Chapter III Demand , Supply, and Equilibrium

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Chapter IIIDemand , Supply, and Equilibrium

• The Single Market
• J.F. OConnor
• 1/19/05

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Outline

• Self-sufficiency versus interdependence
• The economic problem and alternative ways of
  solving it
• Monetary economy versus barter
• Demand and factors affecting demand
• Supply and factors affecting supply
• Equilibrium in the market

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• Social Efficiency of the market equilibrium
• How does the equilibrium change when the factors
  affecting demand and supply change?
• Government intervention in the market price
  floor, price ceiling, tax and subsidy.

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Two Contrasting Economies

• Self-sufficiency (Subsistence)
• Each unit, individual or family, produces the
  goods and services that it wants.
• Each unit consumes what it produces.
• Kentucky 1770.

• Interdependent
• Each unit produces little if any of the goods and
  services that it wants.
• Each unit consumes little if any of the services
  that it produces.
• Kentucky 2002

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The Economic Problem

• What goods and services will be produced and who
  will produce them? (Choice)
• How will the goods and services be produced? (
  Organization)
• For whom will the goods and services be produced?
  (Distribution)
• Who makes economic decisions and by what process?
  (System)

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Solving the Economic Problem

• Not very complicated for the self-sufficient
  units in a subsistence economy
• The modern economy, with its specialization,
  needs a mechanism to
  a) bring potential buyers and
  sellers of each product together
  b) coordinate the
  plans of the specialized individuals and groups
• A system of markets is one such mechanism
  
  

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A Modern Market

• Barter economy goods are exchanged for other
  goods.
• Monetary economy goods are exchanged for money.
• We have talked about the value of oranges in
  terms of apples. We could also value all the
  other goods in the economy in terms of apples.
  Apples would then be the unit of account.
  However, we still have a problem in that we need
  a medium of exchange and apples are not too
  convenient. So we introduce money.

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The Role of Money

• The unit of account
• The medium of exchange
• A store of value
• The importance of money in the market process is
  that it allows one to sell what one has without
  having to find a buyer who is selling what you
  want to buy.

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Two Kinds Of Money

• Currency
• Demand deposits - what is in your checking
  account.
• Be careful to distinguish income, wealth, and
  money.

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A Single Market

• One good, say, ice cream, and two kinds of
  people
• Buyers
• Sellers
• Demand represents the intentions of buyers.
• Supply represents the intentions of sellers.

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Demand

• Demand gives the relationship between the
  quantity of the good that buyers are willing and
  able to purchase and the price of the good, while
  other factors affecting quantity demanded are
  held constant.
• We can represent demand in a table, a graph, or
  an equation. Accordingly, we talk about a demand
  schedule, curve, or function.

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Factors Affecting Demand

• Prices of other goods
• Income of buyers
• Preferences or tastes of buyers
• Number of buyers
• Expectations about prices
• Advertising ?

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Demand Schedules
Two buyers, Cath and Nick
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Demand Curve
The market demand is the sum of the individual
demands
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Supply

• Supply is the relationship between the quantity
  of the good that sellers are willing and able to
  supply and the price of the good, while other
  factors affecting quantity supplied are constant.
• We can represent supply in a table, a graph, or
  an equation. Accordingly, we talk about a supply
  schedule, curve, or function.

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Factors Affecting Supply

• Input prices
• Technology of production
• Number of sellers
• Expectations

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Supply Schedules
Two sellers, Ben and Jerry
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Supply Curve
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Market Equilibrium

• Balancing Demand and Supply.
• The equilibrium price is the price at which the
  quantity demanded is equal to the quantity
  supplied.
• If you have excess demand or excess supply the
  market is not in equilibrium. Why?
• Excess demand (shortage) increases price excess
  supply (surplus) depresses price.

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Market Demand and Supply
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Market Equilibrium
Equilibrium price 2 quantity 7 units
Supply
Demand
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Markets and Social Welfare

• Social optimal quantity of a good
• The quantity that results in the maximum possible
  economic surplus.
• The socially optimal quantity will occur where
  the marginal cost equals the marginal benefit.
• Economic efficiency
• Occurs when all goods and services are produced
  and consumed at their respective socially optimal
  levels.

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Markets and Efficiency

• Efficiency Principle
• Efficiency is an important social goal.
• Everyone can have a larger slice of a larger pie.
• Equilibrium Principle
• A market in equilibrium leaves no unexploited
  opportunities for individuals.
• No cash on the table remains.
• All opportunities for profit have been exploited.
• Efficiency occurs when
• the market-demand curve captures all the marginal
  benefits of the good.
• the market-supply curve captures all the marginal
  costs of the good.

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Terminology

• If the goods price changes, you have a
• change in quantity demanded
• A movement along the demand curve
• change in quantity supplied
• A movement along the supply curve
• If something else changes, you have a
• change in demand
• A shift of the entire demand curve
• change in supply
• A shift of the entire supply curve

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Fig. 4.9An Increase in the Quantity Demanded
Versus an Increase in Demand
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Increase in Demand

• Means the demand curve shifts right
• Caused by factors other than the price of the
  good
• For a normal good, an increase in income
• An increase in the price of a substitute or a
  decrease in the price of a complement
• An increase in the number of buyers
• Change in preferences

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Increase in Demand
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Increase in Demand

• Note that demand increases by 6 units but the new
  equilibrium quantity is only 3 units greater than
  old. Why?
• Note that the increase in demand results in a
  movement up the supply curve.
• You should analyze a decrease in demand.

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Increase in Supply

• Sellers are willing to supply more units of the
  good at each price.
• Major Causes
• decrease in input prices
• improvement in technology of production
• increase in the number of sellers

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Increase in Supply

• Increase in supply results in an increase in the
  equilibrium quantity and a decrease in price.
• Note that the increase in supply results in a
  movement down the demand curve.
• You should analyze a decrease in supply

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Free Markets and Equilibrium

• Free markets have an automatic tendency to
  eliminate excess supply and excess demand.
• Surplus leads producers to decrease the price
• Shortage leads producers to increase the price

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Reasons for Government Activity

• Efficiency Concerns
• Imperfect Competition
• Externalities
• Public goods
• Equity considerations
• Distribution of outcomes
• Distribution of endowments

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Legislation and Markets

• Market equilibrium does not mean that everyone
  has what they want.
• E.G. a poor person may not be able to afford the
  item at the equilibrium price.
• Legislators protect consumers by using
• price ceilings
• A maximum allowable price specified by law
• Price signal is too low, so consumers want too
  much
• e.g. rent controls, limits on the price of
  gasoline
• Result in shortages

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Legislation and Markets

• Legislators protect producers by using
• price floors
• A minimum allowable price specified by law
• For example, price supports, minimum wage
• Price signal is too high, so consumers dont want
  as much.
• Result in surpluses

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Fig. 4.6An Unregulated Housing Market
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Fig. 4.7Rent Controls
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Economists and the Poor

• Economists realize there are more effective ways
  of helping the poor than violating the free
  market system.
• Using rent controls or price ceilings results in
  inefficiency for everyone.
• Using a direct income transfer to the poor is a
  more efficient way to help.

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Fig. 4.8Price Controls in the Hamburger Market
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and
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Shifts in Supply

• Favorable changes to the producer shift supply
  curve rightward.
• lower equilibrium price
• higher equilibrium quantity
• Unfavorable changes to the producer shift supply
  leftward.
• higher equilibrium price
• lower equilibrium quantity

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Fig. 4.10The Effect on the Skateboard Market of
an Increase in the Price of Fiberglass
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Shifts in Supply

• Changes in the Cost of Production
• Changes in Technology
• Changes in Weather
• Changes in Expectations

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Fig. 4.11The Effect on the Market for New Houses
of a Decline in Carpenters Wage Rates
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Fig. 4.12The Effect of Technical Change on the
Market for Manuscript Revisions
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Shifts in Demand

• Complements
• Substitutes
• Income
• Preferences
• Demand curve shifts rightward
• higher equilibrium price
• higher equilibrium quantity
• Demand curve shifts leftward
• lower equilibrium price
• lower equilibrium quantity

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Fig. 4.13The Effect on the Market for Tennis
Balls of a Decline in Court Rental Fees
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Complements

• Goods that are more valuable when used in
  combination--e.g. tennis balls and tennis courts.
• Two goods are complements in consumption if an
  increase in the price of one causes a leftward
  shift in the demand curve for the other.

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Substitutes

• Goods that replace each other--e.g. email
  messages and overnight letters.
• Two goods are substitutes in consumption if an
  increase in the price of one causes a rightward
  shift in the demand curve for the other.

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Fig. 4.14Effect on the Market for Overnight
Letter Delivery of a Decline in the Price of
Internet Access
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Income

• Normal good
• One whose demand curve shifts right when the
  incomes of buyers increase.
• Inferior good
• One whose demand curves shifts left when the
  incomes of buyers increase.

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Fig. 4.15The Effect of a Federal Pay Raise on
the Rent for Conveniently Located Apartments
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Simultaneous Shifts

• If, at the same time,
• Demand decreases and Supply increases
• Demand shifts left
• Lower price, lower quantity
• Supply shifts right
• Lower price, higher quantity
• We can predict that price will fall
• But, what happens to quantity?
• We must know the magnitude of the shifts

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Fig. 4.16Four Rules Governing the Effects of
Supply and Demand Shifts
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Fig. 4.17 The Effects of Simultaneous Shifts in
Supply and Demand
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Fig. 4.18Seasonal Variation in the Air Travel
and Corn Markets
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Economic System

• An economic system is a set of arrangements for
  solving the economic problem.
• Important Features
• Ownership of resources
• Procedure for making decisions
• Objectives of decision makers

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Alternative Systems

• Pure Capitalism
• Private ownership
• Decentralized decision making
• Cooperative System
• Communal ownership
• Democratic decision making

• Communal Command
• Communal ownership
• Centralized decision making
• Mixed Systems
• Democratic capitalism
• Democratic socialism

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Mixed Open Economy

• Consumer sovereignty
• Substantial private ownership and private
  enterprise production.
• Substantial use of markets to guide resource
  allocation.
• Substantial government activity
• Significant international trade