Macroeconomics: Principles, Applications, and Tools NINTH EDITION Chapter 4 Demand, Supply, and Market Equilibrium In recent years, thousands of workers have moved to North Dakota to work in the oil industry. Between 2009 and 2012, mining employment in the state increased by about 11,000 jobs and total employment increased by over 40,000 jobs. Given the limited options for increasing the housing stock in the short run, the increase in the demand for housing increased housing prices dramatically. In the town of Williston, the rent for a two-bedroom apartment increased from $350 per month to $2,000.
Learning Objectives 4.1 Describe and explain the law of demand. 4.2 Describe and explain the law of supply. 4.3 Explain the role of price in reaching a market equilibrium. 4.4 Describe the effect of a change in demand on the equilibrium price. 4.5 Describe the effect of a change in supply on the equilibrium price. 4.6 Use information on price and quantity to determine what caused a change in price.
DEMAND, SUPPLY, AND MARKET EQUILIBRIUM The model of demand and supply explains how a perfectly competitive market operates. Perfectly competitive market A market with many buyers and sellers of a homogeneous product and no barriers to entry. Demand The quantity of goods or services that a consumer is willing and able to purchase at various prices. Supply The quantity of goods or services that a seller is willing and able to offer at various prices over some time period.
4.1 THE DEMAND CURVE Quantity demanded The amount of a product that consumers are willing and able to buy. Demand schedule A table that shows the relationship between the price of a product and the quantity demanded, ceteris paribus.
4.1 THE DEMAND CURVE Here is a list of the variables that affect an individual consumer s decision, using the pizza market as an example: The price of the product (for example, the price of a pizza) The consumer s income The price of substitute goods (for example, the prices of tacos or sandwiches or other goods that can be consumed instead of pizza) The price of complementary goods (for example, the price of lemonade or other goods consumed with pizza) The consumer s preferences or tastes and advertising that may influence preferences The consumer s expectations about future prices
4.1 THE DEMAND CURVE The Individual Demand Curve and the Law of Demand Individual demand curve A curve that shows the relationship between the price of a good and quantity demanded by an individual consumer, ceteris paribus. Law of demand There is a negative relationship between price and quantity demanded, ceteris paribus. Change in quantity demanded A change in the quantity consumers are willing and able to buy when the price changes; represented graphically by movement along the demand curve.
4.1 THE DEMAND CURVE The Individual Demand Curve and the Law of Demand According to the law of demand, the higher the price, the smaller the quantity demanded, everything else being equal. Therefore, the demand curve is negatively sloped: When the price increases from $6 to $8, the quantity demanded decreases from seven pizzas per month (point c) to four pizzas per month (point b). AL S DEMAND SCHEDULE FOR PIZZAS Point Price Quantity of Pizzas per Month a $10 1 b 8 4 c 6 7 d 4 10 e 2 13
4.1 THE DEMAND CURVE From Individual Demand to Market Demand The market demand equals the sum of the demands of all consumers. In this case, there are only two, so at each price the market quantity demanded equals the quantity demanded by Al plus the quantity demanded by Bea. At a price of $8, Al s quantity is four pizzas (point a) and Bea s quantity is two pizzas (point b), so the market quantity demanded is six pizzas (point c). Market demand curve A curve showing the relationship between price and quantity demanded by all consumers, ceteris paribus. Each consumer obeys the law of demand, so the market demand curve is negatively sloped. QUANTITY OF PIZZA DEMANDED Price Al + Bea = Market Demand $8 4 2 6 6 7 4 11 4 10 6 16 2 13 8 21
APPLICATION 1 THE LAW OF DEMAND FOR YOUNG SMOKERS APPLYING THE CONCEPTS #1: What is the Law of Demand? As price decreases and we move downward along the market demand for cigarettes, the quantity of cigarettes demanded increases for two reasons. First, people who smoked cigarettes at the original price respond to the lower price by smoking more. Second, some people start smoking. A change in cigarette taxes in Canada illustrates the second effect, the new-smoker effect. In 1994, several provinces in eastern Canada cut their cigarette taxes and the price of cigarettes in the provinces decreased by roughly 50 percent. Researchers tracked the choices of 591 youths from the Waterloo Smoking Prevention Program, and concluded that the lower price increased the smoking rate by roughly 17 percent.
4.2 THE SUPPLY CURVE Suppose you ask the manager of a firm, How much of your product are you willing to produce and sell? The manager s decision about how much to produce depends on many variables, including the following, using pizza as an example: The price of the product (for example, the price per pizza) The wage paid to workers The price of materials (for example, the price of dough and cheese) The cost of capital (for example, the cost of a pizza oven) The state of production technology (for example, the knowledge used in making pizza) Producers expectations about future prices Taxes paid to the government or subsidies (payments from the government to firms to produce a product)
4.2 THE SUPPLY CURVE The Individual Supply Curve and the Law of Supply Quantity supplied The amount of a product that firms are willing and able to sell. Supply schedule A table that shows the relationship between the price of a product and quantity supplied, ceteris paribus. Individual supply curve A curve showing the relationship between price and quantity supplied by a single firm, ceteris paribus.
4.2 THE SUPPLY CURVE The Individual Supply Curve and the Law of Supply Law of supply There is a positive relationship between price and quantity supplied, ceteris paribus. Change in quantity supplied A change in the quantity firms are willing and able to sell when the price changes; represented graphically by movement along the supply curve. Minimum supply price The lowest price at which a product will be supplied.
4.2 THE SUPPLY CURVE The Individual Supply Curve and the Law of Supply The supply curve of an individual supplier is positively sloped, reflecting the law of supply. As shown by point a, the quantity supplied is zero at a price of $2, indicating that the minimum supply price is just above $2. An increase in price increases the quantity supplied to 100 pizzas at a price of $4, to 200 pizzas at a price of $6, and so on. INDIVIDUAL SUPPLY SCHEDULE FOR PIZZA Point Price Quantity of Pizzas per Month a $2 0 b 4 100 c 6 200 d 8 300 e 10 400
4.2 THE SUPPLY CURVE Why Is the Individual Supply Curve Positively Sloped? MARGINAL PRINCIPLE Consistent with the Law of Supply, increase the level of an activity as long as its marginal benefit exceeds its marginal cost. Choose the level at which the marginal benefit equals the marginal cost. In general, the supply curve shows the marginal cost of production. From Individual Supply to Market Supply Market supply curve A curve showing the relationship between the market price and quantity supplied by all firms, ceteris paribus.
4.2 THE SUPPLY CURVE From Individual Supply to Market Supply The market supply is the sum of the supplies of all firms. In Panel A, Lola is a low-cost producer who produces the first pizza once the price rises above $2 (shown by point a). Panel B, Hiram is a high-cost producer who doesn t produce pizza until the price rises above $6 (shown by point f ). To draw the market supply curve, we sum the individual supply curves horizontally. At a price of $8, market supply is 400 pizzas (point m), equal to 300 from Lola (point d) plus 100 from Hiram (point g). Market supply curve A curve showing the relationship between the market price and quantity supplied by all firms, ceteris paribus. QUANTITY OF PIZZA SUPPLIED Price Lola + Hiram = Market Supply 2 0 0 0 4 100 0 100 6 200 0 200 8 300 100 400 10 400 200 600
4.2 THE SUPPLY CURVE From Individual Supply to Market Supply The market supply is the sum of the supplies of all firms. The minimum supply price is $2 (point a), and the quantity supplied increases by 10,000 for each $2 increase in price to 10,000 at a price of $4 (point b), to 20,000 at a price of $6 (point c), and so on.
4.2 THE SUPPLY CURVE Why Is the Market Supply Curve Positively Sloped? To explain the positive slope, consider the two responses by firms to an increase in price: Individual firm. As we saw earlier, a higher price encourages a firm to increase its output by purchasing more materials and hiring more workers. New firms. In the long run, new firms can enter the market and existing firms can expand their production facilities to produce more output.
APPLICATION 2 LAW OF SUPPLY AND WOOLYMPICS APPLYING THE CONCEPTS #2: What is the Law of Supply? In the 1990s, the world price of wool decreased by about 30 percent, and prices have remained relatively low since then. Based on the law of supply, we would expect the quantity of wool supplied by New Zealand and other exporters to decrease, and that s what happened. Land that formerly grew grass for wool-producing sheep has been converted into other uses, including dairy products, forestry, and the domestication of deer. There have been several attempts to revive the wool industry by boosting the demand for wool and thus increase its price. The United Nations General Assembly declared 2009 as the International Year of Natural Fibers, with the objective to raise awareness and stimulate demand for natural fibers. In 2012, the Federated Farmers of New Zealand proposed that sheep shearing be added to the Commonwealth Games and Olympics as a demonstration sport. Of course, it s not obvious that Olympic shearing would increase the demand for wool, and then there is the problem of what to do with all the sheared wool. Extreme knitting?
4.3 MARKET EQUILIBRIUM: BRINGING DEMAND AND SUPPLY TOGETHER Market equilibrium A situation in which the quantity demanded equals the quantity supplied at the prevailing market price. Excess demand (shortage) A situation in which, at the prevailing price, the quantity demanded exceeds the quantity supplied. Excess Demand Causes the Price to Rise Excess supply (surplus) A situation in which the quantity supplied exceeds the quantity demanded at the prevailing price. Excess Supply Causes the Price to Drop
4.3 MARKET EQUILIBRIUM: BRINGING DEMAND AND SUPPLY TOGETHER At the market equilibrium (point a, with price = $8 and quantity = 30,000), the quantity supplied equals the quantity demanded. At a price below the equilibrium price ($6), there is excess demand the quantity demanded at point c exceeds the quantity supplied at point b. At a price above the equilibrium price ($12), there is excess supply the quantity supplied at point e exceeds the quantity demanded at point d.
APPLICATION 3 SHRINKING WINE LAKES APPLYING THE CONCEPTS #3: What are the consequences of a price above the equilibrium price? Under the Common Agricultural Policy (CAP) the European Union uses a number of policies to support the agricultural sectors of its member countries. Under a minimum-price policy the government sets a price above the market-equilibrium price. The EU guarantees farmers minimum prices for products such as grain, dairy products, and wine. This policy causes artificial excess supply: if the minimum price exceeds the market-equilibrium price, the quantity supplied will exceed the quantity demanded. To support the minimum prices, the EU purchases any output that a farmer cannot sell at the guaranteed price and stores the excess supply in facilities labeled by the European press as butter mountains and wine lakes. In recent years the EU has reformed its agriculture policy by reducing and in some cases eliminating minimum prices. As a result, the butter mountains and wine lakes are shrinking.
4.4 MARKET EFFECTS OF CHANGES IN DEMAND Change in Quantity Demanded versus Change in Demand (A) A change in price causes a change in quantity demanded, a movement along a single demand curve. For example, a decrease in price causes a move from point a to point b, increasing the quantity demanded. (B) A change in demand caused by changes in a variable other than the price of the good shifts the entire demand curve. For example, an increase in demand shifts the demand curve from D 1 to D 2. Change in demand A shift of the demand curve caused by a change in a variable other than the price of the product.
4.4 MARKET EFFECTS OF CHANGES IN DEMAND Increases in Demand Shift the Demand Curve Normal good A good for which an increase in income increases demand. Inferior good A good for which an increase in income decreases demand. Substitutes Two goods for which an increase in the price of one good increases the demand for the other good. Complements Two goods for which a decrease in the price of one good increases the demand for the other good.
4.4 MARKET EFFECTS OF CHANGES IN DEMAND Increases in Demand Shift the Demand Curve TABLE 4.1 Increase in Demand Shift the Demand Curve to the Right When this variable. Income, with normal good Income, with inferior good Price of a substitute good Price of complementary good Population Consumer preferences for good Expected future price Increase or decreases The demand curve shifts in the direction
4.4 MARKET EFFECTS OF CHANGES IN DEMAND Increases in Demand Shift the Demand Curve An increase in demand shifts the demand curve to the right: At each price, the quantity demanded increases. At the initial price ($8), there is excess demand, with the quantity demanded (point b) exceeding the quantity supplied (point a). The excess demand causes the price to rise, and equilibrium is restored at point c. To summarize, the increase in demand increases the equilibrium price to $10 and increases the equilibrium quantity to 40,000 pizzas.
4.4 MARKET EFFECTS OF CHANGES IN DEMAND Decreases in Demand Shift the Demand Curve A decrease in demand shifts the demand curve to the left: At each price, the quantity demanded decreases. At the initial price ($8), there is excess supply, with the quantity supplied (point a) exceeding the quantity demanded (point b). The excess supply causes the price to drop, and equilibrium is restored at point c. To summarize, the decrease in demand decreases the equilibrium price to $6 and decreases the equilibrium quantity to 20,000 pizzas.
4.4 MARKET EFFECTS OF CHANGES IN DEMAND Decreases in Demand Shift the Demand Curve TABLE 4.2 Increase in Demand Shift the Demand Curve to the Left When this variable. Income, with normal good Income, with inferior good Price of a substitute good Price of complementary good Population Consumer preferences for good Expected future price Increase or decreases The demand curve shifts in the direction
APPLICATION 4 CHINESE DEMAND AND PECAN PRICES APPLYING THE CONCEPTS #4: How does a change in demand affect the equilibrium price? Between 2006 and 2009, Chinese imports of US pecans increased from 9 million pounds per year to 88 million pounds. The increase in demand from China is roughly 30 percent of the total annual crop. The increase in demand was caused in part by widespread reports in the Chinese media that pecans promote brain and cardiovascular health. As a result of the increase in demand, the equilibrium price of pecans increased by about 50 percent, increasing the price of pecan pie, a holiday favorite.
4.5 MARKET EFFECTS OF CHANGES IN SUPPLY Change in Quantity Supplied versus Change in Supply (A) A change in price causes a change in quantity supplied, a movement along a single supply curve. For example, an increase in price causes a move from point a to point b. (B) A change in supply (caused by a change in something other than the price of the product) shifts the entire supply curve. For example, an increase in supply shifts the supply curve from S 1 to S 2. For any given price (for example, $6), a larger quantity is supplied (25,000 pizzas at point c instead of 20,000 at point a). The price required to generate any given quantity decreases. For example, the price required to generate 20,000 pizzas drops from $6 (point a) to $5 (point d ).
4.5 MARKET EFFECTS OF CHANGES IN SUPPLY Increases in Supply Shift the Supply Curve TABLE 4.3 Changes in Supply Shift the Supply Curve Downward and to the Right When this variable. Wage Price of materials or capital Technological advance Government subsidy Expected future price Number of producers Increase or decreases The supply curve shifts in this direction
4.5 MARKET EFFECTS OF CHANGES IN SUPPLY An Increase in Supply Decreases the Equilibrium Price An increase in supply shifts the supply curve to the right: At each price, the quantity supplied increases. At the initial price ($8), there is excess supply, with the quantity supplied (point b) exceeding the quantity demanded (point a). The excess supply causes the price to drop, and equilibrium is restored at point c. To summarize, the increase in supply decreases the equilibrium price to $6 and increases the equilibrium quantity to 36,000 pizzas.
4.5 MARKET EFFECTS OF CHANGES IN SUPPLY Decreases in Supply Shift the Supply Curve TABLE 4.4 Changes in Supply Shift the Supply Curve Upward and to the Left When this variable. Wage Price of materials or capital Tax Expected future price Increase or decreases The supply curve shifts in this direction Number of producers
4.5 MARKET EFFECTS OF CHANGES IN SUPPLY A Decrease in Supply Increases the Equilibrium Price A decrease in supply shifts the supply curve to the left. At each price, the quantity supplied decreases. At the initial price ($8), there is excess demand, with the quantity demanded (point a) exceeding the quantity supplied (point b). The excess demand causes the price to rise, and equilibrium is restored at point c. To summarize, the decrease in supply increases the equilibrium price to $8 and decreases the equilibrium quantity to 24,000 pizzas.
4.5 MARKET EFFECTS OF CHANGES IN SUPPLY Simultaneous Changes in Demand and Supply (A) Larger increase in demand. If the increase in demand is larger than the increase in supply (if the shift of the demand curve is larger than the shift of the supply curve), both the equilibrium price and the equilibrium quantity will increase. (B) Larger increase in supply. If the increase in supply is larger than the increase in demand (if the shift of the supply curve is larger than the shift of the demand curve), the equilibrium price will decrease and the equilibrium quantity will increase.
APPLICATION 5 THE HARMATTAN AND THE PRICE OF CHOCOLATE APPLYING THE CONCEPTS #5: How does a change in supply affect the equilibrium price? Every year around harvest time for the cocoa crop in West Africa, the harmattan, a dry dusty wind from the Sahara desert, sweeps through cocoa plantations in Ghana and Ivory Coast, drying the pods and reducing yields. In 2015, the harmattan was longer than usual (14 days compared to the usual 5 days), so crop yields were lower than usual. The decrease in supply from the long harmattan was one factor n the large increase in the world price of cocoa in 2015.
4.6 PREDICTING AND EXPLAINING MARKET CHANGES TABLE 4.5 Market Effects of Changes in Demand or Supply Change in Demand or Supply Increase in demand Decrease in demand Increase in supply Decrease in supply How does the equilibrium price change? How does the equilibrium quantity change
APPLICATION 6 WHY LOWER DRUG PRICES? APPLYING THE CONCEPTS #6: What explains a decrease in price? Ted Koppel, host of the ABC news program Nightline, once said, "Do you know what's happened to the price of drugs in the United States? The price of cocaine, way down, the price of marijuana, way down. You don't have to be an expert in economics to know that when the price goes down, it means more stuff is coming in. That's supply and demand." According to Koppel, the price of drugs dropped because the government's efforts to control the supply of illegal drugs had failed. In other words, the lower price resulted from an increase in supply. Is Koppel's economic detective work sound? In Table4.5, Koppel s explanation of lower prices is the third case--increase in supply. This is the correct explanation only if along with a decrease we experience an increase in the equilibrium quantity. But according to the U.S. Department of Justice, the quantity of drugs consumed actually decreased during the period of dropping prices. Therefore, the correct explanation of lower prices is the second case-- Decrease in demand. Lower demand not a failure of the government's drug policy and an increase in supply was responsible for the decrease in drug prices.
Learning Objectives 4.1 Describe and explain the law of demand. 4.2 Describe and explain the law of supply. 4.3 Explain the role of price in reaching a market equilibrium. 4.4 Describe the effect of a change in demand on the equilibrium price. 4.5 Describe the effect of a change in supply on the equilibrium price. 4.6 Use information on price and quantity to determine what caused a change in price.
KEY TERMS Change in demand Change in quantity demanded Change in quantity supplied Change in supply Complements Demand schedule Excess demand (shortage) Excess supply (surplus) Individual demand curve Individual supply curve Inferior good Law of demand Law of supply Market demand curve Market equilibrium Market supply curve Minimum supply price Normal good Perfectly competitive market Quantity demanded Quantity supplied Substitutes Supply schedule
Questions? Homework Ch4, pp 84-87 1.5, 2.8, 3.6, 4.1, 5.1, 6.1