OUTLINE -- LESSONS 3a, 3b, 3c
Understanding Individual Markets: Demand and Supply

3a - Demand

Parts of this lecture can be found at:
http://www.harpercollege.edu/mhealy/eco211/lectures/microch3-17.htm

Additional Web Pages for this lecture:

The type of news articles that pertain to this chapter:

I. Introduction: Prices and the 5Es

II. Demand

A. Definition
1. a schedule
2. various quantities
3. willing and able
4. various prices
5. given time period
6. ceteris paribus
7. demand is NOT how much we buy

B. Demand Schedule and Curve [sdtabblk.gif] [sdpoint.gif] [sdline.gif]

C. Law of Demand

1. there is an inverse relationship between price and quantity demanded
2. why?
a. common sense
b. diminishing marginal utility
c. income effect
d. substitution effect

D. Market Demand

1. definition
2. graphically

E. Determinants of Demand (VODKA)

1. the price of the product
2. the non-price determinants of demand

 

V. Two Kinds of Changes Involving Demand

A. Change in Quantity Demanded
1. caused ONLY by a change in the PRICE of the product
2. a movement ALONG a SINGLE demand curve

B. Change in Demand

1. shifting the demand curve / a new demand schedule
a. an increase in demand
b. a decrease in demand

2. caused by a CHANGE in the non-price determinants of demand

a. Pe -- expected price
b. Pog -- price of other goods
1) substitute goods
2) complementary goods
3) independent goods

c. I -- income

1) normal goods
2) inferior goods

d. N -- number of POTENTIAL consumers

1) population change
2) expanded marketing area
3) new competitor
(changes individual demand curve but NOT market demand curve)
4) change in eligible consumers (i.e. drinking age)

e. T -- tastes and preferences

3b - Supply
 

III. Supply

A. Definition
1. a schedule
2. various quantities
3. willing and able
4. various prices
5. given time period
6. ceteris paribus
7. supply is NOT the quantity available for sale

B. Supply Schedule and Curve sssupply.gif sdspnt.gif sdsline.gif

C. Law of Supply

1. there is a direct relationship between price and quantity supplied
2. why?
a. common sense
b. increasing costs because some resources are fixed
c. increasing costs because not all resources are identical

D. Market Supply

E. Determinants of Supply

1. the price of the product
2. the non-price determinants of supply

 

VI. Two Kinds of Changes Involving Supply

A. Change in Quantity Supplied schgqs.gif
1. caused ONLY by a change in the PRICE of the product
2. a movement ALONG a SINGLE supply curve

B. Change in Supply slineinc.gif

1. shifting the supply curve / a new supply schedule
a. an increase in supply
b. a decrease in supply

2. caused by a CHANGE in the non-price determinants of supply

a. Pe -- expected price
b. Pog -- price of other goods ALSO PRODUCED BY THE FIRM
c. Pres -- price of resources
d. T --technology
e. T --taxes and subsidies
f. N -- number of sellers

3c - Market Equilibrium and Efficiency

IV. Market Equilibrium -- Equilibrium Price and Quantity

A. Market Equilibrium
1. define equilibrium
2. find market equilibrium sdequil.gif

B. Market Disequilibrium

1. surpluses
2. shortages

 

What causes prices to change?

   

VII. Changes in Demand AND Supply

A. Case 1: D changes and supply stays the same dinc.gif
B. Case 2: S changes and demand stays the same sinc.gif
C. Case 3: D and S both change
1. S increases, D decreases
2. S decreases, D increases SDdisd.gif
3. S increases, D increases SDdisi.gif
4. S decreases, D decreases

VIII. Examples:

  • Chapter Appendix: Additional Examples of Supply and Demand
    • I. Changes in Supply and Demand

      A. Lettuce

      • 1. Weather events affect agricultural markets, usually on the supply side.

        2. Extreme weather that destroys crops will reduce the supply, raising equilibrium price and lowering equilibrium quantity.

      B. Exchange Rates

      • 1. One of the largest foreign exchange markets is the euro-dollar market.

        2. The price of a euro is expressed in dollars and is determined by demand and supply of euros.

        3. U.S. firms require euros to buy goods from European countries and this is reflected by the demand for euros.

        4. When European countries buy goods from the U.S. they must convert euros to dollars thereby creating the supply of euros.

        5. Increased popularity of European goods in the U.S. increases the demand for euros, causing equilibrium price to increase and the dollar depreciates while the euro appreciates.

      C.Pink Salmon

      • 1. This is an example of simultaneous changes in both supply and demand.

        2. An increase in supply occurs because of more efficient fishing boats, the development of fish farms, and new entrants to the industry.

        3. There is a decrease in demand because of changes in consumer preference, and an increase in income shows pink salmon to be an inferior good.

        4. Both changes put downward pressure on the price of pink salmon. Because we know that the increase in supply of pink salmon exceeded the decrease in demand, we can also determine that the quantity purchased increased.

      D. Gasoline

      • 1. U.S. gas prices have rapidly increased over the past few years.

        2. Middle East politics and military conflicts (both real and anticipated) have disrupted supply, tending to drive gas prices up.

        3. Increased popularity of SUVs and other low-gas-mileage vehicles has increased the demand for gas, also tending to drive the price up.

        4. While theoretically the affect on quantity is indeterminate, in reality the quantity purchased has increased, suggesting that the increase in demand exceeded the decrease in supply.

      E. Sushi

      • 1.Despite fast-growing popularity of sushi bars in the United States, prices have remained relatively constant.

        2.The increase in demand can be attributed to an increased taste for sushi.

        3.The opening of sushi bars in response to expected and realized demand has increased the supply of sushi, helping to keep the price stable.

    II. Preset Prices

    • A. Preset prices are similar to price floors and ceilings in that they tend to result in shortages or surpluses. They differ from floors and ceilings in that they are set by sellers, not by government policy.

      B. Olympic Figure Skating Finals

      • 1.Prices for sporting events are commonly preset.

        2. Despite the high preset prices for events such as the figure skating finals, shortages often result as people are willing to buy more tickets at that price than are available.

        3.Shortages tend to result in legal or illegal secondary markets (e.g., ticket scalping).

      C. Olympic Curling Preliminaries

      • 1. Less popular sporting events (for which prices are still preset) tend to result in surpluses (empty seats at the arena).

 

 

 

IX. The Market System and Efficiency
See: YELLOW PAGES: The supply and demand model and allocative efficiency

 

A. Introduction: The Market System and Efficiency

A. Equilibrium price and allocative efficiency

B. Two models

a. MB = MC (MSB = MSC)

b. Consumer and producer surplus

 

B. The MB=MC model

1. WHAT WE GET:
a. Goal of businesses: Maximize Profits
b. Therefore, they will produce where:
  • the Market Equilibrium quantity
  • the quantity where Qs=Qd
  • the is "what we get"

 

  • Graphically:

c. Assumptions: pure capitalism

2. WHAT WE WANT: ALLOCATIVE EFFICIENCY

a. Review :
(1) Allocative Efficiency
definition - using our limited resources to produce:
  • The quantity of goods and services that maximizes society's satisfaction
  • using resources to produce more CDs that people want and fewer cassette tapes that they don't want
  • no shortages and no surpluses

(2) Benefit-Cost Analysis

definition -
the selection of ALL possible alternatives where the marginal benefits are greater than the marginal cost

select all where: MB > MC
up to where: MB = MC
but never where: MB < MC

3. Allocative Efficiency is achieved where:

a. MSB=MSC
1) define Marginal Social Benefits (MSB)

2) define Marginal Social Costs (MSC)

3) therefore if society gets

all quantities where: MSB > MSC
up to where: MSB = MSC
but never where: MSB < MSC

this will be the quantity where society's Satisfaction will be maximized or the allocatively efficient quantity

b. Graphically:

 

4. THEREFORE:

a. Businesses will produce the profit maximizing or market equilibrium quantity - the quantity where Qd=Qs

b. Society wants the allocatively efficient quantity - the quantity where MSB=MSC

c. WHAT WE GET = WHAT WE WANT if:

1) Market Demand = Marginal Social Benefits (D=MSB)
a) law of diminishing marginal utility
b) assuming no positive externalities (no spillover benefits) D=MSB

2) Market Supply = Marginal Social Costs (S=MSC)

a) law of increasing costs
b) assuming no negative externalities (no spillover costs) S=MSC

5. Competitive Markets and Allocative Efficiency (MSB=MSC)

a. if there are no negative externalities (no spillover costs,) then S = MSC,

b. if there are no positive externalities (no spillover benefits), then D = MSB,

c. Graphically:

d. Then: WHAT WE GET = WHAT WE WANT and market economies achieve allocative efficiency

 

In a market economy with no spillover benefits and no spillover costs:

the profit maximizing or market equilibrium quantity
(what we get)

WILL BE THE SAME AS

the allocative efficient quantity
(what we want)

C. Consumer and Producer Surplus Model to show why the equilbrium price maximizes society's satisfaction

1. Consumer Surplus
a. definition
  • the difference between the maximum price a consumer is (or consumers are) willing to pay for a product and the actual price.

 

  • The surplus, measurable in dollar terms, reflects the extra utility gained from paying a lower price than what is required to obtain the good.

c. graph

  • Consumer surplus (CS) is measured and represented graphically by the area under the demand curve and above the equilibrium price.

 

  •  

    c. calculate

    • Consumer surplus can be measured by calculating the difference between the maximum willingness to pay and the actual price for each consumer, and then summing those differences.

 

  • d. Consumer surplus and price are inversely related - all else equal, a higher price reduces consumer surplus.

2. Producer Surplus

a. definition
  • the difference between the actual price a producer receives (or producers receive) and the minimum acceptable price.

     

b. graph

  • Producer surplus (PS) is measured and represented graphically by the area above the supply curve and below the equilibrium price.

 

c. calculate

  • Producer surplus can be measured by calculating the difference between the minimum acceptable price and the actual price for each unit sold, and then summing those differences.

 

 

d. Producer surplus and price are directly related - all else equal, a higher price increases producer surplus

3. Efficiency at equilibrium

a. Efficiency is attained at equilibrium, where the combined consumer and producer surplus is maximized.

 

 

  • Consumers receive utility up to their maximum willingness to pay, but only have to pay the equilibrium price.
  • Producers receive the equilibrium price for each unit, but it only costs the minimum acceptable price to produce.

     

b. Allocative efficiency occurs at quantity levels where three conditions exist:

  • MB = MC (MSB = MSC)
  • maximum willingness to pay = minimum acceptable price
  • combined consumer and producer surplus is at a maximum

4. Allocative Inefficiency (Deadweight Losses)

a. producing too little:
  • underproduction reduces both consumer and producer surplus, and efficiency is lost because both buyers and sellers would be willing to exchange a higher quantity.
  • the efficiency loss (deadweight loss) of producing too little is the brown triangle on the figure below
    • The sum of producer and consumer surplus at the equilibirum level of output was the triangle abc
    • at the lower level of output the sum of consumer and producer surplus is adec
    • so the efficiency loss of producing too little is the brown triangle dbe
    • between Q2 and Q1 the maximum willingness to pay of consumers is above the minimum acceptable price of seller

 

b. producing too much:

  • overproduction causes inefficiency because past the equilibrium quantity, it costs society more to produce the good than it is worth to the consumer in terms of willingness to pay.
  • the efficiency loss (deadweight loss) of producing too little is the tan triangle on the figure below
    • at the higher level of output the efficiency loss caused by producing too much (Q3) is the tan triangle bfg
    • between Q1 and Q3 the maximum willingness to pay of consumers is below the minimum acceptable price of seller, this subtracts from society's net benefit

 

Efficiency loss from underproduction = c + d

 

 

Efficiency loss from underproduction = e + f