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P R I N C I P L E S O F

P R I N C I P L E S O F

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P R I N C I P L E S O F

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  1. P R I N C I P L E S O F FOURTH EDITION The Market Forces of Supply and Demand 4

  2. In this chapter, look for the answers to these questions: • What factors affect buyers’ demand for goods? • What factors affect sellers’ supply of goods? • How do supply and demand determine the price of a good and the quantity sold? • How do changes in the factors that affect demand or supply affect the market price and quantity of a good? • How do markets allocate resources? CHAPTER 4 THE MARKET FORCES OF SUPPLY AND DEMAND

  3. Markets and Competition 0 • A market is a group of buyers and sellers of a particular product. • A competitive market is one with many buyers and sellers, each has a negligible effect on price. • A perfectly competitive market: • all goods exactly the same • buyers & sellers so numerous that no one can affect market price – each is a “price taker” • In this chapter, we assume markets are perfectly competitive. CHAPTER 4 THE MARKET FORCES OF SUPPLY AND DEMAND

  4. Demand 0 • Demand comes from the behavior of buyers. • The quantity demanded of any good is the amount of the good that buyers are willing and able to purchase. • Law of demand: the claim that the quantity demanded of a good falls when the price of the good rises, other things equal CHAPTER 4 THE MARKET FORCES OF SUPPLY AND DEMAND

  5. Helen’s Demand Schedule & Curve Price of Lattes Quantity of Lattes 0 CHAPTER 4 THE MARKET FORCES OF SUPPLY AND DEMAND

  6. Price Helen’s Qd Ken’s Qd $0.00 16 + 8 = 24 1.00 14 + 7 = 21 2.00 12 + 6 = 18 3.00 10 + 5 = 15 4.00 8 + 4 = 12 5.00 6 + 3 = 9 6.00 4 + 2 = 6 Market Demand versus Individual Demand 0 • The quantity demanded in the market is the sum of the quantities demanded by all buyers at each price. • Suppose Helen and Ken are the only two buyers in the Latte market. (Qd = quantity demanded) Market Qd

  7. The Market Demand Curve for Lattes 0 P Q CHAPTER 4 THE MARKET FORCES OF SUPPLY AND DEMAND

  8. Demand Curve Shifters 0 • The demand curve shows how price affects quantity demanded, other things being equal. • These “other things” are non-price determinants of demand (i.e., things that determine buyers’ demand for a good, other than the good’s price). • Changes in them shift the D curve… • Q = f ( P, ….other variables…..) • THE KEY – these are factors that change buyer behavior! CHAPTER 4 THE MARKET FORCES OF SUPPLY AND DEMAND

  9. Summary: Variables That Affect Demand 0 Variable A change in this variable… Price …causes a movement along the D curve No. of buyers …shifts the D curve Income …shifts the D curve Price ofrelated goods …shifts the D curve Tastes …shifts the D curve Expectations …shifts the D curve CHAPTER 4 THE MARKET FORCES OF SUPPLY AND DEMAND

  10. P Q Demand Curve Shifters: # of buyers 0 Suppose the number of buyers increases. Then, at each price, quantity demanded will increase (by 5 in this example). CHAPTER 4 THE MARKET FORCES OF SUPPLY AND DEMAND

  11. Demand Curve Shifters: income 0 • Demand for a normal good is positively related to income. • An increase in income causes increase in quantity demanded at each price, shifting the D curve to the right. (Demand for an inferior good is negatively related to income. An increase in income shifts D curves for inferior goods to the left.) CHAPTER 4 THE MARKET FORCES OF SUPPLY AND DEMAND

  12. Demand Curve Shifters: prices of related goods 0 • Two goods are substitutes if an increase in the price of one causes an increase in demand for the other. • Example: pizza and hamburgers. An increase in the price of pizza increases demand for hamburgers, shifting hamburger demand curve to the right. • Other examples: Coke and Pepsi, laptops and desktop computers, compact discs and music downloads CHAPTER 4 THE MARKET FORCES OF SUPPLY AND DEMAND

  13. Demand Curve Shifters: prices of related goods 0 • Two goods are complements if an increase in the price of one causes a fall in demand for the other. • Example: computers and software. If price of computers rises, people buy fewer computers, and therefore less software. Software demand curve shifts left. • Other examples: college tuition and textbooks, bagels and cream cheese, eggs and bacon CHAPTER 4 THE MARKET FORCES OF SUPPLY AND DEMAND

  14. Demand Curve Shifters: expectations 0 • Expectations affect consumers’ buying decisions. • Examples: • If people expect their incomes to rise, their demand for meals at expensive restaurants may increase now. • If the economy turns bad and people worry about their future job security, demand for new autos may fall now. CHAPTER 4 THE MARKET FORCES OF SUPPLY AND DEMAND

  15. ACTIVE LEARNING 1: Demand curve A. The price of iPods falls B. The price of music downloads falls C. The price of compact discs falls Draw a demand curve for music downloads. What happens to it in each of the following scenarios? Why? 14

  16. Price of music down-loads P1 D2 D1 Q2 Q1 Quantity of music downloads ACTIVE LEARNING 1: A. price of iPods falls Music downloads and iPods are complements. A fall in price of iPods shifts the demand curve for music downloads to the right. 15

  17. P2 Q2 ACTIVE LEARNING 1: B. price of music downloads falls Price of music down-loads The D curve does not shift. Move down along curve to a point with lower P, higher Q. P1 D1 Q1 Quantity of music downloads 16

  18. P1 D1 D2 Q1 Q2 ACTIVE LEARNING 1: C. price of CDs falls CDs and music downloads are substitutes. A fall in price of CDs shifts demand for music downloads to the left. Price of music down-loads Quantity of music downloads 17

  19. Supply 0 • Supply comes from the behavior of sellers. • The quantity supplied of any good is the amount that sellers are willing and able to sell. • Law of supply: the claim that the quantity supplied of a good rises when the price of the good rises, other things equal CHAPTER 4 THE MARKET FORCES OF SUPPLY AND DEMAND

  20. Starbucks’ Supply Schedule & Curve 0 P Q CHAPTER 4 THE MARKET FORCES OF SUPPLY AND DEMAND

  21. Price Starbucks Jitters $0.00 0 + 0 = 0 1.00 3 + 2 = 5 2.00 6 + 4 = 10 3.00 9 + 6 = 15 4.00 12 + 8 = 20 5.00 15 + 10 = 25 6.00 18 + 12 = 30 Market Supply versus Individual Supply 0 • The quantity supplied in the market is the sum of the quantities supplied by all sellers at each price. • Suppose Starbucks and Jitters are the only two sellers in this market. (Qs = quantity supplied) Market Qs

  22. P Q The Market Supply Curve 0 CHAPTER 4 THE MARKET FORCES OF SUPPLY AND DEMAND

  23. Supply Curve Shifters 0 • The supply curve shows how price affects quantity supplied, other things being equal. • These “other things” are non-price determinants of supply. • Changes in them shift the S curve… • Q = f (P, … other variables …. ) • THE KEY -- factors that change sellers’ behavior. CHAPTER 4 THE MARKET FORCES OF SUPPLY AND DEMAND

  24. Supply curves shift … the logic! • Decisions of firms shift the curve; in brief, more profits lead to more supply (& vice versa). • Less costs …. More profits …. More supply. • Higher costs… Less profits ….. Less supply • Reasons why costs change?? • Technical progress … Less costs …more supply • Input prices up … more costs ….. less supply • New taxes or regulation.. Costs up ..less supply CHAPTER 4 THE MARKET FORCES OF SUPPLY AND DEMAND

  25. Supply Curve Shifters: input prices 0 • Examples of input prices: wages, prices of raw materials. • A fall in input prices makes production more profitable at each output price, so firms supply a larger quantity at each price, and the S curve shifts to the right. CHAPTER 4 THE MARKET FORCES OF SUPPLY AND DEMAND

  26. P Q Supply Curve Shifters: input prices 0 Suppose the price of milk falls. At each price, the quantity of Lattes supplied will increase (by 5 in this example). CHAPTER 4 THE MARKET FORCES OF SUPPLY AND DEMAND

  27. Supply Curve Shifters: technology 0 • Technology determines how much inputs are required to produce a unit of output. • A cost-saving technological improvement has same effect as a fall in input prices, shifts the S curve to the right. CHAPTER 4 THE MARKET FORCES OF SUPPLY AND DEMAND

  28. Supply Curve Shifters: # of sellers 0 • An increase in the number of sellers increases the quantity supplied at each price, shifts the S curve to the right. CHAPTER 4 THE MARKET FORCES OF SUPPLY AND DEMAND

  29. Supply Curve Shifters: expectations 0 • Suppose a firm expects the price of the good it sells to rise in the future. • The firm may reduce supply now, to save some of its inventory to sell later at the higher price. • This would shift the S curve leftward. CHAPTER 4 THE MARKET FORCES OF SUPPLY AND DEMAND

  30. Summary: Variables That Affect Supply 0 Variable A change in this variable… Price …causes a movement along the S curve Input prices …shifts the S curve Technology …shifts the S curve No. of sellers …shifts the S curve Expectations …shifts the S curve CHAPTER 4 THE MARKET FORCES OF SUPPLY AND DEMAND

  31. ACTIVE LEARNING 2: Supply curve 0 Draw a supply curve for tax return preparation software. What happens to it in each of the following scenarios? A.Retailers cut the price of the software. B.A technological advance allows the software to be produced at lower cost. C.Professional tax return preparers raise the price of the services they provide. 30

  32. Price of tax return software S1 P1 P2 Q2 Q1 Quantity of tax return software ACTIVE LEARNING 2: A. fall in price of tax return software The S curve does not shift. Move down along the curve to a lower Pand lower Q. 31

  33. S2 Q2 ACTIVE LEARNING 2: B. fall in cost of producing the software Price of tax return software The S curve shifts to the right: at each price, Q increases. S1 P1 Q1 Quantity of tax return software 32

  34. Price of tax return software S1 Quantity of tax return software ACTIVE LEARNING 2: C. professional preparers raise their price This shifts the demand curve for tax preparation software, not the supply curve. 33

  35. P S D Q Market Equilibrium price and quantity : 0 The price that equates quantity supplied with quantity demanded CHAPTER 4 THE MARKET FORCES OF SUPPLY AND DEMAND

  36. P Surplus S D Q Surplus: 0 when quantity supplied is greater than quantity demanded Facing a surplus, sellers try to increase sales by cutting the price. This causes QD to rise and QS to fall… …which reduces the surplus. CHAPTER 4 THE MARKET FORCES OF SUPPLY AND DEMAND

  37. P S D Q Shortage: 0 when quantity demanded is greater than quantity supplied Example: If P = $1, thenQD = 21 lattes andQS = 5 lattes resulting in a shortage of 16 lattes Shortage CHAPTER 4 THE MARKET FORCES OF SUPPLY AND DEMAND

  38. P S D Shortage Q Shortage: 0 when quantity demanded is greater than quantity supplied Facing a shortage, sellers raise the price, causing QD to fall and QS to rise, …which reduces the shortage. CHAPTER 4 THE MARKET FORCES OF SUPPLY AND DEMAND

  39. Steps to Analyzing Changes in Equilibrium • To determine the effects of any event: • 1. Decide whether the event shifts the D curve, the S curve, or both. • 2. Decide in which direction each curve shifts. • 3. Use Demand-Supply diagram to see how the shift changes the equilibrium Price and Quantity. CHAPTER 4 THE MARKET FORCES OF SUPPLY AND DEMAND

  40. Market Analysis: Variables That Affect Marketfor Ipod-like devices. 0 what happens to the market for Ipod devices? The U.S. economy enters a serious recession I-tunes increases the price of downloads to $5/song, to pay royalties to music industry. The price of Ipod devices increases by $100. CHAPTER 4 THE MARKET FORCES OF SUPPLY AND DEMAND

  41. More Demand or Supply affecting the market for Ipod-like devices? • A price war between Microsoft and Sony, the two largest producers of video games, reduces the price of video games by 50%. • Apple agrees to double all its employees’ salaries, since its stock price doubled in 2006. • To teach technology to K-6 graders, federal law requires that all students receive instruction using the Ipod as an example • Ipod increases its price by $125. • Microprocessors used in IPOL-like devices fall by 50% in cost, and are five times faster. • Blackberry starts to sell an identical device, called Bpod. • Federal prosecutors begin a nationwide campaign to prosecute illegal downloading, announcing $5,000 fines for a first offense. CHAPTER 4 THE MARKET FORCES OF SUPPLY AND DEMAND

  42. Terms for Shift vs. Movement Along Curve • Change in supply: a shift in the S curve • occurs when a non-price determinant of supply changes (like technology or costs) • Change in the quantity supplied:a movement along a fixed S curve • occurs when P changes • Change in demand: a shift in the D curve • occurs when a non-price determinant of demand changes (like income or # of buyers) • Change in the quantity demanded:a movement along a fixed D curve • occurs when P changes CHAPTER 4 THE MARKET FORCES OF SUPPLY AND DEMAND

  43. P price of hybrid cars S1 P1 D1 Q Q1 quantity of hybrid cars Demand and Supply EXAMPLE: Analyzing the Market for Hybrid Cars CHAPTER 4 THE MARKET FORCES OF SUPPLY AND DEMAND

  44. P S1 P2 P1 D2 D1 Q Q1 Q2 EXAMPLE 1: A Change in Demand EVENT TO BE ANALYZED: Increase in price of gas. STEP 1: D curve shifts because price of gas affects demand for hybrids. S curve does not shift, because price of gas does not affect cost of producing hybrids. STEP 2: D shifts rightbecause high gas price makes hybrids more attractive relative to other cars. STEP 3: The shift causes an increase in price and quantity of hybrid cars. CHAPTER 4 THE MARKET FORCES OF SUPPLY AND DEMAND

  45. P S1 S2 P1 P2 D1 Q Q1 Q2 EXAMPLE 2: A Change in Supply EVENT: New technology reduces cost of producing hybrid cars. STEP 1: S curve shifts because event affects cost of production. D curve does not shift, because production technology is not one of the factors that affect demand. STEP 2: S shifts rightbecause event reduces cost, makes production more profitable at any given price. STEP 3: The shift causes price to fall and quantity to rise. CHAPTER 4 THE MARKET FORCES OF SUPPLY AND DEMAND

  46. P S1 S2 P2 P1 D2 D1 Q Q1 Q2 EXAMPLE 3: A Change in Both Supply and Demand EVENTS:price of gas rises AND new technology reduces production costs STEP 1: Both curves shift. STEP 2: Both shift to the right. STEP 3: Q rises, but effect on P is ambiguous: If demand increases more than supply, P rises. CHAPTER 4 THE MARKET FORCES OF SUPPLY AND DEMAND

  47. P S1 S2 P1 P2 D2 D1 Q Q1 Q2 EXAMPLE 3: A Change in Both Supply and Demand EVENTS:price of gas rises AND new technology reduces production costs STEP 3, cont. But if supply increases more than demand, P falls. CHAPTER 4 THE MARKET FORCES OF SUPPLY AND DEMAND

  48. Example: D & S and the Jet-ski Market • Explain with D & S diagrams how the jet-ski market would be affected: • 1. Economy enters a serious recession, household incomes fall. • 2. The price of jet-skis declines by 20%. • 3. The price of fiberglass falls by one third, AND it is announced that jet skiing will become an Olympic sport in 2008, with medals awarded in multiple age classes. CHAPTER 4 THE MARKET FORCES OF SUPPLY AND DEMAND

  49. P S1 P1 P2 D2 D1 Q Q1 Q2 A. Recession begins, incomes fall. The market for jet-skis STEPS 1. D curve shifts 2. D shifts left 3. P and Q both fall. CHAPTER 4 THE MARKET FORCES OF SUPPLY AND DEMAND 48

  50. B. Price of jet skis falls by 20% • We have no information about any variable that shifted either the demand or supply curve. • Something caused the price to change. • 1. Either curve may have shifted, or both. • 2. Government regulations may have imposed a new price. CHAPTER 4 THE MARKET FORCES OF SUPPLY AND DEMAND