Chapter 4: DEMAND & Supply

Demand First! What do we mean by (Consumer) Demand?

Demand Curve ◦Graph depicting the relationship between the price of a certain commodity and the amount of it that consumers are willing and able to purchase at that given price.

◦Graphic representation of a demand schedule.

Demand curve

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The demand schedule is a table that shows the quantity demanded at each price.The demand curve, which graphs the demand schedule, illustrates how the quantity demanded of the good changes as its price varies. Because a lower price increases the quantity demanded, the demand curve slopes downward.

Price ofIce-cream cone

Quantity ofCones demanded

$0.000.501.001.502.002.503.00

12 cones1086420

0 1210 1191 2 3 4 5 6 7 8Quantity of Ice-Cream Cones

$3.00

2.50

2.00

1.50

1.00

0.50

Price of Ice-Cream

Cones 1. A decreasein price . . .

2. . . . increases quantityof cones demanded.

Different Types of Demand Curves: Linear and Non-Linear

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Shape of Demand Curve – depends on consumer’s response to price changes.If always constant -> linear. If it varies with price changes -> non-linear

Qty D = a – b*Price Log(Qty D) = a – b*Price

Different Types of Demand Curves:Individual and Market Demand Curves

Market Demand Curve = Sum of Individual Demand Curves for the Product

Market DemandMarket

Demand

What Role Does Demand Play in Market Behavior/Analysis?

Demand curves are used to estimate behaviors in competitive markets,

Combined with supply curves they can be used to estimate the equilibrium price (the price at which sellers together are willing to sell the same amount as buyers together are willing to buy, also known as market clearing price) and the equilibrium quantity (the amount of that good or service that will be produced and bought without surplus/excess supply or shortage/excess demand) of that market.[

Demand/Supply and Market Equilibrium

How People Make Decisions

Principle 3: Rational people think at the margin Rational people

◦ Systematically & purposefully do the best they can to achieve their objectives

What are Marginal changes◦ Small incremental adjustments to a plan of action

Rational decision maker – take action only if◦ Marginal (additional) benefits > Marginal (additional) costs◦ Or if value of consuming next unit > market price

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From the Demand Side First Law of Demand

◦ What Does Law Of Demand Mean?◦ all other factors being equal, as the price of a

good or service increases, consumer quantity demanded for the good will decrease and vice versa.

Investopedia explains Law Of Demand...◦ summarizes the effect price changes on

consumer behavior. For example, a consumer will purchase more pizzas if the price of pizza falls. The opposite is true if the price of pizza increases.

◦ http://www.investopedia.com/terms/l/lawofdemand.asp

A Demand Example

Individual's Demand Curve

$0.00

$2.00

$4.00

$6.00

$8.00

$10.00

$12.00

1 2 3 4 5 6 7 8 9 10

Quantity Demanded

Price

per u

nit Price

Price Qty Demanded

$10.00 1

$9.00 2

$8.00 3

$7.00 4

$6.00 5

$5.00 6

$4.00 7

$3.00 8

$2.00 9

$1.00 10

Computing Marginal Value

Price Qty Demanded

$10.00 1

$9.00 2

$8.00 3

$7.00 4

$6.00 5

$5.00 6

$4.00 7

$3.00 8

$2.00 9

$1.00 10

Total and Marginal Value

Price Qty Demanded Amt Paid Marginal Value Total Value

$10.00 1 $10.00 $10.00 $10.00

$9.00 2 $18.00 $9.00 $19.00

$8.00 3 $24.00 $8.00 $27.00

$7.00 4 $28.00 $7.00 $34.00

$6.00 5 $30.00 $6.00 $40.00

$5.00 6 $30.00 $5.00 $45.00

$4.00 7 $28.00 $4.00 $49.00

$3.00 8 $24.00 $3.00 $52.00

$2.00 9 $18.00 $2.00 $54.00

$1.00 10 $10.00 $1.00 $55.00

Price x Qty Dem

Area under Demand

Difference in TV(3)-TV(2)

MV is also equal to price paid

Consumer’s Marginal Value Some basic definitions

◦ Total Willingness-to-pay: “value in use”◦ How much would you be willing to pay for x units of the good than go

entirely without?◦ Equals the area under the demand curve up to x units

Individual's Demand Curve

$0.00

$2.00

$4.00

$6.00

$8.00

$10.00

$12.00

1 2 3 4 5 6 7 8 9 10

Quantity Demanded

Pri

ce

pe

r u

nit

Price

WTP for 4 units

In Graphic TermsNote: (again) price = marginal value

Consumer is willing to buy up to P = MV

Price, Total & Marginal Use Value

$0.00

$2.00

$4.00

$6.00

$8.00

$10.00

$12.00

1 2 3 4 5 6 7 8 9 10

Quantity Demanded

Do

llars

$0.00

$10.00

$20.00

$30.00

$40.00

$50.00

$60.00

Price

Marginal Value

Total Value

Why Do People Buy Things?

1. Because they are better off buying the good◦ Value in consumption/use > price paid = opportunity cost of spending it on next

best alternative

2. How much better off?◦ Difference between the maximum amount you would be willing to pay for each

unit of the good◦ Minus the amount you have to give up (i.e., what you have to pay to get it)

Economists call this difference “Consumer Surplus” CS = MaxWTP(Q*) – Price x Q* Max WTP(0:Q*) = MV(1) + MV(2) + …. + MV(Q*)

◦ Area under the demand curve up to the last unit purchased (Q*)

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Calculating Consumer Surplus

Consumer surplus is the difference between the total amount that consumers are willing and able to pay for a good or service (indicated by the demand curve) and the total amount that they actually do pay (i.e. the market price).

Rational decision maker – takes action only if

Marginal benefits > Marginal costs

Ten principles of economics

From Chapter1

How People Make Decisions1: People Face Trade-offs2: The Cost of Something Is What You Give Up to Get It3: Rational People Think at the Margin4: People Respond to Incentives

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Ceteris Paribus What’s it mean?

Ceteris paribus or caeteris paribus is a Latin phrase meaning "with other things the same" or "other things being equal or held constant".

What are we “holding constant” when we “draw” the an individual’s demand curve?◦ Major factors (80/20 rule) that affect a consumer’s demand for a good

◦ Individual’s Income◦ Price of Substitutes for the goods◦ Price of Complements (goods consumed/used with the good being studied)◦ Future Price of the good◦ Product Quality◦ Individual’s Taste and Preferences

◦ And if we are modelling market demand (all customers)◦ All of the above + number of people in the market (and how much they buy at each price)

Table 4.1 Factors That Shift the Demand Curve

Appendix

FIGURE 1A-5

Showing Three Variables on a Graph

Graphs of Two Variables

Taking into Account More Than Two Variables on a Graph

Shift of the Entire Curve Shift out/right of the Demand Curve

◦ WTP increases for all Qd

Shift in/left of the Demand Curve◦ WTP decreases for all levels of Qd

Shift out/right

Shift in/left

D2

Increase in Demand

Decrease in Demand

EXHIBIT 3.3Income as a Determinant of Demand

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Factors That Can Shift Demand Income

◦ Normal good◦ As income rises, quantity demanded increases at a given price -> Demand curve shifts out◦ Superior good – percent of budget spent on good increases more than percent increase in income

◦ Demand curve shift is very large

◦ Inferior good◦ As income rises, quantity demanded decreases at a given price

◦ Demand curve shifts in

Factors That Can Shift Demand Substitutes

◦ Goods that are similar to the “good in question” (or being analyzed)◦ E.g., Pepsi/Coke

Shifts in Demand Curve◦ If price of substitute increases, then demand for “GIQ” shifts out as it

becomes relatively less expensive◦ If price of substitute decreases, then demand for “GIQ” shifts in as it becomes

relatively more expensive◦ “closer” the substitute -> more demand curve shifts (i.e., greater cross-price

elasticity)◦ For substitutes: relative price matters!

Factors That Can Shift Demand Complements

◦ Goods that are “jointly consumed” with “GIQ”, e.g. coffee & cream

Demand Curve shifts◦ Price of complement increases, then demand for “GIQ” shifts in as total cost

of consumption has increased◦ Price of complement decreases, then demand for “GIQ” shifts out as total

cost of consumption has decreased◦ For complements: total cost of consumption matters!

Factors That Can Shift Demand Product Quality

◦ Better or improved product quality increases (relative) demand◦ Demand curve shifts out

Future price (hedge market) of the good◦ If the price is expected to go up in the future -> increases current demand (shift out/right)

◦ Cheaper to consume today and stockpile◦ If the price is expected to decrease in the future -> decrease current demand (shift in/left)

◦ Wait to buy (christmas/after christmas sales)

Taste and Preferences◦ Always assumed constant unless you have empirical proof (new MRI imaging)

Factor that Affects the ONLY Aggregate Market Demand Curve

As the population/number of buyers (Nb) increases -> Market Demand curve shifts outward

Market Demand: Maybe a little bit different

Market Demand may be kinked as new buyers enter at different price points

When it’s only Tom – Tom’s D is the market

Harry joins the Market

Dick joins

Table 4.1 Factors That Shift the Demand Curve

Key Assumptions Demand Curve

For a given (individual’s) demand curve◦ These factors are held constant (ceteris paribus):

◦ Price of: ◦ substitutes, ◦ complements, ◦ future price of the good

◦ income, ◦ quality, and ◦ taste and preferences

And for a market demand curve: ◦ number of buyers (Nb)

Only price and quantity demanded are allowed to vary

EXHIBIT 3.4Distinguishing Change in Demand from Change in Quantity Demanded

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Starbucks will raise prices across the country, but it's worse in Seattle

Price hikes coming Tuesday on some popular Starbucks (Nasdaq: SBUX) beverages are expected to bring the average Starbucks bill across the U.S. up an average 1 percent. But in Seattle, the average price will rise as much as 3.5 times that amount.The price increase nationally is attributed to rising cost – not in coffee, but in rent, personnel-related costs, and other operation expenses.The growing difference between prices in Seattle and the rest of the nation comes amid a strong economy in Seattle, propped up by a technology boom and rising costs for real estate, The Seattle Times reports.