Demand, Supply, and Market Equilibrium

1. Demand, Supply, andMarket Equilibrium Chapter 3

2. In this chapter, you will learn: What demand is and what affects it. What supply is and what affects it. How supply & demand together determine market equilibrium. How changes in supply & demand affect equilibrium prices & quantities. What government-set prices are and how they can cause product surpluses & shortages.

3. Markets Consist of large numbers of independently acting buyers & sellers of standardized products These are highly competitive markets All such markets involve demand, supply, price, and quantity

4. Demand • A schedule or curve that shows the various amounts of a product that consumers are willing & able to buy at all prices during a specific period of time • Can be easily shown in table form (Demand schedule) • Table shows relationship between price and quantity demanded at each price • Table does not tell us which price will exist in the market…depends on interaction of demand and supply

5. Law of demand Fundamental characteristic: Other things equal, as price falls, the quantity demanded rises As price rises, quantity demanded falls In short, negative or inverse relationship between price and quantity demanded (Law of Demand)

6. Why Inverse Relationship? People ordinarily do buy more of a product at a lower price (common sense) In any specific time period, each buyer of a product will derive less satisfaction (or benefit, or utility) for each successive unit of the product consumed (diminishing marginal utility) Income & substitution effects Lower price – increases purchasing power of a buyer’s money income, enabling the buyer to purchase more At a lower price, buyers have the incentive to substitute what is now less expensive product for similar products that are now more expensive

7. Demand curve (Fig. 3.1) • Quantity demanded on horizontal axis • Price on vertical axis • Downslope reflects the law of demand • People buy more of a product, service, or resource as its price falls. (inverse or negative relationship)

8. Market demand • By adding the quantities demanded by all consumers at each price, we can calculate the market demand (Fig. 3.2) • Price is most important influence on demand • Determinants of demand • When determinants change, the demand curve will shift to the right or left • Consumers’ tastes (preferences), # of buyers, consumers’ income, prices of related goods, consumer expectations

9. Change in Demand Change in demand schedule or curve is called a “change in demand” Increase in demand = rightward shift of curve Decrease in demand = leftward shift of curve

10. Increase in Demand may be caused by: • Favorable change in consumer taste • Increase in # of buyers • Rising income if product is normal good • Falling income if product is inferior good • An increase in price of a substitute good • A decrease in price of a complementary good • New expectation that either prices or income will be higher in future • Reverse these for decrease in demand

11. Changes in Qty. Demanded Movement from one point to another point on a fixed demand curve Cause of such a change is an increase or decrease in the price of the product under consideration

12. Supply (3.2) • Schedule or curve showing various amounts of a product that producers are willing & able to make available for sale at all prices during a period of time • Supply schedule – shows quantities of a product that will be supplied at various prices • Law of supply – positive or direct relationship that prevails between price & quantity supplied…as price rises, quantity supplied rises too • Higher prices represent more revenue to the producer which increases their incentives to produce

13. Supply curve 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 Relationship is positive or direct

14. Market supply We sum the quantities supplied by each producer at each price. Price – vertical axis Quantity supplied – horizontal axis

15. Determinants of supply • Price is most significant influence on quantity supplied of any product • Other factors can and do affect supply • A change in supply will shift the entire supply curve • A shift to the right increases supply • A shift to the left decreases supply

16. Basic Determinants of Supply Resource prices Technology Taxes & subsidies Prices of other goods Producer expectations # of sellers

17. Changes in Quantity Supplied Movement from one point to another on a fixed supply curve Cause of such a movement is a change in the price of the specific product being considered

18. Market equilibrium (3.3) • Only price where the intentions of buyers & sellers match • No shortage or surplus & equilibrium • Competition among buyers & among sellers drives the price to equilibrium

19. Surplus Above equilibrium (supply>demand) Encourages sellers to offer more but discourages many consumers from buying it Surpluses drive prices down to equilibrium

20. Shortage Below equilibrium (demand>supply) Discourages sellers from devoting resources to the product Consumers desire more of the product at the lower price

21. Efficient allocation • Competition among producers forces them to use the best technology & right mix of productive resources • Otherwise, their costs will be too high relative to the market price …unprofitable • Productive efficiency • Production of a good in the least costly way • Allocative efficiency • Producing the mix of goods & services most wanted by society

22. Changes in demand (show graphically) • Supply stays constant but demand increases • Increase in both price & quantity • Decrease in demand • Decreases both price & quantity • Changes in Supply • Demand is constant • Increase in supply lowers price & increases quantity • Decrease in supply increases price & lowers quantity

23. Complex Cases (show graphically) Supply increase; demand decrease Supply decrease; demand increase Supply increase; demand increase Supply decrease; demand decrease

24. Government-set prices • Sometimes government concludes that supply & demand will produce prices that are unfairly high for buyers or unfairly low to sellers • Government may place legal limits on how high or low a price may go • Is that a good idea?

25. Price ceiling • Maximum legal price a seller may charge for a product or service • A price at or below the ceiling is legal; a price above is not • Rationale: enable consumers to obtain an “essential” good or service that they couldn’t afford at equilibrium • Example: Rent Control • Maximum price for rent that can be charged for housing • Ceilings result in a shortage which leads to illegal black markets • Product or service sold above the ceiling to meet the excess demand created by the ceiling

26. Price floor • Minimum price fixed by the government • A price at or above the price floor is legal • Price floors are invoked when the market economy does not provide sufficient income for certain groups of resource suppliers or producers • Creates a surplus of the product or service. • Examples: • Minimum wage • Target price for agricultural products