Chapter 4-Demand and Supply

Producers

People that make or sell things

Consumers

People who buy things

Slope of Supply curve

Positive

Equilibrium

The market is in equilibrium at the point where supply and demand intersect— where quantity supplied equals quantity demanded. Equilibrium is the unique price-quantity combination at which the market "clears," meaning there is no surplus or shortage. The graph shown in Figure 4.7 illustrates a market in equilibrium. Equilibrium is identified at point E.

How do markets reach equilibrium

Through trial and error. The more information that buyers and sellers have, the faster this takes place.

Price elasticity of supply

is the relative response of the quantity supplied to a change in price. The formula for price % change in Qs/% change in P

Income elasticity of demand

measures the responsiveness of quantity demanded to a change in income and is what determines whether or not goods are normal or inferior. Forumla is %change in Qd/%change in income

Change in demand vs change in supply (definitions)

A change in demand means that for every price there is a new quantity demanded. A change in supply means that for every price there is a new quantity supplied.

Increasing marginal cost

As producers make and sell more, the cost of producing each additional unit increases.

Law of Demand

Consumers tend to buy higher quantities at lower prices than they do at higher prices.

What is the slope of a demand curve

Negative (Figure 4.1)

Inferior goods

an increase in income leads to a decrease in demand and which a decrease in income leads to an increase in demand. Consumers judge these goods to be inferior because when they have more income, they choose to do something else with it and buy less of these unusual goods. example: Second-hand clothing, bus tickets, used cars, and generic toilet paper

Inferior vs normal

i. If Ei > 0, then the good is normal. ii. If Ei < 0, then the good is inferior.

Price elasticity of demand formula

Ed= %Change in Qd/ %change in P

Elasticity

In general, elasticity measures the sensitivity of quantity changes to price changes.

Alternate formula for Price elasticity of demand

(P/Q)(1/M) M is the slope of the demand curve, assuming a linear demand function. Interpreting this formula: Since P and Q change in opposite directions (recall the law of demand?), this elasticity coefficient will be negative. Economic convention disregards the negative sign, taking the absolute value, and then comparing it to 1.

What could cause a change in equilibrium

1. Whenever supply or demand changes, the equilibrium price and quantity change.

Decrease in demand effect (4.11)

A decrease in demand (leftward shift) results in a decrease in the equilibrium price and quantity as illustrated in Figure 4.11. Note again the difference between this decrease in demand and the previous decrease in quantity demanded. Note that as before this causes a decrease in price and consequently a decrease in quantity supplied, though no change in the supply function.

Change in expected price and demand

A change in expected prices results in a change in demand. If consumers expect the price of a good or service to increase, then they demand more now. If, however, they expect the price of a good or service to decrease, then they demand less now. For example, if consumers expect car prices to rise next year, then they are more likely to purchase cars this year. If consumers expect house prices to fall in the future, then they are less likely to buy a house now. Some consumers will choose to wait to take advantage of future price declines.

Change of price of related goods and the effect of demand

A change in the price of related goods can lead to a change in demand. Consumer patterns indicate that two special types of related goods have such an effect: substitutes and complements.

Decrease in supply and affect on equilibrium

A decrease in supply (leftward shift) results in an increase in the equilibrium price but a lower equilibrium quantity as illustrated in Figure 4.13. Note again the difference between this decrease in supply and the previous decrease in quantity supplied. Note that as before this causes an increase in price and consequently a decrease in quantity demanded, though no change in the demand function.

portion of the consumer's income the purchase would require.

A good or service that requires a significant portion of a consumer's income to purchase tends to have elastic demand, but a good or service that requires only a small portion of income tends to have inelastic demand. If a $ 20,000 car increases in price by 10 percent, that $ 2,000 increase may really change buyers' decisions and reduce sales. But a 100 percent increase in the price of paper clips will probably not influence the number of paper clips the average consumer uses very much at all.

Increase in demand effect (4.10)

An increase in demand (rightward shift) results in an increase in the equilibrium price and quantity as shown in Figure 4.10. Note that this is distinct from an increase in quantity demanded because the whole function has changed (a shift of the line rather than movement along it to a new point). Note that in response to the increase in demand, price rose and the quantity supplied increased (even though supply remains unchanged).

Increase of supply and affect on equilibrium

An increase in supply (rightward shift) results in a lower equilibrium price and an increase in the equilibrium quantity as shown in Figure 4.12. Note again the difference between this increase in supply and the previous increase in quantity supplied. Note that as before this causes a decrease in price and consequently an increase in quantity demanded, though no change in the demand function.

Total revenue test

Another way to determine price elasticity of demand is the total revenue test. First, calculate total revenue by multiplying price by quantity (P X Q). Compare the change in price to the change in total revenue. If the price and total revenue change in the same direction, then demand is inelastic. If the price changes but total revenue remains constant, then demand is unit elastic. Finally, if price changes, but total revenue moves in the opposite direction, then demand is elastic.

Why does the Law of Demand exist?

Because of the Income effect, Substitution effect, and diminishing marginal utility

What causes change in demand?

Changes in demand are caused by changes in consumers' tastes, consumers' incomes, the price of related goods, expected prices, and the size of the market (number of buyers). These are collectively referred to as the determinants of demand.

What are changes in supply caused by

Changes in supply are caused by changes in the price of inputs, competition (number of firms), technology, changes in the price of related goods and services, and changes in expected prices.

changes in the price of related goods and services

Changes in the price of related goods and services also affect supply. When goods are produced at the same time, such as beef and leather, an increase in the price of one leads to an increase in the supply of the other, or a complement in production (" by-product" is pretty close). -More often, however, goods are produced at the expense of other goods. Consider farmers who have a fixed amount of land on which to grow crops. The decision to grow corn because it is more profitable results in a decrease in the supply of wheat and vice versa. ➤ For the Bic Corporation, plastic can be made into lighters, pens, or disposable razors. As the number of smokers has declined in recent decades, the decrease in the price of lighters has probably shifted the supply curves for pens and razors to the right. These goods that represent alternative uses of resources are called substitutes in production.

Complementary

Complementary goods are goods that are consumed together like movie tickets and popcorn or hot dogs and hot dog buns. If the price of a good increases, then the demand for the complement decreases. For example, an increase in the price of movie tickets results in a decrease in the demand for popcorn. If, however, the price of a good decreases, then the demand for the complement good increases. For example, a decrease in the price of hot dogs results in an increase in the demand for hot dog buns.

Consumer Surplus

Consumer surplus is the difference between the price a consumer is willing to pay and the prevailing market price. In the supply and demand model shown in Figure 4.17, it is the triangle formed underneath the demand curve above the equilibrium price. Consumer surplus can always be found below the demand curve, above the price paid and to the left of quantity purchased.

Consumer's tastes

Consumers' tastes refers to a preference or a desire for a good or service. If the desire or preference increases, then demand increases. If, however, the desire or preference for the good or service decreases, then demand decreases. This determinant of demand is the right one to think of for fads, popularity due to health, coolness, or celebrity endorsement of a product, and other similar situations.

Demand

Consumers' willingness and ability to buy a good or service at the various prices that exist in a market in a given time. Demand expresses an inverse relationship between quantity demanded and price, other things being equal.

Cross price elasticity of demand

Cross price elasticity of demand determines whether goods are complements or substitutes. It is the relative change in the quantity demanded of one good (x) in response to the change in price of a related good (y). Formula is %change in Qdx/ %change in Py

Deadweight Loss

Deadweight Loss occurs whenever the market is not in equilibrium. Deadweight loss is the sum of producer and consumer surplus that could have been achieved had the equilibrium price and quantity prevailed in the market. In the previous graph on quantity control, deadweight loss was identified by area DWL. In Figure 4.18, the effect of an excise tax, or per unit tax on production, on total surplus is shown. Ps is the price suppliers earn, Pd is the price that buyers pay. The difference between them reflects the amount of the excise tax. The area labeled government surplus represents the tax revenue generated by the excise tax. DWL is the area of deadweight loss created by the tax.

Diminishing Marginal Utility

Each additional unit of a good or service that a person consumes gives them less benefit, usefulness, or utility than the previous unit. This is referred to as diminishing marginal utility. The decision to consume an additional unit involves the consumer weighing the marginal benefit of the decision against the marginal cost. Because of diminishing marginal utility, the only way a person will consume more of a good is if the marginal cost or price is lower.

Examples of price ceilings

Examples of price ceilings include rent controls and limits on gas prices.

Examples of price floor

Examples of price floors include the minimum wage and agricultural price supports.

Necessity vs luxury

If the good or service is a necessity, then demand tends to be inelastic. For example, changes in the price of necessary medicines have little effect on the quantity demanded. To the contrary, a good or service that is not necessary tends to have relatively elastic demand. Luxury goods tend to have elastic demand, and, unsurprisingly, addictive or habit-forming goods tend to have inelastic demand.

Why does increasing marginal cost exist

Firms use the cheapest and best-suited resources first and then need to bring factors of production that aren't as useful, easy to obtain, or well-suited to making the good in question. This means that at some point, units become more expensive to make. Firms experience diminishing marginal returns as they increase production. Even if additional units of labor (for example) are just as well-trained as the first few workers hired, at some point because other factors of production are fixed in the short run (perhaps capital equipment and the factory size), additional workers will increase production by successively less and less.

Figure 4.8 Analysis

For example, if a price is higher than the market equilibrium price, as illustrated in Figure 4.8, then the amount producers offer for sale (quantity supplied) is greater than the amount consumers are willing to buy (quantity demanded) and a surplus results. Excess units on shelves of sellers create incentives to reduce the price which causes the quantity supplied to decrease (remember the law of supply?) and the quantity demanded to increase as consumers respond to the law of demand. Eventually the marlet corrects itself.

Price Ceiling

If a government believes that a market price is too high, then it may put a price ceiling on a good or service. A price ceiling is a maximum price that producers and consumers are not allowed to exceed. Figure 4.15 illustrates a price ceiling and its effect on the market. -As shown in Figure 4.14, Pe and Qe are the market equilibrium price and quantity. Pc is the price ceiling. Qs refers to quantity supplied and Qd refers to quantity demanded. When a price ceiling is an effective price ceiling, it results in the quantity demanded being greater than the quantity supplied. Thus, it must be below the equilibrium price to be effective. This results in a shortage equal to Qd Qs.

Price floor

If a government believes that the market equilibrium price for a good is too low, it may put a price floor on a good or service. A price floor is a minimum price that producers and consumers are not allowed to undermine. Figure 4.15 (below) illustrates a price floor and its effect on the market. In the graph, Pe and Qe are the market equilibrium price and quantity. Pf is the price floor. Qs refers to quantity supplied and Qd refers to quantity demanded. When a price floor is an effective price floor, it results in the quantity demanded being less than the quantity supplied. Thus, to take effect, the price floor must be above the equilibrium price. This results in a surplus equal to Qs - Qd.

Figure 4.9 Analysis

If a price is lower than the market equilibrium price (illustrated in Figure 4.9), then the amount producers offer for sale (quantity supplied) is less than the amount consumers are willing to buy (quantity demanded) and a shortage results. Consumers vie for the limited number available and sellers sense the shortages, driving up the price which causes the quantity demanded to decrease and the quantity supplied to increase as producers respond to the law of supply. Eventually this results in the shortage disappearing and the market reaching equilibrium.

amount of time the consumer has available to make a buying decision

If ample time to make a decision exists, then demand is elastic. If a purchasing decision must be made immediately, then demand is inelastic. In the short run, gasoline has a very inelastic demand because people are locked into their commuting patterns. Given time, people might be "driven" to use less gas as they first set up carpools, then find alternative modes of transit (by buying hybrid cars or using mass transit), then develop lifestyles that avoid long commutes (by moving closer to work, getting a job closer to home, or telecommuting).

Availability of substitutes

If no close substitutes exist, demand is inelastic. If ready substitutes are available, demand is elastic. For example, the demand for electricity tends to be inelastic, while the demand for German sports cars is elastic.

Changes in expected price

If producers expect the price of their good or service to increase, then they are less willing to offer it for sale now. However, if producers expect the price of their good to decrease, then they are more willing to offer it for sale now.

Price of inputs

If the price of inputs changes, then the ability of a producer to supply its product changes. An increase in the price of inputs results in less supply as per-unit production costs rise, while a decrease in the price of inputs results in an increase in supply as per-unit production costs fall. For example, an increase in the price of cocoa leads to a decrease in the supply of chocolate candy. A decrease in the price of coffee beans leads to an increase in the supply of coffee grounds.

Unit Elastic

If the quantity change is proportional to the price change, it can be described as unit elastic. If Ed is 1

Relatively elastic

If the quantity change is relatively large compared to the price change, the change can be described as relatively elastic. If Ed > 1, then demand is elastic.

Technology

Improvements in technology often result in an increase in the ability of producers to supply their products. The adoption of the assembly line resulted in an increase in the supply of cars during the early twentieth century just as the invention of the printing press increased the supply of books five hundred years earlier.

Figure 4.2 Analysis

In Figure 4.2, point A corresponds to a price of $ 5 and a quantity demanded of 12.

Figure 4.3 Analysis

In Figure 4.3, a decrease in the price of a good from $ 5 to $ 4 illustrates the law of demand as the quantity demanded increases from 12 to 15. Note that this is a change in quantity demanded and not a change in demand (the function is unchanged, but we have "slid" along it to a different price-quantity combination).

Figure 4.5 Analysis

In Figure 4.5, point A corresponds to a price of $ 5 and a quantity supplied of 12.

Figure 4.6 Analysis

In the graph below (Figure 4.6), an increase in the price of a good from $ 5 to $ 6 illustrates the law of supply as the quantity supplied increases from 12 to 15. -Note that this graph shows an increase in quantity supplied rather than an increase in supply. The supply function is unchanged. A change in price has caused "sliding" along the function to a new price-quantity combination.

Reason for law of supply

Increasing marginal cost

MERIT

M - Market Size E - Expected Prices R - Related Prices I - Income T - Tastes

Market size and demand

Market size, or the number of possible consumers, affects demand. If the market size increases, then demand increases. If, however, the market size decreases, then the demand decreases. For example, if a state lowers the legal driving age from 16 to 14, then the demand for cars, gasoline, auto insurance, and wrecker services all increase.

Competition

More competition leads to more supply and less competition lead to less supply. For example, if a new hamburger restaurant enters the fast-food industry, then the supply of hamburger meals increases. If a business exits an industry, then there is less supply. More suppliers means more supply!

Price elasticity of demand

Price elasticity of demand shows the response of quantity demanded to a change in price

Producer Surplus

Producer surplus is the difference between the price a producer is willing to accept and the prevailing market price. In the supply and demand model below, it is the triangle formed above the supply curve and below the equilibrium price. Producer surplus can always be found above the supply (or marginal cost) curve, below the price received, and to the left of quantity sold.

Law of supply

Producers tend to want to offer higher quantities for sale at higher prices than at lower prices.

Supply

Producers' willingness and ability to sell a good or service at the various prices that exist in the market at a given time is called supply. Supply expresses a direct or positive relationship between quantity supplied and price, other things being equal.

Price and Quantity Controls

Sometimes governments may decide that market prices are unfair— that the market produces too much or that markets do not allocate goods and services to those desperately in need. When this is the case, governments may put price or quantity controls on the market.

Substitute goods

Substitute goods are goods that are consumed in place of each other like movie theater tickets and video rentals. If the price of a good increases, then the demand for its substitute increases. For example, an increase in the price of movie tickets results in an increase in the demand for movie rentals. If, however, the price of a substitute decreases, then the demand for the other substitute decreases. For example, a decrease in the price of movie tickets results in a decrease in the demand for movie rentals.

TRICE

T - Technology R - Related Prices I - Input Prices C - Competition E - Expected Prices

Determinant for price elasticity of supply

The determinant of price elasticity of supply is the time available for the product to be produced and sold. If production is time-consuming, then price elasticity of supply is inelastic. If producers are able to respond quickly to price changes, then price elasticity of supply is elastic. i. If Es > 1, then supply is elastic. Example: plastic toys. ii. If Es < 1, then supply is inelastic. Example: fine wine.

What determines whether a good is inelastic

The factors that determine price elasticity of demand are whether or not the good is a necessity or a luxury, the availability of substitutes, the amount of time the consumer has available to make a buying decision, and the portion of the consumer's income the purchase would require.

Total economic surplus

Total economic surplus, the sum of consumer and producer surpluses, is maximized at the equilibrium price and quantity.

Quantity Control

When a government wants to limit the amount of a good in a market, it may put a quantity control, such as a quota, in place. In Figure 4.16, a quantity control labeled Qc has been placed on the market. The quantity produced at Qc is less than the equilibrium quantity (Qe). This results in a supply price (Ps) and a demand price (Pd). The demand price is what is paid, and the difference between the two results in a much higher price being paid to the producer than would have occurred at the equilibrium price (Pe).

Substitution effect

When the price of a good changes, it is changing relative to the price of other goods. Consumers tend to substitute away from more expensive goods toward cheaper goods. For example, a person may have a grocery list with both beef and chicken on it. A decrease in the price of chicken will probably lead him or her to purchase more chicken and less beef. An increase in the price of chicken will probably make beef seem relatively cheaper and lead to a lower quantity of chicken purchased. This tendency is referred to as the substitution effect.

Income effect

When the price of a good or service changes, then so does the consumer's ability to purchase the good or service. When prices rise, the consumer's buying power decreases and so the consumer cannot afford to buy as much. When prices fall, the consumer's buying power increases and so the consumer can afford to purchase more.

Normal goods

an increase in income results in an increase in demand, while a decrease in income results in a decrease in demand. Most goods are normal goods

Substitute vs complement

i. If Exy > 0, then the good or service is a substitute. ii. If Exy < 0, then the good or service is a complement.

Inelastic

if the quantity change is relatively small compared to the price change, it can be described as inelastic. If Ed < 1

Consumers' incomes

the amount of money they have available for buying things, affect the demand for goods and services. For most goods and services (normal goods), an increase in income results in an increase in demand, while a decrease in income results in a decrease in demand.