Individual & Market Demand and Supply

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1 Mr Sydney Armstrong ECN 1100 Introduction to Microeconomic Lecture Note (3) Individual & Market Demand and Supply The tools of demand and supply can take us a far way in understanding both specific economic issues and how the entire economy works. With our circular flow model in the early lecture, we identify the participant in the product and resource market. We argued that prices are determined by the interaction between buyers and sellers in those markets. According to McConnell and Brue a market can be defined as an institution or mechanism that brings together buyers (demanders) and sellers (suppliers) of particular goods, services or resources. Markets exist in many forms. The gas station heading to town, website, music stores etc. All situations that link potential buyers with potential sellers are markets. Some markets are local while others are national or international. Some are highly personal (face to face contact between participants) others are impersonal (with participants never seeing or knowing each other). In our discussion here we will assume that our market is perfectly competitive. Demand Demand is a schedule or a curve that shows the various amounts of a product that consumers are willing and able to purchase at each of a series of possible prices during a specified period of time. Demand shows the quantities of a product that will be purchased at various possible prices, other things equal. Demand can be easily shown in a table form called a demand schedule. In our definition we say willing and able because willingness alone is not effective in the market. You may be willing to buy a cell phone, but if that willingness is not backed by the necessary dollars, it will not be effective and therefore, will not be reflected in the market. per Quantity demanded orange per week $ The table above does not tell us which of the five possible prices will actually exist in the orange market. That depends on demand and supply. Demand is simply a statement of buyer s plans, or intentions with respect to the purchase of a product.

2 Law of Demand A fundamental characteristic of demand is this: Ceteris Paribus, as price falls, the quantity demanded rises and as price rises, the quantity demanded falls. In short, there is a negative or inverse relationship between price and quantity demanded. Economists call this inverse relationship the law of demand. They are three explanations which address the reason for this inverse relationship between price and quantity demanded. The law of demand is consistent with common sense. People ordinarily do buy more of a product at a low price than at a high price. is an obstacle that deters consumers from buying. The higher that obstacle, the less of a product they will buy; the lower the obstacle, the more they will buy. The fact that businesses have sales is evidence of their belief in the law of demand In any specific time period, each buyer of a product will derive less satisfaction from each successive unit of the product consumed. The second hamburger will yield less satisfaction to the consumer than the first and the third still less than the second. That is, consumption is subject to diminishing marginal utility. And because successive units of a particular product yield less and less marginal utility, consumers will buy additional units only if the price progressively reduced. The law of demand can also be explained in terms income and substation effects. The income effect indicated that a lower price increases the purchasing power of a buyer s money income, enabling the buyer to purchase more of the product than he or she could buy before. A higher price has the opposite effect. The substitution effect suggests that at a lower price, buyers have the incentive to substitute a less expensive good for similar products that are now relatively more expensive. The product whose price has fallen is now a better dal relative to the other products.

The Demand curve The inverse relationship between price and quantity demanded for any product can be represented on a simple graph, in which, by convention, we measure quantity demanded on the

3 The Demand curve The inverse relationship between price and quantity demanded for any product can be represented on a simple graph, in which, by convention, we measure quantity demanded on the horizontal axis and price on the vertical axis such a graph is called a demand curve. Its downward slope reflects the law of demand. P1 a P2 b Q1 Q2 Quantity Demanded Market Demand So far we have concentrated on just one consumer. But competition requires that more than one buyer be present in each market. By adding the quantities demanded by all consumers at each of the various possible prices, we can get from individual demand to market demand. Market Demand for Orange, Three Buyers per Orange First Buyer (Mark) Determinants of demand Quantity Demanded Second Buyer (Clifford) Third Buyer (Simone) $ = = = = = 221 Total Quantity Demanded per week In constructing the demand curve above, we assume that price is the most important influence on the amount of any product purchased. But we know other factors can and do affect purchases. These factors, called determinants of demand, are assumed to be constant when a demand curve like the one above is drawn. They are the other things equal in the relationship

4 between price and quantity demanded. When any of these determinants change, the demand curve will shift to the right or left. For this reason determinants of demand are sometimes referred to as demand shifters. The basic determinants of demand are: 1. Consumers taste (preferences) 2. The number of consumers in the market 3. Consumers Incomes 4. of related goods (substitutes and complements) 5. Consumers expectations about future prices and incomes Change in demand A change in one or more of the determinants of demand will change the demand data (the demand schedule) and therefore the location of the demand curve. A change in the demand schedule or, graphically, a shift in the demand curve is called a change in demand. If consumers desire to buy more oranges at each possible price than is reflected in column 4 in the table above, that increase in demand is shown as a shift of the demand curve to the right from D to D1 in the graph below. Conversely, a decrease in demand occurs when consumers buy less orange at each possible price than in is indicated in column 4 of the table above. The leftward shift of the demand curve from D to D2 in the graph below shows this situation. Increase in demand D 1 Decrease D in Demand D 2 Quantity Demanded Examining how changes in each determinant affect demand. Taste: A favorable change in consumer taste (preference) for the product- a change that makes the product more desirable means that more of it will be demanded at each price. Demand will increase and the demand curve will shift to the right. An unfavorable change in consumer preference will decrease demand and shift the demand curve to the left.

5 Number of Buyers: An increase in the number of buyers in a market increases demand and therefore shifts the demand curve to the right. Likewise a decrease in the number of buyers will decrease demand and thus shift the demand curve to the left. Income: How changes in income affect demand is a more complex matter. For most products, a rise in income causes an increase in demand. Consumers typically buy more chicken, furniture and computers as their incomes increase. On the other hand, the demand for such products decline as consumers incomes fall. Product whose demand varies directly with income is called normal goods. Although most products are normal goods, there are some exceptions. As incomes increase beyond some point, the demand for used tires, third-hand cars may decrease, because the higher incomes enable consumers to buy new version of those products. Goods whose demand varies inversely with income are called inferior goods. s of Related Goods: A change in the price of a related good may either increase or decrease the demand for a product, depending on whether the related good is a substitute or a compliment. A substitute good is one that can be used in place of another good. A complementary good is one that is used together with another good. Substitutes: Beef and chicken are example of substitute goods or substitutes. When the price of beef rises, consumers buy less beef and increase the demand for chicken. Conversely, as the price of beef falls, consumers buy more of beef and decrease their demand for chicken. When two products are substitutes of each other the price of one and the demand for the other move in the same direction. Complements: Complementary goods are goods that are used together and are usually demanded together. If the price of gasoline falls and as a result you drive your car more often, the extra driving increases your demand for motor oil. Thus gas and motor oil are jointly demanded; they are complements. So it is with bread and butter, cameras and film, CD and CD players. When two products are complements the price of one and the demand of the other good move in the opposite directions. Expectations: Changes in consumers expectations may shift demand. A newly formed expectation of higher future prices may cause consumers to buy now in order to beat the anticipated price increase, thus increasing current demand. In contrast, a newly formed expectation of falling prices may decrease current demand for products. Similarly, a change in expectations concerning future income may prompt consumers to change their current spending. For example a person making one of the 20/20 team in IPL or CPL may splurge on new luxury cars in anticipation of a lucrative professional cricket contract. Or workers who become fearful of losing their jobs may reduce their demand for, say, vacation travel.

6 Changes in Demand vs. changes in Quantity Demanded A change in demand must not be confused with a change in quantity demanded. A change in demand is a shift of the entire demand curve to the right or left. It occurs because the consumer s state of mind about purchasing the product has been altered in response to a change in one or more of the determinants of demand. Recall that demand is a schedule or a curve; therefore, a change in demand means a change in the entire schedule and a shift of the entire curve. In contrast, a change in the quantity demanded is a movement from one point to another point on a fixed demand schedule or demand curve. The cause of such a change is an increase or decrease in the price of the products. Supply Supply is a schedule or curve showing the amount of a product that producers are willing and able to make available for sale at each of a series of possible prices during a specific period other things equal. per Quantity supply orange per week $ The Law of Supply The table above shows a positive or direct relationship that prevails between price and quantity supplied. As price rises, the quantity supplied rises; as price falls, the quantity supplied falls. This relationship is called the law of supply. A supply schedule tells us that firms will produce and offer for sale more of their product at a higher price than at a lower price. This again is basically common sense. is an obstacle from the stand point of the consumer, who is on the paying end. The higher the price the less the consumer will buy. But the supplier is on the receiving end of the product s price. To a supplier, price represents revenue, which serves as an incentive to produce and sell a product. The higher the price, the greater the incentive and the greater the quantity supplied.

7 The supply curve As with demand, it is convenient to represent supply graphically. Market Supply of Oranges, 200 Producers Quantity Supply Total Quantity per Orange Single Producer Supply per week $5 60 * 200 = 12, * 200 = 10, * 200 = 7, * 200 = 4, * 200 = 1,000 The data above assume that there are 200 suppliers in the market, each willing and able to supply orange to first table above. We obtain the market supply curve by horizontally adding the supply curves of the individual producers. Note that the axes are the same as those used in our graph of market demand, except for the change from quantity demanded to quantity supplied on the horizontal axis. P1 b P2 a Q2 Q1 Quantity Supply Determinants of Supply In constructing a supply curve, we assume that price is the most significant influence on the quantity supplied of any product. But other factors (the other things equal) can and do affect supply. The supply curve is drawn on the assumption that these other things are fixed and do not change. If one of them does change, a change in supply will occur, meaning that the entire supply curve will shift. The basic determinants of supply are:

8 1. Resource prices 2. Technology 3. Taxes and subsidies 4. expectation 5. The number of sellers in the market A change in any one or more of these determinants of supply, or supply shifters, will move the supply curve for a product either right or left. A shift to the right, as from S to S1 in the graph below, signifies an increase in supply: Producers supply larger quantities of the product at each possible price. A shift to the left, as from S to S2 in the graph below, indicates a decrease in supply: producers offer less output at each price. A decrease in supply S1 S An increase in supply S2 Quantity Supply Changes in Supply Let s consider how changes in each of the determinants affect supply. The key idea is that costs are a major factor underlying supply curves; anything that affects costs usually shifts the supply curve. Resource s: The prices of the resources used in the production process help determine the costs of production incurred by firms. Higher resource prices raise production costs and assuming a particular product price, squeeze profits. That reduction in profits reduces the incentive for firms to supply output at each possible price. In contrast, lower resource prices reduce production costs and increase profits. So when resource prices fall, firms supply greater output at each possible price.

9 Technology: Improvements in technology enable firms to produce units of output with fewer resources. Because resources are costly, using fewer of them lowers production costs and increases supply. Taxes and Subsidies: Businesses treat most tax as costs. An increase in sales or property taxes will increase production costs and reduce supply. In contrast, subsidies are taxes in reverse. If the government subsidizes the production of a good, it in effect lowers the production costs and increases supply. Number of Sellers: Other things equal, the larger the number of suppliers, the greater the market supply. As more firms enter tan industry, the supply shifts to the right. Conversely, the smaller the number of firms in the industry, the less the market supply. This means that as firms leave an industry, the supply curve shifts to the left. Home work: explain how price expectations affect supply. Change in Supply vs. change in quantity supplied The distinction between a change in supply and a change in the quantity supplied is parallel to the distinction between a change in demand and a change in quantity demanded. Because supply is a schedule or curve, a change in supply means a change in the entire schedule or a shift of the entire curve. An increase in supply shifts the curve to the right while a decrease in supply is depicted by a leftward shift of the entire curve. The cause of a change in supply is a change in one or more of the determinants of supply. In contrast, a change in quantity supplied is a movement from one point to another on the same supply curve. The cause of such a movement is a change in the price of the product being considered. Market Equilibrium We can now bring together supply and demand to see how the buying decisions of households and the selling decision of businesses interact to determine the price and the quantity actually bought and sold.

10 Total Quantity Supply per week Total Quantity Demanded per week Surplus (+) Shortage (-) $ Economists called the price when there is no surplus or shortage, the equilibrium price or market clearing. By equilibrium we mean in balance or at rest. This indicates that what is demand is equal to that which is supplied. From our table above which can also be shown graphically the equilibrium price is $3 and the equilibrium quantity is 7000 units. Shortage A shortage occurs when quantity demanded is greater than quantity supplied. From our table above a shortage would occur at prices $1 and 2 in fact any price below equilibrium price would result in a shortage. When there is a shortage there would be an upward pressure on price. Shortage is equal to quantity supply less quantity demanded, which would be negative. Surpluses A surplus would occur when the quantity supply is greater than quantity demanded. From our table it would occur at prices $4 and 5 in fact any price above equilibrium price would result in a surplus. The existence of a surplus puts a downward pressure on the price of the product. Surplus is equal to quantity supply less quantity demanded, which would be positive. Surplus 4 3 e 2 S D Shortage Q 7000

11 Changes in Supply, Demand and Equilibrium We know that demand might change because of changes in one or more of its determinants. Likewise Supply might change in response to changes in one or more of its determinants. The question is then asked, what will happen to equilibrium price and quantity when supply or demand changes. Changes in Demand suppose that supply is constant and demand increases, as shown in the graph (A) below. As a result, the new intersection of the supply and demand curves is at higher values on both the price and quantity axes. Clearly, an increase in demand raises both equilibrium price and equilibrium quantity. Conversely, a decrease in demand while supply is constant as shown in graph (B) below reduces both equilibrium price and equilibrium quantity. Graph A Graph B Pe1 e1 Pe e Pe e Pe1 e1 D1 S D S D1 D Qe Qe1 Quantity Qe1 Qe Quantity Changes in Supply Now suppose that demand is constant but supply increases as with Graph (C) below. The new intersection of supply and demand is located at a lower equilibrium price but at a higher equilibrium quantity. An increase in supply reduces equilibrium piece but increases equilibrium quantity. In contrast, if supply decreases while demand is unchanged, as with graph (D), the equilibrium price rises while the equilibrium quantity declines.

12 Graph (C) Graph (D) Pe e Pe1 e1 Pe1 e1 Pe e S D S1 D S1 Q S Qe Qe1 Quantity Qe1 Qe Quantity Effect of changes in both Supply and Demand Changes in Supply Changes in Demand Effect on Equilibrium Effect on Equilibrium Quantity Increase Decrease Decrease Indeterminate Decrease Increase Increase Indeterminate Increase Increase Indeterminate Increase Decrease Decrease Indeterminate Decrease Government-Set s In some instance the general public and the government conclude that supply and demand have resulted in prices that are either unfairly high to buyers or unfairly low to sellers. In such instance the government may intervene by legally limiting how high or low a price may go. Ceiling and Shortages A price ceiling sets the maximum legal price a seller may charge for a product or service. A price at or below the ceiling is legal; a price above is not. The rationale for establishing price ceilings on specific products is that they enable some consumers to obtain essential goods or services that they could not afford at the equilibrium price an e.g. of such intervention price was rent controls in the US in the early 2000 s. There are 2 problems associated with this type of intervention: Rationing Problem and Black Markets.

13 Floor and Surplus Floors are minimum prices fixed by the government. A price at or above the price floor is legal; a price below is not. floors are usually invoked when society feels that the free functioning of the market system has not provided a sufficient income for certain groups of resource suppliers or producers. Examples of price floors include price support for agriculture products and the minimum wage. The notes came from McConnell &Brue, Economics, 15th edition, 2002 You are required to supplement this with additional reading.

AP Microeconomics Chapter 3 Outline

AP Microeconomics Chapter 3 Outline I. Learning Objectives In this chapter students should learn: II. Markets III. Demand A. What demand is and how it can change. B. What supply is and how it can change. C. How supply and demand interact