Econ 2113: Principles of Microeconomics

Spring 2009 ECU

Demand, Supply and Equilibrium

Chapter 3

Demand

  You demand something if  You want it.  You can afford it.  You have a definite plan to buy it.

Demand

  Quantity demanded: the amount consumers demand at a particular price.

  Demand: the entire relationship between price and quantity demanded.

  The Law of Demand: All else equal, the higher is the price of a good, the smaller is the quantity demanded.

Law of Demand

  Example: How much would you pay for an A in this class?

100 $0.01 60 $50 30 $100 10 $200 2 $500 Quantity Price

The Demand Curve

Interpretation of Demand (ways to read the demand curve)

  Horizontal interpretation   Quantity demanded at a given price

  Vertical interpretation   Reservation price of the marginal buyer (or

marginal unit)

  Buyer’s reservation price: the largest dollar amount the buyer would be willing to pay for a good (benefit the buyer receives from the good)

Why is the demand curve downward sloping?

  The substitution effect: the change in the quantity demanded of a good that results from buyers substituting into other goods when the price of that good changes.

  The income effect: the change in the quantity demanded of a good that results from the reduction in purchasing power when the price of a good increases.

Change in quantity demanded vs. a change in demand

  Change in quantity demanded  Movement along the demand curve that

occurs in response to a change in price

  Change in demand  A shift of the entire demand curve

Change in Demand

  Change in the entire relationship between price and quantity demanded.

  An increase in demand means that the quantity demanded is higher at every price.

  A decrease in demand means that the quantity demanded is lower at every price

Movements along the curve vs. shifts in the curve

Factors that lead to changes (shifts) in demand

  Prices of related goods   Expected future prices

  Income   Expected future income

  Population   Preferences

Changes in the price of related products: substitutes

  If the price of a substitute good goes up, then demand will go up.

  Two goods are substitutes in consumption if an increase in the price of one causes an increase in the demand for the other

  Red Bull vs. Monster   Overnight letter delivery service and Internet access

Price

Quantity

D1

D0 to D1: Decrease in Demand

Change in Demand: Decrease in the Price of a Substitute

D0

7

10 15

Changes in the price of related products: complements

  If the price of a complementary good goes up, then demand will go down.

  Two goods are complements in consumption if an increase in the price of one causes a decrease in the demand for the other

  Hot dogs and hot dog buns   Tennis balls and court rental fees

Changes in income

  Normal goods: If income increases, demand for normal goods increases.   A normal good is one whose demand increases when the

incomes of buyers increase

  Inferior goods: If income increases, demand for inferior goods decreases.   An inferior good is one whose demand decreases when the

incomes of buyers increase

Price

Quantity

D0

D1 6

7

D0 to D1: Increase in Demand

Change in Demand: Increase in Income (Normal Good)

13

Supply

  A firm will supply a good if it:

  has the resources and technology to produce it

  can profit from producing it

  has made a definite plan to produce and sell it

Law of Supply

  Other things remaining the same, the higher the price of a good, the greater is the quantity supplied

  Sellers must receive a higher price to produce additional units of a product to cover higher opportunity costs of each additional unit

  Supply curve is upward-sloping   Principle of “low-hanging fruit”   Increasing opportunity costs

Interpretation of Supply

  Horizontal interpretation   Quantity produced/supplied at a given price

  Vertical interpretation   Shows the marginal cost for producing each

additional unit - or reservation price of the marginal seller

  Seller’s reservation price: the smallest dollar amount for which a seller would be willing to sell an additional unit (equal to marginal cost)

The Supply Curve

Change in Supply

  Change in the entire relationship between price and quantity supplied.

  An increase in supply means that the quantity supplied is higher at every price.

  A decrease in supply means that the quantity supplied is lower at every price

Movements along the curve vs. shifts in the curve

Supply

 The five main factors that change supply of a good are   The prices of productive resources   Expected future prices   The number of suppliers   Technology

Supply

  Prices of Productive Resources   If the price of resource used to produce a good rises, the minimum price that a supplier is willing to accept for producing each quantity of that good rises.   So a rise in the price of productive resources decreases supply and shifts the supply curve leftward.

Supply

  Expected Future Prices   If the price of a good is expected to rise in the future, supply of the good today decreases and the supply curve shifts leftward.

  The Number of Suppliers   The larger the number of suppliers of a good, the greater is the supply of the good. An increase in the number of suppliers shifts the supply curve rightward.

Price

Quantity

S0

S1

8

7 5

S0 to S1: Increase in supply

Change in Supply from Entry of New Firms

6

Supply

  Technology   Advances in technology create new products and lower the cost of producing existing products, so advances in technology increase supply and shift the supply curve rightward.   A natural disaster is a negative technology change, which decreases supply and shifts the supply curve leftward.

Market Equilibrium

  In equilibrium, price equates the quantity supplied and the quantity demanded.

  Equilibrium price (P*): the price at which quantity supplied = quantity demanded.

  Equilibrium quantity (Q*): the quantity bought and sold at the equilibrium price.

Putting it all together

  Market equilibrium: buyers and sellers are satisfied with the price.   ‘satisfied’: buyers are buying the amount

they want to buy & sellers are selling the amount they want to sell, at that price

Equilibrium

Market Equilibrium

  Equilibrium: balance

  Equilibrium in the market occurs when supply equals demand

QxS = Qx

d

  At that point there are no forces on the price in either direction

Price

Quantity

S

D

5

6 12

Shortage 12 - 6 = 6

6

If price is too low:

7

Price

Quantity

S

D

9

14

Surplus 14 - 6 = 8

6

8

8

If price is too high:

7

Predicting changes in equilibrium price and quantity

•  Changes in demand an supply will cause changes in the equilibrium price and quantity

Price

Quantity

P

P’

Q Q’

S

D’ D

An increase in demand will lead to an increase in both the equilibrium price and quantity

Four Rules Governing the Effects of Supply And Demand Shifts

Price

Quantity

P’

P

Q’ Q

S

D D’

A decrease in demand will lead to a decrease in both the equilibrium price and quantity

Four Rules Governing the Effects of Supply And Demand Shifts

P’

P

Q Q’

S’

D

S Price

Quantity

An increase in supply will lead to a decrease in the equilibrium price and an increase in the equilibrium quantity

Four Rules Governing the Effects of Supply And Demand Shifts

P

P’

Q’ Q

S

D

S’ Price

Quantity

An decrease in supply will lead to an increase in the equilibrium price and a decrease in the equilibrium quantity

Four Rules Governing the Effects of Supply And Demand Shifts

The Effects Of Simultaneous Shifts In Supply And Demand

Price ($/bag)

Millions of bags per month

P

Q

S

D

P’

Q’

D’

S’ S’ after reduction in price of corn harvesting equipment

D’ after discovery that oils are harmful to people’s health

The Market for Corn Tortilla Chips

Mathematically finding equilibrium price and quantity

QD=1000-5P, QS=100+4P

BLACKBOARD: Graph these supply and demand curves and find the equilibrium price and quantity