Topic 2-Shifts in Supply and Demand PDF

Topic 2. SHIFTS IN SUPPLY AND DEMAND [BM] Chap. 2, Appendix A.2. [M] Chap. 4 Humberto Llavador and Rosemarie Nagel What do we learn today? 2  TODAY... More on the Theory of competitive marke...

Topic 2. SHIFTS IN SUPPLY AND DEMAND [BM] Chap. 2, Appendix A.2. [M] Chap. 4 Humberto Llavador and Rosemarie Nagel What do we learn today? 2  TODAY... More on the Theory of competitive markets. Analysis of Supply: – Variable Costs vs. Fixed Costs. – Long Term Analysis Vs. Short Term Analysis Comparative Statics Movements along the curve vs. shifts of the curve 3  REVIEW: COMPETITIVE EQUILIBRIUM THEORY Market: a group of buyers and sellers of a particular good or service Competitive Market: a market in which there are so many buyers and so many sellers that each has a negligible impact on the market price Characteristics of a perfectly competitive market: The goods being offered for sale are exactly the same. The buyers and sellers are so numerous that no single buyer or seller has any influence over the market price. Because buyers and sellers must accept the market price as given, they are often called "price takers.” 4  REVIEW: COMPETITIVE EQUILIBRIUM THEORY: SUPPLY AND DEMAND Which are the exogenous variables in the theory of Competitive Markets? Necessary data (input) – Supply Curve – Demand Curve Which are the variables predicted by the Theory of Competitive Markets? Prediction (output) – P*: Equilibrium Price – Q*: Equilibrium Quantity – Market surplus (consumers’ + producers’) 5 Your experimental results 6  THE SUPPLY CURVE Difference in "costs" between Experiment 1 and Experiment 2: – Experiment 1: apple suppliers incurred costs only if they actually sold (variable cost). – Experiment 2: fishermen incurred costs regardless of whether they sell or not (fixed cost) 7  ANALYSIS OF THE SUPPLY Definition: The costs that have already been incurred and cannot be reduced by altering the production are known as non-recoverable or fixed costs. The costs that vary when the number of units sold varies are called variable costs. Definition: long-term decisions are the decisions taken thinking of the future at a time when non- recoverable costs are not yet non-recoverable. Once non-recoverable cost have already been incurred, the decisions are called short-term decisions. 8  ANALYSIS OF THE SUPPLY Apples in Experiment 1: variable costs à the minimum price to accept is the variable cost. Example: variable cost = 5, => reserve price (minimum price at which seller accepts to sell) = 5. Fish in Experiment 2: only fixed costs à the minimum price to accept is any price > 0 (because any positive price will help cover the fixed costs already incurred). Ex: fixed costs = 10 and variable costs = 0, Reserve price = 0. 9  SHIFT IN SUPPLY Let us analyze what happens to supply between Session 1 and Session 2 of Experiment 2. We draw the Supply in Session 1 and Session 2 and compare the predictions of (P *, Q *), called the equilibrium in the two situations. 10 Table of Distribution of the Supply Table of Supply (Data in Session 1) In Session 1 Type Amount Cost Price Amounts FIXED Range (P) Offered Offer 15 10 P 0 15 11 Table of Distribution of the Table of Supply Supply In Session 1: (We must (Data in Session 1) construct it from left hand table) Type Amount Cost Price Amounts FIXED Range (P) Offered Offer 15 10 P 0 15 12 Table of Distribution of the Table of Supply Supply In Session 1: (We must (Data in Session 1) construct it from left hand table) Type Amount Cost Price Amounts FIXED Range (P) Offered Offer 15 10 P 0 15 13  SUPPLY TABLE à SUPPLY CURVE (1) P SUPPLY (1) P Q 25 P = 0 15 5 15 20 30 Q 14 Table of Distribution of the Table of Supply Supply In Session 2: (We must (Detail in Session 2) construct it from left hand table) Type Amount Cost Price Amounts FIXED Range (P) Offered Offer 25 10 P 0 25 15 Table of Distribution of the Table of Supply Supply In Session 2: (We must (Detail in Session 2) construct it from left hand table) Type Amount Cost Price Amounts FIXED Range (P) Offered Offer 25 10 P 0 25 16 Table of Distribution of the Supply Table of Supply (Detail in Session 2) In Session 2 Type Amount Cost Price Amounts FIXED Range (P) Offered Offer 25 10 P = 0 25 17  SUPPLY TABLE à SUPPLY CURVE P P Q Supply2 25 P=0 25 5 20 30 Q 18 PRICE AND QUANTITY EQUILIBRIUM (1) AND (2) P SUPPLY (1) SUPPLY (2) 30 POINT OF EQUILIBRIUM (1): 25 DEMAND DEMAND = SUPPLY (1) 20 P1 *= 15, Q1 *= 15 15 POINT OF EQUILIBRIUM (2): 10 DEMAND = SUPPLY (2) P2 *= 5, Q2 *= 25 5 15 20 25 30 Q 19  BENEFITS IN EQUILIBRIUM P SUPPLY (1) Consumer surplus SUPPLY (2) 6 ´ 5 = 30 30 Profits of POINT OF EQUILIBRIUM (1): 25 sellers DEMAND DEMAND = SUPPLY (1) (15´15)–(15´10) 20 = 75 P1 *= 15, Q1 *= 15 Fix costs!!! 15 POINT OF EQUILIBRIUM (2): NOT IN GRAPH 10 DEMAND = SUPPLY (2) 5 P2 *= 5, Q2 *= 25 5 10 15 20 25 30 Q 20  BENEFITS IN EQUILIBRIUM (2) P SUPPLY (1) SUPPLY (2) 30 POINT OF EQUILIBRIUM (1): 25 DEMAND DEMAND = SUPPLY (1) 20 P1 *= 15, Q1 *= 15 15 Consumer POINT OF EQUILIBRIUM (2): surplus 10 (5´5)+(17´10) = DEMAND = SUPPLY (2) 195 P2 *= 5, Q2 *= 25 5 Profits of sellers (25´5)–(15´10) = -25 5 10 15 20 25 30 Q 21 Fix costs!!! Not in graph  WHAT HAS HAPPENED? When supply increases, it shifts to the right (outward): – Equilibrium price: Decreases – Equilibrium quantity: Increases Exercise: When demand increases, it shifts to the right (outward). What happens with: – Equilibrium price? Increases – Equilibrium quantity? Stay the same (in this case) 22  COMPARATIVE STATICS Comparative statics: a procedure to predict how external causes (shifts in the supply curve or demand curve) will affect the economic variables of interest (P*, Q*, and surplus), keeping all else constant (ceteris paribus) 23  COMPARATIVE STATICS: HOW? 1. The curves of supply and demand prior to the variation are plotted and the prediction of the equilibrium values of economic variables of interest are observed. (P1, Q1) 2. The curves of supply and demand after the variation are plotted, and the new equilibrium values are predicted. (P2, Q2) 3. We compare the equilibrium values these variables had before the variation with those afterwards. (P1, Q1) vs. (P2, Q2) 24  THE SUPPLY CURVE Definition: The supply curve tells us the total amount of goods which the suppliers of goods would like to sell at each possible prices. Supply: schedule of all pairs of prices and quantities at which the supplier is willing to sell. 25  DETERMINANTS OF THE SUPPLY CURVE a. An increase in supply at any given price is represented by a shift of the supply curve to the right. b. A decrease in supply at any given price is represented by a shift of the supply curve to the left. Because the market supply curve holds other things (e.g. input prices) constant, the supply curve will shift if any of these factors changes. 1. Input Prices (these are the prices for input goods, like wheel of a car) 2. Technology 3. Expectations 4. Number of Sellers 26  THE DEMAND CURVE Definition: The demand curve tells us the total amount which buyers would like to acquire a good at each of the possible prices 27  SHIFTS IN THE DEMAND CURVE a. An increase in demand is represented by a shift of the demand curve to the right. Example: new immigrants b. A decrease in demand is represented by a shift of the demand curve to the left. If any of these other factors change, the demand curve will shift. 1. Income: The relationship between income and quantity demanded depends on what type of good the product is. 2. Prices of Related Goods a. Definition of substitutes: two goods for which an increase in the price of one good leads to an increase in the demand for the other. b. Definition of complements: two goods for which an increase in the price of one good leads to a decrease in the demand for the other. 3. Tastes 4. Expectations: (i) Future income; (ii) Future prices 5. Number of Buyers 28 THREE STEPS TO ANALYZING CHANGES IN EQ M To determine the effects of any event, 1. Decide whether event shifts S curve, D curve, or both. 2. Decide in which direction curve shifts. 3. Use supply-demand diagram to see how the shift changes eq m P and Q. 29  SHIFTS IN THE CURVE VS. MOVEMENTS ALONG THE CURVE Increase in the valuation of a good: Shift in the demand curve The quantity demanded increases due to a drop in the price: movement along the demand curve Cost reduction due to a technological change: shift in the supply curve Supply is reduced because of a decrease in the price: movement along the supply curve 30 EXAMPLE: THE MARKET FOR HYBRID CARS P price of S1 hybrid cars Hybrid car is a car that uses P1 less gas than other cars, because it produces (electric) energy while driving, which then can be used for driving D1 Q Q1 quantity of hybrid cars 31 EXAMPLE 1: A SHIFT IN DEMAND EVENT TO BE ANALYZED: Increase in price of gas P (not in graph, exogenous). S1 STEP 1: P2 D curve shifts, because STEP 2: price of gas P1 affects demand for D shifts right ** hybrids. because STEP 3: high gas S curve price doeshybrids makes not D1 D2 The shift shift, causes because an price more attractive Q increase of gas in price does not cars. Q1 Q2 relative to other and quantity affect cost of of hybrid cars. producing hybrids. ** more people want cars which use less gas 32 EXAMPLE 1: A SHIFT IN DEMAND Notice: P When P rises, S1 producers supply a larger quantity P2 of hybrids, even though the S curve P1 has not shifted. Always be careful D1 D2 to distinguish b/w a shift in a curve Q Q1 Q2 and a movement along the curve. 33 EXAMPLE 2: A SHIFT IN SUPPLY EVENT: New technology reduces cost of P producing hybrid cars. S1 S2 STEP 1: S curve shifts because STEP 2: event affects P1 cost of production. S shifts right P2 D curve does because event not STEPbecause shift, 3: reduces cost, D1 The shift causes production technology makes production Q price is not to onefallof the Q1 Q2 more profitable at and quantity factors that to rise. affect any given price. demand. 34 SHIFTS IN SUPPLY AND DEMAND Use the three-step method to analyze the effects of each event on the equilibrium price and quantity of music downloads. Event A: A fall in the price of CDs Event B: Sellers of music downloads negotiate a reduction in the royalties (=payment for each song they sell). Event C: Events A and B both occur. 35  A. FALL IN PRICE OF CDS (EXOGENOUS), SOME DEMANDERS PREFER TO BUY CDS INSTEAD TO DOWNLOAD The market for STEPS P music downloads 1. D curve shifts S1 2. D shifts left P1 3. P and Q both fall. P2 D2 D1 Q Q2 Q1 36  B. FALL IN COST OF ROYALTIES STEPS The market for P music downloads 1. S curve shifts S1 S2 2. S shifts right P1 3. P falls, Q rises. P2 (Royalties are part of sellers costs) D1 Q Q1 Q2 37  C. FALL IN PRICE OF CDS AND FALL IN COST OF ROYALTIES STEPS 1. Both curves shift (see parts A & B). 2. D shifts left, S shifts right. 3. P unambiguously falls. Effect on Q is ambiguous: The fall in demand reduces Q, the increase in supply increases Q. 38 SHIFTS WITH LINEAR SUPPLY AND DEMAND Supply: P = 10 + Q (Positive Slope (1)) Demand: P = 20-Q (Pending Refusal (-1)) What if Demand becomes P = 30-Q? What if Supply becomes P = 5 + Q? 39  BASELINE (1): LINEAR SUPPLY AND DEMAND Supply: P = 10 + Q (Positive Slope (1)) Demand: P = 20-Q (Negative Slope (-1)) P SUPPLY 20 15 10 DEMAND 0 5 10 Q 40  DEMAND DISPLACEMENT: DEMAND (2) P = 30-Q Supply (Equal): P = 10 + Q Demand (1): P = 20-Q à Demand (2): P = 30-Q P 30 SUPPLY Equilibrium (2): 20 Supply = Demand (2) P * increases P2 *= 20, Q2 *= 10 15 Equlilibrium (1): DEMAND (2) Supply = Demand (1) 10 P1 *= 15, Q1 *= 5 DEMAND (1) 0 5 10 30 Q 41 Q * increases  EXERCISE Compute analitically the effects of a shift in the demand curve on: (i) the equilibrium price, (ii) equilibrium quantity, and (iii) consumers’ and producers’ surplus 42  DEMAND SHIFT: DEMAND (2) P = 30-Q Calculate the equilibrium (1): P = 10 + Q P = 20-Q 10+Q=20-Qà2Q=10à Q1*=5 P1*=10+5=15 Consumer Surplus: [(20-15) * 5] / 2 = 12.5 Producer Profits : [(15-10) * 5] / 2 = 12.5 Calculate the equilibrium (2): P = 10 + Q P = 30-Q 10+Q=30-Qà2Q=20à Q2*=10 P2*=10+10=20 Consumer Surplus: [(30-20) * 10] / 2 = 50 Producer Profits : [(20-10) * 10] / 2 = 50 43  SHIFT IN SUPPLY: SUPPLY (2) P = 5 + Q Supply (1): P = 10 + Q à Supply (2): P = 5 + Q Demand (Equal): P = 20-Q P 30 SUPPLY (1) Equilibrium (1): Supply = Demand (1) SUPPLY (2) 20 P1 *= 15, Q1 *= 5 Q * decreases 15 Equilibrium (2): Offer 10 (2) = Demand P2 *= 12.5, Q2 *= 7.5 DEMAND 0 5 10 30 Q 44 Q * increases  EXERCISE Compute analitically the effects of a shift in the supply curve on: (i) the equilibrium price, (ii) equilibrium quantity, and (iii) consumers’ and producers’ surplus 45  SHIFT IN SUPPLY: SUPPLY (2) P = 5 + Q Calculate the equilibrium (1): P = 10 + Q P = 20-Q 10+Q=20-Qà2Q=10à Q1*=5 P1*=10+5=15 Consumer Surplus: [(20-15) * 5] / 2 = 12.5 Producer Profits : [(15-10) * 5] / 2 = 12.5 Calculate the equilibrium (2): P=5+Q P = 20-Q 5+Q=20-Qà2Q=15à Q2*=7.5 P2*=5+7.5=12.5 Consumer Surplus: [(20-12.5) * 7.5] / 2 = 28,125 Producer Profits : [(12.5-5) * 7.5] / 2 = 28,125 46  SUMMARY Analysis of Supply – Fixed Costs Vs. Variable Costs – How do they affect the construction of the Supply Table and Supply Curve? Comparative Statics: Shift in Supply and Demand curves analytically and graphically with staggered as well as linear curves. – What happens to Q *? – What happens to P *? – What happens to profits at equilibrium? 47  RECOMMENDATIONS AND TASKS Recomendations: – Read Topic 2 and Appendix A.2 in [BM] and chapter 5 in [M] – Do exercises 1.3-1.6 in Appendix A.2. [BM] For next week’s seminar: – Do the homework! (no experiment) 48