Demand and Supply CHAPTER 4 EYE ONS Demand Law of Demand Supply Demand curve Law of Market Forces Supply curve Demand Schedule Law of Supply Supply schedule Quantity demanded Minimum wage law Quantity supplied Change in demand Change in supply Change in quantity demanded Change in quantity supplied Shortage/excess demand Shortage/excess supply Equilibrium price Complement Inferior Good Equilibrium quantity Complement in production Normal Good Market equilibrium Substitute Price ceiling/cap Substitute in production Price floor Using Demand and Supply The demand and supply model is going to be a big part of the rest of your life! 1. You will use it again and again during your economics course. • D/S model is one of the major economic tools • Having a firm grasp of it will bring an immediate payoff. 2. You better appreciation how your economic world works • By understanding the laws of D/S • By being aware of how prices adjust to balance the two opposing forces Example: When you hear someone complaining about a price hike and blaming it on someone’s greed think about •The law of market forces and how demand and supply determine price •You will know how supply and demand influence the price of clothing, music, food, and many other items that you purchase What is COMPETITIVE MARKETS a market? In this chapter, we study a competitive market that has so many buyers and so many sellers that no individual buyer or seller can influence the price. CHAPTER 4 Demand • Law of Demand • # price = $ Qty Demanded • Quantity Demanded: • Amount willing and able to BUY during a specific period at a specific price • Per unit of time (2 bottles a day) • Demand • Relationship between Qty Demanded and Price • List of quantities at different prices • Portrayed as 1) schedule or 2) curve DEMAND – Schedule and Curve CHAPTER 4 Changes in Demand • Change in Quantity Demanded: • Price change of given good results in a change in buying habits • Change in Demand • Any Influence Other than Price results in a change in buying habits 1. Price of related goods In Consumption • Substitute good – a good that can be consumed in the place of another good Apples & • # price of substitute good = $ Qty Dem for that good oranges • # price of substitute good = # Demand for other good • Complement good – a good that can be consumed with another good Ice cream & • # price of complement good = $ Qty Dem for that good choc syrup • # price of complement good = $ Demand for other good CHAPTER 4 Changes in Demand • Change in Quantity Demanded: • Price change of given good results in a change in buying habits • Change in Demand • Any Influence Other than Price results in a change in buying habits 2. Income • Normal good : # income = # demand BMWs or Ramon Noodles • Inferior good : # income = $ demand 3. Expectations • Expected future prices # = ‘buy it now’ = #demand • Expected future income # = ‘take a vacation’ CHAPTER 4 Changes in Demand • Change in Quantity Demanded: • Price change of given good results in a change in buying habits • Change in Demand • Any Influence Other than Price results in a change in buying habits 4. Number of Buyers • # # of buyers = # demand 5. Preferences (Demand # for one item and $ for another item) • Better information: ‘Smoking’ # demand for cigarettes and $ demand for nicotine patches • Introduction of new good: Introduction of MP3’s $ demand for CD’s, #demand for internet service CHAPTER 4 Changes in Demand A Change in the Demand for Roses In a normal month, the price is $40 a bouquet and 6 million bouquets are sold. Valentine’s Day in February the demand for roses increases and the demand curve shifts In February, the equilibrium price rises and rightward. the equilibrium quantity increases. CHAPTER 4 Supply • Law of Supply • # price = # Qty Supplied • Quantity Supplied: • Amount willing and able to SELL during a specific period of time at a specific price • Per unit of time (2 bottles a day) • Supply • Relationship between Qty Supplied and Price • List of quantities at different prices • Portrayed as 1) schedule or 2) curve SUPPLY – Schedule and Curve CHAPTER 4 Changes in Supply • Change in Quantity Supplied: • Price change of given good results in a change in selling plans • Change in Supply • Any Influence Other than price results in a change in selling plans In Production 1. Price of related goods • Substitute good – a good that can be produced in the place of SUV another good & • # price of substitute good = # Qty Supplied for that good Truck • # price of substitute good = $ Supply for other good • Complement good – a good that can be produced with another good Cream & • # price of complement good = # Qty Supplied for that Skim milk good • # price of complement good = # Supply for other good CHAPTER 4 Changes in Supply • Change in Quantity Supplied: • Price change of given good results in a change in selling plans • Change in Supply • Any Influence Other than price results in a change in selling plans Steel Crisis 2. Prices of resources and other inputs • # price of resource = $ supply Orange Juice 3. Expectations Frost kills FL oranges • Expected future prices # = $ supply ‘suppliers stock up now to get future high prices’ CHAPTER 4 Changes in Supply • Change in Quantity Supplied: • Price changes result in a change in Selling plans • Change in Supply • Any Other Influence results in a change in selling plans 4. Number of Sellers • # # of sellers= # supply 5. Productivity – Output per unit of Input • Technological Change: $cost • Improvements = # productivity and #supply • Natural Events: #cost • hurricanes =$ productivity and $ supply CHAPTER 4 Changes in Supply A Change in the Supply of Flat Panel TVs A few years ago, the price of a 42- inch flat panel TV was $6,000. Advances in technology have lowered the cost of production and the supply increased. The equilibrium The equilibrium The quantity price decreased. quantity increased. demanded increased. CHAPTER 4 Market Equilibrium • Equilibrium is when Qty Demanded = Qty Supplied CHAPTER 4 Market Equilibrium • Equilibrium is when Qty Demanded = Qty Supplied Shortage = excess demand Surplus = Excess supply Shortage = Price rises Until market is in equilibrium Surplus = Price falls CHAPTER 4 Effects of Changes in Demand • When equilibrium is disturbed, the market immediately begins to adjust (short-term) and eventually arrives at a NEW equilibrium (long-term) MARKET EQUILIBRIUM Effects of Change in Demand … in action Event: A new zero-calorie sports drink is invented. To work out the effects on the market for bottled water: 1. Does the event change demand or supply? • The new drink is a substitute for bottled water, so the demand for bottled water changes 2. Does the event Increase or Decrease demand or supply? • The demand for bottled water decreases, the demand curve shifts leftward. 3. What are the new equilibrium price and quantity and how have they changed (increase or decrease)? • What are the new equilibrium price and equilibrium quantity and how have they changed? MARKET EQUILIBRIUM – Bottled Water Market Figure 4.7(b) shows the outcome. 1. A decrease in demand shifts the demand curve leftward. 2. At $1.00 a bottle, there is a surplus, so the price falls. 3. Quantity supplied decreases along the supply curve. 4. Equilibrium quantity decreases. MARKET EQUILIBRIUM When demand changes: • The supply curve does not shift. • But there is a change in the quantity supplied. • Equilibrium price and equilibrium quantity change in the same direction as the change in demand. CHAPTER 4 Effects of Changes in Supply • When equilibrium is disturbed, the market immediately begins to adjust (short-term) and eventually arrives at a NEW equilibrium (long-term) MARKET EQUILIBRIUM Effects of Change in Demand … in action Event: Drought dries up some springs in the United States. To work out the effects on the market for bottled water: 1. Does the event change demand or supply? • Drought changes the supply of bottled water. 2. Does the event Increase or Decrease demand or supply? • The supply of bottled water decreases, the supply curve shifts leftward. 3. What are the new equilibrium price and quantity and how have they changed (increase or decrease)? • What are the new equilibrium price and equilibrium quantity and how have they changed? MARKET EQUILIBRIUM – Bottled Water Market Figure 4.8(b) shows the outcome. 1. A decrease in supply shifts the supply curve leftward. 2. At $1.00 a bottle, there is a shortage, so the price rises. 3. Quantity demanded decreases along the demand curve. 4. Equilibrium quantity decreases. MARKET EQUILIBRIUM When supply changes: • The demand curve does not shift. • But there is a change in the quantity demanded. • Equilibrium price changes in the same direction as the change in supply. • Equilibrium quantity changes in the opposite direction to the change in supply. CHAPTER 4 Changes in Both Demand and Supply • We cannot say what happens to PRICE or QUANTITY without knowing the MAGNITUDE of the changes When two events occur at the same time, work out how each event influences the market: 1. Does each event change demand or supply? 2. Does either event increase or decrease demand or increase or decrease supply? 3. What are the new equilibrium price and equilibrium quantity and how have they changed? CHAPTER 4 Changes in Both Demand and Supply CHAPTER 4 Changes in Both Demand and Supply CHAPTER 4 Changes in Both Demand and Supply CHAPTER 4 Changes in Both Demand and Supply CHAPTER 4 Changes in Both Demand and Supply SUPPLY CURVE SUPPLY CURVE SUPPLY CURVE UNCHANGED SHIFTS TO THE RIGHT SHIFTS TO THE LEFT DEMAND CURVE Q unchanged Q increases Q decreases UNCHANGED P unchanged P decreases P increases DEMAND CURVE Q increases Q increases or SHIFTS TO THE RIGHT Q increases P increases or decreases P increases decreases P increases DEMAND CURVE Q decreases Q increases or Q decreases SHIFTS TO THE LEFT P decreases decreases P increases or P decreases decreases CHAPTER 4 Price Rigidities • What happens if the Price does NOT adjust THREE COMMON REASONS WHY PRICE DOES NOT ADJUST • Price Floor – lowest LEGAL price to trade or sell a good, service or factor of production • Price Ceiling – highest LEGAL price to trade or sell a good, service or factor of production • Sticky Price – buyer and seller agree on price for a fixed period or seller infrequently changes price in given market CHAPTER 4 Price Rigidities – Price Floor Minimum • What happens if the Price does NOT adjust Wage Price Floor [minimum wage] • Price Floor set ABOVE the equilibrium point DOES effect the market • Price Floor set BELOW the equilibrium point DOES NOT effect the market • Don’t forget to quantify the effects • Surplus of 4000 workers CHAPTER 4 Price Rigidities – Price Ceiling Rent Control College Tuition • What happens if the Price does NOT adjust Price Ceiling [parking spaces] • Price Floor set ABOVE the equilibrium point DOES NOT effect the market • Price Floor set BELOW the equilibrium point DOES effect the market • Don’t forget to quantify the effects • Shortage of 2000 parking spaces CHAPTER 4 Price Rigidities – Sticky Prices • Sticky Price = Buyer and Seller AGREE on a price for a PERIOD of time • Long-term contracts • Labor unions • Interest rates • Commodity trade • Prices DO adjust but, NOT quick enough to avoid shortages and surpluses The Federal Minimum Wage The federal government’s Fair Labor Standards Act sets the minimum wage, but most states set their own minimum wage rate at a higher level than the federal minimum. The minimum wage creates unemployment. But how much unemployment does it create? Until recently, most economists believed that a 10 percent increase in the minimum wage rate decreased teenage employment by between 1 and 3 percent. The Federal Minimum Wage David Card and Alan Kruger claim that a rise in the minimum wage rate increases the employment rate of low-income workers. They suggest three reasons: 1. Workers become more conscientious and productive. 2. Worker are less likely to quit, so costly labor turnover is reduced. 3. Managers make a firm’s operations more efficient. The Federal Minimum Wage But most economists are skeptical about these ideas. They suggest: 1. With labor more productive and lower turnover costs, firms would willingly pay a wage equal to the minimum wage. 2. Firms anticipate a rise in the minimum wage, so they cut the number of workers ahead of the rise in the minimum wage. Unemployment does not increase after a rise in minimum wage rate. 3. Looking at employment misses the effect on the supply of labor—a higher minimum wage increases the supply as people drop out of high school to look for work. CHAPTER 4 Analyzing the News When Wal-Mart slashes prices or enters a new market the Summary: Key Points in the Article company has the same impact as an increase in supply as Giant retailer Wal-Mart upended the market shown above. A new market participant of that size forces for flat-panel televisions last November competitors to emulate and lower prices. However, profit when it made the decision to drop price margins get competed away to the point where the least below the $1,000 mark for the 42-inch efficient eventually go out of business. screens. The impact on Wal-Mart was minimal since the stores quickly sold inventories and replenished with a flood of new flat panels from new factories. However the impact on the company’s competitors was dramatic. Circuit City Stores, Tweeter Home Entertainment Group, and CompUSA have all been forced to close stores and lay off employees as the companies price-matched Wal-Mart’s televisions. While Wal-Mart’s move did catch some off guard, many analysts pointed out the similar impact on grocery store chains when Wal-Mart entered the grocery business. Others noted that several toy chains entered bankruptcy largely due to Wal-Mart’s fierce price cutting. Wal-Mart maintains that consumers benefit due to lower prices. Wal-Mart’s competitors hope that at least a few customers will continue to want their televisions installed and might prefer a wider selection. CHAPTER 4 Analyzing the News Summary: Key Points in the Article A number of factors other than a change in price The price of oil topped $72 a barrel on the have impacted the potential supply of oil. These all heels of news that eight foreign oil culminate in a decrease in oil supply, or expected workers were kidnapped from a Nigerian decrease, and subsequent increase in the price of oil drilling rig. Iran’s uncertain nuclear oil. future also created additional uncertainty about the political stability of another oil rich region. Recent Nigerian militant violence includes blowing up oil pipelines and other acts of violence designed to disrupt the country’s oil production. To date, the Nigerian violence has resulted in the shut-in of 500,000 barrels of oil per day at a time when global production only exceeds consumption by about two million barrels of oil per day. Gasoline futures surged as well due to a production slowdown resulting from a Texas refinery that sustained lightning-related fire damage and subsequent disruption in output. Elsewhere, OPEC decided to leave its output quotas unchanged. Growth in global oil demand slowed a little but remains strong with U.S. gasoline demand up about one per cent over the same period last year. CHAPTER 4 Analyzing the News Summary: Key Points in the Article Note that both the supply and demand shifts would Cocoa futures are riding high due to drought, result in a higher cocoa price taken in isolation. political unrest, and changing consumer Since all three factors have hit this market tastes. Two major factors have combined to simultaneously, it is not surprising that prices have restrict the supply of cocoa; a drought in risen as rapidly and are substantial increases. Western Africa and civil unrest in the Ivory Coast. The Ivory Coast is the planet’s biggest producer of cocoa. The result is a 5.5% drop in the production of cocoa over the previous year. Cocoa prices have responded accordingly and are near a three year high with prices increasing by 44% since November 2005. The demand side is also affecting prices. Consumer tastes have shifted toward darker chocolates and dark chocolate requires more cocoa to manufacture. The change in preference is driven partially by health reasons. Dark chocolates are higher in antioxidants and considered to be healthier than other chocolates. Some studies link dark chocolate consumption to lower blood pressure. Since dark chocolates are also higher margin products, manufacturers have been happy to oblige. However, the combined effect of the supply and demand factors is a certain recipe for higher cocoa prices. CHAPTER 4 Analyzing the News Summary: Key Points in the Gold prices are being pushed by investor demand Article for gold increasing while at the same time jewelry The rising price of gold as a demand for gold is falling. The net impact, coupled jewelry input has pushed many with net supply changes due to lower mining consumers to postpone jewelry production and higher scrap production, has settled purchases. The result is that prices above the $900 mark. However, gold traders gold traders are becoming more are having difficulty forecasting direction and the cautious about the current price ultimate settling price. level until it is determined how much of the current $900 price is the result of inflation hedging and how much is derived from jewelry demand. Meanwhile global output fell about 1 percent last year as production costs increased. Many traders indicate that jewelers have evaporated from the gold market. Meanwhile many jewelry items are being melted down and returned to the market as scrap to take advantage of the current high prices. Much of the demand appears to be investor driven as stocks tumble and interest rates fall. CHAPTER 4 Analyzing the News Summary: Key Points in the Article Note that at price P there are more toys demanded Production problems, coupled with than there are toys supplied. This shortage, higher than expected consumer demand, particularly in game consoles, can be best visualized are contributing to shortages of certain by the fact that some consumers are buying game toys this holiday season. Many of the consoles at store prices and selling them on Ebay Chinese factories are experiencing labor for a large profit. The Ebay price would be shortages as high-tech job creation equivalent to the price at equilibrium point A. causes many Chinese to move off of the assembly line. Power outages have also contributed to lower productivity in the manufacturing regions of southern China. Unfortunately these problems came at the wrong time and have limited supplies of numbers of toys including Sony’s PlayStation 3. In addition to the supply problems, consumer demand was underestimated. Last year’s sales data were extrapolated to this year and many retailers placed very conservative orders. The limited supply and underestimated demand has created a real shortage of some toys. The result is a hot secondary market on Ebay for many toys such as the PlayStation 3 and Mattel’s TMX Elmo. The Elmo retails for $40 but is fetching $65 on Ebay.