Chapter 1: Demand and Supply

Transcription

1 Chapter 1: Demand and Supply Types of markets: A market is any arrangement that enables buyers and sellers to get information and do business with each other. A competitive market is a market that has many buyers and many sellers so that no single buyer or seller can influence the price. Broadly speaking there are two types of markets: Goods markets are markets where final products from businesses or firms are exchanged. Households and firms are usually buyers, and firms are sellers. Factor markets are markets for the factors of production. These factors include labor, capital, raw materials, and entrepreneurship, etc. For example, in labor markets, households are sellers and firms are buyers. The demand for a factor exists because there is a demand for goods that the resource helps to produce. The demand for each factor is thus a derived demand; it is derived from the demand of consumers for products. For example, engineers are needed to design cars. A car manufacturers demand for engineers thus depends entirely upon the demand for cars. The demand for engineers is a derived demand. Principles of demand and supply The demand function represents buyers' behavior. Prices influence the consumers' purchase decisions. The demand function can be depicted as a negatively sloped demand curve. All else equal, as the price of a good rises, consumer demand falls. This is mainly due to the availability of substitutes, which are goods that perform similar functions. As the price of a good falls, consumer demand rises. Therefore, there is an inverse relationship between the price of a good and the amount that consumers are willing to buy. The demand curve normally slopes downward. It tells the analyst the quantity that consumers are willing to buy for each possible price when all other influences on consumers' planned purchases remain the same. Example 1- Refer to the graph below. What is the quantity demanded when price is $4.00 per week? Answer: Two cassettes per week. The demand curve tells how much is demanded at each price. To determine the quantity demanded, find $4.00 on the vertical axis and read across until you meet the demand curve. Then read the quantity from the horizontal axis. When any factor that influences buying plans, other than the price of the good changes, there is a change in demand for that good. When the quantity of the good that people plan to buy changes at each and every price, there is a new demand curve. These factors are include changes in income, number of consumers in the market, changes in the price of a related good, etc. Example 2-Assume the graph below reflects demand in the automobile market. Which arrow best captures the impact of increased consumer income on the automobile market?

2 Answer: D. Income is a shift factor of demand. An increase in income increases the number of automobiles demanded at each price. Therefore demand has shifted to the right. When demand increases, the quantity that people plan to buy increases at each and every price so the demand curve shifts rightward. When demand decreases, the quantity that people plan to buy decreases at each and every price so the demand curve shifts leftward. A Change in the Quantity Demanded Versus a Change in Demand The demand curve isolates the impact of price on the amount of a product purchased. A change in quantity demanded (caused by price change ONLY) is a movement along a demand curve from one point to another. Changes in other factors (anything other than price) such as income, tastes, expectations and the prices of closely related goods will shift the entire demand curve inwards or outwards. This is referred to as change in demand. Example 3 -Refer to the graph below. Consumers began purchasing more of a product due to a decrease in price. Which arrow best represents this statement? Answer: C. A change in price causes a movement along the demand curve. When price falls, the movement is downward and to the right. The Supply Function and the Supply Curve Resources and technology determine what it is possible to produce. Supply reflects a decision about which technologically feasible items are best to produce. The supply function represents sellers' behavior. Prices influence the producers' supply decisions. The supply function can be depicted as a positively sloped supply curve. All else equal, a higher price will increase the producer's incentive to supply the good. Higher price increases the producer's profit, which is the excess of sales revenue over the cost of production. As the price of a good falls, its supply falls as well. Therefore, there is a direct relationship between the price of a good and the amount of that good that will be supplied. The supply curve slopes upward. It tells the analyst the quantity that producers are willing to supply for each price when all other influences on producers' planned sales remain the same. Example 4 -The graph below displays the quantity associated with price in a supply table.

3 To find the quantity supplied at a price of $1, extend a horizontal line from $1 to the supply curve and drop a vertical line down to the quantity axis. It will intersect it at 0. This is the quantity that will be associated with a price of $1 on a supply table. The law of supply results from the general tendency for the marginal cost of producing a good or service to increase as the quantity produced increases. A supply curve is also a minimum-supply-price curve. The greater the quantity produced, the higher is the price that a firm must offered to be willing to produce that quantity. A Change in Supply Changes in other factors will influence the amount of products that producers are willing to supply. These factors include prices of productive resources, expected future prices, the number of suppliers, taxes, etc. These factors affect the opportunity cost of supplying a good, and are held constant when drawing a supply curve. Changes in these factors will shift the entire supply curve for the good. Example 5 - Refer to the graph below. A shift from S1 to S0 in the graph above would most likely occur for what reason? A. An increase in the number of suppliers in the market. B. A decrease in taxes levied on the good produced in the market. C. An increase in the price of the good produced in the market. D. An increase in the cost of producing this good. Answer: D. An increase in the cost of producing the good causes supply to shift leftward. An increase in the number of firms and a decrease in taxes cause supply to shift rightward. A change in price causes a movement along supply, not a shift. A Change in the Quantity Supplied Versus a Change in Supply The quantity supplied of a good or service is the amount that producers plan to sell during a given time period at a particular price. Price is just one of the factors that affect the producers' supply decisions. The supply curve isolates the impact of price on the quantity of a product supplied, and assumes that all other factors stay the same. A change in quantity supplied is caused by a price change ONLY. It is a movement along the same supply curve. When one of the other factors that influence selling plans changes, there is a change in supply and a shift of the supply curve.

4 Example 6 -A tax will shift the supply curve up by the amount of the tax. At every price level, less is supplied. For example, at price P 0, originally Q 0 is supplied. After the tax, Q 1 is supplied at price P 0. Aggregate Demand and Aggregate Supply An aggregate demand curve is simply a schedule that shows amounts of a product that buyers collectively desire to purchase at each possible price level. An aggregate supply curve is simply a curve showing the amounts of product that all firms will produce at each price level. Example 1- Refer to the graph below. What is the market quantity that would be supplied at a price of $2.00? Market quantity is the sum of individual quantities supplied at each price. At price of $2.00, Ann supplies 4, Barry supplies 3, Charlie supplies 0. Market supply is 7. Market Equilibrium Equilibrium is a state in which conflicting forces are in balance. In equilibrium, it will be possible for both buyers and sellers to realize their choices simultaneously. The following graph depicts the market supply and demand for concert tickets at Madison Square Garden in New York City. Equilibrium price and quantity are where the supply and demand curves intersect. Draw a horizontal line from the intersection to the price axis. This is equilibrium price - $60. Draw a vertical line from the intersection to the quantity axis. This is equilibrium quantity It is equilibrium because quantity

5 demanded equals quantity supplied at $60 per ticket. At this price there is neither surplus (excess supply) nor shortage (excess demand), so there is no downward or upward pressure for the price to change. Surplus will push prices downward towards equilibrium. Suppose the price is initially above the equilibrium price (P 0 ) and sites at P 1. Quantity supplied (Q 1s ) will exceed quantity demanded (Q 1D ), creating a surplus. The surplus will put downward pressure on prices since producers will begin to lower their prices to sell the surplus. As a result, the price will fall, the quantity supplied will decrease and the quantity demanded will increase until the equilibrium price (P 0 ) is restored. This process involves movements along supply-and-demand curves since the changes are caused by price fluctuations. Similarly, shortages push prices upward towards equilibrium. Because the price rises if it is below equilibrium, falls if it is above equilibrium, and remains constant if it is at the equilibrium, the price is pulled toward the equilibrium and remains there until some event changes the equilibrium. We refer to such an equilibrium as being stable because whenever price is disturbed away from equilibrium, it tends to converge back to that equilibrium. An unstable equilibrium is an equilibrium that is not restored if disrupted by an external force. While most equilibria studied in economics are of the stable variety, a few cases of unstable equilibria do emerge from time to time, in limited circumstances. Market interference: The negative impact on total surplus. The equilibrium price set by the market mechanism is often deemed to be unfair: buyers complain that the price is too high, while sellers believe that it is too low. In such cases, the government may regulate the price of the good or service. This is known as price control. A price control is a government-mandated price that may either be greater or less than the market equilibrium price. Price ceilings and floors are two types of price controls. A Price Ceiling A price ceiling is a legal restriction that prohibits exchanges at prices greater than a designated price - the ceiling price. Price ceilings are usually imposed when the equilibrium price is considered too high to be fair. A typical price ceiling results in a lower price than market forces would produce. A shortage will result in a situation in which the quantity demanded by consumers exceeds the quantity supplied by producers at the existing price. A typical example of price ceiling is "rent ceiling", implemented by over 200 U.S. cities. If the rent ceiling is set above the equilibrium rent, it has no effect. The market works as if there were no ceiling. But if the rent ceiling is set below the equilibrium rent, it has powerful effects.

6 If a rent ceiling is set below the equilibrium price P 0, for example at P 1, there is a reduction in the quantity that producers are willing to supply qs and an increase in the quantity that consumers demand q d relative to the original equilibrium quantity q. Because the legal price cannot eliminate the shortage, other mechanisms operate. For example, a black market is an illegal market that operates alongside a legal market in which a price ceiling or other restriction has been imposed. A shortage of housing creates a black market in housing. Illegal arrangements are made between renters and landlords at rents above the rent ceiling - and generally above what the rent would have been in an unregulated market. A rent ceiling leads to an inefficient use of resources. The quantity of rental housing is less than the efficient quantity and there is a deadweight loss. A rent ceiling decreases the quantity of rental housing, shrinks the producer and consumer surplus by using resources such as search activity, and creates a deadweight loss. A Price Floor A price floor is a minimum price that can be legally charged. It usually fixes the price of a good or resource above the market equilibrium level. Price floors are usually imposed when the equilibrium price is considered too low to be fair. Agricultural price supports and minimum wage legislation are examples of price floors.

7 If a price floor is set above the equilibrium price, p0, for example at p1, there is a reduction in quantity demanded from q0 to qd, whilst the quantity supplied increases from q0 to qs. The result is a surplus of qsqd. Example 1 - Refer to the graph below. A price floor set by the government would be binding and cause the greatest distortion in the market if it were established at what price? Answer: $3.00. Given the supply and demand curves in the graph, equilibrium price is $2.25. A price floor will be binding only if it is above the equilibrium price. So a price floor of $1.50 would not distort the market. The higher the floor above equilibrium price, the greater the market distortion (surplus). A price floor at $3.00 would create a larger surplus than a price floor at $2.50. It creates a deadweight loss.

8 Note that a surplus does not mean the good is no longer scarce: people just desire less of the good at the current price than sellers desire to bring to the market. A decline in price would eliminate the surplus but not the scarcity of the item. Taxes When a tax is imposed, the government can make either the buyer or the seller legally responsible for payment of the tax. However, the person who writes the check to the government is not necessarily the one who bears the tax burden. Example 2 -The following graph illustrates how a $1,000 tax placed on the sale of used cars would affect the market. Assumption: all used cars are identical. Before the imposition of the tax, used cars sold for a price of $7,000 (point A). The tax has statutorily been placed on the seller, shifting the supply curve upward by exactly the amount of tax ($1,000). Now the price will rise to $7,400 (point B). Therefore, despite the tax being statutorily imposed on sellers, the higher price shifts some of the tax burden to buyers. o o o A buyer will now pay $400 more for a used car. A seller now receives $7,400 from the sale of a used car, but, after sending the tax of $1,000 to the government, the seller retains only $6,400. This is exactly $600 less than the seller would have received had the tax not been imposed. In this case, each $1,000 of tax revenue transferred to the government imposes a burden of $400 on the buyer and a $600 burden on sellers. As the example shows, the imposition of the $1,000 tax on used cars causes the number of units exchanged to fall from 750 to 500. As trade results in mutual gains for both buyers and sellers, the loss of mutual benefits that would have been derived had the tax not eliminated 250 units of exchange also imposes a cost on buyers and sellers. The loss is referred to as the deadweight loss of taxation. In the exhibition, the triangle ABC measures the size of the deadweight loss. It generates neither revenue for the government nor gains for any other party. The incidence of a tax depends on the responsiveness of buyers and of sellers to a change in price. It tends to fall more heavily on whichever side of the market has the least attractive options elsewhere and thus is less sensitive to price changes. This is because an inelastic curve indicates there are few substitutes available. When demand is relatively inelastic and supply elastic, the primary burden of a tax will fall on buyers. Initially, gas costs 50 cents per liter and 1,000 liters are sold per day. The demand curve is relatively inelastic, indicating there are few alternatives to gas.

9 A 20c tax per liter on suppliers shifts the supply curve up by 20c, establishing a new equilibrium price (65c) and quantity (950 liters). Consumers pay 15c more - meaning they have paid 15c of the 20c tax. Suppliers receive 65c from consumers, pay 20c to the government and are left with 45c - 5c less than before. Suppliers have thus paid 5c towards the tax. The tax incidence is thus: Consumers - 15c. Suppliers - 5c. Consumers pay more because their demand curve was relatively more inelastic than the supply curve. When demand is relatively elastic compared to supply, sellers will bear the larger share of the tax burden. Consider the diagram below. Here demand is relatively elastic and supply relatively inelastic. The demand for luxury boats is relatively elastic as rich people have many alternatives as to how to spend their money. A $25,000 tax on the sale of these boats thus causes a large reduction in quantity demanded (10 thousand to 5 thousand). As the selling price only rises from $100,000 to $105,000, buyers have only paid only $5,000 of the tax. Sellers have thus paid $20,000 and received only $80,000 per yacht sold. The deadweight loss is reduced if the elasticity of either demand or supply is reduced (i.e. its curve becomes steeper). Except in the extreme cases of perfectly inelastic demand or supply when the quantity remains the same, imposing a tax creates inefficiency. In practice, taxes usually are levied on goods and services with an inelastic demand or an inelastic supply. Alcohol, tobacco, and gasoline have inelastic demand, so the buyers of these items pay most the tax on them. Labor has a low elasticity of supply, so the seller - the worker - pays most of the income tax and most of the Social Security tax. Consumer surplus, producer surplus, and total surplus Consumer surplus is the area below the demand curve but above the actual price paid. It is the difference between the amount consumers are willing to pay and the amount they have to pay for a good. Consider the market for a good.

10 If the market price is $100, then the 30th unit will not sell because those who demand it are only willing to pay $60 for the good. At $100, the 17th unit will sell because those who demand it are willing to pay up to $100 for the good. At $100, the 5th unit will sell because those who demand it are willing to pay up to $133 for the good. For all those goods under 17 units, people are willing to pay more than $100 for it. The area, represented by the distance above the actual price paid and below the demand curve, is called consumer surplus. This area represents the net gains to buyers from market exchange. Lower market prices increase the amount of consumer surplus in the market. Producer Surplus The producer surplus is the difference between the minimum supply price, represented by the supply curve, and the actual sales price. It is measured by the area below the price and above the supply curve, up to the quantity sold. It accrues to owners of a firm and resource suppliers. Example

11 The actual selling price of bananas is $9 per kg. Now imagine that there are only 10,000 kg bananas being supplied at the moment. The marginal cost per kg is only $3 but the selling price is $9. So there is an additional $6 per kg being raised. This is the producer surplus per kg. The total producer surplus when 10,000 kg are produced is thus $60,000. Due to the surplus, more producers enter the market and another 10,000 kg are produced, so there are now 20,000 kg of bananas on the market. The marginal costs of producing these additional 10,000 kg have risen to $4. Producer surplus is not the same as profit. Remember that profit is the return that accrues to owners of a firm and is the difference between sales revenue and total (not marginal) costs of production. Total Surplus The following figure shows that a competitive market creates an efficient allocation of resources at equilibrium. In equilibrium, the quantity demanded equals the quantity supplied. At the equilibrium quantity, marginal benefit equals marginal cost, so the quantity is the efficient quantity. The sum of consumer and producer surplus is maximized at this efficient level of output. It is here that all potential gains from production and exchange are realized.