Chapter 4 Supply and Demand - An Initial Look

Supply and Demand:
4
An Initial Look
PowerPoint Slides prepared by:
Philip Heap, James Madison University
Copyright ©2016 Cengage Learning. All Rights Reserved. May not be scanned, copied
or duplicated, or posted to a publicly accessible website, in whole or in part.
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The Invisible Hand
• Adam Smith and the “Invisible Hand”
• By pursuing their own self-interests, people in a market
system are “led by an invisible hand” to promote the
well-being of the community
• Self-interest does not mean selfish
• “Invisible hand” means not people’s intent
• What happens when we interfere with the market?
• Usury laws, laws against scalping
Copyright ©2016 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 2
Demand and Quantity Demanded
• Quantity demanded
• Number of units of a good that consumers are willing and
can afford to buy over a specified period of time
• Depends on price, other things equal
• Demand schedule
• A table that shows how the quantity demanded changes
as the price changes, other things equal
• Shows the relationship between price and quantity
demanded, holding other determinants constant
Table 1 Demand Schedule for Beef
What happens to
quantity demanded as
price falls (rises)?
• Demand schedule
• As price rises (falls), quantity demanded (falls) rises
• Demand Curve
• A graphical representation of a demand schedule
Figure 1 Demand Curve for Beef
D A
$7.50
B
7.40
C
7.30
Price per Pound
E
7.20
F
7.10
G
7.00
H
6.90
D
0 45 50 55 60 65 70 75
Quantity Demanded in Millions of Pounds per Year

• Shifts of the Demand Curve
• Do not confuse movements along a demand curve with
shifts of the demand curve
• A change in the price of a good: movement
• A change in other variables: shift
Figure 2 Movements along versus Shifts of a Demand
Curve
D0 D1
$7.30 C
Price per Pound
7.10 F
D0 D1
0 Quantity Demanded in Millions of Pounds per Year
• What can cause the demand curve to shift?
• Consumer Income
• Population: size and composition
• Consumer Preferences (Tastes)
• Prices of related goods
• Substitutes
• Complements
Figure 3 Shifts of the Demand Curve: Increase
Beef market
D1 Consumer incomes increase
D0 Price of pork rises
Price of hamburger buns falls
Price
“Eating beef good for your health”
D1
D0
Quantity demanded
(a)
Figure 3 Shifts of the Demand Curve: Decrease
Beef market
Consumer incomes decrease D0

D2
Price of pork falls
Price of buns rises
Price
“Eating beef increases
cholesterol”
D0
D2
Quantity
(b)
Supply and Quantity Supplied
• Quantity supplied
• Number of units of a good that producers want to sell
over a specified period of time
• Depends on the price, other things equal
• As the price rises (falls), quantity supplied rises (falls)
• Why?
• Supply schedule
• A table that shows how the quantity supplied changes as
the price changes, other things equal
Table 2 Supply Schedule for Beef
• Supply curve
• A graphical representation of a supply schedule
• Shows the relationship between price and quantity
supplied, holding other determinants constant
Figure 4 Supply Curve for Beef
S
$7.50 a
7.40 b
7.30
Price per Pound
7.20 e
7.10 f
7.00 g
6.90 h
S
0 30 40 50 60 70 80 90
Quantity Supplied in Millions of Pounds per Year
• Shifts of the Supply Curve
• Do not confuse movements along a demand curve with
shifts of the demand curve
• A change in the price of a good: movement
• A change in other variables: shift
Figure 5 Movements along versus Shifts of a Supply
Curve
S0
S1
$7.30 c
Price per Pound
7.10 f
S0 S1
0 Quantity Supplied in Millions of Pounds per Year
• What can cause the supply curve to shift?
• Industry size: # firms
• Technological progress
• Prices of inputs
• Prices of related outputs: multiproduct industries
Figure 6 Shifts of the Supply Curve: Increase
Beef market
More ranchers
S0 New growth hormone
Price feed falls
Price
S1 Price of leather falls
S0
S1
Quantity
(a)
Figure 6 Shifts of the Supply Curve:
Decrease
Beef market
Less ranchers S2
Price feed rises
Price of leather rises S0
Price
S2
S0
Quantity
(b)
Supply and Demand Equilibrium
• Supply-demand diagram
• Graphs the supply and demand curves
• Determines the equilibrium price and quantity
• Shortage
• Excess quantity demanded over quantity supplied
• Buyers cannot purchase what they desire at current price
• When there is a shortage the price will increase
• Surplus
• Excess quantity supplied over quantity demanded
• Sellers cannot sell what they desire at current price
• When there is a surplus the price will decrease
• Equilibrium
• Quantity demanded is equal to quantity supplied
• No inherent forces that produce change
• Equilibrium will occur as a result of “outside events”
Table 3 Determination of the Equilibrium Price and
Quantity of Beef
Figure 7 Supply-Demand Equilibrium
D S
A
$7.50 a
How much is the
7.40
surplus?
7.30
Price per Pound
E
7.20
7.10
g G How much is the
7.00
shortage?
6.90
S D
0 30 40 50 80 90 60 70
Quantity in Millions of Pounds per Year
• The Law of Supply and Demand
• In a free market, forces of supply and demand push the
price towards equilibrium
• Quantity demanded = Quantity supplied
• Markets may have long term shortages or surpluses
Effects of Demand Shifts on Equilibrium
What happens to the equilibrium price and quantity when

demand shifts?
• Demand shifts outward (right)
• Equilibrium price rises and quantity rises
• Demand curve: Shifts inward (left)
• Equilibrium price falls and quantity falls
Figure 8 The Effects of Shifts of the Demand Curve
Price per pound

Price per pound
D1
D0 S D0 S
D2
T
$7.30
E R L E
7.20 $7.20
7.10 M
D1
S D0 S D0
D2
60 70 75 45 50 60
Quantity Quantity
(a) (b)
Effects of Supply Shifts on Equilibrium
What happens to the equilibrium price and quantity when

supply shifts?
• Supply shifts outward (right)
• Equilibrium price falls and quantity rises
• Supply shifts inward (left)
• Equilibrium price rises and quantity falls
Figure 9 Effects of Shifts of the Supply Curve
S2
Price per pound
D S0 D
V S0
Price per pound

$7.40
S1
E U E
$7.20 7.20
J I
7.10 S2
S0
S1 D D
S0
60 65 78 37.5 50 60
Quantity Quantity
(a) (b)
Who Really Pays That Tax?
• Suppose the government imposes a gasoline tax of 10 cents
imposed on seller.
• Does the price increase by 10 cents?
• What happens to the supply curve?
• The tax decreases supply – shift up by 10 cents
Figure 10 Who Pays for a New Tax on Products?
S1
D
Price per gallon
M S0
$2.64
E1
2.60
2.54
S1
E0
S0 D
Q2 Q1
30 50
Millions of gallons per year
• Suppose the government imposes a gasoline tax of 10 cents
imposed on seller.
• The price will increase but by less than 10 cents
• Price increased from $2.54 to $2.60
• Consumers pay 6 cents of the tax (2.60 – 2.54)
• Sellers pay 4 cents of the tax (2.54 – 2.50)
Figure 10 Who Pays for a New Tax on Products?
S1
D
Price per gallon
M S0
$2.64
E1
2.60
2.54
S1
E0
S0 D
Q2 Q1
30 50
Millions of gallons per year
• In most cases, a tax on any good will be paid partly by
consumers and partly by producers.
Battling the Invisible Hand
• What happens when those in government are not satisfied
with the market outcome?
• Government can impose constraints on market prices by
imposing price ceilings or price floors.
• How does the market fight back?
Price Ceilings
• Price Ceilings
• A maximum that the price charged for a commodity
cannot legally exceed
• Imposed when authorities believe the market price is
“too high”
• Consequences
1. Persistent shortage develops since quantity demand
exceeds quantity supplied
• Leads to inefficient allocation methods: queuing,
rationing
Price Ceilings
• Consequences cont.
2. An illegal or “black market” often arises
• Scalping of concert, sports tickets
3. Illegal market prices higher than the market price
• Illegal drugs
4. A portion of the illegal price ends up in the hands of the
illicit supplier – not the producer of the good
5. A decrease in investment in the industry
• Agricultural price controls in Zimbabwe
Rent Controls in New York City
• Market rent is $2,000 per month. Government imposes a
rent ceiling of $1,200. What are the consequences?
Figure 11 Supply-Demand Diagram for Rental
Housing
D S
Rent per month
E
Market rent
$2,000
B
Rent ceiling
1,200
C
S D
2.5 3 3.5
Millions of dwellings rented per month
Rent Controls in New York City
• Market rent is $2,000 per month. Government imposes a
rent ceiling of $1,200 . What are the consequences?
• End up with a shortage of 1 million apartments
• Black market prices: bribes, key money, other add-ons
• Property owners/landlords may do what?
• Convert apartments to office space and other uses
• Inadequate maintenance
• Abandon buildings
• Rent controls impose costs that offset part/all the benefits
• So why do rent controls persist?
Price Floors
• Price Floors
• A legal minimum below which the price charged for a
commodity is not permitted to fall
• Imposed when authorities believe the market price is
“too low”
• Symptoms
1. Surplus develops because sellers cannot find enough
buyers
Price Floors
• Symptoms cont.
2. Surplus of goods leads to problem of disposal
• U.S. purchase of agriculture surplus
3. Sellers may offer disguises and unwanted discounts
• Airline fares under regulation
4. Over investment in the industry
Farm Price Supports: Sugar Prices
• “Temporary method of dealing with an emergency” (1933)
• The “emergency” still with us today
• Consequences
• Unsellable surpluses purchased by government
• Taxpayer pays twice: taxes and higher prices
• Shipped surplus to poor foreign countries
• Good or bad for these countries?
• Sugar Policies
• Low interest loans
• Guarantee that price would not fall below some level
• To maintain “price floor”
• Limited domestic production
• Restricted imports
Figure 12 Supporting the Price of Sugar
S1
D S0
50¢
Price
25¢
S1
D
S0
Quantity
• Sugar Policies
• So by restricting supply, price stays high
• Who gains and who loses?
• Sugar producers win
• Consumer pay: higher sugar, candy soda … prices
A Can of Worms
• Other problems with price controls
• Favoritism and Corruption
• Who gets to buy/sell the available limited quantity
• Unenforceability
• Too many suppliers and attempts to evade increase
costs and prices
• Auxiliary restrictions
• Additional regulations to maintain price controls
A Can of Worms
• Other problems with price controls cont.
• Limitation of Transaction Volume
• Same for both ceilings and floors
• Misallocation of resources
• Farmers feed animals bread instead of grain
A Can of Worms
• Free markets efficiently deal with the “how, what, for whom”
• Government’s attempt to correct for flaws in the market

mechanism can cause more serious damage.

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Supply and Demand:

Quantity Demanded in Millions of Pounds per Year

0 Quantity Demanded in Millions of Pounds per Year

“Eating beef good for your health”

Consumer incomes decrease D0

0 Quantity Supplied in Millions of Pounds per Year

S1 Price of leather falls

What happens to the equilibrium price and quantity when

Price per pound

What happens to the equilibrium price and quantity when

Price per pound

Millions of dwellings rented per month

• Government’s attempt to correct for flaws in the market

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