Supply, Demand, and Equilibrium

1. Supply, Demand, and Equilibrium Today: An introduction to supply and demand, and how they relate to equilibrium

2. Who is very hungry and likes bananas? • All the bananas you care to eat for one person (up to however many I have) • NOT extra credit, since you get free bananas • You are eating bananas at your own risk • You are not allowed to share bananas with anyone else • Please report to me how many bananas you eat in about 40 minutes

3. Previously • The 7 Core Principles • Thinking like an economist • Marginal cost and benefit • Working with graphs

4. Today: Markets • Supply, demand, and equilibrium • What causes shifts in supply and demand? • What happens when supply and/or demand shifts?

5. Central organization versus Markets • Central economic organization is rare today • Most economic activity today occurs in markets • Markets do fail sometimes, but this is the focus of other chapters (e.g. Chapters 8 and 10)

6. Markets • Markets consist of buyers and sellers • Assume many buyers and many sellers • Fractional amounts of goods can be produced • We will talk about supply and demand for most markets • Exceptions will be dealt with accordingly as we get to them

7. Core principle related to demand • Cost-benefit analysis • Recall energy drinks example • Think “reservation price” when you think “willingness to pay” (“WTP”)

8. Demand • Demand states how much of a good that buyers are willing to purchase given each price • Demand is typically shown on a graph, but it is occasionally displayed on a table

9. Demand • A fundamental characteristic of demand is that as the price of a good increases, demand typically goes down (all else constant) • Recall that WTP for energy drinks decreases as you consume more • Thus, each demand curve is downward sloping if we graphed it • By convention, quantity is on the horizontal axis and price on the vertical axis

10. Core principles related to supply • Increasing opportunity cost • We want to produce at the lowest cost for each additional unit • Also called “low-hanging-fruit” principle • Incentive principle • Businesses will supply less when some units are not profitable • Businesses will supply more when producing more could lead to higher profits

11. Supply • Supply states how much of a good that sellers are willing to sell given each price • Similar to demand, supply is typically shown on a graph

12. Supply • Low-cost sellers typically enter a market before high-cost sellers • Thus, we would expect that the sellers with lowest cost to sell a particular good • Supply is then assumed to be upward sloping

13. Discrete versus continuous • Although many products can only be purchased in discrete amounts, we usually assume continuous curves • Why? (Come to class to find out) • In this class, most common curve used is linear • We will typically ignore the “discreteness” problem in supply/demand analysis

14. Graphing supply and demand

15. Equilibrium principle • Another core principle • “No cash on the table”  “stable” • Nobody can be made better off by changing her/his decision • Does not address potential actions that groups of people can make • Later topic, especially with market failure

16. Equilibrium: 4 units purchased, at a price of 6

17. Why is a price of 6 equilibrium? • To show that 6 is the equilibrium price, we will show that prices above and below are not in equilibrium • We will prove by contradiction that this price could not be equilibrium • Suppose that a price (P) of 4 is equilibrium

18. At P = 4: Quantity demanded is 6, quantity supplied is 3.33

19. At P = 4: Quantity demanded is 6, quantity supplied is 3.33 • When P is 4, people are demanding a quantity that is higher than what is supplied • Is this an equilibrium? • No, this is not stable • Someone can increase their production slightly, and sell at a price of 5 to make more profits

20. Now suppose that P = 9 is an equilibrium

21. Now suppose that P = 9 is an equilibrium • Quantity supplied is 6 • Quantity demanded is 1 • This is not stable either • Someone not selling their entire stock can sell for P = 7 to make more money

22. A change in supply versus a movement along the supply curve • A change in supply leads to a shift of the entire supply curve • A movement along the supply curve can occur when the supply curve does not move • Movement occurs when there is a change in price • Similar ideas apply for changes in demand versus a movement along demand curves

23. What causes shifts in demand? • Price changes of complements and substitutes • Example of complements: baseballs and baseball bats • Example of substitutes: two different brands of cola

24. What causes shifts in demand? • Income changes • Most goods are normal goods, meaning that when income increases, the demand curve shifts to the right • Some goods are inferior, meaning that when income increases, the demand curve shifts to the left • Changes in preferences, population, and expected future prices

25. What is happening here?

26. What is happening here? • The demand curve shifts to the right • There is a movement along the supply curve, since supply does not change

27. What is happening here? • Note that at any price, a higher quantity is demanded on curve D2 than on D1 • The new equilibrium price (P) and quantity (Q) are higher when demand shifts from D1 to D2

28. What causes shifts in supply? • Anything that changes the cost of production • If the cost of production decreases, supply shifts to the right • If the cost of production increases, supply shifts to the left • A change in number of suppliers • Expectations of future prices

29. What happens when both supply and demand shift? • An example: Both supply and demand shift right

30. Shift in supply… • …causes Q to increase and P to decrease • Movement from A to B A B

31. Shift in demand… • …causes Q to increase and P to increase • Movement from B to C C B

32. What can we conclusively say about changes in Q and P? • Change in supply causes Q to increase and P to decrease • Change in demand causes Q to increase and P to increase • The only conclusion when both supply and demand shift right is that Q increases

33. Now that we have talked about supply and demand… • …let’s talk about bananas • How many bananas did our volunteer eat today? • Why not any more? • We will talk about what happened here on Monday

34. Summary • The intersection of demand and supply curves determines equilibrium • Equilibrium is stable • Change in S or D causes the curve to shift • A movement along the supply curve can occur when the supply curve does not move • Same with demand • Both supply and demand can shift, but be careful of your conclusions