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Demand and

Supply

Notes and teaching tips: 5, 7, 43 and 48.

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After studying this chapter, you will be able to

Describe a competitive market and think about a price as an opportunity cost
Explain the influences on demand
Explain the influences on supply
Explain how demand and supply determine prices and quantities bought and sold
Use the demand and supply model to make predictions about changes in prices and quantities

What causes the big swings in the prices of coffee and bananas?

Why does the price of oil keep rising?

You know that economics is about the choices people make to cope with scarcity and how those choices respond to incentives.

Prices act as incentives. How do people respond to prices?

This chapter explains how markets determine prices and why prices change.

A market is any arrangement that enables buyers and sellers to get information and do business with each other.

A competitive market is a market that has many buyers and many sellers so no single buyer or seller can influence the price.

The money price of a good is the amount of money needed to buy it.

The relative price of a good—the ratio of its money price to the money price of the next best alternative good—is its opportunity cost.

Markets and Prices

Before you jump into the demand-supply model, be sure that your students understand that a price in economics is a relative price and that a relative price is an opportunity cost. Also spend some class time ensuring that they appreciate the key lessons of Chapter 2:

a) Prosperity comes from specialisation and exchange.

b) Specialisation and exchange requires the social institutions of property rights and markets.

c) We must understand how markets work.

You might like to explain that the most competitive markets are explicitly organised as auctions. An interesting market to describe is that at Aalsmeer in Holland, which handles a large percentage of the world’s fresh cut flowers. Roses grown in Columbia are flown to Amsterdam, auctioned at Aalsmeer, and are in vases in New York, London, and Tokyo all in less than a day. If you have an Internet connection in your classroom, you can participate in a simulation of an auction of flowers. http://www.youtube.com/watch?v=O5V7USbDBwA.

If you demand something, then you

1. Want it,

2. Can afford it, and

3. Have made a definite plan to buy it.

Wants are the unlimited desires or wishes people have for goods and services. Demand reflects a decision about which wants to satisfy.

The quantity demanded of a good or service is the amount that consumers plan to buy during a particular time period, and at a particular price.

Demand

The Law of Demand

The law of demand states:

Other things remaining the same, the higher the price of a good, the smaller is the quantity demanded; and

the lower the price of a good, the larger is the quantity demanded.

The law of demand results from

Substitution effect
Income effect

Demand

Estimating the demand for Coke (or bottled water) in the classroom.

Of the hundreds of classroom experiments that are available today, very few are worth the time they take to conduct. The classic demand-revealing experiment is one of the most productive and worthwhile ones.

Bring to class two bottles of ice-cold, ready-to-drink Coke, bottled water, or sports drink. (If your class is very large, bring six bottles).

Tell the students that you have these drinks and ask them to indicate if they would like one. Most hands will go up and you are now ready to make two points:

1. The students have just revealed a want but not a demand.

2. You don’t have enough bottles to satisfy their wants, so you need an allocation mechanism.

Ask the students to suggest some allocation mechanisms. You might get suggestions such as: give them to the oldest, the youngest, the tallest, the shortest, the first-to-the-front-of-the-class. For each one, point out the difficulty/inefficiency/inequity.

If no one suggests selling them to the highest bidder, tell the class that you are indeed going to do just that. Tell them that this auction is real. The winner will get the drink and will pay.

Now ask for a show of hands of those who have some cash and can afford to buy a drink. Explain that these indicate an ability to buy but not a definite plan to buy.

Substitution Effect

When the relative price (opportunity cost) of a good or service rises, people seek substitutes for it, so the quantity demanded of the good or service decreases.

Income Effect

When the price of a good or service rises relative to income, people cannot afford all the things they previously bought, so the quantity demanded of the good or service decreases.

Demand

Demand Curve and Demand Schedule

The term demand refers to the entire relationship between the price of the good and quantity demanded of the good.

A demand curve shows the relationship between the quantity demanded of a good and its price when all other influences on consumers’ planned purchases remain the same.

Demand

Figure 3.1 shows a demand curve for energy bars.

Demand

A rise in the price, other things remaining the same, brings a decrease in the quantity demanded and a movement up along the demand curve.

A fall in the price, other things remaining the same, brings an increase in the quantity demanded and a movement down along the demand curve.

Demand

Willingness and
Ability to Pay

A demand curve is also a willingness-and-ability-to-pay curve.

The smaller the quantity available, the higher is the price that someone is willing to pay for another unit.

Willingness to pay measures marginal benefit.

Demand

A Change in Demand

When some influence on buying plans other than the price of the good changes, there is a change in demand for that good.

The quantity of the good that people plan to buy changes at each and every price, so there is a new demand curve.

When demand increases, the demand curve shifts rightward.

When demand decreases, the demand curve shifts leftward.

Demand

Six main factors that change demand are

The prices of related goods
Expected future prices
Income
Expected future income and credit
Population
Preferences

Demand

Prices of Related Goods

A substitute is a good that can be used in place of another good.

A complement is a good that is used in conjunction with another good.

When the price of a substitute for an energy bar rises or when the price of a complement of an energy bar falls, the demand for energy bars increases.

Demand

Expected Future Prices

If the expected future price of a good rises, current demand for the good increases and the demand curve shifts rightward.

Income

When income increases, consumers buy more of most goods and the demand curve shifts rightward.

A normal good is one for which demand increases as income increases.

An inferior good is a good for which demand decreases as income increases.

Demand

Expected Future Income and Credit

When expected future income increases or when credit is easy to obtain, the demand might increase now.

Population

The larger the population, the greater is the demand for all goods.

Preferences

People with the same income have different demands if they have different preferences.

Demand

Figure 3.2 shows an increase in demand.

Because an energy bar is a normal good, an increase in income increases the demand for energy bars.

Demand

A Change in the Quantity Demanded Versus a Change in Demand

Figure 3.3 illustrates the distinction between a change in demand and a change in the quantity demanded.

Demand

Movement Along the Demand Curve

When the price of the good changes and everything else remains the same, the quantity demanded changes and there is a movement along the demand curve.

Demand

A Shift of the Demand Curve

If the price remains the same but one of the other influences on buyers’ plans changes, demand changes and the demand curve shifts.

Demand

If a firm supplies a good or service, then the firm

1. Has the resources and the technology to produce it,

2. Can profit from producing it, and

3. Has made a definite plan to produce and sell it.

Resources and technology determine what it is possible to produce. Supply reflects a decision about which technologically feasible items to produce.

The quantity supplied of a good or service is the amount that producers plan to sell during a given time period at a particular price.

Supply

The Law of Supply

The law of supply states:

Other things remaining the same, the higher the price of a good, the greater is the quantity supplied; and

the lower the price of a good, the smaller is the quantity supplied.

The law of supply results from the general tendency for the marginal cost of producing a good or service to increase as the quantity produced increases (Chapter 2, page 33).

Producers are willing to supply a good only if they can at least cover their marginal cost of production.

Supply

Supply Curve and Supply Schedule

The term supply refers to the entire relationship between the quantity supplied and the price of a good.

The supply curve shows the relationship between the quantity supplied of a good and its price when all other influences on producers’ planned sales remain the same.

Supply

Figure 3.4 shows a supply curve of energy bars.

Supply

A rise in the price of an energy bar, other things remaining the same, brings an increase in the quantity supplied.

Minimum Supply Price

A supply curve is also a minimum-supply-price curve.

As the quantity produced increases, marginal cost increases.

The lowest price at which someone is willing to sell an additional unit rises.

This lowest price is marginal cost.

Supply

A Change in Supply

When some influence on selling plans other than the price of the good changes, there is a change in supply of that good.

The quantity of the good that producers plan to sell changes at each and every price, so there is a new supply curve.

When supply increases, the supply curve shifts rightward.

When supply decreases, the supply curve shifts leftward.

Supply

The six main factors that change supply of a good are

The prices of factors of production
The prices of related goods produced
Expected future prices
The number of suppliers
Technology
State of nature

Supply

Prices of Factors of Production

If the price of a factor of production used to produce a good rises, the minimum price that a supplier is willing to accept for producing each quantity of that good rises.

So a rise in the price of a factor of production decreases supply and shifts the supply curve leftward.

Supply

Prices of Related Goods Produced

A substitute in production for a good is another good that can be produced using the same resources.

The supply of a good increases if the price of a substitute in production falls.

Goods are complements in production if they must be produced together.

The supply of a good increases if the price of a complement in production rises.

Supply

Expected Future Prices

If the expected future price of a good rises, the supply of the good today decreases and the supply curve shifts leftward.

The Number of Suppliers

The larger the number of suppliers of a good, the greater is the supply of the good. An increase in the number of suppliers shifts the supply curve rightward.

Supply

Technology

Advances in technology create new products and lower the cost of producing existing products.

So advances in technology increase supply and shift the supply curve rightward.

The State of Nature

The state of nature includes all the natural forces that influence production—for example, the weather.

A natural disaster decreases supply and shifts the supply curve leftward.

Supply

Figure 3.5 shows an increase in supply.

An advance in the technology for producing energy bars increases the supply of energy bars and shifts the supply curve rightward.

Supply

A Change in the Quantity Supplied Versus a Change in Supply

Figure 3.6 illustrates the distinction between a change in supply and a change in the quantity supplied.

Supply

Movement Along the Supply Curve

When the price of the good changes and other influences on sellers’ plans remain the same, the quantity supplied changes and there is a movement along the supply curve.

Supply

A Shift of the Supply Curve

If the price remains the same but some other influence on sellers’ plans changes, supply changes and the supply curve shifts.

Supply

Equilibrium is a situation in which opposing forces balance each other. Equilibrium in a market occurs when the price balances the plans of buyers and sellers.

The equilibrium price is the price at which the quantity demanded equals the quantity supplied.

The equilibrium quantity is the quantity bought and sold at the equilibrium price.

Price regulates buying and selling plans.
Price adjusts when plans don’t match.

Market Equilibrium

The magic of market equilibrium and the forces that bring it about and keep the market there need to be demonstrated with the basic diagram, with intuition, and, if you’ve got the time, with hard evidence in the form of further class activity.

You might want to begin with the demand curve experiment and explain that in that market, the supply was fixed (vertical supply curve) at the quantity of bottles that you brought to class. The equilibrium occurred where the market demand curve (demand by the students) intersected your supply curve.

Then you might use the supply curve experiment and explain that in that market, demand was fixed (vertical demand curve) at the quantity that you had decided to buy. The equilibrium occurred where the market supply curve (supply by the students) intersected your demand curve.

Point out that the trades you made in your little economy made buyers and sellers better off.

If you want to devote a class to equilibrium and the gains from trade in a market, you might want to run a double oral auction. There are lots of descriptions of these and one of the best is at Marcelo Clerici-Arias’s Web site at Stanford University—http://www.stanford.edu/~marcelo/index.html?Teaching/Docs/Experiments/Auction/auction.htm~mainFrame

Price as a Regulator

Figure 3.7 illustrates the equilibrium price and equilibrium quantity.

If the price is $2.00 a bar, the quantity supplied exceeds the quantity demanded.

There is a surplus of
6 million energy bars.

Market Equilibrium

If the price is $1.00 a bar, the quantity demanded exceeds the quantity supplied.

There is a shortage of
9 million energy bars.

If the price is $1.50 a bar, the quantity demanded equals the quantity supplied.

There is neither a shortage nor a surplus of energy bars.

Market Equilibrium

Price Adjustments

At any price above the equilibrium price, a surplus forces the price down.

At any price below the equilibrium price, a shortage forces the price up.

At the equilibrium price, buyers’ plans and sellers’ plans agree and the price doesn’t change until some event changes either demand or supply.

Market Equilibrium

An Increase in Demand

Figure 3.8 shows that when demand increases the demand curve shifts rightward.

At the original price, there is now a shortage.

The price rises, and the quantity supplied increases along the supply curve.

Predicting Changes in Price and Quantity

The whole chapter builds up to this section, which now brings all the elements of demand, supply, and equilibrium together to make predictions.

Students are remarkably ready to guess the consequences of some event that changes either demand or supply or both. They must be encouraged to work out the answer and draw the diagram.

Explain that the way to answer any question that seeks a prediction about the effects of some events on a market has five steps. Walk them through the steps and have one or two students work some examples in front of the class. The five steps are:

1.Draw a demand-supply diagram and label the axes with the price and quantity of the good or service in question.

2. Think about the events that you are told occur and decide whether they change demand, supply, both demand and supply, or neither demand nor supply.

3. Do the events that change demand or supply bring an increase or a decrease?

4. Draw the new demand curve and supply curve on the diagram. Be sure to shift the curves in the correct direction—leftward for decrease and rightward for increase. (Lots of students want to move the curves upward for increase and downward for decrease—works ok for demand but exactly wrong for supply. Emphasise the left-right shift.)

5. Find the new equilibrium and compare it with the original one.

Walk them through the steps and have one or two students work some examples in front of the class.

It is critical at this stage to return to the distinction between a change in demand (supply) and a change in the quantity demanded (supplied). You can now use these distinctions to describe the effects of events that change market outcomes.

At this point, the students know enough for it to be worthwhile emphasising the magic of the market’s ability to coordinate plans and reallocate resources.

An Increase in Supply

Figure 3.9 shows that when supply increases the supply curve shifts rightward.

At the original price, there is now a surplus.

The price falls, and the quantity demanded increases along the demand curve.

Predicting Changes in Price and Quantity

All Possible Changes in Demand and Supply

A change in demand or supply or both demand and supply changes the equilibrium price and the equilibrium quantity.

Predicting Changes in Price and Quantity

Change in Demand with No Change in Supply

When demand increases,

there is a movement up along the supply curve.

The equilibrium price rises and the equilibrium quantity increases.

Predicting Changes in Price and Quantity

When demand decreases, the equilibrium price falls and the equilibrium quantity decreases.

Predicting Changes in Price and Quantity

Change in Supply with
No Change in Demand

When supply increases,

there is a movement down along the demand curve.

The equilibrium price falls and the equilibrium quantity increases.

Predicting Changes in Price and Quantity

When supply decreases,

the equilibrium price rises and the equilibrium quantity decreases.

Predicting Changes in Price and Quantity

Increase in Both Demand and Supply

An increase in demand and an increase in supply increase the equilibrium quantity.

The change in equilibrium price is uncertain because the increase in demand raises the equilibrium price and the increase in supply lowers it.

Predicting Changes in Price and Quantity

Decrease in Both Demand and Supply

A decrease in both demand and supply decreases the equilibrium quantity.

The change in equilibrium price is uncertain because the decrease in demand lowers the equilibrium price and the decrease in supply raises it.

Predicting Changes in Price and Quantity

Decrease in Demand and Increase in Supply

A decrease in demand and an increase in supply lowers the equilibrium price.

The change in equilibrium quantity is uncertain because the decrease in demand decreases the equilibrium quantity and the increase in supply increases it.

Predicting Changes in Price and Quantity

Increase in Demand and Decrease in Supply

An increase in demand and a decrease in supply raises the equilibrium price.

The change in equilibrium quantity is uncertain because the increase in demand increases the equilibrium quantity and the decrease in supply decreases it.

Predicting Changes in Price and Quantity