THE MARKET FORCES OF SUPPLY AND DEMAND

1
THE MARKET FORCES OF SUPPLY AND DEMAND

• Chapter 4

2
The Market Forces of Supply and Demand

• Supply and demand are the two words that
  economists use most often.
• Supply and demand are basic forces that make
  market economies work.
• Understanding S and D takes you a long way toward
  understanding EC 110.

3
The Market Forces of Supply and Demand

• Modern microeconomics is about supply, demand,
  and market equilibrium.
• Rational human behavior lies behind S and D.
• Equilibrium refers to a state of rest within a
  model.

4
Markets and Competition

• The terms supply and demand refer to the behavior
  of people . . .
• . . . as they interact with one another in
  markets.

5
Market

• A market consists of a group of potential buyers
  and sellers of a particular good or service.
• Buyers and sellers interact with one another in
  the market.
• Market interactions between buyers and sellers
  lead to an equilibrium in which prices and
  quantities traded are determined.
• Markets determine prices and quantities traded as
  they adjust to equilibrium.

6
Market

• Buyers are the sources of demand.
• Sellers are the sources of supply.

7
Recall the Circular Flow

• Two Very Different Kinds of markets
• Product or Goods Markets
• Resource or Input Markets
• In product markets
• Individuals are buyers their behavior gives
  rise to demand.
• Business firms are sellers their behavior gives
  rise to supply.

8
Recall the Circular Flow

• Compared to product or Goods Markets, the Sources
  of D and S are generally reversed in resource
  markets.
• In Resource Markets
• Business firms are buyers their behavior gives
  rise to Demand.
• Individuals are sellers and their behavior
  gives rise Supply.

9
Market Type A Competitive Market

• A competitive market is a market. . .
• . . . with many buyers and sellers
• . . . that is not controlled by any one person
• . . . in which a narrow range of prices are
• established upon which buyers and
  sellers act.
• In a competitive market prices are determined by
  the forces of S D.

10
Market Type Perfect and Otherwise

• Perfect Competition
• Products are the same
• Numerous buyers and sellers so that each has no
  influence over price
• Monopoly
• One seller and seller controls price

11
Market Types Perfect Otherwise

• Oligopoly
• Few sellers
• Not always aggressive competition
• Monopolistic Competition
• Many sellers
• Differentiated products

12
The S and D Model

• Most Important Model in EC 110
• A powerful model that can be used to explain many
  puzzling questions
• The model is a part of positive economics.
• It focuses on interdependent behavior of buyers
  and sellers in markets.

13
The Concept of Demand

• Quantity demanded is the amount of a good that
  buyers are willing and able to purchase at a
  particular price.

14
Demand Schedule

• The demand schedule is a table that shows the
  relationship between the price of the good and
  the quantity demanded.
• When we construct a demand schedule we assume
  factors other than price per unit that affect the
  quantity the buyer is willing to purchase at that
  price are held constant.

15
Ceteris Paribus

• The assumption that other things are held
  constant is widely used in economic models and we
  have special name for it -- Ceteris Paribus.
• Ceteris Paribus is a Latin phrase that means that
  all variables other than the ones being studied
  are assumed to be constant.

16
Demand Curve

• The demand curve is the downward-sloping line
  relating price to quantity demanded.
• It is constructed Ceteris Paribus.

17
Demand for Ice Cream
18
Demand for Ice Cream
19
Demand for Ice Cream
20
Law of Demand

• The law of demand states that there is an inverse
  relationship between price and quantity demanded,
  Ceteris Paribus.

21
What a Demand Curve Shows

• A D curve shows shows two important and related
  things
• It shows the quantity the buyer is willing and
  able to purchase at a particular price.
• It shows the maximum price the buyer will pay
  for a particular quantity.
• The quantity the buyer is willing and able to
  purchase at a particular price is called the
  quantity demanded.
• The maximum price a buyer will pay for a
  particular quantity is called the demand price.

22
What a Demand Curve Shows Quantity Demanded

• At any particular price there is a specific
  quantity demanded.
• The Law of D insures that, at a lower price,
  there will be a larger quantity demanded.
• Conversely, at a higher price, the Law of D
  insures that there will be a smaller quantity
  demanded.

23
What a Demand Curve Shows Demand Price

• The D curve shows the maximum price a buyer or
  group of buyers will pay for a particular
  quantity (called the quantity demanded).
• Buyers will never pay more than the maximum, but
  would gladly pay less.
• The maximum price is called the demand price.

24
Whats Behind the Law of Demand?

• Why do demand curves slope negatively?
• The keys to this most important economic law are
• Rational Behavior by Buyers the Principle of
  Substitution.
• Rational buyers substitute away from a good (buy
  less) as it becomes more pricey.
• Rational buyers substitute in favor of a good
  (buy more) as it becomes less expensive relative
  to other goods.

25
Determinants of Demand

• Market price -- determines the quantity demanded
• Other determinants of Demand
• Consumer income
• Prices of related goods
• Tastes
• Expectations
• Number of consumers

26
Income
Price of Ice-Cream Cones

• As income increases the demand for a normal good
  will increase.

Demand curve, D 1
Quantity of Ice-Cream Cones
0
27
Income
Price of Ice-Cream Cones

• As income increases the demand for a normal good
  will increase.

Increase in demand
Demand curve, D 2
Demand curve, D 1
Quantity of Ice-Cream Cones
0
28
Income

• As income increases the demand for an inferior
  good will decrease.

Price of Ice-Cream Cones
Demand curve, D 1
Quantity of Ice-Cream Cones
0
29
Income

• As income increases the demand for an inferior
  good will decrease.

Price of Ice-Cream Cones
Decrease in demand
Demand curve, D 1
Demand curve, D 3
Quantity of Ice-Cream Cones
0
30
Prices of Related Goods

• When a fall in the price of one good reduces the
  demand for another good, the two goods are called
  substitutes.

31
Prices of Related Goods

• When a fall in the price of one good increases
  the demand for another good, the two goods are
  called complements.

32
Factors That Shift the D Curve to the Right
(Increase Demand)

• Income
• A rise in income (normal goods)
• A fall in Income (Inferior goods)
• Changes in the Price of Related Goods
• A rise in the price of substitutes
• A fall in the price of complements
• A Change in Tastes
• The good becomes more desirable.
• A Change in Expectations
• Price is expected to rise.
• An Increase in the No. of Buyers

33
Factors That Shift the D Curve to the Left
(decrease demand)

• Income
• A fall in income (normal goods)
• A rise in Income (inferior goods)
• Changes in the Price of Related Goods
• A fall in the price of substitutes
• A rise in the price of complements
• A Change in Tastes
• The good becomes less desirable.
• A Change in Expectations
• Price is expected to fall.
• A Decrease in the No. of Buyers

34
Change in Quantity Demanded versus Change in
Demand

• Change in Demand
• ? A shift in the demand curve, either to the
  left or right.
• ? Caused by a change in a determinant other than
  the price.

35
Change in Quantity Demanded versus Change in
Demand

• Change in Quantity Demanded
• ? Movement along the demand curve.
• ? Caused by a change in the price of the
  product.

36
Change in Quantity Demanded versus Change in
Demand
37
Changes in Quantity Demanded
Price of Cigarettes, per Pack
4.00
2.00
D1
0
12
20
Number of Cigarettes Smoked per Day
38
Changes in Quantity Demanded
Price of Cigarettes, per Pack
A tax that raises the price of cigarettes results
in a movement along the demand curve.
4.00
2.00
D1
0
12
20
Number of Cigarettes Smoked per Day
39
Changes in Quantity Demanded
Price of Cigarettes, per Pack
A tax that raises the price of cigarettes results
in a movement along the demand curve.
C
4.00
A
2.00
D1
0
12
20
Number of Cigarettes Smoked per Day
40
Changes in Quantity Demanded
Price of Cigarettes, per Pack
A tax that raises the price of cigarettes results
in a movement along the demand curve.
C
4.00
A
2.00
D1
0
12
20
Number of Cigarettes Smoked per Day
41
Change in Demand
42
Change in Demand
Price of Cigarettes, per Pack
2.00
D1
0
10
20
Number of Cigarettes Smoked per Day
43
Change in Demand
Price of Cigarettes, per Pack
A policy to discourage smoking shifts the demand
curve to the left.
2.00
D1
0
10
20
Number of Cigarettes Smoked per Day
44
Change in Demand
Price of Cigarettes, per Pack
A policy to discourage smoking shifts the demand
curve to the left.
2.00
D 2
D1
0
10
20
Number of Cigarettes Smoked per Day
45
Change in Demand
Price of Cigarettes, per Pack
A policy to discourage smoking shifts the demand
curve to the left.
B
A
2.00
D 2
D1
0
10
20
Number of Cigarettes Smoked per Day
46
The Concept of Supply

• Quantity supplied is the amount of a good that
  sellers are willing and able to sell at a
  particular price.

47
Determinants of Supply in Markets for Goods
Services

• Market price determines quantity supplied
• Other Determinants of S include
• Input prices
• Technology
• Seller Expectations
• Number of producers/sellers

48
Law of Supply

• The law of supply states that there is a direct
  (positive) relationship between price and
  quantity supplied, Ceteris Paribus .

49
Supply Schedule

• The supply schedule is a table that shows the
  relationship between the price of the good and
  the quantity supplied, Ceteris Paribus .

50
Supply Curve

• The supply curve is the upward-sloping line
  relating price to quantity supplied.

51
Supply Curve
52
Supply Curve
53
Supply Curve
54
What a Supply Curve Shows

• A S curve shows shows two important and related
  things
• It shows the quantity the seller is willing and
  able to sell at a particular price.
• It shows the minimum price the seller will
  accept for a particular quantity.
• The quantity the seller is willing and able to
  sell at a particular price is called the
  quantity supplied.
• The minimum price a buyer will accept for a
  particular quantity is called the supply price.

55
What a Supply Curve Shows Quantity Supplied

• At any particular price there is a specific
  quantity supplied.
• The Law of S generally (usually) insures that, at
  a higher price, there will be a larger quantity
  supplied.
• Conversely, at a lower price, the Law of S
  usually insures that there will be a smaller
  quantity supplied.

56
What a Supply Curve Shows Supply Price

• The S curve shows the minimum price a seller or
  group of buyers will accept for a particular
  quantity (called the quantity supplied).
• Sellers will never accept less than the minimum,
  but would gladly accept more.
• The minimum price is called the supply price.

57
Whats Behind the Law of Supply?

• Why do Supply curves slope positively or have
  zero slope?
• The keys to this economic law are
• Rational Behavior, Opportunity Costs, and
  Sellers Profit Seeking behavior.
• Rational sellers insist on receiving a higher
  price if they have higher opportunity costs.
  Price must cover costs.
• Rational sellers shift their production in favor
  of goods that are more profitable to produce and
  sell. They shift away from goods that have
  negative profits (losses).

58
Change in Quantity Supplied versus Change in
Supply

• Change in Quantity Supplied
• ? Movement along the supply curve.
• ? Caused by a change in the market
• price of the product.

59
Change in Quantity Supplied versus Change in
Supply

• Change in Supply
• ? A shift in the supply curve, either to
• the left or right.
• ? Caused by a change in a
• determinant other than price, i.e., one
  of
• the things impounded in the Ceteris
• Paribus assumption.

60
Change in Quantity Supplied versus Change in
Supply
61
Increase in Supply
62
Increase in Supply
Price of Ice-Cream Cone
Supply curve, S1
0
Quantity of Ice-Cream Cones
63
Increase in Supply
Price of Ice-Cream Cone
Supply curve, S1
Supply curve, S2
Increase in supply
0
Quantity of Ice-Cream Cones
64
Decrease in Supply
Price of Ice-Cream Cone
Supply curve, S1
0
Quantity of Ice-Cream Cones
65
Decrease in Supply
Price of Ice-Cream Cone
Supply curve, S3
Supply curve, S1
Decrease in supply
0
Quantity of Ice-Cream Cones
66
Factors That Shift the S Curve to the Right
(Increase Supply)

• Resource Prices
• A fall in input prices
• Technological Knowledge
• An improvement in technology shifts the S curve
  rightward.
• A Change in Seller Expectations
• Price is expected to fall.
• An Increase in the No. of Sellers

67
Factors That Shift the S Curve to the Left
(decrease supply)

• Resource Prices
• A fall in input prices
• A Change in Seller Expectations
• Sellers expect price to rise.
• A Decrease in the No. of Sellers

68
Supply and Demand Together

• Equilibrium Price
• ? The price that balances supply and demand.
  On a graph, it is the price at which the supply
  and demand curves intersect.

69
Supply and Demand Together

• Equilibrium Quantity
• ? The quantity that balances supply
• and demand. On a graph, it is the
• quantity at which the supply and
• demand curves intersect.

70
Equilibrium of Supply and Demand
71
Equilibrium of Supply and Demand
Price of Ice-Cream Cone
Supply
2.00
Demand
0
1
2
3
4
5
6
7
8
9
10
11
12
13
Quantity of Ice-Cream Cones
72
Equilibrium of Supply and Demand
Price of Ice-Cream Cone
Supply
Equilibrium
2.00
Demand
0
1
2
3
4
5
6
7
8
9
10
11
12
13
Quantity of Ice-Cream Cones
73
Equilibrium of Supply and Demand
74
Markets Not in Equilibrium

• Disequilibrium
• Excess Supply exists if
• ? Price is above equilibrium price.
• ? In this situation, sellers are unable
• to sell all they want at the going
• market price.

75
Markets Not in Equilibrium

• Disequilibrium
• Excess Demand exists if
• ? Price is below equilibrium price.
• ? Consumers are unable to buy all
• they want at the going price.
• ? Some buyers cannot find sellers.
• ? Price rises when excess D exists.

76
Excess Supply
Price of Ice-Cream Cone
Supply
2.00
Demand
0
4
7
10
Quantity of Ice-Cream Cones
77
Excess Supply
Price of Ice-Cream Cone
Supply
2.00
Demand
0
4
7
10
Quantity of Ice-Cream Cones
78
Excess Supply
Price of Ice-Cream Cone
Supply
2.50
2.00
Demand
0
4
7
10
Quantity of Ice-Cream Cones
79
Excess Supply
Price of Ice-Cream Cone
Supply
2.50
2.00
Demand
0
4
7
10
Quantity of Ice-Cream Cones
Quantity demanded
Quantity supplied
80
Excess Supply
Price of Ice-Cream Cone
Excess supply
Supply
2.50
2.00
Demand
0
4
7
10
Quantity of Ice-Cream Cones
Quantity demanded
Quantity supplied
81
Excess Demand
Price of Ice-Cream Cone
Supply
2.00
Demand
0
4
7
10
Quantity of Ice-Cream Cones
82
Excess Demand
Price of Ice-Cream Cone
Supply
2.00
Demand
0
4
7
10
Quantity of Ice-Cream Cones
83
Excess Demand
Price of Ice-Cream Cone
Supply
2.00
1.50
Demand
0
4
7
10
Quantity of Ice-Cream Cones
84
Excess Demand
Price of Ice-Cream Cone
Supply
2.00
1.50
Demand
0
4
7
10
Quantity of Ice-Cream Cones
Quantity demanded
Quantity supplied
85
Excess Demand
Price of Ice-Cream Cone
Supply
2.00
1.50
Excess demand
Demand
0
4
7
10
Quantity of Ice-Cream Cones
Quantity demanded
Quantity supplied
86
Applying the S and D Model

• The primary purpose of the S and D model is to
  help us understand how real world events and
  changes in market conditions cause changes in the
  interactions between buyers and sellers, which
  then causes fundamental changes in prices and
  quantities traded.
• We use our knowledge of what happens in the model
  to predict what will happen in the real world
  under similar circumstances.

87
Applying the S and D Model

• When a real world event impacting upon a market
  occurs, then D changes, S changes, or both D and
  S change.
• The original equilibrium before the event is no
  longer an equilibrium, but it is the starting
  point for figuring out what will happen.
• The S and D model will adjust to a new
  equilibrium.
• Applying the S and D model to figure out how the
  world changes following the event is called
  comparative static analysis.

88
Analyzing Changes in Market Equilibrium

• Decide whether the event shifts the supply or
  demand curve (or both).
• Decide whether the curve(s) shift(s) to the left
  or right.
• Determine how the shift affects equilibrium price
  and quantity.

89
How an Increase in Demand Affects the Equilibrium
Price of Ice-Cream Cone
Supply
2.00
Initial equilibrium
D1
0
7
10
Quantity of Ice-Cream Cones
90
How an Increase in Demand Affects the Equilibrium
Price of Ice-Cream Cone
1. Hot weather increases the demand for ice
cream...
Supply
2.00
Initial equilibrium
D1
0
7
10
Quantity of Ice-Cream Cones
91
How an Increase in Demand Affects the Equilibrium
Price of Ice-Cream Cone
1. Hot weather increases the demand for ice
cream...
Supply
2.00
Initial equilibrium
D2
D1
0
7
10
Quantity of Ice-Cream Cones
92
How an Increase in Demand Affects the Equilibrium
Price of Ice-Cream Cone
1. Hot weather increases the demand for ice
cream...
Supply
2.50
New equilibrium
2.00
Initial equilibrium
D2
D1
0
7
10
Quantity of Ice-Cream Cones
93
How an Increase in Demand Affects the Equilibrium
Price of Ice-Cream Cone
1. Hot weather increases the demand for ice
cream...
Supply
2.50
New equilibrium
2.00
2. ...resulting in a higher price...
Initial equilibrium
D2
D1
0
7
10
Quantity of Ice-Cream Cones
94
How an Increase in Demand Affects the Equilibrium
95
How a Decrease in Supply Affects the Equilibrium
Price of Ice-Cream Cone
S1
Initial equilibrium
2.00
Demand
10
0
1
2
3
4
5
6
7
8
9
11
12
13
Quantity of Ice-Cream Cones
96
How a Decrease in Supply Affects the Equilibrium
Price of Ice-Cream Cone
1. An earthquake reduces the supply of ice
cream...
S1
Initial equilibrium
2.00
Demand
10
0
1
2
3
4
5
6
7
8
9
11
12
13
Quantity of Ice-Cream Cones
97
How a Decrease in Supply Affects the Equilibrium
Price of Ice-Cream Cone
1. An earthquake reduces the supply of ice
cream...
S2
S1
Initial equilibrium
2.00
Demand
10
0
1
2
3
4
5
6
7
8
9
11
12
13
Quantity of Ice-Cream Cones
98
How a Decrease in Supply Affects the Equilibrium
Price of Ice-Cream Cone
1. An earthquake reduces the supply of ice
cream...
S2
S1
New equilibrium
2.50
Initial equilibrium
2.00
Demand
10
0
1
2
3
4
5
6
7
8
9
11
12
13
Quantity of Ice-Cream Cones
99
How a Decrease in Supply Affects the Equilibrium
Price of Ice-Cream Cone
1. An earthquake reduces the supply of ice
cream...
S2
S1
New equilibrium
2.50
Initial equilibrium
2.00
2. ...resulting in a higher price...
Demand
10
0
1
2
3
4
5
6
7
8
9
11
12
13
Quantity of Ice-Cream Cones
100
How a Decrease in Supply Affects the Equilibrium
Price of Ice-Cream Cone
1. An earthquake reduces the supply of ice
cream...
S2
S1
New equilibrium
2.50
Initial equilibrium
2.00
2. ...resulting in a higher price...
Demand
10
0
1
2
3
4
7
8
9
11
12
13
Quantity of Ice-Cream Cones
3. ...and a lower quantity sold.