Supply, Demand, and Equilibrium

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Supply, Demand, and Equilibrium

• Today An introduction to supply and demand, and
  how they relate to equilibrium

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Who is very hungry and likes bananas?

• All the bananas you care to eat for one person
  (up to however many I have)
• NOT extra credit, since you get free bananas
• You are eating bananas at your own risk
• You are not allowed to share bananas with anyone
  else
• Please report to me how many bananas you eat in
  about 40 minutes

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Previously

• The 7 Core Principles
• Thinking like an economist
• Marginal cost and benefit
• Working with graphs

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Today Markets

• Supply, demand, and equilibrium
• What causes shifts in supply and demand?
• What happens when supply and/or demand shifts?

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Central organization versus Markets

• Central economic organization is rare today
• Most economic activity today occurs in markets
• Markets do fail sometimes, but this is the focus
  of other chapters (e.g. Chapters 8 and 10)

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Markets

• Markets consist of buyers and sellers
• Assume many buyers and many sellers
• Fractional amounts of goods can be produced
• We will talk about supply and demand for most
  markets
• Exceptions will be dealt with accordingly as we
  get to them

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Core principle related to demand

• Cost-benefit analysis
• Recall energy drinks example
• Think reservation price when you think
  willingness to pay (WTP)

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Demand

• Demand states how much of a good that buyers are
  willing to purchase given each price
• Demand is typically shown on a graph, but it is
  occasionally displayed on a table

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Demand

• A fundamental characteristic of demand is that as
  the price of a good increases, demand typically
  goes down (all else constant)
• Recall that WTP for energy drinks decreases as
  you consume more
• Thus, each demand curve is downward sloping if we
  graphed it
• By convention, quantity is on the horizontal axis
  and price on the vertical axis

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Core principles related to supply

• Increasing opportunity cost
• We want to produce at the lowest cost for each
  additional unit
• Also called low-hanging-fruit principle
• Incentive principle
• Businesses will supply less when some units are
  not profitable
• Businesses will supply more when producing more
  could lead to higher profits

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Supply

• Supply states how much of a good that sellers are
  willing to sell given each price
• Similar to demand, supply is typically shown on a
  graph

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Supply

• Low-cost sellers typically enter a market before
  high-cost sellers
• Thus, we would expect that the sellers with
  lowest cost to sell a particular good
• Supply is then assumed to be upward sloping

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Discrete versus continuous

• Although many products can only be purchased in
  discrete amounts, we usually assume continuous
  curves
• Why? (Come to class to find out)
• In this class, most common curve used is linear
• We will typically ignore the discreteness
  problem in supply/demand analysis

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Graphing supply and demand
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Equilibrium principle

• Another core principle
• No cash on the table ? stable
• Nobody can be made better off by changing her/his
  decision
• Does not address potential actions that groups of
  people can make
• Later topic, especially with market failure

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Equilibrium 4 units purchased, at a price of 6
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Why is a price of 6 equilibrium?

• To show that 6 is the equilibrium price, we will
  show that prices above and below are not in
  equilibrium
• We will prove by contradiction that this price
  could not be equilibrium
• Suppose that a price (P) of 4 is equilibrium

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At P 4 Quantity demanded is 6, quantity
supplied is 3.33
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At P 4 Quantity demanded is 6, quantity
supplied is 3.33

• When P is 4, people are demanding a quantity that
  is higher than what is supplied
• Is this an equilibrium?
• No, this is not stable
• Someone can increase their production slightly,
  and sell at a price of 5 to make more profits

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Now suppose that P 9 is an equilibrium
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Now suppose that P 9 is an equilibrium

• Quantity supplied is 6
• Quantity demanded is 1
• This is not stable either
• Someone not selling their entire stock can sell
  for P 7 to make more money

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A change in supply versus a movement along the
supply curve

• A change in supply leads to a shift of the entire
  supply curve
• A movement along the supply curve can occur when
  the supply curve does not move
• Movement occurs when there is a change in price
• Similar ideas apply for changes in demand versus
  a movement along demand curves

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What causes shifts in demand?

• Price changes of complements and substitutes
• Example of complements baseballs and baseball
  bats
• Example of substitutes two different brands of
  cola

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What causes shifts in demand?

• Income changes
• Most goods are normal goods, meaning that when
  income increases, the demand curve shifts to the
  right
• Some goods are inferior, meaning that when income
  increases, the demand curve shifts to the left
• Changes in preferences, population, and expected
  future prices

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What is happening here?
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What is happening here?

• The demand curve shifts to the right
• There is a movement along the supply curve, since
  supply does not change

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What is happening here?

• Note that at any price, a higher quantity is
  demanded on curve D2 than on D1
• The new equilibrium price (P) and quantity (Q)
  are higher when demand shifts from D1 to D2

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What causes shifts in supply?

• Anything that changes the cost of production
• If the cost of production decreases, supply
  shifts to the right
• If the cost of production increases, supply
  shifts to the left
• A change in number of suppliers
• Expectations of future prices

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What happens when both supply and demand shift?

• An example Both supply and demand shift right

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Shift in supply

• causes Q to increase and P to decrease
• Movement from A to B

A
B
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Shift in demand

• causes Q to increase and P to increase
• Movement from B to C

C
B
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What can we conclusively say about changes in Q
and P?

• Change in supply causes Q to increase and P to
  decrease
• Change in demand causes Q to increase and P to
  increase
• The only conclusion when both supply and demand
  shift right is that Q increases

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Now that we have talked about supply and demand

• lets talk about bananas
• How many bananas did our volunteer eat today?
• Why not any more?
• We will talk about what happened here on Monday

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Summary

• The intersection of demand and supply curves
  determines equilibrium
• Equilibrium is stable
• Change in S or D causes the curve to shift
• A movement along the supply curve can occur when
  the supply curve does not move
• Same with demand
• Both supply and demand can shift, but be careful
  of your conclusions