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Chapter Three Supply, Demand, and the Market Process

Chapter Three Supply, Demand, and the Market Process. The Law of Demand. Law of Demand. Law of Demand: the inverse relationship between the price of a good and the quantity consumers are willing to purchase . As the price of a good rises, consumers buy less.

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Chapter Three Supply, Demand, and the Market Process

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  1. Chapter ThreeSupply, Demand, and the Market Process

  2. The Law of Demand

  3. Law of Demand • Law of Demand: the inverse relationship between the price of a good and the quantity consumers are willing to purchase. • As the price of a good rises, consumers buy less. • The availability of substitutes (goods that perform similar functions) explains this negative relationship.

  4. Market Demand Schedule • A market demand schedule is a table that shows the quantity of a good people will demand at varying prices. • Consider the market for cellular phone service. A market demand schedule lays out the quantity of cell phone service demanded in the market at various prices. • We can graph these points (the different prices and respective quantities demanded) to make a demand curve for cell phone service.

  5. Market Demand Schedule Price(monthly bill) 140 Cellular phone subscribers(millions) Cellular phone service price(avg. monthly bill) 120 $ 143 2.1 $ 92 7.6 100 $ 73 16.0 $ 58 33.7 80 $ 46 55.3 $ 41 69.2 60 Demand 40 Quantity(million subscribers) 0 10 20 30 40 50 60 70

  6. Market Demand Schedule Price(monthly bill) • Notice how the law of demand is reflected by the shape of the demand curve. • As the price of a good rises … consumers buy less. 140 120 100 80 60 Demand 40 Quantity(million subscribers) 0 10 20 30 40 50 60 70

  7. Market Demand Schedule Price(monthly bill) • The height of the demand curve at any particular quantity shows the maximum priceconsumers are willing to pay for that additional unit. • Thus, the height of the curve reflects the consumer’s valuation of the marginal unit. • For example, when 16 million units are consumed, the value of the last unit is $73. 140 120 100 80 60 Demand 40 Quantity(million subscribers) 0 10 20 30 40 50 60 70

  8. Changes in Demand versus Changes in Quantity Demanded

  9. Changes in Demand and Quantity Demanded • Change in Demand – a shift in the entire demand curve. • Change in Quantity Demanded – a movement along the same demand curve in response to a change in its price.

  10. D2 An Increase in Demand Price(dollars) • If DVDs cost $30 each, the demand curve for DVDs, D1, indicates that Q1units will be demanded. • If the price of DVDs falls to $10, the quantity demanded of DVDs will increase to Q2 units (where Q2> Q1). • Several factors will change the demand for the good (shift the entire demand curve). • As an example, suppose consumer income increases. The demand for DVDs at all prices will increase. • After the shift of demand, Q3units are demanded at $10 instead of Q2 (Q3> Q2> Q1). 30 20 10 D1 Quantity(DVDs per month) Q1 Q2 Q3

  11. D2 A Decrease in Demand Price(dollars) • If a pizza costs $20, then the demand curve for pizzas, D1, indicates that 200 units will be demanded. • If the price falls to $10, the quantity demanded of pizzas will increase to 300 units. • If the number of pizza consumers changes, then the demand for it will generally change. • For example, in a college town during the summer students go home and the demand for pizzas at all prices decreases. • After the shift of demand, 200 units are demanded at $10. 20 10 D1 Quantity(Pizzas per week) 200 300 0

  12. Demand Curve Shifters • The following will lead to a change in demand (a shift in the entire curve): • Changes in consumer income • Change in the number of consumers • Change in the price of a related good • Changes in expectations • Demographic changes • Changes in consumer tastes and preferences

  13. The Law Of Supply

  14. Law of Supply • Law of Supply: there is a positive relationship between the price of a product and the amount of it that will be supplied. • As the price of a product rises, producers will be willing to supply a larger quantity.

  15. Supply Market Supply Schedule Price(monthly bill) 140 Cellular phone subscribers(millions) Cellular phone service price(avg. monthly bill) 120 $ 60 5.0 $ 73 11.0 100 $ 80 15.1 $ 91 18.2 80 $ 107 21.0 $ 120 22.5 60 40 Quantity(million subscribers) 0 10 20 30 40 50 60 70

  16. Supply Market Supply Schedule Price(monthly bill) • Notice how the law of supply is reflected by the shape of the supply curve. • As the price of a good rises … producers supply more. 140 120 100 80 60 40 Quantity(million subscribers) 0 10 20 30 40 50 60 70

  17. Supply Market Supply Schedule Price(monthly bill) • The height of the supply curve at any quantity shows the minimum price necessary to induce producers to supply that unit. • The height of the supply curve at any quantity also shows the opportunity cost of producing that unit. • Here, producers require $73 to induce them to supply the 11 millionth unit … 140 120 100 80 while they would require $91 to supply the 18.2 millionth unit. 60 40 Quantity(million subscribers) 0 10 20 30 40 50 60 70

  18. Changes in Supply versus Changes in Quantity Supplied

  19. Changes in Supply and Quantity Supplied • Change in Supply – a shift in the entire supply curve. • Change in Quantity Supplied – movement along the same supply curve in response to a change in its price.

  20. S2 S1 An Decrease in Supply Price(dollars) • If the market price for gasoline is $3.00 a gallon, the supply curve for gasoline S1 indicates Q1units would be supplied. • If the price fell to $2.00, the quantity supplied would fallto Q2 units (where Q2< Q1). • If, somehow, the opportunity costs for gasoline producers changed then the supply of gas would change. • Consider the case where the cost of crude oil (an input in the production of gasoline) increases … $3 $2 $1 the supply of gasoline at all potential market prices would fall. Now at $2.00, Q3 units are supplied instead of Q2 (Q3 < Q2 < Q1). Quantity(units of gasoline per year) Q3 Q2 Q1

  21. Supply Curve Shifters • The following will cause a change in supply (a shift in the entire curve): • Changes in resource prices • Changes in technology • Elements of nature and political disruptions • Changes in taxes

  22. How Market Prices are Determined

  23. Quantity supplied= 600 Quantity demanded = 450 Market Equilibrium S • This table & graph indicate demand & supply conditions of the market for calculators. • Equilibrium will occur where the quantity demanded equals the quantity supplied. If the price in the market differs from the equilibrium level, market forces will guide it to equilibrium. • A price of $12 in this market will result in a quantity demanded of 450 … • With an excess supply present, there will be downward pressure on price to clear the market. Price($) 13 12 11 10 9 and a quantity supplied of 600 … 8 D resulting in an excess supply. 7 Quantity 450 500 550 600 650 Quantitysupplied(per day) Quantitydemanded(per day) Conditionin themarket Directionof pressureon price Price(dollars) Excess supply Downward > 12 600 450 10 550 550 8 500 650

  24. Quantity demanded= 650 Quantity supplied= 500 Market Equilibrium S • A price of $8 in this market will result in quantity supplied of 500 … • With an excess demand present, there will be upward pressure on price to clear the market. Price($) and a quantity demanded of 650 … resulting in an excess demand. 13 12 11 10 9 8 D 7 Quantity 450 500 550 600 650 Quantitysupplied(per day) Quantitydemanded(per day) Conditionin themarket Directionof pressureon price Price(dollars) Excess supply Downward > < 12 600 450 10 550 550 Excess demand Upward 8 500 650

  25. Quantity supplied= 550 Quantity demanded= 550 Market Equilibrium S • A price of $10 in this market results in quantity supplied of 550 … • With market balance present, there will be an equilibrium present and the market will clear. Price($) and a quantity demanded of 550 … resulting in market balance. 13 12 11 10 9 8 D 7 Quantity 450 500 550 600 650 Quantitysupplied(per day) Quantitydemanded(per day) Conditionin themarket Directionof pressureon price Price(dollars) Excess supply Downward > = < 12 600 450 MarketBalance Equilibrium 10 550 550 Excess demand Upward 8 500 650

  26. Excess supply Equilibrium price Excess demand Market Equilibrium S • At every price above market equilibrium there is excess supply and there will be downward pressure on the price level. • At every price below market equilibrium there is excess demand and there will be upward pressure on the price level. • At the equilibriumprice, quantity demanded and quantity supplied are in balance. Price($) 13 12 11 10 9 8 D 7 Quantity 450 500 550 600 650 Quantitysupplied(per day) Quantitydemanded(per day) Conditionin themarket Directionof pressureon price Price(dollars) Excess supply Downward > = < 12 600 450 MarketBalance Equilibrium 10 550 550 Excess demand Upward 8 500 650

  27. How Markets Respond to Changes in Supply & Demand

  28. Effects of a Change in Demand • When demand decreases– the equilibrium price and quantity will fall. • When demand increases – the equilibrium price and quantity will rise.

  29. D2 Market Adjustment to an Increase in Demand • Consider the market for eggs. • Prior to the Easter season, the market for eggs produces an equilibrium where supplyequals demand1at a price of $0.80 a dozen & output of Q1. • Every year during the Easter holiday the demand for eggs increases (shifts from D1 to D2). • What happens to the equilibrium price and output level? • Now at $0.80, quantity demanded exceeds quantity supplied. An upward pressure on price induces existing suppliers to increase their quantity supplied. Equilibrium occurs at output level Q2and price $1.00. • What happens to price and output after the Easter holiday? Price($ per doz) S 1.20 1.00 0.80 0.60 D1 Quantity(million doz eggs per week) Q1 Q2

  30. Effects of a Change in Supply • When supply decreases– the equilibrium price will rise and the equilibrium quantity will fall. • When supply increases – the equilibrium price will fall and the equilibrium quantity will rise.

  31. S2 Market Adjustment to a Decrease in Supply • Consider the market for lemons. • Initially equilibrium is present where supply1 equals demand at a market price of $0.20 and output of Q1. • Suppose adverse weather, such as occurred in California in January 2007, reduces the supply of lemons (shift from S1 to S2). • What happens to both the price and output level in the market? • Now at $0.20, quantity demanded exceeds quantity supplied. Upward pressure on price reduces quantity demanded by consumers. Equilibrium occurs at a price of $0.30 and output level of Q2. • What happens to price and output when weather returns to normal? Price($ per lemon) S1 0.40 0.30 0.20 0.10 D Quantity(millions of lemons per week) Q1 Q2

  32. The Invisible Hand Principle

  33. The Invisible Hand • Invisible hand: the tendency of market prices to direct individuals pursuing their own self interests into productive activities that also promote the economic well-being of society. • This direction, provided by markets, is a key to economic progress.

  34. The Invisible Hand “ Every individual is continually exerting himself to find out the most advantageous employment for whatever capital [income] he can command. It is his own advantage, indeed, and not that of the society which he has in view. But the study of his own advantage naturally, or rather necessarily, leads him to prefer that employment which is most advantageous to society…He intends only his own gain, and he is in this, as in many other cases, led by an invisible hand to promote an end which was not part of his intention.” – Adam Smith, The Wealth of Nations (1776)

  35. Communicating Information • Product prices communicate up-to-date information about the consumers’ valuation of additional units of each commodity. • Without the information provided by market prices it would be impossible for decision-makers to determine how intensely a good was desired relative to its opportunity cost.

  36. Coordinating Actions of Market Participants • Price changes coordinate the choices of buyers and sellers and bring them into harmony. • Price changes create profits and losses which change production levels for products.

  37. Motivating Economic Participants • Suppliers have an incentive to produce efficiently (at a low cost). • Entrepreneurs have an incentive to both innovate and produce goods that are highly valued relative to cost. • Resource owners have an incentive both to develop and supply resources that producers value highly.

  38. Market Order • Competitive markets – the forces of supply and demand – lead to market order, low-cost production, and economic progress. • The pricing system coordinates the choices of literally millions of consumers, producers, and resource owners and thereby provides market order. • Central planning is neither necessary nor helpful. • The market process works so automatically that the coordination and order it generates is often taken for granted. Thus the expression “invisible hand” is quite descriptive of the process.

  39. Qualifications • The efficiency of market organization is dependent upon: • The presence of competitive markets. • Well-defined and enforced private property rights.

  40. End of Chapter 3

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