Theory of Supply and Demand

Overview*Market (who, what, how)Supply and demand is an economic modelDesigned to explain how prices are determined in certain types of marketsWhat you will learn in this chapterHow the model of supply and demand works and how to use it

The law of demandThe law of supplyThe determination of market equilibriumFactors shifting demand or supply curves

Markets*In economics, a market is not a place but rather a group of buyers and sellers with the potential to trade with each other Market is defined not by its location but by its participantsFirst step in an economic analysis is to define and characterize the market or collection of markets to analyzeEconomists think of the economy as a collection of individual markets

How Broadly Should We Define The Market*Defining the market often requires economists to group things togetherAggregation is the combining of a group of distinct things into a single wholeMarkets can be defined broadly or narrowly, depending on our purposeHow broadly or narrowly markets are defined is one of the most important differences between Macroeconomics and Microeconomics

Defining Macroeconomic Markets*Goods and services are aggregated to the highest levelsMacro models lump all consumer goods into the single category consumption goodsMacro models will also analyze all capital goods as one marketMacroeconomists take an overall view of the economy without getting bogged down in details

Defining Microeconomic Markets*Markets are defined narrowlyFocus on models that define much more specific commoditiesAlways involves some aggregationBut stops it reaches the highest level of generality that macroeconomics investigates

Buyers and Sellers*Buyers and sellers in a market can beHouseholdsBusiness firmsGovernment agenciesAll three can be both buyers and sellers in the same market, but are not alwaysFor purposes of simplification this text will usually follow these guidelinesIn markets for consumer goods, well view business firms as the only sellers, and households as only buyersIn most of our discussions, well be leaving out the middleman

Competition in Markets*In imperfectly competitive markets, individual buyers or sellers can influence the price of the productIn perfectly competitive markets (or just competitive markets), each buyer and seller takes the market price as a givenWhat makes some markets imperfectly competitive and others perfectly competitive?Perfectly competitive markets have many small buyers and sellersEach is a small part of the market, and the product is standardizedImperfectly competitive markets have just a few large buyers and sellersOr else the product of each seller is unique in some way

Using Supply and Demand*Supply and demand model is designed to explain how prices are determined in perfectly competitive marketsPerfect 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 economists tool kit

*(example: laptop computers; orange juice)

Demand*A households quantity demanded of a goodSpecific amount household would choose to buy over some time period, givenA particular price that must be paid for the goodAll 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, givenA particular price they must pay for the goodAll other constraints on households

Quantity Demanded*Implies a choiceHow much households would like to buy when they take into account the opportunity cost of their decisions?Is hypotheticalMakes no assumptions about availability of the goodHow much would households want to buy, at a specific price, given real-world limits on their spending power?Stresses pricePrice of the good is one variable among many that influences quantity demandedWell assume that all other influences on demand are held constant, so we can explore the relationship between price and quantity demanded

The Law of Demand*The price of a good rises and everything else remains the same, the quantity of the good demanded will fall Ceteris ParibusThe words, everything else remains the same are importantIn the real world many variables change simultaneouslyHowever, in order to understand the economy we must first understand each variable separatelyThus we assume that, everything else remains the same, in order to understand how demand reacts to price

*Consider an example from our real life: the price of laptop decreases, how is the total number of computer bought changed?

The Demand Schedule*Demand scheduleA list showing the quantity of a good that consumers would choose to purchase at different prices, with all other variables held constantDemand V.S. Quantities demanded

- demand is the entire relationship between price and quantity - quantities demanded are specific amount of goods buyers want to buy

The Demand Curve*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 demandEach point on the curve shows the total buyers would choose to buy at a specific priceLaw of demand tells us that demand curves virtually always slope downward

*Emphasize the other things constant Emphasize the price influenceExercise and example: - Illustrate the example of maple syrup in the textbook how to draw the graph? what is the relations? Is it the linear relation?

Figure 1: The Demand Curve*ABPhp4.002.00

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*Maple syrup exampleHorizontal axis;Vertical axisPoints A and B, interpretationNegative relationsMove along the curve price change

Shifts vs. Movements Along The Demand Curve*Move along the demand curveFrom a change in the price of the good we analyzeIn maple syrup example, Figure 1A fall in price would cause a movement to the right along the demand curve (point A to B)See figure 3(a)

Figure 3(a): Movements Along and Shifts of The Demand Curve*P2Q2Q1Q3P1P3

Shifts vs. Movements Along The Demand Curve*Shift of demand curvea change in other things than price of the good causes a shift in the demand curve itself, for example, incomeIn Figure 2Demand curve has shifted to the right of the old curve (from Figure 1) as income has risenA change in any variable that affects demandexcept for the goods pricecauses the demand curve to shift

Figure 2: A Shift of The Demand Curve*BCPhp2.0060,00080,000

Change in Quantity Demanded vs. Change in Demand*Language is important when discussing demandQuantity demanded meansA particular amount that buyers would choose to buy at a specific priceIt is a number represented by a single point on a demand curveWhen a change in the price of a good moves us along a demand curve, it is a change in quantity demandThe term demand meansThe entire relationship between price and quantity demandedand represented by the entire demand curveWhen something other than price changes, causing the entire demand curve to shift, it is a change in demand

Income: Factors That Shift The Demand Curve*An increase in income has effect of shifting demand for normal goods to the rightHowever, a rise in income shifts demand for inferior goods to the leftA rise in income will increase the demand for a normal good, and decrease the demand for an inferior goodNormal good and inferior good are defined by the relation between demand and income

Wealth: Factors That Shift The Demand Curve*Your wealthat any point in timeis the total value of everything you own minus the total dollar amount you owe

- ExampleAn increase in wealth willIncrease demand (shift the curve rightward) for a normal goodDecrease demand (shift the curve leftward) for an inferior good

Prices of Related Goods: Factors that Shift the Demand Curve*Substitutegood that can be used in place of some other good and that fulfills more or less the same purposeExampleA rise in the price of a substitute increases the demand for a good, shifting the demand curve to the rightComplementused together with the good we are interested inExampleA rise in the price of a complement decreases the demand for a good, shifting the demand curve to the left

Other Factors That Shift the Demand Curve*PopulationAs the population increases in an areaNumber of buyers will ordinarily increaseDemand for a good will increaseExpected PriceAn expectation that price will rise (fall) in the future shifts the current demand curve rightward (leftward)TastesCombination of all the personal factors that go into determining how a buyer feels about a goodWhen tastes change toward a good, demand increases, and the demand curve shifts to the rightWhen tastes change away from a good, demand decreases, and the demand curve shifts to the left

Small Summary-- Factors Affecting Demand*Income (depends on goods nature: normal or inferior)Wealth (depends on goods nature)Prices of substitutes (positively related) Prices of complements (negatively related)Population (positively related)Expected price (positively related)Tastes (positively related)

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

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

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

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

Supply*A firms quantity supplied of a good is the specific amount its managers would choose to sell over some time period, givenA particular price for the goodAll 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, givenA particular price for the goodAll other constraints on firms

Quantity Supplied*Implies a choiceQuantity that gives firms the highest possible profits when they take account of the constraints presented to them by the real worldIs hypotheticalDoes not make assumptions about firms ability to sell the goodHow much would firms managers want to sell, given the price of the good and all other constraints they must consider?Stresses priceThe price of the good is just one variable among many that influences quantity suppliedWell assume that all other influences on supply are held constant, so we can explore the relationship between price and quantity supplied

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 riseThe words, everything else remains the same are importantIn the real world many variables change simultaneouslyHowever, in order to understand the economy we must first understand each variable separatelyWe assume everything else remains the same in order to understand how supply reacts to price

The Supply Schedule and The Supply Curve*Supply scheduleshows quantities of a good or service firms would choose to produce and sell at different prices, with all other variables held constantSupply curvegraphical depiction of a supply scheduleShows quantity of a good or service supplied at various prices, with all other variables held constant

Figure 4: The Supply Curve*FG2.00

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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 curveIn Figure 4A rise (fall) in price would cause a rightward (leftward) movement along the supply curveA drop in transportation costs will cause a shift in the supply curve itselfIn Figure 5Supply curve has shifted to the right of the old curve (from Figure 4) as transportation costs have droppedA change in any variable that affects supplyexcept for the goods pricecauses the supply curve to shift

Figure 5: A Shift of The Supply Curve*S2GJS160,000$4.00

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Factors That Shift the Supply Curve*Input pricesA 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 GoodsWhen the price of an alternate good rises (falls), the supply curve for the good in question shifts leftward (rightward)TechnologyCost-saving technological advances increase the supply of a good, shifting the supply curve to the right

Factors That Shift the Supply Curve*Number of Firms An increase (decrease) in the number of sellerswith no other changesshifts the supply curve to the right (left)Expected PriceAn expectation of a future price increase (decrease) shifts the current supply curve to the left (right)

Factors That Shift the Supply Curve*Changes in weather Favorable weatherIncreases crop yieldsCauses a rightward shift of the supply curve for that cropUnfavorable weather Destroys cropsShrinks yieldsShifts the supply curve leftwardOther unfavorable natural events may effect all firms in an areaCausing a leftward shift in the supply curve

Figure 6(a): Changes in Supply and in Quantity Supplied*P2Q3Q1Q2P1P3

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

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Entire supply curve shifts rightward when: price of input price of alternate good number of firms expected price technological advance favorable weather

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

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Entire supply curve shifts rightward when: price of input price of alternate good number of firms expected price unfavorable weather

Summary: Factors That Shift The Supply Curve*The short list of shift-variables for supply that we have discussed is far from exhaustiveIn some cases, even the threat of such events can cause serious effects on productionBasic principle is always the sameAnything that makes sellers want to sell more or less of a good at any given price will shift supply curve

Equilibrium: Putting Supply and Demand Together*When a market is in equilibriumBoth price of good and quantity bought and sold have settled into a state of restThe equilibrium price and equilibrium quantity are values for price and quantity in the market but, once achieved, will remain constantUnless and until supply curve or demand curve shiftsThe equilibrium price and equilibrium quantity can be found on the vertical and horizontal axes, respectivelyAt point where supply and demand curves cross

Figure 7: Market Equilibrium*EHJ1.00Php3.00DS50,00075,00025,000Excess Demand

Excess Demand*Excess demandAt a given price, the excess of quantity demanded over quantity suppliedPrice of the good will rise as buyers compete with each other to get more of the good than is available

Figure 8: Excess Supply and Price Adjustment*KLE3.00DS$5.0050,00035,00065,000Excess Supply at $5.00

Excess Supply*Excess SupplyAt a given price, the excess of quantity supplied over quantity demandedPrice of the good will fall as sellers compete with each other to sell more of the good than buyers want

Solve for Equilibrium Algebraically*Suppose that demand is given by the equation , where is quantity demanded, P is the price of the good. Supply is given by where is quantity supplied. What is the equilibrium price and quantity?

Income Rises: What Happens When Things Change*Income rises, causing an increase in demandRightward shift in the demand curve causes rightward movement along the supply curveEquilibrium price and equilibrium quantity both riseShift of one curve causes a movement along the other curve to new equilibrium point

Figure 9*EF'3.00D1D2SPhp4.0050,00060,000

A Storm Hits: What Happens When Things Change*A storm causes a decrease in supplyWeather is a shift variable for supply curveAny change that shifts the supply curve leftward in a market will increase the equilibrium priceAnd decrease the equilibrium quantity in that market

Figure 10: A Shift of Supply and A New Equilibrium*E'E3.00DPhp5.0050,00035,000

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Using Supply and Demand: The Invasion of Kuwait*Why did Iraqs 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 KuwaitA significant decrease in the oil industrys productive capacity caused a shift in the supply curve to the leftPrice of oil increased

Figure 12: The Market For Oil*P2DE'

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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 gasRise in the price of a substitute increases demand for a goodRise in price of oil caused demand curve for natural gas to shift to the rightThus, the price of natural gas rose

Figure 13: The Market For Natural Gas*P4P3FQ3Q4

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Figure 11: Changes in the Market for Handheld PCs*

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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 moveWhen both curves shift (and we know the direction of the shifts) we can determine the direction for either price or quantitybut not bothDirection of the other will depend on which curve shifts by more

The Three Step Process*Key Step 1Characterize the MarketDecide which market or markets best suit problem being analyzed and identify decision makers (buyers and sellers) who interact thereKey Step 2Find the EquilibriumDescribe conditions necessary for equilibrium in the market, and a method for determining that equilibriumKey Step 3What Happens When Things ChangeExplore how events or government polices change market equilibrium

Example: rental apartmentDemand & Supply DiagramEquilibrium P & QWhy Php1000 can not be equilibrium?Effects from a tornado destroying some apartments.

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rent(Peso)quantity demandedquantity supplied80030101000251412002217140019191600172118001522

Demand for two bedroom rental apartment*

Summaries*Through the study of the chapter, you will be able to Characterize a market.Use a demand schedule and a demand curve to demonstrate the law of demand.Explain the difference between a change in demand (shift of the curve) and a change in quantity demanded (movement along the curve).List the factors that will lead to a change in demand, and give examples of each.Similar analysis for supply side.Explain how equilibrium price and quantity are determined in a competitive market.Explain what will happen in a competitive market after a shift in the supply curve, the demand curve, or both.Describe the three steps economists take to answer almost any question about the economy.

*(example: laptop computers; orange juice)*Consider an example from our real life: the price of laptop decreases, how is the total number of computer bought changed? *Emphasize the other things constant Emphasize the price influenceExercise and example: - Illustrate the example of maple syrup in the textbook how to draw the graph? what is the relations? Is it the linear relation?*Maple syrup exampleHorizontal axis;Vertical axisPoints A and B, interpretationNegative relationsMove along the curve price change