Supply and Demand:

1
Supply and Demand An Introduction
2
What, How, and For Whom? Central Planning Versus
the Market

• Three Problems All Economic Systems Must Address
• What should be produced?
• How should it be produced?
• For whom will it be produced?

3
What, How, and For Whom? Central Planning Versus
the Market

• Centralized Economic Organizations
• Agrarian society
• Former Soviet Union
• Cuba
• North Korea
• China (?)

4
What, How, and For Whom? Central Planning Versus
the Market

• Free-Market or Capitalist Economic System
• Individual choices determine
• Which careers to pursue
• Which products to produce or buy
• When to start and shut-down a business
• Who gets what is decided by individual
  preferences and purchasing power

5
Buyers and Sellers In Markets

• Market
• Consists of all buyers and sellers of a good or
  service
• What do you think?
• What determines the price of pizza, gasoline, a
  car wash, or other goods and services?

6
Buyers and Sellers In Markets

• The Demand Curve
• A schedule or graph that tells us the quantity of
  a good that buyers wish to buy at each price

7
Buyers and Sellers In Markets

• A Property of Demand
• As price of a good or service goes down the
  quantity consumers wish to buy will increase
• Therefore, the demand curve is downward-sloping

8
The Daily DemandCurve for Pizza in Chicago
Price ( per slice)
Quantity (1000s of slices per day)
9
Buyers and Sellers In Markets

• The Demand Curve
• Why do buyers purchase a less quantity at higher
  prices and vice-versa?
• (or Why does the demand curve slope downward)?

10
Buyers and Sellers In Markets

• The Substitution Effect
• The change in the quantity demanded of a good
  that results because buyers switch to substitutes
  when the price of the good changes

11
Buyers and Sellers In Markets

• The Income Effect
• The change in the quantity demanded of a good
  that results because a change in the price of a
  good changes the buyers purchasing power

12
Buyers and Sellers In Markets

• The Cost-Benefit Principle
• The reservation price is the benefit the buyer
  receives from the good
• The cost of the good is its market price
• If the reservation price (benefit) exceeds the
  market price (cost) the consumer will purchase
  the good
• At higher prices, benefit will exceed cost for a
  smaller quantity than at lower prices

13
Buyers and Sellers In Markets
Price ( per slice)
Quantity (1000s of slices per day)
14
Buyers and Sellers In Markets
Horizontal Interpretation
Price ( per slice)
Price determines quantity demanded
4
3
2
Demand
8
12
16
15
Buyers and Sellers In Markets
Vertical Interpretation
Price ( per slice)
Quantity measures the marginal buyers
reservation price
4
3
2
Demand
8
12
16
16
Buyers and Sellers In Markets

• The Supply Curve
• A curve or schedule showing the quantity of a
  good that sellers wish to sell at each price

17
Buyers and Sellers In Markets

• Question
• Will the opportunity cost of producing additional
  units of pizza increase or decrease?
• HintLow-hanging-fruit principle

18
Buyers and Sellers In Markets

• The Supply Curve
• Sellers must receive a higher price to produce
  additional units of product to cover the higher
  opportunity costs of each additional unit

19
The Daily SupplyCurve for Pizza in Chicago
Price ( per slice)
Quantity (1000s of slices per day)
20
The Daily SupplyCurve for Pizza in Chicago
Horizontal Interpretation
Price ( per slice)
Supply
4
Shows the quantity produced for each price
3
2
Quantity (1000s of slices per day)
8
12
16
21
The Daily SupplyCurve for Pizza in Chicago
Vertical Interpretation
Price ( per slice)
Supply
4
Shows the marginal cost (reservation price) for
producing each additional unit
3
2
Quantity (1000s of slices per day)
8
12
16
22
The Daily SupplyCurve for Pizza in Chicago

• Sellers Reservation Price
• The smallest dollar amount for which a seller
  would be willing to sell an additional unit,
  generally equal to marginal cost

23
Market Equilibrium

• Equilibrium
• A system is in equilibrium when there is no
  tendency for it to change
• Market Equilibrium
• Occurs in a market when all buyers and sellers
  are satisfied with their respective quantities at
  the market price

24
The Equilibrium Price and Quantity of Pizza In
Chicago
Price ( per slice)
4
3
2
Quantity (1000s of slices per day)
8
12
16
25
Market Equilibrium

• Equilibrium Price and Equilibrium Quantity
• The values of price and quantity for which
  quantity supplied and quantity demanded are equal

26
Market Equilibrium

• What Do You Think?
• Would buyers prefer a lower price than the
  equilibrium price?
• Would sellers prefer a higher price than the
  equilibrium price?

27
Excess Supply
Price ( per slice)
4
3
2
Quantity (1000s of slices per day)
8
12
16
28
Excess Demand
Price ( per slice)
Supply
4
Excess demand 8,000 slices per day
3
2
Demand
Quantity (1000s of slices per day)
8
16
29
Points Along the Demand and Supply Curves of a
Pizza Market
30
Graphing Supply and Demand and Finding the
Equilibrium Price and Quantity
Price (per slice)
Supply
5
4
The Equilibrium Price 2.50 The Equilibrium
Quantity 5
3
2.50
2
1
Demand
Quantity (1000s of slices per day)
0
4
10
2
6
8
5
31
Market Equilibrium

• What Do You Think?
• Is the market equilibrium always an ideal outcome
  for all market participants?

32
An Unregulated Housing Market
Monthly Rent (/apartment)
Supply
What Do You Think? Is 1600 more than some people
can afford?
1,600
Demand
Quantity (Millions of apartments/day)
2
33
Rent Controls
Monthly Rent (/apartment)
Supply
2,400
Excess demand 2 million apartments per month
1,600
Controlled 800
Demand
Quantity (Millions of apartments/day)
1
0
2
3
34
Market Equilibrium

• Rent Controls Reconsidered
• Other consequences of rent controls
• Maintenance will decline and housing quality will
  fall
• Illegal payments
• Creation of co-ops and conversion to condominiums
• Reduction in household mobility
• Discrimination

35
Price Controls In The Pizza Market
Price ( per slice)
Supply
4
Excess demand 8,000 slices per day
3
Price ceiling 2
Demand
Quantity (1000s of slices per day)
8
12
16
36
Market Equilibrium

• Pizza Price Controls?
• Market responses to a pizza price ceiling
• Long lines
• Preferential treatment to selected customers
• Alternative pricing strategies
• Poorer quality ingredients
• Black-market pizzas

37
Predicting and Explaining Changes In Prices and
Quantities

• Distinguishing Between
• A change in the quantity demanded
• A movement along the demand curve that occurs in
  response to a change in price
• A change in demand
• A shift of the entire demand curve

38
An Increase In Quantity Demanded vs. An Increase
In Demand
Price (/can)
6
5
4
3
2
1
Quantity (1000s of cans/day)
0
4
12
2
10
6
8
39
An Increase In Quantity Demanded vs. An Increase
In Demand
Price (/can)
D
D
6
5
4
Increase in demand
3
2
D
1
D
Quantity (1000s of cans/day)
12
0
40
Predicting and Explaining Changes In Prices and
Quantities

• Change in the quantity supplied
• A movement along the supply curve that occurs in
  response to a change in price
• Change in supply
• A shift of the entire supply curve

41
An Increase In Quantity Supplied vs. An Increase
In Supplied
Price (/can)
6
5
4
3
2
1
Quantity (1000s of cans/day)
4
10
2
0
6
8
42
An Increase In Quantity Supplied vs. An Increase
In Supplied
Price (/can)
6
S
S
5
4
3
Increase in supply
2
1
S
S
Quantity (1000s of cans/day)
4
10
2
0
6
8
43
The Effect on the Market for TennisBalls of a
Decline in Court-Rental Fees
Price (/ball)
Quantity (letters/month)
44
Predicting and Explaining Changes In Prices and
Quantities

• Shifts in Demand
• Complements
• Two goods are complements in consumption if an
  increase (decrease) in the price of one cause a
  decrease (increase) in the demand for the other

45
The Effect on the Market for Overnight
LetterDelivery of a Decline in the Price of
Internet Access
Price (/letter)
Quantity (letters/month)
46
Predicting and Explaining Changes In Prices and
Quantities

• Shifts in Demand
• Substitutes
• Two goods are substitutes in consumption if an
  increase (decrease) in the price of one causes an
  increase (decrease) in the demand for the other

47
Predicting and Explaining Changes In Prices and
Quantities

• What do you think?
• How will a decline in airfares affect inter-city
  bus fares and the price of hotel rooms in resort
  communities?

48
Predicting and Explaining Changes In Prices and
Quantities

• Economic Naturalist
• When the Federal Government implements a large
  pay increase for its employees, why do rents for
  apartments near Washington Metro stations go up
  relative to rents for apartments located far away
  from Metro stations?

49
The Effect of a Federal Pay Raise on the Rent for
Conveniently Located Apartments in Washington D.C.
Rent (dollars per month)
Conveniently located apartments (units per month)
50
Predicting and Explaining Changes In Prices and
Quantities

• Shifts in Demand
• Changes In Demand
• An increase (decrease) in the demand for a good
  will shift the demand curve to the right (left)

51
Predicting and Explaining Changes In Prices and
Quantities

• A Change In Income
• Normal Good
• One whose demand increases (decreases) when the
  incomes of buyers increase (decrease)

52
Predicting and Explaining Changes In Prices and
Quantities

• A Change In Income
• Inferior Good
• One whose demand decreases (increases) when the
  incomes of buyers increase (decrease)

53
The Effect of the Release of JurassicPark on the
Market for Toy Dinosaurs
Price
S
P
D
Toy Dinosaurs (units per month)
Q
54
The Effect of a Credible Rumor onthe Market for
Apple Macintosh Computers
Price
S
P
D
Apple Computers (units per month)
Q
55
The Effect of the Increase inthe Population of
Potential Buyers
Price
S
P
D
Housing NY City (units per month)
Q
56
Predicting and Explaining Changes In Prices and
Demand

• Factors That Cause an Increase (rightward or
  upward shift) in Demand
• A decrease in the price of complements to the
  good or service
• An increase in the price of substitutes for the
  good or service
• An increase in income (for a normal good)

57
Predicting and Explaining Changes In Prices and
Demand

• Factors That Cause an Increase (rightward or
  upward shift) in Demand
• An increased preference by demanders for the good
  or service
• An increase in the population of potential buyers
• An expectation of higher prices in the future

58
The Effect on the Skateboard Market of an
Increase in the Price of Fiberglass
Price (/skateboard)
S
60
D
Quantity (skateboards/month)
1000
59
Predicting and Explaining Changes In Prices and
Quantities

• What Do You Think?
• Does the increase in the cost of fiberglass have
  any effect on the demand curve for skateboards?

60
The Effect on the Market for New Houses of a
Decline in Carpenters Wage Rates
Price (1000/house)
S
120
D
Quantity (houses/month)
40
61
The Effect of Technical Change on the Market for
the Term Paper Revisions
Price (/revision)
S
55
D
Quantity (millions of revisions per year)
12
62
Predicting and Explaining Changes In Prices and
Demand

• Factors That Cause an Increase (rightward or
  upward shift) in Supply
• A decrease in the cost of materials, labor, or
  other inputs used in the production of the good
  or service
• An improvement in technology that reduces the
  cost of producing the good or service

63
Predicting and Explaining Changes In Prices and
Demand

• Factors That Cause an Increase (rightward or
  upward shift) in Supply
• An improvement in the weather, especially for
  agricultural products
• An increase in the number of suppliers
• An expectation of lower prices in the future

64
Four Rules Governing the Effects of Supply And
Demand Shifts
An increase in demand will lead to an increase in
both the equilibrium price and quantity
Price
S
P
P
D
D
Quantity
Q
Q
65
Four Rules Governing the Effects of Supply And
Demand Shifts
A decrease in demand will lead to a decrease in
both the equilibrium price and quantity
Price
S
P
P
D
D
Quantity
Q
Q
66
Four Rules Governing the Effects of Supply And
Demand Shifts
An increase in supply will lead to a decrease in
the equilibrium price and an increase in the
equilibrium quantity
Price
S
S
P
P
D
Quantity
Q
Q
67
Four Rules Governing the Effects of Supply And
Demand Shifts
An decrease in supply will lead to an increase in
the equilibrium price and a decrease in the
equilibrium quantity
Price
S
S
P
P
D
Quantity
Q
Q
68
The Effects Of Simultaneous Shifts In Supply And
Demand
The Market for Corn Tortilla Chips
Price (/bag)
Millions of bags per month
69
The Effects Of Simultaneous Shifts In Supply And
Demand
The Market for Corn Tortilla Chips
Price (/bag)
S
P
D
Millions of bags per month
Q
70
Predicting and Explaining Changes In Prices and
Demand

• Assume
• A vitamin found in corn chips helps protect
  against cancer and heart diseases
• Swarm of locusts destroys part of the corn crop
• What Do You Think?
• What will happen to the equilibrium price and
  quantity of corn chips?

71
Predicting and Explaining Changes In Prices and
Demand

• Economic Naturalist
• Why do the prices of some goods, like airline
  tickets to Europe, go up during the months of
  heaviest consumption, while others, like sweet
  corn, go down?

72
Seasonal Variation in Air Travel
73
Seasonal Variation in Corn Markets
74
Markets And Social Welfare

• Cash On The Table
• Assume
• All exchange is purely voluntary
• If so
• The buyers reservation price exceeds the
  sellers reservation price and both the buyer and
  seller receive an economic surplus

75
Markets And Social Welfare

• Cash On The Table
• Buyers surplus
• The difference between the buyers reservation
  price and the price he or she actually pays

76
Markets And Social Welfare

• Cash On The Table
• Sellers surplus
• The difference between the price received by the
  seller and his or her reservation price

77
Markets And Social Welfare

• Cash On The Table
• Total surplus
• The difference between the buyers reservation
  price and the sellers reservation price

78
Markets And Social Welfare

• Cash On The Table
• Economic metaphor for unexploited gains from
  exchange

79
Price Controls In The Pizza Market
Price ( per slice)
Quantity (1000s of slices per day)
80
Price Controls In The Pizza Market
Excess demand 8,000 slices/day

• Assume price controls 2
• Quantity supplied falls to 8,000
• Buyers reservation price (4) is greater than
  sellers (2)
• Both would benefit from additional production
• There is CASH ON THE TABLE

Price ( per slice)
4
3
2
D
S
Quantity (1000s of slices per day)
8
12
16
81
Markets And Social Welfare

• Smart For One, Dumb For All
• Socially optimal quantity
• The quantity of a good that results in the
  maximum possible economic surplus from producing
  and consuming the good
• The socially optimal quantity occurs when MC MB

82
Markets And Social Welfare

• Smart For One, Dumb For All
• Economic efficiency occurs when all goods and
  services are produced and consumed at their
  respective socially optimal levels

83
Markets And Social Welfare

• Smart For One, Dumb For All
• The Efficiency Principle
• Maximize the economic surplus
• Increases the economic pie

84
Markets And Social Welfare

• Smart For One, Dumb For All
• When is the market equilibrium efficient?
• When all cost of producing the good or service
  are borne directly by the seller
• When all benefits from the good or service accrue
  directly to buyers

85
Markets And Social Welfare

• Smart For One, Dumb For All
• Inefficient market equilibrium
• When some costs of production fall on people
  other than those who sell the good or service

86
Markets And Social Welfare

• Example Pollution
• The market is in equilibrium MC MB
• MC however underestimates the cost to society of
  producing the good
• Therefore, the market produces more than the
  efficient amount and there is no incentive for
  producers and consumers to alter their behavior

87
Markets And Social Welfare

• Smart For One, Dumb For All
• Inefficient market equilibrium
• When some benefits from the good or service
  accrue to people who did not buy the good or
  service

88
Markets And Social Welfare

• Example Vaccinations
• The market is in equilibrium MC MB
• MB underestimates the benefits to society of
  consuming the vaccinations
• The market produces less than the efficient
  amount of vaccinations and there is no incentive
  for producers and consumers to alter their
  behavior

89
Markets And Social Welfare

• Smart For One, Dumb For All
• In these markets
• Buyers and sellers are behaving rationally
• Market equilibrium exists
• There are no unexploited opportunities for
  individuals
• Economic surplus is not maximized

90
Markets And Social Welfare

• The Equilibrium Principle
• A market in equilibrium leaves no unexploited
  opportunities for individuals, but may not
  exploit all gains achievable through collective
  action.

91
End of Chapter