Demand and Supply Chapter 4, pages 99-‐122 Chapter 5, pages 125-‐148
Theories and Predic@ons • We need to be able to predict the consequences of – alterna@ve policies, and – events that may be outside our control
• The mental tool we use to make such predic@ons is called a theory • A theory is of no use if its predic@ons are inaccurate SUPPLY AND DEMAND
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We need a theory of prices • The theory of demand and supply is a simple example of an economic theory • It can be used to make predic@ons about the price and quan@ty of some commodity • In a free-‐market economy, most economic decisions are guided by prices • Therefore, without a reliable theory of prices, you will get nowhere in economic analysis SUPPLY AND DEMAND
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Assume perfect compe@@on • The theory of supply and demand assumes that commodi@es are traded in perfectly compe@@ve markets • A perfectly compe--ve market is a market in which – there are many buyers – many sellers – and all sellers sell the exact same product
• As a result, each buyer and seller has a negligible impact on the market price SUPPLY AND DEMAND
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Demand • Quan%ty demanded is the amount of a good that buyers are willing and able to purchase • Demand is a full descrip@on of how the quan@ty demanded changes as the price of the good changes.
SUPPLY AND DEMAND
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Catherine’s Demand Schedule and Demand Curve Price of Ice-‐Cream Cone $3.00 2.50 1. A decrease in price ...
2.00 1.50 1.00 0.50 6 7 8 9 10 11 12 Quan%ty of Ice-‐Cream Cones 2. ... increases quan@ty of cones demanded.
0 1 2 3 4 5
SUPPLY AND DEMAND
Copyright © 2004 South-‐Western
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Market Demand is the Sum of Individual Demands
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Law of Demand • The law of demand states that – the quan%ty demanded of a good falls when the price of the good rises, and vice versa, provided all other factors that affect buyers’ decisions are unchanged
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“provided all other factors … are unchanged” • That’s an important phrase in the wording of the Law of Demand • The quan@ty demanded of a consumer good such as ice cream depends on – – – – – –
The price of ice cream The prices of related goods Consumers’ incomes Consumers’ tastes Consumers’ expecta@ons about future prices and incomes Number of buyers, etc
• The Law of Demand says that the quan@ty demanded of a good is inversely related to its price, provided all other factors are unchanged SUPPLY AND DEMAND
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Why Might Demand Increase? Quantity Demanded Price Situation A
0.00 0.50 1.00 1.50 2.00 2.50 3.00
12 10 8 6 4 2 0
Situation B
20 16 12 8 6 4 2
• How can we explain the difference in Catherine’s behavior in situa@ons A and B? • Why does she consume more in situa@on B at every possible price?
SUPPLY AND DEMAND
Price
10 Quan@ty Demanded
Shi]s in the Market Demand Curve • … are caused by changes in:
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– Consumer income – Prices of related goods – Tastes – Expecta@ons, say, about future prices and prospects – Number of buyers
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Shi]s in the Demand Curve Price of Ice-‐Cream Cone Increase in demand
Decrease in demand
Demand curve, D 3 0 SUPPLY AND DEMAND
Demand curve, D 1
Demand curve, D 2
Quan%ty of Ice-‐Cream Cones
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Shi]s in the Demand Curve • Consumer Income
– As income increases the demand for a normal good will increase – As income increases the demand for an inferior good will decrease
• Prices of Related Goods
– When a fall in the price of one good reduces the demand for another good, the two goods are called subs-tutes – When a fall in the price of one good increases the demand for another good, the two goods are called complements SUPPLY AND DEMAND
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The Law of Demand—Explana@ons • There are two ways to explain the Law of Demand – Subs@tu@on effect – Income effect
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Subs@tu@on Effect • When the price of a good decreases, consumers subs@tute that good instead of other compe@ng (subs@tute) goods
1. When the price of Coke decreases…
Clothes
Coke
2. Consump%on of Pepsi decreases…
Books
Movies
SUPPLY AND DEMAND
3. Consump%on of Coke increases
Pepsi 15
Income Effect • A decrease in the price of a commodity is essen@ally equivalent to an increase in consumers’ income
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Lower Prices = Higher Income Situation A Price of an Apple
$1.00
Price of an Orange
$2.00
Income
$10.00
If prices fall, Situa@on A becomes Situa@on C.
If income rises, Situa@on A becomes Situa@on B.
Situation B Price of an Apple
$1.00
Price of an Orange
$2.00
Income
$20.00
Situation C Price of an Apple
$0.50
Price of an Orange
$1.00
Income
$10.00 SUPPLY AND DEMAND
Q: Which change is befer? A: They are both equally desirable. A fall in prices is equivalent to an increase in income.
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Income Effect • Consumers respond to a decrease in the price of a commodity as they would to an increase in income • They increase their consump@on of a wide range of goods, including the good that had a price decrease
1. When the price of Coke decreases…
Clothes
Coke
2. Consumers feel richer…
Books
Movies
SUPPLY AND DEMAND
3. Consump%on of Coke and other goods increases
Pepsi 18
SUPPLY • Quan-ty supplied is the amount of a good that sellers are willing and able to sell • Supply is a full descrip@on of how the quan@ty supplied of a commodity responds to changes in its price
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Ben’s supply schedule and supply curve Price of Ice-‐Cream Cones $3.00 Price of Ice-‐cream cone
Quan@ty of Cones supplied
$0.00 0.50 1.00 1.50 2.00 2.50 3.00
0 cones 0 1 2 3 4 5
2.50 2.00 1.50 1.00
Supply curve 1. An increase in price . . .
2. . . . increases quan@ty of cones supplied.
0.50 0 1 2 3 4 5 6 7 8 9 10 11 12 Quan@ty of Ice-‐Cream Cones
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Market supply and individual supplies Price of ice-‐cream cone
Ben
$0.00 0.50 1.00 1.50 2.00 2.50 3.00
0 0 1 2 3 4 5
Jerry +
0 0 0 2 4 6 8
Market =
0 0 1 4 7 10 13
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Market supply and individual supplies Price of Ice Cream Cones $3.00
Ben’s supply
+
SBen
Price of Ice Cream Cones $3.00
Jerry’s supply
=
Price of Ice Cream Cones
SJerry
$3.00
2.50
2.50
2.50
2.00
2.00
2.00
1.50
1.50
1.50
1.00
1.00
1.00
0.50
0.50
0.50
0 1 2 3 4 5 6 7 8 9 10 11 12 Quan@ty of Ice-‐Cream Cones
0 1 2 3 4 5 6 7 Quan@ty of Ice-‐Cream Cones
Market supply
SMarket
0 2 4 6 8 10 12 14 16 18 Quan@ty of Ice-‐Cream Cones 22
Law of Supply • The law of supply states that, the quan%ty supplied of a good rises when the price of the good rises, as long as all other factors that affect suppliers’ decisions are unchanged
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Law of Supply—Explana@on • How can we make sense of the numbers in Ben’s supply schedule? • The best guess is that his costs must be something like the cost schedule below. A specific icecream cone
It’s cost ($)
1st
0.75
2nd
1.35
3rd
1.75
4th
2.30
5th
2.85
6th
3.10
In this way, the Law of Supply follows from the assump%on of Increasing Costs (or, Diminishing Returns)
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Shi]s in the Supply Curve: What causes them? Price of Ice-‐Cream Cone
Supply curve, S 3
Decrease in supply
Supply curve, S 1
Supply curve, S 2
Increase in supply
0 SUPPLY AND DEMAND
Quan%ty of Ice-‐Cream Cones 25
Supply Shi] • How could Ben’s supply have increased? Ice-cream cone
It’s cost ($) Before
After
1st
0.75
0.45
2nd
1.35
0.85
3rd
1.75
1.45
4th
2.30
1.95
5th
2.85
2.45
6th
3.10
2.90
Ben’s Supply Schedule Price ($)
Quantity Supplied Before
After
0.00
0
0
0.50
0
1
1.00
1
2
1.50
2
3
2.00
3
4
2.50
4
5
3.00
5
6
Anything that reduces produc%on costs, shiOs supply to the right. SUPPLY AND DEMAND
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Shi]s in the Supply Curve… • … are caused by changes in – Input prices – Technology – Number of sellers (short run)
• The market supply will shi] right if – Raw materials or labor becomes cheaper – The technology becomes more efficient – Number of sellers increases SUPPLY AND DEMAND
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Equilibrium: Interac@on of demand and supply • We have seen what demand and supply are • We have seen why demand and supply may shi] • Now it is @me to say something about how buyers and sellers collec@vely determine the market outcome • To do this, we assume equilibrium • Law of supply and demand – The price of any good adjusts to bring the quan-ty supplied and the quan-ty demanded for that good into balance SUPPLY AND DEMAND
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Equilibrium • We assume that the price will automa@cally reach a level at which the quan@ty demanded equals the quan@ty supplied
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SUPPLY AND DEMAND TOGETHER Demand Schedule
Supply Schedule
At $2.00, the quan@ty demanded is equal to the quan@ty supplied! SUPPLY AND DEMAND
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Equilibrium of supply and demand Price of Ice-‐Cream Cones $3.00 2.50 2.00
Supply Equilibrium price
Equilibrium
1.50 1.00 0.50
Equilibrium quan@ty
Demand
0 1 2 3 4 5 6 7 8 9 10 11 12 Quan@ty of Ice-‐Cream Cones
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Equilibrium • Can we jus@fy the assump@on of equilibrium?
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Markets Not in Equilibrium (a) Excess Supply Price of Ice-‐Cream Cone
Supply Surplus
$2.50 2.00
Demand
0
4 Quan@ty demanded
7
10 Quan@ty supplied
SUPPLY AND DEMAND
Quan%ty of Ice-‐Cream Cones 33
Markets Not in Equilibrium • Surplus – When price exceeds equilibrium price, then quan@ty supplied is greater than quan@ty demanded • There is excess supply or a surplus • Suppliers will lower the price to increase sales, thereby moving toward equilibrium
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Markets Not in Equilibrium (b) Excess Demand Price of Ice-‐Cream Cone
Supply
$2.00 1.50 Shortage Demand
0
4 Quan@ty supplied
7
10 Quan@ty demanded
SUPPLY AND DEMAND
Quan%ty of Ice-‐Cream Cones 35
Markets Not in Equilibrium • Shortage – When price is less than equilibrium price, then quan@ty demanded exceeds the quan@ty supplied • There is excess demand or a shortage • Suppliers will raise the price due to too many buyers chasing too few goods, thereby moving toward equilibrium
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