Theory of Supply and Demand Hall and Lieberman, 3rd edition, Thomson SouthWestern, Chapter 3

1
Theory of Supply and Demand Hall and Lieberman,
3rd edition, Thomson South-Western, Chapter 3

2
Overview

• Market (who, what, how)
• Supply and demand is an economic model
• Designed to explain how prices are determined in
  certain types of markets
• What you will learn in this chapter
• How the model of supply and demand works and how
  to use it
• The law of demand
• The law of supply
• The determination of market equilibrium
• Factors shifting demand or supply curves

3
Markets

• In economics, a market is not a place but rather
  a group of buyers and sellers with the potential
  to trade with each other
• Market is defined not by its location but by its
  participants
• First step in an economic analysis is to define
  and characterize the market or collection of
  markets to analyze
• Economists think of the economy as a collection
  of individual markets

4
How Broadly Should We Define The Market

• Defining the market often requires economists to
  group things together
• Aggregation is the combining of a group of
  distinct things into a single whole
• Markets can be defined broadly or narrowly,
  depending on our purpose
• How broadly or narrowly markets are defined is
  one of the most important differences between
  Macroeconomics and Microeconomics

5
Defining Macroeconomic Markets

• Goods and services are aggregated to the highest
  levels
• Macro models lump all consumer goods into the
  single category consumption goods
• Macro models will also analyze all capital goods
  as one market
• Macroeconomists take an overall view of the
  economy without getting bogged down in details

6
Defining Microeconomic Markets

• Markets are defined narrowly
• Focus on models that define much more specific
  commodities
• Always involves some aggregation
• But stops it reaches the highest level of
  generality that macroeconomics investigates

7
Buyers and Sellers

• Buyers and sellers in a market can be
• Households
• Business firms
• Government agencies
• All three can be both buyers and sellers in the
  same market, but are not always
• For purposes of simplification this text will
  usually follow these guidelines
• In markets for consumer goods, well view
  business firms as the only sellers, and
  households as only buyers
• In most of our discussions, well be leaving out
  the middleman

8
Competition in Markets

• In imperfectly competitive markets, individual
  buyers or sellers can influence the price of the
  product
• In perfectly competitive markets (or just
  competitive markets), each buyer and seller takes
  the market price as a given
• What makes some markets imperfectly competitive
  and others perfectly competitive?
• Perfectly competitive markets have many small
  buyers and sellers
• Each is a small part of the market, and the
  product is standardized
• Imperfectly competitive markets have just a few
  large buyers and sellers
• Or else the product of each seller is unique in
  some way

9
Using Supply and Demand

• Supply and demand model is designed to explain
  how prices are determined in perfectly
  competitive markets
• Perfect competition is rare but many markets come
  reasonably close
• Perfect competition is a matter of degree rather
  than an all or nothing characteristic
• Supply and demand is one of the most versatile
  and widely used models in the economists tool kit

10
Demand

• A households quantity demanded of a good
• Specific amount household would choose to buy
  over some time period, given
• A particular price that must be paid for the good
• All other constraints on the household
• Market quantity demanded (or quantity demanded)
  is the specific amount of a good that all buyers
  in the market would choose to buy over some time
  period, given
• A particular price they must pay for the good
• All other constraints on households

11
Quantity Demanded

• Implies a choice
• How much households would like to buy when they
  take into account the opportunity cost of their
  decisions?
• Is hypothetical
• Makes no assumptions about availability of the
  good
• How much would households want to buy, at a
  specific price, given real-world limits on their
  spending power?
• Stresses price
• Price of the good is one variable among many that
  influences quantity demanded
• Well assume that all other influences on demand
  are held constant, so we can explore the
  relationship between price and quantity demanded

12
The Law of Demand

• The price of a good rises and everything else
  remains the same, the quantity of the good
  demanded will fall
• The words, everything else remains the same are
  important
• In the real world many variables change
  simultaneously
• However, in order to understand the economy we
  must first understand each variable separately
• Thus we assume that, everything else remains the
  same, in order to understand how demand reacts
  to price

13
The Demand Schedule

• Demand schedule
• A list showing the quantity of a good that
  consumers would choose to purchase at different
  prices, with all other variables held constant
• Demand V.S. Quantities demanded
• - demand is the entire relationship between
  price and quantity
• - quantities demanded are specific
  amount of goods buyers want to buy

14
The Demand Curve

• The market demand curve (or just demand curve)
  shows the relationship between the price of a
  good and the quantity demanded , holding constant
  all other variables that influence demand
• Each point on the curve shows the total buyers
  would choose to buy at a specific price
• Law of demand tells us that demand curves
  virtually always slope downward

15
Figure 1 The Demand Curve
A
4.00
B
2.00
D
40,000
60,000
16
Shifts vs. Movements Along The Demand Curve

• Move along the demand curve
• From a change in the price of the good we analyze
• In maple syrup example, Figure 1
• A fall in price would cause a movement to the
  right along the demand curve (point A to B)
• See figure 3(a)

17
Figure 3(a) Movements Along and Shifts of The
Demand Curve
P2
P1
P3
Q2
Q1
Q3
18
Shifts vs. Movements Along The Demand Curve

• Shift of demand curve
• a change in other things than price of the good
  causes a shift in the demand curve itself, for
  example, income
• In Figure 2
• Demand curve has shifted to the right of the old
  curve (from Figure 1) as income has risen
• A change in any variable that affects
  demandexcept for the goods pricecauses the
  demand curve to shift

19
Figure 2 A Shift of The Demand Curve
B
C
2.00
60,000
80,000
20
Change in Quantity Demanded vs. Change in
Demand

• Language is important when discussing demand
• Quantity demanded means
• A particular amount that buyers would choose to
  buy at a specific price
• It is a number represented by a single point on a
  demand curve
• When a change in the price of a good moves us
  along a demand curve, it is a change in quantity
  demand
• The term demand means
• The entire relationship between price and
  quantity demandedand represented by the entire
  demand curve
• When something other than price changes, causing
  the entire demand curve to shift, it is a change
  in demand

21
Income Factors That Shift The Demand Curve

• An increase in income has effect of shifting
  demand for normal goods to the right
• However, a rise in income shifts demand for
  inferior goods to the left
• A rise in income will increase the demand for a
  normal good, and decrease the demand for an
  inferior good
• Normal good and inferior good are defined by the
  relation between demand and income

22
Wealth Factors That Shift The Demand Curve

• Your wealthat any point in timeis the total
  value of everything you own minus the total
  dollar amount you owe
• - Example
• An increase in wealth will
• Increase demand (shift the curve rightward) for a
  normal good
• Decrease demand (shift the curve leftward) for an
  inferior good

23
Prices of Related Goods Factors that Shift the
Demand Curve

• Substitutegood that can be used in place of some
  other good and that fulfills more or less the
  same purpose
• Example
• A rise in the price of a substitute increases the
  demand for a good, shifting the demand curve to
  the right
• Complementused together with the good we are
  interested in
• Example
• A rise in the price of a complement decreases the
  demand for a good, shifting the demand curve to
  the left

24
Other Factors That Shift the Demand Curve

• Population
• As the population increases in an area
• Number of buyers will ordinarily increase
• Demand for a good will increase
• Expected Price
• An expectation that price will rise (fall) in the
  future shifts the current demand curve rightward
  (leftward)
• Tastes
• Combination of all the personal factors that go
  into determining how a buyer feels about a good
• When tastes change toward a good, demand
  increases, and the demand curve shifts to the
  right
• When tastes change away from a good, demand
  decreases, and the demand curve shifts to the left

25
Small Summary -- Factors Affecting Demand

• Income (depends on goods nature normal or
  inferior)
• Wealth (depends on goods nature)
• Prices of substitutes (positively related)
• Prices of complements (negatively related)
• Population (positively related)
• Expected price (positively related)
• Tastes (positively related)

26
Figure 3(b) Movements Along and Shifts of The
Demand Curve

• Entire demand curve shifts rightward when
• income or wealth ?
• price of substitute ?
• price of complement ?
• population ?
• expected price ?
• tastes shift toward good

D2
D1
27
Figure 3(c) Movements Along and Shifts of The
Demand Curve

• Entire demand curve shifts leftward when
• income or wealth ?
• price of substitute ?
• price of complement ?
• population ?
• expected price ?
• tastes shift toward good

D1
D2
28
Supply

• A firms quantity supplied of a good is the
  specific amount its managers would choose to sell
  over some time period, given
• A particular price for the good
• All other constraints on the firm
• Market quantity supplied (or quantity supplied)
  is the specific amount of a good that all sellers
  in the market would choose to sell over some time
  period, given
• A particular price for the good
• All other constraints on firms

29
Quantity Supplied

• Implies a choice
• Quantity that gives firms the highest possible
  profits when they take account of the constraints
  presented to them by the real world
• Is hypothetical
• Does not make assumptions about firms ability to
  sell the good
• How much would firms managers want to sell,
  given the price of the good and all other
  constraints they must consider?
• Stresses price
• The price of the good is just one variable among
  many that influences quantity supplied
• Well assume that all other influences on supply
  are held constant, so we can explore the
  relationship between price and quantity supplied

30
The Law of Supply

• States that when the price of a good rises and
  everything else remains the same, the quantity of
  the good supplied will rise
• The words, everything else remains the same are
  important
• In the real world many variables change
  simultaneously
• However, in order to understand the economy we
  must first understand each variable separately
• We assume everything else remains the same in
  order to understand how supply reacts to price

31
The Supply Schedule and The Supply Curve

• Supply scheduleshows quantities of a good or
  service firms would choose to produce and sell at
  different prices, with all other variables held
  constant
• Supply curvegraphical depiction of a supply
  schedule
• Shows quantity of a good or service supplied at
  various prices, with all other variables held
  constant

32
Figure 4 The Supply Curve
S
4.00
G
2.00
F
40,000
60,000
33
Shifts vs. Movements Along the Supply Curve

• A change in the price of a good causes a movement
  along the supply curve
• In Figure 4
• A rise (fall) in price would cause a rightward
  (leftward) movement along the supply curve
• A drop in transportation costs will cause a shift
  in the supply curve itself
• In Figure 5
• Supply curve has shifted to the right of the old
  curve (from Figure 4) as transportation costs
  have dropped
• A change in any variable that affects
  supplyexcept for the goods pricecauses the
  supply curve to shift

34
Figure 5 A Shift of The Supply Curve
S2
S1
4.00
J
G
60,000
80,000
35
Factors That Shift the Supply Curve

• Input prices
• A fall (rise) in the price of an input causes an
  increase (decrease) in supply, shifting the
  supply curve to the right (left)
• Price of Related Goods
• When the price of an alternate good rises
  (falls), the supply curve for the good in
  question shifts leftward (rightward)
• Technology
• Cost-saving technological advances increase the
  supply of a good, shifting the supply curve to
  the right

36
Factors That Shift the Supply Curve

• Number of Firms
• An increase (decrease) in the number of
  sellerswith no other changesshifts the supply
  curve to the right (left)
• Expected Price
• An expectation of a future price increase
  (decrease) shifts the current supply curve to the
  left (right)

37
Factors That Shift the Supply Curve

• Changes in weather
• Favorable weather
• Increases crop yields
• Causes a rightward shift of the supply curve for
  that crop
• Unfavorable weather
• Destroys crops
• Shrinks yields
• Shifts the supply curve leftward
• Other unfavorable natural events may effect all
  firms in an area
• Causing a leftward shift in the supply curve

38
Figure 6(a) Changes in Supply and in Quantity
Supplied
S
P2
P1
P3
Q3
Q1
Q2
39
Figure 6(b) Changes in Supply and in Quantity
Supplied
S1

• Entire supply curve shifts rightward when
• price of input ?
• price of alternate good ?
• number of firms ?
• expected price ?
• technological advance
• favorable weather

S2
40
Figure 6(c) Changes in Supply and in Quantity
Supplied
S2

• Entire supply curve shifts rightward when
• price of input ?
• price of alternate good ?
• number of firms ?
• expected price ?
• unfavorable weather

S1
41
Summary Factors That Shift The Supply Curve

• The short list of shift-variables for supply that
  we have discussed is far from exhaustive
• In some cases, even the threat of such events can
  cause serious effects on production
• Basic principle is always the same
• Anything that makes sellers want to sell more or
  less of a good at any given price will shift
  supply curve

42
Equilibrium Putting Supply and Demand Together

• When a market is in equilibrium
• Both price of good and quantity bought and sold
  have settled into a state of rest
• The equilibrium price and equilibrium quantity
  are values for price and quantity in the market
  but, once achieved, will remain constant
• Unless and until supply curve or demand curve
  shifts
• The equilibrium price and equilibrium quantity
  can be found on the vertical and horizontal axes,
  respectively
• At point where supply and demand curves cross

43
Figure 7 Market Equilibrium
S
E
3.00
H
J
1.00
Excess Demand
D
50,000
75,000
25,000
44
Excess Demand

• Excess demand
• At a given price, the excess of quantity demanded
  over quantity supplied
• Price of the good will rise as buyers compete
  with each other to get more of the good than is
  available

45
Figure 8 Excess Supply and Price Adjustment
Excess Supply at 5.00
S
5.00
L
K
E
3.00
D
50,000
35,000
65,000
46
Excess Supply

• Excess Supply
• At a given price, the excess of quantity supplied
  over quantity demanded
• Price of the good will fall as sellers compete
  with each other to sell more of the good than
  buyers want

47
Solve for Equilibrium Algebraically

• Suppose that demand is given by the equation
  , where is quantity
  demanded, P is the price of the good. Supply is
  given by where is
  quantity supplied.
• What is the equilibrium price and quantity?

48
Income Rises What Happens When Things Change

• Income rises, causing an increase in demand
• Rightward shift in the demand curve causes
  rightward movement along the supply curve
• Equilibrium price and equilibrium quantity both
  rise
• Shift of one curve causes a movement along the
  other curve to new equilibrium point

49
Figure 9
S
F'
4.00
E
3.00
D2
D1
50,000
60,000
50
An Ice Storm Hits What Happens When Things Change

• An ice storm causes a decrease in supply
• Weather is a shift variable for supply curve
• Any change that shifts the supply curve leftward
  in a market will increase the equilibrium price
• And decrease the equilibrium quantity in that
  market

51
Figure 10 A Shift of Supply and A New
Equilibrium
S2
S1
E'
5.00
E
3.00
D
50,000
35,000
52
Using Supply and Demand The Invasion of Kuwait

• Why did Iraqs invasion of Kuwait cause the price
  of oil to rise?
• Immediately after the invasion, United States led
  a worldwide embargo on oil from both Iraq and
  Kuwait
• A significant decrease in the oil industrys
  productive capacity caused a shift in the supply
  curve to the left
• Price of oil increased

53
Figure 12 The Market For Oil
S2
S1
E'
P2
E
P1
D
Q2
Q1
54
Using Supply and Demand The Invasion of Kuwait

• Why did the price of natural gas rise as well?
• Oil is a substitute for natural gas
• Rise in the price of a substitute increases
  demand for a good
• Rise in price of oil caused demand curve for
  natural gas to shift to the right
• Thus, the price of natural gas rose

55
Figure 13 The Market For Natural Gas
S
F'
P4
F
D2
P3
D1
Q3
Q4
56
Figure 11 Changes in the Market for Handheld PCs
S2002
S2003
A
500
B
400
D2002
D2003
2.45
3.33
57
Both Curves Shift

• When just one curve shifts (and we know the
  direction of the shift) we can determine the
  direction that both equilibrium price and
  quantity will move
• When both curves shift (and we know the direction
  of the shifts) we can determine the direction for
  either price or quantitybut not both
• Direction of the other will depend on which curve
  shifts by more

58
The Three Step Process

• Key Step 1Characterize the Market
• Decide which market or markets best suit problem
  being analyzed and identify decision makers
  (buyers and sellers) who interact there
• Key Step 2Find the Equilibrium
• Describe conditions necessary for equilibrium in
  the market, and a method for determining that
  equilibrium
• Key Step 3What Happens When Things Change
• Explore how events or government polices change
  market equilibrium

59
Example rental apartment

• Example problem 4, chapter 3 in textbook.
• Demand Supply Diagram
• Equilibrium P Q
• Why 1000 can not be equilibrium?
• Effects from a tornado destroying some apartments.

60
Demand for two bedroom rental apartment
61
Summaries

• Through the study of the chapter, you will be
  able to
• Characterize a market.
• Use a demand schedule and a demand curve to
  demonstrate the law of demand.
• Explain the difference between a change in demand
  (shift of the curve) and a change in quantity
  demanded (movement along the curve).
• List the factors that will lead to a change in
  demand, and give examples of each.
• Similar analysis for supply side.
• Explain how equilibrium price and quantity are
  determined in a competitive market.
• Explain what will happen in a competitive market
  after a shift in the supply curve, the demand
  curve, or both.
• Describe the three steps economists take to
  answer almost any question about the economy.