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Chapter 03: Supply and Demand

McGraw-Hill/Irwin

13e

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Supply and Demand

The neat thing about gasoline prices is that great big board outside the station that allows you to keep constant track of how the price of gas changes.
… or it may be a huge source of aggravation to you.
Why do gasoline prices fluctuate so much?
What causes its price to rise? … to fall?

Gasoline prices interest nearly everybody, more so than widget prices.

You could spark interest by getting your students to keep track of gas price changes.

You could come back to gas prices as an example for just about everything in this chapter.

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Supply and Demand

The goal of this chapter is to explain how supply and demand really work.
What determines the price of a good or service?
How does the price of a product affect its production and consumption?
Why do prices and production levels often change?

You could revisit your talk about those evil, greedy “big oil” companies, right?

Keep in mind that price changes when either supply or demand shifts.

It is easy to get sidetracked if you don’t concentrate solely on a power-absent free market at first to get the basics of the market mechanism down.

Then add power elements.

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Learning Objectives

03-01. Know the nature and determinants of market demand.
03-02. Know the nature and determinants of market supply.
03-03. Know how market prices are established.
03-04. Know what causes market prices to change.
03-05. Know how government price controls affect market outcomes.

You could use these outcomes to review the chapter at the end.

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Market Participants

All participants, for the most part, are trying to obtain the maximum return from the scarce resources they have.
Consumers: maximize the utility (satisfaction of unmet wants) they can get from available incomes.
Businesses: maximize profits by selling goods that satisfy while keeping costs low.
Government: maximize the general welfare of society.
These motives explain most market activity.

It might be worthwhile to tell why these participants actually participate.

Again, it might be worthwhile to remind the class about Adam Smith’s story of making myself better off by making others better off.

“It is not from the benevolence of the butcher, the brewer, and the baker that we expect our dinner, but from their regard to their own interest.”

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Specialization and Trade

Most of us cannot produce everything we want to consume.
Time, talent, and resource constraints.
We should specialize and produce what we can at a lower opportunity cost than others.
Produce more than we need for ourselves and ...
… trade the excess for the goods we want to consume (which are produced by other specialists).

This reviews the concept that all of us are suppliers of a specialty and that we rely on others to produce the things we want and need.

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Application: International Trade

This logic applies to international trade.
We specialize in production in which we have a lower opportunity cost and sell the excess to other countries.
Other countries specialize in production in which they have a lower opportunity cost and sell the excess to us.
Because of this, both nations are able to consume more than if they had to produce everything for themselves.

Expanding the concept of specialization to international trade is a logical progression here.

The conventional wisdom is that imports are bad and exports are good (normative statements).

It could be the basis of a good discussion.

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The Circular Flow

There are two markets and four participants:
Consumers:
They are owners of factors of production (e.g., labor) who supply them to business firms in the factor market and earn income.
They purchase goods and services in the product market.

These next two slides create the circular flow in the third slide.

You might want to take time to discuss each market fully as well as each participant.

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The Circular Flow

Business firms: they produce goods and services for the product market using the factors of production they bought from their owners in the factor market.
Governments: they acquire resources in the factor market and provide services to both consumers and firms.
International participants: they supply imports and purchase exports in the product market and buy and sell resources in the factor market.

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The Circular Flow

Goods and services

supplied

Factors of

production supplied

Goods and services

demanded

Factors of

production demanded

Exports

Imports

Exports

International

participants

Consumers

International

participants

Business

Firms

Governments

Product

markets

Factor

markets

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Locating Markets

A market exists wherever an exchange (transaction) takes place.
Every market transaction involves an exchange of dollars for goods and service (in product markets) or resources (in factor markets).
In the circular flow, goods and services or resources flow one way, and dollars flow the opposite way.

Examples: Face-to-face markets (the local snack bar); electronic market (Amazon); a brokered market (stock market);

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Exercise

Write down a product market in which you participated recently.
Were you a buyer or seller?
Write down a factor market in which you participated recently.
Were you a buyer or seller?

This is simple, but it might straighten out a student or two who has not yet mastered the difference between a product market and a factor market.

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Supply and Demand

Supply: the ability and willingness to sell specific quantities of a good at alternative prices in a given time period, ceteris paribus.
Demand: the ability and willingness to buy specific quantities of a good at alternative prices in a given time period, ceteris paribus.
Ceteris paribus: the assumption that nothing else is changing.

This might be a good time to caution your students not to complicate the explanation.

Ceteris paribus means everything else stays the same.

Somebody will try to insert a superfluous action into a simple discussion, violating the ceteris paribus assumption.

It might be a good idea to stick to the simple (ceteris paribus) situation now and promise to discuss the more complicated version later.

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The Law of Demand

Law of demand: the quantity demanded of a good in a given time period increases as its price falls, ceteris paribus (and vice versa).
Inverse relationship between price (P) and quantity demanded (Qd).
A downward-sloping curve on a market diagram.

The best “given time period” to use is “now.”

Example: Write $10 on the board. Put a price of $2 next to it and ask how many could one buy.

Then change the price first to $2.50 and next to $1, and repeat the question each time.

It is a simple, effective way to demonstrate the P-Qd relationship.

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Individual Demand and Market Demand

Each of us has a demand for a good or a service if we are willing and able to pay for it.
The amount we buy depends on its price.
If the price goes up, we buy less.
If the price goes down, we buy more.
Market demand is the collective summation of all buyers’ individual demands.

Suggested board example: draw five individual downward-sloping demand curves.

Then add up the curves at the high end, in the middle, and at the low end.

The collective (market) demand curve is also a downward-sloping line.

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Demand Schedule and Curve

Fig 3.2

Price	Quantity Demanded
$50	1
45	2
40	3
35	5
30	7
25	9
20	12
15	15
10	20

Quantity

Price

$50

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Factors That Set Demand Behavior (Determinants of Demand)

Tastes.
Income.
Expectations.
Other goods:
Substitutes.
Complements.
Number of buyers.

If any of these factors change, demand behavior changes.
A demand behavior change is shown by shifting the demand curve.
Increase in demand: shift the curve right.
Decrease in demand: shift the curve left.

The first four categories determine both individual and market demand; add the fifth to derive market demand.

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Changing Demand
(Shifting the Demand Curve)

Demand increases (shifts right) when
Taste for the good increases.
Income increases.
Price of a substitute rises.
Price of a complement falls.
Future prices are expected to rise.
Number of buyers increases.
Vice versa, and demand decreases (shifts left).

Tastes change: you grow up and give up childish things and prefer more adult things. Or advertising can change tastes overnight.

Income: get a raise and you can afford to buy more things.

Substitute: double the price of Coke and your demand for Pepsi, whose price has not changed, will increase.

Complement: Big Macs go on sale, so we buy more Big Macs. We also increase our orders of fries, even though their price didn’t change.

Expectations: your tank is at 1/2. You’re convinced gas prices will rise tomorrow, so you top off today.

Number of buyers: attendance at the game is 10,000, and 10,000 hot dogs are sold. Increase the attendance to 20,000, and the demand for hot dogs goes up.

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Movements vs. Shifts

Change in quantity demanded: movement along a demand curve in response to a change in price.
Change in demand: a shift of the demand curve due to a change in one or more of the determinants of demand.

Do not let your students use these terms as synonyms. The first is a number; the second is a behavior.

Example: If I smoke, it is a behavior. I have a demand for cigarettes.

I smoke 20 cigarettes a day; that’s a number--the quantity demanded. Smoking and 20 are not synonyms.

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Movements vs. Shifts

Initial demand

Movement along curve

Shift in demand

Increased demand

Movement along the curve: buyer’s behavior does not change; buyers only react to a price change.

Shift the curve: buyers’ behavior does change.

Fig 3.3

$45

Quantity

Price

Here is a great graphic to emphasize the difference between moving along the curve due to a price change and shifting the curve due to a determinant change.

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Law of Supply

Law of supply: the quantity of a good supplied in a given time period increases as its price increases, ceteris paribus, and vice versa.
Direct relationship between price (P) and quantity supplied (Qs).
It is an upward-sloping curve on a market diagram.

It might be a good idea to parallel your discussion of supply to your discussion of demand.

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Supply Schedule and Curve

Price	Quantity Supplied (Qs)
$50	20
40	15
30	10
20	5
10	1

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Factors that Set Supply Behavior (Determinants of Supply)

Technology
Factor Costs.
Taxes and subsidies.
Expectations.
Other goods.
Number of sellers.

If any of these factors change, supply behavior changes.
This type of change is shown by shifting the supply curve.
Increase in supply: shift the curve right.
Decrease in supply: shift the curve left.

The first five categories deal with both individual and market supply; the sixth is added to derive market supply.

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Changing Supply
(Shifting the Supply Curve)

Supply increases (shifts right) when
New technology lowers operating costs.
Factor costs decrease.
Taxes decrease or subsidies increase.
Future prices are expected to rise.
Price of alternative goods fall.
Number of sellers increases.
Vice versa, and supply decreases (shifts left).

Tech: a higher-cost technology will not be freely adopted; only cost-lowering technology will be adopted.

Costs: with no change in price, lowering costs increases profit, which is the most powerful motivator on the supply side.

Taxes: they are just another cost, so see above.

Expectations: you expect to get paid more for your goods, and that motivates you to produce more.

Number of sellers: more product will be put into the market.

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Movements vs. Shifts

Change in quantity supplied: movement along the supply curve due to a change in price.
Change in supply: a shift in the supply curve due to one or more changes in the determinants of supply.

Again, do not let your students use these as synonyms.

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Movements vs. Shifts

Initial supply

Increased

supply

Movement

along curve

Shift in

supply

Graphically shows the difference. One is due to a change in price; the other is due to a change in one of the determinants.

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Individual Supply and Market Supply

Each producer is willing and able to produce a good or service if he or she can make a profit.
The amount produced depends on its price.
If the price goes up, more will be produced.
If the price goes down, less will be produced.
Market supply is the collective summation of all producers’ individual supplies.

You could put five individual supply curves on the board and summarize them as you did for demand.

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Putting a Market Together

The interaction of buyers and sellers makes a market.
Equilibrium: only one price and quantity combination is compatible with the intentions of both buyers and sellers.
Equilibrium is located where the demand curve and supply curve intersect.

It might be instructive to stress that all the points on the graph except the equilibrium point represent situations where the buyers and sellers disagree.

They agree only at the equilibrium point.

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Equilibrium

No shortage exists.
No surplus exists.
Qd = Qs = Qe.
The price will not change until there is a shift in demand or in supply.

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Equilibrium

Markets reach equilibrium because buyers have a demand behavior (raise price, buy less, and vice versa) and sellers have a supply behavior (raise price, supply more, and vice versa).
No one is in charge!
The market mechanism (Adam Smith’s “invisible hand”) leads the market to equilibrium.
At equilibrium, quantity demanded (Qd) equals quantity supplied (Qs) at the equilibrium price (Pe).
We say that the market mechanism signals the desired outcome at Pe.

Someone may insist on bringing into the discussion a power manipulator, who could force the market to move.

It might be important to keep the discussion free of such complication at this time.

Promise to discuss the complication after this basic discussion of markets is complete.

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Resolving a Market Surplus

Market surplus: the amount by which quantity supplied (Qs) exceeds quantity demanded (Qd) at a given price; excess supply.
Price is too high.
Qs > Qd, a surplus.
Buyer and seller behaviors kick in.
Price will fall to equilibrium price, Pe.

Phigh

Surplus

When a new product comes onto the market, the sellers must set a price. If they set it too high, there will be a surplus.

In a surplus, sellers can’t sell the amount they wanted to and get stuck with excess inventory.

They are unhappy, and lower the price to move out the goods.

This triggers the two behaviors and drives the price down.

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Resolving a Market Shortage

Market shortage: The amount by which quantity demanded (Qd) exceeds quantity supplied (Qs) at a given price; excess demand.
Price is too low.
Qs < Qd, a shortage.
Buyer and seller behaviors kick in.
Price will rise to equilibrium price, Pe.

Plow

Shortage

If the firm sets the price too low, a shortage situation is created.

Unhappy buyers find that the product is sold out.

In order to ensure that they get one next time, they offer a higher price for it.

This starts the bidding process, and the price will begin to move upward.

The upward-moving price triggers both buyer and seller behaviors.

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What Causes the Price to Change?

Price changes when equilibrium is upset.
… due to a shift in demand (a change in buyers’ behavior), or …
… due to a shift in supply (a change in sellers’ behavior).
After the shift, a surplus or a shortage is created, and the market mechanism goes into effect to find the new equilibrium.

It is instructive to

- Emphasize that if they see the price rising, the market is in shortage and out of equilibrium and is searching for a new equilibrium point.

- Emphasize that if they see the price falling, the market is in surplus and out of equilibrium and is searching for a new equilibrium point.

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Demand Increases

Buyers’ behavior changes.
Demand shifts right.
Old equilibrium is upset.
Creates a shortage.
Price rises.
A new equilibrium is established.
Price rises from P1 to P2.
Quantity rises from Q1 to Q2.

Shortage

Note when the curve shifts here and in the next three slides, it immediately creates disequilibrium.

Then market forces you just described take over to move the market to its new equilibrium.

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Demand Decreases

Buyers’ behavior changes.
Demand shifts left.
Old equilibrium is upset.
Creates a surplus.
Price falls.
A new equilibrium is established.
Price falls from P1 to P2.
Quantity falls from Q1 to Q2

Surplus

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Supply Increases

Sellers’ behavior changes.
Supply shifts right.
Old equilibrium is upset
Creates a surplus.
Price falls.
A new equilibrium is established.
Price falls from P1to P2.
Quantity rises from Q1 to Q2.

Surplus

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Supply Decreases

Sellers’ behavior changes.
Supply shifts left.
Old equilibrium is upset
Creates a shortage.
Price rises.
A new equilibrium is established.
Price rises from P1to P2.
Quantity falls from Q1 to Q2.

Shortage

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Summary: When Do Prices Change?

Only when a market is in disequilibrium.
Shortage? Price rises.
Surplus? Price falls.
A shift in either demand or supply causes the price to change, BUT….
A price change does NOT cause
… the demand curve to shift or
… the supply curve to shift.

You can’t emphasize enough the fact that a simple change in a good’s price does not cause the demand curve or the supply curve for that good to shift.

In fact, it is just the opposite: a curve shift sets into motion the market activity that changes the price.

Think stimulus and reaction. Sneak up behind me and poke me in the ribs and I’ll jump. But…if I jump, that doesn’t cause you to sneak up behind me and poke me in the ribs. Reaction does not cause stimulus.

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Exercise

If income increases, demand shifts and the price will
If tastes decrease, demand shifts and the price will
If cost of inputs rise, supply shifts and the price will
If the number of sellers increase, supply shifts and the price will

right

fall

left

rise

right

fall

rise

left

After doing this exercise, it might be a good time to review the determinants and the curve shifts once again.

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Market Outcomes

The market mechanism affects WHAT, HOW, and FOR WHOM to produce.
WHAT? Markets determine which goods are desired and which are profitable.
HOW? Profit-seeking producers will strive to produce goods in the most efficient way.
FOR WHOM? To obtain a good, one must be both willing and able to purchase it.

This is a review of what we covered in previous chapters.

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Price Controls

Governments may impose an arbitrary maximum price (price ceiling) or a minimum price (price floor) on a market.
The result is that the market cannot reach equilibrium.

Now might be the time to start talking about power centers intervening in the market.

Here we use government as the power center.

It might be useful to emphasize that a market will, if left alone, reach equilibrium.

If interfered with by a power center, it may not.

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Price Ceiling

Government imposes a maximum price less than Pe.
This generates a shortage (Qd > Qs).
The market mechanism cannot clear the market.
A permanent shortage exists.

Price

ceiling

Shortage

Example: rent control laws. Results: landlords convert some units to other uses that might be more profitable.

Few new units are built. More applicants show up for the units.

In order to lower costs, some landlords begins to skimp on maintenance, and the units deteriorate.

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Price Floor

Government imposes a minimum price greater than Pe.
This generates a surplus (Qs > Qd).
The market mechanism cannot clear the market.
A permanent surplus exists.

Price

floor

Surplus

Example: farm support laws. To improve the income of the farmer, an artificially high price is set on the crop.

Buyers of the crop then buy less. Producers of the crop plant more.

No one buys the surplus. Government steps in and buys it up (to keep the farmers’ income up).

Government can’t legally sell it below the price floor, so it stores it or destroys it, which is a huge resource waste.

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The Economy Tomorrow

There is an organ transplant market.
The supply of organs is limited by the number of people willing to provide an organ to transplant.
Market incentives could increase the number of organs available.
Congress bans the purchase or sale of organs.
Organs are supplied at a price ceiling of $0.
This generates a shortage of organs.
Increase the price, and the quantity supplied goes up, reducing the shortage.

You could get a lot of grief talking about this.

The current attitude is that we shouldn’t harvest organs just to sell them.

Somehow only altruistic methods should be used.

If one cannot put a market price on an organ, then the price is zero.

This is a very low price ceiling, and there will be a persistent shortage of the organs.

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