Supply and Demand

Markets and Competition

• Market: A group of buyers and sellers of a particular good or service.
  • Buyers determine the demand.
  • Sellers determine the supply.
• Competitive Market: Many buyers and sellers with negligible impact on market price.
• Perfectly Competitive Market:
  • Goods are the same.
  • Numerous buyers and sellers; no one affects market price (price takers).

Demand

• Quantity Demanded: The amount buyers are willing and able to purchase.
• Law of Demand: Other things equal, when the price of a good rises, the quantity demanded falls, and vice versa.

Demand Schedule

• A table showing the relationship between the price of a good and the quantity demanded.
• Example: Sam’s demand for lattes.

Market Demand

• Sum of all individual demands for a good or service.
• Market demand curve: Sum the individual demand curves horizontally.
  • To find the total quantity demanded at any price, add the individual quantities.
• Example: Market demand versus individual demand (Sam and Dean example).

Demand Curve Shifters

• The demand curve shows how price affects quantity demanded, other things being equal.
• These “other things” are non-price determinants of demand.
• Changes in these factors shift the demand curve.

Number of Buyers

• Increase in number of buyers: Increases quantity demanded at each price; shifts demand curve to the right.
• Decrease in number of buyers: Decreases quantity demanded at each price; shifts demand curve to the left.

Income

• Normal Good: Increase in income leads to an increase in demand (shifts curve to the right).
• Inferior Good: Increase in income leads to a decrease in demand (shifts curve to the left).

Prices of Related Goods

• Substitutes: An increase in the price of one good leads to an increase in the demand for the other.
  • Example: Pizza and hamburgers. If the price of pizza increases, the demand for hamburgers increases, shifting the hamburger demand curve to the right.
  • Other examples: Coke and Pepsi, laptops and tablets, music CDs and music downloads.
• Complements: An increase in the price of one good leads to a decrease in the demand for the other.
  • Example: Computers and software. If the price of computers rises, people buy fewer computers and less software. The software demand curve shifts left.
  • Other examples: College tuition and textbooks, bagels and cream cheese, eggs and bacon.

Tastes

• Anything that causes a shift in tastes toward a good will increase demand for that good and shift its demand curve to the right.
  • Example: The Atkins diet increased demand for eggs, shifting the egg demand curve to the right.

Expectations About the Future

• Expect an increase in income: Increase in current demand.
• Expect higher prices: Increase in current demand.
  • Example: If people expect their incomes to rise, their demand for meals at expensive restaurants may increase now.

Supply

• Quantity Supplied: Amount of a good sellers are willing and able to sell.
• Law of Supply: Other things equal, when the price of a good rises, the quantity supplied of the good rises, and vice versa.

Supply Schedule

• A table showing the relationship between the price of a good and the quantity supplied.
• Example: Starbucks’ supply of lattes.

Market Supply

• Sum of the supplies of all sellers of a good or service.
• Market supply curve: Sum of individual supply curves horizontally.
  • To find the total quantity supplied at any price, add the individual quantities.
• Example: Market supply versus individual supply (Starbucks and Peet’s example).

Supply Curve Shifters

• The supply curve shows how price affects quantity supplied, other things being equal.
• These “other things” are non-price determinants of supply.
• Changes in these factors shift the supply curve.

Input Prices

• Supply is negatively related to the prices of inputs.
  • Examples: Wages, prices of raw materials.
• A fall in input prices makes production more profitable at each output price.
  • Firms supply a larger quantity at each price.
  • The supply curve shifts to the right.

Technology

• Determines how much inputs are required to produce a unit of output.
• A cost-saving technological improvement has the same effect as a fall in input prices, shifts the supply curve to the right.

Number of Sellers

• An increase in the number of sellers increases the quantity supplied at each price and shifts the supply curve to the right.

Expectations About Future

• Example: Events in the Middle East lead to expectations of higher oil prices; owners of Texas oilfields reduce supply now, save some inventory to sell later at the higher price; supply curve shifts left. Sellers may adjust supply when their expectations of future prices change (if the good is not perishable).

Supply and Demand Together

• Equilibrium: Price has reached the level where quantity supplied equals quantity demanded.
• Equilibrium Price: The price where quantity supplied = quantity demanded.
• Equilibrium Quantity: Quantity supplied and demanded at the equilibrium price.

Markets Not in Equilibrium

• Surplus (Excess Supply): Quantity supplied is greater than quantity demanded.
  • Facing a surplus, sellers try to increase sales by cutting the price, causing quantity demanded to rise and quantity supplied to fall, which reduces the surplus.
  • Prices continue to fall until the market reaches equilibrium.
• Shortage (Excess Demand): Quantity demanded is greater than quantity supplied.
  • Facing a shortage, sellers raise the price, causing quantity demanded to fall and quantity supplied to rise, which reduces the shortage.
  • Prices continue to rise until the market reaches equilibrium.

Analyzing Changes in Equilibrium

• Three steps to analyzing changes in equilibrium:
  • Decide whether the event shifts the supply curve, the demand curve, or both.
  • Decide whether the curve shifts to the right or to the left.
  • Use the supply-and-demand diagram to compare the initial and the new equilibrium and to assess effects on equilibrium price and quantity.

Example: The Market for Hybrid Cars

• Event 1: Increase in the price of gas.
  • Demand curve shifts because the price of gas affects the demand for hybrids.
  • Demand shifts right because high gas prices make hybrids more attractive relative to other cars.
  • The shift causes an increase in price and quantity of hybrid cars.
• Event 2: New technology reduces the cost of producing hybrid cars.
  • Supply curve shifts because the event affects the cost of production.
  • Supply shifts right because the event reduces cost, making production more profitable at any given price.
  • The shift causes the price to fall and quantity to rise.
• Event 3: Price of gas rises AND new technology reduces production costs.
  • Both curves shift.
  • Both shift to the right.
  • Quantity rises, but the effect on price is ambiguous: If demand increases more than supply, the price rises. If supply increases more than demand, the price falls.

How Prices Allocate Resources

• Prices adjust to balance supply and demand in market economies.
• These equilibrium prices are the signals that guide economic decisions and thereby allocate scarce resources.

Summary

• Economists use the model of supply and demand to analyze competitive markets with many buyers and sellers, all of whom are price takers.
• The demand curve shows how the quantity of a good demanded depends on the price.
  • Law of Demand: As the price of a good falls, the quantity demanded rises; the demand curve slopes downward.
  • Other determinants of demand: income, prices of substitutes and complements, tastes, expectations, and number of buyers. If one of these factors changes, the demand curve shifts.
• The supply curve shows how the quantity of a good supplied depends on the price.
  • Law of Supply: As the price of a good rises, the quantity supplied rises; the supply curve slopes upward.
  • Other determinants of supply: input prices, technology, expectations, and number of sellers. If one of these factors changes, the supply curve shifts.
• The intersection of the supply and demand curves determines the market equilibrium. At the equilibrium price, quantity demanded = quantity supplied.
• The behavior of buyers and sellers naturally drives markets toward their equilibrium.
  • When the market price is above the equilibrium price, there is a surplus of the good, which causes the market price to fall.
  • When the market price is below the equilibrium price, there is a shortage, which causes the market price to rise.
• To analyze how any event influences a market, we use the supply-and-demand diagram to examine how the event affects the equilibrium price and quantity.
  • Decide whether the event shifts the supply curve or the demand curve (or both).
  • Decide in which direction the curve shifts.
  • Compare the new equilibrium with the initial one.
• In market economies, prices are the signals that guide economic decisions and thereby allocate scarce resources.