Supply,Demand, and the Market Process

1
Supply,Demand, and the Market Process
Chapter 3
2

• 1. Consumer Choice and the Law of Demand

3
Law of Demand

• Law of Demand There is an inverse relationship
  between the price of a good and the quantity
  consumers are willing to purchase.

• As price of a good rises, consumers buy less.
• The availability of substitutes --goods that do
  similar functions -- explains this negative
  relationship.

4
Market Demand Schedule

• A market demand schedule is a table that shows
  the quantity of a good people will demand at
  varying prices.

• Consider the market for cellular phones. A
  market demand schedule lays out the amount of
  cell phones that are demanded in the market for a
  spectrum of prices.
• We can graph these points (price and the
  respective demand) to make a demand curve for
  cell phones.

5
Market Demand Schedule
Price(monthly bill)
140
Cell Phone Price(monthly bill)
Millions of Cell Phone Subscribers
120
123 2.1
100
107 3.5
92 5.3
80
79 7.6
73 11.0
60
63 16.0
56 24.1
10
15
5
20
25
30
Quantity(of Cell Phone Subscribers)
6
Market Demand Schedule
Price(monthly bill)
140
120

• Notice how the law of demand is reflected by
  the shape of the demand curve.

100

• As the price of a good rises

80

• . . . consumers buy less.

60
10
15
5
20
25
30
Quantity(of Cell Phone Subscribers)
7
Market Demand Schedule
Price(monthly bill)
140
120

• The height of the demand curve at any
  quantity shows the maximum price that
  consumers are willing to pay for that
  additional unit.

100
80

• Here, for the 11th unit . . .

• . . . consumers are only willing to pay up to
  73 for it.

60

• While they would be willing to pay up to 92
  for the 5.3 (millionth) unit.

10
15
5
20
25
30
Quantity(of Cell Phone Subscribers)
8
Consumer Surplus

• Consumer Surplus - the area below the demand
  curve but above the actual price paid.

• Consumer surplus is the difference between the
  amount consumers are willing to pay and the
  amount they have to pay for a good.
• Lower market prices will increase consumer
  surplus.

9
Consumer Surplus
Price(monthly bill)

• Lets consider the market for cellular phones
  again. This time we will assume that the
  demand for cell phones is more linear and
  that the market price is 100.

140
120

• If the market price is 100, then the 25th
  unit will not sell because those who demand it
  are only willing to pay 60 for cellular
  phone service.

100
80

• At 100, the 15th unit will sell because
  those who demand it are willing to pay up to
  100 for cellular phone service.

60

• At 100, the 10th unit will sell because
  those who demand it are willing to pay up to
  120 for cellular phone service.

10
15
5
20
25
30
Quantity(of Cell Phone Subscribers)
10
Consumer Surplus
Price(monthly bill)
140

• For all those goods under 15 units, people
  are willing to pay more than 100 for service.

120

• The area, represented by the distance above
  the actual price paid and below the demand
  curve, is called consumer surplus.

100
80

• This area represents the net gains to buyers
  from market exchange.

60
10
15
5
20
25
30
Quantity(of Cell Phone Subscribers)
11
Elastic and Inelastic Demand Curves

• Elastic demand - quantity demanded is sensitive
  to small price changes.

• Easy to substitute away from good.
• Inelastic demand - quantity demanded is not
  sensitive to price changes.
• Difficult to substitute away from good.

12
Elastic and Inelastic Demand Curves

• If the market price for gasoline was to rise
  from 1.25 to 2.00, the quantity demanded
  in the market decreases insignificantly
  (from 8 to 7 units).

2.00
Gasoline
1.25

• If the market price for tacos rises from 1.25
  to 2.00, the quantity demanded in the
  market decreases significantly (from 8 to 1
  unit).

1
2
3
4
5
6
7
8
9
10
2.00
Tacos
1.25

• Taco demand is highly sensitive to price
  changes and can be described as elastic
  gasoline demand is relatively insensitive to
  price changes and can be described as
  inelastic.

6
10
1
2
3
4
5
7
8
9
13

• 2. Changes in Demand Versus Changes in
  Quantity Demanded

14
Changes in Demand and Quantity Demanded

• Change in Demand - shift in entire demand curve.

• Change in Quantity Demanded - movement along the
  same demand curve in response to a price change.

15
Change in Demand
Price(dollars)
25

• If CDs cost 15 each, the CD demand curve D1
  shows that 10 units would be demanded.

20

• If the price of CDs changed to 7.50, the
  quantity demanded for CDs would increase to
  20 units.

15

• If, somehow, the preferences for CDs changed
  then the demand for CDs may change.

10
5

• Here we will assume that consumer income
  increases, increasing demand for CDs at all
  price levels. At 15 15 units are now demanded.

D1
10
15
5
20
25
10
15
20
30
Quantity(of Compact Disks per yr)
16
Demand Curve Shifters

• Changes in Consumer Income

• Change in the Number of Consumers
• Change in Price of Related Good
• Changes in Expectations
• Demographic Changes
• Changes in Consumer Tastes and Preferences

17

• Questions for Thought

1. Which of the following do you think would lead
to an increase in the current demand for beef
(a) higher pork prices, (b) higher
incomes, (c) higher prices of feed grains
used to feed cows, (d) good weather
conditions leading to a bumper (very
good) corn crop, (e) an increase in the
price of beef?
2. What is being held constant when a demand
curve for a specific product (like shoes or
apples, for example) is constructed? Explain why
the demand curve for a product slopes downward
and to the right.
18

• 3. Producer Choice and the Law of Supply

19
Producers

• Opportunity Cost of Production - the sum of the
  producers cost of employing each resource
  required to produce the good.

• Firms will not stay in business for long unless
  they are able to cover the cost of all resources
  employed, including the opportunity cost of those
  owned by the firm.

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Role of Profits and Losses

• Profit occurs when revenues are greater than cost.

• Firms supplying goods for which consumers are
  willing to pay more than the opportunity cost of
  resources used will make a profit.
• Firms making a profit will expand and those with
  a loss will contract.

21
Law of Supply

• Law of Supply - there is a positive relationship
  between the price of a product and the amount of
  it that will be supplied.

• As the price of a product rises, producers will
  be willing to supply more.

22
Market Supply Schedule
Price(monthly bill)
140
Quantity of Cell PhonesSupplied
Cell Phone Price(monthly bill)
120
60 5.0
100
73 11.0
80 15.1
80
91 18.2
107 21.0
60
120 22.5
135 24.1
10
15
5
20
25
30
Quantity(of Cell Phone Subscribers)
23
Market Supply Schedule
Price(monthly bill)
140
120

• Notice how the law of supply is reflected by
  the shape of the supply curve.

100

• As the price of a good rises

80

• . . . producers supply more.

60
10
15
5
20
25
30
Quantity(of Cell Phone Subscribers)
24
Market Supply Schedule
Price(monthly bill)
140

• The height of the supply curve at any
  quantity shows the minimum price necessary
  to induce producers to supply that next unit
  to market.

120
100

• Here, for the 11th unit . . .

• . . . producers require 73 to induce them to
  supply it.

80

• The height of the supply curve at any
  quantity also shows the opportunity cost
  of producing that next unit of the good.

60
10
15
5
20
25
30
Quantity(of Cell Phone Subscribers)
25
Producer Surplus
Price(monthly bill)

• Lets consider the market for cellular phones
  again. This time we will assume that the
  supply for cell phones is more linear and
  that the market price is 100.

Supply
140
120

• If the market price is 100, then the 25th
  unit will not be produced because the cost of
  supplying it exceeds the market price of
  140.

100
80

• At 100, the 15th unit will be produced
  because those who supply it are willing to do
  so for for at least 100.

60

• At 100, the 10th unit will be produced
  because those who supply it are willing to do
  so for at least 80.

10
15
5
20
25
30
Quantity(of Cell Phone Subscribers)
26
Producer Surplus
Price(monthly bill)
Supply
140

• For market outputs of less then 15 units,
  producers are willing to supply the good for
  100.

120

• The area represented by the distance above
  the supply curve but below the actual sales
  price is called producer surplus.

100

• This area is the difference between the
  minimum amount required to induce producers to
  supply a good and the amount they actually
  receive.

80
60
10
15
5
20
25
30
Quantity(of Cell Phone Subscribers)
27
Elastic and Inelastic Supply Curves

• Elastic supply- quantity supplied is sensitive to
  small price changes.

• Inelastic supply - quantity supplied is not
  sensitive to price changes.

28
Elastic and Inelastic Supply Curves

• If the market price for motor oil was to rise
  from 1.25 to 2.00, the quantity supplied
  in the market increases insignificantly
  (from 7 to 8 units).

2.00
1.25

• If the market price for burgers rises from
  1.25 to 2.00, the quantity supplied in the
  market increases substantially (from 1 to 8
  units).

1
2
3
4
5
6
7
8
9
10
2.00
1.25

• Burger supply is highly sensitive to price
  changes and can be described as elastic
  motor oil supply is relatively insensitive
  to price changes and can be described as
  inelastic.

6
10
1
2
3
4
5
7
8
9
29
Short Run and Long Run

• Short Run - Firms dont have enough time to
  change plant size.
• Supply tends to be inelastic in the short run.

• Long Run - Firms have enough time to change plant
  size.
• Supply tends to be much more elastic in the long
  run.

30

• 4. Changes in Supply Versus Changes in
  Quantity Supplied

31
Changes in Supply and Quantity Supplied

• Change in Supply - shift in entire supply curve.

• Change in Quantity Supplied - movement along the
  same supply curve in response to a price change.

32
Change in Supply
Price(dollars)
2.50

• If the market price for gas is 1.50 a
  gallon, the gasoline supply curve S1 shows
  that 20 units would be supplied.

The Market forGasoline
S1
2.00

• If the market price of gas changed to .75,
  the quantity supplied of gasoline would
  decrease to 10 units.

1.50

• If, somehow, the opportunity costs for gas
  manufacturers changed then the supply of gas
  may change.

1.00
.50

• Here we will assume that the cost of crude
  oil (an input in gasoline) increases,
  decreasing the supply of gas at all price
  levels. Now at 1.50, 15 units of gasoline are
  supplied.

10
15
5
20
25
10
15
20
30
Quantity(Millions of Gal of Gas)
33
Supply Curve Shifters

• Changes in Resource Prices

• Change in Technology
• Elements of Nature and Political Disruptions
• Changes in Taxes

34

• Questions for Thought

What must a firm do in order to make profit?
1. What are profits and losses?
2. Define consumer and producer surplus. What is
meant by economic efficiency and how does it
relate to consumer and producer surplus?
35

• 5. How Market Prices are Determined

36
Market Equilibrium

• This table and graph indicate the demand and
  supply conditions for oversized playing cards.

• Equilibrium will occur where the quantity
  demanded equals the quantity supplied. If the
  price in the market exceeds the equilibrium
  level, market forces will guide it to equilibrium.

13
12
11
10
9

• A price of 12 in this market will result in . .
  .

8
resulting
in excess supply.

quantity supplied of 600 . . .
quantity demanded of 450 and
7

• With an excess supply present, there will be
  downward pressure on price to clear the market.

350
400
400
450
500
550
600
650
Excess Supply
Quantity Supplied 600
Downward
Quantity Demanded 450
37
Market Equilibrium
13

• A price of 8 in this market will result in . .
  .

12
resulting
in excess demand.

quantity demanded of 650 . . .
quantity supplied of 500 and
11
10

• With an excess demand present, there will be
  upward pressure on price to clear the market.

9
8
7
350
400
400
450
500
550
600
650
Excess Supply
Quantity Supplied 500
Downward
Quantity Demanded 650
ExcessDemand
Upward
38
Market Equilibrium
13

• A price of 10 in this market will result in . .
  .

12
resulting
in a balance.

quantity demanded of 550 . . .
quantity supplied of 550 and
11
10

• With a balance present, there will be an
  equilibrium and the market will clear.

9
8
7
350
400
400
450
500
550
600
650
Quantity Supplied 550
Excess Supply
Downward
Balance
Equilibrium
Quantity Demanded 550
ExcessDemand
Upward
39
Market Equilibrium

• At every price above market equilibrium there
  is excess supply and there will be downward
  pressure on the price level.

13
12
11
10

• At every price below market equilibrium there
  is excess demand and there will be upward
  pressure on the price level.

9
8
7

• It is at equilibrium that prices will rest.

350
400
400
450
500
550
600
650
Excess Supply
Downward
Balance
Equilibrium
ExcessDemand
Upward
40
Net Gains to Buyers and Sellers
Price(monthly bill)

• Returning to the market for cell phones, if
  the market price is driven to equilibrium
  through market pressures to exist where supply
  equals demand, then the market equilibrium
  in the cell phone market should be driven to
  100 per month.

Supply
140
120
100

• If the area above the market price and below
  the demand curve is called consumer surplus . .
  .

80

• . . . and the area above the supply curve but
  below the market price is called producer
  surplus . . .

60

• . . . Then the combined area represented in
  the graph to the right represents the net
  gains to buyers and sellers. It is here that
  all potential gains from production and
  exchange are realized.

10
15
5
20
25
30
Quantity(of Cell Phone Subscribers)
41

• 6. How Markets Respond to Changes in Supply
  and Demand

42
Effects of a Change in Demand

• If Demand decreases, the equilibrium price and
  quantity will fall.

• If Demand increases, the equilibrium price and
  quantity will rise.

43
Market Adjustment to an Increase in
Demand

• Consider the market for eggs.

Price( per doz)

• Prior to Easter season, the market for eggs
  produces an equilibrium where Supply equals
  Demand1 at a market price of .80 and
  output of Q1.

Supply
1.40
1.20

• When the Easter season arrives, the demand by
  consumers for eggs increases from Demand1 to
  Demand2. What happens to the equilibrium
  price and output level?

1.00

.80

• At .80 a dozen the quantity demanded
  exceeds the quantity supplied. There is
  upward pressure on price inducing the
  existing suppliers to increase their quantity
  supplied to Q2, pushing the equilibrium price
  up to 1.00.

.60
Q1
Q2
Quantity(million doz eggsper week)

• What happens to equilibrium price and output
  after the Easter season?

44
Effects of a Change in Supply

• If Supply decreases, the equilibrium price will
  rise and the equilibrium quantity will fall.

• If Supply increases, the equilibrium price will
  fall and the equilibrium quantity will rise.

45
Market Adjustment to a Decrease in
Supply

• Consider the market for romaine lettuce.

• Prior to a season of adverse weather affecting
  the yield of the market, an equilibrium exists
  where Supply equals Demand1 with a market
  price of 1.80 and output of Q1.

Price( per head)
2.40
2.20

• When the season of adverse weather arrives
  the supply of romaine lettuce falls,
  decreasing the supply from supply1 to supply2.
  What happens to the equilibrium price and
  output level?

Supply1
2.00

1.80

• At 1.80 a head the quantity demanded exceeds
  the quantity supplied. There is upward
  pressure on price inducing the existing
  consumers to decrease their quantity demanded
  to Q2, drawing up the equilibrium price to
  2.00.

1.60
Q2
Q1
Quantity(million heads lettuceper week)

• What happens to equilibrium price and output
  when the weather returns to normal?

46

• 7. Time and the Adjustment Process

47
Time and the Adjustment Process

• With the passage of time, the market adjustments
  of both producers and consumers will be more
  complete.

• Both demand and supply are more elastic in the
  long run than in the short run.

48
Time and Adjustment to Increase in
Demand

• Consider the market for laptop computers.

• We begin in the short run in equilibrium at
  output level Q1 and price level P1.

SupplySR
Price

• When the demand for laptops unexpectedly
  increases from demand1 to demand2, suppliers
  do there best to increase product in the
  market, pushing the price level upward to P2.
  What happens to the equilibrium price and
  output in the long run, after suppliers have a
  chance to change their capacity?

P2
P3

P1

• With time suppliers expand output pivoting
  the supply curve to its long run
  representation. The new equilibrium is where
  demand equals supply. The result, a further
  increase in equilibrium output, to Q3, and a
  reduction in the equilibrium price to P3.

Q2
Q1
Q3
Quantity
49

• 8. Invisible Hand Principle

50
Invisible Hand

• Invisible hand- the tendency of market prices to
  direct individuals pursuing their own interest
  into productive activities that also promote the
  economic well-being of society.

51
Communicating Information

• Product prices communicate up-to-date information
  about the consumers valuation of additional
  units of each commodity.

• Without the information provided by market price
  it would be impossible for decision-makers to
  determine how intensely a good was desired
  relative to its opportunity cost.

52
Coordinating Actions of Market
Participants

• Price changes bring the decisions of buyers and
  sellers into harmony.

• Price changes create profits and losses which
  change production levels for various products.

53
Prices and Market Order

• Market order is the result of market prices, not
  central planning.

54
Qualifications

• The efficiency of market organization is
  dependent upon

• The presence of competitive markets.
• Well-defined and enforced private property
  rights.

55

• Questions for Thought

1. A drought during the summer of 1988 sharply
reduced the 1988 output of wheat, corn,
soybeans, and hay. Indicate the expected impact
of the drought on the following a. Prices of
feed grains and hay during the
summer of 88. b. Price of cattle during the
fall of 88. (Hint What has
happened to the opportunity cost of
maintaining cattle during the upcoming
winter?) c. Price of cattle during the summer
and fall of 89.
2. What is the invisible hand principle? Does
it indicate that good intentions are necessary
if ones actions are going to be beneficial to
others?
56
EndChapter 3