Macroeconomics ECON 2302 May 2011 Marilyn Spencer, Ph.D. Professor of Economics Chapter 3

MacroeconomicsECON 2302May 2011

Marilyn Spencer, Ph.D.

Professor of Economics

Chapter 3

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CHAPTER 3 Where Prices Come From:The Interaction of Demand and Supply

The intense competition among firms selling energy

drinks is a striking example of how the market responds to changes in consumer tastes.

3.1 The Demand Side of the Market

Discuss the variables that influence demand.

3.2 The Supply Side of the Market

Discuss the variables that influence supply.

3.3 Market Equilibrium: Putting Demand and Supply Together

Use a graph to illustrate market equilibrium.

3.4 The Effect of Demand and Supply Shifts on EquilibriumUse demand and supply graphs to predict changes in prices and quantities

Chapter Outline and Learning Objectives

Where Prices Come From: Interaction of Demand & Supply

CHAPTER 3

Perfectly Competitive Market A market that meets the conditions of:

1. Many buyers and sellers,

2. All firms selling identical products

3. No barriers to new firms entering the market

4. Low cost information

Where Prices Come From:The Interaction of Demand and Supply

Demand schedule A table showing the relationship between the price of a product and the quantity of the product demanded.Quantity demanded The amount of a well defined good or service that a consumer is willing and able to purchase at a given price, during some given time period.Demand curve A curve that shows the relationship between the price of a well defined product and the quantity of the product demanded, during some given time period.Market demand The demand by all the consumers of a given good or service.

The Demand Side of the MarketDemand Schedules and Demand Curves:

Discuss the variables that influence demand.

3.1 LEARNING OBJECTIVE

FIGURE 3-1 A Demand Schedule and Demand Curve

As price changes, consumers change the quantity of energy drinks they are willing to buy. We can show this as a demand schedule in a table or as a demand curve on a graph. They both show that as the price of energy drinks falls, the quantity demanded rises. When the price is $3.00, consumers buy 60 million cans/day. When the price drops to $2.50, consumers buy 70 million cans. Therefore, the demand curve for energy drinks is downward sloping.

The Demand Side of the Market: Demand Schedules and Demand Curves

Law of demand The rule that, holding everything else constant, when the price of a product falls, the quantity demanded of the product will increase, and when the price of a product rises, the quantity demanded of the product will decrease.

The Demand Side of the Market: The Law of Demand

The Demand Side of the MarketIndividual Demand and Market Demand

Market demand The demand for a product by all the consumers in a given geographical area.

Deriving the Market Demand Curve from Individual Demand Curves

Substitution effect The change in the quantity demanded of a good that results from a change in price, making the good more or less expensive relative to other goods that are substitutes.

Income effect The change in the quantity demanded of a good that results from the effect of a change in the good’s price on consumers’ purchasing power.

The Demand Side of the Market: What Explains the Law of Demand?

Ceteris paribus (“all else equal”) condition The requirement that when analyzing the relationship between two variables—such as price and quantity demanded—other variables must be held constant.

A shift of a demand curve is an increase or a decrease in demand. A movement along a demand curve is an increase or a decrease in the quantity demanded.

The Demand Side of the Market: Holding Everything Else Constant:

The Ceteris Paribus Condition

FIGURE 3-2

Shifting theDemand Curve

When consumers increase the quantity of a product they want to buy at a given price, the market demand curve shifts to the right, from D1 to D2.When consumers decrease the quantity of a product they want to buy at a given price, the demand curve shifts to the left, from D1 to D3.

The Demand Side of the Market: Holding Everything Else Constant:

The Ceteris Paribus Condition

Normal good A good for which the demand increases as income rises and decreases as income falls.

Inferior good A good for which the demand increases as income falls and decreases as income rises.

1. Income

Many variables other than price can influence market demand.

The Demand Side of the Market: Variables That Shift Market Demand

Are Big Macs an Inferior Good?

McDonald’s restaurants experienced increased sales during 2008 and 2009,

despite the recession.

Makingthe

Connection

Big Macs seem to fit the economic definition of an inferior good because demand increased as income fell. But remember that inferior goods are not necessarily of low quality, they are just goods for which consumers increase their demand as their incomes fall.

Substitutes Goods and services that can be used for the same purpose.

Complements Goods and services that are used together.

2. Prices of related goods

Consumers can be influenced by an advertising campaign for a product. And our tastes can also change because of new interests, new friends, and new decisions over time.

3. Tastes

The Demand Side of the Market: Variables That Shift Market Demand, cont.

Demographics The characteristics of a population with respect to age, race, and gender.

4. Size of the population and demographics

5. Expected future prices

Consumers choose not only which products to buy but also when to buy them.


The Aging of the Baby Boom Generation

Makingthe

Connection

Older people have a greater D for medical care than do younger people.

Aging boomers will also have an effect on the housing market.

What other effects will the aging of the baby boom generation have on the economy?

TABLE 3-1 Variables That Shift Market Demand Curves








FIGURE 3-3 A Change in Demand versus a Change in Quantity Demanded

If the price of energy drinks falls from $3 to $2.50, the result will be a movement along the D curve from point A to point B - an increase in quantity demanded from 60 M cans to 70 M cans. If consumers’ incomes increase, or if another factor changes that makes consumers want more of the product at every price, the D curve will shift to the right—an increase in demand.

The Demand Side of the Market: A Change in Demand versus a Change in Quantity Demanded

In this case, the increase in demand from D1 to D2 causes the quantity of energy drinks demanded at a price of $3 to increase from 60 M cans at point A to 80 M cans at point C.

Red Bull and the FutureDemand for Energy Drinks

Makingthe

Connection

Will Red Bull continue to grow its share of the energy drink market?

It is important for managers to accurately forecast the demand for their products because it helps them determine how much of a good to produce.

Supply schedule A table that shows the relationship between the price of a well defined product and the quantity of the product supplied, in some given time period.

Supply curve A curve that shows the relationship between the price of a well defined product and the quantity of the product supplied, in some given time period.

The Supply Side of the Market

Supply Schedules and Supply Curves

Quantity supplied The amount of a well defined good or service that a firm is willing and able to supply at a given price, within some given time period.

Discuss the variables that influence supply.

3.2 Learning Objective

The Supply Side of the Market: Supply Schedules and Supply Curves

FIGURE 3-4 A Supply Schedule and Supply Curve

As the P changes, the makers of Red Bull, Monster Energy, Rockstar, and the firms producing energy drinks change the Q they are willing to supply. We can show this as a supply schedule in a table or as a supply curve on a graph.

They both show that as the P of energy drinks rises, firms will increase the Q they supply.At a P of $2.50 per can, firms will supply 90 M cans. At a P of $3, firms will supply 100 M cans.

Law of supply The rule that, holding everything else constant, increases in price cause increases in the quantity supplied, and decreases in price cause decreases in the quantity supplied.

The Supply Side of the Market:

The Law of Supply

The Supply Side of the MarketIndividual Supply and Market Supply

3 - 7

Deriving the Market Supply Curve from the Individual Supply Curves

FIGURE 3-5

Shifting the Supply Curve

When firms increase the Q of a product they want to sell at a given P, the S curve shifts to the right. The shift from S1 to S3 represents an increase in supply.When firms decrease the Q of a product they want to sell at a given P, the supply curve shifts to the left. The shift from S1 to S2 represents a decrease in supply.

The Supply Side of the Market:

The Law of Supply

3. Prices of substitutes in production

4. Number of firms in the market

5. Expected future prices & other changes in expectations

Technological change A positive or negative change in the ability of a firm to produce a given level of output with a given quantity of inputs.

The following are the most important variables that shift market supply:

1. Prices of inputs

2. Technological change/change in productivity

The Supply Side of the Market: Variables That Shift Market Supply

TABLE 3-2 Variables That Shift Market Supply Curves


TABLE 3-2 Variables That Shift Market Supply Curves (continued)


TABLE 3-2 Variables That Shift Market Supply Curves (continued)


FIGURE 3-6 Change in Supply v. Change in Quantity Supplied

If the P of energy drinks rises from $2 to $2.50/can, the result will be a movement up the S curve from point A to point B - an increase in quantity supplied by Red Bull, Monster Energy, Rockstar, and others from 80 M to 90 M cans.

If the P of an input decreases, or another factor changes that makes sellers supply more of the product at every price, the S curve will shift to the right - an increase in supply.

The Supply Side of the Market: Change in Supply v. Change in Quantity Supplied

The increase in supply, S1 to S2, causes Q of energy drinks supplied at a P of $2.50 to increase from 90 M cans at point B to 110 M cans at point C.

Market Equilibrium: Putting Demand & Supply Together

FIGURE 3-7

Market Equilibrium

Where the D curve crosses the S curve determines market equilibrium. In this case, the D curve for energy drinks crosses the S curve at a P of $2 and a Q of 80 M cans/day. Only at this point is the Q of energy drinks consumers are willing to buy equal to the Q that Red Bull, Monster Energy, Rockstar, and the other firms are willing to sell:

Use a graph to illustrate market equilibrium.


The quantity demanded is equal to the quantity supplied.

Market equilibrium A situation in which quantity demanded equals quantity supplied.

Competitive market equilibrium A market equilibrium with many buyers and many sellers.

Market Equilibrium: Putting D & S Together

Surplus A situation in which the quantity supplied is greater than the quantity demanded.

Shortage A situation in which the quantity demanded is greater than the quantity supplied.

How Markets Eliminate Surpluses and Shortages


FIGURE 3-8 The Effect of Surpluses and Shortages on the Market Price

How Markets Eliminate Surpluses and Shortages

When the market P > equilibrium, there will be a surplus. In the figure, a price of $2.50 for energy drinks results in 90 M cans supplied but only 70 M cans demanded, for a surplus of 20 M. As Red Bull, Monster Energy, Rockstar, and the others cut the P to dispose of the surplus, the P will fall to the equilibrium of $2.When the market P < equilibrium, there will be a shortage. P of $1 results in 100 M cans demanded but only 60 M cans supplied, for a shortage of 40 M cans. As consumers who are unable to buy energy drinks offer to pay higher prices, the P will rise to the equilibrium of $2.


Demand and Supply Both Count

Keep in mind that the interaction of demand and supply determines the equilibrium price.

Neither consumers nor firms can dictate what the equilibrium price will be.

No firm can sell anything at any price unless it can find a willing buyer, and no consumer can buy anything at any price without finding a willing seller.


Solved Problem 3-3Demand and Supply Both Count: A Tale of Two Letters

Both D and S count when determining market P.The D for Lincoln’s letters is much greater than the D for Booth’s letters, but the S of Booth’s letters is very small. Historians believe that only 8 letters written by Booth exist today.

The Effect of Demand and SupplyShifts on Equilibrium: Increase in Supply

FIGURE 3-9

The Effect of an Increase in Supply on Equilibrium

1. As Coca-Cola enters the market for energy drinks, a larger Q of energy drinks will be supplied at every P, so the market S curve shifts to the right, from S1 to S2, which

causes a surplus of cans at the original price, P1.

If a firm enters a market, as Coca-Cola entered the market for energy drinks when it launched Full Throttle, the equilibrium price will fall, and the equilibrium quantity will rise:

Use demand and supply graphs to predict changes in prices and quantities.3.4 Learning Objective

2. The equilibrium P falls from P1 to P2.3. The equilibrium Q rises from Q1 to Q2.

The Falling Price ofLCD Televisions

Makingthe

Connection

An increase in S drove the P of a typical large LCD television from $4,000 in fall 2004 to $1,000 at the end of 2008, increasing the quantity demanded worldwide from 8 million to 105 million.

FIGURE 3-10 The Effect of an Increase in Demand on Equilibrium

Increases in income cause equilibrium P & Q to rise:

1. Because energy drinks are normal, as income grows, the Q demanded increases at every P, and the market D curve shifts right, from D1 to

D2, causing a

shortage at the original price, P1.

The Effect of Demand and SupplyShifts on Equilibrium: Increase in Demand

2. The equilibrium P rises from P1 to P2.3. The equilibrium Q rises from Q1 to Q2.

FIGURE 3-11 Shifts in Demand and Supply over Time

In panel (a), D shifts to the right more than S, and the equilibrium price rises:

1. Demand shifts to the right more than supply.2. Equilibrium price rises from P1 to P2.

In panel (b), S shifts to the right more than D, and the equilibrium price falls:

1. Supply shifts to the right more than demand.2. Equilibrium price falls from P1 to P2.

The Effect of Demand and SupplyShifts on Equilibrium: The Effect of Shifts

in D and S over Time

TABLE 3-3 How Shifts in Demand and Supply Affect Equilibrium Price (P) and Quantity (Q)

SUPPLY CURVE UNCHANGED

SUPPLY CURVESHIFTS TO THE RIGHT

SUPPLY CURVE SHIFTS TO THE LEFT

DEMAND CURVE UNCHANGED

Q unchangedP unchanged

Q increasesP decreases

Q decreasesP increases

DEMAND CURVESHIFTS TO THE RIGHT

Q increasesP increases

Q increasesP increases ordecreases

Q increases or decreases P increases

DEMAND CURVESHIFTS TO THE LEFT

Q decreasesP decreases

Q increases or decreasesP decreases

Q decreasesP increases ordecreases

The Effect of Demand and SupplyShifts on Equilibrium:

The Effect of Shifts in D and S

Solved Problem 3-4High Demand and Low Prices in the Lobster Market?

Supply and demand for lobster both increase during the summer, but the increase in supply is greater than the increase in demand; therefore, equilibrium price falls.

Effect of D and S Shifts on EquilibriumShifts in a Curve versus Movements along a Curve

Don’t Let This Happen to YOU! Remember: A Change in a Good’s Price Does Not Cause the Demand or Supply Curve to Shift!

Use demand and supplygraphs to predict changesin prices and quantities.


When analyzing markets using D and S curves, remember that when a shift in a D or S curve causes a change in equilibrium P, the change in P does not cause a further shift in D or S.

How Does Advertising Help Red Bull Increase Demand for Its Energy Drink?

AN INSIDE LOOK>>

Advertising may cause an increase in the demand for Red Bull.

Ceteris paribus (“all else equal”) condition

Competitive market equilibrium

Complements

Demand curve

Demand schedule

Demographics

Income effect

Inferior good

Law of demand

Law of supply

Market demand

Market equilibrium

Normal good

Perfectly competitive market

Quantity demanded

Quantity supplied

Shortage

Substitutes

Substitution effect

Supply curve

Supply schedule

Surplus

Technological change

KEY TERMS

Reality check to have been completed before we begin Ch. 4: Pre-read Ch. 4, including:

Review Questions (not in text):Consumer surplus is used as a measure of a consumer’s net

benefit from purchasing a good or service. Explain why consumer surplus is a measure of net benefit.

Why would economists use a term like “deadweight loss” to describe the impact on consumer and producer surplus from a price control?”

Problems and Applications:3rd ed., p. 130, 4A.5, 4A.6, 4A.7 & 4A.8; (2nd ed., p. 134,

4A.5, 4A.6, 4A.7 & 4A.8; 1st edition: 1-4 on p. 129).

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Macroeconomics ECON 2302 May 2011 Marilyn Spencer, Ph.D. Professor of Economics Chapter 3