Topic 3. Demand and Supply

Econ 103 Topic 3 page 1 Topic 3 Demand and Supply Text reference: Chapter 3 and 4. Assumptions of the competitive model. Demand: -Determinants of demand -Demand curves -Consumer surplus -Divisibility - Law of demand -Change in demand

Econ 103 Topic 3 page 2 -Changes in the quantity demanded -Normal and inferior goods -Complements and substitutes -Individual demand and market demand

Econ 103 Topic 3 page 3 In Topic 2, Person 1 and Person 2 exchanged fish and mushrooms and increased their well-being with trade. In real economies, goods are exchanged for money, not other goods. Prices are measured in $s, not fish. Usually there is more than one buyer and seller. Typically prices are determined by the interaction of all buyers and sellers. This topic analyses the interactions of the buyers and sellers in the competitive market.

Econ 103 Topic 3 page 4 The Competitive Market Model: Assumptions: Many potential buyers of the good being offered Each potential buyer is small relative to the overall market and cannot influence price. Can buy as much of the good as he or she wants without affecting price. Many potential sellers of the good. Each seller is small relative to overall market and cannot influence price. Can sell as much or as little without affecting the price.

Econ 103 Topic 3 page 5 The model is highly unrealistic for many markets. However, this will provide a useful base model for analysis. Potential buyers in a market are known as the demand side. Potential sellers in a market are known as the supply side. In competitive markets, demand and supply jointly determine: -the quantity of goods that are produced and consumed -the price at which goods sell for. Buyers and sellers are both better off as a result of market trades.

Econ 103 Topic 3 page 6 The measurement of social welfare will allow us to see this. Competitive markets will under certain circumstances, maximize consumer and producer well-being. In this sense, we say competitive markets are efficient.

Econ 103 Topic 3 page 7 Demand What determines how much of a given good a potential buyer is willing to buy? What are the determinants of demand? -There are many determinants of demand -price of the good in question is the most obvious one.

Econ 103 Topic 3 page 8 Recall from Topic 1 regarding coffee consumption. We were looking at how much I was willing to pay for coffee one morning. Coffee MB of coffee 1 $5 2 $3 3 $1 This is my demand schedule for coffee. This table contains the information needed to determine how many coffees I will buy at a given price.

Econ 103 Topic 3 page 9 We will represent this information graphically by drawing my demand curve for coffee. Demand (D) curve plots the quantities I am willing to buy at different prices for the good, holding everything else constant. The quantity I am willing to buy at a certain price is called the quantity demanded.

Econ 103 Topic 3 page 10 Graphical representation of my MB schedule is actually my demand curve. We label the horizontal axis Q (quantity). $ 5 3 Each point from the MB schedule is plotted. 1 0 1 2 3 Quantity

Econ 103 Topic 3 page 11 $ 5 3 1 0 1 2 3 Plot each point from the MB schedule. Then join up points with stair-step line. That line is the MB curve. Quantity MB curve

Econ 103 Topic 3 page 12 Recall: in Topic 1, we used this information to see how much coffee I would buy at a price of $1.25 a cup. Compare MB of each cup to MC, and buy if MB>MC. $ If coffee is $1.25, I buy 2 cups. 5 3 1 0 1 2 3 P= $1.25=MC of coffee Quantity The same information could be used to see what I would do at different prices.

Econ 103 Topic 3 page 13 Now suppose P=$3.25 The MC > MB only for one cup of coffee, so if P=$3.25, Q=1. $ 5 MB curve can be used to tell us what Q we would buy at any possible price. Which is just what a demand curve tells us. 3 P= $3.25=MC of coffee 1 0 1 2 3 My MB curve is my demand curve! Quantity

Econ 103 Topic 3 page 14 We can use the demand curve diagrams to measure consumer well-being. That is, we can measure a consumer s net benefit (NB) from a given purchase choice. We called this happiness profit in Topic 1. Here we will use its formal name consumer surplus. Consumer Surplus is the difference between what a consumer is willing to pay for a given Q of a good, and what the consumer actually has to pay for that Q. Total benefits of consumption minus total costs of consumption.

Econ 103 Topic 3 page 15 Consumer Surplus Recall that I am willing to pay $5 for the first cup of coffee. On the demand curve diagram, that willingness to pay can be represented by the area under the demand curve, as quantity goes for 0 to 1. $ 5 first coffee gives me $5 of happiness 3 1 0 1 2 3 Quantity

Econ 103 Topic 3 page 16 Recall, that I am willing to pay $3 for the second coffee. On the demand curve diagram, that willingness to pay can be represented by the area under the demand curve as quantity goes from 1 to 2. $ 5 3 second coffee gives me $3 of happiness. Third coffee gives me $1 of happiness. 1 0 1 2 3 Quantity

Econ 103 Topic 3 page 17 When price =$1.25 and I buy 2 coffees, total happiness from coffee= $5 + $3 = $8. $8 = the maximum amount of money I would have been willing to spend to get those 2 coffees. $ 5 But I didn t have to spend $8 3 I had to spend $2.50= P*Q. 1 0 1 2 3 P=$1.25 = MC of coffee Quantity

Econ 103 Topic 3 page 18 Consumer Surplus: willingness to pay minus actual cost=$8-$2.50=$5.50. My $2.50 bought me $8 of happiness. Consumer surplus = $5.50. $ 5 3 CS is the area below the demand curve and above the price line up to the quantity bought. 1 0 1 2 3 P=$1.25 = MC of coffee Quantity

Econ 103 Topic 3 page 19 Consumer surplus can be used to analyze changes in consumer well-being as market conditions change. If price increases to $2.50: $ 5 When price is $2.50 CS= $3. 3 P=$2.50 When price is $1.25 CS= $5.50. P=$1.25 = MC of coffee 1 Quantity 0 1 2 3 CS= $8-$5 = $3 CS can be used to analyze changes I consumer well-being as market conditions change: $5.50-$3= $2.50 Change in CS.

Econ 103 Topic 3 page 20 Demand: Notice the contrast of the stair-step demand curve to the smooth demand curve in chapter 3 of the text. The difference is due to the assumptions about what we call the divisibility of goods. We could allow coffee to be sold in very small fractions of a millilitre:

Econ 103 Topic 3 page 21 $ Demand Curve Quantity In the limit, we will have so many tiny stairs that effectively the demand curve becomes perfectly smooth. Assume the demand curves can be drawn as perfectly smooth.

Econ 103 Topic 3 page 22 Often we will also assume the demand curves are linear. This is not because we think they are, just because it makes analysis easier. $ Demand Curve Quantity

Econ 103 Topic 3 page 23 We can still calculate CS and changes in CS as before: $ -Consumer was WTP (A+B+C) for Q 1 units. -Consumer only had to pay (B+C) for Q1 units. A P1 Demand Curve B C Q1 Quantity Consumer surplus = area A.

Econ 103 Topic 3 page 24 If price falls to P2, quantity demanded increases to Q2 $ P 1 P 2 -Consumer was WTP (A+B+C+E+F) for Q 2 units. -Consumer only had to pay (C+F) for Q 2 units. A Demand Curve B E -New CS = area (A+B+E) C F Q1 Q2 Quantity

Econ 103 Topic 3 page 25 Law of Demand: the demand curve slopes downward if marginal benefit falls as consumption rises. Does not have to be true, however. There are cases of vertical and horizontal demand curves. $ Note: if price falls and quantity rises, we refer to this as a change in quantity P1 demanded. Implies a movement along the Demand Curve. Q1 Q2 Quantity

Econ 103 Topic 3 page 26 So far we have only talked explicitly about one determinant of demand: the price of the good. Other determinants of demand include: consumer income, prices of related goods, tastes or preferences, expectations about the future. Changes in these things are represented by shifts of the entire demand curve.

Econ 103 Topic 3 page 27

Econ 103 Topic 3 page 28 Example: Suppose my income increases. holding the price of coffee constant, would I buy or less? It depends on whether coffee is a normal or inferior good to me. If income increases and I buy more of a good: normal. Or less if income falls. If income increases and I buy less of a good: inferior. Or more if income falls. Changes in income will shift my demand curve right increase in demand) or left (decrease in demand).

Econ 103 Topic 3 page 29 $ P1 Note: Income increased and coffee is normal for me -At original income I am willing to buy Q 1 at P 1. -At new income I am willing to buy Q 2 at P 1. Increase in demand D1 D2 Q1 Q2 Quantity Willing to buy more than before at any possible price. The entire demand curve has shifted to the right.

Econ 103 Topic 3 page 30 Prices of Related Goods: The relationship between my demand for coffee and other prices depends on the relationship between coffee and other goods. It depends on whether other goods are substitutes for or complements to my consumption of coffee. A substitute is a good I could consume instead of coffee. Eg. Tea A complement is a good I like to consume with coffee. Eg. Egg McMuffin Changes in the price of related goods will also shift my demand curve left or right.

Econ 103 Topic 3 page 31 Other Prices: Tea is a substitute and its price falls. At original price of tea, I am willing to buy Q2 coffees at price P1. At a lower price for tea, I am willing to buy just Q1 coffees at price P1. $ Willing to buy less than before at any possible price. P1 Decrease in demand D2 D1 Q1 Q2 Quantity

Econ 103 Topic 3 page 32 Tastes/preferences Obviously how much coffee I am willing to buy depends also on how I feel about coffee. Do I like it or not? If so, how much do I like it? If my tastes change, my demand curve will shift accordingly. Expectations: If I think coffee is going to be more (or less) expensive tomorrow, I might buy more (or less) today. This would be represented by a shift of the demand curve.

Econ 103 Topic 3 page 33 So far we have been looking at one individual s demand curve. There are many potential buyers of most goods. We need to be able to derive market demand curves from individual demand curves. Simply add up the quantity demanded at each and every price.

Econ 103 Topic 3 page 34 Supply: Determinants of supply, supply curves, producer surplus, the law of supply, changes in quantity supplied, changes in supply, individual supply, market supply. Recall the fish and mushroom example. We will now represent mushroom in $, not fish. We can convert the MC of mushrooms into dollar $s. Assume a competitive environment. There are many sellers and buyers. No one firm can influence price.

Econ 103 Topic 3 page 35 The market price for fish is $10 / fish. Output per day Mushrooms Fish 0 15 10 +10 14 20 +10 11 30 +10 6 40 +10 0-1 -3-5 -6 -MC of 1 st 10 mushrooms =1/10 Fish =$1. -MC of 2 nd 10 mushrooms = 3/10 fish= $3. -MC of 3 rd 10 mushrooms = 5 /10 fish = $5. -MC of 4 th 10 mushrooms = 6 /10 fish = $6.

Econ 103 Topic 3 page 36 We can use the MC information to figure out how many mushrooms will be produced and sold at different mushroom prices. The MC tells us all we need to know about supply decisions. We will see that the graphical representation of MC schedule is the producer s supply curve.

Econ 103 Topic 3 page 37 $ 6 5 4 3 2 1 0 10 20 30 40 Quantity mushrooms Plot each point from the MC schedule.

Econ 103 Topic 3 page 38 $ 6 5 4 3 MC curve 2 1 0 10 20 30 40 Quantity mushrooms Join up the points with a stair-step line. That line is the MC curve.

Econ 103 Topic 3 page 39 We can use marginal analysis to examine supply decisions. Simply compare MB and MC of each step where here each step is an increase in output. $ 6 5 4 3 MC curve 2 1 0 10 20 30 40

Econ 103 Topic 3 page 40 Assume the market price is $4: $ 6 5 4 Pm 3 MC curve is the supply curve 2 1 0 10 20 30 40 In a competitive market, the seller s MB is the market price Pm. If Pm=$4, then MB> MC for quantity up to 20 mushrooms. Tells us that at Pm=$4, 20 mushrooms will be supplied.

Econ 103 Topic 3 page 41 We use supply curve diagrams to measure producer wellbeing. We can measure a producer s net benefit from a given sales choice. This referred to as producer surplus. Producer surplus is the difference between the minimum payment a producer had to receive in order to be willing to sell a given quantity and the actual payment it received for that quantity. A seller needs to at least receive enough $ to cover MC in order to be willing to sell a given amount.

Econ 103 Topic 3 page 42 To calculate the minimum payment required for the 20 mushrooms sold, add up all the MCs. $ 6 5 4 Pm 3 MC curve 2 1 0 10 20 30 40 Quantity of mushrooms MC of 1 st 10 mushroom = $10. } Producer needs at least $40 to be willing MC of 2 nd 10 mushrooms= $30 to sell 20 mushrooms. Producer actually receives revenue of $80 for selling 20 mushrooms. Q P 20 4 $ 80 Producer surplus is the difference between the two: $80-$40=$40.

Econ 103 Topic 3 page 43 Producer surplus can be used to analyze changes in the wellbeing of the producer as market conditions change. Suppose the market price increased from $4 to $5.50. $ 5.50 6 Pm N 5 4 Pm 3 S curve 2 1 Quantity sold increases to 30 mushrooms. 0 10 20 30 40 Quantity of mushrooms Producer surplus also increases.

Econ 103 Topic 3 page 44 The minimum payment needed to sell 30 mushrooms: 10+30+50 = $90. This is the area under the S curve up to Q=30. Revenue now= $ 5. 50 30 $ 165 PS=$165-$90=$75. This is an increase in producer well-being of $75-$40=$35!

Econ 103 Topic 3 page 45 In this example the supply curve is a stair-step function. Implicitly, we are assuming that mushrooms can only be sold in 10 unit increments. We can easily allow for a greater degree of divisibility. In the limit, if the good is infinitely divisible, we will have perfectly smooth supply curves. The supply curve slopes upward or positively if MC is increasing as production increases. This is known as the law of supply.

Econ 103 Topic 3 page 46 Movements and Shifts in Supply $ S P1 P2 If there is a decrease in price and quantity falls, this is a change in quantity supplied, NOT a decrease in supply. Q2 Q1 Quantity A change in quantity supplied is represented by a movement along the supply curve.

Econ 103 Topic 3 page 47 There are other determinants that affect how much of a good a producer is prepared to sell at each price. All these other determinants of supply will cause the supply curve to shift. Example: Input prices are another determinant of supply. Wages, raw material costs, etc. Example: Technology: technological process make resources relatively more productive in production. Example: Changes in Expectations: if a producer believes that market price will be higher in the future, current supply decisions may change.

Econ 103 Topic 3 page 48 Example: Number of Producers: Competitive markets are characterized by many potential sellers. If more suppliers enter an industry, the market supply function will increase (shift) to the right.

Econ 103 Topic 3 page 49 Market Price: Although in a competitive environment each individual seller and buyer take price as given and have no influence on price, collectively, their actions determine price. Market price is determined by the interaction of supply and demand. Equilibrium: defn.: A state of rest or balance due to the equal action of opposing forces; or equal balance between any powers, influences, etc.; equality of effect. Forces, powers and influence in the competitive markets are supply and demand.

Econ 103 Topic 3 page 50 Equilibrium is a competitive market is an outcome in which supply and demand are in equal balance. Where Q Q D S. Point where supply and demand cross is the equilibrium point: Q E Also known as the equilibrium quantity. Price $ S P E Equilibrium Q E D Q

Econ 103 Topic 3 page 51 How does the market get to the equilibrium point? In competitive markets, the mechanism is price. Suppose P > P E : Price $ P E P Excess S Q E S Equilibrium D Q The market is not in balance; not in equilibrium. There is a gap between QS and QD called a surplus or excess supply. To clear the excesses, price has to fall. Too many sellers and too few buyers put downward pressure on price. Market forces put pressure on price to fall.

Econ 103 Topic 3 page 52 As price falls: -there is an increase in quantity demanded (movement along the demand curve; and -there is a decrease in quantity supplied; a movement along the supply curve. Price $ P E P S Equilibrium D Qs Q E QD Q The gap between demand and supply is closed as both sides of the market adjust to falling price. There will be pressure for price to fall as long as there is excess supply. Only when price is at PE there is no further change in market price.

Econ 103 Topic 3 page 53 Excess Demand: Suppose P<PE: Price $ S Q D >Q S. There is a gap called a shortage or excess demand. There will be upward pressure on price. The gap will close from both sides of the market. P E P Excess demand Equilibrium D Qs Q E QD Q Upward pressure on Price stops once price reaches P E. Once a market is in equilibrium, it should stay there until changes occur in the market condition.

Econ 103 Topic 3 page 54 Example: suppose consumers income increases. In the market for a normal good what would happen? Price $ D1 D2 S Increase in income leads to an increase in demand: the demand curve shifts to the right. P E At price PE, the quantity demanded is greater that quantity supplied: Qs>QD. Q E QD Q At price PE, quantity supplied is QE. There is excess demand in the market. Excess demand puts upward pressure on price.

Econ 103 Topic 3 page 55 As price rises, the quantity demanded decreases, partially offsetting the original increase in demand in the market for a normal good. Price $ D1 D2 S We have a movement along the new demand curve D2. P E 2 P E Q E Q E 2 QD Q Also, as price increases, quantity supplied increases as a movement along the supply curve. Excess demand in eliminated by change on both sides of the market.

Econ 103 Topic 3 page 56 Consumer and Producer Surplus Consumer and producer surplus measure consumer and producer well-being. CS+PS is a measure of the net benefit accruing to all participants in a market. $ P E CS PS S D CS+PS is either market surplus or private surplus. The text refers to this as total surplus. QE

Econ 103 Topic 3 page 57 Market Surplus: We have seen that we can calculate market surplus by finding CS and PS and adding them together. We can also calculate market surplus directly, without thinking about its distribution between consumers and producer. We do this by focussing just on the quantity traded in a market.

Econ 103 Topic 3 page 58 Recall that the: -demand curve can also be interpreted as the MB curve and; -supply curve can also be interpreted as the MC curve. $ A B QE MC S MB D Area under the demand curve can be used to calculate total benefits to consumers; Equivalent to total WTP. Total benefits of Q E units = areas A+B Q Area under the supply curve can be used to calculate total cost of supplying a given quantity: Adding up MCs of each unit. Cost of supplying Q E units = area B.

Econ 103 Topic 3 page 59 Taking total benefits and subtracting cost of supply leaves area A. Area A = market surplus, given QE units.. $ A B QE MC S MB D Q We are not thinking at all about its distribution between consumers and producer. But we do not need to think about that if all we are interested in is the overall amount of market surplus. We can use market surplus to start thinking about efficiency in the context of competitive markets.

Econ 103 Topic 3 page 60 We have only loosely talked about efficiency so far. A situation is inefficient if we could rearrange things such that at least someone is better of and no-one is worse off. To build a more defined and stronger concept of efficiency in a market context, we will start the process with market surplus.

Econ 103 Topic 3 page 61 Key Point: At the competitive market equilibrium, market surplus is maximized. Overall net benefits cannot be higher at any quantity not equal to QE. $ MC A C Consider quantities such the QL< QE. Consumer benefits= A + B. Cost of supplying = B Market surplus = A B QL QE MB Q Market surplus is C lower at QL than at QE.

Econ 103 Topic 3 page 62 Consider a higher amount: $ MC A C B D MB QE QH Q Consider quantities such the QH > QE. Consumer benefits= A+B+D. Cost of supplying = B+D+C Market surplus = A-C Market surplus is C lower at QH than at QE. Market surplus is lower at any output where QE Q. Market surplus is maximized at QE.