LESSON 2 The Market Forces of Supply and Demand
Assigned Reading 1.
Mankiw, N. Gregory, et al. 2014. Principles of Microeconomics (6th Canadian Edition). Toronto: Nelson Education Ltd. Chapter 4: The Market Forces of Supply and Demand Chapter 17: Oligopoly (pages 371-378 only)
Recommended Reading 1.
Mankiw, N. Gregory, et al. 2014. Study Guide to Accompany Principles of Microeconomics (6th Canadian Edition). Toronto: Nelson Education Ltd. Chapter 4: The Market Forces of Supply and Demand
Learning Objectives After studying this lesson, students should be able to: 1.
explain the concept of a competitive market;
identify the factors that determine market demand;
explain why the demand curve slopes downward to the right;
show how the market demand curve is constructed by adding up the individual demand curves;
identify the factors that determine market supply;
explain why the supply curve slopes upward to the right;
understand the types of changes that can shift the entire demand or supply curve;
understand how and why demand and supply forces establish market prices and quantities; and
explain how prices and markets allocate society's scarce resources.
Instructor's Comments One of the cornerstones of a market economy is the interaction of supply and demand. Unfortunately, these terms are not well understood – you can read the newspapers on any given day and find examples of the misuse of supply and demand, as the terms take on a very specific meaning in economics that differs from their everyday use. This lesson explains what an economist means by supply and demand and shows how various factors that change either supply or demand ultimately lead to changes in market prices and quantities.
An example of this misuse and one of the important aspects of this lesson is the difference between a shift in demand or supply, i.e., an increase or decrease in demand (supply), and a movement along these curves. For an economist, a change in prices does not increase or decrease demand (supply), but rather causes a movement along a curve and a change in the quantity demanded (supplied). For the former to hold, there must be some external change that causes the entire demand or supply curve to shift. Examples of such a change for a demand curve include changes in income, wealth, population, tastes or preferences, and the prices of substitute or complimentary goods. For a supply curve, a shift can be caused by changes in the technology of production or the prices of the inputs into the production process. Modern microeconomics is about supply, demand, and market equilibrium. Students should learn not only how an equilibrium is determined, but also how prices are used by consumers and suppliers to make important decisions about the uses of society's scarce resources. Although supply and demand schedules are abstract and invisible, they can easily explain the movement of prices and the allocation of resources in a market economy such as ours. To understand how supply and demand can be applied to real estate, consider Tables 2A and 2B. The two tables give data on the long-run demand and supply for office properties.
Table 2A: The Demand for Office Rentals Point
Table 2B: The Supply of Rental Offices Point
It is easy to understand why the quantity of offices demanded decreases as the price of offices rises. Some businesses will not be able to operate profitably at high rents. Other businesses will decide to lease less space, while others may choose to employ home offices (a substitute product) if the price is too high. It is also easy to understand why the long-run quantity of offices supplied increases as the price of offices rises. At a higher price, more developers can realize returns high enough to cover their costs and any risk premium that they might assign to investment. This would lead them to build larger office buildings, as the higher marginal cost of taller buildings is matched by the higher marginal benefit of the increased rents. Suppose that the price of offices was $4,000. In this case, there is excess supply, since the quantity supplied is 40, but the quantity demanded at this high price is only 20. What effect will this have? Some actual or potential suppliers of offices will exit the market. For example, some projects that are in the planning stage will not be carried out, while some buildings may be converted to other uses. Other suppliers will be forced to choose between not having a tenant at all – and thus earning no rent at all – or lowering their prices. Most will choose the latter, and so when there is excess supply, price would tend to fall.
The Market Forces of Supply and Demand
Suppose that the price of offices was $2,000. In this case, there is a shortage (also known as excess demand) since the quantity supplied is 20, but the quantity demanded at this high price is greater, equal to 40. What effect will this have? More office suppliers will enter the market. Others will choose to raise their prices, since there are some demanders of office space who will find no space at all. At the same time, the demanders who have been shut-out by the market will be forced to choose between not renting property – perhaps, by working out of their houses – or paying more in order to ensure that they find an office. Many will choose the latter, and so when there is a shortage, price would tend to rise. As the text notes, the competitive market is in equilibrium at a price where the quantity supplied equals the quantity demanded. In other words, at the market equilibrium price there is neither a shortage nor excess supply. In this example, the competitive equilibrium price is $3,000. As noted above, whenever the price is higher than the equilibrium price, there will be a surplus, and price will tend to fall towards the equilibrium price. Similarly, when price is lower than the equilibrium price, there will be excess demand and price will tend to rise. The demand curve gives the quantity that would be purchased as a function of price, holding other important factors constant. What sort of economic factors must be held constant? Let us consider the demand for housing. It is well-established that consumers demand more housing when their incomes rise. In the language of the text, housing is a normal good. Similarly, they will demand more housing in one city when the price of housing in a nearby city is higher. The price of nearby housing is a substitute good. Furthermore, consumers will demand more housing if households are larger. Any of these changes will result in a greater quantity being demanded at any price. This is represented graphically by a shift outward (to the right) of the demand curve. What sort of factors would shift the supply curve, say for industrial property? Possibly the most important cause of a shift would be the availability of land zoned for industry. This is an example of an input cost. Another might be the weather. Weather is an important factor in the supply of agricultural goods. As anyone who has worked in construction certainly knows, the weather also impacts the cost and time-to-build for real estate projects. A change in technology could shift the supply curve for industrial property. For instance, improvements in building construction in the 19th century allowed the construction of the multi-level factories that were the centres of cities during that period. Finally, a change in the price of a substitute product could also shift the supply curve. For instance, if rentals for commercial land were to rise, some industrial land might be converted. This would decrease the supply of industrial land at any price.
Review and Discussion Questions 1.
Use a graph to show the effect of a decrease in the cost of production on the market equilibrium price and quantity for margarine. Briefly explain your reasoning.
How would the change in equilibrium price and quantity for margarine in (a) affect the equilibrium price and quantity of butter (assuming butter and margarine are substitutes)? Use a graph to illustrate your answer and briefly explain your reasoning.
Suppose that tires and gasoline are complements. Use a graph to show the effect of a decrease in the price of gasoline on the market equilibrium price and quantity of tires. Briefly explain your reasoning.
Which of the following is the best description of the rationing function of prices? (1) (2) (3) (4)
Assuming bread and butter are complementary goods, an increase in the price of bread would: (1) (2) (3) (4)
The ability of the price system to generate an equitable distribution of income The capacity of a competitive market to equate the quantity demanded and the quantity supplied of a good The fact that ration coupons are needed to alleviate wartime shortages of goods The tendency of supply and demand to shift in opposite directions
shift the demand curve for butter. shift the supply curve for butter. cause a movement along the demand curve for butter. cause a movement along the supply curve for butter.
Which of the following would NOT be likely to shift the demand curve for housing? (1) (2) (3) (4)
A change in mortgage interest rates An increase in immigration A decrease in the price of softwood lumber None of the above
Explain the meaning of the following terms: normal good, inferior good, substitutes, and complements.
Suppose that the equilibrium price in a market is $10, but the existing market price is $8. What will happen in the market? What if the existing market price is $15?
If an event occurred that changed a market equilibrium, how would an economist go about analyzing the change in equilibrium?
The market for groceries is quite competitive, meaning that the price charged for a food item is about the same regardless of where the item is purchased. Since grocery stores are widely scattered throughout a city and between cities, what is it that guarantees the prices will be "competitive" between stores?
For each of the following situations in the market for owner-occupied housing, determine whether the quantity demanded changes or the demand curve shifts, and determine the direction of the change. (a) (b) (c) (d)
Consumer income increases. The price of housing increases. Science determines that taking long vacations to places with warm weather in the winter reduces high blood pressure. The government announces that allowed levels of immigration will increase by 50%.
Does the development of a new low-cost method for preventing water penetration of the exterior walls and the subsequent water damage of multi-storey wood frame residential buildings lead to a movement along or shift in the supply curve? What is the effect on the supply, demand, quantity supplied, and quantity demanded of high-rise concrete residential buildings?
Ketchup is a complement (as well as a condiment) for hot dogs. If the price of hot dogs rises, what happens to the market for ketchup? For tomatoes? For tomato juice? For orange juice?
The Market Forces of Supply and Demand
ASSIGNMENT 2 CHAPTER 4: The Market Forces of Supply and Demand CHAPTER 17: Oligopoly
Marks: 1 mark per question. 1.
Suppose that in a supply-and-demand diagram of the market for condominiums, the equilibrium point moved downward and to the right. What could have caused this? (1) (2) (3) (4)
An increase in the supply of land that can be used for condominiums and other multi-family housing A fall in the price of single-family houses A rise in the price of cement A shift in preferences towards living in condominiums and away from apartment suites
There are two types of video game consoles in the market: Z-Box and FunStation. Each console has a variety of games, but each game can only be played with either a Z-Box or a FunStation. If the price of Z-Boxes increases, what can we expect to happen in the market? A. B. C. D. (1) (2) (3) (4)
Options A and B will occur. Options B and D will occur. Options C and D will occur. Options A and C will occur.
The market demand for office space is the: (1) (2) (3) (4)
The demand for Z-Boxes increases and the demand for Z-box games decreases. The demand for FunStations increases and the demand for Z-Box games increases. The demand for FunStations increases and the demand for Z-box games decreases. The demand for Z-Boxes decreases and the demand for FunStation games increases.
vertical sum of the individual demands for office space. average of the individual demands for office space. horizontal sum of the individual demands for office space. horizontal product of the individual demands for office space.
There are thousands upon thousands of wheat farmers who produce and sell wheat and there are millions upon millions of consumers who use wheat and wheat products. This market for wheat would be considered: (1) (2) (3) (4)
oligopolistic. monopolistic. almost perfectly competitive. monopolistically competitive.
Assignment 2 continued on the next page 2.5
Suppose that John receives a pay increase. We would expect: (1) (2) (3) (4)
John's demand for normal goods to remain unchanged. John's demand for inferior goods to decrease. John's demand for luxury goods to decrease. John's demand for normal goods to decrease.
Is the below supply and demand graph in equilibrium at price P0? (1) (2) (3) (4)
No, at P0 there are more people willing to supply the commodity than there are willing to pay for it. No, at P0 there are more people willing to pay for the commodity than there are willing to supply it. No, at P0 the number of suppliers is decreasing and the number of those who demand the commodity is increasing and the supply and demand must be stable in order to facilitate equilibrium. Yes, it is in equilibrium.
THE NEXT TWO (2) QUESTIONS ARE BASED ON THE FOLLOWING INFORMATION: Joe's Supply Schedule of Wooden Hope Chests
Price of a Hope Chest
Number of Hope Chests Supplied
Assignment 2 continued on the next page 2.6
The Market Forces of Supply and Demand
When the price is $50: (1) (2) (3) (4)
As the price increases from $50: (1) (2) (3) (4)
buyers would tend to buy more from this seller. the owners of the raw materials used in production would raise the prices for the raw materials. other sellers would also raise their price. buyers will tend to make their purchases elsewhere.
Other things being equal, when the price of a good falls, the quantity supplied of the good also falls. This is the law of: (1) (2) (3) (4)
price equals quantity. it is possible for there to be a shortage. firms have an incentive to increase production. none of the above are correct.
If a seller in a competitive market chooses to charge more than the market price, then: (1) (2)
Joe's incentive to produce remains constant. Joe desires to produce fewer hope chests. Joe's incentive to produce hope chests increases. Joe obviously doesn't respond to an increase in price above $50.
When a market is in equilibrium: (1) (2) (3) (4)
Joe obviously feels that there is insufficient incentive to build any hope chests. Joe will reduce the number of hope chests he produces with any further decrease in price. the quantity demanded is zero. none of the above answers are correct.
increasing costs. nature. supply. demand.
Mary produces three different goods; good X, good Y, and good Z. Holding all else constant, if the market price of good X increases, we would expect: (1) (2) (3) (4)
Mary to be less willing to produce and sell Y and Z. Mary to be more willing to produce and sell Y and Z. the demand for Y and Z to decrease. the demand for Y and Z to increase.
Assignment 2 continued on the next page 2.7
Ice cream is a favourite treat of the residents of Cove City. Which of the following changes would shift the demand curve for ice cream in Cove City? A. B. C. D. (1) (2) (3) (4)
A and C B, C, and D A, B, and D All of the above
In market economies: (1) (2) (3) (4)
prices guide economic decisions and thereby allocate scarce resources. prices ensure that quantity supplied and quantity demanded are in balance. prices determine how much of a good buyers choose to purchase and how much sellers choose to produce. all of the above answers are correct.
Which of the following would be a likely result if the city implemented a rent control level (maximum rent amount) that was lower than the current equilibrium rent? A. B. C. D. (1) (2) (3) (4)
The number of residents in Cove City doubles after an immigration boom. A new drug comes on the market that cures lactose intolerance. All lactose intolerant Cove City residents take this drug. Dairy Fairy, the largest ice cream shop in Cove City, drastically reduces the price of all of their ice cream products. The price of candy apples, the other favourite treat in Cove City, skyrockets due to a shortage of apples.
Rent control increases supply in a city because low rents increase demand and increased demand results in increased supply. Rent control increases demand for rent controlled housing. Rent control decreases supply because there would be fewer suppliers willing to supply housing at the rent controlled price. Rent control decreases demand for rent controlled housing because fewer consumers are willing to pay for housing at the rent controlled price.
A and B B and C A and D C and D
Which of the following would cause both the equilibrium price and equilibrium quantity of bananas to decrease? (1) (2) (3) (4)
A higher price for apples A lower price for apples An increase in consumer income, assuming bananas are normal goods More buyers
Assignment 2 continued on the next page 2.8
The Market Forces of Supply and Demand
In a market, to find the total amount supplied at a particular price: (1) (2) (3) (4)
Motor City has a large automobile manufacturing industry and every adult resident in Motor City owns a car manufactured by Motor City Automobiles. In the last year, there have been two large changes to Motor City: a new technology has decreased the cost of producing cars and there has been an influx of families moving to Motor City. All of these migrating families plan to buy a car once they move to Motor City. How does this affect the price and quantity demanded of automobiles in Motor City? (1) (2) (3) (4)
Income The price of related goods The number of buyers The price of the good itself
Which of the following would be an example of an oligopolistic market? (1) (2) (3) (4)
Price increases and quantity demanded increases. Price increases and quantity demanded decreases. Price decreases and quantity demanded increases. The change in price is unknown and the quantity demanded increases.
Which of the following is NOT a determinant of an individual's willingness and ability to purchase a good or service? (1) (2) (3) (4)
we must add up all of the amounts firms are willing and able to supply at that price. we need the demand for the good. the tastes and preferences of buyers must be established. the income level of buyers would need to be determined.
A domestic potato market Air travel The software industry Retail gasoline stations
Planning Ahead Project 1 requires you to submit written answers to questions based on Lessons 1-5. You should read ahead to Project 1 so that you have a better idea of what is expected on this assignment. You may want to prepare answers to the questions from Lesson 2 now, while the materials are fresh in your mind, rather than waiting until Project 1 is due. This project is more comprehensive than the weekly assignments and will require considerable time and effort – to avoid anxiety in completing this project, please begin this work ahead of time.
End of Assignment 2 2.9