Supply and Demand I. Markets – a set of rules for the negotiation of exchange between buyers and sellers. Prices communicate market conditions. II. Demand Demand compares the quantity demanded (qd for individuals, Qd for a market) and the price of a product. A. Individual Demand: compare prices and qd for an individual, holding all else constant. Example: Demand Schedule Alice’s desired pounds of chicken per week: Price = MB qd $5.00 0 $3.00 1 $2.00 2 $1.50 3 $1.20 4 $1.00 5 Demand Curve P 5 4 3 2 1 D 0 1 2 3 4 5 q There are actually two ways to interpret what the demand schedule and the demand curve show us. 1. They give the quantity of the g/s demanded at each possible price. 2. They show the maximum that an individual is willing to pay to purchase an extra amount. B. Market demand: gives the total Qd by all individuals at each price (equals market MB). Market demand is simply the sum of all individual demands. Example: Price Alice’s qd Bob’s qd Market Qd $5.00 0 1 1 $3.00 1 1.5 2.5 $2.00 2 2.3 4.3 $1.50 3 3.1 6.1 In all cases, as the price of a g/s rises the quantity demanded falls, and vice versa (all else constant). This is the Law of Demand, and it always holds true (we will discuss the theoretical possibility of violating the law of demand later in the course). III. Shifts in the Demand Curve. A. Prices of Related Goods 1. Substitutes Example: If the price of Pepsi doubles, then some (not all) people ma switch from buying Pepsi to buying Coke (Pepsi and Coke are substitutes). Thus, whatever the going price of Coke, there will be a greater quantity demanded for Coke. Since there is a greater Qd at each given price of Coke, the entire demand curve shifts – we say that Demand for Coke rises as the price of Pepsi rises. The demand for a substitute will always move in the same direction as the price of its substitute. Pepsi market (the price increases from P1 to P2 and Qd decreases). P P2 P1 D 0 Q1 Q2 Q Coke market (Qd increases for any given price). P D2 D1 0 Q The distinction between quantity demanded and demand is an important one – demand only changes when a variable besides the price of the g/s in question changes. When the good or service’s own price changes only quantity demanded changes, not demand! 2. Complements – two g/s that are typically consumed together (e.g. milk and cereal, peanut butter and jelly, shoes and shoe laces). Example: If the price of peanut butter rises, then Qd for peanut butter will fall. Since jelly is often used with peanut butter, the Qd for jelly will also fall at whatever the current price of jelly may be. Therefore, demand for jelly decreases. Peanut butter market (the price increases from P1 to P2 and Qd decreases). P P2 P1 D 0 Q1 Q2 Q Jelly market (Qd decreases for any given price). P D1 D2 0 Q B. Income 1. Normal goods – when an individual’s income rises, we typically see that the person will demand more of a g/s, all else held constant. It depends on the individual, but market-wide this is the case for most g/s. 2. Inferior goods – for some g/s as our incomes rise we will want to buy less at a given price (as in each of the other cases we hold other demand determinant, including the price, constant to focus on the specific effect of a change in income). An example might be Ramen Noodles, which are often consumed by college students on a tight budget, but when they graduate and see an increase in their income, they switch away to other food items. C. Tastes – obviously people’s tastes and trends in preferences can have an effect on demand. Advertising may have some role to play here, but as the famous economist Frederic Hayek noted: Many preferences are created by the social environment. Literature, art, and music are all acquired tastes. A person’s demand for hearing a Mozart concerto may have D. Expectations Example: If everyone expects there to be a dearth of champagne and high prices in late December then many people will start buying champagne in early December or late November at whatever the given price (all else constant). Note that this will drive the price up making the expectation self-fulfilling. IV. Supply Supply compares the quantity supplied (qs for individuals, Qs for a market) and the price of a product. A. Individual Supply: compare prices and qs for an individual, holding all else constant. Example: Supply Schedule Fanta Corps supply of 20oz. bottles of orange soda per week: Price qs $5.00 100,000 $3.00 95,000 $2.00 85,000 $1.50 70,000 $1.20 50,000 $1.00 25,000 There are two ways to interpret what the supply schedule and the supply curve show us. 1. They give the quantity of the g/s supplied at each possible price. 2. They show the minimum amount that a firm must be compensated to produce a given quantity. B. Market Supply: gives the total Qs by all individuals at each price. Market supply is simply the sum of all individual firms’ supplies. V. Shifts in the supply curve. A. Input Prices Example: Suppose the price of oats decreases, and that oats are a major input in production of granola. Then a granola producer will not need to be compensated as much (because its costs are lower), to produce the same amount of granola. Thus, all else equal, the supply of a g/s (at every price) will increase if input prices decrease (and vice versa). Granola market (Qs increases for any given price). P S1 S2 0 Q B. Technology: the term “technology” is used to indicate the way factors of production (inputs) are used to produce g/s. Technology is a broad term and includes items such as changes in the weather or natural disasters. C. Expectations. D. The Number of Suppliers (affects market supply): as more firms enter an industry, the total supply of that industries product can increase. VI. Market Equilibrium Example: Suppose the market demand and supply for beach towels are given below. $ 30 25 S 20 15 10 5 D 0 10 20 30 40 50 60 70 80 Q (mil.) Here, equilibrium quantity (Q*) is 50 million at an equilibrium price (P*) of $15. At the equilibrium price, consumers get exactly the quantity they are willing to buy at that price and producers can sell exactly the amount they are willing to sell at that price (Qd = Qs). VII. Changes in Equilibrium If both supply and demand change, then we can be certain of a change in either the equilibrium quantity or price, but the direction of change in one of the two will be uncertain unless we have more information. The resulting equilibrium will depend on the amount of the shifts and the amounts Qd and Qs change as price changes. The measure of these changes is called “elasticity”.
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