ECON 200 chapter 3: Where Prices Come From: The Interaction of Demand and Supply
What Determines the Price of Premium Bottled Water?
-Demand for premium water -How many bottles do consumers want to buy? -Affected by price of the premium bottled water Affected by other factors, including prices of other goods (why because rationality and respond to incentives) -Supply of premium bottled water -How many bottles are producers willing to sell? -Affected by price of the premium bottled water -Affected by other factors, including prices of other goods
What Explains the Law of Demand? When the price of a good falls, two effects take place (Substitution and income):
1. Consumers substitute toward the good whose price has fallen. 2. Consumers have more purchasing power, which is like an increase in income. Substitution effect: The change in the quantity demanded of a good that results from a change in price, making the good more or less expensive relative to other goods that are substitutes. Income effect: The change in the quantity demanded of a good that results from the effect of a change in the good's price on a consumers' purchasing power.
demand curve
A curve that shows the relationship between the price of a product and the quantity of the product demanded.
technological change
A firm may experience a positive or negative change(shifting supply curve) in its ability to produce a given level of output with a given quantity of inputs. Examples: — A new, more productive variety of wheat would increase the supply of wheat. — Governmental restrictions on land use for agriculture might decrease the supply of wheat.
Law of demand
A rule that states that, holding everything else constant, when the price of a product falls, the quantity demanded of the product will increase, and when the price of a product rises, the quantity demanded of the product will decrease.
Figure 3.2 Shifting the Demand curve A change in something other than price that affects demand causes the entire demand curve to shift.
A shift to the right (D1 to D2) is an increase in demand. A shift to the left (D1 to D3) is a decrease in demand. As the demand curve shifts, the quantity demanded will change, even if the price doesn't change. The quantity demanded changes at every possible price.
Shortage
A situation in which quantity demanded is greater than quantity supplied
Surplus
A situation in which quantity supplied is greater than quantity demanded
demand schedule
A table that shows the relationship between the price of a product and the quantity of the product demanded.
The Effect of an Increase in Demand on Equilibrium Suppose incomes increase. What happens to the equilibrium in the premium bottled water market?
Bottled water is a normal good, so as income rises, demand shifts to the right (D1 to D2). Equilibrium price rises (P1 to P2). Equilibrium quantity rises (Q1 to Q2).
(Changes in prices) Expectations about Future Prices
Consumers decide which products to buy and when to buy them. Future products are substitutes for current products. — An expected increase in the price tomorrow increases demand today. — An expected decrease in the price tomorrow decreases demand today. Example: If you found out the price of gasoline would go up tomorrow, you would increase your demand today.
Complements
Goods and services that are used together. Examples: Big Mac and McDonald's fries, Hot dogs and hot dog buns. However the same increase in the price of a Big Mac would decrease the demand for McDonald's fries (shifts demand curve to the left). A decrease in the price of a Big Mac would increase the demand for McDonald's's fries (shifts demand curve) to the right)
Substitutes
Goods and services that can be used for the same purpose. Examples: Big Mac and Whopper, Ford F-150 and Dodge Ram, Jeans and Khakis. Effects of Changes in the Price of Related Goods Substitutes: An increase in the price of a Big Mac would increase the demand for Whoppers (shifts demand curve to the right) A decrease in the price of Big Mac would decrease the demand for Whoppers (shifts demand curve to the left).
(Changes in prices) Tastes
If consumer's tastes change, they may buy more or less of the product. Example: If consumers become more concerned about eating healthily, they might decrease their demand for fast food.
(Changes in prices) income
Increase in income increases demand if product is normal, decreases demand if product is inferior. Effects of Changes in Income An increase in income would increase the demand for new clothes, ceteris paribus. However, the same increase in income would likely decrease the demand for second-hand clothes (inferior goods).
(Changes in prices) Prices of related goods
Increase in price of related good increases demand if products are substitutes, decreases demand if products are complements.
Prices of Related Goods in Production (substitutes)
Many firms can produce and sell alternative products. Substitute in production: An increase in the price of one substitute good causes a decrease in the supply of the other. A decrease in the price of one substitute good causes an increase in the supply of the other. Example: An Illinois farmer can plant corn or soybeans. If the price of soybeans rises, he will plant (supply) less corn. Sometimes, two products are necessarily produced together. Complement in production Example: Cattle provide both beef and leather. An increase in the price of beef encourages more cattle farming, and hence increase the supply of leather.
Number of Firms and Expected Future Prices
More firms in the market will result in more product available at a given price (greater supply). Fewer firms → supply decreases. If a firm anticipates that the price of its product will be higher in the future, it might decrease its supply today in order to increase it in the future. If a firm anticipates that the price of its product will be lower in future, it may increase supply to decrease supply in the future.
Normal goods vs inferior goods
Normal goods: Goods for which the demand increases as income rises and decreases as income falls. -Examples:New clothes, Restaurant meals, and Vacations Inferior goods: Goods for which the demand increases as income falls and decreases as income rises. -Examples: Thrift store and Ramen noodles
Shifts in Demand and Supply over Time (1 of 3)
Over time, it is likely that both demand and supply will change. For example, as new firms enter the market for premium bottled water and incomes increase, we expect: The supply curve will shift to the right, and The demand curve will shift to the right. What does our model predict? S↑ → (P↓ and Q↑) D↑ → (P↑ and Q↑) So we can be sure equilibrium quantity will rise, but the effect on equilibrium price is not clear. This panel shows demand shifting more than supply: equilibrium price and quantity both rise. This panel shows supply shifting more than demand: quantity rises, but equilibrium price falls. Without knowing the relative size of the changes, the effect on equilibrium price is ambiguous. It is possible, but unlikely, that the equilibrium price will remain unchanged.
Demand and Supply Both Count
Price is determined by the interaction of buyers and sellers. Neither group can dictate price in a competitive market (i.e. one with many buyers and sellers). However changes in supply and/or demand will affect the price and quantity traded.
What Factors Influence Market Supply?
Prices of inputs, Technological change, Prices of substitutes and complements in production, Number of firms in the market, Expected future prices.
A Change in Supply versus a Change in Quantity Supplied
Quantity Supplied: A change in the price of the product causes a movement along the supply curve. Change in supply: Any other change affecting supply causes the entire supply curve to shift.
supply schedule and curve
Supply schedule: A table that shows the relationship between the price of a product and the quantity of the product supplied. Supply curve: A curve that shows the relationship between the price of a product and the quantity of the product supplied.
Shifts of a Curve vs. Movements along a Curve
Suppose an increase in supply occurs. We now know: Equilibrium quantity will increase, and Equilibrium price will decrease. It is tempting to believe the decrease in price will cause an increase in demand. But this is incorrect. The decrease in price will cause a movement along the demand curve but not an increase in demand. Why? The demand curve already describes how much of the good consumers want to buy, at any given price. When the price change occurs, we just look at the demand curve to see what happens to how much consumers want to buy.
Quantity Demanded (Qd)
The amount of a good or service that a consumer is willing and able to purchase at a given price.
Quantity supplied
The amount of a good or service that a firm is willing and able to supply at a given price.
Demographics
The characteristics of a population with respect to age, race, and gender. Increases in the number of people buying something will increase the amount demanded. Example: An increase in the elderly population increases the demand for medical care.
Ceteris paribus ("all else equal") condition
The requirement that when analyzing the relationship between two variables—such as price and quantity demanded—other variables must be held constant. -When drawing the demand curve, we assume ceteris paribus
Law of supply
The rule that, holding everything else constant, increases in price cause increases in the quantity supplied, and decreases in price cause decreases in the quantity supplied. A shift to the right (S1 to S3) is an increase in supply. A shift to the left (S1 to S2) is a decrease in supply As the supply curve shifts, the quantity supplied will change, even if the price doesn't change. The quantity supplied changes at every possible price. Law of supply implies a upward sloping supply curve which means that the slope of the price-quantity curve is positive, meaning that the parameter β is positive. In other words since price and quantity have positive relation, β is positive.
The Effect of Surpluses and Shortages on the Market Price
To find surplus subtract quantity supplied minus quantity demanded What if the price were $2.00 instead? At a price of $2.00, consumers want to buy 4 million bottles, while producers want to sell 6 million. This gives a surplus: of 2 million bottles; a situation in which quantity supplied is greater than quantity demanded. Prediction: sellers will compete among themselves, driving the price down. Now what if the price were $0.50? At a price of $0.50, consumers want to buy 7 million bottles, while producers want to sell 3 million. To find shortage subtract quantity demanded minus quantity supplied This gives a shortage of 4 million bottles; a situation in which quantity demanded is greater than quantity supplied. Prediction: sellers will realize they can increase the price and still sell as many bottles of water, so the price will rise.
The Effect of an Increase in Supply on Equilibrium. The graph shows the market for premium bottled water before PepsiCo enters the market.
When PepsiCo enters, more bottles are supplied at any given price—an increase in supply from S1 to S2. Equilibrium price falls from P1 to P2. Equilibrium quantity rises from Q1 to Q2. By how much will price fall? By how much will quantity rise? We cannot say, without knowing more information. For now, we can only predict that price will fall and quantity traded will rise.
What is upward sloping demand curve?
a DEMAND CURVE that shows a direct rather than an inverse relationship between the price of a product and quantity demanded per period of time, over part or all of its length.
Substitute in production
a good that can be produced in place of another good. an increase in the price of a substitute in production, decreases supply curve to the left.
perfectly competitive market
a market with (1) many buyers and sellers, (2) all firms selling identical products, and (3) no barriers to new firms entering the market. -To analyze the market for premium bottled water, we need a model of how buyers and sellers behave. -While these assumptions are quite restrictive, the model is still useful for analyzing many markets.
Change in demand
any other change affecting demand causes the entire demand curve to shift
(Change in price) Inputs
are things used in the production of a good or service. For a smartwatch, inputs include the computer processor, plastic, and labor. An increase in the price of an input decreases the profitability of selling the good, causing a decrease in supply. A decrease in the price of an input increases the profitability of selling the good, causing an increase in supply.
What are the demand curve shifters
income, prices of related goods, tastes, population and demographic, expected future prices
Market equilibrium
is a situation in which quantity demanded equals quantity supplied. At a price of $1.50, consumers want to buy 5 bottles per day, and producers want to sell 5 million bottles per day. We say the equilibrium price in this market is $1.50, and the equilibrium quantity is 5 million bottles per day. Since buyers and sellers want to trade the same quantity at the price of $1.50, we do not expect the price to change. <10 firms not competitive market (not enough firms) Also called Optimal price and optimal quantity P star and q star
Prices of complements in production
pairs of goods that must be produced together. The supply of a good increases if the price of one of its complements in production rises. The supply a good decreases if the price of one of its complements in production falls
market supply
the decisions of (generally) firms about how much of a product to provide at various prices.
Market Demand
the demand by all the consumers of a given good or service. -We begin our analysis of where prices come from by investigating how buyers behave. 13) On midterm study guide. The market demand curve (a) is found by adding vertically the individual demand curves. (b) slopes upward. (c) represents the sum of the prices that all the buyers are willing to pay for a given quantity of the good. (d) represents the sum of the quantities demanded by all the buyers at each price of the good.
