Chapter 2 Supply and Demand

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Chapter 2 Supply and Demand. Introduction. The model of supply and demand is one of the most important tools in economics. The model is a simple presentation of exchange that captures the behavior of both buyers and sellers. The Demand Curve for Oil.

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Chapter 2

Supply and Demand

Introduction

The model of supply and demand is one of the most important tools in economics.

The model is a simple presentation of exchange that captures the behavior of both buyers and sellers.

The Demand Curve for Oil

Demand represents the behavior of buyers.

A Demand Curve is a function that shows the quantity demanded at different prices.

The Quantity Demanded is the quantity that buyers are willing and able to purchase at a particular price.

The Demand Curve for Oil

The Law of Demand indicates an inverse relationship between price and quantity demanded.

When price rises, all else equal, quantity demanded falls.

When price falls, all else equal, quantity demanded rises.

Demand curves consistent with the law of demand are downward sloping.

Demand Curves

The Demand Curve for Oil is a Function Showing the Quantity of Oil Demanded at Different Prices

Price of Oil per Barrel

\$55

\$20

\$5

Demand

Quantity of Oil (MBD)

5

25

50

Demand Curves

Demand curves can be read in two ways:

Horizontally: How much buyers are willing and able to purchase at a given price.

Vertically: The maximum price for which buyers are willing to pay for a given quantity.

Demand curves thus reveal the quantity demanded at a given price or the maximum willingness to pay for a given quantity.

The Demand Curve for Oil

Price of Oil per Barrel

\$55

\$20

Start

Demand

\$5

Quantity of Oil (MBD)

5

25

50

End

The Demand Curve for Oil

Price of Oil per Barrel

\$55

\$20

End

Demand

\$5

Quantity of Oil (MBD)

5

25

50

Start

Demand Curves

Why is the demand curve downward sloping?

A good is not equally valuable in all of its uses.

At a high price, a good is consumed in only its highest valued use.

At a low price, a good is also consumed in its lower valued uses.

The value of a good’s use will depend on the availability of substitutes.

The Demand Curve for Oil

When the price of oil is high, oil will only be used in higher valued uses. As the price falls, oil will also be used in lower valued uses

Price of Oil per Barrel

Higher Valued Uses of Oil

\$120

Lower Valued Uses of Oil

\$20

Demand

Quantity of Oil (MBD)

20

120

Consumer Surplus

Consumer Surplusis the consumer’s gain from exchange, or the difference between the maximum price a consumer is willing to pay for a given quantity and the market price.

Total consumer surplus is the sum of consumer surplus of all buyers.

Graphically, total consumer surplus is measured by the area below the demand curve and above the price.

Consumer Surplus

Consumer Surplus is the Area beneath the Demand Curve and above the Price

Price of Oil per Barrel

Area of Triangle

Height

The President’s Consumer Surplus

80

Total Consumer Surplus at a Price of \$20

½(Base x Height)

Base

Joe’s Consumer Surplus

½(80-20)x90 = \$2,700

20

Demand

Quantity of Oil (MBD)

90

What Shifts the Demand Curve?

The demand curve

An increase in demand means that quantity demanded at a given price increases, or the maximum willingness to pay for a given quantity rises.

Graphically, an increase in demand shifts the demand curve outwards, up, and to the right.

A decrease in demand means that quantity demanded at a given price decreases, or the maximum willingness to pay for a given quantity falls.

Graphically, a decrease in demand shifts the demand curve inwards, down, and to the left.

Change in Demand

An Increase in Demand

Price per Unit

Greater Willingness to Pay for the Same Quantity

\$50

Greater Quantity Demanded at the Same Price

\$25

New Demand

Old Demand

Quantity

80

70

Change in Demand

A Decrease in Demand

Price per Unit

Lower Willingness to Pay for the Same Quantity

\$50

Less Quantity Demanded at the Same Price

\$25

Old Demand Curve

New Demand Curve

Quantity

70

80

Important Demand Shifters

Important Demand Shifters

Income

Population

Price of Substitutes

Price of Complements

Expectations

Tastes

Important Demand Shifters - Income

The effect of changes in income on demand depends on the nature of the good in question.

A Normal Goodis a good for which demand increases (decreases) when income increases (decreases).

An Inferior Goodis a good for which demand decreases (increases) when income increases (decreases).

Important Demand Shifters - Population

As the population of an economy changes, the number of buyers of a particular good also changes, directly influencing its demand.

More buyers of a good increases its demand.

Fewer buyers of a good decreases its demand.

Important Demand Shifters - Price of Substitutes

Two goods are Substitutes if a decrease (increase) in the price of one good leads to a decrease (increase) in demand for the other good.

Important Demand Shifters - Price of Complements

Two goods are Complements if a decrease (increase) in the price of one good leads to an increase (decrease) in the demand for the other.

Important Demand Shifters - Expectations

The expectation of a higher (lower) price for a good in the future increases (decreases) current demand for the good.

Consumers will adjust their current spending in anticipation of the direction of future prices in order to obtain the lowest possible price.

Important Demand Shifters - Tastes

Tastes and preferences are subjective and will vary among consumers.

Some issues like seasonal changes or fads, however, will have rather predictable effects on demand.

What Shifts the Demand Curve?

A change in quantity demandedis NOT the same as a change in demand.

Quantity demanded changes only when the price of a good changes.

Graphically, a change in quantity demanded is represented by a movement along a fixed demand curve.

Demand changes only when a non-price factor (demand shifter) changes.

Graphically, a change in demand is represented by a shift in the entire demand curve.

Economic growth in India is raising the incomes of Indian workers. What do you predict will happen to the demand for automobiles? What about the demand for charcoal bricks for home heating?
• As the price of oil rises, what do you predict will happen to the demand for mopeds?
The Supply Curve for Oil

Supply represents the behavior of sellers.

A Supply Curveis a function that shows the quantity supplied at different prices.

The Quantity Suppliedis the quantity that producers are willing and able to sell at a particular price.

The Supply Curve for Oil

The Law of Supplyindicates a direct relationship between price and quantity supplied.

When price rises, all else equal, quantity supplied rises.

When price falls, all else equal, quantity supplied falls.

Supply curves consistent with the law of supply are upward sloping.

Supply Curves

The Supply Curve for Oil is a Function Showing the Quantity of Oil Supplied at Different Prices

Price of Oil per Barrel

Supply Curve for Oil

\$55

\$20

\$5

Quantity of Oil (MBD)

10

50

30

Supply Curves

Supply curves can be read in two ways:

Horizontally: How much suppliers are willing and able to sell at a given price.

Vertically: The minimum price for which suppliers are willing to sell a given quantity.

Supply curves, thus, reveal the quantity supplied at a given price, or the minimum price at which suppliers will sell a given quantity.

The Supply Curve for Oil

Price of Oil per Barrel

Supply Curve for Oil

\$55

Start

\$20

\$5

Quantity of Oil (MBD)

10

30

50

End

Supply Curves

Price of Oil per Barrel

Supply Curve for Oil

\$55

End

\$20

\$5

Quantity of Oil (MBD)

10

30

50

Start

Supply Curves

Why is the supply curve upward sloping?

The cost of producing a good is not equal across all suppliers.

At a low price, a good is produced and sold only by the lowest cost suppliers.

At a high price, a good is also produced and sold by higher cost suppliers.

The Supply Curve for Oil

The Supply Curve for Oil

Price of Oil per Barrel

Supply

\$60

Oil Shale Profitable Here

\$40

Higher Cost Oil

Low Cost Oil

\$20

Quantity of Oil (MBD)

20

40

60

80

100

ProducerSurplus

Producer Surplusis the producer’s gain from exchange, or the difference between the market price and the minimum price at which producers would be willing to sell a given quantity.

Total producer surplus is the sum of the producer surplus of each seller.

Graphically, total producer surplus is measured by the area above the supply curve and below the price.

Producer Surplus

Producer Surplus is the Area Above the Supply Curve and Below the Price

Price of Oil per Barrel

\$60

Supply Curve

\$40

\$20

Total Producer Surplus at a Price of \$40

Quantity of Oil (MBD)

20

40

60

80

Important Supply Shifters

Changes in Supply

An increase in supply means that quantity supplied at a given price increases, or the minimum willingness to sell for a given quantity falls.

Graphically, an increase in supply shifts the supply curve down and to the right.

A decrease in supply means that quantity supplied at a given price decreases, or the minimum willingness to sell a given quantity rises.

Graphically, a decrease in supply shifts the supply curve up and to the left.

Changes in supply are inversely related to the costs of production.

Change in Supply

Lower Costs Increase Supply

Price of Oil per Barrel

Old Supply

Greater Quantity Supplied at the Same Price

New Supply

\$50

\$10

Willing to Sell Same Quantity at Lower Prices

Quantity of Oil (MBD)

20

80

Change in Supply

Higher Costs Decrease Supply

Price of Oil per Barrel

Smaller Quantity Supplied at the Same Price

New Supply

Old Supply

\$50

Higher Price Needed to Sell Same Quantity

\$10

Quantity of Oil (MBD)

20

80

Important Supply Shifters

Important Supply Shifters

Technological Innovations

Input Prices

Taxes and Subsidies

Expectations

Entry or Exit of Producers

Changes in Opportunity Costs

Important Supply Shifters - Technological Innovations

A technological innovation makes sellers willing to supply a greater quantity at a given price, or the new technology allows producers to sell a given quantity at a lower price.

A technological innovation lowers costs and increases supply.

Important Supply Shifters - Input Prices

A decrease (increase) in the price of an input makes sellers willing to supply a greater (lesser) quantity at a given price, or the lower (higher) input price allows producers to sell a given quantity at a lower (higher) price.

A decrease (increase) in the price of an input lowers (raises) costs and increases (decreases) supply.

Important Supply Shifters - Taxes and Subsidies

A tax on output makes sellers willing to supply a lesser quantity at a given price, or the tax forces producers to sell a given quantity at a higher price.

A tax on output raises costs and decreases supply.

A subsidy on production makes sellers willing to supply a greater quantity at a given price, or the subsidy allows producers to sell a given quantity at a lower price.

A subsidy on production lowers costs and increases supply.

Important Supply Shifters - Taxes and Subsidies

With a \$10 Tax Suppliers Require a \$10 Higher Price to Sell the Same Quantity

Price of Oil per Barrel

Supply With \$10 Tax

\$50

Supply Without Tax

\$10

\$10

\$10

\$40

60

Quantity of Oil (MBD)

Important Supply Shifters - Expectations

The expectation of a higher (lower) price for a good in the future decreases (increases) current supply of the good.

Sellers will adjust their current offerings in anticipation of the direction of future prices in order to obtain the highest possible price.

Important Supply Shifters - Expectations

Expectations Can Shift the Supply Curve

Price per Unit

Supply Today with Expectation of Future Price Increase

Supply Today

Into Storage

Quantity

Important Supply Shifters - Entry or Exit of Producers

As producers enter and exit the market, the number of sellers of a particular good changes, directly influencing supply.

Entry implies more sellers in the market increasing supply.

Exit implies fewer sellers in the market decreasing supply.

Important Supply Shifters - Entry or Exit of Producers

Entry Increases Supply

Greater Quantity Supplied at the Same Price

Price

Domestic Supply

Lower Price for the Same Quantity Supplied

Quantity

Important Supply Shifters - Changes in Opportunity Costs

Inputs used in production have opportunity costs, and sellers will choose to employ those inputs in the production of the highest priced finished goods.

Sellers will supply less (more) of a good if the price of an alternate good using the same inputs rises (falls).

Important Supply Shifters – Changes in Opportunity Costs

Higher (Opportunity) Costs Reduce Supply

Price per Unit

Higher Price Required to Sell the Same Quantity

Supply with High Opportunity Costs

\$7

Supply with Low Opportunity Costs

\$5

Smaller Quantity Supplied at the Same Price

Quantity of Soybeans (Millions of Bushels)

2,800

2,000

What Shifts the Supply Curve?

A change in quantity suppliedis NOT the same as a change in supply.

Quantity supplied changes only when the price of a good changes.

Graphically, a change in quantity supplied is represented by a movement along a fixed supply curve.

Supply changes only when a non-price factor changes.

Graphically, a change in supply is represented by a shift in the entire supply curve.

Technological innovations in chip making have driven down the costs of producing computers. What happens to the supply curve for computers? Why?
• The U.S. government subsidizes making ethanol as a fuel made from corn. What effect does the subsidy have on the supply curve for ethanol?
Demand represents the behavior of buyers.
• A demand curve is a function that shows the quantity demanded at different prices.
• Demand curves are downward sloping.
• Consumer Surplus is the consumer’s gain from exchange, or the difference between the maximum price a consumer is willing to pay for a given quantity and the market price.
• Graphically, total consumer surplus is measured by the area below the demand curve and above the price.
An increase in demand shifts the demand curve upward, out, and to the right.
• A decrease in demand shifts the demand curve inward, down, and to the left.
• Important Demand Shifters
• Income
• Population
• Price of Substitutes
• Price of Complements
• Expectations
• Tastes
Supply represents the behavior of sellers.
• A supply curve is a function that shows the quantity supplied at different prices.
• Supply curves are upward sloping.
• Producer Surplus is the producer’s gain from exchange, or the difference between the market price and the minimum price at which producers would be willing to sell a given quantity.
• Graphically, total producer surplus is measured by the area above the supply curve and below the price.
• A decrease in supply shifts the supply curve up and to the left.
• Important Supply Shifters
• Technological Innovations
• Input Prices
• Taxes and Subsidies
• Expectations
• Entry or Exit of Producers
• Changes in Opportunity Costs