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Lecture 3 Supply and Demand

• Market• The law of demand, shifts vs. movements along

the demand curve, factors that shift the demand curve

• The law of supply, shifts vs. movements along the supply curve, factors that shift the supply curve

• Equilibrium: putting demand and supply together• What happens when demand curve or supply

curve shifts?

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Supply and Demand

• Supply and demand is an economic model– Designed to explain how prices are determined

in certain types of markets

• The price of a good or service is what must be given in exchange for the good. Price measures the scarcity. Prices provide our economy with incentives to use scarce resources efficiently.

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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• First step in an economic analysis is to define and

characterize the market or collection of markets to analyze, Markets can be defined broadly or narrowly, depending on our purpose.

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Buyers and Sellers

• Buyers and sellers in a market can be– Households– Business firms– Government agencies

• All three can be both buyers and sellers in the same market, but are not always

• 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”

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Competition in Markets

– Perfectly competitive markets have many small buyers and sellers, e.g., farmer’s market, big city hot dog market

• Each is a small part of the market, and the product is standardized, and each buyer and seller takes the market price as a given

– Imperfectly competitive markets have just a few large buyers and sellers, e.g., local electricity company

• The product of each seller is unique in some way, each buyer or seller has some influence over the price.

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Using Supply and Demand

• Supply and demand model is designed to explain how prices are determined in perfectly competitive markets– Perfect competition is rare but many markets come

reasonably close– Perfect competition is a matter of degree rather than an

all or nothing characteristic

• Supply and demand is one of the most versatile and widely used models in the economist’s tool kit

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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

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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– How much would households want to buy, at a specific price, given

real-world limits on their spending power?

• Stresses price– Price of the good is one variable among many that influences

quantity demanded– We’ll assume that all other influences on demand are held

constant, so we can explore the relationship between price and quantity demanded

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The Law of Demand

• States that when the price of a good rises and everything else remains the same, the quantity of the good demanded will fall (e.g., air travel, magazines, education, etc)– The words, “everything else remains the same” are

important• 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

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The Demand Schedule and The Demand Curve

• Demand schedule– A list showing the quantity of a good that consumers would choose

to purchase at different prices, with all other variables held constant

• The market demand curve (or just demand curve) shows the relationship between the price of a good and the quantity demanded , holding constant all other variables that influence demand– 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

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Demand Schedule for Maple Syrup in U.S.A.

Price

(per bottle)

Quantity Demanded

(Bottles per Month)

$1.00 75,000

2.00 60,000

3.00 50,000

4.00 40,000

5.00 35,000

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Figure 1: The Demand Curve

Number of Bottles per Month

Price per Bottle

A

B

$4.00

2.00

D

40,000 60,000

At $2.00 per bottle, 60,000 bottles are demanded (point B).

When the price is $4.00 per bottle, 40,000 bottles are demanded (point A).

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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 (Figure1, assume annual average U.S. household income $40,000; Figure, change from $40-$50,000 )

• 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

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Figure 2: A Shift of The Demand Curve

B C$2.00

60,000 80,000

D1D2

An increase in income shifts the demand curve for maple syrup from D1 to D2.

Number of Bottles per Month

Price per Bottle

At each price, more bottles are demanded after the shift

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Dangerous Curves: “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 demand

– 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

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Income: Factors That Shift The Demand Curve

• An increase in income has effect of shifting demand for normal goods to the right– However, a rise in income shifts demand for

inferior goods to the left– Examples: housing, automobiles, health club

memberships, etc.

• A rise in income will increase the demand for a normal good, and decrease the demand for an inferior good (e.g. instant noodles).

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Wealth: Factors That Shift The Demand Curve

• Your 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

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Prices of Related Goods: Factors that Shift the Demand Curve

• Substitute—good that can be used in place of some other good and that fulfills more or less the same purpose, e.g., different types of meat– 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, e.g., pancake mix and maple syrup– A rise in the price of a complement decreases the

demand for a good, shifting the demand curve to the left

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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

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Figure 3(a): Movements Along and Shifts of The Demand Curve

Quantity

Price

P2

Q2 Q1 Q3

P1

P3

Price increase moves us leftward along demand curve

Price increase moves us rightward along demand curve

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Figure 3(b): Movements Along and Shifts of The Demand Curve

Quantity

Price

D2

D1

Entire demand curve shifts rightward when:• income or wealth ↑• price of substitute ↑• price of complement ↓• population ↑• expected price ↑• tastes shift toward good

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Figure 3(c): Movements Along and Shifts of The Demand Curve

Quantity

Price

D1

D2

Entire demand curve shifts leftward when:• income or wealth ↓• price of substitute ↓• price of complement ↑• population ↓• expected price ↓• tastes shift toward good

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Supply

• A firm’s quantity supplied of a good is the specific amount its managers would choose to sell over some time period, given– A particular price for the good– All other constraints on the firm

• Market quantity supplied (or quantity supplied) is the specific 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

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Quantity Supplied

• Implies a choice– Quantity that gives firms the highest possible profits when they

take account of the constraints presented to them by the real world

• Is hypothetical– Does not make assumptions about firms’ ability to sell the good– How much would firms’ managers want to sell, given the price of

the good and all other constraints they must consider?

• Stresses price– The price of the good is just one variable among many that

influences quantity supplied– We’ll assume that all other influences on supply are held constant,

so we can explore the relationship between price and quantity supplied

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The Law of Supply

• States that when the price of a good rises and everything else remains the same, the quantity of the good supplied will rise– The words, “everything else remains the same”

are important• In the real world many variables change

simultaneously• However, in order to understand the economy we

must first understand each variable separately• We assume “everything else remains the same” in

order to understand how supply reacts to price

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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

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Figure 4: The Supply Curve

F

G

2.00

S

40,000 60,000

$4.00

At $4.00 per bottle, quantity supplied is 60,000 bottles (point G).

When the price is $2.00 per bottle, 40,000 bottles are supplied (point F).

Number of Bottles per Month

Price per Bottle

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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

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Figure 5: A Shift of The Supply Curve

S2

GJ

S1

60,000

$4.00

80,000

A decrease in transportation costs shifts the supply curve for maple syrup from S1 to S2.

Number of Bottles per Month

Price per Bottle

At each price, more bottles are supplied after the shift

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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

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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)

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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

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Figure 6(a): Changes in Supply and in Quantity Supplied

P2

Q3 Q1 Q2

P1

P3

Quantity

Price Price increase moves us rightward along supply curve

S

Price increase moves us leftward along supply curve

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Figure 6(b): Changes in Supply and in Quantity Supplied

Quantity

Price

S2

S1Entire supply curve shifts rightward when:• price of input ↓• price of alternate good ↓• number of firms ↑• expected price ↑• technological advance• favorable weather

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Figure 6(c): Changes in Supply and in Quantity Supplied

Quantity

Price

S1

S2Entire supply curve shifts rightward when:• price of input ↑• price of alternate good ↑• number of firms ↓• expected price ↑• unfavorable weather

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In Summary: Factors That Shift The Supply Curve

• The short list of shift-variables for supply that we have discussed is far from exhaustive

• In some cases, even the threat of such events can cause serious effects on production

• Basic principle is always the same– Anything that makes sellers want to sell more or less of

a good at any given price will shift supply curve

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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

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Figure 7: Market Equilibrium

E

HJ1.00

$3.00

D

S

50,000 75,00025,000

Excess Demand

4. until price reaches its equilibrium value of $3.00

.

2. causes the price to rise . . .

3. shrinking the excess demand . . .

1. At a price of $1.00 per bottle an excess demand of 50,000 bottles . . .

Number of Bottles per Month

Price per Bottle

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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

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Figure 8: Excess Supply and Price Adjustment

3. shrinking the excess supply . . .

K L

E3.00

D

S

$5.00

50,00035,000 65,000

Excess Supply at $5.00

2. causes the price to drop,

4. until price reaches its equilibrium value of $3.00.

Number of Bottles per Month

Price per Bottle

1. At a price of $5.00 per bottle an excess supply of 30,000 bottles . . .

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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

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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

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Figure 9

1. An increase in demand . . .E

F'

3.00

D1

D2

S

$4.00

50,000 60,000

3. to a new equilibrium.

5. and equilibrium quantity increases too.

2. moves us along the supply curve . . .

Number of Bottles of Maple Syrup per Period

Price per Bottle

4. Equilibrium price increases

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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

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Figure 10: A Shift of Supply and A New Equilibrium

E'

E3.00

D

$5.00

50,00035,000

S2 S1

Number of Bottles

Price per Bottle

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Figure 11: Changes in the Market for Handheld PCs

1. An increase in supply . . .

2. and a decrease in demand . . .

5. and quantity decreased as well.

A

B$400

D2003

S2002

S2003

D2002

$500

2.45 3.33 Millions of Handheld PCs per Quarter

Price per Handheld

PC

4. Price decreased . . .

3. moved the market to a new equilibrium.

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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

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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

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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

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Figure 12: The Market For Oil

P2

D

E'

P1E

Q2 Q1

S2

S1

Barrels of Oil

Price per Barrel of Oil

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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

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Figure 13: The Market For Natural Gas

Cubic Feet of Natural Gas

Price per Cubic Foot of Natural

Gas

P4

P3

F

Q3 Q4

S

D2

F'

D1