C H A P T E R 2

SUPPLY AND DEMAND

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DEFINITIONS

• Supply and Demand: the name of the most important model in all economics• Price: the amount of money that must be paid for a unit of output•Market: any mechanism by which buyers and sellers exchange goods or services•Output: the good or service and/or the amount of it sold

DEFINITIONS (CONTINUED)• Consumers: those people in a market who are wanting to exchange money for goods or services• Producers: those people in a market who are wanting to exchange goods or services for money• Equilibrium Price: the price at which no consumers wish they could have purchased more goods at that price; no producers wish that they could have sold more• Equilibrium Quantity: the amount of output exchanged at the equilibrium price

QUANTITY DEMANDED AND QUANTITY SUPPLIED

•Quantity demanded: how much consumers are willing and able to buy at a particular price during a particular period of time

•Quantity supplied: how much firms are willing and able to sell at a particular price during a particular period of time

CETERIS PARIBUS• As I talked about before economists use models

to focus on what is most important

• Models typically hold other variables constant to examine the effect of other variables.

• For example in looking at the supply and demand for peanut butter we typically hold the price of jelly constant

• We sometimes use the Latin phrase ceteris paribus which means “holding other things equal” to identify this case.

DEMAND AND SUPPLY

•Demand is the relationship between price and quantity demanded, ceteris paribus.

• Supply is the relationship between price and quantity supplied, ceteris paribus.

FIGURING OUT THE DEMAND CURVE

• There are really two different parts to it which are similar

• One is the “extensive margin” that is who buys the good

• The second is the “intensive margin” or how much of the good each person buys

• Guell focuses on the intensive margin, but I want to start with the extensive as I think it is easier to think about

EXTENSIVE MARGIN

• Think about something like an ipad where there is really no reason to buy more than one• Suppose there are 5 people in the economy and

this is what they are willing to pay:

Name WTPJim $200Jackie $400Bill $600Sally $800Lisa $1000

DEMAND CURVE

So what does demand look like:• At $1200 I sell no ipads• At $1000 I sell to Lisa only• At $800 I sell 2• At $600 I sell 3• At $400 I sell 4• And at $200 I sell5

0 1 2 3 4 5 60

200400600800

100012001400

Price

ipads

INTENSIVE DEMAND

• Now suppose it is just one worker say me• I like to go to basketball games (either pro or college)• Suppose the seats are all the same, how many

games would I go to?• At $200 per seat I would probably go to a game• At $50 per seat I would probably go to like 4 games a year• At $25 I would go to like 15• At $5 I would go to like 20• At $0 I would go to like 20• Thus demand slopes down for me-the larger the price the

fewer games I would go to• Demand in the economy picks up both the intensive

and extensive margin

THE LAW OF DEMAND

The relationship between price and quantity demanded is a negative or inverse one.

This occurs both on the extensive and intensive margin

There are 3 reasons to expect it on the intensive margin

The Substitution Effect• moves people toward the good that is now

cheaper or away from the good that is now more expensive • If the price of Mobil gas goes up I buy more

Amoco

The Real Balances Effect• When a price increases it decreases your

buying power causing you to buy less.

• If I live in New York and am spending almost all of my money on rent, if rent doubles I have to move into cheaper place because I can’t afford my current place any more

The Law of Diminishing Marginal Utility• The amount of additional happiness that

you get from an additional unit of consumption falls with each additional unit.

• This is what was really going on with my basketball tickets-I like going but I get tired of it if I go to two many games

• Pretty much any good we can think of has this characteristic

Put it all together and we are pretty confident that demand curves slope down

P

Q

p

q

DETERMINANTS OF DEMAND• Taste• Income• Normal Goods• Inferior Goods

• Price of Other Goods• Complement• Substitute

• Population of Potential Buyers• Expected Price• Excise Taxes• Subsidies

MOVEMENTS IN THE DEMAND CURVE

Determinant Result of an increase in the determinant

Result of a decrease in the determinant

Taste D shifts right D shifts leftIncome-Normal Good D shifts right D shifts leftIncome-Inferior Good D shifts left D shifts rightPrice of Other Goods-Complement

D shifts left D shifts right

Price of Other Goods-Substitute

D shifts right D shifts left

Population of Potential Buyers D shifts right D shifts leftExpected Future Price D shifts right D shifts leftExcise Taxes D shifts left D shifts rightSubsidies D shifts right D shifts left

P

Times Eating Out

Example: Demand for Eating Out When Income Falls

p

q1q2At a given price people eat out less

P

Ketchup

Example: Demand for ketchup when the price of beef falls

p

q2q1At a given price thePeople want more Ketchup

A PITFALL: CONFUSING MOVEMENT ALONG VS. SHIFTS IN DEMAND

• Price changes cause movements along a demand curve.

• Other factors will cause shifts in demand.

• These are not the same

• The “Quantity Demanded” can change either because the price change or because the demand curve changed

P

Q

Two ways that Quantity Demanded can Increase:

SUPPLY

• Supply is more complicated and harder to think about than demand (at least for me)• In demand for an ipad a person buys an ipad and

brings it home• In supply for an ipad you have to design it, buy all

the components, build it, ship it, sell it in the store• The Law of Supply is the statement that there is a

positive relationship between price and quantity supplied.• If I am trying to sell something, the higher is the

price the more I will want to sell

WHY DOES THE LAW OF SUPPLY MAKE SENSE?

• Because of Increasing Marginal Costs firms require higher prices to produce more output.

• Because many firms produce more than one good, an increase in the price of good A makes it (at the margin) more profitable so resources are diverted from good B to produce more of good A (think about the PPF)

THE SUPPLY SCHEDULE

Price Individual Qs QS for 10 firms

$0.00 0 0$0.50 0 0$1.00 1,000 10,000$1.50 2,000 20,000$2.00 3,000 30,000$2.50 4,000 40,000

THE SUPPLY CURVE

0 10 20 30 40 50

P

Q (in thousands)

$2.50

$2.00

$1.50

$1.00

$0.50

0

Supply

MOVEMENTS IN THE SUPPLY CURVEDeterminant Result of an

increase in the determinant

Result of a decrease in the determinant

Price of Inputs S shifts left S shifts right

Technology S shifts right S shifts leftPrice of Other Potential Outputs S shifts left S shifts

rightNumber of Sellers S shifts right S shifts leftExpected Future Price S shifts left S shifts

rightExcise Taxes S shifts left S shifts

rightSubsidies S shifts right S shifts left

NUMBER OF SELLERS GOES UP

0 10 20 30 40 50

P

Q (in thousands)

$2.50

$2.00

$1.50

$1.00

$0.50

0

At a given price supplywill increase

PRICE OF AN INPUT GOES UP

0 10 20 30 40 50

P

Q (in thousands)

$2.50

$2.00

$1.50

$1.00

$0.50

0

At a given price supplywill decrease

MARKET EQUILIBRIUM• A competitive market is in equilibrium

when price has moved to a level at which quantity demand equals quantity supplied of that good.• Competitive markets have many buyers and

sellers and none is large enough to individually affect the price.

• Why do markets reach an equilibrium?• If prices are too high, there is excess supply (a

surplus) and firms will lower prices.• If prices are too low, there is excess demand (a

shortage) and firms will raise prices.

A COMBINED SUPPLY AND DEMAND SCHEDULE

Price QD QS Shortage

Surplus

$0.00 50,000

0 50,000

$0.50 40,000

0 40,000

$1.00 30,000

10,000

20,000

$1.50 20,000

20,000

$2.00 10,000

30,000

20,000

$2.50 0 40,000

40,000

THE SUPPLY AND DEMAND MODEL

0 10 20 30 40 50

P

Q (in thousands)

$2.50

$2.00

$1.50

$1.00

$0.50

0

Supply

Demand

Equilibrium

WHAT IF PRICE TOO HIGH?

0 10 20 30 40 50

P

Q (in thousands)

$2.50

$2.00

$1.50

$1.00

$0.50

0

Supply

Demand

Surplus

WHAT IF PRICE TOO LOW?

0 10 20 30 40 50

P

Q (in thousands)

$2.50

$2.00

$1.50

$1.00

$0.50

0

Supply

DemandShortage

WHAT IF PRICE OF A SUBSTITUTE INCREASES?

New Demand

New Equilibrium

0 10 20 30 40 50

P

Q/t

$2.50

$2.00

$1.50

$1.00

$0.50

0

Demand

Supply

Old Equilibrium

Prices QuantitiesDemand Increases

Increase Increase

WHAT IF GOOD GETS BAD REVIEWS?

New Demand

New Equilibrium

0 10 20 30 40 50

P

Q/t

$2.50

$2.00

$1.50

$1.00

$0.50

0

Demand

Supply

Old Equilibrium

Prices QuantitiesDemand Increases

Increase Increase

Demand Decreases

Decrease Decrease

TECHNOLOGY IMPROVES

0 10 20 30 40 50

P

Q/t

$2.50

$2.00

$1.50

$1.00

$0.50

0Demand

Supply

Old Equilibrium

New Equilibrium

New Supply

Prices QuantitiesDemand Increases

Increase Increase

Demand Decreases

Decrease Decrease

Supply Increases

Fall Increases

AN INCREASE IN COST OF AN INPUT

0 10 20 30 40 50

P

Q/t

$2.50

$2.00

$1.50

$1.00

$0.50

0Demand

Supply

Old EquilibriumNew Equilibrium

New Supply

Prices QuantitiesDemand Increases

Increase Increase

Demand Decreases

Decrease Decrease

Supply Increases

Decrease Increase

Supply Falls Increase Decrease

WHY THE NEW EQUILIBRIUM?• If there is a change in supply or demand then without

a change in the price of the good, there will be a shortage or a surplus.• Suppose the cost of an input increased-firms would no

longer be willing to sell at the same price• They raise prices• As a result consumers purchase less

AN INCREASE IN COST OF AN INPUT

0 10 20 30 40 50

P

Q/t

$2.50

$2.00

$1.50

$1.00

$0.50

0Demand

SupplyNew Supply

shortage

As a result of the shortage, employers can raise pricesto new equilibrium whereshortage goes away