Supply, Demand, and Equilibrium

Today: An introduction to supply and demand, and how

they relate to equilibrium

Who is very hungry and likes bananas? All the bananas you care to eat for one

person (up to however many I have) NOT extra credit, since you get free bananas

You are eating bananas at your own risk You are not allowed to share bananas

with anyone else Please report to me how many bananas

you eat in about 40 minutes

Previously The 7 Core Principles Thinking like an economist Marginal cost and benefit Working with graphs

Today: Markets Supply, demand, and equilibrium What causes shifts in supply and

demand? What happens when supply and/or

demand shifts?

Central organization versus Markets Central economic organization is

rare today Most economic activity today

occurs in markets Markets do fail sometimes, but this

is the focus of other chapters (e.g. Chapters 8 and 10)

Markets Markets consist of buyers and sellers Assume many buyers and many

sellers Fractional amounts of goods can be

produced We will talk about supply and

demand for most markets Exceptions will be dealt with accordingly

as we get to them

Core principle related to demand Cost-benefit analysis

Recall energy drinks example Think “reservation price” when you think

“willingness to pay” (“WTP”)

Demand Demand states how much of a

good that buyers are willing to purchase given each price

Demand is typically shown on a graph, but it is occasionally displayed on a table

Demand A fundamental characteristic of demand is

that as the price of a good increases, demand typically goes down (all else constant) Recall that WTP for energy drinks decreases as

you consume more Thus, each demand curve is downward

sloping if we graphed it By convention, quantity is on the horizontal

axis and price on the vertical axis

Core principles related to supply Increasing opportunity cost

We want to produce at the lowest cost for each additional unit

Also called “low-hanging-fruit” principle Incentive principle

Businesses will supply less when some units are not profitable

Businesses will supply more when producing more could lead to higher profits

Supply Supply states how much of a good

that sellers are willing to sell given each price

Similar to demand, supply is typically shown on a graph

Supply Low-cost sellers typically enter a

market before high-cost sellers Thus, we would expect that the

sellers with lowest cost to sell a particular good

Supply is then assumed to be upward sloping

Discrete versus continuous Although many products can only be

purchased in discrete amounts, we usually assume continuous curves Why? (Come to class to find out)

In this class, most common curve used is linear

We will typically ignore the “discreteness” problem in supply/demand analysis

Graphing supply and demand

Equilibrium principle Another core principle

“No cash on the table” “stable” Nobody can be made better off by

changing her/his decision Does not address potential actions

that groups of people can make Later topic, especially with market failure

Equilibrium: 4 units purchased, at a price of 6

Why is a price of 6 equilibrium? To show that 6 is the equilibrium

price, we will show that prices above and below are not in equilibrium

We will prove by contradiction that this price could not be equilibrium

Suppose that a price (P) of 4 is equilibrium

At P = 4: Quantity demanded is 6, quantity supplied is 3.33

At P = 4: Quantity demanded is 6, quantity supplied is 3.33 When P is 4, people are demanding

a quantity that is higher than what is supplied

Is this an equilibrium? No, this is not stable Someone can increase their

production slightly, and sell at a price of 5 to make more profits

Now suppose that P = 9 is an equilibrium

Now suppose that P = 9 is an equilibrium

Quantity supplied is 6

Quantity demanded is 1

This is not stable either

Someone not selling their entire stock can sell for P = 7 to make more money

A change in supply versus a movement along the supply curve A change in supply leads to a shift of the

entire supply curve A movement along the supply curve can

occur when the supply curve does not move Movement occurs when there is a change in

price Similar ideas apply for changes in demand

versus a movement along demand curves

What causes shifts in demand? Price changes of complements and

substitutes Example of complements: baseballs

and baseball bats Example of substitutes: two different

brands of cola

What causes shifts in demand? Income changes

Most goods are normal goods, meaning that when income increases, the demand curve shifts to the right

Some goods are inferior, meaning that when income increases, the demand curve shifts to the left

Changes in preferences, population, and expected future prices

What is happening here?

What is happening here? The demand

curve shifts to the right

There is a movement along the supply curve, since supply does not change

What is happening here? Note that at any

price, a higher quantity is demanded on curve D2 than on D1

The new equilibrium price (P) and quantity (Q) are higher when demand shifts from D1 to D2

What causes shifts in supply? Anything that changes the cost of

production If the cost of production decreases,

supply shifts to the right If the cost of production increases,

supply shifts to the left A change in number of suppliers Expectations of future prices

What happens when both supply and demand shift? An example: Both supply and

demand shift right

Shift in supply… …causes Q to increase and P to

decrease Movement from A to B

A

B

Shift in demand… …causes Q to increase and P to

increase Movement from B to C

B C

What can we conclusively say about changes in Q and P? Change in supply causes Q to

increase and P to decrease Change in demand causes Q to

increase and P to increase The only conclusion when both

supply and demand shift right is that Q increases

Now that we have talked about supply and demand… …let’s talk about bananas How many bananas did our

volunteer eat today? Why not any more? We will talk about what happened

here on Monday

Summary The intersection of demand and supply

curves determines equilibrium Equilibrium is stable Change in S or D causes the curve to shift A movement along the supply curve can

occur when the supply curve does not move Same with demand

Both supply and demand can shift, but be careful of your conclusions