Demand and Supply Udayan Roy

Demand and Supply Udayan Roy

Theories and Predictions We need to be able to predict the consequences of – alternative policies, and – events that may be outside our control The mental tool we use to make such predictions is called a theory A theory is of no use if its predictions are inaccurate SUPPLY AND DEMAND 2

We need a theory of prices The theory of demand and supply is a simple example of an economic theory It can be used to make predictions about the price and quantity of some commodity In a free-market economy, most economic decisions are guided by prices Therefore, without a reliable theory of prices, you will get nowhere in economic analysis SUPPLY AND DEMAND 3

Assume perfect competition The theory of supply and demand assumes that commodities are traded in perfectly competitive markets A perfectly competitive market is a market in which – there are many buyers – many sellers – and all sellers sell the exact same product As a result, each buyer and seller has a negligible impact on the market price SUPPLY AND DEMAND 4

DEMAND SUPPLY AND DEMAND 5

Demand Quantity demanded is the amount of a good that buyers are willing and able to purchase Demand is a full description of how the quantity demanded changes as the price of the good changes. SUPPLY AND DEMAND 6

Catherine’s Demand Schedule and Demand Curve Price of Ice-Cream Cone 3.00 2.50 1. A decrease in price . 2.00 1.50 1.00 0.50 6 7 8 9 10 11 12 Quantity of Ice-Cream Cones 2. . increases quantity of cones demanded. 0 1 2 3 4 5 SUPPLY AND DEMAND 7 Copyright 2004 South-Western

Market Demand is the Sum of Individual Demands SUPPLY AND DEMAND 8

Law of Demand The law of demand states that – the quantity demanded of a good falls when the price of the good rises, and vice versa, provided all other factors that affect buyers’ decisions are unchanged SUPPLY AND DEMAND 9

“provided all other factors are unchanged” That’s an important phrase in the wording of the Law of Demand The quantity demanded of a consumer good such as ice cream depends on – – – – – – The price of ice cream The prices of related goods Consumers’ incomes Consumers’ tastes Consumers’ expectations about future prices and incomes Number of buyers, etc The Law of Demand says that the quantity demanded of a good is inversely related to its price, provided all other factors are unchanged SUPPLY AND DEMAND 10

Why Might Demand Increase? Quantity Demanded Price Situation A 0.00 0.50 1.00 1.50 2.00 2.50 3.00 12 10 8 6 4 2 0 Situation B 20 16 12 8 6 4 2 How can we explain the difference in Catherine’s behavior in situations A and B? Why does she consume more in situation B at every possible price? SUPPLY AND DEMAND Price 11 Quantity Demanded

Shifts in the Market Demand Curve are caused by changes in: – Consumer income – Prices of related goods – Tastes – Expectations, say, about future prices and prospects – Number of buyers SUPPLY AND DEMAND 12

Shifts in the Demand Curve Price of Ice-Cream Cone Increase in demand Decrease in demand Demand curve, D3 0 SUPPLY AND DEMAND Demand curve, D1 Demand curve, D2 Quantity of Ice-Cream Cones 13

Shifts in the Demand Curve Consumer Income – As income increases the demand for a normal good will increase – As income increases the demand for an inferior good will decrease Prices of Related Goods – When a fall in the price of one good reduces the demand for another good, the two goods are called substitutes – When a fall in the price of one good increases the demand for another good, the two goods are called complements SUPPLY AND DEMAND 14

The Law of Demand—Explanations There are two ways to explain the Law of Demand – Substitution effect – Income effect SUPPLY AND DEMAND 15

Substitution Effect When the price of a good decreases, consumers substitute that good instead of other competing (substitute) goods 1. When the price of Coke decreases Clothes Coke 2. Consumption of Pepsi decreases Books Movies SUPPLY AND DEMAND 3. Consumption of Coke increases Pepsi 16

Income Effect A decrease in the price of a commodity is essentially equivalent to an increase in consumers’ income SUPPLY AND DEMAND 17

Lower Prices Higher Income Situation A Price of an Apple 1.00 Price of an Orange 2.00 Income 10.00 If prices fall, Situation A becomes Situation C. If income rises, Situation A becomes Situation B. Situation B Price of an Apple 1.00 Price of an Orange 2.00 Income 20.00 Situation C Price of an Apple 0.50 Price of an Orange 1.00 Income 10.00 SUPPLY AND DEMAND Q: Which change is better? A: They are both equally desirable. A fall in prices is equivalent to an increase in income. 18

Income Effect Consumers respond to a decrease in the price of a commodity as they would to an increase in income They increase their consumption of a wide range of goods, including the good that had a price decrease 1. When the price of Coke decreases Clothes Coke 2. Consumers feel richer Books Movies SUPPLY AND DEMAND 3. Consumption of Coke and other goods increases Pepsi 19

SUPPLY SUPPLY AND DEMAND 20

SUPPLY Quantity supplied is the amount of a good that sellers are willing and able to sell Supply is a full description of how the quantity supplied of a commodity responds to changes in its price SUPPLY AND DEMAND 21

Ben’s supply schedule and supply curve Price of Ice-Cream Cones 3.00 Price of Ice-cream cone Quantity of Cones supplied 0.00 0.50 1.00 1.50 2.00 2.50 3.00 0 cones 0 1 2 3 4 5 2.50 Supply curve 1. An increase in price . . . 2.00 1.50 1.00 2. . . . increases quantity of cones supplied. 0.50 0 1 2 3 4 5 6 7 8 9 10 11 12 Quantity of Ice-Cream Cones 22

Market supply and individual supplies Price of ice-cream cone Ben 0.00 0.50 1.00 1.50 2.00 2.50 3.00 0 0 1 2 3 4 5 Jerry 0 0 0 2 4 6 8 Market 0 0 1 4 7 10 13 23

Market supply and individual suppliesBen’s Jerry’s supply supply Price of Ice Cream Cones 3.00 SBen Price of Ice Cream Cones 3.00 SJerry Price of Ice Cream Cones 3.00 2.50 2.50 2.50 2.00 2.00 2.00 1.50 1.50 1.50 1.00 1.00 1.00 0.50 0.50 0.50 0 1 2 3 4 5 6 7 8 9 10 11 12 Quantity of Ice-Cream Cones 0 1 2 3 4 5 6 7 Quantity of Ice-Cream Cones 0 Market supply SMarket 2 4 6 8 10 12 14 16 18 Quantity of Ice-Cream Cones 24

Law of Supply The law of supply states that, the quantity supplied of a good rises when the price of the good rises, as long as all other factors that affect suppliers’ decisions are unchanged SUPPLY AND DEMAND 25

Law of Supply—Explanation How can we make sense of the numbers in Ben’s supply schedule? The best guess is that his costs must be something like the cost schedule below. A specific icecream cone 1st 2nd 3rd 4th 5th 6th It’s cost ( ) 0.75 1.35 1.75 2.30 2.85 3.10 In this way, the Law of Supply follows from the assumption of Increasing Costs (or, Diminishing Returns) SUPPLY AND DEMAND 26

Shifts in the Supply Curve: What causes them? Price of Ice-Cream Cone Supply curve, S3 Decrease in supply Supply curve, S1 Supply curve, S 2 Increase in supply 0 SUPPLY AND DEMAND Quantity of Ice-Cream Cones27

Supply Shift How could Ben’s supply have increased? Ice-cream cone It’s cost ( ) Before After 1 0.75 0.45 2 1.35 0.85 rd 3 1.75 1.45 4th 2.30 1.95 5th 2.85 2.45 6th 3.10 2.90 st nd Ben’s Supply Schedule Price ( ) Quantity Supplied Before After 0.00 0 0 0.50 0 1 1.00 1 2 1.50 2 3 2.00 3 4 2.50 4 5 3.00 5 6 Anything that reduces production costs, shifts supply to the right. SUPPLY AND DEMAND 28

Shifts in the Supply Curve are caused by changes in – Input prices – Technology – Number of sellers (short run) The market supply will shift right if – Raw materials or labor becomes cheaper – The technology becomes more efficient – Number of sellers increases SUPPLY AND DEMAND 29

EQUILIBRIUM SUPPLY AND DEMAND 30

Interaction of demand and supply We have seen what demand and supply are We have seen why demand and supply may shift Now it is time to say something about how buyers and sellers collectively determine the market outcome To do this, we assume equilibrium SUPPLY AND DEMAND 31

Equilibrium We assume that the price will automatically reach a level at which the quantity demanded equals the quantity supplied SUPPLY AND DEMAND 32

SUPPLY AND DEMAND TOGETHER Demand Schedule Supply Schedule At 2.00, the quantity demanded is equal to the quantity supplied! SUPPLY AND DEMAND 33

Equilibrium of supply and demand Price of Ice-Cream Cones 3.00 2.50 Supply Equilibrium price Equilibrium 2.00 1.50 1.00 0.50 0 Equilibrium quantity Demand 1 2 3 4 5 6 7 8 9 10 11 12 Quantity of Ice-Cream Cones 34

Equilibrium Can we justify the assumption of equilibrium? 35

Markets Not in Equilibrium (a) Excess Supply Price of Ice-Cream Cone Supply Surplus 2.50 2.00 Demand 0 4 Quantity demanded 7 10 Quantity supplied SUPPLY AND DEMAND Quantity of Ice-Cream Cones 36

Markets Not in Equilibrium Surplus – When price exceeds equilibrium price, then quantity supplied is greater than quantity demanded There is excess supply or a surplus Suppliers will lower the price to increase sales, thereby moving toward equilibrium SUPPLY AND DEMAND 37

Markets Not in Equilibrium (b) Excess Demand Price of Ice-Cream Cone Supply 2.00 1.50 Shortage Demand 0 4 Quantity supplied 7 10 Quantity demanded SUPPLY AND DEMAND Quantity of Ice-Cream Cones 38

Markets Not in Equilibrium Shortage – When price is less than equilibrium price, then quantity demanded exceeds the quantity supplied There is excess demand or a shortage Suppliers will raise the price due to too many buyers chasing too few goods, thereby moving toward equilibrium SUPPLY AND DEMAND 39

Equilibrium Law of supply and demand – The price of any good adjusts to bring the quantity supplied and the quantity demanded for that good into balance SUPPLY AND DEMAND 40

Equilibrium: skepticism required Although the Law of Supply and Demand is a good place to start the discussion of prices, it should not be taken to be the gospel truth. In some cases the price might get stuck at some other level and quantity supplied and quantity demanded may not be equal. – Example: unemployment SUPPLY AND DEMAND 41

Unemployment: a failure of equilibrium when the wage is too high and stuck Wage Labor surplus (unemployment) Labor Supply Too-high wage Labor demand 0 Quantity demanded Quantity supplied SUPPLY AND DEMAND Quantity of Labor 42

Let’s make some predictions We can use our understanding of the factors that shift the demand and supply curves to predict the consequences of – Alternative policy proposals, and – Events outside our control SUPPLY AND DEMAND 43

How an Increase in Demand Affects the Equilibrium Price of Ice-Cream Cone 1. Hot weather increases the demand for ice cream . . . Supply New equilibrium 2.50 2.00 2. . . . resulting in a higher price . . . Initial equilibrium D D 0 7 10 3. . . . and a higher SUPPLY AND DEMAND quantity sold. Quantity of Ice-Cream Cones 44

How a Decrease in Supply Affects the Equilibrium Price of Ice-Cream Cone S2 1. An increase in the price of sugar reduces the supply of ice cream. . . S1 New equilibrium 2.50 Initial equilibrium 2.00 2. . . . resulting in a higher price of ice cream . . . Demand 0 4 7 3. . . . and a lower SUPPLY AND DEMAND quantity sold. Quantity of Ice-Cream Cones 45

A Shift in Both Supply and Demand Event Effect on Price Effect on Quantity Demand increases Up Up Supply decreases Up Down Both Up Ambiguous SUPPLY AND DEMAND 46

A Shift in Both Supply and Demand SUPPLY AND DEMAND 47

Prediction exercises Effect of a rise in the price of oil on the market for – Hybrid cars – Real estate – Staple foods (corn, wheat, rice) Effect of the development of cheaper and better batteries for electric cars on the market for – traditional cars – gas SUPPLY AND DEMAND 48

Other kinds of markets Factor/resource markets Assets markets Prediction markets – Iowa electronic markets: http://www.biz.uiowa.edu/iem/ – Intrade prediction markets: http://www.intrade.com/ SUPPLY AND DEMAND 49