Transcript Lection 3. Supply and Demand

Natural Price: Context in the Reasonable Dialog
Analysis of a Market
Demand
Law of Demand
Supply
Supply in the Long Run and Short Run
Equilibrium of Supply and Demand
Changes in Demand
Shift Factors in Demand
Changes in Supply
Shift Factors in Supply
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Adam Smith had argued that each good or service has a "natural price." If
the price (of beer, for example), were above the natural price, then more
resources would be attracted into the trade (brewing, in the example),
and the price would return to its "natural" level.
The modern theory of supply and demand differs from Smith's theory in
some important ways. Economists have made some progress in the last
200 years, and great economists such as John Stuart Mill and Alfred
Marshall (and many others) have played their part in the growth of the
modern theory of supply and demand. Nevertheless, the theory of supply
and demand is the modern expression of Smith's great insight about "the
natural price."
To make a long story short, before about the 1850's most economists
accepted the Labor Theory of Value as the theory of the "natural price."
But there were some cases it did not apply to: international trade, for
example. John Stuart Mill suggested a "supply and demand" solution for
prices in international trade. Other economists extended it to apply to
prices in general.
Unlike the "natural price," a long-run theory only, the theory of supply
and demand applies in the short run as well as the long.
Demand is the relationship between price and
quantity demanded for a particular good and service
in particular circumstances.
 For each price the demand relationship tells the
quantity the buyers want to buy at that
corresponding price.
 The quantity the buyers want to buy at a particular
price is called the Quantity Demanded.
 The key point is to distinguish between demand (the
relationship) and quantity demanded. That
distinction is important for microeconomics, although
people often do not make it in ordinary discussion.
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Clearly, the buyers are the people who want or need the product or
service -- but there is more to it than that. The word "demand" refers to the
willingness and ability of people to purchase the good or service in the
market.
The demand relationship expresses that willingness and ability for the
whole range of prices. To say that a person has a demand for a particular
product is to say that the person has money with which to buy and is
willing to exchange the money for the good. People will not demand what
they do not want or need, but a want or a need unbacked by purchasing
power is not a demand.
Similarly, it is not enough that the suppliers possess the good or (the
capacity to perform) the service. Supply also means willingness to sell.
Most of us have experience living in the market economic system, and
that makes economics seem like a common-sense field -- but sometimes
that common-sense feel can be deceptive. People sometimes use the
term "demand" ambiguously -- as if "demand" were the same thing as
need. But it is not. Need without purchasing power will not create effective
demand in the marketplace. Economists sometimes stress this point by
using the term "effective demand" in place of simple "demand."
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Here is an example
based on that estimate.
The prices quoted are
wholesale prices, in
cents of 1972
purchasing power.
Quantity demanded is
measured in millions of
gallons, for the United
States as a whole.
price,
cents/gal.
Quantity
demanded,
millions
of gals.
50
4899.27
60
4355.67
70
3812.07
80
3268.47
90
2724.87
100
2181.27
110
1637.67
120
1094.07
Here is a "demand curve" of the demand for beer in 1960,
based on the estimated numbers from the previous page.
At a higher price, the quantity demanded will be less, ceteris paribus.
(Ceteris paribus means: if nothing else changes to offset the change in price).
 1. The
price must always be adjusted for
inflation. We use the "real" (adjusted)
price, not the nominal price.
 2. The demand relationship can be
represented, and approximated, by
numerical
graphical
mathematical and statistical methods
As with demand, supply may be
represented not only by a table of
numbers, but also by a diagram or a
mathematical equation. Here is a
diagram of the estimated demand for
beer. As before, we put the price on the
vertical axis, and the quantity supplied
on the horizontal axis.
price,
cents/gal.
Quantity
demanded,
millions
of gals.
50
0
60
0
70
0
80
1304.4
90
2894
100
4483.6
110
6073.2
120
7662.8
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With respect to supply, time plays a role that it does not (in most cases) play in the case
of demand.
If there is plenty of time for the suppliers to adjust to a change in the price, we have a
long run analysis. This means the sellers can invest and expand productive capacity, in
response to a high price, or can gradually reduce the productive capacity by underreplacing worn-out equipment in the case of a low price.
However, if the sellers are not sure the high or low price will continue for a long time, a
short run analysis may be more appropriate. In a short run analysis, we treat the plant
and equipment of the industry as inflexibly given. In that case, output can be increased
only by using that fixed plant and equipment more intensively.
Thus, we would expect the adjustment of supply to a change in price to be more
complete in the long run than in the short run.
We do not ordinarily apply the long run versus short run distinction to demand, but there
are some special cases where it might be important. For example, for durable goods
such as cars, buyers might adjust less completely in the short run than in the long, since
they can postpone replacement of their durable goods until the price comes down. In the
long run, the goods wear out and so the consumers cannot postpone replacement long
enough.
In the short run the plant and equipment (productive capacity) of the
industry are fixed
In the long run sellers can change the productive capacity, in response to
the price
The supply relationship will depend on how long the
suppliers have to adjust to a change in the price

This sort of "equilibrium"
exists when the price is just
high enough so that the
quantity supplied just equals
the quantity demanded. If we
superimpose the demand
curve and the supply curve in
the same diagram, we can
easily visualize this
"equilibrium" price. It is the
price at which the two curves
cross. The corresponding
quantity is the quantity that
would be traded in a market
equilibrium.
DEMAND

What we see here is that the quantity demanded
exceeds the quantity supplied -- we have excess
demand. With a price of $30, quantity supplied is
500, while quantity demanded is about 1200. Thus,
demanders will compete against one another,
offering higher prices for the limited supply, and
the price will rise.
SUPPLY

Here we have excess supply -- the quantity
supplied exceeds the quantity demanded.
Quantity supplied is 2000 at a price of 40,
while quantity demanded is only 600. Thus,
suppliers will compete to sell what they
can by cutting the price.
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What we have seen is that the price will
be in constant motion, up or down,
except when quantity demanded is
equal to quantity supplied. That is the
position of rest.
Put another way, it is the price toward
which competition pushes the price. At
equilibrium, there is no competition
either to buy or to sell, because
everyone can buy or sell however much
they may wish, at the going price. But
whenever the market is away from
equilibrium, competition will arise and
tend to force it back.
Competition eliminates itself, by forcing
the market into an equilibrium in which
there is no need to compete. (This is a
very different concept of competition
than the biological "struggle for
survival!)
We have seen that competition forces the
market into equilibrium. However, this
might fail if:
 There is only one seller or buyer, hence
no competition
 Sellers or buyers agree ("conspire") not
to compete in this way
 It is illegal to compete by offering a
higher or lower price
 People are unable to compete by price
offer -- for example, they do not know
who else buys or sells the item, or are
unsure of the quality of the good or
dervice offered by other traders.
INCREASE
DECREASE
Here are some things that would cause the demand
curve to shift:
1. A change in income for the average consumer.
 If an increase in income causes an increase in the
demand for a particular good, that good is called a
"normal" good. Example: steak.
 If an increase in income causes a decrease in the
demand for a particular good, that good is called an
"inferior" good. Example: red beans.
2. A change in the population.
3. Changes in the prices of other goods.
 Complements.
 Substitutes.
4. Changes in consumer tastes.
INCREASE
DECREASE
Here are some things that would cause the
supply curve to shift:
1. Changes in the prices of input goods.
 Labor
 Raw materials
2. A change in technology.
3. Changes in natural conditions.
 Rainfall
 Environmental Conditions
DEMAND

Before the increase in income, demand was
D1 and supply was S, so that the equilibrium
quantity of food sold was Q1 and the price
per unit of food sold was p1. However, the
increase in income resulted in a shift of the
demand curve rightward, as shown by D2,
and a new equilibrium quantity at Q2 and a
price of p2.
SUPPLY
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With normal weather, supply would be
S1 and demand is D, so that the
equilibrium quantity of food sold was Q1
and the price per unit of food sold was
p1. However, bad weather shifts the
supply curve leftward, as shown by S2,
and a new equilibrium quantity at Q2
and a price of p2.
EXCISE TAX
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The figure shows the impact of an excise tax. From
the point of view of sellers, the tax decreases
demand from D to D'; the vertical distance
between the two curves is the tax. The price paid
to the seller falls, but not as much as the tax,
because the cutback in production moves
downward along the supply curve.
SUBSIDY
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Accordingly, the figure shows the subsidy shifting the supply
curve to the right, from S1 to S2. The vertical distance is the
amount of the subsidy: one dollar per bushel. Demand is D,
as usual. With supply S1 -- before the subsidy is given -- the
market equilibrium price is p1 and the equilibrium
production is Q1. With supply S2 -- when the subsidy is given
-- the market equilibrium price is p2 and the equilibrium
production is Q2. We may conclude that a subsidy per unit of
production reduces the market price (though not quite by
the full amount of the subsidy) and increases the production
of the item subsidized.
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Sometimes we need to know
something about the numerical
characteristics of the demand
relationship. For example: we
know that if the price is cut,
quantity sold will increase. But
how much will it increase.
We cannot say much about this in
general. The answer will vary
from industry to industry. The
answer may be different for
agriculture, for example, than for
computers.
What we can do is define some
general terminology and
principles to understand these
differences.
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Elasticity of demand is a
measure of how strongly the
quantity demanded responds
to a change in price.
We can see that the elasticity
is related to the slope (and the
derivative) but is not quite the
same as the slope of the
demand curve.
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While elasticity and slope are not the same
thing, we can roughly correlate elastic
demand with a shallow slope of the demand
curve, and conversely. The figure above
shows an example of high elasticity: a
small decline in price (about 20%) leads to
a large increase in quantity (about 120%),
so that elasticity would be about 6.

This figure shows an example of
inelasticity: a large decrease in price
(about 75%) leads to a small increase in
quantity (about 25%), so that elasticity
would be about 0.33.
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e>1 we say that "demand is
elastic."
As in "The demand for
computers is elastic."
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e<1 we say that "demand is
inelastic."
As in "The demand for
public transportation is
inelastic."
Elasticity will be greater:
•When substitutes are closer and more numerous
•When the proportion of the budget spent is larger
Elasticity is a key to
understanding the relationship
between price and sales
revenue.
Example: Demand for public
transportation is inelastic -probably about 0.3. So, when
the price is raised by 1%,
quantity demanded declines by
only three-tenths of 1%, and
revenue increases by seventenths of 1%.
Example: The demand for
computers is elastic, so when
prices are cut by 1%, quantity
demanded increases by more
than 1%, and sales revenue
increases.
When
elasticity is
And price
Then
revenue
>1
increases
decreases
>1
decreases
increases
=1
increases
doesn't
change
=1
decreases
doesn't
change
<1
increases
increases
<1
decreases
decreases

Economists use formulae
like "elasticity" to
measure the
responsiveness of
quantity demanded (and
other things) to various
influences.
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For example, we have the
income elasticity of
demand. If the income
elasticity is greater than
one (demand is incomeelastic) then demand
increases more than
proportionately with
income.
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In the agriculture puzzle, it's pretty clear from statistical studies that the income elasticity of demand
for agricultural products (mostly unprocessed food) is less than one. In other words, the demand for
agricultural products is income-inelastic, and that means that the demand for agricultural goods
increases less than in proportion to the overall increase in income. If follows that, when overall income
is increasing, agriculture's share would be decreasing, even if nothing else changed.
For example, suppose that we start with a national income of 100 billion, and farm production is 10
billion, a 10% share. Income increases by 10% to 110 billion, and farm demand and production
increase by 2.5% to 10.25 billion. That reduces the farm share to 9.3%.
This means that, even without the increasing efficiency of farming and the dropping prices, farm
incomes would have been less in proportion to total incomes. When we add the two facts together, we
get a powerful explanation for the decline of the farm industry.
Income elasticity is also a complication for public transportation. It is clear that the demand for public
transportation is income inelastic -- and in fact, it seems likely that public transportation is an inferior
good. I haven't seen clear evidence one way or another on that, but it seems that as people get better
off, they shift from the busses and the subways to their private cars, and if enough of them do it it could
make for a negative income elasticity of demand -- an inferior good.
That would help to explain the recurring crises in public transportation. As the community as a whole
gets better off, demand for most public transportation services drops. (There probably are a few
exceptions). To cover the costs of providing public transportation, it's necessary to raise revenue -- and
because of the inelastic demand (with respect to price), the only way to do that is to raise the fare,
further cutting use of the service.
As we can see, income elasticity of demand, like price elasticity, is an important tool for understanding
economic events.
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Sometimes the price of
one good will influence
the demand for another
good.
If the cross elasticity is
positive then the two
goods are substitutes. If
it is negative, then they
are complements.
For example, butter
and margarine are
substitutes, so we
would expect their
cross-elasticities to be
positive.
We can also apply the elasticity concept to
the supply curve.
We would use the "elasticity of supply" to
measure the response of the supply
curve to a change in price.
 Demand
and Supply in economical
mechanisms
 Factors of demand and supply
 Law of demand
 Market’s reactions for demand’s or
supply’s increase\decrease
 Some means for market’s distortions