MACROECONOMICS - CLUTCH CH. 3 - SUPPLY AND DEMAND.

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2 CONCEPT: INTRODUCTION TO SUPPLY AND DEMAND A market is a group of buyers and sellers of a particular good or service. A market is perfectly competitive when: - The goods for sale are - The buyers and sellers are both Lots of buyers Lots of sellers Each market participant has influence on price Examples of products in (perfectly) competitive markets: Examples of products in less competitive markets: Ceteris Paribus a Latin phrase meaning Page 2

3 PRACTICE: Which of the following goods would most likely be sold in a perfectly competitive market? a) Luxury cars b) Wheat c) Laptop Computers d) Pizza PRACTICE: Products sold in a perfectly competitive market are a) Homogenous b) Heterogeneous c) Efficient d) Inefficient e) Both (a) and (c) PRACTICE: The Latin phrase ceteris paribus means: a) All things are known to change b) Other things change equally c) All things at equilibrium d) Other things being equal Page 3

4 CONCEPT: THE BASICS OF DEMAND Throughout this chapter, most of our analysis is done on the price/quantity graph: Demand relates to the behavior of in our perfectly competitive market. The quantity demanded is the amount of a good that buyers are willing to purchase at a given price. - The demand schedule lists pairs of prices and quantities demanded. The Law of Demand When the price of a good rises, the quantity demanded of that good falls What explains the Law of Demand? Substitution Effect Income Effect The demand curve is a graph showing the relation between the price of a good and its quantity demanded. Demand Schedule for Wheat Price ($) Quantity 9 10, , , , ,000 - Note: Some goods are exceptions to the Law of Demand, but are beyond our scope Page 4

5 CONCEPT: INDIVIDUAL DEMAND AND MARKET DEMAND Every person has their own individual demand curve. This denotes the quantity they would demand at each price. The market demand curve is created from the of all the individual demand curves. Price of a Supreme Pizza ($) Fat Albert s Quantity Demanded Skinny Hendrix s Quantity Demanded Market Demand 10 Fat Albert s Demand 10 Skinny Hendrix s Demand Market Demand When asked to find the market demand: - Sum all the individual demand curves Page 5

6 CONCEPT: SHIFTING DEMAND INTRODUCTION Certain events cause the demand curve to shift on the graph. WARNING! A change in price does not shift the demand curve because it is already a variable in the graph. Change in Price Change in Other Determinants of Demand Increase/Decrease in Increase/Decrease in All else equal Before: use P 1 and Q 1 After: use P 2 and Q 2 All else (NOT?) equal It helps to think of the events that shift demand in terms of good or bad events. Shift Right Shift Left Good thing happens for the product demand = Shift Right Bad thing happens for the product demand = Shift Left Page 6

7 CONCEPT: SHIFTING DEMAND INCOME When a consumer s income changes, the types of goods she buys also changes. Mom s House: Dorm Room: People buy more normal goods when they have money. - Organic food - New furniture - Vacation People buy more inferior goods when they have money. - Canned Soup - Used furniture - Stay -cation EXAMPLE: If craft beer is a normal good, what happens to demand when consumer income rises? What if income decreases? Income Increases Income Decreases Page 7

8 CONCEPT: SHIFTING DEMAND SUBSTITUTE GOODS The price changes of other related goods can affect the demand for a good Two goods are considered to be substitute goods if: - The increase in the price of Good X causes the demand of Good Y to When two variables get larger (or smaller) together, the relationship is directly proportional. - Note: This is NOT a change in price. This is a change in the price of a related product. Examples of substitute goods: Coke and Pepsi Margarine and Butter Apples and Oranges EXAMPLE: Assume that regular toasters and defibrillator toasters are substitute goods. If the price of regular toasters rises: a) What happens to the demand for defibrillator toasters? b) What happens to the demand for regular toasters? Defibrillator Toasters Regular Toasters Page 8

9 CONCEPT: SHIFTING DEMAND COMPLEMENTARY GOODS The price changes of other related goods can affect the demand of a good Two goods are considered to be complementary goods if: - The increase in the price of Good X causes the demand of Good Y to When one variable gets larger as the other falls, the relationship is inversely proportional. - Note: This is NOT a change in price. This is a change in the price of a related product. Examples of complementary goods: Peanut Butter and Jelly DVD players and DVDs Cars and Gasoline EXAMPLE: Assume that defibrillator toasters and Wonderbread are complementary goods. If the price of defibrillator toasters falls: a) What will happen to the demand for Wonderbread? b) What happens to the demand for defibrillator toasters? Wonderbread Defibrillator Toasters Note: What if the two goods are neither substitutes nor complements? Page 9

10 CONCEPT: SHIFTING DEMAND CONSUMER PREFERENCES Consumer preferences change over time. The demand for a product is affected by consumer taste. If changes in customer preferences benefit a good, its demand will Examples of changes in consumer preference: Fitness rises in popularity Fashion Cellular phones EXAMPLE: As a fitness craze sweeps the nation, upside down yoga class membership has skyrocketed. What happens to the demand for protein shakes? Page 10

11 CONCEPT: SHIFTING DEMAND EXPECTATIONS Expectations about the future can affect current demand for a good. If consumers expect prices to increase in the future, the demand for the good today - Directly proportional - Note: This is NOT a change in price. This is a change in expectations about price. Examples of changes in consumer expectations: Inclement weather Future income Expected price changes EXAMPLE: As a hurricane approaches Brazil, fear of a shortage of coffee spreads. What happens to the demand for coffee beans? Page 11

12 CONCEPT: SHIFTING DEMAND NUMBER OF CONSUMERS A change in the amount of consumers in a market will affect demand. If the amount of consumers in a market increases, the demand for the good - Directly proportional Examples of changes in number of consumers: Immigration Birth rate Advertising EXAMPLE: After Clutchtopia introduced its Free Pizza For Everybody Policy, immigration to the awesome country skyrocketed, doubling its population. What happens to the demand for bar soap in Clutchtopia? Page 12

13 CONCEPT: DEMAND SHIFT SUMMARY DEMAND (INSPEC) Income: Normal Goods Consumer Income Demand for Normal Goods Directly Proportional Substitutes Price of Substitute Demand for Good Preferences for a Good Preferences for Good Demand for Good Consumer Expectations Expected Future Price Demand for Good (now) Number of Consumers Number of Consumers Demand for Good Inversely Proportional Income: Inferior Goods Consumer Income Demand for Inferior Goods Complements Price of Complement Demand for Good Change in Price Change in Price Change in Quantity Demanded A change in the price of a good does not shift the demand curve, we move along the demand curve. Page 13

14 PRACTICE: What happens in the market for blenders if consumers decide that juicing their vegetables is better than blending their vegetables? a. Demand shifts to the left b. Demand shifts to the right c. Supply shifts to the left d. Supply shifts to the right PRACTICE: What happens in the market for beef jerky if customers expect a price increase in the future? a. Demand shifts to the left b. Demand shifts to the right c. Supply shifts to the left d. Supply shifts to the right PRACTICE: If cheese in a can is an inferior good, what happens to its market when consumer income increases? a. Demand shifts to the left b. Demand shifts to the right c. Supply shifts to the left d. Supply shifts to the right Page 14

15 CONCEPT: THE BASICS OF SUPPLY Supply relates to the behavior of in our perfectly competitive market. The quantity supplied is the amount of a good that sellers are willing to produce. - The supply schedule lists pairs of prices and quantities supplied. The Law of Supply When the price of a good rises, the quantity supplied of that good rises The supply curve is a graph showing the relation between the price of a good and its quantity supplied. Supply Schedule for Wheat Price ($) Quantity 9 60, , , , , Page 15

16 CONCEPT: INDIVIDUAL SUPPLY AND MARKET SUPPLY Every producer has their own individual supply curve. This denotes the quantity they would supply at each price. The market supply curve is created from the of all the individual supply curves. Price of a Supreme Pizza ($) Papa Yum s Quantity Supplied Dominope s Quantity Supplied Market Supply 10 Papa Yum s Supply 10 Dominope s Supply Market Supply When asked to find the market supply: - Sum all the individual supply curves Page 16

17 CONCEPT: SHIFTING SUPPLY INTRODUCTION Certain events cause the supply curve to shift on the graph. WARNING! A change in price does not shift the supply curve because it is already a variable in the graph. Change in Price Change in Other Determinants of Supply Increase/Decrease in Increase/Decrease in All else equal Before: use P 1 and Q 1 After: use P 2 and Q 2 All else (NOT?) equal It helps to think of the events that shift supply in terms of good or bad events. Shift Right Shift Left Good thing happens for the product supply = Shift Right Bad thing happens for the product supply = Shift Left Page 17

18 CONCEPT: SHIFTING SUPPLY INPUT PRICES Changes in the price of inputs of a good (i.e. labor and materials) affects the good s supply. If input prices increase, supply will - Inversely proportional - Note: This is NOT a change in price. This is a change in input prices. Examples of input price changes: Minimum wage increases Price of gasoline decreases Price of microchips decreases EXAMPLE: If the cost of plastic, which is necessary for the production of the noodle-cooling chopsticks, rises, what will happen to the supply curve in this industry? Noodle-cooling Chopsticks Page 18

19 CONCEPT: SHIFTING SUPPLY TECHNOLOGY Changes in technology affect the supply of a good. If technology increases, supply will - Directly proportional Examples of technology increases: Wireless technology Industrial Revolution Movie Rentals EXAMPLE: A new super pizza oven has revolutionized the time it takes to bake a stuffed crust pizza. Stuffed crust pizzas can be hot and ready in less than one minute! What happens to the supply of stuffed crust pizza? Page 19

20 CONCEPT: SHIFTING SUPPLY TAXES AND SUBSIDIES Taxes and subsidies can affect the supply of a good. Businesses treat most taxes as costs. If taxes increase, supply will - Inversely Proportional Subsidies are basically reverse taxes. If subsidies increase, supply will - Directly Proportional Examples of changes in taxes and subsidies: Property taxes School funding Agricultural subsidies EXAMPLE: The new president of a well-known country has decided to slash funding for the arts. What will happen to the supply of arts education? Page 20

21 CONCEPT: SHIFTING SUPPLY SUBSTITUTES IN PRODUCTION Factories can usually produce more than just one good. If the price of a substitute in production increases, the supply of a product will - Inversely Proportional - Note: This is NOT a change in price. This is a change in price of a related product. Examples of possible substitutes in production: Basketballs and Volleyballs Corn and Wheat Pizzas and Calzones EXAMPLE: A company that produces peanut butter is also equipped to make almond butter. The company noticed that the prices of almond butter are rising. a. What will happen to the supply of peanut butter? b. What will happen to the supply of almond butter? Peanut Butter Almond Butter Page 21

22 CONCEPT: SHIFTING SUPPLY EXPECTATIONS Like demand, expectations about the future can affect current supply for a good. However, the supply side is trickier. If suppliers expect prices to increase in the future, the supply for the good today - Note: This is NOT a change in price. This is a change in expectations about price. Examples of changes in producer expectations: Expected price changes EXAMPLE: Señor Coffee makes artisanal coffees in an underdeveloped part of town. When, all of a sudden, a relentless mob of hipsters moves into the neighborhood. Señor Coffee knows that hipsters will pay way too much for artisanal coffee and expects future prices in the artisanal coffee industry to rise. a. What happens if Señor Coffee stores some of his current production for sale when prices increase? b. What happens to the supply of artisanal coffee if Señor Coffee hires another worker to anticipate demand? Storage Hire Worker Page 22

23 CONCEPT: SHIFTING SUPPLY NUMBER OF SUPPLIERS A change in the amount of suppliers in a market will affect supply. If the amount of suppliers in a market increases, the supply for the good - Directly Proportional Examples of changes in number of suppliers: WNBA Tattoo Parlors EXAMPLE: Jimmy Freezer sells ice cream in a small town. All of a sudden, it seems like everybody and their moms are selling ice cream on every corner. What has happened to the supply of ice cream? Page 23

24 CONCEPT: SHIFTING SUPPLY NATURE Nature can have positive or negative effects on supply. If there is a positive event in nature, the supply for the good - Directly Proportional Examples of events in nature: Good weather Bad Weather EXAMPLE: It seems like all season long the ideal amount of sunshine and rain has graced the farmlands in Iowa. a. How will this affect the supply of wheat? b. What if, instead of sunshine and rain, a meteor struck a different farm in Iowa every day of the season? Sunshine Meteors Page 24

25 CONCEPT: BIG DADDY SHIFT SUMMARY Directly Proportional DEMAND (INSPEC) Income: Normal Goods Consumer Income Demand for Normal Goods Substitutes Price of Substitute Demand for Good Preferences for a Good Preferences for Good Demand for Good Consumer Expectations Expected Future Price Demand for Good (now) Number of Consumers Number of Consumers Demand for Good SUPPLY (NESTS) Nature Good Nature Event Supply of Good Producer Expectations of Future Price: Hire Hiring new workers Supply of Good Subsidies Subsidies Supply of Good Technology Technology Supply of Good Number of Suppliers Number of Suppliers Supply of Good Inversely Proportional Income: Inferior Goods Consumer Income Demand for Inferior Goods Complements Price of Complement Demand for Good (SITE) Substitute in Production Price of Substitute in Prod. Supply of Good Input Prices Input Price Supply of Good Taxes Taxes Supply of Good Producer Expectations of Future Price: Storage Storing current production Supply of Good Change in Price Change in Price Change in Quantity Demanded A change in the price of a good does not shift the demand curve, we move along the demand curve. Change in Price Change in Quantity Supplied A change in the price of a good does not shift the demand curve, we move along the demand curve. Page 25

26 PRACTICE: What happens in the market for corn if the government decides to subsidize farmers? a. Demand shifts to the left b. Demand shifts to the right c. Supply shifts to the left d. Supply shifts to the right PRACTICE: What happens in the market for corn if the price of wheat, a substitute in production, decreases? a. Demand shifts to the left b. Demand shifts to the right c. Supply shifts to the left d. Supply shifts to the right PRACTICE: What happens in the market for corn if producers expect a future price increase, and begin to put production into storage? a. Demand shifts to the left b. Demand shifts to the right c. Supply shifts to the left d. Supply shifts to the right Page 26

27 CONCEPT: SUPPLY AND DEMAND TOGETHER EQUILIBRIUM Now, supply and demand will be analyzed together on one graph. The market is in equilibrium when - Equilibrium price the price that balances Qs and Qd - Equilibrium quantity the Qs and Qd at the equilibrium price Finding equilibrium on a graph Finding equilibrium in a schedule Price of a Supreme Pizza Market Demand Market Supply Page 27

28 CONCEPT: SUPPLY AND DEMAND TOGETHER SURPLUS AND SHORTAGE Sometimes the market is not in equilibrium. If the price is set too high, we have a surplus: If the price is set too low, we have a shortage: The law of supply and demand claims that the market price continually adjusts to balance Qs and Qd Page 28

29 CONCEPT: SUPPLY AND DEMAND TOGETHER DEMAND SHIFTS When demand shifts, the equilibrium price and quantity changes. For now, hold supply constant. Demand shifts right Steps for Analyzing Changes in Equilibrium 1. Decide whether the event shifts demand or supply (or both). 2. Decide the shift direction 3. Find new price and quantity: P2 and Q2 4. Compare to original: P1 and Q1 Demand shifts left Page 29

30 CONCEPT: SUPPLY AND DEMAND TOGETHER SUPPLY SHIFTS When supply shifts, the equilibrium price and quantity changes. For now, hold demand constant. Supply shifts right Steps for Analyzing Changes in Equilibrium 1. Decide whether the event shifts demand or supply (or both). 2. Decide the shift direction 3. Find new price and quantity: P2 and Q2 4. Compare to original: P1 and Q1 Supply shifts left Page 30

31 PRACTICE: If the economy booms and incomes rise, what happens in the markets for inferior goods? a. Prices and quantities both rise b. Prices and quantities both fall c. Prices rise and quantities fall d. Prices fall and quantities rise PRACTICE: A change in which of the following will NOT shift the demand curve for ice cream? a. The price of frozen yogurt b. The price of ice cream c. The price of ice cream cones d. The income of ice cream consumers PRACTICE: A decrease in will cause a movement along a given supply curve, which is called a change in. a. supply, demand b. demand, supply c. demand, quantity supplied d. supply, quantity demanded Page 31

32 PRACTICE: Gum and mints are substitutes. If the price of gum increases, what happens in the market for mints? a. The supply curve shifts to the left b. The supply curve shifts to the right c. The demand curve shifts to the left d. The demand curve shifts to the right PRACTICE: Which of the following situations would lead to an increase in the equilibrium price of carrots and a decrease in the equilibrium quantity of carrots sold? a. An increase in the price of hummus, a complement to carrots b. An increase in the price of celery, a substitute for carrots c. An increase in the price of fertilizer, an input for carrots d. An increase in consumers incomes, assuming carrots are a normal good PRACTICE: The discovery of a new fertilizer will shift the curve for carrots, leading to a equilibrium price. a. demand, higher b. demand, lower c. supply, higher d. supply, lower Page 32

33 CONCEPT: SUPPLY AND DEMAND TOGETHER SHIFTS IN BOTH SUPPLY AND DEMAND When both supply and demand shift, the information about equilibrium price and quantity is sometimes less clear. However, if both supply and demand shift, one variable (price or quantity) will always be WARNING! The way you draw the shifts will make a difference when both supply and demand shift. Supply shifts right, Demand shifts right Incorrect Incorrect Correct Page 33

34 CONCEPT: SUPPLY AND DEMAND TOGETHER SHIFTS IN BOTH SUPPLY AND DEMAND Steps for Analyzing Changes in Equilibrium 1. Decide whether the event shifts demand or supply (or both). 2. Decide the shift direction 3. Find new price and quantity: P2 and Q2 4. Compare to original: P1 and Q1 Supply shifts left, Demand shifts left P Q Supply shifts right, Demand shifts right P Q Supply shifts left, Demand shifts right P Q Supply shifts right, Demand shifts left P Q Page 34

35 PRACTICE: What happens in the market for cream cheese if (1) the price of butter, a substitute for cream cheese, falls and (2) the cost of milk, an input in cream cheese production, rises? a. Equilibrium price rises, equilibrium quantity falls b. Equilibrium price falls, equilibrium quantity falls c. Equilibrium price ambiguous, equilibrium quantity rises d. Equilibrium price ambiguous, equilibrium quantity falls PRACTICE: If the wages of bus drivers increases at the same time that the income of consumers decrease, what happens in the market for bus rides (assuming that bus rides are an inferior good)? a. Equilibrium price rises, equilibrium quantity ambiguous b. Equilibrium price rises, equilibrium quantity rises c. Equilibrium price falls, equilibrium quantity ambiguous d. Equilibrium price ambiguous, equilibrium quantity rises PRACTICE: If producers of garden hoses have discovered new technology to improve production, while the number of gardeners increases, what happens in the market for garden hoses? a. Equilibrium price rises, equilibrium quantity ambiguous b. Equilibrium price falls, equilibrium quantity falls c. Equilibrium price ambiguous, equilibrium quantity rises d. Equilibrium price ambiguous, equilibrium quantity falls Page 35

36 PRACTICE: What happens in the market for tennis balls if (1) the price of tennis rackets, a complement for tennis balls, increases and (2) the price of baseballs, a substitute in production, decreases? a. Equilibrium price rises, equilibrium quantity ambiguous b. Equilibrium price ambiguous, equilibrium quantity falls c. Equilibrium price ambiguous, equilibrium quantity rises d. Equilibrium price falls, equilibrium quantity ambiguous PRACTICE: What happens in the market for wheat if (1) the cost of fertilizer, an input in production, increases and (2) tornadoes ravages the Midwest, where wheat is grown? a. Equilibrium price rises, equilibrium quantity ambiguous b. Equilibrium price rises, equilibrium quantity falls c. Equilibrium price falls, equilibrium quantity rises d. Equilibrium price ambiguous, equilibrium quantity falls PRACTICE: What happens in the market for online tutoring services if (1) the government decides to provide funding for online tutors and (2) the price of private tutoring, a substitute for online tutoring services, increases? a. Equilibrium price rises, equilibrium quantity ambiguous b. Equilibrium price ambiguous, equilibrium quantity falls c. Equilibrium price falls, equilibrium quantity ambiguous d. Equilibrium price ambiguous, equilibrium quantity rises Page 36

37 CONCEPT: SUPPLY AND DEMAND TOGETHER QUANTITATIVE ANALYSIS We can use algebraic equations to find equilibrium price and quantity. Plotting the equation of a demand curve on a graph: P = 800 2Q ( 1000 Quantity Solve for Price Isolating Variables: We may need to rearrange the equation to put the other variable by itself: P = 800 2Q ( Page 37

38 Plotting the equation of a supply curve on a graph: P = Q * 1000 Quantity Solve for Price Isolating Variables: We may need to rearrange the equation to put the other variable by itself: P = Q * Page 38

39 CONCEPT: SUPPLY AND DEMAND TOGETHER QUANTITATIVE ANALYSIS We can find the equilibrium quantity and price from the equations of the demand and supply curves. Step 1 (if needed): Rearrange the supply and demand equations so that both have the same isolated variable. Step 2: Set the demand and supply curve equal to each other. At equilibrium, Qd = Qs, so use Q for both of them. Step 3: Solve for the remaining variable using algebra. Step 4: Use your answer from step two in either curve to solve for the other variable. Demand P = 800 2Q ( Q ( = P Supply P = Q * Q * = P 200 Step 2 Step 3 Step 4 Page 39

40 EXAMPLE: The supply and demand curves for ice cream are as follows: P = Q ( Q * = 150P 100 What is the equilibrium price and quantity of ice cream? a. P* = $1, Q* = 50 b. P* = $2, Q* = 200 c. P* = $3, Q* = 350 d. P* = $4, Q* = 500 PRACTICE: The supply and demand curves for a product are as follows: Q ( = P P = 1 40 Q * + 6 What is the equilibrium price and quantity of the product? a. P* = $60, Q* = 5760 b. P* = $70, Q* = 4960 c. P* = $80, Q* = 4160 d. P* = $90, Q* = 3360 Page 40

41 CONCEPT: SUPPLY AND DEMAND TOGETHER QUANTITATIVE ANALYSIS The equilibrium reached algebraically can be found on the graph as the of supply and demand. Demand P = 800 2Q ( Q ( = P Supply P = Q * Q * = P Price Quantity Demanded Quantity Supplied Page 41