Ch. 3: Supply and Demand: Theory

Del Mar College

John Daly©2003 South-Western Publishing, A Division of Thomson Learning

Demand

• Demand is: the willingness and ability of buyers to purchase different quantities of a good at different prices during a specific period of time.

• The Law of Demand: as the price of a good rises, quantity demanded of that good falls; as the price of a good falls, quantity demanded of that good rises.

Prices

• Absolute Price: the price of a good in monetary terms (Ex: A new Car costs $30,000).

• Relative Price: the price of a good in terms of another good (Ex: A new Car costs 30 computers)

• Relative price is calculated by dividing the absolute price of one product with the absolute price of another product (Ex: A Car costs $30,000; A Computer costs $1,000; The relative cost of a Car is 30 Computers)

More Prices

• As the absolute price of a good increases, if nothing else changes, the relative price of a good increases (if a Car costs $36,000 and a computer costs $1000, the relative cost of the Car is 36 computers).

Why Quantity Demanded Goes Down As Price Goes Up

• People substitute lower-priced goods for higher-priced goods.

• The Law of Diminishing Marginal Utility: for a given time period, the marginal (additional) utility or satisfaction gained by consuming equal successive units of a good will decline as the amount consumed increases.

Four Ways to Represent The Law Of Demand

• In Words: “As price rises, quantity demanded falls”

• In Symbols: PQd• In a Demand Schedule• In a Demand Curve

The Demand Curve & Demand Schedule

(a)

(b)

Causes of Change in the Demand Curve

• Income

• Preferences

• Prices of Related Goods

• Number of Buyers

• Expectations of Future Price

Income Changes in DemandShifts in Demand Curves

• The demand for a good increases if people are willing and able to buy more of the good at all prices.

• A normal good is a good the demand for which rises(falls) as income rises(falls).

• An inferior good is a good the demand for which rises(falls) as income falls(rises).

Preferences, Substitutes and Related Goods

• Preferences affect the amount of a good they are willing to buy at a particular price (Ex: favorite food, favorite author)

• If the demand for product X increases as the price for Y increases, and the demand for product X falls as the price for Y falls, X and Y are substitutes (Ex:Coke and Pepsi).

• If the price of product A falls as the demand for product B rises, and the price of product A rises as the demand for product B falls, A and B are Related Goods (Ex: Ketchup and Hot Dog Buns).

Number of Buyers and Expectation of Future Price

• The demand for a good in a particular market area is related to the number of buyers in the area: More Buyers, More Demand; Fewer Buyers, Less Demand.

• Buyers who expect a price to be higher next month will buy the good this month, increasing demand. Buyers who expect a price to be lower next month will wait to buy the good next month, reducing demand.

Shifting the Demand Curve• A change in Demand causes a shift in the Demand curve.• A change in the Quantity Demanded moves a point along

the current Demand curve.• If Demand increases, the curve shifts to the right.• If Demand decreases, the curve shifts to the left.

Q & A

• As Sandi’s income rises, her demand for popcorn rises. As Mark’s income falls, his demand for prepaid telephone cards rises. What kinds of goods are popcorn and telephone cards for the people who demand each?

• Why are demand curves downward sloping?• Give an example that illustrates how to derive a

market demand curve.• What factors can change demand? What factors

can change quantity demanded?

Supply

• Supply is the willingness and ability of sellers to produce and offer to sell different quantities of a good at different prices during a specific period of time

• Law of Supply: As the price of a good rises, the quantity supplied of the good rises; and as the price of a good falls, the quantity supplied of the good falls.

The Supply Curve

Why Supply Curves Slope Upwards

An Upward-sloping supply curve reflects the fact that under certain conditions, a higher price is an incentive to producers to produce more of a good.

Market Supply Curve

• The Market Supply Curve represents the price-quantity combinations for all sellers of a particular good.

• An Individual supply curve represents the price-quantity combinations for a single seller

Shifting the Supply Curve

• If the price of a relevant resource changes, the supply curve will shift (EX: wood prices increase, cost of a new house increases as well)

• Technology can increase the quantity supplied by producing more of a product with the same quantity of resources supplied.

• If the number of sellers increase, the supply curve will shift.

• If the price of a good is expected to be higher in the future, the supply curve will shift

Shifting the Supply Curve• Taxes increase unit costs• Government restrictions can change the supply curve by

increasing or limiting production.• A Change in the Supply Curve is a shift in the Supply

Curve, not merely moving up and down the same curve.

Q & A

• What would the Supply Curve of houses in your city look like in the next 10 hours? In three months?

• Which way (if any) does the Supply Curve shift if there is a decrease in the number of sellers? If there is a per-unit tax is placed on the production of the good? If the price of a relevant resource falls?

• Why do most Supply Curves slope upward?

The MarketPutting Supply and Demand Together

Market Language

• If the quantity supplied is greater than the quantity demanded, the good has a surplus or excess supply.

• If quantity demanded is greater thean quantity supplied, a shortage or excess demand exists.

• The price at which a quantity demanded equals the quantity supplied is the equilibrium price, or the market-clearing price.

• A market that has too much of a good or too little of a good is considered to be in disequilibrium.

More Market Language

• The quantity that corresponds to the equilibrium price is the equilibrium quantity.

• Any price at which quantity demanded is not equal to quantity supplied is a disequilibrium price.

• A market that exhibits either a surplus or a shortage is said to be in disequilibrium.

• A market in which quantity demanded equals quantity supplied is said to be in equilibrium.

Moving to Equilibrium• Why does the price fall when there is a surplus?• Why does the price rise when there is a shortage?• Mutually beneficial trade drives the market towards

equilibrium.

Viewing Equilibrium In Terms of Consumers’ and Producers’ Surplus

• Consumers’ Surplus: the difference between the maximum or highest amount buyers would be willing to pay and the price they actually pay.

• Producers’ Surplus: the difference between the price sellers receive for the god and the minimum or lowest price they would be willing to sell the good for.

What Can Change Equilibrium Price and Quantity

• Demand rises and supply is constant: Equilibrium price rises, Equilibrium quantity rises.

• Demand falls, supply is constant: Equilibrium price falls, Equilibrium quantity falls.

• Supply rises, demand is constant: Equilibrium price falls, Equilibrium quantity rises.

• Supply falls, demand is constant: Equilibrium price rises, Equilibrium quantity falls.

What Can Change Equilibrium Price and Quantity Part 2

• Demand rises and supply falls by an equal amount: Equilibrium rises, Equilibrium quantity is constant.

• Demand falls and supply rises by an equal amount: Equilibrium price falls, Equilibrium quantity is constant.

• Demand rises by a greater amount than supply falls: Equilibrium price and quantity rise.

• Demand rises by a lesser amount than supply falls: Equilibrium price rises, Equilibrium quantity falls.

Q & A

• When a person goes to the store and buys milk or bread, supply and demand cannot apply because there is no auctioneer. Do you Agree or Disagree? Why or Why not?

• The price of a given-quality personal computer is cheaper today than it was 5 years ago. Is this a result of Lower Demand for Computers? Why or Why Not?

Price Controls

• Price Ceiling: a government mandated price above which legal trades may not be made.

• Price Ceilings may cause:

1) Shortages

2) Fewer Exchanges

3) Non-price Rationing Devices

4) Buying and Selling at a Prohibited Price

5) Tie in Sales

Price Floor

• A price floor is a government mandated minimum price below which legal trades cannot be made.

• Price floors can cause Surpluses and Fewer Exchanges.

Q & A

• Do buyers prefer lower prices to higher prices?

• Who might argue for a Price Ceiling? A Price Floor? Why would they argue their viewpoint?