chapter three the supply and demand model. 3 | 2 copyright © houghton mifflin company. all rights...

Chapter Three

The Supply and

Demand Model

Copyright © Houghton Mifflin Company. All rights reserved. 3 | 2

Applications

• The supply and demand model can explain the following events

1. Why are ticket scalpers for Final Four seats (or any sold out sporting event) able to sell tickets for as much as $5000?

2. Why do gasoline prices rise and fall so easily?

3. Why do prices of computers drop when new models are introduced in the market?


Demand: Definitions

• Demand: A relationship between price and the quantity demanded, all other things equal.

• 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.


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.


Demand Schedule: An Example


Demand Curve

• Demand Curve: The graphical representation of demand. The information it contains describes the quantity of a good that a buyer is willing to purchase at different prices.– Note: Both the demand curve and the demand

schedule should describe the same information.


Demand Curve: An Example (cont’d)

Figure 3.1 The Demand Curve for Bicycles (Million Bicycles per Year)


The Law of Demand

• The Law of Demand: The tendency for the quantity demanded of a good to decline as its price rises. – Note: For a demand curve to be consistent

with the Law of Demand, the demand curve must be downward sloping.


The Law of Demand (cont’d)

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.

A

B

This scenario can be depicted as a movement from point A to point B in the Figure 3.1 above.

Figure 3.1 The Demand Curve for Bicycles (Million Bicycles per Year)


Demand: Definition Revisited

• Demand: Relationship between price and the quantity demanded, all other things equal.

• What are the other things that we hold equal? While the price of a good is a major variable that affects the quantity of a good that consumers are willing to buy, other variables can also affect consumer’s quantity demanded.


Demand: All Other Things Equal

• The following variables also affect the quantity demanded of a good, and are held constant when analyzing the law of demand:– Consumer’s Preferences– Consumer’s Information– Consumer’s Income– Number of Consumers in the Market– Consumer’s Expectations of Future Prices– Prices of Closely Related Goods

a) substitutes b) complements


Consumer’s Preferences

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

• Examples: 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.


Consumer’s 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. For example:– Car owners bought fewer Firestone tires once they

learned of the mass recall of Firestone tires.– Demand for Krispy Kreme doughnuts declined when

people got information that eating fewer carbohydrates can facilitate weight loss (a.k.a., the Atkins Diet).


Consumer’s Incomes

• An increase in incomes can result in an increase or a decrease in the quantity of goods/services demanded.

• Normal Goods: Goods for which demand increases when the consumer’s income rises and decreases when consumer’s income falls.– Examples: Jewelry, luxury cars.


Consumer’s Incomes (cont’d)

• Inferior Goods: Goods for which demand decreases when the consumer’s income rises and increases when consumer’s income falls.

• Typical examples: Spam, the Big Mac, riding the bus, snow shovels.

Note: The term “typical examples” is used above because some consumers may consider Spam and the Big Mac as normal goods.


Number of Consumers in the Market

• An increase in the number of consumers in the market is likely to result in an increase in the demand for the good or service, while a decline in the number of consumers will likely result in a smaller demand for the good or service.

• Example: The demand for electricity in your city increases as the population increases.


Consumer’s Expectation of Future Prices

• If people expect the price of a good will increase, they will buy it before the price increases. If they expect the price of a good to decrease, they will wait before the price drops.

• Question: What will you do if a credible source tells you that gasoline prices will go up by $1.00 per gallon tomorrow?


Prices of Closely Related Goods

• Two goods are related if they are either substitutes or complements.

• Substitute: A good that has many of the same characteristics as and can be used in place of another good.

• Example: Coke is a substitute for Pepsi, riding a car is a substitute for taking the bus, downloaded music is a substitute for music CDs.


Prices of Closely Related Goods (cont’d)

• Complement: A good that is consumed or used together with another good.

• Examples: Gasoline is a complement to SUVs, cream is a complement to coffee, learning economics by reading your economics textbook is a complement to going to class.


Complements and Substitutes

• 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 a increase in the demand for the other good.


Examples1) Since coffee and cream are

complements, then an increase in the price of coffee will discourage consumers to buy cream.

2) Since Coke and Pepsi are substitutes, an increase in the price of Coke will encourage consumers to buy more Pepsi.

Complements and Substitutes (cont’d)


Shifts vs. Movement

P

QD

P1

P2

Q1 Q2

A

B

Movement along the demand curve: A change in the quantity demanded of a good brought along by a change in its price. A decrease in price can be seen in the diagram above as a movement from A to B, in the same supply curve. An increase in the price is depicted as a movement from point B to A.


• A shift in demand: a movement of the demand curve brought about by a change other than the price of the good. The demand curve can shift left (a decrease in demand) or shift right (an increase in demand).

Shifts vs. Movement (cont’d)


An Increase in Demand

P

Q

D1D2

An increase in demand is illustrated as a shift in the demand curve to the right.

Possible causes1) Greater preference 2) More population3) Incomes increase

(normal good) 4) Incomes decrease

(inferior good)5) Expected future price

increase.6) More expensive

substitute7) Less expensive

complement


An decrease in demand is illustrated as a shift in the demand curve to the left.

Possible causes1) Less preference 2) Less population3) Incomes decrease (normal

good) 4) Incomes increase (inferior

good)5) Expected future price

decrease.6) Less expensive substitute7) More expensive

complement

A Decrease in Demand

P

Q

D1D2


Shifts vs. Movements: SummaryFigure 3.3


Supply: Definitions

• Supply: A relationship between price and the quantity supplied, all other things equal.

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


Supply Schedule

Supply Schedule: A tabular representation of the supply curve. The information it contains describes the quantity of a particular good that a seller is willing to sell at different prices.


Supply Schedule (cont’d)

Table 3.2 The Supply Schedule for Bicycles (Millions of Bicycles per Year)

Price Quantity Supplied

140 1

160 4

180 7

200 9

220 11

240 13

260 15

280 16

300 17


Supply Curve

• Supply Curve: The graphical representation of supply. The information it contains describes the quantity of a good that a seller is willing to sell at different prices.

• Note: Both the supply curve and the supply schedule should describe the same information.


Supply Curve: an Example

Figure 3.4 The Supply Curve for Bicycles (Million Bicycles per Year)


The Law of Supply

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

• Note: For a supply curve to be consistent with the Law of Supply, the supply curve must be upward sloping.


The Law of Supply (cont’d)

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

This scenario can be depicted as a movement from point A to point B in the figure above.


Supply: Definition Revisited

• Supply: Relationship between price and the quantity supplied, all other things equal.

• What are the other things that we hold equal? While the price of a good is a major variable that affects the quantity of a good that sellers are willing to sell, other variables can also affect seller’s quantity supplied.


Supply: All Other Things Equal

• The following variables also affect the quantity supplied of a good, and are held constant when analyzing the law of supply.1. Technology

2. The price of goods used as an input in production

3. Number of firms in the market

4. Seller’s expectations of future prices

5. Government taxes, subsidies and regulations


Technology

• Any change in the amount that a firm can produce with a given amount of inputs can be considered a change in technology. Improvements in technology will encourage the firm to produce more at the same price.


• Examples: The introduction of high yielding varieties of corn will allow corn farmers to produce more corn, given the same amount of land, water, fertilizer and machinery.

Technology (cont’d)


The Price of Goods Used in Production

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

• Example: When oil and gasoline prices increase, some airlines chose to cut back on the number of flights on some routes.


The Number of Firms in the Market

• If more firms in the market increase, supply increases, as more goods or services will be available for sale at each price.


Seller’s Expectations of Future Prices

• If a firm expects the price of the good they are selling will increase in the future, they will sell less today and sell more in the future when prices are higher. Similarly, if a firm expects the price of the good they are selling will decrease in the future, they will sell more today.


Example • Stockholders of Google will hold off on selling

their stocks if they expect the prices of the stock will rise in the future. On the other hand, stockholders of Google will sell more stocks if they expect the prices of the stock will drop in the future.

Seller’s Expectations of Future Prices (cont’d)


Government Taxes, Subsidies and Regulations

• Increases in taxes (payments by firms to the government) or decreases in subsidies (payment by the government to firms) can reduce the quantity that firms are willing to sell at a given price. Decreases in taxes or increases in the subsidies can increase the quantity that firms are willing to sell at a given price. – Example: Community colleges decreased the

number of classes offered in 2002 when the State of California reduced the subsidies to the community college system.


Government Taxes, Subsidies and Regulations (cont’d)

• 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: Government pollution regulation

forces bus companies to seek alternative fuel sources (natural gas) that may raise costs and decrease supply.


Shifts vs. Movement

P

Q

P2

P1

Q1 Q2

A

B

Movement along the supply curve: A change in the quantity supplied of a good brought along by a change in its price. An increase in price can be seen in the diagram above as a movement from A to B, in the same supply curve. A decrease in the price is depicted as a movement from point B to A.

Supply


PS S1

Q

An increase in supply is illustrated as a shift in the supply curve to the right.

An Increase in Supply

Possible causes1) Better technology2) Less expensive inputs3) More firms4) A lower expected price in

the future5) More subsidies or less

taxes


P

Q

S3 S2

A Decrease in Supply

Possible causes1) Deteriorating technology2) More expensive inputs3) Fewer firms4) A higher expected price

in the future5) Less subsidies or more

taxes

An decrease in supply is illustrated as a shift in the supply curve to the left.


Movements Vs. Shifts: SummaryFigure 3.6


Supply and Demand: A ReviewFigure 3.7


Market Equilibrium: Combining Supply and Demand

• When consumers buy goods and producers sell goods, their interaction lead to the determination of an equilibrium price in the market.

• Equilibrium price: The price at which the quantity that sellers are willing to sell equals the quantity that consumers are willing to purchase.


Market Not in Equilibrium

• 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): 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.


Finding the Equilibrium: An Example

Quantity Quantity Surplus, Shortage Price rises

Price Demanded Supplied or Equilibrium or Falls

140 18 1 Shortage=17 Price rises

160 14 4 Shortage = 10 Price rises

180 11 7 Shortage = 4 Price rises

200 9 9 Equilibrium No Change

220 7 11 Surplus = 4 Price falls





Table 3.3 Supply and Demand Schedule for Bicycles (millions per year)


Equilibrium

5 10 15

20QuantityMillions of Bicycles

Price(Dollars per Bicycle)

140

160

180

200

220

240

260

280

300

Demand

Supply

At equilibrium, the quantity supplied equals the quantity demanded, which in this case is at q=9.

Q*=9


Shortage

5 10 15 20

Quantity Millions of Bicycles


140

160

180

200

220

240

260

280

300

Demand

Supply

4 14

At P=160, QS= 4 and QD= 14. The shortage = 10. The shortage will cause the price to rise.

Shortage amount


Surplus

5 10 15 20Quantity Millions of Bicycles


140

160

180

200

220

240

260

280

300

Demand

Supply

3

At P=260, QS= 15 and QD= 3. The surplus = 12. The surplus will cause the price to fall.

Surplus Amount


Effects of a Change in Demand and/or Supply

• Changes in either supply or demand (or both) will result in shifts in either the supply curve or the demand curve (or both), respectively. These shifts in the supply curve and the demand curve will result in the change in prices and quantities.


Effects of an Increase in DemandFigure 3.9

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


Effects of a Decrease in DemandFigure 3.9 cont’d

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


Effects of an Increase in SupplyFigure 3.10

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


Effects of a Decrease in SupplyFigure 3.10 cont’d

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


Supply and Demand in Action:

Real World Examples


Why Gas Prices Increased in 2005

• Gasoline Prices increased in 2005 because of two reasons.

• 1st reason: Increased use of SUVs (a complement) increased the demand for gasoline. This can be depicted in Fig. 3.12 as a movement from equilibrium pt. A to equilibrium pt. B.


Why Gas Prices Increased in 2005 (cont’d)

• 2nd reason: Declining refining capacity for gasoline shifted the supply curve to the right. This moved the equilibrium price higher, as seen in Fig. 3.12 as a movement from equilibrium pt. B to equilibrium pt. C.


Combined Effects of Simultaneous Increase in Demand and Decrease in Supply of Gasoline

Quantity Gallons of Gasoline

Fig. 3.12


Energy Policies

• Since the high prices of gasoline hurt both American consumers and businesses, what can policymakers do to lower prices? Policies aimed at increasing supply and decreasing demand can help lower the equilibrium price for gasoline.


Energy Policies (cont’d)

• Supply Policies: To lower oil/gasoline prices, one policy is to develop new sources of oil. More oil wells can increase the supply and shift the supply curve to the right. In Figure 3.13, this will move the equilibrium from point A to point B.

• Note: Programs that promote the development of new energy alternatives such as bio-diesel, will shift the demand curve for gasoline down, since bio-diesel is a substitute for gasoline. However, it will increase the supply of energy.


Energy Policies (cont’d)

• Demand Policies: Another policy to help lower oil/gasoline prices is to encourage energy conservation . Conservation can decrease the demand and shift the demand curve to the left. In Figure 3.13, this will move the equilibrium from point B to point C.


Combined Effects of Two Energy Policies

120 130 140Quantity Gallons of Gasoline

Fig. 3.13


Interference with Market Prices

• So far, our analysis of supply and demand involves situations where the equilibrium can be reached. In this section, we will analyze the effects of price controls on the market. The two types of government price controls are:

1) Price Ceilings

2) Price Floors


Interference with Market Prices (cont’d)

• Price Control: A government law or regulation that sets or limits the price to be charged for a particular good

• Maximum Price Laws/Price Ceiling: A government price control that sets the maximum allowable price for a good

• Minimum Price Laws/ Price Floor: A government price control that sets the minimum allowable price for a good


Maximum Price Law


Maximum Price Laws

• Since most maximum price laws (price ceilings) are imposed below the equilibrium price, quantity demanded is greater than quantity supplied, resulting in a shortage. There is pressure for prices to rise into the illegal region in Fig. 3., but the price ceiling prevents this. The shortage will persist unless demand decreases or supply increases enough to bring the equilibrium below the maximum price (P*).

• Note: A maximum price above the equilibrium price will bring the market into equilibrium.


Rent Control

• Rent control is a maximum price law. Housing that is subject to rent control faces a maximum price below the equilibrium. Ultimately, rent controlled housing experiences a shortage, as quantity demanded is greater than the quantity of housing supplied.


Rent Control (cont’d) Figure 3.14


Minimum Price Law

• Since most minimum price laws (price floors) are imposed above the equilibrium price, quantity supplied is greater than quantity demanded, resulting in a surplus. There is pressure for prices to fall into the illegal region in the next figure, but the price floor prevents this. The surplus will persist unless demand increases or supply decreases enough to bring the equilibrium above the maximum price (P*).

• Note: a minimum price below the equilibrium price will bring the market into equilibrium.


Minimum Price Law (cont’d)


Minimum Wage Laws

• Since Jan. 2002, the federal government has imposed a minimum wage = $5.15 per hour. This implies that all workers covered by the minimum wage law must be paid $5.15 or higher.


The Federal Minimum Wage Law


Key Words/Phrases to Remember

• Demand, demand curve and the law of demand

• Supply, supply curve and the law of supply

• Equilibrium

• Shift in supply vs. movement along the supply curve

• Shift in demand vs. movement along the demand curve


• Surpluses and shortages

• Price floors / minimum price laws

• Price ceilings / maximum price laws

Key Words/Phrases to Remember (cont’d)

chapter three the supply and demand model. 3 | 2 copyright © houghton mifflin company. all rights...

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