Transcript Supply and Demand - Wayne State College

Demand and Supply
This material is about markets and
how price and quantity traded are
determined in a market.
1
Overview
The model of demand and supply is the basic model of how
buyers and sellers interact in a market. Some goals of this
chapter are that you learn about 1) the separate parts of the model
(the demand part and the supply part), 2) how the separate parts
interact to give us a market price and market quantity traded, and
3) how one market outcome may have an impact on another
market.
In the recent past year we have seen that changes in the oil
market have lead to changes in the gasoline market, and changes
in the gas market have lead to changes the SUV market.
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 human’s 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
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Supply and Demand Graph
P
S1
P1
D1
Q
Q1
By the way, in the
graph we have
numbers. You
should think
numerically. Say P1
= $2.50 and Q1 = 52.
Any price higher
than P1 is more than
2.50 and any
quantity more than
Q1 is more than 52.
What is the quantity on the supply curve if the price is 1.75? Can the
quantity be 52?
5
Demand Increase
When demand
increases (the
demand curve
shifting to the right)
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
Conclusion: When demand rises both P and Q in the market rise.
6
Demand Decrease
When demand
decreases (the
demand curve shifts
to the left) the market
price decreases to P2
and the quantity
traded decreases to
Q2.
P
S1
P1
P2
D1
D2
Q
Q2
Q1
Conclusion: when demand falls P and Q in the market fall.
7
Supply Increase
When the supply
increases (the supply
curve shifts to the
right) we see a lower
market price P2 and
a higher quantity
traded Q2.
P
S1
S2
P1
P2
D1
Q
Q1
Q2
Conclusion: A higher supply means the price in the market falls but
the quantity traded in the market rises.
8
Supply Decrease
P
When the supply
falls (the supply
curve shifting to the
left) the market
prices rises to P2 and
the quantity traded
falls to Q2.
S2
S1
P2
P1
D1
Q
Q2 Q1
Conclusion: when supply falls the market price rises and the quantity
traded in the market falls.
9
Now, let’s 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.
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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
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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.
Price
at the
point
Quantity, Q
Quantity at the point
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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
(which we will study in a
little while).
D1
Quantity, Q
13
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.
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Law of Demand
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.
P
1) The demand curve is downward sloping as
you look at the graph from left to right, and
D
2) The demand curve is in a certain position or
location that could change.
Q
Let’s think about each of these points in more detail. Let’s 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.
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Law of Demand
Here are 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 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
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units if a lower price can be paid.
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.)
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P
P1
In the graph at P1, although folks
could probably buy more of the
product, quantity demanded is
only Q1.
D
Q1
Q
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.
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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
Q1
Q
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 (the ceteris
paribus assumption). 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.
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People’s 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.
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Determinants of Demand
Determinant of demand change
Consumer taste for the good rises
Consumer taste for the good falls
Income increase for normal good
Income decrease for normal good
Income increase for inferior good
Income decrease for inferior good
Complementary good price increase
Complementary good price decrease
Substitute good price increase
Substitute good price decrease
Increase in consumers in market
Decrease in consumers in market
Price expected in future rises
Price expected in future falls
demand shifts to
right
left
right
left
left
right
left
right
right
left
right
left
right
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left
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 don’t 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 CD’s 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
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here.
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.
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Determinants 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.
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Demand from many
Consumers
A determinant of demand
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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. Let’s start with just two consumers
in the market.
P
P
P
c1
Consumer 1
Q
Consumer 2
Q
Market
c2
Q
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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.
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P
Supply in general refers to how much of a
product producers want to sell. In the graph
here you should note two things.
S
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.
Q
Let’s 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.
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Let’s 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.
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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
Q1
Q
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.
30
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
P
S
P1
Q1
Q
understanding that other things that influence supply are
held constant (the ceteris paribus assumption). 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
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unit. Producers would rather do something else.
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 is called 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 32
we say there is a change in the quantity supplied.
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.
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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 other goods rises
they devote more resources there than in the past and
supply rises for that good, but supply for other goods they
make falls.
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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 won’t know until later.)
If the number of sellers rises the supply rises.
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Special Case and a general
statement for you
Let’s say that in a certain market each producer is exactly
the same. (Do all convenience stores have the same basic
set up, for example?) Let’s also say if the price of the good
is $1.25 each seller will supply 100 units. Then, if there are
n firms the total supply in the market will be n times 100 or
100n.
In general when I mention supply or demand I really mean
the market supply or demand. I would point out specifically
if I wanted you to think about supply or demand for one firm
or one consumer.
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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
37
Price, P
Notice at this
price P1 the
quantity
demanded
equals the
quantity
supplied.
S1
P1
D1
Quantity, Q
Q1
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Price, P
S1
Pa
D1
Qd
Qs
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, or
excess supply.
Quantity, Q
39
Price, P
S1
Pb
D1
Qs
Qd
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 or
excess demand.
Quantity, Q
40
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 where demand and supply cross in
our graphs we see Qs > 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, or excess supply, 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.
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2) When the price is below where demand and supply cross
in our graphs from the previous slides we see Qs < 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, or
excess demand, 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) above help us understand why
the price will change when conditions in the world change.
42
Let’s turn to this next.
For any market
story this is
where your
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
43
Here we have a
demand
increase. Slide
21 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
44
At P1, since Qd
> 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
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Price, P
D2
S1
P2
P1
D1
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.
Quantity, Q
Q1
Qd
Q2
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Let’s 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).
Note that with an increase in demand we get a higher price
and then a decrease in the quantity demanded and an
increase in the quantity supplied.
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.
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From this
starting point
let’s now look at
the story of a
supply increase.
Price, P
S1
P1
D1
Quantity, Q
Q1
48
Here we have a
supply increase.
Slide 33 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
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At P1, since Qs
> 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
50
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
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Let’s 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.
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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.
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