Chapter 3 Notes

3Demand, Supply, and Market Equilibrium

Chapter Objectives• Demand Defined and What Affects It• Supply Defined and What Affects It• How Supply & Demand Together

Determine Market Equilibrium• How Changes in Supply and Demand

Affect Equilibrium Prices and Quantities

• Government-Set Prices and their Implications for Surpluses & Shortages

Demand• Demand Defined• Demand Schedule• Law of Demand–Diminishing Marginal Utility–Income Effect–Substitution Effect

• Demand Curve• Market Demand

3.1

3.2

3.3

3.4

• Demand – the desire to have a good or service and the ability to pay for it.

• The 2 factors of desire and ability are both necessary

• Ex. I have the desire to go on a European vacation, but I can not afford it. Therefore, I do not possess demand for it.

What is demand?

Demand Defined

• Expressed on a schedule or curve that shows the various amounts of a product that consumers are willing and able to purchase at each of a series of possible prices during a specified period of time

• Show quantities of a product that will be purchased at various psb prices, other things equal

• Table showing how much of a product an individual is willing & able to buy @ each price in the market.

• Market demand schedule – table showing how much all consumers are willing to buy @ each price

Demand Schedule

• Inverse relationship between price and quantity demanded

• States that when price increases, quantity demanded decreases

• When P. dec., QD. inc.

• Ppl buy less at higher prices, more at lower prices

Law of Demand

Explanations of the Law of Demand• Why the inverse relationship b/w P and QD?

• 1. Common sense—think about it!• 2. Diminishing marginal utility – marginal

benefit from using each additional unit of a product during a given period will decline.

• Ex. You get more satisfaction from the first glass of lemonade than the second, third, fourth…and are therefore not willing to pay as much for each additional unit

Explanations of the Law of Demand

• 3. Income and substitution effects • income effect – change in the amount that

consumers will buy b/c the purchasing power of their income changes, although income itself doesn’t change.

• Ex. You go to the store to buy ground beef, it is on sale, you feel wealthier and buy more.

Explanations of the Law of Demand

• 2. substitution effect – change in the amount that people will buy b.c they substitute goods instead.

• Ex. You go to the store to buy ground beef but you see ground turkey is on sale for ½ the price so you buy that instead.

• Graph showing how much of a product an individual will buy @ each price

• Graphic representation of demand schedule and law of demand

• Slopes downward from left to right• Market demand curve – graph showing data from

market demand schedule• Price on Y-axis, Quantity on X-axis

• See p.45 Figure 3.1

Demand Curve

Individual Demand 6

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IndividualDemand

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• -change in the amt. of a product consumers will buy b/c of a change in price

• Shown by a movement along the demand curve

Change in Quantity Demanded

Individual Demand

• Tastes• Number of Buyers• Income–Normal Goods– Inferior Goods

• Price of Related Goods– Substitute Good–Complementary Good–Unrelated Goods

• Consumer Expectations

Determinants of Demand

• Something prompts consumers to buy different amounts @ every price

• Represented by shifts of the demand curve• Inc. in demand – curve shifts right• Dec. in demand – curve shifts left

• Influenced by 6 factors

Change in Demand

• If consumer income inc., demand inc.• If income dec., demand dec.

Ex. a factory closes, ppl lose jobs, income falls and demand dec.

Factor 1: Income

• 2 types of goods:

• Normal goods – goods for which demand inc. as income inc.

• Ex. most goods such as TVs, steaks, IPODS, etc…

• Inferior goods - goods for which demand dec. as income inc.

• Ex. Generics, Ramen noodles, etc…

• # of consumers, population changes, seasonal tourist trends

• If market size inc., demand inc.

Factor 2: Market Size

• Advertising, trends, styles, popularity, celebrity endorsements

• If consumer tastes inc., demand inc.

Factor 3: Consumer tastes

• Refers to expectations of future prices

• If consumers expect a future price inc., current demand inc.

Factor 4: Consumer Expectations

• g/s that can be used in place of each other

• Ex. Coke and Pepsi, wireless phones and traditional phones

• If demand for substitute inc., demand for original item dec.

Factor 5: Substitute Goods

• Goods used together so a rise in the demand for one inc. as the demand for another inc.

• Ex. digital cameras and photo printers, cars and gas

Factor 6: Complements

Individual Demand 6

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Demand Can Increase or Decrease

Increase in Demand

Decrease in Demand

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Individual Demand 6

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Demand Can Increase or Decrease

Decrease in Demand

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An Increase in DemandMeans a Movementof the Line

A Movement BetweenAny Two Points on a

Demand Curve is Called a Change in Quantity

Demanded

Supply• Supply Defined• Supply Schedule• Law of Supply–Revenue Implications–Marginal Cost

• Supply Curve• Market Supply

• Willingness and ability of producers to offer a g/s for sale• Expressed as a schedule or curve showing the various

amounts of a product that producers are willing and able to sell at each of a series of psb prices during a specified period

• Producer = anyone who is willing to provide a g/s

• Ex. worker, company, farmers, etc…

• Profit motivates producers to inc. supply

What is supply?

• Direct (positive) relationship between P and QSS

• When P. inc., QS inc.

• When P. dec., QS dec.

Law of Supply

• Table showing how much of a g/s an individual producer is willing and able to sell @ each P.

• Market supply schedule – lists how much of a g/s all producers will sell @ each P.

• See p.51 Figure 3.4

Supply Schedule

• Supply schedule data in graphic form• Shows law of supply in graph form• Slopes upward from left to right

• Market supply curve – market supply schedule in graph form

• See p.102 Figure 3.4

Supply Curve

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• Changes in quantity supplied – inc. or dec. in the amount of a g/s that producers are willing to sell b/c of a change in P.

• -shown by movement to different points along the S. curve

What Factors Affect Supply?

Individual Supply

• Resource Prices• Technology• Taxes and Subsidies• Prices of Other Goods• Producer Expectations• Number of Sellers

Determinants of Supply

• Occur when a change in the marketplace causes producers to sell different amounts @ every price.

• Inc. in S, curve shifts right• Dec. in S, curve shifts left

• 6 Factors influence supply

Changes in Supply

• Price of resources used to make products• Ex. Cost of nuts used to make candy bars

• Input costs inc., Supply dec.

Factor 1: Input Costs

• Amt of a g/s a person can produce in a given time

• Ex. More skilled & educated workers, labor strike

• Inc. productivity, Supply inc.

Labor Productivity

• Excise tax – taxes production/sale of certain goods• Tax inc., Supply dec.

• Subsidy – gov. payment for part of production cost• Subsidy inc., supply inc.

• Regulation – rules/laws controlling business beh. (Ex. Pollution, worker safety)

• New regulation, Supply dec.

Factor 2: Government Action

• Applying science & innovation to production• Ex. Robots on assembly line, computers, etc…

• Inc. in technology, Supply inc.

Factor 3: Technology

Factor 4: Prices of Other Goods

• Substitution in production that may occur when higher prices of other goods a seller produces entice the producer to switch production to those other goods in order to increase profits.

• See example on page 52.

• If producers expect a future P. inc, they will withhold current supply.

Factor 5: Producer Expectations

• More producers of a product, Supply inc.

• Ex. Fast food restaurants, auto manufacturers

Factor 6: # of Producers

Individual Supply 6

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Supply Can Increase or Decrease

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An Increase in SupplyMeans a Movementof the Line

A Movement BetweenAny Two Points on a

Supply Curve is Called a Change in Quantity

Supplied

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Market Equilibrium

• Equilibrium Price• Equilibrium Quantity• Surplus• Shortage• Rationing Function of Prices

3.1

Seeking Equilibrium: Demand and Supply

• Market equilibrium – situation in which the quantity demanded for a service is equal to the quantity supplied

• Two curves intersect at point of market equilibrium.

• Equilibrium price(market-clearing price) – price at which QS = QD; equilibrium quantity can also be determined

Reaching the Equilibrium Price

• Trial and error may be necessary for the market to arrive at equilibrium.

• Market may have a surplus: QS>QD• Market may have a shortage: QD>QS

Surpluses and Shortages• Surpluses happen when prices are too high

relative to demand (excess supply)• With surplus, prices tend to fall; producers cut

back production

• Shortages happen when prices are too low relative to demand (excess demand)

• With shortage, prices rise; producers increase quantity supplied

Market Equilibrium

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200 Buyers & 200 Sellers

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$4 Price Floor

6,000 BushelSurplus

$2 Price Ceiling

7,000 BushelShortage

Rationing Function of Prices

• Ability of the forces of S and D to establish a P at which selling and buying decisions are consistent

• At equilibrium, there is no shortage and no surplus

Efficient Allocation

• Competitive market also allocate societies’• resources efficiently• Results in productive efficiency – production of any

particular good in the least costly way• Also results in allocative efficiency – the particular mix of

G&S most highly valued by society, assuming minimum-cost production.

• Demand essentially reflects the MB of a good, while supply reflects MC of producing a good. At the intersection of the S and D curves, MB=MC, resulting in allocative efficiency!

Market Equilibrium

• Changes in S and D affect Equilibrium• Changes in Equilibrium• Efficient Allocation–Productive Efficiency–Allocative Efficiency

• Supply Increase; Demand Decrease• Supply Decrease;

Demand Increase• Supply Increase;

Demand Increase• Supply Decrease;

Demand Decrease

Market EquilibriumPrice Quantity

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Government-Set Prices• Price Ceilings on Gasoline• Rationing Problem• Black Markets• Rent Controls• Price Floors on Wheat• Optimal Allocation of

Resources3.2

Intervention in the Price System:

• At times the government or other entity will interfere in the price system to keep prices from going too high.

• Price Ceiling – legal max. price a seller may charge for a product

• -set below equilibrium price, so a shortage results• Ex. Rent control – legal price ceilings on rent,

leads to housing shortages • Ex. gasoline –See p.58

Rationing Resources and Products

• In periods of national emergency, the gov. may distribute products or resources

• Rationing – way of allocating products using factors other than price

• -occurred in U.S. during WWII

• May lead to black market – illegal buying and selling of products

Price Floors

• Gov. decides to intervene in the price system in order to increase income to certain producers

• Price Floor –legal minimum price buyers may pay for a product

• Ex. Minimum wage or price floor on wheat – See p.59

A Legal Market for Human Organs

• Waiting List for Transplants• Demand for Organs• Vertical Supply of Organs• Incentive Role of Market and Up-Sloping

Supply• Increases Quantity• Decreases Price• Moral Objections• Increase the Cost of Health Care• Better to Legalize and Regulate?

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A Legal Market for Human Organs

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P0 Q1 Q2 Q3

Supply of OrgansDemand for Organs

Shortage at Zero PriceQ1 – Q3

Supply With Price Incentive

At Price P1 theShortage is ReducedBy Q1 – Q2