ECON 320

Demand Schedule and Demand Curve: Conceptually let's figure out the average for all of the factors above except the price of the good or the service. We will let price and QD vary, but we will keep the other factors constant at their average value. What we will end up with is a demand schedule.

**** ACTIVITY: DEMAND INDIVIDUAL AND MARKET DEMAND SCHEDULES ****

We can horizontally sum QD for each buyer at a given market price to arrive at market QD. Repeat for different prices. That is how we create the market demand schedule.

A demand schedule describes how QD varies as price varies. If we plot the demand schedule on a graph we will get a demand curve.

Law of Demand: There is an inverse relationship between P and QD. Why?

Principle of substitution: As the price of the good rises, some people will switch to substitute goods and services to the extent that they are available.
Income effect: A price increase affects the budget in a manner similar to a reduction in income, and for normal goods this means a reduction in QD.

A demand curve shows the inverse relationship between quantity demanded and price, holding all other factors (such as income) constant.

Now suppose that average income increases. How do you think this will affect the demand schedule and the demand curve?

Normal goods: As income rises, so too does demand.

Inferior goods: As income rises, demand falls.

What is an example of a normal good? An inferior good?

Now suppose instead that the number of buyers increases. How will this affect the demand schedule and the demand curve?

Now suppose that buyers expect that prices in the near future will be considerably higher than they are today. How will this affect today's demand schedule and demand curve?

Suppose that gasoline and gas-guzzling SUV's are complementary goods, and that the price of gasoline triples. How will this affect the demand schedule and the demand curve for SUV's?

Supply:

Supply Function: Quantity Supplied (QS) = Function of:

Price of the good or service.
Taxes and subsidies.
Technology.
Cost of inputs such as capital, labor, and intermediate goods.
Number of sellers.
Price of production substitutes.
Seller expectations of future prices.

Just like with demand, when we go from a supply function to a supply schedule and curve, we calculate the average value of all the factors that influence QS other than the price of the good itself, and hold them constant.

The supply schedule and curve shows the direct relationship between price and quantity supplied. Why does the supply curve slope upwards?

One simple reason is that higher prices raise the profitability of producing a larger quantity, and provides an incentive for more sellers to enter the market. Example: How many of you would sell your car (if you have one) for $1000? ... $2000? ... $10,000? ... $20,000? ... $40,000? You can see that there tends to be a direct relationship between P and QS.

Just like with demand, we can horizontally sum QS for each seller at a given price, and repeat at different prices, to arrive at the market supply schedule.

If we plot the market supply schedule we will end up with the market supply curve.

Shifts in Market Supply: If we change any of the factors that we held constant to develop the supply schedule and curve, we will cause the supply curve to shift. For example, suppose that the cost of inputs declines by a large amount. Then what will happen?

At any given price, QS will increase. This leads to a whole new supply schedule, and results in an outward shift (an increase) in supply.

Repeat for all the other factors other than the price of the good or service.

NOTE: A change in the price of the good or service will cause movement upward or downward along a GIVEN supply or demand curve, but will NOT make the supply or the demand curve shift. Why?

Equilibrium:

Now draw the supply and the demand curves on the same diagram. Under competitive conditions, what will the market price be?

1. Suppose first that the prevailing market price lies above the place where supply and demand cross. What will be QD? What will be QS? Is one larger than the other? Do we have a shortage or a surplus?

How will the market resolve the surplus that occurs when price is above the intersection of S and D? For example, suppose that stores like Bloomingdales stocks a large quantity of expensive fall fashion clothing that ends up much less popular than expected. In other words, the industry anticipated much higher demand than what actually exists for the clothing. How will the surplus be resolved?

Any other examples of surpluses and how markets resolve them?

2. Now suppose that the prevailing market price lies below the place where supply and demand cross. What will be QD? What will be QS? Is one larger than the other? Do we have a shortage or a surplus?

How will the market resolve the shortage that occurs when price is below the intersection of S and D? For example, suppose that demand is higher than expected for some toy at Christmas time, and there is a shortage at stores. What will tend to happen? Suppose that the supply curve for gasoline shifts inwards (declines). At the old price of gasoline this will create a shortage. How will the market tend to resolve this shortage?

Does our culture have any impact in determining how shortages and surpluses are resolved for various goods and services at various times and places? Think of some examples, such as food during wartime.

3. Note that when price is above the intersection of S and D, market forces tend to cause price to fall, and when price is below the intersection of S and D, market forces tend to cause price to rise. The only place where market forces neither are pushing price up nor pushing price down is when price occurs at the intersection of S and D. Why?

Equilibrium means that if neither S nor D change, then market P and Q will also remain unchanged. In the real world many markets experience daily volatility in S and D, causing frequent changes in P and Q. Think of an equilibrium as a magnet pulling price toward it. Price may not get all the way to the equilibrium before some shock occurs that makes S or D shift, which will again displace P and Q.

Therefore equilibrium occurs in a market when there is neither a shortage nor a surplus.

Comparative Statics: Examples...

Suppose that the orange market is in equilibrium, and then a freeze occurs that destroys 1/2 of the orange crop. How will the equilibrium be changed?
Suppose that computer hardware and software are consumer complements, and the price of hardware falls by 1/2. How will this affect the market equilibrium for computer software?
Suppose that the federal government imposes a pollution tax of $0.02 per KwH on producers of electricity. How will this tax increase change the equilibrium in the market for electricity? What if instead there was a particularly hot summer, and people were running their A/C a lot more than usual? How would this change the equilibrium in the market for electricity?

Price Ceilings and Floors:

A price ceiling is a regulated price (a type of government intervention in the market) that is effective when it is BELOW the equilibrium price. Example: Rent control. What is the intended effect? What are the unintended consequences? Is quantity traded in the market larger or smaller than the equilibrium quantity? Why? Is there a shortage or a surplus?

A price floor is a regulated price (a type of government intervention in the market) that is effective when it is ABOVE the equilibrium price. Example: Minimum wage. What is the intended effect? What are the unintended consequences? Is quantity traded in the market larger or smaller than the equilibrium quantity? Why? Is there a shortage or a surplus?