Transcript Lecture3

Supply and Demand
• Supply and demand is an economic model
– Designed to explain how prices are
determined in certain types of markets
Hall & Leiberman;
Economics: Principles
1
Markets
• Specific location where buying and selling takes
place, such as
– Supermarket or a flea market
• In economics, a market is not a place but rather
– A group of buyers and sellers with the potential to
trade with each other
• Economists think of the economy as a collection
of individual markets
Hall & Leiberman;
Economics: Principles
2
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
Hall & Leiberman;
Economics: Principles
3
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
Hall & Leiberman;
Economics: Principles
4
Defining Microeconomic Markets
• Markets are defined narrowly
– Focus on models that define much more
specific commodities
• Always involves some aggregation
– Stops short of the broad levels of generality
that macroeconomics investigates
Hall & Leiberman;
Economics: Principles
5
Buyers and Sellers
• Buyers and sellers in a market can be
– Households
– Business firms
– Government agencies
• For purposes of simplification this text will
usually follow these guidelines
– In markets for consumer goods, we’ll view business
firms as the only sellers, and households as only
buyers
– In most of our discussions, we’ll be leaving out the
“middleman”
Hall & Leiberman;
Economics: Principles
6
Using Supply and Demand
• Supply and demand model is designed to
explain how prices are determined in perfectly
competitive markets
• Supply and demand is one of the most versatile
and widely used models in the economist’s tool
kit
Hall & Leiberman;
Economics: Principles
7
Demand
• A household’s 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
Hall & Leiberman;
Economics: Principles
8
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
• Stresses price
– Price of the good is one variable among many that influences
quantity demanded
– We assume that all other influences on demand are held
constant
Hall & Leiberman;
Economics: Principles
9
The Law of Demand
• When the price of a good rises and
everything else remains the same, the
quantity of the good demanded will fall
• 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
Hall & Leiberman;
Economics: Principles
10
The Demand Schedule and The
Demand Curve
• Demand schedule
– A list showing the quantity demanded of a good at
different prices, all else held constant
• The market demand curve shows the
relationship between price of a good and the
quantity demanded, all else constant
– 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
Hall & Leiberman;
Economics: Principles
11
Figure 1: The Demand Curve
Price per
Bottle
When the price is $4.00
per bottle, 40,000 bottles
are demanded (point A).
$4.00
A
B
2.00
At $2.00 per bottle,
60,000 bottles are
demanded (point B).
D
40,000
Hall & Leiberman;
Economics: Principles
60,000
Number of Bottles
per Month
12
Shifts vs. Movements Along The
Demand Curve
• A change in the price of a good causes a movement
along the demand curve
• In Figure 1
– A fall (rise) in price would cause a movement to the right (left)
along the demand curve
• A change in income causes a shift in the demand curve
itself
• 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 demand—except for the
good’s price—causes the demand curve to shift
Hall & Leiberman;
Economics: Principles
13
Figure 2: A Shift of The Demand
Curve
Price per
Bottle
An increase in income
shifts the demand curve for
maple syrup from D1 to D2.
At each price, more bottles
are demanded after the
shift
B
C
$2.00
60,000
Hall & Leiberman;
Economics: Principles
D1
D2
80,000
Number of Bottles
per Month
14
“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 demanded
– The term demand means
• The entire relationship between price and quantity
demanded—and 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
Hall & Leiberman;
Economics: Principles
15
Factors That Shift The Demand
Curve: Income
• An increase in income shifts demand for
normal goods to the right
• Inferior goods
• A rise in income will increase the demand
for a normal good, and decrease the
demand for an inferior good
Hall & Leiberman;
Economics: Principles
16
Factors That Shift The Demand
Curve: Wealth
• Wealth—at any point in time—is the total
value of everything you own minus the
total dollar amount you owe
• 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
Hall & Leiberman;
Economics: Principles
17
Factors that Shift the Demand
Curve – Price of related goods
• Substitute—good that can be used in place of
some other good and that fulfills more or less the
same purpose
– A rise in the price of a substitute increases the
demand for a good, shifting the demand curve to the
right
• Complement—used together with the good we
are interested in
– A rise in the price of a complement decreases the
demand for a good, shifting the demand curve to the
left
Hall & Leiberman;
Economics: Principles
18
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
Hall & Leiberman;
Economics: Principles
19
Figure 3(a): Movements Along and
Shifts of The Demand Curve
Price
Price increase moves us
leftward along demand
curve
P2
Price increase moves us
rightward along demand
curve
P1
P3
Q2
Hall & Leiberman;
Economics: Principles
Q1
Q3
Quantity
20
Figure 3(b): Movements Along and
Shifts of The Demand Curve
Price
Entire demand curve shifts
rightward when:
• income or wealth ↑
• price of substitute ↑
• price of complement ↓
• population ↑
• expected price ↑
• tastes shift toward good
D2
D1
Quantity
Hall & Leiberman;
Economics: Principles
21
Figure 3(c): Movements Along and
Shifts of The Demand Curve
Price
Entire demand curve shifts
leftward when:
• income or wealth ↓
• price of substitute ↓
• price of complement ↑
• population ↓
• expected price ↓
• tastes shift toward good
D1
D2
Quantity
Hall & Leiberman;
Economics: Principles
22
Supply
• A firm’s quantity supplied of a good is the
amount it would choose to sell over some time
period, given
– A particular price for the good
– All other constraints on the firm
• Market quantity supplied is the 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
Hall & Leiberman;
Economics: Principles
23
Quantity Supplied
• Implies a choice
– Quantity that gives firms the highest possible profits in the given
circumstances
• Is hypothetical
– Does not make assumptions about firms’ ability to sell the good
• Stresses price
– The price of the good is just one variable among many that
influences quantity supplied
– We assume that all else is held constant, so we can explore the
relationship between price and quantity supplied
Hall & Leiberman;
Economics: Principles
24
The Law of Supply
• When the price of a good rises and
everything else remains the same, the
quantity of the good supplied will rise
• In the real world many variables change
simultaneously
• We assume “everything else remains the same” in
order to understand how supply reacts to price
Hall & Leiberman;
Economics: Principles
25
The Supply Schedule and The
Supply Curve
• Supply schedule—shows quantities of a
good or service firms would choose to
produce and sell at different prices, with all
other variables held constant
• Supply curve—graphical depiction of a
supply schedule
– Shows quantity of a good or service supplied
at various prices, with all other variables held
constant
Hall & Leiberman;
Economics: Principles
26
Figure 4: The Supply Curve
Price per
Bottle
When the price is $2.00
per bottle, 40,000 bottles
are supplied (point F).
$4.00
2.00
G
At $4.00 per bottle,
quantity supplied is
60,000 bottles (point G).
F
40,000
Hall & Leiberman;
Economics: Principles
S
60,000
Number of Bottles
per Month
27
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 supply—except for the
good’s price—causes the supply curve to shift
Hall & Leiberman;
Economics: Principles
28
Figure 5: A Shift of The Supply
Curve
Price per
Bottle
A decrease in transportation
costs shifts the supply curve for
maple syrup from S1 to S2.
S1
S2
At each price, more bottles
are supplied after the shift
$4.00
G
60,000
Hall & Leiberman;
Economics: Principles
J
80,000
Number of Bottles
per Month
29
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 rightward
(leftward)
• Technology
– Cost-saving technological advances increase the
supply of a good, shifting the supply curve to the right
Hall & Leiberman;
Economics: Principles
30
Factors That Shift the Supply Curve
• Number of Firms
– An increase (decrease) in the number of
sellers—with no other changes—shifts 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)
Hall & Leiberman;
Economics: Principles
31
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
Hall & Leiberman;
Economics: Principles
32
Figure 6(a): Changes in Supply
and in Quantity Supplied
Price
S
Price increase moves
us rightward along
supply curve
P2
P1
Price increase moves
us leftward along
supply curve
P3
Hall & Leiberman;
Economics: Principles
Q3
Q1
Q2
Quantity
33
Figure 6(b): Changes in Supply and
in Quantity Supplied
Price
Entire supply curve shifts
rightward when:
• price of input ↓
• price of alternate good ↓
• number of firms ↑
• expected price ↑
• technological advance
• favorable weather
Hall & Leiberman;
Economics: Principles
S1
S2
Quantity 34
Figure 6(c): Changes in Supply
and in Quantity Supplied
Price
Entire supply curve shifts
rightward when:
• price of input ↑
• price of alternate good ↑
• number of firms ↓
• expected price ↑
• unfavorable weather
Hall & Leiberman;
Economics: Principles
S2
S1
Quantity 35
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
Hall & Leiberman;
Economics: Principles
36
Figure 7: Market Equilibrium
Price per
Bottle
2. causes the price
to rise . . .
3. shrinking the
excess demand . . .
S
E
$3.00
1.00
H
4. until price reaches its
equilibrium value of $3.00
.
J
Excess Demand
D
1. At a price of $1.00 per
bottle an excess demand
of 50,000 bottles . . .
Hall & Leiberman;
Economics: Principles
25,000 50,000 75,000
Number of Bottles
per Month
37
Excess Demand: Putting Supply
and Demand Together
• 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
Hall & Leiberman;
Economics: Principles
38
Figure 8: Excess Supply and Price
Adjustment
Price per
Bottle
1. At a price of $5.00 per
bottle an excess supply
of 30,000 bottles . . .
Excess Supply at $5.00 S
$5.00
2. causes the
price to drop,
3.00
3. shrinking the
excess supply . . .
L
K
E
4. until price reaches its
equilibrium value of
$3.00.
D
35,000 50,000 65,000
Hall & Leiberman;
Economics: Principles
Number of Bottles
per Month
39
Excess Supply: Putting Supply and
Demand Together
• 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
Hall & Leiberman;
Economics: Principles
40
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
Hall & Leiberman;
Economics: Principles
41
Figure 9
Price per
Bottle
4. Equilibrium
price
increases
3. to a new
equilibrium.
S
$4.00
3.00
2. moves us along
the supply
curve . . .
F'
E
1. An increase in
demand . . .
D2
D1
5. and equilibrium quantity
increases too.
Hall & Leiberman;
Economics: Principles
50,000 60,000
Number of Bottles of
Maple Syrup per Period
42
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
Hall & Leiberman;
Economics: Principles
43
Figure 10: A Shift of Supply and A
New Equilibrium
Price per
Bottle
$5.00
3.00
S2
S1
E'
E
D
35,000 50,000
Hall & Leiberman;
Economics: Principles
Number of Bottles
44
Figure 11: Changes in the Market
for Handheld PCs
Price per
Handheld
PC
3. moved the market to
a new equilibrium.
2. and a decrease
in demand . . .
4. Price
decreased . . .
A
$500
B
S2002
S2003
1. An increase in
supply . . .
$400
D2002
5. and quantity
decreased as well.
D2003
2.45 3.33
Hall & Leiberman;
Economics: Principles
Millions of Handheld PCs
per Quarter
45
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 quantity—but not
both
– Direction of the other will depend on which curve
shifts by more
Hall & Leiberman;
Economics: Principles
46
The Three Step Process
• Key Step 1—Characterize the Market
– Decide which market or markets best suit problem
being analyzed and identify decision makers (buyers
and sellers) who interact there
• Key Step 2—Find the Equilibrium
– Describe conditions necessary for equilibrium in the
market, and a method for determining that equilibrium
• Key Step 3—What Happens When Things
Change
– Explore how events or government polices change
market equilibrium
Hall & Leiberman;
Economics: Principles
47
Using Supply and Demand: The
Invasion of Kuwait
• Why did Iraq’s 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 industry’s
productive capacity caused a shift in the
supply curve to the left
• Price of oil increased
Hall & Leiberman;
Economics: Principles
48
Figure 12: The Market For Oil
Price per
Barrel of Oil
S2
S1
E'
P2
E
P1
D
Q2
Hall & Leiberman;
Economics: Principles
Q1
Barrels of Oil
49
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
Hall & Leiberman;
Economics: Principles
50
Figure 13: The Market For Natural
Gas
Price per Cubic
Foot of Natural
Gas
S
F'
P4
F
D2
P3
D1
Q3
Hall & Leiberman;
Economics: Principles
Q4
Cubic Feet of
Natural Gas
51