Supply and Demand

1
Supply and Demand
2
Overview
It has been said you can teach a parrot economics
by having the bird say supply and demand. That
would be decent. But, think how much larger a
humans brain is and how that brain can do so
much more. For a few slides I want you to think
in a mechanical manner and study some graphs. I
want you to focus on supply and demand, just as
the parrot would say. I want you to look at
where the curves cross and see what price and
what quantity occurs. After this mechanical look
at supply and demand we will want to add economic
ideas to our presentation so that you can use
that brain of yours in a manner the parrot is not
able.
3
Supply and Demand Graph
In a market for a product with demand D1 and
supply S1 we would see P1 as the price and Q1 as
the amount traded. This P and Q is where the
curves cross.
P
S1
P1
D1
Q
Q1
4
Demand Increase
When demand increases we see the price in the
market rise to P2 and the quantity traded
increase to Q2.
P
S1
P2
P1
D2
D1
Q
Q1
Q2
5
Demand Decrease
When demand decreases the market price decreases
to P2 and the quantity traded decreases to Q2.
P
S1
P1
P2
D1
D2
Q
Q1
Q2
6
Supply Increase

When the supply increases we see a lower market
price P2 and a higher quantity traded Q2.
P
S1
S2
P1
P2
D1
Q
Q1
Q2
7
Supply Decrease
When the supply falls the market prices rises to
P2 and the quantity traded falls to Q2.
P
S2
S1
P2
P1
D1
Q
Q1
Q2
8
Now, lets expand our ideas to incorporate
economic meaning into our graphs. In some sense
the discussion will still be general. Our
presentation will be about a market. There are
tons of markets. There is a market for corn,
wheat, Mt. Dew in a 20 ounce bottle, Microsoft
stock, and many more. Our study of supply and
demand is the scientific way folks go about
explaining the pattern of price movements and/or
quantity traded movements.
9
Price, P
Along this axis we measure the price per unit of
a product. At the bottom we start at zero and
move our way up.
Along this axis we measure quantity in units of a
good or service. On the left we start at zero
and as we go right we go to larger amounts.
Quantity, Q
10
Price, P
We could look at any point in the graph and at
that point we can get a feel for the quantity at
that point and the price at that point. This
point would correspond to the other graph in that
this point is for a certain day. On other days
we could be a a different point and we want to
build a theory of that movement.
Price at the point
Quantity, Q
Quantity at the point
11
Price, P
2) Note here that after the curve shifted, we
will move along the new demand curve and call the
movement a change in the quantity demanded.
D2
1) Note here that when the demand shifted we
would say it shifted because of a change in demand
D1
Quantity, Q
12
So, we have gotten warmed up to the model of
supply and demand. Now we want to look at 1)
The demand side of the market, 2) The supply side
of the market, 3) The interaction of supply and
demand and how these determine the price in the
market and the quantity traded in the market, and
4) Changes in supply and demand and how that
leads to price and quantity traded changes.
13
Law of Demand
P
Demand in general refers to how much of a product
consumers are willing and able to buy. In the
graph here you should note two things. 1) The
demand curve is downward sloping as you look at
the graph from left to right, and 2) The demand
curve is in a certain position or location that
could change.
D
Q
Lets think about each of these points in more
detail. Lets start with point 1. When we say
the demand curve is downward sloping we say this
is a reflection of the law of demand. The law of
demand is a statement that when the price of the
product changes the quantity demanded moves in
the opposite direction. PLEASE draw in two
points on the demand curve in this graph. Now
start at one point and as you move to the other
point do you note that as the price changes the
quantity demanded changes in the opposite
direction? Law of Demand Price and quantity
demanded are inversely related.
14
Law of Demand
Here are the economic theories about why the law
of demand holds. The theories reinforce each
other. 1) It is common sense you and I see
people want more the lower the price or they want
less the higher the price. (Granted this first
one is not much theory, just observation.) 2)
Diminishing Marginal Utility (DMU) When you
think of a certain time period, like an hour, a
day, or any other common unit of time, economic
theory suggests that as more of a good is
consumed during that time period more utility is
gained but each successive unit consumed adds
less utility than the previous unit. This is the
idea of DMU. So, if each additional unit adds
less utility than previous units, then the
consumer would only take the additional units if
a lower price can be paid.
15
Law of Demand
3) Income and substitution effects of a price
change When the price of a good falls the
consumer who purchases some of the good initially
has more money left in their pocket. It is as if
the consumer has more income (hence the income
effect of a price change.) Thus, the lower
price means the consumer wants a larger quantity
of the good. The substitution effect is the idea
that when the price of a good falls consumers
take more of the good and use it in substitution
for something else. Take steak, please! If
steak becomes lower in price some folks will take
more of it and have less scrod, or chicken (or
some other meat in their diet.)
16
P
P1
In the graph at P1, although folks could probably
buy more of the product, quantity demanded is
only Q1.
D
Q
Q1
But, if the price was lower than P1 you see there
would be movement down the demand curve. The
economic theory for this is, again, common sense,
DMU, and the income and substitution effects of a
price change. So, the price of the product is a
major factor in how much of a product consumers
want. But there are other things that have an
influence as well.
17
P
A few slides back I mentioned that we need to pay
attention to the position or location of the
demand curve and that maybe the location could
change.
P1
D
Q
Q1
What I now want to make explicit is that Q1 was
demanded at P1 with the understanding that other
things that influence demand are held constant.
If these other things should change then at P1
the amount people want could change and the
demand would shift. Demand shifting to the right
is an increase in demand and shifting to the left
is a decrease in demand.
18
Peoples income is a factor that leads the demand
curve to be in a certain location. This means if
income should change the demand curve will shift
to a new location. Other factors that lead to a
shift in the demand include the expectations
consumers have, price of related goods, consumer
taste and preference, and the number of consumers
in the market. On the next slide is a table that
will list how the demand curve will shift given a
change in a determinant of demand. Note the
table does not include the price of the product
itself. If the price changes there is a movement
along the demand curve and we say there is a
change in the quantity demanded.
19
Determinants of Demand
Determinant of demand change demand shifts
to Consumer taste for the good rises right Consume
r taste for the good falls left Income increase
for normal good right Income decrease for normal
good left Income increase for inferior
good left Income decrease for inferior
good right Complementary good price
increase left Complementary good price
decrease right Substitute good price
increase right Substitute good price
decrease left Increase in consumers in
market right Decrease in consumers in
market left Price expected in future rises
right Price expected in future falls left
20
Determinants of Demand
Over time consumers might have a change in taste
and preference for goods. An example would be
that over time in the US we have become more
health conscious and thus goods that contribute
to good health have had an increase in demand and
those that dont have had a decline in
demand. Income has an impact on the amount
consumers want. We think about two types of
goods here normal and inferior goods. Normal
goods are defined as those that when we get more
(less) income we want more (less) of the good.
Music CDs might be an example of a normal
good. An inferior good is one where when income
rises (falls) we want less (more) of the good.
Music cassettes might be an example here.
21
Determinants of Demand
Complementary goods are defined as goods used in
combination with each other. Coffee and donuts
are complements (there is no i in this
complement) for me, what about you? If the price
of donuts goes up I will want less donuts (law of
demand) and since I have coffee with my donuts I
will want less coffee. The price of donuts
changing has changed my demand for
coffee. Substitute goods are defined as goods
where one of the goods could be used in place of
the other. Coke and Pepsi work for me. If the
price of Pepsi changes the demand for Coke will
change in the opposite direction.
22
Demand from many Consumers

• A determinant of demand

23
In the section on demand it was mentioned that
the demand in the market is influenced by the
number of consumers in the market. Basically we
saw that if the number of consumers increased the
demand would increase and if the number of
consumers fell the demand would fall. Here I want
to enhance what has already been said by looking
at how a market demand curve is constructed.
Lets start with just two consumers in the market.
P
P
P
c1 c2
Consumer 1 Consumer 2 Market
Q
Q
Q
24
On the previous screen you see the separate
demands from each consumer. The way to get the
market demand is through what is called a
horizontal summation of the individual demand
curves. Basically what is done is that at each
price the quantity demanded from each individual
is added across horizontally. At the price shown
in the graph you can see that I took the quantity
demanded from the first consumer and added the
quantity demanded from the second consumer to get
the total market quantity demanded. If I had
three consumers I would do the same thing, except
I would add in all three consumers, of
course. The market supply curve you will
encounter later is found in a similar way you
horizontally add the supply curve from each firm
in the market. Hey, check this out. If you had n
identical consumers and at a price of Pn you had
each consumer demand N units, then total market
demand would be N N N N (N added n times),
or total amount demanded at Pn of nN.
25
Determinant of Demand
In the future goods and services will probably
have a price tag on them. It is thought that
what we expect the future price to be will have
an impact on our demand today. More specifically,
if, as we look to the future, if we expect future
prices to change to even higher levels then we
will increase our demand today in hopes of
getting the good before the price goes up. If we
expect the future price to fall we will cut back
on our current demand.
26
P
Supply in general refers to how much of a product
producers want to sell. In the graph here you
should note two things. 1) The supply curve is
upward sloping as you look at the graph from left
to right, and 2) The supply curve is in a
certain position or location that could change.
S
Q
Lets think about each of these points in more
detail. When we say the supply curve is upward
sloping we say this is a reflection of the law of
supply. The law of supply is a statement that
when the price of the product changes the
quantity supplied moves in the same direction.
So, if the price should rise, the quantity
supplied will rise , and if the price should fall
the quantity supplied will fall. Law of Supply
Price and quantity supplied are directly, or
positively, related.
27
Lets consider the story about why the supply
curve is upward sloping. Production of a good or
service takes time and producers have lots of
things they would like to do. When the price of
a good is low producers look at their options and
conclude at a low price that they will make a few
units but then do something else because there is
not a big payoff to production. But, if the
price is higher they do not mind giving up other
things to produce here because they will get more
for their efforts.
28
P
In the graph at P1, although producers could
probably make more of the product, quantity
supplied is only Q1 because producers have
decided they do not want to give up other things
to make more of Q.
S
P1
Q
Q1
But, If the price was higher than P1 you see
there would be movement up the supply curve.
Some producers would say that since they get more
for producing this item they give up doing other
stuff and they are happy to supply a greater
quantity of this good. So, the price of the
product is a major determinant of how much of a
product producers want to make. But there are
other things that have an influence as well.
29
P
A few slides back I mentioned that we need to pay
attention to the position or location of the
supply curve and that maybe the location could
change. What I now want to make explicit is that
Q1 was supplied at P1 with the
S
P1
Q
Q1
understanding that other things that influence
supply are held constant. If these other things
should change then at P1 the amount producers
want to make could change and the supply would
shift. As an example, say the company is making
candy and the price of sugar, a major input to
the product, goes up. Then at P1, since it costs
more to make a unit of candy, the producer will
make less because there is less profit to be made
per unit. Producers would rather do something
else.
30
So, on the previous slide we see the supply curve
would shift left when the price of an input to
the production process went up. Similarly the
supply curve would shift right when the price of
an input falls. The price of an input is a
factor that leads the supply curve to be in a
certain location. This means if the input price
should change the supply curve will shift to a
new location. Other factors that lead to a shift
in the supply include the state of technological
sophistication used in production (what I call
the state of technology), the number of sellers,
taxes and subsides, prices of other goods that
might be made, and the price sellers expect to
see in the future. On the next slide is a table
that will list how the supply curve will shift
given a change in a factor of supply. Note the
table does not include the price of the product
itself. If the price changes there is a movement
along the supply curve and we say there is a
change in the quantity supplied.
31
Factor of supply change supply shifts to Input,
or resource, price increase left Input price
decline right Increase in state of
technology right Decrease in state of technology
left Increase in tax (or subsidy
decrease) left Decrease in tax (or increase in
subsidy) right Increase in producers in
market right Decrease in producers in
market left Increase in price of other goods to
make left Decrease in price of other goods to
make right Increase in expected future
price left Decrease in expected future
price right Please note that when a factor
changes in such a way that supply shifts to the
right we could also say supply has increased and
if a factor changes in such a way that supply
shifts to the left we could also say supply has
decreased.
32
Determinant of Supply
When resources prices rise it becomes more
expensive to produce and so at a given price of
output supply falls. Better technologies make it
easier to produce and so supply rises. Higher
taxes are a drag so supply falls with them, while
higher subsides increase supply. If producers
make more than 1 type of good with the same basic
resources then if the output price of 1 rises
they devote more resources there than in the past
and supply rises.
33
Determinant of Supply
Sellers also look to the future and they form an
expectation of what they think will happen. If
that expectation changes they change their
current behavior. For example, if sellers expect
the future price to be higher than what they used
to expect then their current supply will fall in
hopes of selling more at the higher expected
future price. (Note, their expectation could be
wrong, but they wont know until later.) If the
number of sellers rises the supply rises.
34
Price, P
Now that we have considered supply and demand
separately we will bring the two together and see
how buyers and sellers interact in a market.
S
D
Quantity, Q
35
Price, P
Notice at this price P1 the quantity demanded
equals the quantity supplied.
S1
P1
D1
Quantity, Q
Q1
36
Price, P
Notice that when you look at any price above
where the curves cross, like at Pa, the quantity
supplied is greater than the quantity demanded
a surplus
S1
Pa
D1
Quantity, Q
Qs
Qd
37
Price, P
Notice that when you look at any price below
where the curves cross, like at Pb, the quantity
supplied is less than the quantity demanded a
shortage
S1
Pb
D1
Quantity, Q
Qd
Qs
38
Notice on the previous three slides that I have
put the subscript 1 on the labels for the supply
and demand curves. I do this to have you
understand that when we consider the interaction
of supply and demand we initially have supply and
demand located in place because the determinants
that can shift these curves are fixed at a
certain level for the time being. Later these
curves can shift, but for now we have them fixed
in place. Theory of Price Change 1) When the
price is above P1 in our graphs from the previous
slides we see Qs gt Qd, meaning we have a surplus.
All buyers at this price (as recognized by the
amount on the demand curve) would get to buy, but
not all sellers would get to sell. This surplus
of items means some sellers have an incentive to
change. They would lower the price so that they
do not have any left over items.
39
2) When the price is below P1 in our graphs from
the previous slides we see Qs lt Qd, meaning we
have a shortage. All sellers at this price (as
recognized by the amount on the supply curve)
would get to sell, but not all buyers would get
to buy. This shortage of items means some buyers
have an incentive to change. They would bid up
the price in an attempt to get the item. 3) When
the price is P1 we see Qs Qd. All buyers and
sellers are able to buy and sell, respectively,
what they want at this price. Neither group has
an incentive to change. Item 3) here defines
equilibrium in the market. Take this to mean you
should focus your attention on were the curves
cross. But items 1) and 2) help us understand
why the price will change when conditions in the
world change. Lets turn to this next.
40
For any market story this is where you mind
should be, on this graph with all the knowledge
you have in these notes up to this point.
Price, P
S1
P1
D1
Quantity, Q
Q1
41
Here we have a demand increase. Slide 19 should
remind you how a demand increase can happen.
Note at the initial price P1 Qs Q1 but demand
is now Qd.
Price, P
D2
S1
P1
D1
Quantity, Q
Q1
Qd
42
At P1, since Qd gt Qs, we have a shortage and with
a shortage the price will rise. The price will
rise to P2.
Price, P
D2
S1
P2
P1
D1
Quantity, Q
Q1
Qd
43
Note as the price rises due to the shortage both
a) the quantity supplied rises from Q1 to Q2 and
b) the quantity demanded falls from Qd to Q2.
The shortage is gone.
Price, P
D2
S1
P2
P1
D1
Quantity, Q
Q1
Qd
Q2
44
Lets summarize what is on the last 4 slides. 1)
We have the market at some starting point. Note
the equilibrium price and quantity traded, P1 and
Q1. 2) The demand increases creating a
shortage. 3) The shortage means the price will
rise. 4) The shortage is eliminated because with
the higher price the a) quantity supplied rises
and b) the quantity demanded falls (from the new
higher level). Overall, the increase in demand
resulted in 1) An increase in the market price,
and 2) An increase in the quantity traded in the
market.
45
From this starting point lets now look at the
story of a supply increase.
Price, P
S1
P1
D1
Quantity, Q
Q1
46
Here we have a supply increase. Slide 31 should
remind you how a supply increase can happen.
Note at the initial price P1 Qd Q1 but supply
is now Qs.
Price, P
S1
S2
P1
D1
Quantity, Q
Q1
Qs
47
At P1, since Qs gt Qd, we have a surplus and with
a surplus the price will fall. The price will
fall to P2.
Price, P
S1
S2
P1
P2
D1
Quantity, Q
Q1
Qs
48
Note as the price falls due to the surplus both
a) the quantity supplied falls from Qs to Q2 and
b) the quantity demanded rises from Q1 to Q2.
The surplus is gone.
Price, P
S1
S2
P1
P2
D1
Quantity, Q
Q1
Qs
Q2
49
Lets summarize what is on the last 4 slides. 1)
We have the market at some starting point. Note
the equilibrium price and quantity traded, P1 and
Q1. 2) The supply increases creating a
surplus. 3) The surplus means the price will
fall. 4) The surplus is eliminated because with
the lower price the a) quantity demanded rises
and b) the quantity supplied falls (from the new
higher level). Overall, the increase in supply
resulted in 1) An decrease in the market price,
and 2) An increase in the quantity traded in
the market.
50
What have we learned? Among other things 1) The
price and quantity traded in a market are
determined by the interaction of supply and
demand. 2) The price and quantity traded in a
market will change if there is a change in supply
or demand.