Unit 3: Supply and Demand

Introduction

Why does a superstar athlete like LeBron James make almost more money per season than the rest of his team combined?  Why are diamonds expensive?  Why do heart surgeons make more money than sanitation workers?  You probably guessed it, supply and demand.  This unit will look at supply and demand and how they interact in the marketplace to determine the prices we pay for the goods and services we purchase.

Prices influence both buyers and sellers into making economic decisions.  If the price for computers goes down, it will stimulate more demand to purchase computers.  If the price of corn goes up, it will stimulate farmers into producing more corn.  This is how the marketplace works.   This section will look at the market processes that influence the demand side of the equation.

Demand

A good place to begin is to discuss what constitutes demand.  Demand refers to  the quantities of a product that people are willing and able to purchase at a given price during some period of time.  The term quantity demanded refers to a point on the demand curve- the quantity demanded at a particular price.   A demand curve can be used to illustrate the relationship between quantity demanded and price.

dcurvetutor2u-demand-theory-4-638

A change in quantity demanded caused ONLY by a change in the PRICE of the product. On a graph it is represented by a movement ALONG a SINGLE demand curve.

dchgqd

The graphs above  demonstrate the law of demand.  The law of demand states that  as price decreases, quantity demanded increases.  An inverse relationship exists.  The law of demand is dependent on ceteris paribus–  all other factors remaining unchanged.

In economics, the term utility refers to the measure of satisfaction received from consuming a good or service.  The law of demand does not go on for infinity.  There are limits.  The law of diminishing marginal utility describes how the last item consumed will be less satisfying than the one before.  This means at some point, no matter how low the price is, consumers will purchase less.

A change in quantity demanded can be illustrated by  a movement between points along a stationary demand curve.  Once again, demand is influenced by price.   On the demand curve above, this is seen in the movement from point A to point B.

A shift in demand can also occur.  A shift in demand refers to  an increase (rightward change) or decrease (leftward change) in the quantity demanded at each possible price.  This shift is influenced by non-price determinants.  An example of an increase and a decrease in demand are pictured below.

Demand_Shift3

shiftdemandd

increaseanddecreaseindemand

When there is a change in demand itself we get a new demand schedule and curve. We have to change the numbers in the demand schedule and this will SHIFT the demand curve.

If there is an increase in demand ( D) the demand curve moves to the RIGHT.

dlineinc

Market demand is the horizontal summation of the individual demand curves. Or, instead of just my individual demand for a product what if there were two people, or more, in the market. the result would be that for each price, the quantities demanded would be greater since there are more people. The prices stay the same, but the quantities get larger, or the demand graph shifts horizontally (to the right).

Graphically:

dmkt

 

The most important distinction to keep in mind is that a change in quantity demanded is a movement along a single curve, while a shift in demand involves the creation of a second curve.

movement_along_a_demand_curve_versus_a_shift_in_demand-147195D7BB97B1D730F

Non-Price Determinants of Demand

There are other factors besides price that influence consumers to purchase products.  In explaining the various factors, I will try to use attending a musical concert as an example, as well as everyday life events.

1.  A Change in income. If you receive a raise you are likely to increase your demand for goods.  If you get laid off, your demand for goods will likely decrease.  When income increases, consumers buy more.  When income decreases, consumers buy less.  If you normally attend two musical concert per year, but you receive a nice raise, you will probably increase your demand for musical concerts.

2.  A Change in taste.  Fads, fashions, and the advertising of new products influence consumer decisions.    Some examples of fads from our pop culture include hula hoops and Pokeman cards.  With respect to a musical concert, when a band is “hot” demand for their tickets is high.  When the band loses its appeal, demand for its tickets will be low.

3.  A Change in the price of a substitute good.   A substitute good competes with another good for consumer purchases.  Examples of substitute goods include juice and soda, margarine and butter, and video cassette tapes and DVD’s.   If the price of soda increases too much, consumer may decide to drink juice instead.  If on the same night of a musical concert,  a local sporting event is offering tickets at half the price of the musical concert, then consumers may be more willing to attend (demand) tickets to the sporting event, instead of the musical concert.

a.  Heroin, OxyContin, and Substitute Goods

b.  Increase in Demand From the Movie: Hudsucker Proxy

4.  A Change in the price of a complementary good. A complementary good is jointly consumed with another good.  Examples include cars and gasoline, tuition and textbooks, and milk and cereal.  If the price of milk increases dramatically, consumers will decide to purchase less milk, and consequently, less cereal.  An example of a complementary goods at the musical concert would be might be parking.  If parking rates were extremely high, it might deter people from attending.  If there were reduced rates, or free parking, it might encourage more people to attend the musical concert.  The relationship between complementary goods and demand can be understood as:   If the price of good A ( tuition)  increases, then the demand for B (textbooks) goes down or decreases.

5.  A Change in buyer expectations.  If consumers think the price of a good will increase in the future, they may decide to buy more of it now so that they pay less.   Suppose that a storm damages a large part of the orange crop.  Consumers may run out and buy all the oranges they can find in anticipating the price of oranges increasing.  Looking at the musical concert once again,  if a band announces it is their “farewell’ tour,  then the expectations of consumers will increase the demand for tickets.

6.  A Change in the Number of Buyers.  Population growth will increase the demand for products because the pool of consumers has grown.  Population decline will have the opposite effect.  The Baby Boom generation has affected demand for goods over the course of their lifetimes.  In terms of musical concerts,  bands popular to baby boomers, such as the Rolling Stones,  still have the highest grossing tours because of the huge number of baby boomers.

Derived Demand

One last aspect of understanding the concept of demand is the term derived demand.  Derived demand describes the situation when there is a demand placed on one good or service as a result of changes in the price for some other related good or service. For example, when students enroll in college, they increase the demand for instructors to teach classes.  The college then goes out and hires instructors (derived demand) to teach those courses.  Another example would be how the demand for cellphones have created a demand for cell phone cases, chargers, and headsets. Derived demand creates a ripple effect within the local community and within and among related industries.

Closely related to derived demand is the concept of the output effect.  The output effect is the change in quantity demanded of an input due to a change in the firm’s output level that results from an increase in the input’s price. For example, a higher input price (steel) leads to a lower output (automobiles) and therefore less of the input (steel) being demanded.

Supply

Why is it that farmers are more willing to grow certain crops one year and different crops the next?  The price they receive for the crop they grow determines what seeds the farmers will sow.  The information below will help you to understand the supply side of the equation.

Supply focuses on the producer of goods and services.  Supply refers to the quantities of a product that producers are willing and able to offer at a given price during some period of time.  Like demand, there are price and non-price determinants for supply.  Producers make decisions on how much to supply based on profitability.

The supply side of the equation also has a law.  The law of supply states that sellers will offer more of a good at a higher price and less at a lower price.  This law can also be graphically displayed.

supplycurvesupply_curve_expansion

 

change in Quantity supplied occurs when there is  a movement between points along a stationary supply curve.  Once again, this movement is influenced by price.  This change can be seen in the graph above with the movement from point A to point B.  A change in Quantity supplied caused ONLY by a change in the PRICE of the product. It is represented by a movement ALONG a SINGLE supply curve.

schgqs

 

There can also be a shift in supply.  A shift in supply refers to an increase (rightward change) or a decrease (leftward change) in the quantity supplied at each possible price.   These shifts are influenced by non-price determinants.

shiftsupplyi

shiftsupplyd

icreaseanddecreaseshiftinsupply

A change in supply is caused by a change in the non-price determinants of supply. These are the factors that we assumed were constant when we used the ceteris paribus assumption to develop the supply curve. If there is an increase in supply (( S) the supply curve moves to the RIGHT. At the same prices, the quantities supplied will be greater.

sstabinc

The most important distinction to keep in mind is that a change in quantity supplied is a movement along a single curve, while a shift in supply involves the creation of a second curve.

movement_along_a_supply_curve_versus_a_shift_in_supply-147197BD9B82BC9819B

Non-Price Determinants of Supply

There are other factors besides price that influence producers to sell products.  In explaining the various factors, I will try to use producing computers as an example, as well as everyday life events.  A brief description of each is provided below.

1. Change in technology.  New, efficient technology makes it possible to offer more products at any possible selling price.  Technology such as computers and robots have made it possible to reduce production costs and increase the supply of goods and services.  In the computer industry, there have technological advances  that have brought down the cost of producing computers.

2.  Change in production costs.  A change in the cost of labor, or taxes, or a resource needed to produce a good, impacts the decisions of sellers on how much to produce.  If you are producing computers, and the price of computer chips increases, then it will cost more to produce a computer.  This may force you out of business, because consumers will demand fewer computers at higher prices.

3.  Change in the number of sellers.   An increase or decrease in the number of sellers can influence the production of goods and services.  If the United States removes a restriction of foreign imports, then there are more sellers in the market.   The supply of computers will increase if the number of businesses producing computers increase.

4.  Change in supplier expectations.  Expectations of the future can influence the production of goods and services.   If prices of a good or service is expected to rise in the future, sellers may hold back production in the present in the hopes of making more profit by selling more in the future.  For example, if farmers think the future of the price of corn to decline, they will increase the present supply of corn, in the hopes of making more money now.  The supply of computers will decrease if the price of a computer is expected to rise in the future, and vise versa.

1.  Explorations in Supply

 

Equilibrium Price

English economist Alfred Marshall once wrote concerning equilibrium price, “We might as reasonably dispute whether it is the upper or the under blade of a pair of scissors that cuts a piece of paper, as whether value is governed by utility (demand) or cost of production (supply).   What he was trying to say is that when supply and demand meet in the marketplace, a market price is created.  This is equilibrium price.  The best way to visualize equilibrium price to place the supply and demand curves in the same diagram.

Equilibrium price refers to the price that makes the quantity demanded equal to the quantity supplied.  Equilibrium in a market occurs when the price balances the plans of buyers and sellers.  It sets the value of the product.  On a supply and demand curve, equilibrium price is represented by the point where the demand and supply curves intersect.  It is possible in some markets to sell the same good for different prices.  This happens because consumers don’t have the time to comparison shop.  But in markets where buyers have had time to shop around and compare, prices tend to converge at a uniform price.

equilibriumprice1

sdequil

Shortages and Surpluses

Sometimes the interests of sellers and consumers don’t balance and the result is either an excess of demand or an excess of supply.  When that happens there exists either a shortage or a surplus.   A shortage is a situation where there is an excess at some price of quantity demanded over quantity supplied.  On a supply and demand curve a shortage is represented by points below the equilibrium price.  When a shortage exists buyers are competing with one another for limited quantities of goods.  For sellers, it is an opportunity to raise prices and increase sales.  Buyers, on the other hand, become frustrated because they are willing to spend money, but cannot find a particular good or service to purchase.

shortage

sddis6

A surplus is a situation where there is an excess at some price of quantity supplied over quantity demanded.  On a supply and demand curve a surplus is represented by points above the equilibrium price.  When a surplus exists buyers have an oversupply of product to choose from and will probably pay less for goods and services.  For sellers, they are competing with other suppliers for customers and their prices will fall, as will their sales.

surplus

sddis12

 

Sometimes the government will intervene in the economy to create a surplus or shortage situation.  Why would a government do this?  Because there is often a strong political demand for government intervention.  When governments intervene, they impose price controls, which are a legal restriction on how high or how low a market price may go.  A price floor  is a price above equilibrium legislated by the government.  It results in a surplus.  The government declares that there is a price for which a good or service may not be sold for less than that price.  This price is set above the equilibrium price.  A price floor, such as the minimum wage legislation, means that the lowest effective market price must not be below the given “floor”.  Examples of price floors are agricultural price supports and  minimum wage laws.  Price floors create inefficiencies, most notably, in wasted resources.  Price floors may also encourage illegal activity.  An example of this is when workers desperate for work, offer to work at less than the minimum wage.

Case Study: Agricultural Price Support

In order to keep the price of agricultural products high the government must eliminate the surplus by either destroying the crops or bribing the farmers not to produce.   Sometimes there is an additional burden on taxpayers because the government will spend money to store some of the surplus.

farmpricesupport

 

A price ceiling is a price below equilibrium legislated by the government. The intent of government intervention in the economy is to help people who have to pay high prices.  Price ceilings are usually imposed in times of crisis, such as a war.  However, this action results in a shortage.  The government declares that there is a price for which a good or service may not be sold for more than that price.  This price is set below the equilibrium price. A price ceiling, such as rent control, means that the market price can be lower, but not higher than the given ceiling.  If a shortage for a product occurs (and price cannot adjust to eliminate it), a method for rationing the good must develop. During World War II,  our government issued ration coupons to alleviate shortages.  Examples of price ceilings are rent controls and fixing gas prices.  Price ceilings create inefficiencies in the market.   There are consumers who desire the good badly, and are willingly to pay a high price for it, but can not find it.   Because of this strong desire to have a good and the willingness to pay high prices,  price ceilings often generate black markets.  Black markets are illegal markets where goods that are in strong demand are bought and sold.

Case Study: Lines at the Gas Pump

In 1973, OPEC raised the price of crude oil which led to a reduction in the supply of gasoline.  The federal government put price ceilings into place which further increased shortages.  Motorists were then forced to spend large amounts of time in line at the gas pump ( which is how the gas was rationed.)  These people waiting in line could have been doing something more enjoyable or productive.

priceceiling1

Market Inefficiencies

The information covered thus far in this unit shows how in a perfect world the “market” can efficiently allocate resources for the production of goods, use the price mechanism to stimulate production, and how changes in demand can affect what is produced as well as, force workers to leave a dying industry to move to a growing one.

But the world is not perfect.  There are things that prevent the market from operating perfectly. Even though the market does not operate perfectly, it is still a more preferable system than a command economy.  There are a number of factors that prevent a market from operating smoothly.  Some of them are:

1)  the market domination of monopolies and oligopolies  (unit 5)

2)  public goods    (unit 7)

3)  the existence of externalities    (unit 7)

4)  undesirable income and wealth distribution     (unit 6)

These market failures will be discussed in more detail in upcoming units.  However, they all share a common solution”  government intervention.  But what does market failure mean?  Market failure refers to situations where there exists waste in the market. In other words, we could produce more goods with the resources we have and supply more people with those goods if not for the inefficiency.

 

Elasticity

Suppose you own a bicycle business and you are thinking of raising your prices.  You are naturally curious how your customers are going to react.  You know that at a higher price consumers will buy fewer bicycles.  But you are tempted by the extra money that can be made by selling your bicycles at a higher price.  What should you do?  Your decision will be based on the total revenues you collect.  What are total revenues?  Continue to read below to find out more about elasticity.

Elasticity describes the responsiveness ( in percentage terms) of the quantity demanded to changes in price.  Knowing how sensitive a product is to a change in price is important in pricing goods and services.  Elasticity is a tool that an owner of a business can use to understand how consumers will change their behavior when you, as a business owner, change the price of a product.  There are five categories of price elasticity.  The categories of perfectly elastic and perfectly inelastic lean towards being more theoretical.  There are few real world examples for those two categories.

Categories of Elasticity

1.  Perfectly Elastic:  A price change causes Q demanded to change by an indefinitely larger percentage- a small decrease in price would cause buyers to increase buying from zero to all they desired.

2.  Elastic:  A given % change in price results in a larger % change in Q demanded.  The elasticity coefficient is greater than 1 but less than infinity.  For example, if a business reduces the price of televisions by 20%, and the demand for these cheaper televisions increases by 50%, this demonstrates that the televisions are elastic.

3.  Unitary Elastic:  A given % change in price results in an equal % change in Q demanded-  The elasticity coefficient always equals 1.   For example, if a business reduces the price of coffee makers by 20%, and the demand for these cheaper coffee makers increases by 20%, this demonstrates that the coffee makers are unitary elastic.

4.  Inelastic:  a given % change in price results in a smaller % change in quantity demanded.  The elasticity coefficient is greater than 0 but less than 1.  For example, if a business reduces the price of sandwich bag by 20%, and the demand for these cheaper sandwich bags increases by only 10%, this demonstrates that the sandwich bags are inelastic.

5.  Perfectly Inelastic:  A given % change in price results in no % change in Q demanded.  This usually occurs with necessities such as life saving drugs like insulin.

Elasticity and Total Revenue

Elasticity can also be understood by its relationship to total revenues.  Total revenues refers to the total number of dollars a firm earns from the sale of a good or service.  It is calculated by multiplying price times quantity (price x quantity).  In other words, elasticity deals with income (money that goes into the cash register) not with profits.  Elasticity tells the seller what happens to total revenue as the price of a product increases or decreases.

For elastic demand, the change in total revenue is in the opposite direction of price.  In other words, if the price of a product is decreased, total revenue increases.  For inelastic demand the change in total revenue is in the same direction.  In other words, if the price of a product is decreased, the change in total revenue also decreases.  With respect to total revenues, unitary demand is unaffected by changes in price.

Characteristics that Affect Elasticity

There are factors that influence why a good or service is elastic, inelastic or unitary.  those factors are discussed below.

A)  Nature of the product.   Necessities tend to be inelastic, such as salt, and luxuries, such as stereos, tend to be elastic.

B)  Durability of the product.   Durable goods such as cars and TV’s tend to be elastic and non-durable goods, such as garbage bags,  tend to be inelastic.

C)   Size of the expenditure.   Small expenditures tend to be inelastic, and large expenditures are elastic.  Other things remaining the same, the greater the proportion of income spent on a good, the more elastic is the demand for it.  For example, if there is a sale on an expensive item such as automobiles (or if the interest rates are low, such as 0%), then there will be a large number of people who will seek to purchase a new car.  On the other hand,  if the good represents a small fraction of your income, such as butter, then the elasticity will be low, since most people can still afford to buy as much butter as they need as before the price increase.

D)  Substitute goods.    Substitute goods tend to be elastic.  For example, metals have substitutes such as plastics, so the demand for metals is elastic.  The question to ask here is, can people easily find a substitute when the price of a good or service goes up?  If the answer is yes, then the price elasticity will be elastic.

E)  Complementary goods.   Complementary goods tend to be inelastic.  For example, if the price of coffee decreases,  it will probably not affect the amount of sugar you buy to put in your coffee.

F)  Time.  If you give people longer to change their behavior, they will be able to make larger adjustments.  Here is where habit enters the picture.  Because habits are slow to break, a change in price is not likely to have a large immediate impact on demand.  If you give people a chance to adjust, however, they may very well be able to ‘break’ their habits and thus we could expect a larger response to the price change in the long-run.   Elasticity can also be affected in the short-run.   For example, if a store held a one day sale,  price elasticity would be high, because people would shift their buying to the sale day believing the opportunity for savings to be temporary.  On the other hand, if consumers believe the price cut will be permanent, the price elasticity will be smaller, since there is no advantage to buying sooner rather than later.

The amount of time one has to respond to a price change affects the size of that response. For most goods, in the short run, buyers tend to purchase nearly the same quantity as before a price change. So in the short run, demand tends to be price inelastic. But given time, buyers can alter their consumption behavior and look for hard to find substitutes. So in the long run, demand tends to be price elastic. Take an increase in the price of gasoline for example. If you do not learn about the price increase until you pull up to the pump (and you believe gas prices have increased at all gas stations) you will likely top off your tank as usual. But given time, you can find ways to drive your car shorter distances, buy a car that gets better gas mileage, or even move so that you live closer to where you work. So in the long run, you will be much more responsive to a price increase than you can be in the short run.

Think of elastic and inelastic goods this way.  People will get in their car and drive to a store to buy a product that is elastic, such as a new bedroom set.  The reason for this is that the potential savings is large.  They probably will not run out to the store if the price change is on an inelastic good, such as sandwich bags.

Characteristics of Elastic and Inelastic Goods.

Elastic                                         Inelastic

durable                                        non-durable

expensive                                    inexpensive

luxuries                                        necessities

substitute goods                        complementary goods

 

Midpoint Formula for Elasticity

 

Application of Economics:  Elasticity and the War on Drugs

In the United States over the past few decades, there has been an ongoing “war” against the use of recreational drugs. This war on drugs has many costs, one of which is that it has made the United States have the highest percentage of its citizens imprisoned than any other developed nation.   Leaving aside the moralistic arguments found in other disciplines,  lets see how the field of economics views this social issue.

The government’s use of laws to restrict drug use has had an effect on the supply of drugs to the market.  Costs increase and those suppliers not willing to take the risk, leave the market.   The remaining suppliers are usually controlled by organized crime, with its connections, financial resources, and firepower.  The effect then of tougher enforcement of drug laws, is to make it more riskier and costly to supply drugs, which then results in the decreased supply of illegal drugs.

For drug users, on the demand side,  the drug war makes it more expensive to support their drug habits.   Because most drugs are addictive, the demand for illegal drugs tend to be inelastic.  In other words, the quantity needed by users does not drop off because of the increased risk.   In fact, because of the tougher penalties, the drug user is less worried about committing other crimes, such as theft, to support their habit.

This brings us to the question, should drugs be legalized?   What does the field of economics have to say if recreational drugs became legal?  There may be both good news and bad news.  The bad news is that drug use would probably increase due to the drop in price.   The good news would be that there would probably be less crime to obtain the money for a drug habit since prices would be lower.  Additionally,  the violent crime associated with territorial disputes would disappear if drug users could obtain drugs legally from a pharmacy.   There are some supporters of legalizing drugs who say that the state could discourage drug use by imposing a sales tax on drugs.   This might work.  But if the sales tax was too high, then it would allow a return to drug pushers and the violence that accompanies the illegal drug trade.  Legal or illegal, drugs have an economic cost to society.

 

Bibliography

 

Parkin, Michael      2000  Economics (5th Edition)  New York:   Addison- Wesley

Slavin, Stephen L.      1999   Economics  (5th Edition)   New York:   Irwin McGraw-Hill

Taylor, John B.

2001 Economics.  Boston: Houghton Mifflin Company

Tregarthen, Timothy.

2000 Economics (2nd Edition) New York:  Worth Publishers

Tucker, Irvin B.         1995  Survey of Economics   New York:  West Publishing Company

 

Copyright ©2007, 2014 Glenn Hoffarth All Rights Reserved

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