Demand, Supply, and Market Equilibrium

Chapter 3

Let’s see what you know…

Objectives

• Demand Defined and What Affects It• Supply Defined and What Affects It• How Supply & Demand Together

Determine Market Equilibrium• How Changes in Supply and Demand

Affect Equilibrium Prices and Quantities• Government-Set Prices and their

Implications for Surpluses & Shortages

Markets • Markets bring buyers (those who demand) and sellers

(suppliers) together and enable exchanges of goods and services at competitive prices

• Demand is a desire that exists among people and manifests itself as a willingness to sacrifice something of value, such as money, for something else of value, which here happen to be goods and services. The willingness of consumers to own them is reflected as demand and those goods and services they seek to purchase are provided by producers who are seeking a profit. We refer to these goods and services as supply. When these two variables, demand and supply, interact in ways that create an agreement among those who want the goods and those who have them, we say we have reached market equilibrium.

Demand• Demand Defined

– The desire to own a good or purchase the benefits provided by a service

• Demand Schedule– In the event we were to list these quantities and prices for a good in a simple tabular form,

we would have created a demand schedule for ourselves.

• Law of Demand• Recall that when we continually tested the predictability of a notion and it never

failed, it became a law. We now encounter our first law of economic study: The Law of Demand. Simply stated, the law of demand maintains that "all else equal, as price falls, the quantity demanded rises, and as price rises, the quantity demanded falls." The "all else equal" assumption associated with the demand curve is also familiar to us.

• We earlier identified it by the Latin name of ceteris paribus and it represents the assumption that we hold all other things equal so we may study the single variable (or very limited number of variables) of interest to us in that moment.

• Market Demand– In the event we were able to accumulate the demand schedules for all individuals and

summarize them into one schedule, we would have captured a demand schedule for market demand.

Demand Curve: What causes the inverse relationship between price and qty. demanded?

• Common sense among consumers• Diminishing marginal utility

– Stated more simply, the more we consume of something, the less we enjoy the next unit of the good consumed. In order for us to continue to consume additional consecutive units of a good, something must change in ways that prompt us to continue consumption. Therefore, more units of a good or service will be consumed in consecutive consumption only in the event in which market price continues to decline.

– What does that look like? (refer to « Cool Hand Luke » & « Dumb and Dumber » & « Nutty Professor » Clips)

• The income effect– The income effect indicates that a lower price for a good will increase the purchasing power of a

buyer's money income and will enable the buyer to purchase more of the good than they did before the change in price.

• The substitution effect– The substitution effect suggests that as prices increase for a good, the price change will induce

buyers to migrate from buying the good to choosing a substitute good with a lower "relative" price.

– What does it look like? (refer to « Rent » clip)

Individual Demand 6

5

4

3

2

1

0 10 20 30 40 50 60 70 80 Quantity Demanded (bushels per week)

Pri

ce (

per

bu

shel

)

P Qd

$5

4

3

2

1

10

20

35

55

80

IndividualDemand

P

Q

D

Changes in Demand

• Change in demand causes a shift in the demand curve

• An outward shift represents an increase in demand and more is desired at every price in the market

• An inward shift represents a decrease in demand and less is desired at every price

What causes a change in demand?

• Tastes• Number of Buyers• Income

– Normal Goods• More of this good will be demanded as income increases• Examples: luxury autos, designer clothes, and fine jewlery

– Inferior Goods• Demand will decrease for this good/service as income increases• Examples: generic store brand of groceries

• Price of Related Goods– Substitute Good– Complementary Good– Unrelated Goods

• Consumer Expectations

Individual Demand 6

5

4

3

2

1

0

Quantity Demanded (bushels per week)

Pri

ce (

per

bu

shel

)

P Qd

$5

4

3

2

1

10

20

35

55

80

IndividualDemand

P

Q

D1

2 4 6 8 10 12 14 16 18

Demand Can Increase or Decrease

Increase in Demand

Decrease in Demand

D2

D3

Individual Demand 6

5

4

3

2

1

0

Quantity Demanded (bushels per week)

Pri

ce (

per

bu

shel

)

P Qd

$5

4

3

2

1

10

20

35

55

80

IndividualDemand

P

Q

D1

2 4 6 8 10 12 14 16 18

Demand Can Increase or Decrease

Decrease in Demand

D2

D3

An Increase in DemandMeans a Movementof the Line

A Movement BetweenAny Two Points on a

Demand Curve is Called a Change in

QuantityDemanded

What is the difference between change in demand and change in quantity demanded?

• Change in Demand- Something other than price is causing the demand curve to shift

• Change in Quantity Demanded – Price is causing an increase or decrease in demand and it is represented by movement along the curve

• Let’s pratice….refer to worksheet

Supply• Supply Defined

– Supply is defined as a schedule or curve showing the amounts of a product that producers are willing and able to make available for sale at each of a series of possible prices during a specific period. Supply curves also generally portray a positive slope, whereas demand curves normally possess a negative slope. A review of the appendix section involving graphs will both confirm and reinforce these conceptual relationships.

• Supply Schedule• Law of Supply

– The Law of Supply states that as price rises, the quantity supplied rises; and as prices falls, the quantity supplied falls. It is critical to note that the relationship between price and quantity is a direct relationship. As price moves, quantity supplied moves in the same direction. Therefore we say the relationship between price and quantity when studying supply is direct, or positive, and the relationship between price and quantity when studying demand is indirect or negatively related.

– Revenue Implications– Marginal Cost

• Supply Curve• Market Supply

Individual Supply 6

5

4

3

2

1

0

Quantity Supplied (bushels per week)

Pri

ce (

per

bu

shel

)

P Qs

$5

4

3

2

1

60

50

35

20

5

IndividualSupply

P

Q

S1

10 20 30 40 50 60 70

Determinants of Supply

• Resource Prices• Technology• Taxes and Subsidies• Prices of Other Goods• Producer Expectations• Number of Sellers

Possible Causes of Supply Increase

• Decrease in the prices of resources used to produce the good or service

• Improvement in technology, which increase productivity

• Lower taxes and/or higher subsidies for producers

• Higher prices for substitutes and/or lower prices

for complimentary goods • Changes in expectations of prices in the future

• An increase in the number of suppliers in the market

Possible Causes of Supply Decrease

• Increase in the prices of resources used to produce the good or service

• Higher taxes and/or lower subsidies for producers

• Lower prices for substitutes and/or higher prices

for complimentary goods • Changes in expectations of prices in the future

• A decrease in the number of suppliers in the market

Individual Supply

6

5

4

3

2

1

0

Quantity Supplied (bushels per week)

Pri

ce (

per

bu

shel

)

P Qs

$5

4

3

2

1

60

50

35

20

5

IndividualSupply

P

Q

S1

Supply Can Increase or Decrease

S2

S3

2 4 6 8 10 12 14

Individual Supply

6

5

4

3

2

1

0

Quantity Supplied (bushels per week)

Pri

ce (

per

bu

shel

)

P Qs

$5

4

3

2

1

60

50

35

20

5

IndividualSupply

P

Q

S1

Supply Can Increase or Decrease

S2

S3

An Increase in SupplyMeans a Movementof the Line

A Movement BetweenAny Two Points on a

Supply Curve is Called a Change in Quantity

Supplied

2 4 6 8 10 12 14

The difference between change in supply and change in quantity supplied

• Think back to the difference when we talked about demand….What do you think the difference is?

• Talk with your team and develop and anser.– What would the difference look like in a graphical

representation?

Market Equilibrium

• Equilibrium Price

• Equilibrium Quantity

• Surplus

• Shortage

• Rationing Function of Prices

Market Equilibrium

6

5

4

3

2

1

0 2 4 6 8 10 12 14 16 18Bushels of Corn (thousands per week)

Pri

ce (

per

bu

shel

)

P Qd

$5

4

3

2

1

2,000

4,000

7,000

11,000

16,000

MarketDemand

200 BuyersP Qs

$5

4

3

2

1

12,000

10,000

7,000

4,000

1,000

MarketSupply

200 Sellers

200 Buyers & 200 Sellers

7

3

D

S

$4 Price Floor

6,000 BushelSurplus

$2 Price Ceiling

7,000 BushelShortage

Market Equilibrium• Changes in Demand• Changes in Supply• Changes in Equilibrium

– Let’s practice…refer to worksheet

• Efficient Allocation– Productive Efficiency– Allocative Efficiency

• Supply Increase; Demand Decrease

• Supply Decrease; Demand Increase

• Supply Increase; Demand Increase

• Supply Decrease; Demand Decrease

Market EquilibriumPrice Quantity

?

?

?

?

Market EquilibriumWhat does it look like?

« A Beautiful mind » (2001)

« Charlie and the Chocolate Factory » (2005) & « Charlie and the Chocolate

Factory » (1971) clips

Government Set-Prices• Price Ceilings on Gasoline & Rent Control

– The first occurs when government imposes a price ceiling. One such example is found when rental rates in urban markets are capped through legislation or ordinances. The resulting response in the market is often very inefficient.

– One can deduce quickly that the wrong signals are sent to the market because consumers would be inclined to demand more housing at the lower ceiling rental rate than the market will provide. This is precisely what we observe when viewing the impact of price ceilings from a graphical perspective as well. There are persistent shortages.

– What does that look like?

• Rationing Problem• Black Markets

– Refer to “Blood Diamond” Clip

• Price Floors on Wheat– Legislation is passed favoring payments to producers which equates to an arbitrary price floor. Producers receive actual market price for

their product when selling in the open market, then the government programs provide additional payments on a per unit of production basis. The profit-maximizing perspective of this system provides the incentive for producers to maximize production, and thus also maximize subsidy payments too. This extra compensation serves the same function as imposing a price floor in the market and disequilibrium is the result. There will be persistent surpluses.

• Optimal Allocation of Resources

So are price ceilings a good idea?• One might be tempted to perceive price ceilings to be

favorable for consumers and in fact, a rent freeze does tend to benefit the few consumers who receive favorable rental rates.

• However over time, landlords tend to neglect maintenance on rent-controlled properties as a means of offsetting some of the losses incurred with the imposition of the ceiling.

• In addition, there are no market incentives to build more property in rent-controlled zones.

• Over time shortages appear and even those initial consumers who were benefiting from the lower rental rate eventually lose their benefit.

So are price floors a good idea?• In addition, one might be tempted to perceive that price floors assure that we

have adequate food stocks in the feed grain sector even in lean years and doing so is in the best interest of the public.

• This might be the case on very rare occasions, but in most years surplus production has resulted in the problematic process of dealing with excess inventory.

• Although it is true that consumers would most likely pay more for major feed grains in the event price floors were eliminated. The question for consumers is more a matter of whether to pay in the market with a market system, or pay in the market and in taxes for the subsidized system.

Key Terms Page• demand• demand schedule• law of demand• diminishing marginal utility• income effect• substitution effect• demand curve• determinants of demand• normal goods• inferior goods• substitute good• complementary good• change in demand• change in quantity demanded

• supply• supply schedule• law of supply• supply curve• determinants of supply• change in supply• change in quantity supplied• equilibrium price• equilibrium quantity• surplus• shortage• price ceiling• price floor

Practice

• Interactive Graphs

• Key Questions

• Quiz #1-Team Challenge

• Quiz #2-Individual Knowledge Check

• Have you been listening?