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Supply,Demand, and the Market Process

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Title: Supply,Demand, and the Market Process


1
Supply,Demand, and the Market Process
Chapter 3
2
  • 1. Consumer Choice and the Law of Demand

3
Law of Demand
  • Law of Demand There is an inverse relationship
    between the price of a good and the quantity
    consumers are willing to purchase.
  • As price of a good rises, consumers buy less.
  • The availability of substitutes --goods that do
    similar functions -- explains this negative
    relationship.

4
Market Demand Schedule
  • A market demand schedule is a table that shows
    the quantity of a good people will demand at
    varying prices.
  • Consider the market for cellular phones. A
    market demand schedule lays out the amount of
    cell phones that are demanded in the market for a
    spectrum of prices.
  • We can graph these points (price and the
    respective demand) to make a demand curve for
    cell phones.

5
Market Demand Schedule
Price (monthly bill)
140
Cell Phone Price (monthly bill)
Millions of Cell Phone Subscribers
120
123 2.1
100
107 3.5
92 5.3
80
79 7.6
73 11.0
60
63 16.0
56 24.1
10
15
5
20
25
30
Quantity (of Cell Phone Subscribers)
6
Market Demand Schedule
Price (monthly bill)
140
120
  • Notice how the law of demand is reflected by
    the shape of the demand curve.

100
  • As the price of a good rises

80
  • . . . consumers buy less.

60
10
15
5
20
25
30
Quantity (of Cell Phone Subscribers)
7
Market Demand Schedule
Price (monthly bill)
140
120
  • The height of the demand curve at any
    quantity shows the maximum price that
    consumers are willing to pay for that
    additional unit.

100
80
  • Here, for the 11th unit . . .
  • . . . consumers are only willing to pay up to
    73 for it.

60
  • While they would be willing to pay up to 92
    for the 5.3 (millionth) unit.

10
15
5
20
25
30
Quantity (of Cell Phone Subscribers)
8
Consumer Surplus
  • Consumer Surplus - the area below the demand
    curve but above the actual price paid.
  • Consumer surplus is the difference between the
    amount consumers are willing to pay and the
    amount they have to pay for a good.
  • Lower market prices will increase consumer
    surplus.

9
Consumer Surplus
Price (monthly bill)
  • Lets consider the market for cellular phones
    again. This time we will assume that the
    demand for cell phones is more linear and
    that the market price is 100.

140
120
  • If the market price is 100, then the 25th
    unit will not sell because those who demand it
    are only willing to pay 60 for cellular
    phone service.

100
80
  • At 100, the 15th unit will sell because
    those who demand it are willing to pay up to
    100 for cellular phone service.

60
  • At 100, the 10th unit will sell because
    those who demand it are willing to pay up to
    120 for cellular phone service.

10
15
5
20
25
30
Quantity (of Cell Phone Subscribers)
10
Consumer Surplus
Price (monthly bill)
140
  • For all those goods under 15 units, people
    are willing to pay more than 100 for service.

120
  • The area, represented by the distance above
    the actual price paid and below the demand
    curve, is called consumer surplus.

100
80
  • This area represents the net gains to buyers
    from market exchange.

60
10
15
5
20
25
30
Quantity (of Cell Phone Subscribers)
11
Elastic and Inelastic Demand Curves
  • Elastic demand - quantity demanded is sensitive
    to small price changes.
  • Easy to substitute away from good.
  • Inelastic demand - quantity demanded is not
    sensitive to price changes.
  • Difficult to substitute away from good.

12
Elastic and Inelastic Demand Curves
  • If the market price for gasoline was to rise
    from 1.25 to 2.00, the quantity demanded
    in the market decreases insignificantly
    (from 8 to 7 units).

2.00
Gasoline
1.25
  • If the market price for tacos rises from 1.25
    to 2.00, the quantity demanded in the
    market decreases significantly (from 8 to 1
    unit).

1
2
3
4
5
6
7
8
9
10
2.00
Tacos
1.25
  • Taco demand is highly sensitive to price
    changes and can be described as elastic
    gasoline demand is relatively insensitive to
    price changes and can be described as
    inelastic.

6
10
1
2
3
4
5
7
8
9
13
  • 2. Changes in Demand Versus Changes in
    Quantity Demanded

14
Changes in Demand and Quantity Demanded
  • Change in Demand - shift in entire demand curve.
  • Change in Quantity Demanded - movement along the
    same demand curve in response to a price change.

15
Change in Demand
Price (dollars)
25
  • If CDs cost 15 each, the CD demand curve D1
    shows that 10 units would be demanded.

20
  • If the price of CDs changed to 7.50, the
    quantity demanded for CDs would increase to
    20 units.

15
  • If, somehow, the preferences for CDs changed
    then the demand for CDs may change.

10
5
  • Here we will assume that consumer income
    increases, increasing demand for CDs at all
    price levels. At 15 15 units are now demanded.

D1
10
15
5
20
25
10
15
20
30
Quantity (of Compact Disks per yr)
16
Demand Curve Shifters
  • Changes in Consumer Income
  • Change in the Number of Consumers
  • Change in Price of Related Good
  • Changes in Expectations
  • Demographic Changes
  • Changes in Consumer Tastes and Preferences

17
  • Questions for Thought

1. Which of the following do you think would lead
to an increase in the current demand for beef
(a) higher pork prices, (b) higher
incomes, (c) higher prices of feed grains
used to feed cows, (d) good weather
conditions leading to a bumper (very
good) corn crop, (e) an increase in the
price of beef?
2. What is being held constant when a demand
curve for a specific product (like shoes or
apples, for example) is constructed? Explain why
the demand curve for a product slopes downward
and to the right.
18
  • 3. Producer Choice and the Law of Supply

19
Producers
  • Opportunity Cost of Production - the sum of the
    producers cost of employing each resource
    required to produce the good.
  • Firms will not stay in business for long unless
    they are able to cover the cost of all resources
    employed, including the opportunity cost of those
    owned by the firm.

20
Role of Profits and Losses
  • Profit occurs when revenues are greater than cost.
  • Firms supplying goods for which consumers are
    willing to pay more than the opportunity cost of
    resources used will make a profit.
  • Firms making a profit will expand and those with
    a loss will contract.

21
Law of Supply
  • Law of Supply - there is a positive relationship
    between the price of a product and the amount of
    it that will be supplied.
  • As the price of a product rises, producers will
    be willing to supply more.

22
Market Supply Schedule
Price (monthly bill)
140
Quantity of Cell Phones Supplied
Cell Phone Price (monthly bill)
120
60 5.0
100
73 11.0
80 15.1
80
91 18.2
107 21.0
60
120 22.5
135 24.1
10
15
5
20
25
30
Quantity (of Cell Phone Subscribers)
23
Market Supply Schedule
Price (monthly bill)
140
120
  • Notice how the law of supply is reflected by
    the shape of the supply curve.

100
  • As the price of a good rises

80
  • . . . producers supply more.

60
10
15
5
20
25
30
Quantity (of Cell Phone Subscribers)
24
Market Supply Schedule
Price (monthly bill)
140
  • The height of the supply curve at any
    quantity shows the minimum price necessary
    to induce producers to supply that next unit
    to market.

120
100
  • Here, for the 11th unit . . .
  • . . . producers require 73 to induce them to
    supply it.

80
  • The height of the supply curve at any
    quantity also shows the opportunity cost
    of producing that next unit of the good.

60
10
15
5
20
25
30
Quantity (of Cell Phone Subscribers)
25
Producer Surplus
Price (monthly bill)
  • Lets consider the market for cellular phones
    again. This time we will assume that the
    supply for cell phones is more linear and
    that the market price is 100.

Supply
140
120
  • If the market price is 100, then the 25th
    unit will not be produced because the cost of
    supplying it exceeds the market price of
    140.

100
80
  • At 100, the 15th unit will be produced
    because those who supply it are willing to do
    so for for at least 100.

60
  • At 100, the 10th unit will be produced
    because those who supply it are willing to do
    so for at least 80.

10
15
5
20
25
30
Quantity (of Cell Phone Subscribers)
26
Producer Surplus
Price (monthly bill)
Supply
140
  • For market outputs of less then 15 units,
    producers are willing to supply the good for
    100.

120
  • The area represented by the distance above
    the supply curve but below the actual sales
    price is called producer surplus.

100
  • This area is the difference between the
    minimum amount required to induce producers to
    supply a good and the amount they actually
    receive.

80
60
10
15
5
20
25
30
Quantity (of Cell Phone Subscribers)
27
Elastic and Inelastic Supply Curves
  • Elastic supply- quantity supplied is sensitive to
    small price changes.
  • Inelastic supply - quantity supplied is not
    sensitive to price changes.

28
Elastic and Inelastic Supply Curves
  • If the market price for motor oil was to rise
    from 1.25 to 2.00, the quantity supplied
    in the market increases insignificantly
    (from 7 to 8 units).

2.00
1.25
  • If the market price for burgers rises from
    1.25 to 2.00, the quantity supplied in the
    market increases substantially (from 1 to 8
    units).

1
2
3
4
5
6
7
8
9
10
2.00
1.25
  • Burger supply is highly sensitive to price
    changes and can be described as elastic
    motor oil supply is relatively insensitive
    to price changes and can be described as
    inelastic.

6
10
1
2
3
4
5
7
8
9
29
Short Run and Long Run
  • Short Run - Firms dont have enough time to
    change plant size.
  • Supply tends to be inelastic in the short run.
  • Long Run - Firms have enough time to change plant
    size.
  • Supply tends to be much more elastic in the long
    run.

30
  • 4. Changes in Supply Versus Changes in
    Quantity Supplied

31
Changes in Supply and Quantity Supplied
  • Change in Supply - shift in entire supply curve.
  • Change in Quantity Supplied - movement along the
    same supply curve in response to a price change.

32
Change in Supply
Price (dollars)
2.50
  • If the market price for gas is 1.50 a
    gallon, the gasoline supply curve S1 shows
    that 20 units would be supplied.

The Market for Gasoline
S1
2.00
  • If the market price of gas changed to .75,
    the quantity supplied of gasoline would
    decrease to 10 units.

1.50
  • If, somehow, the opportunity costs for gas
    manufacturers changed then the supply of gas
    may change.

1.00
.50
  • Here we will assume that the cost of crude
    oil (an input in gasoline) increases,
    decreasing the supply of gas at all price
    levels. Now at 1.50, 15 units of gasoline are
    supplied.

10
15
5
20
25
10
15
20
30
Quantity (Millions of Gal of Gas)
33
Supply Curve Shifters
  • Changes in Resource Prices
  • Change in Technology
  • Elements of Nature and Political Disruptions
  • Changes in Taxes

34
  • Questions for Thought


What must a firm do in order to make profit?
1. What are profits and losses?
2. Define consumer and producer surplus. What is
meant by economic efficiency and how does it
relate to consumer and producer surplus?
35
  • 5. How Market Prices are Determined

36
Market Equilibrium
  • This table and graph indicate the demand and
    supply conditions for oversized playing cards.
  • Equilibrium will occur where the quantity
    demanded equals the quantity supplied. If the
    price in the market exceeds the equilibrium
    level, market forces will guide it to equilibrium.

13
12
11
10
9
  • A price of 12 in this market will result in . .
    .

8
resulting
in excess supply.

quantity supplied of 600 . . .
quantity demanded of 450 and
7
  • With an excess supply present, there will be
    downward pressure on price to clear the market.

350
400
400
450
500
550
600
650
Excess Supply
Quantity Supplied 600
Downward
Quantity Demanded 450
37
Market Equilibrium
13
  • A price of 8 in this market will result in . .
    .

12
resulting
in excess demand.

quantity demanded of 650 . . .
quantity supplied of 500 and
11
10
  • With an excess demand present, there will be
    upward pressure on price to clear the market.

9
8
7
350
400
400
450
500
550
600
650
Excess Supply
Quantity Supplied 500
Downward
Quantity Demanded 650
Excess Demand
Upward
38
Market Equilibrium
13
  • A price of 10 in this market will result in . .
    .

12
resulting
in a balance.

quantity demanded of 550 . . .
quantity supplied of 550 and
11
10
  • With a balance present, there will be an
    equilibrium and the market will clear.

9
8
7
350
400
400
450
500
550
600
650
Quantity Supplied 550
Excess Supply
Downward
Balance
Equilibrium
Quantity Demanded 550
Excess Demand
Upward
39
Market Equilibrium
  • At every price above market equilibrium there
    is excess supply and there will be downward
    pressure on the price level.

13
12
11
10
  • At every price below market equilibrium there
    is excess demand and there will be upward
    pressure on the price level.

9
8
7
  • It is at equilibrium that prices will rest.

350
400
400
450
500
550
600
650
Excess Supply
Downward
Balance
Equilibrium
Excess Demand
Upward
40
Net Gains to Buyers and Sellers
Price (monthly bill)
  • Returning to the market for cell phones, if
    the market price is driven to equilibrium
    through market pressures to exist where supply
    equals demand, then the market equilibrium
    in the cell phone market should be driven to
    100 per month.

Supply
140
120
100
  • If the area above the market price and below
    the demand curve is called consumer surplus . .
    .

80
  • . . . and the area above the supply curve but
    below the market price is called producer
    surplus . . .

60
  • . . . Then the combined area represented in
    the graph to the right represents the net
    gains to buyers and sellers. It is here that
    all potential gains from production and
    exchange are realized.

10
15
5
20
25
30
Quantity (of Cell Phone Subscribers)
41
  • 6. How Markets Respond to Changes in Supply
    and Demand

42
Effects of a Change in Demand
  • If Demand decreases, the equilibrium price and
    quantity will fall.
  • If Demand increases, the equilibrium price and
    quantity will rise.

43
Market Adjustment to an Increase in
Demand
  • Consider the market for eggs.

Price ( per doz)
  • Prior to Easter season, the market for eggs
    produces an equilibrium where Supply equals
    Demand1 at a market price of .80 and
    output of Q1.

Supply
1.40
1.20
  • When the Easter season arrives, the demand by
    consumers for eggs increases from Demand1 to
    Demand2. What happens to the equilibrium
    price and output level?

1.00

.80
  • At .80 a dozen the quantity demanded
    exceeds the quantity supplied. There is
    upward pressure on price inducing the
    existing suppliers to increase their quantity
    supplied to Q2, pushing the equilibrium price
    up to 1.00.

.60
Q1
Q2
Quantity (million doz eggs per week)
  • What happens to equilibrium price and output
    after the Easter season?

44
Effects of a Change in Supply
  • If Supply decreases, the equilibrium price will
    rise and the equilibrium quantity will fall.
  • If Supply increases, the equilibrium price will
    fall and the equilibrium quantity will rise.

45
Market Adjustment to a Decrease in
Supply
  • Consider the market for romaine lettuce.
  • Prior to a season of adverse weather affecting
    the yield of the market, an equilibrium exists
    where Supply equals Demand1 with a market
    price of 1.80 and output of Q1.

Price ( per head)
2.40
2.20
  • When the season of adverse weather arrives
    the supply of romaine lettuce falls,
    decreasing the supply from supply1 to supply2.
    What happens to the equilibrium price and
    output level?

Supply1
2.00

1.80
  • At 1.80 a head the quantity demanded exceeds
    the quantity supplied. There is upward
    pressure on price inducing the existing
    consumers to decrease their quantity demanded
    to Q2, drawing up the equilibrium price to
    2.00.

1.60
Q2
Q1
Quantity (million heads lettuce per week)
  • What happens to equilibrium price and output
    when the weather returns to normal?

46
  • 7. Time and the Adjustment Process

47
Time and the Adjustment Process
  • With the passage of time, the market adjustments
    of both producers and consumers will be more
    complete.
  • Both demand and supply are more elastic in the
    long run than in the short run.

48
Time and Adjustment to Increase in
Demand
  • Consider the market for laptop computers.
  • We begin in the short run in equilibrium at
    output level Q1 and price level P1.

SupplySR
Price
  • When the demand for laptops unexpectedly
    increases from demand1 to demand2, suppliers
    do there best to increase product in the
    market, pushing the price level upward to P2.
    What happens to the equilibrium price and
    output in the long run, after suppliers have a
    chance to change their capacity?

P2
P3

P1
  • With time suppliers expand output pivoting
    the supply curve to its long run
    representation. The new equilibrium is where
    demand equals supply. The result, a further
    increase in equilibrium output, to Q3, and a
    reduction in the equilibrium price to P3.

Q2
Q1
Q3
Quantity
49
  • 8. Invisible Hand Principle

50
Invisible Hand
  • Invisible hand- the tendency of market prices to
    direct individuals pursuing their own interest
    into productive activities that also promote the
    economic well-being of society.

51
Communicating Information
  • Product prices communicate up-to-date information
    about the consumers valuation of additional
    units of each commodity.
  • Without the information provided by market price
    it would be impossible for decision-makers to
    determine how intensely a good was desired
    relative to its opportunity cost.

52
Coordinating Actions of Market
Participants
  • Price changes bring the decisions of buyers and
    sellers into harmony.
  • Price changes create profits and losses which
    change production levels for various products.

53
Prices and Market Order
  • Market order is the result of market prices, not
    central planning.

54
Qualifications
  • The efficiency of market organization is
    dependent upon
  • The presence of competitive markets.
  • Well-defined and enforced private property
    rights.

55
  • Questions for Thought

1. A drought during the summer of 1988 sharply
reduced the 1988 output of wheat, corn,
soybeans, and hay. Indicate the expected impact
of the drought on the following a. Prices of
feed grains and hay during the
summer of 88. b. Price of cattle during the
fall of 88. (Hint What has
happened to the opportunity cost of
maintaining cattle during the upcoming
winter?) c. Price of cattle during the summer
and fall of 89.
2. What is the invisible hand principle? Does
it indicate that good intentions are necessary
if ones actions are going to be beneficial to
others?
56
End Chapter 3
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