theory of supply and demand presentation by said cherkaoui, ph.d

Theory of Supply and Demand Presentation by Said Cherkaoui, Ph.D.

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Overview

Market (who, what, how) Supply and demand is an economic model

Designed to explain how prices are determined in certain types of markets

What you will learn in this chapter How the model of supply and demand works and how

to use it1. The law of demand2. The law of supply3. The determination of market equilibrium4. Factors shifting demand or supply curves

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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.

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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

participants First step in an economic analysis is to define and

characterize the market or collection of markets to analyze

Economists think of the economy as a collection of individual markets

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How Broadly Should We Define The Market

Defining the market often requires economists to group things together Aggregation is the combining of a group of distinct

things into a single whole Markets can be defined broadly or narrowly,

depending on our purpose How broadly or narrowly markets are defined is

one of the most important differences between Macroeconomics and Microeconomics

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Defining Macroeconomic Markets

Goods and services are aggregated to the highest levels Macro models lump all consumer goods

into the single category “consumption goods”

Macro models will also analyze all capital goods as one market

Macroeconomists take an overall view of the economy without getting bogged down in details

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Defining Microeconomic Markets

Markets are defined narrowly Focus on models that define much more

specific commodities Always involves some aggregation

But stops it reaches the highest level of generality that macroeconomics investigates

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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

In imperfectly competitive markets, individual buyers or sellers can influence the price of the product

In perfectly competitive markets (or just competitive markets), each buyer and seller takes the market price as a given

What makes some markets imperfectly competitive and others perfectly competitive? Perfectly competitive markets have many small buyers

and sellers Each is a small part of the market, and the product is

standardized Imperfectly competitive markets have just a few large

buyers and sellers Or else the product of each seller is unique in some way

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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

The price of a good rises and everything else remains the same, the quantity of the good demanded will fall 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

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

Demand V.S. Quantities demanded - demand is the entire relationship between price and quantity

- quantities demanded are specific amount of goods buyers want to buy

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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 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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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

Move along the demand curve From a change in the price of the good we

analyze In maple syrup example, Figure 1

A fall in price would cause a movement to the right along the demand curve (point A to B)

See figure 3(a)

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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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“Shifts” vs. “Movements Along” The Demand Curve

Shift of demand curve a change in other things than price of the good

causes a shift in the demand curve itself, for example, income

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.


Price per Bottle

At each price, more bottles are demanded after the shift

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“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 A rise in income will increase the demand for a

normal good, and decrease the demand for an inferior good

Normal good and inferior good are defined by the relation between demand and income

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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

- Example 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 Example 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 Example 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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Small Summary-- Factors Affecting Demand

Income (depends on good’s nature: normal or inferior)

Wealth (depends on good’s nature) Prices of substitutes (positively related) Prices of complements (negatively related) Population (positively related) Expected price (positively related) Tastes (positively related)

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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).


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.


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 leftward (rightward)

Technology Cost-saving technological advances increase the

supply of a good, shifting the supply curve to the right

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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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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

40

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

41

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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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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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 . . .


Price per Bottle

44

Excess Demand

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.


Price per Bottle

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

46

Excess Supply

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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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

48

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

50

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

51

Figure 12: The Market For Oil

P2

D

E'

P1E

Q2 Q1

S2

S1

Barrels of Oil

Price per Barrel of Oil

52

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

53

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

54

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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theory of supply and demand presentation by said cherkaoui, ph.d

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