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Demand and Supply
The Power of Trade
• Voluntary versus involuntary exchange
• An intuitive approach to gains in trade
• Using an economic model to demonstrate
the gains from trade
Voluntary Exchange
• All parties to a voluntary exchange must be
made better off
• Allow for specialization and division of
labor
• Increase interdependence
• Promote cooperation rather than conflict
An intuitive Approach to Gains
From Trade
• Self-sufficiency
– Pros: independence
– Cons: loss of efficiency, variety in consumption
and production
• Trade with Yakima?
• Trade with other states?
• Trade with other nations?
History of Trade
• Tribal to feudal times
• Adam Smith (1776) and David Ricardo
(1817)
• The costs of not trading (e.g. lamb example)
• Distribution impacts: consumers win but
some producers and workers lose
• The cost of protectionism
Markets: The power of Demand
and Supply
• Competitive Markets
–
–
–
–
identical or homogeneous goods
many sellers and buyers
perfect Information
free entry and exit
• Non-Competitive Markets
– Monopoly – one seller
– Oligopoly – few sellers
– Monopolistically Competitive – differentiated products
Demand
• The demand curve
– Price and the quantity demanded
• Rational behavior
– Utility maximization MB=MC
– Boxes example
– Law of Demand – as the price of a product falls, ceteris
paribus (all other things equal), the quantity demanded
of the good will rise
• Law of Diminishing Marginal Utility – Jelly bean example
• Income and substitution effects
– Substitution effect – consumers will substitute the now relatively
cheaper good for other now relatively more expensive goods
– Income effect – a decrease in any price, ceteris paribus, increases
the purchasing power of the consumer’s income leading.
Therefore, consumer will purchase more of a normal good.
• Demand schedule – is a table of the various prices
and the quantities that a consumer will demand at
those prices.
• Individual demand curve – is a graph relating
price and quantity demanded for a consumer.
• Market demand curve – is a graph reflecting the
sum of individual consumer demands in a market.
Catherine’s Demand Schedule
Figure 1 Catherine’s 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
• The demand function – lists all of the determinants
of demand and includes:
– Price of the Good - law of demand
– Price of related goods
• Complements – as the Pc goes up QD of the good goes down
• Substitutes - as the Ps goes up QD of the good goes up
–
–
–
–
Income – normal vs. inferior goods
Number of Buyers
Tastes
Expectations – future prices, shortages, other conditions
• QD =F ( P(-), PR (Pc(-), Ps(+)) ,I (normal (+), inferior(-)), N(+), T(+), E)
• Movement along and shifts of the demand
curve
– Movement – only change in the price of the
good
– Shifts – changes in any determinant but the
prices of the good
– Curve versus function
– Schedules
– Graphs
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
Supply
• Price and the quantity supplied
– Rational behavior an the profit motive
– Law of diminishing returns
• Supply schedule
• Individual supply curve
• Market supply curve
Ben’s Supply Schedule
Figure 5 Ben’s 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
• The supply function
–
–
–
–
–
Price of the Good
Input prices
technology
number of sellers
expectations
• QS =F ( P, I, N, E, T)
Figure 7 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
Market Equilibrium
• Equilibrium price and quantity = market clearing
price and quantity
• Disequilibrium prices and quantities
– Shortage
– Surplus
• Comparative static analysis: changes in
equilibrium prices and quantities
• Shifts in curves versus movement along revisited
• Changes in demand and supply
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
Figure 9 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
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
Figure 9 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
Figure 9 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
Figure 10 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
Figure 11 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
The Invisible Hand
• Economic Agents are motivated by self-interest
– consumers by utility maximization
– Producers by profit maximization
• Market prices as signals for resource allocation
and coordinate consumer and producer behavior
• Market or the Price System and Efficiency
Demand and Supply Applications
•
•
•
•
Market for Water
Market for Gas
Shortages and Surplus
Price Controls
– Price ceilings
– Price floors