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Supply, Demand, and the Market Process
Lesson 3

 

Demand - The Consumers

1. Demand Schedule - shows the quantity and price of a good, which consumers are willing to buy, ceteris paribus.

  • Note - demand has a time unit!
  • Demand curve is a graph of the demand schedule.
Buyer's demand for coffee (per year)
Price
($ per pound)
Quantity demanded
(pounds)
$2.50 5
$2.00 10
$1.50 15
$1.00 20
$0.50 25

 

Buyer's Demand Curve
Price
A demand curve
Quantity
  • Law of Demand - as the market price increases, the quantity demanded for a good decreases, ceteris paribus.
    • The slope of the line
  • Why?
    1. Common sense
      • When products are expensive, people buy less
      • The principle behind business discounts
    2. Law of Diminishing Marginal Utility - consuming additional units of a good yield less and less additional utility i.e. satisfaction.
      • Example: Hypothetical case for pizza
        • utils are fictional units for satisfaction
      • 1st slice, a person receives 100 utils (lots of satisfaction), so he values it at $5 per slice.
      • 2nd slice, a person receives 20 utils (some gain in utility), so he values it at $3 per slice.
      • 3rd slice, a person receives 5 utils (very little gain in utility), so he values it at $1 per slice.
        • Total utility = 125 utils; total spent = $9 for 3 slices of pizza
    3. Composed of two effects.
      • Income effect - as a product's price decreases, a constant income buys more
        • Example: Monthly income is $1,000 and price of beef decreased
          • Income effect - you can buy more beef with fixed income
            • Real income increased
      • Substitution effect - as price of a product decreases, people start buying it and “substitute away” from more expensive, similar goods.
        • Price change affects consumer's behavior
      • Example: As the price decreases for Coca-Cola relative to Pepsi, people substitute Coke for Pepsi

2. Market Demand Function

  • Two people are in the market.
    • Each person has their demand function.
    • The quantity denoted by q is for a person, while Q is the total market quantity.
    • Likewise, demand by a consumer is denoted by d, while market demand is D.
    • Market demand - at each market price, horizontally sum the quantity that each consumer buys.

Deriving a market demand function

Changes in Demand Versus Changes in Quantity Demanded

1. "Change in Demand" - the demand curve shifts. Shift curves only "left" or "right." Do not think of shifting curves "up" or "down."
Demand decreases Demand increases
A decrease in demand An increase in demand

"Change in Quantity Demanded" - movement along the same demand curve, because the price changed.

Movement along Demand Curve
Movement along a demand function

2. Shifting the demand curve to the right; demand increases

  1. Income:
    1. Normal good - as income increases, people have more money, and buy more, ceteris paribus
      • Majority of goods
    2. Inferior good - as income decreases, people have less money and buy more inferior goods, ceteris paribus
      • Rice and Ramen Noodles
  2. Number of consumers increases
    • More people in the market to buy goods, ceteris paribus
  3. Price of other goods
    1. Substitute good's price increases
      • The price of DVD's increases, therefore, the demand increases for VCR tapes, ceteris paribus
    2. Complement good's price decreases
      • The price of DVD's decreases, therefore, the demand for DVD players increases, ceteris paribus
  4. Expectations - consumer expectations of future prices, future availability, or future income.
    • During 1999 people believed widespread water shortages would occur from Y2K. Thus, demand for water increased during 1999, ceteris paribus.
  5. Demographic changes - population of infants is greatly increasing, demand increases for baby goods, ceteris paribus.
  6. Changes in consumer tastes and preferences - for example, a report stated coffee reduced colon cancer, demand for coffee increases, ceteris paribus.
  7. Weather - if the summer is very hot, then people drink more Pepsi, ceteris paribus
Blue arrow If the opposite occurs, then the demand curves will shift left, i.e. decrease.

Supply - The Producers

1. Opportunity cost of production -all production costs are opportunity costs. The labor, machines, and other resources could produce other goods.

Profits = Total Revenue - Total Costs

  • Role of Profits and Losses
    • Profit: Total revenue > total cost
      • Consumer's value > resource value
      • Industry expands
    • Loss: Total revenue < total cost
      • Consumer's value < resource value
      • Industry contracts
      • Resources should be used to produce something else
  • Supply schedule - shows the quantity and price of a good that firms are willing to produce/sell, ceteris paribus. A supply curve is a graph of the supply schedule.
  • Law of Supply - as the good's price increases, then quality supplied increases, ceteris paribus.
  • Why?
    • As the price increases, the producers receive more revenue.
    • Note - as production increases, then production costs may increase. The higher price off-sets the additional production costs.
    • Note - the supply schedule has a time unit
Farmers' Supply of Tomatoes (per week)
Price
($ per pound)
Quantity supplied
(1,000 pounds)
$5 60
$4 50
$3 35
$2 20
$1 10

 

Supply Curve
Price
A supply curve
Quantity

2. The short-run market supply is the horizontal sum of the all firms' short-run supply curves. (Just like the demand curve). Market supply is derived from two firms below:

Deriving a market supply curve

 

Changes in Supply Versus Changes in Quantity Supplied

1. "Change in Supply" - entire supply curve shifts. Shift curves only "left" or "right." Do not think of shifting curves "up" or "down."

Supply increases Supply decreases
An increase in supply A decrease in supply

"Change in Quantity Supplied" - movement along the same supply curve in response to a price change.

Movement along Supply Curve
Movement along a supply curve

2. Shifting the supply curve to the right; supply increases.

  1. Resource prices
    • Labor wages or resource materials' price decreases, firms can supply more because of lower production costs
  2. Technological advances
    • Technology allows firms to produce more output, using the same levels of resources
  3. Nature and political disruptions
    • Favorable weather for growing crops, resolving wars, etc.
  4. Decrease in taxes or increase government subsidies
    • Decrease business cost and firms can provide more at each price
  5. Price of other goods
    • Price for corn increases, so non-corn farmers start growing corn
  6. Producer's expectations of future prices.
    • Firms expect sugar prices to be higher next year. Some firms hoard sugar now, and sell the supply of sugar for next year
  7. Number of sellers
    • More sellers in the market means more is produced
Blue arrow If the opposite occurs, then the supply curves will shift left, i.e. decrease.

How Market Prices Are Determined

  • Market - an institution that brings buyers and sellers together for specific goods and services.
    • Examples:
      • New York Stock Exchange - market for buyers and sellers of stock for well-known corporations
      • Foreign currency market
      • Commodity market
    • Assumption:
      • The markets are perfectly competitive, i.e. large number of independent buyers and sellers
      • No government intervention
      • Perfect knowledge of prices
  • Equilibrium - a state of rest; market price and quantity do not change
    • Equilibrium price - market price where the forces of supply and demand are equal
    • Equilibrium quantity - market quantity where the forces of supply and demand are equal
The Market for Potato Chips
A competitive market is stable
  • At $2, quantity supplied = quantity demanded:
    • Equilibrium price = $2
    • Equilibrium quantity = 10 units
  • At $3, quantity supplied > quantity demanded:
    • Surplus
    • Suppliers have to much product, so price falls until it equals $2
  • At $1 , quantity supplied < quantity demanded:
    • Shortage
    • Consumers demand more than what is in stock, so they bid prices up until it equals $2

How Markets Respond to Changes in Supply and Demand

Example 1

  • Price of chicken increases (Substitute)
  • Demand for beef increases (shifts right)
    • Consumers substitute beef for chicken
    • Equilibrium price and quantity increase
Beef Market
A demand increase in a market

Example 2

  • Scientists found Nutrasweet causes brain cancer (Tastes and Preferences)
  • Demand decreases (shifts left)
    • Equilibrium price and quantity decrease
Nutra-sweet
A demand decrease in a market

Example 3

  • Technological advances in making computer chips
  • Supply increase (shifts right)
    • "cheaper computer chips"
    • Equilibrium price decreases
    • Quantity increases
Computers
A supply increase in a market

Example 4

  • Labor unions are successful in raising workers' wages at car factories
  • Supply decreases (shifts left)
    • Production cost increase
    • Equilibrium price increases
    • Quantity decreases
Automobiles
A supply decrease in a market

 

Economics of Price Controls

Price controls - government mandated prices. Government thinks price is too high or too low.

1. Price ceilings - a legally established maximum price that sellers may charge.

  • Government thinks rent is too expensive.  The market price is P*, but the government sets maximum price at P~.
  • Rent control price < market rent:
    • Direct effect (When P* > P~).
      • Quantity demanded (Qd) > quantity supplied (Qs).
      • Shortage
    • Shortage does not disappear, because of the price control
Rental Market
Price, Rent
A government price control
Quantity, Tenants
  • Secondary effects of price ceilings.
    • Long waiting lists.
    • "Under the table" payments to landlord.
    • Buying expensive furniture from landlord.
    • The lower price (i.e. rent) causes investors to avoid investing in new housing.
    • The quality of housing will deteriorate.
      • Less maintenance and repairs, which lower costs.
Blue arrow If P~ > P*, then the price control has no effect on the market.

2. Price Floor - a legally established minimum price that buyers must pay.

  • Government thinks workers' wages are too low and set the minimum wage rate to $5.30 per hour (P~).
  • Employers demand workers, while employees supply labor.
    • Direct effect (When P~ > P*).
      • Quantity supplied (Qs) > quantity demanded (Qd).
      • Surplus
      • i.e. unemployment in this case
Labor Market (Unskilled workers)
Price
Government price control creates a surplus
Quantity
  • Secondary effects of price ceilings.
    • Employers reduce the following benefits.
      • Health insurance
      • Job training
      • Pension plans
    • Minimum wage usually hurts unskilled labor, the poor, and teenagers.
Blue arrow If P* > P~ , then the price control has no effect on the market, such as professional jobs which pay more than $5.30 per hour.

 

Black Markets

  • Black Market - markets that operate outside the legal system
    • Also called the hidden economy or underground economy
    • Illegal products and services
    • Avoid high taxes
    • Avoid costly regulations
    • Circumvent price controls
    • Decline in civic loyalty to government
  • Black markets have:
    • More defective products
    • Higher profits
    • Higher risk:
      • Arrests
      • Court fines and fees
      • Jail or prison sentence
      • Greater violence from enforcing contracts

Terminology

  • demand schedule
  • demand curve
  • law of demand
  • diminishing marginal utility
  • income effect
  • substitution effect
  • normal goods
  • inferior goods
  • substitute good
  • complement good
  • change in demand
  • change in quantity demanded
  • opportunity cost of production
  • supply schedule
  • law of supply
  • supply curve
  • change in supply
  • change in quantity supplied
  • market
  • equilbrium
  • equilibrium price
  • equilibrium quantity
  • price ceiling
  • shortage
  • price floor
  • surplus
  • black markets
 

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