Basics of Supply and Demand

1. Basics of Supply and Demand Market Mechanism

2. Introduction • What are supply and demand? • How does a market mechanism work? • What are the effects of changes in market equilibrium?

3. 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

4. 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

5. 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

6. 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

7. The Supply Curve • 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

8. 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

9. 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

10. 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

11. D P D’ P2 P1 Q0 Q1 Q2 Q Change in Demand • Income Increases • Purchased Q0, at P2 and Q1 at P1 • Now purchased Q1 at P2 and Q2 at P1 • Same for all prices • Demand Curve shifts right

12. The Demand Curve • 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

13. 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

14. 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

15. 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 wishes to buy at the current price can and all producers who wish to sell at that price can

16. 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

17. 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

18. 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.

19. 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

20. 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.

21. 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.

22. 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

23. 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

24. 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

25. 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

26. The Price of a College Education • The real price of a college education rose 55 percent from 1970 to 2002. • Increases in costs of modern classrooms and wages increased costs of production – decrease in supply • Due to a larger percentage of high school graduates attending college, demand increased

27. S2002 P (annual cost in 1970 dollars) $3,917 S1970 $2,530 D2002 D1970 Q (millions enrolled)) 8.6 13.2 Market for a College Education New equilibrium was reached at $4,573 and a quantity of 12.3 million students