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:

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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

 

Youtube video on Price Floors and Price Ceilings

As was mentioned up above, supply and demand have an enormous influence on prices. On the demand side, consumers are effected, and on the supply side, producers/suppliers are affected. The price of a good or a service can be influenced by shortages and surpluses. Because of this, there are times when consumers and producers will see prices go up (inflation) and prices decreasing (deflation).

Inflation

Our country tries to support policies that will improve our long term economic growth.  Another goal of our government is to strive to keep prices stable.  Every administration tries to avoid inflation problems because they know voters tend to blame higher prices on whoever is in office.  This section will explain what inflation is, how the government measures it, and the consequences to inflation.

inflation1Inflation refers to the increase in the average price of goods and services in the economy.  It represents an increase in the overall average level of prices and not an increase in the price of any specific product.  During the late 1970’s and early 1980’s the United States experienced a time of rising prices.  The opposite of inflation is deflation.  Deflation is a decrease in the average price level of goods and services.  During the Great Depression of the 1930’s, the United States experienced a period of deflation.  Since the 1950’s, the United States’ inflation rate has ranged from a low of zero to a high of thirteen percent, with most years averaging around 4 percent.  Is this good or bad?  To some people (especially those on a fixed income like retirees), any increase is bad.  But compared to other countries, (Brazil in 1989 1,700% or Bolivia in 1985 at 50,000%) are inflation rates are low.

1. Inflation Based Comparison of Top Grossing Movies of All-Time

2.  Deflation Explained (Youtube Video)

3.  Inflation or Deflation (Youtube Video/song)

4.  Historical Inflation Rates 1914 to 2010

5.  New Inflation Formula Would Reduce Benefits

6.  How Companies Try to Mask Inflation

annualinflation

 

Core Inflation

If you have watched the business section of the evening news, you will have noticed a new term being used recently to describe a way of understanding the effect of inflation.  That term is “core inflation”.   Core inflation is generally defined as a chosen measure of inflation (e.g., the Consumer Price Index or CPI) that excludes the more volatile categories of food and energy prices.  There are reasons why these items are removed.  Food and energy are more sensitive to price changes.  With respect to food, there might be a drought or a natural disaster, such as a hurricane or frost, might destroy an entire crop, creating a shortage, and thus driving up prices.  Energy prices too, are subject to rapid rate increases.  If there is a terrorist attack somewhere in the world, or if the OPEC cartel decides to limit production or raise prices, the price of oil and gas can climb upward quickly.   This means that quick increases in the prices for food and energy do not necessarily mean that inflation is affecting the economy as a whole.   In other words, it might mean that the price of food and energy is increasing, but the price of everything else is staying the same or going down.  So the argument is used that if we were to include food and energy that economists would be overstating the affect of inflation.  But by excluding food and energy, can economists be also “understating” the affects of inflation?  Don’t most families spend a good portion of their income on food and energy?  And if so, does not using the “core inflation” rate as a measuring tool, understate the problem of inflation on the economy?

The United States government uses the consumer price index to measure the rate of inflation.  The consumer price index (CPI), measures changes in the average price of consumer goods and services.  This index is compiled monthly by the Bureau of Labor Statistics (BLS).  Each month officials at the BLS contact retail store, homeowners, and tenants in selected cities around the country to record average prices for a “market basket” of different goods purchased by the typical family (approximately 90,000 items).  So the CPI then looks at the average prices paid by a variety of people, in a variety of locations, buying a variety of products.

Computing the Consumer Price Index

 

Criticisms of the CPI

There are a number of criticisms about using the CPI.  The first criticism is that many consumers have a different “market basket” of goods than the CPI’s market basket.  This difference may over or under state the impact of inflation.  An example would be retired persons.  They may buy some products (prescription drugs) that the average family does not. Another problem is the CPI does not make adjustments for changes in quality.  For example, look at new computers.  A new computer can do significantly more work than an older one and probably costs less.  Finally, the CPI does not make allowances for the law of demand and the substitution of goods.  For example, if the price of oranges increases, the demand will decrease, and consumers could then buy cheaper apples, thus overstating the rate of inflation.

Consequences of Inflation- Who Does it Hurt?

There are a number of problems associated with inflation.  Some groups  are negatively affected by inflation.  They are:

1)   Workers and those on fixed incomes. Why?  Because inflation shrinks income.  If the percentage change in income is less than the inflation rate, then your purchasing power is shrinking.  For example, if your income rises 3%, but the inflation rate is 5%, then your purchasing power is declining.

2)   Owners of wealth benefit if their assets increase faster than inflation.  In most cases it does.  An example would be those who own real estate or stocks. The poor, who don’t own much real estate or stock, therefore feel the pain of inflation more.

3)  People who save their money.  If you are a saver and inflation rates are higher than interest rates, then you are losing purchasing power.  For example, if the bank is paying 2% interest on your money, but the inflation rate is 5%, then your money has lost 3% of its value.

4)    Finally, if you lend money to someone, and the inflation rate is higher than the interest rate, then you as a lender are losing purchasing power.  For example, if a parent lends money to a son or daughter at 5% interest, and the inflation rate is 10%, then the lender is losing purchasing power.

a) Why The Rich Hate Inflation

 

Types of Inflation

The first type of inflation is demand-pull.  Demand-pull inflation is a rise in prices due to too much spending (demand).  In other words it is too many dollars chasing too few goods.  Demand pull inflation occurs when sellers are unable to supply all the goods and services buyers demand. Demand-pull inflation usually occurs when the economy is at or near full employment.  An example of demand-pull inflation occurred after World War II when there was more money in the economy than there were goods for sale. The second type of inflation is cost-push.  Cost-push inflation is a rise in prices due to an increase in the cost of production.  Increases in the cost of labor, raw materials, equipment, and borrowing  money,  push up the cost of production.  An example of cost-push inflation occurred in the 1970’s when the price for oil increased, which caused oil related products to increase in price as well.

Hyperinflation

Sometimes there is an extremely rapid rise in prices.  This is called hyperinflation.  Inflation rates of over 100% per year are generally considered hyperinflation.  There are many causes to hyperinflation.  The first is that consumers lose confidence in the economy and begin hoarding goods.  They buy today because they think it might cost more to buy tomorrow.  The debtor-lender contracts are also jeopardized.  For example, homeowners might find it increasingly difficult to make payments when interest rates rise unexpectedly.  A wage-price spiral also occurs.  This is when workers ask for an increase in wages to meet the increase in prices, which causes prices to rise again, which causes workers to ask for more wage increases, which causes prices to rise….   During periods of hyperinflation, wealthy people will often put their money into safer investments such as gold, jewelry, art, or other currencies looking for a return that is higher than the inflation rate, rather than into capital investment like new factories or machines which might help the country.  Finally, hyperinflation is often the result of a government’s decision to increase the money supply.  Governments hope for a short term solution, but get instead a long term problem.  This occurred in Germany after World War I in the 1920’s, and in Latin American countries such as Bolivia in the 1980’s.   In Yugoslavia in 1993-1994,  the currency (dinar) experienced severe hyperinflation.  The picture below is a $500 billion note.

1.  Pictures of Hyperinflation from Zimbabwe

hyperinflation

Below is a $100 Trillion Dollar Bank Note from Zimbabwe which was put into circulation in 2010.

zimbabwe-100-trillion-dollar-bill-reverse

hyperinflation2

1923 Weimar Republic inflation: A German woman feeding a stove with Papiermarks, which burned longer than the amount of firewood people could buy with them.

 

 

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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