Chapter 4 Demand and Supply

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Chapter 4 Demand and Supply
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Objectives

• After studying this chapter, you will be able to
• Explain the influences on demand
• Explain the influences on supply
• Explain how demand and supply determine prices
  and quantities bought and sold
• Use demand and supply to make predictions about
  changes in prices and quantities

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• This chapter explains how prices are determined
  and how markets guide and coordinate choices.

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Markets and Prices

• A market is any arrangement that enables buyers
  and sellers to get information and do business
  with each other.
• A market has two sides buyers and sellers
• Market for goods, services, resources, inputs,
  money, securities.
• Physical market and non-physical market

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• Markets vary in the intensity of competition.
• A competitive market is a market that has many
  buyers and many sellers so no single buyer or
  seller can influence the price.
• The most competitive markets are explicitly
  organized as auctions. Here is an interesting
  market at Aalsmeer in Holland, which handles a
  large percentage of the worlds fresh cut
  flowers. Roses grown in Colombia are flown to
  Amsterdam, auctioned at Aalsmeer, and are in
  vases in New York, London, and Tokyo all in less
  than a day.

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• The money price of a good is the amount of money
  needed to buy it.
• The relative price of a goodthe ratio of its
  money price to the money price of the next best
  alternative goodis its opportunity cost.

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More on Relative price

• Example if the money price of coffee is 1 a
  cup, and the money price of gum is 50 a pack,
  then the opportunity cost of one cup of coffee is
  2 packs of gum.
• A normal way of expressing a relative price is in
  terms of a basket of all goods and services.

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Relative prices

• Thus, generally to calculate relative price, we
  divide the money price of a good by the money
  price of a basket of all goods (called a price
  index).
• The theory of demand and supply determines the
  relative price. When we say the price will fall,
  we mean its price will fall relative to the
  average price of other goods and services.

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Demand

• If you demand something, then you
• Want it,
• Can afford it, and
• Have made a definite plan to buy it.
• Wants are the unlimited desires or wishes people
  have for goods and services. Demand reflects a
  decision about which wants to satisfy.

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• The quantity demanded of a good or service is the
  amount that consumers plan to buy during a
  particular time period, and at a particular
  price.
• The quantity demanded is not necessarily the same
  as the quantity actually bought.

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Demand

• What Determines Buying Plans?
• 1. The price of the good,
• 2. The prices of other goods,
• 3. Expected future prices,
• 4. Income,
• 5. Population, and
• 6. Preferences.

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• The Law of Demand
• Other things remaining the same, the higher the
  price of a good, the smaller is the quantity
  demanded.
• The law of demand results from
• a substitution effect
• an income effect

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• Substitution effectwhen the relative price
  (opportunity cost) of a good or service rises,
  people seek substitutes for it, so the quantity
  demanded decreases.
• Income effectwhen the price of a good or service
  rises relative to income, people cannot afford
  all the things they previously bought, so the
  quantity demanded decreases.

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• Example
• Think about the price of recordable compact disc
  (a CD-R).
• Substitutes an audiotape and prerecorded CD.
• What will happen when the price drops from 3 to
  1.5? For substitution effect, people substitute
  CD-Rs for tapes and prerecoded CDs. For income
  effect, people can buy more CD-Rs. Therefore, the
  quantity of CD-Rs demanded increases.

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• Demand Curve and Demand Schedule
• The term demand refers to the entire relationship
  between the price of the good and quantity
  demanded of the good.
• The quantity demanded refers to a point on a
  demand curve ? the quantity demanded at a
  particular price.

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• A demand curve shows the relationship between the
  quantity demanded of a good and its price when
  all other influences on consumers planned
  purchases remain the same.
• A demand schedule lists the quantities demanded
  at each price when all the other influences
  remain the same.

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• Figure 3.1 shows a demand curve for recordable
  compact discs (CD-Rs).
• A rise in the price, other things remaining the
  same, brings a decrease in the quantity demanded
  and a movement along the demand curve.

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• A demand curve is also a willingness-and-ability-t
  o-pay curve.
• The smaller the quantity available, the higher is
  the price that someone is willing to pay for
  another unit.
• Willingness to pay measures marginal benefit.

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• A Change in Demand
• When any factor that influences buying plans
  other than the price of the good changes, there
  is a change in demand for that good. The quantity
  of the good that people plan to buy changes at
  each and every price, so there is a new demand
  curve.
• When demand increases, the quantity that people
  plan to buy increases at each and every price so
  the demand curve shifts rightward.
• When demand decreases, the quantity that people
  plan to buy decreases at each and every price so
  the demand curve shifts leftward.

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• Several factors that change demand
• Prices of related goods
• A substitute is a good that can be used in place
  of another good.
• A complement is a good that is used in
  conjunction with another good.
• When the price of substitute for CD-Rs rises or
  when the price of a complement for CD-Rs falls,
  the demand for CD-Rs increases.

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• Figure 3.2 shows the shift in the demand curve
  for CD-Rs when the price of CD burner falls.
• Because a CD burner is a complement of a CD-R,
  the demand for CD-Rs increases.

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• Expected future prices
• (Substitute over time)
• If the price of a good is expected to rise in the
  future, current demand increases and the demand
  curve shifts rightward.

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• Example
• Suppose that Florida is hit by a frost that
  damages the seasons orange crop. What will you
  expect the price of orange juice in the future?
  (increase)
• What will happen to your current consumption of
  orange juice today based on your expectation?
• What will happen to your future demand?

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• Income
• When income increases, consumers buy more of most
  goods and the demand curve shifts rightward.
• A normal good is one for which demand increases
  as income increases.
• An inferior good is a good for which demand
  decreases as income increases. (potatoes,
  long-distance travel-air travel/bus trips)

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• Population
• The size and the age structure also influence the
  changes of demand.
• The larger the population, the greater is the
  demand for all goods.
• The larger the proportion of the population in a
  given age group, the greater is the demand for
  the goods and services used by that age group.

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• The demand for parking spaces is much greater in
  New York City than it is in Charleston.
• For example, the number of Americans ages 20-24
  decreased by 2 million during 1988-1998. As a
  result, the demand for college places decreased.

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Exercises

• In the market for scooters, several events occur,
  one at a time. Explain the influence of each
  event on the quantity demanded of scooters and on
  the demand for scooters. Illustrate the effects
  of each event by either a movement along the
  demand curve or a shift in the demand curve for
  scooters, and say which event (or events)
  illustrates the law of demand in action. These
  events are

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Exercises

• The price of a scooter falls.
• The price of a bicycle falls.
• Citing rising injury rates, cities and towns ban
  scooters from sidewalks.
• Average income increases.
• Rumor has it that the price of a scooter will
  rise next month.
• The number of buyers increases.

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Note

• The demand curve shows the quantity of demand
  buyers would hypothetically purchase at different
  prices during the same time period.
• It does not show the quantity actually bought at
  different prices at different times.

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• In the real world we usually only observe
  historical price-quantity combinations,
• so it is often difficult to distinguish between
  movement along a demand curve and
• shifts between demand curves.

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• Prices and quantities observed at different times
  in the real world may result from shifting demand
  curves and not movement along a demand curve.
• Simply connecting the points may not give a good
  estimate of a demand curve.

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HISTORICAL DATA ON PRICE AND QUANTITY
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PLOT OF HISTORICAL DATA ON PRICE AND QUANTITYA
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PLOT OF HISTORICAL DATA AND TRUE DEMAND
CURVES FOR JANUARY, FEBRUARY, AND MARCH
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Supply

• If a firm supplies a good or service, then the
  firm
• Has the resources and the technology to produce
  it,
• Can profit from producing it, and
• Has made a definite plan to produce and sell it.

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• Resources and technology determine what it is
  possible to produce. Supply reflects a decision
  about which technologically feasible items to
  produce.
• The quantity supplied of a good or service is the
  amount that producers plan to sell during a given
  time period at a particular price.

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• What Determines Selling Plans?
• The amount of any particular good or service that
  a firm plans to supply is influenced by
• 1. The price of the good,
• 2. The prices of resources needed to produce it,
• 3. The prices of related goods produced,
• 4. Expected future prices,
• 5. The number of suppliers, and
• 6. Available technology.

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• The Law of Supply
• Other things remaining the same, the higher the
  price of a good, the greater is the quantity
  supplied.
• The law of supply results from the general
  tendency for the marginal cost of producing a
  good or service to increase as the quantity
  produced increases.
• Producers are willing to supply only if they at
  least cover their marginal cost of production.

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• Supply Curve and Supply Schedule
• The term supply refers to the entire relationship
  between the quantity supplied and the price of a
  good.
• The supply curve shows the relationship between
  the quantity supplied of a good and its price
  when all other influences on producers planned
  sales remain the same.

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• Figure 3.4 shows a supply curve of recordable
  compact discs (CD-Rs).
• A rise in the price, other things remaining the
  same, brings an increase in the quantity supplied
  and a movement along the supply curve.

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• A supply curve is also a minimum-supply-price
  curve.
• The greater the quantity produced, the higher is
  the price that a firm must be offered to be
  willing to produce that quantity.

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• A Change in Supply
• When any factor that influences selling plans
  other than the price of the good changes, there
  is a change in supply of that good. The quantity
  of the good that producers plan to sell changes
  at each and every price, so there is a new supply
  curve.
• When supply increases, the quantity that
  producers plan to sell increases at each and
  every price so the supply curve shifts rightward.
• When supply decreases, the quantity that
  producers plan to sell decreases at each and
  every price so the supply curve shifts leftward.

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• The factors that change supply
• Prices of relevant resources
• If the price of resource used to produce a good
  rises, the minimum price that a supplier is
  willing to accept for producing each quantity of
  that good rises. So a rise in the price of
  productive resources decreases supply and shifts
  the supply curve leftward.

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• Examples
• The rise of jet fuel in 2001 decreased the supply
  of air transportation.
• A rise in the minimum wage decreases the supply
  of hamburgers.

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• Prices of related goods produced
• A substitute in production for a good is another
  good that can be produced using the same
  resources. Goods are complements in production if
  they must be produced together.
• The supply of a good increases and its supply
  curve shifts rightward if the price of a
  substitute in production falls or if the price of
  a complement in production rises.

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• Examples
• Dairy farms sell products other than milk. If
  cheese prices rise sharply, farmers may decide to
  use some raw milk to make cheese, thereby
  reducing milk supplied (supply curve shifts
  inward)
• Suppose the price of beef goes up, which
  increases the meat supplied. In turn, that will
  raise the number of cowhides. (outward shift)

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• Expected future prices
• If the price of a good is expected to fall in the
  future, current supply increases and the supply
  curve shifts rightward.

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• The number of suppliers
• The larger the number of suppliers of a good, the
  greater is the supply of the good. An increase in
  the number of suppliers shifts the supply curve
  rightward.

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• Example
• Over the past two years, there has been a huge
  increase in the number of firms that design and
  manage Web sites. As a result, the supply of
  Internet and World Wide Web services has
  increased enormously.

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• Technology
• Advances in technology create new products and
  lower the cost of producing existing products, so
  they increase supply and shift the supply curve
  rightward.

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• Example
• The use of new technologies in the Taiwan
  factories that make CD-Rs for Imation Enterprises
  Corp., a Minnesota based firm, have lowered the
  cost of producing a CD-R and increased its supply.

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• Figure 3.5 shows how an advance in the technology
  for producing recordable CDs increases the supply
  of CD-Rs and shifts the supply curve for CD-Rs
  rightward.

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• A Change in the Quantity Supplied Versus a Change
  in Supply
• Figure 3.6 illustrates the distinction between a
  change in supply and a change in the quantity
  supplied.

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• When the price of the good changes and other
  influences on selling plans remain the same,
  there is a change in the quantity supplied and a
  movement along the supply curve.

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• When one of the other factors that influence
  selling plans changes, there is a change in
  supply and a shift of the supply curve.

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Exercises

• In the market for SUVs, several events occur one
  at a time. Explain the influence of each event on
  the quantity supplied of SUVs and the supply of
  SUVs. Illustrate the effects of each event by
  either a movement along the supply curve or a
  shift of the supply curve of SUVs, and say which
  event (or events) illustrates the law of supply
  in action. The events are

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• The price of a truck rises.
• The price of an SUV falls.
• The price of an SUV is expected to fall next
  year.
• An SUV engine defect requires a huge and costly
  manufacturer's recall to replace the defective
  engines.
• A new robot technology lowers the cost of
  producing SUVs.

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Market Equilibrium

• Equilibrium is a situation in which opposing
  forces balance each other. Equilibrium in a
  market occurs when the price balances the plans
  of buyers and sellers.
• The equilibrium price is the price at which the
  quantity demanded equals the quantity supplied.
• The equilibrium quantity is the quantity bought
  and sold at the equilibrium price.
• Price regulates buying and selling plans.
• Price adjusts when plans dont match.

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Example Demand and supply schedule
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• Price as a Regulator
• Figure 3.7 illustrates the equilibrium price and
  equilibrium quantity in the market for CD-Rs.
• If the price of a disc is 2, the quantity
  supplied exceeds the quantity demanded and there
  is a surplus of discs.

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• If the price of a disc is 1, the quantity
  demanded exceeds the quantity supplied and there
  is a shortage of discs.

• If the price of a disc is 1.50, the quantity
  demanded equals the quantity supplied and there
  is neither a shortage nor a surplus of discs.

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• Price Adjustments
• At prices above the equilibrium, a surplus forces
  the price down.
• At prices below the equilibrium, a shortage
  forces the price up.
• At the equilibrium price, buying plans and
  selling plans agree and the price doesnt change.

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• Because the price rises if it is below
  equilibrium, falls if it is above equilibrium,
  and remains constant if it is at the equilibrium,
  the price is pulled toward the equilibrium and
  remains there until some event changes the
  equilibrium.

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Predicting Changes in Price and Quantity

• A Change in Demand
• An increase in demand shifts the demand curve
  rightward and creates a shortage at the original
  price.

• The price rises and the quantity supplied
  increases.

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• A Change in Supply
• An increase in supply shifts the supply curve
  rightward and creates a surplus at the original
  price.

• The price falls and the quantity demanded
  increases.

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A Change in Both Demand and Supply

• A change in both demand and supply changes the
  equilibrium price and the equilibrium quantity,
  but we need to know the relative magnitudes of
  the changes to predict some of the consequences.

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• Figure 3.10 shows the effects of a change in both
  demand and supply in the same direction. An
  increase in both demand and supply increases the
  equilibrium quantity but has an uncertain effect
  on the equilibrium price.

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• Figure 3.11 shows the effects of a change in both
  demand and supply when they change in opposite
  directions. An increase in supply and a decrease
  in demand lowers the equilibrium price but has an
  uncertain effect on the equilibrium quantity.

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Mathematical Note

• Given demand and supply function, can you find
  out the equilibrium price and quantity?

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End of Chapter 3