Modern Principles: Macroeconomics

Tyler Cowen and Alex Tabarrok

Chapter 2 Supply and Demand

Copyright © 2010 Worth Publishers • Modern Principles: Macroeconomics • Cowen/Tabbarrok

• •

Introduction

The model of

supply and demand

one of the most important tools in economics.

is The model is a simple presentation of exchange that captures the behavior of both buyers and sellers.

Slide 2 of 55

• •

The Demand Curve for Oil

Demand represents the behavior of buyers.

A

Demand Curve

is a function that shows the quantity demanded at different prices.

 The

Quantity Demanded

is the quantity that buyers are willing and able to purchase at a particular price.

Slide 3 of 55

• •

The Demand Curve for Oil

The

Law of Demand

indicates an inverse relationship between price and quantity demanded.

 When price rises, all else equal, quantity demanded falls.

 When price falls, all else equal, quantity demanded rises.

Demand curves consistent with the law of demand are downward sloping.

Slide 4 of 55

Demand Curves

The Demand Curve for Oil is a Function Showing the Quantity of Oil Demanded at Different Prices Price of Oil per Barrel $55

Price

$55 $20 $5

Quantity Demanded

5 25 50 $20 $5 5 25 50 Demand Quantity of Oil (MBD) Slide 5 of 55

• •

Demand Curves

Demand curves can be read in two ways: 

Horizontally:

How much buyers are willing and able to purchase at a given price.



Vertically:

The maximum price for which buyers are willing to pay for a given quantity.

Demand curves thus reveal the quantity demanded at a given price or the maximum willingness to pay for a given quantity.

Slide 6 of 55

The Demand Curve for Oil

Horizontal Reading Price of Oil per Barrel $55 Start $20 $5 5 25 End 50 Demand Quantity of Oil (MBD) Slide 7 of 55

The Demand Curve for Oil

Vertical Reading Price of Oil per Barrel $55 End $20 $5 5 25 Start 50 Demand Quantity of Oil (MBD) Slide 8 of 55

•

Demand Curves

Why is the demand curve

downward sloping

?

 A good is not equally valuable in all of its uses.

• At a high price, a good is consumed in only its highest valued use.

• At a low price, a good is also consumed in its lower valued uses.

 The value of a good’s use will depend on the availability of substitutes.

Slide 9 of 55

The Demand Curve for Oil

When the price of oil is high, oil will only be used in higher valued uses. As the price falls, oil will also be used in lower valued uses Price of Oil per Barrel Higher Valued Uses of Oil $120 $20 20 120 Lower Valued Uses of Oil Demand Quantity of Oil (MBD) Slide 10 of 55

• • •

Consumer Surplus

Consumer Surplus

is the consumer’s gain from exchange, or the difference between the maximum price a consumer is willing to pay for a given quantity and the market price.

Total consumer surplus is the sum of consumer surplus of all buyers.

Graphically, total consumer surplus is measured by the area below the demand curve and above the price.

Slide 11 of 55

Consumer Surplus

Consumer Surplus is the Area beneath the Demand Curve and above the Price Price of Oil per Barrel The President’s Consumer Surplus Height Area of Triangle 80 Total Consumer Surplus at a Price of $20 ½(Base x Height) Base Joe’s Consumer Surplus ½(80-20)x90 = $2,700 20 90 Demand Quantity of Oil (MBD) Slide 12 of 55

•

What Shifts the Demand Curve?

The demand curve  An

increase

in demand means that quantity demanded at a given price increases, or the maximum willingness to pay for a given quantity rises.

• Graphically, an increase in demand shifts the demand curve

outwards, up, and to the right

.

 A

decrease

in demand means that quantity demanded at a given price decreases, or the maximum willingness to pay for a given quantity falls.

• Graphically, a decrease in demand shifts the demand curve

inwards, down, and to the left

.

Slide 13 of 55

Change in Demand

An Increase in Demand Price per Unit $50 Greater Willingness to Pay for the Same Quantity Greater Quantity Demanded at the Same Price $25 70 80 New Demand Old Demand Quantity Slide 14 of 55

Change in Demand

A Decrease in Demand Price per Unit $50 Lower Willingness to Pay for the Same Quantity Less Quantity Demanded at the Same Price $25 70 80 Old Demand Curve New Demand Curve Quantity Slide 15 of 55

•

Important Demand Shifters

Important Demand Shifters 1.

Income 2.

Population 3.

Price of Substitutes 4.

Price of Complements 5.

Expectations 6.

Tastes Slide 16 of 55

Important Demand Shifters - Income

1.

The effect of changes in income on demand depends on the nature of the good in question.

 A

Normal Good

is a good for which demand increases (decreases) when income increases (decreases).

 An

Inferior Good

is a good for which demand decreases (increases) when income increases (decreases).

Slide 17 of 55

Important Demand Shifters - Population

2.

As the

population

of an economy changes, the

number of buyers

of a particular good also changes, directly influencing its demand.

 More buyers of a good increases its demand.

 Fewer buyers of a good decreases its demand.

Slide 18 of 55

Important Demand Shifters - Price of Substitutes

3.

Two goods are

Substitutes

if a decrease (increase) in the price of one good leads to a decrease (increase) in demand for the other good.

Slide 19 of 55

Important Demand Shifters - Price of Complements

4.

Two goods are

Complements

if a decrease (increase) in the price of one good leads to an increase (decrease) in the demand for the other.

Slide 20 of 55

Important Demand Shifters - Expectations

5.

The

expectation

of a higher (lower) price for a good in the future increases (decreases) current demand for the good.

 Consumers will adjust their current spending in anticipation of the direction of future prices in order to obtain the lowest possible price. Slide 21 of 55

Important Demand Shifters - Tastes

6.

Tastes and preferences are subjective and will vary among consumers.

 Some issues like seasonal changes or fads, however, will have rather predictable effects on demand.

Slide 22 of 55

•

What Shifts the Demand Curve?

A

change in quantity demanded

is

NOT

the same as a

change in demand

.

 Quantity demanded changes only when the price of a good changes.

 Graphically, a change in quantity demanded is represented by a movement along a fixed demand curve.

 Demand changes only when a non-price factor (demand shifter) changes.

 Graphically, a change in demand is represented by a shift in the entire demand curve.

Slide 23 of 55

CHECK YOURSELF  Economic growth in India is raising the incomes of Indian workers. What do you predict will happen to the demand for automobiles? What about the demand for charcoal bricks for home heating?

 As the price of oil rises, what do you predict will happen to the demand for mopeds?

Slide 24 of 55

• •

The Supply Curve for Oil

Supply represents the behavior of sellers.

A

Supply Curve

is a function that shows the quantity supplied at different prices.

 The

Quantity Supplied

is the quantity that producers are willing and able to sell at a particular price.

Slide 25 of 55

• •

The Supply Curve for Oil

The

Law of Supply

indicates a direct relationship between price and quantity supplied.

 When price rises, all else equal, quantity supplied rises.

 When price falls, all else equal, quantity supplied falls.

Supply curves consistent with the law of supply are upward sloping.

Slide 26 of 55

Supply Curves

The Supply Curve for Oil is a Function Showing the Quantity of Oil Supplied at Different Prices Price of Oil per Barrel $55 Supply Curve for Oil

Price

$55 $20 $5

Quantity Supplied

50 30 10 $20 $5 10 30 50 Quantity of Oil (MBD) Slide 27 of 55

• •

Supply Curves

Supply curves can be read in two ways: 

Horizontally:

How much suppliers are willing and able to sell at a given price.



Vertically:

The minimum price for which suppliers are willing to sell a given quantity.

Supply curves, thus, reveal the quantity supplied at a given price, or the minimum price at which suppliers will sell a given quantity.

Slide 28 of 55

The Supply Curve for Oil

Horizontal Reading Price of Oil per Barrel $55 Supply Curve for Oil Start $20 $5 10 30 End 50 Quantity of Oil (MBD) Slide 29 of 55

Supply Curves

Vertical Reading Price of Oil per Barrel $55 Supply Curve for Oil End $20 $5 10 30 Start 50 Quantity of Oil (MBD) Slide 30 of 55

•

Supply Curves

Why is the supply curve

upward sloping

?

 The cost of producing a good is not equal across all suppliers.

• At a low price, a good is produced and sold only by the lowest cost suppliers.

• At a high price, a good is also produced and sold by higher cost suppliers.

Slide 31 of 55

The Supply Curve for Oil

The Supply Curve for Oil Price of Oil per Barrel $60 Supply Oil Shale Profitable Here $40 Higher Cost Oil $20 Low Cost Oil 20 40 60 80 100 Quantity of Oil (MBD) Slide 32 of 55

• • •

Producer

Surplus

Producer Surplus

is the producer’s gain from exchange, or the difference between the market price and the minimum price at which producers would be willing to sell a given quantity.

Total producer surplus is the sum of the producer surplus of each seller.

Graphically, total producer surplus is measured by the area above the supply curve and below the price.

Slide 33 of 55

Producer Surplus

Producer Surplus is the Area Above the Supply Curve and Below the Price Price of Oil per Barrel $60 Supply Curve $40 $20 20 40 Total Producer Surplus at a Price of $40 60 80 Quantity of Oil (MBD) Slide 34 of 55

•

Important Supply Shifters

Changes in Supply  An

increase in supply

means that quantity supplied at a given price increases, or the minimum willingness to sell for a given quantity falls.

• Graphically, an increase in supply shifts the supply curve down and to the right.

 A

decrease in supply

means that quantity supplied at a given price decreases, or the minimum willingness to sell a given quantity rises.

• Graphically, a decrease in supply shifts the supply curve up and to the left.

 Changes in supply are

inversely

related to the costs of production.

Slide 35 of 55

Change in Supply

Lower Costs Increase Supply Price of Oil per Barrel Greater Quantity Supplied at the Same Price Old Supply New Supply $50 $10 20 Willing to Sell Same Quantity at Lower Prices 80 Quantity of Oil (MBD) Slide 36 of 55

Change in Supply

Higher Costs Decrease Supply Price of Oil per Barrel Smaller Quantity Supplied at the Same Price New Supply Old Supply $50 $10 20 Higher Price Needed to Sell Same Quantity 80 Quantity of Oil (MBD) Slide 37 of 55

•

Important Supply Shifters

Important Supply Shifters 1.

Technological Innovations 2.

Input Prices 3.

Taxes and Subsidies 4.

Expectations 5.

Entry or Exit of Producers 6.

Changes in Opportunity Costs Slide 38 of 55

Important Supply Shifters - Technological Innovations

1.

A technological innovation makes sellers willing to supply a greater quantity at a given price, or the new technology allows producers to sell a given quantity at a lower price.

 A technological innovation

lowers costs

and

increases supply

.

Slide 39 of 55

Important Supply Shifters - Input Prices

2.

A decrease (increase) in the price of an input makes sellers willing to supply a greater (lesser) quantity at a given price, or the lower (higher) input price allows  producers to sell a given quantity at a lower (higher) price.

A decrease (increase) in the price of an input lowers (raises) costs and increases (decreases) supply.

Slide 40 of 55

Important Supply Shifters - Taxes and Subsidies

• 3.

 A

tax

on output makes sellers willing to supply a lesser quantity at a given price, or the tax forces producers to sell a given quantity at a higher price.

A tax on output raises costs and decreases supply.

 A

subsidy

on production makes sellers willing to supply a greater quantity at a given price, or the subsidy allows producers to sell a given quantity at a lower price.

A subsidy on production lowers costs and increases supply.

Slide 41 of 55

Important Supply Shifters - Taxes and Subsidies

With a $10 Tax Suppliers Require a $10 Higher Price to Sell the Same Quantity Price of Oil per Barrel Supply With $10 Tax $50 Supply Without Tax $40 60 Quantity of Oil (MBD) Slide 42 of 55

Important Supply Shifters - Expectations

4.

The expectation of a higher (lower) price for a good in the future decreases (increases) current supply of the good.

 Sellers will adjust their current offerings in anticipation of the

direction of future prices

in order to obtain the highest possible price.

Slide 43 of 55

Important Supply Shifters - Expectations

Expectations Can Shift the Supply Curve Price per Unit Supply Today with Expectation of Future Price Increase Supply Today Into Storage Quantity Slide 44 of 55

Important Supply Shifters - Entry or Exit of Producers

5.

As producers enter and exit the market, the number of sellers of a particular good changes, directly influencing supply.



Entry

implies more sellers in the market

increasing supply

.



Exit

implies fewer sellers in the market

decreasing supply

.

Slide 45 of 55

Important Supply Shifters - Entry or Exit of Producers

Entry Increases Supply Price Greater Quantity Supplied at the Same Price Domestic Supply Domestic Supply Plus Canadian Imports Lower Price for the Same Quantity Supplied Quantity Slide 46 of 55

Important Supply Shifters - Changes in Opportunity Costs

6.

Inputs used in production have

opportunity costs

, and sellers will choose to employ those inputs in the production of the highest priced finished goods.

 Sellers will supply less (more) of a good if the price of an alternate good using the same inputs rises (falls).

Slide 47 of 55

Important Supply Shifters – Changes in Opportunity Costs

Higher (Opportunity) Costs Reduce Supply Price per Unit Higher Price Required to Sell the Same Quantity $7 Supply with High Opportunity Costs Supply with Low Opportunity Costs $5 2,000 Smaller Quantity Supplied at the Same Price Quantity of Soybeans (Millions of Bushels) 2,800 Slide 48 of 55

•

What Shifts the Supply Curve?

A

change in quantity supplied

is

NOT

the same as a

change in supply

.

 Quantity supplied changes only when the price of a good changes.

 Graphically, a change in quantity supplied is represented by a movement along a fixed supply curve.

 Supply changes only when a non-price factor changes.

 Graphically, a change in supply is represented by a shift in the entire supply curve.

Slide 49 of 55

CHECK YOURSELF  Technological innovations in chip making have driven down the costs of producing computers. What happens to the supply curve for computers? Why?

 The U.S. government subsidizes making ethanol as a fuel made from corn. What effect does the subsidy have on the supply curve for ethanol?

Slide 50 of 55

• • • • • 

Takeaway

Demand represents the behavior of buyers.

A demand curve is a function that shows the quantity demanded at different prices.

Demand curves are downward sloping.

Consumer Surplus is the consumer’s gain from exchange, or the difference between the maximum price a consumer is willing to pay for a given quantity and the market price.

Graphically, total consumer surplus is measured by the area below the demand curve and above the price.

Slide 51 of 55

• • • 

Takeaway

An increase in demand shifts the demand curve upward, out, and to the right.

A decrease in demand shifts the demand curve inward, down, and to the left.

Important Demand Shifters 1.

2.

3.

4.

5.

6.

Income Population Price of Substitutes Price of Complements Expectations Tastes Slide 52 of 55

• • • • • 

Takeaway

Supply represents the behavior of sellers.

A supply curve is a function that shows the quantity supplied at different prices.

Supply curves are upward sloping.

Producer Surplus is the producer’s gain from exchange, or the difference between the market price and the minimum price at which producers would be willing to sell a given quantity.

Graphically, total producer surplus is measured by the area above the supply curve and below the price.

Slide 53 of 55

• • • 

Takeaway

An increase in supply shifts the supply curve down and to the right.

A decrease in supply shifts the supply curve up and to the left.

Important Supply Shifters 1.

2.

3.

4.

5.

6.

Technological Innovations Input Prices Taxes and Subsidies Expectations Entry or Exit of Producers Changes in Opportunity Costs Slide 54 of 55