Supply and Demand

CHAPTER 3 – the market forces of supply and demand

I.                    The market forces of supply and demand

-          Supply and demand are the forces that make market economies work

-          They are the ones to determine prices in the market + how prices allocate the economy’s scarce resources – What are the market forces of supply and demand responsible for in market economies?

-          The supply and demand model is based off assumptions, like most other models

II.                  The assumptions of the market model

-          Supply and demand are referred to the behaviors of people as they interact with each other in the markets

-          Market – a group of buyers and sellers of a specific good or service

-          Competitive market – a market in which there are many buyers and sellers, so they are able to impact the price of the good or service. Characteristics include: (1) all goods for sale are the same and (2) no buyer/seller can influence market price on their own

-          Quantity demanded – the amount of a good that buyers are willing and able to purchase

-          Law of demand – the claim that, other things equal, the quantity demanded of a good fall when the price of the good rises

-          Demand schedule – a table that shows the relationship between the price of the good and the quantity demanded

-          Demand curve – a graph of the relationship between the price of a good and the quantity demanded

-          Market demand – the sum of all individual demands for a particular good or service

Movement along the demand curve – a movement along the demand curve occurs when there is a change in the price of the commodity, leading to a change in the quantity demanded while other factors stay constant.

I.                    It results solely from price fluctuations (rise or fall)

II.                  Upward movement indicates a contract of demand. Price rises, demand is less.

III.                Downward movement represents an expansion in demand (to the right too). Price falls, consumers demand more.

Shift of the demand curve – a shift in the demand curve occurs when there is a change in the quantity demanded at each possible price due to factors other than the price itself.

I.                    Income, taste and preferences, price of related goods, expectations.

II.                  Right shift means an increase in demand.

III.                Left means a decrease in demand.

III.                Shifts versus movements along the demand curve

-          The income effect – incomes remain constant. A fall in the price of milk means that consumers can now afford to buy more with their income

-          The substitution effect – good or service is lower in price compared to others, so some consumers will choose the substitute of the more expensive good/service with the cheaper version of it – What is the substitution affect?

-          Substitutes – two goods for which an increase in the price of one good leads to an increase in the demand for the other (think of generic named brands and name-brand items)

-          Complements – two goods for which an increase in the price of one good leads to a decrease in the demand for the other. They also have a negative impact on demand. (peanut butter and jelly)

-          Normal good – the demand for a good fall when income falls or rises, as income rises

-          Inferior good – the demand for a good rise when income falls (like ramen)

IV.                Supply

-          Quantity supplied – the amount of a good that sellers are willing and able to sell

-          Law of supply – the claim that, other things equal, the quantity supplied of a good rises when the price of the good rises

-          Supply schedule – a table that shows the relationship between the price of the good and the quantity supplied

-          Supply curve – the graph of the relationship between the price of a good and the quantity supplied

Shifts in the supply curve – occurs when there is a change in supply due to factors other than the price of the good itself.

1.      Profitability of other goods in production and prices of goods in joint supply

2.      Technology

3.      Natural/social factors such as the weather and changing attitudes

4.      Input prices – the prices of the factors of production

5.      Expectations of producers about the future state of the market

6.      A change in the number of sellers in the market

Movement along the supply curve – a movement along the supply curve occurs due to a change in the price of the good itself.

A shift to the left on the supply curve means a decrease in supply. Like if the price of steel beams goes up, there’ll be people who are less willing to buy.

Right is an increase in supply. People will buy the steel beams if it isn’t too expensive.

V.                  Supply and demand together

-          Equilibrium price – the price that balances quantity supplied and quantity demanded. On a graph, it is the price at which the supply and demand curves intersect

-          Equilibrium Quantity – the quantity supplied and the quantity demanded at the equilibrium price. On a graph, it is the quantity at which the supply and demand curves intersect

-          Surplus – when price > equilibrium, the quantity supplied > quantity demanded. There is an excess of supply, which results in the lowering of prices to increases sales

-          Shortage – price < equilibrium price, then quantity demanded > the quantity supplied. There is a shortage, which results in prices being raised due too many buyers and too few goods.

-          Law of supply and demand – the claim that the price of any good adjusts to bring the quantity supplied and the quantity demanded for that good into balance

VI.                Prices as signals

-          The main function of price in a free market is to act as a signal of both buyers and sellers

-          For buyers, price tells them something about what they have to give up (usually an amount of money) to acquire the benefits

-          For sellers, price acts as a signal in relation to the profitability of production

VII.              Analyzing changes in equilibrium

Three steps to analyzing changes in equilibrium.

1.      Decide whether the event shifts the supply or demand curve (or both)

2.      Decide whether the curve(s) shift(s) to the left or to the right.

3.      Use the supply and demand diagram to see how the shift affects equilibrium price and quantity

What happens to price and quantity when supply or demand shifts?

VIII.            Elasticity

-          Allows us to analyze supply and demand with greater precision.

-          Is a measure of how much buyers and sellers respond to changes in market conditions.

IX.                The Price Elasticity of Demand

-          Price elasticity of demand – a measure of how much the quantity demanded of a good responds to a change in the price of that good.

-          The determinants are – availability of close substitutes, necessities versus luxuries, proportion of income devoted to the product, and time horizon

-          Demand tends to be more elastic if the larger the number of close substitutes, if the good is a luxury, the more narrowly defined the market, and the longer the time period

Equation: Price elasticity of demand = % change in quantity demanded/% change in price

-          Midpoint method – preferable when calculating the price elasticity of demand because it gives the same answer regardless of the direct of the change

Equation: Price elasticity of demand = (Q1-Q2) / [(Q2+Q1)/2] /// (P1-P2) / [(P2+P1)/2]

Example:

-          % change in price = (6-4)/5 x 100% = 40%

-          % change in quantity demanded = (120-80)/100= 40%

-          Price of elasticity of demand = 40/40 = 1

-          Point elasticity of demand method – measures elasticity at a particular point on the demand curve. Price elasticity of demand = P/Qd x dQd/dP

-          Price inelastic demand – quantity demanded does not respond strongly to price changes and price elasticity of demand is less than one (x < 1). For example, a 22% increase in price leads to an 11% decrease in quantity demanded.

-          Price elastic demand – quantity demanded responds strongly to changes in price and price elasticity is greater than one (x > 1). For example, a 22% increase in price leads to a 67% decrease in quantity demanded.

-          Perfectly price inelastic – quantity demanded does not respond to price changes

-          Perfect price elastic – quantity demanded changes infinitely with any change in price

-          Unit Price Elastic – quantity demanded changes by the same percentage as the price. For example, a 22% increase in price leads to a 22% decrease in quantity demanded

-          Price elasticity of demand measures how much quantity demanded responds to the price, as it is related to the slope of the demand curve.

-          Total revenue – the amount paid by buyers and received by sellers of a good (TR = P x Q)

-          With a price inelastic demand curve, let’s say there’s an increase in price which leads to a decrease in quantity that is proportionately smaller and that makes total revenue increase.

-          At points with a low price and a high quantity, demand is inelastic.

-          At points with a high price and a low quantity, demand is elastic.

X.                  Other demand elasticities

-          Income elasticity of demand – measures how much the quantity demanded of a good responds to a change in consumers’ income

-          Income elasticity of demand = % change in quantity demanded / % change in income

-          Higher income raises the quantity demanded for normal goods but lowers the quantity demanded for inferior goods

-          Demand for goods consumers regard as necessities tends to be income elastic. For example, food, fuel, gas, utilities, clothes, and medical.

-          Demands for goods consumers regard as luxuries tend to be income elastic. For example, sport cars, furs, and expensive foods.

-          Cross-price elasticity of demand – measures how much the quantity demanded of one good responds to a change in the price of another good

-          Substitutes have positive cross-price elasticities.

-          Complements have negative cross-price elasticities.

XI.                The price elasticity of supply

-          Price elasticity of supply – measure of how much the quantity supplied of a responds to a change in the price of that good

-          The determinants are time period – supply is more price elastic in the long run; productive capacity and the ability of sellers to change the amount of the good they produce; size of the firm/industry; mobility of the factors of production

Equation: Price elasticity of supply = % change in quantity supplied / % change in price

Example: (15%)/(10%) = 1.5

-          Midpoint method – measures the price elasticity of supply between two points, denoted (Q1, P1) and (Q2, P2)

Price elasticity of supply = (Q2-Q1)/([Q2-Q1]/2) // (P2 – P1)/([P2+P1]/2)

-          Point elasticity of supply – method measures elasticity at a particular

Price elasticity of supply = P/Qs x dQs/dP

In general, the flatter the slope of the supply curve that passes through a given point, the more elastic the supply

-          Perfectly Priced Inelastic Supply – an increase in price leaves the quantity supplied unchanged

-          Price inelastic supply – an increase in price leads to an increase in quantity supplied

-          Unit elastic supply – an increase in price leads to an increase in quantity supplied (by the same %??)

-          Price elastic supply – an increase in price leads to a decrease in quantity supplied

-          Perfectly price elastic supply – at any price above 4 (or 1?), quantity supplied is infinite. At exactly #, producers will supply any quantity. At a price below #, quantity supplied is zero.