- Good x may be a normal good or an inferior good. If x is a normal good, Q x

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1 1. and Supply - Basics: Supply and notes, page 1, Bruce Brown A. In a particular market, the quantity demanded by consumers (per period) of good x will be represented by: Q x D. Q x D depends on (or is a function of ) the following: i) P x - the price of good x. ii) I - the (average) level of income of the potential buyers. iii) P y - the price of some other good, either a substitute or complement. iv) - Tastes and Preferences. v) - Future price of x expected by buyers (when in doubt assume this is constant - the effect depends on such things as whether the good is storable ). Along the demand curve for good x, only P x changes while the other four items are theoretically held constant (this assumes that the price this period changes while the price expected by consumers in the future is constant). Quantity, demanded per period - As the price of good x increases from to the quantity demanded will fall from to, all else constant. This reflects the law of demand P and Q D are inversely related if all else is constant. - Good x may be a normal good or an inferior good. If x is a normal good, Q x D increases as I increases. That is, the demand curve for good x will shift rightward as income increases, all else constant. - Good x and y may be substitute goods (e.g., butter and margarine) or complementary goods (e.g., beer and pretzels). If substitutes, when P y increases the demand curve for x will shift rightward - an increase in the demand for x. If complements, when P y decreases the demand curve for x will shift rightward - an increase in the demand for good x (note the demand for good y is not shown, and typically, any effect the change in P x has on it is ignored). P x The demand curve for x shifts rightward - this means that at any one given P x, the quantity consumers will want to buy is greater. This could be the result of an increase in income (if x is a normal good), a decrease in income (if x is an inferior good), an increase in P y (if x and y are substitutes), or a reduction in P y (if x and y are complements) Q x

2 B. Supply The quantity supplied by producers (per period) of good x (Q x S ) will depend on: Supply and notes, page 2, Bruce Brown i) P x - the price of good x - if P x increases, all else constant, the quantity that profit maximizing firms will bring to the market to be sold will increase (all else constant) reflected by rightward or upward movement along the supply curve. ii) - Input prices, (e.g., wages and cost per unit of capital) - increase in input price shifts supply left. iii) - Technology - improvement in technology shifts supply rightward. iv) - The weather (for agricultural goods) - bad weather that destroys crops shifts supply leftward. v) - Future price of x expected by sellers (when in doubt assume this is constant - the effect depends on such things as whether the good is storable ). Along the supply curve for good x, only P x changes while the other four items are theoretically held constant (thus price this period changes while price expected by producers in the future is constant). Supply Curve - As the price of good x increases from to the quantity supplied will increase from to, all else constant. This reflects the direct or positive relationship between P and Q S if all else is constant. C. Equilibrium Quantity supplied per period Market forces push an economy toward equilibrium, where Q S = Q D. Ignore time and any trades which might occur outside of equilibrium. Surplus Supply Curve P 3 Shortage Quantity supplied per period - If price is above equilibrium, at P 3 for example, the quantity supplied will be greater than the quantity demanded. A surplus will tend to push price downward toward. - If price is below equilibrium, at for example, the quantity demanded will be greater than the quantity supplied. A shortage will tend to push price upward toward.

3 D. Specific example of how supply and demand work Supply and notes, page 3, Bruce Brown In General: Society may benefit from actions of selfish people when: i) property rights are well defined, ii) laws are clear and obeyed, iii) buyers and sellers are well informed, and iv) interaction takes place within competitive markets with many sellers and buyers. Specifically: Individuals motivated only by personal greed may move scarce goods to a disaster area where they are needed. Government price controls intended to help the victims may actually hurt them. This provides one example of how government policy may have unintended effects. Suppose: 1) The market for building materials in a particular city is competitive and initially in equilibrium 2) An earthquake destroys homes and people respond by quickly trying to rebuild them. Supply Curve, both before and after earthquake after earthquake Q 3 Quantity of Building Materials i) Initial equilibrium price is, with units bought and sold each period. ii) After an earthquake demand for building materials shifts rightward. iii) The equilibrium price increases to - this higher price reflects the increased scarcity of building material in this city, but it seems unfair that victims must pay a higher price. iv) If government passes a law restricting the price of building materials to (a price ceiling, effective after the earthquake) then a shortage will occur, with supplied and Q 3 units demanded each period. With this control of prices, even individuals willing to pay or more may not be able to purchase building materials. v) If price were allowed to increase to (as would occur in a free market ) users of building materials would receive a clear signal to use less this period (and only rebuild structures essential for living now, and postpone rebuilding less essential structures like garages). Potential suppliers of building materials would receive a clear signal to move materials to the area that suffered the earthquake. vi) If the price is allowed to increase to, even selfish people who care only about earning money for themselves and not at all about the victims, will have an incentive to bring building materials to the area that experienced the disaster. This is sometimes referred to as the invisible hand of the market which guides selfish individuals to benefit society (it is invisible because no conscience action by government is needed).

4 Supply and notes, page 4, Bruce Brown vii) This assumes that the selfishness is directed through competitive markets and laws are obeyed. A selfish seller of building materials may destroy the supplies of competitors to keep the price artificially high. This would definitely not benefit society. viii) The lesson of this example is not that greed is good but that greed can benefit society when channeled through competitive markets, with well defined property rights, and well informed buyers and sellers. ix) Government could best help the victims by increasing the supply of building materials (for example by keeping the roads open) and not by artificially trying to control the price. This example concerned building materials but could have used drinking water, batteries, or anything for which demand increases after an earthquake. For example, in Northridge California after a major earthquake in 1994, the price of drinking water increased from approximately one dollar per gallon ( four liters) to ten dollars. Some individuals (including news commentators) stated that this was immoral price gouging which should be prevented by government. But those stores which did not raise their price of water soon had no more left, and those stores which did raise their price still had some for those people who really needed it. Thirsty individuals who really needed water and were willing to pay ten dollars per gallon to get it, benefited as a result. In such a disaster, some people may earn high profits - for example those with fresh drinking water. This could be seen as a reward for maintaining a large supply of goods needed after a disaster. Government can effectively help the victims by providing fresh drinking water. They should not simply make it illegal to increase price. That is, in general good government policy can use the natural functioning of markets, rather than working against them. 10. Worth of a Good - Karl Marx thought that the true value of a good was determined by the value of the labor (direct and indirect) that went into producing it. This is called the labor theory of value. - Jeremy Bentham and other economists in the 1800 s thought that the true value of a good was determined by the utility one got by consuming it (these economists are utilitarians ). - Alfred Marshall reconciled these two positions when he created the demand and supply model. The true value of one more unit of a good to society could be theoretically determined by the equilibrium price, which was determined by both demand (utility) and supply (cost of production). In theory, the equilibrium price shows both the marginal cost to society of producing one more unit and the marginal benefit to the person who would consume it (and so to society). The demand and supply curves could be thought of as two blades of a pair of scissors; and just as both blades cut simultaneously, so too do both demand and supply simultaneously determine market price (value).

5 11. Examples using supply and demand Supply and notes, page 5, Bruce Brown A. Beef Boycott Following a period of rapidly rising beef prices, beef consumers became angry and organized a boycott. That is, buyers would stop buying beef to show producers that they could not continue to charge prices that consumers considered unreasonably high. During the boycott prices of beef did fall, but then after the boycott ended beef prices jumped back up again. A simple supply and demand analysis (with stable, upward-sloping supply) would predict this. If the boycott shifts D left, the equilibrium price falls, but then when the boycott is removed and D shifts rightward, price increases. Supply & P 3 -original, and after boycott - boycott & Quantity of beef, per period B. Hog cycle or cobweb Assume it takes small baby pigs one year to grow into hogs for sale, demand for hogs is stable, and farmers decide how many pigs to raise based on the current year price of hogs. We will show the supply of hogs in a particular year as determined by the number of pigs farmers started to raise in the previous year. The price of hogs can fluctuate from year to year, and in years with high prices of hogs farmers raise many pigs, but then in the next year the increased supply of hogs reduces their price, causing farmers to reduce the number of pigs they raise so that in the year after the supply of hogs falls, increasing their price... Supply - odd years - few pigs raised previous yr. Supply - even years - many pigs raised prev. yr. Quantity of Hogs - per period

6 Supply and notes, page 6, Bruce Brown 12. and Supply - Restated; Consumer and Producer Surplus Most all economic problems to be solved can be categorized as either dealing with i) equilibrium or ii) optimization. The demand curve can be theoretically derived by the solutions of individual utility maximization problems of consumers. The supply curve can be theoretically derived by the solutions of individual profit maximization (or if output is predetermined, cost minimization) problems of firms. and supply can be used to determine equilibrium market price and quantity. Typically, demand and supply analysis assumes that the market is in equilibrium, and that changes to either supply shifters or demand shifters imply changes in this equilibrium. Comparative statics exercises show an initial equilibrium, a new equilibrium, and compare them. It is as if the economy jumps from one equilibrium to another. How price and quantity may change within an economy which is moving from one equilibrium to another is a complex issue which we will not consider. It is useful to imagine that buyers and sellers are coordinated by an auctioneer who clears the market so that all units are bought and sold at the same price. It is also useful to imagine that the good is homogeneous (each unit of the good is identical to any other one). Although certainly unrealistic, demand and supply analysis based on these convenient simplifying assumptions can be very useful in understanding some important features of complicated real world markets. Consider price to be the independent variable when drawing demand and supply. As price changes (for an unexplained, exogenous, reason), the quantity demanded and quantity supplied change in response. The demand and supply diagram has the independent variable (price) on the vertical axis (and so differs from the way mathematicians typically draw graphs). This is why an increase in supply is a rightward shift in supply, and an increase in demand is a rightward shift in demand (it is almost always better to think of the shifts as being left and right, rather than up and down; one exception is when describing the effect of sales or excise taxes). Typically one thinks of plugging in an exogenous price and getting Q X d or Q X s ; but in certain circumstances it is useful to consider choosing ( plugging in ) either Q X d or Q X s and considering the height of demand or supply above the chosen quantity. The height of demand above a particular Q shows the reservation price of the represented buyer (the highest price they would accept and still buy this unit). If the market price is below their reservation price, then buyers purchase the unit. The difference between their reservation price and the market price shows the consumer surplus received by the buyer from purchasing this specific unit. The sum of these vertical distances for all individual units can be shown as a triangle, reflecting the consumer surplus received by the group of buyers in this market. The height of supply above a particular Q shows the reservation price of the represented seller (the lowest price they would accept and still sell the unit). With standard competitive assumptions, this reflects the marginal cost of producing this unit. If price is above their reservation price, then the firm sells this unit. The difference between their reservation price and the market price depicts the producer (or seller ) surplus received by the firm selling this unit. The sum of these vertical distances for all individual units can be shown as a triangle, reflecting the producer surplus received by the group of sellers in this market. Because vertical distance is measured in terms of $ per unit of the good and the horizontal distance is in terms of units of the good; the triangular areas reflecting consumer surplus and producer surplus are measured in terms of $ (in total, not per unit) and reflect the overall benefit received by the group of buyers and sellers respectively, from the existence of this market.

7 Supply and notes, page 7, Bruce Brown reservation price of consumer purchasing unit B P * A consumer surplus received by individual purchasing unit q 1 C Q * Quantity, per Triangle ABC represents the consumer surplus received by the group of all buyers. It is the area above the market price and below the demand curve Supply P * reservation price of firm producing and selling unit D F E producer surplus received by firm selling unit q 1 Q * Quantity, per Triangle DEF represents the producer surplus received by the group of all sellers. It is the area below the market price and above the supply curve When drawing demand and supply we assume that the units are lined up so that units purchased by buyers with higher reservation prices are further to the left, and units sold by producers with lower reservation prices (and so lower marginal cost) are further to the left.