McGraw-Hill/Irwin © 2009 The McGraw-Hill Companies, All Rights Reserved Chapter 4 Supply and...

McGraw-Hill/Irwin ©2009 The McGraw-Hill Companies, All Rights Reserved

Chapter 4

Supply and Demand

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Chapter Objectives

At the end of this lesson, you will be able to:• Define and explain demand in a product or

service market• Define and explain supply• Determine the equilibrium point in the market

for a specific good, given data on supply and demand at different price levels

• Understand what causes shifts in demand and supply

• Understand how price ceilings cause shortages

• Understand how price floors cause surplusesCopyright 2009 by The McGraw-Hill Companies, Inc. All rights reserved.

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Demand

The schedule of quantities of a good or service that people are willing and able to buy at different prices• Sometimes a schedule is also called a

table Demand shows how much quantity of a good or

service can be sold at different prices People pay for goods or services according to

how many benefits those goods or services will yield

Generally less quantity will be demanded as prices increase since people will find relatively less expensive substitutes to provide similar levels of benefits

Copyright 2009 by The McGraw-Hill Companies, Inc. All rights reserved.

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Demand Schedule and Curve

$500

450

400

350

300

250

200

150

100

50

10 20 30 40 50 60 70Quantity (in thousands)

D

Table 1

Price QD

$500 1,000

450 3,000

400 7,000

350 12,000

300 19,000

250 30,000

200 45,000

150 57,000

100 67,000

Price $250Price $250

Quantity 30,000Quantity 30,000


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Shifts in Demand

A change in the price of a good or service moves us along a given demand schedule/curve• Shifts in supply move us along a given

demand schedule/curve

A change in the demand schedule results in a shift of the demand schedule/curve• If consumer preferences change for whatever

reason that will shift the demand curve either outward or inward depending upon the nature of the change


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Demand Curve Shift Out

When a demand curve shifts outward people are willing to buy more goods or services at the same price

Preferences change and the product or service is perceived to yield more benefits than before

If scientific studies come out that show DVD’s increase people’s life expectancy, we may expect an outward shift

Price(dollars)

30

20

10

Q1

D1

Q2 Q3

D2D2

Quantity(DVDs per year)


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Demand Curve Shift In

When a demand curve shifts inward, people are willing to buy fewer goods at previous prices

Preferences change and the good or service is perceived to yield fewer benefits than before

If scientific studies demonstrated those who consumed pizza had fewer dates than those who did not, we could expect an inward shift of the demand curve

Price(dollars)

20

10

200 300

D1

Quantity(Pizzasper week)

00

D2D2


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Questions for Thought and Discussion

Why do markets show that people demand fewer goods at higher prices?

What would happen to demand for the various services and products under the following scenarios? Will the curve shift and in which direction?

• Oprah Winfrey expresses concern about mad cow disease and beef. What happens to the demand for hamburgers?

• The National Institute for Health releases a study that shows mandarin oranges reduce the probability of getting cancer. What happens to demand for mandarin oranges?

• The manufacturers of Frisbees discover a new, less expensive polymer to make Frisbees. What happens to the demand for Frisbees?


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Supply

Is the “schedule” of quantities of a good or service that people are willing to sell at different prices

In general, the higher the price, the more of a good or service individuals are willing to supply. As price increases so does quantity provided

This happens because different producers face different opportunity costs and as the price increases or decreases, producing a good or service becomes more or less attractive to producers at the margins


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Supply Schedule

$500

450

400

350

300

250

200

150

100

50

10 20 30 40 50 60 70Quantity (in thousands)

SPrice QS $500 62,000 $450 59,000 $400 54,000 $350 48,000 $300 40,000 $250 30,000 $200 16,000 $150 7,000 $100 2,000

Quantity Supplied is a point on the curve


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Shifts in Supply

Changes in the demand schedule (consumer behavior) moves us along an existing supply schedule (the market with the producers who could respond relatively quickly to consumer behavior)

Changes in the cost of factors of production or increases in productivity shift the supply curve


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Supply Curve Shift Inwards

When a supply curve shifts inwards, businesses will only supply what they did before the shift at higher prices

As costs change for businesses, opportunity cost change

If the cost of oil hits 100 dollars a barrel that would shift the supply curve in and raise prices for gas assuming demand remains the same

Price(dollars)

Quantity(units ofgasoline per year)

$2.00

$1.50

$1.00

Q3 Q2 Q1

S2S2 S1S1


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Supply Shift Outwards

When a supply curve shifts outwards businesses are willing to supply the same amount that they did before the shift at lower price levels

Improvements in technology, lower resource costs, or higher factor productivity can result in this sort of shift

If gasoline refiners could find a good substitute for oil to produce gasoline that was less costly, this would result in an outward shift in the gasoline supply curve

Price(dollars)

Quantity(units ofgasoline per year)

$2.00

$1.50

$1.00

Q3 Q2 Q1

S2S2 S1S1


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Equilibrium

Equilibrium price is the price at which quantity demanded equals quantity supplied.

A surplus occurs when the market price is above equilibrium price.

A shortage occurs when the market price is below equilibrium price.


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A Picture of Equilibrium

Equilibrium occurs at the point where supply equals demand

In others words, costs for the marginal producer equal the benefits of the marginal consumer

If price were higher than equilibrium, more producers would want to produce goods or services than consumers would want to consume

If the price were lower, more consumers would want to consume goods or services than producers would want to produce

140

120

100

80

60

5 10 15 20 25

Price(monthly bill)

Quantity(Millions of I Phone Subscribers)

30

Supply

Demand


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Shifts and Equilibrium

If there are shifts in demand or supply a new equilibrium point will be found on the basis of new perceived benefits or changes in costs

In this instance a demand driven increase for I phones pushes price up and the quantity of subscriptions up

140

120

100

80

60

5 10 15 20 25

Price(monthly bill)

Quantity(Millions of I Phone Subscribers)

30

Supply

Demand

Demand 2

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Why is equilibrium viewed to be efficient? What happens if price is not at an

equilibrium point? What do prices represent to producers

and consumers?

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Government and the Market

The government may ensures the smooth operation of the markets by protecting property rights, guaranteeing enforcement of legal contracts, and issuing a supply of money that buyers and sellers readily accept

• Property rights are essential to a free and prosperous nation

Government sometimes interferes with the free operation of the markets by

• Imposing prices floors and price ceilings• This creates the problems of shortages and surpluses

While governmental interference with the market system can have adverse affects, the government does have a substantial supportive role to play in a market economy.

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Price Floors

Sometimes producers do not like the price they are getting for their product

They may lobby the government to put in a price floor

A price floor results in a surplus being supplied at the higher price

Suppliers end up supplying more than consumers want to buy

Minimum wage is a classic example of a price floor

QEQE

Price

Quantity

PricefloorPricefloor

D

QD QS

7

S

10

SurplusSurplus

Number of workers hired

QE

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Minimum Wage as a Price Floor

If you note, workers want to supply QS worth of themselves at 10 dollars an hour

Employers want to hire QD at that price

The end result is QD workers are hired at 10 dollars an hour

Fewer workers are hired with a price floor than would be hired under market equilibrium conditions at a wage rate of 7 dollars an hour

Price

Quantity

PricefloorPricefloor

D

QD QS

7

S

10

SurplusSurplus

Number of workers hired

QE

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Who Benefits and Who Is Hurt by the Minimum Wage

Everybody who would be making seven dollars an hour but is now getting ten dollars an hour benefits from minimum wage

Everybody who would have been employed at seven dollars an hour but is now unemployed at ten dollars an hour is hurt

Consumers who could have purchased the good or service produced at a lower price but cannot because of the higher cost of making the good or service are hurt

Most economists generally believe efficiency is a good thing and distorting the price mechanism that gives us this efficiency does more harm than good


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How do you think price floors for agricultural commodities would impact the market for these commodities?

Does the minimum wage help the poor? How do you think the minimum wage impacts your life?


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Price Ceilings

Sometimes buyers do not like the price they need to pay for a good or service

They may lobby government to put a price cap on what sellers can charge

A classic example of a price ceiling is rent control

Price(rent)

Quantity of housing units

PriceceilingPriceceiling

D

QS QD

P0

S

P1

ShortageShortage

Rental housing market

QE


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Rent Control as a Price Ceiling

When rent control is in place producers can not charge a price above P1.

At P1 landlords (producers) are only willing to supply QS but potential renters want QD at this price

A shortage results and instead of having QE units of housing rented, only QS units of housing are rented

Price(rent)

Quantity of housing units

PriceceilingPriceceiling

D

QS QD

P0

S

P1

ShortageShortage

Rental housing market

QE


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Who Benefits and Who Is Hurt by Rent Control

People who live in rent controlled properties get their housing at bargain prices

People looking for housing will have a harder time finding housing and will have to put up with more inconveniences in the housing market because rent control reduces the incentives of business people to provide quality housing options

Rent control can misallocate a scarce resource (housing) to people who value the resource less than market value


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If price floors and price ceilings are inefficient why do politicians make laws that create these inefficiencies?

Can you think of any time when rent control would be a good policy choice for a government?


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Gasoline Markets and Price – Hurricane Katrina Case Study

Hurricane Katrina and the market solution• Temporarily shut down off shore wells• Briefly put 10% of our refineries out of

commission• Result – a sudden drop in oil supply• The government took a “hands” off approach• Gasoline prices rose sharply – duh?• People could buy all they wanted at sharply

increased prices with no wait at the pumps


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Gasoline Markets and Price: Oil Embargoes and a Government Response Case Study

Oil crises in the 1970’s• Middle east countries curtailed oil shipments to the

United States• Resulted in reduced oil supply• Government’s solution – restrict purchases and

hold down prices• The result – long gas lines in many parts of the

country• People paid less but waited much longer to

purchase gas at moderately higher prices (sometimes one to two hours)


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Summation of Market Outcomes to Reduction in Supply

Short Run• Prices Rise• Many people cut back on their driving

Long Run• People buy more gas efficient cars• Higher prices encourage greater

exploration for oil• Higher prices encourage the

development of alternative energy sources


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Summation of Government Intervention Solution to Supply Reduction

Short Run• Prices are held down or climb slowly• People cut back on their driving very little if any• Significant waits at the gas pumps occur and time

becomes the rationing method for gasoline Long Run

• People have little incentive to buy more gas efficient cars

• Lower prices discourage greater exploration for oil• Threat of government interference in energy sector

discourages the development of alternative energy sources


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Closing Comments

Most economists probably believe price ceilings do more harm than good in the long run

Most people probably think in the short run and want government to do something about higher prices

Government probably is inclined to get involved Corporate greed probably can and will influence

government actions The result . . . who knows? But past history

indicates it probably won’t be good for the consumer


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Was allowing the price mechanism to allocate gas more fair than forcing people to wait in lines or buy gas on days based upon the numbers on their license plates?

Would corporations have incentives to lobby the government for price floors or ceilings?


McGraw-Hill/Irwin © 2009 The McGraw-Hill Companies, All Rights Reserved Chapter 4 Supply and...

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