Economics: Supply and Demand Model

Understanding Supply and Demand

What Economics Studies

  • Economics primarily studies how consumers and producers make decisions when faced with scarce income.

  • It investigates the outcomes that result from these decisions, particularly within markets.

The Supply and Demand Model (Chapter 3)

  • Purpose: This model helps explain various market phenomena.

  • Questions it can answer:

    • Why did the price of ventilators rise significantly during the COVID-19 crisis?

    • What causes computer prices to fall over time, opposing the general trend of rising prices for most other goods?

    • Why are roses more expensive on Valentine's Day?

  • Outline of Learning:

    • Questions addressable using the model.

    • Assumptions and results of the model, both abstractly and with artificial numbers.

    • Real-world applications of the framework.

    • Required learning outcomes.

Key Assumptions and Simplifications of the Model

  1. Single Market: The model assumes the analysis focuses on only one specific market.

  2. Identical Goods: All goods bought and sold within that market are considered identical.

  3. Uniform Price & Information: All goods sell for the same price, and all market participants (buyers and sellers) possess the same information regarding prices, quality, etc.

  4. Many Buyers and Sellers: There are a large number of independent buyers and sellers in the market, no single one having significant market power.

Demand

  • Definition: Demand represents the relationship between the price of a good and the quantity consumers are willing and able to purchase, holding all other factors constant (Ceteris Paribus).

    • Price: The monetary or other goods amount required to obtain a specific good.

    • Quantity Demanded: The specific amount of a good that people desire to buy at a given price during a defined period.

  • Law of Demand: This fundamental principle states that as the price of a good rises, the quantity demanded of that good tends to decline.

    • Graphical Representation: Consequently, a demand curve consistent with the Law of Demand must be downward sloping, illustrating a negative relationship between price and quantity demanded.

Violations of the Law of Demand

  • Veblen Goods (Luxury/Status Goods): These are goods where a higher price makes them more desirable because they signal wealth or status. For example, designer handbags or luxury cars might see increased demand as their price rises, as the elevated price enhances their status symbol.

  • Speculative/Expectations-driven Demand: If consumers anticipate that prices will continue to rise in the future, they may increase their current demand, even at higher prices, to avoid even higher future costs. Examples include housing bubbles, cryptocurrency surges, or certain tech stocks in rapidly growing markets.

  • Giffen Goods: These are rare inferior goods for which the income effect outweighs the substitution effect, leading to an increase in quantity demanded as price rises. During the Depression, poor households, when staples like bread or potatoes became more expensive, might have bought more of them. They could no longer afford more expensive foods (like meat), so they substituted towards the cheaper staple even if its price increased, just to meet basic calorie needs.

Example: Demand for Bicycles

Price ()

Quantity Demanded (Millions of Bicycles Per Year)

140

18

160

14

180

11

200

9

220

7

240

5

260

3

280

2

300

1

Shifts in the Demand Curve

  • Changes in quantity demanded refer to movements along a given demand curve, caused solely by a change in the good's own price.

    • An increase in price leads to a decrease in quantity demanded (upward movement along the curve).

    • A decrease in price leads to an increase in quantity demanded (downward movement along the curve).

  • Changes in demand refer to shifts of the entire demand curve, caused by factors other than the good's own price. These factors include:

    • Preferences: Changes in consumer tastes or popularity (e.g., a good becoming fashionable increases demand, shifting the curve right).

    • Number of Consumers: An increase in the number of potential buyers in the market (e.g., population growth) increases demand.

    • Consumers' Information: New information (e.g., health benefits or risks) can alter demand.

    • Consumers' Income:

      • Normal Goods: As income rises, demand for these goods increases (and vice-versa).

      • Inferior Goods: As income rises, demand for these goods decreases (and vice-versa).

    • Expectations of Future Prices: If consumers expect prices to rise in the future, current demand may increase.

    • Price of Related Goods:

      • Substitutes: Goods that can be used in place of each other (e.g., butter and margarine). If the price of a substitute rises, demand for the original good increases.

      • Complements: Goods that are typically consumed together (e.g., gasoline and SUVs). If the price of a complement rises, demand for the original good decreases.

Supply

  • Definition: Supply represents the relationship between the price of a good and the quantity producers are willing and able to sell, holding all other factors constant (Ceteris Paribus).

    • Price: The revenue producers receive for selling a specific good.

    • Quantity Supplied: The specific amount of a good that sellers are willing to offer for sale at a given price during a defined period.

  • Law of Supply: This principle states that as the price of a good rises, the quantity supplied of that good tends to increase.

    • Graphical Representation: Consequently, a supply curve consistent with the Law of Supply must be upward sloping, illustrating a positive relationship between price and quantity supplied.

Violation of the Law of Supply

  • Backward-bending Labor Supply Curve: At very high wage rates, some workers might prefer more leisure over supplying additional labor. Beyond a certain point, a higher wage could lead to a decrease in the quantity of labor supplied as the income effect (desire for more leisure) outweighs the substitution effect (desire for more earnings).

Example: Supply for Bicycles

Price ()

Quantity Supplied (Millions of Bicycles Per Year)

140

1

160

4

180

7

200

9

220

11

240

13

260

15

280

16

300

17

Shifts in the Supply Curve

  • Changes in quantity supplied refer to movements along a given supply curve, caused solely by a change in the good's own price.

    • An increase in price leads to an increase in quantity supplied (upward movement along the curve).

    • A decrease in price leads to a decrease in quantity supplied (downward movement along the curve).

  • Changes in supply refer to shifts of the entire supply curve, caused by factors other than the good's own price. These factors include:

    • Technology: New inventions or improved production methods typically increase efficiency, leading to an increase in supply (shift right).

    • Weather: Especially critical for agricultural products; favorable weather increases supply, unfavorable weather decreases it.

    • Number of Firms in Market: An increase in the number of producers means more goods can be supplied, shifting supply right.

    • Price of Goods Used in Production (Inputs): An increase in the cost of inputs (like fertilizer, labor, raw materials) reduces profitability and decreases supply (shift left).

    • Expectations of Future Prices: If firms expect prices to rise in the future, they might reduce current supply (e.g., farmers storing goods to sell next year) to sell at a higher price later.

    • Government Taxes, Subsidies, Regulations:

      • Taxes (e.g., commodity taxes): Increase production costs, decreasing supply.

      • Subsidies (e.g., agricultural subsidies): Reduce production costs, increasing supply.

      • Regulations (e.g., safety regulations): Can increase compliance costs, decreasing supply.

Overview of Supply and Demand

  • Supply describes firms:

    • Supply curve is upward sloping.

    • Law of Supply: Price and quantity supplied are positively related.

    • Movements along the curve: Price rises \rightarrow quantity supplied rises; Price falls \rightarrow quantity supplied falls.

    • Shifts in supply due to: Technology, Weather, Number of firms, Price of inputs, Expectations of future prices, Government policies (taxes, subsidies, regulations).

  • Demand describes consumers:

    • Demand curve is downward sloping.

    • Law of Demand: Price and quantity demanded are negatively related.

    • Movements along the curve: Price rises \rightarrow quantity demanded falls; Price falls \rightarrow quantity demanded rises.

    • Shifts in demand due to: Preferences, Number of consumers, Consumers' information, Consumers' income (normal vs. inferior goods), Expectations of future prices, Price of related goods (substitutes vs. complements).

Market Equilibrium

  • Equilibrium Price: The specific price at which the quantity that sellers are willing to sell precisely equals the quantity that consumers are willing to purchase. At this price, the market