Supply and Demand Basics

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1 Supply and Demand Basics I. Demand A. Demand is a schedule that shows the various amounts of a product consumers are willing and able to buy at each specific price in a series of possible prices during a specified time period. A demand curve is the graphic depiction of this schedule. - The companion text does not fully explain that the market demand schedule/curve is a compilation of individual demand schedules/curves. Therefore, overall demand for a good or service is known as market demand. B. Law of Demand: Other things being equal, as price increases, the corresponding quantity demanded falls. In short: P QD This represents a movement along the schedule/curve. As represented by the movement from Q1 to Q2. Market for Oreos There are three reasons for this phenomenon. The companion book only talks about the first two. However, the third is important in order to tie in marginal analysis and better understand the slope of the cure in relation to tastes and preferences: 1. Income effect: A higher price decreases the purchasing power of money income enabling the consumer to buy less at a higher price (or more at a higher price). In essence, people will feel poorer as the prices increases. This can be interpreted as a decline in their real income.

2 2. Substitution effect: A higher price gives an incentive to substitute another lower priced good for the now relatively higher priced good. Therefore buyers will then purchase substitutes that are cheaper (in this case buying fewer bags of Oreos and more Chips Ahoy). 3. Diminishing marginal utility: The decrease in added satisfaction that results as one consumes additional units of a good or service, i.e., the second bag of Oreos yields less extra satisfaction (or utility) than the first. A note on curves: They can be straight and are drawn so in most textbooks (see Glanville and above). Later on we will see them as being elastic and inelastic and they will be straight in those cases as well. C. Determinants of Demand: the other things, besides price, which can affect demand. Changes in determinants cause changes in demand. In other words: Determinant Demand or a in the Demand curve, from D to D1. Market for Oreos 1. Tastes and preferences: The companion mentions marketing as a means of changing tastes. However, it is possible for other means to impact demand. Word of mouth/peer pressure or medical research are also examples through which tastes can be shaped. 2. Income: more leads to an increase in demand, less to a decrease in demand for normal goods. There are some exceptions here: a. There can be goods whose demand varies inversely with income which are called inferior goods. b. Giffen goods are the exception. As the income of poor may not rise, but as the price of staples (say rice) falls, they treat the leftover

3 resources as new income and will buy more expensive food such as pork (in China). 3. Number and prices of related goods also affect demand. This is separated out into two categories. It would be easier to keep them in one as they are themselves related. a. Substitute goods: The price of the substitute good and demand for the other good are directly related. Also, if the quantity of substitutes increases, then demand will drop for Oreos. If the price of Oreos rises, demand for Chips Ahoy should increase. b. Complementary goods: When goods are complements, there is an inverse relationship between the price of one and the demand for another. If the price of milk goes up, then the demand for Oreos will go down. 4. Number of buyers: More buyers (increase in population) will increase demand. Conversely, fewer buyers (decrease in population) will decrease demand. 5. Expectations: Consumer views about future prices, product availability, and income can shift demand! Even weather can factor into the decision!!!!!

4 II. Supply A. Supply is a schedule that shows the various amounts of a product producers are willing and able to produce and sell at each specific price in a series of possible prices during a specified time period. A supply curve is the graphic depiction of this schedule. - The companion text does not differentiate by explaining that the market supply schedule/curve is a compilation of individual supply schedules/curves. Therefore, overall supply for a good or service is known as market supply, which is the aggregation of the individual supply schedules. B. Law of Supply: Producers will produce and sell more of their product at a high price than at a low price. Restated: there is a direct relationship between price and quantity supplied. In short: P QS This represents a movement along the schedule/curve. As represented by the movement from Q1 to Q2. Market for Oreos There are several reasons for this. Again, the companion text is a little less distinctive about the explanations for the relationship between P and QS. 1. Given product costs, a higher price means greater profits and thus an incentive to increase the quantity supplied. We can extend this by explaining that firms may switch from producing another, less profitable, good in order to increase production of the good who s price is increasing. For example, Nabisco would switch from making Chips Ahoy to Oreos. 2. As firms supply more, they are likely to find that beyond a certain level of output costs rise more and more rapidly. Consequently they have to be able to charge higher prices to be persuaded to produce extra output. While this is one explanation, it needs to be thought of in the context of

diminishing returns. This may not be efficient. Moreover, while they may be asking for a higher price, they may be the least efficient producer. This might be indicative of a flawed factor input mix.

5 diminishing returns. This may not be efficient. Moreover, while they may be asking for a higher price, they may be the least efficient producer. This might be indicative of a flawed factor input mix. 3. Finally, there is the long term. Over time, if the price of a good stays high, new producers will be encouraged to enter the market, thereby increasing overall market supply. This usually addressed in the section of determinants of supply as it will actually shift the curve. Remember the duck example from class. However, these latecomers are usually the least efficient producers. More later on this in the theory of the firm and trade. A note on curves: They can be horizontal or vertical as well as downward sloping. This will be a topic of discussion of the theory of the firm. Later on we will see them as being elastic and inelastic and they will be straight in those cases as well. C. Determinants of Supply: the other things, besides price, which can affect supply. Changes in determinants cause changes in supply. In other words: from S to S1. Determinant Supply or a in the Supply curve, 1. Resource prices: A rise in resource prices will cause a decrease in supply or leftward shift in supply curve. A decrease in resource prices will cause an increase in supply or a rightward shift in the supply curve. Examples of resource costs would be wages, raw materials, rents, and interest rates. 2. Technological change: A technological improvement means more efficient production and lower costs, so an increase in supply or a rightward shift in the curve results. This is a fascinating area for investigation. 3. Government actions: This refers primarily to taxes (increase costs), which reduces supply and subsidies that lower production costs and increase supply.

6 This can also include regulations which can increase production costs and decrease supply. 4. Prices of related goods: If price of substitute production good rises, producers might shift production toward the higher priced good, causing a decrease in supply of the original good. In the case of a jointly produced or complementary good, if the price of beef goes up, then the supply of hides (therefore leather) will increase. 5. Expectations: Expectations about the future price of a product can cause producers to increase or decrease current supply. If coffee growers anticipate a rise in the price of coffee, they will endeavor to plant more trees. 6. Nature, random shocks and other unpredictable events: Glanville finally gets his day!!! Yes, weather and unpredictable events can shift a supply curve. However, depending on the good/service this can be a temporary phenomenon and, arguably, more local than global. Wars or terrorist attacks can be examples of man made events that can disrupt supply. A final note on Company behavior. He suggests that the aims of producers will shift the curve. This is really a matter of debate as it relates to decisions made by a firm. Companies make these decisions based on many different reasons. Therefore we will always make the assumption that firms will act to maximize their profits.

7 III. Practice: Here are some application problems: 1. The following figures are the assumed supply and demand schedules for rugby balls in Accra, Ghana: Price Q. demanded (p.a.) Price Q. supplied (p.a.) , , , , , , , , , a. Plot supply and demand curves and indicate the equilibrium price and quantity. b. What effect will an increase in the price of leather have on the equilibrium price and quantity of rugby balls, assuming all other things remain constant (Use a diagram to illustrate). c. What effect will a decrease in the price of American footballs have on the equilibrium price and quantity of rugby balls assuming all other things are held constant (Use a diagram to illustrate)?

8 2. Define equilibrium as it relates to markets. Describe the process by which a market reaches a new equilibrium. Include an appropriate diagram. 3. The demand for mobiles and home computers has increased yet the price has fallen. Explain this paradox.

9 4. Consumers expressed outrage at the high price of snow shovels after the recent snowstorm in Washington, DC, with newspaper editorials accusing suppliers of unconscionable price gouging. Use a supply and demand graph to assist in explaining the increase in the price of snow shovels after the recent snowstorm.

10 5. The following figures are the assumed supply and demand schedules for haircuts in Bia Xin village of the Shunyi District outside of Beijing, China: Price Quantity Demanded Quantity Supplied ( ) (Thousands of units) (Thousands of units) a) Draw the demand and supply curves from the data in the table above. b) What is the equilibrium quantity demanded and supplied? 1. Will there be a glut or a shortage in the market if the price is 33? Will there be a glut or a shortage in the market if the price is 38? 2. Draw new supply curves assuming that quantity supplied at any given price: a. Increased by 10 units. b. Halved

Ch. 3 LECTURE NOTES Markets II. Demand

Ch. 3 LECTURE NOTES Markets II. Demand Ch. 3 LECTURE NOTES I. Markets A. A market, as introduced in Chapter 2, is an institution or mechanism that brings together buyers (demanders) and sellers (suppliers) of particular goods and services.