Transcript Chapter 5 SUPPLY AND DEMAND: AN INITIAL LOOK

Demand, Supply
and Equilibrium
Contents
● Deriving the Supply Curve
● Supply and Demand Equilibrium
● Effects of Demand and Supply Shifts on
Equilibrium
● Welfare Properties of Equilibrium
● Fighting the Invisible Hand: The Market
Fights Back
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The Invisible Hand
● Supply and demand  automatic solution
to economic problems
● Interference in markets 
counterproductive consequences
● Invisible hand = in the pursuit of selfinterest, individuals promote social wellbeing
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Deriving Supply Curve
● Recall example with garages from previous
lecture
● Consider the cost schedule for Al
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1: Al’s Total, Average, and
Marginal Costs
TABLE
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Marginal Cost per Added Garage (thousands $)
FIGURE
1: Marginal Cost Curve
50
MC
45
40
35
30
25
20
15
10
5
0
1
2
3
4
5
6
7
8
Output, Garages per Year
(c) Marginal Cost
9
10
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Supply Curve
● Supply curve of a firm is the increasing part
of its marginal cost curve
● Why only increasing part?
♦ Because when MC decrease with Q, it is
optimal to increase output
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2: Marginal Cost Curve
and Supply Curve
Marginal Cost per Added Garage (thousands $)
FIGURE
50
MC
45
40
35
Supply Curve
30
25
20
15
10
5
0
1
2
3
4
5
6
7
8
Output, Garages per Year
Marginal Cost
9
10
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From Individual to Market
Supply
● We derived supply of single firm
● In every market there are usually many
producers
● The market supply is a sum of all individual
supply curves
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Supply and Quantity
Supplied
● Sellers (producers)  supply
● Quantity supplied = amount that producers
wish to sell at each price
● Law of supply = price and the quantity
supplied are positively related, all else equal
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2
Supply Schedule for Milk
TABLE
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Supply and Quantity
Supplied
● The Supply Schedule and the Supply Curve
♦ Supply Schedule = a table showing the
quantity of demand at each price for some good
♦ Supply Curve = graph of a supply schedule
■Positive slope
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3
Supply Curve for Milk
FIGURE
a
$1.50
S
b
Price per Quart
1.40
c
1.30
e
1.20
f
1.10
g
1.00
h
.90
0
S
30
40
50
60
70
80
90
Quantity Supplied
in Billions of Quarts per Year
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Supply and Quantity
Supplied
● Shifts of the Supply Curve
♦ Movement along a supply curve due to
■Changes in price
♦ Shift between supply curves due to
■Changes in industry size (entry and exit)
■Changes in production technology
■Changes in prices of inputs
■Changes in prices of related outputs
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4 Movements along
versus Shifts of a Supply Curve
FIGURE
S0
Price per Quart
S1
c
$1.30
f
1.10
S0
S1
Quantity Supplied
in Billions of Quarts per Year
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5
Shifts of the Supply Curve
FIGURE
S2
S0
Price
S1
S0
Price
S0
S2
S1
S0
Quantity
(a)
Quantity
(b)
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Refresher on Demand
● Buyers  demand
● Quantity demanded = the amount that
buyers wish to purchase at each price
● Law of demand = price and the quantity of
demand are negatively related, all else equal
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Refresher on Demand
● The Demand Schedule
♦ Table showing the quantity of demand at each
price for some good
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3
Demand Schedule for Milk
TABLE
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Demand and Quantity
Demanded
● The Demand Curve
♦ Graph of a demand schedule
♦ Negative slope
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FIGURE
6 Demand Curve for Milk
Price per Quart
D
$1.50
A
B
1.40
C
1.30
E
1.20
F
1.10
G
1.00
H
.90
D
0
45
50
55
60
65
70
75
Quantity Demanded
in Billions of Quarts per Year
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Demand and Quantity
Demanded
● Shifts of the Demand Curve
♦ Movement along a demand curve due to
■Changes in price
♦ Shift between demand curves due to
■Changes in consumers’ incomes
■Changes in number of consumers (population)
■Changes in consumers’ preferences (tastes)
■Changes in prices and availability of related goods
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7 Movements along a
versus Shifts of a Demand Curve
FIGURE
D1
Price per Quart
D0
$1.30
1.10
C
F
D1
D0
Quantity Demanded in Billions of Quarts per year
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Supply and Demand
Equilibrium
● There is normally one price where quantity of
supply = quantity of demand
● This price  equilibrium
● An equilibrium price on the market is such
that at this price quantity demanded is equal to
the quantity supplied
*
*
● So equilibrium is a pair P ,Q


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Supply and Demand
Equilibrium
● Below equilibrium price  shortage
● Above equilibrium price  surplus
● Surpluses and shortages  changes in price
● Changes in price  restoration of
equilibrium
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4 Equilibrium Price &
Quantity of Milk
TABLE
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Supply and Demand
Equilibrium
● Interaction of supply and demand 
equilibrium
● A market not in equilibrium  equilibrium
● Equilibrium = a state of rest
● “Outside events” cause a change of the
equilibrium
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8
Supply-Demand Equilibrium
FIGURE
D
a
A
$1.50
S
Price per Quart
1.40
1.30
E
1.20
1.10
g
G
1.00
.90
0
D
S
30
40
50
60
70
80
90
Quantity
in Billions of Quarts per Year
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Demand Shifts on SupplyDemand Equilibrium
● Shifts in Demand
♦ Changes in any of the non-price determinants
of demand and/or supply  change of
equilibrium
♦ Shifts of the demand curve  change
equilibrium price and quantity in the same
direction
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9 The Effects of Shifts of
the Demand Curve
FIGURE
D1
S
T
$1.30
E
1.20
D0
Price per Quart
Price per Quart
D0
R
S
D2
E
$1.20
L
M
1.10
D1
D0
S
60 70 75
Quantity
(a)
D0
S
D2
45 50 60
Quantity
(b)
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Supply Shifts and SupplyDemand Equilibrium
● Shifts in Supply
♦ Shifts of the supply curve  change in
equilibrium price and quantity in opposite
directions
♦ Old equilibrium position  new equilibrium
position
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10 Effects of Shifts of
the Supply Curve
FIGURE
S2
D
S0
E
I
$1.20
J
1.10
S1
V
Price per Quart
Price per Quart
D
$1.40
S0
E
U
1.20
S2
S0
S0
S1
D
60
Quantity
(a)
65
D
78
37.5
50
60
Quantity
(b)
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Rule of Thumb
● When demand curve shifts, we move along
the supply curve
● When supply curve shifts, we move along
the demand curve
● Always draw a diagram to make sure you
understand what happens
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Sometimes we cannot say
much…
● When both supply and demand curve shift,
we usually have problems with predicting
new equilibium:
♦ Can predict price, not quantity
♦ Or can predict quantity, not price
● Because it is the degree of shifts in both
curves that determine the final outcome
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Consumer Surplus
● Consumer Surplus is the difference
between the maximum amount that the
consumer is willing to pay for the product
and the price that she actually gets to pay
● Graphically it is the area above the
equilibrium price and below the market
demand line
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Producer Surplus
● Producer Surplus is the difference
between the price at which the producer
happens to sell the product and her costs
(i.e. the smallest amount of money she is
willing to accept in exchange for the
product she offers)
● Graphically it is the area below the
equilibrium price and above the market
supply line
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11 Consumer and
Producer Surplus
FIGURE
$1.50
D
Price per Quart
1.40
1.30
S
CS
1.20
1.10
PS
1.00
.90
0
30
40
50
60
70
80
90
Quantity
in Billions of Quarts per Year
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Some Geometry Refresher
● Area of the triangle:
1
S   base  height
2
● Let us compute these for the example we just had
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Calculating CS and PS
● CS:
♦ base = 60 − 0 = 60
♦ height = 1.50 − 1.20 = 0.3
♦ Area = 0.5 * 60 * 0.3 = $9 bln
● PS:
♦ base = 60 − 0 = 60
♦ height = 1.20 − 1.00 = 0.2
♦ Area = 0.5 * 60 * 0.2 = $6 bln
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Total Surplus and Welfare
● Welfare is understood in economics as some
measure of well-being of agents
♦ We saw an example – utility of consumer
● For market with many agents, natural
measure is Total Surplus (TS)
● TS = CS + PS
● In previous example, TS = 9 + 6 = $15 bln
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Why Market Economy?
● We like free market economy because it
maximizes Total Surplus
● Only those buyers with high willingness to
pay buy
● Only those sellers with low costs sell
● Total Surplus is the biggest possible in this
case
● This says nothing about equality!
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Fighting the Invisible Hand:
The Market Fights Back
● A Can of Worms
♦ Favoritism and corruption
♦ Unenforceability
♦ Limitation of the volume of transactions
♦ Misallocation of resources
● Let us see what our model predicts about
fighting the invisible hand
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Welfare Analysis of Policies
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Benchmark Case
● We first analyze the case when the market
system works on its own
● This is the benchmark case
● We will show all other cases decrease TS
● Here CS = A + B + C
●
PS = H + L + G
●
TS = A + B + C + H + L + G
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Benchmark Case
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Price Ceiling
● Now suppose government introduces price
ceiling
● Must be below P2, say, P3
● What are CS, PS, TS now?
● Since at P3 quantity demanded exceeds
quantity supplied, there is shortage
● So only Q 1 units are sold
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Price Ceiling
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Price Ceiling
● Here CS = A + B + G
●
PS = L
●
TS = A + B + L + G
● Notice the blue triangle C + H is now NOT
in the TS
● This is called Dead Weight Loss (DWL) –
measure of inefficiency
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Fighting the Invisible Hand:
The Market Fights Back
● Restraining the Market Mechanism: Price
Ceilings
♦ Shortages
♦ Black markets with higher prices
♦ Underinvestment
♦ Vested interests that resist change
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Price Floor
● Now suppose government introduces price
floor
● Must be above P2, say, P1
● What are CS, PS, TS now?
● Since at P1 quantity supplied exceeds
quantity demanded, there is surplus
● Again only Q1 units are sold
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Price Floor
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Price Floor
● Here CS = A
●
PS = L + B + G
●
TS = A + B + L + G
● Notice the blue triangle C + H is now NOT
in the TS again
● So we again have DWL from interfering
with the market mechanism
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Fighting the Invisible Hand:
The Market Fights Back
● Restraining the Market Mechanism: Price
Floors
♦ Surpluses
♦ Disposal problems
♦ Overinvestment
♦ Vested interests that resist change
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More Complicated Example
● By simply fixing price we make some group
better off at the expense of the other group
● Total result is negative, however
● Maybe government can help?
● Suppose again fix price at P1 as a floor,
but government buys all the surplus that
consumers do not want to buy
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More Complicated Example
Extra
Costs
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More Complicated Example
● Clearly costs of government intervention do
not compensate the extra gain for producer
● So intervention is in general not a good idea
● Later on in the course we will see examples
when government intervention is beneficial
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Tax Policy Analysis
● Suppose government wants to introduce a
tax on producers
● There are many different taxes
● We consider the easiest – per-unit sales tax
● It means that producers have to pay a fixed
amount of money to the government for
every unit they have sold
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Tax Policy Analysis
● Costs of producers stay the same
● So they translate tax into price one-for-one
♦ Suppose the government introduces a sales tax of 10
cents per gallon of milk
♦ This shifts supply curve up
♦ How much equilibrium changes is determined by
demand elasticity
● However, all tax burden is split between
consumer and producer
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10 Who Pays for a New
Tax on Products?
FIGURE
Price per Gallon
D
S1
M
$1.64
E1
1.60
S0
1.54
S1
E0
D
S0
Q2
Q1
30
50
Millions of Gallons per Year
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Tax Policy Analysis
● Notice that both consumers and producers
pay tax, even though government wants to
tax producers only
● How tax burden is split between consumers
and producers?
♦ Depends on price elasticities of supply and
demand
♦ Or, more precise, on the relative elasticity
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A Simple But Powerful
Lesson
● Self-interested actions of buyers and sellers
 laws of supply and demand
● Difficult to resist
● Interference  counterproductive effects
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The End
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