The Foundation of Economics:

1
The Foundation of Economics

• Supply and Demand Analysis

2
Demand

• Demand represents how much of a good consumers
  are willing and able to purchase at a given
  price, holding all else constant
• Willing (wants) Able (resources)
• I might be willing to buy an exotic sports car,
  but I cannot afford it
• I could afford to buy an Ashlee Simpson CD, but I
  really dont want it
• The Law of Demand explains what we intuitively
  know
• The quantity demanded is inversely related to
  price
• As price increases, we demand fewer units of the
  good. As price decreases, we will demand more
  units of the good.
• Individual Demand vs. Market Demand

3
Demand Curves

• The law of demand helps us explain the downward
  sloping shape of the demand curve
• At high prices (20 per CD), fewer CDs are
  demanded
• At lower prices (14 per CD), consumers are
  willing and able to buy more CDs

4
Demand Schedule

• On the previous slide, we saw a demand curve
• If the values are presented in a table form, we
  call that a demand schedule

5
Movement Along the Demand Curve

• Demand vs. Quantity demanded
• The demand for CDs is refers to the entire demand
  curve
• The quantity of CDs demanded refers to the number
  of units purchased, at a given price
• Movement along the demand curve is caused by
  price changes
• Substitution Effect as the price of a good
  changes, it becomes more or less expensive
  relative to other goods
• Income Effect as the price of a good changes,
  it changes a consumers purchasing power

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Substitution and Income Effects
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All Else Constant

• The demand curve represents the relationship
  between price and quantity, holding all else
  constant
• What do we hold constant?
• Consumer income
• Consumer tastes and preferences
• Consumer expectations
• The number of consumers in the market
• The prices of related goods
• Changes in any of these elements will shift the
  demand curve

8
Increase in Demand

• Consumer income goes up
• Consumers are worried about being sued for
  downloading music illegally online
• The prices of DVD and movie tickets go up
• Theres an increase in the U.S. population

9
Decrease in Demand

• Consumer income goes down
• The price of MP3 players goes down
• The prices of DVD and movie tickets go down
• Consumers believe the record companies will stop
  suing downloaders

10
Supply

• Supply- represents how much of a good producers
  are willing and able to provide (or offer) at a
  given price, holding all else constant
• Once again, willing and able are key words
• Willing at higher prices producing this good
  becomes more attractive than other options
• Able as you produce more, your costs increase
• Law of Supply
• The quantity supplied is directly (positively)
  related to price
• As price goes up, producers are willing to supply
  more of the good
• As price goes down, producers are not willing to
  supply as much of the good
• Market Supply vs. Individual Supply

11
Supply Curves

• The law of supply helps us explain the upward
  sloping shape of the supply curve
• At high prices (20 per CD), more CDs are
  supplied
• At lower prices (14 per CD), firms are less
  willing and able to produce CDs

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All Else Constant

• The supply curve represents the relationship
  between price and quantity offered, holding all
  else constant
• What do we hold constant?
• Technology Level
• Changes in Resource Prices
• Producer expectations
• The number of producers in the market
• The prices of alternative goods (shifting
  resources)
• Changes in any of these elements will shift the
  supply curve

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Increase in Supply

• A new technology emerges to burn CDs more cheaply
• The price of CD-ROMS goes down (less attractive
  alternative)
• Producers expect future lawsuits to put
  file-sharing services out of business
• Theres an increase in the number of record
  companies

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Decrease in Supply

• A number of firms go out of business or exit the
  industry
• Record companies agree to install expensive
  anti-theft devices on all new CDs produced
  (expensive new technology)
• It becomes very expensive to market and promote
  artists (billboards, marking videos, etc.)

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Putting Supply Demand TogetherMarket
Equilibrium
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Market Equilibrium

• Market equilibrium the price at which the
  quantity consumers are willing and able to
  purchase matches the quantity that producers
  supply
• Graphically, equilibrium is the point where the
  demand curve intersects the supply curve
• P represents the equilibrium price in the market
  for CDs
• Q represents the equilibrium quantity (sales) in
  the market for CDs
• Equilibrium is the stable point where the market
  clears

S
Price per CD
P
D
Q
Quantity of CDs
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Prices Above the Equilibrium Price

• Consider a price above the equilibrium price (P)
• At a price of P, the quantity demanded does not
  equal the quantity supplied
• Quantity supplied exceeds the quantity demanded
• This is called a SURPLUS
• What happens?
• Prices are bid down (cut) to the equilibrium
  level

S
Surplus
Price per CD
P
P
D
Q
QD
QS
Quantity of CDs
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Prices Below the Equilibrium Price

• Consider a price below the equilibrium price (P)
• At a price of P, the quantity demanded does not
  equal the quantity supplied
• Quantity demanded exceeds the quantity supplied
• This is called a SHORTAGE
• What happens?
• Prices are bid up (increased) to the
  equilibrium level

S
Price per CD
P
P
D
Q
QD
QS
Quantity of CDs
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Changes in Equilibrium Price and Quantity

• A market will remain in equilibriumuntil there
  is a change in one (or more) of the determinants
  of demand or supply
• Shifts in either the demand curve or the supply
  curve (or both) result changes in the equilibrium
  price and quantity
• We can use our knowledge of Supply and Demand to
  predict the new equilibrium price and quantity

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Shifts in the Demand Curve

• Suppose consumers are worried about being sued
  for illegally downloading music so the demand for
  CDs shifts out
• If the price stayed at P, there would be a
  shortage and prices would be bid up
• New equilibrium price and output have both
  increased

S
Price per CD
P
P
D
D
Q
Q
Quantity of CDs
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Shifts in the Supply Curve

• Suppose that record companies expect the recent
  lawsuits to put file-sharing services out of
  business so the supply of CDs shifts out
• If the price stayed at P, there would be a
  surplus and prices would be bid up
• New equilibrium the equilibrium price is lower,
  but the equilibrium output will be greater

S
Price per CD
S
P
P
D
Q
Q
Quantity of CDs
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On Your Own

• I have only shown two cases demand and supply
  shift out
• Determine what happens to equilibrium prices and
  output when
• The demand curve for CDs shifts back (a decrease
  in demand)
• The supply curve for CDs shifts back (a decrease
  in supply)

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When Supply Demand Both Shift

• It is possible that events can shift both the
  supply curve and the demand curve simultaneously
• If both curves shift, our predictions about the
  new equilibrium price and quantity will depend on
  which shift dominates the other

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Supply Demand Decrease
S

• If the cost of promoting a musician increases and
  file-sharing makes buying CDs less attractive,
  then we may get a situation such as this one.
• In this situation, the price remains the same but
  the total output decreases
• If the shifts were more unequal, you can see how
  we might get different predictions

S
Price per CD
P
D
D
Q
Q
Quantity of CDs
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Unequal Shifts in Supply Demand
S
S
S
S
Price per CD
Price per CD
P
P
P
P
D
D
D
D
Q
Q
Q
Q
Quantity of CDs
Quantity of CDs
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Results

• On the lefthand side, the supply shift dominated
  the demand shift and equilibrium price increased
• On the righthand side, the demand shift dominated
  the supply shift and the equilibrium price
  decreased
• In both cases, equilibrium output decreased
• We would need to know which shift dominates in
  order to determine the new equilibrium price
• On your owntry some of the other possible shifts
• Demand increase, but Supply decreases
• Supply increases, while Demand decreases
• Both Supply and Demand increase simultaneously
• Focus on trying to determine whether equilibrium
  price and quantity increase or decrease for each
  case

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Disequilibrium

• Disequilibrium a condition in which there is a
  mismatch between the amount of a good consumers
  are willing to purchase and the amount producers
  are willing to supply
• As we saw before, disequilibrium is usually a
  temporary situation
• But there are some cases (typically due to
  regulations that affect the functioning of the
  market) where the disequilibrium is not temporary
• Price Floors
• Price Ceilings

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Price Floors

• Price Floor a minimum price below which a good
  cannot be sold
• Example Agriculture Subsidies or Minimum wage
  laws
• To guarantee farmers a certain profit level, the
  government sets minimum prices for products like
  wheat, tobacco, and rice
• The result is a surplus

Surplus
S
Price
PF
P
D
Q
Quantity
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Price Ceilings

• Price ceiling an upper limit on the price that
  can be charged for a good
• Example rent control or salary caps in sports
• To save consumers money, rules are sometimes put
  in place to allow consumers to pay prices below
  what the market would set (below P)
• The result is a shortage

S
Price
P
PC
D
Shortage
Q
Quantity
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Salary Caps in Hockey

• The National Hockey League Players' Association
  says it won't accept a salary cap. "We believe in
  letting the market system operate and letting
  owners pay players what they're worth, not a
  penny more or a penny less,'' says Ted Saskin,
  senior director for business affairs for the
  union.

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Next time The Economic Decision Markers

• Households, Firms, and the Government