econ chapter 3

7/30/2019 Econ Chapter 3

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Click to edit Master subtitle

Chapter three:DEMAND, SUPPLY ANDMARKETS

Where do prices come from?

1

Gas prices seen spiking again inspring;Associated Press, Jan 31, 2008


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Where Do These Numbers ComeFrom?

2

Acres of corn planted (2007) 94,000,000

Median Price of a New Home (2008) $232,000

Average tuition cost for 4 years (privateuniversity) $169,000

Average tuition cost for 4 years (public, in-state)

$82,000

Average annual wage, kindergarten

teachers

$50,000

Average annual wage, business schoolprofessors

$77,000

Average annual wage, law school professors $101,000

Number of jobs lost, June 2009 467,000

Price of 2009 BMW M5 $85,000


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OVERVIEW / Questions ofthe Day

3

Where do prices come from? How are they determined?

What do we mean by a market

How do we use supply and demand?

What motivates buyers or sellers?

What is the invisible hand?

What happens to the market when conditions change?


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MARKETS

Demand and supply is an economic model, used to explainprices

Show where prices come from

Predict how they change

Demand and supply, together, make up a market

The model works best when

All goods areThere are so many individual buyers and sellers that

4


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Markets Determine Prices,So What? Q: Why do we care about the market ?

A: Because markets determine the prices and quantityof goods and services

Q: Why do we care about prices?

A: Because prices direct economic activity and answerour 3 Big Questions

1. What goods/services to produce?

2. How to produce them?

3. How to allocate the goods/services Using a market mechanism is one way to coordinate

economic activity

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What is a Market?

Demand and supply make up two sides of a MARKET

A collection of buyers and sellers that, through their actions orpotential interactions, determine the price of goods/services

Any institution that facilitates the voluntary exchange ofgoods and services for other goods/services or money

The institution through which buyers and sellers interact andengage in voluntary exchange

Interactions between buyers and sellers that determine theprice of good/service

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Market:Examples

Any good or service where one group of people wish toprovide/produce/sell the good and another group of peoplewish to buy the good makes a market

Goods Market food, clothes, CDs, cars, tickets, etc Services Market Car repair, Haircuts, Law services

Resource Market inputs to production

Credit Market borrowing/lending

Currency Market Dollars, Euros, Ten, Yuan, Bhat Labor Markets Teachers, police, truck drivers, lawyers

Commodities Markets Wheat, gold, oil, copper, tin

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Market: Definition

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Market definition who is included and who is excludedfrom a particular market

This can be a subjective process

You can examine the model from different perspectives

From very broad to very narrow

Market for automobiles (cars and trucks, new and used)

Market for new automobiles(no used)

Market for new cars(no trucks/SUVs)

Market for sedans(4-door only)

Market for new entry-level luxury new sedans


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DEMAND

All those willing and able to buy the good/service make upthe demand side of the market

All those interested or even potentially interested, whetherhouseholds, firms or government

Back to our basic question:

What to produce? How muchof a good to produce?

How many jet airplanes to produce each month?How many Boeing jet airplanes to produce each

month?

How many Boeing 787 jet airplanes to produce eachmonth?

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How much do buyers want?

Part of the answer lies with buyers how much do they wantexactly?

What affects how much they want?

What could change in your life to induce you to buy more

or less of a good/service than you do right now?

1. Price of the good/service itself

------------------------------------------------------------------------------------------------

2. Income of consumers

3. Prices of related goods

4. Price expectations by consumers

5. Preferences/Tastes of consumers

6. Others

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Price

Quantity Demanded The amount of a good or service thatpeople are willing and able to buy at various prices, ceterisparibus

Ceteris Paribus means holding all factors (2,-6) constant

Law of Demand Price and quantity demanded arenegatively related, ceteris paribus

As price rises, quantity demanded falls

people wish to buy less of the good as it becomes more

expensive As price falls, quantity demanded rises

people wish to buy more of the good as it becomescheaper

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There are 3 ways to show the negative relationship betweenprice (P) and quantity demanded (Qd)

1. Demand Function a mathematical representation of the

relationship between P and Qd

2. Demand a table showing the relationship between P and Qd

3. Demand Curve the line of demand

Price and Quantity Demanded

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Demand Function: Example

Demand Function A mathematical formula that showsthe relationship between the price of the good/service (P)and the amount demanded(Qd)

Suppose fictional person named K demands do-dads We can write Ks demand for do-dads as a function

This will show the relationship between the price of do-dads (P) and the amount he wishes to buy per month(Qd):

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Demand Schedule: Example

Demand Schedule

A table that shows the relationshipbetween the price of the good andthe amount demanded

Example Ksdemand for do-dads

14

Price(do-

dads)

Ks QuantityDemanded(per month)

$18 0

15 1

12 2

9 3

6 4

We can fill in the schedule byplugging numbers into thefunction


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Demand Curve: Example

P

18

15

9

3 4 Q (do-dads/month)1

6

2

12

Plot the schedule to getthe demand curve

Price(do-

dads)

Ks QuantityDemanded

(per month)

$18 0

15 1

12 29 3

6 4


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Other Factors

Remember: These points and this curve are ceterisparibus

WHEN THEY CHANGE, THEY SHIFTTHE DEMAND CURVE

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Demand Shifters: Income

Normal Goods have a positive relationship betweenincome and amount demanded

As your income , so does the amount you demand

As Ks income increases, K purchases more do-dads permonth, even if the price stays the same, shifting eachpoint to the right

Opposite also true as income , so does the amount ofthe good buyers demand, shifting each point to the left

Inferior Goods the exception to the rule; as incomegoes up, so does the amount demanded

Examples?

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Demand Shifters: Income

P

18

15

9


6

D

2

12

If Ks incomerises

Price(do-

dads)

Ks OldQd(per

month)

Ks NewQd (permonth)

$18 0

15 1

12 2

9 36 4


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Demand Shifters: Prices of RelatedGoods

When 2 goods are related, it means that when the price ofgood A changes, buyers react by changing the amount theybuy of good B

Complement Goods goods that complement each other

Substitute Goods goods consumed in place of oneanother

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Demand Shifters:Prices of RelatedGoods

Complement Goods goods consumed as a complement toone another

Examples?

How are these related?

A decrease in the price of the first good causes a decrease inthe amount demanded of the second good (a shift left in the

demand curve) Opposite also true

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Demand Shifters: Prices of RelatedGoods

Substitute Goods consumed in place of one another

Examples?

How are these related?

A decrease in the price of the first good causes

Opposite also true

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Demand Shifters:Tastes/Preferences

Preferences/tastes change over time; some goods becomemore popular, some become less popular

When a good becomes more popular/fashionable, demand

shifts right at every point Opposite also true when a good becomes less popular,

demand shifts left at every point

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Demand Shifters:Price Expectations

Buyers sometimes expect the price of the good to change inthe future, and this may affect how much of the good theywant to buy today

If buyers think the price of the good will rise in the near future,will they want to buy more or less today?

Buyers will want to buy more if they think price will rise infuture

Buyers will want to buy less if they think price will drop in

future

Opposite also true

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Demand Shifters:Any Others

Anything, other than a change in the price of the good itself,that makes buyers wish to buy more or less of the good willshift the demand curve

An increase in demand is a shift to the right A decrease in demand is a shift to the left

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Individual and MarketDemand Market Demand the summation of each individuals

quantity demanded at every price

As an example, lets simplify our world to 3 people who demanddo-dads K, L, and M:

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Ks Demand

P Q

18 0

15 1

12 2

9 3

6 4

3 5

Ls

Demand

P Q

18 0

15 0

12 2

9 4

6 6

3 8

Ms

DemandP Q

18 0

15 0

12 0

9 1

6 2

3 3

Market

DemandP Q

18

15

12

9

6

3


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Market Demand

128 164 Q (do-

18

15

12

9

3

6

P

126

PriceMarket

Demand

(permonth)

$18 0

15 1

12 4

9 8

6 12

3 16


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Summary: Market DemandShifters

Increase in Market Demand Increase in consumer

incomes

Decrease in price of acomplement good

Increase in price of asubstitute good

More popular

Belief that price will rise

in near future Increase in number of

buyers

Any change (Other thanthe price of the good

itself) that would cause

Decrease in Market Demand Decrease in consumer

incomes

Increase in price of acomplement good

Decrease in price of asubstitute good

Less popular

Belief that price will fall innear future

Decrease in number ofbuyers

Any change (OTHER THANTHE PRICE OF THE GOODITSELF) that would causeconsumers to buy less ofthe good/service

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Demand vs. QuantityDemanded

Q (do-dads/month)

D

P

D

A change in the priceof the good itself willcause a movementalong the demand

curve and is called achange in quantitydemanded

A change in anything

else shifts the entiredemand curve and iscalled a change indemand

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Draw a typical demand curve for bacon. What happens toit under each of the following situations? Increase ordecrease? Shift left or right?

Price of eggs falls

Increase in Demand curve shifts right

Price of bacon falls

Increase in Quantity Demanded move downthe curve

A new report by the American Health Institute warnsagainst increased risk of heart attacks from eating bacon

Decrease in demand curve shifts left29

Practice


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SUPPLY

The other of the market: All those willing and able toproduce/sell/supply the good/service make up supply

All those interested or even potentially interested, whetherhouseholds, firms or government

Back to our basic questions:

What to produce? (How much of a good to produce?)

How many airplanes per month?

How many Boeing airplanes per month? How many Boeing 787 airplanes per month?

How many do-dads?

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How much do sellers want to make?

Part of the answer lies with buyers but the other part of theanswer lies with the sellers: How much are they willing toproduce?

What affects how much they want to make?

1. Price of the good/service itself

2. Price of inputs

3. Expected price

4. Change in technology of production

5. Others

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Price of the Good/Service itself

Quantity Supplied The amount of a good or service thatsellers are willing and able to supply at various prices, ceterisparibus

Again, holding all factors (except price) constant

Law of Supply Price and quantity supplied are positivelyrelated, ceteris paribus

As price rises, quantity supplied rises

firms wish to supply more of the good when the price rises

As price falls, quantity supplied falls

firms wish to supply less of the good as it becomescheaper

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Price and Quantity Supplied

Like demand, there are 3 ways to show this relationshipbetween price and quantity supplied (Qs)

1. Supply Function mathematical representation of the

relationship between P and Qs2. Supply Schedule table that shows the relationship betweenP and Qs

3. Supply Curve graphical representation of the relationshipbetween P and Qs

~All 3 show the exact same thing, just in different formats

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Example:Supply Function andSchedule

Buds supplyschedule

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Price

(do-dads)

BudsQuantitySupplied

(permonth)

$18 10

15 8

12 6

9 4

6 2

We can fill in the schedule byplugging numbers into thefunction:

Suppose that there is afictional producer of do-dads: Mr. Bud

Buds supply function isgiven by:

P = $3 + (3/2)Qs


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Example: Supply Curve

P

18

15

9

4 10 Q (do-8

6

6

12

From the supply schedule to the supplycurve

2

Price(do-

dads)

BudsQuantitySupplied

(permonth)

$18 10

15 8

12 6

9 4

6 2


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Other Factors

Remember: These points are all ceterisparibus

ALL OTHER FACTORS THAT AFFECTTHE QUANTITIES OF GOODS SELLERS

ARE PREPARED TO SUPPLY ARESHIFT FACTORS

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Supply Shifters: Price of Inputs

To produce the good or service, firms have to buy inputs

Firms buy labor, capital, fuel, electricity, transportation,raw materials, etc and produce some output

What happens to the amount of output a firm can/desires toproduce if the price of its inputs rises, (holding the price ofthe output good it sells the same)?

It becomes more expensive to produce, so the firm willproduce less

Opposite also true

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Supply Shifters: Price of Inputs

P

18

15

9


6

S

6

12

Suppose hops is an input to do-dads, and the price of hopsrises

2

Price(do-

dads)

BudsOldQs

(permonth)

BudsNew Qs

(per

month)

$18 10 8

15 8 6

12 6 4

9 4 2

6 2 0


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Supply Shifters: Price Expectations

Sellers sometimes expect the price of the good to change in thefuture, and this may affect how much of the good they want toproduce and sell today

If sellers think the price of the good will fall in the futureThey might supply more today (while the price is still high)

This would shift the supply curve to the right

Opposite also true If sellers believe the price will rise in the future, they may

reduce supply now, shifting supply to the left

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Supply Shifters: Advance in Technology

A change in technology increases the productivity of the firmand its workers, meaning the firm can produce more outputwith the same amount of resources/inputs

A change in technology always increases productivity and thisalways increases supply (shift to the right)

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Supply Shifters: Any others

Anything, other than a change in the price of the gooditself, that makes sellers wish to supply more or less of thegood will shift the supply curve

Examples Weather

Government REgulations

An increase in supply is a shift to the right

A decrease in supply is a shift to the left

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Individual and Market Supply

Market Supply the summation of each firms quantity suppliedat every price

As an example, lets simplify our world to 2 firms who supply do-dads: Mr.Bud and Ms. Coors

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BudsSupply CoorsSupply MarketSupply

P Q P Q P Q

$18 10 $18 7 $18 17

15 8 15 6 15 14

12 6 12 5 12 1

9 4 9 4 9 8

6 2 6 3 6 5

3 0 3 2 3 2


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MarketSupply

1

1

8 1

4

5

Q (do-

18

15

12

9

3

6

P

1

7

243

Price

MarketSupply

(per

month$18 17

15 14

12 11

9 8

6 5

3 2


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Summary: Market Supply Shifters

Increase in MarketSupply

Decrease in price ofinputs

Advancement inproduction technology

Belief that price will fall inthe near future

Increase in the number ofsellers

Any change (Other thanthe price of the gooditself) that would cause

producers to sell more ofthe ood service

Decrease in MarketSupply

Increase in price ofinputs

Belief that price will risein the near future

Decrease in the number

of sellers Any change (OTHER

THAN THE PRICE OF THEGOOD ITSELF) that wouldcause producers to sell

less of the good/service

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Supply vs. QuantitySupplied

Q (do-dads/month)

SP

S

A change in theprice of the gooditself will cause amovement along

the supply curveand is called achange in quantitysupplied

A change in

anything else shiftsthe entire supplycurve and is calleda change in supply

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Draw a typical supply curve for tennis racquets. Whathappens to it under each of the following situations?Increase or Decrease? Shift left or right?

Price of cow gut (used for racquet string) falls

Increase in Supply curve shifts right

A fall in the number of racquet manufacturers

Decrease in Supply curve shifts left

A fall in the price of tennis balls

No change in Supply

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Practice


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MARKETS AND EQUILIBRIUM

Bringing supply and demand together creates our (free)market

Why is the market so important?

Because that is where the price of the good/service isdetermined

Because that is where the quantity of the good/service isdetermined

Market Equilibrium the price where quantity demanded(by consumers) is equal to quantity supplied (by producers)

What happens if we bring our 5 people together?

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The Market for Do-Dads48

What happens if we bring our 5 people together? K, L, M, Mr. Bud and Mrs. Coors

How many do-dads will Mr. Bud and Ms. Coors produce in

total? How much will each one produce?

How many do-dads will K, L and M buy in total?

How many will K get? M? L?

What will be the market price?

Market

Marke Market


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MarketEquilibrium

1

1

1

2

8 1

4

5

Q (do-

18

15

12

9

3

6

P (do-

dads)

1 42 1

649

Price

Market

Supply

MarketDeman

d

$18 17 0

15 14 1

12 11 4

9 8 86 5 12

3 2 16P* is the equilibrium price (orthe market clearing price)

Q* is the equilibriumquantity


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At Equilibrium

The market is at rest; there is no tendency for change no forces pushing P or Q higher or lower

Sellers can sell as much as they want

provided that they are willing to sell the good a P* (how much does Bud want to sell?)

Buyers can buy as much as they want

provided that they are willing ot pay price P* (how much does K want to buy?)

Quantity demanded (Qd) equals quantity supplied (Qs)

the exact amount buyers want is the exact amount sellersproduce

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What if we arent at equilibrium?

If the market is not in equilibrium, then market forces willbegin to push itself back towards equilibrium

If the current price is higher than P*, then K,L,M ,Mr.Bud orMrs.Coors will be guided to change their behavior that willeffectively push P back down to P*

If the current price is lower than P*, then K,L,M, Mr.Bud andMrs.Coors will be guided to change their behavior that willeffectively push P back up to P*

This is known as the invisible hand of the market

How does it work?

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The Invisible Hand:P > P*

11

84Q (do-

18

12

9

S

D

P

What happens to K, L, M, Bud and Coors if P =

$12?

52

Qd = 4 do-dads:

K wants 2

L wants 2

M wants 0

Qs = 11 do-dads


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The Invisible Hand:P < P*

12

85Q (do-

18

6

9

S

D

P What happens to K, L, M, Bud and Coors if

P = $6?

53

Qd = 12 do-dads

M wants 4

L wants 6

K wants 2

Qs = 5


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Equilibrium in the Do-dad Market

The price of $9 is the only price where K, L, M, Bud andCoors are

At a price of $9

Bud wishes to produce (and sell) 4, and he does Coors wishes to produce (and sell) 4, and she does

K wants to buy 3 and he does

L wants to buy 4 and she does M wants to buy 1, and he does

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Markets andAllocation

8 Q (do-dads month

9

MarketSupply

MarketDemand

At P = $9, buyers wishto buy a total of8 do-

dads:

At P = $9, sellers wish tosupply a total of8 do-dads:

P

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The market

In a theoretically free market, markets determine the pricefor each good/service (P*), and this determines:

how much of the good to produce (Q*)

who gets to buy the good

who gets to sell the good

how much each buyer gets and how much each seller sells

This is how we answer our 3 Big Questions What to make, how to make, and how to divide

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Supply/Demand like Tug of


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Supply/Demand like Tug ofWar

57

Buyers Sellers

Low Price! Low Price! High Price! High Price!


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What does this all mean?58

What do prices mean?

What does it mean if a new Lexus LS 460 sells for $75,000?

What does it mean if the average plumber earns $20/hour?

Where do these numbers come from and what do they

mean?

Clearly this is complicated and involves a lot of factors, but wecan focus on two main ideas:

1. Supply the price of a good/service reflects its scarcity (theopportunity cost to society of producing it)

2. Demand the price of a good/service reflects the value thatbuyers place upon it

Markets Determine Prices so


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59

Markets Determine Prices, sowhat?

Market for rawlumber

Market forMarket forMarket for

P

P*

Q

D

S

Markets, through

the price system,direct oureconomic activity

P

P*

Q

D

S P

P*

Q

D

S P

P*

Q

D

S


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CHANGES IN EQUILIBRIUM

How do changes in supply and/or demand affect our market? How does it change the equilibrium price (P*) and quantity

(Q*)?

Three steps to finding the new equilibrium1. Does the event affect supply or demand? Or both?

2. Which direction is the shift? (Increase or decrease?)

3. Where is the new equilibrium (P*,Q*) relative to the oldequilibrium?

q Has price risen or fallen?

q Has quantity risen or fallen?

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Change in Equilibrium example


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Market for coffee after an improvement in thetechnology of processing coffee beans

P*

Q

*

MarketDemand

P

coffee

Q

(coffee)

MarketSupply

An improvement intechnology ofproduction makesproducing easier

P Q

Falls Rises

originale

61

This causes anincrease in supply

The supply curveshifts right

Newsupply

Newsupply



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Market for gasoline during summer

P*

Q

*

MarketDemand

P

gas

Q

(gas)

MarketSupply

Summer is prime

vacation time formany families

originale

P Q

Rises Falls62

This means Cartripsto the Grand Canyon...

This causes an increasein demand for gasoline

The demand curve

for gas shifts right

N

ewDemand

N

ewDemand



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Market for coffee after an unusually poor growingseason

P*

Q*

MarketDemand

P

coffee

Q

(coffee)

MarketSupply

P Q

Rises Falls

originale

newe

63

Decrease in Supply

NewSu

pply

NewSu

pply



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Market for coffee after a fall in the price of Red Bull

P*

Q

*

MarketDemand

P

coffee

Q

(coffee)

MarketSupply

A fall in the price ofRed Bull would causepeople to buy moreRed Bull

originale

P Q

Falls Falls64

Decrease in Demand forcoffee

NewDemand

NewDemand

Simultaneous Changes in Demand and


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Simultaneous Changes in Demand andSupply

What happens in the market for gasoline if there is adisruption in the refineries AND consumers fear thatprices will rise in the future?

D

S

P (pergallon)

Q (gallons ofgas)

P

Q65

Decrease in Supplyfrom refineries

Increase in Demandfrom buyers expectations

NewSu

pply

NewSu

pply

New

Dem

and

New

Dem

and


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Does that result make sense?

A decrease in supply causes:

q Increase in P; decrease in Q

An increase in demand causes:

q Increase in P; increase in Q

They both cause an increase in P but the effect on Q isoffsetting

For yourself, see what happens with

an increase in both supply and demand a decrease in both supply and demand

a decrease in demand and an increase in supply

66

Practice


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For each of the following scenarios, determine the effect on

the equilibrium price and quantity

Market for DVDs

Fall in the price of home theater systems

A decrease in the cost of plastic (used to make DVDs)

Market for new homes

Dramatic fall in stock market reduces consumer wealth

An increase in the price of lumber/timer

67

Practice

Summary Shifting Demand &


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Summary Shifting Demand &Supply

Shifts in D Increase in D Increase in P and Q

Decrease in D Decrease in P and Q

Shifts in S

Increase in S Decrease in P, Increase in Q Decrease in S Increase in P, Decrease in Q

Simultaneous Shifts in D and S

Increase in both D and S Increase in Q, P ambiguous Decrease in both D and S Decrease in Q, P ambiguous

Increase in D, Decrease in S Increase in P, Q ambiguous

Decrease in D, Increase in S Decrease in P, Q ambiguous

68

Key Concepts and Terms


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Key Concepts and TermsKey Terms

Markets and Market Definition

Demand Quantity demanded and the Law of Demand Demand Shifters

Supply Quantity supplied and the Law of Supply

Supply Shifters Market Equilibrium and Finding Changes in Equilibrium

Key Ideas The price of goods/services come from interactions

between buyers and sellers Changes in price cause a change in quantity demanded

(supplied) and are movements along the given curve Changes in anything else cause a change in demand

(supply) and are shifts in the curve

Increases are shifts to the right; decreases are shifts to the 69

Gas Prices and the Onset of


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Before the start of the second Iraq War, oil

exports from Iraq began to fallWhat should happen to the price of crude oil? It should rise (as supply from Iraq decreased), but

it actually began to fall

This was because other oil exporters (such asSaudi Arabia) increased their output At the onset of the first Iraq War, the price of oil spiked

quickly (due to demand fears there was an increase indemand)

However, after there was little early supply disruption,prices readjusted very quickly

the Iraq War

econ chapter 3

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