Demand, Supply and the

Interaction of Markets

• Why is sugar relatively cheap and the price of gasoline so high? Surprisingly the answer to both is the same, namely supply and demand.

This unit will focus on both supply and demand individually and then explore what occurs when they are put together. In the first part of these

notes we will look more fully at

• Demand – ability and willingness to buy things.

The Law of Demand

• As price rises other factors unchanged demand will fall and vice versa.

Income Effect

If the price of a good goes down then the consumer will have what is known as the Income Effect, this simply states the change in consumption resulting from an increase in the consumer’s real income.

Price of the meal goes down… increase in real income.

Substitution Effect

Another concept about demand is that when the price of one good rises relative to other, the consumer will substitute the higher priced good for the cheaper good, this is known as the substitution effect.

Diminishing Marginal Utility

In consuming a product we will incur what is known in economics as diminishing marginal utility. This concept states that as a person consumes more of a good in a specified time they will receive less satisfaction from each consumed unit.

# Of Doughnuts

Total Utils Marginal Utility

1 25 25

2 48 23

3 60 12

4 70 10

Unit of satisfaction

Creating a Demand Curve

• A demand curve simply illustrates in graphical form the amount of a good people are willing to purchase at a given amount of money. Occasionally we are given a demand schedule to generate a demand curve from. The problem with a schedule is that they have limited utility in that they only show us those few prices and quantities shown in the table.

• A graph give us more utility and therefore is more valuable to us in that it will show us all points in-between the points on the schedule. The schedule and curve next, demonstrates this.

Quantity

Price

Demand Schedule for Pizza

Demand Schedule for pizza demand in which the quantity refers to thousands of pizzas demanded per week. Notice the flaw in the schedule in which we only know the amount of pizzas ordered at the prices posted. What would people demand at $5 or $9? This is why these have a limited utility.

P Q

$4 14

$6 12

$8 10

$10 8

$12 6

Pizza Demand CurveP Q

$4 14

$6 12

$8 10

$10 8

$12 6

Price

You can now clearly see what quantities will be bought at all the in-between prices. This gives the graph more utility. The key to the graph is understanding its makeup. The vertical column is always going to be price while the horizontal base will always be quantity. The key to understanding quantity is to know the units we are dealing in. Always look under the graph to see what the quantity is. (example Q X 1,000)

Changes in Demand• In the graph our demand

curve is shifting to the right; this signifies that demand is increasing.

• If the curve shifts to the left then demand is decreasing. In this example we are also using the supply curve to determine equilibrium price and quantity, which will come into play later on the in the unit.

An out-ward or right-ward shift in demand increases both equilibrium price and quantity.

Demand Response Effects• Explanation of demand response

effects on a quantity (Q); price (P) graph. Under inelastic demand (no other alternative for product) (D1) extremely high price (P1) may result on a strained electricity market.

• If demand response measures are employed the demand becomes more elastic (D2). A much lower price will result on the market (P2).

• It is estimated that a 5% lowering of demand would result in a 50% price reduction during the peak hours of the California Electricity crisis in 2000-2001. The market also becomes more resilient to intentional withdrawal of offers from the supply side.

Main Causes for a Change in Demand

Changes in consumer’s incomes. When consumers experience an increase in income they tend to buy more of those types of goods that they like. Conversely a loss of income tends to decrease their demand.

Main Causes for a Change in Demand• The prices of related goods. When the prices of

other goods related to the product in question changes, it can effect demand. In this case we have two types of goods to consider.– Substitute Goods – Two goods like coffee

and tea in which an increase in the price of one increases demand for the other. In this case, if the price of coffee were to rise and tea prices remained stable, if we see an increase in the demand for tea we can say that tea is a substitute for coffee.

– Complements – Two goods for which an increase in the price of one decreases demand for the other. For example, if the price of DVD movies were to drop in price drastically and at the same time we saw a huge spike in the demand for DVD players we can safely assume that they are complements.

Main Causes for a Change in Demand• The number and composition of consumers

This takes into account the growth of a population as well as its breakdown. For instance if we have a large number of births we can expect to see future demand curves shift to the right simply because of population growth. However, we will also see the demand curves for certain types of goods change due to the age group of the emerging population.

• However, we will also see the demand curves for certain types of goods change due to the age group of the emerging population. For example, within four to six years after a baby boom we can expect the demand for tricycles to increase dramatically.

Main Causes for a Change in Demand Changes in consumer expectations - • When people assume that they will get a

job or that an economic windfall is coming to them they tend to increase their demand for goods and services.

• Also, if consumers feel that a product will be cheaper today relative to future prices they might increase their demand for those products today. An example for this would occur if the government imposed new regulations on catching fish that will cause the price for seafood to rise in the future, many people will demand more fish now at the lower price before the new rules are in place.

Main Causes for a Change in Demand

Consumer tastes – Populations change their preferences for certain products over time. When these tastes change so does the demand for certain products. Look at cigarettes. In the 40s and 50s nearly everyone smoked, however during the last thirty years we have seen a shift away from smoking as more people become aware of the dangers involved.

Changes in Quantity Demanded

We all have certain products that we like from Snickers bars to Domino’s Pizza. However much we like these goods, what happens when the price for those goods rise. The law of demand tells us the answer, when the price goes up our demand for those goods will fall. Let us look at the demand curve and how this works.

Supply• In order to have supply you

have to have the ability and willingness of sellers to make goods available for sale.

• Law of Supply – The higher the price, the larger the quantity supplied.

• Just as with demand, supply uses schedules and curves, which are simply mirror images of their demand counterparts.

Supply Schedule for Dr. Pibb

Five Determinants of Supply

1.The cost of the resources used to make the good – any changes in the cost of a resource used to make a good will effect the supply of that good. Generally, an increase in the price of resources will generally lead to a lessened supply while a decrease in price will lead to an increased supply of goods.

Five Determinants of Supply2. The price of other goods these

resources could make – This really looks at the opportunity cost of making a good. A good example of this is found in WW2, at the beginning of the war silk was used to make stockings but due to the emergency, all silk production was put into military applications. In short, parachutes were deemed more important than stockings so that their supply dropped while parachute production increased. In an effort to restore the equilibrium, cosmetics manufacturers who had materials not critical to the war effort put them to use and developed leg paint.

Supply and Demand in a Wartime Economy

Silk and Nylon Stockings

WW2 brought changes to America as everyday items became scarce form rationing and military requirements became paramount. Women were asked to give up their stockings and the government wanted them to know why.

• Leg paint was a substitute good. Even though it never really was popular the wartime emergency took precedence and women complied. Today leg paint is being reintroduced to American woman…again.

• DuPont introduced nylon stockings to American women in 1939 at the world’s fair. A pair sold for $1 at the time and were liked because they came in more colors than silk and were a bit more run resistant.

• Around the same time nylon went into full scale production in the US, WWII was raging in Europe. Nylon was found to be the perfect replacement for silk in the manufacture of parachutes. It was just as light but stronger and far cheaper to produce. It was also used for ropes, tents, ponchos and tires. Even though nylon stockings were introduced in 1940, they were still a scarce commodity and the ladies had to wait until after the war as the majority of nylon fibers produced went into the war effort.

• Commodities in the United States were all rationed for the duration. Pricing and disbursement were at the control of the OPA or Office of Price Administration. Below is a sample of rationing booklets that all Americans were required to have.

• Gasoline was not in short supply but rubber was. The idea behind rationing was to eliminate unnecessary trips and conserve rubber. At this point most of the rubber plantations of Asia were in control of the Japanese. While Nylon helped to reduce or dependence on this source of rubber it was not enough to meet the demands of the civilian population as well as military Note the urging to keep your speed at 35 as a way to make tires last longer.

Five Determinants of Supply3. Changes in Technology –

Advances in technology tend to make supplies more readily available. Generally, advances in chemistry, biology and electronics create new products like cell phones or increase the quality of existing products like TVs. In the picture with leg paint, it was soon replaced by the introduction of a new product nylon. This new product replaced silk in parachutes, airplane tires and other applications and allowed women to get nylons but not in their pre-war quantities.

Five Determinants of Supply4. Producer expectations –

Transforming natural resources into finished products is what producers do. If at any point they feel there is more profit to be made by converting those resources into a more profitable product then there will be a ripple effect on supply. For example, with an increase in the demand for ethanol and more demand for corn many wheat farmers are shifting production into that field. The net result is more corn production but less wheat production. The diminished supply in this market translates into higher prices to the consumer.

Five Determinants of Supply5. Changes in the number of

sellers in a market – In the past the government has regulated markets which keeps them artificially small. However for the last thirty years it has been the government's policy to deregulate markets such as trucking, banking, telecommunications and airlines. In essence this has allowed the number of firms in this field to expand and with it the supply of the product.

(One Ringy-Dingy)

Supply and Demand Together

• When we combine Demand and Supply curves together we develop a very helpful tool to aid us in understanding how a market works. Where the two curves intersect is known as the equilibrium point, or the point where quantity supplied equals quantity demanded (Qs=Qd).

• This is almost a mythical point as sit is in a continued state of flux changing with seasons or prevailing preferences. Generally, the market will be out of alignment. When you have a price that is too much you will find yourself north of equilibrium which results in a surplus.

Supply and Demand Together

Supply and Demand Together• The only way the market can return to

equilibrium is to lower the price of the commodity. When the price for an item it too low you have a much more serious problem in that you now have a shortage. When this occurs, you must raise the price of the good.

• This serves as a rationing mechanism eliminating demand by those people not wanting to pay that high a price. This is the general layout of all S&D curves that you will see in this and subsequent economics courses. These curves were first used in the 1890s and have remained virtually unchanged since then.

The Interaction of Supply and Demand

When we see changes in both supply and demand we are experiencing the interaction in a market. When this occurs we will see changes in both the price and quantity. To demonstrate how this works lets look at the curve.

Let us say the gasoline hits $8 a gallon and consumers begin to scream to the Congress for relief. A compliant Congress agrees and decrees a price ceiling of $4 a gallon. That will happen in the above market? At eight dollars a gallon the market was in equilibrium and we were supplied with all the gasoline we required.

•However, at the new price of $4 the law of demand tells us that consumers will demand more gasoline as it is seen as a better deal.

•Facing that is the law of supply that states as the price goes down so to will be amount supplied. The net result in this market is that we will have a shortage of gasoline resulting in long lines at the pump and a very nervous population wondering when or where they will be able to fill their tanks. In this case the government must restore market equilibrium artificially by rationing gasoline to reflect the new lower levels of supply. This was done in WW2 and every car got a sticker to put in the windshield.

Price Floors• While price ceilings are the rarer of the two

interventions, price floors have happened quite regularly in the field of agriculture. Lets look at how this works: Say that wheat farmers are complaining to Congress that they cannot make a profit when the market price for a bushel of wheat is $3.When you factor in costs of pesticide, irrigation, equipment and time farmers are unable to grow the product at that price. Congress agrees to institute a price floor which means that the price established is the lowest price the commodity can sell for. If Congress decides that $5 is the new price what will occur?