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Supply and Demand

Chapter 3

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Learning Objectives

Describe how the demand and supply curves summarize the behavior of buyers and sellers in the marketplace.
Supply and demand curves interact to determine equilibrium price and quantity.
Shifts in supply and demand curves cause prices and quantities to change
Explain and apply the Efficiency Principle and the Equilibrium Principle (also called the “No-Cash-on-the-Table Principle”).
Price Controls

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What, How, and For Whom?

Every society answers three basic questions

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WHAT	Which goods will be produced? How much of each?

HOW	Which technology? Which resources are used?

FOR WHOM	How are outputs distributed? Need? Income?

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Central Planning Vs. Free Markets

Central Planning

Decisions by individuals or small groups

Agrarian societies
Government programs

Sets prices and goals for the group

Individual influence is limited

The Market

Buyers and sellers signal wants and costs

Resources and goods are allocated accordingly

Interaction of supply and demand answer the three basic questions

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Mixed economies use both the market and central planning

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Applications in Transportation:

Who should do transportation? ��US vs China�US vs Europe�US vs South America�US vs Mexico

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Applications in Commerce: ��Who should do retail?

�Government vs Amazon?

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Venezuela - Central Planning

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Is Uber the free market’s best answer to transportation? ��Can government do better?

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SUPPLY AND DEMAND

A competitive market:

Many buyers and sellers
Same good or service�

The supply and demand model is a model of how a competitive market works. �
Five key elements:

Demand curve
Supply curve
Demand and supply curve shifts
Market equilibrium
Changes in the market equilibrium

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Buyers and Sellers in the Market

The market for any good consists of all the buyers and sellers of the good
Buyers and sellers have different motivations

Buyers want to benefit from the good
Sellers want to make a profit

Market price balances two forces

Value buyers derive from the good
Cost to produce one more unit of the good

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Demand

A demand curve illustrates the quantity buyers would purchase at each possible price
Demand curves have a negative slope

Consumers buy less at higher prices
Consumers buy more at lower prices

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$4

$2

8

16

Q

P

D

Demand for Pizzas

(1000s of slices/day)

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DEMAND CURVE

↑Price = ↓Demand

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Demand Slopes Downward

Buyers value goods differently

The buyer’s reservation price is the highest price an individual is willing to pay for a good

Demand reflects the entire market, not one consumer

Lower prices bring more buyers into the market
Lower prices cause existing buyers to buy more

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Income and Substitution Effects

Buyers buy more at lower prices and buy less at higher prices
What happens when price goes up?

The substitution effect: Buyers switch to substitutes when price goes up
The income effect: Buyers' overall purchasing power goes down

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Interpreting the Demand Curve

Horizontal interpretation of demand:

Given price, how much will buyers buy?
At a price of $4, the quantity demanded is 8,000 slices/day.

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$4

$2

8

16

Q

P

D

Demand for Pizzas

(1000s of slices/day)

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Interpreting the Demand Curve

Vertical interpretation of demand:

Given the quantity to be sold, what price is the marginal consumer willing to pay?
If 8,000 slices are sold the marginal consumer is willing to pay $4 per slice.

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$4

$2

8

16

Q

P

D

Demand for Pizzas

(1000s of slices/day)

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GASOLINE: GLOBAL COMPARISON

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

1.0

1.4

0.6

0.2

$8

7

6

5

4

3

0

I

taly

France

Canada

United States

Japan

Germany

Spain

United Kingdom

Price of gasoline (per gallon)

Consumption of gasoline (gallons per day per capita)

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MOVEMENT ALONG THE DEMAND CURVE

A movement along the demand curve is a change in the quantity demanded of a good that is the result of a change in that good’s price.

7

8.1

9.7

0

10

15

13

17

$2.00

1.75

1.50

1.25

1.00

0.75

0.50

D

1

D

2

A

C

B

A shift of the demand curve…

… is not the same thing as a movement along the demand curve

Price of cotton (per pound)

Quantity of cotton (billions of pounds)

Figure 3-3: Movement Along the Demand Curve Versus Shift of the Demand Curve

The rise in quantity demanded when going from point A to point B reflects a movement along the demand curve: it is the result of a

fall in the price of the good. The rise in quantity demanded when going from point A to point C reflects a shift of the demand curve:

it is the result of a rise in the quantity demanded at any given price.

VERY IMPORTANT - distinguish between a “shift” and a “movement along” a curve.

I also give the students the general rule: any change in the value of the variables on the vertical and horizontal axis causes a “movement along” the curve. To generate a shift, we need an outside shock (change in the value of outside - exogenous – variables, which we were assuming to be constant (Ceteris Paribus), such as population, tastes, etc…

This is also a good opportunity to underline the difference between “demand” and “quantity demanded”.

In ordinary speech most people, including professional economists, use the word demand casually. For example, an economist might say “the demand for air travel has doubled over the past 15 years, partly because of falling air fares” when he or she really means that the quantity demanded has doubled. It’s OK to be a bit sloppy in ordinary conversation. But when you’re doing economic analysis, it’s important to make the distinction between changes in the quantity demanded, which involve movements along a demand curve, and shifts of the demand curve.

A movement along a curve occurs when:

1. A change in the value of the variable measured on the horizontal axis leads to a change in the value of the variable measured on the vertical axis, and vice versa. (For example, a change in x leads to a change in y, and vice versa.)

2. The values of both variables change. (For example, both x and y change.)

A shift of a curve occurs when the value of only one variable changes while the value of the other variable stays the same. (For example, x changes while y stays the same, or y changes while x stays the same.)

Class exercise questions:

You can ask your students the following exercise questions:

- The price of a can of Coke has increased from $1 to $3. Does this cause a movement along or a shift of the demand curve for Coke? Why?

- A new scientific research has proven that a regular Coke drinker lives on the average 5 years longer. Does this finding cause a movement along or a shift of the demand curve for Coke? Why?

You can ask them to write their answers on a piece of paper, supported by graphical explanations. At the end, you can ask students to correct each other’s answers.

Ten minutes would be enough to you through this exercise.

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INCREASE IN DEMAND VS INCREASE IN QUANTITY DEMANDED

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SHIFTS OF THE DEMAND CURVE

A “decrease in demand” means a leftward shift of the demand curve: �at any given price, consumers demand a smaller quantity than before. �(D1→D3)

Price

Quantity

D

3

D

1

D

2

Increase in demand

Decrease in demand

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WHAT CAUSES A DEMAND CURVE TO SHIFT

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.
↓Price of Substitute = ↓ Demand

Complements: Two goods are complements if a fall in the price of one good makes people more willing to buy the other good.
↓Price of Complement = ↑Demand

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RELATED GOODS

Substitutes

Competing products or services

Compliments

Products or services that go together

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WHAT CAUSES DEMAND CURVE TO SHIFT

Changes in Income�

Normal Goods: When a rise in income increases the demand for a good — the normal case — we say that the good is a normal good.
Inferior Goods: When a rise in income decreases the demand for a good, it is an inferior good.

Changes in Tastes (Trends – eg fashion)

Changes in Price Expectations

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Uber & Demand Shifters��1. Population�2. Substitutes�3. Taste Trends�4. Income�5. Price Expectations��

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The Supply Curve

The supply curve illustrates the quantity of a good that sellers are willing to offer at each price

If the price is less than opportunity cost, offer more

Opportunity cost differs among sellers due to:

Technology ^■ Different costs such as rent
Skills ^■ Expectations

The Low-Hanging Fruit Principle explains the upward sloping supply curve
The seller’s reservation price is the lowest price the seller would be willing to sell for

Equal to marginal cost

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SUPPLY SCHEDULE

A supply schedule shows how much of a good or service would be supplied at different prices.

Supply Schedule for Cotton
Price of cotton (per pound)	Quantity of cotton supplied (billions of pounds)
$2.00	11.6
1.75	11.5
1.50	11.2
1.25	10.7
1.00	10.0
0.75	9.1
0.50	8.0

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SUPPLY CURVE

Quantity of cotton (billions of pounds)

Price of cotton �(per pound)

7

0

9

11

15

13

17

$2.00

1.75

1.50

1.25

1.00

0.75

0.50

As price rises, the quantity supplied rises.

A supply curve shows graphically how much of a good or service people are willing to sell at any given price.

Supply curve, S

Figure 3-6: The Supply Schedule and the Supply Curve

The supply curve and the supply schedule reflect the fact that supply curves are usually upward sloping: the quantity supplied rises when the price rises.

This could be another opportunity to remind students the definition of “slope”. They should understand that the basic supply curve for a normal good is “upward sloping” and also the intuition of its slope. As the price goes up, producers receive more for each unit of good they sell and hence they are willing to increase the amount supplied. There is a positive relationship between price and quantity supplied: as one goes up, the other one also goes up.

Alternatively, you could delay the explanation about the slope until later and then go more into the details of the ”upward slope,” its intuition, exceptions, etc…

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Interpreting the Supply Curve

Horizontal interpretation of supply:

Given price, how much will suppliers offer?
At a price of $2, suppliers are willing to sell 8,000 slices/day.

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Q

P

S

Supply of Pizzas

(1000s of slices/day)

$4

$2

8

16

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Interpreting the Supply Curve

Vertical interpretation of supply:

Given the quantity to be sold, what is the opportunity cost of the marginal seller?
If 8,000 slices are sold, the marginal cost of producing the 8,000^th slice is $2.

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$4

$2

8

16

Q

P

S

Supply of Pizzas

(1000s of slices/day)

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INCREASE IN SUPPLY

A shift of the supply curve is a change in the quantity supplied of a good at any given price.

Technology adoption in cotton-growing business →

more cotton producers

7

0

9

11

13

15

17

$2.00

1.75

1.50

1.25

1.00

0.75

0.50

S

1

S

2

Price of cotton (per pound)

Quantity of cotton (billions of pounds)

Supply curve

after

new technology

Supply curve �before�new technology

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MOVEMENT ALONG THE SUPPLY CURVE

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.

7

0

10

11.2

12

15

17

$2.00

1.75

1.50

1.25

1.00

0.75

0.50

S

1

S

2

A

C

B

Price of cotton (per pound)

Quantity of cotton (billions of pounds)

… is not the same thing as a shift of the supply curve

A movement along the supply curve…

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SHIFT OF THE SUPPLY CURVE

S

3

S

1

S

2

Price

Quantity

Decrease in supply

Increase in supply

Any “decrease in supply” means a leftward shift of the supply curve:� at any given price, there is a decrease in the quantity supplied. �(S₁→ S₃)

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Causes of Shifts in Supply

A change in the price of an input

Fiberglass for skateboards, construction wages

A change in technology

Desktop publishing and term papers
Internet distribution of products (e-commerce)

Weather (agricultural commodities and outdoor entertainment)
Number of sellers in the market
Expectation of future price changes

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Price changes never cause a shift in supply

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INPUT PRICES

Gas
Food
Metals
Wood
Labor
ETC

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Shifts in Supply: Skateboards

Costs of production affect the supply of a product
Cost of fiberglass for skateboards increases

Supply decreases

With no change in demand, �the price of skateboards �increases to $80 and quantity �decreases to 800

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(skateboards/month)

$80

800

$60

P

S

Supply of Skateboards

1,000

D

S'

600

Q

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Shift in Supply: Home Construction

Cost of labor used to produce houses decreases

Supply increases

Demand is constant
The price of houses�decreases to $90,000 �per house
Quantity increases to 50

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$120

40

$90

Q

P

S'

The Market for New Houses

50

D

S

(houses/month)

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RELATED GOODS – SUPPLY SIDE

Substitutes in production

compete for resources on the production side
The more the substitute is produced the less the other is produced
↓Price of Substitute in Production = ↑Supply

Complements in production

Shares resources on the production side
they go together as more of one is produced, more the other is produced
↑Price of Complement in Production = ↑Supply

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RELATED GOODS – SUPPLY SIDE

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Technology

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Technology

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Technology

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PRICE EXPECTATIONS

If you expect prices to be higher:

Maximizing goal = More $$$
↑Future Price = ↓Supply Now

If you expect prices to be Low:

Maximizing goal = More $$$
↓Future Price = ↑Supply Now

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POPULATION OF SELLERS

↓No of Sellers = ↓Supply

↑No of Sellers = ↑Supply

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Amazon & Supply Shifters��1. No. of Sellers�2. Input Prices�3. Technology�4. Compliments in Production�5. Price Expectations��

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Market Equilibrium

A system is in equilibrium when there is no tendency for it to change
The equilibrium price is the price at which the supply and demand curves intersect
The equilibrium quantity is the quantity at which the supply and demand curves intersect
The market equilibrium occurs when all buyers and sellers are satisfied with their respective quantities at the market price

At the equilibrium price, quantity supplied equals quantity demanded

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Market Equilibrium

Quantity supplied

equals quantity

demanded AND

Price is on supply and demand curves
No tendency to change P or Q

Buyers are on their demand curve
Sellers are on their supply curve

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12

Q

P

S

Market for Pizzas

(1000s of slices/day)

D

$3

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Excess Supply and Excess Demand

Excess Supply

At $4, 16,000 slices supplied and 8,000 slices demanded

Excess Demand

At $2, 8,000 slices supplied 16,000 slices demanded

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$4

8

16

Q

P

S

Market for Pizzas

(1000s of slices/day)

D

$2

8

16

Q

P

S

Market for Pizzas

(1000s of slices/day)

D

Surplus

Shortage

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Incentive Principle: Excess Supply at $4

Each supplier has an incentive to decrease the price in order to sell more
Lower prices decrease the surplus
As price decreases:

the quantity offered for sale decreases along the supply curve
the quantity demanded increases along the demand curve

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$4

8

16

Q

P

S

Market for Pizzas

(1000s of slices/day)

D

$3.50

$3

12

Equilibrium

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SURPLUS

There is a surplus of a good when the quantity supplied exceeds the quantity demanded. Surpluses occur when the price is above its equilibrium level.

7

0

10

15

13

17

$2.00

1.75

1.50

1.25

1.00

0.75

0.50

Supply

Demand

8.1

11.2

E

Surplus

Quantity demanded

Quantity supplied

Price of cotton (per pound)

Quantity of cotton (billions of pounds)

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Incentive Principle: Excess Demand at $2

Each supplier has an incentive to increase the price in order to sell more
Higher prices decrease the shortage
As price increases

the quantity offered for sale increases along the supply curve
As price increases, the quantity demanded decreases along the demand curve.

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$2.50

$2

8

16

Q

P

S

Market for Pizzas

(1000s of slices/day)

D

$3

12

Equilibrium

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SHORTAGE

7

0

10

15

13

17

$2.00

1.75

1.50

1.25

1.00

0.75

0.50

Supply

Demand

9.1

11.5

E

Shortage

Quantity demanded

Quantity supplied

Price of cotton (per pound)

Quantity of cotton (billions of pounds)

There is a shortage of a good when the quantity demanded exceeds the quantity supplied. Shortages occur when the price is below its equilibrium level.

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The Psychology of Supply and Demand��A Tragic Love Story

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COACHELLA SHORTAGE?

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COACHELLA SURPLUS?

The Price of Admission�

Compare the box office price for a recent Justin Timberlake concert in Miami, Florida, to the StubHub.com price for seats in the same location: $88.50 versus $155.

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COACHELLA TICKETS

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COACHELLA TICKETS 2014

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COACHELLA TICKETS 2014

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PRICE CONTROLS

Regulation gone wrong.

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Change in Vacancy Rate by City Cluster, 1990–2010

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Rent Controls Are Price Ceilings

A price ceiling is a maximum allowable price, set by law
Rent controls set a maximum price that can be charged for a given apartment
If the controlled price is below equilibrium, then:

Quantity demanded increases
Quantity supplied decreases
A shortage results

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2

Q

P

S

Market for NYC Apartments

(millions of apartments/day)

D

$1,600

$800

3

1

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Should we solve homelessness with lower housing prices?

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If we didn’t have enough food, would you tell farmers to lower their prices?

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Would farmers want to grow more?

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The problem is supply not price.

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Movement along the Demand Curve

When price goes up, quantity demanded goes down
When price goes down, buyers move to a new, higher quantity demanded
A change in quantity demanded results from a change in the price of a good.

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$2

$1

8

10

Q

P

D

Demand for Canned Tuna

(1000s of cans/day)

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Shift in Demand

If buyers are willing to buy more at each price, then demand has increased

Move the entire demand curve to the right
Change in demand

If buyers are willing to buy less at each price, then demand has decreased

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$2

8

10

Q

P

D

Demand for Canned Tuna

(1000s of cans/day)

D'

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Movement Along the Supply Curve

When price goes up, quantity supplied goes up
When price goes up, sellers move to a new, higher quantity supplied
A change in quantity supplied results from a change in the price of a good.

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$4

$2

8

16

Q

P

S

Supply of Pizzas

(1000s of slices/day)

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Shift in Supply

Supply increases when sellers are willing to offer more for sale at each possible price

Moves the entire supply curve to the right

Supply decreases when sellers are willing to offer less for sale at each possible price

Moves the entire supply curve to the left

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$2

8

Q

P

S

Supply of Pizzas

(1000s of slices/day)

S'

9

$2

8

Q

P

S*

Supply of Tuna

(1000s of cans/day)

S

9

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Tennis Market

If rent for tennis court decreases, demand for tennis balls increases

Tennis courts and tennis balls are complements

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P

Q

Tennis Court Rentals

$7

$10

D

(100s rentals/day)

4

11

$1.40

Tennis Ball Sales

P

Q

$1.00

D

(millions of balls/day)

40

58

D'

S

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Causes of Shifts in Demand

Price of complementary goods

Tennis courts and tennis balls

Price of substitute goods

Internet and overnight delivery are substitutes

Income: normal or inferior goods?
Preferences

Dinosaur toys after Jurassic Park movie

Number of buyers in the market
Expectations about the future

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Price changes never cause a shift in demand

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Apartments Near DC Metro

If government wages rise, demand for apartments near Metro stations increases

Demand increases

Price increases
Quantity increases

Demand for a normal good increases when income increases

Demand for an inferior good increases when income decreases

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Convenient Apartments

P

Q

(units/month)

D'

D

S

P

P'

Q

Q'

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Supply and Demand Shifts: Four Rules

1. An increase in demand will lead to an increase in both equilibrium price and quantity

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Q

P

D

D'

S

Q'

Q

P

P'

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Supply and Demand Shifts: Four Rules

2. An decrease in demand will lead to a decrease in both equilibrium price and quantity

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Q

P

D

D'

S

Q'

Q

P

P'

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Supply and Demand Shifts: Four Rules

3. An increase in supply will lead to a decrease in the equilibrium price and an increase in the equilibrium quantity.

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Q

P

D

S

Q'

Q

P

P'

S'

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Supply and Demand Shifts: Four Rules

4. An decrease in supply will lead to an increase in the equilibrium price and a decrease in the equilibrium quantity.

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Q

P

D

S

Q'

Q

P

P'

S'

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Supply and Demand Both Change: Tortilla Chips

Oils used for frying are harmful AND the price of harvesting equipment decreases

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Price ($/bag)

Millions of bags per month

P

Q

S

D

P'

Q'

D'

S'

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Changes in Supply and Demand

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	Supply
Demand	Increases	Decreases
Increases	P Depends Q Increases	P Increases Q Depends
Decreases	P Decreases Q Depends	P Depends Q Decreases

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Efficiency and Equilibrium

Markets communicate information effectively

Value buyers place on the product
Opportunity cost of producing the product

Markets maximize the difference between benefits and costs
Market outcomes are the best provided that

The market is in equilibrium AND
No costs or benefits are shared with the public

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Cash on the Table

Buyer's surplus: buyer's reservation price minus the market price
Seller's surplus: market price minus the seller's reservation price
Total surplus = buyer's surplus + seller's surplus

Total surplus is buyer's reservation price – seller's reservation price

No cash on the table when surplus is maximized

No opportunity to gain from additional sales or purchases

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Efficiency Principle

The socially optimal quantity maximizes total surplus for the economy from producing and selling a good

Economic efficiency – all goods are produced at their socially optimal level

Efficiency Principle: equilibrium price and quantity are efficient if:

Sellers pay all the costs of production
Buyers receive all the benefits of their purchase

Efficiency: marginal cost equals marginal benefit

Production is efficient if total surplus is maximized

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Smart for One, Dumb for All

Producers sometimes shift costs to others

Pollution is like getting free waste disposal services
Total marginal cost = seller's marginal cost plus marginal cost of pollution
When costs are shifted, supply is greater than socially optimal

Buyers may create benefits for others

Marginal benefit is less than the full social benefit
Vaccinations, my neighbor's landscaping
The demand for these goods is less than socially optimal

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Equilibrium Principle

Equilibrium Principle: a market in equilibrium leaves no unexploited opportunities for individuals

BUT it may not exploit all gains achievable through collective action
Only when the seller pays the full cost of production and the buyer captures the full benefit of the good is the market outcome socially optimal

Regulation, taxes and fines, or subsidies can move the market to optimal level

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Supply and Demand

3-94

Supply

�

Efficiency Principle�

Equilibrium Principle

Equilibrium Price and Quantity

Demand

�

Changes

Changes

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The Algebra of Supply and Demand

Chapter 3 Appendix

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From Graphs to Equations …

Sample equations

P = 16 – 2 Q^d

is a straight-line demand curve with intercept 16 on the vertical (P) axis and a slope of – 2�

P = 4 + 4 Q^s

is a straight-line supply curve with intercept 4 and a slope of 4

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… To Equilibrium P and Q

Equilibrium is where P and Q are the same for demand and supply

Set the two equations equal to each other (P = P) and solve for Q (Q^s = Q^d= Q^*)

16 – 2 Q^*=4 + 4 Q^*

6 Q^*= 12

Q^* = 2

Use either the supply or demand curve and Q^*= 2 to find price

P = 16 – 2 Q^*

P = $12

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P = 4 + 4 Q^*

P = $12