shift Market Demand Curves
The Demand Side of the Market:
Variables That Shift Market Demand
TABLE 3-1
Variables That Shift Market Demand Curves
The Demand Side of the Market:
Variables That Shift Market Demand
TABLE 3-1 Variables That Shift Market Demand Curves
The Demand Side of the Market:
Variables That Shift Market Demand
TABLE 3-1 Variables That Shift Market Demand Curves
The Demand Side of the Market: A Change in Demand
versus a Change in Quantity Demanded
FIGURE 3-3
A Change in Demand versus a Change in Quantity Demanded
If the price of energy
drinks falls from $3 to
$2.50, the result will be a
movement along the D
curve from point A to point
B - an increase in quantity
demanded from 60 M cans
to 70 M cans.
If consumers’ incomes
increase, or if another
factor changes that makes
consumers want more of
the product at every price,
the D curve will shift to the
right—an increase in
demand.
In this case, the increase in demand from D1
to D2 causes the quantity of energy drinks
demanded at a price of $3 to increase from 60
M cans at point A to 80 M cans at point C.
Making Red Bull and the Future
the
Demand for Energy Drinks
Connection
It is important
for managers to
accurately
forecast the
demand for their
products because
it helps them
determine how
much of a good
to produce.
Will Red Bull continue to grow its
share of the energy drink market?
3.2 Learning Objective
Discuss the variables that
influence supply.
The Supply Side of the Market
Quantity supplied The amount of a well defined good or
service that a firm is willing and able to supply at a given
price, within some given time period.
Supply Schedules and Supply Curves
Supply schedule A table that shows the relationship
between the price of a well defined product and the quantity
of the product supplied, in some given time period.
Supply curve A curve that shows the relationship
between the price of a well defined product and the quantity
of the product supplied, in some given time period.
The Supply Side of the Market:
Supply Schedules and Supply Curves
FIGURE 3-4
A Supply Schedule and Supply Curve
As the P changes, the makers of
Red Bull, Monster Energy,
Rockstar, and the firms
producing energy drinks change
the Q they are willing to supply.
We can show this as a supply
schedule in a table or as a supply
curve on a graph.
They both show that as the P of
energy drinks rises, firms will
increase the Q they supply.
At a P of $2.50 per can, firms
will supply 90 M cans. At a P of
$3, firms will supply 100 M cans.
The Supply Side of the Market:
The Law of Supply
Law of supply The rule that, holding everything else
constant, increases in price cause increases in the quantity
supplied, and decreases in price cause decreases in the
quantity supplied.
The Supply Side of the Market
Individual Supply and Market Supply
3-7
Deriving the Market
Supply Curve from the
Individual Supply Curves
The Supply Side of the Market:
The Law of Supply
FIGURE 3-5
Shifting the Supply Curve
When firms increase the Q
of a product they want to
sell at a given P, the S curve
shifts to the right. The shift
from S1 to S3 represents an
increase in supply.
When firms decrease the Q
of a product they want to
sell at a given P, the supply
curve shifts to the left. The
shift from S1 to S2 represents
a decrease in supply.
The Supply Side of the Market:
Variables That Shift Market Supply
The following are the most important variables that shift
market supply:
1. Prices of inputs
2. Technological change/change in productivity
Technological change A positive or negative change
in the ability of a firm to produce a given level of
output with a given quantity of inputs.
3. Prices of substitutes in production
4. Number of firms in the market
5. Expected future prices & other changes in expectations
The Supply Side of the Market:
Variables That Shift Market Supply
TABLE 3-2
Variables That Shift Market Supply Curves
The Supply Side of the Market:
Variables That Shift Market Supply
TABLE 3-2
Variables That Shift Market Supply Curves (continued)
The Supply Side of the Market:
Variables That Shift Market Supply
TABLE 3-2 Variables That Shift Market Supply Curves (continued)
The Supply Side of the Market:
Change in Supply v. Change in Quantity Supplied
FIGURE 3-6
Change in Supply v. Change in Quantity Supplied
If the P of energy drinks
rises from $2 to $2.50/can,
the result will be a
movement up the S curve
from point A to point B - an
increase in quantity supplied
by Red Bull, Monster
Energy, Rockstar, and others
from 80 M to 90 M cans.
If the P of an input
decreases, or another factor
changes that makes sellers
supply more of the product
at every price, the S curve
will shift to the right - an
increase in supply.
The increase in supply, S1 to S2, causes Q of energy
drinks supplied at a P of $2.50 to increase from 90
M cans at point B to 110 M cans at point C.
3.3 Learning Objective
Use a graph to illustrate
market equilibrium.
Market Equilibrium:
Putting Demand & Supply Together
FIGURE 3-7
Market Equilibrium
Where the D curve crosses
the S curve determines
market equilibrium.
In this case, the D curve
for energy drinks crosses
the S curve at a P of $2 and
a Q of 80 M cans/day.
Only at this point is the Q
of energy drinks
consumers are willing to
buy equal to the Q that
Red Bull, Monster Energy,
Rockstar, and the other
firms are willing to sell:
The quantity demanded is
equal to the quantity supplied.
Market Equilibrium: Putting D & S Together
Market equilibrium A situation in which quantity
demanded equals quantity supplied.
Competitive market equilibrium A market
equilibrium with many buyers and many sellers.
Market Equilibrium: Putting D & S Together
How Markets Eliminate Surpluses and Shortages
Surplus A situation in which the quantity supplied is
greater than the quantity demanded.
Shortage A situation in which the quantity
demanded is greater than the quantity supplied.
Market Equilibrium: Putting D & S Together
How Markets Eliminate Surpluses and Shortages
FIGURE 3-8
The Effect of Surpluses and Shortages on the Market Price
When the market P > equilibrium,
there will be a surplus. In the
figure, a price of $2.50 for energy
drinks results in 90 M cans
supplied but only 70 M cans
demanded, for a surplus of 20 M.
As Red Bull, Monster Energy,
Rockstar, and the others cut the P to
dispose of the surplus, the P will
fall to the equilibrium of $2.
When the market P < equilibrium,
there will be a shortage. P of $1
results in 100 M cans demanded
but only 60 M cans supplied, for a
shortage of 40 M cans. As
consumers who are unable to buy
energy drinks offer to pay higher
prices, the P will rise to the
equilibrium of $2.
Market Equilibrium: Putting D & S Together
Demand and Supply Both Count
Keep in mind that the interaction of demand and supply
determines the equilibrium price.
Neither consumers nor firms can dictate what the
equilibrium price will be.
No firm can sell anything at any price unless it can find a
willing buyer, and no consumer can buy anything at any
price without finding a willing seller.
Solved Problem
3-3
Demand and Supply Both Count: A Tale of Two Letters
Both D and S count
when determining
market P.
The D for Lincoln’s
letters is much
greater than the D
for Booth’s letters,
but the S of Booth’s
letters is very small.
Historians believe
that only 8 letters
written by Booth
exist today.
3.4 Learning Objective
Use demand and supply graphs to predict changes in prices and quantities.
The Effect of Demand and Supply
Shifts on Equilibrium: Increase in Supply
FIGURE 3-9
The Effect of an Increase in
Supply on Equilibrium
If a firm enters a market, as CocaCola entered the market for
energy drinks when it launched
Full Throttle, the equilibrium
price will fall, and the
equilibrium quantity will rise:
1.
As Coca-Cola enters the
market for energy drinks, a
larger Q of energy drinks will
be supplied at every P, so the
market S curve shifts to the
right, from S1 to S2, which
causes a surplus of cans at the
original price, P1.
2.
3.
The equilibrium P falls from P1 to P2.
The equilibrium Q rises from Q1 to Q2.
Making
The Falling Price of
Connection LCD Televisions
the
An increase in S drove the P of a typical large LCD television
from $4,000 in fall 2004 to $1,000 at the end of 2008, increasing
the quantity demanded worldwide from 8 million to 105 million.
The Effect of Demand and Supply
Shifts on Equilibrium: Increase in Demand
FIGURE 3-10
The Effect of an Increase in Demand on Equilibrium
Increases in income cause
equilibrium P & Q to rise:
1.
Because energy
drinks are
normal, as
income grows,
the Q demanded
increases at every
P, and the market
D curve shifts
right, from D1 to
D2, causing a
shortage at the
original price, P1.
2.
3.
The equilibrium P rises from P1 to P2.
The equilibrium Q rises from Q1 to Q2.
The Effect of Demand and Supply
Shifts on Equilibrium: The Effect of Shifts
in D and S over Time
FIGURE 3-11
Shifts in Demand and Supply over Time
In panel (a), D shifts to the right more than S, and
the equilibrium price rises:
1. Demand shifts to the right more than supply.
2. Equilibrium price rises from P1 to P2.
In panel (b), S shifts to the right more than D, and
the equilibrium price falls:
1. Supply shifts to the right more than demand.
2. Equilibrium price falls from P1 to P2.
The Effect of Demand and Supply
Shifts on Equilibrium:
The Effect of Shifts in D and S
TABLE 3-3
How Shifts in Demand and Supply Affect Equilibrium Price (P) and Quantity (Q)
SUPPLY CURVE
UNCHANGED
SUPPLY CURVE
SHIFTS TO THE RIGHT
SUPPLY CURVE
SHIFTS TO THE LEFT
DEMAND CURVE
UNCHANGED
Q unchanged
P unchanged
Q increases
P decreases
Q decreases
P increases
DEMAND CURVE
SHIFTS TO THE RIGHT
Q increases
P increases
Q increases
P increases or
decreases
Q increases or
decreases
P increases
DEMAND CURVE
SHIFTS TO THE LEFT
Q decreases
P decreases
Q increases or
decreases
P decreases
Q decreases
P increases or
decreases
Solved Problem
3-4
High Demand and Low Prices in
the Lobster Market?
Supply and demand for
lobster both increase
during the summer, but
the increase in supply is
greater than the increase
in demand; therefore,
equilibrium price falls.
3.4 Learning Objective
Use demand and supply
graphs to predict changes
in prices and quantities.
Effect of D and S Shifts on Equilibrium
Shifts in a Curve versus Movements along a Curve
Don’t Let This Happen to YOU! Remember: A Change in a Good’s Price
Does Not Cause the Demand or Supply Curve to Shift!
When analyzing markets using D and S curves, remember that when a shift in a D or S curve
causes a change in equilibrium P, the change in P does not cause a further shift in D or S.
AN INSIDE
LOOK
>> How Does Advertising Help Red Bull Increase
Demand for Its Energy Drink?
Advertising may cause an increase in the demand for Red Bull.
KEY TERMS
Ceteris paribus (“all else equal”)
condition
Competitive market equilibrium
Complements
Demand curve
Demand schedule
Demographics
Income effect
Inferior good
Law of demand
Law of supply
Market demand
Market equilibrium
Normal good
Perfectly competitive market
Quantity demanded
Quantity supplied
Shortage
Substitutes
Substitution effect
Supply curve
Supply schedule
Surplus
Technological change
Reality check to have been
completed before we begin Ch. 4:
Pre-read Ch. 4, including:
Review Questions (not in text):
 Consumer surplus is used as a measure of a consumer’s net
benefit from purchasing a good or service. Explain why
consumer surplus is a measure of net benefit.
 Why would economists use a term like “deadweight loss” to
describe the impact on consumer and producer surplus from a
price control?”
Problems and Applications:
 3rd ed., p. 130, 4A.5, 4A.6, 4A.7 & 4A.8; (2nd ed., p. 134,
4A.5, 4A.6, 4A.7 & 4A.8; 1st edition: 1-4 on p. 129).