1 How do changes in demand affect prices? Hurricane Katrina and Baton Rouge Housing Prices

2. 1 How do changes in demand affect prices? Hurricane Katrina and Baton Rouge Housing Prices 2 What could explain a decrease in price? Ted Koppel Tries to Explain Lower Drug Prices 3 How does the adoption of new technology affect prices? Electricity from the Wind 4 How do changes in supply affect prices? The Bouncing Price of Vanilla Beans 5 How do changes in one market affect other markets? Platinum, Jewelry, and Catalytic Converters

3. DEMAND, SUPPLY, AND MARKET EQUILIBRIUM • perfectly competitive marketA market with so many buyers and sellers that no single buyer or seller can affect the market price.

4. 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) • • The price of complementary goods (for example, the prices of beer or lemonade) • • The consumer’s preferences or tastes and advertising that may influence preferences • • The consumer’s expectations about future prices • quantity demandedThe amount of a product that consumers are willing and able to buy.

5. THE DEMAND CURVE 4.1 • The Individual Demand Curve and the Law of Demand • demand scheduleA table that shows the relationship between the price of a product and the quantity demanded, ceteris paribus.

6. THE DEMAND CURVE 4.1 • The Individual Demand Curve and the Law of Demand • individual demand curveA curve that shows the relationship between the price of a good and quantity demanded by an individual consumer, ceteris paribus. • FIGURE 4.1The Individual Demand Curve

7. THE DEMAND CURVE 4.1 • The Individual Demand Curve and the Law of Demand • law of demandThere is a negative relationship between price and quantity demanded, ceteris paribus. • change in quantity demandedA change in the quantity consumers are willing and able to buy when the price changes; represented graphically by movement along the demand curve.

8. THE DEMAND CURVE 4.1 • From Individual Demand to Market Demand • market demand curveA curve showing the relationship between price and quantity demanded by all consumers, ceteris paribus. • FIGURE 4.2From Individual to Market Demand

9. Extra Application 6 STARBUCKS GAINS ON CHANGES IN EXPECTATIONS • Starbucks, the specialty coffee chain, announced September sales that were higher than investors expected. The company’s sales growth was six percent higher than the previous period. The street estimate had only projected an increase of 3.4 percent. How does a change in expectations impact stock prices? • The sales growth was attributed to reintroduction of some popular products, falling gas prices providing some “economic relief,” and colder weather. • The company’s stock price responded accordingly to the increased sales numbers and closed up 7.6 percent. As investors adjust sales (and profits) expectations, the demand for Starbucks’ stocks will increase and is represented by a rightward shift in the demand curve. Note that prices will move higher as a result. It is only the “unexpected” portion of the sales announcement that will actually shift the demand and move price. The “expected” increase of 3.4 percent is already factored into the price by investors.

10. Extra Application 11 SIP SLOWLY—THESE DRINKS ARE EXPENSIVE • Beverage consultants and barkeepers note that the newest trend in the business is exotic cocktails. The trade is moving upscale with some new drinks costing thousands of dollars. • The most expensive list is topped by drinks with diamonds and other precious stones used as garnish. • One drink blends champagne and vintage cognac poured over a sugar cube. Add a 0.6 carat diamond and the blend runs $4,350 a drink. • The most expensive non-garnished drink is the “Ritz Side Car” served at Bar Hemingway in the Paris Ritz which uses an 1830 vintage cognac. For the equivalent of $515 a drink, patrons can sample a cognac from the days of Napoleon. Scarcity drives prices higher. In the case of rare drinks, the fact that supply is so limited causes any increase in demand to push the price higher. Lately an increase in demand for exotic drinks has pushed many of truly rare alcohols higher.

11. 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) • quantity suppliedThe amount of a product that firms are willing and able to sell.

12. THE SUPPLY CURVE 4.2 • The Individual Supply Curve and the Law of Supply • supply scheduleA table that shows the relationship between the price of a product and quantity supplied, ceteris paribus. • individual supply curveA curve showing the relationship between price and quantity supplied by a single firm, ceteris paribus.

13. THE SUPPLY CURVE 4.2 The Individual Supply Curve and the Law of Supply • FIGURE 4.3The Individual Supply Curve

14. THE SUPPLY CURVE 4.2 • The Individual Supply Curve and the Law of Supply • law of supplyThere is a positive relationship between price and quantity supplied, ceteris paribus. • change in quantity suppliedA 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 priceThe lowest price at which a product will be supplied.

15. THE SUPPLY CURVE 4.2 Why Is the Individual Supply Curve Positively Sloped? From Individual Supply to Market Supply • market supply curveA curve showing the relationship between the market price and quantity supplied by all firms, ceteris paribus.

16. THE SUPPLY CURVE 4.2 From Individual Supply to Market Supply • FIGURE 4.4From Individual to Market Supply

17. THE SUPPLY CURVE 4.2 From Individual Supply to Market Supply • FIGURE 4.5The Market Supply Curve with Many Firms

18. THE SUPPLY CURVE 4.2 • 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.

19. 4.3 MARKET EQUILIBRIUM: BRINGING DEMAND AND SUPPLY TOGETHER • market equilibriumA situation in which the quantity demanded equals the quantity supplied at the prevailing market price. • FIGURE 4.6Market Equilibrium

20. MARKET EQUILIBRIUM: BRINGING DEMAND AND SUPPLY TOGETHER 4.3 • Excess Demand Causes the Price to Rise • excess demand (shortage)A situation in which, at the prevailing price, the quantity demanded exceeds the quantity supplied. Excess Supply Causes the Price to Drop • excess supply (surplus)A situation in which at the prevailing price the quantity supplied exceeds the quantity demanded.

21. 4.4 MARKET EFFECTS OF CHANGES IN DEMAND ▼FIGURE 4.7Change in Quantity Demanded Versus Change in Demand Change in Quantity Demanded Versus Change in Demand • change in demandA shift of the demand curve caused by a change in a variable other than the price of the product.

22. MARKET EFFECTS OF CHANGES IN DEMAND 4.4 Increases in Demand Shift the Demand Curve • normal goodA good for which an increase in income increases demand. • inferior goodA good for which an increase in income decreases demand. • substitutesTwo goods for which an increase in the price of one good increases the demand for the other good.

23. MARKET EFFECTS OF CHANGES IN DEMAND 4.4 Increases in Demand Shift the Demand Curve

24. MARKET EFFECTS OF CHANGES IN DEMAND 4.4 Increases in Demand Shift the Demand Curve • complementsTwo goods for which a decrease in the price of one good increases the demand for the other good. • FIGURE 4.8An Increase in Demand Increases the Equilibrium Price

25. MARKET EFFECTS OF CHANGES IN DEMAND 4.4 Decreases in Demand Shift the Demand Curve • FIGURE 4.9A Decrease in Demand Decreases the Equilibrium Price

26. MARKET EFFECTS OF CHANGES IN DEMAND 4.4 Decreases in Demand Shift the Demand Curve

27. Extra Application 9 HOME LOAN APPLICATIONS FALL • Consumer home mortgage applications fell to the lowest level of the year according to an industry trade group. The seasonally adjusted applications fell by 1.6 from the previous week. While mortgage rates fell slightly from the previous week, the average rate is still near its four year high. • Much of the blame was laid on rising adjustable rate mortgages (ARMs) since these mortgages have been more popular recently. • Overall, the number of ARMs represents about 28 percent of all new applications, substantially lower than the high of 36.6 percent in March 2005. • While some homeowners appear to be switching ARMs to fixed rates, most analysts expect fixed rates to go even higher in the coming year. A decrease in the demand for home mortgages would be represented by a shift in the demand curve from D1 to D0. If the change in mortgage quantities demanded is truly due to a change in mortgage interest rates then it is not a demand shift. Since the interest rate is the “price” of a mortgage, it would really be a movement up an existing curve as represented by moving from Point a to Point c which would happen if the price rises due to a change in the supply of home mortgages.

28. 4.5 MARKET EFFECTS OF CHANGES IN SUPPLY A Decrease in Demand Decreases the Equilibrium Price Change in Quantity Supplied Versus Change in Supply • change in supplyA shift of the supply curve caused by a change in a variable other than the price of the product. • FIGURE 4.10Change in Quantity Supplied Versus Change in Supply

29. MARKET EFFECTS OF CHANGES IN SUPPLY 4.5 Increases in Supply Shift the Supply Curve

30. MARKET EFFECTS OF CHANGES IN SUPPLY 4.5 An Increase in Supply Decreases the Equilibrium Price • FIGURE 4.11An Increase in Supply Decreases the Equilibrium Price

31. MARKET EFFECTS OF CHANGES IN SUPPLY 4.5 Decreases in Supply Shift the Supply Curve

32. MARKET EFFECTS OF CHANGES IN SUPPLY 4.5 A Decrease in Supply Increases the Equilibrium Price • FIGURE 4.12A Decrease in Supply Increases the Equilibrium Price

33. MARKET EFFECTS OF CHANGES IN SUPPLY 4.5 Simultaneous Changes in Demand and Supply • FIGURE 4.13Market Effects of Simultaneous Changes in Demand and Supply

34. Extra Application 7 MONTANA STONE BUSINESS IS ROCK SOLID • Strong construction in western states and design trends are pushing the demand for Montana stone higher. More than 100 stone quarries have begun operations in the past seven years. Architects increasingly utilize stone to create distinctiveness and fit with the natural surroundings. Montana has capitalized on this growth industry and producers market Montana stone since the state’s name is synonymous with ruggedness. • Thirty-five states currently produce stone. • According to the U.S. Geological Survey, production of non-crushed stone increased by 19 percent between 2001 and 2005 with expected continued growth. • Stone imports are also expected to increase with Italy leading the way. • Prices of natural stone vary tremendously. An increase in demand for building stone has pushed prices higher moving equilibrium from point a to point b. The higher prices attracted more suppliers to the market which pushes prices back down to point c. Of course each variety of stone will have its own market with high substitutability between markets.

35. Extra Application 8 OIL CLOSES AT RECORD HIGH • Iran’s nuclear program concerns and Nigerian supply problems combined to push oil to a record high of $70.40 a barrel. Some analysts expect prices to rise above $75 a barrel in the near future unless there is a substantial fall in demand. The recent price spike surpasses the post-Katrina supply induced problems although Katrina’s aftermath continues to reduce supply in the Gulf of Mexico by about 300,000 barrels a day. • High oil prices continue to push gasoline prices closer to the $3 a gallon mark. • Experts contend that while current prices are high, oil would have to exceed $90 a barrel to exceed inflation adjusted highs set twenty years ago. • Minor supply disruptions or small increases in demand could quickly create a shortage, placing even more upward pressure on prices. An increase in demand along with a reduction in supply creates a recipe for rising prices. Price is the market mechanism that allocates scarce resources among competing ends.

36. Extra Application 10 FDA PANEL APPROVES NEW OVER-THE-COUNTER DIET PILL • An advisory committee to the Food and Drug Administration (FDA) voted to recommend approval of an over-the-counter (OTC) version of the prescription diet pill orlistat. The fat-blocking drug has been approved as a prescription-only diet medication since 1999. GlaxoSmithKline Consumer Healthcare, the drug’s manufacturer, still needs to obtain final FDA approval to market the proposed reduced strength OTC form of orlistat. While the final approval could still be months away, the FDA typically follows committee recommendations. • Glaxo estimates that between five and six million Americans would buy the pill on a consistent basis, at a cost expected to be between $12 and $25 a week. FDA approval to market this diet pill over-the-counter is equivalent to opening a new market. Many more individuals will purchase the product since a prescription will no longer be required. Graphically these sales will be shown as a shift in demand from D0 to D1. Since most of a drug’s cost is in development and marketing, the profit margin on selling this drug over-the-counter will also be quite lucrative.

37. 4.6 PREDICTING AND EXPLAINING MARKET CHANGES

38. 4.7 APPLICATIONS OF DEMAND AND SUPPLY HURRICANE KATRINA AND BATON ROUGE HOUSING PRICES APPLYING THE CONCEPTS #1:How do changes in demand affect prices? • FIGURE 4.14Hurricane Katrina and Housing in Baton Rouge • Hurricane Katrina flooded much of New Orleans, causing about 250,000 residents to relocate to nearby Baton Rouge. • An increase in the population of Baton Rouge increased the demand for housing, shifting the demand curve to right. • The excess demand caused fierce competition among buyers for the limited supply of homes. • The equilibrium price increased from $130,000 (point a) to $156,000 (point b).

39. TED KOPPEL TRIES TO EXPLAIN LOWER DRUG PRICES APPLYING THE CONCEPTS #2:What could explain a decrease in price? • FIGURE 4.15Ted Koppel and the Falling Price of Drugs • According to Ted Koppel, the price of drugs dropped because the government’s efforts to control the supply of illegal drugs had failed. • According to the U.S. Department of Justice, the quantity of drugs consumed actually decreased during the period of dropping prices. • When both the price and the quantity decrease, that means demand has decreased. • The decrease in price was caused by a decrease in demand, not an increase in supply.

40. ELECTRICITY FROM THE WIND APPLYING THE CONCEPTS #3:How does the adoption of new technology affect prices? • Technological innovations in generating electricity from the wind decreased production costs, shifting the supply curve downward and to the right. • The equilibrium price decreased and the equilibrium quantity increased. • FIGURE 4.16Wind Power and Electricity

41. THE BOUNCING PRICE OF VANILLA BEANS APPLYING THE CONCEPTS #4:How do changes in supply affect prices? • A cyclone destroyed much of Madagascar’s crop in 2000, shifting the supply curve upward and to the left. • By 2005, the vines replanted in Madagascar - along with new vines planted in other countries - started producing vanilla beans, and the supply curve shifted downward and to the right, beyond the supply curve for 2000. • The price dropped to $25 per kilogram, half the price that prevailed in 2000. • An example of technological progress: The increase in supply from other countries was facilitated by the development of a sun-tolerant variety of the vanilla plant. • FIGURE 4.17The Bouncing Price of Vanilla Beans

42. PLATINUM, JEWELRY, CATALYTIC CONVERTERS APPLYING THE CONCEPTS #5:How do changes in one market affect other markets? • The law of demand for jewelry. The increase in the price of platinum increased the equilibrium price of platinum jewelry, and consumers responded by purchasing less platinum jewelry. As a result, the amount of platinum used in jewelry decreased, from 2.88 million ounces to 2.20 million ounces. • The law of supply for recycling. The increase in the price of platinum increased the payoff from recycling used platinum, increasing the quantity of platinum supplied through recycling from 0.42 million ounces to 0.70 million ounces.

43. 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 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