Demand, Supply, and Market Equilibrium PDF

Demand, Supply, and Market Equilibrium INTRODUCTION TO ECONOMICS 3 Demand, Supply, and CHAPTER OUTLINE Market Equilibrium Firms and Households: The Basic Decision-Making Units...

Demand, Supply, and Market Equilibrium INTRODUCTION TO ECONOMICS 3 Demand, Supply, and CHAPTER OUTLINE Market Equilibrium Firms and Households: The Basic Decision-Making Units Input Markets and Output Markets: The Circular Flow Demand in Product/Output Markets Changes in Quantity Demanded versus Changes in Demand Price and Quantity Demanded: The Law of Demand Other Determinants of Household Demand Shift of Demand versus Movement Along the Demand Curve From Household Demand to Market Demand Supply in Product/Output Markets Price and Quantity Supplied: The Law of Supply Other Determinants of Supply Shift of Supply versus Movement Along the Supply Curve From Individual Supply to Market Supply Market Equilibrium Excess Demand Excess Supply Changes in Equilibrium Demand and Supply in Product Markets: A Review Looking Ahead: Markets and the Allocation of Resources 2 of 49 Firms and Households: The Basic Decision-Making Units firm An organization that transforms resources (inputs) into products (outputs). Firms are the primary producing units in a market economy. entrepreneur A person who organizes, manages, and assumes the risks of a firm, taking a new idea or a new product and turning it into a successful business. households The consuming units in an economy. 3 of 49 Input Markets and Output Markets: The Circular Flow product or output markets The markets in which goods and services are exchanged. input or factor markets The markets in which the resources used to produce products are exchanged. 4 of 49  Input Markets and Output Markets: The Circular Flow  FIGURE 1 The Circular Flow of Economic Activity Diagrams like this one show the circular flow of economic activity, hence the name circular flow diagram. Here goods and services flow clockwise: Labor services supplied by households flow to firms, and goods and services produced by firms flow to households. Payment (usually money) flows in the opposite (counterclockwise) direction: Payment for goods and services flows from households to firms, and payment for labor services flows from firms to households. Note: Color Guide—In Figure 3.1 households are depicted in blue and firms are depicted in red. From now on all diagrams relating to the behavior of households will be blue or shades of blue and all diagrams relating to the behavior of firms will be red or shades of red. 5 of 49 Input Markets and Output Markets: The Circular Flow labor market The input/factor market in which households supply work for wages to firms that demand labor. capital market The input/factor market in which households supply their savings, for interest or for claims to future profits, to firms that demand funds to buy capital goods. 6 of 49 Input Markets and Output Markets: The Circular Flow land market The input/factor market in which households supply land or other real property in exchange for rent. factors of production The inputs into the production process. Land, labor, and capital are the three key factors of production. Input and output markets are connected through the behavior of both firms and households. Firms determine the quantities and character of outputs produced and the types and quantities of inputs demanded. Households determine the types and quantities of products demanded and the quantities and types of inputs supplied. 7 of 49 Demand in Product/Output Markets A household’s decision about what quantity of a particular output, or product, to demand depends on a number of factors, including:  The price of the product in question.  The income available to the household.  The household’s amount of accumulated wealth.  The prices of other products available to the household.  The household’s tastes and preferences.  The household’s expectations about future income, wealth, and prices. 8 of 49 Demand in Product/Output Markets quantity demanded The amount (number of units) of a product that a household would buy in a given period if it could buy all it wanted at the current market price. 9 of 49 Demand in Product/Output Markets Changes in Quantity Demanded versus Changes in Demand The most important relationship in individual markets is that between market price and quantity demanded. Changes in the price of a product affect the quantity demanded per period. Changes in any other factor, such as income or preferences, affect demand. Thus, we say that an increase in the price of Coca-Cola is likely to cause a decrease in the quantity of Coca-Cola demanded. However, we say that an increase in income is likely to cause an increase in the demand for most goods. 10 of 49 Demand in Product/Output Markets Price and Quantity Demanded: The Law of Demand demand schedule A table showing how much of a given product a household would be willing to buy at different prices. demand curve A graph illustrating how much of a given product a household would be willing to buy at different prices. 11 of 49 Demand in Product/Output Markets Price and Quantity Demanded: The Law of Demand TABLE 3.1 Chloe’s Demand Schedule for Telephone Calls Price Quantity Demanded (Per Call) (Calls Per Month) 0 30.50 25 3.50 7 7.00 3 10.00 1 15.00 0  FIGURE 3.2 Chloe’s Demand Curve The relationship between price (P) and quantity demanded (q) presented graphically is called a demand curve. Demand curves have a negative slope, indicating that lower prices cause quantity demanded to increase. Note that Chloe’s demand curve is blue; demand in product markets is determined by household choice. 12 of 49 Demand in Product/Output Markets Price and Quantity Demanded: The Law of Demand Demand Curves Slope Downward law of demand The negative relationship between price and quantity demanded: As price rises, quantity demanded decreases; as price falls, quantity demanded increases. It is reasonable to expect quantity demanded to fall when price rises, ceteris paribus, and to expect quantity demanded to rise when price falls, ceteris paribus. Demand curves have a negative slope. 13 of 49 Demand in Product/Output Markets Price and Quantity Demanded: The Law of Demand Other Properties of Demand Curves Two additional things are notable about Chloe’s demand curve. As long as households have limited incomes and wealth, all demand curves will intersect the price axis. For any commodity, there is always a price above which a household will not or cannot pay. Even if the good or service is very important, all households are ultimately constrained, or limited, by income and wealth. That demand curves intersect the quantity axis is a matter of common sense. Demand in a given period of time is limited, if only by time, even at a zero price. 14 of 49 Demand in Product/Output Markets Price and Quantity Demanded: The Law of Demand Other Properties of Demand Curves To summarize what we know about the shape of demand curves: 1. They have a negative slope. An increase in price is likely to lead to a decrease in quantity demanded, and a decrease in price is likely to lead to an increase in quantity demanded. 2. They intersect the quantity (X-) axis, a result of time limitations and diminishing marginal utility. 3. They intersect the price (Y-) axis, a result of limited incomes and wealth. 15 of 49 Demand in Product/Output Markets Other Determinants of Household Demand Income And Wealth income The sum of all a household’s wages, salaries, profits, interest payments, rents, and other forms of earnings in a given period of time. It is a flow measure. wealth or net worth The total value of what a household owns minus what it owes. It is a stock measure. 16 of 49 Demand in Product/Output Markets Other Determinants of Household Demand Income And Wealth normal goods Goods for which demand goes up when income is higher and for which demand goes down when income is lower. inferior goods Goods for which demand tends to fall when income rises. 17 of 49 Demand in Product/Output Markets Other Determinants of Household Demand Prices of Other Goods and Services substitutes Goods that can serve as replacements for one another; when the price of one increases, demand for the other decreases. perfect substitutes Identical products. complements, complementary goods Goods that “go together”; a decrease in the price of one results in an increase in demand for the other and vice versa. 18 of 49 Demand in Product/Output Markets Other Determinants of Household Demand Tastes and Preferences Income, wealth, and prices of goods available are the three factors that determine the combinations of goods and services that a household is able to buy. Changes in preferences can and do manifest themselves in market behavior. Within the constraints of prices and incomes, preference shapes the demand curve, but it is difficult to generalize about tastes and preferences. First, they are volatile. Second, tastes are idiosyncratic. 19 of 49 Demand in Product/Output Markets Other Determinants of Household Demand Expectations What you decide to buy today certainly depends on today’s prices and your current income and wealth. There are many examples of the ways expectations affect demand. Increasingly, economic theory has come to recognize the importance of expectations. It is important to understand that demand depends on more than just current incomes, prices, and tastes. 20 of 49 Demand in Product/Output Markets Shift of Demand versus Movement Along a Demand Curve TABLE 3.2 Shift of Chloe’s Demand Schedule Due to increase in Income Schedule D0 Schedule D1 Quantity Demanded Quantity Demanded Price (Calls Per Month at an (Calls Per Month at (Per Call) Income of Php 300 Per an Income of Php Month) 600 Per Month) 0.00 30 35 0.50 25 33 3.50 7 18 7.00 3 12 10.00 1 7 15.00 0 2 20.00 0 0  FIGURE 3.3 Shift of a Demand Curve Following a Rise in Income When the price of a good changes, we move along the demand curve for that good. When any other factor that influences demand changes (income, tastes, and so on), the relationship between price and quantity is different; there is a shift of the demand curve, in this case from D0 to D1. Telephone calls are normal goods. 21 of 49  Demand in Product/Output Markets Shift of Demand versus Movement Along a Demand Curve shift of a demand curve The change that takes place in a demand curve corresponding to a new relationship between quantity demanded of a good and price of that good. The shift is brought about by a change in the original conditions. movement along a demand curve The change in quantity demanded brought about by a change in price. Change in price of a good or service leads to Change in quantity demanded (movement along the demand curve). Change in income, preferences, or prices of other goods or services leads to Change in demand (shift of the demand curve). 22 of 49 Demand in Product/Output Markets Shift of Demand versus Movement Along a Demand Curve  FIGURE 3.4 Shifts versus Movement Along a Demand Curve a. When income increases, the demand for inferior goods shifts to the left and the demand for normal goods shifts to the right. 23 of 49 Demand in Product/Output Markets Shift of Demand versus Movement Along a Demand Curve  FIGURE 3.4 Shifts versus Movement Along a Demand Curve (continued) b. If the price of hamburger rises, the quantity of hamburger demanded declines— his is a movement along the demand curve. The same price rise for hamburger would shift the demand for chicken (a substitute for hamburger) to the right and the demand for ketchup (a complement to hamburger) to the left. 24 of 49 Demand in Product/Output Markets From Household Demand To Market Demand market demand The sum of all the quantities of a good or service demanded per period by all the households buying in the market for that good or service. 25 of 49 Demand in Product/Output Markets From Household Demand To Market Demand  FIGURE 3.5 Deriving Market Demand from Individual Demand Curves Total demand in the marketplace is simply the sum of the demands of all the households shopping in a particular market. It is the sum of all the individual demand curves—that is, the sum of all the individual quantities demanded at each price. 26 of 49 Supply in Product/Output Markets Successful firms make profits because they are able to sell their products for more than it costs to produce them. Profit - The difference between revenues and costs. 27 of 49 Supply in Product/Output Markets Price and Quantity Supplied: The Law of Supply quantity supplied The amount of a particular product that a firm would be willing and able to offer for sale at a particular price during a given time period. supply schedule A table showing how much of a product firms will sell at different prices. 28 of 49 Supply in Product/Output Markets Price and Quantity Supplied: The Law of Supply law of supply The positive relationship between price and quantity of a good supplied: An increase in market price will lead to an increase in quantity supplied, and a decrease in market price will lead to a decrease in quantity supplied. supply curve A graph illustrating how much of a product a firm will sell at different prices. 29 of 49 Supply in Product/Output Markets Price and Quantity Supplied: The Law of Supply TABLE 3.3 Chloe’s Supply Schedule for soybeans Quantity Supplied(per Price bushels produced) P1.50 0 1.75 10,000 2.25 20,000 3.00 30,000 4.00 45,000 5.00 45,000  FIGURE 3.6 Chloe’s Individual Supply Curve A producer will supply more when the price of output is higher. The slope of a supply curve is positive. Note that the supply curve is red: Supply is determined by choices made by firms. 30 of 49 Supply in Product/Output Markets Other Determinants Of Supply The Cost Of Production In order for a firm to make a profit, its revenue must exceed its costs. Cost of production depends on a number of factors, including the available technologies and the prices and quantities of the inputs needed by the firm (labor, land, capital, energy, and so on). 31 of 49 Supply in Product/Output Markets Other Determinants Of Supply The Prices of Related Products Assuming that its objective is to maximize profits, a firm’s decision about what quantity of output, or product, to supply depends on: 1. The price of the good or service. 2. The cost of producing the product, which in turn depends on: The price of required inputs (labor, capital, and land). The technologies that can be used to produce the product. 3. The prices of related products. 32 of 49 Supply in Product/Output Markets Shift of Supply versus Movement Along a Supply Curve movement along a supply curve The change in quantity supplied brought about by a change in price. shift of a supply curve The change that takes place in a supply curve corresponding to a new relationship between quantity supplied of a good and the price of that good. The shift is brought about by a change in the original conditions. 33 of 49  Supply in Product/Output Markets Shift of Supply versus Movement Along a Supply Curve TABLE 3.4 Shift of Supply Schedule for Soybeans Following Development of a New Disease-Resistant Seed Strain SCHEDULE D0 SCHEDULE D1 Quantity Supplied Quantity Price (Bushels per Year Supplied (per Bushel) Using Old Seed) (Bushels per Year Using New Seed) $1.50 0 5,000 1.75 10,000 23,000 2.25 20,000 33,000 3.00 30,000 40,000 4.00 45,000 54,000 5.00 45,000 54,000  FIGURE 3.7 Shift of the Supply Curve or Soybeans Following Development of a New Seed Strain When the price of a product changes, we move along the supply curve for that product; the quantity supplied rises or falls. When any other factor affecting supply changes, the supply curve shifts. 34 of 49 Supply in Product/Output Markets Shift of Supply versus Movement Along a Supply Curve As with demand, it is very important to distinguish between movements along supply curves (changes in quantity supplied) and shifts in supply curves (changes in supply): Change in price of a good or service leads to Change in quantity supplied (movement along a supply curve). Change in income, preferences, or prices of other goods or services leads to Change in supply (shift of a supply curve). 35 of 49 Supply in Product/Output Markets From Individual Supply to Market Supply market supply The sum of all that is supplied each period by all producers of a single product. 36 of 49 Supply in Product/Output Markets From Individual Supply to Market Supply  FIGURE 3.8 Deriving Market Supply from Individual Firm Supply Curves Total supply in the marketplace is the sum of all the amounts supplied by all the firms selling in the market. It is the sum of all the individual quantities supplied at each price. 37 of 49 Market Equilibrium equilibrium The condition that exists when quantity supplied and quantity demanded are equal. At equilibrium, there is no tendency for price to change. Excess Demand excess demand or shortage The condition that exists when quantity demanded exceeds quantity supplied at the current price. 38 of 49 Market Equilibrium Excess Demand  FIGURE 3.9 Excess Demand, or Shortage At a price of $1.75 per bushel, quantity demanded exceeds quantity supplied. When excess demand exists, there is a tendency for price to rise. When quantity demanded equals quantity supplied, excess demand is eliminated and the market is in equilibrium. Here the equilibrium price is $2.50 and the equilibrium quantity is 35,000 bushels. When quantity demanded exceeds quantity supplied, price tends to rise. When the price in a market rises, quantity demanded falls and quantity supplied rises until an equilibrium is reached at which quantity demanded and quantity supplied are equal. 39 of 49 Market Equilibrium Excess Supply excess supply or surplus The condition that exists when quantity supplied exceeds quantity demanded at the current price. 40 of 49 Market Equilibrium Excess Supply  FIGURE 3.10 Excess Supply, or Surplus At a price of $3.00, quantity supplied exceeds quantity demanded by 20,000 bushels. This excess supply will cause the price to fall. When quantity supplied exceeds quantity demanded at the current price, the price tends to fall. When price falls, quantity supplied is likely to decrease and quantity demanded is likely to increase until an equilibrium price is reached where quantity supplied and quantity demanded are equal. 41 of 49 Market Equilibrium Changes In Equilibrium When supply and demand curves shift, the equilibrium price and quantity change.  FIGURE 3.11 The Coffee Market: A Shift of Supply and Subsequent Price Adjustment Before the freeze, the coffee market was in equilibrium at a price of P1.20 per pound. At that price, quantity demanded equaled quantity supplied. The freeze shifted the supply curve to the left (from S0 to S1), increasing the equilibrium price to P2.40. 42 of 49 Market Equilibrium Changes In Equilibrium  FIGURE 3.12 Examples of Supply and Demand Shifts for Product X 43 of 49 Market Equilibrium Changes In Equilibrium Bad News for Orange Juice Fanatics Orange Juice Prices Could Skyrocket After Freeze Destroys Most of California Output City News 44 of 49  Demand and Supply in Product Markets: A Review Here are some important points to remember about the mechanics of supply and demand in product markets: 1. A demand curve shows how much of a product a household would buy if it could buy all it wanted at the given price. A supply curve shows how much of a product a firm would supply if it could sell all it wanted at the given price. 2. Quantity demanded and quantity supplied are always per time period—that is, per day, per month, or per year. 3. The demand for a good is determined by price, household income and wealth, prices of other goods and services, tastes and preferences, and expectations. 45 of 49  Demand and Supply in Product Markets: A Review Here are some important points to remember about the mechanics of supply and demand in product markets: 4. The supply of a good is determined by price, costs of production, and prices of related products. Costs of production are determined by available technologies of production and input prices. 5. Be careful to distinguish between movements along supply and demand curves and shifts of these curves. When the price of a good changes, the quantity of that good demanded or supplied changes—that is, a movement occurs along the curve. When any other factor changes, the curve shifts, or changes position. 6. Market equilibrium exists only when quantity supplied equals quantity demanded at the current price. 46 of 49 Demand and Supply in Product Markets: A Review Why Do the Prices of Newspapers Rise? In 2006, the average price for a daily edition of Manila Bulletin newspaper was P0.50. In 2007, the average price had risen to P0.75. 47 of 49 Looking Ahead: Markets and the Allocation of Resources You can already begin to see how markets answer the basic economic questions of what is produced, how it is produced, and who gets what is produced.  Demand curves reflect what people are willing and able to pay for products; demand curves are influenced by incomes, wealth, preferences, prices of other goods, and expectations.  Firms in business to make a profit have a good reason to choose the best available technology—lower costs mean higher profits.  When a good is in short supply, price rises. As it does, those who are willing and able to continue buying do so; others stop buying. 48 of 49  REVIEW TERMS AND CONCEPTS capital market law of demand complements, complementary law of supply goods market demand demand curve market supply demand schedule movement along a demand curve entrepreneur movement along a supply curve equilibrium normal goods excess demand or shortage perfect substitutes excess supply or surplus product or output markets factors of production profit firm quantity demanded households quantity supplied income shift of a demand curve inferior goods shift of a supply curve input or factor markets substitutes labor market supply curve land market supply schedule wealth or net worth 49 of 49