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2 Chapter 2 Read this chapter together with unit 1 and 2 in the study guide Supply and Demand

3 Topics 1. Demand. 2. Supply. 3. Market Equilibrium. 4. Shocking the Equilibrium. 5. Effects of Government Interventions. 6. When to Use the Supply-and-Demand Model. 2-3 Copyright 2012 Pearson Education. All rights reserved.

4 Demand: Determinants of Demand The following factors determine the demand for a good: Price of the good Tastes Information Prices of other goods Complements and substitutes Income Government rules and regulations Other factors 2-4 Copyright 2012 Pearson Education. All rights reserved.

5 Demand: The Demand Curve Quantity demanded - the amount of a good that consumers are willing to buy at a given price, holding constant the other factors that influence purchases. Demand curve - the quantity demanded at each possible price, holding constant the other factors that influence purchases 2-5 Copyright 2012 Pearson Education. All rights reserved.

6 Figure 2.1 A Demand Curve p, $ per kg Demand curve for pork, D 1 Law of Demand consumers demand more of a good the lower its price, holding constant all other factors that influence consumption Q, Million kg of pork per year 2-6 Copyright 2012 Pearson Education. All rights reserved.

Figure 2.2 A Shift of the Demand Curve p, $ per kg Effect of a 60 increase in the price of beef 3.

8 The Demand Function The processed pork demand function is: Q = D(p, p b, p c, Y) where Q is the quantity of pork demanded p is the price of pork (dollars per kg) p b is the price of beef (dollars per kg) p c is the price of chicken (dollars per kg) Y is the income of consumers (thousand dollars) 2-8 Copyright 2012 Pearson Education. All rights reserved.

9 From the Demand Function to the Demand Curve Estimated demand function for pork: Q = p + 20p b + 3p c + 2Y Using the values p b = 4, p c = 3.33 and Y = 12.5, we have Q = p which is the linear demand function for pork. 2-9 Copyright 2012 Pearson Education. All rights reserved.

10 From the Demand Function to the Demand Curve (cont.) p, $ per kg Q = p Demand cu r v e f or po r k, D 1 If p = $3.30 then, In If If p general, If decreases p p increases = 0, then by $1 by Q = 220 (to $1 $2.30) 286 (to $4.30) then, Q = -20 p Q = 240 = then, slope p Q = Q, Million kg of po r k per y ear 2-10 Copyright 2012 Pearson Education. All rights reserved.

13 Solved Problem Use the inverse demand curve to determine how much the price must change for consumers to buy 1 million more kg of pork per year. Δp = p 2 p 1 = ( Q 2 ) ( Q 1 ) = 0.05(Q 2 Q 1 ) = 0.05ΔQ. The change in quantity is ΔQ = Q 2 Q 1 = (Q 1 + 1) Q 1 = 1, so the change in price is Δp = Copyright 2012 Pearson Education. All rights reserved.

14 Summing Demand Curves The total demand shows the total quantity demanded at each price The total quantity demanded at a given price is the sum of the quantity each consumer demands at that price Q = Q 1 + Q 2 = D 1 (p) + D 2 (p) 2-14 Copyright 2012 Pearson Education. All rights reserved.

16 Supply: Determinants of Supply The following factors determine the supply for a good: Price of the good Costs Government rules and regulations 2-16 Copyright 2012 Pearson Education. All rights reserved.

17 Supply: The Supply Curve Quantity supplied - the amount of a good that firms want to sell at a given price, holding constant other factors that influence firms supply decisions, such as costs and government actions Supply curve - the quantity supplied at each possible price, holding constant the other factors that influence firms supply decisions 2-17 Copyright 2012 Pearson Education. All rights reserved.

18 Figure 2.3 A Supply Curve p, $ per kg 5.30 An increase in the price Supply cu r v e, S causes a movement along the curve and a decrease in the quantity supplied. 300 Q, Million kg of po r k per y ear 2-18 Copyright 2012 Pearson Education. All rights reserved.

Figure 2.4 A Shift of a Supply Curve p, $ per kg A $0.25 increase in the price of hogs.. shifts the supply curve to the left S 2 S 1 3.

19 Figure 2.4 A Shift of a Supply Curve p, $ per kg A $0.25 increase in the price of hogs.. shifts the supply curve to the left S 2 S reducing the quantity supplied at the previous price Q, Million kg of po r k per y ear 2-19 Copyright 2012 Pearson Education. All rights reserved.

20 The Supply Function The processed pork supply function is: Q = S(p, p h ) where Q is the quantity of pork supplied p is the price of pork (dollars per kg) p h is the price of a hog (dollars per kg) 2-20 Copyright 2012 Pearson Education. All rights reserved.

21 From the Supply Function to the Supply Curve Estimated demand function for pork: Q = p 60p h Using the values p h = $1.50 per kg Q = p. What happens to the quantity supplied if the price of processed pork increases by Δp = p 2 p 1? 2-21 Copyright 2012 Pearson Education. All rights reserved.

22 Summing Supply Curves The total supply curve shows the total quantity produced by all suppliers at each price Horizontal sum of each producer s supply curve Sum of all quantities supplied at a given price 2-22 Copyright 2012 Pearson Education. All rights reserved.

24 Solved Problem 2.2 How does a quota set by the United States on foreign steel imports of Q affect the total American supply curve for steel given the domestic supply, S d in panel a of the graph, and foreign supply, S f in panel b? 2-24 Copyright 2012 Pearson Education. All rights reserved.

26 Market Equilibrium Equilibrium - a situation in which no one wants to change his or her behavior equilibrium price is the price at which consumers can buy as much as they want and sellers can sell as much as they want equilibrium quantity is the quantity bought and sold at the equilibrium price 2-26 Copyright 2012 Pearson Education. All rights reserved.

27 Market Equilibrium (cont.) Excess demand the amount by which the quantity demanded exceeds the quantity supplied at a specified price. Excess supply the amount by which the quantity supplied is greater than the quantity demanded at a specified price 2-27 Copyright 2012 Pearson Education. All rights reserved.

28 Figure 2.6 Market Equilibrium p, $ per kg 3.95 Above the equilibrium price. Market equilibrium point! Excess supply = 39 S 3.30 e 2.65 Below the equilibrium price. Excess demand = 39 is below the quantity demanded D is below the quantity supplied the quantity supplied the quantity demanded Q, Million kg of po r k per y ear 2-28 Copyright 2012 Pearson Education. All rights reserved.

30 Equilibrium: Practice Problem The demand function for a good is Q = a bp, and the supply function is Q = c + ep, where a, b, c, and e are positive constants. Solve for the equilibrium price and quantity in terms of these four constants Copyright 2012 Pearson Education. All rights reserved.

32 Shocking the Equilibrium The equilibrium changes only if a shock occurs that shifts the demand curve or the supply curve. These curves shift if one of the variables we were holding constant changes Copyright 2012 Pearson Education. All rights reserved.

33 Figure 2.7a Equilibrium Effects of a Shift of a Demand Curve p, $ per kg A $0.60 increase in the price of beef shifts demand outward Which puts an upward pressure on the price to a new equilibrium e 1 e 2 S D 2 Excess demand = 12 D 1 At the original price there is now excess demand Q, Million kg of pork per year 2-33 Copyright 2012 Pearson Education. All rights reserved.

34 Figure 2.7b Equilibrium Effects of a Shift of a Supply Curve p, $ per kg A $0.25 increase in the price of hogs shifts the supply curve to the left Which puts an upward pressure on the price to a new equilibrium e 2 e 1 S 2 S 1 Excess demand = 15 D At the original price there is now excess demand Q, Million kg of pork per year 2-34 Copyright 2012 Pearson Education. All rights reserved.

35 Solved Problem 2.3 Mathematically, how does the equilibrium price of pork vary as the price of hogs changes if the variables that affect demand are held constant at their typical values? 2-35 Copyright 2012 Pearson Education. All rights reserved.

36 Solved Problem Solve for the equilibrium price of pork in terms of the price of hogs. Q d = p Q s = p 60p h p = p 60p h -60p = p h -p = -1.8 p h 2. Show how the equilibrium price of pork varies with the price of hogs. Since Δp = Δp h, any increase in the price of hogs causes an equal increase in the price of processed pork Copyright 2012 Pearson Education. All rights reserved.

37 Equilibrium Effects of Government Interventions Government action can cause a shift in the supply curve, the demand curve, or both the quantity demanded to be different from quantity supplied 2-37 Copyright 2012 Pearson Education. All rights reserved.

38 Equilibrium Effects of Government Interventions (cont.) Policies that shift supply curves Licensing laws, quotas Policies that cause demand to differ from supply Price ceilings, price floors 2-38 Copyright 2012 Pearson Education. All rights reserved.

39 Figure 2.8 A Ban on Rice Imports Raises the Price in Japan p, P r ice of r ice per pound p 2 e 2 p 1 S (ban) A ban on rice imports shifts the total supply of rice in Japan e 1 S (no ban) which causes the equilibrium to change and the price to increase. Q 2 Q 1 D Q, T ons of r ice per y ear 2-39 Copyright 2012 Pearson Education. All rights reserved.

40 Solved Problem 2.4 What is the effect of a United States quota on sugar of Q on the equilibrium in the U.S. sugar market? Hint: The answer depends on whether the quota binds (is low enough to affect the equilibrium) Copyright 2012 Pearson Education. All rights reserved.

42 Figure 2.9 Price Ceiling on Gasoline p, $ per gallon Supply shifts to the left. S 1 but gas stations must continue to charge a price of p 1.. p 1 = p e 1 Price ceiling D which creates excess demand. Q s Excess demand Q 1 = Q d Q, Gallons of gasoline per month 2-42 Copyright 2012 Pearson Education. All rights reserved.

43 Solved Problem 2.5 Suppose that there is a single labor market in which everyone is paid the same wage. If a binding minimum wage, w, is imposed, what happens to the equilibrium in this market? Answer: Show the initial equilibrium before the minimum wage is imposed. Draw a horizontal line at the minimum wage, and show how the market equilibrium changes Copyright 2012 Pearson Education. All rights reserved.

45 Why Supply Need Not Equal Demand The quantity that firms want to sell and the quantity that consumers want to buy at a given price need not equal the actual quantity that is bought and sold. Example: price ceiling Copyright 2012 Pearson Education. All rights reserved.

46 Perfectly Competitive Markets Everyone is a price taker. Firms sell identical products. Everyone has full information about the price and quality of goods. Costs of trading are low Copyright 2012 Pearson Education. All rights reserved.