Download Chapter 3

Markets, Demand (D), Supply
(S), and Market Prices
Objectives:
Upon completion of this unit, you should understand and be able to answer these key questions:
1.
What are the basic decision-making units in the economy?
2.
What are the relationships between these basic units? How does a circular flow diagram
illustrate these relationships?
3.
What do we mean by ‘quantity demanded?’ What influences quantity demanded on the part
of households?
4.
What is the demand schedule for a product? What are the main features of a demand curve?
What is the law of demand and how is it illustrated by demand curves?
5.
What can change the demand for a product? How does the demand curve react to changes
in demand? What do we mean by normal goods? Inferior goods? Complementary goods?
Substitute goods?
6.
What is the law of supply? What influences the quantity supplied of a good? What are the
features of a supply curve? How do supply curves illustrate the law of supply? What factors
can cause the supply of a product to change and how are these changes reflected in the
supply curve?
7.
What is the equilibrium price for a product? What do we mean by a shortage? A surplus?
8.
How do changes in the supply or demand for a product affect its equilibrium price and
quantity?
Key Concepts
1.
2.
Circular flow model and markets
Demand (D)
a.
b.
c.
d.
3.
Supply (S)
a.
b.
c.
4.
D schedule, D curve, movement along D curve, law of D
Factors affecting D, shift of D curve
Individual and market D
Types of goods (normal, inferior, substitutes, complements)
S schedule, S curve, movement along S curve, law of S
Factors affecting S, shift of S curve
Individual and market S
Market interaction of S&D
a.
b.
c.
d.
Disequilibrium (excess demand, excess supply)
Equilibrium & equilibrium changes (due to shifts in D and/or S)
Market and non market alternatives for allocating goods/services
Price ceilings, price floors, taxes
Circular Flow Model

This is a diagram that shows how 1) funds
and 2) tangible items/services are
exchanged between households and
business firms. It simplifies the description of
an ‘economy down to two types of markets
(input and output) and two types of decision
makers (consumers and firms).
Question
 Suppose
a cold winter shifts the D
curve for oil to the right, while an
oil-worker strike shifts the S curve
of oil to the left. Will there be a
shortage of oil in the market?
Question

Many high school students in California are
currently unable to get into one of the main
public California universities (e.g. USC,
UCLA) even though they are excellent
students. What is the most logical economic
explanation for this?
Question
 Your
instructor often advises
students to buy roses for their
“valentine” the week before
Valentine’s Day. Why?
Some S & D Managerial Implications
1.
2.
Understand how P’s are determined in order to anticipate P
changes and capitalize with strategies related to:
- buying
- selling
- producing
- managing inventories
- staffing
- contracting
Understand how consumers and producers are likely to
respond or be motivated by P changes (i.e. how economic
activities are coordinated) in order to anticipate and capitalize
on those expected responses.
Quote of the Day

“In this world, there are two ways to get rich:
#1. Produce something valuable and sell it to
others.
#2. Steal from those who are successful at
pursuing the first strategy.”
N. Gregory Mankiw
Fortune (June 12, 2000)
D Schedule
= a table showing the quantities
(physical amount or units) of an
item a buyer (or buyers) are willing
to buy at different prices, ceteris
paribus
Law of D
D
curves are downward sloping
ΔP
and ΔQd are in ‘opposite’
directions
Product “Dimensions”

1.
2.
3.
The economic concept of Demand
pertains to a specific item where the
following dimensions are specified:
The form (quality/type)
The location
The time
D Curve Types
1.
2.
3.
One consumer
One firm (i.e. its customers)
One market (i.e. all buyers in the
market)
Question
On a typical day, literally millions
of hamburgers are purchased by
individuals in the U.S. What
factors influence the willingness
and ability of these consumers to
buy hamburgers?
Factors That Affect D for X
1. PX = P of that product (or item) (note ΔP could be
caused by Δ supply)
2. P and/or availability of another item (e.g. Y)
a. Substitutes (PY   D for X)
b. Complements (PY   D for X)
3. Income (I)
a. Inferior (I  D for X)
b. Normal (I  D for X)
4. Type of Item
a. Luxury
b. Necessity
Factors That Affect D for X
5.
Buyer concerns or expectations
a.
b.
c.
6.
7.
8.
9.
10.
11.
12.
Safety
Health
Cost
Advertising
Tastes and preferences
No. of buyers or alternative uses
Govt. policy (e.g. tax)
Seasonality
Interest rates
Profitability of an input – derived demand
Change in “Quantity Demanded” of X
(Due to ΔPX = ΔP of THAT product)
PX
A to B: Increase in quantity demanded
A
10
B
6
D0
4
7
Q
Change in “Demand” for X
(Due to Δ other than ΔP of THAT product)
D0 to D1: Increase in Demand
PX
6
D1
D0
Q
7
13
Graphical Impacts of D (for X) Factor s
1.
2.
ΔPX  movement along the D curve for X
(often called “Δ in quantity demanded”)
Δ any other factor  shift of the D curve for
X (called “Δ in demand”)
Shift to right   D
S Schedule
= a table showing the quantities
(physical amount or units) of an
item a seller (or sellers) are willing
to sell at different prices, ceteris
paribus.
S Curve
= a graph of a S schedule, normally with price
(P) units on the vertical axis.
P
S
Q
Law of S
S
curves are upward sloping
 ΔP
and ΔQS are in the “same” direction
Question
In a typical year recently, U.S.
farmers produce 9-11 billion
bushels of corn. What factors
influence the willingness and
ability of these producers to
produce corn?
Factors that Affect S of X
1.
2.
3.
4.
5.
PX = P of that product or item (note ΔP
could be caused ΔD)
P or profitability of an alternative production
item (e.g. Y) (PY  S of X)
P or cost of an input (e.g. Z) (PZ  S of X)
Taxes
Interest rates
Factors that Affect S of X
6.
7.
8.
9.
10.
Gov’t policies/regulations
Technology
Producer expectations
Weather
Number of producers
Graphical Impacts of S (of X) Factor Δs
1.
2.
ΔPX  movement along the S curve for X
(Often called ‘Δ quantity supplied”)
Δ any other factor  shift of the S curve for
X (often called “Δ in supply”)
Shift to right  S
Change in “Quantity Supplied” of X
(Due to ΔP = ΔP of THAT product)
PX
S0
B
20
10
A
Q
5
10
Change in Supply of X
(Due to Δ other thanΔP of THAT product)
PX
S0
S1
8
6
Q
5
7
Question
What happens if a market price
is either above or below the
equilibrium value?
Equilibrium Price =
Price for which QD = QS
P
(P=0+.01Q)
3.00
S
2.00*
← equilibrium point
(P=4-.01Q)
1.00
D
100
200*
300
Disequilibrium price
 Prices for Qd ≠ QS
P
(P=0+.01Q)
Excess S
3.00
S
2.00
(P=4-.01Q)
Excess D
1.00
D
100
200
300
Q
Solving for Equilibrium P
Mathematically
Set S equation for P = D equation for P, and solve
for equilibrium Q
2.
Plug equilibrium Q back into either the S equation
or the D equation and solve for equilibrium P
Example:
S equation: P = 0 + .01Q
D equation: P = 4 - .01Q
 1) .01Q = 4 - .01Q  .02Q = 4  Q = 200
 2) P = 4 - .01Q  P = 4 - .01(200)  P = 2.00
1.
Econ Quote of the Day
Teach a parrot the terms ‘supply and
demand’ and you’ve got an economist.
- Thomas Carlyle
Invisible Hand

In markets, people pursue their own self
interests by responding to price incentives.

Adam Smith (Wealth of Nations, 1776) noted
it’s almost as if individuals are being led by
an ‘invisible hand’, and this self-regulating
behavior actually promotes the best interests
of society as a whole.
The Role of Market Prices
(i.e. markets):
 To
ration or allocate goods and
services (and resources)
(solving the basic production
problems of what, how, and for
whom in the process).
Equilibrium Changes Over Time
P
P
P
S1
S2
D2
D1
Q
T1
S3
D3
Q
T2
Q
T3
Comparative Statics Analysis


Change one D factor that shifts the D curve:
– Results in a change in P that results in a
movement along a given S curve
Change one S factor that shifts the S curve:
– Results in a change in P that results in a
movement along a given D curve
Equilibrium Changes
Case
1. D
P

Q

2. D
3. S
4. S
5. D, S



?




6. D, S

?
7. D, S
8. D, S

?
?

P Rationing Example #1
S curve shifts to left (or D curve shifts
to right)
 Excess demand (i.e. shortage) exists at
original price
 Market P will rise to ration lower supply

Graph of Equilibrium Change,
Case #1 (DX)
 Shift of D curve for X to right caused by ΔD
factor other than ΔPX causes ΔPX which
causes ΔQS (movement along S curve)
PX
S1
P2
P1
D2
D1
QX
Graph of Equilibrium Change
Case #6 (DX, SX)
PX
S2
S1
P2
P1
D2
D1
QX
Graph of Equilibrium Change
Case #4 (SX)
Shift of S curve of X to left caused by ΔS
factor other than ΔPX causes ΔPX which
causes ΔQd (movement along D curve)
PX
S2
S1
P2
P1
D1
QX
Favorite Trading Rules



“The reaction of the market to news is more
important than the news itself.”
“People who buy headlines end up selling
newspapers.”
“Facts are priceless – opinions are
worthless.”
Rich Felthaus, Refco, July 2004
Question
 Do
the laws of S and D work to
determine the price of an item if
there is only ONE unit of that item
to be sold?
P Rationing Example #2

Extremely limited supply (e.g. QS = 1)
P
is D determined
 P will rise until there is only 1 willing
buyer
“Buy land. They’ve stopped making
it.” (Mark Twain)
P
S
Q (land)
P Rationing Example #3 (resources)
Suppose the demand for a product
increases.
 More profits to produce that product
 Profits encourage firms to buy more capital,
labor, etc.
 Input prices influence what specific
resources are used

Question
 Should
the state of Iowa put a ‘cap’
on college tuition increases to
make a University education more
affordable to everyone?
P Constraint Example #1 – P Ceiling
P Ceiling = max P sellers can charge (below
equilibrium P) usually set by Gov’t
Examples: gasoline (1970s), interest rates,
rental rates, ATM fees
Arguments for: P gouging is bad, not ‘fair’ or
right to charge ‘exorbitant’ Ps, everyone
should be able to buy necessities at
‘reasonable’ prices
P Constraint Example #1 – P Ceiling
(cont’d)
Problem: Excess D still exists  need to
implement alternative rationing mechanisms
such as:
1. Queuing  waiting in line
2. Favored customers  let sellers decide
3. Issuing ration tickets or coupons
“Hidden” costs or problems with non-P
rationing mechanisms
1.
2.
3.
4.
Queuing: cost of waiting in line
Favored customers: bribes, hidden ‘service’
charges
Ration coupons: often end up being
bought/sold legally or illegally (black
market)
General: discourages both producers and
consumers from making needed S and/or D
adjustments
P Constraint Example #2 – P Floor




P floor = min. P buyers must pay (above
equilibrium P)
Examples: minimum wage, ag P supports
Arguments for: needed to keep producers in
business, to generate ‘fair’ income levels
Problem: excess S will be created ( e.g.
surplus production, unemployment, etc.)
P Constraint Example #3
– Import Fee
Fee = tax on imports
Impacts:
 P to U.S. consumers   Qd in U.S.
 QS in U.S.
 Q of imports
 Gov’t revenue
P Constraint example #4 (per unit tax
on buyers)
$
Pw/o
t
Pw
D1(w/o tax)
D2 (w/tax)
Q1
Q
To buy Q1 initially, buyers willing to pay Pw/o. After tax,
buyers willing to pay Pw to keep the same total cost per
unit.
=> Tax causes D curve to shift left (or down by amt of t)
Question
 Is
there any product or service you
currently buy that you consider to
be a ‘really good’ deal for the
money?
Consumer Surplus
Amount willing to pay (value)
- Amount have to pay (cost)
___________________________
= consumer surplus
Consumer Surplus (graphically)
= area under the D curve and above the price line
= CS = ½ Q1 (a-P1)
P
a
P1
CS
D
Cost
Q1
Q
Producer Surplus
Amount paid to sellers
- Amount willing to sell for (cost)
__________________________
= producer surplus
Producer Surplus (graphically)
= area above the S curve and under the price line
= PS = ½ Q1 (P1 – a)
P
S
p1
a
PS
Cost
Q1
Q
Economic Impacts of Deviations Away
from Equilibrium
CS
=
consumer surplus
+ PS
=
producer surplus
__________________________________
=
NSW (net social welfare)
Market Equilibrium & NSW
P
S
CS
NSW = net social welfare
Pe
= PS + CS
PS
D
Max NSW  P = Pe
Q
Qe
NSW Impacts: Q & P
P
P2
Pe
CS
a
PS
S
b
c
D
Q
Q1
Δ net social welfare
=
ΔPS + ΔCS
=
(a-c) + (-a-b)
=
-c-b
=
net welfare loss (deadweight loss)
Q2
ΔNSW
=