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 WTP

Jim $200

Jackie $400

Bill $600

Sally $800

Lisa $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

200

400

600

800

1000

1200

1400

0 2 4 6

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 left

Income-Normal Good D shifts right D shifts left

Income-Inferior Good D shifts left D shifts right

Price 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 left

Expected Future Price D shifts right D shifts left

Excise Taxes D shifts left D shifts right

Subsidies D shifts right D shifts left

P

Times Eating Out

Example: Demand for Eating Out When Income Falls

p

q1 q2

At a given price people eat out less

P

Ketchup

Example: Demand for ketchup when the price of beef falls

p

q2 q1

At a given price the People 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 changes 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 CURVE

Determinant 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 left

Price of Other Potential Outputs S shifts left S shifts right

Number of Sellers S shifts right S shifts left

Expected Future Price S shifts left S shifts right

Excise Taxes S shifts left S shifts right

Subsidies 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 quantity supplied will 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 quantity supplied will 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

Demand Shortage

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 Quantities

Demand 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 Quantities

Demand 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 0

Demand

Supply

Old Equilibrium

New Equilibrium

New Supply

Prices Quantities

Demand 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 0

Demand

Supply

Old Equilibrium

New Equilibrium

New Supply

Prices Quantities

Demand 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 0

Demand

Supply New Supply

shortage

As a result of the shortage, employers can raise prices to new equilibrium where shortage goes away