Chapter 3

The Supply and Demand Model

IntroductionIntroduction

• The supply and demand model can explain the following: Why are ticket scalpers for Final Four seats (or any

sold-out sporting event) able to sell tickets for as much as $5000?

Why do gasoline prices go up or down very easily?

Why do rose prices rise significantly on Valentine’s Day?

DemandDemand

• Demand Demand – a relationship between price and the quantity demanded, all other things equal.

• Price – Price – the amount of money or other goods that one must pay to obtain a particular good.

• Quantity Demanded – the quantity of a good that people want to buy at a given price during a specific time period.

DemandDemand

Demand Schedule: Demand Schedule: a tabular representation of demand. The information it contains describes the quantity of a good that a buyer is willing to purchase at different prices.

The Demand CurveThe Demand Curve

Demand Curve: Demand Curve: a graph of demand showing the downward-sloping relationship between price and quantity demanded.

Figure 1: The Demand

Curve

The Law of DemandThe Law of Demand

• Law of Demand: Law of Demand: the tendency for the quantity demanded of a good to decline as its price rises.

• Note: Note: For a demand curve to be consistent with the Law of Demand, the demand curve must be downward sloping.

A lower price

Leads to a higher quantity demanded

The Law of DemandThe Law of Demand

According to the law of demand, a lower price will result in an increase in the quantity of the good that consumers are willing to buy, holding all else constant.

Figure 1: The Figure 1: The Demand CurveDemand Curve

Shifts in DemandShifts in Demand

Changes in the following can cause the demand cause the demand curve to shiftcurve to shift to the left or to the right:Consumers’ PreferencesConsumers’ InformationConsumers’ IncomeNumber of Consumers in the MarketConsumers’ Expectations of Future PricesPrices of Closely Related Goods

a)a) Substitutes Substitutes b)b) ComplementsComplements

Figure 2: A Shift in the Demand CurveFigure 2: A Shift in the Demand Curve

Figure 2: A Shift in the Demand CurveFigure 2: A Shift in the Demand Curve

Consumers’ PreferencesConsumers’ Preferences

Changes in consumers’ preferences or tastes for a product (relative to another productrelative to another product) will change the amount of they purchase at a given price.

Example: • After September 11, 2001, more consumers

were afraid to fly, resulting in a decrease in the demand for air travel. The demand for gasoline increased, as people chose to drive more to different destinations.

Consumers’ InformationConsumers’ Information

New information New information available to consumers can result in a change in the quantity that consumers buy of a good, even though the price does not change. Examples:Examples:

a) Car owners bought fewer Firestone tires once they learned of the mass recall of Firestone tires.

b) Demand for Krispy Kreme doughnuts declined when people got information that eating fewer carbohydrates can facilitate weight loss (e.g., as in the Atkins diet).

Normal Goods Normal Goods –– goods for which demand increases when the consumers’ income rises and decreases when consumers’ income falls.

Examples: Examples: a) Jewelry b) Luxury cars

Consumers’ IncomesConsumers’ Incomes

Inferior Goods Inferior Goods – goods for which demand decreases when the consumers’ income risesand increases when consumers’ income falls.

Examples:Examples:a) Instant noodlesb) Bus tickets

Consumers’ IncomesConsumers’ Incomes

Number of ConsumersNumber of Consumersin the Marketin the Market

More consumers More consumers in the market will likely resultresult in a larger demandlarger demand for the good or service, while fewer consumers will likely result in a smaller demand for the good or service.

Example: Example: The demand for electricity in your city

increases as the population increases.

Consumers’ Expectations Consumers’ Expectations of Future Pricesof Future Prices

Expectations of higher future prices will increase demand now. Expectations of lower future prices will decrease demand now.

Example: Example: Expectations of higher prices of gasoline in

the future tend to make individuals fill up now.

Substitute Substitute – a good that has many of the same characteristics as and can be used in place of another good.

Examples: Examples: a) Coke is a substitute for Pepsi.b) Riding a car is a substitute for taking the bus. c) Downloading music is a substitute for buying

music CDs.

Prices of Closely Related GoodsPrices of Closely Related Goods

ComplementComplement – a good that is consumed or used together with another good.

Examples: Examples: a) Gasoline is a complement to SUVs.b) Cream is a complement to coffee.

Prices of Closely Related GoodsPrices of Closely Related Goods

Prices of Closely Related GoodsPrices of Closely Related Goods

If two goods are complements, then an increase in the price of one good will result in a decrease in the demand for the other good.

If two goods are substitutes, then an increase in the price of one good will result in an increase in the demand for the other good.

Figure 3: Shifts of versus MovementsFigure 3: Shifts of versus MovementsAlong the Demand CurveAlong the Demand Curve

SupplySupply

• Supply – a relationship between price and the quantity supplied, all other things equal.

• Quantity Supplied Quantity Supplied – the quantity of a good that sellers want to sell at a given price during a specific time period.

SupplySupply

Supply ScheduleSupply Schedule: a tabular representationof the supply curve.

The Supply CurveThe Supply Curve

Supply CurveSupply Curve: the graph of supply showing the upward relationship between price and quantity supplied.

Figure 4: Figure 4: The Supply CurveThe Supply Curve

Law of Supply Law of Supply – the tendency for the quantity supplied of a good in a market to increase as its price rises.

The Law of SupplyThe Law of Supply

A higher price

Leads to a higher quantity supplied

The Law of SupplyThe Law of Supply

According to the law According to the law of supply, a higher of supply, a higher price will result in price will result in an increase in the an increase in the quantity of the good quantity of the good that sellers are that sellers are willing to sell, willing to sell, holding all else holding all else constant. constant.

Figure 4: Figure 4:

The Supply CurveThe Supply Curve

Shifts in SupplyShifts in Supply

Changes Changes in the following can cause the supply cause the supply curve to shiftcurve to shift to the left or to the right:

a)a) TechnologyTechnologyb)b) Weather conditionsWeather conditionsc)c) Prices of inputs used in productionPrices of inputs used in productiond)d) Number of firms in the marketNumber of firms in the markete)e) Expected future selling priceExpected future selling pricef)f) Government taxes, subsidies, and Government taxes, subsidies, and

regulationsregulations

TechnologyTechnology

Anything that changes the amount that a firm can produce with a given amount of inputs can be considered a change in technology. Improvements in technology will correspond to an increase in supply.

Example: Example: Innovations that decrease the time it takes to

produce cars

Weather ConditionsWeather Conditions

Droughts, earthquakes, and hurricanes affect how much of certain goods can be produced.

Examples: Examples: a) An unusually cold winter in 2006 decreased

citrus production in California.b) Hurricanes Katrina and Rita decreased oil

production in Louisiana and Texas.

More expensive inputs (raw materials, land, and capital) increase the cost of production of goods and services, and may force the firm to sell less at a given price.

Example:Example:Higher steel prices in 2002 decreased the

production of household appliances.

The Price of Inputs Used in ProductionThe Price of Inputs Used in Production

The Number of Firms in the MarketThe Number of Firms in the Market

If the number of firms in the market increases, the supply curve shifts to the right. If the number of firms in the market decreases, the supply curve shifts to the left.

Expectations of lower selling prices in the future will increase the supply today as firms decide to sell less in the future when prices are lower. Similarly, expectations of higher selling prices in the future will decrease the supply today as firms decide to sell more in the future when prices are higher.

Expectations of Future PricesExpectations of Future Prices

An increases in taxes (payments by firms to the government) or a decrease in subsidies (payment by the government to firms) will decrease supply. A decrease in taxes or an increase in the subsidies will increase supply.

Government Taxes, Subsidies,Government Taxes, Subsidies,and Regulationsand Regulations

Government Taxes, Subsidies,Government Taxes, Subsidies,and Regulationsand Regulations

Regulations Regulations – government policies or rules that control the firm’s behavior. These regulations can affect the firm’s cost of production and thereby affect supply.

Example: Example: • Government requirements that food vendors

pass sanitary inspection will reduce the number of vendors and decrease supply.

Movement Along the Supply Curve Movement Along the Supply Curve – occurs when a change in the quantity supplied of a good is brought along by a change in its price.

A Shift in the Supply Curve A Shift in the Supply Curve – occurs when a change is brought along by any source other than the price.

Shifts versus MovementShifts versus Movement

Figure 6: Shifts of versus MovementsFigure 6: Shifts of versus Movements

Figure 7: Figure 7: Overview ofOverview ofSupply and Supply and

DemandDemand

Market EquilibriumMarket Equilibrium

Shortage (excess demand) Shortage (excess demand) – a situation in which the quantity demanded is greater than the quantity supplied. This occurs when the price in the market is below the equilibrium price.

Surplus (excess supply) Surplus (excess supply) – a situation in which the quantity supplied is greater than the quantity demanded. This occurs when the current price in the market is above the equilibrium price.

Market EquilibriumMarket Equilibrium

Equilibrium Price Equilibrium Price – the price at which the quantity that sellers are willing to sell equals the quantity that consumers are willing to purchase.

Equilibrium Quantity Equilibrium Quantity – the quantity traded at the equilibrium price.

Market Equilibrium Market Equilibrium –– the situation where the price equals the equilibrium price and the quantity traded equals the equilibrium quantity.

Finding the Equilibrium with a Finding the Equilibrium with a Supply and Demand DiagramSupply and Demand Diagram

If the price is below the equilibrium, a shortage occurs, causing the price to increase until the price reaches equilibrium.

If the price is above the equilibrium, a surplus occurs, causing the price to decrease until the price reaches equilibrium.

Figure 8: Figure 8: Equilibrium Price and Equilibrium QuantityEquilibrium Price and Equilibrium Quantity

Figure 8: Figure 8: Equilibrium Price and Equilibrium QuantityEquilibrium Price and Equilibrium Quantity

Effects of an Increase in DemandEffects of an Increase in Demand

An increase in An increase in demand will shift demand will shift the demand curve the demand curve to the right, to the right, resulting in a resulting in a higher equilibrium higher equilibrium price and quantity.price and quantity.

Figure 9(a): Effects of a Shift in DemandFigure 9(a): Effects of a Shift in Demand

Effects of a Decrease in DemandEffects of a Decrease in Demand

A decrease in A decrease in demand will shift demand will shift the demand curve the demand curve to the left, resulting to the left, resulting in a lower in a lower equilibrium price equilibrium price and quantity.and quantity.

Figure 9(b): Effects of a Shift in DemandFigure 9(b): Effects of a Shift in Demand

Effects of an Increase in SupplyEffects of an Increase in Supply

An increase in An increase in supply will shift the supply will shift the supply curve to the supply curve to the right, resulting in a right, resulting in a lower equilibrium lower equilibrium price and a higher price and a higher equilibrium equilibrium quantity.quantity.

Figure 10(a): Effects of a Shift in SupplyFigure 10(a): Effects of a Shift in Supply

Effects of a Decrease in SupplyEffects of a Decrease in Supply

A decrease in supply A decrease in supply will shift the supply will shift the supply curve to the left, curve to the left, resulting in a higher resulting in a higher equilibrium price and equilibrium price and a lower equilibrium a lower equilibrium quantity.quantity.

Figure 10(b): Effects of a Shift in SupplyFigure 10(b): Effects of a Shift in Supply

Using Using Supply and Demand Supply and Demand

to to Analyze Real-World IssuesAnalyze Real-World Issues

Figure 11: Figure 11: Combined Effect of a Simultaneous Increase in Combined Effect of a Simultaneous Increase in

Demand and Decrease in Supply of GasolineDemand and Decrease in Supply of Gasoline

Figure 12: Figure 12: Predicted Effects of Energy PolicyPredicted Effects of Energy Policy

Key TermsKey Terms

• demanddemand• priceprice• quantity demandedquantity demanded• demand scheduledemand schedule• law of demandlaw of demand• demand curvedemand curve• normal goodnormal good• inferior goodinferior good• substitutesubstitute• complementcomplement• supplysupply

• quantity suppliedquantity supplied• supply schedulesupply schedule• law of supplylaw of supply• supply curvesupply curve• shortage (excess shortage (excess

demand)demand)• surplus (excess supply)surplus (excess supply)• equilibrium priceequilibrium price• equilibrium quantityequilibrium quantity• market equilibriummarket equilibrium