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

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.

Discuss the variables that influence demand.

3.1 LEARNING OBJECTIVE

The Demand Side of the MarketDemand 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.

FIGURE 3-1A Demand Schedule and Demand Curve

The Demand Side of the MarketDemand Schedules and Demand Curves

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.


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

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.

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.

.

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

FIGURE 3-2Shifting 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.

The Demand Side of the MarketHolding Everything Else Constant: The Ceteris Paribus Condition


Horizontal Interpretation

Price determines quantity demanded

Price($ per slice)

4

2

3

8 12 16

Demand

Quantity(1000s of slices per day)


Vertical Interpretation

Quantity measures the marginal buyer’s reservation price

Price($ per slice)

4

2

3

8 12 16

Demand



Many variables other than price can influence market demand. IncomeNormal 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 goodsSubstitutes Goods and services that can be used for the same purpose.

Complements Goods and services that are used together.

Variables That Shift Market Demand


TastesConsumers can be influenced by an advertising campaign for a product.

Population and demographicsDemographics The characteristics of a population with respect to age, race,

and gender.

Expected future pricesConsumers choose not only which products to buy but also when to buy

them.

Variables That Shift Market Demand

Are Big Macs an Inferior Good?

McDonald’s restaurants experienced increased sales during 2008 and 2009, despite the recession.

Makingthe

Connection

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.

YOUR TURN: Test your understanding by doing related problem 1.8 at the end of this chapter.

The Aging of the Baby Boom GenerationMakingthe

Connection

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.YOUR TURN: Test your understanding by doing related problem 1.9 at the end of this chapter.


TABLE 3-1Variables That Shift Market Demand Curves

FIGURE 3-3A Change in Demand versus a Change in Quantity DemandedIf 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.

The Demand Side of the MarketA Change in Demand versus a Change in Quantity Demanded

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

Red Bull and the Future Demand for Energy Drinks

Makingthe

Connection

Will Red Bull continue to grow its share of the energy drink market?

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.


The Supply Side of the MarketQuantity 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.

Buyers and Sellers In MarketsSupply 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?

The Supply Side of the Market

FIGURE 3-4A Supply Schedule and Supply CurveAs 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.

Discuss the variables that influence supply.

3.2 Learning Objective

Supply Schedules and Supply Curves


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.

The Daily SupplyCurve for Pizza in Chicago

Price($ per slice)


4

2

3

8 12 16

Supply

Horizontal Interpretation

Shows the quantity produced

for each price

The Daily SupplyCurve for Pizza in Chicago

Price($ per slice)


4

2

3

8 12 16

Supply

Vertical Interpretation

Shows the marginal cost (reservation

price) for producing each additional unit


FIGURE 3-5Shifting the Supply CurveWhen 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.


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

Variables That Shift Market Supply


TABLE 3-2Variables That Shift Market Supply Curves


TABLE 3-2Variables That Shift Market Supply Curves (continued)


FIGURE 3-6A Change in Supply versus a Change in Quantity Supplied

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.

Market Equilibrium: Putting Demandand Supply Together

FIGURE 3-7Market 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.

Use a graph to illustrate market equilibrium.


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


Market equilibrium A situation in which quantity demanded equals quantity supplied.

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


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.


FIGURE 3-8The Effect of Surpluses and Shortages on the Market PriceWhen 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.

Excess Supply

Price($ per slice)


4

2

3

8 12 16

Supply

Demand

Excess supply = 8,000 slices per day

Excess Demand

Price($ per slice)


4

2

3

8 16

Excess demand = 8,000slices per day

Supply

Demand


Demand and Supply Both CountKeep 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.

Solved Problem

3-3 Demand and Supply Both Count: A Tale of Two Letters

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.

YOUR TURN: For more practice, do related problems 3.4 and 3.5 at the end of this chapter.

The Effect of Demand and SupplyShifts on Equilibrium

FIGURE 3-9The Effect of an Increase in Supply on Equilibrium

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.

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:

Use demand and supplygraphs to predict changesin prices and quantities.


The Falling Price of LCD TelevisionsMaking

theConnection

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.



FIGURE 3-10The Effect of an Increase in Demand on EquilibriumIncreases 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.


FIGURE 3-11Shifts in Demand and Supply over Time

In panel (a), demand shifts to the right more than supply, and the equilibrium price rises:1. Demand shifts to the right more than supply.2. Equilibrium price rises from P1 to P2.

In panel (b), supply shifts to the right more than demand, and the equilibrium price falls:1. Supply shifts to the right more than demand.2. Equilibrium price falls from P1 to P2.


TABLE 3-3How Shifts in Demand and Supply Affect Equilibrium Price (P) and Quantity (Q)

SUPPLY CURVE UNCHANGED

SUPPLY CURVESHIFTS TO THE RIGHT

SUPPLY CURVE SHIFTS TO THE LEFT

DEMAND CURVE UNCHANGED

Q unchangedP unchanged

Q increasesP decreases

Q decreasesP increases

DEMAND CURVESHIFTS TO THE RIGHT Q increases

P increases

Q increasesP increases ordecreases

Q increases or decreases P increases

DEMAND CURVESHIFTS TO THE LEFT

Q decreasesP decreases

Q increases or decreasesP decreases

Q decreasesP increases ordecreases

Solved Problem

3-4 High Demand and Low Prices in the Lobster Market?

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.

YOUR TURN: For more practice, do related problems 4.5 and 4.6 at the end of this chapter.


Shifts in a Curve versus Movements along a Curve

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

YOUR TURN: Test your understanding by doing related problems 4.13 and 4.14 at the end of this chapter.

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.

How Does Advertising Help Red Bull Increase Demand for Its Energy Drink?

AN INSIDE LOOK>>

Advertising may cause an increase in the demand for Red Bull.

Predicting and Explaining Changes In Prices and Demand

• Assume– A vitamin found in corn chips helps protect against cancer

and heart diseases– Swarm of locusts destroys part of the corn crop

• What Do You Think?– What will happen to the equilibrium price and quantity of

corn chips?

Predicting and Explaining Changes In Prices and Demand

• Economic Naturalist– Why do the prices of some goods, like airline tickets to

Europe, go up during the months of heaviest consumption, while others, like sweet corn, go down?

Seasonal Variation in Air Travel

Price($/ticket)

1000s of tickets

S

DS

DW

QW QS

PW

PS

High Consumption and Prices Due to High Demand

Seasonal Variation in Corn Markets

Price($/bushel)

Millions of bushels

SW

D

QW QS

PW

PS

SS

High Consumption and Low Prices due to High Supply

Markets And Social Welfare• Smart For One, Dumb For All

– Socially optimal quantity• The quantity of a good that results in the maximum possible

economic surplus from producing and consuming the good– Private cost The cost borne by the producer of a service.– Private benefit The benefit received by the consumer of a

good or service.– Social cost The total cost of producing a good, including

both the private cost and any external cost.– Social benefit The total benefit from consuming a good,

including both the private benefit and any external benefit.

Externalities• Externality A benefit or cost that affects someone who is not

directly involved in the production or consumption of the good or service.

• Externalities arise when there is a difference between the private cost of production and the social cost, or the private benefit from consumption and the social benefit

• Positive externality When the social benefit exceeds the private benefit of consumption.

• Negative externality When the social cost exceeds the private cost of consumption.

Markets And Social Welfare

• The socially optimal quantity occurs when “social MC” = “social MB”– Economic efficiency occurs when all goods and services are

produced and consumed at their respective socially optimal levels

• The Efficiency Principle• Maximize the economic surplus• Increases the economic pie

Markets And Social Welfare• When is the market equilibrium efficient?

• When all cost of producing the good or service are borne directly by the seller

• When all benefits from the good or service accrue directly to buyers

• Inefficient market equilibrium• When some costs of production fall on people other than those who sell

the good or service• Market failure Situations in which the market fails to produce

the efficient level of output• Example: Pollution

– The market is in equilibrium: MC = MB– MC however underestimates the cost to society of producing the good– Therefore, the market produces more than the efficient amount and

there is no incentive for producers and consumers to alter their behavior

Markets And Social Welfare• Inefficient market equilibrium

• When some benefits from the good or service accrue to people who did not buy the good or service

– In these markets• Buyers and sellers are behaving rationally • Market equilibrium exists• There are no unexploited opportunities for individuals• Economic surplus is not maximized

• Example: Vaccinations• The market is in equilibrium: MC = MB• MB underestimates the benefits to society of consuming the vaccinations• The market produces less than the efficient amount of vaccinations and

there is no incentive for producers and consumers to alter their behavior

Solutions to Externalities• The government can help provide solutions in the case

of a market failure– Taxation for private consumers to “internalize” the social cost.– The government can provide goods in the case of public goods

• Public goods Goods which are nonrival and nonexcludable.– e.g., National defense, lighthouses.– Rival One person’s consumption diminishes another’s ability to consume

that good.– Excludable When consumption of a good can be prevented.– Free riding Benefitting from a good without paying for it.

• Sometimes hard to define if a good is public or not.• Common resource A good that is rival but nonexcludable

– e.g., fish in a river, space in a park or quad.

Coase Theorem

• Coase Theorem The argument of economist Ronald Coase that if transactions costs are low, private bargaining will result in an efficient solution to the problem of externalities.

GECON 200: Lecture 4

Documents

Transcript of GECON 200: Lecture 4