Text transcription of Chapter 4 The Market Forces of Supply and Demand Welcome to the Chapter 4 Lecture on the Market Forces of Supply and Demand. This is the longest chapter for Unit 1, with the most material. We will use the concepts of supply and demand throughout the rest of the semester. It is very important that you understand these concepts now; otherwise future chapters will be very confusing. Let s start off with some basic definitions. First, when we discussion a market in economics, we are referring to a group of buyers and sellers of a particular good. The buyers as a whole will make up the demand for good and the sellers as a whole will make up the supply for the market. To make our analysis a little easier, we are going to concentrate on competitive markets. Competitive markets occur when no single buyer or single seller can influence the market price of the good for sale. In this chapter, we are going to go one step further and assume that markets are perfectly competitive. A perfectly competitive market has three main characteristics. First, the goods offered for sale are homogenous. Homogenous is another word for identical. When all the
goods offered for sale are identical, consumers will be indifferent from who they buy from. The second characteristic is the buyers and sellers are so numerous that no single buyer or single seller can influence the market price. This means that no one has market power or the ability to influence the market. Lastly, buyers and sellers are price takers. The price at which the good is sold for is based on supply and demand, not an individual buyer or seller. I m going to cover demand first, then supply, and then we ll put demand and supply together to form a market and discuss equilibrium. Whenever we discuss demand, think about the behavior of buyers. Quantity demanded or Q d for short, is the amount of a good that buyers are willing and able to buy. The key part of this definition is the willing and able. You might be willing to buy a lot of things, but your ability to purchase products determines your quantity demanded. The law of demand tells us about the general relationship between price and quantity demanded. The definition starts with other things equal. This allows us to only focus only price and quantity demanded. Other things equal, the quantity demand of a good falls when the price rises, and the quantity demanded of a good rises when price falls. This is an inverse relationship. When prices increase, the willingness and ability to buy goods will decrease. When prices decrease, the willingness and ability to buy goods will increase. Let s look at demand on a diagram:
First thing we start with is the table of data. One column for prices, labeled P and one column for quantity demanded, labeled Q d. You should see the law of demand by looking at the data in the table. Higher prices correlate to smaller quantity demanded. Lower prices correlate to larger quantity demanded. When we put the data on a diagram, we need to make sure that the axis are correctly label. All supply and demand diagrams will be labeled the same. Quantity is always on the horizontal axis. Price is always on the vertical axis. As the data is put on the coordinate plane, $5-10, $4-20, $3-35, $2-55, and $1-80, connect all the dots and we have our first demand curve. All demand curves will be labeled with a capital D. All demand curves are downward sloping. Some demand curves will have a bend; others will be perfect linear lines. As long as the demand curve is downward sloping, it is correct. Since we are studying macroeconomics, we want to look at the picture. Rather than focusing on the individual demand for a product, we are going to focus on the market demand for products. Market demand is the sum of all individual demands for a particular good or services. In order to calculate market demand from individual
demand, the process is called horizontal summation in which you add up the individual demand for each price. There is a great example of horizontal summation on page 69 of the textbook for your review. The demand curve is not going to stay in one spot. The demand curve can increase, meaning that there is a change that increases quantity demanded at every price. Remember, quantity demanded refers to the willingness and ability to purchase a good. When there is an increase in demand, the entire curve shifts to the right. The demand curve can also decrease, meaning that there is a change that decreases quantity demanded at every price. Decreases in demand shift the curve to the left. The shifts in the demand curve are illustrated on this diagram. Remember, all diagrams must be label. Quantity is on the horizontal axis. Price is on the vertical axis. We start with the blue downward sloping demand curve, labeled D1. Any increase in demand will cause quantity demanded to increase at every price, therefore the
curve shifts to the right, giving us D2. Any decrease in demand will cause quantity demanded to decrease at every price, therefore causing the curve to shift for the left, giving us D3. What causes the demand curve to shift? One of the five non-price demand shifters. Now, your textbook does not refer to these shifters as non-price shifters. However, I like to add in the non-price part to be very clear that the curve shifts when a factor, other than price, changes. Changes in price will have a completely different impact on the demand curve, which we will discuss in a few moments. The first non-price demand shifter is income. Goods are divided into two groups: normal and inferior. With normal goods, as income rises, demand for normal goods rise. An example of a normal good would be a new t-shirt, bottled water, going out to eat with your friends. As your income goes up, your demand for normal goods increase. With inferior goods, as income rises, demand for inferior goods fall. An example of an inferior good is Ramen noodles, boxed macaroni and cheese, generic drugs, second-hand clothing, or riding the bus. As your income goes up, you typically demand less inferior goods. The second non-price demand shifter is tastes. This shifter is easy If you like something, you demand more of it. I love tea. Therefore, if I get sick, I will increase my demand for tea because I enjoy it so much.
The third non-price factor is the price of related goods. This is considered a non-price factor because we are looking at the price of a good related to the good we are analyzing. Goods can be grouped together as substitutes or complements. Substitutes are pairs of goods used in place of one another. Think of having a BBQ, you can either grill hot dogs OR hamburgers. You can eat an apple or a pear. You can drink tea or coffee in the morning. With substitutes, if the price of one good rises, the demand for the substitute will rise. Suppose you are having a BBQ and you get to the grocery store and the price of hot dogs has increased to $30. You are probably not going to buy the hot dogs, so you buy the substitute good instead. Your demand for hamburger has now increased. Complements are pairs of goods used together. Hot dogs and hot dog buns, tea and honey, coffee and sugar. If the price of one good rises, the demand for the complement will fall. Suppose you are having the BBQ and you get to the grocery store and the price of the hot dogs has increased. You will probably not buy the hot dogs, therefore you have no reason to buy the hot dog buns, the complementary good. The demand for the complement has decreases. The forth non-price demand shifter is expectations. Expectations related to future income or future prices. If you expect your income to change in the future, you might adjust your demand today. If you expect to get a job new week, you might increase your demand today knowing that your income will be higher in the future. The fifth non-price demand shifter is number of buyers. More buyers means more demand, less buyers means less demand. If we are analyzing the demand for college textbooks and we learn that the number of people attending college has increased, then we can conclude that the number of buyers for textbooks has increased, therefore the demand has increased.
We are covering a lot of new material in chapter 4 and it is very important to be aware of the terminology. A change in demand is when the entire demand curve shifts. The only way to have a change in demand is to have a change in one of the five non-price demand shifts. A change in quantity demanded means movement along one demand curve. The only way to have a change in quantity demanded is to have a change in the price of the good. Let s look at this visually. This diagram is illustrating the change in demand, in which the entire curve shifts right as an increase or shifts left as a decrease. A change in income, tastes, price of related goods, expectations or the number of buyers will cause the demand curve to shift.
This diagram is illustrating a change in quantity demanded, due to a change in price. If we start at point A, which corresponds with a price of $1 and a quantity demanded of 8 units. If the price of the good increases to $2, then quantity demanded will decease to 4 units, since the willingness and ability has changed, causes movement along the demand curve. Let s move over to Supply. Whenever we talk about supply, think about the behavior of sellers. Quantity supplied, or Qs for short, is the amount of a good that sellers are willing and able to sell. Again, the willingness and ability is the key part of this definition. Law of supply tells us the general relationship between price and quantity supplied. Just like the law of demand, it starts off with other things equal. This allows us to focus only on the relationship between price and quantity supplied. Other things equal, the quantity supplied of a good rises when the price rises, and quantity supplied of a good falls when price falls. This is a positive or direct relationship. Higher prices mean a larger quantity supplied. Lower prices mean a smaller quantity supplied.
First thing we start with is the table of data. One column for prices, labeled P and one column for quantity supplied, labeled Q S. You should see the law of supply by looking at the data in the table. Higher prices correlate to larger quantity supplied. Lower prices correlate to smaller quantity supplied. When we put the data on a diagram, we need to make sure that the axis are correctly label. All supply and demand diagrams will be labeled the same. Quantity is always on the horizontal axis. Price is always on the vertical axis. As the data is put on the coordinate plane, $5-60, $4-50, $3-35, $2-20, and $1-5, connect all the dots and we have our first supply curve. All supply curves will be labeled with a capital S. All supply curves are upward sloping. Some supply curves will have a bend; others will be perfect linear lines. As long as the supply curve is upward sloping, it is correct. Since we are studying macroeconomics, we want to look at the picture. Rather than focusing on the individual supply for a product, we are going to focus on the market supply for products. Market supply is the sum of the
supplies from all sellers. In order to calculate market supply from individual supply, the process is called horizontal summation in which you add up the individual supply for each price. There is a great example of horizontal summation on page 75 of the textbook for your review. What causes the supply curve to shift? One of the four non-price supply shifters. Now, your textbook does not refer to these shifters as non-price shifters. However, I like to add in the non-price part to be very clear that the curve shifts when a factor, other than price, changes. Changes in price will have a completely different impact on the supply curve, which we will discuss in a few moments. The first non-price supply shifter is input prices. Input prices relate to profits and production costs. Remember, supply is all about behavior of sellers and sellers are in business to make profits. Higher input prices will decrease supply. The logic is that as input prices increase, production costs increase and profits fall. Therefore, firms will decrease the supply in the market. Lower input prices will increase supply. Lower input prices means that production costs will decrease and profits will increase, therefore supply will increase. The second non-price supply shifter is technology. Technological change is beneficial because it creates a more efficient production process that lower costs. When costs are lower, profits will increase, therefore the supply curve will increase. The third non-price supply shifter is expectations. Expectations regarding future prices or future resources prices can affect current supply. The forth non-price supply shifter is number of sellers. More sellers means more supply, less sellers means less supply.
With supply, like demand, it is important to be aware of the terminology. A change in supply occurs when the entire supply curve shifts. The only way for the entire curve to shift is for a change in one of the four nonprice supply shifters. A change in quantity supplied means movement along one supply curve. The only way to have movement along a curve is for the price of the good to change. This diagram is illustrating the change in supply, in which the entire curve shifts right as an increase or shifts left as a decrease. A change in input prices, technology, expectation or the number of sellers will cause the suply curve to shift.
This diagram is illustrating a change in quantity supplied, due to a change in price. If we start at point A, which corresponds with a price of $1 and a quantity supplied of 1 unit. If the price of the good increases to $3, then quantity supplied will decease to 5 units, since the willingness and ability has changed, causes movement along the supply curve. Now that we know about the demand curve and the supply curve, we can put them together to forum a market. Equilibrium will occur at the one unique point at which the demand and supply curves intersect. At equilibrium, the market has reached a price at which quantity demand equals quantity supplied. The corresponding price at the intersection is called equilibrium price, which you will see labeled as P*. The corresponding quantity at the intersection is called equilibrium quantity, which you will see labeled as Q*.
At equilibrium price, buyers can buy all they want and sellers can sell all they want. If some reason the market is not at equilibrium the actions of buyers and sellers will naturally move the market to equilibrium. This diagram is illustrating equilibrium. Quantity is labeled on the horizontal axis. Price is labeled on the vertical axis. The supply curve is upward sloping. The demand curve is downward sloping. Equilibrium occurs at the one unique point of intersection. At equilibrium, the corresponding quantity is called equilibrium quantity. The corresponding price is called equilibrium price.
A surplus will occur if the market is not at equilibrium. If price is above equilibrium price, then a surplus is created. A surplus is also called excess supply. When price is above equilibrium price, quantity supplied is greater than quantity demanded. Since it is not in the best interest of the sellers to have excess supply, firms will respond to a surplus by lowering price until equilibrium price is reached and quantity demand equals quantity supplied. As firms lower the price, quantity supplied will decrease and quantity demanded will increase. This diagram illustrates the surplus or excess supply. We start with quantity of the horizontal axis and price on the vertical axis. The supply curve is upward sloping. The demand curve is downward sloping. At equilibrium, the equilibrium price is $2 and the equilibrium quantity is 7 units. If price is above equilibrium price, say at $2.50, quantity supplied will be 10 units and quantity demanded would be 4 units. The difference between quantity supplied and quantity demanded is the excess supply or surplus.
A shortage will occur if the market is not at equilibrium. If price is below equilibrium price, then a shortage is created. A shortage is also called excess demand. When price is below equilibrium price, quantity demanded is greater than quantity supplied. Since it is not in the best interest of the sellers to have excess demand, firms will respond to a shortage by increasing price until equilibrium price is reached and quantity demand equals quantity supplied. As firms increase the price, quantity supplied will increase and quantity demanded will decrease. This diagram illustrates the shortage or excess demand. We start with quantity of the horizontal axis and price on the vertical axis. The supply curve is upward sloping. The demand curve is downward sloping. At equilibrium, the equilibrium price is $2 and the equilibrium quantity is 7 units. If price is below equilibrium price, say at $1.50, quantity demanded will be 10 units and quantity supplied would be 4 units. The difference between quantity demanded and quantity supplied is the excess demand or shortage.
The last part of the chapter focuses on analyzing equilibrium, which is what you have to do during the week discussion. Except you don t have to draw out any diagrams. We are going to use a three-step process to analyze change in equilibrium when we have a change in one of non-price demand or non-price supply shifters. Once you read over the question, the first thing question you need to answer is does the event shift the demand or the supply curve? Next, which direction does the curve shift? Lastly, draw out the diagram and determine the new equilibrium price and new equilibrium quantity. Let s go over two examples. Example 1 is the Market for Ice Cream. We need to be thinking about the demand and supply for ice cream. The following event occurs It is a hot summer day. This is the ONLY information we have to analyze this market. First, we need to determine which curve is impact by this event. The hot summer day with impact the demand curve because it will affect tastes. Which direction does the curve shift? The hot summer day will increase demand because ice cream is tastier on a hot summer day. Lastly, let s look at the diagram:
As always, the axes are labeled - Quantity on the horizontal axis and price on the vertical axis. Upward sloping supply and downward sloping demand. We start at equilibrium, labeling equilibrium price as P*1 and equilibrium as Q*1. The hot summer day increases the demand for ice cream, shifting the entire demand curve to the right because ice crease is tastier on a hot summer day. There is now a new equilibrium at the intersection of the new demand curve and the old supply curves. Here we can see that the equilibrium price has increased up to P*2 and the equilibrium quantity has increased to Q*2. One more example using the market for ice cream. This time the event is the price of sugar increases. This event will impact the supply curve because sugar is an input into the production of ice cream. An increase in the price of sugar will cause the supply curve to decrease. Higher input prices means that production costs have increased and profits have decreased. Therefore, firms decrease supply. Lastly, the diagram:
Quantity on the horizontal and price on the vertical, downward sloping demand and upward sloping supply. Equilibrium occurs at the unique point at which the demand and supply curves intersect, resulting in equilibrium price labeled as P*1 and equilibrium quantity as Q*1. The increase in the price of sugar causes the supply curve to decrease, shifting left. The new equilibrium occurs at the point where the new supply curve and old demand curves intersect. The equilibrium price has increased and the quantity has decreased. That is the end of the chapter 4 lecture on the market forces of supply and demand. This was a lot of material, so be sure to review any concepts you found confusing. Please note that I did not cover the example on page 82 of the textbook. I will not ask you any questions about what happens with both the demand and supply curves shift at the same time. We will focus our analysis on one curve at a time.