Comprehensive Study Guide on Demand and Supply Analysis

Introduction to Demand and Supply Analysis

Economists utilize demand and supply analysis as a fundamental microeconomic tool, comparable to a carpenter's toolset.
The study of markets is divided into two primary sides: the demand side (buyers) and the supply side (sellers).
Key objectives of demand and supply analysis include:
- Distinguishing between a change in demand and a change in quantity demanded.
- Deriving market demand and market supply through the aggregation of individuals.
- Determining the market equilibrium price ( $P^*$ ) and quantity ( $Q^*$ ).
- Analyzing how the price system under capitalism answers the fundamental questions: "What will be produced?", "How will it be produced?", and "For whom will it be produced?"
- Examining the impact of government interventions, including taxes, subsidies, import tariffs, export subsidies, and price/quantity controls (e.g., rent controls or quotas).
- Studying market behaviors for illegal goods and black markets.

Individual and Market Demand

Definition of Demand: Demand indicates the quantities of a good or service that a household (or individual) is willing and able to purchase at various prices, assuming "other things remain the same" (ceteris paribus).
The Demand Schedule and the Law of Demand:
- A demand schedule (e.g., Table 2.1) shows the relationship between price and quantity demanded.
- Law of Demand: Ceteris paribus, the quantity demanded of a commodity is larger at lower market prices and smaller at higher market prices. There is an inverse relationship between price ( $P$ ) and quantity demanded ( $Q_d$ ).
- Intuitive Reasoning: If the price of a good (e.g., oranges) rises while income and the prices of other goods remain constant, consumers must cut consumption. They often substitute the now more expensive good with relatively cheaper alternatives (e.g., substituting oranges with grapefruit).
The Demand Curve:
- Quantities are measured on the horizontal axis ( $X-axis$ ) and price on the vertical axis ( $Y-axis$ ).
- Although quantity is the dependent variable, this layout follows the tradition of English economist Alfred Marshall ( $1842\text{-}1924$ ), who viewed the curve from the seller's perspective (asking what price is required to sell a specific quantity).
- The curve is downward-sloping (negatively sloped) due to the law of demand.
- Demand curves are not necessarily linear or of constant slope; they are often drawn as straight lines for simplicity.
Aggregation of Market Demand:
- Market demand is derived by summing the quantities demanded by all consumers in the market at each specific price level (horizontal summation).
- Example (Table 2.2): If at a price of $\$10$ , Consumer 1 demands $5\,\text{units}$ and Consumer 2 demands $8\,\text{units}$ , the market demand at $\$10$ is $13\,\text{units}$ .

Changes in Demand vs. Changes in Quantity Demanded

Confusing Terminology:
- Demand: Refers to the entire relationship between price and quantity (the whole curve).
- Quantity Demanded: Refers to a specific point on a stationary demand curve corresponding to a single price.
Movement vs. Shift:
- A change in the price of the good itself results in a movement along a stationary demand curve, referred to as a "change in quantity demanded."
- A violation of the ceteris paribus condition results in a shift of the entire curve, referred to as a "change in demand."
- Increase in Demand: More of the commodity is demanded at every price; the curve shifts to the right.
- Decrease in Demand: Less of the commodity is demanded at every price; the curve shifts to the left.
Determinants of Demand Shifts:
- Changes in Tastes: If Americans start drinking tea more often (imitating the British), demand for tea increases while demand for coffee decreases.
- Changes in Weather: A dry summer decreases demand for umbrellas.
- Changes in Incomes:
  - Normal Goods: Goods for which demand increases as income increases (e.g., tennis racquets, beer, pizza).
  - Inferior Goods: Goods for which demand decreases as income increases (e.g., canned meat, used clothing).
- Changes in Prices of Other Commodities:
  - Substitutes: An increase in the price of Good $X$ leads to an increase in demand for Good $Y$ (e.g., beef and chicken, pizza and hamburgers).
  - Complements: An increase in the price of Good $X$ leads to a decrease in demand for Good $Y$ (e.g., pizza and beer, cars and gasoline).
- Changes in Expectations: Rumors that car prices will rise next year increase demand for cars this year.

Individual and Market Supply

Definition of Supply: Supply indicates the quantities of a good or service that a seller is willing and able to provide at various prices, ceteris paribus.
The Law of Supply:
- Ceteris paribus, the quantity supplied ( $Q_s$ ) will be larger at higher market prices and smaller at lower market prices.
- The relationship is direct; the supply curve has a positive slope (slopes upward from left to right).
Law of Diminishing Returns:
- This provides the theoretical basis for the upward-sloping supply curve.
- Example: In a bicycle factory, if $10\,\text{workers}$ produce $100\,\text{bikes}$ and $20\,\text{workers}$ produce $200$ , adding a $30^{\text{th}}$ worker might only increase total output to $270$ . Because successive units of labor produce less extra output, the cost of producing extra units increases, requiring higher prices to justify production.
Deriving Market Supply:
- Market supply is the horizontal summation of quantities supplied by all sellers at each price level.
- Requirement: This simple summation assumes no specialized inputs are involved, meaning firms can move along individual curves without affecting input prices or overall production costs.

Changes in Supply

Distinguishing Supply from Quantity Supplied:
- Supply: The entire price-quantity relationship (the whole curve).
- Quantity Supplied: A specific point on the curve at one price.
Factors Producing Shifts in the Supply Curve:
- New discoveries (e.g., new natural gas fields shift supply right).
- Availability of new technology (e.g., personal computer technology shifts supply right).
- Changes in weather (e.g., bad weather shifts the supply of wine left).
- Changes in the prices of alternate outputs (e.g., if soybean prices rise, farmers plant fewer acres of wheat, shifting wheat supply left).
- Changes in the supply of inputs (e.g., a reduction in steel supply shifts the car supply curve left).

Market Equilibrium

Equilibrium Defined: Denotes a state of rest where no tendency to change exists. It occurs at the intersection of market demand and market supply.
- Equilibrium Price ( $P^*$ ): The price at which the quantity buyers want to buy equals the quantity sellers want to sell.
- Equilibrium Quantity ( $Q^*$ ): The total quantity transacted at $P^*$ ( $Q_d = Q_s$ ).
Disequilibrium Conditions:
- Excess Supply (Surplus): Occurs when the market price ( $P_1$ ) is above $P^*$ . Sellers cannot sell all they want, putting downward pressure on price.
- Excess Demand (Shortage): Occurs when the market price ( $P_2$ ) is below $P^*$ . Buyers cannot buy all they want, putting upward pressure on price.
The Tatonnement Process:
- Named after French economist Leon Walras ( $1834\text{-}1910$ ), this involves a hypothetical "Walrasian auctioneer" who calls out prices and adjusts them based on bids until supply equals demand ( $Q_s = Q_d$ ). Only then does trade occur.

Comparative Statics: Effects of Shifts in Curves

Comparative statics involves studying the effects of shifts in demand or supply on the equilibrium position (Table 2.5).

Shift Case	Effect on Price ( $P$ )	Effect on Quantity ( $Q$ )
Demand Increase (Supply Unchanged)	Increase $(+)$	Increase $(+)$
Supply Increase (Demand Unchanged)	Decrease $(-)$	Increase $(+)$
Demand Increase & Supply Increase	Indeterminate $(?)$	Increase $(+)$
Demand Increase & Supply Decrease	Increase $(+)$	Indeterminate $(?)$
Demand Decrease (Supply Unchanged)	Decrease $(-)$	Decrease $(-)$

Real-World Examples of Market Dynamics

Example 2.1: Florida Orange Juice Market:
- Historically, prices fluctuated due to supply shifts caused by winter freezes in Florida. In Jan $1982$ , Jan $1984$ , and Jan $1985$ , prices rose to levels between $\$1.65$ and $\$1.90\,\text{per pound}$ .
- Supply eventually shifted right as the industry moved south of Orlando and Brazil became a major producer, causing prices to fall to $\$0.80$ in March $1986$ .
- Subsequent price rises to $\$1.70$ by the end of $1987$ were driven by increased demand fueled by health consciousness.
Example 2.2: The Copper Market:
- In the $1980s$ , prices swung from over $\$1.00\,\text{per pound}$ in $1980$ to $\$0.60$ in $1986$ .
- Demand Decrease: Caused by the shift to fiber optics and plastic pipes.
- Supply Increase: Low-cost producers in Zaire, Chile, and Zambia entered. High-cost U.S. producers (costs above $\$0.65$ ) exited.
- In late $1987$ , prices shot up from $\$0.62$ in June to $\$1.20$ in November due to supply disruptions in Africa and Chile and high demand from South Korea, Japan, and Taiwan.
- Mention of the Hunt Brothers (silver market, $1980$ ): Pushed silver from $\$6$ to $\$50\,\text{per ounce}$ before the market crashed, leaving them with millions instead of billions.

General Principles of Taxes and Subsidies

The Tax/Subsidy Wedge: In the presence of taxes or subsidies, the price buyers pay ( $P_{buyers}$ ) differs from the price suppliers keep ( $P_{sellers}$ ).
Excise (Per Unit) Tax:
- A fixed amount ( $T$ ) on each unit (e.g., gasoline, liquor).
- Equilibrium Identity: $P_{buyers} = P_{sellers} + T$ .
- Graphically, the tax creates a vertical wedge of height $T$ between the demand and supply curves. Quantity transacted falls from $Q_0$ to $Q_1$ .
- Incidence: The price for buyers rises from $P_0$ to $P_1$ , while the price for sellers falls from $P_0$ to $P_2$ .
- Political Misconceptions: Mention of the confusion by President Carter and reporters who argued that a tax would first raise prices, but the resulting "decrease in demand" would then lower them. Economically, there is no shift in the demand curve, only a movement along it toward a new equilibrium where $Q_d = Q_s$ .
Sales Tax (Percentage Tax):
- Unlike a parallel shift/wedge (per unit tax), a percentage tax causes the curves to rotate. For an $8\%$ tax, the wedge is calculated as $(P_{buyers} - P_{sellers}) = 0.08 \times P_{sellers}$ .
Production Subsidy:
- A per-unit subsidy ( $Z$ ) causes the price buyers pay to fall and the price sellers get to rise.
- Equilibrium Identity: $P_{sellers} = P_{buyers} + Z$ .
- Equilibrium quantity increases from $Q_0$ to $Q_1$ .

Import Tariffs and Export Subsidies

Import Tariff ( $T$ ):
- Domestic Price: If the world price is $P_w$ , the tariff raises the domestic price to $P_d = P_w + T$ .
- Domestic quantity supplied increases, domestic quantity demanded decreases, and imports fall.
- Equivalence: A tariff of $T$ is exactly equivalent to a domestic production subsidy of $T$ plus a consumption tax of $T$ .
Export Subsidy ( $Z$ ):
- The government pays $Z$ for every unit exported. This raises the domestic price to $P_d = P_w + Z$ .
- Domestic quantity demanded falls, domestic quantity supplied increases, and total exports increase.
- Government Cost: Represented by the area of the rectangle $BCFE$ , where $BC$ is the quantity of exports.
Example 2.3: The World Sugar Market:
- Sugar accounts for $10\%$ of global available calories.
- History: Regulated by the U.S. since $1789$ . Quota systems established in $1934$ .
- Subsidies: The U.S. subsidizes sugar at $20\text{-}22\,\text{cents per pound}$ , while world prices have dipped as low as $3.5\,\text{cents}$ ( $1985$ ) and $6.5\,\text{cents}$ ( $1987$ ).
- Market Inefficiencies: High price supports led to the development of substitutes like high-fructose corn syrup and forced the Commodity Credit Corporation to dump sugar (selling it to China at $4.75\,\text{cents}$ when the world price was $6.33\,\text{cents}$ ).

Price and Quantity Controls

Price Ceilings: A maximum price set below the equilibrium level (e.g., rent control, natural gas price controls).
- Leads to persistent excess demand (shortages).
- Long-run Considerations: While supply may be fixed in the short run ( $Q_0$ ), facilitating an income transfer from landlords to tenants, in the long run, supply usually shrinks.
Price Floors: A minimum price set above equilibrium (e.g., agricultural price supports, minimum wage).
- Leads to persistent excess supply (gluts).
- In labor markets, the surplus becomes unemployment.
- In agriculture, the government must purchase the surplus (e.g., USDA buyout of $1.6\,\text{million}$ milk cows in $1986$ to reduce milk production).
Quantity Controls (Quotas): A restriction on the units transacted (e.g., import quotas, pollution standards, acreage controls).
- An import quota limiting imports to level $BC$ has the same price effect as a tariff.
- If quantity licenses are auctioned, the government gains revenue equal to the tariff revenue. If given away (lottery), producers reap the windfall gains.

Illegal Activities and Black Markets

Illegal Markets: Buying and selling a prohibited good $X$ (e.g., drugs, human organs).
- Penalties on sellers shift the supply curve left; penalties on buyers shift the demand curve left.
- If only sellers are penalized, price rises sharply but quantity transacted falls less than if both sides were penalized.
Black Markets: Arise when trade occurs at prices above a government-mandated ceiling.
- Examples: Superbowl ticket scalping, trade in communist countries.
- The IRS estimated losses of $\$90\,\text{billion}$ in unpaid taxes due to black market activity and cheating in $1981$ , projected to reach $\$135\,\text{billion}$ by $1985$ .
- Analysis suggests that to control black market prices effectively, it is better to penalize buyers than sellers.

Exceptions to the Laws of Demand and Supply

Goods with Snob Appeal (Conspicuous Consumption): Phrase coined by Thornstein Veblen ( $1899$ ). Demand for items like high-end jewelry or fur coats may fall if prices are reduced because their value is derived from their high cost.
Uncertain Product Quality: Consumers may use price as a signal for quality. If the price is raised, they may assume quality has improved and demand more.
Giffen Goods: Theoretical cases suggested by Robert Giffen where demand curves for certain inferior goods might slope upward. There is little empirical evidence for their existence.

Questions & Discussion

Question 3 (VCR Market): How do events affect equilibrium?
- Incomes Increase: Demand increases, price increases, quantity increases.
- Copyright Enforcement: Likely decreases demand for VCRs used for recording, reducing price and quantity.
- Movie Theater Price Reduction: Theatres are substitutes; decreased theater prices decrease demand for VCRs/home movies.
Question 6 (Political Reasoning Criticism): Criticizing a leader saying "With falling crude oil prices, refineries will struggle to keep up with the increase in demand for gasoline."
- Flaw: Falling input prices (crude oil) cause an increase in supply, not an increase in demand. The result is an increase in quantity demanded due to a lower equilibrium price.
Example 2.5 (Supplier-Induced Demand): Fuchs and Kramer found that in the medical field, more doctors per capita resulted in more per capita visits and operations (visits positively associated with physician density). Fuchs found that a $10\%$ increase in surgeon/population ratio leads to a $3\%$ increase in per capita utilization. This suggests increased supply may not necessarily lower the price of medical care.