Supply and Demand

Key issues

• demand• supply

• market equilibrium• shocking the equilibrium

• effects of government interventions• when to use supply and demand model

Today's questions

What is the effect of a ban on foreign imports of rice into Japan on the supply of rice to the Japanese market?What is the effect of a price control (ceiling)? What is the effect of instituting usury laws? Could the Immigration Reform and Control Actcreate a labor shortage for farmers?

Will the mad cow crisis lower beef prices in theUnited States?

1.

2.3.4.

5.

1

What is the most important thingyou know about economics?

• many people replysupply equals demand

• this statement summarizes a simple, yet powerful model

Supply and demand model

• most widely-used economic model• testable (like all good theories)

• describes how consumers and suppliers interact in a market to determine quantity of a good sold and its price

To use supply and demand model

• you need to determine• buyers' behavior• sellers' behavior

• how they interact

• know where to use the model:

in competitive markets

2

Quantity demanded

is the amount of a good or service thatconsumers want to buy at a given price, holding constant other factors that affect demand

What determines demand?

••

••

••

•

tastesprice of this good

prices of other goods

income

information (cholesterol)government actions

other factors: nicotine, ...

Demand curve

• shows quantity demanded—largest quantity thatconsumers are willing to buy—at each price, holding constant other factors that affect purchases

note: quantity demanded of a good or service can exceed quantity sold (or vice versa)strange demand curve convention: price is on the vertical axis

•

•

3

Figure 2.1 Demand Curve for Canadian Processed Pork

p , $ per kg

14.30

4.30

3.30

2.30

0 200 220 240 286

Q, Million kg of pork per year

Effect of price changes

• movement along the demand curve• demand curve is a concise summary of

the answer to the question:what happens to the quantity demanded as the price changes, holding all other factors constant?

Law of demand

• demand curves slope down

• a drop in price results in an increase in quantity demanded (holding other factors

constant)• one of the most important empirical findingin economics

4

Demand curve for pork, D1

Demand effects of other factors

• change in any factor other than the price ofthe good causes a shift of the demand curve(not a movement along the demand curve)

• this shift of the demand curve is a trick to avoid drawing 3D diagrams

Effect on pork demand of a risein price of beef

• beef is a substitute for pork

• at a given price of pork, a rise in the price of beef causes some people to switch from

beef to pork

Figure 2.2 A Shift of the Pork Demand Curve

p, $ per kg

3.30

D 2

0 176 220 232

Q, Million kg of pork per year

5

Effect of a 60¢ increase in the price of beef

D D1

Summary

• change in the price of a good causes amovement along a demand curve

• change in any other factor besides the price causes a shift of the demand curve

Variable definitions

• Q = quantity of pork demanded (million kgper year)

p = price of pork ($ per kg)pb = price of beef ($ per kg)

pc = price of chicken ($ per kg)

Y = income of consumers (thousand $)

••

••

Demand function

• general functionQ = D(p, pb, pc, Y)

specific (linear) pork demand functionQ = 171 - 20p + 20pb + 3pc + 2Y

•

6

Hold other factors constant

• D1 (Figure 2.1) holds pb, pc, and Y at their typical values:

pb = $4 per kgpc = $3 1/3 per kg

Y = $12.5 thousand• Q = 171 – 20p + 20pb + 3pc + 2Y

= 171 – 20p + (20 x 4) + (3 x 3 1/3) + (2 x 12.5)= 286 – 20p

Figure 2.1 Demand Curve for Canadian Processed Pork

p , $ per kg

14.30

4.30

3.30

2.30

0 200 220 240 286

Q, Million kg of pork per year

Plotting demand function:Intercept

• Q = 286 – 20p

• constant term, 286, is the quantity demanded if price is zero

• Q = 286 - (20 x 0) = 286• D1 hits quantity axis at 286 (price = 0)

7

Demand curve for pork, D1

Plotting demand function: Slope

• Q = 286 – 20p• number on price, 20, is rate at which quantity changes as price

changesQ = Q2 - Q1 = D(p2 ) – D(p1 )

= (286 – 20p2 ) - (286 – 20p1 )= -20(p2 – p1) = -20 p

• p = $1Q = -20 p = -20 million kg per year

Slope of pork demand curve

• p/ Q = [the "rise"]/[the "run"]= [$1 per kg]/[-20 million kg per year]

= -$0.05 per million kg per year• negative sign is consistent with Law of

Demand

Calculus

• Q = 286 – 20p• differentiate:

dQdp

20

8

Summing demand curves

• total demand is sum of demand for all consumers

• suppose there are 2 consumers with demand curves:Q1 = D1(p) Q2 = D2(p)

• total quantity demanded = horizontal sum of quantity each consumer demands at each given price:

Q = Q1 + Q2 = D1(p) + D2(p)

Application Aggregating the Demand for Cling Peaches

p, $ per ton

275

183

0 Q = 4 Q = 18 Q = 22

50f c

Q, Tons of peaches per 10,000 people per year

Quantity supplied

is the amount of a good or service that firmswant to sell at a given price, holding constant other factors that affect supply

9

Demand for

fruit

Total demand

Demand for canned peaches

cocktail

Supply is a function of

••

••

pricecosts of production

government rules and regulations

technology…

Supply curve

increase in price of pork causes a movement along the supply curve (holding fixed other variables that affect supply)supply curve is a concise summary of answer to the question:what happens to the quantity supplied as the price changes holding all other factors constant?

•

•

Figure 2.3 Supply Curve of Canadian Processed Pork

p, $ per kg

5.30 Supply curve, S 1

3.30

0 176 220 300

Q, Million kg of pork per year

10

Effect of price on supply

• supply curve for pork is upward sloping• thus, increase in the price of pork

movement along the supply curve, resultingin larger quantity of pork supplied

There is no "Law of Supply"

market supply curve may be upwardsloping, vertical, horizontal, or downward sloping

Supply effects of other variables

shift in a variable other than price of porkcauses the entire supply curve to shift

11

Figure 2.4 A Shift of Pork Supply Curve

p , $ per kg

S 1

3.30

0 176 205 220

Q, Million kg of pork per year

Summary

• change in price of pork causes a movementalong the supply curve

• when costs, government rules, or other variables that affect supply change, the supply curve shifts

General supply function

Q = S(p, ph),

Q = the quantity of processed pork supplied(million kg per year)

p = price of processed pork ($ per kg)ph = price of a hog ($ per kg)

12

Effect of a 25¢ increase in the price of hogs

S 2

Specific linear pork supplyfunction

Q = 178 + 40p - 60ph,

holding ph fixed at its average value of$1.50 per the supply function is

Q = 88 + 40p

Movement along the supplycurve

• supply function:Q = 88 + 40p

• if price of processed pork increases byp = p2 - p1

• then

Q = 40 p

Calculus

• Q = 88 + 44p• differentiate:

dQdp

44

13

Summing supply curves

total supply curve• horizontal summation of individual

supply curves

• shows total quantity produced by all suppliers at each possible price

Total Supply: The Sum of Domestic and Foreign Supply

(a) Japanese Domestic Supply (b) Foreign Supply (c) Total Supply

p , Price ce on

rice tonper ton )

p * p* p *

p p p

Q *d

Q *f

Q , Tons per yearf

Q * = Q * + Q *d f

Q, Tons per yearQ , Tons per yeard

Solved problem

• What is the effect of a ban on foreignimports of rice into Japan on the supply curve of rice to the Japanese market?

• (suppose that domestic and foreign supplycurves of rice in Japan are linear, upward sloping curves with the same intercept and different slopes)

14

S (no banp, PSf (no ban) per

p, PriSd per t

Restatement of problem

• in most of our problems we are asked todetermine how a change in a variable or policy affects one or more variables

• what changes: foreign rice may no longer be imported

• which affects foreign supply and totalJapanese supply curve

Answer

1. s how what the ban does to the foreign supply: banprevents imports new foreign supply curve, Sf,

lies on the vertical axis

2. compare the new and original foreign supply curves: at prices above the price where foreign supplier originally supplied quantity, the new foreign supply curve lies to left of original one

Answer (continued)

3. s how what happens to new total supply: new total supply curve is the horizontal sum of the Japanese supply curve, Sd, and foreign supply curve, Sf. Thus, new total supply curve is identical to domestic supply curve

4. compare new and original total supply curves: at any price above the price where any quantity was originally supplied by foreign suppliers, the new total supply curve lies to the left of the original one

15

Figure 2.5 Total Supply: The Sum of Domestic and Foreign Supply

(a) Japanese Domestic Supply (b) Foreign Supply (c) Total Supply

p , Price ce on

rice tonper ton )

p * p* p *

p p p

Q *d

Q *f

Q , Tons per yearf

Q = Q * Q * = Q * + Q *d d f

Q, Tons per yearQ , Tons per yeard

Quota

next figure shows the effect of a (nonzero)quota on the supply curve of rice

(a) U.S. Domestic Supply (b) Foreign Supply (c) Total Supply

rice ton

p, Price per ton

ice ton

Sf

p* p* p*

p p p

Q Q * Q Q* Q + Q Q * + Q Q *+ Q *

d dQ , Tons per year

d

f fQ , Tons per year

f

d f d f d f

Q, Tons per year

16

S

S

p, Prper

S d

Sf p, P

per

S (ban) S (no banp, PriSd per t

p, PSf (ban) Sf (no ban) per

Supply and demand: Marketequilibrium

supply and demand curves determine market price and quantityunless price is set so that consumers want to buy exactly as much as suppliers want to sell, some party will be frustratedwhen neither buyers nor sellers are disappointed, market is in equilibrium: no one wants to change his or her behavior

•

•

•

Equilibrium

• equilibrium price: price where• consumers can buy as much as they want

• sellers can sell as much as they want

• equilibrium quantity:quantity bought andsold at the equilibrium price

Figure 2.6 Pork Market Equilibrium

p , $ per kg

Excess supply = 39

3.95

3.30

2.65

0 176 194 207 220 233 246

Q, Million kg of pork per year

17

ExcessS

D

e

Excess demand = 39

Determine equilibrium price

• find price, p, that equates equilibrium demand and

supply quantity: Qd = Qs = Q, equilibrium quantity:• Qd = 286 - 20p (demand function)

• Qs = 88 + 40p (supply function)• Qd = 286 - 20p = 88 + 40p = Qs

286 - 88 = 40p + 20p198 = 60p

3.30 = p

Determine equilibrium quantity

• substitute equilibrium price, p = $3.30, intodemand function or supply function to determine equilibrium quantity:

• Qd = 286 – (20 x 3.30)

= 88 + (40 x 3.30) = Qs

= 220 = Q

Invisible hand

at nonequilibrium price, consumers or firmschange their behavior (market forces)driving price to equilibrium level

18

Market forces drive market toequilibrium

• at prices < equilibrium level: excess demand (amount by which quantity demanded exceeds quantity supplied at the specified price)

• at price > equilibrium level: excess supply• equilibrium price is market clearing price:no excess demand or excess supply

Figure 2.6 Pork Market Equilibrium

p , $ per kg

Excess supply = 39

3.95

3.30

2.65

0 176 194 207 220 233 246

Q, Million kg of pork per year

Shocking the equilibrium

• once an equilibrium is achieved, it canpersist indefinitely because no one applies pressure to change the price

• equilibrium changes only if• demand curve shifts• supply curve shifts

• government intervenes

19

Excess

S

D

e

Exce ss demand = 39

Figure 2.7a Effects of a Shift of the Pork Demand Curve

(a) Effect of a 60¢ Increase in the Price of Beef

p, $ per kg

S3.503.30

1

1

0 176 220 228 232

Excess demand = 12Q, Million kg of pork per year

Figure 2.7b Effects of a Shift of the Pork Demand Curve

(b) Effect of a 25¢ Increase in the Price of Hogsp , $ per kg

e2

3.553.30

1

0 176 205 215 220

Excess demand = 15Q, Million kg of pork per year

Government policies

• ceiling price• price controls• usury laws

• rent control

• floor price: minimum wage

• quotas (restriction on supply)• taxes and tariffs (tax on imports only)

20

S2

S 1

e

D

e2

e D2

D

Zimbabwe price controls

October 2001 during a presidential campaign, Zimbabwe’s government imposed price controls on many basic commodities• foods (about a third of citizens’ daily consumption)• soap• cement

controls led to shortagesthriving black or parallel market developed black market prices 2 to 3 x controlled prices

•

•••

Zimbabwe: Cement

• cement manufacturers stopped accepting new

orders when price controls were imposed

dealers quickly shifted existing supplies to theparallel market

lack of cement crippled the construction industry

by May 2002, the government nearly doubledcontrol price of cement in an effort to induce firms

to resume selling cement

•

•

•

Zimbabwe: Food

sugar is significantly cheaper than in surrounding regions• smuggling to other countries• Zimbabwe suffered from sugar shortage

supermarkets have no maize-meal, sugar, and cooking oil on many daysbakers scaled back operation--they have only half as much flour as before controlsbecause of shortages, many people may starve

•

•

•

•

21

Solved problem: Minimum wage

• What is the effect of a minimum wage on alabor market?

• restatement:

• what changes is that government sets a minimum wage, w*, that must be paid

• affects equilibrium wage, equilibrium hours worked

Minimum Wage

w, wage

w*

w

H d Hs H, Hours worked

H

Excess supply: Unemployment

Supply need not equal demand

• price ceilings or price floors quantity supplied

does not necessarily equal quantity demanded

• quantity supplied = amount firms want to sell at a given price, holding constant other factors that affect supply

• quantity demanded = amount consumers want to buy at a given price, holding constant other factors

22

S

Minimum wage

e

D

Permanent excess demand orsupply

quantity demanded and quantity supplied at a given price need not equal actual quantity that is bought and sold:

can get persistent excess demand (price ceiling)

can get persistent excess supply (price floor)

•

•

Supply equals demand

if someone insists that "demand must equalsupply," they must be defining demand and supply as the actual quantities sold

we define quantities supplied and demanded in terms of peoples' wants

thus, statement that "supply equals demand" is a theory, not merely a definition

•

•

When to use supply and demandmodel

• many buyers and sellers• firms sell identical goods• firms are price takers

• no uncertainty: everyone has full information about price and quality of goods• low transaction costs: buyers and

sellers can trade easily

23

When supply and demand modelis inappropriate

• only a few sellers (auto manufacturers)

• buyers and sellers are uncertain about the market equilibrium (concert music business)

• consumers know much less than sellers about quality or price (used cars)

• high transaction costs (art work)

Use supply and demand model in

••

••

••

•

agricultural marketsfinancial

labor

construction

services

wholesale

retail

1 Demand curve summary

demand curve: relationship between quantity demanded and price, fixing other factorsLaw of Demand: demand curves slope down change in price causes a movement along the demand curvechange in income, tastes, or another factor other than price, causes a shift of the demand curvetotal demand curve = horizontal sum of individuals’ demand curves

•

••

•

•

24

2 Supply curves

supply curve: relationship between quantity supplied and price, holding constant other factors market supply curve need not slope up butfrequently does

change in price causes a movement along the supply curveshift in the price of an input or government regulations cause a shift of the supply curvetotal supply curve = horizontal sum of individual firms’ supply curves

•

•

•

•

•

3 Market equilibrium

• intersection of demand and supply curvesdetermines market equilibrium price and quantitymarket force drive the price and quantity to the equilibrium levels if they are initially too low or too high

•

4 Shocks

change in an underlying factor other thanprice that causes a shift of the supply curve or the demand curve, alters the equilibrium

25

5 Effects of governmentintervention

government policies, such as price controls, can cause the quantity supplied to be greater or less than the quantity demanded, so that there are persistent shortages or excesses

6 When to use supply anddemand model

• supply and demand model is applicable only in competitive markets

• competitive markets: homogeneous goods, many buyers and sellers (price takers)

26