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GECON 200: Lecture 4

GECON 200: Lecture 4. Where Prices Come From: The Interaction of Demand and Supply (Chapter 3), Public Goods and Market Failure (Handout). The Demand Side of the Market.

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GECON 200: Lecture 4

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  1. GECON 200: Lecture 4 Where Prices Come From: The Interaction of Demand and Supply (Chapter 3), Public Goods and Market Failure (Handout)

  2. The Demand Side of the Market • Perfectly Competitive Market A market that meets the conditions of (1) many buyers and sellers, (2) all firms selling identical products, and (3) no barriers to new firms entering the market. 3.1 LEARNING OBJECTIVE Discuss the variables that influence demand.

  3. The Demand Side of the Market • Demand schedule A table showing the relationship between the price of a product and the quantity of the product demanded. • Quantity demanded The amount of a good or service that a consumer is willing and able to purchase at a given price. • Demand curve A curve that shows the relationship between the price of a product and the quantity of the product demanded. • Market demand The demand by all the consumers of a given good or service.

  4. The Demand Side of the Market Demand Schedules and Demand Curves FIGURE 3-1 A Demand Schedule and Demand Curve As the price changes, consumers change the quantity of energy drinks they are willing to buy. We can show this as a demand schedule in a table or as a demand curve on a graph. The table and graph both show that as the price of energy drinks falls, the quantity demanded rises. When the price of energy drinks is $3.00, consumers buy 60 million cans per day. When the price drops to $2.50, consumers buy 70 million cans. Therefore, the demand curve for energy drinks is downward sloping.

  5. The Demand Side of the Market • Law of demand The rule that, holding everything else constant, when the price of a product falls, the quantity demanded of the product will increase, and when the price of a product rises, the quantity demanded of the product will decrease. • A shift of a demand curve is an increase or a decrease in demand. A movement along a demand curve is an increase or a decrease in the quantity demanded

  6. What Explains the Law of Demand? • Substitution effect The change in the quantity demanded of a good that results from a change in price, making the good more or less expensive relative to other goods that are substitutes. • Income effect The change in the quantity demanded of a good that results from the effect of a change in the good’s price on consumers’ purchasing power.

  7. Holding Everything Else Constant: The Ceteris Paribus Condition • Ceteris paribus (“all else equal”) condition The requirement that when analyzing the relationship between two variables—such as price and quantity demanded—other variables must be held constant. • Ceteris paribus also applies to supply curves and nearly all economic analysis to some degree. • .

  8. Buyers and Sellers In Markets • The Cost-Benefit Principle • The reservation price is the benefit the buyer receives from the good • The cost of the good is its market price • If the reservation price (benefit) exceeds the market price (cost) the consumer will purchase the good • At higher prices, benefit will exceed cost for a smaller quantity than at lower prices

  9. The Demand Side of the Market Holding Everything Else Constant: The Ceteris Paribus Condition FIGURE 3-2 Shifting theDemand Curve When consumers increase the quantity of a product they want to buy at a given price, the market demand curve shifts to the right, from D1 to D2. When consumers decrease the quantity of a product they want to buy at any given price, the demand curve shifts to the left, from D1 to D3.

  10. Buyers and Sellers In Markets Horizontal Interpretation Price ($ per slice) Price determines quantity demanded 4 3 2 Demand Quantity (1000s of slices per day) 8 12 16

  11. Buyers and Sellers In Markets Vertical Interpretation Price ($ per slice) Quantity measures the marginal buyer’s reservation price 4 3 2 Demand Quantity (1000s of slices per day) 8 12 16

  12. The Demand Side of the Market Variables That Shift Market Demand • Many variables other than price can influence market demand. • Income • Normal good A good for which the demand increases as income rises and decreases as income falls. • Inferior good A good for which the demand increases as income falls and decreases as income rises. • Prices of related goods • Substitutes Goods and services that can be used for the same purpose. • Complements Goods and services that are used together.

  13. The Demand Side of the Market Variables That Shift Market Demand • Tastes • Consumers can be influenced by an advertising campaign for a product. • Population and demographics • Demographics The characteristics of a population with respect to age, race, and gender. • Expected future prices • Consumers choose not only which products to buy but also when to buy them.

  14. MakingtheConnection • YOUR TURN:Test your understanding by doing related problem 1.8 at the end of this chapter. • Are Big Macs an Inferior Good? Big Macs seem to fit the economic definition of an inferior good because demand increased as income fell. But remember that inferior goods are not necessarily of low quality, they are just goods for which consumers increase their demand as their incomes fall. McDonald’s restaurants experienced increased sales during 2008 and 2009, despite the recession.

  15. MakingtheConnection • YOUR TURN:Test your understanding by doing related problem 1.9 at the end of this chapter. • The Aging of the Baby Boom Generation What effects will the aging of the baby boom generation have on the economy? Older people have a greater demand for medical care than do younger people. Aging boomers will also have an effect on the housing market.

  16. The Demand Side of the Market TABLE 3-1 Variables That Shift Market Demand Curves

  17. The Demand Side of the Market TABLE 3-1 Variables That Shift Market Demand Curves

  18. The Demand Side of the Market TABLE 3-1 Variables That Shift Market Demand Curves

  19. The Demand Side of the Market TABLE 3-1 Variables That Shift Market Demand Curves

  20. The Demand Side of the Market A Change in Demand versus a Change in Quantity Demanded FIGURE 3-3 A Change in Demand versus a Change in Quantity Demanded If the price of digital music players falls from $3.00 to $2.50, the result will be a movement along the demand curve from point A to point B—an increase in quantity demanded from 60 million to 70 million. If consumers’ incomes increase, or if another factor changes that makes consumers want more of the product at every price, the demand curve will shift to the right—an increase in demand. In this case, the increase in demand from D1 to D2 causes the quantity of energy drinks demanded at a price of $3.00 to increase from 60 million cans at point A to 80 million cans at point C.

  21. Predicting and Explaining Changes In Prices and Quantities • Distinguishing Between: • A change in the quantity demanded • A movement along the demand curve that occurs in response to a change in price • A change in demand • A shift of the entire demand curve

  22. MakingtheConnection • YOUR TURN:Test your understanding by doing related problem 1.11 at the end of this chapter. • Red Bull and the Future Demand for Energy Drinks It is important for managers to accurately forecast the demand for their products because it helps them determine how much of a good to produce. Will Red Bull continue to grow its share of the energy drink market?

  23. The Supply Side of the Market • Quantity supplied The amount of a good or service that a firm is willing and able to supply at a given price. • Supply schedule A table that shows the relationship between the price of a product and the quantity of the product supplied. • Market supply The total supply by all the producers of a given good or service.

  24. Buyers and Sellers In Markets Supply curve A curve that shows the relationship between the price of a product and the quantity of the product supplied. • Sellers must receive a higher price to produce additional units of product to cover the higher opportunity costs of each additional unit • Suppliers of goods are not (necessarily) gouging customers when they raise prices. • Do you leave money on the table?

  25. The Supply Side of the Market Supply Schedules and Supply Curves FIGURE 3-4 A Supply Schedule and Supply Curve As the price changes, Red Bull, Monster Energy, Rockstar, and the other firms producing energy drinks change the quantity they are willing to supply. We can show this as a supply schedule in a table or as a supply curve on a graph. The supply schedule and supply curve both show that as the price of energy drinks rises, firms will increase the quantity they supply. At a price of $2.50 per can, firms will supply 90 million cans. At a price of $3.00, firms will supply 100 million cans. 3.2 Learning Objective Discuss the variables that influence supply.

  26. The Supply Side of the Market • Law of supply The rule that, holding everything else constant, increases in price cause increases in the quantity supplied, and decreases in price cause decreases in the quantity supplied.

  27. The Daily SupplyCurve for Pizza in Chicago Horizontal Interpretation Price ($ per slice) Supply 4 Shows the quantity produced for each price 3 2 Quantity (1000s of slices per day) 8 12 16

  28. The Daily SupplyCurve for Pizza in Chicago Vertical Interpretation Price ($ per slice) Supply 4 Shows the marginal cost (reservation price) for producing each additional unit 3 2 Quantity (1000s of slices per day) 8 12 16

  29. The Supply Side of the Market FIGURE 3-5 Shifting the Supply Curve When firms increase the quantity of a product they want to sell at a given price, the supply curve shifts to the right. The shift from S1 to S3 represents an increase in supply. When firms decrease the quantity of a product they want to sell at a given price, the supply curve shifts to the left. The shift from S1 to S2 represents a decrease in supply.

  30. The Supply Side of the Market Variables That Shift Market Supply • The following are the most important variables that shift market supply: • Prices of inputs • Technological change A positive or negative change in the ability of a firm to produce a given level of output with a given quantity of inputs. • Prices of substitutes in production • Number of firms in the market • Expected future prices

  31. The Supply Side of the Market TABLE 3-2 Variables That Shift Market Supply Curves

  32. The Supply Side of the Market TABLE 3-2 Variables That Shift Market Supply Curves (continued)

  33. The Supply Side of the Market TABLE 3-2 Variables That Shift Market Supply Curves (continued)

  34. The Supply Side of the Market A Change in Supply versus a Change in Quantity Supplied FIGURE 3-6 A Change in Supply versus a Change in Quantity Supplied If the price of energy drinks rises from $2.00 to $2.50 per can, the result will be a movement up the supply curve from point A to point B—an increase in quantity supplied by Red Bull, Monster Energy, Rockstar, and the other firms from 80 million to 90 million cans. If the price of an input decreases or another factor changes that makes sellers supply more of the product at every price, the supply curve will shift to the right—an increase in supply. In this case, the increase in supply from S1 to S2 causes the quantity of energy drinks supplied at a price of $2.50 to increase from 90 million cans at point B to 110 million cans at point C.

  35. Market Equilibrium: Putting Demandand Supply Together FIGURE 3-7 Market Equilibrium Where the demand curve crosses the supply curve determines market equilibrium. In this case, the demand curve for energy drinks crosses the supply curve at a price of $2.00 and a quantity of 80 million cans. Only at this point is the quantity of energy drinks consumers are willing to buy equal to the quantity that Red Bull, Monster Energy, Rockstar, and the other firms are willing to sell: The quantity demanded is equal to the quantity supplied. 3.3 Learning Objective Use a graph to illustrate market equilibrium.

  36. Predicting and Explaining Changes In Prices and Quantities • Change in the quantity supplied • A movement along the supply curve that occurs in response to a change in price • Change in supply • A shift of the entire supply curve

  37. Market Equilibrium: Putting Demandand Supply Together • Market equilibrium A situation in which quantity demanded equals quantity supplied. • Competitive market equilibrium A market equilibrium with many buyers and many sellers.

  38. Market Equilibrium: Putting Demandand Supply Together • Surplus A situation in which the quantity supplied is greater than the quantity demanded. • Shortage A situation in which the quantity demanded is greater than the quantity supplied.

  39. Market Equilibrium: Putting Demandand Supply Together FIGURE 3-8 The Effect of Surpluses and Shortages on the Market Price When the market price is above equilibrium, there will be a surplus. In the figure, a price of $2.50 for energy drinks results in 90 million cans being supplied but only 70 million cans being demanded, or a surplus of 20 million. As Red Bull, Monster Energy, Rockstar, and the other firms cut the price to dispose of the surplus, the price will fall to the equilibrium of $2.00. When the market price is below equilibrium, there will be a shortage. A price of $1.00 results in 100 million cans being demanded but only 60 million cans being supplied, or a shortage of 40 million cans. As consumers who are unable to buy energy drinks offer to pay higher prices, the price will rise to the equilibrium of $2.00.

  40. Excess supply = 8,000 slices per day Supply Demand Excess Supply Price ($ per slice) 4 3 2 Quantity (1000s of slices per day) 8 12 16

  41. Excess Demand Price ($ per slice) Supply 4 Excess demand = 8,000 slices per day 3 2 Demand Quantity (1000s of slices per day) 8 16

  42. Market Equilibrium: Putting Demandand Supply Together • Demand and Supply Both Count • Keep in mind that the interaction of demand and supply determines the equilibrium price. • Neither consumers nor firms can dictate what the equilibrium price will be. • No firm can sell anything at any price unless it can find a willing buyer, and no consumer can buy anything at any price without finding a willing seller.

  43. 3-3 Solved Problem Demand and Supply Both Count: A Tale of Two Letters • YOUR TURN:For more practice, do related problems 3.4 and 3.5 at the end of this chapter. Both demand and supply count when determining market price. The demand for Lincoln’s letters is much greater than the demand for Booth’s letters, but the supply of Booth’s letters is very small. Historians believe that only eight letters written by Booth exist today.

  44. The Effect of Demand and SupplyShifts on Equilibrium FIGURE 3-9 The Effect of an Increase in Supply on Equilibrium If a firm enters a market, as Coca-Cola entered the market for energy drinks when it launched Full Throttle, the equilibrium price will fall, and the equilibrium quantity will rise: 1. As Coca-Cola enters the market for energy drinks, a larger quantity of energy drinks will be supplied at every price, so the market supply curve shifts to the right, from S1 to S2, which causes a surplus of cans at the original price, P1. 2. The equilibrium price falls from P1 to P2. 3. The equilibrium quantity rises from Q1 to Q2. 3.4 Learning Objective Use demand and supply graphs to predict changes in prices and quantities.

  45. MakingtheConnection • YOUR TURN:Test your understanding by doing related problem 4.7 at the end of this chapter. • The Falling Price of LCD Televisions An increase in supply drove the price of a typical large LCD television from $4,000 in fall 2004 to $1,000 at the end of 2008, increasing the quantity demanded worldwide from 8 million to 105 million.

  46. The Effect of Demand and SupplyShifts on Equilibrium FIGURE 3-10 The Effect of an Increase in Demand on Equilibrium Increases in income will cause the equilibrium price and quantity to rise: 1. Because energy drinks are a normal good, as income grows, the quantity demanded increases at every price, and the market demand curve shifts to the right, from D1 to D2, which causes a shortage of energy drinks at the original price, P1. 2. The equilibrium price rises from P1 to P2. 3. The equilibrium quantity rises from Q1 to Q2.

  47. The Effect of Demand and SupplyShifts on Equilibrium FIGURE 3-11 Shifts in Demand and Supply over Time In panel (b), supply shifts to the right more than demand, and the equilibrium price falls: In panel (a), demand shifts to the right more than supply, and the equilibrium price rises: 1. Supply shifts to the right more than demand. 2. Equilibrium price falls from P1 to P2. 1. Demand shifts to the right more than supply. 2. Equilibrium price rises from P1 to P2.

  48. The Effect of Demand and SupplyShifts on Equilibrium TABLE 3-3 How Shifts in Demand and Supply Affect Equilibrium Price (P) and Quantity (Q)

  49. 3-4 Solved Problem High Demand and Low Prices in the Lobster Market? • YOUR TURN:For more practice, do related problems 4.5 and 4.6 at the end of this chapter. Supply and demand for lobster both increase during the summer, but the increase in supply is greater than the increase in demand, therefore, equilibrium price falls.

  50. YOUR TURN:Test your understanding by doing related problems 4.13 and 4.14 at the end of this chapter. The Effect of Demand and SupplyShifts on Equilibrium Shifts in a Curve versus Movements along a Curve When analyzing markets using demand and supply curves, it is important to remember that when a shift in a demand or supply curve causes a change in equilibrium price, the change in price does not cause a further shift in demand or supply. Don’t Let This Happen to YOU!Remember: A Change in a Good’s Price Does Not Cause the Demand or Supply Curve to Shift

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