Chapter 3 - Demand PDF

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Chapter 3: Demand When we speak of demand we are looking at the market from the consumers’ point of view. Most students find it fairly easy to understand the demand side of things because they have all been consumers throughout their lives. The law of demand states: There is an inverse relationship between price and quantity demanded, all else constant. Let’s dissect that sentence: As you’ll recall from Appendix A, inverse relationship means that as price rises, quantity demanded falls and as price falls, quantity demanded rises. You’ve probably observed that when a product goes on sale, people tend to buy more of it. Note that I said that price and quantity demanded have an inverse relationship; I did not say that price and demand have an inverse relationship. One of the most difficult concepts for principles students to understand is that the terms “demand” and “quantity demanded” are not synonyms. They are not used interchangeably by economists. By the end of this lecture, you should know when to use each term properly.

We can demonstrate the law of demand in a simple table, called a demand schedule. Suppose that I was selling individual bottles of water to my students and noted the following results:

The graph that accompanies this table would look like this and the resulting curve would be called a demand curve:

Movements along a Demand Curve Notice that the demand curve slopes downward due to the inverse relationship between price and quantity demanded. If we were currently at the top point (P= $1, Qd = 30) and the price of the product fell to $.75, we would move down the curve to the next point. An economist would say, “The decrease in price caused an increase in quantity demanded.” Note that it would be incorrect to say that the decrease in price caused an increase in demand. Demand did not change (otherwise, the entire demand curve would have shifted), but quantity demanded did change.

Changes in Demand For demand to change, something other than the price of the product must change. For example, if the income of my students increased, it would likely follow that I could sell more bottles of water at each price than I had previously. The new demand schedule might look as follows:

Notice that the increase in income has caused the demand curve to shift to the right (indicating that at each possible price, people now want to buy more bottles of water). An economist would call this an increase in demand.

The Determinants of Demand There are five things that can shift the demand curve and they are called the determinants of demand. They are: Price of related goods (substitutes and complements), Income, Number of buyers, Tastes/Preferences, and Expectations of Buyers. The following diagram summarizes the impact of a change in each determinant upon demand:

Determinant

Demand Increase or Decrease?

Direction of Curve Shift?

Price of substitute increases

Increase

Rightward

Price of substitute decreases

Decrease

Leftward

Price of complement increases

Decrease Leftward

Price of complement decreases

Increase

Rightward

Income increases (normal good)

Increase

Rightward

Income decreases (normal good)

Decrease

Leftward

Income increases (inferior good)

Decrease

Leftward

Income decreases (inferior good)

Increase

Rightward

Number of buyers increases

Increase

Rightward

Number of buyers decreases

Decrease

Leftward

Tastes and preferences increase

Increase

Rightward

Tastes and preferences decrease

Decrease

Leftward

Substitutes are things that we choose between, such as Coke or

 Pepsi

Complements are things that go together, such as peanut butter

 and jelly    

Normal goods are goods for which demand and income have a direct relationship --- most goods are normal goods Inferior goods are goods for which demand and income have an inverse relationship; for example, generic toilet paper Tastes/preferences basically means the popularity of a good. This determinant explains a lot of strange things that happen in the world, like why someone would have paid $1,000 for a Beanie Baby twenty years ago or $500 for a Wii gaming system when they first entered the market.

Change in Demand versus Change in Quantity Demanded As shown in Exhibit 5 of the textbook, a change in quantity demanded results from a change in price and is shown on a demand curve graph as a movement along a demand curve. A change in demand means that one of the determinants of demand has changed, and the entire demand curve has shifted to the right or to the left.

Supply When we speak of supply we are looking at the market from the producers’ point of view. The law of supply states: There is a direct relationship between price and quantity supplied, all else constant.

Let’s dissect that sentence: As you’ll recall from Appendix A, direct relationship means that as price rises, quantity supplied rises and as price falls, quantity supplied falls. Motivated by profits, the seller is willing to devote more resources to products with a rising price. Note that I said that price and quantity supplied have a direct relationship; I did not say that price and supply have a direct relationship. As with demand, they are not synonyms for one another. They are not used interchangeably by economists. By the end of this lecture, you should know when to use each term properly. We can demonstrate the law of supply in a simple table, called a supply schedule. Suppose that I was selling individual bottles of water to my students and noted the following results:

Pric e

Quantit y Supplie d

$.25

0

.50

20

.75

55

1.00

80

The graph that accompanies this table would look like this and the resulting curve would be called a supply curve:

Movements along a Supply Curve Notice that the supply curve slopes upward due to the direct relationship between price and quantity supplied. If we were currently at the top point (P= $1, Q s = 80) and the price of the product fell to $.75, we would move down the curve to the next point. An economist would say, “The decrease in price caused a decrease in quantity supplied.” Note that it would be incorrect to say that the decrease in price caused a decrease in supply. Supply did not change (otherwise, the entire supply curve would have shifted), but quantity supplied did change.

Changes in Supply In order for supply to change, something other than the price of the product must change. For example, if the cost of the plastic used to make the bottles increased, it would likely follow that I could not produce as many bottles of water at each price as I had previously. The new supply schedule might look as follows:

Pric e

Quantit y Supplie d

$.25

0

.50

10

.75

30

1.00

50

The supply curve would shift to the left, as follows:

Notice that the increase in resource costs has caused the supply curve to shift to the left (indicating that at each possible price, the producer can no longer produce as many bottles of water as previously). An economist would call this a decrease in supply.

The Determinants of Supply There are five things that can shift the supply curve and they are called the determinants of supply. They are: Subsidies/Taxes, Technology, Resource costs, Expectations of sellers, and the Number of sellers. The following diagram summarizes the impact of a change in each determinant upon supply:

Determinant

Supply Increase or Decrease?

Direction of Curve Shift?

Subsidies increase

Increase

Rightward

Subsidies decrease

Decrease

Leftward

Business taxes increase

Decrease

Leftward

Business taxes decrease

Increase

Rightward

Technology improves

Increase

Rightward

Technology declines

Decrease

Leftward

Resource costs increase

Decrease

Leftward

Resource costs decrease

Increase

Rightward

Number of sellers increases

Increase

Rightward

Number of sellers decreases

Decrease

Leftward

  

A subsidy is generally money that the government sends to businesses to encourage the production of some good or service Business taxes must be paid by the producers to the government, leaving the producer with less money to spend on the production of its goods Resource costs are the costs of producing the good such as labor costs (wages), utilities, rent, leases, etc.

Change in Supply versus Change in Quantity Supplied As shown in Exhibit 10 of the textbook, a change in quantity supplied results from a change in price and is shown on a supply curve graph as a movement along a supply curve. A change in supply means that one of the determinants of supply has changed, and the entire supply curve has shifted to the right or to the left.

Putting Supply and Demand Together In the real world, market prices and quantities are determined by the forces of both demand and supply, together. Let’s take what we know about each and see how they would work in conjunction with one another. We’ll start by combining the demand schedule and the supply schedule into a demand and supply schedule:

Quantity

Quantit y

Pric e

Demande Excess d Supplie d

$.25

110

0

110 Shortage (Qd>Qs)

.50

75

20

55 Shortage (Qd>Qs)

.75

55

55

0 Equilibrium

1.00

30

80

50 Surplus (Qs>Qd)

The column labeled “Excess” gives us a lot of information. We see that at P = $.25, the quantity demanded of water exceeds the quantity supplied of water by 110 bottles. An economist would term this a shortage. Shortages send a signal to the producers to raise the price of the product. As the price rises to $.50, the amount of the shortage falls to 55 bottles of water. Since there is still a shortage, the price would continue to rise until the shortage is eliminated and the quantity demanded equals the quantity supplied. This is called equilibrium. In our example the equilibrium price of bottled water would be $.75 (Pe=$.75) and the equilibrium quantity would be 55 bottles of water (Qe=55). That is the only price at which there is neither a shortage nor a surplus of bottle water. If the price had started at $1, there would have been a surplus of 50 bottles of water. Surpluses send a signal to producers to lower the price of the product. The price would continue to fall until equilibrium was reached. The combined supply and demand graph for this example would look like the following:

Using a combined supply and demand graph, it is easy to see where equilibrium occurs --- it is always at the intersection of the supply curve and the demand curve. See the graph in Exhibit 13 in the textbook, for another example of equilibrium. Equilibrium will only last as long as the determinants of demand and supply remain constant. If one of the determinants of demand changes, the demand curve will shift and a new equilibrium will be created. The same is true for supply. See Exhibit 18 in the textbook, for examples of shifting demand and supply. (Note: you can ignore examples e, f, g, and h as I will not be testing you on multiple concurrent shifts. I prefer to focus on the impact of one curve shifting at a time in Econ 101). For example, suppose that a news story reveals that a research study has found that drinking bottled water improves students’ grades. It is reasonable to assume that this would increase the demand for bottled water, shifting the demand curve to the right. The result would be an increase in both the equilibrium price and the equilibrium quantity of bottled water, as depicted in Exhibit 18 panel (a)....