3 Demand, Supply, and Market Equilibrium
Chapter Objectives • Demand Defined and What Affects It • Supply Defined and What Affects It • How Supply & Demand Together Determine Market Equilibrium • How Changes in Supply and Demand Affect Equilibrium Prices and Quantities • Government-Set Prices and their Implications for Surpluses & Shortages
Markets Defined • Markets bring together buyers (demanders) and sellers (suppliers) of particular goods and services. They take many forms. • A market may be local (fish), national (houses), or international (oil) in scope. • Some markets are highly personal, face-to-face exchanges (fish); others are impersonal and remote (internet marketing). • There are two types of markets • product market (fish) involves goods and services. • resource market (labor market) involves factors of production
Demand Demand Defined • Demand is a schedule or a curve that shows the various amounts of a product that consumers are willing and able to buy at each of a series of possible prices during a specified time period. Example look at the following schedule. • The schedule shows the relationship between various prices and the quantity a consumer is willing and able to purchase at each of these prices. We say willing an able because willingness is not effective in the market. The table does not tell us which of the 5 prices would exist in the market. This depends on demand and supply. • To be meaningful, the demand schedule must have a period of time associated with it, example a day, a week or a month.
6 5 4 3 2 1 0 Price (per bushel) 10 20 30 40 50 60 70 80 Quantity Demanded (bushels per week) Individual Demand P Individual Demand P Qd $5 4 3 2 1 10 20 35 55 80 D Q
Law of Demand • Law of demand “other things being equal, as price increases, the corresponding quantity demanded falls and as price falls, the quantity demanded rises”. • The law of demand can be restated as, “there is an negative or inverse relationship between price and quantity demanded”. • Note the “other-things-equal” assumption refers to consumer income, tastes, prices of related goods, and other things besides the price of the product being discussed. Explanation of the law of demand • Diminishing marginal utility The consumer will derive less satisfaction (utility) form each additional units of the product consumed, e.g., the second “Big Mac” yields less extra satisfaction (or utility) than the first, i.e. consumption is subject to diminishing marginal utility. A consumer will only buy it if its price is less.
Income effect A lower price increases the purchasing power of money income, enabling the consumer to buy more at a lower price. A higher price has the opposite effect. • Substitution effect At a lower price buyers have the incentive to substitute what is now a less expensive product for similar products that are now relatively more expensive. The demand curve • A simple graph illustrates the inverse relationship between price and quantity. • The downward slope indicates lower quantity (horizontal axis) at higher price (vertical axis) and higher quantity at lower price, reflecting the Law of Demand. Market demand • By adding the quantities demanded by all consumers at each of the various prices, we can get from individual demand to market demand (the demand of all consumers in the market).
Determinants of Demand • There are several determinants of demand or the “other things,” besides price, which affect demand. A change in one or more of the determinants of demand will cause the demand data and therefore the location of the demand curve to change. A shift in the demand curve is called a change in demand • Tastes • A favorable change in consumer tastes for a product means that more of it will be demanded at each (current) price. Demand will increase i.e., shifts rightward. Unfavorable change will decrease demand (a shift leftward). • Number of buyers • An increase in the number of buyers is likely to increase demand; fewer buyers will probably decrease demand.
Income • for most products a rise in income causes an increase in demand for superior or normal goods. Less leads to a decrease in demand for normal goods. The rare case of goods whose demand varies inversely with income is called inferior goods, e.g., used cars. • Prices of related goods: • A change in the price of related goods may either increase or decrease the demand for a product depending on whether the related good is a substitute or a complement. • Substitutes(can be used in place of another good): if two goods are substitutes, an increase in the price of one will increase the demand for the other (i.e., directly related). • Complements(goods that are used together, they are demanded jointly): if the price of a complement increase, the demand for the related good will decline, i.e., there is an inverse relationship between the price of one and the demand for the other.
Unrelated goods (independent goods). A change in the price of one has little or no effect on the demand for the other. • Consumer expectations • A newly formed expectations of higher futureprices may cause consumers to buy now in order to beat the anticipated price rises, this will shift the demand rightward, e.g., the real estates market. • A change in expectations concerning futureincome may prompt consumers to change their current spending. Demand shifts rightward (in case of expected higher income) or leftward (in case of expected lower income).
Individual Demand Demand Can Increase or Decrease P 6 5 4 3 2 1 0 Individual Demand Increase in Demand P Qd $5 4 3 2 1 10 20 35 55 80 Price (per bushel) D2 D1 Decrease in Demand D3 Q 2 4 6 8 10 12 14 16 18 Quantity Demanded (bushels per week)
Individual Demand Demand Can Increase or Decrease An Increase in Demand Means a shift of the Line P 6 5 4 3 2 1 0 Individual Demand A Movement Between Any Two Points on a Demand Curve is Called a Change in Quantity Demanded P Qd $5 4 3 2 1 10 20 35 55 80 Price (per bushel) D2 D1 Decrease in Demand D3 Q 2 4 6 8 10 12 14 16 18 Quantity Demanded (bushels per week)
A summary of what can cause an increase in demand a. Favorable change in consumer tastes. b. Increase in the number of buyers. c. Rising income if product is a normal good. d. Falling incomes if product is an inferior good. e. Increase in the price of a substitute good. f. Decrease in the price of a complementary good. g. Consumer expectation of higher prices or incomes in the future. A summary of what can cause a decrease in demand. a. Unfavorable change in consumer tastes. b. Decrease in number of buyers. c. Falling income if product is a normal good. d. Rising income if product is an inferior good. e. Decrease in price of a substitute good. f. Increase in price of a complementary good. • Consumers expectation of lower prices or incomes in the future.
Distinction between a change in quantity demanded and a change in demand • A change in demand is a shift of the demand curve. It occurs due to changes in one of the demand determinants. It will shift the whole demand curve to the right (an increase in demand) or to the left (a fall in demand). • A change in quantity demanded is a movement from on point to another on a fixed demand schedule. It is caused by price changes.
Supply Supply Defined • Supply is a schedule or a curve that shows the various amounts of a product that producers are willing and able to make available for sale at each of a series of possible prices during a specified time period. Law of supply. • All else equal, there is a positive or direct relationship between price and quantity supplied. A supply schedule tells us that firms will produce and offer for sale more of their product at a high price that at a low price. Explanation: • Revenue Implications. For a supplier price represents a revenue, which serves as an incentive to produce and sell a product. The higher the price, the greater the incentive and the greater the quantity supplied.
Marginal Cost. beyond some quantity of production manufacturers usually encounter increasing marginal cost (the added cast of producing one more unit of output). Certain productive resources (e.g., machinery) cannot be expanded quickly, producers will increase other resources such as labor. As more labor are used the added output will be less, and the marginal cost of successive units rises accordingly. The producer will not produce more costly units unless it receives a higher price for them. The supply curve • It shows a direct relationship between the price and quantity supplied. The upward slop of the curve reflects the law of supply – producers offer more of a good or a service or resource for sale as its price rises.
Individual Supply P 6 5 4 3 2 1 0 Individual Supply S1 P Qs $5 4 3 2 1 60 50 35 20 5 Price (per bushel) Q 10 20 30 40 50 60 70 Quantity Supplied (bushels per week)
Market Supply • The sum of quantities supplied by each producer at each price. It is obtained by horizontally adding the supply curves of individual producers in the market. Determinants of supply • A change in any of the supply determinants causes a change in supply and a shift in the supply curve. An increase in supply involves a rightward shift, and a decrease in supply involves a leftward shift. • Resource prices. • A higher resource prices raises production costs and squeeze profits. The reduction in profits reduces the incentive to supply output at each product price, supply shifts leftward. • In contrast lower resource prices will reduce production costs and increase profits, causing an increase in supply or rightward shift in the supply curve.
Technology A technological improvement means more efficient production and lower costs, so an increase in supply or rightward shift in the curve results. • Taxes and subsidies A business tax is treated as a cost, so decreases supply; a subsidy lowers cost of production, so increases supply. • Prices of related goods If the price of substitute production good rises, producers might shift production toward the higher-priced good (alternative), causing a decrease in supply of the original good.
Producer expectations • Expectations about the future price of a product can cause producers to increase or decrease current supply. • Number of sellers • Generally, the larger the number of sellers the greater the supply. Changes in quantity supplied and changes in supply • Distinction between a change in quantity supplied (due to price changes) and a change or shift in supply (due to change in determinants of supply).
Individual Supply Supply Can Increase or Decrease P 6 5 4 3 2 1 0 S3 Individual Supply S1 S2 P Qs $5 4 3 2 1 60 50 35 20 5 Price (per bushel) Q 2 4 6 8 10 12 14 Quantity Supplied (bushels per week)
Individual Supply Supply Can Increase or Decrease A Movement Between Any Two Points on a Supply Curve is Called a Change in Quantity Supplied P 6 5 4 3 2 1 0 S3 Individual Supply S1 S2 P Qs $5 4 3 2 1 60 50 35 20 5 Price (per bushel) An Increase in Supply Means a shift of the Line Q 2 4 6 8 10 12 14 Quantity Supplied (bushels per week)
Market Equilibrium • Market Equilibrium: where quantity supplied equals the quantity demanded: • Equilibrium price • Equilibrium quantity • At prices above this equilibrium, note that there is an excess quantity supplied or surplus. • At prices below this equilibrium, note that there is an excess quantity demandedor shortage. • Market clearing or market price is another name for equilibrium price.
Market Equilibrium 200 Buyers & 200 Sellers Market Demand 200 Buyers Market Supply 200 Sellers 6 5 4 3 2 1 0 6,000 Bushel Surplus S P Qd P Qs $5 4 3 2 1 2,000 4,000 7,000 11,000 16,000 $5 4 3 2 1 12,000 10,000 7,000 4,000 1,000 Price (per bushel) 3 7,000 Bushel Shortage D 7 2 4 6 8 10 12 14 16 18 Bushels of Corn (thousands per week)
Graphically, note that the equilibrium price and quantity are where the supply and demand curves intersect. Note also that it is NOT correct to say supply equals demand! The rationing function of prices • Is the ability of competitive forces of supply and demand to establish a price at which selling and buying decisions are consistent. Efficient allocation • A competitive market forces producers to use the best technology and the right mix of productive resources. The result is productive efficiency: the production of any particular product in the least costly way. • Competitive markets also produce allocative efficiency: to produce the particular mix of goods and services most valued by the society.
Changes in Supply and Demand, and Equilibrium Changing demand (with supply held constant). • Increase in demand will have effect of increasing equilibrium price and quantity • Decrease in demand will have effect of decreasing equilibrium price and quantity Changing supply (with demand held constant). • Increase in supply will have effect of decreasing equilibrium price and increasing quantity • Decrease in supply will have effect of increasing equilibrium price and decreasing quantity
Complex cases • when both supply and demand shift: • Supply increases and demand decreases, price declines, but the new equilibrium quantity depends on relative sizes of shifts in demand and supply. • Supply decreases and demand increases, price rises, but the new equilibrium quantity depends again on relative sizes of shifts in demand and supply. • Supply increases and demand increases. If the increase in supply is greater than the increase in demand the price falls and vice versa • Supply decreases demand decreases. If the decrease in supply is greater than the decrease in demand, equilibrium price will rise and vice versa.
Application: Government-Set Prices (Ceilings and Floors). • Government-set prices prevent the market from reaching the equilibrium price and quantity. A. Price ceilings • The maximum legal price a seller may charge, typically placed below equilibrium. Shortages result as quantity demanded exceeds quantity supplied. Examples: Rent controls and gasoline price controls Rationing problem • Since price ceilings does not lead to an equitable distribution of the product, the government must establish some formal system for rationing, e.g., ration coupons Black Markets • Since the demand is greater than supply, buyers will be willing to pay a higher price, which creates a black market where the product is illegally traded in at price above the ceiling price.
B. Price floors. • The minimum legal price a seller may charge, typically placed below equilibrium. Surpluses result as quantity supplied exceeds quantity demanded. • Examples: Minimum wage and farm price supports. • Note: The minimum wage, for example, will be below equilibrium in some labor markets (large cities as the demand for labor is already high). In that case the price floor has no effect. (Flash film 7)
Government set prices 6 5 4 3 2 1 0 6,000 Bushel Surplus S $4 Price Floor Price (per bushel) 3 $2 Price Ceiling 7,000 Bushel Shortage D 7 2 4 6 8 10 12 14 16 18 Bushels of Corn (thousands per week)
Application: Market Equilibrium Qd = a1 + b1 P; a1>0, b1<0 (1) Qs = a2 + b2 P; a2<0, b2>0 (2) Qd = Qs (3) Equilibrium Condition Solution At equilibrium a1 + b1 P = a2 + b2 P b1 P - b2 P = a2 -a1 P* = ( a2 -a1 ) ÷ ( b1 - b2 )
Example. Given the following information: Qd = 45 - 2 P; a1>0, b1<0 (1) Qs = -15 + 3P; Calculate the equilibrium price and quantity; Solution: At equilibrium: 45-2p = -15 + 3p 5p = 60 P* = 60/5 = 12 Q* = 45 – 2(12) = 21 • Suppose that the government set a floor price 13, what will happen to the market? • Suppose that the government set a ceiling price 10, what will happen to the market?
A Legal Market for Human Organs Last Word • Waiting List for Transplants • Demand for Organs • Vertical Supply of Organs • Incentive Role of Market and Up-Sloping Supply • Increases Quantity • Decreases Price • Moral Objections • Increase the Cost of Health Care • Better to Legalize and Regulate?
A Legal Market for Human Organs Last Word Supply With Price Incentive S1 S2 P Supply of Organs Demand for Organs Shortage at Zero Price Q1 – Q3 P1 At Price P1 the Shortage is Reduced By Q1 – Q2 D1 P0 Q Q1 Q2 Q3
demand demand schedule law of demand diminishing marginal utility income effect substitution effect demand curve determinants of demand normal goods inferior goods substitute good complementary good change in demand change in quantity demanded supply supply schedule law of supply supply curve determinants of supply change in supply change in quantity supplied equilibrium price equilibrium quantity surplus shortage price ceiling price floor Key Terms Page
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