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Principles of Microeconomics, 1st Canadian Edition

Robert H. Frank, Cornell University
Ben S. Bernanke, Princeton University
Lars Osberg, Dalhousie University
Melvin Cross, Dalhousie University
Brian MacLean, Laurentian University

Supply and Demand: An Introduction

Cyberlecture

This chapter introduces you to the market mechanism for allocating goods and services among buyers and sellers. You will also learn why markets usually do a better job of allocating goods and services than bureaucratic rules and regulations.

How can we allocate goods and services?
There are several ways for an economy to allocate goods and services.

everyone can provide all goods and services only for themselves
a central bureaucracy can allocate all goods and services to everyone
markets can allocate all goods and services to everyone
a mixed economy – mostly market allocation combined with some bureaucratic allocation – can allocate all goods and services to everyone

What is a market?
A market is a real or a virtual place where buyers and sellers gather to trade particular goods or services.
A market determines the price of a good or service, and the price depends in part on the cost of production and the value of the product.

What is a supply curve?
A supply curve tells how much of a product sellers will be willing to sell at every possible price.

the higher the price, the more willing producers are to sell their product
the supply curve slopes up

A supply curve reflects the increasing opportunity and marginal costs of the producers of that product.

What is a demand curve?
A demand curve tells how much of a product consumers are willing to buy at every possible price.

the higher the price, the less affordable the product is for consumers
the higher the price, the more likely it is that consumers will substitute into other products
the demand curve slopes down

What is market equilibrium?
Market equilibrium occurs when the forces of demand and supply are equal.

the demand curve and the supply curve intersect

Market equilibrium determines:

the equilibrium price – the price the product will sell for
the equilibrium quantity – the amount of the product that will be bought and sold

To see a market in action, visit http://gemm.com/ where buyers and sellers of hard-to-find music meet in cyberspace. Consumers can search for music from particular recording artists at prices they are willing to pay while sellers can offer their recordings at prices they are willing to accept. Together they determine the equilibrium price and quantity in this virtual market.

A surplus, or excess supply, develops if the market price exceeds the equilibrium price.

sellers want to sell more than consumers wish to purchase
sellers will reduce price, and consumers will purchase more
price will fall to the equilibrium price

A shortage, or excess demand, develops if the market price is less than the equilibrium price.

consumers wish to purchase more than sellers want to supply
consumers will bid up the price, and sellers will sell more
price will rise to the equilibrium price

What is a price ceiling?
A price ceiling is a maximum price set by legislators for a specific product.

the regulated ceiling price is set below the equilibrium price
when price is below the equilibrium price, a shortage develops
- black markets occur and line-ups develop as alternative mechanisms for allocating the product

What is the Efficiency Principle?
The socially optimal amount of a good has been bought and sold when a market is in equilibrium and the demand and supply curves accurately reflect the costs and benefits of production of a good.
If price is above equilibrium, a seller can supply another unit of the good at a lower price, and there will be a consumer who will purchase that unit at the lower price.

both the seller and the consumer are made better off by the transaction
recall the cost-benefit principle: if the marginal benefit of producing a good exceeds the marginal cost, the good should be produced

The Efficiency Principle tells us that economic efficiency is reached when the socially optimal amount of production occurs in an economy.

Visit http://zia.hss.cmu.edu/miller/eep/exp1test.html to take part in a market simulation. When you start the simulation you will be assigned a role as a buyer or a seller in a market with other "virtual" buyers and sellers. It is your job to make the best deal you can, given your role in the game. You will earn "profits", the game's equivalent of economic benefits.

What is the Equilibrium Principle?
If the supply or demand curves do not reflect accurately the costs and benefits of production, the market equilibrium may not maximize social welfare.

if there is a cost to society, such as pollution, that is not borne by the producer
- social welfare will decreased by the cost of pollution
if there is a benefit to society, such as increased health of the population, that is not paid for by consumers
- social welfare will be enhanced by the additional healthiness of all consumers

The Equilibrium Principle tells us that a market in equilibrium has used up all possibilities for exchange between individuals, but may still contain opportunities for gain through collective action.

What are shifts and movements?
The quantity demanded of a product is the amount of a product that consumers wish to purchase at a given price. For example,

when the price is $1, the quantity demanded is 50

Demand is the entire relationship between all the prices and the quantities demanded at those prices.

when price changes, quantity demanded changes
- movement along the demand curve
when all the prices and their quantities demanded change, demand changes
- shift of the demand curve

What changes supply?
When we think of supply, we think of all the quantities supplied at each price. Sometimes events will increase the amount producers wish to supply at each price, or decrease the amount producers wish to supply at each price. There are many events that will change supply but here are three of the most common.

Input prices
if input prices increase, firms can purchase fewer inputs and produce less
the supply curve shifts to the left – that is, a new curve forms to the left of the original curve
price of the product increases while quantity traded decreases

if input prices decrease, firms can purchase more inputs and produce more
the supply curve shifts to the right – that is, a new curve forms to the right of the original curve
price of the product decreases while quantity traded increases

Technology and productivity
when technology changes, firms are able to produce more with the same number of inputs
supply increases, and the supply curve shifts to the right
price of the product decreases while quantity traded increases
Expected future prices
if producers expect the price of their product to be higher in the future, they will supply less now
supply decreases, and the supply curve shifts to the left
price of the product increases while quantity traded decreases
if producers expect the price of their product to be lower in the future, they will supply more now
supply increases, and the supply curve shifts to the right
price of the product decreases while quantity traded increases

Practice Activity 1
Try answering some questions about changes in supply.

Economic Naturalist
So why am I paying $60 for a Christmas tree which only cost $40 a few years ago?

What changes demand?
When we think of demand, we think of all the quantities demanded at each price. Sometimes events will increase the amount we want to consume at each price, or decrease the amount we want to consume at each price. There are many events that will change demand, but here are four of the most common.

Prices of related goods
substitutes – consumers will purchase more of Good A if the price of Good B increases
Good A and Good B are interchangeable in the consumer's preferences, like butter and margarine
demand for Good A increases, and the demand curve shifts to the right
price of the product and quantity traded both increase

if the price of Good B falls, consumers will purchase less of Good A
demand for Good A decreases, and the demand curve shifts to the left
price of the product and quantity traded both decrease

complements – consumers will purchase more of Good A if the price of Good B falls
Good A and Good B are used together, like cars and automobile insurance
demand for Good A increases, and the demand curve shifts to the right
price of the product and quantity traded both increase
if the price of Good B rises, consumers will purchase less of Good A
demand for Good A decreases, and the demand curve shifts to the left
price of the product and quantity traded both decrease
Consumer Incomes
normal good – consumers wish to purchase more as their incomes increase, and less as their incomes decrease
demand curve shifts to the right when incomes increase – that is, a new curve forms to the right of the original curve
price of the product and quantity traded both increase
the demand curve shifts to the left when incomes decrease – that is, a new curve forms to the left of the original curve
price of the product and quantity traded both decrease
inferior good – consumers wish to purchase less as their incomes increase, and more as their incomes decrease
bus transportation is an example of an inferior good – as you earn more money, you buy a car and use less public transportation
when incomes increase, demand decreases, and the demand curve shifts to the left
price of the product and quantity traded both decrease
when incomes decrease, consumers will purchase more of the product, and the demand curve shifts to the right
price of the product and quantity traded both increase
Tastes and preferences
if tastes turn toward a product, consumers purchase more of it, and demand increases
the demand curve shifts to the right
price of the product and quantity traded both increase
if tastes turn against a product, consumers purchase less of it, and demand decreases
the demand curve shifts to the left
price of the product and quantity traded both decrease
Population
if population increases, demand increases, and the demand curve shifts to the right
price of the product and quantity traded both increase
if population decreases, demand decreases, and the demand curve shifts to the left
price of the product and quantity traded both decrease

Practice Activity 2
Try answering some questions about changes in demand.

What happens when both demand and supply change?
If both demand and supply change at the same time, you will be able to predict an increase or decrease in one of the variables only, unless you know whether demand or supply has changed more.
The table below sets out the direction of change of price and quantity when demand and supply change at the same time.

Demand increase PÝ QÝ
Supply increase Pß QÝ
Net Effect: P? QÝ Demand increase PÝ QÝ
Supply decrease PÝ Qß
Net Effect: PÝ Q?
Demand decrease Pß Qß
Supply increase Pß QÝ
Net Effect: Pß Q? Demand decrease Pß Qß
Supply decrease PÝ Qß
Net Effect: P? Qß

If you know that demand changes more than supply changes, then the demand-side effects will prevail. If you know that supply changes more than demand changes, then the supply-side effects will prevail.

Practice Activity 3
Try answering some questions about demand and supply changes.

Understanding Questions
Do I understand this chapter? As a check to your understanding of the material in this chapter, you should be able to answer our questions.

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