SUPPLY AND DEMAND
Did you ever wonder why your shoes cost $39 yet your economics textbook (before cybertexts of course) is $55. Why do teachers earn $30,000 per year while Michael Jordan earns $18 million per year? Isn't education more important than the NBA? Have you ever awakened at 3am with a bad headache and had to rush to the pharmacy to buy some aspirin? How did the store know to have aspirin in stock? You certainly didn't phone ahead or even plan on buying the aspirin, certainly not at 3am.How much aspirin do you think consumers consume each year in the United States? Who coordinates this production to make sure there is enough? What price should be charged for aspirin? In socialist economies, government officials must ultimately decide how much asprin to produce per year and they also decide what price to charge. If the government officials did not plan for your headache at 3am, you are out of luck. There is no aspirin to purchase. In fact, in socialist economies shortages and lack of selection are commonplace.
The amazing thing about a capitalist system is that there is no central planner. Government officials don't tell businesses how much aspirin to produce nor the price to charge. Private producers figure out production levels on their own. The forces of supply and demand hold capitalist economies together. The consumer (indirectly) tells the producer what she is willing to buy and how much she is willing to pay. The producer supplies the product if she can make a profit by doing so. Again, the forces of supply and demand coordinate all this activity.
Suppose consumers decide they do not like small fuel-efficient cars anymore. They prefer the larger 4-wheel drives. Who tells the auto producers to change their production? The market takes care of this. Producers see that the smaller cars are sitting on their lots not selling while the large vehicles are selling like hot cakes. The producers respond to the changing consumer tastes by discounting the smaller cars and producing more of the larger ones.
Supply and demand analysis is an extremely powerful analytical tool, yet it is little understood and often confused. We begin by noting that there is no "law of supply and demand." There are two separate laws: a law of supply and a law of demand. Each works independently of the other. We first disuss the law of demand, then the law of supply and then we apply our analysis to real-world situations.
The Law of Demand and the Demand Curve
We begin with demand because demand is usually easier to understand from our personal experience. We are all consumers and we all demand goods and services. Demand is derived from consumers' tastes and and bound by their income. In other words, given a limited income (whether it be $30,000 or $18 million), the consumer must decide what goods and services to purchase. Within his budget, the consumer will purchase those goods and services that he likes best. Each consumer will purchase different things because everyone likes slightly different things and incomes are different.The Law of Demand holds that other things equal, as the price of a good rises, its quantity demanded will fall, and vice versa. This is a simple, common sense statement. Think of your trips to the grocery store. When the price of an item rises, you buy less of it. When the item is on sale, you purchase more of it. This is all that we mean by the law of demand.
| Price | Quantity Demanded |
|---|---|
| $5 | 10 |
| $4 | 20 |
| $3 | 30 |
| $2 | 40 |
| $1 | 50 |
A Demand Curve is a graphical depiction of the law of demand. We plot price on the vertical axis and quantity demanded on the horizontal axis. The demand curve has a negative slope as the law of demand suggests.
The Law of Supply and the Supply Curve
Supply is a little more difficult to understand because most of us have little experience on the supply side of the market. Supply is derived from producers' desire to maximize profits. When the price of a product rises, the supplier will have an incentive to increase production because he can justify higher costs to produce the product, and there is increased potential to earn a high profit margin.The Law of Supply holds that other things equal, as the price of a good rises, its quantity supplied will rise, and vice versa.
| Price | Quantity Supplied |
|---|---|
| $5 | 50 |
| $4 | 40 |
| $3 | 30 |
| $2 | 20 |
| $1 | 10 |
A Supply Curve is a graphical depiction of a supply schedule plotting price on the vertical axis and quantity supplied on the horizontal axis. The supply curve is upward-sloping, reflecting the law of supply. The market supply curve is derived by horizontally summing each individual's supply curve.
3. Equilibrium: Determination of Price and Quantity
An equilibrium is a situation in which:
- there is no inherent tendency to change,
- quantity demanded = quantity supplied, and
- the market just clears.
A Shortage occurs when quantity demanded exceeds quantity supplied. This implies the market price is too low. A Surplus occurs when quantity supplied exceeds quantity demanded. This implies that the market price is too high. A market will tend to gravitate towards equilibrium. This fact makes our markets stable most of the time.
A Shift versus a Movement Along a Demand Curve
It is essential to distinguish between a movement along a demand curve and a shift in the demand curve. A change in price results in a movement along a fixed demand curve. This is also referred to as a change in quantity demanded. A change in any other variable that influences quantity demanded produces a shift in the demand curve or a change in demand. The terminology can be subtle, but it is very important. Probably 90 percent of the confusion that students have with supply and demand is that they confuse shifts with movements along curves.Example: suppose income rises causing people to rent more videos. Then for the same price, quantity demanded will be higher than before. The left-hand chart below respresents that scenario. As income rises, the quantity demanded for videos at $4 goes from 20 (pt. A) to 40 (pt A').
Moreover, a shift in the demand curve changes the equilibrium position. On the right-hand chart below, the shift in the demand curve moves the market equilibrium from point A to point B, resulting in a higher price (from $3 to $4) and higher quantity (from 30 to 40). If the demand curve shifts to the left, the equilibrium price and quantity will both fall.
5. Factors that Shift the Demand Curve
We focus on four factors that can shift a demand curve:- Change in consumer incomes: an increase (decrease) in income shifts the demand curve to the right (left).
- Population change: an increase (decrease) in population shifts the demand curve to the right (left).
- Consumer Preferences: if preference for a particular good increases (decreases), the demand curve will shift to the right (left).
- Prices of Related Goods:
- Substitutes: goods that can be consumed in place of one another. If the price of a substitute increases (decreases), the demand curve for the original good will shift to the right (left). Example: Pepsi and Coke.
- Complements: goods that are normally consumed together, i.e. hamburgers and french fries. If the price of a complement increases (decreases), the demand curve for the original good will shift to the left (right).
A Shift versus a Movement Along a Supply Curve
Just as with demand curves, it is essential to distinguish between a movement along a given supply curve and a shift in a supply curve. A change in price results in a movement along a fixed supply curve. This is also referred to as a change in quantity supplied. A change in any other variable that influences quantity supplied produces a shift in the supply curve or a change in supply.For example, suppose the cost to a video store of purchasing videos rises. For a given rental price of videos, the video store may have to reduce the quantity of videos it rents. Then for the same price, quantity supplied will be lower than before. The left-hand chart below shows this scenario. Initially at a price of $4, quantity supplied was 40. After the shift of the supply curve, at the same price of $4, quantity supplied is only 20 (point A').
The right-hand chart below shows the new equilibrium after the leftward shift of the supply curve. The equilibrium moves from point A to point B, resulting in a higher price (from $3 to $4) and lower quantity (from 30 to 20). If the supply curve shifts to the right, the equilibrium price will fall and the equilibrium quantity will rise.
Factors that Shift the Supply Curve
We focus on three factors that shift a supply curve:- Change in cost of inputs: an increase (decrease) in inputs costs shifts the supply curve to the left (right).
- Increase in technology: an increase in technological progress shifts the supply curve to the right.
- Change in size of the industry: if size of an industry grows (shrinks) the supply curve will shift to the right (left).
Government Regulation of the Market: Price Ceilings
A Price Ceiling is a legal maximum that can be charged for a good. The ceiling is shown by a horizontal line at the ceiling price which is set below the equilibrium price. The result: a shortage. Qd > Qs.
Good examples of markets with price ceilings are apartment rentals and credit card interest rates.
Is the ceiling a "good" thing? It depends. Some groups will be helped while others will be hurt. Often times, the inefficiency in the market is justified by some equity concern. For example, caps on apartment rents help tenants but hurt landlords.
Often when there is disequilibrium, other methods of rationing
will appear: black-markets, quality deterioration, and so on.
Government Regulation of the Market: Price Floors
A Price Floor is a legal minimum that can be charged for a good. The floor is shown by a horizontal line at the floor price and is set above the equilibrium price. The result is a surplus. Qd < Qs
Common examples of price floors are found in agricultural markets such as sugar, wheat, and milk. The minimum wage is also a price floor because it sets a minimum level that employers can pay employees.
The same tradeoff occurs between equity and efficiency with price floors. Some benefit while others lose.
This module has a Powerpoint slide show.
