paul krugman and robin wells - rutgers...

Microeconomics Third Edition

Chapter 3 Supply and Demand

Copyright © 2013 by Worth Publishers

Paul Krugman and Robin Wells

Demand and supply: introduction 1. We continue to explore the idea of trade and exchange most exchange takes place in markets 2. We start by considering the simplest type of market: the perfectly competitive market, in which all buyers and sellers are “price takers” (no power to affect price)

Demand for a product (good or service)

1. What factors might affect demand (the amount people want to buy)

for a product? • the price of the product • prices of other goods • income • taxes • tastes, information, beliefs, the environment (e.g., temperature, social norms, other consumers)

• expectations about the future

2. Demand function:

DX = f(PX, P1, P2, …, I, T, Z, …) where DX = quantity of good X demanded PX = price of good X (the “own price”) P1 = price of good 1 (etc.) (other prices) I = income T = general environment (e.g., temperature) Z = expectations 3. Demand curve: shows how DX changes as PX changes, with all other factors (prices of other goods, income, expectations, etc.) remaining unchanged – ceteris paribus A. Relationship between DX and PX is negative, so demand curve slopes downwards. B. At each point on the same demand curve, DX and PX are different, but all other factors affecting DX (prices of other goods, income, expectations, etc.) are the same.

B. Note that the demand curve has Price on the vertical axis, and Quantity on the horizontal axis! (to mathematicians, this might be contrary to intuition) C. Note: Demand curve can… extend beyond the horizontal axis coincide with the vertical axis if P = 0, then quantity purchased = Q* (i.e., Q* is consumed if the good is given away for free!) portion of the demand curve below the vertical axis shows the amount “purchased” when the price is negative (if price is negative, you’re paid to consume the good) at any price > P*, quantity demanded = 0 (so demand curve coincides with the vertical axis above P*, the “choke” or “reservation” price)

Unnumbered Figure 3.1 Pay More, Pump Less Krugman and Wells: Microeconomics, Third Edition Copyright © 2013 by Worth Publishers

The dots here are based on real-world data. How would you construct a demand curve using this information?

2. Effect of factors other than “own price” on the demand for X: movements along the demand curve vs. shifts in the demand curve

Suppose PX remains the same, but consumers’ income (I) rises. (Suppose all other things remain unchanged – ceteris paribus.) A. This rise in I might increase the demand for X at any given PX. If so, then X is called a “normal good” (= a good for which demand rises when income rises, ceteris paribus), and the demand curve for X will shift out and to the right. (Note that this implies that demand for X will be greater – because of the rise in income I – at each level of PX. B. If higher I reduces the demand for X at any given PX, then X is called an “inferior good” (= a good for which demand falls when income rises, ceteris paribus), and the demand curve for X will shift back and to the left. (Note that this implies that demand for X will be smaller – because of the rise in income I – at each level of PX.

Econ-speak 101 (Part 1):

“Change in demand” = shift of the demand curve for a good. Note that this can be caused ONLY by a change in something other than the price of that good – e.g., a change in tastes, in income, in the prices of other goods, etc. – but is never caused by a change in the price of the good. “Change in quantity demanded” = movement along the demand curve for a good. Note that this can be caused ONLY by a change in the price of the good itself, and is never caused by changes in anything else!

Normal goods If X is a normal good, then, other things being equal, a rise in income (I) will increase the demand for X at any given PX. If a rise in income (I) increases demand for X at any at any given PX, then X is a normal good. (Think: eating out, Neiman Marcus, champagne… (?))

Inferior goods If X is an inferior good, then, other things being equal, a rise in income (I) will reduce the demand for X at any given PX. If a rise in income (I) reduces demand for X at any at any given PX, then X is an inferior good normal good. (Think: eating macaroni and cheese in, T.J. Maxx, beer… (?)) Whether a good is normal or inferior is an empirical question.

Suppose that between 2007 and 2010, income rises but all other factors relevant to the demand for cotton do not change. If the demand curve for cotton shifts as shown above, then, is cotton a “normal good” or an “inferior good”?

A C is due to a “shift of the demand curve,” caused by something other than the product price (e.g., change in income, change in other prices, etc.). Between A and C, price of cotton is the same!

A B is a “movement along the demand curve,” caused by change in price of cotton. All other factors remain the same!

Here, at any given product price, quantity demanded falls whenever income rises (and rises whenever income falls). Is this a “normal good,” or an “inferior good”?

Substitutes If X and Y are substitutes, then a rise in the price of one of them will increase demand for the other one. (The two goods are “alternatives” to each other.) (Think butter and margarine?) Thus, if a rise in the price of one good raises demand for the other, then the two goods are substitutes.

Complements If X and Y are complements, then a rise in the price of one of them will reduce demand for the other one. (The two goods “go together.”) (Think butter and bread?) Thus, if a rise in the price of one good reduces demand for the other, then the two goods are substitutes. (But one person’s substitutes could be another’s complements. Consider “boilermakers” (= shot of whiskey + glass of beer)!) Whether two goods are substitutes or complements is ultimately an empirical question.

Non-economic factors can also shift the demand curve:

Shifts in the demand curve can be measured either vertically or horizontally. Horizontal shift measures the change in quantity demanded at the same price. (A C (increase of 10) = increase in amount desired when P = 40.) Vertical shift measures the change in price that people are willing to pay, to get the same quantity. (A B (increase of 15) = increase in price that would be paid in order to get 50 units.)

An “increase in demand” means that the demand curve shifts both up and to the right. (You can’t have one without the other!)

The demand curve for the total market, (c), is the horizontal sum of the demand curves for the individuals in the market, (a)+(b): E.g.,at a price of $30, DarIa’s demand is 3 and Dino’s demand is 2. So if there are the only two individuals in the market, then total market demand at the price of $30 is 3 + 2 = 5. (Repeat this for each price to derive the whole market demand curve.)

Supply of a product (good or service) 1. What factors might affect supply (the amount of a product that

producers are willing to produce)? • the price of the product (including taxes) • prices of other products (including taxes) • prices of inputs (machines, workers, etc.) used in production • taxes on profits, inputs, outputs, etc. • technology • expectations

2. Supply function:

SX = f(PX, P1, P2, …, W1, W2, …, T, Z, …) where SX = quantity of good X supplied PX = price of good X P1 = price of good 1 (etc.) W1 = price of input 1 (etc.) T = general environment (e.g., the weather) Z = expectations

3. Supply curve: shows how SX changes as PX changes, with all other factors (prices of other goods, prices of inputs, technology, expectations, etc.) remaining unchanged A. Relationship between SX and PX is positive, so demand curve slopes downwards. B. At each point on the same supply curve, SX and PX are different, but all other factors affecting SX (prices of other goods, prices of inputs, expectations, etc.) are the same. C. Zero output is produced at any price below P*, the “shut-down” or “reservation price,” so supply curve coincides with the vertical axis for all prices below P*.

Econ-speak 101 (Part 2):

“Change in supply” = shift of the supply curve for a good. Note that this can be caused ONLY by a change in something other than the price of that good – e.g., a change in the cost of inputs, in taxes, in the weather, etc. – but is never caused by a change in the price of the good. “Change in quantity supplied” = movement along the supply curve for a good. Note that this can be caused ONLY by a change in the price of the good itself, and is never caused by changes in anything else!

3. Shifts in the supply curve vs. movements along the supply curve A. movement along the supply curve: SX and PX are different,

but all other factors affecting supply (prices of other outputs, prices of inputs, the weather, etc.) remain unchanged.

B. shift in the supply curve: refers to the effect on the quantity of X supplied in response to a change in something other than

the price of X (e.g., a change in technology, labor cost, etc.) C. factors that might cause an “increase in supply” (= shift in supply curve out and to the right, with more SX at each and every PX): better weather, better technology, etc.

factors that might cause a “decrease in supply” (= shift in supply curve back and to the left, with more SX at each and every PX): higher input prices bad weather expectation of higher output price in the future

Shifts in the supply curve can be measured either vertically or horizontally. Horizontal shift measures the change in quantity supplied at the same price. Vertical shift measures the change in price that producers require (or will accept) in order to produce the same quantity. An “increase in supply” means that the supply curve shifts both down and to the right. (Can’t have one without the other!) A “decrease in supply” means that the supply curve shifts both up and to the left. (Can’t have one without the other!)

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Remember that, since we’re describing a perfectly-competitive market, there are many producers (each of which has a supply curve) in the market, rather than just two producers. (To simplify, only two are shown above.) (We’ll discuss other types of markets later in the course.)

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Equilibrium of supply and demand

Equilibrium means “balance,” a “position of rest,” a “situation in which there is no built-in tendency for things to change.” To analyze equilibrium, put supply and demand on the same set of axes. Then ask: At whatever the current price happens to be, is the quantity supplied by producers equal to the quantity demanded by consumers? If so, we have equilibrium (no tendency for anything to change). If not, there will be a tendency for things to change, and things will change in one way or another depending on whether quantity supplied is greater or less than quantity demanded.

First consider what happens if quantity supplied EXCEEDS quantity demanded at the current price, $1.50. Here we have a surplus of 11.2 – 8.1 = 3.1. Goods will pile up in stores. Producers will start to offer a lower price, and will cut back production. Quantity supplied will fall. The price decreases will cause consumers to buy more; quantity demanded will rise (movement along the demand curve).

Eventually, equilibrium will be reached at P = $1.00 and Q = 10. Since quantity supplied equals quantity demanded at this price, there is no further tendency for anything to change.

Now consider what happens if quantity supplied is LESS THAN quantity demanded at the current price, $0.75. Here we have a shortage of 11.5 – 9.1 = 2.4. Goods will disappear from stores! Consumers will offer higher prices in an attempt to get some of the good. Producers will increase production and charge a higher price. Quantity supplied will rise (movement along the supply curve); quantity demanded will fall (movement along the demand curve). The price rises will cause consumers to buy less and producers to make more.

Eventually, equilibrium is reached at P = $1.00 and Q = 10. Since quantity supplied equals quantity demanded at this price, there is no further tendency for anything to change.

Figure 3.16 Simultaneous Shifts of the Demand and Supply Curves Krugman and Wells: Microeconomics, Third Edition Copyright © 2013 by Worth Publishers

What happens if both supply and demand change? The net effect on price and quantity in such cases will depend on whether demand shifts by more or less than supply, and in which direction. (See the above for some examples.)

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