Demand, Supply, and the Market Process
Lecture 4

 

Demand - The Consumers

 

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

Ceteris paribus is a Latin term that means we keep all other factors constant. Only the price changes, so we can determine the impact on quantity demanded.

 

Market Demand for Tea
(per year)
Price
($ per pound)
Quantity demanded
(1,000 kilograms)
$2.50 5
$2.00 10
$1.50 15
$1.00 20
$0.50 25
 
Market Demand for Tea
Price
The demand curve
Quantity (1,000 kilograms)
  • Law of Demand - as the market price increases, the quantity demanded for a good decreases, ceteris paribus.
    • The demand curve has a negative slope.
    • Price and quantity move in opposite directions.
  • 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.
      • 1st Pepsi, a person receives 100 utils (lots of satisfaction), so he values it at $1 per bottle.
      • 2nd bottle, a person receives 20 utils (some gain in utility), so he values it at $0.75 per bottle.
      • 3rd bottle, a person receives 5 utils (very little gain in utility), so he values it at $0.25 per bottle.
        • Total utility = 125 utils; total spent = $2
    3. Composed of two effects.
      • Income effect - as a product's price decreases, a constant income buys more.
        • Real income increases.
        • Example: Monthly income $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. Consumer Surplus - the area below the demand curve but above the actual price paid.
    • Measure of social welfare.
    • An aggregate benefit to all consumers in the market.
  • The market price of tea is $1.50 and consumers buy 15 (thousand) kilograms.
    • I place a $2.50 value on this game, but bought it for $1.50.
    • I received a benefit of $1.00.
  • If the market price of tea decreases to $0.50, consumers' surplus increases!
    • Social welfare increases for consumers.
    • The red area is consumers' surplus.
 
Demand for Tea Demand for Tea
Price Price
Consumers' surplus Consumers' surplus
Quantity (in thousands) Quantity (in thousands)
3. Elasticity
  • Elastic Demand Curves - quantity demanded is sensitive to price changes.
    • Demand curves are relatively flat.
    • Many substitutes.
    • Large income effect.
    • Example: Air travel.
  • Inelastic Demand Curves - quantity demanded is not sensitive to price changes.
    • Demand curves are relatively steep.
    • Few substitutes.
    • Small income effect.
    • Examples: Alcohol, cigarettes, and gasoline.
 
Elastic Demand Curve Inelastic Demand Curve
Price Price
An elastic demand function An inelastic demand function
Quantity Demanded Quantity Demanded

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 curve
2. Shifting the demand curve to the right; demand increases.
  1. Income:
    • Normal good - as income increases, people have more money, and buy more, ceteris paribus.
      • Majority of goods.
    • 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 consumers in the market, the more they buy, ceteris paribus.
  3. Price of other goods.
    • Substitute good's price increases.
      • The price of chicken increases, therefore, the demand increases for beef, ceteris paribus.
      • Consumer's substitute away from the more expensive good.
    • 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.
    • If people believe tea will become more expensive, then people buy more tea to "stock up," causing the tea price to increase, ceteris paribus.
  5. Demographic changes - the average age in the U.S. is increasing, thus, older people increase their demand for health care, 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 soft drinks, ceteris paribus.
Blue arrow If the opposite occurs, then the demand curves will shift left, i.e. decrease.

Supply - The Producers and Sellers

 

1. Supply schedule- shows the quantity and price of a good that producers and sellers are willing to produce or sell, ceteris paribus.
  • Law of Supply - as the good's price increases, then quality supplied increases, ceteris paribus.
    • Supply curves have a positive slope.
    • Why?
      • As the price increases, the producers have an incentive to supply more goods.
      • Note - as production increases, then production costs may also increase. The higher market price off-sets the additional production costs.
 
Producers' Supply of Tomatoes (per week)
Price
($ per pound)
Quantity supplied
(1,000 kilograms)
$5 100
$4 80
$3 60
$2 40
$1 20

 

Supply Function
Price
A supply curve
Quantity (1,000 kilograms)
2. Producer Surplus - the area above the supply curve but below the actual sales price.
  • Measure of social welfare.
  • An aggregate benefit to all producers in the market.
  • Some producers can supply tomatoes to the market for a price lower than $3.00
    • These producers benefit and reflected in producers' surplus
  • Equals total fixed costs + profits
  • The light purple area on the graph.
Supply for Tomatoes
Price
Producers' surplus
Quantity (in thousands)
3. Elasticity
  • Elastic Supply Curves - quantity supplied is sensitive to price changes.
    • Supply curves are relatively flat.
    • Firms have time to change plant size, invest in machines and equipment.
    • This is the long run.
  • Inelastic Supply Curves - quantity supplied is not sensitive to price changes.
    • Supply curves are relatively steep.
    • Firms do not have enough time to change plant size or invests in new equipment.
    • This is the short run.
  • Ex: The price of computer chips increases.
    • Short-run - If Intel is operating below production capacity, then Intel can increase production of chips more labor and resources.
    • Long-run.- If Intel believes the price increase is permanent, Intel can build a new factory to produce chips.
Elastic Supply Curve Inelastic Supply Curve
Price Price
An elastic supply curve An inelastic supply function
Quantity Supplied Quantity Supplied

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
A movement along a supply function
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, ceteris paribus.
  2. Technological advances.
    • Technology allows firms to produce more output, using the same amount of resource inputs, ceteris paribus.
  3. Nature and political disruptions.
    • Favorable weather for growing crops, resolving wars, etc, ceteris paribus.
  4. Gov. decreases taxes or increases subsidies.
    • Decrease business cost and firms can provide more at each price.
  5. Gov. decreases regulations
    • Compliance costs - Firms have specialists who write government reports and ensure employees follow regulations.
      • Also includes investment into machines and equipment to comply with regulations.
      • Example - Electric power companies have to lower air pollution by investing in machines that lower pollution from smoke stacks.
  6. Price of other goods.
    • Price for corn increases, so soybean farmers start growing corn, ceteris paribus.
  7. Producer's expectations of future prices.
    • Firms expect sugar prices to be lower next year. Some firms quickly sell this sugar this year, which increases the supply for this year.
  8. 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.
  • Equilibrium - a state of rest; model does not change.
 
The Market for Cookies
Supply and demand
  • At $2, quantity supplied = quantity demanded:
    • Equilibrium price = $2.
    • Equilibrium quantity = 10 units.
  • At $3, quantity supplied > quantity demanded:
    • Surplus
    • Suppliers are producing too 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

 

Beef Market Soft Drink Market
The demand function increases The demand function decreases
  • Price of chicken increases (Substitute).
  • Demand for beef increases (shifts right).
    • Consumers substitute beef for chicken.
    • Both equilibrium price and quantity increase.
  • Consumers experience an unusual cold summer (Weather).
  • Demand decreases (shifts left).
    • Both equilibrium price and quantity decrease.
Computer Market Automobile Market
The supply increases The supply function decreases
  • Technological advances in making computer chips (Technology).
  • Supply increase (shifts right).
    • "cheaper computer chips."
    • Equilibrium price decreases
    • Equilibrium quantity increases.
  • Labor unions are successful in raising workers' wages at car factories.
  • Supply decreases (shifts left).
    • Production cost increase.
    • Equilibrium price increases.
    • Equilibrium quantity decreases.

 

When Two or More Factors Change

  • Do not worry about the graphs!
    • If two factors change, then either the change in market price or market quantity is known while the other is indeterminate.

Invisible Hand Principle - Adam Smith

 

  1. Invisible Hand - market prices direct individuals pursuing their own self-interest into productive activities that also promote the economic well-being of society.
    • Ex: A medical doctor pursuing self-interest to become rich.
      • He cures people.
      • The people remain productive.
      • Society is better off!
  2. Firms' interest is to earn profits
    • Profits = Total Revenue - Total Costs
    • Profit > 0     F Total revenue > total cost
      • Consumer's value > resource value
      • Industry expands
    • Loss < 0     F  Total revenue < total cost.
      • Consumer's value < resource value
      • Industry contracts
      • Resources should be used to produce something else
  3. Prices communicate information.
    • "Brings buyers and sellers into harmony."
    • Example: There is a surplus of apples. Sellers will lower price until all surplus apples are sold (firms' profits may decrease)
    • Example: There is a shortage of apples. Sellers will raise the price until shortage disappears (firms' profits may increase).
  4. Market prices affect millions of consumers and producers around the world.
    • Impossible for government to set prices correctly.
    • Shortages are common in Socialist countries.
  5. Market efficiency depends on:
    • Competitive markets.
    • Well-defined private property rights.
  6. Social Welfare is highest = Consumers' surplus + producers' surplus.
 

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