chapter3 Demand Supply and Market Equilibrium.pdf

Chap 3: Demand, Supply and Market Equilibrium IN THIS CHAPTER YOU WILL LEARN:  What demand is and what affects it.  What supply is and what affects it.  How supply and demand together determine market equilibrium.  How changes in supply and demand affect equilibrium prices and quantities.  Wha...

Chap 3: Demand, Supply and Market Equilibrium IN THIS CHAPTER YOU WILL LEARN:  What demand is and what affects it.  What supply is and what affects it.  How supply and demand together determine market equilibrium.  How changes in supply and demand affect equilibrium prices and quantities.  What government-set prices are and how they can cause product surpluses and shortages. The tools of demand and supply can take us far in understanding how individual markets work. 1- Markets  Markets bring together buyers (demanders) and sellers (suppliers), and they exist in many forms. Examples:  The corner gas station, an e-commerce site, the local music store, the New York Stock Exchange.  Auctioneers bring together potential buyers and sellers of art, livestock, used farm equipment, and, sometimes, real estate.  Some are highly personal, involving face-to-face contact between demander and supplier; others are faceless, with buyer and seller never seeing or knowing each other.  Some markets are local; others are national or international. 1- Markets  To keep things simple, we will focus in this chapter on markets consisting of large numbers of independently acting buyers and sellers of standardized products.  These are the highly competitive markets such as a central grain exchange, a stock market, or a market for foreign currencies in which the price is “discovered” through the interacting decisions of buyers and sellers. All such markets involve demand, supply, price, and quantity. 2- Demand  Demand is a schedule or a curve that shows the various amounts of a product that consumers are willing and able to purchase at each of a series of possible prices during a specified period of time.  Demand shows the quantities of a product that will be purchased at various possible prices, other things equal (ceteris paribus).  Demand can easily be shown in table form.  The table in Figure 3.1 (page 46) is a hypothetical demand schedule for a single consumer purchasing bushels of corn. Note: The table does not tell us which of the five possible prices will actually exist in the corn market. 2-1 Law of Demand  A fundamental characteristic of demand is this: Other things equal (ceteris paribus), as price falls, the quantity demanded rises, and as price rises, the quantity demanded falls. In short, there is a negative or inverse relationship between price and quantity demanded.  Economists call this inverse relationship the law of demand. The other-things-equal assumption is critical here.  Many factors other than the price of the product being considered affect the amount purchased. 2-1 Law of Demand Example:  The quantity of Nikes purchased will depend not only on the price of Nikes but also on the prices of such substitutes as Reeboks, Adidas, and New Balances.  The law of demand in this case says that fewer Nikes will be purchased if the price of Nikes rises and if the prices of Reeboks and Adidas all remain constant.  If the price of Nikes and the prices of all other competing shoes increase by some amount -say, $5- consumers might buy more, less, or the same number of Nikes. 2-1 Law of Demand  Why the inverse relationship between price and quantity demanded? Let’s look at three explanations:  People ordinarily do buy more of a product at a low price than at a high price. Price is an obstacle that deters consumers from buying. The higher that obstacle, the less of a product they will buy; the lower the price obstacle, the more they will buy.  Consumption is subject to diminishing marginal utility because successive units of a particular product yield less and less marginal utility, consumers will buy additional units only if the price of those units is progressively reduced.  The income effect indicates that a lower price increases the purchasing power of a buyer’s money income, enabling the buyer to purchase more of the product than before. 2-2 The Demand Curve  The inverse relationship between price and quantity demanded for any product can be represented on a simple graph, in which, by convention, we measure quantity demanded on the horizontal axis and price on the vertical axis.  In the graph in Figure 3.1 (page 46) we have plotted the five pricequantity data points listed in the accompanying table and connected the points with a smooth curve, labeled D. Such a curve is called a demand curve.  The relationship between price and quantity demanded is inverse (or negative). 2-3 Market Demand  So far, we have concentrated on just one consumer. But competition requires that more than one buyer be present in each market.  By adding the quantities demanded by all consumers at each of the various possible prices, we can get from individual demand to market demand. • If there are just three buyers in the market, as represented in the table in Figure 3.2 (page 48), it is relatively easy to determine the total quantity demanded at each price.  In constructing a demand curve such as D (market) in Figure 3.2, economists assume that price is the most important influence on the amount of any product purchased. 2-3 Market Demand  But economists know that other factors can and do affect purchases. These factors, called determinants of demand, are assumed to be constant when a demand curve like D (market) is drawn.  They are the “other things equal” in the relationship between price and quantity demanded.  When any of these determinants changes, the demand curve will shift to the right or left.  For this reason, determinants of demand are sometimes referred to as demand shifters.  The basic determinants of demand are (1) consumers’ tastes (preferences), (2) the number of buyers in the market, (3) consumers’ incomes, (4) the prices of related goods, and (5) consumer expectations. 2-4 Change in Demand  A change in one or more of the determinants of demand will change the demand data (the demand schedule) in the table accompanying Figure 3.3 (page 49) and therefore the location of the demand curve there.  A change in the demand schedule or, graphically, a shift in the demand curve is called a change in demand. Example: - If consumers desire to buy more corn at each possible price than is reflected in column 2 in the table in Figure 3.3, that increase in demand is shown as a shift of the demand curve to the right, say, from D1 to D2. - Conversely, a decrease in demand occurs when consumers buy less corn at each possible price than is indicated in column 2. The leftward shift of the demand curve from D1 to D3 in Figure 3.3 shows that situation. 2-4 Change in Demand  Now let’s see how changes in each determinant affect demand. 1) Tastes  A favorable change in consumer tastes (preferences) for a producta change that makes the product more desirable-means that more of it will be demanded at each price. Demand will increase; the demand curve will shift rightward.  An unfavorable change in consumer preferences will decrease demand, shifting the demand curve to the left. Example:  Consumers’ concern over the health hazards of cholesterol and obesity have increased the demand for broccoli, low-calorie beverages, and fresh fruit while decreasing the demand for beef, veal, eggs, and whole milk. 2-4 Change in Demand 2) Number of Buyers  An increase in the number of buyers in a market is likely to increase product demand the demand curve will shift rightward  A decrease in the number of buyers will probably decrease demand, shifting the demand curve to the left. Example:  The rising number of older persons in the United States in recent years has increased the demand for motor homes, medical care, and retirement communities. 2-4 Change in Demand 3) Income  How changes in income affect demand is a more complex matter.  For most products, a rise in income causes an increase in demand. Consumers typically buy more steaks, furniture, …  Conversely, the demand for such products declines as their incomes fall. Products whose demand varies directly with money income are called superior goods, or normal goods.  Although most products are normal goods, there are some exceptions.  As incomes increase beyond some point, the demand for used clothing and retread tires may decrease, because the higher incomes enable consumers to buy new versions of those products.  Goods whose demand varies inversely with money income are called inferior goods . 2-4 Change in Demand 4) Prices of Related Goods  A change in the price of a related good may either increase or decrease the demand for a product, depending on whether the related good is a substitute or a complement:  A substitute good is one that can be used in place of another good.  A complementary good is one that is used together with another good.  Substitutes: When two products are substitutes, an increase in the price of one will increase the demand for the other. Conversely, a decrease in the price of one will decrease the demand for the other. Example: When the price of Colgate toothpaste declines, the demand for Crest decreases. 2-4 Change in Demand 4) Prices of Related Goods  Complements: Because complementary goods (or, simply, complements) are used together, they are typically demanded jointly.  Examples include computers and software, cell phones and cellular service, and tea and sugar.  If the price of a complement (for example, sugar) goes up, the demand for the related good (tea) will decline. Conversely, if the price of a complement (for example, tuition) falls, the demand for a related good (textbooks) will increase. 2-4 Change in Demand 5) Consumer Expectations  Changes in consumer expectations may shift demand. A newly formed expectation of higher future prices may cause consumers to buy now in order to “beat” the anticipated price rises, thus increasing current demand.  Similarly, a change in expectations concerning future income may prompt consumers to change their current spending. Example:  workers who become fearful of losing their jobs may reduce their demand for, say, vacation travel. 2-5 Changes in Quantity Demanded  A change in demand must not be confused with a change in quantity demanded.  A change in demand is a shift of the demand curve to the right (an increase in demand) or to the left (a decrease in demand).  It occurs because the consumer’s state of mind about purchasing the product has been altered in response to a change in one or more of the determinants of demand. (See Figure 3.3, page 49)  A change in quantity demanded is a movement from one point to another point- from one price-quantity combination to another- on a fixed demand schedule or demand curve. The cause of such a change is an increase or decrease in the price of the product under consideration. (See Figure 3.3, page 49) 3- Supply  Supply is a schedule or curve showing the various amounts of a product that producers are willing and able to make available for sale at each of a series of possible prices during a specific period.  The table in Figure 3.4 (page 52) is a hypothetical supply schedule for a single producer of corn. It shows the quantities of corn that will be supplied at various prices, other things equal. 3-1 Law of Supply  The table in Figure 3.4 shows a positive or direct relationship that prevails between price and quantity supplied.  As price rises, the quantity supplied rises; as price falls, the quantity supplied falls This relationship is called the law of supply.  A supply schedule tells us that, other things equal, firms will produce and offer for sale more of their product at a high price than at a low price.  To a supplier, price represents revenue, which serves as an incentive to produce and sell a product.  The higher the price, the greater this incentive and the greater the quantity supplied. 3-2 The Supply Curve  As with demand, it is convenient to represent individual supply graphically.  In Figure 3.4, curve S is the supply curve that corresponds with the price–quantity supplied data in the accompanying table.  The upward slope of the curve reflects the law of supply-producers offer more of a good, service, or resource for sale as its price rises.  The relationship between price and quantity supplied is positive, or direct. 3-3 Market Supply  Market supply is derived from individual supply in exactly the same way that market demand is derived from individual demand.  We sum the quantities supplied by each producer at each price. That is, we obtain the market supply curve by “horizontally adding” the supply curves of the individual producers.  The price–quantity supplied data in the table accompanying Figure 3.5 (page 53) are for an assumed 200 identical producers in the market, each willing to supply corn according to the supply schedule shown in Figure 3.4.  Curve S1 in Figure 3.5 is a graph of the market supply data. 3-4 Changes in Supply  Let’s consider how changes in each of the determinants affect supply.  The key idea is that costs are a major factor underlying supply curves; anything that affects costs (other than changes in output itself) usually shifts the supply curve. 1) Resource Prices  The prices of the resources used in the production process help determine the costs of production incurred by firms.  Higher resource prices raise production costs and, assuming a particular product price, squeeze profits that reduces the incentive for firms to supply output at each product price. Example: An increase in the prices of sand Increases the cost of producing concrete and reduce its supply.  In contrast, lower resource prices reduce production costs and increase profits. 3-4 Changes in Supply 2) Technology  Improvements in technology (techniques of production) enable firms to produce units of output with fewer resources.  Because resources are costly, using fewer of them lowers production costs and increases supply. Example  Technological advances in producing flat panel computer monitors have greatly reduced their cost manufacturers will now offer more such monitors than previously at the various prices the supply of flat panel monitors has increased. 3-4 Changes in Supply 3) Taxes and Subsidies  Businesses treat most taxes as costs.  An increase in sales or property taxes will increase production costs and reduce supply.  In contrast, subsidies are “taxes in reverse.” Example: If the government subsidizes the production of a good it in effect lowers the producers’ costs increases supply. 3-4 Changes in Supply 4) Producer Expectations  Changes in expectations about the future price of a product may affect the producer’s current willingness to supply that product.  It is difficult, however, to generalize about how a new expectation of higher prices affects the present supply of a product. Example: Farmers anticipating a higher wheat price in the future might withhold some of their current wheat harvest from the market, thereby causing a decrease in the current supply of wheat. 3-4 Changes in Supply 5) Prices of Other Goods  Firms that produce a particular product, say, soccer balls, can sometimes use their plant and equipment to produce alternative goods, say, basketballs and volleyballs.  The higher prices of these “other goods” may entice soccer ball producers to switch production to those other goods in order to increase profits. This substitution in production results in a decline in the supply of soccer balls. 3-4 Changes in Supply 6) Number of Sellers  Other things equal, the larger the number of suppliers, the greater the market supply.  As more firms enter an industry, the supply curve shifts to the right.  Conversely, the smaller the number of firms in the industry, the less the market supply. This means that as firms leave an industry, the supply curve shifts to the left. Example: The United States and Canada have imposed restrictions on haddock fishing to replenish dwindling stocks. As part of that policy, the Federal government has bought the boats of some of the haddock fishers as a way of putting them out of business and decreasing the catch. The result has been a decline in the market supply of haddock. 3-5 Changes in Quantity Supplied  The distinction between a change in supply and a change in quantity supplied parallels the distinction between a change in demand and a change in quantity demanded.  A change in supply means a change in the schedule and a shift of the curve. The cause of a change in supply is a change in one or more of the determinants of supply.  In contrast, a change in quantity supplied is a movement from one point to another on a fixed supply curve. (See figure 3.5) The cause of such a movement is a change in the price of the specific product being considered. 4- Market Equilibrium 4-1 Equilibrium Price and Quantity  We are looking for the equilibrium price and equilibrium quantity.  The equilibrium price (or market-clearing price) is the price where the intentions of buyers and sellers match.  It is the price where quantity demanded equals quantity supplied. Example:  The table in Figure 3.6 reveals that at $3, and only at that price , the number of bushels of corn that sellers wish to sell (7000) is identical to the number consumers want to buy (also 7000).  At $3 and 7000 bushels of corn, there is neither a shortage nor a surplus of corn. So 7000 bushels of corn is the equilibrium quantity: the quantity demanded and quantity supplied at the equilibrium price in a competitive market.  Graphically, the equilibrium price is indicated by the intersection of the supply curve and the demand curve in Figure 3.6. 4-1 Equilibrium Price and Quantity  Competition among buyers and among sellers drives the price to the equilibrium price.  Once there, it remains unless it is subsequently disturbed by changes in demand or supply (shifts of the curves).  The ability of the competitive forces of supply and demand to establish a price at which selling and buying decisions are consistent is called the rationing function of prices.  In our case, the equilibrium price of $3 clears the market, leaving no burdensome surplus for sellers and no inconvenient shortage for potential buyers.  The market outcome says that all buyers who are willing and able to pay $3 for a bushel of corn will obtain it; all buyers who cannot or will not pay $3 will go without corn. 4-2 Rationing Function of Prices  A competitive market such as that we have described not only rations goods to consumers but also allocates society’s resources efficiently to the particular product. Competition among corn producers forces them to use the best technology and right mix of productive resources.  Otherwise, their costs will be too high relative to the market price and they will be unprofitable. The result is productive efficiency: the production of any particular good in the least costly way. 4-3 Efficient Allocation  The equilibrium price and quantity in competitive markets usually produce an assignment of resources that is “right” from an economic perspective.  Demand essentially reflects the marginal benefit (MB) of the good, based on the utility received.  Supply reflects the marginal cost (MC) of producing the good. The market ensures that firms produce all units of goods for which MB exceeds MC and no units for which MC exceeds MB.  At the intersection of the demand and supply curves, MB equals MC and allocative efficiency results. 4-4 Changes in Supply, Demand and Equilibrium  We know that demand might change because of fluctuations in consumer tastes or incomes, changes in consumer expectations, or variations in the prices of related goods.  Supply might change in response to changes in resource prices, technology, or taxes.  What effects will such changes in supply and demand have on equilibrium price and quantity? 4-4 Changes in Supply, Demand and Equilibrium 1) Changes in Demand  Suppose that the supply of some good (for example, health care) is constant and demand increases, as shown in Figure 3.7a (page 58).  As a result, the new intersection of the supply and demand curves is at higher values on both the price and the quantity axes.  Conversely, a decrease in demand such as that shown in Figure 3.7b reduces both equilibrium price and equilibrium quantity.  We need not fumble with columns of figures to determine the outcomes; we need only compare the new and the old points of intersection on the graph. 4-4 Changes in Supply, Demand and Equilibrium 2) Changes in Supply  What happens if the demand for some good (for example, flash drives) is constant but supply increases, as in Figure 3.7c ?  The new intersection of supply and demand is located at a lower equilibrium price but at a higher equilibrium quantity. (See figure 3.7c ) An increase in supply reduces equilibrium price but increases equilibrium quantity.  In contrast, if supply decreases, as in Figure 3.7d, the equilibrium price rises while the equilibrium quantity declines. 4-4 Changes in Supply, Demand and Equilibrium 3) Complex Cases  When both supply and demand change, the effect is a combination of the individual effects. 3-1) Supply Increase; Demand Decrease  Both changes decrease price, so the net result is a price drop greater than that resulting from either change alone.  What about equilibrium quantity? The direction of the change in quantity depends on the relative sizes of the changes in supply and demand:  If the increase in supply is larger than the decrease in demand, the equilibrium quantity will increase.  But if the decrease in demand is greater than the increase in supply, the equilibrium quantity will decrease. 4-4 Changes in Supply, Demand and Equilibrium 3) Complex Cases 3-2) Supply Decrease; Demand Increase  A decrease in supply and an increase in demand for some good (for example, gasoline) both increase price.  Their combined effect is an increase in equilibrium price greater than that caused by either change separately.  But their effect on equilibrium quantity is again indeterminate, depending on the relative sizes of the changes in supply and demand:  If the decrease in supply is larger than the increase in demand, the equilibrium quantity will decrease.  In contrast, if the increase in demand is greater than the decrease in supply, the equilibrium quantity will increase. 4-4 Changes in Supply, Demand and Equilibrium 3) Complex Cases 3-3) Supply Increase; Demand Increase  What if supply and demand both increase for some good (for example, cell phones)? A supply increase drops equilibrium price, while a demand increase boosts it:  If the increase in supply is greater than the increase in demand, the equilibrium price will fall.  If the opposite holds, the equilibrium price will rise.  The effect on equilibrium quantity is certain: The increases in supply and in demand each raises equilibrium quantity. 4-4 Changes in Supply, Demand and Equilibrium 3) Complex Cases 3-4) Supply Decrease; Demand Decrease  What about decreases in both supply and demand for some good (for example, new homes)?  Because decreases in supply and in demand each reduces equilibrium quantity, we can be sure that equilibrium quantity will fall.  Equilibrium Price?  If the decrease in supply is greater than the decrease in demand, equilibrium price will rise.  If the reverse is true, equilibrium price will fall.  Table 3.3 summarizes these four cases. To understand them fully, you should draw supply and demand diagrams for each case to confirm the effects listed in this table. 4- Application: Government – Set Prices  Prices in most markets are free to rise or fall to their equilibrium levels, no matter how high or low those levels might be.  However, government sometimes concludes that supply and demand will produce prices that are unfairly high for buyers or unfairly low for sellers.  So government may place legal limits on how high or low a price or prices may go. Is that a good idea? 5- Application: Government – Set Prices 5-1) Price Ceilings A price ceiling sets the maximum legal price a seller may charge for a product or service. A price at or below the ceiling is legal; a price above it is not.  The rationale for establishing price ceilings (or ceiling prices) on specific products is that they purportedly enable consumers to obtain some “essential” good or service that they could not afford at the equilibrium price. Example: Examples are rent controls, which specify maximum “prices” in the forms of rent and interest that can be charged to borrowers. 5- Application: Government – Set Prices 5-1) Price Ceilings on Gasoline Graphical Analysis  We can easily show the effects of price ceilings graphically.  When the ceiling price is below the equilibrium price, a persistent product shortage results. (Figure 3.8, page 59)  Because the ceiling price Pc is below the market-clearing price Po, there is a lasting shortage of gasoline. The quantity of gasoline demanded at Pc is Qd and the quantity supplied is only Qs; a persistent excess demand or shortage of amount Qd -Qs occurs.  Despite a sizable enforcement bureaucracy that would have to accompany the price controls, black markets in which gasoline is illegally bought and sold at prices above the legal limits will flourish. 5- Application: Government – Set Prices 5-2) Rent Controls  About 200 cities in the United States, including New York City, Boston, and San Francisco, have at one time or another enacted rent controls: maximum rents established by law (or, more recently, have set maximum rent increases for existing tenants).  Such laws are well intended. Their goals are to protect low-income families from escalating rents caused by perceived housing shortages and to make housing more affordable to the poor. 5- Application: Government – Set Prices 5-2) Rent Controls  What have been the actual economic effects?  On the demand side, it is true that as long as rents are below equilibrium, more families are willing to consume rental housing; the quantity of rental housing demanded increases at the lower price.  But a large problem occurs on the supply side. Price controls make it less attractive for landlords to offer housing on the rental market.  In the short run, owners may sell their rental units or convert them to condominiums.  In the long run, low rents make it unprofitable for owners to repair or renovate their rental units. (Rent controls are one cause of the many abandoned apartment buildings found in larger cities.) 5- Application: Government – Set Prices 5-2) Price Floors A price floor is a minimum price fixed by the government. A price at or above the price floor is legal; a price below it is not.  Price floors above equilibrium prices are usually invoked when society feels that the free functioning of the market system has not provided a sufficient income for certain groups of resource suppliers or producers. Example: Supported prices for agricultural products and current minimum wages are two examples of price (or wage) floors.  Let’s look at the market of wheat. 5- Application: Government – Set Prices 5-2) Price Floors on Wheat  Suppose the equilibrium price for wheat is $2 per bushel and, because of that low price, many farmers have extremely low incomes.  The government decides to help out by establishing a legal price floor or price support of $3 per bushel. (See figure 3.9, page 62 )  What will be the effects?  At any price above the equilibrium price, quantity supplied will exceed quantity demanded- that is, there will be a persistent excess supply or surplus of the product.  Farmers will be willing to produce and offer for sale more than private buyers are willing to purchase at the price floor.  As we saw with a price ceiling, an imposed legal price disrupts the rationing ability of the free market. 5- Application: Government – Set Prices 5-2) Price Floors on Wheat Graphical Analysis  Figure 3.9 illustrates the effect of a price floor graphically. Suppose that S and D are the supply and demand curves for wheat.  Equilibrium price and quantity are Po and Qo, respectively.  If the government imposes a price floor of Pf, farmers will produce Qs but private buyers will purchase only Qd. The surplus is the excess of Qs over Qd.  Conclusion: In all these cases, good intentions lead to bad economic outcomes. Government-controlled prices cause shortages or surpluses, distort resource allocation, and produce negative side effects.