Supply,Demand, and the Market Process Chapter 3. 1. Consumer Choice and the Law of Demand

Supply,Demand, and the Market Process

Chapter 3

1. Consumer Choice and the Law of Demand

Law of Demand Law of Demand: There is an inverse

relationship between the price of a good and the quantity consumers are willing to purchase. As price of a good rises, consumers

buy less. The availability of substitutes --goods

that do similar functions -- explains this negative relationship.

A market demand schedule is a table that shows the quantity of a good people will demand at varying prices.

Market Demand Schedule

Consider the market for cellular phones. A market demand schedule lays out the amount of cell phones that are demanded in the market for a spectrum of prices.

We can graph these points (price and the respective demand) to make a demand curve for cell phones.

Demand

Market Demand Schedule

Cell Phone Price

(monthly bill)

Millions of Cell Phone Subscribers

$123 2.1 $107 3.5 $ 92 5.3 $ 79 7.6 $ 73 11.0 $ 63 16.0$ 56 24.1

Price(monthly bill)

Quantity(of Cell Phone Subscribers)

140

120

100

80

60

5 10 15 20 25 30

Demand

Market Demand SchedulePrice

(monthly bill)


140

120

100

80

60

5 10 15 20 25 30

• Notice how the law of demand is reflected by the shape of the demand curve.• As the price of a good rises …• . . . consumers buy less.

Demand

Market Demand SchedulePrice

(monthly bill)


140

120

100

80

60

5 10 15 20 25 30

• The height of the demand curve at any quantity shows the maximum price that consumers are willing to pay for that additional unit.

• Here, for the 11th unit . . .

• . . . consumers are only willing to pay up to $73 for it.

• While they would be willing to pay up to $92 for the 5.3 (millionth) unit.

Consumer Surplus Consumer Surplus - the area below the

demand curve but above the actual price paid. Consumer surplus is the difference

between the amount consumers are willing to pay and the amount they have to pay for a good.

Lower market prices will increase consumer surplus.

Consumer Surplus• Lets consider the market for cellular phones again. This time we will assume that the demand for cell phones is more linear and that the market price is $100.


140

120

100

80

60

5 10 15 20 25 30

Demand

• If the market price is $100, then the 25th unit will not sell because those who demand it are only willing to pay $60 for cellular phone service.• At $100, the 15th unit will sell because those who demand it are willing to pay up to $100 for cellular phone service.• At $100, the 10th unit will sell because those who demand it are

willing to pay up to $120 for cellular phone service.

MarketPrice = $100

Price(monthly bill)

Consumer Surplus

• For all those goods under 15 units, people are willing to pay more than $100 for service.

Price(monthly bill)


140

120

100

80

60

5 10 15 20 25 30

Demand

• The area, represented by the distance above the actual price paid and below the demand curve, is called consumer surplus.• This area represents the net gains to buyers from market exchange.

MarketPrice = $100

Elastic and Inelastic Demand Curves

Elastic demand - quantity demanded is sensitive to small price changes. Easy to substitute away from good.

Inelastic demand - quantity demanded is not sensitive to price changes. Difficult to substitute away from good.

Elastic and Inelastic Demand Curves

2.00

1.25

2.00

1.25

Gasoline

Tacos

1 2 3 4 5 6 7 8 9 10

1 2 3 4 5 6 7 8 9 10

• If the market price for gasoline was to rise from $1.25 to $2.00, the quantity demanded in the market decreases insignificantly (from 8 to 7 units).• If the market price for tacos rises from $1.25 to $2.00, the quantity demanded in the market decreases significantly (from 8 to 1 unit).• Taco demand is highly sensitive to price changes and can be described as elastic; gasoline demand is relatively insensitive to price changes and can be described as inelastic.

2. Changes in Demand Versus Changes in Quantity Demanded

Changes in Demand and Quantity Demanded

Change in Demand - shift in entire demand curve.

Change in Quantity Demanded - movement along the same demand curve in response to a price change.

Change in DemandPrice

(dollars)

Quantity(of Compact Disks per yr)

25

20

15

10

5

5 10 15 20 25 30

• If CDs cost $15 each, the CD

demand curve D1 shows that 10 units would be demanded.

• If, somehow, the preferences for CDs changed then the demand for CDs may change. • Here we will assume that consumer income increases, increasing demand for CDs at all price levels. At $15 15 units are now demanded.

• If the price of CDs changed to $7.50, the quantity demanded for CDs would increase to 20 units.

D1D2

10 15 20

Demand Curve Shifters

Change in the Number of Consumers Change in Price of Related Good Changes in Expectations Demographic Changes Changes in Consumer Tastes and

Preferences

Changes in Consumer Income

1. Which of the following do you think would lead to an increase in the current demand for beef: (a) higher pork prices, (b) higher incomes, (c) higher prices of feed grains used to feed cows, (d) good weather conditions leading to a bumper (very good) corn crop, (e) an increase in the price of beef?

Questions for Thought:

2. What is being held constant when a demand curve for a specific product (like shoes or apples, for example) is constructed? Explain why the demand curve for a product slopes downward and to the right.

3. Producer Choice and the Law of Supply

Producers Opportunity Cost of Production - the

sum of the producer’s cost of employing each resource required to produce the good.

Firms will not stay in business for long unless they are able to cover the cost of all resources employed, including the opportunity cost of those owned by the firm.

Role of Profits and Losses Profit occurs when revenues are

greater than cost. Firms supplying goods for which

consumers are willing to pay more than the opportunity cost of resources used will make a profit.

Firms making a profit will expand and those with a loss will contract.

Law of Supply Law of Supply - there is a positive

relationship between the price of a product and the amount of it that will be supplied. As the price of a product rises,

producers will be willing to supply more.

Supply

Market Supply Schedule

Cell Phone Price

(monthly bill)

Quantity of Cell Phones

Supplied

$ 60 5.0 $ 73 11.0 $ 80 15.1 $ 91 18.2 $107 21.0 $120 22.5$135 24.1

Price(monthly bill)


140

120

100

80

60

5 10 15 20 25 30

Market Supply SchedulePrice

(monthly bill)


140

120

100

80

60

5 10 15 20 25 30

• Notice how the law of supply is reflected by the shape of the supply curve.• As the price of a good rises …• . . . producers supply more.

Supply

Market Supply SchedulePrice

(monthly bill)


140

120

100

80

60

5 10 15 20 25 30

• The height of the supply curve at any quantity shows the minimum price necessary to induce producers to supply that next unit to market.

• Here, for the 11th unit . . .

• . . . producers require $73 to induce them to supply it.• The height of the supply curve at any quantity also shows the opportunity cost of producing that next unit of the good.

Supply

Producer Surplus• Lets consider the market for cellular phones again. This time we will assume that the supply for cell phones is more linear and that the market price is $100.


140

120

100

80

60

5 10 15 20 25 30

• If the market price is $100, then the 25th unit will not be produced because the cost of supplying it exceeds the market price of $140.• At $100, the 15th unit will be produced because those who supply it are willing to do so for for at least $100.• At $100, the 10th unit will be produced because those who supply it are willing to do so for at least $80.

MarketPrice = $100

Price(monthly bill) Supply

Supply

Producer Surplus

• For market outputs of less then 15 units, producers are willing to supply the good for $100.

Price(monthly bill)


140

120

100

80

60

5 10 15 20 25 30

• The area represented by the distance above the supply curve but below the actual sales price is called producer surplus.• This area is the difference between the minimum amount required to induce producers to supply a good and the amount they actually receive.

MarketPrice = $100

Elastic and Inelastic Supply Curves Elastic supply- quantity supplied is

sensitive to small price changes. Inelastic supply - quantity supplied is

not sensitive to price changes.

Elastic and Inelastic Supply Curves

2.00

1.25

2.00

1.25

1 2 3 4 5 6 7 8 9 10

1 2 3 4 5 6 7 8 9 10

• If the market price for motor oil was to rise from $1.25 to $2.00, the quantity supplied in the market increases insignificantly (from 7 to 8 units).• If the market price for burgers rises from $1.25 to $2.00, the quantity supplied in the market increases substantially (from 1 to 8 units).• Burger supply is highly sensitive to price changes and can be described as elastic; motor oil supply is relatively insensitive to price changes and can be described as inelastic.

Short Run and Long Run Short Run - Firms don’t have enough

time to change plant size. Supply tends to be inelastic in the

short run. Long Run - Firms have enough time to

change plant size. Supply tends to be much more elastic

in the long run.

4. Changes in Supply Versus Changes in Quantity Supplied

Changes in Supply and Quantity Supplied

Change in Supply - shift in entire supply curve.

Change in Quantity Supplied - movement along the same supply curve in response to a price change.

Change in SupplyPrice

(dollars)

Quantity(Millions of Gal of Gas)

2.50

2.00

1.50

1.00

.50

5 10 15 20 25 30

• If the market price for gas is $1.50 a gallon, the gasoline supply curve S1 shows that 20 units would be supplied.

• If, somehow, the opportunity costs for gas manufacturers changed then the supply of gas may change. • Here we will assume that the cost of crude oil (an input in gasoline) increases, decreasing the supply of gas at all price levels. Now at $1.50, 15 units of gasoline are supplied.

• If the market price of gas changed to $.75, the quantity supplied of gasoline would decrease to 10 units.

S1

10 15 20

The Market

forGasoline

S2

Supply Curve Shifters Changes in Resource Prices Change in Technology Elements of Nature and Political

Disruptions Changes in Taxes

What must a firm do in order to make profit?

2. Define consumer and producer surplus. What is meant by economic efficiency and how does it relate to consumer and producer surplus?

Questions for Thought:1. What are profits and losses?

5. How Market Prices are Determined

Market Equilibrium

Price ofCards

(Dollars)

QuantitySupplied

(per month)

QuantityDemanded(per month)

Conditionin the

Market

Directionof Pressure

on Price

12 600 450

10 550 550

8 500 650

350 400400 450 500 550 600 650

789

10111213

> Excess Supply Downward

• This table and graph indicate the demand and supply conditions for oversized playing cards.• Equilibrium will occur where the quantity demanded equals the quantity supplied. If the price in the market exceeds the equilibrium level, market forces will guide it to equilibrium.• A price of $12 in this market will result in . . . resulting in excess supply. quantity supplied of 600 . . . • With an excess supply present, there will be downward pressure on price to clear the market.

Demand

Supply

Quantity Demanded = 450

Quantity Supplied= 600

quantity demanded of 450 and

Market Equilibrium

Price ofCards

(Dollars)

QuantitySupplied

(per month)


Conditionin the

Market


on Price

12 600 450

10 550 550

8 500 650

350 400400 450 500 550 600 650

789

10111213


• A price of $8 in this market will result in . . . resulting in excess demand. quantity demanded of 650 . . . • With an excess demand present, there will be upward pressure on price to clear the market.

Demand

Supply



quantity supplied of 500 and

< ExcessDemand Upward

Market Equilibrium

Price ofCards

(Dollars)

QuantitySupplied

(per month)


Conditionin the

Market


on Price

12 600 450

10 550 550

8 500 650

350 400400 450 500 550 600 650

789

10111213


Demand

Supply



=<

Balance Equilibrium

ExcessDemand Upward

• A price of $10 in this market will result in . . . resulting in a balance. quantity demanded of 550 . . . • With a balance present, there will be an equilibrium and the market will clear.

quantity supplied of 550 and

Market Equilibrium

Price ofCards

(Dollars)

QuantitySupplied

(per month)


Conditionin the

Market


on Price

12 600 450

10 550 550

8 500 650

350 400400 450 500 550 600 650

789

10111213

>=<

Excess Supply Downward

Balance Equilibrium

ExcessDemand Upward

• At every price above market equilibrium there is excess supply and there will be downward pressure on the price level.• At every price below market equilibrium there is excess demand and there will be upward pressure on the price level.• It is at equilibrium that prices will rest.

Demand

Supply

excesssupply

excessdemand

EquilibriumPrice

Net Gains to Buyers and Sellers• Returning to the market for cell phones, if the market price is driven

to equilibrium through market pressures to exist where supply equals demand, then the market equilibrium in the cell phone market

should be driven to $100 per month.

Price(monthly bill)


140

120

100

80

60

5 10 15 20 25 30

Demand

• If the area above the market price and below the demand curve is called consumer surplus . . .• . . . and the area above the supply curve but below the market price is called producer surplus . . . • . . . Then the combined area represented in the graph to the right represents the net gains to buyers and sellers. It is here that all potential gains from production and exchange are realized.

Supply

Market EquilibriumPrice = $100

6. How Markets Respond to Changes in Supply and Demand

Effects of a Change in Demand If Demand decreases, the equilibrium

price and quantity will fall. If Demand increases, the equilibrium

price and quantity will rise.

• Consider the market for eggs. Price($ per doz)

Quantity(million doz eggs

per week)

1.40

1.20

1.00

.80

.60

Q1

Demand1

• Prior to Easter season, the market for eggs produces an equilibrium

where Supply equals Demand1 at a market price of $ .80 and

output of Q1.

Supply

Demand2

Q2

• When the Easter season arrives, the demand by consumers for eggs

increases from Demand1 to

Demand2. What happens to the equilibrium price and output level?• At $ .80 a dozen the quantity demanded exceeds the quantity supplied. There is upward pressure on price inducing the existing suppliers to increase their

quantity supplied to Q2, pushing the equilibrium price up to $1.00.• What happens to equilibrium price and output after the Easter season?

Market Adjustment to an Increase in Demand

`

Effects of a Change in Supply If Supply decreases, the equilibrium

price will rise and the equilibrium quantity will fall.

If Supply increases, the equilibrium price will fall and the equilibrium quantity will rise.

• Consider the market for romaine lettuce.

Price($ per head)

2.40

2.20

2.00

1.80

1.60

Q1

Demand1

• Prior to a season of adverse weather affecting the yield of the market, an equilibrium exists where Supply

equals Demand1 with a market

price of $1.80 and output of Q1.

Q2

• When the season of adverse weather

arrives the supply of romaine lettuce falls, decreasing the supply

from supply1 to supply2. What happens to the equilibrium price and output level?• At $1.80 a head the quantity demanded exceeds the quantity supplied. There is upward pressure on price inducing the existing consumers to decrease their quantity

demanded to Q2, drawing up the equilibrium price to $2.00.• What happens to equilibrium price and output when the weather returns to normal?

Market Adjustment to a Decrease in Supply

Supply2

Supply1

`

Quantity(million heads lettuce

per week)

7. Time and the Adjustment Process

Time and the Adjustment Process

With the passage of time, the market adjustments of both producers and consumers will be more complete. Both demand and supply are more

elastic in the long run than in the short run.

• Consider the market for laptop computers.

Price

Quantity

P1

Q1

Demand1

• We begin in the short run in equilibrium at output level Q1 and price level P1.

Q2

• When the demand for laptops unexpectedly increases from

demand1 to demand2, suppliers do there best to increase product in the market, pushing the price level

upward to P2. What happens to the equilibrium price and output in the long run, after suppliers have a chance to change their capacity?• With time suppliers expand output pivoting the supply curve to its long run representation. The new equilibrium is where demand equals supply. The result, a further increase in equilibrium output, to

Q3, and a reduction in the

equilibrium price to P3.

Time and Adjustment to Increase in Demand

SupplySR

SupplyLR

Demand2

`

Q3

P3

P2

8. Invisible Hand Principle

Invisible Hand Invisible hand- the tendency of market

prices to direct individuals pursuing their own interest into productive activities that also promote the economic well-being of society.

Communicating Information

Product prices communicate up-to-date information about the consumers’ valuation of additional units of each commodity.

Without the information provided by market price it would be impossible for decision-makers to determine how intensely a good was desired relative to its opportunity cost.

Price changes bring the decisions of buyers and sellers into harmony.

Coordinating Actions of Market Participants

Price changes create profits and losses which change production levels for various products.

Prices and Market Order Market order is the result of market

prices, not central planning.

The efficiency of market organization is dependent upon:

Qualifications

The presence of competitive markets. Well-defined and enforced private

property rights.

1. A drought during the summer of 1988 sharply reduced the 1988 output of wheat, corn, soybeans, and hay. Indicate the expected impact of the drought on the following:

a. Prices of feed grains and hay during the summer of ‘88.

b. Price of cattle during the fall of ‘88. (Hint: What has happened to the opportunity cost of maintaining cattle during the upcoming winter?)

c. Price of cattle during the summer and fall of ‘89.

Questions for Thought:

2. What is the “invisible hand” principle? Does it indicate that “good intentions” are necessary if one’s actions are going to be beneficial to others?

EndChapter 3

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Supply,Demand, and the Market Process Chapter 3. 1. Consumer Choice and the Law of Demand