Topic 2: Demand and Supply PDF

EC4101 Topic 2: Demand and Supply How Markets Work Learning objectives What a competitive market is and how it is described by the supply and demand model What the demand curve and supply curve are The difference between movements along a curve and shifts of a curve How the supply and...

EC4101 Topic 2: Demand and Supply How Markets Work Learning objectives What a competitive market is and how it is described by the supply and demand model What the demand curve and supply curve are The difference between movements along a curve and shifts of a curve How the supply and demand curves determine a market’s equilibrium price and equilibrium quantity In the case of a shortage or surplus, how price moves the market back to equilibrium Markets and competition A competitive market: Many buyers and sellers Same good or service Perfect competition Products are identical (homogenous) Numerous buyers and sellers so that each has no influence over price Buyers and sellers are price takers Monopoly One producer only who controls price Competition: perfect and otherwise Oligopoly Few sellers Firms generally rely on non-price competition Monopolistic Competition Many sellers Slightly differentiated products Each seller may set price for its own product Markets and competition The supply and demand model is a model of how a competitive market works Five key elements: Demand curve: determined by buyers Supply curve: determined by sellers Demand and supply curve shifts Market equilibrium Changes in the market equilibrium Demand Demand represents the behaviour of buyers What made him buy it? A demand curve shows the quantity demanded at various prices The quantity demanded: the quantity that buyers are willing (and able) to purchase at a particular price  The Demand Schedule and the Demand Curve Demand Schedule for Coffee Beans Price of coffee (per pound) Price of coffee Quantity of coffee beans (per beans demanded pound) (billions of pounds) €2.00 €2.00 7.1 1.75 1.75 7.5 1.50 1.50 8.1 1.25 1.00 1.25 8.9 0.75 As price falls, the 1.00 10.0 Demand quantity curve, D 0.50 demanded rises 0.75 11.5 0 7 9 11 13 15 17 0.50 14.2 Quantity of coffee (per pound)  Don’t be sloppy in terminology: a “change in a “change in demand” quantity demanded” Changes in Demand vs. Changes in Quantity Demanded Change in demand Change in quantity demanded Price Price €1.00 €1.00 D2.50 D1 D1 10 15 10 14.2 Quantity Quantity  An Increase in Demand An increase in the population and Demand Schedules for Coffee Beans other factors generate an increase Price of coffee Quantity of coffee in demand beans (per pound) beans demanded (billions of pounds) i.e. a rise in the quantity demanded at in 2002 in 2006 any given price €2.00 7.1 8.5 1.75 7.5 9.0 1.50 8.1 9.7 This is represented by the two 1.25 1.00 8.9 10.0 10.7 12.0 demand schedules - one showing 0.75 11.5 13.8 demand in 2002, before the rise in 0.50 14.2 17.0 population, the other showing demand in 2006, after the rise  An Increase in Demand Price of coffee beans (per pound) €2.00 1.75 Demand curve in Increase in 2006 population → 1.50 1.25 more coffee 1.00 drinkers 0.75 Demand curve in 0.50 2002 D D 1 2 0 7 9 11 13 15 17 Quantity of coffee beans (billions of pounds) A shift of the demand curve is a change in the quantity demanded at any given price, represented by the change of the original demand curve to a new position, denoted by a new demand curve Movement Along the Demand Curve A movement along the demand Price of coffee curve is a change in the quantity beans (per A shift of the demanded of a good that is the pound) demand curve… result of a change in that good’s €2.00 price 1.75 … is not the same A C thing as a movement 1.50 along the demand curve 1.25 B 1.00 0.75 0.50 D D 1 2 0 7 8.1 9.7 10 13 15 17 Quantity of coffee beans (billions of pounds) Understanding shifts of the demand curve Important demand shifters: 1. Changes in the prices of related goods or services 2. Changes in income 3. Changes in tastes 4. Changes in expectations 5. Changes in the number of consumers 1. Changes in the prices of related goods Substitutes: Two goods are substitutes if a fall in the price of one of the goods makes consumers less willing to buy the other good The demand for a good will increase (demand curve shifts right) if the price of a substitute good rises and vice versa e.g. ↑Price of leads to ↑demand for 1. Changes in the prices of related goods Complements: Two goods are complements if a fall in the price of one good makes people more willing to buy the other good The demand for a good will increase (demand curve shifts right) if the price of a complementary good falls and vice versa e.g. ↓price of leads to ↑demand for 2. Changes in income Effect on demand depends on the nature of the good in question… Normal Goods: demand increases when income increases (and vice versa) Inferior Goods: Demand decreases when income increases (and vice versa) versus 3. Changes in Preferences and Tastes When tastes change in favour of a good, more people want to buy it at any given price and demand for the good increases (and vice versa) Tastes and preferences are subjective and vary among consumers Seasonal changes/fads have predictable effects on demand… 4. Changes in expectations If consumers have a choice about the timing of a purchase, they buy according to expectations Expectation of a future rise in price of good causes an increase in demand today (and vice versa) Buyers adjust current spending in anticipation of the direction of future prices in order to obtain the lowest possible price e.g. if prices for houses are expected to increase next year, what will happen to sales this year? 5. Changes in the number of consumers As the population of an economy changes, the number of buyers of a particular good also changes (thereby changing its demand) An increase in population (consumers) will increase demand for a good (demand shifts right) and vice versa more = more Market demand versus individual demand Market demand refers to the sum of all individual demand for a particular good or service Graphically, individual demand curves are summed horizontally to obtain the market demand curve  Individual and market demand curves The market demand curve is the horizontal sum of the individual demand curves of all consumers in that market (a) (b) (c) Julie’s Individual Nick’s Individual Market Demand Curve Demand Curve Demand Curve Price of Price of Price of coffee coffee coffee beans (per beans (per beans (per pound) pound) pound) €2 €2 €2 DMarket 1 1 1 DJulie DNick 0 20 30 0 10 20 0 30 40 50 Quantity of coffee Quantity of coffee Quantity of coffee beans (pounds) beans (pounds) beans (pounds) Supply Supply represents the behaviour of sellers A supply curve shows the quantity supplied at various prices. The quantity supplied is the quantity that producers are willing and able to sell at a particular price.  Supply schedule and the supply curve Price of coffee Supply Schedule for Coffee Beans beans (per pound) Quantity of beans Price of coffee supplied Supply beans (billions of curve, S (per pound) pounds) €2.00 Before entry 1.75 As price rises, the €2.00 11.6 1.50 quantity supplied rises 1.75 11.5 1.25 1.50 11.2 1.00 1.25 10.7 0.75 1.00 10.0 0.50 0.75 9.1 0 7 9 11 13 0.50 8.0 Quantity of coffee beans (billions of pounds) An increase in supply The entry of Vietnam into the coffee Supply Schedule for Coffee Beans bean business generated an Price of Quantity of beans supplied increase in supply coffee beans (billions of pounds) i.e. a rise in the quantity supplied at (per pound) Before entry After entry any given price €2.00 11.6 13.9 1.75 11.5 13.8 This event is represented by the two 1.50 11.2 13.4 supply schedules – one showing 1.25 10.7 12.8 supply before Vietnam’s entry, the 1.00 10.0 12.0 other showing supply after Vietnam 0.75 9.1 10.9 came in 0.50 8.0 9.6  An increase in supply Price of coffee beans (per pound) S S 1 2 €2.00 Vietnam enters 1.75 Pre-Vietnam Supply Curve coffee bean 1.50 business → 1.25 more coffee producers 1.00 0.75 Post-Vietnam Supply Curve 0.50 0 7 9 11 13 15 17 Quantity of coffee beans (billions of pounds) A shift of the supply curve is a change in the quantity supplied of a good at any given price  Movement along the supply curve Price of coffee beans (per pound) S S 1 2 €2.00 A movement along the supply 1.75 curve… 1.50 B 1.25 A 1.00 C … is not the 0.75 same thing as a shift of the 0.50 supply curve 0 7 10 11.2 12 15 17 Quantity of coffee beans (billions of pounds) A movement along the supply curve is a change in the quantity supplied of a good that is the result of a change in that good’s price  Shifts of the supply curve Price Any “increase in supply” S 3 S 1 S 2 means a rightward shift of the supply curve: at any Increase in supply given price, there is an increase in the quantity supplied. (S1→ S2) Any “decrease in supply” Decrease in supply means a leftward shift of the supply curve: at any given price, there is a Quantity decrease in the quantity supplied. (S1→ S3) Understanding shifts of the supply curve Important supply shifters include changes in: 1. input prices 2. the prices of related goods or services 3. technology 4. expectations 5. the number of producers 1. Changes in input prices A decrease in the price of an input (all else equal) increases profits and encourages more supply (and vice versa) Drop in increase in = price of supply of What causes a supply curve to shift? Inputs used in production have opportunity costs. Sellers will choose to use inputs whose profit is the highest Sellers will supply less of a good if its profitability falls (and vice versa) There are substitutes and complements in production processes Complement in sugar production? … Molasses Substitute in corn production? … Cotton When a producer sells several products, the quantity of any one good it is willing to supply at any given price depends on the prices of its other co-produced goods What causes a supply curve to shift? Changes in technology Improvements in technology reduces the cost of production (producer can spend less on inputs to produce same level of output) and the supply curve shifts right Changes in expectations An increase in the expected future price of a good reduces supply today (supply curve shifts left) and vice versa Changes in the number of producers An increase in the number of producers of a good shifts supply curve right and vice versa  Individual and market supply curves The market supply curve is the horizontal sum of the individual supply curves of all firms in that market (a) (b) (c) Nescafé’s Individual Kenco’s Individual Supply Market Supply Curve Price of Price of Supply Curve Curve Price of coffee coffee beans coffee SNescaféa beans SKenco beans SMarket (per €2 (per €2 €2 pound) (per pound) pound) 1 1 1 0 1 2 3 0 1 2 0 1 2 3 4 5 Quantity of coffee Quantity of coffee Quantity of coffee beans (pounds) beans (pounds) beans (pounds) Supply, demand and equilibrium Equilibrium in a competitive market: when the quantity demanded of a good equals the quantity supplied of that good The price at which this takes place is the equilibrium price (a.k.a. market-clearing price): Every buyer finds a seller and vice versa The quantity of the good bought and sold at that price is the equilibrium quantity.  Recall…. Demand Schedule for Coffee Supply Schedule for Coffee Beans Beans Quantity of Quantity of Price of coffee beans Price of coffee beans coffee beans demanded coffee beans supplied (per pound) (billions of (per pound) (billions of pounds) pounds) €2.00 7.1 €2.00 11.6 1.75 7.5 1.75 11.5 1.50 8.1 1.50 11.2 1.25 8.9 1.25 10.7 1.00 10.0 1.00 10.0 0.75 11.5 0.75 9.1 0.50 14.2 0.50 8.0  Market equilibrium Price of coffee beans (per pound) Market equilibrium Supply occurs at point E, €2.00 where the supply 1.75 curve and the demand 1.50 curve intersect 1.25 Equilibrium 1.00 E Equilibrium price 0.75 0.50 Demand 0 7 10 13 15 17 Quantity of coffee beans Equilibrium (billions of pounds) quantity  Surplus (excess supply) Price of coffee beans (per pound) There is a surplus of a Supply good when the quantity $2.00 supplied exceeds the 1.75 Surplus quantity demanded. 1.50 Surpluses occur when 1.25 the price is above its E equilibrium level 1.00 0.75 0.50 Demand 0 7 8.1 10 11.2 13 15 17 Quantity of coffee beans (billions of pounds) Quantity Quantity demanded supplied  Shortage (excess demand) Price of coffee beans There is a shortage of a (per pound) good when the quantity Supply €2.00 demanded exceeds the 1.75 quantity supplied. 1.50 Shortages occur when 1.25 the price is below its equilibrium level 1.00 E 0.75 Shortage 0.50 Demand 0 7 9.1 10 11.5 13 15 17 Quantity of coffee beans (billions of pounds) Quantity Quantity supplied demanded Excess supply and demand When there is excess supply or a surplus… Suppliers will lower the price to increase sales, thereby moving toward equilibrium When there is excess demand or a shortage… Suppliers will raise the price due to too many buyers chasing too few goods, thereby moving toward equilibrium Three steps to analysing changes in equilibrium Decide whether an event shifts the supply or demand curve (or both) Decide whether the curve(s) shift(s) to the left or to the right Use the supply and demand model to see how the shift affects equilibrium price and quantity Equilibrium and shifts of the demand curve Price of coffee beans An increase in demand… Supply … leads to a E movement along the 2 supply curve due to a P 2 higher equilibrium price Price E and higher equilibrium rises 1 quantity P 1 D 2 D 1 Q Q 1 2 Quantity of coffee beans Quantity rises Equilibrium and shifts of the supply curve Price of coffee beans S S 2 1 A decrease in supply… E P 2 2 … leads to a movement Price along the demand curve rises due to a higher P E1 equilibrium price and 1 lower equilibrium quantity Demand Q Q Quantity of coffee beans 2 1 Quantity falls Which curve was it anyway? How do you know what caused a price change? Look at the outcome: if the price and quantity move together, it was a demand change… …if they move in opposite directions, a supply change. Simultaneous shifts of supply and demand (a) One possible outcome: Price Rises, Quantity Rises Price of coffee Small decrease The increase in in supply S 2 S 1 demand dominates the decrease in E 2 supply P 2 Two opposing E P 1 forces determining 1 the equilibrium D D 1 2 quantity Large increase in demand Q Q2 Quantity of coffee 1 Simultaneous shifts of supply and demand (b) Another Possibility Outcome: Price Rises, Quantity Falls Price of coffee Large decrease S The decrease in in supply 2 supply dominates S 1 the increase in E P 2 demand 2 E 1 Small increase Two opposing forces P in demand 1 determining the equilibrium quantity D 2 D 1 Q Q Quantity of coffee 2 1 Simultaneous shifts of supply and demand We can make the following predictions about the outcome when the supply and demand curves shift simultaneously: Simultaneous Shifts of Supply Supply Increases Supply Decreases and Demand Demand Price: ambiguous Price: up Increases Quantity: up Quantity: ambiguous Demand Price: down Price: ambiguous Decreases Quantity: ambiguous Quantity: down Summary 1. The supply and demand model illustrates how a competitive market works 2. The demand schedule shows the quantity demanded at each price and is represented graphically by a demand curve. The law of demand says that demand curves slope downward 3. A movement along the demand curve occurs when a price change leads to a change in the quantity demanded. When economists talk of increasing or decreasing demand, they mean shifts of the demand curve – a change in the quantity demanded at any given price Summary 4. There are five main factors that shift the demand curve: A change in the prices of related goods or services A change in income A change in tastes A change in expectations A change in the number of consumers 5. The market demand curve for a good or service is the horizontal sum of the individual demand curves of all consumers in the market. 6. The supply schedule shows the quantity supplied at each price and is represented graphically by a supply curve. Supply curves usually slope upward. Summary 7. A movement along the supply curve occurs when a price change leads to a change in the quantity supplied. When economists talk of increasing or decreasing supply, they mean shifts of the supply curve – a change in the quantity supplied at any given price 8. There are five main factors that shift the supply curve: A change in input prices A change in the prices of related goods and services A change in technology A change in expectations A change in the number of producers 9. The market supply curve for a good or service is the horizontal sum of the individual supply curves of all producers in the market. Summary 10. The supply and demand model is based on the principle that the price in a market moves to its equilibrium price, or market-clearing price, the price at which the quantity demanded is equal to the quantity supplied. This quantity is the equilibrium quantity. When the price is above its market-clearing level, there is a surplus that pushes the price down When the price is below its market-clearing level, there is a shortage that pushes the price up Summary 11. An increase in demand increases both the equilibrium price and the equilibrium quantity; a decrease in demand has the opposite effect. An increase in supply reduces the equilibrium price and increases the equilibrium quantity; a decrease in supply has the opposite effect 12. Shifts of the demand curve and the supply curve can happen simultaneously.