TOOL #3 THE

SUPPLY AND DEMAND MODEL

Our purpose is to illustrate how the supply and demand model can describe a macroeconomic system.

One of the impressive things about the supply and demand model is how many different kinds of situations it can describe.Before turning to macro, we will start by looking at supply and demand in a micro setting. That is, we will consider the supply and demand for individual products, before coming back to look at the macro supply of and demand for all goods and services taken together

Economics imagines the interaction of buyers and sellers can be described as a “market” and modeled

according to the laws of Supply and Demand.

The buyers are the DEMAND SIDE of the market.The sellers are the SUPPLY SIDE of the market

The Supply and Demand Model

D

S

QQ

P

Q0

P0

Let’s look at this picture one piece at a time.

In every case we will be looking at the market for “something.” For this (micro) example let’s use “the market for cars.”

D

Q0

P0

Q

SP

A MARKET

P

Q

The “P” stands for the word “price.”

The horizontal axis always measures the quantity of the good, in this case a number of cars bought and/or sold.

The vertical axis always measures the price of the good, in this case, the price of a car.

The “Q” stands for the word “quantity.”

D

Q0

P0

Q

SP

A MARKET

P

Q

The P and Q axes meet at the “origin” where the values of both variables are zero.

D

Q0

P0

Q

SPA MARKET

00

Q = quantity of cars (millions)

P= Price of a car ($1,000)

THE CAR MARKET

The numbers on each axis increase as we move away from the origin.

larger quantity

Higherprice

(0,0)

Each point on the graph indicates a combination of price and quantity.

Q

P

$40

1

A price of $40,000 and a quantity of 1 million cars

A price of $20,000 and a quantity of 3 million cars

$20

3

DQ0

P0

Q

SP

A MARKET USING symbols for numbers

The symbols P0 and Q0 should be thought of as specific numbers. For example P0 could equal $30,000, the price of a car and Q0 could be a quantity of 2 million cars sold in a year.D

2

30

Q

SP

(Millions)

($1,000)

We are saying that this market is going to result in 2 million cars sold per year at a price of $30,000 per car.

D

2

30

Q

SP

(Millions)

($1,000)

The point of intersection of the two lines – here shown by P0 and Q0 -- will be very important. It is the model’s way of illustrating the equilibrium price and quantity.

Now let’s look at the meaning of the two lines, labeled D and S.

D

Q0

P0

Q

SP

The downward sloping Demand curve -- labeled D -- illustrates the “Law of Demand.”

DEMAND

DQ0

P0

Q

SP

A MARKET

The Law of Demand: All other things being equal (ceteris paribus), the higher the price of a good, the less of it people will want to buy.

DQ

PDEMAND

The Demand curve “pairs up” the prices and quantities that “go together.” A high price (P0) goes with a low quantity (Q0).

Q

P

D

DEMAND

P0

Q0

P1

Q1

A low price (P1) goes with a high quantity (Q1).

DQ0

P0

Q

SP

A MARKET

Q

P

D

Demand

P0

Q0

P1

Q1

OTHER STATEMENTS OF THE LAW OF DEMAND

1. Price and Quantity Demanded are inversely related, ceteris paribus.

2. An increase of Price will cause buyers to want to buy less, ceteris paribus.

3. Demand curves slope downward.

DQ0

P0

Q

SP

A MARKET

The upward sloping Supply curve - labeled S - illustrates the “Law of Supply.”

SUPPLY

The Law of Supply: All other things being equal (ceteris paribus), the higher the price of a good, the more of it firms will offer.

This is so because producing and selling a good is more profitable the higher the price.

D

P0

Q

S

PA MARKET

Q0

Q

P S

The Supply curve “pairs up” the prices and quantities that “go together.”

SUPPLY

A high price (P1) goes with a high quantity (Q1).

A low price (P0) goes with a low quantity (Q0).

D

P0

Q

S

PA MARKET

Q0

Q

P S

P1

Q1Q0

P0

SUPPLY

OTHER STATEMENTS OF THE LAW OF SUPPLY

1. Price and Quantity Supplied are directly related, ceteris paribus.

2. The lower the price, the less suppliers will offer, ceteris paribus.

3. Supply curves slope upward.

D

P0

Q

S

PA MARKET

Q0

P1

Q

P S

Q1Q0

P0

A MARKET –Supply and Demand Together

D

S

QQ

P

Q0

P0

The Price P0 is the only price at which the quantity buyers demand (Q0) is also the quantity that sellers want to supply.

We refer to these as the equilibrium price and the equilibrium quantity. By that we mean that those are the price and quantity to which the market will move.

Equilibrium and the Law of Market Forces

Markets move toward equilibrium according the Law of Market Forces. The Law has two parts --

1. a surplus of a product will drive its price _____.

2. a shortage of a product will drive its price ___.

Watch how this produces equilibrium in each case.

down

up

A SURPLUS means that the quantity demanded is more than/ less than the quantity supplied.

Equilibrium and Law of Markets

P Q supplied increases/decreases

P Q demanded increases/decreases

More demanded and less supplied eliminates the surplus. The market hits equilibrium -- prices and quantities stop changing -- when quantities supplied and demanded are equal.

Due to the surplus, the price will rise/fall, activating both the law of demand and the law of supply.

(Law of D)

(Law of S)

A SHORTAGE means that the quantity demanded is more than / less than the quantity supplied.

Due to the shortage the price will rise/fall, activating both the law of demand and the law of supply.

P Q supplied increases/decreases

P Q demanded increases/decreases

Less demanded and more supplied eliminates the shortage. The market hits equilibrium -- prices and quantities stop changing -- when quantities supplied and demanded are equal.

Equilibrium and Law of Markets

(Law of D)

(Law of S)

The equilibrium price and quantity in a market depend on two factors

1. Demand – buyers’ willingness to spend, and2. Supply – the ability of sellers to produce and sell

Until now we have asked, “How does the price effect the amount people will buy and sell?” Now we want to ask the reverse question: “How do the amounts that people want to buy and sell effect price?”

CHANGES OF SUPPLY AND DEMAND

This will be answered by the FOUR LAWS of SUPPLY and DEMAND

What happens if supply or demand change?

CHANGE OF DEMAND

There are many reasons why demand might change. Let’s start by examining the one that will be most important when we get back to macroeconomics.

Demand changes if (without a price change) buyers are willing to spend more or less on a product (or, in macro, on all products.)

An change in the willingness to spend on a product (without a price change) must indicate that consumers, for some reason, want this product more or less than they used to.

CHANGE OF DEMAND

The first of the FOUR LAWS: D Q, P

This says: If consumer demand increases (i.e. buyers are willing to increase their spending on a product) then: more of the good will be produced (Q ), and the price of the good will rise (P)The second of the FOUR LAWS: D Q, P

This says: If consumer demand decreases (i.e. buyers are willing to decrease their spending on a product) then: less of the good will be produced (Q ) and the price of the good will fall (P)

GRAPHING A CHANGE OF DEMAND

S

Q

P

Q0

P0

D0

D1

Q1

P1

D↓ => P ↓, Q ↓D↑ => P↑, Q↑

An increase of demand A decrease of demand

Q

SP

Q0

P0

D0 D1

Q1

P1

CHANGE OF SUPPLY

A supply decrease has the reverse description: producers want to sell less, or insist on higher price.

A supply increase means either:(a) producers are willing sell more even without a price change, or

(b) sellers are willing to lower the price (to sell a given quantity) of the product.

A change of supply refers to a change of producers’ ability to produce. A supply change can be seen either of two ways:

CHANGE OF SUPPLY

There are many reasons why supply might change.The one that will be most important when we get back to macroeconomics will be a change of cost of production

Production costs change for two main reasons:

1. a change of the quantity and quality of the factors of production – most importantly, technological improvement.

2. a reduction in the cost of some factor of production

CHANGE OF SUPPLY

The next of the FOUR LAWS: S Q, P

This says: If supply increases (i.e. sellers are able to increase production) then: -- more of the good will be produced (Q ), and -- the price of the good will fall (P )The last of the FOUR LAWS: S Q, P

This says: If supply decreases (i.e. sellers must decrease production) then: -- less of the good will be produced (Q ) and -- the price of the good will rise (P)

GRAPHING CHANGES OF SUPPLY

S ↑ => Q ↑, P ↓

An increase of supply

S ↓ => Q ↓, P ↑

Q

S0

P

Q0

P0

D

S1

Q1

P1

A decrease of supply

S1

Q1

P1

DQ

P

Q0

P0

S0

1. An increase is shown by shifting the curve to the right. This works for both supply and demand.

Comments of Graphing

2. Supply shifts look backwards to a lot of people. Remember rule #1, above, and avoid describing curve shifts as “up” or “down.”

3. There are many reasons, other than those given so far, as to why demand or supply might change. In fact each individual market has its own list of shifters.

THAT’S ALL FOR NOW