Supply and Demand

1. Supply and Demand

2. In economics we use a model of supply and demand in an attempt to understand market outcomes for a good or service. Of particular interest are two basic questions: 1) What determines the price of a product, and 2) What determines the quantity of a product sold. Before I get into this I want to present something totally different. I want to talk about the weather. In particular, I want to talk about the highest temperature in Wayne, Nebraska on each and every day. At the bottom I have a graph of the highest temperature on each day for the year 2006 (I made up the data, but do you think it covers the basic idea?) Highest temperature on the day Day of the year J F M A M J J A S O N D

3. Notes about graph: 1) The long term we see the highest temperature occurred sometime in July or August. 2) When you look at any three or four day period (a shorter time frame than the whole year) you see ups and downs of the highest temperature. Why does the highest temperature each day follow the pattern I have shown? The accepted answer comes from the science areas of astronomy and physics. In these sciences there are theories about how the earth is tilted and how it rotates around the sun. These ideas provide us with our understanding of the pattern of daily high temperatures.

4. Now, instead of thinking about the weather we could consider a market. There is a market for corn, wheat, Mt. Dew in a 20 ounce bottle, Microsoft stock, and many more. Some folks use a graph similar to the one I had with the weather example. The vertical axis variable may be the price of the product or the quantity (number of units) of the product traded. Our study of supply and demand is the scientific way folks go about explaining the pattern of price movements and/or quantity traded movements. When we study supply and demand we use a different graph than the one I have used so far. But it is related. Let’s turn to that graph next.

5. 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

6. 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. This point would correspond to the other graph in that this point is for a certain day. On other days we could be a a different point and we want to build a theory of that movement. Price at the point Quantity, Q Quantity at the point

7. Price, P In economics, often times the only point you need to focus your attention on is where two curves cross. Quantity, Q

8. Price, P If a curve should shift – here the demand shifts – you can focus your attention on the new intersection. D2 D1 Quantity, Q

9. 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 D1 Quantity, Q

10. 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.

11. P Demand in general refers to how much of a product consumers want 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. D Q Let’s think about each of these points in more detail. 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. So, if the price should rise, the quantity demanded will fall, and if the price should fall the quantity demanded will rise. Law of Demand – Price and quantity demanded are inversely related.

12. Let’s consider one more thing about the law of demand. Let’s take an example from our life. Any music CD costs about 15 bucks, give or take a few $’s. At that price you and I could probably buy more than we do, but we would have to give up other things (like milk and cookies, what were you thinking?) to get even more CD’s. In order to get us to demand an even greater quantity the price has to be lowered and we therefore do not have to give up as much of the other things we enjoy. It works the other way as well. If the price becomes higher we have a lower quantity demanded because at the higher price we have to give up too much of other things we like and so we reduce our quantity demanded for the CD’s.

13. P In the graph at P1, although folks could probably buy more of the product, quantity demanded is only Q1 because folks have decided they do not want to give up other things to get more of Q. P1 D Q Q1 But, If the price was lower than P1 you see there would be movement down the demand curve. Some folks would say that since they do not have to give up as much other stuff to get more units here, they are happy to demand a greater quantity. So, the price of the product is a major determinant of how much of a product consumers want. But there are other things that have an influence as well.

14. 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. If these other things should change then at P1 the amount people want could change and the demand would shift. Let’s go back to our CD example. We said if the price was P1 folks would demand Q1 units. But, if people get more income it is likely they can afford more things and thus the demand for CD’s would shift to the right.

15. So, on the previous slide we see the demand curve would shift right when a people’s income would go up. Similarly we would expect the demand curve would shift left if people’s income should fall. 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 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 factor 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.

16. Factor of demand change demand shifts to 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 Please note that when a factor changes in such a way that demand shifts to the right we could also say demand has increased and if a factor changes in such a way that demand shifts to the left we could also say demand has decreased.

17. 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.

18. 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.

19. 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.

20. 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. 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.

21. 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 I call the state of technology), the number of sellers 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.

22. Factor of supply change supply shifts to Input price increase left Input price decline right Increase in state of technology right Decrease in state of technology left Increase in expected future price left Decrease in expected future price right Increase in producers in market right Decrease in producers in market left 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.

23. 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

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

25. 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 S1 Pa D1 Quantity, Q Qs Qd

26. 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 S1 Pb D1 Quantity, Q Qd Qs

27. 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 factors 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 P1 in our graphs from the previous slides 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 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.

28. 2) When the price is below P1 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 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) help us understand why the price will change when conditions in the world change. Let’s turn to this next.

29. For any market story this is where you mind should be, on this graph with all the knowledge you have in these notes. Slides 16 and 22 mention how supply or demand could change. Price, P S1 P1 D1 Quantity, Q Q1

30. Here we have a demand increase. Slide 16 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

31. 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

32. 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

33. 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). 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.

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

35. Here we have a supply increase. Slide 22 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

36. 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

37. Note as the price falls due to the surplus both a) the quantity supplied falls from Qs to Q2 and b) the quantity demanded rises from Q1 to Q2. The surplus is gone. Price, P S1 S2 P1 P2 D1 Quantity, Q Q1 Qs Q2

38. 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 supply increases creating a surplus. 3) The surplus means the price will fall. 4) The surplus is eliminated because with the lower price the a) quantity demanded rises and b) the quantity supplied falls (from the new higher level). Overall, the increase in supply resulted in 1) An decrease in the market price, and 2) An increase in the quantity traded in the market.

39. What have we learned? Among other things 1) The price and quantity traded in a market are determined by the interaction of supply and demand. 2) The price and quantity traded in a market will change if there is a change in supply or demand.