Chapter 4

Unit 2Supply and DemandDemandThe interaction of supply and demand creates the market price1Section 1: Understanding DemandDemand is the desire, ability and willingness to pay for something. Demand represents the buyers in a marketThe Law of DemandWhen a goods price is low, consumers will buy more When a goods price is high, consumers will buy less

The law of demand is the result of two interacting behaviors:

The Substitution EffectWhen people react to a price change by buying less of that good and more of other goodsExample - The Income EffectThe change in consumption from a change in real income. At $3.80/gallon you cannot afford to buy as much gas as you would at $3.00/gallon

The Income Effect (cont)Normal Good people buy more if their income increases example - Inferior Good people buy more if their income decreases example - Giffen Good an inferior good with no close substitutes; as its price increases, so does quantity demandedVeblen Good a luxury good whose quantity demand increases as price increases, conspicuous consumption

Demand ScheduleA table that lists the quantities that will be purchased at various prices Schedules can be for an individual or a given populationDemand forPriceQtyDemand Curve A graph representation of a demand scheduleUsed to predict how people will change their buying habits when price rises or fallsCan change easily depending on related variablesShifts in the Demand CurveRemember, a change in price only causes a change in quantity demand, not a change in demand

Changes in Demand A change (shift) in demand is when at the same price, quantity demanded rises or falls.What causes a change in demand?There are at least six reasons why demand can change1. Income when income changes, people demand more or different types of goods

132. Consumer ExpectationsIf people expect the price of something to increase in the future, demand will increase nowOpposite is also true

4. Changes in Taste, PreferencesFads can increase demand temporarilyBandwagon effect everybody elsePreferences can also show long term changesEx: More low fat food3. Change in PopulationMore people want more stuff!Opposite is also true5. Change in price of complement- If the price of a good increases, demand for its complement decreases- opposite is also true

(what causescont)6. Change in price of a substitute If the price of a good increases, demand for its substitute increasesOpposite is also true

The Supply CurveSupply is the amount of goods and services that producers are willing to produce at given pricesThe Law of Supply as prices increase, producers are willing to supply a greater quantity of a good or serviceSupply and price are positively relatedExplanation for the Law of supply:1. Higher ProductionThe expectations of higher prices is an incentive for more companies to produce more 2. Market Entry When prices and profits are high in a market, that is an incentive for other businesses to enter the market

The Supply ScheduleA supply schedule is a chart showing the quantities that will be supplied at various prices A change in quantity supplied occurs when the price changes and producers change the amount they will produceWageHours Supplied$0$7$10Changes in SupplyJust as there are factors that cause the demand curve to changeThere are also several factors that cause the supply curve to changeAs with demand, right is an increase, left is a decreaseInput CostsChange in the cost of factors of production higher costs decrease supplyTechnology new technology increases supplyGovernment 3. Subsidies a government payment that supports a business or market Subsidies increase the supply curve4. Taxes & Regulations Taxes & Regs. decrease the supply curve

Other Factors5. Future Expectations of prices if producers expect prices to increase, they will decrease supply now6. Number of suppliers more producers increases supplyReviewWe have the supply curve, the demand curve and factors that shift the curvesThese can be used to predict the price and quantity at which a good is bought or soldEqulibriumThe intersection of S and D is the equilibrium.The price at this point is the equilibrium price and the quantity is the equilibrium quantity

If supply or demand shifts, the market is in disequilbriumIf qty demand is greater than qty supplied, a shortage resultsPrices will rise and qty supplied will increases until the market is in equilibriumIf qty supplied is greater than qty demanded, a surplus results Prices will decrease and qty supplied will decrease until the market is in equilibrium

Price ControlsIn a few cases, market forces do not determine pricesGovernments have some power to set prices There are two types of price controls

1. Price Ceiling Government imposed price below the equilibrium point, therefore creating a shortageThe maximum legal price that can be charged price capsEx: rent controls in large cities, Medicare or Medicaid payments by the governmentRent ControlP* - equilibrium priceP Price CeilingPf Q* - Equilibrium quantityQd Quantity demandedQs Quantity SuppliedQd Qs = amount of shortage

Problems with Price CeilingsInefficient Allocation to consumers

Wasted ResourcesSearch costs increase (Price Pf), high security depositsLower Quality Landlords cut maintenance or abandon buildingsBlack Markets Bribes, 2. Price Floor The minimum legal price that can be charged price supportsThis price is above the equilibrium point, therefore creating a surplusEx: agricultural price supports, minimum wage

34Minimum WageW* - Equilibrium wageWmin minimum wageL* - equilibrium qty of workersLs number of people willing to workLD number of people hiredLs-Ld=# people unemployed

Quantity ControlsThe government seeks to limit not the price, but the quantity of an item Effects of Price CeilingOverproduction Inflationary effects in related markets

Elasticity of DemandElasticity is how much a price change affects the quantity demandedElastic: a small change in price will cause a large change in quantity demandedInelastic: a change in price will cause little change in quantity demanded

Factors Affecting Elasticity1. Availability of Substitutes the fewer substitutes an item has, the greater its inelasticity 2. Necessity v. Luxury if its considered a necessity, then the greater its inelasticity 3. Percentage of income- if an item uses a large portion of your income, it is more likely to be elastic. If Coke is priced at $1.00 & $1.09 at two stores, you probably wont care. But, if a car youre interested in varies from $18,000 to $19,800 (10%) you might care.4. Change over Time - a good is more elastic if the purchase can be delayed. In emergencies, people are more likely to pay higher prices

Elasticity on the Demand CurveSteep line = inelasticShallow line = elasticVertical line = perfectly inelasticCalculating Elasticity Demand Elasticity is the slope of the demand curveIf the % change in quantity > % change in price, demand is elasticIf the % change in quantity< % change in price, demand is inelasticIf the % change in quantity = % change in price, demand is unit elastic

Demand Elasticity = Percentage Change in Quantity Demanded Percentage Change in Price

Price Effect v. Quantity EffectTotal Revenue and ElasticityTotal Revenue = Price x QtyA rise in price means less qty demandIf an item is elastic, and prices rise, total revenue will decreaseIf an item is inelastic, and prices rise, total revenue increaseWhy?Change in PriceTotal RevenueUpUp InelasticDownDownInelasticUpDownElasticDownUpElasticUp/Down=Unit ElasticElasticity of SupplyThe quantity reaction of the producers to a price changeAn inelastic supply means that producers cannot quickly increase or decrease production if price increasesAn elastic supply means that producers can quickly increase or decrease production if the price increases

Real world examples of perfectly elastic and inelastic supply are easier to find than for demandExamples? Factors that determine supply elasticityAvailability of inputs Time required for production