Supply and Demand - Macmillan Learning

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Supply and Demand

Using the basic tools of supply and demand to determine how prices and quantities are set in a market economy Piet Mall/Corbis

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Learning Objectives 3.1

Describe the characteristics and purposes of markets.

3.2

Describe the nature of demand, demand curves, and the law of demand.

3.3

3.4

Describe the determinants of demand and be able to forecast how a change in one or more of these determinants will change demand. Explain the difference between a change in demand and a change in quantity demanded. Describe the nature of supply, supply curves, and the law of supply.

3.6

Describe the determinants of supply and be able to forecast how a change in one or more of these determinants will change supply.

3.8

product that many people typically can obtain easily from another source free of charge? The bottled water industry! This

industry began its meteoric rise in the early 1990s, and today, the ubiquitous bottle of water has changed the way we live. It also has created new concerns regarding the environmental

3.5

3.7

W

hat $100+ billion global industry sells a

impact of the billions of plastic bottles used and discarded.

The bottled water industry took off as consumers changed their hydration habits, spurred by greater awareness of the health benefits of drinking water, including weight loss, illness prevention, and overall health maintenance. As water consumption increased, people started wanting something more than just ordinary water Determine market equilibrium price from the tap. They desired water that was purer, more consistent and output. in taste, or infused with flavor or minerals. Plus, consumers wantDetermine and predict how price and ed water that was easy to carry. Bottled water was the product output will change given changes to consumers wanted, and the market was willing to provide it. supply and demand in the market. Bottled water comes from many sources, both domestic and foreign, and consists of either spring water (from natural springs underneath the Earth’s surface) or purified water (ordinary tap water that undergoes a complex purification process). As the industry grew, new varieties of water were made available. Water from exotic faraway springs, vitamin-infused water, flavored water, and carbonated water were some of the choices consumers were given. The total amount of water produced for the bottled water industry continued to increase as long as there were customers willing to pay for it in the market. In the late 2000s, falling incomes from a deteriorating global economy, concerns about the harmful effects of discarded plastic bottles on the environment, increased use of home water purification devices, and even some laws against the use of bottled water eventually halted the market’s growth. The economy has since improved, and the bottled water industry responded to the environmental concerns by using bottles made from recycled plastic or by using new technologies to reduce the plastic content in water bottles, again responding to the desires of consumers. As a result, sales increased again. Consumers have many choices of what water to buy and where to buy it. Even so, the bottled water market is one in which prices vary considerably depending on the location of purchase. A single bottle of water of the same brand might cost $0.69 at a grocery store, $0.99 at a convenience store, $1.25 from a vending machine, $1.49 at a local coffee shop, and $3.00 or more at a theme park, sports stadium, or movie theater. How can the same product be sold in different places at so many different prices? This chapter analyzes the various factors influencing how consumers value goods in different settings and circumstances. We also study how producers take costs and incentives into account in determining what products to produce, how much to produce, and what prices to charge. The interaction between consumers and producers within a market determines the prices we pay. In any given market, prices are determined by “what the market will bear.” Which factors determine what the market will bear, and what happens when events that occur in the

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marketplace cause prices to change? For answers to these questions, economists turn to supply and demand analysis. The basic model of supply and demand presented in this chapter will let you determine why product sales rise and fall, in what direction prices move, and how many goods will be offered for sale when certain events happen in the marketplace. Later chapters use this same model to explain complex phenomena such as how wages are set and how personal income is distributed. This chapter introduces some of the basic economic concepts you need to know to understand how the forces of supply and demand work. These concepts include markets, the law of demand, demand curves, the determinants of demand, the law of supply, supply curves, the determinants of supply, and market equilibrium. markets Institutions that bring buyers and sellers together, so they can interact and transact with each other.

MARKETS

A market is an institution that enables buyers and sellers to interact and transact with one another. A lemonade stand is a market because it allows people to exchange money for a product, in this case, lemonade. Ticket scalping, which remains illegal or highly restricted in some states, similarly represents market activity, since it leads to the exchange of money for tickets, whether it takes place in person outside the stadium Do Markets Exist for Everyone, Including Dogs or online. and Cats? The Internet, without a physical location, has dramatically expanded Over 78 million dogs and 86 million cats call the United the notion of markets. Online marStates home, with many times ket sites such as eBay permit firms more finding homes around the and individuals to sell a large numworld. Over four in ten U.S. ber of low-volume products, ranghouseholds include at least one ing from rare collectible items to an pet, which is often treated as a extra box of unused diapers, and still beloved member of the family. make money. This includes students The expenses associated with who resell their textbooks on Amapet ownership often extend bezon.com and Half.com. The Internet yond the basic necessities of also has launched markets for virtual luxury as they or their owners travel, food and vet checkups. goods. For example, buying virtual Total spending on pet-related has boomed over the past decade. Pet consumerism has even gone products in the United States has tools, cash, and animals in online increased every year since 2001, high-tech. Since the introduction of games has become an important part surpassing $60 billion in 2015. Even tablets, programmers have introduced of social media sites. during the depths of the economic new tablet apps designed for cats, inEven though all markets have downturn of 2007 to 2009, spending cluding games that are played feline the same basic component—the on pets continued to increase. The versus human. Such apps highlight transaction—they can differ in a seeming immunity of the pet goods the ability of businesses to turn pets number of ways. Some markets are market to economic hardships raises into consumers, whose desires (even quite limited because of their geoan interesting question of to whom if imagined by their owners) turn into graphical location, or because they the market is geared: the pets or their actual purchases. offer only a few different products The power of consumer decisions sometimes fanatical owners? for sale. The New York Stock ExManufacturers of pet goods have extending beyond the wants of humans increased the types of “consumer” demonstrates the broad reach of marchange  serves as a market for just a goods and services for pets. These kets. Because humans share a deep single type of financial instrument, include a greater selection of pet connection with their furry loved ones, stocks, but it facilitates exchanges foods and toys, but increasingly sell- they will often incorporate their pets’ worth billions of dollars daily. Comers are being more creative in their desires into real consumption choices. pare this to the neighborhood flea offerings. For example, the number And based on the growth of this market, market, which is much smaller and of pet spas, pet hotels, and even pet it’s likely that dogs and cats will conmay operate only on weekends, but airlines, allowing pets to bathe in tinue to be avid consumers. offers everything from food and crafts  to T-shirts and electronics. Jefferson Graham

ISSUE

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Cement manufacturers are typically restricted to local markets due to high transportation costs, whereas Internet firms can easily do business with customers around the world.

The Price System When buyers and sellers exchange money for goods and services, accepting some offers and rejecting others, they are also doing something else: They are communicating their individual desires. Much of this communication is accomplished through the prices of items. If buyers value a particular item sufficiently, they will quickly pay its asking price. If they do not buy it, they are indicating they do not believe the item to be worth its asking price. Prices also give buyers an easy means of comparing goods that can substitute for each other. If the price of margarine falls to half the price of butter, this will suggest to many consumers that margarine is a better deal. Similarly, sellers can determine what goods to sell by comparing their prices. When prices rise for tennis rackets, this tells sporting goods store operators that the public wants more tennis rackets, leading the store operators to order more. Prices, therefore, contain a considerable amount of useful information for both consumers and sellers. For this reason, economists often call our market economy the price system.

price system A name given to the market economy because prices provide considerable information to both buyers and sellers.

CHECKPOINT MARKETS ■

Markets are institutions that enable buyers and sellers to interact and transact business.



Markets differ in geographical location, products offered, and size.



Prices contain a wealth of information for both buyers and sellers.



Through their purchases, consumers signal their willingness to exchange money for particular products at particular prices. These signals help businesses decide what to produce, and how much of it to produce.



The market economy is also called the price system.

QUESTION: What are the important differences between the markets for financial securities such as the New York Stock Exchange and your local farmer’s market? Answers to the Checkpoint questions can be found at the end of this chapter.

DEMAND Whenever you purchase a product, you are voting with your money. You are selecting one product out of many and supporting one firm out of many, both of which signal to the business community what sorts of products satisfy your wants as a consumer. Economists typically focus on wants rather than needs because it is so difficult to determine what we truly need. Theoretically, you could survive on tofu and vitamin pills, living in a lean-to made of cardboard and buying all your clothes from thrift stores. Most people in our society, however, choose not to live in such austere fashion. Rather, they want something more, and in most cases they are willing and able to pay for more.

Willingness-to-Pay: The Building Block of Market Demand Imagine sitting in your economics class around mealtime. In your rush to class, you did not have a chance to make a sandwich at home or to stop at the cafeteria on your way to class. You think about foods that sound appealing to you (just about anything at this point), and plan to go to the cafeteria immediately after class and buy a sandwich. Given your growling stomach, you think more about what you want on your sandwich and less about how much the sandwich will cost. In your mind, your willingness-to-pay (WTP) for that sandwich can be quite high, say, $10 or even more.

willingness-to-pay An individual’s valuation of a good or service, equal to the most an individual is willing and able to pay.

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FIGURE 1

FROM INDIVIDUAL WILLINGNESS-TO-PAY TO MARKET DEMAND

In panel A, you would be willing to pay up to $10 for your first sandwich and $4 for the second. Jane, however, is only willing to pay up to $6 for her first sandwich and $2 for a second (panel B). Placing the WTP for sandwiches by you and Jane in order from the highest to lowest value, we generate a market with two consumers shown in panel C. As more and more individuals are added to the market, the demand for sandwiches becomes a smooth downward-sloping line, shown in panel D.

Panel A Your WTP

Panel B Jane’s WTP

1

1

Panel D Total Market

Panel C Two-Person Market

12 10 8

Price ($)

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6 4 2 0 2

2

1

2

3

4

Quantity

Economists refer to WTP as the maximum amount one would be willing to pay for a good or service, which represents the highest value that a consumer believes the good or service is worth. Of course, one always hopes that the actual price would be much lower. In your case, WTP is the cutoff between buying a sandwich and not buying a sandwich. WTP varies from person to person, from the circumstances each person is in to the number of sandwiches one chooses to buy. Suppose your classmate ate a full meal before she came to class. Her WTP for a sandwich would be much lower than yours because she isn’t hungry at that moment. Similarly, after you buy and consume your first sandwich, your WTP for a second sandwich would decrease because you would be less hungry. The desires consumers have for goods and services are expressed through their purchases in the market. Figure 1 illustrates how individuals’ WTP is used to derive market demand curves. Suppose you are willing to pay up to $10 for the first sandwich and $4 for the second sandwich (shown in panel A), while Jane, your less-hungry classmate, would pay up to $6 for her first sandwich and only $2 for her second sandwich (shown in panel B). If we take the WTP for your two sandwiches and the WTP of Jane’s two sandwiches and place all four values in order from highest to lowest, a two-person market for sandwiches is created as shown in panel C. Notice how the distance between steps becomes smaller in the two-person market. Now suppose we combine the WTPs for everybody in the class (or for an entire city or country) into a single market. What would that diagram look like? In large markets, the difference in WTP between each unit of a good becomes so small that it becomes a straight line, as shown in panel D. These illustrations show how ordinary demand curves, which we will discuss in detail in the remainder of this section, are developed from the perceptions of what individual consumers believe a good or service is worth to them (their WTP). Let’s now discuss an important characteristic of market demand. demand The maximum amount of a product that buyers are willing and able to purchase over some time period at various prices, holding all other relevant factors constant (the ceteris paribus condition).

The Law of Demand: The Relationship Between Quantity Demanded and Price Demand refers to the goods and services people are willing and able to buy during a certain period of time at various prices, holding all other relevant factors constant (the ceteris paribus condition). Typically, when the price of a good or service increases (say your favorite

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Supply and Demand

Bloomberg/Getty Images

café raises its prices), the quantity demanded will decrease because fewer and fewer people will be willing and able to spend their money on such things. However, when prices of goods or services decrease (think of sales offered the day after Thanksgiving), the quantity demanded increases. In a market economy, there is a negative relationship between price and quantity demanded. This relationship, in its most basic form, states that as price increases, the quantity demanded falls, and conversely, as price falls, the quantity demanded increases. This principle, when all other factors are held constant, is known as the law of demand. The law of demand states that the lower a product’s price, the more of that product consumers will purchase during a given time period. This straightforward, commonsense notion happens because, as a product’s price drops, consumers will substitute the now cheaper product for other, more expensive products. Conversely, if the product’s price rises, consumers will find other, less expensive products to substitute for it. To illustrate, when videocassette recorders first came on the market 35 years ago, they cost $3,000, and few homes had one. As VCRs became less and less expensive, however, more people bought them, and others found more uses for them. Two decades later, VCRs became obsolete as DVD players became the standard means of watching movies at home. Today, DVD players are becoming obsolete as digital movie streaming surpassed DVD sales. Similarly, digital music players have altered the structure of the music business, and digital cameras have essentially replaced cameras that use film. Time is an important component in the demand for many products. Consuming many products—watching a movie, eating a pizza, playing tennis—takes some time. Thus, the price of these goods includes not only their monetary cost but also the opportunity cost of the time needed to consume them. It follows that, all other things being equal, including the cost of a ticket, we would expect more consumers to attend a two-hour movie than a fourhour movie. The shorter movie simply requires less of a time investment.

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The Demand Curve The law of demand states that as price decreases, quantity demanded increases. When we translate demand information into a graph, we create a demand curve. This demand curve, which slopes down and to the right, graphically illustrates the law of demand. A demand curve shows both the willingness-to-pay for any given quantity and what the quantity demanded will be at any given price. In Figure 1, we saw how individual demands (measured by willingness-to-pay) can be combined to represent market demand, which can consist of many consumers. For simplicity, from this point we will assume that all demand curves, including those for individuals, are linear (straight lines). Consider the market for gaming apps, games that can be downloaded onto one’s smartphone or tablet. The mobile gaming industry is a $25 billion industry. Although each gaming app costs no more than a few dollars to download, sales of gaming apps have surpassed sales of PC and console games. Gaming apps such as Candy Crush Saga, Angry Birds, and Words with Friends have each been downloaded hundreds of millions of times. Let’s examine the relationship between the price of gaming apps and the quantity demanded by individual consumers and the market. For simplicity, assume that all gaming apps are the same price. Suppose Abe and Betty are the only two consumers in the market for gaming apps. Figure 2 shows each of their annual demands using a demand schedule and a demand curve. A demand schedule is a table indicating the quantities consumers are willing to purchase at each price. Looking at the demand schedule, we can see that both Abe and Betty are willing to buy more gaming apps as the price decreases. When the price is $10, Abe is willing to buy 10 games, while Betty buys none. When the price falls to $8, Abe is willing to buy 15 games and Betty would buy 5. We can take the values from the demand schedule in the table and graph them in a figure, with price shown on the vertical axis and quantity of gaming apps on the horizontal

The day after Thanksgiving, dubbed “Black Friday,” is when stores offer steep discounts to jumpstart the holiday shopping season. This leads to massive quantities of goods sold, in an example of the law of demand.

law of demand Holding all other relevant factors constant, as price increases, quantity demanded falls, and as price decreases, quantity demanded rises.

demand curve A graphical illustration of the law of demand, which shows the relationship between the price of a good and the quantity demanded.

demand schedule A table that shows the quantity of a good a consumer purchases at each price.

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FIGURE 2

MARKET DEMAND: HORIZONTAL SUMMATION OF INDIVIDUAL DEMAND CURVES

Abe and Betty’s demand schedules (the table) and their individual demand curves (the graph) for gaming apps are shown. Abe will purchase 15 gaming apps when the price is $8, buy 25 apps when the price falls to $4, and buy more as prices continue to fall. Betty will purchase 5 gaming apps when the price is $8 and buy 15 when the price falls to $4. The individual demand curves for Abe and Betty are shown as Da and Db, respectively, and are horizontally summed to get market demand, DMkt. Horizontal summation involves adding together the quantities demanded by each individual at each possible price.

horizontal summation The process of adding the number of units of the product purchased or supplied at each price to determine market demand or supply.

12 10 c

8

Price ($)

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6 e

4

Price

Abe

Betty

Market

$12 10 8 6 4 2

0 10 15 20 25 30

0 0 5 10 15 20

0 10 20 30 40 50

2

0

10

20

DMkt

Da

Db 30

40

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Quantity (gaming apps)

axis, following the convention in economics of always placing price on the vertical axis and quantity on the horizontal axis. By doing so, we can create a demand curve for both Abe and Betty. Both the table and the graph convey the same information. They also both portray the law of demand. As the price decreases, Abe and Betty demand more gaming apps. Although individual demand curves are interesting, market demand curves are far more important to economists, as they can be used to predict changes in product price and quantity. Further, one can observe what happens to a product’s price and quantity and infer what changes have occurred in the market. Market demand is the sum of individual demands. To calculate market demand, economists simply add the number of units of a product all consumers will purchase at each price. This process is known as horizontal summation. Turning to the demand curves in Figure 2, the individual demand curves for Abe and Betty, Da and Db, are shown. For simplicity, let’s assume they represent the entire market, but recognize that this process would work for any larger number of people. Note that at a price of $10 a game, Betty will not buy any, although Abe is willing to buy 10 apps at $10 each. Above $10, therefore, the market demand is equal to Abe’s demand. At $10 and below, however, we add both Abe’s and Betty’s demands at each price to obtain market demand. Thus, at $8, individual demand is 15 for Abe and 5 for Betty; therefore, the market demand is equal to 20 (point c). When the price is $4 an app, Abe buys 25 and Betty buys 15, for a total of 40 apps (point e). The heavier curve, labeled DMkt, represents this market demand; it is a horizontal summation of the two individual demand curves. This all sounds simple in theory, but in the real world estimating market demand curves is tricky, given that many markets contain millions of consumers. Economic analysts and marketing professionals use sophisticated statistical techniques to estimate the market demand for particular goods and services in the industries they represent. The market demand curve shows the maximum amount of a product consumers are willing and able to purchase during a given time period at various prices, all other relevant factors being held constant. Economists use the term determinants of demand to refer to these other, nonprice factors that are held constant. This is another example of the use of ceteris paribus: holding all other relevant factors constant.

Determinants of Demand Up to this point, we have discussed only how price affects the quantity demanded. When prices fall, consumers purchase more of a product; thus quantity demanded rises. When

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prices rise, consumers purchase less of a product; thus, quantity demanded falls. But several other factors besides price also affect demand, including what people like, what their income is, and how much related products cost. More specifically, there are five key determinants of demand: (1) tastes and preferences; (2) income; (3) prices of related goods; (4) the number of buyers; and (5) expectations regarding future prices, income, and product availability. When one of these determinants changes, the entire demand curve changes. Let’s see why. Tastes and Preferences We all have preferences for certain products over others, easily perceiving subtle differences in styling and quality. Automobiles, fashions, phones, and music are just a few of the products that are subject to the whims of the consumer. Remember Crocs, those brightly colored rubber sandals with the little air holes that moms, kids, waitresses, and many others favored? They were an instant hit. Initially, demand was D0 in Figure 3. They then became such a fad that demand jumped to D1 and for a short while Crocs were hard to find. Eventually, Crocs were everywhere. Fads come and go, and now the demand for them settled back to something like D2, less than the original level. Notice an important distinction here: More Crocs weren’t sold because the price was lowered; the entire demand curve shifted rightward when they were hot and more Crocs could be sold at all prices. Now that the fad has subsided, fewer will be sold at all prices. It is important to keep in mind that when one of the determinants changes, such as tastes and preferences, the entire demand curve shifts. Income Income is another important factor influencing consumer demand. Generally speaking, as income rises, demand for most goods will likewise increase. Get a raise, and you are more likely to buy more clothes and acquire the latest technology gadgets. Your demand curve for these goods will shift to the right (such as from D0 to D1 in Figure 3). Products for which demand is positively linked to income—when income rises, demand for the product also rises—are called normal goods. There are also some products for which demand declines as income rises, and the demand curve shifts to the left. Economists call these products inferior goods. As income grows, for instance, the consumption of discount clothing and cheap motel stays will likely fall as individuals upgrade their wardrobes and stay in more comfortable hotels when traveling. Similarly, when you graduate from college and your income rises, your consumption of ramen noodles will fall as you begin to cook tastier dinners and eat out more frequently.

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determinants of demand Nonprice factors that affect demand, including tastes and preferences, income, prices of related goods, number of buyers, and expectations.

normal good A good for which an increase in income results in rising demand.

inferior good A good for which an increase in income results in declining demand.

Prices of Related Goods The prices of related commodities also affect consumer decisions. You may be an avid concertgoer, but with concert ticket prices often topping $100, further rises in the price of concert tickets may entice you to see more movies and

FIGURE 3

SHIFTS IN THE DEMAND CURVE

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Price ($)

40 30 20 D1 10

D0 D2

0

5

10

15

20

The demand for Crocs originally was D0. When they became a fad, demand shifted to D1 as consumers were willing and able to purchase more at all prices. Once the fad cooled off, demand fell (shifted leftward) to D2 as consumers wanted less at each price. When a determinant such as tastes and preferences changes, the entire demand curve shifts.

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Quantity of Crocs Sold (millions of pairs)

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substitute goods Goods consumers will substitute for one another. When the price of one good rises, the demand for the other good increases, and vice versa.

complementary goods Goods that are typically consumed together. When the price of a complementary good rises, the demand for the other good declines, and vice versa.

fewer concerts. Movies, concerts, plays, and sporting events are good examples of substitute goods, because consumers can substitute one for another depending on their respective prices. When the price of concerts rises, your demand for movies increases, and vice versa. These are substitute goods. Movies and popcorn, on the other hand, are examples of complementary goods. These are goods that are generally consumed together, such that an increase or decrease in the consumption of one will similarly result in an increase or decrease in the consumption of the other—see fewer movies, and your consumption of popcorn will decline. Other complementary goods include cars and gasoline, hot dogs and hot dog buns, and ski lift tickets and ski rentals. Thus, when the price of lift tickets increases, the quantity of lift tickets demanded falls, which causes your demand for ski rentals to fall as well (shifts to the left), and vice versa. The Number of Buyers Another factor influencing market demand for a product is the number of potential buyers in the market. Clearly, the more consumers there are who would be likely to buy a particular product, the higher its market demand will be (the demand curve will shift rightward). As our average life span steadily rises, the demands for medical services and retirement communities likewise increases. As more people than ever enter universities and graduate schools, demand for textbooks and backpacks increases. Expectations About Future Prices, Incomes, and Product Availability The final factor influencing demand involves consumer expectations. If consumers expect shortages of certain products or increases in their prices in the near future, they tend to rush out and buy these products immediately, thereby increasing the present demand for the products. The demand curve shifts to the right. During the Florida hurricane season, when a large storm forms and begins moving toward the coast, the demand for plywood, nails, bottled water, and batteries quickly rises. The expectation of a rise in income, meanwhile, can lead consumers to take advantage of credit in order to increase their present consumption. Department stores and furniture stores, for example, often run “no payments until next year” sales designed to attract consumers who want to “buy now, pay later.” These consumers expect to have more money later, when they can pay, so they go ahead and buy what they want now, thereby increasing the present demand for the promoted items. Again, the demand curve shifts to the right. The key point to remember from this section is that when one of the determinants of demand changes, the entire demand curve shifts rightward (an increase in demand) or leftward (a decline in demand). A quick look back at Figure 3 shows that when demand increases, consumers are willing to buy more at all prices, and when demand decreases, they will buy less at each and every price.

Changes in Demand Versus Changes in Quantity Demanded

change in demand Occurs when one or more of the determinants of demand changes, shown as a shift in the entire demand curve.

When the price of a product rises, consumers buy fewer units of that product. This is a movement along an existing demand curve. However, when one or more of the determinants changes, the entire demand curve is altered. Now at any given price, consumers are willing to purchase more or less depending on the nature of the change. This section focuses on this important distinction between changes in demand versus changes in quantity demanded. A change in demand occurs whenever one or more of the determinants of demand change and demand curves shift. When demand changes, the demand curve shifts either to the right or to the left. Let’s look at each shift in turn. Demand increases when the entire demand curve shifts to the right. At all prices, consumers are willing to purchase more of the product in question. Figure 4 shows an increase in demand for gaming apps; the demand curve shifts from D0 to D1. Notice that more gaming apps are purchased at all prices along D1 as compared to D0. Now look at a decrease in demand, when the entire demand curve shifts to the left. At all prices, consumers are willing to purchase less of the product in question. A drop in consumer income is normally associated with a decrease in demand (the demand curve shifts to the left, as from D0 to D2 in Figure 4).

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FIGURE 4

CHANGES IN DEMAND VERSUS CHANGES IN QUANTITY DEMANDED

Increase in demand (curve shifts)

10 a

8

Price ($)

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b

Increase in quantity demanded (movement along a curve)

6 D1

c

4 2

D0 D2

0

10

20

30

40

A shift in the demand curve from D0 to D1 represents an increase in demand, and consumers will buy more of the product at each price. A shift from D0 to D2 reflects a decrease in demand. A movement along D0 from point a to point c indicates an increase in quantity demanded; this type of movement can only be caused by a change in the price of the product.

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Quantity (gaming apps)

Whereas a change in demand can be brought about by many different factors, a change in quantity demanded can be caused by only one thing: a change in product price. This is shown in Figure 4 as a reduction in price from $8 to $4, resulting in sales (quantity demanded) increasing from 20 (point a) to 40 (point c) apps. This distinction between a change in demand and a change in quantity demanded is important. Reducing price to increase sales is different from spending a few million dollars on Super Bowl advertising to increase sales at all prices. These concepts are so important that a quick summary is in order. As Figure 4 illustrates, given the initial demand D0, increasing sales from 20 to 40 apps can occur in either of two ways. First, changing a determinant (say, increasing advertising) could shift the demand curve to D1 so that 40 apps would be sold at $8 (point b). Alternatively, 40 apps could be sold by reducing the price to $4 (point c). Selling more by increasing advertising causes an increase in demand, or a shift in the entire demand curve. Simply reducing the price, on the other hand, causes an increase in quantity demanded, or a movement along the existing demand curve, D0, from point a to point c.

change in quantity demanded Occurs when the price of the product changes, shown as a movement along an existing demand curve.

CHECKPOINT DEMAND ■

A person’s willingness-to-pay is the maximum amount she or he values a good to be worth at a particular moment in time and is the building block for demand.



Demand refers to the quantity of products people are willing and able to purchase at various prices during some specific time period, all other relevant factors being held constant.



The law of demand states that price and quantity demanded have an inverse (negative) relation. As price rises, consumers buy fewer units; as price falls, consumers buy more units. It is depicted as a downward-sloping demand curve.



Demand curves shift when one or more of the determinants of demand change.



The determinants of demand are consumer tastes and preferences, income, prices of substitutes and complements, the number of buyers in a market, and expectations about future prices, incomes, and product availability.



A shift of a demand curve is a change in demand, and occurs when a determinant of demand changes.

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A change in quantity demanded occurs only when the price of a product changes, leading consumers to adjust their purchases along the existing demand curve.

QUESTIONS: Sales of electric plug-in cars, such as the Tesla, have risen in recent years. Despite their relatively high price compared to gasoline-powered cars and the limited distance the cars can travel before requiring a recharge, other manufacturers are adding new models of plug-ins to their lines. What has led to the rising popularity of plug-in cars? Is this an increase in demand or an increase in quantity demanded? Answers to the Checkpoint questions can be found at the end of this chapter.

SUPPLY The analysis of a market economy rests on two foundations: supply and demand. So far, we’ve covered the demand side of the market. Let’s focus now on the decisions businesses make regarding production numbers and sales. These decisions cause variations in product supply.

The Law of Supply: The Relationship Between Quantity Supplied and Price supply The maximum amount of a product that sellers are willing and able to provide for sale over some time period at various prices, holding all other relevant factors constant (the ceteris paribus condition).

law of supply Holding all other relevant factors constant, as price increases, quantity supplied rises, and as price declines, quantity supplied falls.

supply curve A graphical illustration of the law of supply, which shows the relationship between the price of a good and the quantity supplied.

Supply is the maximum amount of a product that producers are willing and able to offer for sale at various prices, all other relevant factors being held constant. The quantity supplied will vary according to the price of the product. What explains this relationship? As we saw in the previous chapter, businesses inevitably encounter rising opportunity costs as they attempt to produce more and more of a product. This is due in part to diminishing returns from available resources, and in part to the fact that when producers increase production, they must either have existing workers put in overtime (at a higher hourly pay rate) or hire additional workers away from other industries (again at premium pay). Producing more units, therefore, makes it more expensive to produce each individual unit. These increasing costs give rise to the positive relationship between product price and quantity supplied to the market. Unfortunately for producers, they can rarely charge whatever they would like for their products; they must charge whatever the market will permit. But producers can decide how much of their product to produce and offer for sale. The law of supply states that higher prices will lead producers to offer more of their products for sale during a given period. Conversely, if prices fall, producers will offer fewer products to the market. The explanation is simple: The higher the price, the greater the potential for higher profits and thus the greater the incentive for businesses to produce and sell more products. Also, given the rising opportunity costs associated with increasing production, producers need to charge these higher prices to increase the quantity supplied profitably. Let’s return to our market for gaming apps. Why do programmers spend countless hours developing new gaming apps? Because they have an incentive to do so. Much like how consumers download more gaming apps when the price goes down, the opposite is true for suppliers. As the price rises, programmers are more willing to create new games, enhance existing games, and provide more server capacity (to ensure games operate smoothly) and technical support, all to increase the quantity of gaming apps supplied. Although gaming apps are not a physical good, the law of supply still applies. This is no different than an oil producer drilling for more oil when the price rises. In each case, producers respond to changes in price.

The Supply Curve Just as demand curves graphically display the law of demand, supply curves provide a graphical representation of the law of supply. The supply curve shows the maximum

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FIGURE 5

SUPPLY OF GAMING APPS

S0 10

Price ($)

8 6 4

Price

Quantity

$2 4 6 8 10

10 20 30 40 50

2

0

65

10

20

30

40

50

This supply curve graphs the supply schedule and shows the maximum quantity of gaming apps that producers will offer for sale over some defined period of time. The supply curve is positively sloped, reflecting the law of supply. In other words, as prices rise, quantity supplied increases; as prices fall, quantity supplied falls.

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Quantity (gaming apps)

amounts of a product a producer will furnish at various prices during a given period of time. While the demand curve slopes down and to the right, the supply curve slopes up and to the right.1 This illustrates the positive relationship between price and quantity supplied: The higher the price, the greater the quantity supplied.

Market Supply Curves As with demand, economists are more interested in market supply than in the supplies offered by individual firms. To compute market supply, use the same method used to calculate market demand, horizontally summing the supplies of individual producers. A hypothetical market supply curve for gaming apps is depicted in Figure 5. The quantity of gaming apps that producers will offer for sale increases as the price of gaming apps rises. The opposite would happen if the price of gaming apps falls.

Determinants of Supply Like demand, several nonprice factors help to determine the supply of a product. Specifically, there are six determinants of supply: (1) production technology, (2) costs of resources, (3) prices of related commodities, (4) expectations, (5) the number of sellers (producers) in the market, and (6) taxes and subsidies. Production Technology Technology determines how much output can be produced from given quantities of resources. If a factory’s equipment is old and can produce only 50 units of output per hour, then no matter how many other resources are employed, those 50 units are the most the factory can produce in an hour. If the factory is outfitted with newer, more advanced equipment capable of turning out 100 units per hour, the firm can supply more of its product at the same price as before, or even at a lower price. In Figure 6, this would be represented by a shift in the supply curve from S0 to S1. At every single price, more would be supplied. Technology further determines the nature of products that can be supplied to the market. A hundred years ago, the supply of computers on the market was zero because computers did not yet exist. More recent advances in microprocessing and miniaturization brought a wide array of products to the market that were not available just a few years 1

determinants of supply Nonprice factors that affect supply, including production technology, costs of resources, prices of related commodities, expectations, number of sellers, and taxes and subsidies.

There are some exceptions to positively sloping supply curves. But for our purposes, we will ignore them for now.

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FIGURE 6

SHIFTS IN THE SUPPLY CURVE

The supply of gaming apps originally is S0. If supply shifts to S1, producers are willing to sell more at all prices. If supply falls, supply shifts leftward to S2. Now firms are willing to sell less at each price. When a determinant of supply changes, the entire supply curve shifts.

S2

S0

10 8

Price ($)

66

S1

6 4 2

0

10

20

30

40

50

60

Quantity (gaming apps)

ago, including mini-tablets, auto engines that go 100,000 miles between tune-ups, and constant-monitoring insulin pumps that automatically keep a diabetic patient’s glucose levels under control. Costs of Resources Resource costs clearly affect production costs and supply. If resources such as raw materials or labor become more expensive, production costs will rise and supply will be reduced (the supply curve shifts to the left, from S0 to S2 in Figure 6). The reverse is true if resource costs drop (the supply curve shifts to the right, from S0 to S1). The growing power of microchips along with their falling cost has resulted in cheap and plentiful electronics and computers. Nanotechnology—manufacturing processes that fashion new products through the combination of individual atoms—may soon usher in a whole new generation of inexpensive products. However, when the cost of resources (such as oil and farm products) rise, the cost of products using those resources in their manufacture will go up, leading to the supply being reduced (the supply curve shifts leftward). If labor costs rise because immigration is restricted, this drives up production costs of California vegetables (fewer farmworkers) and software in Silicon Valley (fewer software engineers from abroad) and leads to a shift in the supply curve to the left in Figure 6. Prices of Related Commodities Most firms have some flexibility in the portfolio of goods they produce. A vegetable farmer, for example, might be able to grow celery or radishes, or some combination of the two. Given this flexibility, a change in the price of one item may influence the quantity of other items brought to market. If the price of celery should rise, for instance, most farmers will start growing more celery. And since they all have a limited amount of land on which to grow vegetables, this reduces the quantity of radishes they can produce. Hence, in this case, the rise in the price of celery may well cause a reduction in the supply of radishes (the supply curve for radishes shifts leftward). Expectations The effects of future expectations on market supplies can be confusing, but it need not be. When sellers expect prices of a good to rise in the future, they are likely to restrict their supply in the current period in anticipation of receiving higher prices in some future period. Examples include homes and stocks—if you believe prices are going up, you’d be less likely to sell today, which decreases the supply of such goods (supply shifts to the left). Similarly, expectations of price reductions can increase supply as sellers try to sell off their inventories before prices drop (supply shifts to the right).

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Eventually, if prices do rise in the next period, producers would increase the quantity supplied of the good; however, this would be due to the law of supply, not due to a shift of the supply curve. In other words, rising prices result in a movement along the supply curve. Only when producers anticipate a change in a future price, causing a reaction now, does supply shift. Number of Sellers Everything else being held constant, if the number of sellers in a particular market increases, the market supply of their product increases. It is no great mystery why: Ten dim sum chefs can produce more dumplings in a given period than five dim sum chefs. Taxes and Subsidies For businesses, taxes and subsidies affect costs. An increase in taxes (property, excise, or other fees) will shift supply to the left and reduce it. Subsidies are the opposite of taxes. If the government subsidizes the production of a product, supply will shift to the right and rise. A proposed new tax on expensive health care insurance plans may reduce supply (the tax is equivalent to an increase in production costs), while today’s subsidies to ethanol producers expand ethanol production.

Changes in Supply Versus Changes in Quantity Supplied A change in supply results from a change in one or more of the determinants of supply; it causes the entire supply curve to shift. An increase in supply of a product, perhaps because advancing technology has made it cheaper to produce, means that more of the commodity will be offered for sale at every price. This causes the supply curve to shift to the right, as illustrated in Figure 7 by the shift from S0 to S1. A decrease in supply, conversely, shifts the supply curve to the left, since fewer units of the product are offered at every price. Such a decrease in supply is represented by the shift from S0 to S2. A change in supply involves a shift of the entire supply curve. In contrast, the supply curve does not move when there is a change in quantity supplied. Only a change in the price of a product can cause a change in the quantity supplied; hence, it involves a movement along an existing supply curve rather than a shift to an entirely different curve. In Figure 7, for example, an increase in price from $4 to $8 results in an increase in quantity supplied from 20 to 40 apps, represented by the movement from point a to point c along S0. In summary, a change in supply is represented in Figure 7 by the shift from S0 to S1 or S2, which involves a shift in the entire supply curve. For example, an increase in supply from S0

Increase in quantity supplied (movement along a curve)

S2

S0

10 c

Price ($)

8

S1

6 a b Increase in supply (curve shifts)

2

0

10

change in quantity supplied Occurs when the price of the product changes, shown as a movement along an existing supply curve.

CHANGES IN SUPPLY VERSUS CHANGES IN QUANTITY SUPPLIED

FIGURE 7

4

change in supply Occurs when one or more of the determinants of supply change, shown as a shift in the entire supply curve.

20

30

40

50

A shift in the supply curve from S0 to S1 represents an increase in supply, because businesses are willing to offer more of the product to consumers at all prices. A shift from S0 to S2 reflects a decrease in supply. A movement along S0 from point a to point c represents an increase in quantity supplied; this type of movement can only be caused by a change in the price of the product.

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to S1 results in an increase in supply from 20 gaming apps (point a) to 40 (point b) provided at a price of $4. More apps are provided at the same price. In contrast, a change in quantity supplied is shown in Figure 7 as a movement along an existing supply curve, S0, from point a to point c caused by an increase in the price of the product from $4 to $8. As on the demand side, this distinction between changes in supply and changes in quantity supplied is crucial. It means that when a product’s price changes, only quantity supplied changes—the supply curve does not move. A summary of the determinants for both supply and demand is shown in Figure 8. FIGURE 8

SUMMARY OF CHANGES IN DEMAND AND SUPPLY AND THEIR DETERMINANTS

Panel B Supply

10

10

8

8

6 D1

Price ($)

Price ($)

Panel A Demand

4

S2 S0

6

S1

4

2

D2 10

0

20

30

D0

2

50

0

40

10

Quantity (gaming apps)

20

30

40

50

Quantity (gaming apps)

Determinants of Demand

Determinants of Supply

Decrease in Demand

Increase in Demand

Tastes and prefer-

Tastes and prefer-

Technology

ences fall.

ences rise.

deteriorates.

Income falls (for

Income rises (for

Resource costs rise.

Resource costs fall.

normal goods).

normal goods).

Price of substitutes

Price of substitutes

Price of production

Price of production

falls.

rises.

substitute rises.

substitute falls.

Price of complements

Price of complements

Price expectations for

Price expectations for

rises.

falls.

future rise.

future fall.

Number of buyers

Number of buyers

Number of sellers

Number of sellers

falls.

rises.

falls.

rises.

Price expectations for

Price expectations for

Taxes rise or subsidies

Taxes fall or subsidies

future fall.

future rise.

fall.

rise.

Various factors cause a market demand curve to shift to the left (decrease in demand) or shift to the right (increase in demand) in panel A. Similarly, various factors cause a market supply curve to

Decrease in Supply

Increase in Supply Technology improves.

shift to the left (decrease in supply) or shift to the right (increase in supply) in panel B. The table summarizes the factors influencing demand and supply shifts.

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69

CHECKPOINT SUPPLY ■

Supply is the quantity of a product producers are willing and able to put on the market at various prices, all other relevant factors being held constant.



The law of supply reflects the positive relationship between price and quantity supplied: The higher the market price, the more goods supplied, and the lower the market price, the fewer goods supplied.



As with demand, market supply is derived by horizontally summing the individual supplies of all of the firms in the market.



A change in supply occurs when one or more of the determinants of supply change.



The determinants of supply are production technology, the cost of resources, prices of related commodities, expectations about future prices, the number of sellers or producers in the market, and taxes and subsidies.



A change in supply is a shift in the supply curve. A shift to the right reflects an increase in supply, while a shift to the left represents a decrease in supply.



A change in quantity supplied is only caused by a change in the price of the product; it results in a movement along the existing supply curve.

QUESTIONS: At the end of the term, bookstores often increase the prices offered to students for their used textbooks in order to stock their shelves for the following term. Would an increase in the buyback price affect the supply or the quantity supplied of used textbooks? Suppose an unusually difficult professor leads to many students having to retake the course the next term. How might this affect the supply for used textbooks? Answers to the Checkpoint questions can be found at the end of this chapter.

MARKET EQUILIBRIUM Supply and demand together determine the prices and quantities of goods bought and sold. Neither factor alone is sufficient to determine price and quantity. It is through their interaction that supply and demand do their work, just as two blades of a scissors are required to cut paper. A market will determine the price at which the quantity of a product demanded is equal to the quantity supplied. At this price, the market is said to be cleared or to be in equilibrium, meaning that the amount of the product that consumers are willing and able to purchase is matched exactly by the amount that producers are willing and able to sell. This is the equilibrium price and the equilibrium quantity. The equilibrium price is also called the market-clearing price. Figure 9 puts together Figures 2 and 5, showing the market supply and demand for gaming apps. It illustrates how supply and demand interact to determine equilibrium price and quantity. Clearly, the quantities demanded and supplied equal one another only where  the supply and demand curves cross, at point e. From the table in Figure 9, you can see that quantity demanded and quantity supplied are the same at only one price. At $6 per app, sellers are willing to provide exactly the same quantity as consumers would like to purchase. Hence, at this price, the market clears, since buyers and sellers both want to transact the same number of units. The beauty of a market is that it automatically works to establish the equilibrium price and quantity, without any guidance from anyone. To see how this happens, let us assume that gaming apps are initially priced at $8, a price above their equilibrium price. As we can see by comparing points a and b, sellers are willing to supply more apps at this price than consumers are willing to buy. Economists characterize such a situation as one of excess supply, or surplus. In this case, at $8, sellers supply 40 apps to the market (point b), yet buyers want to purchase only 20 (point a). This leaves an excess of 20 apps overhanging the market; these unsold apps ultimately become surplus inventories.

equilibrium Market forces are in balance when the quantities demanded by consumers just equal the quantities supplied by producers.

equilibrium price The price at which the quantity demanded is just equal to quantity supplied.

equilibrium quantity The output that results when quantity demanded is just equal to quantity supplied.

surplus Occurs when the price is above market equilibrium, and quantity supplied exceeds quantity demanded.

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Chapter 3

FIGURE 9

EQUILIBRIUM PRICE AND QUANTITY OF GAMING APPS

Market equilibrium is achieved when quantity demanded and quantity supplied are equal at the market price. In this graph, that equilibrium occurs at point e, at an equilibrium price of $6 and an equilibrium output of 30. If the market price is above equilibrium ($8), a surplus of 20 computer apps will result (b − a), and market forces would drive the price back down to $6. When the market price is too low ($4), a shortage of 20 computer apps will result (d − c), and businesses will raise the offering prices until equilibrium is again restored.

shortage Occurs when the price is below market equilibrium, and quantity demanded exceeds quantity supplied.

S0 10 a

8

Price ($)

70

Surplus

b

Price $8 6 4

e

6 c

4

Quantity Demanded

Quantity Supplied

20 30 40

40 30 20

d Shortage

2 D0 0

10

20

30

40

50

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Quantity (gaming apps)

Here is where the market kicks in to restore equilibrium. As inventories rise, most firms cut production. Some firms, moreover, start reducing their prices to increase sales. Other firms must then cut their own prices to remain competitive. This process continues, with firms cutting their prices and production, until most firms have managed to exhaust their surplus inventories. This happens when prices reach $6 and quantity supplied equals 30, because consumers are once again willing to buy up the entire quantity supplied at this price, and the market is restored to equilibrium. In general, therefore, when prices are set too high, surpluses result, which drive prices back down to their equilibrium levels. If, conversely, a price is initially set too low, say, at $4, a shortage results. In this case, buyers want to purchase 40 apps (point d), but sellers are only providing 20 (point c), creating a shortage of 20 apps. Because consumers are willing to pay more than $4 to obtain the few apps available on the market, they will start bidding up the price of gaming apps. Sensing an opportunity to make some money, firms will start raising their prices and increasing production once again until equilibrium is restored. Hence, in general, excess demand causes firms to raise prices and increase production. When there is a shortage in a market, economists speak of a tight market or a seller’s market. Under these conditions, producers have no difficulty selling off all their output. On the other hand, when a surplus of goods floods the market, this gives rise to a buyer’s market, because buyers can buy all the goods they want at attractive prices. We have now seen how changing prices naturally works to clear up shortages and surpluses, thereby returning markets to equilibrium. Some markets, once disturbed, will return to equilibrium quickly. Examples include the stock, bond, and money markets, where trading is nearly instantaneous and extensive information abounds. Other markets react very slowly. Consider the labor market, for instance. When workers lose their jobs due to a plant closing, most will search for new jobs that pay at least as much as the salary at their previous jobs. Some will be successful, while others might struggle, having to settle for a lower-paying position after a long job search. Similarly, real estate markets can be slow to adjust because sellers will often refuse to accept a price below what they are asking, until the lack of sales over time convinces sellers to adjust the price downward. These automatic market adjustments can make some buyers and sellers feel uncomfortable: It seems as if prices and quantities are being set by forces beyond anyone’s control. In fact, this phenomenon is precisely what makes market economies function so efficiently.

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Without anyone needing to be in control, prices and quantities naturally gravitate toward equilibrium levels. Adam Smith was so impressed by the workings of the market that he suggested that it is almost as if an “invisible hand” guides the market to equilibrium. Given the self-correcting nature of the market, long-term shortages or surpluses are almost always the result of government intervention, as we will see in the next chapter. First, however, we turn to a discussion of how the market responds to changes in supply and demand, or to shifts of the supply and demand curves.

71

ALFRED MARSHALL (1842–1924)

Moving to a New Equilibrium: Changes in Supply and Demand Once a market is in equilibrium and the forces of supply and demand balance one another out, the market will remain there unless an external factor changes. But when the supply curve or demand curve shifts (some determinant changes), equilibrium also shifts, resulting in a new equilibrium price and/or output. The ability to predict new equilibrium points is one of the most useful aspects of supply and demand analysis.

ritish economist Alfred Marshall is considered the father of the modern theory of supply and demand—that price and output are determined by both supply and demand. He noted that the two go together like the blades of a scissors that cross at equilibrium. He assumed that changes in quantity demanded were only affected by changes in price, and that all other factors remained constant. Marshall also is credited with developing the ideas of the laws of demand and supply, and the concepts of consumer surplus and producer surplus— concepts we will study in the next chapter. With financial help from his uncle, Marshall attended St. John’s College, Cambridge, to study mathematics and physics. However after long walks through the poorest sections of several European cities and seeing their horrible conditions, he decided to focus his attention on political economy. In 1890 he published Principles of Economics. In it he introduced many new ideas, though he would never boast about them as being novel. In hopes of appealing to the general public, Marshall buried his diagrams in footnotes. And, although he is credited with many economic theories, he would always clarify them with various exceptions and qualifications. He expected future economists to flesh out his ideas. Above all, Marshall loved teaching and his students. His lectures were known to never be orderly or systematic because he tried to get students to think with him and ultimately think for themselves. At one point near the turn of the 20th century, essentially all of the leading economists in England had been his students. More than anyone else, Marshall is given credit for establishing economics as a discipline of study. He died in 1924.

B

Information from E. Ray Canterbery, A Brief History of Economics: Artful Approaches Predicting the New Equilibrium to the Dismal Science (Hackensack, NJ: World Scientific), 2001; Robert Skidelsky, When One Curve Shifts When only John Maynard Keynes: Volume 2, The Economist as Saviour 1920–1937 (New York: supply or only demand changes, the Penguin Press), 1992; and John Maynard Keynes, Essays in Biography (New York: Norton), 1951. change in equilibrium price and equilibrium output can be predicted. We begin with changes in supply. Changes in Supply Figure 10 shows what happens when supply changes. Equilibrium initially is at point e, with equilibrium price and quantity at $9 and 30, respectively. But let us assume that a rise in wages or the bankruptcy of a key business in the market Eric Chiang (the number of sellers falls) causes a decrease in supply. When supply declines (the supply curve shifts from S0 to S2), equilibrium price rises to $12, while equilibrium output falls to 20 (point a). If, on the other hand, supply increases (the supply curve shifts from S0 to S1), equilibrium price falls to

When Universal Studios in Florida expanded its popular Wizarding World of Harry Potter attraction in 2014 with the opening of Diagon Alley and Hogwarts Express, demand for Universal Studios tickets increased. A one-day ticket (allowing entry to both parks) now exceeds $160. And that doesn’t include the wand (another $30 to $40) needed to operate many of the Harry Potter experiences!

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FIGURE 10 When supply alone shifts, the effects on both equilibrium price and output can be predicted. When supply increases (S0 to S1), equilibrium price will fall and output will rise. When supply declines (S0 to S2), the opposite happens: Equilibrium price will rise and output will fall.

EQUILIBRIUM PRICE, OUTPUT, AND SHIFTS IN SUPPLY

S2

18

S0

15 a

12

Price ($)

72

S1 e

9

b

6

3 D0 0

10

20

30

40

50

60

Quantity

$6, while equilibrium output rises to 40 (point b). This is what has happened in the electronics industry: Falling production costs have resulted in more electronic products being sold at lower prices. We have seen how equilibrium price and quantity will change when supply changes. When supply increases, equilibrium price will fall and output will rise; when supply decreases, equilibrium price will rise and output will fall. Changes in Demand The effects of demand changes are shown in Figure 11. Again, equilibrium is initially at point e, with equilibrium price and quantity at $9 and 30, respectively.

When demand alone changes, the effects on both equilibrium price and output can again be determined. When demand grows (D0 to D1), both price and output rise. Conversely, when demand falls (D0 to D2), both price and output fall.

EQUILIBRIUM PRICE, OUTPUT, AND SHIFTS IN DEMAND

18

S0

15

Price ($)

FIGURE 11

b

12 e

9 a

6

D1

D0

3 D2 0

10

20

30

40

50

60

Quantity

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ISSUE The great California wines of the 1990s put California vineyards on the map. Demand, prices, and exports grew rapidly. Overplanting of new grapevines was a result. When driving along Interstate 5 or Highway 101 north of Los Angeles, one can see vineyards extending for miles, and most were planted in the mid- to late 1990s. The 2001 recession reduced the demand for California wine, and a rising dollar made imported wine relatively cheaper. The result was a sharp drop in demand for California wine and a huge surplus of grapes. Bronco Wine Company president Fred Franzia made an exclusive deal with Trader Joe’s, an unusual supermarket that features innovative food and wine products. He bought the excess grapes at distressed prices, and in his company’s modern plant produced inexpensive wines—chardonnay, merlot, cabernet sauvignon, shiraz, and sauvignon blanc—under the Charles Shaw label. Consumers flocked to Trader Joe’s for wine costing $1.99 a bottle and literally hauled cases of wine out by the carload. In less than a decade, 400 million bottles of Two-Buck Chuck, as

joel zatz/Alamy

Two-Buck Chuck: Will People Drink $2-a-Bottle Wine?

it is known, have been sold. This is not rotgut: The 2002 shiraz beat out 2,300 other wines to win a double gold medal at the 28th Annual International Eastern Wine Competition in 2004. Still, to many Napa Valley vintners, it is known as Two-Buck Upchuck. Two-Buck Chuck was such a hit that other supermarkets were forced to offer their own discount wines. This good, low-priced wine has had the effect of opening up markets. People

who previously avoided wine because of the cost have begun drinking more. However, the influence of Two-Buck Chuck, which sold 60 million bottles in 2012, may be waning. Because of the rising costs of producing the wine in recent years, largely due to the severe California drought, Two-Buck Chuck is now sold between $2.99 and $3.99 per bottle. Although the price is still a bargain, the product that changed the wine industry may need a new nickname.

But let us assume that the economy then enters a recession and incomes sink, or perhaps the price of some complementary good soars; in either case, demand falls. As demand decreases (the demand curve shifts from D0 to D2), equilibrium price falls to $6, while equilibrium output falls to 20 (point a). During the same recession just described, the demand for inferior goods (beans and bologna) will rise, as falling incomes force people to switch to less expensive substitutes. For these products, as demand increases (shifting the demand curve from D0 to D1), equilibrium price rises to $12, and equilibrium output grows to 40 (point b). Like changes in supply, we can predict how equilibrium price and quantity will change when demand changes. When demand increases, both equilibrium price and output will rise; when demand decreases, both equilibrium price and output will fall. Predicting the New Equilibrium When Both Curves Shift When both supply and demand change, things get tricky. We can predict what will happen with price in some cases and output in other cases, but not what will happen with both. Figure 12 portrays an increase in both demand and supply. Consider the market for corn. Suppose that an increase in corn-based ethanol production causes demand for corn to increase. Meanwhile, suppose that bioengineering results in a new corn hybrid that uses less fertilizer and generates 50% higher yields, causing supply to also increase. When demand increases from D0 to D1 and supply increases from S0 to S1, output grows to Q1 as shown in the left panel.

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Chapter 3

FIGURE 12

INCREASE IN SUPPLY, INCREASE IN DEMAND, AND EQUILIBRIUM

When both demand and supply increase, output will clearly rise, but what happens to the new equilibrium price is uncertain. If demand grows relatively more than supply, price will rise, but if supply grows relatively more than demand, price will fall.

e

S0

a

Price increases because the increase in demand exceeds the increase in supply.

Price

S1

P0

e

a

e

a

Price remains the same because the increase in demand is the same as the increase in supply.

D1 D0 0

Q0

e a

Q1

Price decreases because the increase in demand is less than the increase in supply.

Quantity

But what happens to the price of corn is not so clear. If demand and supply grow the same, output increases, but price remains at P0 (also captured in the middle panel to the right). If demand grows relatively more than supply, the new equilibrium price will be higher (top panel on the right). Conversely, if demand grows relatively less than supply, the new equilibrium price will be lower (bottom panel on the right). Figure 12 is just one of the four possibilities when both supply and demand change. The other three possibilities are shown in Table 1 along with the four possibilities when just one curve shifts. When only one curve shifts, the direction of change in equilibrium price and quantity is certain. But when both curves shift, the direction of change in either the equilibrium price or quantity will be indeterminate.

TABLE 1

THE EFFECT OF CHANGES IN DEMAND OR SUPPLY ON EQUILIBRIUM PRICES AND QUANTITIES

One Curve Shifting

Both Curves Shifting

Change in Demand

Change in Supply

Change in Equilibrium Price

Change in Equilibrium Quantity

No change

Increase

Decrease

Increase

No change

Decrease

Increase

Decrease

Increase

No change

Increase

Increase

Decrease

No change

Decrease

Decrease

Increase

Increase

Indeterminate

Increase

Decrease

Decrease

Indeterminate

Decrease

Increase

Decrease

Increase

Indeterminate

Decrease

Increase

Decrease

Indeterminate

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Eric Chiang

Tokyo Disneyland: Is THAT the Line for Space Mountain?! What are some factors that cause Tokyo Disneyland to be so crowded even during the middle of winter? ow long are you willing to wait to experience your favorite ride at a theme park? 20 minutes? 60 minutes? How about 3 hours? On an ordinary day at Tokyo Disneyland, one of the most popular theme parks in the world, the line for its famous attractions such as Space Mountain, Splash Mountain, and Tower of Terror can reach 200 minutes. . . . That’s over a 3-hour wait to enjoy a 3-minute ride! What causes lines to form at theme parks? Theme park rides have lines because the quantity of rides demanded exceeds the quantity supplied. Why is that? Because most theme parks

H

A 200-minute wait for a ride at Tokyo Disneyland.

charge a fixed admission fee for unlimited rides, visitors typically demand more rides than the theme park is able to supply, even if a ride is operating at full capacity. The extent of the shortage, and consequently the length of wait time, are influenced largely by market factors. First, consider the role of preferences. Disneyland has a worldwide following, and for those living in Japan, visiting Tokyo Disneyland is certainly

GO TO

75

ND THE WO

RLD

AROU

Supply and Demand

easier than visiting Disney parks in California or Florida. Second, consider the number of potential buyers. Tokyo Disneyland is located in a metropolitan area with over 30 million people. The sheer number of potential visitors will lead to higher demand. And third, consider the role of pricing. Given its popularity, Tokyo Disneyland could charge higher prices to reduce the quantity demanded. Yet, in 2016 a one-day adult admission to Tokyo Disneyland cost only $58, while its counterparts in California and Florida charged nearly $120. The combination of preferences, proximity to potential buyers, and relatively low prices cause demand for Tokyo Disneyland rides to far exceed the park’s reasonable capacity (at least by U.S. standards), creating massive lines. Yet for enthusiastic Disney fans, smiling faces abound. Despite the crowds, it’s still the “Happiest Place on Earth!”

TO PRACTICE THE ECONOMIC CONCEPTS IN THIS STORY

CHECKPOINT MARKET EQUILIBRIUM ■

Together, supply and demand determine market equilibrium, which occurs when the quantity supplied exactly equals quantity demanded.



The equilibrium price is also called the market-clearing price.



When quantity demanded exceeds quantity supplied, a shortage occurs and prices are bid up toward equilibrium. When quantity supplied exceeds quantity demanded, a surplus occurs and prices are pushed down toward equilibrium.



When supply and demand change, equilibrium price and output change.



When only one curve shifts, the resulting changes in equilibrium price and quantity can be predicted.



When both curves shift, we can predict the change in equilibrium price in some cases or the change in equilibrium quantity in others, but never both. We have to determine the relative magnitudes of the shifts before we can predict both equilibrium price and quantity.

QUESTIONS: In China, where lines are a routine part of everyday life, a growing industry of professional line waiters has developed. Exactly as it sounds, these people are paid an average of $3 an hour to wait in line for others, a wage that is higher than what a typical factory worker in China earns. Today, the professional line waiter has popped up in cities around the world, including New York, though at significantly higher prices than in China. Given that one can pay someone to wait, what might happen in the market for goods and services most prone to long waiting lines, such as prime concert tickets or the latest technology gadget? Answers to the Checkpoint questions can be found at the end of this chapter.

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76

chapter summary Section 1 Markets A market is an institution that

3.1 enables buyers and sellers to

Determinants of Demand: How Demand

Section 2 Demand

3.3 Curves Shift

Demand refers to the goods and services people are willing

3.2 and able to buy during a period of time. It is a horizontal

Price

summation of individual demand curves in a defined market.

D

Quantity

robertharding/Corbis

Markets can be as simple as a lemonade stand, as large as an automobile lot, as valuable as the stock market, as virtual as an Internet shopping site, or as illegal as a ticket scalping operation.



Tastes and preferences: Demand shifts right.



Income: Demand for normal goods shifts right, while demand for inferior goods shifts left.



Price of substitutes: Demand shifts right.



Price of complements: Demand shifts left.



Number of buyers: Demand shifts right.



Price expectations: Demand shifts right.

Bryan Smith/ZUMA Press

Corbis/SuperStock

Stars and Stripes/Alamy

interact and transact with one another.

Buyers and sellers communicate their desires in a market through the prices at which goods and services are bought and sold. Hence, a market economy is called a price system.

When investors expect stock prices to increase, demand for stock increases.

The law of demand states that as prices increase, quantity demanded falls, and vice versa, resulting in a downwardsloping demand curve.

Quantity

Price

Flint/Corbis

Roller coasters are a lot of fun, but riding the same one over and over gives less satisfaction with each ride; therefore, willingness-to-pay falls with each ride.

A “change in demand” is a shift of the entire demand curve and is caused by a change in a nonprice demand factor. A “change in quantity demanded” is a movement from one point to another on the same demand curve, and is caused only by a change in price of that good.

Price

A Common Confusion

3.4 in Terminology

Quantity

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77

Philip Gostelow/Aurora Photos/Corbis

Section 3 Supply Supply analysis works the same way as demand, but look-

3.5 ing at the market from the firm’s point of view.

Price

S

Determinants of Supply: How

3.6 Supply Curves Shift

Quantity The law of supply states that as price increases, firms want to supply more, and vice versa. It leads to an upward-sloping supply curve.



Production technology: Supply shifts right.



Cost of resources: Supply shifts left.



Price of related commodities: Supply shifts left.



Price expectations: Supply shifts left.



Number of sellers: Supply shifts right.



Taxes: Supply shifts left.



Subsidies: Supply shifts right.

Section 4 Market Equilibrium Market equilibrium occurs at the price at which the

3.7 quantity supplied is equal to quantity demanded, and where the demand and supply curves intersect.

How does equilibrium change?

Which curve slopes up and which slopes down? Two tricks to aid in memory: ■

S“up”ply contains the word “up” for upward-sloping.



Only the fingers on your right hand can make a “d” for demand. Hold that hand up in front of you!

A shift in demand or supply will change

3.8 equilibrium price and quantity.

Higher oil prices raise the cost of resins used to produce surfboards.

S0

Price

robertingharding premium/Corbis

S1

Summary of Demand and Supply Shifts on Equilibrium Price and Quantity: D shifts right: D shifts left: S shifts right: S shifts left:

P↑ P↓ P↓ P↑

Q↑ Q↓ Q↑ Q↓

D0

Quantity Supply of surfboards shifts left, raising equilibrium price and lowering equilibrium quantity.

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78

Chapter 3

KEY CONCEPTS markets, p. 56 price system, p. 57 willingness-to-pay, p. 57 demand, p. 58 law of demand, p. 59 demand curve, p. 59 demand schedule, p. 59 horizontal summation, p. 60 determinants of demand, p. 61

normal good, p. 61 inferior good, p. 61 substitute goods, p. 62 complementary goods, p. 62 change in demand, p. 62 change in quantity demanded, p. 63 supply, p. 64 law of supply, p. 64 supply curve, p. 64

determinants of supply, p. 65 change in supply, p. 67 change in quantity supplied, p. 67 equilibrium, p. 69 equilibrium price, p. 69 equilibrium quantity, p. 69 surplus, p. 69 shortage, p. 70

QUESTIONS AND PROBLEMS Check Your Understanding 1. Product prices give consumers and businesses a lot of information besides just the price. What kinds of information? 2. Name and explain the determinants of demand. Why are they important? 3. Assume there is a positive relationship between aging and cholesterol levels. As the world population ages, will the demand for cholesterol drugs increase, decrease, or remain the same? Would this cause a change in demand or a change in quantity demanded? 4. Describe some of the reasons why supply changes. Improved technology typically results in lower prices for most products. Why do you think this is true? Describe the difference between a change in supply and a change in quantity supplied. 5. If a strong economic recovery boosts average incomes, what would happen to the equilibrium price and quantity for a normal good? How about for an inferior good? 6. Suppose the market for tomatoes is in equilibrium, and events occur that simultaneously shift both the demand and supply curves to the right. Is it possible to determine how the equilibrium price and/or quantity would change? Explain.

Apply the Concepts 7. Demand for tickets to sporting events such as the Super Bowl has increased. Has supply increased? What does the answer to this tell you about the price of these tickets compared to prices a few years ago? 8. Suppose the price of monthly data plans required to access the Internet anywhere using a tablet computer falls. How would this affect the market for tablet computers? 9. Using the accompanying figures, answer the following questions: a. On the Demand panel: ■ Show an increase in demand and label it D1. ■ Show a decrease in demand and label it D2. ■ Show an increase in quantity demanded. ■ Show a decrease in quantity demanded. ■ What causes demand to change? ■ What causes quantity demanded to change? b. On the Supply panel: ■ Show an increase in supply and label it S1. ■ Show a decrease in supply and label it S2.

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Supply and Demand

■ ■ ■ ■

79

Show an increase in quantity supplied. Show a decrease in quantity supplied. What causes supply to change? What causes quantity supplied to change? Supply

Demand

Price

Price

S0

D0

Quantity

Quantity

10. Several medical studies have shown that drinking red wine in moderation is good for the heart. How would such a study affect the public’s demand for wine? Would it have an impact on the type of grapes planted in new vineyards? 11. Assume initially that the demand and supply for premium coffees (one-pound bags) are in equilibrium. Now assume Starbucks introduces the world to premium blends, and so demand rises substantially. Describe what will happen in this market as it moves to a new equilibrium. If a hard freeze eliminates Brazil’s premium coffee crop, what will happen to the price of premium coffee? 12. Over the past decade, cruise ship companies have dramatically increased the number of mega-ships (those that carry 3,000 passengers or more), increasing the supply of cruises. At the same time, the popularity of cruising has increased among consumers, increasing demand. Explain how these two effects can coincide with a decrease in the average price of cruise travel.

In the News 13. In 2015 Google’s Self-Driving Cars had driven over 1 million miles on public roads and were involved in only twelve minor accidents, all of which were caused by the non-selfdriving car. In response to the early success of self-driving cars, nearly every major auto manufacturer in the world is developing its own version of a driverless car (CBS News, “Driverless Cars Prepare to Hit the Road,” October 4, 2015), potentially increasing the supply of such cars in the market. What factors might cause demand for driverless cars to take off and become the new standard? What factors might cause demand to falter, leading the industry to fail? 14. When the Segway was unveiled in 2001, many believed it would become the future of transportation, replacing bicycles and even cars. Yet this expensive, bulky device never quite took off other than those used in Segway tours offered in many cities and by security officers in malls and airports. A decade later, other companies began developing newer, lighter, and less expensive motorized transportation devices such as the IO Hawk. A February 23, 2015, online article by Oxy.com, “This Motorized Skateboard Might Kick Segway to the Curb,” suggests that Segways may become obsolete. Using a demand and supply diagram for Segways, show the effect of the introduction of the IO Hawk on the market for Segways. Based on the article, are Segways and IO Hawks substitutes or complements?

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80

Chapter 3

Solving Problems

WORK IT OUT

interactive activity

15. A popular tradition when traveling to Hawaii is to receive a lei, a wreath of flowers to welcome guests. Although a lei can be made of flowers, leaves, nuts, or even candy and money, orchids remain the most popular flower used to create them. Suppose that supply and demand in the orchid lei market in Hawaii are as represented in the table below:

Price ($/unit)

Quantity Demanded (thousands)

Quantity Supplied (thousands)

5

24

8

10

20

12

15

16

16

20

12

20

25

8

24

b. Assume that the Hawaiian lei industry increases its use of orchids from Thailand (where they are grown at a lower price), allowing orchid lei supply to increase by 8,000 units at every price. Illustrate the increase in the supply in your graph. Label the new supply curve (S1). What will the new equilibrium price in the market be? Label that point b.

a. Graph both the supply (S0) and demand (D0) curves. What is the current equilibrium price? Label that point a.

c. Now assume that luxury hotels in Hawaii begin costcutting measures by no longer presenting guests with a lei upon check-in, reducing orchid lei demand by 8,000 units at every price. Label the new demand curve (D1). What will the new equilibrium price be? Label this new equilibrium point c. d. Subsequently assume that severe monsoons and civil unrest in Thailand lead to a reduction in orchid production, reducing supply back to the original curve (S0). What will the new equilibrium price be? Label this new equilibrium point d.

16. The following figure shows the supply and demand for strawberries. Answer the questions that follow. Supply and Demand of Strawberries S0

5

Price ($)

4 3 2 1 D0 0

10

20

30

40

50

Quantity

a. Indicate the equilibrium price and equilibrium quantity. b. Suppose sellers try to sell strawberries at $4. How much of a shortage or a surplus of strawberries would result?

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Supply and Demand

81

c. Now suppose that the demand for strawberries falls by 10 units at every price. Draw the new demand curve in the figure, and estimate what the new equilibrium price and equilibrium quantity would be. d. If sellers still try to sell strawberries at $4, would the shortage or the surplus increase or decrease?

#

USING THE NUMBERS

17. According to By the Numbers, about how many times larger is the bottled water market in the United States in the year 2014 compared to 1984? 18. According to By the Numbers, in which 6-month period between July 2012 and January 2015 did Uber experience the greatest increase in terms of number of drivers? Would you describe the growth of Uber drivers over this 2.5-year period as linear (constant growth) or exponential (rising growth)?

ANSWERS TO QUESTIONS IN CHECKPOINTS Checkpoint: Markets 57 The market for financial securities is a huge, well-organized, and regulated market compared to local farmer’s markets. Trillions of dollars change hands each week in the financial markets, and products are standardized. Checkpoint: Demand 63 The ability to avoid high gasoline prices, a general rise in environmental consciousness, incentives such as preferred parking and reduced tolls offered by some states, an increase in the availability of charging stations (reducing opportunity cost), and improvements in quality have all led to an increase in demand for plug-in electric cars. These factors led to a change in demand, because factors other than the price of the car itself have led to an increase in demand for these cars. However, as the costs of production eventually fall, prices will decrease, which will result in an increase in quantity demanded. Checkpoint: Supply 69 A higher textbook buyback price would entice more students to sell their textbooks instead of keeping them. Because the price of the offer has increased, it results in an increase in the quantity supplied of used textbooks. If, however, many students are forced to retake a class, they would likely not sell their textbooks; hence, the supply of used textbooks would shift to the left. Checkpoint: Market Equilibrium 75 Waiting in line for a new product or a good deal adds to the cost of acquiring a good. For those with higher opportunity costs of time, hiring a professional line waiter reduces this cost, making the product more affordable. Therefore, professional line waiters would cause an increase in demand for goods and services more prone to lines, causing even greater lines and shortages if prices do not adjust upward.

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Supply and Demand - Macmillan Learning

3 Supply and Demand Using the basic tools of supply and demand to determine how prices and quantities are set in a market economy Piet Mall/Corbis ...

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