Demand and Supply

Demand and Supply This material is about markets and how price and quantity traded are determined in a market.

Overview The model of demand and supply is the basic model of how buyers and sellers interact in a market. Some goals of this chapter are that you learn about 1) the separate parts of the model (the demand part and the supply part), 2) how the separate parts interact to give us a market price and market quantity traded, and 3) how one market outcome may have an impact on another market. In the recent past year we have seen that changes in the oil market have lead to changes in the gasoline market, and changes in the gas market have lead to changes the SUV market.

Overview It has been said you can teach a parrot economics by having the bird say “supply and demand.” That would be decent. But, think how much larger a human’s brain is and how that brain can do so much more. For a few slides I want you to think in a mechanical manner and study some graphs. I want you to focus on “supply and demand,” just as the parrot would say. I want you to look at where the curves cross and see what price and what quantity occurs. After this mechanical look at supply and demand we will want to add economic ideas to our presentation so that you can use that brain of yours in a manner the parrot is not able.

Supply and Demand Graph In a market for a product with demand D1 and supply S1 we would see P1 as the price and Q1 as the amount traded. This P and Q is where the curves cross. P S1 P1 D1 Q Q1

Supply and Demand Graph By the way, in the graph we have numbers. You should think numerically. Say P1 = $2.50 and Q1 = 52. Any price higher than P1 is more than 2.50 and any quantity more than Q1 is more than 52. P S1 P1 D1 Q Q1 What is the quantity on the supply curve if the price is 1.75? Can the quantity be 52?

Demand Increase When demand increases (the demand curve shifting to the right) we see the price in the market rise to P2 and the quantity traded increase to Q2. P S1 P2 P1 D2 D1 Q Q1 Q2 Conclusion: When demand rises both P and Q in the market rise.

Demand Decrease When demand decreases (the demand curve shifts to the left) the market price decreases to P2 and the quantity traded decreases to Q2. P S1 P1 P2 D1 D2 Q Q2 Q1 Conclusion: when demand falls P and Q in the market fall.

Supply Increase When the supply increases (the supply curve shifts to the right) we see a lower market price P2 and a higher quantity traded Q2. P S1 S2 P1 P2 D1 Q Q1 Q2 Conclusion: A higher supply means the price in the market falls but the quantity traded in the market rises.

Supply Decrease When the supply falls (the supply curve shifting to the left) the market prices rises to P2 and the quantity traded falls to Q2. P S2 S1 P2 P1 D1 Q Q1 Q2 Conclusion: when supply falls the market price rises and the quantity traded in the market falls.

Now, let’s expand our ideas to incorporate economic meaning into our graphs. In some sense the discussion will still be general. Our presentation will be about a market. There are tons of markets. There is a market for corn, wheat, Mt. Dew in a 20 ounce bottle, Microsoft stock, and many more. Our study of supply and demand is the scientific way folks go about explaining the pattern of price movements and/or quantity traded movements.

Price, P Along this axis we measure the price per unit of a product. At the bottom we start at zero and move our way up. Along this axis we measure quantity in units of a good or service. On the left we start at zero and as we go right we go to larger amounts. Quantity, Q

Price, P We could look at any point in the graph and at that point we can get a feel for the quantity at that point and the price at that point. Price at the point Quantity, Q Quantity at the point

Price, P 2) Note here that after the curve shifted, we will move along the new demand curve and call the movement a change in the quantity demanded. D2 1) Note here that when the demand shifted we would say it shifted because of a change in demand (which we will study in a little while). D1 Quantity, Q

So, we have gotten warmed up to the model of supply and demand. Now we want to look at 1) The demand side of the market, 2) The supply side of the market, 3) The interaction of supply and demand and how these determine the price in the market and the quantity traded in the market, and 4) Changes in supply and demand and how that leads to price and quantity traded changes.

Law of Demand Demand in general refers to how much of a product consumers are willing and able to buy. In the graph here you should note two things. 1) The demand curve is downward sloping as you look at the graph from left to right, and 2) The demand curve is in a certain position or location that could change. P D Q Let’s think about each of these points in more detail. Let’s start with point 1. When we say the demand curve is downward sloping we say this is a reflection of the law of demand. The law of demand is a statement that when the price of the product changes the quantity demanded moves in the opposite direction. PLEASE draw in two points on the demand curve in this graph. Now start at one point and as you move to the other point do you note that as the price changes the quantity demanded changes in the opposite direction? Law of Demand – Price and quantity demanded are inversely related.

Law of Demand Here are economic theories about why the law of demand holds. The theories reinforce each other. 1) It is common sense – you and I see people want more the lower the price or they want less the higher the price. (Granted this first one is not much theory, just observation.) 2) Diminishing Marginal Utility (DMU) – When you think of a certain time period, like an hour, a day, or any other unit of time, economic theory suggests that as more of a good is consumed during that time period more utility is gained but each successive unit consumed adds less utility than the previous unit. This is the idea of DMU. So, if each additional unit adds less utility than previous units, then the consumer would only take the additional units if a lower price can be paid.

Law of Demand 3) Income and substitution effects of a price change When the price of a good falls the consumer who purchases some of the good initially has more money left in their pocket. It is as if the consumer has more income (hence the “income effect” of a price change.) Thus, the lower price means the consumer wants a larger quantity of the good. The substitution effect is the idea that when the price of a good falls consumers take more of the good and use it in substitution for something else. Take steak, please! If steak becomes lower in price some folks will take more of it and have less scrod, or chicken (or some other “meat” in their diet.)

P P1 In the graph at P1, although folks could probably buy more of the product, quantity demanded is only Q1. D Q Q1 But, if the price was lower than P1 you see there would be movement down the demand curve. The economic theory for this is, again, common sense, DMU, and the income and substitution effects of a price change. So, the price of the product is a major factor in how much of a product consumers want. But there are other things that have an influence as well.

P A few slides back I mentioned that we need to pay attention to the position or location of the demand curve and that maybe the location could change. P1 D Q Q1 What I now want to make explicit is that Q1 was demanded at P1 with the understanding that other things that influence demand are held constant (the ceteris paribus assumption). If these other things should change then at P1 the amount people want could change and the demand would shift. Demand shifting to the right is an increase in demand and shifting to the left is a decrease in demand.

People’s income is a factor that leads the demand curve to be in a certain location. This means if income should change the demand curve will shift to a new location. Other factors that lead to a shift in the demand include the expectations consumers have, price of related goods, consumer taste and preference, and the number of consumers in the market. On the next slide is a table that will list how the demand curve will shift given a change in a determinant of demand. Note the table does not include the price of the product itself. If the price changes there is a movement along the demand curve and we say there is a change in the quantity demanded.

Determinants of Demand Determinant of demand change demand shifts to Consumer taste for the good rises right Consumer taste for the good falls left Income increase for normal good right Income decrease for normal good left Income increase for inferior good left Income decrease for inferior good right Complementary good price increase left Complementary good price decrease right Substitute good price increase right Substitute good price decrease left Increase in consumers in market right Decrease in consumers in market left Price expected in future rises right Price expected in future falls left

Determinants of Demand Over time consumers might have a change in taste and preference for goods. An example would be that over time in the US we have become more health conscious and thus goods that contribute to good health have had an increase in demand and those that don’t have had a decline in demand. Income has an impact on the amount consumers want. We think about two types of goods here: normal and inferior goods. Normal goods are defined as those that when we get more (less) income we want more (less) of the good. Music CD’s might be an example of a normal good. An inferior good is one where when income rises (falls) we want less (more) of the good. Music cassettes might be an example here.

Determinants of Demand Complementary goods are defined as goods used in combination with each other. Coffee and donuts are complements (there is no “i” in this complement) for me, what about you? If the price of donuts goes up I will want less donuts (law of demand) and since I have coffee with my donuts I will want less coffee. The price of donuts changing has changed my demand for coffee. Substitute goods are defined as goods where one of the goods could be used in place of the other. Coke and Pepsi work for me. If the price of Pepsi changes the demand for Coke will change in the opposite direction.

Determinants of Demand In the future, goods and services will probably have a price tag on them. It is thought that what we expect the future price to be will have an impact on our demand today. More specifically, if, as we look to the future, if we expect future prices to change to even higher levels then we will increase our demand today in hopes of getting the good before the price goes up. If we expect the future price to fall we will cut back on our current demand.

Demand from many Consumers A determinant of demand

In the section on demand it was mentioned that the demand in the market is influenced by the number of consumers in the market. Basically we saw that if the number of consumers increased the demand would increase and if the number of consumers fell the demand would fall. Here I want to enhance what has already been said by looking at how a market demand curve is constructed. Let’s start with just two consumers in the market. P P P c1 c2 Consumer 1 Consumer 2 Market Q Q Q

On the previous screen you see the separate demands from each consumer. The way to get the market demand is through what is called a horizontal summation of the individual demand curves. Basically what is done is that at each price the quantity demanded from each individual is added across horizontally. At the price shown in the graph you can see that I took the quantity demanded from the first consumer and added the quantity demanded from the second consumer to get the total market quantity demanded. If I had three consumers I would do the same thing, except I would add in all three consumers, of course. The market supply curve you will encounter later is found in a similar way – you horizontally add the supply curve from each firm in the market. Hey, check this out. If you had n identical consumers and at a price of Pn you had each consumer demand N units, then total market demand would be N + N + N …+ N (N added n times), or total amount demanded at Pn of nN.

P Supply in general refers to how much of a product producers want to sell. In the graph here you should note two things. 1) The supply curve is upward sloping as you look at the graph from left to right, and 2) The supply curve is in a certain position or location that could change. S Q Let’s think about each of these points in more detail. When we say the supply curve is upward sloping we say this is a reflection of the law of supply. The law of supply is a statement that when the price of the product changes the quantity supplied moves in the same direction. So, if the price should rise, the quantity supplied will rise , and if the price should fall the quantity supplied will fall. Law of Supply – Price and quantity supplied are directly, or positively, related.

Let’s consider the story about why the supply curve is upward sloping. Production of a good or service takes time and producers have lots of things they would like to do. When the price of a good is low producers look at their options and conclude at a low price that they will make a few units but then do something else because there is not a big payoff to production. But, if the price is higher they do not mind giving up other things to produce here because they will get more for their efforts.

P In the graph at P1, although producers could probably make more of the product, quantity supplied is only Q1 because producers have decided they do not want to give up other things to make more of Q. S P1 Q Q1 But, If the price was higher than P1 you see there would be movement up the supply curve. Some producers would say that since they get more for producing this item they give up doing other stuff and they are happy to supply a greater quantity of this good. So, the price of the product is a major determinant of how much of a product producers want to make. But there are other things that have an influence as well.

P A few slides back I mentioned that we need to pay attention to the position or location of the supply curve and that maybe the location could change. What I now want to make explicit is that Q1 was supplied at P1 with the S P1 Q Q1 understanding that other things that influence supply are held constant (the ceteris paribus assumption). If these other things should change then at P1 the amount producers want to make could change and the supply would shift. As an example, say the company is making candy and the price of sugar, a major input to the product, goes up. Then at P1, since it costs more to make a unit of candy, the producer will make less because there is less profit to be made per unit. Producers would rather do something else.

So, on the previous slide we see the supply curve would shift left when the price of an input to the production process went up. Similarly the supply curve would shift right when the price of an input falls. The price of an input is a factor that leads the supply curve to be in a certain location. This means if the input price should change the supply curve will shift to a new location. Other factors that lead to a shift in the supply include the state of technological sophistication used in production (what is called the state of technology), the number of sellers, taxes and subsides, prices of other goods that might be made, and the price sellers expect to see in the future. On the next slide is a table that will list how the supply curve will shift given a change in a factor of supply. Note the table does not include the price of the product itself. If the price changes there is a movement along the supply curve and we say there is a change in the quantity supplied.

Factor of supply change supply shifts to Input, or resource, price increase left Input price decline right Increase in state of technology right Decrease in state of technology left Increase in tax (or subsidy decrease) left Decrease in tax (or increase in subsidy) right Increase in producers in market right Decrease in producers in market left Increase in price of other goods to make left Decrease in price of other goods to make right Increase in expected future price left Decrease in expected future price right Please note that when a factor changes in such a way that supply shifts to the right we could also say supply has increased and if a factor changes in such a way that supply shifts to the left we could also say supply has decreased.

Determinant of Supply When resources prices rise it becomes more expensive to produce and so at a given price of output supply falls. Better technologies make it easier to produce and so supply rises. Higher taxes are a drag so supply falls with them, while higher subsides increase supply. If producers make more than 1 type of good with the same basic resources then if the output price of other goods rises they devote more resources there than in the past and supply rises for that good, but supply for other goods they make falls.

Determinant of Supply Sellers also look to the future and they form an expectation of what they think will happen. If that expectation changes they change their current behavior. For example, if sellers expect the future price to be higher than what they used to expect then their current supply will fall in hopes of selling more at the higher expected future price. (Note, their expectation could be wrong, but they won’t know until later.) If the number of sellers rises the supply rises.

Special Case and a general statement for you Let’s say that in a certain market each producer is exactly the same. (Do all convenience stores have the same basic set up, for example?) Let’s also say if the price of the good is $1.25 each seller will supply 100 units. Then, if there are n firms the total supply in the market will be n times 100 or 100n. In general when I mention supply or demand I really mean the market supply or demand. I would point out specifically if I wanted you to think about supply or demand for one firm or one consumer.

Price, P Now that we have considered supply and demand separately we will bring the two together and see how buyers and sellers interact in a market. S D Quantity, Q

Price, P Notice at this price P1 the quantity demanded equals the quantity supplied. S1 P1 D1 Quantity, Q Q1

Price, P Notice that when you look at any price above where the curves cross, like at Pa, the quantity supplied is greater than the quantity demanded – a surplus, or excess supply. S1 Pa D1 Qs Quantity, Q Qd

Price, P Notice that when you look at any price below where the curves cross, like at Pb, the quantity supplied is less than the quantity demanded – a shortage or excess demand. S1 Pb D1 Qd Qs Quantity, Q

Notice on the previous three slides that I have put the subscript 1 on the labels for the supply and demand curves. I do this to have you understand that when we consider the interaction of supply and demand we initially have supply and demand located in place because the determinants that can shift these curves are fixed at a certain level for the time being. Later these curves can shift, but for now we have them fixed in place. Theory of Price Change 1) When the price is above where demand and supply cross in our graphs we see Qs > Qd, meaning we have a surplus. All buyers at this price (as recognized by the amount on the demand curve) would get to buy, but not all sellers would get to sell. This surplus, or excess supply, of items means some sellers have an incentive to change. They would lower the price so that they do not have any left over items.

2) When the price is below where demand and supply cross in our graphs from the previous slides we see Qs < Qd, meaning we have a shortage. All sellers at this price (as recognized by the amount on the supply curve) would get to sell, but not all buyers would get to buy. This shortage, or excess demand, of items means some buyers have an incentive to change. They would bid up the price in an attempt to get the item. 3) When the price is P1 we see Qs = Qd. All buyers and sellers are able to buy and sell, respectively, what they want at this price. Neither group has an incentive to change. Item 3) here defines equilibrium in the market. Take this to mean you should focus your attention on were the curves cross. But items 1) and 2) above help us understand why the price will change when conditions in the world change. Let’s turn to this next.

For any market story this is where you mind should be, on this graph with all the knowledge you have in these notes up to this point. Price, P S1 P1 D1 Quantity, Q Q1

Here we have a demand increase. Slide 21 should remind you how a demand increase can happen. Note at the initial price P1 Qs = Q1 but demand is now Qd. Price, P D2 S1 P1 D1 Quantity, Q Q1 Qd

At P1, since Qd > Qs, we have a shortage and with a shortage the price will rise. The price will rise to P2. Price, P D2 S1 P2 P1 D1 Quantity, Q Q1 Qd

Note as the price rises due to the shortage both a) the quantity supplied rises from Q1 to Q2 and b) the quantity demanded falls from Qd to Q2. The shortage is gone. Price, P D2 S1 P2 P1 D1 Quantity, Q Q1 Qd Q2

Let’s summarize what is on the last 4 slides. 1) We have the market at some starting point. Note the equilibrium price and quantity traded, P1 and Q1. 2) The demand increases creating a shortage. 3) The shortage means the price will rise. 4) The shortage is eliminated because with the higher price the a) quantity supplied rises and b) the quantity demanded falls (from the new higher level). Note that with an increase in demand we get a higher price and then a decrease in the quantity demanded and an increase in the quantity supplied. Overall, the increase in demand resulted in 1) An increase in the market price, and 2) An increase in the quantity traded in the market.

From this starting point let’s now look at the story of a supply increase. Price, P S1 P1 D1 Quantity, Q Q1

Here we have a supply increase. Slide 33 should remind you how a supply increase can happen. Note at the initial price P1 Qd = Q1 but supply is now Qs. Price, P S1 S2 P1 D1 Quantity, Q Q1 Qs

At P1, since Qs > Qd, we have a surplus and with a surplus the price will fall. The price will fall to P2. Price, P S1 S2 P1 P2 D1 Quantity, Q Q1 Qs

Demand and Supply