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Microeconomics

Second Edition

Chapter 4

Demand, Supply, and Equilibrium

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Learning Objective

4.1 Markets

4.2 How Do Buyers Behave?

4.3 How Do Sellers Behave? 4.4 Supply and Demand in Equilibrium 4.5 What Would Happen if the Government Tried to

Dictate the Price of Gasoline?

Key Ideas (1 of 3)

In a perfectly competitive market, (1) sellers all sell an identical good or service, and (2) any individual buyer or any individual seller isn’t powerful enough on his or her own to affect the market price of that good or service.

The demand curve plots the relationship between the market price and the quantity of a good demanded by buyers.

Key Ideas (2 of 3)

The supply curve plots the relationship between the market price and the quantity of a good supplied by sellers.

The competitive equilibrium price equates the quantity demanded and the quantity supplied.

Key Ideas (3 of 3)

When prices are not free to fluctuate, markets fail to equate quantity demanded and quantity supplied.

Markets (1 of 4)

Why do brown eggs cost more than white eggs?

Before jumping into demand and supply, position the material as having the ability to answer a lot of questions that we see in the real world. For example, why do brown eggs cost more than white eggs? Give students an opportunity to suggest answers. A popular answer is that they are healthier or organic. Pursue that—why would that make them cost more? Invite other answers. Some students may say that consumers want them more. Again, pursue that—ask why? Don’t respond as to whether the answers are correct or incorrect; just make note of what their answers are so you can refer to them later. In the meantime, you can smile knowingly, and tell them the answer will be revealed by the end of the chapter.

Markets (2 of 4)

The market price is the price at which buyers and sellers conduct transactions.

Set up the idea of a market by inviting students to think about how they would buy a used car from a private individual. They would answer an ad, and go take the car for a test drive. If they decide they want the car, it’s now time to sit down with the seller and talk about the price over the kitchen table. The seller presents a price, the buyer counteroffers, etc. until a price is reached. The point to be made here is that this is a market that has two sides (demand and supply) and that reaches an agreement on price. The further point is that all markets work the same way. The communication between the two sides of the market gets more complicated as the number of participants increases, but the communication (“that price is too low”; “that price is too high”) is the same; the mechanism for communicating these wishes is just not the same as the “kitchen table” method.

Markets (3 of 4)

In a perfectly competitive market every buyer pays and every seller charges the same market price, no buyer or seller is big enough to influence that market price, and all sellers sell an identical good or service.

It is also helpful at this point to talk about what a market does not do. It does not allocate goods and services to those who deserve them (what if you need the car to keep your job—does that influence the seller?) or any other measure of fairness. The market allocates to those who can afford to pay, not those who need, deserve, or want it but who cannot pay for it.

How Do Buyers Behave? (1 of 25)

Quantity Demanded

The amount of a good that buyers are willing to purchase at a given price.

Demand Schedule

A table that reports the quantity demanded at different prices, holding all else equal.

Demand Curve

Plots the quantity demanded at different prices.

Relate these definitions back to the exercise of selling off an A. As you call off various price points, draw the demand schedule and enter the quantities at each price.

How Do Buyers Behave? (2 of 25)

How much are you willing to pay for a Snickers Bar?

Demand Schedule

Price	Quantity Demanded
$0.25	20
$0.50	15
$0.75	10
$1.00	5
$1.25	3
$1.50	1

Point out that the demand curve slopes down, illustrating that different students have different levels of willingness to pay.

This table of data is embedded and by double clicking the graph, the instructor can edit and update the data taken from class on the spot to illustrate the demand curve. Or use the created data here to explore the downward slope of the demand curve.

Demand Curve for Snickers Bars

Price 20.0 15.0 10.0 5.0 3.0 1.0 0.25 0.5 0.75 1.0 1.25 1.5

Quantity

Price

How Do Buyers Behave? (3 of 25)

Why are some students willing to pay more for an Snickers bar than others? That is, why isn’t the price the same for everyone?

Answers may include because some students are not hungry at the moment; because some students don’t like Snickers bars; become some students simply don’t have the cash to pay for the candy bar. Direct students to recognizing that the answers indicate that the benefits of an Snickers bar are different for different students, and that the demand curve reflects the benefit of the good. Also, point out that some maybe don’t have cash on them and use this to illustrate the importance of income and the budget constraint. It’s not simply a matter of what consumers want, it’s also about the amount of benefit we get per dollar we spend. Can we afford the satisfaction we derive from the Snickers bar?

How Do Buyers Behave? (4 of 25)

Market Demand Curve

The sum of the individual demand curves of all the potential buyers. The market demand curve plots the relationship between the total quantity demanded and the market price, holding all else equal.

Ask your students, if I currently teach 3 sections of this course, how can I develop a relationship among all my students that illustrates the relationship between market price and quantity demanded? Demonstrate the horizontal addition with two additional graphs.

Exhibit 4.2 Aggregation of Demand Schedules and Demand Curves

How Do Buyers Behave? (7 of 25)

Shifts of the Demand Curve occur when one of the following changes:

1. tastes and preferences

2. income and wealth

3. availability and prices of related goods

4. number and scale of buyers

5. buyers’ expectations about the future

How Do Buyers Behave? (6 of 25)

Remember your willingness to pay for an Snickers?

What if there was a vending machine right outside our classroom offering a variety of candy bars all for $0.25?

Ask the students if this change in the number of choices available in the market and the price of substitutes changed their willingness to pay for a Snickers bar.

How Do Buyers Behave? (8 of 25)

Demand Schedule

Price	Quantity Demanded
$0.25	20
$0.50	15
$0.75	10
$1.00	5
$1.25	3
$1.50	1

Demand Schedule

Price	Quantity Demanded
$0.25	8
$0.50	6
$0.75	4
$1.00	2
$1.25	1
$1.50	0

With access to a variety of cheap substitutes, students would pay less for an Snickers than before. The effect would be a shift in demand.

Demand Curve for Snickers Bars

Price 20.0 15.0 10.0 5.0 3.0 1.0 0.25 0.5 0.75 1.0 1.25 1.5

Quantity

Price

Demand Curve for Snickers Bars

Price 20.0 15.0 10.0 5.0 3.0 1.0 0.25 0.5 0.75 1.0 1.25 1.5 8.0 6.0 4.0 2.0 1.0 0.0 0.25 0.5 0.75 1.0 1.25 1.5

Quantity

Price

How Do Buyers Behave? (9 of 25)

What if I told you that we will be meeting today for 5 hours and you won’t be allowed to leave the room for the entire time!

Would that change your willingness to pay for the Snickers?

Ask the students if this change in the number of choices available in the market and the price of substitutes changed their willingness to pay for a Snickers bar.

How Do Buyers Behave? (10 of 25)

Showing the shift of the demand curve in the opposite direction. You would be willing to pay more because you would be hungry at some point and the Snickers would be your only option for food.

Demand Curve for Snickers Bars

Price 20.0 15.0 10.0 5.0 3.0 1.0 0.25 0.5 0.75 1.0 1.25 1.5 30.0 25.0 20.0 15.0 12.0 10.0 0.25 0.5 0.75 1.0 1.25 1.5

Quantity

Price

How Do Buyers Behave? (11 of 25)

Exhibit 4.4 Shifts of the Demand Curve vs. Movement Along the Demand Curve

Point out the difference between changes in a good’s price and changes in the other factors that determine demand. When anything other than price changes, it shifts the curve = change in demand. When the price changes, it’s a movement along = change in quantity demanded.

How Do Sellers Behave? (14 of 25)

Quantity Supplied

The amount of a good that sellers are willing to sell at a given price.

Supply Schedule

A table that reports the quantity supplied at different prices.

Supply Curve

Plots the quantity supplied at different prices.

As with constructing the demand schedule, call off prices, recording the quantity supplied at each price, developing a supply schedule.

How Do Sellers Behave? (13 of 25)

How much would you have to be paid to sell you smartphone right now in class?

To parallel soliciting the demand schedule for an candy bar, use smartphones to demonstrate to students the idea of supply. Ask them how many of them have a smartphone. Most, if not all, will raise their hands. Tell them that you’ve been authorized to conduct a buyback program and you would like to purchase their smartphones. Start with a relatively low value, say $25 and ask by a show of hands, how many would be willing to bring their phone down in exchange for $25? You may not get any takers or maybe someone with a cracked screen or older smartphone raises their hand. Next, increase the price and ask for a show of hands and continue this all the way to a max price of, say, $500 or $1,000.

As with the demand schedule, construct a supply schedule (although in this case, students might be less willing to publicly indicate what their willingness to accept price is).

How Do Sellers Behave? (15 of 25)

Supply Schedule

Price	Quantity Demanded
$25	5
$100	10
$175	15
$250	20
$325	25
$400	30

Supply Curve for Smartphones

Price 5.0 10.0 15.0 20.0 25.0 30.0 25.0 100.0 175.0 250.0 325.0 400.0

Quantity

Price

How Do Sellers Behave? (16 of 25)

Why are more of you willing to sell your smartphone at the higher the price?

Why is the price not the same for everybody?

Draw students’ attention to the positive slope and ask why it is the case that the higher the price, the more students are willing to sell their phones. That is, why is the price not the same for everybody?

How Do Sellers Behave? (17 of 25)

Market Supply Curve

Plots the relationship between the total quantity supplied and the market price, holding all else equal.

Again, pose the situation that you have two other sections of this class and you have asked those classes the same question (i.e., Why are some students willing to pay more for an Snickers bar than others? That is, why isn’t the price the same for everyone?) How can I represent the market’s (all micro students) relationship between price and quantity that they’re willing to provide?

How Do Sellers Behave? (22 of 25)

Exhibit 4.7 Aggregation of Supply Schedules and Supply Curves

Again, make the point that the same supply relationships hold whether the example refers to their payment requirement for the candy and oil producers’ requirements for providing their oil to the market.

How Do Sellers Behave? (20 of 25)

Shifts of the Supply Curve occur when one of the following changes:

1. input prices

2. technology

3. number and scale of sellers

4. sellers’ expectations about the future

How Do Sellers Behave? (23 of 25)

What if a new technology made it easier to access previously unavailable oil reserves (e.g. fracking)?

Would highly efficient, low cost suppliers require more or less to participate in the market?

How Do Sellers Behave? (24 of 25)

Shift of Supply Curve for Oil

Show this reduction in cost graphically--this shift could be an example of a decrease in input price, defined broadly. The shift could also reflect a change in technology.

How Do Sellers Behave? (25 of 25)

Exhibit 4.9 Shifts of the Supply Curve versus Movement along the Supply Curve

Point out that the same kinds of relationships are at work as with demand—when the market price changes, it’s a movement along the curve = change in quantity supplied; when one of the other factors change, it’s a shift in supply = change in supply.

Supply and Demand in Equilibrium (1 of 21)

Competitive Equilibrium

The point at which the market comes to an agreement about what the price will be (competitive equilibrium price) and how much will be exchanged (competitive equilibrium quantity) at that price.

Reaching an equilibrium can sometimes seem rather magical to students, so it might be helpful to go back to the buying a car example. You, representing the demand side of the market, and the seller, representing the supply side, haggle back and forth until you reach an agreement on the price of the car. This exchange represents a market at equilibrium—a price ($5,000, for example) and a quantity (1 car) have been agreed upon. The same haggling occurs with many buyers and many sellers except that it is largely invisible. When inventories build up on shelves, that is the demand side of the market telling the suppliers that the price is too high. When businesses face an unexpected cost increase, they produce less than at the old price, letting the demand side of the market know that price needs to increase for them to fully participate again.

Supply and Demand in Equilibrium (3 of 21)

Exhibit 4.10 Demand Curve and Supply Curve for Oil

Establishing an equilibrium is about incentives to change. When the market is at equilibrium, there is no incentive (on the part of buyers or sellers) for the price to change. Every buyer who is able and willing to pay $100 can buy what he or she wants. Every seller who is able and willing to sell at $100 can find a buyer. It’s worth pointing out again that the market allocates this particular scarce resource by the equilibrium price; not who deserves the oil, or needs it the most, or who will use it most efficiently.

Supply and Demand in Equilibrium (2 of 21)

Excess Demand

Occurs when consumers want more than suppliers provide at a given price. This situation results in a shortage.

Excess Supply

Occurs when suppliers provide more than consumers want at a given price. This situation results in a surplus.

Supply and Demand in Equilibrium (4 of 21)

Exhibit 4.11 Excess Supply

Supply and Demand in Equilibrium (5 of 21)

Exhibit 4.12 Excess Demand

Supply and Demand in Equilibrium (6 of 21)

Exhibit 4.13 A Leftward Shift of the Supply Curve

A leftward shift in the supply curve raises the equilibrium price and lowers the equilibrium quantity. The original equilibrium is located at the grey dot. The new equilibrium is marked by the black dot, where the original

demand curve and the new supply curve intersect.

Supply and Demand in Equilibrium (8 of 21)

It’s time to revisit the question:

Why do brown eggs cost more than white eggs?

Remind students of the answers they gave when you first posed the question: that they are healthier or organic; that consumers want them more. Most of the answer will be about some aspect of demand, so explore that graphically.

Supply and Demand in Equilibrium (9 of 21)

Demand Side:

brown eggs are healthier or organic

What’s wrong with this picture?

Compare the two equilibrium points. If the reason for brown eggs’ price is something to do with demand, then the price would be higher than the price for white eggs, which is what we observe in the real world. But the quantity would also be higher than white eggs, which is not what we observe. If the answer is not in the demand side of the market, then it must be in the supply side. So pose the question—what about the supply of brown eggs would make it different than the supply of white eggs? [Note: some students might have already suggested that there are fewer brown eggs than white eggs, but when you ask them why, they usually can’t formulate an answer.] Review the things that shift the supply curve—what could account for a difference between the two kinds of eggs? Someone will eventually say that the cost of producing brown eggs is higher. Which is correct—show that graphically.

Supply and Demand in Equilibrium (10 of 21)

Supply Side:

brown eggs are more expensive to produce

Looking at the two equilibrium points, you can see that the price for brown eggs is higher, which is what we observe; and the quantity is less than that of white eggs, which is also what we observe. So, the explanation matches what we see in the real world. But the question is not completely answered. Why would brown eggs be more expensive to produce than white eggs? Sometimes a student will suggest that a different kind of chicken lays them (which is correct)—if so, ask what difference that would make, remembering the factors that shift supply. At this point, you often will have to reveal the complete answer—brown eggs are laid by Rhode Island Red chickens, which are larger (and therefore more expensive to feed) than regular chickens.

This exercise does two things: it makes a direct connection between a real world observation and possible explanations for it. And by exploring the possible explanations, students can think through the implications for shifts of demand and supply.

Supply and Demand in Equilibrium (13 of 21)

Why doesn’t the price of beer increase right before Super Bowl Sunday?

Point out that there is the same increase in demand prior to an event. Why doesn’t the price increase? Let them ponder for a bit, then lead them to understand that what we observe in the real world is a price increase for roses, caused by an increase in demand. We observe no price increase in beer, in spite of there being an increase in demand. Something else (supply) must be changing in the beer market that is not changing in the roses market. Ask, what would happen with supply to keep the price the same, in spite of demand increasing? Supply must be increasing as well, as beer producers ramp up production based on expectations. But why wouldn’t rose producers do the same thing? If rose producers make a mistake in predicting the increase in demand, they are stuck because roses are perishable. If beer producers make a mistake, their inventory will keep.

Supply and Demand in Equilibrium (15 of 21)

Both the Demand Curve and Supply Curve Shift Right

Students often have trouble and get confused when both curves shift at the same time. Invite them to think of each shift separately and ask themselves a series of questions:

--what shifts, demand or supply?

--does it shift to the right or to the left?

--what is the effect on price? On quantity?

Going back to the Super Bowl and beer example, we see that the first shift is demand, which increases because it’s the Super Bowl, so that’s a shift to the right. That will increase price and quantity, if looked at in isolation of supply. If beer producers increase production based on expectations, that’s a shift of supply, to the right. That would lower price and increase quantity, if looked at in isolation of demand. So in both cases, quantity increases. In the first case (demand), price increases, but price decreases with the supply shift. So in this case, the effect on price is indeterminate and depends on the size of the shift, but the effect on quantity is definite since quantity increases in both cases.

Supply and Demand in Equilibrium (16 of 21)

The Demand Curve Shifts Right and the Supply Curve Shifts Left

If demand shifts right (ignoring supply), price and quantity both increase

If supply shifts left (ignoring demand), price increases, but quantity decreases

Therefore, the effect of both shifts is unambiguous with respect to price, but indeterminate with respect to quantity

Supply and Demand in Equilibrium (17 of 21)

The Demand Curve Shifts Left and the Supply Curve Shifts Right

In this case, if demand shifts left (ignoring supply), price will increase and quantity will decrease

If supply shifts right (ignoring demand), both price and quantity will increase.

Therefore, the effect of both shifts is that price will increase, but the effect on quantity depends upon the relative size of the shifts.

Supply and Demand in Equilibrium (18 of 21)

Both the Demand Curve and the Supply Curve Shift Left

Finally, if demand shifts left (ignoring supply), both price and quantity decrease.

If supply shifts left (ignoring demand), price increases, but quantity decreases.

Therefore, the effect of both shifts is that price may increase or decrease, but quantity will definitely decrease.

Supply and Demand in Equilibrium (19 of 21)

Effects of Shifts of Demand and Supply

Change in Supply

	Change in	Demand
	Incr. Demand	Decr. Demand
Incr. Supply	Equil. P ? Equil. Q	Equil. P Equil. Q ?
Decr. Supply	Equil. P Equil. Q ?	Equil. P ? Equil. Q

Summary of shift and effects.