Chapter 2: Demand, Supply, and Market Equilibrium PDF

Chapter 2: Demand, supply and market equilibrium A/ Introduction 1/ Objective Present the two sides of the market: the demand (D) and the supply (S). From the demand side: define the D, examine the factors that affect it, and present market D From the supply side: define the supply, check the facto...

Chapter 2: Demand, supply and market equilibrium A/ Introduction 1/ Objective Present the two sides of the market: the demand (D) and the supply (S). From the demand side: define the D, examine the factors that affect it, and present market D From the supply side: define the supply, check the factors that affect it, and present market supply Market equilibrium: looking at both sides simultaneously  equilibrium dynamics 2/ Definitions Firms (producing units in an economy):  Organizations using inputs (labor, capital, land) to produce output (goods and services)  Of different scales (small, large, and small and medium sized enterprises (SMEs))  Profit-maximizing firms: most of the firms seek profit-making (sell their products for more than it costs to produce them) Households (consuming units):  There are different “types” of households: single-person household, a married couple, a family…etc.  Their consumption depends mainly on: i) tastes/preferences; ii) prices; iii) income/wealth Output markets  Where goods and services intended for the use of households are exchanged  In these markets: firms → Supply  they produce and offer goods and services Households → Demand  they buy available goods and services Input markets  Where inputs (labor, capital, land) intended for use by firms are exchanged  In these markets roles are inversed: households → Supply (labor, capital, land); and firms → Demand (labor, capital) B/ Demand in output markets 1/ Objective Study the demand (D) for a single good that an individual household decides to consume within a certain period of time Note: the D is always defined per period of time 2/ Definition of a quantity demanded It is the amount (quantity) of a product that a household is willing and able to buy in a given period at the current market price, holding other things constant (ceteris paribus) 3/ The law of D The D schedule: 1 Definition: a schedule that shows the quantities of a product that a household is able and willing to buy at different possible prices during a period of time, ceteris paribus Anna’s example: the schedule shows Anna’s demand for telephone calls Price ($/call) Quantity demanded (calls/month) 0 30 0.5 25 3.5 7 7 3 10 1 15 0 “Reading” the schedule: if telephone calls were free  Anna would call her boyfriend every day during the month (30 times)…etc. Note: the D schedule does not tell us which price will ultimately prevail in the market: it is simply a "mind" process revealing how many calls Anna would be willing to do at different possible prices The D curve: Definition: a graph illustrating how much of a given product a household would be willing to buy at different prices during a given period of time, ceteris paribus; it is simply the graphical counterpart of a D schedule By convention, we illustrate the price on the Y-axis (vertical axis) and the quantity on the X-axis (horizontal axis) P A B Q (calls/month) The negative relationship between quantity demanded and price: the table and the graph show that at lower prices Anna would call her boyfriend more often, while at higher prices she would call him less frequently  There is an inverse (negative) relationship between quantity demanded and price (the law of demand). On the graph, the negative relationship is reflected via the negative slope. 2 Explanation of the negative relationship between the quantity demanded and the price:  Households have limited financial resources (income (Y), wealth (W)) to allot over a wide range of goods and services  an increase of the price of a particular good, ceteris paribus (holding other things constant),  fewer resources are available to purchase the rest of the goods  ↘ the quantity purchased of the product whose price increases  Law of diminishing marginal utility: Defining total utility: the satisfaction (pleasure) associated with the consumption of a given good during a given time period Defining marginal utility: the satisfaction associated with the consumption of an additional unit of a given good during a given time period Within a given time period, an additional/successive unit of a consumed good is likely associated with a lower utility (the utility associated with a first ice cream cone is probably higher than the one associated with a second one. The third cone is worth less and so on)  If each additional unit of a good is worth less to you, you are not going to be willing to pay as much for it  the only way for you to get extra units of the good is when the price drops => explanation of a downward slope in the demand curve. We can use the concept of diminishing marginal utility in Anna’s example: the demand curve is a way to illustrate how much she is willing to pay per phone call → at a price of $7, she calls her boyfriend 3 times per month. A fourth call is worth less for here  she is not willing to pay $7 for a fourth call; she will only make 3 calls at that price. If the price were $3.5 she would make a fourth (and more) call. Remark : it intersects the Y axis (after a certain price, the quantity demanded is 0 (due to limited financial resources)); it intersects the X axis (even if the price is 0, there is a limit to the quantity demanded in a given period of time (due to time constraints and the law of decreasing marginal utility) 4/ From household demand to market demand Definition: The sum of all the quantities of a good/service demanded per period by all households in an economy Price ($) Qd by A Qd by B Qd by C Total Qd in the market (Q) 3.5 4 1 4 9 1.5 8 3 9 20 3  Example of an economy with 2 households A + A' A' P0 A B + B' B' B P1 5/ Other determinants of D Introduction: Economists acknowledge that, besides the price, the quantity demanded for a given product is affected by other factors. For instance, the quantity that you would be willing to purchase of Pepsi Cola depends not only on its price, but also on the price of products that you can consume in lieu of Pepsi, such as the price of Coca Cola, or Seven Up. In what follows, we consider all the major factors that would affect the quantity demanded for a product. We also consider what happens when each of the latter changes. What are the factors that are kept constant in the famous "ceteris paribus"?  Y (income) and W (wealth) Definition of Y: the sum of financial earnings in a given period of time; month/year. It is thus a flow measure  we must specify a time period for it  it is defined per month/year. Definition of W: the total value of what a household owns – what it owes measured at any point in time  it is a stock measure. A positive relationship between Y/W levels and D: generally, the quantity demanded (QD) tends to rise when Y/W levels rise (at every possible price) and vice versa. Normal (superior) goods (definition): goods for which QD goes up when income is higher (at every possible price) and for which QD goes down when income is lower (at every possible price) Inferior goods (definition): goods for which QD goes down when income is higher (at every possible price) and vice versa: public transport or certain goods for which better- quality substitutes exist  Prices of other goods Remark: since financial resources are allotted over a wide range of goods and services ΔP of any good affects the demand of other goods. We distinguish between substitutes and complementary goods. Substitutes are goods that can serve as replacements for one another  when the price of one good increases the QD for its substitute increases, at every possible price (bananas/apples). Complementary goods are goods that “go 4  together”  when the price of one good increases, the QD for its complements decreases, at every possible price (milk/cornflakes)  Tastes/preferences Δ in tastes/preferences also affects the market behavior: within the constraints of prices and income, preferences affect the D curve. Example: when consumers started taking care of their health with fitness objectives, they started preferring consuming fruits and vegetables as opposed to meat and fatty food => increase in the quantity demanded of fruits at every possible level  Expectations about prices and Y/W While deciding how much to consume of a given good, we take into account not only today’s prices and income, but also expectations about future P, Y, and W. Example how expectations affect QD (at every possible price): if you anticipate a severe and prolonged increase of the price of a bundle of bread  you will buy more at any given (current) price => the D for bread increases  Number of buyers: an increase in the number of buyers will increase Qd at every price level => the D curve shifts to the right; vice versa 5/ Shift of the D versus movement along the D curve Back to the future: definition of the D curve: It is the (negative) relationship between the price and the quantity demanded of a given good, holding other elements constant. Movement along the D curve: any ΔP  a ΔQD  a movement along the initial D curve Shift of the D: a Δ in any of the abovementioned 4 elements  a new relationship between the P and QD  a new D curve  a shift of the initial D curve (this is why the 5 elements are also called D shifters) Back to Anna’s example Price ($/call) (t0) D0 schedule (t1) D1 schedule Qd (calls/month at an Y of Qd (calls/month at an Y of $300/month) $600/month) 0 30 31 0.5 25 33 3.5 7 18 7 3 12 10 1 7 15 0 2 20 0 0 At (t0), we assume that Anna had a part-time job that paid $300. At (t1), she got a raise, so that her job now pays $600. With higher Y, Anna would probably call her boyfriend more frequently, at any possible price  there is a new relationship between price and QD  there is a new D curve  a shift of the D curve to the right 5 In general, a change in any of the other determinants of demand will shift the demand curve either to the right (increase in demand) or to the left (drop in demand): C/Supply (S) in output markets 1/ The law of S QS: definition The quantity supplied (QS) is the amount of a particular product that a firm is willing and able to offer for sale at a given price (current price) during a given time period, ceteris paribus S schedule: A table showing how much of a product a firm is able and willing to sell at alternative possible prices during a period of time, ceteris paribus: for instance, the following table shows quantities of soybeans that a given farmer is able and willing to sell at different prices. A farmer’s supply schedule for soybeans Price ($/bushel) Qs (bushels/year) 1.5 0 1.75 10 000 2.25 20 000 3 30 000 4 45 000 5 55 000 If the market price were $1.5, the farmer will not be willing to enter the market (Qs is 0): recall that microeconomics looks at profit-maximizing firms. Profit is the difference between revenues and costs at a price of $1.5 revenues are not sufficient to generate a positive profit  a price of $1.5 will not compensate the farmer’s costs of production  it is not profitable to produce soybeans. At a higher price, $1.75, some soybean production takes place as it becomes profitable. Higher prices (> $1.75) justify an increase in Qs (for example by using more intensive farming techniques (fertilizers or equipments) that were not cost-justified at lower prices). 6 We therefore can conclude that, ceteris paribus, there is a positive relationship between market price and Qs: an increase in market price leads to an increase in Qs  the law of S The law of S: An increase in market price will  an increase in the Qs, and vice versa S curve: We can illustrate the S schedule using a diagram (the S curve) P B A QS It has a positive slope that reflects the law of S (the positive relationship between Qs and the price)  It intersects the Y axis (at a price ≤ 1.5$ → costs > revenue  no profits  no production) 2/ From individual S to market S 1/ Definition Market S: the sum of all that is supplied each period by all producers of a given product; Deriving market S from 3 firms’S curves: Price ($) Qs by firm A Qs by firm B Qs by firm C Total Qs in the market (Q) 3 30 000 10 000 25 000 65 000 1.75 10 000 5 000 10 000 25 000 3/ Other determinants of S Introduction As was the case when deriving the demand schedule/curve, economists acknowledge that, besides the price, the quantity supplied of a given product is affected by other factors. For instance, the quantity that you would be willing to sell of wheat depends not only on its price, but also on the price of products that you can produce in lieu of wheat, such as soybeans. What are the factors that are kept constant in the famous "ceteris paribus"?  Resource prices: Prices of input affect costs of production:↗ input prices  ↗ costs of production  ↘ production (↘QS at every possible price level) (example: airlines faced higher fuel cost  airlines cut some low-profit routes); and vice versa 7   Technology/technological changes can have a significant impact on the cost of production over time. Let us consider the agricultural example (technological innovations in agriculture): introduction of technological innovations (fertilizers, new machinery, bioengineering)  ↗ productivity (i.e. ↗ yield/acre)  ↗ production (↗QS at every possible price level)  Taxes and subsidies: higher taxes paid by businesses => higher cost => decrease in Qs at every possible price level decrease in S (vice versa); a subsidy is a "tax in reverse": thus larger subsidies => reduction in the cost of production => increase in S (vice versa)  Prices of related products: Firms often react to variations of the prices (ΔP) of related products; Example (agricultural land that is used to produce wheat; an increase in the price of soybean  producers will use more land to produce soybeans  ↘ production of wheat: ↘ QS at every possible price level)  Number of sellers: an increase in the number of sellers will lead to an increase in market supply (vice versa) 4/ Shifts of S versus movement along the S curve Back to the future 2: S curve definition: It is the relationship between the price and the Qs of a given product, holding other elements constant When only the price varies  variation in QS  a movement along the S curve When any other factor (that was held constant, also called supply shifters) varies  new relationship between the price and the QS  a new S curve  a shift of the S curve Example Price ($/bushel) (t0) S0 schedule (t1) S1 schedule Qs (bushels/year using old Qs (bushels/year using new fertilizer) fertilizer) 1.5 0 5 000 1.75 10 000 15 000 2.25 20 000 25 000 3 30 000 35 000 4 45 000 50 000 5 55 000 60 000 8 Suppose that a breakthrough in the production has occurred: the introduction of a new fertilizer that will imply more yield/acre  this technological change would enable farmers to produce more soybeans at any possible price level  a new relationship between price and Qs  a new S curve  a shift of the S curve. In general, a change in any of the other determinants of demand will shift the demand curve either to the right (increase in demand) or to the left (drop in demand): P B A QS D/ Market equilibrium 1/ Objective See how S and D interact in the market to determine the market (equilibrium) price At any moment, 3 cases can exist in every market:  Excess D (shortage of supply): when at the current price level, QD exceeds Qs  Excess S (surplus): when at the current price level, Qs exceeds QD  Equilibrium: when Qs = QD at the current price 2/ Excess D The road to equilibrium: When excess D occurs, there is a tendency for price to increase as demanders compete against each other for limited QS. First example (auction): first, at the starting low price → there are many bidders (buyers) relatively to the quantity supplied (1 unit)  excess D  price goes up  ↘ QD (many bidders drop out) until the last man standing. Second example (agriculture market): 9  P ($/bushel) S D E A B Qs: 25,000 Qd:50,000 Q (bushels/month Analysis:  Starting point: price = $1.75; Qd = 50,000; Qs = 25,000 => excess D (of 25,000)  competition among buyers for the limited QS  ↗ price  As price goes up: o On the supply side: it becomes more profitable for producers to use more intensive farming techniques for soybean production (Qs increases along the SAME supply curve) o On the demand side: some will substitute other cereals for soybeans (Qd drops along the SAME demand curve) o Thus, excess D shrinks  The process of an increase in the price continues (as long as there is excess D)  It stops when excess D is 0 => when Qd = Qs => intersection between the D and S curves  Equilibrium: equilibrium price ($2.5) and equilibrium quantity (35,000). 3/ Excess S Excess S exists when the Qs exceeds the QD at the current price. Back to the auction example: if the initial price is too high  no bidder would want to buy  Excess S (0 Qs)  ↘ price (the seller would like to attract potential buyers) 10 Agricultural market example: P S A B E D 20,000 40, 000 Q Analysis:  Starting point: price = $3; Qd = 20,000; Qs = 40,000 => excess S (of 20,000)  competition among suppliers for the limited QD  drop in the price  As price goes down: o On the supply side: it becomes more profitable for producers to use less intensive farming techniques (Qs decreases along the SAME supply curve) o On the demand side: some will substitute soybeans for other cereals (Qd increased along the SAME demand curve) o Thus, excess S shrinks  The process of a decrease in the price continues (as long as there is excess S)  It stops when excess S is 0 => when Qd = Qs => intersection between the D and S curves  Equilibrium: equilibrium price ($2.5) and equilibrium quantity (35,000). Remark: the same “process” happens after Christmas holidays: during the holidays, some items are not totally sold out (as expected)  excess S  there is a cut in p (this explains the sales) 3/ Equilibrium Definition of equilibrium: a situation where there is no tendency for further price adjustments  when QD = Qs Where Qs = Qd; the equilibrium market price is known as the market clearing price: the price where the intentions of buyers and sellers match; Rationing function of the prices: the ability of the price movements to match Qd and Qs and reach a level where the intentions of buyers and sellers match is known as the rationing function of the price: at the equilibrium price, there is no excess supply and no excess D 11 4/ Changes in equilibrium When D curve and/or S curve vary  the equilibrium varies Example: the drought that affected S of wheat worldwide (2007): drop in S (leading to an increase in p and a drop in q): S1 P E S0 P1 B P0 A D Qs1 Qe1 Qe0; Qs0 = Qd Q Analysis:  Initial equilibrium: QS0 = QD (Qe0) and P = P0  The supply curve shifts to the left (from S0 to S1)  At the initial equilibrium price, there is now excess D (QD > QS1)  The price will increase: QD drops + QS (along the new S curve) increases  The process continues to reach the equilibrium: higher price and smaller amount exchanged 12