Chapter 3: Basic Elements of Supply and Demand

CHAPTER 3: BASIC ELEMENTS OF SUPPLY AND DEMAND “What is a cynic? A man who knows the price of everything and the value of nothing.”

Oscar Wilde SUMMARY 1. The analysis of supply and demand shows how a market mechanism solves the three problems of what, how, and for whom. A market blends together demands and supplies. Demand comes from consumers who are spreading their dollar votes among available goods and services, while businesses supply the goods and services with the goal of maximizing their profits.

A. The Demand Schedule 2. A demand schedule shows the relationship between the quantity demanded and the price of a commodity, other things held constant. Such a demand schedule, depicted graphically by a demand curve, holds constant other things like family incomes, tastes, and the prices of other goods. Almost all commodities obey the law of downward-sloping demand, which holds that quantity demanded falls as a good’s price rises. This law is represented by a downward-sloping demand curve.

3. Many influences lie behind the demand schedule for the market as a whole: average family incomes, population, the prices of related goods, tastes, and special influences. When these influences change, the demand curve will shift.

B. The Supply Schedule 4. The supply schedule (or supply curve) gives the relationship between the quantity of a good that producers desire to sell – other things constant – and that good’s price. Quantity supplied generally responds positively to price, so the supply curve is upward-sloping.

5. Elements other than the good’s price affect its supply. The most important influence is the commodity’s production cost, determined by the state of technology and by input prices. Other elements in supply include the prices of related goods, government policies, and special influences.

C. Equilibrium of Supply and Demand 6. The equilibrium of supply and demand in a competitive market occurs when the forces of supply and demand are in balance. The equilibrium price is the price at which the quantity demanded just equals the quantity supplied. Graphically, we find the equilibrium at the intersection of the supply and demand curves. At a price above the equilibrium, producers want to supply more than consumers want to buy, which results in a surplus of goods and exerts downward pressure on price. Similarly, too low a price generates a shortage, and buyers will therefore tend to bid price upward to the equilibrium.

7. Shifts in the supply and demand curves change the equilibrium price and quantity. An increase in demand, which shifts the demand curve to the right, will increase both equilibrium price and quantity. An increase in supply, which shifts the supply curve to the right, will decrease price and increase quantity demanded.

8. To use supply-and-demand analysis correctly, we must (a) distinguish a change in demand or supply (which produces a shift of a curve) from a change in the quantity demanded or supplied (which represents a movement along a curve); (b) hold other things constant, which requires distinguishing the impact of a change in a commodity’s price from the impact of changes in other influences; and (c) look always for the supply-and-demand equilibrium, which comes at the point where forces acting on price and quantity are in balance.

9. Competitively determined prices ration the limited supply of goods among those who demand them.

FURTHER READING AND INTERNET WEBSITES Further Reading Supply-and-demand analysis is the single most important and useful tool in microeconomics. Supply-and-demand analysis was developed by the great British economist Alfred Marshall in Principle of Economics. To reinforce your understanding, you might look in textbooks on intermediate microeconomics. Two good references are Hal R. Varian, Intermediate Microeconomics: A Modern Approach, and Edwin Mansfield and Gary Yohe, Microeconomics: Theory and Applications.

A recent survey of the economic issues in immigration is in George Borjas, Heaven’s Door: Immigration Policy and the American Economy.

Websites Websites in economics are proliferating rapidly, and it is hard to keep up with all the useful sites. A good place to start is always www.rfe.org. Another useful starting point for Internet resources in economics can be found at http://www.oswego.edu/~economic/econweb.htm You can examine a study of the impact of immigration on American society from the National Academy of Sciences, The New Americans (1997), at www.nap.edu. This site provides free access to over 1000 studies from economics and the other social and natural sciences.

QUESTIONS FOR DISCUSSION 1. a. Define carefully what is meant by a demand schedule or curve. State the law of downward-sloping demand. Illustrate the law of downward-sloping demand with two cases from your own experience.

The demand schedule shows the relationship between the market price of a good and the quantity demanded of that good, other things held constant.

For example, the demand schedule for a box of cornflakes could be: Demand Schedule for Cornflakes Price Quantity demanded ($ per box) (millions of boxes per year) P Q 5 9 4 10 3 12 2 15 1 20

A B C D E

The demand curve represents the demand schedule graphically:

Price of cornflakes ($ per box)

Demand Curve for Cornflakes 6

D

5 4 3 2 1

D

0 0

5

10

15

20

Quantity of cornflakes (millions of boxes per year)

25

The law of downward-sloping demand is: when the price of a commodity is raised (and other things are held constant), buyers tend to buy less of the commodity. Conversely, when the price is lowered, other things being constant, quantity demanded increases.

Two examples from my personal experience:  buying items that are given a special discount. For example, a ‘3 for 2’ lowers the price of each item, and I buy more than I would otherwise.  buying a newspaper subscription during a discount period. b. Define the concept of a supply schedule or curve. Show that an increase in supply means a rightward and downward shift of the supply curve. Contrast this with the rightward and upward shift of the demand curve implied by an increase in demand.

The supply schedule shows the relationship between the market price of a commodity and the quantity of that commodity that producers are willing to produce and sell, other things held constant.

For example, the supply schedule for a box of cornflakes could be:

A B C D E

Supply Schedule for Cornflakes Price Quantity supplied ($ per box) (millions of boxes per year) P Q 5 18 4 16 3 12 2 7 1 0

The supply curve represents the demand schedule graphically:

Price of cornflakes ($ per box)

Supply Curve for Cornflakes 6 S

5 4 3 2 1 0

S

0

5

10

15

20

Quantity of cornflakes (millions of boxes per year)

An increase in supply increases the quantity supplied at each price:

Price of cornflakes ($ per box)

Supply Curve for Cornflakes 6

S

5

S'

4 3 2 1 0

S'

S 0

5

10

15

20

25

Quantity of cornflakes (millions of boxes per year)

The solid curve SS, is the original supply curve. The dashed curve S’S’, is the new, shifted, supply curve. The supply curve has shifted to the right (and looks as if it has shifted downwards).

If instead, demand had increased, the quantity demanded at each price will increase:

Price of cornflakes ($ per box)

Demand Curve for Cornflakes 6

D'

D

5 4 3 2 1

D

0 0

5

10

15

20

D' 25

30

Quantity of cornflakes (millions of boxes per year)

The solid curve DD, is the original demand curve. The dashed curve D’D’, is the new, shifted, demand curve. The demand curve has shifted to the right (and looks as if it has shifted upwards).

2. What might increase the demand for hamburgers? What would increase the supply? What would inexpensive frozen pizzas do to the market equilibrium for hamburgers? To the wages of teenagers who work at McDonald’s?

An increase in demand for hamburgers could be caused by:  An increase in average incomes. As people’s incomes increase, they will spend more on hamburgers.  An increase in population. More people will buy more hamburgers.  An increase in the price and availability of related goods. If the price of fried chicken increases, people will substitute more hamburgers.

 A change in tastes or preferences. The arrival of fast food chains changes people’s preferences for food, so people buy more hamburgers.  A change in special influences. An effective advertising campaign or celebrity endorsement makes people want more hamburgers.

An increase in supply of hamburgers could be caused by:  An improvement in technology. More efficient ovens produce hamburgers at lower cost.  A reduction in input prices. Cheaper beef and wheat would mean hamburgers could be produced more cheaply.  A reduction in prices of related goods. A reduction in the price of fried chicken would reduce the profitability of producing fried chicken, and producers will shift production to hamburgers.  A change in government policy. Relaxing regulations on food safety and public health, removing quotas and tariffs on imported beef and wheat, reducing the minimum wage would all increase the supply of hamburgers.  A change in special influences. Expectations of strong future demand and prices for hamburgers will increase their supply.

Inexpensive frozen pizzas will attract consumers to demand more frozen pizzas and less hamburgers. The demand for hamburgers will decrease, and the demand curve will shift leftwards. Assuming no change in supply, the price of hamburgers and the quantity demanded will decrease. The demand for teenagers to work at McDonald’s will decrease, and so will their wages.

3.

Explain why the price in competitive markets settles down at the equilibrium intersection of supply and demand. Explain what happens if the market price starts out too high or too low.

Consider the supply and demand curves for cornflakes: Supply and Demand Curves for Cornflakes

Price of cornflakes ($ per box)

6

Surplus

D

5

S

4

E

3 2

Shortage 1

D

S

0 0

5

10

15

20

25

Quantity of cornflakes (millions of boxes per year)

At the market equilibrium, E, the quantity demanded equals the quantity supplied, and there is no tendency for prices to rise or fall.

If the market price starts out too high, say at $5, the quantity supplied is greater than the quantity demanded. There is a surplus of cornflakes. Cornflakes will pile up on the supermarket shelves. In order to sell these, the supermarket will start cutting prices, increasing the quantity demanded and decreasing the quantity supplied.

Eventually the price will reduce to the equilibrium price at E. If the market price starts out too low, say at $2, the quantity demanded is greater than the quantity supplied. There is a shortage of cornflakes. To reduce the shortage, the price is raised, decreasing the quantity demanded and increasing the quantity supplied.

Eventually the price will increase to the equilibrium price at E.

4. Explain why each of the following is false: a. A freeze in Brazil’s coffee-growing region will lower the price of coffee.

A freeze in Brazil’s coffee-growing region will reduce the supply of coffee. The supply curve will shift to the left, as less coffee is supplied at each price. Assuming that the demand for coffee remains the same, the equilibrium price will be higher, not lower, than before, as shown below.

(N.B. P denotes Price. Q denotes Quantity. DD denotes Demand curves.

SS denotes Supply curves. E denotes Equilibrium. Suffix, ‘, denotes a shifted curve or equilibrium. The bold red arrows indicate the change in price and quantity due to a shifted curve)

P

D

S'

S

Price

E' E S'

S

D Quantity

Q

b. “Protecting” American textile manufacturers from Chinese clothing imports will lower clothing prices in the United States.

“Protecting” America from Chinese clothing imports will reduce the supply of clothing in the United States, increasing, not decreasing, price, as in 4.a.

c.

The rapid increase in college tuitions will lower the demand for college.

A rise in college tuitions (fees) will reduce the quantity of college tuition demanded. But this is not the same as a reduction in demand.

We have here a movement along the demand curve, as the quantity demanded responds to a change in price – not a shift of the curve.

P

D

Price

E' E

D Quantity

Q

d. The war against drugs, with increased interdiction of imported cocaine, will lower the price of domestically produced marijuana.

The war against drugs reduces imports of cocaine, reducing the supply of cocaine. The same reasoning and curves as in 4.a. applies.

Marijuana is a related good of cocaine, so as the price of cocaine increases, so will price of domestically produced marijuana. The war against drugs has made drugs a very lucrative commodity.

5. The following are four laws of supply and demand. Fill in the blanks. Demonstrate each law with a supply-and-demand diagram. a. An increase in demand generally raises price and raises quantity demanded.

P

D

D'

S

Price

E' E

D

S

D' Q

Quantity

b. A decrease in demand generally lowers price and lowers quantity demanded.

P

D'

S

D

Price

E E'

D'

S Quantity

D Q

c. An increase in supply generally lowers prices and raises quantity demanded.

P

D

S'

S

Price

E E'

D

S'

S

Q

Quantity

d. A decrease in supply generally raises price and lowers quantity demanded.

P

D

S'

S

Price

E' E

S'

D

S Quantity

Q

6. For each of the following, explain whether quantity demanded changes because of a demand shift or a price change, and draw a diagram to illustrate your answer. a. As a result of decreased military spending, the price of Army boots falls.

Army boots are purchased by military spending, i.e. military spending provides the demand for Army boots. Decreased military spending decreases demand for Army boots – this is a demand shift…

P

Price

D'

S

D

E'

E

D'

S Quantity

D Q

…which leads to a fall in price. b. Fish prices fall after the pope allows Catholics to eat meat on a Friday.

Meat is a close substitute for fish. If meat is allowed to be eaten on a Friday, Catholics will substitute meat for fish. The demand for fish will be reduced due to a demand shift. The reasoning, and the curves, will be the same as in 6.a. The price of fish falls.

c.

An increase in gasoline taxes lowers the consumption of gasoline.

An increase in gasoline taxes will raise the price of gasoline. Due to the law of downward-sloping demand, an increase in price will lower the quantity demanded, because of a price change. Consumption of gasoline will be reduced.

P

D

Price

E' E

D Q

Quantity

d. After the Black Death struck Europe in the fourteenth century, wages rose.

The Black Death reduced the supply of labourers, raising their wages (the price of their labour)‌ P

D

S'

S

Price

E' E

S'

D

S Quantity

Q

7. Examine the graph for the price of gasoline in Figure 3-1, page 46. Then, using a supply-and-demand diagram, illustrate the impact of each of the following on price and quantity demanded:

a. Improvements in transportation lower the costs of importing oil into the United States in the 1960s.

Improvements in transportation reduced the costs of production – both improved technology and reduced input prices. This will have increased the supply of gasoline, lowering the price of gasoline and raising the quantity demanded.

P

D

S'

S

Price

E E'

S

D

S' Quantity

Q

b.

After the 1973 war, oil producers cut oil production sharply.

A cut in oil production led to a decrease in gasoline supply, as oil is an input to gasoline and its scarcity would have increased input prices‌ P

D

S'

S

Price

E' E

S'

D

S

Q

Quantity

‌which would have raised the price and lowered quantity demanded.

This helps explain why gasoline prices rose substantially in the first oil shock after 1973. c.

After 1980, smaller automobiles get more miles per gallon.

An increase in miles per gallon mean that motorists need less gasoline for their driving. This reduced the demand for gasoline, lowering the price and the quantity demanded: P

D'

S

D

Price

E E'

D'

S Quantity

D Q

d. A record-breaking cold winter in 1995-1996 unexpectedly raises the demand for heating oil.

Heating oil is a related good of gasoline; both use oil as an input. If the demand for heating oil increased, the demand for oil will also have increased‌ P

D

D'

S

Price

E' E

D

S

D' Q

Quantity

‌raising its price and lowering the quantity demanded, doing the same for gasoline. e. A global economic recovery in 1999-2000 leads to a sharp upturn in oil prices.

P

D

D'

S

Price

E' E

D

S Quantity

D' Q

The global economic recovery would have increased average incomes.

People would choose to take more holidays, buy more goods and services‌ all of which would have increased the demand for gasoline.

This would have raised the price and raised the quantity demanded.

This helps explain the rapidly rising gasoline price in the early 2000s.

8. Examine Figure 3-3 on page 49. Does the price-quantity relationship look more like a supply curve or a demand curve?

Assuming that the demand curve was unchanged over this period, trace supply curves for 1972 and 2000 that would have generated the (P,Q) pairs for those years. Explain what forces might have led to the shift in the supply curve.

The above chart is downward-sloping – so it looks more like a demand curve.

Assuming a constant demand curve, the supply curves that would have generated the (P,Q) pairs would look something like this:

S

D

1000

100

S'

10

1 0.0001

0.001

S

0.01

0.1

1

10

100

S' 0.1

1000

10000

D

The forces that might have led to the shift in the supply curve are:  The technology available to make computers has improved drastically. The amount of transistors and other devices that can be placed on a given area of silicon has increased hugely (Moore’s Law states that transistor density has doubled every two years). This will have increased supply.  Inputs prices will have reduced. Production will have been outsourced to areas where labour costs are much lower, such as China. This will have increased supply.  Prices of related goods, such as keyboards and software, will have fallen. This will have increased supply.  Government policy, in providing funding for research for advanced technology and for technical education, will have increased supply.  Special influences, such as the appeal of icons such as Bill Gates and Steve Jobs, have helped increase the supply of talent into the computing industry. Expectations of future technological advancement, such as Moore’s Law, and expectations of future demand – Bill Gate’s vision of “A computer on every desk and in every home” have helped increase supply.

9. From the following data, plot the supply and demand curves and determine the equilibrium price and quantity: Supply and Demand for Pizzas Quantity Quantity Price demanded supplied ($ per box) (pizzas per semester) (pizzas per semester) 10 0 40 8 10 30 6 20 20 4 30 10 2 40 0 0 125 0

What would happen if the demand for pizzas tripled at each price?

What would occur if the price were initially set at $4 per pizza?

Plotting the supply and demand schedule given above gives: Supply and Demand for Pizzas

Price ($ per pizza)

12

D

10

S

8

E

6 4 2

D

S

0 0

20

40

60

80

100

120

140

Quantity (pizzas per semester)

We can see that the equilibrium price is $6 per pizza, while the equilibrium quantity is 20 pizzas per semester.

Tripling the demand for pizzas at each price: Supply and Demand for Pizzas

Price ($ per pizza)

12

D, D' S

10

E'

8 6

E

4 2

S

0 0

D'

D 100

200

300

400

Quantity (pizzas per semester)

The new equilibrium price is $8 per pizza, and the new equilibrium quantity is 30 pizzas per semester.

If the price was initially set at $4 per pizza, there will be a shortage of pizzas. More pizzas are demanded than supplied. To reduce the shortage, pizza prices will increase, encouraging production and discouraging consumption of pizzas. The quantity supplied increases while the quantity demanded decreases. There will be movement up and along the curves until the equilibrium price is reached.