Lecture 3

Supply and Demand

Theory of Supply• A thought experiment with the following assumptions:

– All apartments are identical– Each apartment has a different owner– There are 10 owners interested in selling their

apartments– Owners are intelligent, well-informed people; they

weigh the costs and benefits of their actions– Owners care only about their own monetary interests

(self-interested rational behavior)– They are only interested in price, but they have

different ideas about what is an acceptable price

Theory of Supply

• Supply scheduleA table showing the quantity of a good or service that would

be offered by the sellers at each possible price

• Supply curveShows the same information in a graph

A Supply Schedule for Apartments Price ($1000s) 100 99 98 97 96 95 94 93 92 91 90 Quantity of Apartments Supplied 10 9 8 7 6 5 4 3 2 1 0

At a price of$96,000...

(7, 97)

Supply

(6, 96)

...6 apartmentsare offered forsale.

0 1 2 63 875 11109

91

99

97

98

96

90

94

95

92

93

4

Quantity of Apartments

Pri

ce o

f Ap

art

me

nts

($

10

00

s)

101

100

A Supply Schedule for Apartments Price ($1000s) 100 99 98 97 96 95 94 93 92 91 90 Quantity of Apartments Supplied 10 9 8 7 6 5 4 3 2 1 0

Theory of Supply• Change in quantity suppliedMovement along a supply curve in response to a price change• Change in supplyA shift of the supply curve in response to a determinant other

than price• Ceteris paribus«All else constant» or «other things equal»• Market supplyThe supply from all sellers in the market• Individual supplyThe supply from one individual seller

At a price of$96,000...

S1 S2

...8 apartments areoffered for sale.

0 1 2 63 875 1310 11 129

91

99

97

98

96

90

94

95

92

93

4

Quantity of Apartments

Pri

ce o

f Ap

art

me

nts

($

10

00

s)

101

When does the supply curve shift to the right (outward)?

S1S2

0 10 3020 5040

20

80

60

40

Quantity of Belts (number per month)

Pri

ce o

f B

elts

($

)When does the supply curve shift

to the left (inward)?

Nonprice determinants of supply

1. Available technology of production

2. Resource prices

3. The number of producers

4. Producer expectations about future prices and technology

5. Prices of related goods and services

Theory of Demand

• Assumptions:– 10 potential buyers for these apartments– They are well-informed – They make decisions based on rational self-

interest– They regard $100,000 as too high, but some of

them are willing to buy the apartments as price falls

Theory of Demand

• Demand scheduleA table showing the quantity of a good or service that

buyers are willing to purchase at each possible price

• Demand curveShows the same information in a graph

A Demand Schedule for Apartments Price ($1000s) 100 99 98 97 96 95 94 93 92 91 90 Quantity of Apartments Demanded 0 1 2 3 4 5 6 7 8 9 10

At a price of$96,000...

(3, 97)

Demand

(4, 96)

...4 apartmentsare desired bybuyers.

0 1 2 63 875 11109

91

99

97

98

96

90

94

95

92

93

4

Quantity of Apartments

Pri

ce o

f Ap

art

me

nts

($

10

00

s)

101

100

A Demand Schedule for Apartments Price ($1000s) 100 99 98 97 96 95 94 93 92 91 90 Quantity of Apartments Demanded 0 1 2 3 4 5 6 7 8 9 10

Theory of Demand• Change in quantity demandedMovement along a demand curve in response to a price change• Change in demandA shift of the demand curve in response to some determinant other than price• Effective demandThe desire for a product combined with a purchasing ability on side of the

consumer• Market demandThe demand from all buyers in the market• Individual demandThe demand from one individual buyer• Derived demandDemand for an input based on demand for the output it will help to produce

At a price of$96,000...

D1

D2

...8 apartmentsare desired bybuyers.

0 1 2 63 875 11109

91

99

97

98

96

90

94

95

92

93

4

Quantity of Apartments

Pri

ce o

f Ap

art

me

nts

($

10

00

s)

101

When does the demand curve shift to the right (outward)?

0 5 1510 2520

25

40

45

35

30

Quantity of Tables (number per month)

Pri

ce o

f Ta

ble

s ($

)

50

D2

D

When does the demand curve shift to

the left (inward)?

Nonprice determinants of demand

1. Tastes and preferences

2. Incomes and/or available assets

3. Availability and prices of related goods and services

4. Consumer expectations about future prices and incomes

5. The number of consumers

The theory of market adjustmentCombined Supply and Demand Schedules for Apartments Price ($1000s) 100 99 98 97 96 95 94 93 92 91 90 Quantity of Apartments Supplied 10 9 8 7 6 5 4 3 2 1 0 Quantity of Apartments Demanded 0 1 2 3 4 5 6 7 8 9 10

Surplus

Shortage

(1, 91) (9, 91)

(1, 99) (9, 99)

D

S

0 1 2 63 875 11109

91

99

97

98

96

90

94

95

92

93

4

Quantity of Apartments

Pri

ce o

f Ap

art

me

nts

($

10

00

s)

101

100

Market adjustment• SurplusA situation in which the quantity that sellers wish to sell at the stated price

is greater than the quantity that buyers will buy at that price

• ShortageA situation in which the quantity that buyers wish to buy at the stated price

is greater than the quantity that sellers are willing to sell at that price

• EquilibriumA situation that has reached a resting point, where there are no forces that

create change

Market adjustment

• Market-clearing equilibriumA situation in which the quantity supplied is equal to the

quantity demanded

• Theory of market adjustmentThe theory that market forces will tend to make price and

quantity to move toward the equilibrium point

• Market disequilibriumA situation of either shortage or surplus

(5, 95)

D

E

S

0 1 2 63 875 11109

91

99

97

98

96

90

94

95

92

93

4

Quantity of Apartments

Pri

ce o

f Ap

art

me

nts

($

10

00

s)

101

100

Market clearing equilibrium

Market adjustment

• Static modelA model that ignores time, implicitly assuming that all

adjustments occur anonymously

• Dynamic modelA model that takes into account the passage of time

required for changes to occur

Shifts in SupplySupply and Demand Schedules After an Increase in Supply (Only)

Price ($1000s) 100 99 98 97 96 95 94 93 92 91 90 Quantity of Apartments Supplied 12 11 10 9 8 7 6 5 4 3 2 Quantity of Apartments Demanded 0 1 2 3 4 5 6 7 8 9 10

D

Surplus

0 1 2 63 875 11109

91

99

97

98

96

90

94

95

92

93

4

Quantity of Apartments

Pri

ce o

f Ap

art

me

nts

($

10

00

s)

101

100 S1

E1

E2

S

Shifts in DemandSupply and Demand Schedules After an Increase in Demand (Only) Price ($1000s) 100 99 98 97 96 95 94 93 92 91 90 Quantity of Apartments Supplied 10 9 8 7 6 5 4 3 2 1 0 Quantity of Apartments Demanded 4 5 6 7 8 9 10 11 12 13 14

Shortage

0 1 2 63 875 11109

91

99

97

98

96

90

94

95

92

93

4

Quantity of Apartments

Pri

ce o

f Ap

art

me

nts

($

10

00

s)

101

100 S

D1

E1

E2

D

Explaining real-world prices and quantities

Price

Quantity

Year

Pric

e (2

000

dolla

rs p

er b

arre

l)

Qua

ntity

(m

illio

ns o

f ba

rrel

s pe

r da

y)

2006

1986

1981

19781973

19741979

1996

1995 2001

Pric

e (2

000

dolla

rs p

er b

arre

l)

Quantity (millions of barrels per day)

1969 1995

1979

1981

2006

1996

1986

197820041985

1980

S

E

D

15

$52

Quantity

Pri

ce

S

D

15

$52

Quantity

(b)(a)

Can the empirical data from the year 2006 be represented as an equilibrium in the oil market?

Or is it a disequilibrium?

13 1514

30

40

50

60

Quantity

1979

1980

1981

Pri

ce (

$)

Quantity

Pri

ce (

$)

(b)(a)

D

S2

S1

Oil market: 1979-1981

1514

18

22

Quantity

1996

1995Pri

ce (

$)

QuantityP

rice

($

)

(b)(a)

S

D2

D1

Oil market: 1995-1996

Price floor

E

S

D

Quantity

QD QE QS

Pfloor

PE

A law or agreement that puts a lower limit on prices

Price ceiling

E

S

D

Quantity

QS QE QD

Pceiling

PE

A law or agreement that puts a upper limit on prices