Microeconomics: Supply and Demand

Microeconomics: Supply and Demand

Learning Objectives

• Understand Demand (Section 2.1)

• Understand Supply (Section 2.2)

• Analyze Market Equilibrium (Section 2.3)

• Examine the impact of Shocks to Equilibrium (Section 2.4)

• Explore the Effects of Government Interventions (Section 2.5)

• Determine When to Use the Supply-and-Demand Model (Section 2.6)

Demand: Determinants of Demand

• Consumers' decisions on how much to buy are based on a good's price and several other factors:

  • Tastes: Individual preferences and fashions.

  • Information: Knowledge about the product, its quality, and availability.

  • Prices of Other Goods: Prices of substitute or complement goods.

  • Income: Consumers' purchasing power.

  • Government Rules and Regulations: Policies such as taxes, subsidies, or restrictions.

  • Other Factors: Any other relevant influences not explicitly listed.

The Demand Curve

• Quantity Demanded ($Q$): The specific amount of a good or service that consumers are willing and able to buy at a given price, assuming all other factors influencing purchases remain constant.

• Demand Curve: A graphical representation showing the quantity demanded at each possible price, while holding other influencing factors constant.

Law of Demand

• The Law of Demand states that consumers demand more of a good when its price is lower, and less when its price is higher, assuming all other factors influencing consumption are held constant.

Effects of Other Factors on Demand

• Substitute: A good or service that can be consumed instead of another good or service. An increase in the price of a substitute typically increases the demand for the original good.

• Complement: A good or service that is typically consumed jointly with another good or service. An increase in the price of a complement typically decreases the demand for the original good.

• Distinction between Movement Along and Shift of a Demand Curve:

  • A movement along a demand curve is caused only by a change in the price of the good itself.

  • A shift of a demand curve is caused by a change in any factor other than the good's own price (e.g., changes in tastes, income, prices of substitutes/complements, information, or government rules).

  • Example (Figure 2.2): An increase in average income from $\$35,000$ to $\$50,000$ results in a shift of the demand curve for coffee from $D^1$ to $D^2$, indicating that at any given price, a higher quantity of coffee is demanded.

The Demand Function

• The demand function expresses the quantity demanded as a function of its price and other determinants.

• For coffee, the general demand function is: $Q = D(p, p_s, Y)$

  • $Q$: Quantity of coffee demanded (millions of tons per year).

  • $p$: Price of coffee (dollars per lb).

  • $p_s$: Price of sugar (dollars per lb).

  • $Y$: Average annual household income in high-income countries (thousands of dollars).

• Estimated World Demand Function for Green Coffee Beans: $Q = 12 - 2p + p_s + 0.5Y$

• Linear Demand Function (with specific values): Using assumed values like $p_s = \$1$ per lb and $Y = \$35,000$ per year ($Y=35$ for thousands of dollars):
  $Q = 12 - 2p + 1 + 0.5(35)$
  $Q = 12 - 2p + 1 + 17.5$
  $\mathbf{Q = 30.5 - 2p}$
  This simplified function shows the relationship between quantity demanded and coffee price, holding sugar price and income constant.

Solved Problem 2.1: Price Change for Quantity Increase

• Question: How much would the price have to fall for consumers to be willing to buy 1 million more tons of coffee per year?

• Given: The linear demand function for coffee: $Q = 30.5 - 2p$

• Step 1: Express Price as a Function of Quantity (Inverse Demand Curve):
  $Q = 30.5 - 2p$
  $2p = 30.5 - Q$
  $\mathbf{p = 15.25 - 0.5Q}$

• Step 2: Calculate the Change in Price for a 1 Million Ton Increase in Quantity:

  • Change in quantity is $\Delta Q = 1$ million tons.

  • Using the inverse demand curve, the change in price is: $\Delta p = -0.5 \times \Delta Q$

  • $\Delta p = -0.5 \times 1 = -\$0.50$

• Answer: The price must fall by $\$0.50$ per lb for consumers to buy 1 million more tons of coffee per year.

Summing Demand Curves (Market Demand)

• The total quantity demanded in a market at a given price is the sum of the quantities demanded by each individual consumer at that price.

• This process is called aggregation or horizontal summation of individual demand curves to derive the market demand curve.

• Application (Figure 2.15): Aggregating corn demand curves involves summing the quantities demanded for feed and food at each price to get the aggregate demand.

Supply

• Firms determine how much of a good to supply based on the good's price and other factors:

  • The Costs of Production: Includes wages, raw material prices, energy costs, and technology.

  • Government Rules and Regulations: Policies like taxes, subsidies, environmental regulations, or licensing requirements.

The Supply Curve

• Quantity Supplied ($Q$): The amount of a good or service that firms are willing to sell at a given price, holding constant other factors that influence their supply decisions (e.g., costs and government actions).

• Supply Curve: A graphical representation showing the quantity supplied at each possible price, while holding other influencing factors constant.

• Example (Figure 2.3): The estimated global supply curve for coffee shows the relationship between the quantity supplied per year and the price per lb, assuming costs and other factors affecting supply remain unchanged.

A Shift of a Supply Curve

• A change in any factor other than the good's own price (e.g., production costs, technology, government rules, or prices of other goods that can be produced) causes a shift of the supply curve.

• Example (Figure 2.4): An increase in the price of cocoa (a potential substitute in production, or a joint product) from $\$3$ to $\$6$ per lb might cause a shift of the coffee supply curve from $S^1$ to $S^2$. If cocoa production becomes more profitable, firms might shift resources away from coffee, decreasing coffee supply for any given coffee price.

The Supply Function

• The supply function expresses the quantity supplied as a function of its price and other determinants.

• For coffee, the general supply function is: $Q = S(p, p_c)$

  • $Q$: Quantity of coffee supplied (millions of tons per year).

  • $p$: Price of coffee (dollars per lb).

  • $p_c$: Price of cocoa (dollars per lb).

• Estimated Coffee Supply Function: $Q = 9.5 + 0.5p - 0.3p_c$

• Linear Supply Function (with specific value): Using an assumed value like $p_c = \$3$ per lb:
  $Q = 9.5 + 0.5p - 0.3(3)$
  $Q = 9.5 + 0.5p - 0.9$
  $\mathbf{Q = 8.6 + 0.5p}$
  This indicates that if the price of coffee increases by $\$1$, the quantity supplied increases by $0.5$ million tons per year.

Summing Supply Curves (Market Supply)

• The total supply curve shows the total quantity produced by all suppliers in a market at each possible price.

• It is the horizontal sum of each individual producer's supply curve, meaning at any given price, all individual quantities supplied are added together.

• Example (Figure 2.5): Total supply can be derived by summing domestic supply and foreign supply for a particular good, resulting in the aggregate total supply curve.

Solved Problem 2.2: Quotas on Sugar Imports

• Question: How does a quota set by the United States on foreign sugar imports (e.g., $\bar{Q}$) affect the total American supply curve for sugar, given a domestic supply curve ($S<em>d$) and foreign supply curve ($S</em>f$)?

• Answer (Figure 2.25):

  • Without a quota, the total supply in the U.S. is the horizontal sum of domestic and foreign supply ($S<em>d + S</em>f$).

  • If a quota ($\bar{Q}$) is imposed on foreign imports, the foreign supply becomes vertical at $\bar{Q}$ for quantities greater than $\bar{Q}$ (meaning imports cannot exceed $\bar{Q}$).

  • The total U.S. supply curve becomes the domestic supply plus the quota: $S<em>{total} = S</em>d + \bar{Q}$. This results in a kinked total supply curve. At prices where foreign suppliers would offer less than $\bar{Q}$, the original summed supply curve applies. However, at prices where foreign suppliers would offer more than $\bar{Q}$, the total supply is constrained by the quota, leading to a new total supply curve that is effectively shifted to the left and becomes steeper at higher quantities due to the foreign supply limit.

Market Equilibrium

• Equilibrium: A situation in a market where no participant (buyer or seller) has an incentive to change their behavior.

• Equilibrium Price ($p_e$): The price at which the quantity consumers are willing to buy precisely equals the quantity sellers are willing to sell.

• Equilibrium Quantity ($Q_e$): The amount of the good that consumers buy and suppliers sell at the equilibrium price.

• Determining Equilibrium Graphically (Figure 2.22): The equilibrium point ($e$) is where the demand curve ($D$) and the supply curve ($S$) intersect.

• Determining Equilibrium Mathematically:

  • Set the quantity demanded equal to the quantity supplied.

  • Given Demand: $Q_D = 30.5 - 2p$

  • Given Supply: $Q_S = 8.6 + 0.5p$

  • Equilibrium condition: $Q<em>D = Q</em>S$
    $30.5 - 2p = 8.6 + 0.5p$
    $21.9 = 2.5p$
    $p = \frac{21.9}{2.5} = \$8.76$

  • Substitute $p<em>e = \$8.76$ into either the demand or supply function to find $Q</em>e$:
    $Q<em>e = 30.5 - 2(8.76) = 30.5 - 17.52 = 12.98$ $Q</em>e = 8.6 + 0.5(8.76) = 8.6 + 4.38 = 12.98$

  • Equilibrium: Price is $\$8.76$ per lb, and Quantity is $12.98$ million tons per year.

Forces that Drive the Market to Equilibrium

• Disequilibrium: A situation where the quantity demanded is not equal to the quantity supplied.

• Excess Demand (Shortage): Occurs when the quantity demanded exceeds the quantity supplied at a specified price (QD > QS). This puts upward pressure on price as buyers compete for limited goods.

• Excess Supply (Surplus): Occurs when the quantity supplied is greater than the quantity demanded at a specified price (QS > QD). This puts downward pressure on price as sellers compete to sell off excess goods.

• Markets naturally adjust through price changes to eliminate excess demand or supply, moving towards equilibrium.

Shocking the Equilibrium

• Market equilibrium changes only if a shock occurs that shifts either the demand curve, the supply curve, or both.

• These curves shift if one of the underlying variables held constant when drawing the curves changes (e.g., tastes, income, government policies, or costs of production).

• Example 1: Increase in Price of Cocoa (Supply Shift) - Figure 2.7(a) and Solved Problem 2.3:

  • Assume an increase in the price of cocoa from $\$3$ to $\$6$ per lb.

  • Original Demand: $Q = 30.5 - 2p$

  • Original Supply: $Q = 8.6 + 0.5p$

  • Original Equilibrium: $p<em>{e1} = \$8.76$, $Q</em>{e1} = 12.98$

  • New Supply Function: With $p_c = \$6$
    $Q = 9.5 + 0.5p - 0.3(6) = 9.5 + 0.5p - 1.8 = 7.7 + 0.5p$

  • New Equilibrium: Set new supply equal to demand:
    $30.5 - 2p = 7.7 + 0.5p$
    $22.8 = 2.5p$
    $p_{e2} = \frac{22.8}{2.5} = \$9.12$

  • New Quantity: $Q_{e2} = 30.5 - 2(9.12) = 30.5 - 18.24 = 12.26$ million tons/year.

  • Change: Price increases by $\$0.36$ ($9.12 - 8.76$), and quantity decreases by $0.72$ million tons ($12.98 - 12.26$).

  • This shock (increased cocoa price) shifted the coffee supply curve to the left, resulting in a higher equilibrium price and lower equilibrium quantity for coffee.

• Example 2: Increase in Income (Demand Shift) - Figure 2.7(b):

  • An increase in average income ($\$15,000$ in this example) shifts the demand curve to the right.

  • This leads to a new equilibrium with a higher price and a higher quantity.

Effects of Government Interventions

• Government actions can influence markets in two primary ways:

  1. Shifting Supply or Demand Curves: Policies that directly affect production costs or consumer willingness to pay.

  2. Creating a Divergence between Quantity Demanded and Quantity Supplied: Policies that restrict prices or quantities, leading to disequilibrium.

• Policies that shift supply curves:

  • Licensing Laws: Can restrict entry into a market, reducing supply.

  • Quotas: Limits on the quantity of a good that can be imported or produced domestically.

    • Example (Figure 2.8): Ban on Rice Imports in Japan: A ban shifts the supply curve for rice in Japan dramatically to the left (removing foreign supply), leading to a much higher equilibrium price and lower quantity.

    • Solved Problem 2.4 (U.S. Sugar Quota): A binding quota on foreign sugar imports ($\bar{Q}$) effectively caps foreign supply at that level. The total supply curve becomes domestic supply plus the quota. If the quota is binding, it will increase the domestic price and reduce the total quantity available to consumers compared to a free-trade scenario.

• Policies that cause quantity demanded to differ from quantity supplied (Price Controls):

  • Price Ceilings: A maximum legal price that can be charged for a good or service.

    • Example (Figure 2.9): Price Ceiling on Gasoline: If a price ceiling ($\bar{p}$) is set below the equilibrium price ($p<em>e$), it creates excess demand (a shortage) because QD > Q_S. The market price cannot rise to clear the shortage.

  • Price Floors: A minimum legal price that can be charged for a good or service.

    • Solved Problem 2.5 (Minimum Wage): A binding minimum wage ($\bar{w}$) acts as a price floor in the labor market. If set above the equilibrium wage ($w^*$), it leads to excess supply of labor, which is unemployment (LS > LD). Employers demand less labor, and workers are willing to supply more, at the higher minimum wage.

Why the Quantity Supplied Need Not Equal the Quantity Demanded

• Common Confusion: It is often mistakenly believed that demand must always equal supply.

• In reality, the quantity that firms want to sell and the quantity that consumers want to buy at a given price need not equal the actual quantity that is bought and sold.

• This occurs when government interventions prevent the price from adjusting to its equilibrium level.

• Example: With a price ceiling, the quantity demanded exceeds the quantity supplied, but actual transactions are limited to the quantity supplied, not the quantity demanded, because sellers cannot be forced to sell more than they are willing at the regulated price.

When to Use the Supply-and-Demand Model

• The supply-and-demand model is most appropriate and yields the most accurate predictions for markets that exhibit characteristics of perfect competition.

• Conditions for a Perfectly Competitive Market:

  • Everyone is a Price Taker: Individual consumers and firms are so small relative to the market that their individual buying or selling decisions do not affect the market price. They must accept the prevailing market price.

  • Firms Sell Identical Products (Homogeneous Goods): Products sold by different firms are perfect substitutes for one another.

  • Everyone Has Full Information: Buyers and sellers have complete knowledge about prices, quality, and availability of goods.

  • Costs of Trading are Low: Transaction costs (e.g., search costs, negotiation costs) are negligible, allowing for easy entry and exit from the market.

• Application: Quantities and Prices of Genetically Modified Foods (Figure 2.49): Consumer concern about genetically modified (GM) foods can significantly impact demand curves. If there is little consumer concern, GM foods might have a high quantity and relatively stable price. If substantial consumer concern arises, demand could shift left, leading to lower quantities and potentially lower prices for GM foods, or a segregated market with different prices for GM and non-GM varieties. The model helps analyze these shifts and their market outcomes.