Review - Supply and Demand
Lecture 2

 

Demand - The Consumers

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

  • Note - demand has a time unit!
  • Marshallian Demand Curve is a graph of the demand schedule
Buyer's demand for restraurants (per year)
Price
($ per meal)
Quantity demanded
(number of meals per week)
$7.50 5
$5.00 10
$2.50 15
$1.00 20
$0.50 25

 

Buyers' Demand Curve
Price
A graph of 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 is negative
    • Note - demand for a Giffin good has a positive slope
  • 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.
        • Example: As the price decreases for Coca-Cola relative to Pepsi, people substitute Coke for Pepsi
        • Price change affects consumer's behavior
      • Income effect plays an important role in the three welfare measures
        • Marshallian demand function (measurable)
        • Hicksian demand function (theoretical)

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 the market demand function from individual demand functions

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
Demand decreases Demand increases

"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. Disposble income - consumer income remaining after paying payroll taxes
    1. Normal good - as income increases, people have more money, and buy more, ceteris paribus
      • Majority of goods, including tourism
    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 - price increases
      • The price of DVD's increases, therefore, the demand increases for VCR tapes, ceteris paribus
    2. Complement good - 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. Tastes and preferences - for example, a report stated coffee reduced colon cancer, demand for coffee increases, ceteris paribus.
    • Fashion - some places like Greece and Florida fall in and out of vogue
    • Advertising - can have a big impact; The Learning Channel (TLC) has numerous travel shows
    • Quality - differences in restruarants, hotels, vacation packages, etc.
  6. Weather - if the summer is very hot, then people drink more Pepsi, ceteris paribus
  7. Opportunity for leisure
Blue arrow If the opposite occurs, then the demand curves will shift left, i.e. decrease.

Supply - The Producers

1. Supply schedule - shows the quantity and price of a good that firms are willing to produce/sell, ceteris paribus.

  • Supply curve - 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
Supply of Hotel Rooms (per week)
Price
($ per room)
Quantity Supplied
(number of rooms)
$50 100
$40 80
$30 60
$20 40
$10 20

 

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 the maket supply curve from two firms

 

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
The supply curve increases The supply curve decreases

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

Movement along Supply Curve
Moving along a demand 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 Cruise Vacation
Equilibrium market price
  • At $1,000, quantity supplied = quantity demanded:
    • Equilibrium price = $1,000
    • Equilibrium quantity = 10 (thousand) units
  • At $1,500, quantity supplied > quantity demanded:
    • Surplus
    • Suppliers have to much product, so price falls until it equals $1,000
  • At $500 , quantity supplied < quantity demanded:
    • Shortage
    • Consumers demand more than what is in stock, so they bid prices up until it equals $1,000

How Markets Respond to Changes in Supply and Demand

Example 1

  • Market - Vacation in Cancun
  • Travel agents increase the price for vacation packages for Los Cabos
  • Substitutes- Los Cabos is located in western Mexico, while Cancun is in eastern Mexico
  • Demand for Cancun vacation packages increases (shifts right)
    • Travelers vacation more in Cancun
    • Equilibrium price and quantity increase
Vacation in Cancun
Market demand increases

Example 2

  • Violence and protests erupt in Egypt
  • Tastes and Preferences - travellers are concerned for their safety
  • Demand decreases (shifts left)
    • Less travellers vacation in Egypt
    • Equilibrium price and quantity decrease
Vacation in Egypt
Market demand decreases

Example 3

  • Peace and political stability returns to Egypt
  • Business climate becomes favorable to businesses again
  • Supply increase (shifts right)
    • Equilibrium price decreases
    • Quantity increases
Vacation in Egypt
Market supply increases

Example 4

  • Thailand increases a tax on all hotels and restraurants
  • Hotels and restraurants increase their prices
  • Supply decreases (shifts left)
    • Business cost increase
    • Equilibrium price increases
    • Quantity decreases
Vacation in Thailand
Market supply decreases

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

  • Marshallian demand schedule
  • Marshallian 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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