1 Chapter 2 Supply and Demand Key issues • demand • supply • market equilibrium • shocking the equilibrium • effects of government interventions • when to use supply and demand model Today's questions 1. What is the effect of a ban on foreign imports of rice into Japan on the supply of rice to the Japanese market? 2. What is the effect of a price control (ceiling)? 3. What is the effect of instituting usury laws? 4. Could the Immigration Reform and Control Act create a labor shortage for farmers? 5. Will the mad cow crisis lower beef prices in the United States? What is the most important thing you know about economics? • many people reply supply equals demand • this statement summarizes a simple, yet powerful model Supply and demand model • most widely-used economic model • testable (like all good theories) • describes how consumers and suppliers interact in a market to determine quantity of a good sold and its price To use supply and demand model • you need to determine • buyers' behavior • sellers' behavior • how they interact • know where to use the model: in competitive markets 2 Quantity demanded is the amount of a good or service that consumers want to buy at a given price, holding constant other factors that affect demand What determines demand? • tastes • price of this good • prices of other goods • income • information (cholesterol) • government actions • other factors: nicotine, Demand curve • shows quantity demanded—largest quantity that consumers are willing to buy—at each price, holding constant other factors that affect purchases • note: quantity demanded of a good or service can exceed quantity sold (or vice versa) • strange demand curve convention: price is on the vertical axis Figure 2.1 Demand Curve for Canadian Processed Pork p , $ per kg 200 220 Demand curve for pork, D 1 240 286 Q, Million kg of pork per year 0 2.30 3.30 4.30 14.30 Effect of price changes • movement along the demand curve • demand curve is a concise summary of the answer to the question: what happens to the quantity demanded as the price changes, holding all other factors constant? Law of demand • demand curves slope down • ⇒ a drop in price results in an increase in quantity demanded (holding other factors constant) • one of the most important empirical finding in economics 3 Demand effects of other factors • change in any factor other than the price of the good causes a shift of the demand curve (not a movement along the demand curve) • this shift of the demand curve is a trick to avoid drawing 3D diagrams Effect on pork demand of a rise in price of beef • beef is a substitute for pork • at a given price of pork, a rise in the price of beef causes some people to switch from beef to pork Figure 2.2 A Shift of the Pork Demand Curve p, $ per kg 220176 Effect of a 60¢ increase in the price of beef D 1 D 2 232 Q, Million kg of pork per year 0 3.30 Summary • change in the price of a good causes a movement along a demand curve • change in any other factor besides the price causes a shift of the demand curve Variable definitions • Q = quantity of pork demanded (million kg per year) • p = price of pork ($ per kg) • p b = price of beef ($ per kg) • p c = price of chicken ($ per kg) • Y = income of consumers (thousand $) Demand function • general function Q = D(p, p b , p c , Y) • specific (linear) pork demand function Q = 171 - 20p + 20p b + 3p c + 2Y 4 Hold other factors constant • D 1 (Figure 2.1) holds p b , p c , and Y at their typical values: p b = $4 per kg p c = $3 1/3 per kg Y = $12.5 thousand • Q = 171 – 20p + 20p b + 3p c + 2Y = 171 – 20p + (20 x 4) + (3 x 3 1/3) + (2 x 12.5) = 286 – 20p Figure 2.1 Demand Curve for Canadian Processed Pork p , $ per kg 200 220 Demand curve for pork, D 1 240 286 Q, Million kg of pork per year 0 2.30 3.30 4.30 14.30 Plotting demand function: Intercept • Q = 286 – 20p • constant term, 286, is the quantity demanded if price is zero • Q = 286 - (20 x 0) = 286 • D 1 hits quantity axis at 286 (price = 0) Plotting demand function: Slope • Q = 286 – 20p • number on price, 20, is rate at which quantity changes as price changes ∆Q = Q 2 - Q 1 = D(p 2 ) – D(p 1 ) = (286 – 20p 2 ) -(286 – 20p 1 ) = -20(p 2 – p 1 ) = -20∆p • ∆p = $1 ⇒ ∆Q = -20∆p = -20 million kg per year Slope of pork demand curve • ∆p/∆Q = [the "rise"]/[the "run"] = [$1 per kg]/[-20 million kg per year] = -$0.05 per million kg per year • negative sign is consistent with Law of Demand Calculus • Q = 286 – 20p • differentiate: 20 dQ dp =− 5 Summing demand curves • total demand is sum of demand for all consumers • suppose there are 2 consumers with demand curves: Q 1 = D 1 (p) Q 2 = D 2 (p) • total quantity demanded = horizontal sum of quantity each consumer demands at each given price: Q = Q 1 + Q 2 = D 1 (p) + D 2 (p) Application Aggregating the Demand for Cling Peaches p, $ per ton 50 Q, Tons of peaches per 10,000 people per year 0 275 183 Total demand Demand for canned peaches Demand for fruit cocktail Q c =18 Q =22Q f = 4 Quantity supplied is the amount of a good or service that firms want to sell at a given price, holding constant other factors that affect supply Supply is a function of • price • costs of production • government rules and regulations • technology… Supply curve • increase in price of pork causes a movement along the supply curve (holding fixed other variables that affect supply) • supply curve is a concise summary of answer to the question: what happens to the quantity supplied as the price changes holding all other factors constant? Figure 2.3 Supply Curve of Canadian Processed Pork p, $ per kg 220176 Supply curve, S 1 300 Q, Million kg of pork per year 0 3.30 5.30 6 Effect of price on supply • supply curve for pork is upward sloping • thus, increase in the price of pork ⇒ movement along the supply curve, resulting in larger quantity of pork supplied There is no "Law of Supply" market supply curve may be upward sloping, vertical, horizontal, or downward sloping Supply effects of other variables shift in a variable other than price of pork causes the entire supply curve to shift Figure 2.4 A Shift of Pork Supply Curve p, $ per kg 205176 Effect of a 25¢ increase in the price of hogs S 1 S 2 220 Q, Million kg of pork per year 0 3.30 Summary • change in price of pork causes a movement along the supply curve • when costs, government rules, or other variables that affect supply change, the supply curve shifts General supply function Q = S(p, p h ), Q = the quantity of processed pork supplied (million kg per year) p = price of processed pork ($ per kg) p h = price of a hog ($ per kg) 7 Specific linear pork supply function Q = 178 + 40p - 60p h , holding p h fixed at its average value of $1.50 per the supply function is Q = 88 + 40p Movement along the supply curve • supply function: Q = 88 + 40p • if price of processed pork increases by ∆p = p 2 - p 1 • then ∆Q = 40∆p Calculus • Q = 88 + 44p • differentiate: 44 dQ dp = Summing supply curves total supply curve • horizontal summation of individual supply curves • shows total quantity produced by all suppliers at each possible price Total Supply: The Sum of Domestic and Foreign Supply p, Price per ton p, Price per ton p, Price per ton Q d * S d Q f * Q *= Q d * + Q f * Q d , Tons per year Q f , Tons per year Q, Tons per year (a) Japanese Domestic Supply (b) Foreign Supply (c) Total Supply p* p* p* S(no ban)S f (no ban) p p p Solved problem • What is the effect of a ban on foreign imports of rice into Japan on the supply curve of rice to the Japanese market? • (suppose that domestic and foreign supply curves of rice in Japan are linear, upward sloping curves with the same intercept and different slopes) 8 Restatement of problem • in most of our problems we are asked to determine how a change in a variable or policy affects one or more variables • what changes: foreign rice may no longer be imported • whichaffectsforeign supply and total Japanese supply curve Answer 1. show what the ban does to the foreign supply: ban prevents imports ⇒ new foreign supply curve, S f , lies on the vertical axis 2. compare the new and original foreign supply curves: at prices above the price where foreign supplier originally supplied quantity, the new foreign supply curve lies to left of original one Answer (continued) 3. show what happens to new total supply: new total supply curve is the horizontal sum of the Japanese supply curve, S d , and foreign supply curve, S f . Thus, new total supply curve is identical to domestic supply curve 4. compare new and original total supply curves: at any price above the price where any quantity was originally supplied by foreign suppliers, the new total supply curve lies to the left of the original one Figure 2.5 Total Supply: The Sum of Domestic and Foreign Supply p, Price per ton p, Price per ton p, Price per ton Q d * S d S f (ban) Q f * Q = Q d * Q *= Q d * + Q f * Q d , Tons per year Q f , Tons per year Q, Tons per year (a) Japanese Domestic Supply (b) Foreign Supply (c) Total Supply p* p* p* S(ban) S(no ban)S f (no ban) p p p Quota next figure shows the effect of a (nonzero) quota on the supply curve of rice p, Price per ton p, Price per ton p, Price per ton S d Q, Tons per year (a) U.S. Domestic Supply (b) Foreign Supply (c) Total Supply p* p* p* p p p S S Q d Q f Q d , Tons per year Q f , Tons per year Q d * Q f * S f S f Q d *+ Q f *Q d *+ Q f Q d + Q f 9 Supply and demand: Market equilibrium • supply and demand curves determine market price and quantity • unless price is set so that consumers want to buy exactly as much as suppliers want to sell, some party will be frustrated • when neither buyers nor sellers are disappointed, market is in equilibrium: no one wants to change his or her behavior Equilibrium • equilibrium price: price where • consumers can buy as much as they want • sellers can sell as much as they want • equilibrium quantity:quantity bought and sold at the equilibrium price Figure 2.6 Pork Market Equilibrium p, $ per kg 220176 D S e 233 246194 207 Q, Million kg of pork per year 0 3.95 3.30 2.65 Excess supply = 39 Excess demand = 39 Determine equilibrium price • find price, p, that equates equilibrium demand and supply quantity: Q d = Q s = Q, equilibrium quantity: • Q d = 286 - 20p (demand function) • Q s = 88 + 40p (supply function) • Q d = 286 - 20p = 88 + 40p = Q s 286 - 88 = 40p + 20p 198 = 60p 3.30 = p Determine equilibrium quantity • substitute equilibrium price, p = $3.30, into demand function or supply function to determine equilibrium quantity: • Q d = 286 – (20 x 3.30) = 88 + (40 x 3.30) = Q s = 220 = Q Invisible hand at nonequilibrium price, consumers or firms change their behavior (market forces) driving price to equilibrium level 10 Market forces drive market to equilibrium • at prices < equilibrium level: excess demand (amount by which quantity demanded exceeds quantity supplied at the specified price) • at price > equilibrium level: excess supply • equilibrium price is market clearing price: no excess demand or excess supply Figure 2.6 Pork Market Equilibrium p, $ per kg 220176 D S e 233 246194 207 Q, Million kg of pork per year 0 3.95 3.30 2.65 Excess supply = 39 Excess demand = 39 Shocking the equilibrium • once an equilibrium is achieved, it can persist indefinitely because no one applies pressure to change the price • equilibrium changes only if • demand curve shifts • supply curve shifts • government intervenes Figure 2.7a Effects of a Shift of the Pork Demand Curve D 1 D 2 S 1760 220 228 232 Q, Million kg of pork per year Excess demand = 12 3.30 3.50 e 2 e 1 p, $ per kg (a) Effect of a 60¢ Increase in the Price of Beef Figure 2.7b Effects of a Shift of the Pork Demand Curve S 1 Q, Million kg of pork per year 3.30 3.55 e 1 e 2 D p, $ per kg (b) Effect of a 25¢ Increase in the Price of Hogs 1760 220205 215 Excess demand = 15 S 2 Government policies • ceiling price • price controls • usury laws • rent control • floor price: minimum wage • quotas (restriction on supply) • taxes and tariffs (tax on imports only) [...]... Unemployment 11 Permanent excess demand or supply Supply equals demand quantity demanded and quantity supplied at a given price need not equal actual quantity that is bought and sold: • can get persistent excess demand (price ceiling) • can get persistent excess supply (price floor) if someone insists that "demand must equal supply, " they must be defining demand and supply as the actual quantities sold... curve: relationship between quantity demanded and price, fixing other factors • Law of Demand: demand curves slope down • change in price causes a movement along the demand curve • change in income, tastes, or another factor other than price, causes a shift of the demand curve • total demand curve = horizontal sum of individuals’ demand curves 12 2 Supply curves • supply curve: relationship between quantity... factors • market supply curve need not slope up but frequently does • change in price causes a movement along the supply curve • shift in the price of an input or government regulations cause a shift of the supply curve • total supply curve = horizontal sum of individual firms’ supply curves 4 Shocks change in an underlying factor other than price that causes a shift of the supply curve or the demand curve,... supply, " they must be defining demand and supply as the actual quantities sold • we define quantities supplied and demanded in terms of peoples' wants • thus, statement that "supply equals demand" is a theory, not merely a definition When to use supply and demand model When supply and demand model is inappropriate • • • • many buyers and sellers firms sell identical goods firms are price takers no... wage Supply need not equal demand S w* Minimum wage e w • price ceilings or price floors ⇒ quantity supplied does not necessarily equal quantity demanded • quantity supplied = amount firms want to sell at a given price, holding constant other factors that affect supply • quantity demanded = amount consumers want to buy at a given price, holding constant other factors D Hd H Hs H, Hours worked Excess supply: ... easily Use supply and demand model in • • • • • • • agricultural markets financial labor construction services wholesale retail • only a few sellers (auto manufacturers) • buyers and sellers are uncertain about the market equilibrium (concert music business) • consumers know much less than sellers about quality or price (used cars) • high transaction costs (art work) 1 Demand curve summary • demand curve:... government policies, such as price controls, can cause the quantity supplied to be greater or less than the quantity demanded, so that there are persistent shortages or excesses 6 When to use supply and demand model • supply and demand model is applicable only in competitive markets • competitive markets: homogeneous goods, many buyers and sellers (price takers) 13 ... equilibrium • intersection of demand and supply curves determines market equilibrium price and quantity • market force drive the price and quantity to the equilibrium levels if they are initially too low or too high 5 Effects of government intervention government policies, such as price controls, can cause the quantity supplied to be greater or less than the quantity demanded, so that there are persistent... a presidential campaign, Zimbabwe’s government imposed price controls on many basic commodities • foods (about a third of citizens’ daily consumption) • soap • cement • controls led to shortages • thriving black or parallel market developed • black market prices 2 to 3 x controlled prices Zimbabwe: Food Zimbabwe: Cement • cement manufacturers stopped accepting new orders when price controls were imposed . excess demand (price ceiling) • can get persistent excess supply (price floor) Supply equals demand if someone insists that " ;demand must equal supply, " they must be defining demand. use supply and demand model • you need to determine • buyers' behavior • sellers' behavior • how they interact • know where to use the model: in competitive markets 2 Quantity demanded is. 1 Chapter 2 Supply and Demand Key issues • demand • supply • market equilibrium • shocking the equilibrium • effects of government interventions • when to use supply and demand model Today's