Supply and Demand

Introduction

The abstract model of markets and perfect competition assumes:

  1. uniform price throughout market
  2. perfect information
  3. large number of buyers and sellers
  4. price takers
These assumptions never are met completely.  Models are judged by the accuracy of their predictions, not by the realism of their assumptions.  If the assumptions do not hold completely the conclusions are not totally invalid, in fact they may be substantially correct.  The results will not be mathematically precise, but will still give general conclusions that may be evaluated.

Demand -- Consumer Choice

Most people will attempt to obtain most satisfaction/dollar spent

law of demand

law of demand -- ceteris paribus, the quantity of a good demanded (Qd) by buyers tends to rise as the price (P) of the good falls, and to fall as the price of the good rises

P rises - Qd falls; P falls - Qd rises

as price rises - opportunity cost rises
as price falls - opportunity cost falls

common sense idea! -- inverse relationship

Economists state the common sense idea with somewhat more care.

demand -- quantity of a good or service that consumers are willing and able to purchase during a specified time period,  ceteris paribus

demand curve

With a demand curve one holds all other factors constant except price.  This gives us an economic model of how price affects quantity demanded exclusively -- isolates on the impact of price

depicts the relationship between price and quantity demanded
 

        P                                           Q
Hot Dogs/lb.                    Hot Dogs/month

    $0                                            25
      1                                            20
      2                                            15
      3                                            10
      4                                              5

notice that the axes are "flipped" (independent variable is on the vertical axis and the dependent variable is on the horizontal axis) -- makes no technical difference

change in quantity demanded versus a change in demand

when the price of the product changes the quantity of the good which consumers are willing and able to purchase changes -- this is a ”change in quantity demanded"

graphically, a change in quantity demanded is illustrated by a movement along a demand curve

If any of the "other" factors (which influence demand), other than price change, a "change in demand" occurs.

A "change in demand" influences the whole demand relationship relative to price.  This is illustrated by a shift in a demand curve.

The graph below illustrates an increase in demand:

The graph below illustrates a decrease in demand:

factors other than price which influence demand:

Each of these factors will cause the entire demand curve to be displaced, to shift.  This shifting is illustrated in the diagrams above.

1.  consumer Incomes

If consumer incomes increase with a normal good -- demand will increase

If consumer incomes fall with a normal good -- demand will decrease

for example, if the commodity is a normal good and you lose your job because of a recession, demand will fall:

normal good -- increase in consumer income increases demand and vice versa
inferior good -- increase in consumer income decreases demand and vice versa

2.  price of other goods:

complementary goods -- goods for which the increase (decrease) in price of one results in the decrease (increase) in demand of the other good

e.g. lamps/light bulbs

If the price of lamps fall, more light bulbs will be needed to fill the incresed number of lamps.  More light to the world!

substitute goods -- a pair of goods for which the increase (decrease) in price of one results in the increase (decrease) in the demand of the other.

e.g. butter/margarine, Chevy/Fords

The price of butter sky-rockets as a bovine shortage engulfs the nation.  The demand for margarine will increase:

3.  time is an important element in the response of buyers to a price increase

e.g. price of gas increases, in SR must use more gas, but, as time passes adapt to smaller cars, the demand for large gas guzzlers falls.

4.    tastes -- change therefore demand increases or decreases depending on whether consumers like or dislike the product

Supply -- Producer Choice

Most firms will attempt to produce the amount of product that maximizes profit

law of supply

law of supply -- the quantity of a good supplied by sellers tends to rise as the price of the good rises, and to fall as the price of the good falls

supply -- gives quantities of a specific good producers will produce at various price levels, ceteris paribus.

supply curve

depicts the relationship between price and quantity supplied

        P                                            Q
Hot Dogs/lb.                    Hot Dogs/ month

    $0                                               0
      1                                               5
      2                                             10
      3                                            15
      4                                             20
      5                                             25
 


shows the specific quantity of a good or service that suppliers are willing and able to provide at different prices

exhibits positive slope due to profit (excess of sales revenue relative to cost of production) motive

change in quantity supplied versus a change in supply

when price of the good changes a change in quantity supplied results -- "movement along" a supply curve

if price were to increase:

when we have a factor "other" than price of good in question change a change in supply results -- shift in the supply curve

if a factor other that price causes supply to increase the entire curve shifts to the right:

if a factor other that price causes supply to decrease the entire curve shifts to the left:

factors which affect position of supply curve:

Each of these factors will cause the entire supply curve to be displaced, to shift.  This shifting is illustrated in the diagrams above.

1.  technology -- if technology improves (higher output per unit of resource) supply increases
2.  input prices -- if input prices rise supply falls

3.  prices of other goods -- price of another good (opportunity cost) rises supply falls
Supply and Demand

market -- an abstract concept that encompasses the trading arrangements of buyers and sellers that underlie the forces of supply and demand

market -- an institutional arrangement aiding the buying and selling of goods and services that spontaneously develops when people are allowed to freely exchange their labor time and the fruits of their work

equilibrium -- quantity demanded equals quantity supplied at a given price, a state of balance between supply and demand

equilibrium price -- the price that equates the quantity demanded and the quantity supplied

supply and demand analysis

        P                                    Qs                                  Qd
Hot Dogs/lb.             Hot Dogs/month            Hot Dogs/month
        0                                        0                                  25
        1                                        5                                  20
        2                                      10                                  15
      *2.5                                   12.5                               12.5
        3                                      15                                  10
        4                                      20                                    5
        5                                      25                                    0

If Qd not equal to Qs there will be a tendency for market price to rise or fall until an equilibrium is reached

Qd > Qs

as inventories fall firms increase price (recognize that some consumers are willing to pay more therefore P rises) therefore Qs rises and Qd falls -- movement along both curves

Qs > Qd

as inventories increase firms decrease price (realize this must occur to maintain sales and profits) therefore Qs falls and Qd increases -- movement along both curves

"markets are stable"!

repealing the "LAWS" of supply and demand

have prices set by legislative action

price ceiling -- a legally established maximum price that sellers may charge

shortage will result

price system (rationing) is interrupted! non price factors will be important in the rationing process

Sellers can afford to be more selective

reduce the incentives of producers to supply - resources flow to other sources

price floor -- legally established minimum price that buyers must pay for a good or resource

surplus will result

e.g. Ag. price supports, minimum wage laws

non price factors are again important

buyers can be more selective

unsold merchandise and underutilized resources will result