Chapter 3Where Prices Come From:

The Interaction of Demand and Supply

Demand and supply are the two sides of the market for goods and services (factors of production also).

Demand and Supply are important because their interaction determines the prices of goods and services

Typically, demand reflects consumers’ behavior while supply reflects the producers’ behavior

1. Quantity demanded - The quantity of a good or service that a consumer is willing to purchase at a given price.

Q

175

150125

Price($) Price($)

3 4

100

5 6

75

70

D-curve

Notice that both the demand schedule (table) and curve (graph) show that the relationship between the price and quantity demanded.

What is the nature of the relationship? Inverse.

2.The Law of Demand

a.The Law of Demand shows an inverse price-quantity relationship i.e. as price decreases, qt demanded increases, and vice-versa, holding everything else constant

3. What are the justifications of 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 consumer purchasing power.

Law of Diminishing Marginal Utility (wait until chapter 10 in the text)

The giffen-good case- As price increases, the quantity demanded increases (Potatoes in Ireland; rice in China)

Bandwagon effect- People buy expensive goods to be like others- Air Nike Shoes

The snob effect- conspicuous consumption-expensive car to stand out from the crowd

ΔQ demanded- refers to a movement along the same demand curve due a price change only

Δ in Demand refers to the shift in the whole demand curve due to other factors than the price of the good

D0

D1

D2Q

Price

A

B

C

Movement from A to C is change in Qt

demanded

A shift in D-curve from D0 to D1 or D2 is change in demand

Δ Price of related goods

◦Substitutes Goods and services that can be used for the same purpose. P Coke D pepsi

◦Complements Goods that are used together. P camera rises=> Q films sold will decrease

Δ Income◦Normal good A good for which the demand increases as income rises and decreases as income falls (New Car).

◦Inferior good A good for which the demand increases as income falls, and decreases as income rises (Used car).

Δ Tastes (smoking and lung cancer; mad cow disease and demand for beef)

Δ Population and demographics (demand for housing and school as population increases

◦Demographics The characteristics of a population with respect to age, race, and gender.

Δ Expected future prices( current demand increases if prices are expected to rise in the future)

D0

D1

D2Q

Price

A

B

C

Movement from A to C is change in Qt

demanded

A shift in D-curve from D0 to D1 or D2 is change in demand

8. Quantity supplied The quantity of a good or service that a firm is willing to supply at a given price.

Supply scheduleSupply schedule A table that shows the A table that shows the relationship between the price of a product and the relationship between the price of a product and the quantity of the product supplied.quantity of the product supplied.

Supply curveSupply curve A curve that shows the A curve that shows the relationship between the price of a product relationship between the price of a product and the quantity of the product demanded.and the quantity of the product demanded.

Hewlett-Packard’s SupplySchedule and Supply Curve

3- 6

Price

75

S-Curve

100

8 8.5 10

175

9. Law of supply shows a positive price- quantity relationship, i.e. as price increases, qt supplied increases and vice- versa

10. ΔQt Supplied and vs Δ in Supply

ΔQt Supplied refers to a movement along the same supply curve due to a change in product price

Δ in Supply refers to a shift in the whole supply curve due to factors other than the product price

Δ in Price of inputs (labor cost, capital cost, etc.)

Δ in Technology◦Improvement in technology reduces and increases supply (positive) and lack of it will increase cost and reduce supply (negative)

Δ in Prices of substitutes in production

Δ Expected future prices

Δ Number of firms in the market

PriceS0

S2

S1

Decrease

Increase

12. Market equilibrium price -A situation where quantity demanded equals quantity supplied.

Competitive market equilibrium A market equilibrium with many buyers and many sellers.

S

D

Price

Pe=100

19.5Q

125Surplus

18.5 21.5

The Effect of Surpluses and Shortages on the Market Price

Qe

D

75

13a. Surplus A situation in which the quantity supplied is greater than the quantity demanded.

13b. Shortage A situation in which the quantity demanded is greater than the quantity supplied.

When price is set above the market eq. price, a surplus will occur; but it will be eliminated because competition will force sellers to accept lower and lower prices

When price is set below the market eq. price, a shortage will occur; but it will be eliminated because competition will force buyers higher and higher prices up the eq. price

At equilibrium, there are no surpluses, nor shortages!

14. The market equilibrium price does not tell us anything about fairness. It only tells us that who ever can pay the price will be get the Qe.

15. The market equilibrium price is important because it channels resources to their best use.

When consumers buy a good or service they channel resources to the production of that good or service

Price of DVD Production of DVDs by hiring workers, investing machines to make DVDs, etc.

If demand increases and supply remains constant, then both eq. price and quantity will increase. Illustrate.

If supply increases (deceases) and demand remains the same, then eq. decreases (increases) and eq. qt increases (decreases). Illustrate.

If both demand and supply increase, then we cannot predict what happens to the eq. price. It depends on the price elasticity of demand and supply. Illustrate.