Chapter 2 Market forces: Demand and Supply Demand

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1 Chapter 2 Market forces: Demand and Supply Demand Market demand curve A curve indicating the total quantity of a good all consumers are willing and able to purchase at each possible price, holding the prices of related goods, income, advertising, and other variables constant. Demand shifters Variables other than the price of a good that influence demand are known as demand shifters. For a demand curve, the movement along the demand curve is called change in quantity demanded. Whenever advertising, income, or the price of related goods changes, it leads to a change in demand; the position of the entire demand curve shifts. A rightward shift in demand curve is called an increase in demand, since more of the good is demanded at each price. A leftward shift in the demand curve is called a decrease in demand. Income Whether an increase in income shifts the demand curve to the right or to the left depends on the nature of consumer consumption patterns. Accordingly, economists distinguish between two types of good: normal and inferior goods. A good whose demand increases when consumer incomes rise is called a normal good. Changes in income tend to have profound effects on the demand for durable goods, and these effects are typically amplified in developing countries and rural areas. Inferior good is a case of a increase in income reduces the demand for a good. Example like Bologna, bus travel, and generic jeans are inferior goods. Price of related goods

2 Substitutes: Goods for which an increase (decrease) in the price of one good leads to an increase (decrease) in the demand for the other good. Like Coke and Pepsi. Substitutes need not serve the same function; for example, automobiles and housing could be substitutes. Complements: Goods for which an increase (decrease) in the price of one good leads to decrease (increase) in the demand of the other good. Advertising and consumer tastes Advertising often provides consumers with information about the existence or quality of a product, which in turn induces more consumers to buy the product. These types of advertising message are known as informative advertising. Advertising can also influence demand by altering the underlying tastes of consumers. For example, advertising that promotes the latest fad in clothing may increase the demand for a specific fashion item by making consumers perceive it as the thing to buy. These types of advertising message are known as persuasive advertising. Population The demand for a product is also influenced by changes in the size and composition of the population. Generally, as the population rises, more and more individuals wish to buy a given product. Consumer Expectations If consumers expect future prices to be higher, they will substitute current purchase for future purchases. This behavior is called stockpiling and generally occurs when products are durable in nature. The current demand for a perishable product such as bananas generally is not affected by expectations of higher future prices. Other Factors Health scare-cigarette; baby birth-diapers The demand function

3 Demand function: a function that describes the how much of a good will be purchased at alternative prices of that good and related goods, alternative income levels, and alternative values of other variables affecting demand. Linear demand function: It is a representation of the demand function in which the demand for a given good is a linear function of prices, income levels, and other variables influencing demand. Consumer surplus It is the value consumers get from a good but do not have to pay for. More generally, consumer surplus is the area above the price paid for a good but below the demand curve. The problem 2-2 is a good example in illustrating this. Supply Market supply curve A curve indicating the total quantity of a good that all producers in a competitive market would produce at each price, holding input prices, technology, and other variables affecting supply constant. Changes in the price of a good lead to a change in quantity supplied of that good. This corresponds to a movement along a given supply curve. Supply shifters Variables that affect the position of the supply curve are called supply shifters, and they include the prices of inputs, the level of technology, the number of firms in the market, taxes, and producer expectations; changes in these variables will make supply curve shift, and these shifts are called change in supply. Input price As the price of an input rises, producers are willing to produce less output at each given price. Technology or government regulations

4 Changes that make it possible to produce a given output at a lower cost have the effect of increasing supply. Conversely, natural disasters that destroys existing technology and government regulations, such as emissions standards that have an adverse effect on businesses. Number of firms The relationship between number of firms and supply curve is positive related. Substitutes in production Taxes An excise tax has the effect of decreasing the supply of a good. Excise tax is a tax on each unit of output sold, where the tax revenue is collected from the supplier. Ad valorem tax literally means according to the value. An ad valorem tax is a percentage tax; it will be higher for high-priced items. Producer expectations Selling a unit of output today and selling a unit of output tomorrow are substitute in production. If firms expect prices to be higher in the future and the product is not perishable, producers can hold back output today and sell it later at a higher price. This will shift the current supply curve to the left. The supply function It describes how much of a good will be produced at alternative prices of the good, alternative prices of inputs, and alternative values of other variables that affect supply. The graphic supply curve reveals how much producers must receive to be willing to produce each additional unit of good. Producer surplus it is the amount of money producers receive in excess of the amount necessary to induce them to produce the good.

5 Geometrically, producer surplus is the area above the supply curve but below the market price of the good. Market Equilibrium Competitive market equilibrium Equilibrium in a competitive market is determined by the intersection of the maeket demand and supply curves. The equilibrium price is the price that equates quantity demanded with quantity supplied. Market restrictions and market equilibrium Price ceilings It is the maximum legal price that can be charged in a market. The result is that there is not enough of the good to satisfy all consumers willing and able to purchase it at the price ceiling. Price ceiling discriminate against people who have a high opportunity cost of time and do not like to wait in lines. Full economic price: the dollar amount paid to a firm under a price ceiling, plus the nonpecuniary price. Reference is on page 55 in text. Since price ceilings reduce the quantity available in the market, such regulations reduce social welfare even if they do not result in long lines. Each point on the demand curve represents the amount consumers would be willing to pay for an additional unit, while each point on the supply curve indicates the amount producers would have to receive to induce them to sell an additional unit. The vertical difference between the demand and supply curves at each quantity therefore represents the change in social welfare (consumer value less relevant production costs) associated with each incremental unit of output. The key point is that in the presence of a shortage created by a ceiling, managers must use some method other than price to allocate the goods. Depending on which method is used, some consumers will benefit and others will be worse off.

6 Price Floors It is the minimum legal price that can be charged in a market. Like minimum wage. The result is buyers end up paying a higher price and purchasing fewer units. More reference is on page 59 in text. Comparative statics The study of the movement from one equilibrium to another is known as comparative static analysis. Change in demand The point is to understand the figure on page 61 in text. Change in supply Simultaneous shifts in supply and demand In the case of supply decrease and demand increase, there are two outcomes. One is quantity increase, price increase; the other one is quantity decrease, price increase. The different outcomes depend on the magnitude of the supply curve shift. Nature of the change increase in demand decrease in demand Increase in supply Price: Ambiguous Price: Decrease Quantity: increase Quantity: ambiguous Decrease in supply Price: increases Price: Ambiguous Quantity: Ambiguous Quantity: decreases

Chapter 4. Demand, Supply and Markets. These slides supplement the textbook, but should not replace reading the textbook

Chapter 4. Demand, Supply and Markets. These slides supplement the textbook, but should not replace reading the textbook Chapter 4 Demand, Supply and Markets These slides supplement the textbook, but should not replace reading the textbook 1 What is a market? A group of buyers and sellers with the potential to trade 2 What