Demand and Supply: a brief review

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1 Demand and Supply: a brief review Introduction The most important tools in economics are supply, demand, and the idea of equilibrium. Even if you understand little else, you may rightly claim yourself economically literate if you understand these tools. Fail to understand these tools and you will understand little else. (Cowen and Tabarrok, 2011, p. 27) Demand Curve A demand curve is a function that shows the quantity demanded at different prices. It shows the quantity that demanders are willing and able to buy at different prices. Quantity Demanded The quantity demanded is the quantity that buyers are willing and able to buy at a particular price. 1

2 Law of Demand The lower the price, the greater the quantity demandedthis is often called the law of demand. What does a demand curve mean? What does the demand curve mean? Why is the quantity of oil demanded higher when the price is low? The fact that oil is not equally valuable in all of its possible uses explains why the demand curve for oil has a negative slope. When the price of oil is high, consumers will choose to use oil only in its most valuable uses (e.g., gasoline and jet fuel). As the price of oil falls, consumers will choose to also use oil in its less and less valued uses (heating and making rubber duckies). Two ways to read a demand curve It can be read horizontally or vertically. Horizontally given the price of a good, how much will consumers buy? Start with the price. then to get Q. Vertically given the amount people want to buy, what price are they willing to pay? Start at Q. Read then to get price. 2

3 Figure 1: A graph from (Cowen and Tabarrok, 2011, ch. 3): Two ways to read a demand curve. 3

4 Consumer Surplus What benefits do consumers get from trade? It depends on the difference between what they are willing to pay and what they actually have to pay. Consumer Surplus Consumer surplus is the consumers gain from exchange, or the difference between the maximum price a consumer is willing to pay for a certain quantity and the market price. Total consumer surplus Total consumer surplus is measured by the area beneath the demand curve and above the price. 4

5 Figure 2: A graph from (Cowen and Tabarrok, 2011, ch. 3). Given the price of oil is $20, the consumer surplus will be the area above $20 and below the demand curve, which is shaded in green. 5

6 Changes in Demand When something alters what you are willing to pay for a good, we say that demand has changed. Graphically, this appears as a shift in the location of the demand curve. There is a new set of prices for each quantity (or new quantities for each set of prices). Increase in Demand Consumers are willing to buy more of the good at existing prices. Demand shifts to the right. Decrease in Demand Consumers are don t want to buy as much of the good at existing prices. Demand shifts to the left. What changes or shifts demand? 1. Income (a) Normal goods as income rises people tend to buy more of the good. e.g., a new luxury car. (b) Inferior goods as income rises, people buy less of the good. e.g., an old clunker (used car). 2. Population more people, more demand for goods 3. Prices of related goods 6

7 (a) Substitutes as the substitutes price rises, demand for a good increases. Beef becomes more expensive and demand for Chicken increases. (b) Complements as the complements price rises, demand for a good decreases. Gas is more expensive and demand for gas guzzler trucks falls. 4. Expectations expected higher prices in the future will increase demand for the product today. If prices are expected to fall in the future, people tend to wait, which diminished today s demand. 5. Tastes and preferences 7

8 Figure 3: A graph from (Cowen and Tabarrok, 2011, ch. 3). Demand is changing the curves shift right (increase) or left (decrease) 8

9 Bibliography Cowen, Tyler and Alex Tabarrok (2011), Modern Principles of Economics, 2nd edn, Worth, New York. 9