Chapter 2

1. Chapter 2 The Basics of Supply and Demand

2. Introduction • What are supply and demand? • What is the market mechanism? • What are the effects of changes in market equilibrium? • What are elasticities of supply and demand? Chapter 2

3. Topics to Be Discussed • How do short-run and long-run elasticities differ? • How do we understand and predict the effects of changing market conditions? • What are the effects of government intervention – price controls? Chapter 2

4. Supply and Demand • Supply and demand analysis can: • Help us understand and predict how world economic conditions affect market price and production • Analyze the impact of government price controls, minimum wages, price supports, and production incentives on the economy • Determine how taxes, subsidies, tariffs and import quotas affect consumers and producers Chapter 2

5. Supply • If a firm supplies a good or service, then the firm • 1. Has the resources and the technology to produce it, • 2. Can profit from producing it, and • 3. Has made a definite plan to produce and sell it. • Resources and technology determine what it is possible to produce. Supply reflects a decision about which technologically feasible items to produce. • The quantity supplied of a good or service is the amount that producers plan to sell during a given time period at a particular price.

6. Supply • The Law of Supply • The law of supply states: • Other things remaining the same, the higher the price of a good, the greater is the quantity supplied; and • the lower the price of a good, the smaller is the quantity supplied.

7. Supply • Supply Curve and Supply Schedule • The term supply refers to the entire relationship between the quantity supplied and the price of a good. • The supply curve shows the relationship between the quantity supplied of a good and its price when all other influences on producers’ planned sales remain the same.

8. Supply • Figure shows a supply curve of energy bars. • A rise in the price of an energy bar, other things remaining the same, brings an increase in the quantity supplied.

9. S P2 P1 Q1 Q2 The Supply Curve Price ($ per unit) The Supply Curve Graphically The supply curve slopes upward demonstrating that at higher prices firms will increase output Quantity Chapter 2

10. Supply and Demand • The Supply Curve • The relationship between the quantity of a good that producers are willing to sell and the price of the good. • Measures quantity on the x-axis and price on the y-axis Chapter 2

11. Figure 2.2: Demand Curve for U.S. Corn Market (hypothetical) 2-11

12. The Supply Curve • Other Variables Affecting Supply • Costs of Production • Labor • Capital • Raw Materials • Lower costs of production allow a firm to produce more at each price and vice versa Chapter 2

13. Supply • Prices of Productive Resources • If the price of resource used to produce a good rises, the minimum price that a supplier is willing to accept for producing each quantity of that good rises. • Eg. The P of jet fuel ↑; the supply of air transportation ↓ • So a rise in the price of productive resources decreases supply and shifts the supply curve leftward.

14. Supply • Prices of Related Goods Produced • A substitute in production for a good is another good that can be produced using the same resources. • The supply of a good increases if the price of a substitute in production falls. • Eg. If P of energy gel ↑; the SS of energy bars ↓ • Goods are complements in production if they must be produced together. • The supply of a good increases if the price of a complement in production rises. the price of car; the SS of car components

15. Supply • Expected Future Prices • If the price of a good is expected to rise in the future, supply of the good today decreases and the supply curve shifts leftward. • The Number of Suppliers • The larger the number of suppliers of a good, the greater is the supply of the good. An increase in the number of suppliers shifts the supply curve rightward.

16. Supply • Technology • Advances in technology create new products and lower the cost of producing existing products, so advances in technology increase supply and shift the supply curve rightward. • A natural disaster is a negative technology change, which decreases supply and shifts the supply curve leftward.

17. S S’ P1 P2 Q0 Q1 Q2 Change in Supply P • The cost of raw materials falls • Produced Q1 at P1 and Q0 at P2 • Now produce Q2 at P1 and Q1 at P2 • Supply curve shifts right to S’ Q Chapter 2

18. The Supply Curve-summary • Change in Quantity Supplied • Movement along the curve caused by a change in price • Change in Supply • Shift of the curve caused by a change in something other than price • Change in costs of production Chapter 2

19. Demand • If you demand something, then you • 1. Want it, • 2. Can afford it, and • 3. Have made a definite plan to buy it. • Wants are the unlimited desires or wishes people have for goods and services. Demand reflects a decision about which wants to satisfy. • The quantity demanded of a good or service is the amount that consumers plan to buy during a particular time period, and at a particular price.

20. Demand • The Law of Demand • The law of demand states: • Other things remaining the same, the higher the price of a good, the smaller is the quantity demanded; and • the lower the price of a good, the larger is the quantity demanded. • The law of demand results from • Substitution effect • Income effect

21. Demand • Substitution effect • When the relative price (opportunity cost) of a good or service rises, people seek substitutes for it, so the quantity demanded of the good or service decreases. • Income effect • When the price of a good or service rises relative to income, people cannot afford all the things they previously bought, so the quantity demanded of the good or service decreases.

22. Demand • Demand Curve and Demand Schedule • The term demand refers to the entire relationship between the price of the good and quantity demanded of the good. • A demand curve shows the relationship between the quantity demanded of a good and its price when all other influences on consumers’ planned purchases remain the same.

23. Supply and Demand • The Demand Curve • The relationship between the quantity of a good that consumers are willing to buy and the price of the good. • Measures quantity on the x-axis and price on the y-axis Chapter 2

24. P2 P1 D Q2 Q1 The Demand Curve Price ($ per unit) The demand curve slopes downward demonstrating that consumers are willing to buy more at a lower price as the product becomes relatively cheaper. Quantity Chapter 2

25. Shifts and Movements Along a Demand Curve • Change in price of the product causes a movement along the demand curve • A change in the quantity demanded • Change in another factor causes the entire demand curve to shift • A change in demand 2-25

26. Demand • A Movement along the Demand Curve • When the price of the good changes and everything else remains the same, the quantity demanded changes and there is a movement along the demand curve.

27. Demand • A Shift of the Demand Curve • If the price remains the same but one of the other influences on buyers’ plans changes, • demand changes and the demand curve shifts.

28. The Demand Curve • Other Variables Affecting Demand • Income • Increases in income allow consumers to purchase more at all prices • Consumer Tastes • Price of Related Goods • Substitutes • Complements Chapter 2

29. Demand • Six main factors that change demand are • The prices of related goods • Expected future prices • Income • Expected future income • Population • Preferences

30. Demand • Prices of Related Goods • A substitute is a good that can be used in place of another good. • Bus ride vs train ride • If the P of substitute for bus ride ↑; people buy less of the substitute and more train ride • Thus, demand for train ride↑ • Summary: (An increase in the price of one product causes buyers to demand more of the other, all else equal)

31. A complement is a good that is used in conjunction with another good. • If the price of sugar ↑; people buy more coffee. • Sugar and coffee are complement • Summary: An increase in the price of product causes buyers to demand less of the other, all else equal

32. Demand • Expected Future Prices • If the price of a good is expected to rise in the future, • current demand fore the good increases • and the demand curve shifts rightward.

33. Income • When income increases, consumers buy more of most goods and the demand curve shifts rightward. • A normal good is one for which demand increases as income increases. • Eg. Air travel • An inferior good is a good for which demand decreases as income increases. • Eg. Long-distance bus trips

34. Demand • Expected Future Income • When income is expected to increase in the future, the demand might increase now. • Population • The larger the population, the greater is the demand for all goods. • Preferences • People with the same income have different demands if they have different preferences.

35. The Demand Curve-summary • Changes in quantity demanded • Movements along the demand curve caused by a change in price. • Changes in demand • A shift of the entire demand curve caused by something other than price. • Income • Preferences Chapter 2

36. The Market Mechanism • The market mechanism is the tendency in a free market for price to change until the market clears • Markets clear when quantity demanded equals quantity supplied at the prevailing price • Market Clearing price – price at which markets clear Chapter 2

37. S Price ($ per unit) P0 D Quantity Q0 The Market Mechanism The curves intersect at equilibrium, or market- clearing, price. Quantity demanded equals quantity supplied at P0 Chapter 2

38. The Market Mechanism • In equilibrium • There is no shortage or excess demand • There is no surplus or excess supply • Quantity supplied equals quantity demanded • Anyone who wished to buy at the current price can and all producers who wish to sell at that price can Chapter 2

39. Market Surplus • The market price is above equilibrium • There is excess supply - surplus • Downward pressure on price • Quantity demanded increases and quantity supplied decreases • The market adjusts until new equilibrium is reached Chapter 2

40. Price ($ per unit) S Surplus P1 P0 D Quantity QD Q0 QS The Market Mechanism • Price is above the market clearing price – P1 • Qs > QD • Price falls to the market-clearing price • Market adjusts to equilibrium Chapter 2

41. The Market Mechanism • The market price is below equilibrium: • There is a excess demand - shortage • Upward pressure on prices • Quantity demanded decreases and quantity supplied increases • The market adjusts until the new equilibrium is reached. Chapter 2

42. Price ($ per unit) S P3 P2 D Shortage Quantity QS QD Q3 The Market Mechanism • Price is below the market clearing price – P2 • QD > QS • Price rises to the market-clearing price • Market adjusts to equilibrium Chapter 2

43. The Market Mechanism • Supply and demand interact to determine the market-clearing price. • When not in equilibrium, the market will adjust to alleviate a shortage or surplus and return the market to equilibrium. • Markets must be competitive for the mechanism to be efficient. Chapter 2

44. Changes In Market Equilibrium • Equilibrium prices are determined by the relative level of supply and demand. • Changes in supply and/or demand will change in the equilibrium price and/or quantity in a free market. Chapter 2

45. D P S S’ P1 P3 Q1 Q3 Q Q2 Changes In Market Equilibrium • Raw material prices fall • S shifts to S’ • Surplus at P1 between Q1, Q2 • Price adjusts to equilibrium at P3, Q3 Chapter 2

46. D D’ P S P1 P3 Q1 Q3 Q2 Q Changes In Market Equilibrium • Income Increases • Demand increases to D1 • Shortage at P1 of Q1, Q2 • Equilibrium at P3, Q3 Chapter 2

47. P2 P1 D P D’ S S’ Q1 Q2 Q Changes In Market Equilibrium • Income Increases & raw material prices fall • Quantity increases • If the increase in D is greater than the increase in S price also increases Chapter 2

48. Shifts in Supply and Demand • When supply and demand change simultaneously, the impact on the equilibrium price and quantity is determined by: • The relative size and direction of the change • The shape of the supply and demand models Chapter 2

49. ELASTICITY OF DEMAND AND SUPPLY

50. Elasticities of Supply and Demand • Not only are we concerned with what direction price and quantity will move when the market changes, but we are concerned about how much they change. • Elasticity gives a way to measure by how much a variable will change with the change in another variable. • Specifically, it gives the percentage change in one variable resulting from a one percent change in another. Chapter 2