ECON 2100 Principles of Microeconomics (Summer 2016) Supply, Demand, and Market Equilibrium

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1 ECON 21 Principles of Microeconomics (Summer 216) Supply, Demand, and Market Equilibrium Relevant readings from the textbook: Mankiw, Ch. 4 The Market Forces of Supply and Demand Suggested problems from the textbook: Chapter 4 Questions for Review (Page 86): 1, 3, 4, 6, 7, 8, and 9 Chapter 4 Quick Check Multiple Choice (Page 86): 1, 2, 3, 4, 5, and 6 Chapter 4 Problems and Applications (Pages 87-88): 1, 3, 4, 6, 8, 1, and 11 Definitions and Concepts: Market the collection of all potential buyers and all potential sellers of a particular good or service. The two primary types of decision makers in markets are households and firms. They interact with one another in two distinct markets: Markets for Finished Goods/Services (in which households are the buyers and firms are the sellers) and Markets for Factors of Production (in which households are the sellers and firms are the buyers). The Circular Flow Diagram provides a simplified representation of the interaction between households and firms in the Markets for Finished Goods/Services and the Markets for Factors of Production. Perfectly Competitive Market a market in which no individual buyer and no individual seller can substantially influence market price by changing his own behavior. Two primary conditions which must be met for a market to be perfectly competitive : (i) all goods offered for sale are identical and (ii) there are many buyers and many sellers. In perfectly competitive markets, all buyers and all sellers are price takers (i.e., nobody has any market power ). The free interaction between buyers and sellers in markets results in an outcome which can be summarized by: (i) an equilibrium quantity of trade (amount traded) and (ii) an equilibrium price (price at which trade takes place). Quantity Demanded the number of units of a good that buyers are willing and able to purchase at a particular price. Demand the entire relationship between the price of a good and quantity demanded, all other factors fixed. Demand Schedule a table which provides a numerical summary of Demand.

2 Demand Curve a graph which provides a visual illustration of Demand. Law of Demand all other factors fixed, the quantity demanded of a good will be larger at lower prices (visually, demand curves are downward sloping). Buyer s Reservation Price the maximum dollar amount a buyer is willing to give up in order to acquire an item. The height of the demand curve at any particular quantity illustrates the reservation price of the buyer of that unit. Distinction between Change in Demand and Change in Quantity Demanded : A change in own price results in a change in quantity demanded of a good, and is illustrated by a movement along a fixed demand curve. A change in any other factor other than own price (i.e., the determinants of demand which are held fixed when determining the relation between price and quantity demanded which is demand) will potentially result in a change in demand, which would be illustrated by a movement or shift of the entire demand curve. Increase in Demand a change in demand consistent with buyers becoming more willing to purchase a good in that quantity demanded increases at every price (visually a rightward shift of the demand curve). Decrease in Demand a change in demand consistent with buyers becoming less willing to purchase a good in that quantity demanded decreases at every price (visually a leftward shift of the demand curve). Common Determinants of Demand the following changes will result in an increase in demand (changing these factors in the opposite direction would result in a decrease in demand): 1. A decrease in the price of a Complement Good 2. An increase in the price of a Substitute Good 3. An increase in income (for a Normal Good) 4. A decrease in income (for an Inferior Good) 5. An increased preference by consumers for the good 6. An increase in market size (e.g., increase in population) 7. An expectation of higher future prices Quantity Supplied the number of units of a good that sellers are willing and able to sell at a particular price. Supply the entire relationship between the price of a good and quantity supplied, all other factors fixed. Supply Schedule a table which provides a numerical summary of Supply.

3 Supply Curve a graph which provides a visual illustration of Supply. Law of Supply all other factors fixed, the quantity supplied of a good will be larger at higher prices (visually, supply curves are upward sloping). Seller s Reservation Price the minimum dollar amount a seller is willing to accept in exchange for an item The height of the supply curve at any particular quantity illustrates the reservation price of the seller of that unit. Distinction between Change in Supply and Change in Quantity Supplied : A change in own price results in a change in quantity supplied of a good, and is illustrated by a movement along a fixed supply curve. A change in any other factor other than own price (i.e., the determinants of supply which are held fixed when determining the relation between price and quantity supplied which is supply) will potentially result in a change in supply, which would be illustrated by a movement or shift of the entire supply curve. Increase in Supply a change in supply consistent with sellers becoming more willing to sell a good in that quantity supplied increases at every price (visually a rightward shift of the supply curve). Decrease in Supply a change in supply consistent with sellers becoming less willing to sell a good in that quantity supplied decreases at every price (visually a leftward shift of the supply curve). Common Determinants of Supply the following changes will result in an increase in supply (changing these factors in the opposite direction would result in a decrease in supply): 1. A decrease in the cost of any factors of production needed to produce the good 2. An improvement in technology that reduces production costs 3. A favorable realization of natural events 4. An increase in market size 5. An expectation of lower future prices Equilibrium a stable state for a system which will persist as long as outside factors do not change. In the context of market equilibrium we need to identify a price/quantity pair that is stable in the sense that no individual buyer and no individual seller can benefit by altering their own behavior. Excess Supply a situation in which quantity supplied is greater than quantity demanded Excess Demand a situation in which quantity demanded is greater than quantity supplied

4 Three noteworthy features of the market equilibrium in the model of Supply and Demand the identified equilibrium is: Stable if we are there we will stay there, unless outside forces change [which it had to be by definition ] Self Enforcing at higher prices there is downward pressure on price; at lower prices there is upward pressure on price => therefore if we are at some other price, we will be pushed toward the equilibrium price [this did not have to be the case] Unique so long as the Law of Demand and Law of Supply both hold, there will be one and only one intersection of Supply/Demand (and therefore one and only one equilibrium) [this did not have to be the case] Impact of Changes in Supply/Demand on Equilibrium Outcome. An Increase in Demand (for whatever reason) will result in: an increase in equilibrium quantity and an increase in equilibrium price. A Decrease in Demand (for whatever reason) will result in: a decrease in equilibrium quantity and a decrease in equilibrium price. An Increase in Supply (for whatever reason) will result in: an increase in equilibrium quantity and a decrease in equilibrium price. A Decrease in Supply (for whatever reason) will result in: a decrease in equilibrium quantity and an increase in equilibrium price.

5 Circular Flow Diagram: Households Supply of Labor, Land, Capital, and other factors of production Income as Wages and Rents Consumer Expenditures Consumption of Finished Goods and Services Markets for Factors of Production (labor, land, capital, etc.) Markets for Goods and Services (output of firms) Labor, Land, Capital, and other factors of production hired Wages and Rents paid Firm Revenues Output of Finished Goods and Services Firms

6 5 Market Equilibrium What prices are stable? : price Supply Excess Supply at a price of $5: quantity supplied (of 75) is greater than quantity demanded (of 15) [i.e., more sellers than buyers ] => downward pressure on price 3 2 Demand Excess Demand at a price of $2: quantity demanded (of 15) is greater than quantity supplied (of 4) [i.e., more buyers than sellers ] => upward pressure on price quantity D(5)=15 S(2)=4 D(3)=S(3)=55 S(5)=75 D(2)=15 Is a high price of p H 5 stable? At this price: buyers are willing and able to buy 15 units, while sellers are willing and able to sell 75 units. Since quantity supplied is greater than quantity demanded, there is excess supply. 6 of the sellers who would like to sell the item for $5 are not able to find buyers each of these sellers would have an incentive to instead accept $49.99 (and sell the item for one cent less, as opposed to not selling the item) => downward pressure on price. Any price for which there is excess supply is not stable. Is a low price of p L 2 stable? At this price: buyers are willing and able to purchase 15 units, while sellers are willing and able to sell 4 units. Since quantity demanded is greater than quantity supplied, there is excess demand. 65 of the buyers who would like to purchase the item for $2 are not able to find sellers each of these buyers would have an incentive to instead offer $2.1 (and buy the item for one cent more, as opposed to not buying the item) => upward pressure on price. Any price for which there is excess demand is not stable Only stable price is at the intersection of the demand curve and the supply curve. Only at this price do we have (quantity demanded)=(quantity supplied). At p * 3 : buyers are willing and able to purchase 55 units and sellers are willing and able to purchase 55 units (no excess demand ; no excess supply ). Further, all those potential buyers that don t make a purchase at this price do not want to make a purchase at this price. Likewise, all those potential sellers that don t make a sale at this price do not want to make a sale at this price. Nobody has anything to gain by changing their behavior => Stable Outcome. Market Equilibrium occurs at the intersection of supply and demand: equilibrium price is p * 3 and equilibrium quantity is q * 55.

7 Impact of Change in Demand on Market Equilibrium: High Price price Supply Low Price Demand (A) Demand (B) quantity Low Quantity High Quantity Increase in demand (for whatever reason): shift from Demand (B) to Demand (A) => increase equilibrium price, increase equilibrium quantity. Decrease in demand (for whatever reason): shift from Demand (A) to Demand (B) => decrease equilibrium price, decrease equilibrium quantity. Impact of Change in Supply on Market Equilibrium: High Price price Supply (A) Supply (B) Low Price Demand quantity Low Quantity High Quantity Increase in supply (for whatever reason): shift from Supply (A) to Supply (B) => decrease equilibrium price, increase equilibrium quantity. Decrease in supply (for whatever reason): shift from Supply (B) to Supply (A) => increase equilibrium price, decrease equilibrium quantity.

8 Problems: 1, 1. Consider a market in which demand is given by the demand function D( p) and p supply is given by the function S ( p) 5 p 1, 5 (for p 3 ). A. Determine the numerical value of quantity demanded and quantity supplied at each of the following prices: p 5, p 8, and p 1. B. Is there Excess Demand, Excess Supply, or neither at each of the three prices considered in part (1.a)? Explain. C. Based upon your answers thus far (without any further calculations), can you determine a range in which the equilibrium price in this market must lie? Explain. 2. Consider a market in which demand is given by the demand function D( p) 5, 625 p and supply is given by the supply function S ( p) 875p 17, 5 (for p 2 ). A. Is there Excess Demand, Excess Supply, or neither at a price of p 3? Explain. B. Graphically illustrate the equilibrium outcome in this market. C. Numerically determine the values of equilibrium price and equilibrium quantity in this market. Multiple Choice Questions: 1. Since early May there has been an increase in both the price and quantity traded of #3 Tampa Bay Buccaneers Jerseys. Which of the following would have led to this observed change in the market outcome for this good? A. An increase in supply. B. A decrease in supply. C. An increase in demand. D. A decrease in demand. 2. In a free market economy, households A. acquire consumption goods and services from firms. B. provide labor and other factors of production to firms. C. receive income from firms in the form of wages and rents. D. All of the above answers are correct. 3. Which of the following could never lead to an increase in the demand for tacos? A. an increase in the price of burritos (a substitute good). B. a decrease in the price of Coca-Cola (a complement good). C. a decrease in the price of tacos. D. an increase in consumer income (assuming tacos are a normal good).

9 4. The Circular Flow Diagram A. directly illustrates why the free interaction of buyers and sellers in markets will lead to a unique equilibrium price and a unique equilibrium quantity of trade. B. explains why the claim that the Coriolis Effect influences the direction that water flows down a drain (i.e., clockwise in the southern hemisphere but counterclockwise in the northern hemisphere) is an incorrect claim. C. illustrates the general interaction between households and firms in both the Markets for Finished Goods/Services and the Markets for Factors of Production. D. shows how inputs flow through the entire production process, from raw materials and natural resources, to intermediate goods/services, and ultimately to consumers/households as finished consumption goods/services. 5. The Demand for Milk A. refers to the entire relationship between the price of milk and the quantity that consumers are willing and able to purchase, all other factors fixed. B. refers to the amount of milk that people choose to purchase at the prevailing market price. C. is the only thing that is relevant for determining the equilibrium price of milk. D. is determined only by the nutritional value of drinking milk. 6. Recall that the market equilibrium in the model of supply and demand is a Self Enforcing equilibrium. This characteristic can be described by noting that A. if a market is currently not at its equilibrium, market forces will push price toward the equilibrium price (since there is downward pressure on price at prices above the equilibrium price, and there is upward pressure on price at prices below the equilibrium price). B. if a market is currently at its equilibrium, it will stay there (unless outside forces change). C. as long as the Law of Demand and Law of Supply both hold, there will only be one unique equilibrium outcome in a market. D. the equilibrium outcome in a market can only ever be realized as a result of government intervention in the market. 7. The Law of Demand states that A. it should be against the law for firms to not supply goods which consumers demand. B. consumers will always choose to purchase more of a good as their income increases. C. all other factors fixed, the quantity demanded of a good will be greater when its price is lower. D. an increase in demand is visually illustrated by a rightward shift of the demand curve.

10 8. A seller s reservation price A. refers to the maximum dollar amount a buyer is willing to pay for an item. B. refers to the minimum dollar amount a seller is willing to accept in exchange for an item. C. is visually illustrated by the height of the supply curve. D. More than one of the above answers is correct. For questions 9 through 11, refer to the graph below, which illustrates the supply and demand for hats in 214. price Supply Demand 214 quantity ,3 9. At a price of $15.5 per hat, there would be in this market. A. neither Excess Demand nor Excess Supply B. Excess Demand C. Excess Supply D. None of the above answers are correct (since the graph does not convey enough information to determine if there is Excess Demand and/or Excess Supply at this price). 1. In equilibrium hats will be traded, each at a price of. A. (37); ($8.5) B. (37); ($19.25) C. (71); ($14.) D. (1,3); ($14.) 11. Suppose that on December 31, 214 there is an improvement in hat making technology which leads to a decrease in the costs of producing hats. As a result of this change, it must be that the equilibrium price of hats in 215 will be A. exactly equal to $8.5. B. less than $14. (with the exact value depending upon the magnitude of the change in costs). C. exactly equal to $14.. D. above $14. (with the exact value depending upon the magnitude of the change in costs).

11 Answers to Problems: 1, 1A. Quantity demanded at each of the given prices is: D ( 5) 2,, 5 1, 1, D ( 8) 1,25, and D ( 1) 1,. Likewise, quantity supplied at each 8 1 price is: S ( 5) (5)(5) 1,5 1,, S ( 8) (5)(8) 1,5 2, 5, and S ( 1) (5)(1) 1,5 3,5. 1B. At a price of p 5 there is Excess Demand, since D( 5) 2, 1, S(5). At a price of p 8 there is Excess Supply, since D( 8) 1,25 2,5 S(8). At a price of p 1 there is Excess Supply, since D( 1) 1, 3,5 S(1). 1C. Based upon the answers thus far, we can infer that the unique equilibrium price must be above p 5 (since there is Excess Demand at this price) but below p 8 (since there is Excess Supply at this price). 2A. At p 3 there is Excess Demand, since D ( 3) 5, (625)(3) 31, 25 is greater in value than S ( 3) (875)(3) 17,5 8, 75. 2B. price 8 p* 2 quantity q* 2C. Numerically, the equilibrium price is the unique price for which D( p) S( p). For the specified functions, we have: 5, 625p 875 p 17,5 5, 1,5 p 17,5 67,5 1,5 p * p 67,5 45 1,5 From her it follows that the equilibrium quantity is: * * * q D( p ) S( p ) D(45) S(45) 21,875

12 Answers to Multiple Choice Questions: 1. C 2. D 3. C 4. C 5. A 6. A 7. C 8. D 9. C 1. C 11. B