The market forses of supply and demand

In this chapter,
look for the answers to these questions:
What factors affect buyers’ demand for goods?
What factors affect sellers’ supply of goods?
How do supply and demand determine the price of a good and the quantity sold?
How do changes in the factors that affect demand or supply affect the market price and quantity of a good?
How do markets allocate resources?

THE MARKET FORCES OF SUPPLY AND DEMAND
Markets and Competition
A market is a group of buyers and sellers of a particular product.
A competitive market is one with many buyers and sellers, each has a negligible effect on price.
In a perfectly competitive market:
All goods exactly the same
Buyers & sellers so numerous that no one can affect market price – each is a “price taker”
In this chapter, we assume markets are perfectly competitive.

THE MARKET FORCES OF SUPPLY AND DEMAND
Demand
The quantity demanded of any good is the amount of the good that buyers are willing and able to purchase.
Law of demand: the claim that the quantity demanded of a good falls when the price of the good rises, other things equal

THE MARKET FORCES OF SUPPLY AND DEMAND
The Demand Schedule
Demand schedule:
a table that shows the relationship between the price of a good and the quantity demanded
Example:
Helen’s demand for lattes.
Notice that Helen’s preferences obey the
Law of Demand.

THE MARKET FORCES OF SUPPLY AND DEMAND
Helen’s Demand Schedule & Curve

Market Demand versus Individual Demand
The quantity demanded in the market is the sum of the quantities demanded by all buyers at each price.
Suppose Helen and Ken are the only two buyers in the Latte market. (Qd = quantity demanded)
Market Qd

THE MARKET FORCES OF SUPPLY AND DEMAND
P
Q
The Market Demand Curve for Lattes

THE MARKET FORCES OF SUPPLY AND DEMAND
Demand Curve Shifters
The demand curve shows how price affects quantity demanded, other things being equal.
These “other things” are non-price determinants of demand (i.e., things that determine buyers’ demand for a good, other than the good’s price).
Changes in them shift the D curve…

THE MARKET FORCES OF SUPPLY AND DEMAND
Demand Curve Shifters: # of Buyers
Increase in # of buyers
increases quantity demanded at each price, shifts D curve to the right.

THE MARKET FORCES OF SUPPLY AND DEMAND
Suppose the number of buyers increases.
Then, at each P,
Qd will increase
(by 5 in this example).
Demand Curve Shifters: # of Buyers

THE MARKET FORCES OF SUPPLY AND DEMAND
Demand for a normal good is positively related to income.
Increase in income causes
increase in quantity demanded at each price, shifts D curve to the right.
(Demand for an inferior good is negatively related to income. An increase in income shifts D curves for inferior goods to the left.)
Demand Curve Shifters: Income

THE MARKET FORCES OF SUPPLY AND DEMAND
Two goods are substitutes if an increase in the price of one causes an increase in demand for the other.
Example: pizza and hamburgers.
An increase in the price of pizza
increases demand for hamburgers,
shifting hamburger demand curve to the right.
Other examples: Coke and Pepsi,
laptops and desktop computers,
CDs and music downloads
Demand Curve Shifters: Prices of Related Goods

THE MARKET FORCES OF SUPPLY AND DEMAND
Two goods are complements if an increase in the price of one causes a fall in demand for the other.
Example: computers and software.
If price of computers rises, people buy fewer computers, and therefore less software.
Software demand curve shifts left.
Other examples: college tuition and textbooks,
bagels and cream cheese, eggs and bacon
Demand Curve Shifters: Prices of Related Goods

THE MARKET FORCES OF SUPPLY AND DEMAND
Anything that causes a shift in tastes toward a good will increase demand for that good
and shift its D curve to the right.
Example:
The Atkins diet became popular in the ’90s,
caused an increase in demand for eggs,
shifted the egg demand curve to the right.
Demand Curve Shifters: Tastes

THE MARKET FORCES OF SUPPLY AND DEMAND
Expectations affect consumers’ buying decisions.
Examples:
If people expect their incomes to rise,
their demand for meals at expensive restaurants may increase now.
If the economy sours and people worry about their future job security, demand for new autos may fall now.
Demand Curve Shifters: Expectations

THE MARKET FORCES OF SUPPLY AND DEMAND
Summary: Variables That Influence Buyers
Variable A change in this variable…
Price …causes a movement along the D curve
# of buyers …shifts the D curve
Income …shifts the D curve
Price of
related goods …shifts the D curve
Tastes …shifts the D curve
Expectations …shifts the D curve

A. The price of iPods falls
B. The price of music downloads falls
C. The price of CDs falls
A C T I V E L E A R N I N G 1
Demand Curve
Draw a demand curve for music downloads. What happens to it in each of
the following scenarios? Why?

A C T I V E L E A R N I N G 1
A. Price of iPods falls
Music downloads and iPods are complements.
A fall in price of iPods shifts the demand curve for music downloads
to the right.

A C T I V E L E A R N I N G 1
B. Price of music downloads falls
The D curve
does not shift.
Move down along curve to a point with lower P, higher Q.
Price of music down-loads
Quantity of
music downloads
D1
P1
Q1

A C T I V E L E A R N I N G 1
C. Price of CDs falls
CDs and
music downloads are substitutes.
A fall in price of CDs shifts demand for music downloads
to the left.
Price of music down-loads
Quantity of
music downloads

THE MARKET FORCES OF SUPPLY AND DEMAND
Supply
The quantity supplied of any good is the amount that sellers are willing and able to sell.
Law of supply: the claim that the quantity supplied of a good rises when the price of the good rises, other things equal

THE MARKET FORCES OF SUPPLY AND DEMAND
The Supply Schedule
Supply schedule:
A table that shows the relationship between the price of a good and the quantity supplied.
Example:
Starbucks’ supply of lattes.
Notice that Starbucks’ supply schedule obeys the
Law of Supply.

THE MARKET FORCES OF SUPPLY AND DEMAND
Starbucks’ Supply Schedule & Curve
P
Q

Market Supply versus Individual Supply
The quantity supplied in the market is the sum of
the quantities supplied by all sellers at each price.
Suppose Starbucks and Jitters are the only two sellers in this market. (Qs = quantity supplied)
Market Qs

THE MARKET FORCES OF SUPPLY AND DEMAND
The Market Supply Curve

THE MARKET FORCES OF SUPPLY AND DEMAND
Supply Curve Shifters
The supply curve shows how price affects quantity supplied, other things being equal.
These “other things” are non-price determinants of supply.
Changes in them shift the S curve…

THE MARKET FORCES OF SUPPLY AND DEMAND
Supply Curve Shifters: Input Prices
Examples of input prices: wages, prices of raw materials.
A fall in input prices makes production
more profitable at each output price,
so firms supply a larger quantity at each price,
and the S curve shifts to the right.

THE MARKET FORCES OF SUPPLY AND DEMAND
Suppose the price of milk falls.
At each price, the quantity of
Lattes supplied
will increase
(by 5 in this example).
Supply Curve Shifters: Input Prices

THE MARKET FORCES OF SUPPLY AND DEMAND
Supply Curve Shifters: Technology
Technology determines how much inputs are required to produce a unit of output.
A cost-saving technological improvement has
the same effect as a fall in input prices,
shifts S curve to the right.

THE MARKET FORCES OF SUPPLY AND DEMAND
Supply Curve Shifters: # of Sellers
An increase in the number of sellers increases the quantity supplied at each price,
shifts S curve to the right.

THE MARKET FORCES OF SUPPLY AND DEMAND
Supply Curve Shifters: Expectations
Example:
Events in the Middle East lead to expectations of higher oil prices.
In response, owners of Texas oilfields reduce supply now, save some inventory to sell later at the higher price.
S curve shifts left.
In general, sellers may adjust supply* when their expectations of future prices change.
(*If good not perishable)

THE MARKET FORCES OF SUPPLY AND DEMAND
Summary: Variables that Influence Sellers
Variable A change in this variable…
Price …causes a movement along the S curve
Input Prices …shifts the S curve
Technology …shifts the S curve
# of Sellers …shifts the S curve
Expectations …shifts the S curve

A C T I V E L E A R N I N G 2
Supply Curve
Draw a supply curve for tax
return preparation software.
What happens to it in each
of the following scenarios?
A. Retailers cut the price of
the software.
B. A technological advance
allows the software to be
produced at lower cost.
C. Professional tax return preparers raise the price of the services they provide.

A C T I V E L E A R N I N G 2
A. Fall in price of tax return software
S curve does
not shift.
Move down
along the curve
to a lower P
and lower Q.

A C T I V E L E A R N I N G 2
B. Fall in cost of producing the software
S curve shifts to the right:
at each price,
Q increases.
Price of tax return software
Quantity of tax return software
S1
P1
Q1

A C T I V E L E A R N I N G 3
C. Professional preparers raise their price
This shifts the demand curve for tax preparation software, not the supply curve.

THE MARKET FORCES OF SUPPLY AND DEMAND
Supply and Demand Together
Equilibrium:
P has reached
the level where
quantity supplied equals
quantity demanded

THE MARKET FORCES OF SUPPLY AND DEMAND
Equilibrium price:
the price that equates quantity supplied with quantity demanded

THE MARKET FORCES OF SUPPLY AND DEMAND
Equilibrium quantity:
the quantity supplied and quantity demanded at the equilibrium price

THE MARKET FORCES OF SUPPLY AND DEMAND
Surplus (a.k.a. excess supply):
when quantity supplied is greater than quantity demanded
Surplus
Example:
If P = $5,
then
QD = 9 lattes
and
QS = 25 lattes
resulting in a
surplus of 16 lattes

THE MARKET FORCES OF SUPPLY AND DEMAND
Surplus (a.k.a. excess supply):
when quantity supplied is greater than quantity demanded
Facing a surplus,
sellers try to increase sales by cutting price.
This causes
QD to rise
…which reduces the surplus.
and QS to fall…

THE MARKET FORCES OF SUPPLY AND DEMAND
Surplus (a.k.a. excess supply):
when quantity supplied is greater than quantity demanded
Facing a surplus,
sellers try to increase sales by cutting price.
This causes
QD to rise and QS to fall.
Surplus
Prices continue to fall until market reaches equilibrium.

THE MARKET FORCES OF SUPPLY AND DEMAND
Shortage (a.k.a. excess demand):
when quantity demanded is greater than quantity supplied
Example:
If P = $1,
then
QD = 21 lattes
and
QS = 5 lattes
resulting in a
shortage of 16 lattes
Shortage

THE MARKET FORCES OF SUPPLY AND DEMAND
Shortage (a.k.a. excess demand):
when quantity demanded is greater than quantity supplied
Facing a shortage,
sellers raise the price,
causing QD to fall
…which reduces the shortage.
and QS to rise,

THE MARKET FORCES OF SUPPLY AND DEMAND
Shortage (a.k.a. excess demand):
when quantity demanded is greater than quantity supplied
Facing a shortage,
sellers raise the price,
causing QD to fall
and QS to rise.
Shortage
Prices continue to rise until market reaches equilibrium.

THE MARKET FORCES OF SUPPLY AND DEMAND
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.

THE MARKET FORCES OF SUPPLY AND DEMAND
EXAMPLE: The Market for Hybrid Cars

THE MARKET FORCES OF SUPPLY AND DEMAND
STEP 1:
D curve shifts
because price of gas affects demand for hybrids.
S curve does not shift, because price of gas does not affect cost of producing hybrids.
STEP 2:
D shifts right
because high gas price makes hybrids more attractive relative to other cars.
EXAMPLE 1: A Shift in Demand
EVENT TO BE
ANALYZED:
Increase in price of gas.
STEP 3:
The shift causes an increase in price
and quantity of hybrid cars.

THE MARKET FORCES OF SUPPLY AND DEMAND
EXAMPLE 1: A Shift in Demand
P2
Q2
Notice: When P rises, producers supply
a larger quantity
of hybrids, even though the S curve has not shifted.
Always be careful to distinguish b/w a shift in a curve and a movement along the curve.

Terms for Shift vs. Movement Along Curve
Change in supply: a shift in the S curve
occurs when a non-price determinant of supply changes (like technology or costs)
Change in the quantity supplied:
a movement along a fixed S curve
occurs when P changes
Change in demand: a shift in the D curve
occurs when a non-price determinant of demand changes (like income or # of buyers)
Change in the quantity demanded:
a movement along a fixed D curve
occurs when P changes

THE MARKET FORCES OF SUPPLY AND DEMAND
STEP 1:
S curve shifts
because event affects cost of production.
D curve does not shift, because production technology is not one of the factors that affect demand.
STEP 2:
S shifts right
because event reduces cost,
makes production more profitable at any given price.
EXAMPLE 2: A Shift in Supply
EVENT: New technology reduces cost of producing hybrid cars.
STEP 3:
The shift causes price to fall
and quantity to rise.

THE MARKET FORCES OF SUPPLY AND DEMAND
EXAMPLE 3: A Shift in Both Supply and Demand
EVENTS:
price of gas rises AND
new technology reduces production costs
STEP 1:
Both curves shift.
STEP 2:
Both shift to the right.
STEP 3:
Q rises, but effect
on P is ambiguous:
If demand increases more than supply, P rises.

THE MARKET FORCES OF SUPPLY AND DEMAND
EXAMPLE 3: A Shift in Both Supply and Demand
STEP 3, cont.
EVENTS:
price of gas rises AND
new technology reduces production costs
But if supply increases more than demand,
P falls.

A C T I V E L E A R N I N G 3
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 they must pay for each song they sell.
Event C: Events A and B both occur.

A C T I V E L E A R N I N G 3
A. Fall in price of CDs
2. D shifts left
The market for music downloads
1. D curve shifts
3. P and Q both fall.
STEPS

A C T I V E L E A R N I N G 3
B. Fall in cost of royalties
The market for music downloads
1. S curve shifts
2. S shifts right
3. P falls,
Q rises.
STEPS
(Royalties are part of sellers’ costs)

A C T I V E L E A R N I N G 3
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.

THE MARKET FORCES OF SUPPLY AND DEMAND
CONCLUSION:
How Prices Allocate Resources
One of the Ten Principles from Chapter 1:
Markets are usually a good way to organize economic activity.
In market economies, prices adjust to balance supply and demand. These equilibrium prices are the signals that guide economic decisions and thereby allocate scarce resources.

CHAPTER SUMMARY
A competitive market has many buyers and sellers, each of whom has little or no influence
on the market price.
Economists use the supply and demand model to analyze competitive markets.
The downward-sloping demand curve reflects the Law of Demand, which states that the quantity buyers demand of a good depends negatively on the good’s price.

CHAPTER SUMMARY
Besides price, demand depends on buyers’ incomes, tastes, expectations, the prices of substitutes and complements, and number of buyers.
If one of these factors changes, the D curve shifts.
The upward-sloping supply curve reflects the Law of Supply, which states that the quantity sellers supply depends positively on the good’s price.
Other determinants of supply include input prices, technology, expectations, and the # of sellers. Changes in these factors shift the S curve.

CHAPTER SUMMARY
The intersection of S and D curves determines the market equilibrium. At the equilibrium price, quantity supplied equals quantity demanded.
If the market price is above equilibrium,
a surplus results, which causes the price to fall.
If the market price is below equilibrium,
a shortage results, causing the price to rise.