Introduction to microeconomics

Introduction to microeconomics
Lecture 3 Supply and demand

The marginal and cost-benefit principles http://www.economist.com/multimedia?bclid=1777382270001&bctid=1722339398001 What cost benefit principle is being discussed”? Express this in marginal terms How does opportunity cost relate to this problem? What do you need to improve decisions?

Core ideas What is an economic model? The nature of supply Price as the “prime independent” variable Shift in supply (the other independent variables) The nature of demand Price as the “prime independent” variable Shift in demand (the other independent variables) The market place model (scissors) – ceteris paribus again Key assumption - Consumer and producer sovereignty ( freedom to transact) The concept of the “scissors” and equilibrium Key assumption – Many buyers and sellers Shifts in demand and supply change equilibrium price and quantity Key assumption – Information is costless

The market A market is any exchange of goods and services Labour market (university teaching, hiring at Burger King, …) Services (information, sports, sec trade…) Goods (wheat, oil….) A market unites willing buyers and willing sellers Markets may be periodic (auction for art, labour market) or continuous (world market for oil) Depends on the institutional arrangements Markets exist only when transactions occur Example: Once I accepted the job at U of M (in 1974), I did not continuously re-negotiate my wage every day Why not?

Supply Each seller needs to cover the costs of creating the goods/services for sale The higher the price the higher the net return (price – costs) Each seller has a reservation price (a price too low to cover costs) Different sellers will have different costs Therefore, as price rises (just how to be discussed), new and higher cost sellers are attracted to the market (Why?) The total volume (quantity) of goods and services supplied increases.

Figure 3.1: the Supply Curve of Hamburgers Price Quantity LO2: Market Supply

Key assumption of a supply curve Costs for each seller remain static (But different sellers probably have different costs) The supply “curve” (we are using a straight line for simplicity) applies at a point in time (comparative statics) The upward slope also reflects opportunity costs (lower sellers that do not increase the volume of goods offered, give up higher net returns. Therefore as price rises New higher cost sellers come into the market Existing sellers find ways to increase the volume of goods offered to not incur the lost of higher net returns (i.e. avoid the opportunity cost of giving up net revenue) Price is the main independent variable

The Math of the Supply Curve The supply curve could also be written algebraically Qs = a + bPs The parameter a is the horizontal intercept The parameter b is the reciprocal of the slope of the supply curve The plus sign indicates a direct, positive relationship between quantity supplied and price Based on Figure 3.1, a = 0 and b =4 Qs = 4Ps If price increases by one dollar, quantity supplied will increase by 4000 hamburgers

The other independent variables for supply What other factors affect supply? Technology Changes in these other independent variables shift the supply relationship For any given price, supply increases/decreases because Technology has lowered/raised cost … … Qs = a + bPs+ c(rain) … (droughts reduce supply of wheat)

Increase in supply due to technical change S0 S1 Price Technology lowers costs Shift supply to right Increases amount supplier at every price. Allows new sellers to enter Encourages existing sellers to increase amount offered P0 Q1 Q0 Quantity

Demand Each consumer develops an assessment of value for every good/service offered For most of us, we have a value of “0” for most goods (we are completely uninterested) If ballet shoes were $0, I would not be tempted! My granddaughter would take hundreds (especially the pink ones) Consumers have a reservation price (a price to high to induce purchase) Different consumers have different valuations of a good As the price falls, consumers with lower valuations enter and register their demand As price falls, existing consumers register increased demand (opportunity cost again) At $500 a single iPhone 5 is purchased At $50, why not get a back-up and one for the spouse?

Figure 3.2: the Demand Curve of Hamburgers Price Quantity LO3: Market Demand

The math of the demand curve The demand curve could also be written algebraically Qd = c - dPd The parameter c is the horizontal intercept The parameter d is the reciprocal of the slope of the demand curve The minus sign indicates a negative relationship between quantity demanded and price Based on Figure 3.2, c = 24 and d =4 Qd = 24 - 4Pd If price increases by one dollar, quantity demanded will decrease by 4000 hamburgers

The other independent variables of demand Demand is affected by Increases in income … … Changes in these other independent variables shift the demand relationship For any given price, demand increases/decreases because Income has increases/decreases … … QD = a + bPD + c(income) … (income increases shift demand out for every given price

Increase in demand to income increase Income increases allow consumers to raise reservation price Demand shifts to right Increases amount demanded at every price. Allows new consumers to enter Encourages existing consumers increase amount demanded D0 D1 Price P0 Q1 Q0 Quantity

Figure 3.3: the Equilibrium of Hamburgers LO4: Market Equilibrium

FIGURE 3.4: Excess Supply Excess supply = 8000 hamburgers/day Supply Demand LO4: Market Equilibrium

Excess Supply More sellers arrive with hamburgers They are willing to supply 16 at the current price ($4), but consumers are willing to purchase only 8 Sellers have a choice Allow 8 burgers to spoil, feed them to the dogs, or give to Winnipeg Harvest (getting $0 for each burger donated) Dropping price (sellers with low costs will still make some money and sellers with high costs will cover some of their outlays even though the cost of a burger is higher than the price) High cost sellers will lead the way in lowering price, forcing other low cost sellers to match the lower price (or risk losing all their sales). Over time, high cost sellers may be forced out of business.

FIGURE 3.5: Excess Demand Supply Excess demand = 8000 hamburgers/day Demand LO4: Market Equilibrium

Excess Demand More consumers register their demand than sellers can satisfy At the price of $2 consumers demand 16 burgers, but suppliers are willing to offer An alert seller notices that burgers are “flying off the grill” and raises the price (opportunity cost)

Box 3.3: Market EquilibriumSupply equals Demand The supply curve Qs = a + bPs The demand curve Qd = c – dPd Qs = Qd a + bPs = c – dPd Therefore Substitute P* into the supply/demand equation It is common to denote equilibrium points by * LO4: Market Equilibrium

Box 3.3: Market EquilibriumSupply equals Demand (Example) The supply curve Qs = 0 + 4Ps The demand curve Qd = 24 – 4Pd Qs = Qd 0 + 4Ps = 24 – 4Pd Therefore Substitute P* into the supply equation LO4: Market Equilibrium

Equilibrium price and quantity The intersection od demand and supply shows the market equilibrium Sellers who price above P*will lose all their customers Sellers that price below P* are giving up revenue D0 S0 Price P* Q* Quantity

Sellers that undercut the market Seller A decides to sell at PA. Recall that this model assumes that there are many buyers and sellers Seller A is a very small portion of the market and will not influence P* Seller A gives up rectangle abcd No other seller will follow since that can sell everything at P* D0 S0 Price P* a b c d Q* Quantity

The Effect on the Market for New Houses of a Decline in the Price of Lumber S S′ 160 150 D 40 50 LO6: Shifts in Supply and Demand

Effect of Technical Change on the Market for French Fries LO6: Shifts in Supply and Demand

Substitutes and complements Substitute (Good A and B) Goods and services consumers see as equivalent (iPhone and Blackberry) Perfect substitutes Imperfect substitutes Price increase/decrease in Good A will create a increase/decrease in demand for Good B Complement (Good A and B) Goods and services that must be consumed jointly (car and gas) A price increase/decrease in A causes a decrease/increase in demand for Good B The “coupling” between good A and good B is a measure of their substitutability or complementarity

FIGURE 3.9: The Effect on the Market for Tennis Balls of a Decline in Court Rental Fees S 1.40 1.00 D′ D 40 58 LO6: Shifts in Supply and Demand

FIGURE 3.10: Effect on the Market for Overnight Letter Delivery of a Decline in the Price of Internet Access S P P′ D D′ Q Q′ LO6: Shifts in Supply and Demand

FIGURE 3.12: Four Simple Rules An increase in demand will lead to an increase in both the equilibrium price and quantity. A decrease in demand will lead to a decrease in both equilibrium price and quantity. An increase in supply will lead to a decrease in the equilibrium price and an increase in the equilibrium quantity. A decrease in supply will lead to an increase in the equilibrium price and a decrease in the equilibrium quantity. LO6: Shifts in Supply and Demand

FIGURE 3.14: Seasonal Variation in the Air Travel and Corn Markets SW SS PW S PS PS PW DS D DW QW QS QW QS LO6: Shifts in Supply and Demand

Model Assumptions All participants small - that no single buyer or seller can influence price. Buyers or sellers cannot form combinations (monopoly) that can influence price. Suppliers provide an identical product; Information on price and quality of the good/service is freely available to all buyers and sellers. Transactions are easy - buyers and sellers meet easily to conduct transactions.

Write down a trade-off you made today. In hindsight did you make the right choice? Why do some university courses have waiting lists after the first day of registration, while others never fill up? (The price is constant across courses, while the demand for courses and the number of seats available are different.)

Problem In 2010, the March price of strawberries (US) was $1.25/lb. compared to $3.49 in 2009. Some growers ploughed the fields and started to grow melons; others froze their harvest and sold their output to jam and juice processors. Is this a rational strategy – why/why not (what are the assumptions) What would have happened if growers offered consumers a “pick for free” option (hint: who would have participated, what would have happened to the available supply; what costs does a grower have?) What is the impact on the costs facing jam/juice producers?

# 15 p 75 Since both the demand and supply curves for tofu have shifted to the right, the equilibrium quantity of tofu sold is higher than before. The equilibrium price may be either higher (left panel) or lower (right panel).

#17, p75 It is not appropriate to use supply and demand in this case because there is only one supplier and because price is determined by a regulatory authority. Price is not determined by an equilibrium of supply with demand.

Problem Price What are the equilibrium price and quantity in this market? What is the state of the market when the price is $3? What is the state of the market when the price is $7? If price in this market is $7, explain the adjustment process that will bring the market back to equilibrium. 7 5 3 Quantity 100 175 225 Answers Equilibrium P = $5 and equilibrium Q = 175 A shortage (excess demand) of 120 A surplus (excess supply) of 120 The surplus of 120 signals firms to lower the price, which reduces the quantity supplied and increases the quantity demanded until the equilibrium price of $5 is reached.

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Introduction to microeconomics