Markets: Demand and Supply

Chapter 3

Market

n Interaction between potential buyers and sellers

n Controlled by:

n Buyer’s demand behavior

n Seller’s supply behavior

Buyers and Sellers

n Buyers:

n Compare value in use (MB) to price (P=MC)

n Sellers:

n Compare price (P=MB) to costs of production (MC)

Mutually Agreeable Trade

n Both buyer and seller must agree that MB > MC, or no trade:

n Buyer’s MB (value in use)

n > Buyer’s MC (price) = Seller’s MB (price)

n > Seller’s MC (production costs)

Incentives

n Buyer:

n to be better off after the trade than before the trade

n value > price

n Seller:

n to be better off after the trade than before the trade

n price > cost to produce and market

Mutually Agreeable Trade (chart)

n Both sides will agree to this trade.

Mutually Agreeable Trade? (chart)

n Who will not agree to this trade?

What Sets the (actual) Price?

n The interaction of:

n buyers’ behavior (law of demand) and

n sellers’ behavior (law of supply).

Demand

n The willingness and ability of buyers to purchase different quantities of a good at different prices during a specific time period.

Law of Demand

n Short-run relationship between P and Qd

n Assumes nothing else changes

n If price (P) rises, quantity demanded (Qd) falls

n If price (P) falls, quantity demanded (Qd) rises

Law of Demand (chart)

Demand and Quantity Demanded: The Difference

n When the word is used alone, demand is the behavior pattern of buyers. It is an attitude.

n In contrast, quantity demanded is an amount. There is one particular Qd for each P.

Why does the Demand Curve Slope Downward?

n Two reasons:

n At higher prices, your current income can’t buy as much.

n Diminishing Marginal Utility: the next one you buy is not as useful to you (MB is lower) as the first one, so it has to be at a lower price (MC is lower) for you to buy it.

Factors that Set Demand Behavior

n Income

n Preferences

n Number of Buyers

n Expectations of future prices

n Price changes of related goods

n Substitutes

n Complements

Factors that Set Demand Behavior

n If any of these factors change, our demand behavior changes.

n A demand behavior change is shown by shifting the demand curve.

n Increase in demand: shift the curve to the right.

n Decrease in demand: shift the curve left.

Shifting Demand

n Demand increases (shift right) when:

n income increases

n preferences increase

n number of buyers increase

n we expect higher prices in the future

n price of a substitute rises

n price of a complement good falls

n Qd increases for each possible P

Shifting Demand

n Demand decreases (shift left) when:

n income decreases

n preferences decrease

n number of buyers decrease

n we expect lower prices in the future

n price of a substitute falls

n price of a complement good rises

n Qd decreases for each possible P

Does A Changing Price Shift the Demand Curve?

n A change in the price DOES NOT shift the demand curve.

n However:

n raise the price and quantity demanded falls.

n lower the price and quantity demanded rises.

Change in Demand and Change in Quantity Demanded (chart)

Supply

n The willingness and ability of sellers to produce and offer to sell different quantities of a good at different prices during a specific time period.

Law of Supply

n Short-run relationship between P and Qs

n Assumes nothing else changes

n If price (P) rises, quantity supplied (Qs) rises

n If price (P) falls, quantity supplied (Qs) falls

Law of Supply (chart)

Supply and Quantity Supplied: The Difference

n When the word is used alone, supply is the behavior pattern of sellers. It is an attitude.

n In contrast, quantity supplied is an amount. There is one particular Qs for each P.

Why does the Supply Curve Slope Upward?

n Two reasons:

n As price rises and costs don’t change, profit grows, that’s incentive to supply more to the market.

n Approaching maximum capacity: Costs rise sharply as production increases, so price must rise to cover those costs, or no more production will occur.

Factors that Set Supply Behavior

n Costs

n Inputs (resources)

n Taxes

n Technology

n Number of Sellers

Factors that Set Supply Behavior

n If any of these factors change, our supply behavior changes.

n A supply behavior change is shown by shifting the supply curve.

n Increase in supply: shift the curve to the right.

n Decrease in supply: shift the curve left.

Shifting Supply

n Supply increases (shift right) when:

n input costs decrease

n new technology that lowers costs is implemented

n number of sellers increase

n Qs increases for each possible P

Shifting Supply

n Supply decreases (shift left) when:

n input costs increase

n old technology that becomes obsolete is kept

n number of sellers decrease

n Qs decreases for each possible P

Does A Changing Price Shift the Supply Curve?

n A change in the price DOES NOT shift the supply curve.

n However:

n raise the price and quantity supplied rises.

n lower the price and quantity supplied falls.

Change in Supply and a Change in Quantity Supplied (chart)

Making a Market (chart)

Surplus (chart)

Shortage (chart)

Equilibrium (chart)

Demand increases (chart)

n Demand shifts right.

n Old equilibrium is upset.

n A new equilibrium

is established.

n Price rises from P₁ to P₂.

n Quantity rises from Q₁ to Q₂

Demand decreases (chart)

n Demand shifts left.

n Old equilibrium is upset.

n A new equilibrium

is established.

n Price falls from P₁ to P₂.

n Quantity falls from Q₁ to Q₂

Supply increases (chart)

n Supply shifts right.

n Old equilibrium is upset.

n A new equilibrium

is established.

n Price falls from P₁ to P₂.

n Quantity rises from Q₁ to Q₂

Supply decreases (chart)

n Supply shifts left.

n Old equilibrium is upset.

n A new equilibrium

is established.

n Price rises from P₁ to P₂.

n Quantity falls from Q₁ to Q₂

Why do prices change?

n Prices change only when a market is in disequilibrium

n Shortage? Price rises

n Surplus? Price falls

Why do prices change?

n A demand curve shift causes price to change.

n A supply curve shift causes price to change.

n BUT a price change does not cause a:

n Shift in the demand curve

n Shift in the supply curve

Another Look at Market Equilibrium

n For each buyer, the demand curve shows his valuation of a good (his MB).

n His MC is the price.

n For each seller, the supply curve shows is production costs (his MC).

n His MB is the price.

Consumer Surplus

n This is how much better off buyers are having bought the good.

n = MB – P

n = the area below the demand curve and above the equilibrium price.

Consumer Surplus (chart)

Producer Surplus

n This is how much better off sellers are having sold the good.

n = P - MC

n = the area below the equilibrium price and above the supply curve.

Producer Surplus (chart)

Betterment of Society

n Three groups in society:

n Buyers – better off by consumer surplus

n Sellers – better off by producer surplus

n Everyone else – neither better nor worse off

n Total society betterment due to trade equals consumer surplus plus producer surplus.