Unit 2: The Market (Supply & Demand)

Law of Demand: Diminishing Marginal Utility

Because the marginal benefit (MB) decreases with each additional unit consumed (i.e. diminishing marginal utility), the marginal cost (MC) that one is willing to pay (i.e. price) for each additional unit must also decrease so that MB ≥ MC; so if P↓, Qd↑

Graphs of Demand Elasticity

As demand becomes more inelastic, the demand curve gets steeper until it reaches perfectly inelastic demand (a change in price results in no change to Qd) As demand becomes more elastic, the demand curve gets flatter until it reaches perfectly elastic demand (any change in price results in no Qd; Qd = 0)

Graphs of Supply Elasticity

As supply becomes more inelastic, the supply curve gets steeper until it reaches perfectly inelastic supply (a change in price results in no change to Qs) As supply becomes more elastic, the supply curve gets flatter until it reaches perfectly elastic supply (any change in price results in no Qs; Qs = 0)

Demand Determinant: Income

If a consumer's income increases, demand for normal goods (high quality, name brand, new) increase (D↑) and demand for inferior goods (low quality, generic, used) decrease (D↓). If a consumer's income decreases, demand for normal goods (high quality, name brand, new) decrease (D↓) and demand for inferior goods (low quality, generic, used) increase (D↑). Example: If a consumer's earns a pay raise, their demand for Smucker's (name brand) strawberry jam (a normal good) will increase (D↑) and their demand for Great Value (Walmart's generic/store brand) strawberry jam (an inferior good) will decrease (D↓).

Demand Determinant: Expectation of Future Price

If future prices of a good are expected to increase, current demand for that good will increase (D↑) to take advantage of the lower relative price at present. If future prices of a good are expected to decrease, current demand for that good will decrease (D↓) as consumers will wait for the discounted price. Example: If Amazon announces a huge sale (60% off) on TVs beginning on Black Friday, then consumers will be less inclined to buy a TV in the weeks leading up to Black Friday (D↓) due to the lower expected future price.

Supply Determinant: Cost of Inputs

If input costs (i.e. factors of production, resources, intermediate goods, labor, etc.) increase, then profit potential decreases and supply of goods and services decreases (S↓) If input costs (i.e. factors of production, resources, intermediate goods, labor, etc.) decrease, then profit potential increases and supply of goods and services increases (S↑) Example: If the cost of steel increases, then the profit margin for producing cars decreases and supply of cars decreases (S↓).

Demand Determinant: Popularity (Tastes/Preferences)

If popularity (tastes/preferences) of a good increases, demand increases (D↑). If popularity (tastes/preferences) of a good decreases, demand decreases (D↓). Example: Over time, consumer tastes/preferences have shifted away from gas-guzzling SUVs (D↓) to fuel efficient hybrid vehicles (D↑), as depicted.

Supply Determinant: Expectation of Future Price

If producers expect prices will increase in the future, then the current supply will decrease (S↓) because they want to maintain their reserves and sell in the future when prices, and therefore profits, are higher If producers expect prices will decrease in the future, then the current supply will increase (S↑) Example: If Leighow Oil expects oil prices are going to increase next month when temperatures drop, then they are going to decrease the current supply (S↓) and wait to supply when the price is higher in the future so they can maximize their profit.

Supply Determinant: Technology/Productivity

If production methods improve productivity (output per input), typically through technological innovations, then supply increases (S↑) Example: Tractors have improved the productivity of farmers in plowing fields, fertilizing, and harvesting crops, so supply of crops has increased over time (S↑).

Supply Elasticity Determinant: Cost of Output

If the cost of producing additional units of output is low (readily accessible and cheap inputs), then supply is ELASTIC If the cost of producing additional units of output is high (difficult to access inputs that are expensive), then supply is INELASTIC Example: The inputs necessary to produce lemonade are relatively cheap and easily accessible (water, lemons, and sugar), so as price the price of lemonade increases, it is easy to scale up production (Qs), so supply is elastic.

Supply Elasticity Determinant: Method of Production

If the good is manufactured (i.e. machine made), then supply is ELASTIC If the good is handcrafted (a more labor intensive and time-consuming process), then supply is INELASTIC Example: Handcrafted candles take much longer to produce because they are more labor intensive than machine made candles, so it is more difficult to scale up production (Qs) when price increases, so supply is inelastic.

Demand Elasticity Determinant: Necessity to Buyer

If the good/service is considered a luxury (less necessary), then demand is ELASTIC If the good/service is considered a necessity (more necessary), then demand is INELASTIC Example: Since insulin is necessary for a Type 1 diabetic, their demand for insulin would not likely decrease (inelastic demand) even if the price were to increase.

Demand Elasticity Determinant: Narrowly vs. Broadly Defined

If the good/service is narrowly defined (e.g. North Face jacket), then demand is ELASTIC. If the good/service is broadly defined (e.g. 'clothing'), then demand is INELASTIC. *This determinant is closely tied to number of substitutes available. Typically, the more narrowly defined the good, the more substitutes available, and vice versa.

Demand Elasticity Determinant: Share of Income

If the good/service represents a large share of income/spending, then demand is ELASTIC. If the good/service represents a small share of income/spending, then demand is INELASTIC. Example: If the price of a pack of gum increases 20% from $0.50 to $0.60, the consumer might not even notice since it's such a small change (10 cents) relative to their total income/spending (inelastic demand). On the other hand, if a person's rent increases by 20% from $1,000/month to $1,200/month, they might be more inclined to find a new apartment because $200 makes up a much larger share of their total income/spending (elastic demand).

Demand Determinant: Population (Number of Buyers)

If the number of potential buyers/consumers increases (i.e. population increases), then the demand for goods/services also increases (D↑). If the number of potential buyers/consumers decreases, then the demand for goods/services also decreases (D↓). Example: Elderly people like to go to Florida for the cold winter months, so demand for condominiums/retirement homes increases (D↑) during the winter months and then decreases (D↓) during the summer.

Supply Determinant: Number of Sellers

If the number of sellers/producers of a good/service increases in the market, then the *supply of that good/service will increase (S↑) If there are fewer sellers/producers of a good/service in the market, then the *supply of that good/service will decrease (S↓) *Note: NOT referring to the market share of a single producer, but the overall production in a market by all sellers. Example: If a new pizza shop opens in Danville, then the supply of pizza in the Danville market will increase (OIP, Unida, Domino's, etc. supply will not increase).

Demand Determinant: Substitutes

If the price of a good increases the quantity demanded for that good will decrease (according to the Law of Demand), but consumers still want the satisfaction of that type of good, so the demand for a substitute good will increase (D↑) even if it's price remains the same. If the price of a good decreases, the demand for a substitute good will decrease (D↓). Example: If McDonald's increases it's prices, the quantity demanded of McDonald's food will decrease (move along the curve), but people will still want fast food so demand for Burger King (a substitute for McDonald's) will increase (shift right).

Demand Determinant: Complementary Goods

If the price of a good increases the quantity demanded for that good will decrease (according to the Law of Demand), so the demand for complementary goods will also decrease (D↓) even if it's price remains the same. If the price of a good decreases, the demand for complementary goods will increase (D↑). Example: If the price of peanut butter decreases (let's say there's a sale), then the quantity demanded of peanut butter should increase (Qd↑) but so too should the demand for jelly (D↑) since it complements peanut butter (i.e. they are used together).

Law of Demand: Income Effect

If the price of a good or service increases but income does not change, the purchasing power of the consumer's income is lower and they will be able to purchase fewer goods and services: P↑, Purchasing Power↓, Qd↓ Example: If you budget $100 for MP3 purchases through iTunes each year and the cost per song is $1.00, you can purchase 100 MP3 files. If the price (P) of songs is increased to $1.25 but your budget for music remains the same ($100), then your purchasing power is decreased and you will only be able to afford (Qd) 80 MP3s: P↑, Qd↓

Law of Demand: Substitution Effect

If the price of the of a good or service increases, so too does the opportunity cost of consuming that good or service, so consumers typically seek out a *substitute (alternative)* that has not experienced a price increase to maintain utility/satisfaction at a lower relative price/opportunity cost; so if P↑ (good/service), Qd↓ and relative P↓ (substitute), Qd↑ *Note: Even if the substitute/alternative has a higher price than the original good/service, when the price increases for the good/service, the opportunity cost of the substitute/alternative decreases, so some consumers will shift to substitute/alternative

Supply Elasticity Determinant: Level of Capacity

If the producer is not at full capacity (i.e. has the ability to produce more), then supply is ELASTIC If the producer is at full capacity (i.e. operating at maximum production levels), then supply is INELASTIC Example: If Hawkins Chevrolet is only using half of its lot space and is only open 6 hours per day, they are not at full capacity because they could increase their inventory and extend their hours of operation, so their supply is elastic.

Demand Elasticity Determinant: Availability of Substitutes

If there are many substitutes available, then demand is ELASTIC If there are few or no substitutes available, then demand is INELASTIC Example: Since there are many different brands of t-shirts, if Nike increases the price of their t-shirts, Qd can easily decrease (elastic demand) as consumers shift to a substitute such as Adidas, Under Armour, etc.

Demand Elasticity Determinant: Who Pays the Bill?

If you are responsible for paying the bill yourself, then you are more sensitive to a price change, so demand is ELASTIC. If somebody else is paying the cost of the good/service, then you are less concerned with a price change, so demand is INELASTIC. Example: If tuition is increased, a college student that is paying their own tuition is more likely to transfer to a cheaper college/university (elastic demand) than one whose parents pay the tuition (inelastic demand).

Demand Elasticity Determinant: Amount of Time to Adapt

In the long-run, consumers have more time to adapt to a change in price, therefore demand is ELASTIC In the short-run, consumers have less time to adapt to a change in price, therefore demand is INELASTIC Example: If the price of home heating oil increases in the middle of January, the quantity demanded will not decrease significantly for the remainder of the winter (inelastic demand) because the consumer doesn't have time to adapt (i.e. switch to a different heating system). If the price is still high by spring/summer, the consumer might get a natural gas or wood-burning stove since they have time to adapt, causing quantity demand for oil to decrease (elastic demand).

Supply Elasticity Determinant: Amount of Time to Adapt

In the long-run, producers have more time to adapt to a change in price, therefore supply is ELASTIC In the short-run, producers have less time to adapt to a change in price, therefore supply is INELASTIC Example: If corn prices increase in July, a farmer is unable to produce more corn for that growing season since they sowed (planted) their fields in the spring for the fall harvest, so supply is inelastic in the short-run. If corn prices are still higher the following April when they go to sow their fields, then they might plant more acres of corn to increase the quantity supplied, so in the long-run the supply is elastic.

Determinants of Demand

Non-price factors that determine the quantity demanded of a good or service, including: - Income - Popularity ("Tastes") - Expectation of Future Price - Substitutes - Complements - Population (Number of Buyers) *cause of shift of the demand curve left (D↓) or right (D↑)

Determinants of Supply

Non-price factors that determine the quantity supplied of a good or service, including: - Cost of Inputs - Technology/Productivity - Subsidy - Excise Tax - Regulation - Expectation of Future Price - Number of Sellers/Producers *cause of shift of the supply curve left (S↓) or right (S↑)

supply curve

a graph of the direct relationship (positive correlation) between the price of a good/service and the quantity supplied: P↑, Qs↑ and P↓, Qs↓

demand curve

a graph of the inverse relationship (negative correlation) between the price of a good/service and the quantity demanded: P↓, Qd↑ and P↑, Qd↓

Price Ceiling

a legal maximum on the price at which a good/service can be sold; keeps prices below the market equilibrium price, which is considered to be "too high," but results in a shortage (excess demand) Examples: rent control, anti-price gouging during disasters, price controls to combat inflation

Price Floor

a legal minimum on the price at which a good/service can be sold; keeps prices above the market equilibrium price, which is considered to be "too low," but results in a surplus (excess supply) Examples: minimum wage, price supports for agricultural products, cigarettes (as a way to reduce Qd)

Law of Demand

as the price of a good or service decreases, the quantity demanded increases (ceteris paribus): P↓, Qd↑ (causes movement along the demand curve) or... as the price of a good or service increases, the quantity demanded decreases (ceteris paribus): P↑, Qd↓ (causes movement along the demand curve) There is an inverse/negative correlation between price and quantity demanded!

Law of Supply

as the price of a good or service decreases, the quantity supplied decreases (ceteris paribus): P↓, Qs↓ (causes movement along the supply curve) or... as the price of a good or service increases, the quantity supplied increases (ceteris paribus): P↑, Qs↑ (causes movement along the supply curve) There is a positive correlation between price and quantity supplied!

Demand Decreases (D↓)

demand curve shifts left

Demand Increases (D↑)

demand curve shifts right

Shortage

excess demand - occurs when the price is below market equilibrium (Qs < Qd)

Surplus

excess supply - occurs when the price is above market equilibrium (Qs > Qd)

Supply Determinant: Excise Tax

excise tax - n. a tax levied on the production of a good (typically on a per item basis); used to discourage the production of goods/services that are legal, but have negative externalities (i.e. societal costs) such as cigarettes, alcohol, fuel, etc. If the government enacts an excise tax to increase the cost of production, then it decreases profitability and supply decreases (S↓) If the government removes an excise tax, then producing the good/service becomes more profitable and supply increases (S↑) Example: Pennsylvania enacts a $7.24/gallon excise tax on the production of liquor. If PA were to lower that tax, then the supply of liquor in the state would increase (S↑).

profit

profit = total revenue - total cost *maximizing profit is the main goal of a producer

Supply Determinant: Regulation

regulation - n. a rule or directive made and maintained by an authority (typically the government); typically used to guarantee safety standards for employees, prevent pollution, etc. If the government implements a regulation that increases the cost of production, then profit potential decreases and supply decreases (S↓) If the government eliminates costly regulations, then profitability improves and supply increases (S↑) Example: The Clean Water Act in 1972 created new rules regarding water pollution that forced producers to improve water purification systems, which lowered profits and decreased supply (S↓).

revenue

revenue = price x quantity *money earned by selling goods and services; increasing revenue can increase profit

Supply Determinant: Subsidy

subsidy - n. a sum of money granted by the government or a public body to assist an industry or business; typically provided for goods/services that aren't profitable but are necessary/beneficial for society (e.g. subsidies to pharmaceutical companies to research new drugs to treat diseases) If the government provides a payment for each unit of a good produced, then it increases revenue/decreases costs and acts as an incentive to increase supply (S↑) If the government ends a subsidy, then it decreases the profit potential, so the incentive to produce is reduced and supply decreases (S↓) Example: The U.S. government pays approximately $20 billion in farm subsidies to increase supply of agricultural products (S↑).

Supply Decreases (S↓)

supply curve shifts left

Supply Increase (S↑)

supply curve shifts right

elasticity of demand

the ability of a consumer to respond to a change in price; "If price increases, how much can consumers decrease their quantity demanded of a good (and vice versa)?" If the consumer can respond easily, demand is said to be ELASTIC (a small change in price results in a large change in Qd) If the consumer cannot respond easily, demand is said to be INELASTIC (a large change in price results in a small change in Qd)

elasticity of supply

the ability of a producer/seller to respond to a change in price; "If price increases, how much can producers increase their quantity supplied of a good (and vice versa)?" If the sellers can respond easily, supply is said to be ELASTIC (a small change in price results in a large change in Qs) If the seller cannot respond easily, supply is said to be INELASTIC (a large change in price results in a small change in Qs)

equilibrium price and quantity

the price and quantity at the intersection of the supply and demand curves for a good/service *the equilibrium price is the only price where the desires of consumers (Qd) and the desires of producers (Qs) agree; when the market is out of equilibrium (price is too high or low), there will be a surplus or shortage, respectively, and market forces (i.e. the invisible hand) will push the price toward equilibrium **changes (shifts) to supply and demand will change the equilibrium price and quantity

demand

the willingness and ability to consume a good or service at various prices

supply

the willingness and ability to produce a good or service at various prices In order to be willing and able, must have access to . . . - required resources - skill to produce - opportunity to profit