Principles of Microeconomics Problem Set

Supply & Demand Equilibrium

Changes in Equilibrium

ECO 105: Principles of Microeconomics Topic 2: Equilibrium and Interactions Across Markets

Brian Phelan DePaul University

September 11, 2017

Brian Phelan DePaul University ECO 105: Principles of Microeconomics

Supply & Demand Equilibrium

Changes in Equilibrium

Outline

Equilibrium is the outcome (price and quantity) that emerges when buyers and sellers get together.

Before discussing equilibrium, we will briefly introduce:

Markets Demand Supply

Brian Phelan DePaul University ECO 105: Principles of Microeconomics

Supply & Demand Equilibrium

Changes in Equilibrium

Where does economic activity take place?

Markets!

What is a market?

A market is a place (not necessarily a physical location - e.g. the Internet) where buyers and sellers get together to trade. A market is defined both by a product and (potentially) a geographic area.

The market for crude oil is a single global market with a common price. The market for haircuts is both characterized by a variation in services and a geographic region.

There are two broad types of markets: markets for goods/services and factor markets.

We focus almost exclusively on goods/services markets in this class.

Brian Phelan DePaul University ECO 105: Principles of Microeconomics

Supply & Demand Equilibrium

Changes in Equilibrium

Common Assumption on Markets

It is common to assume that markets are perfectly competitive.

This means that there are:

many buyers and sellers homogeneous product perfect information no entry/exit costs.

This is somewhat of a restrictive assumption (though common), but gives us cool properties.

Implies that neither firms nor consumers can influence prices

We’ll assume it for the first half of course

Brian Phelan DePaul University ECO 105: Principles of Microeconomics

Supply & Demand Equilibrium

Changes in Equilibrium

Demand

Individual decisions on what to decide characterized by their demand function.

Demand for a particular good (e.g. Cubs Tickets) is a function of the following characteristics:

Preferences (or tastes) Price of the good Income Prices of Related Goods

substitutes complements

Expectations about preferences, prices, or income

Previously described individual decisions by comparing marginal benefits with marginal costs. How do each of the above map into costs or benefits?

Brian Phelan DePaul University ECO 105: Principles of Microeconomics

Supply & Demand Equilibrium

Changes in Equilibrium

Demand Function and Demand Curve

Demand Function:

Quantity Demand=f(Price of good, Preferences, Income, Price of Related Goods, Expectations)

Demand Curve:

Quantity Demand=f(Price of good, Preferences, Income, PriceofRelatedGoods, Expectations)

Demand curve holds everything fixed except price of good. Describes relationship between prices and quantity demanded

Common to assume that demand increases when prices fall and vice versa

Referred to as Law of Demand

From Individual demand curves to market demand curves Demand curves are individual in nature. Why? Number of customers now matters

Brian Phelan DePaul University ECO 105: Principles of Microeconomics

Supply & Demand Equilibrium

Changes in Equilibrium

Supply

Firm-level decisions on what to produced characterized by their supply function.

Supply of a particular good (e.g. corn or wheat) is a function of the following characteristics:

Production Technology Input Prices Price of the Good Prices of Related Goods

Can the firm realistically switch production?

Expectations about technology and prices

Before we said, production decision based upon comparison of marginal benefits and costs. How do each of the above map into costs or benefits?

Brian Phelan DePaul University ECO 105: Principles of Microeconomics

Supply & Demand Equilibrium

Changes in Equilibrium

Supply Function and Supply Curve

Supply Function:

Quantity Supplied=f(Price of good, Production Technology, Input Prices, Price of Related Goods, Expectations)

Supply Curve:

Quantity Supplied=f(Price of good, ProductionTechnology, InputPrices, PriceofRelatedGoods, Expectations)

Supply Curve holds everything else fixed and describes relationship between quantity supplied and price

Common to assume that supply increases when prices increase and vice versa

Referred to as Law of Supply

Examples of different firm-level supply curves

Going from firm-level supply curves to market supply curves Number of firms now matters

Brian Phelan DePaul University ECO 105: Principles of Microeconomics

Supply & Demand Equilibrium

Changes in Equilibrium

Bringing Demand and Supply Together

Demand curve describes ... the total quantity (of a good) demanded by consumers at every price

Supply curve describes ... the total quantity (of a good) supplied by firms at every price Outcome in market (prices and quantities bought/sold) characterized by intersection of the supply and demand curve.

Supply and Demand Together

P Equilibrium:Equilibrium:

$5.00

$6.00 P

D S Equilibrium: P has reached the level where

Equilibrium: P has reached the level where

$3 00

$4.00 the level where quantity supplied equals

the level where quantity supplied equals

$2.00

$3.00 q quantity demanded q

quantity demanded

$0.00

$1.00

Q

© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

3737

0 5 10 15 20 25 30 35

Brian Phelan DePaul University ECO 105: Principles of Microeconomics

Supply & Demand Equilibrium

Changes in Equilibrium

Why is it an Equilibrium?

How do we know that the intersection and supply and demand is the outcome that will result?

Suppose firms charge too high of a price... Surplus (a.k.a. excess supply):

when quantity supplied is greater than

P

when quantity supplied is greater than quantity demanded

Example:

$5.00

$6.00 P

D SSurplus Example: If P = $5, then

$3 00

$4.00 then

QD = 9 lattes and

$2.00

$3.00 and QS = 25 lattes

resulting in a

$0.00

$1.00

Q

g surplus of 16 lattes

© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

4040

0 5 10 15 20 25 30 35

Brian Phelan DePaul University ECO 105: Principles of Microeconomics

Supply & Demand Equilibrium

Changes in Equilibrium

Moving to Equilibrium from Excess Supply

If firms charge too high of a price, they will not be able to sell all of the goods they produce.

Rather than collect $0 on the excess supply, they lower prices to try to sell them.

This pushes prices down toward the equilibrium price.

As prices fall, quantity supplied will also decline as it is no longer profitable for some firms to produce the good in the marketplace.

Brian Phelan DePaul University ECO 105: Principles of Microeconomics

Supply & Demand Equilibrium

Changes in Equilibrium

Why is Equilibrium the Intersection?

Suppose firms charge too low of a price...

Shortage (a.k.a. excess demand): when quantity demanded is greater than

P

when quantity demanded is greater than quantity supplied

E l

$5.00

$6.00 P

D S Example: If P = $1,

then

$3 00

$4.00 then

QD = 21 lattes and

$2.00

$3.00 and QS = 5 lattes

resulting in a

$0.00

$1.00

Q

shortage of 16 lattes Shortage

© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

4343

0 5 10 15 20 25 30 35

Brian Phelan DePaul University ECO 105: Principles of Microeconomics

Supply & Demand Equilibrium

Changes in Equilibrium

Moving to Equilibrium from Excess Demand

If firms charge too low of a price, they will not be able to meet all of the demand that exists.

Consumers will line up to buy the good and firms will start raising prices because they’ll see that they are going to sell out.

This pushes prices up toward the equilibrium price.

As prices rise, quantity supplied will increase as it becomes profitable for more firms to enter.

Brian Phelan DePaul University ECO 105: Principles of Microeconomics

Supply & Demand Equilibrium

Changes in Equilibrium

Stability of Equilibrium

Equilibrium is stable because the equilibrium price ensures that QD = QS .

This implies that no firm would have any incentive to change its production or prices; and there would be no shortage of goods.

Our logic about stability related to the market misinterpreting demand, but could firms manipulate demand?

i.e. What happens if a single firm firms changes its prices? However, recall that this is a perfectly competitive market:

many buyers and sellers homogeneous product perfect information no entry/exit costs.

Brian Phelan DePaul University ECO 105: Principles of Microeconomics

Supply & Demand Equilibrium

Changes in Equilibrium

Showing Equilibrium

We can show equilibrium using a graph with supply and demand curves.

Review Question: What goes on x-axis? What on y-axis?

However, but we can also show it using equations.

QS = 3P − 18 QD = 62 − 2P

What is the equilibrium implied by these equations?

Solution: Set QD = QS and solve for P. Once you have P, plug it back into either equation and you should get the same equilibrium quantity.

Brian Phelan DePaul University ECO 105: Principles of Microeconomics

Supply & Demand Equilibrium

Changes in Equilibrium

Change in Equilibrium

Equilibrium is stable so long as everything held fixed to derive the supply and demand curve does not change.

However, these things will change over time. Supply Curve assumes:(1) Technology fixed, (2) Costs fixed, and (3) Prices of other goods fixed.

If any of these changes, the supply curve will shift

Demand Curve assumes:(1) Preferences fixed, (2) Incomes fixed, and (3) Prices of other goods fixed.

If any of these changes, the demand curve will shift

Brian Phelan DePaul University ECO 105: Principles of Microeconomics

Supply & Demand Equilibrium

Changes in Equilibrium

Thinking about Changes in Equilibrium

Step 1: Has something that was previously held fixed changed?

Step 2: If yes, what changed?

Step 3: Does this change affect supply or demand?

Step 4: Which way will the curve shift?

Step 5: What happens to optimal P and Q?

Brian Phelan DePaul University ECO 105: Principles of Microeconomics

Supply & Demand Equilibrium

Changes in Equilibrium

Examples of Changes in Equilibrium

Suppose the American Medical Association discovers that people who eat ice cream live longer. What will (likely) happen in the market for ice cream?

Discuss the difference between shift in curve or movement along curve (change in quantity demanded/supplied).

Suppose a new fertilizer is developed that increases soybean yields. What happens to market for soybeans? Tofu?

Why do hotel prices in the Caribbean increase in the winter and fall in the summer?

How is the market for smart phones affected if:

Samsung is pushed out of the market due to patent issues The price of wireless data falls

Brian Phelan DePaul University ECO 105: Principles of Microeconomics

Supply & Demand Equilibrium

Changes in Equilibrium

Examples of Changes in Equilibrium II

Suppose technological change has made it such that we can turn corn into fuel for our car. What happens in the market for corn?

This is a preference shock for corn that increases demand - P and Q both increase.

What happens in the market for wheat? Is supply affected?

How is supply affected?

Is demand affected?

How is demand affected?

What is the net effect on P and Q?

Suppose President Obama increases ethanol requirements in gasoline. Why might the poor really not like this policy?

Brian Phelan DePaul University ECO 105: Principles of Microeconomics

Supply & Demand Equilibrium

Changes in Equilibrium

Policy Changes towards Ethanol

Energy Independence and Security Act of 2007 Stated purpose – To move the U.S. towards

greater energy independence and security increase production of clean renewable fuels improve energy efficiency generally and in the federal government

Specific actions associated with it

increase mandated fuel economy in cars subsidize hybrid cars test renewable fuels in federal fleet of cars.

Open Fuel Standard Act of 2011

Would mandate that a certain share of cars be “alternative fuel capable.” Never passed, but most cars are capable of burning gasoline that is 10% ethanol.

Brian Phelan DePaul University ECO 105: Principles of Microeconomics

Supply & Demand Equilibrium

Changes in Equilibrium

Corn and Wheat Prices

200

300

400

500

600

Energy Security and  Independence Act  2007

Open Fuel  Standards Act  of 2010

0

100

M ar ‐0 3

A ug

‐0 3

Ja n‐ 04

Ju n‐ 04

N ov ‐0 4

A pr ‐0 5

Se p‐ 05

Fe b‐ 06

Ju l‐0

6

D ec ‐0 6

M ay ‐0 7

O ct ‐0 7

M ar ‐0 8

A ug

‐0 8

Ja n‐ 09

Ju n‐ 09

N ov ‐0 9

A pr ‐1 0

Se p‐ 10

Fe b‐ 11

Ju l‐1

1

D ec ‐1 1

M ay ‐1 2

O ct ‐1 2

Corn Wheat

Brian Phelan DePaul University ECO 105: Principles of Microeconomics

Supply & Demand Equilibrium

Changes in Equilibrium

Examples of Changes in Equilibrium III

Government engages in an advertising campaign to limit dairy fat in milk trying to change preferences.

It works in one sense – that people start drinking more low-fat milk – but not in the way you want it to, total dairy fat consumption does not decline. Why?

Farmers don’t throw out the dairy fat, they simply use it to make more cheese and ice cream.

Shift out in supply curve for cheese and ice cream leads to lower prices and greater consumption.

There is no effect of the government policy on consumption – and lost money on ad campaign.

Brian Phelan DePaul University ECO 105: Principles of Microeconomics

Supply & Demand Equilibrium

Changes in Equilibrium

Examples of Changes in Equilibrium IV

The price of a gallon of gas adjusts frequently and seasonally, but the overall trend over the past 10 years is a steady increase - doubling in that time. Why?

What events have affected the supply and demand for gasoline? How would these shift supply or demand?

Seasonally?

Temporarily?

What long term trends are in play?

Recent Events?

Brian Phelan DePaul University ECO 105: Principles of Microeconomics

Supply & Demand Equilibrium

Changes in Equilibrium

Historical Gas Prices I

2.5

3

3.5

4

4.5

1

1.5

2

Brian Phelan DePaul University ECO 105: Principles of Microeconomics

Supply & Demand Equilibrium

Changes in Equilibrium

Historical Gas Prices II

2.5

3

3.5

4

4.5

Asian Currency 

Persian Gulf War

Hurricane Katrina

Pipeline Attacks in  Nigeria Arab 

Spring

1

1.5

2

y Crisis

9/11 & Tech Bubble Burst

Great Recession

Brian Phelan DePaul University ECO 105: Principles of Microeconomics

Supply & Demand Equilibrium

Changes in Equilibrium

What Drives Long-Term Trends?

Is it supply or demand? Daily World Consumption of Crude Oil 

(1000's of Barrels) Source: Statistical Review of World Energy 2010

85000

90000

80000

70000

75000

65000

55000

60000

50000 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009

Quantity demanded is growing, but so are prices. Thus...?

Brian Phelan DePaul University ECO 105: Principles of Microeconomics

Supply & Demand Equilibrium

Changes in Equilibrium

What Drives Long-Term Trends II

Crude Oil  Ratio of Production‐to‐Consumption

Source: Statistical Review of World Energy 2010 1

0 98

0.99

0.97

0.98

0.96

0.95

0.94 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009

Supply cannot keep up with growing demand! Demand driving higher prices

Brian Phelan DePaul University ECO 105: Principles of Microeconomics

Supply & Demand Equilibrium

Changes in Equilibrium

Interactions across Markets

How are higher prices for gas likely to affect equilibrium in the market for SUVs and trucks?

Relationship between Gas Prices & SUV Sales Comparing %Δ in Gas Prices (x‐axis) and %Δ in Share of Trucks Sold (y‐axis)

1986‐2010

0.1

0.12

Car and Truck Sales Data from WardsAuto.com

0.06

0.08

0.02

0.04

‐0.02

0 ‐0.3 ‐0.2 ‐0.1 0 0.1 0.2 0.3

‐0.06

‐0.04

‐0.1

‐0.08

Brian Phelan DePaul University ECO 105: Principles of Microeconomics