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Lesson 8 - Supply and Demand Analysis

 

Before students can study how international exchange rates, students need to know how a market is defined, and which factors influence market prices and quantities

 

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

Ceteris paribus is a Latin term that means we keep all other factors constant.  Only the price changes, so we can determine the impact on quantity demanded. 

 

Market Demand for Tea
(per year)
Price
($ per pound)		 Quantity demanded
(1,000 kilograms)
$2.50 5
$2.00 10
$1.50 15
$1.00 20
$0.50  25
 
Market Demand for Tea
Price
Quantity (1,000 kilograms)
  • Law of Demand - as the market price increases, the quantity demanded for a good decreases, ceteris paribus.
    • The demand curve has a negative slope.
    • Price and quantity move in opposite directions.
  • 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.
      • 1st Pepsi, a person receives 100 utils (lots of satisfaction), so he values it at $1 per bottle.
      • 2nd bottle, a person receives 20 utils (some gain in utility), so he values it at $0.75 per bottle.
      • 3rd bottle, a person receives 5 utils (very little gain in utility), so he values it at $0.25 per bottle.
        • Total utility = 125 utils; total spent = $2
    3. Composed of two effects.
      • Income effect - as a product's price decreases, a constant income buys more.
        • Real income increases.
        • Example:  Monthly income $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. Consumer Surplus - the area below the demand curve but above the actual price paid.
    • Measure of social welfare.
    • An aggregate benefit to all consumers in the market.
  • The market price of tea is $1.50 and consumers buy 15 (thousand) kilograms. 
    • I place a $2.50 value on this game, but bought it for $1.50. 
    • I received a benefit of $1.00. 
  • If the market price of tea decreases to $0.50, consumer surplus increases!
    • Social welfare increases for consumers.
    • The red area is consumer surplus.
 
Demand for Tea Demand for Tea
Price Price
Quantity (in thousands) Quantity (in thousands)
3.  Elasticity
  • Elastic Demand Curves - quantity demanded is sensitive to price changes.
    • Demand curves are relatively flat.
    • Many substitutes.
    • Large income effect.
    • Example: Air travel.
  • Inelastic Demand Curves - quantity demanded is not sensitive to price changes.
    • Demand curves are relatively steep.
    • Few substitutes.
    • Small income effect.
    • Examples: Alcohol, cigarettes, and gasoline.
 
Elastic Demand Curve Inelastic Demand Curve
Price Price
Quantity Demanded Quantity Demanded
 

Changes in Demand Versus Changes in Quantity Demanded
1.  "Change in Demand" - the demand curve shifts.  Shift curves only "left" or "right."  Do not think of shifting curves "up" or "down."
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:
    • Normal good - as income increases, people have more money, and buy more, ceteris paribus.
      • Majority of goods.
    • 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 consumers in the market, the more they buy, ceteris paribus.
  3. Price of other goods.
    • Substitute good's price increases. 
      • The price of chicken increases, therefore, the demand increases for beef, ceteris paribus. 
      • Consumer's substitute away from the more expensive good.
    • 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. 
    • If people believe tea will become more expensive, then people buy more tea to "stock up," causing the tea price to increase, ceteris paribus.
  5. Demographic changes - the average age in the U.S. is increasing, thus, older people increase their demand for health care, 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 ddrink more soft drinks, ceteris paribus.
If the opposite occurs, then the demand curves will shift left, i.e. decrease.

Supply - The Producers and Sellers
1. Supply schedule- shows the quantity and price of a good that producers and sellers are willing to produce or sell, ceteris paribus.
     
  • Law of Supply - as the good's price increases, then quality supplied increases, ceteris paribus.
      •  
    • Supply curves have a positive slope.
    • Why?
      • As the price increases, the producers have an incentive to supply more goods.
      • Note - as production increases, then production costs may also increase.  The higher market price off-sets the additional production costs.
 
Producers' Supply of Tomatoes (per week)
Price 
($ per pound)		 Quantity supplied
(1,000 kilograms)
$5 100
$4 80
$3 60
$2 40
$1  20
 
Supply Function
Price
Quantity (1,000 kilograms)
2.  Producer Surplus - the area above the supply curve but below the actual sales price.
  • Measure of social welfare.
  • An aggregate benefit to all producers in the market.
  • Some producers can supply tomatoes to the market for a price lower than $3.00
    • These producers benefit and reflected in producer surplus
  • Equals total fixed costs + profits
  • The light purple area on the graph.
 
Supply for Tomatoes
Price
Quantity (in thousands)
3. Elasticity 
  • Elastic Supply Curves - quantity supplied is sensitive to price changes.
    • Supply curves are relatively flat.
    • Firms have time to change plant size, invest in machines and equipment.
    • This is the long run.
  • Inelastic Supply Curves - quantity supplied is not sensitive to price changes.
    • Supply curves are relatively steep.
    • Firms do not have enough time to change plant size or invests in new equipment.
    • This is the short run.
  • Ex:  The price of computer chips increases. 
    •  
    • Short-run - If Intel is operating below production capacity, then Intel can increase production of chips more labor and resources.
    • Long-run.- If Intel believes the price increase is permanent, Intel can build a new factory to produce chips.
 
Elastic Supply Curve Inelastic Supply Curve
Price Price
Quantity Supplied Quantity Supplied
 

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, ceteris paribus.
  2. Technological advances.
    • Technology allows firms to produce more output, using the same amount of resource inputs, ceteris paribus.
  3. Nature and political disruptions.
    • Favorable weather for growing crops, resolving wars, etc, ceteris paribus.
  4. Gov. decreases taxes or increases subsidies.
    • Decrease business cost and firms can provide more at each price.
  5. Gov. decreases regulations
    • Compliance costs - Firms have specialists who write government reports and ensure employees follow regulations.
      • Also includes investment into machines and equipment to comply with regulations.
      • Example - Electric power companies have to lower air pollution by investing in machines that lower pollution from smoke stacks.
  6. Price of other goods.
    • Price for corn increases, so soybean farmers start growing corn, ceteris paribus.
  7. Producer's expectations of future prices.
    • Firms expect sugar prices to be lower next year.  Some firms quickly sell this sugar this year, which increases the supply for this year.
  8. 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 ffor well-known corporations.
      • Foreign currency market.
      • Commodity market.
    • Assumption:
      • The markets are perfectly competitive, i.e. large number of independent buyers and sellers.
  • Equilibrium - a state of rest; model does not change.<
 
The Market for Cookies
  • At $2, quantity supplied = quantity demanded:
    • Equilibrium price = $2.
    • Equilibrium quantity = 10 units.
  • At $3, quantity supplied > quantity demanded:
    • Surplus 
    • Suppliers are producing too 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
Beef Market Soft Drink Market
  • Price of chicken increases (Substitute). 
  • Demand for beef increases (shifts right).
    • Consumers substitute beef for chicken. 
    • Both equilibrium price and quantity increase.
  • Consumers experience an unusual cold summer (Weather). 
  • Demand decreases (shifts left).
    • Both equilibrium price and quantity decrease.
Computer Market Automobile Market
  • Technological advances in making computer chips (Technology). 
  • Supply increase (shifts right).
    • "cheaper computer chips."
    • Equilibrium price decreases
    • Equilibrium quantity increases.
  • Labor unions are successful in raising workers' wages at car factories. 
  • Supply decreases (shifts left).
    • Production cost increase.
    • Equilibrium price increases.
    • Equilibrium quantity decreases.

 

When Two or More Factors Change
  • The next lesson introduces change in supply and demand! 
    • If two factors change, then either the change in market price (or market quantity) is known while the other is indeterminate.

Invisible Hand Principle - Adam Smith
  1. Invisible Hand - market prices direct individuals pursuing their own self-interest into productive activities that also promote the economic well-being of society.
    • Ex:  A medical doctor pursuing self-interest to become rich. 
      • He cures people. 
      • The people remain productive.
      • Society is better off!
  2. Firms'  interest is to earn profits
    • Profits = Total Revenue - Total Costs
    • Profit > 0     F Total revenue > total cost
      • Consumer's value > resource value
      • Industry expands
    • Loss < 0     F  Total revenue < total cost.
      • Consumer's value < resource value
      • Industry contracts
      • Resources should be used to produce something else
  3. Prices communicate information.
    • "Brings buyers and sellers into harmony."
    • Example:  There is a surplus of apples.  Sellers will lower price until all surplus apples are sold (firms' profits may decrease)
    • Example:  There is a shortage of apples.  Sellers will raise the  price until shortage disappears (firms' profits may increase).
  4. Market prices affect millions of consumers and  producers around the world.
    • Impossible for government to set prices correctly.
    • Shortages are common in Socialist countries.
  5. Market efficiency depends on:
    • Competitive markets.
    • Well-defined private property rights.
  6. Social Welfare is highest = Consumer surplus + producer surplus.