CHAPTER 3 Where Prices Come From: The Interaction of Demand and Supply

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1 CHAPTER 3 Where s Come From: The Interaction of Demand and Supply Chapter Outline and Learning Objectives Section 3.1: The Demand Side of the Market Learning Objective: List and describe the variables that influence demand. Section 3.2: The Supply Side of the Market Learning Objective: List and describe the variables that influence supply. Section 3.3: Market Equilibrium: Putting Demand and Supply Together Learning Objective: Use a graph to illustrate market equilibrium. Section 3.4: The Effect of Demand and Supply Shifts on Equilibrium Learning Objective: Use demand and supply graphs to predict changes in prices and quantities. Author Videos You ll Find in Revel Visit Revel to watch the following short videos, which the authors developed and filmed to provide realworld reinforcement of key concepts. These videos will help you learn to interpret articles you read on the Web and in newspapers. Concept Checks follow each video so you can confirm your understanding. 1. Chapter Introduction: How Smart is Your Watch? 2. Apply the Concept: Are Smartwatches Substitutes for Smartphones? 3. Apply the Concept: Tough Times for Big Macs and Golf 4. Apply the Concept: Forecasting the Demand for iphones 5. Apply the Concept: San Francisco Uses Variable s to Deal with a Parking Shortage 6. Apply the Concept: Demand and Supply Trashes Plastic Recycling 218 Pearson Education, Inc.

2 26 CHAPTER 3 Where s Come From: The Interaction of Demand and Supply Video Animations of Figures and Tables You ll Find in Revel Revel includes short video animations of every numbered figure and several numbered tables. You can watch a lecture-style presentation of the concepts, and you can stop, start, and replay the animation as often as necessary to gain a full understanding of the concepts. Concept Checks follow each figure so you can confirm your understanding. Chapter Highlights 3.1 The Demand Side of the Market Learning Objective: List and describe the variables that influence demand. A perfectly competitive market is a market where there are many buyers and sellers, all the products sold are identical, and there are no barriers to new firms entering the market. These assumptions are very restrictive and apply exactly to only a few markets, such as the markets for wheat and other agricultural products. However, the model of demand and supply can be very useful in analyzing markets where competition among sellers is intense, even if there are relatively few sellers and the products being sold are not identical. Although many factors influence the willingness and ability of consumers to buy a particular product, the main influence on consumer decisions is the product s price. The quantity demanded of a good or service is the amount that a consumer is willing and able to purchase at a given price. A demand schedule is a table showing the relationship between the price of a product and the quantity of the product demanded. A demand curve shows this same relationship in a graph. Because quantity demanded always increases in response to a decrease in price, this relationship is called the law of demand. The law of demand is explained by the substitution and income effects. The substitution effect is the change in the quantity demanded of a good that results from a change in price, making the good more or less expensive relative to other goods that are substitutes. The income effect is the change in the quantity demanded of a good that results from the effect of a change in the good s price on consumer purchasing power. Ceteris paribus ( all else equal ) is the requirement that when analyzing the relationship between two variables such as price and quantity demanded other variables must be held constant. When one of the nonprice factors that influence demand changes, the result is a shift in the demand curve an increase or decrease in demand. The most important nonprice factors that influence demand are prices of related goods (substitutes and complements), income, tastes, population and demographics, and expected future prices. 218 Pearson Education, Inc.

3 CHAPTER 3 Where s Come From: The Interaction of Demand and Supply 27 The income that consumers have available to spend affects their willingness to buy a good. A normal good is a good for which demand increases as income rises and decreases as income falls. An inferior good is a good for which demand increases as income falls and decreases as income rises. When consumers tastes for a product increase, the demand curve for the product will shift to the right, and when consumers tastes for a product decrease, the demand curve for the product will shift to the left. Two products are rarely perfect substitutes because consumers may find them more or less useful for some purposes. Substitutes are goods and services that can be used for the same purpose, while complements are goods that are used together. A decrease in the price of a substitute for a good, such as a tablet computer, causes the quantity demanded of the substitute, such as a laptop computer, to increase (a move along the demand curve for laptop computers), which causes the demand for tablet computers to fall. A fall in demand means that the demand curve for tablet computers will shift to the left. An increase in the price of laptop computers causes the quantity of laptop computers demanded to decrease, shifting the demand curve for tablet computers to the right. Changes in prices of complements have the opposite effect. A decrease in the price of a complement for smartphones causes the quantity demanded of the complement, say an app, to increase, shifting the demand curve for smartphones to the right. An increase in the price of apps causes the quantity of apps demanded to decrease, shifting the demand curve for smartphones to the left. As population increases, the demand for most products increases. Demographics are the characteristics of a population with respect to age, race, and gender. As demographics change, the demand for particular goods will increase or decrease because as different demographic groups become more prevalent in the population their unique preferences will become more prevalent in the market. If enough consumers become convinced that a good will be selling for a lower price in the near future, then the demand for the good will decrease in the present. If enough consumers become convinced that the price of a good will be higher in the near future, then the demand for the good will increase in the present. Study Hint People often confuse a change in quantity demanded with a change in demand. When the price of a good or service changes, it can cause changes in the quantity demanded of that good or service. This change is described as a movement along a demand curve. Notice that the price of the good or service is on the vertical axis. Changes in demand result in shifts of the demand curve and are caused by changes in factors other than the price of the good itself. Be careful about how these terms are used. When demand increases (shifts to the right), we do not say that there has been an increase in the quantity demanded. Rather, we say there has been an increase in demand. If there is an increase in the quantity demanded, the cause of that would be a decrease in the price, and the increase in quantity demanded would be shown as a movement along the demand curve, not a shift. 218 Pearson Education, Inc.

4 28 CHAPTER 3 Where s Come From: The Interaction of Demand and Supply Take time to study Figure 3.3, which shows the difference between a change in demand and a change in quantity demanded. (dollars per smartwatch) A shift of the demand curve is a change in demand. $45 A C 4 A movement along the demand curve is a change in quantity demanded. B Demand, D 1 D (millions of smartwatches per week) Figure 3.3: A Change in Demand versus a Change in Demanded 218 Pearson Education, Inc.

5 CHAPTER 3 Where s Come From: The Interaction of Demand and Supply 29 Also take time to study Table 3.1, which lists all the variables that shift market demand curves. Table 3.1 Variables That Shift Market Demand Curves An increase in... shifts the demand curve... because... D 1 D 2 D 2 D 1 D 1 D 2 D 2 D 1 D 1 D 2 D 1 D 2 D 1 D Pearson Education, Inc.

6 3 CHAPTER 3 Where s Come From: The Interaction of Demand and Supply Extra Solved Problem 3.1 Supports Learning Objective 3.1: List and describe the variables that influence demand. Suppose that Justin needs to buy an automobile. Justin has decided to purchase a new Toyota Prius. Justin s neighbor tells him that Toyota will be offering a $3,5 rebate on all its automobiles starting next month. a. Assuming that Justin can wait until next month to buy an automobile, what effect will the rebate have on Justin s demand for a Prius? b. Which of the variables that influence demand would explain Justin s change in demand? Solving the Problem Step 1: Review the chapter material. This problem is about variables that shift market demand, so you may want to review the section Variables That Shift Market Demand. Step 2: Answer question (a) by considering how a rebate that begins next month will affect Justin s current demand for the Toyota Prius. Justin s demand for the Toyota Prius will decrease now and increase next month as he will wait to make his purchase in order to take advantage of the rebate. Step 3: Answer question (b) by determining which variable has affected Justin s demand for the Prius. Other things being equal, as the expected future price of the Prius falls, the demand for Priuses will fall in the present period. PRACTICE ASSIGNMENTS for Section 3.1: The Demand Side of the Market Learning Objective: List and describe the variables that influence demand. Many concepts in economics build on each other, so it s important to test your understanding before moving on to a new section. Go to Revel to complete the exercises in the Practice Assignment for this learning objective and receive instant feedback and tutorial help. If your instructor did not assign these exercises to you, go to the Revel table of contents and click on Practice: Section Pearson Education, Inc.

7 CHAPTER 3 Where s Come From: The Interaction of Demand and Supply The Supply Side of the Market Learning Objective: List and describe the variables that influence supply. Many variables influence the willingness and ability of firms to sell a good or service. The most important of these variables is the price of the good or service. supplied is the amount of a good or service that a firm is willing to sell at a given price. A supply schedule is a table that shows the relationship between the price of a product and the quantity of the product supplied. A supply curve shows this same relationship in a graph. The law of supply states that, holding everything else constant, increases in the price of the good or service cause increases in the quantity supplied, and decreases in the price of the good or service cause decreases in the quantity supplied. Variables other than the price of the product affect supply. When any of these variables change, a shift in supply an increase or a decrease in supply results. The following are the most important variables that shift supply: prices of inputs used in production, technological change, prices of related goods (substitutes and complements) in production, the number of firms in the market, and expected future prices. If the price of an input (for example, labor or energy) used to produce a good rises, the supply of the good will decrease, and the supply curve will shift to the left. If the price of an input decreases, the supply of the good will increase, and the supply curve will shift to the right. Technological change is a positive or negative change in the ability of a firm to produce a given level of output with a given amount of inputs. A positive technological change will shift a firm s supply curve to the right, while a negative technological change will shift a firm s supply curve to the left. An increase in the price of an alternative good (B) that a firm could produce instead of producing good A will shift the firm s supply curve for good A to the left. If a firm expects the price of its product will rise in the future, then the firm has an incentive to decrease supply in the present and increase supply in the future. When firms enter a market, the market supply curve shifts to the right. When firms exit a market, the market supply curve shifts to the left. 218 Pearson Education, Inc.

8 32 CHAPTER 3 Where s Come From: The Interaction of Demand and Supply Study Hint The law of supply may seem logical because producers earn more profit when the price they sell their product for rises. But consider Figure 3.4 and the following question: If Apple can earn a profit from selling 5 million smartwatches per week at a price of $35, why not increase quantity supplied to 6 million and make even more profit? The upward slope of the supply curve is due not only to the profit motive but to the increasing marginal cost of producing smartwatches. (Increasing marginal costs were discussed in Chapter 2.) Apple will increase its quantity supplied from 5 million to 6 million in Figure 3.4 only if the price it will receive is $4 because the cost of producing 1 million more smartwatches is greater than the cost of the previous 1 million smartwatches. Supply Schedule (dollars per (millions of smartwatch) smartwatches per week) $ (dollars per smartwatch) $ As the price of smartwatches rises, the quantity supplied increases. Supply (millions of smartwatches per week) Figure 3.4: A Supply Schedule and Supply Curve As with demand and quantity demanded, be careful not to confuse a change in quantity supplied (due only to a change in the price of a product) and a change in supply (a shift of the supply curve in response to one of the nonprice factors). Constant reinforcement of this is necessary. Be careful not to refer to an increase in supply as a downward shift or a decrease in supply as an upward shift. Because demand curves are downward sloping, an increase in demand appears in a graph as an upward shift. But because supply curves are upward sloping, a decrease in supply appears in a graph as an upward shift. You should always refer to both changes in demand and supply as being shifts to the right for an increase and shifts to the left for a decrease to avoid confusion. 218 Pearson Education, Inc.

9 CHAPTER 3 Where s Come From: The Interaction of Demand and Supply 33 Take time to study Figure 3.6, which shows the difference between a change in supply and a change in quantity supplied. (dollars per smartwatch) A movement along the supply curve is a change in quantity supplied. Supply, S 1 S 2 $45 4 A B C A shift in the supply curve is a change in supply (millions of smartwatches per week) Figure 3.6: A Change in Supply versus a Change in Demanded 218 Pearson Education, Inc.

10 34 CHAPTER 3 Where s Come From: The Interaction of Demand and Supply Also take time to study Table 3.2, which lists all the variables that shift market supply curves. Table 3.2 Variables That Shift Market Supply Curves An increase in... shifts the supply curve... because... the price of an input S 2 S 1 the costs of producing the good rise. productivity S 2 S 1 the costs of producing the good fall. the price of a substitute in production S 2 S 1 more of the substitute is produced and less of the good is produced. the price of a complement in production S 1 S 2 more of the good and the complementary good are produced. the number of firms in the market S 1 S 2 additional firms result in a greater quantity supplied at every price. the expected future price of the product S 2 S 1 less of the good will be offered for sale today to take advantage of the higher price in the future. Extra Solved Problem 3.2 To (Soy)bean or not to (Soy)bean? Supports Learning Objective 3.2: List and describe the variables that influence supply. Iowa, Illinois, Nebraska, Minnesota, and Indiana are the top five producers of corn in the United States. Although climate and soil conditions in these states make them well suited for growing corn, these five states are also the top soybean producers in the United States. Each year, farmers in these states must decide how many acres of land to plant with corn and how many acres to plant with soybeans. 218 Pearson Education, Inc.

11 CHAPTER 3 Where s Come From: The Interaction of Demand and Supply 35 a. If both crops can be grown on the same land, why would a farmer choose to produce corn rather than soybeans? b. Which of the variables that influence supply would explain a farmer s choice to produce soybeans or corn? Solving the Problem Step 1: Review the chapter material. This problem is about variables that shift supply, so you may want to refer to the section Variables That Shift Market Supply. Step 2: Answer question (a) by discussing the factors that would influence a farmer s choice. Among the factors that would influence a farmer s choice is the expected profitability of the two crops. A farmer will grow corn rather than soybeans if he expects the profits from growing corn will be greater than those earned from growing soybeans. Step 3: Answer question (b) by evaluating which variables are most likely to affect supply in the markets for corn and soybeans. Other things being equal, as the price of soybeans falls relative to the price of corn, the supply of corn would rise. Because corn and soybeans are alternate products a farmer could use in production, the variable prices of substitutes in production would most likely explain the farmer s choice. PRACTICE ASSIGNMENTS for Section 3.2: The Supply Side of the Market Learning Objective: List and describe the variables that influence supply. Many concepts in economics build on each other, so it s important to test your understanding before moving on to a new section. Go to Revel to complete the exercises in the Practice Assignment for this learning objective and receive instant feedback and tutorial help. If your instructor did not assign these exercises to you, go to the Revel table of contents and click on Practice: Section Pearson Education, Inc.

12 36 CHAPTER 3 Where s Come From: The Interaction of Demand and Supply 3.3 Market Equilibrium: Putting Demand and Supply Together Learning Objective: Use a graph to illustrate market equilibrium. The purpose of markets is to bring buyers and sellers together. The interaction of buyers and sellers in markets results in firms producing goods and services consumers both want and can afford. At market equilibrium, the price of the product makes quantity demanded equal quantity supplied. A competitive market equilibrium is a market equilibrium with many buyers and many sellers. The market price (the actual price you would pay for the product) will not always be the equilibrium price. A surplus is a situation in which the quantity supplied is greater than the quantity demanded, which occurs when the market price is above the equilibrium price. Firms have an incentive to increase sales by lowering price. As the market price is lowered, quantity demanded will rise, and quantity supplied will fall until the market reaches equilibrium. A shortage is a situation in which quantity demanded is greater than the quantity supplied, which occurs when the market price is below the equilibrium price. Some consumers will want to buy the product at a higher price to make sure they get what they want. As the market price rises, the quantity demanded will fall not everyone will want to buy at a higher price and quantity supplied will rise until the market reaches equilibrium. At the competitive market equilibrium, there is no reason for the price to change unless either the demand curve or the supply curve shifts. Study Hint It s very important to understand how demand and supply interact to reach equilibrium. Remember that adjustments to a shortage or a surplus represent changes in quantity demanded (not demand) and quantity supplied (not supply). Solved Problem 3.3 (see below) shows how the demand and supply for the letters written by Lincoln and Booth determine the price for the letters written by each author. Because the supply is low relative to the demand for Booth s letters, his letters sell for a high equilibrium price. Similarly, because the supply of Lincoln s letters is large relative to their demand, his letters sell for a lower equilibrium price. Market or actual prices are easy to understand because these are the prices consumers are charged. Solved Problem 3.3: Demand and Supply Both Count: A Tale of Two Letters Which letter is likely to be worth more: one written by Abraham Lincoln or one written by his assassin, John Wilkes Booth? Lincoln is one of the greatest presidents, and many people collect anything he wrote. The demand for letters written by Lincoln surely would seem to be much greater than the demand for letters written by Booth. Yet, when R.M. Smythe and Co. auctioned off on the same day a letter written by Lincoln and a letter written by Booth, the Booth letter sold for $31,5, and the Lincoln letter sold for only $21,85. Use a demand and supply graph to explain how the Booth letter has a higher market price than the Lincoln letter, even though the demand for letters written by Lincoln is greater than the demand for letters written by Booth. Solving the Problem Step 1: Review the chapter material. This problem is about prices being determined at market equilibrium, so you may want to review the section Market Equilibrium: Putting Demand and Supply Together. 218 Pearson Education, Inc.

13 CHAPTER 3 Where s Come From: The Interaction of Demand and Supply 37 Step 2: Draw demand curves that illustrate the greater demand for Lincoln s letters. Begin by drawing two demand curves. Label one Demand for Lincoln s letters and the other Demand for Booth s letters. Make sure that the Lincoln demand curve is much farther to the right than the Booth demand curve. (dollars per letter) Demand for Lincoln s letters Demand for Booth s letters of letters Step 3: Draw supply curves that illustrate the equilibrium price of Booth s letters being higher than the equilibrium price of Lincoln s letters. Based on the demand curves you have just drawn, think about how it might be possible for the market price of Lincoln s letters to be lower than the market price of Booth s letters. This outcome can occur only if the supply of Lincoln s letters is much greater than the supply of Booth s letters. Draw on your graph a supply curve for Lincoln s letters and a supply curve for Booth s letters that will result in an equilibrium price of Booth s letters of $31,5 and an equilibrium price of Lincoln s letters of $21,85. You have now solved the problem. (dollars per letter) Supply of Booth s letters Supply of Lincoln s letters $31,5 21,85 Demand for Lincoln s letters Demand for Booth s letters of letters Extra Credit: The explanation for this puzzle is that both demand and supply count when determining market price. The demand for Lincoln s letters is much greater than the demand for Booth s letters, but the supply of Booth s letters is very small. Historians believe that only eight letters written by Booth exist today. (Note that the supply curves for letters written by Booth and by Lincoln are upward sloping, even though only a fixed number of each of these letters is available and, obviously, no more can be produced. The upward slope of the supply curves occurs because the higher the price, the larger the quantity of letters that will be offered for sale by people who currently own them.) 218 Pearson Education, Inc.

14 38 CHAPTER 3 Where s Come From: The Interaction of Demand and Supply PRACTICE ASSIGNMENTS for Section 3.3: Market Equilibrium: Putting Demand and Supply Together Learning Objective: Use a graph to illustrate market equilibrium. Many concepts in economics build on each other, so it s important to test your understanding before moving on to a new section. Go to Revel to complete the exercises in the Practice Assignment for this learning objective and receive instant feedback and tutorial help. If your instructor did not assign these exercises to you, go to the Revel table of contents and click on Practice: Section The Effect of Demand and Supply Shifts on Equilibrium Learning Objective: Use demand and supply graphs to predict changes in prices and quantities. Increases in demand can be caused by any change in a variable that affects demand except price. For example, demand will increase if income increases (for a normal good), income decreases (for an inferior good), the price of a substitute increases, the price of a complement decreases, taste for the good increases, population increases, or the expected future price of the product increases. A decrease in demand results in a lower equilibrium price and lower equilibrium quantity. Decreases in demand can be caused by any change in a variable that affects demand except the price of the product itself. For example, demand will decrease if income decreases (for a normal good), income increases (for an inferior good), the price of a substitute decreases, the price of a complement increases, taste for the good decreases, population decreases, or the expected future price of the product decreases. 218 Pearson Education, Inc.

15 CHAPTER 3 Where s Come From: The Interaction of Demand and Supply 39 Increases in supply result from: a decrease in an input price, positive technological change, a decrease in the price of a substitute in production, an increase in the number of firms in the market, and a lower expected future product price. A decrease in supply results in a higher equilibrium price and a lower equilibrium quantity. Decreases in supply result from the following nonprice factor changes: an increase in an input price, negative technological change, an increase in the price of a substitute in production, a higher expected future product price, and a decrease in the number of firms in the market. Study Hint When demand shifts, the equilibrium price and quantity both change in the same direction as the shift. For example, an increase in demand (graphed as a shift to the right of demand) results in an increase in both the price and the equilibrium quantity. However, when supply changes, the equilibrium quantity changes in the same direction as the shift of the supply curve, but the equilibrium price changes in the opposite direction. For example, an increase in supply (graphed as a shift to the right of supply) results in an increase in the equilibrium quantity but a decrease in the equilibrium price. PRACTICE ASSIGNMENTS for Section 3.4: The Effect of Demand and Supply Shifts on Equilibrium Learning Objective: Use demand and supply graphs to predict changes in prices and quantities. Many concepts in economics build on each other, so it s important to test your understanding before moving on to a new section. Go to Revel to complete the exercises in the Practice Assignment for this learning objective and receive instant feedback and tutorial help. If your instructor did not assign these exercises to you, go to the Revel table of contents and click on Practice: Section Pearson Education, Inc.