Supply, Demand, and the Market Process
Lesson 3

Demand - The Consumers

1. Demand Schedule - shows the quantity and price of a good, which consumers are willing to buy, ceteris paribus.

• Note - demand has a time unit!
• Demand curve is a graph of the demand schedule.

Buyer's Demand Curve
Price
Quantity

• Law of Demand - as the market price increases, the quantity demanded for a good decreases, ceteris paribus.
  • The slope of the line
• Why?
  1. Common sense
     • When products are expensive, people buy less
     • The principle behind business discounts
  2. Law of Diminishing Marginal Utility - consuming additional units of a good yield less and less additional utility i.e. satisfaction.
     • Example: Hypothetical case for pizza
       • utils are fictional units for satisfaction
     • 1st slice, a person receives 100 utils (lots of satisfaction), so he values it at $5 per slice.
     • 2nd slice, a person receives 20 utils (some gain in utility), so he values it at $3 per slice.
     • 3rd slice, a person receives 5 utils (very little gain in utility), so he values it at $1 per slice.
       • Total utility = 125 utils; total spent = $9 for 3 slices of pizza
  3. Composed of two effects.
     • Income effect - as a product's price decreases, a constant income buys more
       • Example: Monthly income is $1,000 and price of beef decreased
         • Income effect - you can buy more beef with fixed income
           • Real income increased
     • Substitution effect - as price of a product decreases, people start buying it and “substitute away” from more expensive, similar goods.
       • Price change affects consumer's behavior
     • Example: As the price decreases for Coca-Cola relative to Pepsi, people substitute Coke for Pepsi

2. Market Demand Function

• Two people are in the market.
  • Each person has their demand function.
  • The quantity denoted by q is for a person, while Q is the total market quantity.
  • Likewise, demand by a consumer is denoted by d, while market demand is D.
  • Market demand - at each market price, horizontally sum the quantity that each consumer buys.

Changes in Demand Versus Changes in Quantity Demanded

Demand decreases	Demand increases

"Change in Quantity Demanded" - movement along the same demand curve, because the price changed.

Movement along Demand Curve

2. Shifting the demand curve to the right; demand increases

1. Income:
   1. Normal good - as income increases, people have more money, and buy more, ceteris paribus
      • Majority of goods
   2. Inferior good - as income decreases, people have less money and buy more inferior goods, ceteris paribus
      • Rice and Ramen Noodles
2. Number of consumers increases
   • More people in the market to buy goods, ceteris paribus
3. Price of other goods
   1. Substitute good's price increases
      • The price of DVD's increases, therefore, the demand increases for VCR tapes, ceteris paribus
   2. Complement good's price decreases
      • The price of DVD's decreases, therefore, the demand for DVD players increases, ceteris paribus
4. Expectations - consumer expectations of future prices, future availability, or future income.
   • During 1999 people believed widespread water shortages would occur from Y2K. Thus, demand for water increased during 1999, ceteris paribus.
5. Demographic changes - population of infants is greatly increasing, demand increases for baby goods, ceteris paribus.
6. Changes in consumer tastes and preferences - for example, a report stated coffee reduced colon cancer, demand for coffee increases, ceteris paribus.
7. Weather - if the summer is very hot, then people drink more Pepsi, ceteris paribus

If the opposite occurs, then the demand curves will shift left, i.e. decrease.

Supply - The Producers

1. Opportunity cost of production -all production costs are opportunity costs. The labor, machines, and other resources could produce other goods.

Profits = Total Revenue - Total Costs

• Role of Profits and Losses
  • Profit: Total revenue > total cost
    • Consumer's value > resource value
    • Industry expands
  • Loss: Total revenue < total cost
    • Consumer's value < resource value
    • Industry contracts
    • Resources should be used to produce something else
• Supply schedule - shows the quantity and price of a good that firms are willing to produce/sell, ceteris paribus. A supply curve is a graph of the supply schedule.
• Law of Supply - as the good's price increases, then quality supplied increases, ceteris paribus.
• Why?
  • As the price increases, the producers receive more revenue.
  • Note - as production increases, then production costs may increase. The higher price off-sets the additional production costs.
  • Note - the supply schedule has a time unit

Supply Curve
Price
Quantity

2. The short-run market supply is the horizontal sum of the all firms' short-run supply curves. (Just like the demand curve). Market supply is derived from two firms below:

Changes in Supply Versus Changes in Quantity Supplied

1. "Change in Supply" - entire supply curve shifts. Shift curves only "left" or "right." Do not think of shifting curves "up" or "down."

Supply increases	Supply decreases

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

Movement along Supply Curve

2. Shifting the supply curve to the right; supply increases.

1. Resource prices
   • Labor wages or resource materials' price decreases, firms can supply more because of lower production costs
2. Technological advances
   • Technology allows firms to produce more output, using the same levels of resources
3. Nature and political disruptions
   • Favorable weather for growing crops, resolving wars, etc.
4. Decrease in taxes or increase government subsidies
   • Decrease business cost and firms can provide more at each price
5. Price of other goods
   • Price for corn increases, so non-corn farmers start growing corn
6. Producer's expectations of future prices.
   • Firms expect sugar prices to be higher next year. Some firms hoard sugar now, and sell the supply of sugar for next year
7. Number of sellers
   • More sellers in the market means more is produced

If the opposite occurs, then the supply curves will shift left, i.e. decrease.

How Market Prices Are Determined

• Market - an institution that brings buyers and sellers together for specific goods and services.
  • Examples:
    • New York Stock Exchange - market for buyers and sellers of stock for well-known corporations
    • Foreign currency market
    • Commodity market
  • Assumption:
    • The markets are perfectly competitive, i.e. large number of independent buyers and sellers
    • No government intervention
    • Perfect knowledge of prices
• Equilibrium - a state of rest; market price and quantity do not change
  • Equilibrium price - market price where the forces of supply and demand are equal
  • Equilibrium quantity - market quantity where the forces of supply and demand are equal

The Market for Potato Chips

• At $2 , quantity supplied = quantity demanded:
  • Equilibrium price = $2
  • Equilibrium quantity = 10 units
• At $3 , quantity supplied > quantity demanded:
  • Surplus
  • Suppliers have to much product, so price falls until it equals $2
• At $1 , quantity supplied < quantity demanded:
  • Shortage
  • Consumers demand more than what is in stock, so they bid prices up until it equals $2

How Markets Respond to Changes in Supply and Demand

Economics of Price Controls

Price controls - government mandated prices. Government thinks price is too high or too low.

1. Price ceilings - a legally established maximum price that sellers may charge.

• Government thinks rent is too expensive.  The market price is P*, but the government sets maximum price at P~ .
• Rent control price < market rent:
  • Direct effect (When P* > P~ ).
    • Quantity demanded ( Qd ) > quantity supplied ( Qs ).
    • Shortage
  • Shortage does not disappear, because of the price control

Rental Market
Price, Rent
Quantity, Tenants

• Secondary effects of price ceilings.
  • Long waiting lists.
  • "Under the table" payments to landlord.
  • Buying expensive furniture from landlord.
  • The lower price (i.e. rent) causes investors to avoid investing in new housing.
  • The quality of housing will deteriorate.
    • Less maintenance and repairs, which lower costs.

If P~ > P*, then the price control has no effect on the market.

2. Price Floor - a legally established minimum price that buyers must pay.

• Government thinks workers' wages are too low and set the minimum wage rate to $5.30 per hour ( P~ ).
• Employers demand workers, while employees supply labor.
  • Direct effect (When P~ > P*).
    • Quantity supplied ( Qs ) > quantity demanded ( Qd ).
    • Surplus
    • i.e. unemployment in this case

Labor Market (Unskilled workers)
Price
Quantity

• Secondary effects of price ceilings.
  • Employers reduce the following benefits.
    • Health insurance
    • Job training
    • Pension plans
  • Minimum wage usually hurts unskilled labor, the poor, and teenagers.

If P* > P~ , then the price control has no effect on the market, such as professional jobs which pay more than $5.30 per hour.

Black Markets

• Black Market - markets that operate outside the legal system
  • Also called the hidden economy or underground economy
  • Illegal products and services
  • Avoid high taxes
  • Avoid costly regulations
  • Circumvent price controls
  • Decline in civic loyalty to government
• Black markets have:
  • More defective products
  • Higher profits
  • Higher risk:
    • Arrests
    • Court fines and fees
    • Jail or prison sentence
    • Greater violence from enforcing contracts

Terminology