Markets, Demand (D), Supply (S), and Market Prices

1
Markets, Demand (D), Supply (S), and Market
Prices
2
Objectives

• Upon completion of this unit, you should
  understand and be able to answer these key
  questions
• What are the basic decision-making units in the
  economy?
• What are the relationships between these basic
  units? How does a circular flow diagram
  illustrate these relationships?
• What do we mean by quantity demanded? What
  influences quantity demanded on the part of
  households?
• What is the demand schedule for a product? What
  are the main features of a demand curve? What is
  the law of demand and how is it illustrated by
  demand curves?
• What can change the demand for a product? How
  does the demand curve react to changes in demand?
  What do we mean by normal goods? Inferior
  goods? Complementary goods? Substitute goods?
• What is the law of supply? What influences the
  quantity supplied of a good? What are the
  features of a supply curve? How do supply curves
  illustrate the law of supply? What factors can
  cause the supply of a product to change and how
  are these changes reflected in the supply curve?
• What is the equilibrium price for a product?
  What do we mean by a shortage? A surplus?
• How do changes in the supply or demand for a
  product affect its equilibrium price and quantity?

3
Key Concepts

• Circular flow model and markets
• Demand (D)
• a. D schedule, D curve, movement along D curve,
  law of D
• b. Factors affecting D, shift of D curve
• c. Individual and market D
• d. Types of goods (normal, inferior, substitutes,
  complements)
• Supply (S)
• a. S schedule, S curve, movement along S curve,
  law of S
• b. Factors affecting S, shift of S curve
• c. Individual and market S
• Market interaction of SD
• Disequilibrium (excess demand, excess supply)
• Equilibrium equilibrium changes (due to shifts
  in D and/or S)
• Market and non market alternatives for allocating
  goods/services
• Price ceilings, price floors, taxes

4
Circular Flow Model

• This is a diagram that shows how 1) funds and 2)
  tangible items/services are exchanged between
  households and business firms. It simplifies the
  description of an economy down to two types of
  markets (input and output) and two types of
  decision makers (consumers and firms).

5
Question

• Suppose a cold winter shifts the D curve for oil
  to the right, while an oil-worker strike shifts
  the S curve of oil to the left. Will there be a
  shortage of oil in the market?

6
Question

• Many high school students in California are
  currently unable to get into one of the main
  public California universities (e.g. USC, UCLA)
  even though they are excellent students. What is
  the most logical economic explanation for this?

7
Question

• Your instructor often advises students to buy
  roses for their valentine the week before
  Valentines Day. Why?

8
Some S D Managerial Implications

• 1. Understand how Ps are determined in order to
  anticipate P changes and capitalize with
  strategies related to
• - buying
• - selling
• - producing
• - managing inventories
• - staffing
• - contracting
• 2. Understand how consumers and producers are
  likely to respond or be motivated by P changes
  (i.e. how economic activities are coordinated) in
  order to anticipate and capitalize on those
  expected responses.

9
Quote of the Day

• In this world, there are two ways to get rich
• 1. Produce something valuable and sell it to
  others.
• 2. Steal from those who are successful at
• pursuing the first strategy.
• N. Gregory Mankiw
• Fortune (June 12, 2000)

10
D Schedule

• a table showing the quantities (physical amount
  or units) of an item a buyer (or buyers) are
  willing to buy at different prices, ceteris
  paribus

11
Law of D

• D curves are downward sloping
• ?P and ?Qd are in opposite directions

12
Product Dimensions

• The economic concept of Demand pertains to a
  specific item where the following dimensions are
  specified
• The form (quality/type)
• The location
• The time

13
D Curve Types

• One consumer
• One firm (i.e. its customers)
• One market (i.e. all buyers in the market)

14
Question

• On a typical day, literally millions of
  hamburgers are purchased by individuals in the
  U.S. What factors influence the willingness and
  ability of these consumers to buy hamburgers?

15
Factors That Affect D for X

• 1. PX P of that product (or item) (note ?P
  could be caused by ? supply)
• 2. P and/or availability of another item (e.g. Y)
• a. Substitutes (?PY ? ? D for X)
• b. Complements (?PY ? ? D for X)
• 3. Income (I)
• a. Inferior (?I ? ?D for X)
• b. Normal (?I ? ?D for X)
• 4. Type of Item
• a. Luxury
• b. Necessity

16
Factors That Affect D for X

• Buyer concerns or expectations
• Safety
• Health
• Cost
• Advertising
• Tastes and preferences
• No. of buyers or alternative uses
• Govt. policy (e.g. tax)
• Seasonality
• Interest rates
• Profitability of an input derived demand

17
Change in Quantity Demanded of X(Due to ?PX
?P of THAT product)
PX
A to B Increase in quantity demanded
A
10
B
6
D0
Q
4
7
18
Change in Demand for X(Due to ? other than ?P
of THAT product)
D0 to D1 Increase in Demand
PX
6
D1
D0
Q
7
13
19
Graphical Impacts of D (for X) Factor s

• ?PX ? movement along the D curve for X (often
  called ? in quantity demanded)
• ? any other factor ? shift of the D curve for X
  (called ? in demand)
• Shift to right ? ? D

20
S Schedule

• a table showing the quantities (physical amount
  or units) of an item a seller (or sellers) are
  willing to sell at different prices, ceteris
  paribus.

21
S Curve

• a graph of a S schedule, normally with price
  (P) units on the vertical axis.

P
S
Q
22
Law of S

• S curves are upward sloping
• ?P and ?QS are in the same direction

23
Question

• In a typical year recently, U.S. farmers produce
  9-11 billion bushels of corn. What factors
  influence the willingness and ability of these
  producers to produce corn?

24
Factors that Affect S of X

• PX P of that product or item (note ?P could be
  caused ?D)
• P or profitability of an alternative production
  item (e.g. Y) (?PY ? ?S of X)
• P or cost of an input (e.g. Z) (PZ ? ?S of X)
• Taxes
• Interest rates

25
Factors that Affect S of X

• Govt policies/regulations
• Technology
• Producer expectations
• Weather
• Number of producers

26
Graphical Impacts of S (of X) Factor ?s

• ?PX ? movement along the S curve for X (Often
  called ? quantity supplied)
• ? any other factor ? shift of the S curve for X
  (often called ? in supply)
• Shift to right ? ?S

27
Change in Quantity Supplied of X (Due to ?P
?P of THAT product)
PX
S0
B
20
A
10
Q
5
10
28
Change in Supply of X(Due to ? other than?P of
THAT product)
PX
S0
S1
8
6
Q
7
5
29
Question

• What happens if a market price is either above
  or below the equilibrium value?

30
Equilibrium Price Price for which QD QS
P
(P0.01Q)
3.00
S
2.00
? equilibrium point
(P4-.01Q)
1.00
D
100
200
300
31
Disequilibrium price ? Prices for Qd ? QS
P
(P0.01Q)
Excess S
3.00
S
2.00
(P4-.01Q)
Excess D
1.00
D
Q
100
200
300
32
Solving for Equilibrium P Mathematically

• Set S equation for P D equation for P, and
  solve for equilibrium Q
• Plug equilibrium Q back into either the S
  equation or the D equation and solve for
  equilibrium P
• Example
• S equation P 0 .01Q
• D equation P 4 - .01Q
• 1) .01Q 4 - .01Q ? .02Q 4 ? Q 200
• 2) P 4 - .01Q ? P 4 - .01(200) ? P 2.00

33
Econ Quote of the Day

• Teach a parrot the terms supply and demand and
  youve got an economist.
• - Thomas Carlyle

34
Invisible Hand

• In markets, people pursue their own self
  interests by responding to price incentives.
• Adam Smith (Wealth of Nations, 1776) noted its
  almost as if individuals are being led by an
  invisible hand, and this self-regulating
  behavior actually promotes the best interests of
  society as a whole.

35
The Role of Market Prices (i.e. markets)

• To ration or allocate goods and services (and
  resources)
• (solving the basic production problems of what,
  how, and for whom in the process).

36
Equilibrium Changes Over Time
P
P
P
S1
S2
S3
D2
D1
D3
Q
Q
Q
T1
T3
T2
37
Comparative Statics Analysis

• Change one D factor that shifts the D curve
• Results in a change in P that results in a
  movement along a given S curve
• Change one S factor that shifts the S curve
• Results in a change in P that results in a
  movement along a given D curve

38
Equilibrium Changes
39
P Rationing Example 1

• S curve shifts to left (or D curve shifts to
  right)
• Excess demand (i.e. shortage) exists at original
  price
• Market P will rise to ration lower supply

40
Graph of Equilibrium Change, Case 1 (?DX)

• ? Shift of D curve for X to right caused by ?D
  factor other than ?PX causes ?PX which causes ?QS
  (movement along S curve)

PX
S1
P2
P1
D2
D1
QX
41
Graph of Equilibrium ChangeCase 6 (?DX, ?SX)
PX
S2
S1
P2
P1
D2
D1
QX
42
Graph of Equilibrium ChangeCase 4 (?SX)

• Shift of S curve of X to left caused by ?S
  factor other than ?PX causes ?PX which causes ?Qd
  (movement along D curve)

PX
S2
S1
P2
P1
D1
QX
43
Favorite Trading Rules

• The reaction of the market to news is more
  important than the news itself.
• People who buy headlines end up selling
  newspapers.
• Facts are priceless opinions are worthless.
• Rich Felthaus, Refco, July 2004

44
Question

• Do the laws of S and D work to determine the
  price of an item if there is only ONE unit of
  that item to be sold?

45
P Rationing Example 2

• Extremely limited supply (e.g. QS 1)
• P is D determined
• P will rise until there is only 1 willing buyer

46
Buy land. Theyve stopped making it. (Mark
Twain)
S
P
Q (land)
47
P Rationing Example 3 (resources)

• Suppose the demand for a product increases.
• More profits to produce that product
• Profits encourage firms to buy more capital,
  labor, etc.
• Input prices influence what specific resources
  are used

48
Question

• Should the state of Iowa put a cap on college
  tuition increases to make a University education
  more affordable to everyone?

49
P Constraint Example 1 P Ceiling

• P Ceiling max P sellers can charge (below
  equilibrium P) usually set by Govt
• Examples gasoline (1970s), interest rates,
  rental rates, ATM fees
• Arguments for P gouging is bad, not fair or
  right to charge exorbitant Ps, everyone should
  be able to buy necessities at reasonable prices

50
P Constraint Example 1 P Ceiling (contd)

• Problem Excess D still exists ? need to
  implement alternative rationing mechanisms such
  as
• Queuing ? waiting in line
• Favored customers ? let sellers decide
• Issuing ration tickets or coupons

51
Hidden costs or problems with non-P rationing
mechanisms

• Queuing cost of waiting in line
• Favored customers bribes, hidden service
  charges
• Ration coupons often end up being bought/sold
  legally or illegally (black market)
• General discourages both producers and
  consumers from making needed S and/or D
  adjustments

52
P Constraint Example 2 P Floor

• P floor min. P buyers must pay (above
  equilibrium P)
• Examples minimum wage, ag P supports
• Arguments for needed to keep producers in
  business, to generate fair income levels
• Problem excess S will be created (? e.g.
  surplus production, unemployment, etc.)

53
P Constraint Example 3 Import Fee

• Fee tax on imports
• Impacts
• ? P to U.S. consumers ? ? Qd in U.S.
• ? QS in U.S.
• ? Q of imports
• ? Govt revenue

54
P Constraint example 4 (per unit tax on buyers)

Pw/o
t
Pw
D1(w/o tax)
D2 (w/tax)
Q1
Q

• To buy Q1 initially, buyers willing to pay Pw/o.
  After tax, buyers willing to pay Pw to keep the
  same total cost per unit.
• gt Tax causes D curve to shift left (or down by
  amt of t)

55
Question

• Is there any product or service you currently buy
  that you consider to be a really good deal for
  the money?

56
Consumer Surplus

• Amount willing to pay (value)
• Amount have to pay (cost)
• ___________________________
• consumer surplus

57
Consumer Surplus (graphically)
area under the D curve and above the price line
CS ½ Q1 (a-P1)
P
a
CS
P1
D
Cost
Q
Q1
58
Producer Surplus

• Amount paid to sellers
• Amount willing to sell for (cost)
• __________________________
• producer surplus

59
Producer Surplus (graphically)
area above the S curve and under the price line
PS ½ Q1 (P1 a)
P
S
p1
PS
Cost
a
Q
Q1
60
Economic Impacts of Deviations Away from
Equilibrium

• CS consumer surplus
• PS producer surplus
• __________________________________
• NSW (net social welfare)

61
Market Equilibrium NSW
P
S
NSW net social welfare
CS
Pe
PS CS
PS
Max NSW ? P Pe
D
Q
Qe
62
NSW Impacts ?Q ?P
P
S
CS
P2
a
b
Pe
c
PS
D
Q
Q2
Q1

• ?NSW ? net social welfare
• ?PS ?CS
• (a-c) (-a-b)
• -c-b
• net welfare loss (deadweight loss)