HISTORY OF SUPPLY AND DEMANDThe Question to be Addressed: What Determines the Price of the Good?

WHAT DETERMINES THE PRICE OF A GOOD? An Answer from David Ricardo and Karl Marx… The Labor Theory of Value - The price of a good is

determined by the cost of production, and the cost of production is dictated by the quantity and quality of labor utilized.

 What of the other factors of production? Capital: Capital is simply stored up labor. Land: Ricardo argued that the price of corn

determined the price of land, rather than the price of land determining the price of corn. In other words, the price of land is price determined, not price determining.

What about demand? In the long-run, assuming competition, price will equal the cost of production. This comes directly from the work of Adam Smith

MORE ON THE LABOR THEORY OF VALUE

Karl Marx wished to show that even if capitalism worked exactly as Ricardo believed, capitalism was still a very poor economic system.

Consequently, Marx utilized the labor theory of value to explain prices.

Given this explanation, Marx offered the following argument: If the value of labor determines value, and value mostly is given to the owners of capital, is it not the case that labor is exploited?

UTILITY THEORY Karl Marx published Das Kapital in 1867. In the early 1870s, three different writers – Stanley Jevons, Leon Walras, Carl Menger – offered a different answer to “what determines prices?”

Utility - the satisfaction one receives from a good.

“The fact is, that labor once spent has no influence on the future value of any article: it is gone and lost forever. In commerce, bygones are for ever bygones.” W.S. Jevons, 1871

THE MARSHALLIAN CROSS Marshall addressed the issue of what determines prices

by considering the impact of time: If one considered the very short-run, where supply was

fixed, Jevons, Menger and Walras were correct. Prices were solely determined by demand.

If one considers the long-run, where firms can enter and exit the industry, the price of the good will equal the cost of production. Hence, Ricardo and Marx are mostly correct.

If one considers the short-run, where firms can alter supply in response to price changes, then both supply and demand will determine prices.

Hence we have the Marshallian Cross, or what we call today the basic model of supply and demand

Demand (definitions)

Market - group of buyers and sellers of a particular good or service.

Demand - To be considered in demand for a good you must be able and willing to purchase the good in various quantities at various prices.

The Law of Demand - Quantity demanded rises as price falls, ceteris paribus. Quantity demanded falls as price rises, ceteris paribus

Quantity demanded - refers to a specific amount that will be demanded per unit of time at a specific price, ceteris paribus.

Law of Diminishing Marginal Utility - states that 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.

Demand curve - a curve relating how much a good is demanded at various prices.

THE DEMAND CURVE A demand curve is the graphic representation of

the relationship between price and quantity demanded

McG

raw-H

ill/Irwin

7

Colander, Economics

Demand

P

Q

The demand curve is downward sloping

As price increases, quantity demanded

decreasesP0

Q1

P1

Q0

Demand Shift FactorsNormal good - a good the demand for which rises as income rises.Inferior goods - a good the demand for which falls as income rises.Substitutes - two goods that satisfy similar needs or desires. If two goods are substitutes then as the price of one rises, demand for the other good will increase.Complements - two goods that are used jointly in consumption. If two goods are complements then as the price of one rises, demand for the other good will decrease.

More Demand Shift Factors

Number of buyers and sellers in a market

Tastes and Preferences

Expectations

and… taxes (more on this later)

SHIFTS IN DEMAND VERSUS MOVEMENTS ALONG A DEMAND CURVE

McG

raw-H

ill/Irwin

10

Colander, Economics

Demand

P

Q

A change in price causes a movement

along the demand curve$1

100

$2

200

Movement along a demand curve

B

A

SHIFTS IN DEMAND VERSUS MOVEMENTS ALONG A DEMAND CURVE

McG

raw-H

ill/Irwin

11

Colander, Economics

Demand0

P

Q

A change in a shift factor causes a shift in demand

$1

150 200

Shift in demand

B A

Demand1

Supply

Supply -To be considered to supply a good you must be able and willing to produce (and sell) the good in various quantities at various prices.

Law of Supply – as the price of a good rises, producers will supply more of the good, ceteris paribus.

Supply curve - a curve relating how much a good is supplied at various prices.

Supply Shift Factors Prices of a factor of production (labor, land, capital)

Number of sellers

Price of a substitute in production (i.e. something else a producer can produce)

Technology

and… taxes (more on this later)

THE SUPPLY CURVE A supply curve is the graphic representation of

the relationship between price and quantity supplied

McG

raw-H

ill/Irwin

14

Colander, Economics

Supply

P

Q

The supply curve is upward sloping

As price increases, quantity supplied

increasesP0

Q1

P1

Q0

SHIFTS IN SUPPLY VERSUS MOVEMENTS ALONG A SUPPLY CURVE

McG

raw-H

ill/Irwin

15

Colander, Economics

A change in price causes a movement

along the supply curve

Movement along a supply curve

Supply

P

Q

$50

4.3

$80

4.1

B

C

SHIFTS IN SUPPLY VERSUS MOVEMENTS ALONG A SUPPLY CURVE

McG

raw-H

ill/Irwin

16

Colander, Economics

A change in a shift factor causes a shift in

supply

Shift in Supply

S0

P

Q

S1

Equilibrium and Disequilibrium

Equilibrium- when opposing dynamic forces cancel each other out.

Equilibrium Price - The price at which the quantity demanded of the good equals the quantity supplied.

Market Surplus - The amount by which the quantity supplied exceeds the quantity demanded at a given price.

Market Shortage - The amount by which the quantity demanded exceeds the quantity supplied at a given price.

THE INTERACTION OF SUPPLY AND DEMAND

McG

raw-H

ill/Irwin

18

Colander, Economics

Supply

P

Q

P0

P1

Demand

Excess demand causes upward

pressure on price

Excess supply Excess supply

causes downward pressure on price

Excess demand

P*

Supply and Demand Example

Given: Income in a market increases for a normal good.

Impact1. Demand for the good will increase.2. At the current price quantity demand exceeds quantity supplied. Hence there

is a shortage.3. Producers will raise price.4. As price rises, producers will increase quantity supplied.5. As price rises, consumers will decrease quantity demanded.6. Producers will produce more and consumers will demand less until the price

of the good equates quantity supplied and quantity demanded.

Conclusion◦ Price of the good will rises.◦ Quantity produced and sold will also rise.

Limitations of Supply and Demand

1. Other things do not remain constant: Simplistic, two dimensional, analysis has problems.

2. The Fallacy of Composition - the false assumption that what is true for a part will also be true for the whole.

◦ If one firm changes supply, demand is unaffected. If all firms increase output, income also increases, thus changing demand.

◦ If one firm changes price, quantity demand will change. If all firms change prices, no change in demand is expected.

◦ Absolute (money) price - the price of a good in money terms◦ Relative prices - the price of a good in terms of another good.◦ Demand is dictated by changes in relative prices, not changes in money

prices. i.e. if all prices change, demand is unchanged.

CONSUMER SURPLUS

Willingness to Pay – the maximum amount that a buyer will pay for a good. Consumer Surplus – a buyer’s willingness to pay minus the amount the buyer actually pays. Use the demand curve to measure consumer surplus. NOTE: Consumer surplus measures the benefits that buyers receive from a good as the buyer themselves perceive it.

PRODUCER SURPLUS

Cost – the value of everything a seller must give up to produce a good.

Producer Surplus – the amount a seller is paid for a good minus the seller’s cost.

Using the supply curve to measure producer surplus.

TAXES Tax Incidence – the study of who bears the burden of taxation A Tax on Buyers or SellersA tax on buyers will shift the demand curve downward by the size of the tax.

A tax on sellers will shift the supply curve upward by the size of the tax.

LessonsTaxes reduce output in the marketBuyers and sellers share the burden of the tax

The decision to tax depends upon a comparison of the cost of taxation with the benefits of government spending.

THE DEADWEIGHT LOSS OF TAXATION The tax may shift supply or demand, depending upon whether the tax is placed on the producers or the buyers. To understand the cost of the tax, compare welfare without the tax to welfare with the tax. After the tax, note the size of consumer surplus, producer surplus, tax revenue and deadweight loss.

The Effects of a Tax...From a text by Gregory Mankiw

Price

0 QuantityQuantity without tax

Supply

Demand

Price without

tax

Price buyers pay

Quantity with tax

Size of tax

Price sellers

receive

Tax Revenue... From a text by Gregory Mankiw

Price

0 QuantityQuantity without tax

Supply

Demand

Price sellers

receive

Quantity with tax

Size of tax (T)

Quantity sold (Q)

Tax Revenue (T x Q)

Price buyers pay

How a Tax Affects Welfare... From a text by Gregory Mankiw

Quantity0

Price

Demand

Supply

Q1

A

B C

F

D E

Q2

Tax reduces consumer surplus by (B+C) and producer surplus by (D+E)Tax revenue = (B+D)

Deadweight Loss = (C+E)

Price buyerspay = PB

P1

Price without tax

=

PSPrice sellers receive

=

DEADWEIGHT LOSS OF TAXATION, CONT.

Deadweight Loss and Tax Revenue as Taxes Vary The smaller the tax, the less deadweight loss will be created.

The larger the tax, the greater the deadweight loss.

A Review of the Laffer Curve and Supply Side Economics

Deadweight Loss and Tax Revenue... From a text by Gregory Mankiw

PB

QuantityQ20

Price

Q1

Demand

Supply

Tax revenuePS

Deadweightloss

(a) Small Tax

Demand

Supply

Taxrevenue

PB

QuantityQ20

Price

Q1

PS

Deadweightloss

Deadweight Loss and Tax Revenue... From a text by Gregory Mankiw

(b) Medium Tax

Tax

reve

nue

PB

QuantityQ20

Price

Q1

Demand

Supply

PS

Deadweightloss

Deadweight Loss and Tax Revenue... From a text by Gregory Mankiw

(c) Large Tax

Deadweight Loss and Tax Revenue Vary with the Size of the Tax... From a text by Gregory Mankiw

(a) Deadweight LossDeadweight

Loss

0 Tax Size

Deadweight Loss and Tax Revenue Vary with the Size of the Tax... From a text by Gregory Mankiw

(b) Revenue (the Laffer curve)TaxRevenue

0 Tax Size