The big picture marcoeconomics 12e parkin chapter 03

 Changes in demand and/or supply lead to changes in the price of the good or service and in the quantity produced and consumed..  The law of demand states that other things remaining t

T h e B i g P i c t u r e

Where we have been:

In Chapter 3, the students have their first encounter with demand and supply and the powerful forces that determine price and quantity in a competitive market Chapter 3 builds on Chapter 2, which provides the simplest rigorous description of the economic problem and the implications of the pursuit of an efficient use of resources If you have time, it is worth forging links between Chapters 2 and 3 Chapter 2 explains why we trade in markets Chapter 3

shows how trade in markets determines where on the PPF the economy

operates

Where we are going:

Demand and supply lie at the heart of the principles course Eventually in the microeconomics class we derive the demand curve and the supply curve from deeper views of the choices that people and firms make And in the

macroeconomic class, the lessons learned here apply, albeit with subtle differences, to the aggregate supply-aggregate demand model

N e w i n t h e Tw e l f t h E d i t i o n

The content of this chapter is largely the same except for the Economics in the News sections, which are now replaced with new current topics of coffee and bananas The banana article is at the end of the chapter along with the extended Economic Analysis of the end-of-chapter articles There is a reduction in the

section covering all possible shifts of demand and supply The content now focuses

on situations where both curves shift, which allows for two simpler figures to be used to illustrate shifts The single shifts of curves are already covered earlier so there is no loss of content There is a new Worked Problem at the end of the

chapter The Worked Problem gives demand and supply schedules for roses and then asks the students how the market adjusts if the price is lower and higher than the equilibrium price It follows up by asking the students to determine the equilibrium price and quantity Then the Worked Problem asks the students to calculate new equilibrium prices and quantities when the supply changes and when the demand and supply both change The Worked Problem shows the

students how to make these calculations In particular, it demonstrates how to calculate the new equilibrium when the demand and supply change using the new

C h a p t e r

23

demand and supply schedules and using a supply and demand diagram To

include the new Worked Problem without lengthening the chapter, some problems have been removed from the Study Plan Problem and Applications These

problems are in the MyEconLab and are called Extra Problems

24

Demand and Supply

 In our market-based economy, the interaction of demand and supply in markets determines the prices of goods and services and the quantity produced and

consumed

 Changes in demand and/or supply lead to changes in the price of the good or service and in the quantity produced and consumed

 Markets vary in the intensity of competition This chapter studies a competitive market, which is a market that has many buyers and sellers, so no single buyer or

seller can influence price

 The money price of a good or service is the number of dollars that must be given

up for it The ratio of one (money) price to another is called a relative price A

relative price is an opportunity cost The theory of demand and supply determines

relative prices and so when we use the word “price” we mean “relative price.”

To point out the importance of relative prices, ask your students if turkey at 40¢ a pound is

a good buy Tell them that is all they know—turkey is 40¢ a pound Generally most students respond that turkey at this price is cheap and a good buy Then tell them that steak is 8¢ a pound Now is turkey such a good buy? Students realize that the relative price of turkey is

5 pounds of steak per pound of turkey and so turkey is actually expensive Point out to them that these money prices are actual prices from circa 1800 At that time, turkey was relatively quite expensive because turkeys could fly and needed to be hunted rather than harvested! Also point out to them the unimportance of the money price and the crucial importance of the relative price

 The price of a good or service affects the quantity people plan to buy The quantity

demanded of a good or service is the amount that consumers plan to buy during a

given time period at a particular price

 The law of demand states that other things remaining the same, the higher the

price of a good, the smaller is the quantity demanded; and the lower the price of a good, the greater the quantity demanded The law of demand occurs for two

reasons:

 Substitution Effect: When the relative price of good changes, the opportunity cost

of the good changes An increase in the price increases the opportunity cost of buying the good and people respond by buying less of the good and buying more

of its substitutes

 Income Effect: A change the price of a good changes the amount that a person can afford to buy When the price of a good rises, people cannot afford to buy the same quantities that they purchased before, so the quantities bought of some goods and services must decrease Normally the good whose price rises is one of the goods for which less is purchased

Demand Curve and Demand Schedule

 The demand for a

good refers to the

entire relationship

between the price of

[Type text]

Price (dollar

s per unit)

Quantity demande d (units)

the good and the quantity demanded of the good The table gives a demand

schedule

 A demand curve shows the relationship between the quantity demanded of a good

and its price when all other influences on consumers’ planned purchases remain the same The figure illustrates the demand curve resulting from the demand schedule

 The demand curve is a willingness-to-pay curve—for each quantity, the price along the demand curve is the highest price a consumer is willing to pay for that unit of

output which means that a demand curve is a marginal benefit curve.

Of the hundreds of classroom experiments that are available today, very few are worth the time they take to conduct The classic demand-revealing experiment is one of the most productive and worthwhile ones Bring to class two bottles of ice-cold, ready-to-drink Mt Dew, bottled water, or sports drink (If your class is very large, bring six bottles) Tell the students that you have these drinks and ask them to indicate if they would like one Most hands will go up Tell the class that you are going to sell them to the high bidder Tell them that this auction is real The winner will get the drink and will pay Ask for a show of hands

of those who have some cash and can afford to buy a drink Explain that these indicate an ability to buy but not a definite plan to buy Now begin the auction Appoint a student to count hands (more than one for a big class) Begin at a low price: say 10¢ a bottle and count the number willing to buy Raise the price in 10¢ increments and keep the tally of the number who are willing to buy at each price When the number willing to buy equals the number of bottles you have for sale, do the transactions (If you make a profit, and you might do so, tell the students that the profit, small though it is, will go the department fund for undergraduate activities—and deliver on that promise.) Now use the data to make a demand curve for Mt Dew (or other drink) in your classroom today You can easily

emphasize the law of demand And, now that you have a demand curve, you can do some thought experiments that will shift it Ask: How would this demand curve have been

different if the temperature in the classroom was 10 degrees higher/lower? How would this demand curve have been different if half the class was sick and absent today? How would this demand curve have been different if there was a Coke machine right in the classroom?

A Change in Demand (Demand Shifters)

 When any factor that influences buying plans other than the price of the good

changes, there is a change in demand and the demand curve shifts An increase in

demand shifts the demand curve rightward and a decrease in demand shifts the demand curve leftward Six factors change demand:

 Prices of Related Goods: A substitute is a good that can be used in place of another good (tea and coffee) and a complement is a good that is used in

conjunction with another good (sugar and coffee) A rise in the price of a

substitute or a fall in the price of a complement increases the demand for the good

 Expected Future Prices: If the price of a good is expected to rise in the future, the demand for the good today increases

 Income: A normal good is one for which demand increases as income increases;

an inferior good is one for which demand decreases as income increases.

 Expected Future Income and Credit: When

expected future income increases, demand

today increases When credit becomes

easier to obtain, demand increases

 Population: The larger the (relevant)

population, the greater the demand

 Preferences: Preferences are an individual’s attitudes toward goods and services.

If people “like” a good more, the demand for it increases

A Change in the Quantity Demanded Versus a Change in Demand

 A change in price results in a movement along the demand curve, which is change

in the quantity demanded A change in other factors shifts the demand curve,

which is a change in demand

 In the figure, the movement along demand curve D0 from point a to point b as a

result of the price rising from $2 to $4 is a change in the quantity demanded The

shift of the demand curve from D0 to the new demand curve D1 is a change in

demand

II Supply

 The price of a good or service affects the quantity firms plan to sell The quantity

supplied of a good or service is the amount that firms plan to sell during a given

time period at a particular price

 The law of supply states that other things remaining the same, the higher the

price of a good, the greater is the quantity supplied; and the lower the price of a good, the smaller the quantity supplied The law of supply occurs because an

increase in the quantity of a good produced results in an increase in its marginal cost So the price must rise in order to induce firms to increase the quantity they produce

Supply Curve and Supply Schedule

relationship

the quantity

gives a supply

schedule

shows the relationship between the quantity

supplied of a good and its price when all

other influences on producers’ planned sales

remain the same The figure illustrates the

supply curve resulting from the supply

schedule

 The supply curve is a minimum-supply-price curve—for each quantity, the price along the supply curve is the lowest price a producer must receive in order to

produce that unit of output which means that a supply curve is a marginal cost

curve.

A Change in Supply (Supply Shifters)

 When any factor that influences selling plans other than the price of the good

changes, there is a change in supply and the supply curve shifts An increase in

supply shifts the supply curve rightward and a decrease in supply shifts the supply curve leftward Six factors change supply:

 Prices of Productive Resources: If the price of a resource used to produce the good rises, the supply of the good decreases

 Prices of Related Goods Produced: A substitute in production is a good that can

be produced using the same resources and a complement in production is a good that must be produced with the initial good A fall in the price of a substitute in production or a rise in the price of a complement in production increases the supply of the good

 Expected Future Prices: If the price of a good is expected to rise in the future, the supply of the good today decreases

 Number of Suppliers: If the number of suppliers increases, the supply increases

 Technology: Technology refers to the ways in which factors of production are used

to produce a good A technological advance increases the supply of a good

 The State of Nature: The state of nature includes all natural forces that influence supply Bad weather or an earthquake decreases the supply of a good

Price (dollar

s per unit)

Quantit y supplie d (units)

A Change in the Quantity Supplied Versus a

Change in Supply

 A change in price results in a movement

the quantity supplied A change in

other factors shifts the supply curve,

which is a change in supply

 In the top figure, the movement along

supply curve S0 from point a to point b as a

the supply curve from S0 to the new

supply curve S1 is a change in supply

III Market Equilibrium

 An equilibrium is a situation in which

opposing forces balance

 The equilibrium price is the price at

which the quantity demanded equals the

quantity supplied The equilibrium

the equilibrium price In the figure, the

equilibrium price is $3 and the

equilibrium quantity is 30 per week

Price as a Regulator and Price Adjustments

 The price of a good regulates the

quantities demanded and supplied

 Shortage: If the price is below the

equilibrium price, consumers plan to buy

more than firms plan to sell A shortage

results, which forces the price higher, toward the equilibrium price In the figure,

there is a shortage at any price below $3 and so the price is forced higher, toward

the equilibrium price

 Surplus: If price is above the equilibrium, firms plan to sell more than consumers

plan to buy A surplus results, which forces the price lower, toward the equilibrium

price In the figure, there is a surplus at any price above $3 and so the price is forced lower, toward the equilibrium price

 The price continues to adjust until the quantity supplied equals quantity demanded

To help students have a base of knowledge from which build tell them to memorize “Home Base”—the basic Supply and Demand curves showing an initial starting position with

proper labels on the axis’ and an initial equilibrium, P0 and Q0 on the axis at the

intersection of the two curves “Home Base” provides them a starting place for every story problem they face Then as you work through examples, be sure to ask them what “shifter”

is changing This procedure will keep them using the economic tool rather than just going

with a gut feeling

The magic of market equilibrium and the forces that bring it about and keep the market

there need to be demonstrated with the basic diagram, with intuition, and, if you’ve already used the demand experiment outlined above, with hard evidence in the form of the class

activity Using the experiment is straightforward Start by explaining that in that market, the supply was fixed (vertical supply curve) at the quantity of bottles that you brought to class The equilibrium occurred where the market demand curve (demand by the students) intersected your supply curve Point out that the trades you made in your little economy made both buyers and sellers better off

Back in the dim mists of time, circa 1870 or so, economists struggled to understand if it was

the supply or the demand that determined the price and quantity of a good Nowadays we

know that these efforts were misguided To borrow from the great economist Alfred

Marshall, demand and supply curves are like the blades on a pair of scissors It does not make sense to ask which blade does the cutting because the cutting takes both blades and

occurs at the intersection of the two blades Likewise, it takes both the demand and supply

to determine the price and quantity and the price and quantity are determined at the intersection of the demand and supply curves

IV Predicting Changes in Price and Quantity

The demand and supply model can be used to determine how changes in factors affect a good’s price and quantity

A Change In Demand

 If the demand for a good or service

increases, the demand curve shifts

rightward As a result, the equilibrium price

rises and the equilibrium quantity

increases

 If the demand for a good or service

decreases, the demand curve shifts

leftward As a result, the equilibrium price

falls and the equilibrium quantity

decreases

 Supply does not change and the supply

curve does not shift Instead there is a

change in the quantity supplied and a

movement along the supply curve

 The figure illustrates an increase in

demand In the figure the demand curve shifts from D0 to D1 As a result, the

equilibrium price rises from $3 to $4 and the equilibrium quantity increases from 30

to 40 The supply curve does not shift; there is, however, a movement along the supply curve

An Economic in the News feature discusses the factors that have led to higher college tuition Because enrollment has also increased, the analysis concludes that increases in demand are the factor that has created the higher tuition

A Change In Supply

 If the supply of a good or service

increases, the supply curve shifts

rightward As a result, the equilibrium

price falls and the equilibrium quantity

increases

 If the supply of a good or service

decreases, the supply curve shifts

leftward As a result, the equilibrium price rises and the equilibrium quantity

decreases

 Demand does not change and the demand curve does not shift Instead there is a

change in the quantity demanded and a movement along the demand curve

 The figure illustrates an increase in supply In the figure the supply curve shifts from

S0 to S1 As a result, the equilibrium price falls from $3 to $2 and the equilibrium

quantity increases from 30 to 40 The demand curve does not shift; there is,

however, a movement along the demand curve

An Economic in the News explores the factors that led to a fall in the price of coffee The

analysis concludes that a bumper crop of coffee lies behind the fall in price

The whole chapter builds up to this section, which now brings all the elements of demand,

supply, and equilibrium together to make predictions Students are remarkably ready to

guess the consequences of some event that changes either demand or supply or both They must be encouraged to work out the answer and draw the diagram Explain that the way to answer any question that seeks a prediction about the effects of some event(s) on a market has five steps Once you have already worked an example or two, walk them through the

steps and have one or two students work some examples in front of the class The five steps are:

1 Draw a demand-supply diagram and label the axes with the price and quantity of the

good or service in question

2 Think about the event(s) that you are told occur and decide whether they change

demand, supply, or both demand and supply

3 Determine if the events that change demand or supply bring an increase or a decrease

4 Draw the new demand curve and supply curve on the diagram Be sure to shift the

curve(s) in the correct direction—leftward for decrease and rightward for increase (Lots

of students want to move the curves upward for increase and downward for decrease—

this view works ok for demand but is exactly wrong for supply So emphasize the

left-right shift.)

5 Find the new equilibrium and compare it with the original one

It is critical at this stage to return to the distinction between a change in demand (supply)

and a change in the quantity demanded (supplied) You can now use these distinctions to

describe the effects of events that change market outcomes At this point, the students

know enough for it to be worthwhile emphasizing the magic of the market’s ability to

coordinate plans and reallocate resources

Demand and Supply Change in the Same Direction

 If both the demand and the supply of a good or service increase, both the demand

and supply curves shift rightward The quantity unambiguously increases but the

effect on the price is ambiguous

 If the increase in demand is greater than the increase in supply, the price rises

 If the increase in demand is the same size

as the increase in supply, the price does

not change

 If the increase in demand is less than the

increase in supply, the price falls

 If both the demand and the supply of a good

or service decrease, both the demand and

supply curves shift leftward The quantity unambiguously decreases but the effect

on the price is ambiguous

 If the decrease in demand is greater than the decrease in supply, the price falls

 If the decrease in demand is the same size as the decrease in supply, the price does not change

 If the decrease in demand is less than the decrease in supply, the price rises

 The figure illustrates an increase in both demand and supply In the figure the

demand curve shifts from D0 to D1 and the supply curve shifts from S0 to S1 The shifts are the same size, so the equilibrium price does not change and the

equilibrium quantity increases from 30 to 50