CHAPTER 3: BASIC ELEMENTS OF SUPPLY AND DEMAND What is a cynic?

A man who knows the price of everything and the value of nothing. Oscar Wilde SUMMARY 1. The analysis of supply and demand shows how a market mechanism solves the three problems of what, how, and for whom. A market blends together demands and supplies. Demand comes from consumers who are spreading their dollar votes among available goods and services, while businesses supply the goods and services with the goal of maximizing their profits. A. The Demand Schedule 2. A demand schedule shows the relationship between the quantity demanded and the price of a commodity, other things held constant. Such a demand schedule, depicted graphically by a demand curve, holds constant other things like family incomes, tastes, and the prices of other goods. Almost all commodities obey the law of downwardsloping demand, which holds that quantity demanded falls as a goods price rises. This law is represented by a downward-sloping demand curve. 3. Many influences lie behind the demand schedule for the market as a whole: average family incomes, population, the prices of related goods, tastes, and special influences. When these influences change, the demand curve will shift. B. The Supply Schedule 4. The supply schedule (or supply curve) gives the relationship between the quantity of a good that producers desire to sell other things constant and that goods price. Quantity supplied generally responds positively to price, so the supply curve is upward-sloping. 5. Elements other than the goods price affect its supply. The most important influence is the commoditys production cost, determined by the state of technology and by input prices. Other elements in supply include the prices of related goods, government policies, and special influences. C. Equilibrium of Supply and Demand 6. The equilibrium of supply and demand in a competitive market occurs when the forces of supply and demand are in balance. The equilibrium price is the price at which the quantity demanded just equals the quantity supplied. Graphically, we find the equilibrium at the intersection of the supply and demand curves. At a price above the equilibrium, producers want to supply more than consumers want to buy, which results in a surplus of goods and exerts downward pressure on price. Similarly, too low a price generates a shortage, and buyers will therefore tend to bid price upward to the equilibrium. 7. Shifts in the supply and demand curves change the equilibrium price and quantity. An increase in demand, which shifts the demand curve to the right, will increase both

equilibrium price and quantity. An increase in supply, which shifts the supply curve to the right, will decrease price and increase quantity demanded. 8. To use supply-and-demand analysis correctly, we must (a) distinguish a change in demand or supply (which produces a shift of a curve) from a change in the quantity demanded or supplied (which represents a movement along a curve); (b) hold other things constant, which requires distinguishing the impact of a c hange in a commoditys price from the impact of changes in other influences; and (c) look always for the supply-and-demand equilibrium, which comes at the point where forces acting on price and quantity are in balance. 9. Competitively determined prices ration the limited supply of goods among those who demand them. CONCEPTS FOR REVIEW Supply-and-demand analysis, demand schedule or curve, DD, law of downward-sloping demand, influences affecting demand curve Supply schedule or curve, SS, influences affecting supply curve, equilibrium price and quantity Shifts of supply and demand curves, all other things held constant, rationing by prices FURTHER READING AND INTERNET WEBSITES Further Reading Supply-and-demand analysis is the single most important and useful tool in microeconomics. Supply-and-demand analysis was developed by the great British economist Alfred Marshall in Principle of Economics. To reinforce your understanding, you might look in textbooks on intermediate microeconomics. Two good references are Hal R. Varian, Intermediate Microeconomics: A Modern Approach, and Edwin Mansfield and Gary Yohe, Microeconomics: Theory and Applications. A recent survey of the economic issues in immigration is in George Borjas, Heavens Door: Immigration Policy and the American Economy. Websites Websites in economics are proliferating rapidly, and it is hard to keep up with all the useful sites. A good place to start is always www.rfe.org. Another useful starting point for Internet resources in economics can be found at http://www.oswego.edu/~economic/econweb.htm You can examine a study of the impact of immigration on American society from the National Academy of Sciences, The New Americans (1997), at www.nap.edu. This site provides free access to over 1000 studies from economics and the other social and natural sciences.

QUESTIONS FOR DISCUSSION 1. a. Define carefully what is meant by a demand schedule or curve. State the law of downward-sloping demand. Illustrate the law of downward-sloping demand with two cases from your own experience. The demand schedule shows the relationship between the market price of a good and the quantity demanded of that good, other things held constant. For example, the demand schedule for a box of cornflakes could look like this:
Demand Schedule for Cornflakes (1) (2) Price Quantity demanded ($ per box) (millions of boxes per year) P Q 5 9 4 10 3 12 2 15 1 20

A B C D E

The demand curve is the graphical representation of the demand schedule.

Demand Curve for Cornflakes

Price of cornflakes (dollars per box)
6 5 4 3 2 1 0 0 5 10 15 20 25

Quantity of cornflakes (millions of boxes per year)

The law of downward-sloping demand is: When the price of a commodity is raised (and other things are held constant), buyers tend to buy less of the commodity. Similarly, when the price is lowered, other things being constant, quantity demanded increases. Two examples from my personal experience: When a store drastically reduces prices of food (such as pastries or chocolate) just before its best before date, I will buy more of these than I normally would. Another example was when the Financial Times offered a cheap years subscription online, I decided to buy it, whereas I would not have subscribed at full price.

b. Define the concept of a supply schedule or curve. Show that an increase in supply means a rightward and downward shift of the supply curve. Contrast this with the rightward and upward shift of the demand curve implied by an increase in demand. The supply schedule shows the relationship between the market price of a commodity and the quantity of that commodity that producers are willing to produce and sell, other things held constant. For example, the supply schedule for a box of cornflakes could look like this:
Supply Schedule for Cornflakes (1) (2) Price Quantity supplied ($ per box) (millions of boxes per year) P Q 5 18 4 16 3 12 2 7 1 0

A B C D E

The supply curve is the graphical representation of the supply schedule.

Supply Curve for Cornflakes

Price of cornflakes (dollars per box)
6 5 4 3 2 1

S
0 0 5 10 15 20

Quantity of cornflakes (millions of boxes per year)

If there is an increase in supply, then the quantity supplied at each price will increase. A new schedule, with quantity supplied increased by 5 million boxes per year at each price, is:

A B C D E

(1) Price ($ per box) P 5 4 3 2 1

Supply Schedule for Cornflakes (2) (3) Quantity supplied Quantity supplied (millions of boxes per year) (millions of boxes per year) Q Q' 18 23 16 21 12 17 7 13 0 5

This gives the supply curves:

Supply Curve for Cornflakes

Price of cornflakes (dollars per box)
6 5 4 3 2 1 0 0 5 10 15 20 25

S'

S'

Quantity of cornflakes (millions of boxes per year)

The solid curve SS, is the original supply curve. The dashed curve SS, is the new, shifted, supply curve. The supply curve has shifted to the right (and looks as if it has shifted downwards). If instead, demand had increased, the quantity demanded at each price will increase. A new schedule, with quantity demanded increased by 5 million boxes per year at each price, is:
Demand Schedule for Cornflakes (1) (2) (3) Price Quantity demanded Quantity demanded ($ per box) (millions of boxes per year) (millions of boxes per year) P Q Q' 5 9 14 4 10 15 3 12 17 2 15 20 1 20 25

A B C D E

This gives the demand curves:

Demand Curve for Cornflakes

Price of cornflakes (dollars per box)
6 5 4 3 2 1 0 0 5 10 15 20 25 30

D'

D'

Quantity of cornflakes (millions of boxes per year)

The solid curve DD, is the original demand curve. The dashed curve DD, is the new, shifted, demand curve. The demand curve has shifted to the right (and looks as if it has shifted upwards). 2. What might increase the demand for hamburgers? What would increase the supply? What would inexpensive frozen pizzas do to the market equilibrium for hamburgers? To the wages of teenagers who work at McDonalds? An increase in demand for hamburgers (as opposed to an increase in quantity demanded due to a change in price) could be caused by: An increase in average incomes. As peoples incomes increase, they will spend more on hamburgers. An increase in population. More people will buy more hamburgers, even if each person does not buy any more hamburgers than before. An increase in the price and availability of related goods. If the price of fried chicken increases, people will substitute more hamburgers. A change in tastes or preferences. The arrival of fast food chains will change peoples preferences for food, meaning people will buy more hamburgers. A change in special influences. An effective advertising campaign or celebrity endorsement makes people want more hamburgers.

An increase in supply of hamburgers (as opposed to an increase in quantity supplied due to a change in price) could be caused by: An improvement in technology. More efficient ovens mean that hamburgers can be produced at lower cost. A reduction in input prices. A reduction in the cost of beef and wheat would mean hamburgers could be produced more cheaply.

A reduction in prices of related goods. A reduction in the price of fried chicken would reduce the profitability of producing fried chicken, and produces will shift production to hamburgers. A change in government policy. Relaxing regulations on food safety and public health, removing quotas and tariffs on imported beef and wheat, reducing the minimum wage would all increase the supply of hamburgers. A change in special influences. Expectations of strong future demand and prices for hamburgers will increase their supply.

Inexpensive frozen pizzas will attract consumers to demand more frozen pizzas and therefore less hamburgers. The demand for hamburgers will decrease, and the demand curve will shift leftwards. Assuming no change in supply, the price of hamburgers and the quantity demanded will decrease. The demand for teenagers to work at McDonalds will decrease, and so will their wages. 3. Explain why the price in competitive markets settles down at the equilibrium intersection of supply and demand. Explain what happens if the market price starts out too high or too low. Consider the supply and demand schedules of cornflakes (as discussed in Question 1):
Combining Supply and Demand for Cornflakes (1) (2) (3) Price Quantity supplied Quantity demanded ($ per box) (millions of boxes per year) (millions of boxes per year) P Q Q 5 18 9 4 16 10 3 12 12 2 7 15 1 0 20

A B C D E

Supply and Demand Curves for Cornflakes

Price of cornflakes (dollars per box)
6

D
5 4 3 2 1 0 0 5 10

Surplus

E Shortage S
15 20

D
25

Quantity of cornflakes (millions of boxes per year)

At the market equilibrium the quantity demanded equals the quantity supplied. There is no tendency for prices to rise or fall at the equilibrium. Looking at the above table, we see that at $3 a box, 12 million boxes of cornflakes are supplied and 12 million boxes are demanded. All supply and demand orders are filled, the books are cleared of orders, and demanders and suppliers are satisfied. The same thing can be seen by looking at the supply and demand curves. Where the demand curve DD and supply curve SS intersect at point E - the quantity demanded equals the quantity supplied. At E, we can see the equilibrium price is $3 (see where a horizontal line from E intersects the vertical axis) and the equilibrium quantity is 12 million boxes per year (see where a vertical line from E intersects the horizontal axis). Now, imagine the market price starts out too high at $5. This can be seen towards the top of the curves diagram. Here we see that the quantity supplied (18 million boxes) is greater than the quantity demanded (9 million boxes). There is a surplus of cornflakes. Cornflakes will pile up on the supermarket shelves. In order to sell these, the supermarket will start cutting prices. As prices decrease, the quantity demanded will increase (we will move along the demand curve DD as shown by the arrows) but the quantity supplied will be reduced (we will move along the supply curve SS as shown by the arrows). Eventually the price will reduce to the equilibrium price at E. Now, imagine the market price starts out too low, at $2. This can be seen towards the bottom of the curves diagram. Here we see that the quantity demanded (15 million boxes) is greater than the quantity supplied (7 million boxes). There is a shortage of cornflakes. Long queues will form at the supermarket for cornflakes. Buyers will bid up their prices in order to get the scarce cornflakes. As prices increase, the quantity demanded will decrease (we will move along the demand curve DD as shown by the arrows) but the quantity supplied will increase (we will move along the supply curve SS as shown by the arrows). Eventually the price will increase to the equilibrium price at E. 4. Explain why each of the following is false: a. A freeze in Brazils coffee-growing region will lower the price of coffee. A freeze in Brazils coffee-growing region will reduce the supply of coffee. The supply curve will shift to the left, as less coffee is supplied at each price. Assuming that the demand for coffee remains the same, the equilibrium price will be higher, not lower, than before, as shown below. (N.B. Price on the vertical axis is denoted by P. Quantity on the horizontal axis is denoted by Q. Demand curves are denoted DD. Supply curves are denoted by SS. E represents the intersection of the two curves, which gives the equilibrium price and quantity. An apostrophe, , is suffixed to the D, S, or E to indicate a shifted curve or equilibrium. The bold red arrows indicate the change in price and quantity due to a shifted curve)

D E'

S'

Price

E S'

Quantity

b. Protecting American textile manufacturers from Chinese clothing imports will lower clothing prices in the United States. Protecting America from Chinese clothing imports will reduce the supply of clothing in the United States, increasing, not decreasing, price, as in 4.a. c. The rapid increase in college tuitions will lower the demand for college.

A rise in college tuitions (fees) will reduce the quantity of college tuition demanded. But this is not the same as a reduction in demand. We have here a movement along the demand curve, as the quantity demanded responds to a change in price. If the demand was to change, this would be a shift of the demand curve, as one of the elements underlying the demand curve (such as average incomes, population, prices of related goods, tastes or special influences) would have changed.

D E'

Price

D Quantity

In fact, the increase in college tuitions will be a reduction on the supply of college tuition at each price. The reasoning, and curves, will be as in 4.a. The supply curve, shifted to the left to SS, will intersect with the original demand curve DD at a higher price and lower quantity demanded but the demand will not have changed (DD has not shifted.) d. The war against drugs, with increased interdiction of imported cocaine, will lower the price of domestically produced marijuana. The war against drugs, by reducing imports of cocaine, will lead to a reduction in the supply of cocaine. The same reasoning and curves as in 4.a. applies to cocaine in this instance. Marijuana is a related good of cocaine, so as the price of cocaine increases, so the price of domestically produced marijuana will be higher. The war against drugs has made drugs a very lucrative commodity. 5. The following are four laws of supply and demand. Fill in the blanks. Demonstrate each law with a supply-and-demand diagram. a. An increase in demand generally raises price and raises quantity demanded.

D'

E'

Price

D'

Quantity

The demand curve shifts rightwards, from DD to DD, as a greater quantity is demanded at each price. The supply curve SS remains where it is. The equilibrium, given by the intersection of the supply and demand curves, moves from E to E. E is clearly at a higher price and higher quantity than E (it is higher up on the vertical P axis and further along on the horizontal Q axis). The bold red arrows indicate the change in price and quantity due to the new equilibrium. The price is raised and the quantity is raised.

b. A decrease in demand generally lowers price and lowers quantity demanded.

D'

Price

E'

S Quantity

D'

The demand curve shifts leftwards, from DD to DD, as a lesser quantity is demanded at each price. The supply curve SS remains where it is. The equilibrium, given by the intersection of the supply and demand curves, moves from E to E. E is clearly at a lower price and lower quantity than E (it is lower down on the vertical P axis and nearer in on the horizontal Q axis). The bold red arrows indicate the change in price and quantity due to the new equilibrium. The price is lowered and the quantity is lowered. c. An increase in supply generally lowers prices and raises quantity demanded.

S'

Price

E'

S'
Quantity

The supply curve shifts rightwards, from SS to SS, as a greater quantity is supplied at each price. The demand curve DD remains where it is. The equilibrium, given by the intersection of the supply and demand curves, moves from E to E. E is clearly at a lower

price and higher quantity than E (it is lower down on the vertical P axis and further along on the horizontal Q axis). The bold red arrows indicate the change in price and quantity due to the new equilibrium. The price is lowered and the quantity is raised. d. A decrease in supply generally raises price and lowers quantity demanded.

S'

E'

Price

S'

S Quantity

The supply curve shifts leftwards, from SS to SS, as a lesser quantity is supplied at each price. The demand curve DD remains where it is. The equilibrium, given by the intersection of the supply and demand curves, moves from E to E. E is clearly at a higher price and lower quantity than E (it is higher up on the vertical P axis and nearer in on the horizontal Q axis). The bold red arrows indicate the change in price and quantity due to the new equilibrium. The price is raised and the quantity is lowered. 6. For each of the following, explain whether quantity demanded changes because of a demand shift or a price change, and draw a diagram to illustrate your answer. a. As a result of decreased military spending, the price of Army boots falls. Army boots are purchased by military spending, i.e. military spending provides the demand for Army boots. Decreased military spending decreases demand for Army boots this is a demand shift

D'

Price

E'

S Quantity

D'

(See 5.b. for a fuller explanation of a decrease in demand) which leads to a fall in price. b. Fish prices fall after the pope allows Catholics to eat meat on a Friday. Meat is a close substitute for fish. If meat is allowed to be eaten on a Friday, Catholics will substitute meat for fish (not necessarily because of price effects, but because the special influence of the pope had prevented people from indulging their tastes for meat). The demand for fish will be reduced due to a demand shift. The reasoning, and the curves, will be the same as in 6.a. The price of fish falls. c. An increase in gasoline taxes lowers the consumption of gasoline. An increase in gasoline taxes will raise the price of gasoline. Due to the law of downwardsloping demand, an increase in price will lower the quantity demanded, because of a price change. Consumption of gasoline will be reduced.

D E'

Price

D Quantity

d. After the Black Death struck Europe in the fourteenth century, wages rose. The Black Death reduced the supply of labourers (economics has a very dry way of describing millions of deaths!)

S'

E'

Price

S'

S Quantity

(See 5.d. for a fuller explanation of a decrease in supply) which will have raised the price of the labourers, i.e. wages rose (if you survived!). Note: only supply shifted, not demand. Quantity demanded changed because of a price change, caused by a supply shift altering the equilibrium price. 7. Examine the graph for the price of gasoline in Figure 3-1, page 46. Then, using a supplyand-demand diagram, illustrate the impact of each of the following on price and quantity demanded:

a. Improvements in transportation lower the costs of importing oil into the United States in the 1960s. Improvements in transportation reduced the costs of production both improved technology and reduced input prices. This will have increased the supply of gasoline

S'

Price

E'

S' Quantity

(See 5.c. for a fuller explanation of an increase in supply) which will have lowered the price of gasoline and raised the quantity demanded. This helps to explain why gasoline prices fell in the 1960s. b. After the 1973 war, oil producers cut oil production sharply. A cut in oil production led to a decrease in gasoline supply, as oil is an input to gasoline and its scarcity would have increased input prices

S'

E'

Price

S'

Quantity

(See 5.d. for a fuller explanation of a decrease in supply)

which would have raised the price and lowered quantity demanded. This helps explain why gasoline prices rose substantially in the first oil shock after 1973. (N.B. The price of oil rising due to a cut in its production is also explained in the above diagram.) c. After 1980, smaller automobiles get more miles per gallon. An increase in miles per gallon mean that motorists need less gasoline for their driving. This reduced the demand for gasoline

D'

Price

E'

S Quantity

D'

(See 5.b. for a fuller explanation of a decrease in demand) which would have lowered price and lowered quantity demanded. This helps explain why the gasoline price fell sharply after 1980. d. A record-breaking cold winter in 1995-1996 unexpectedly raises the demand for heating oil. Heating oil is a related good of gasoline; both use oil as an input and will use similar production techniques it is an alternative output of the production process. If the demand for heating oil increased

D'

E'

Price

S Quantity

D'

(See 5.a. for a fuller explanation of an increase in demand) its price would have been raised. As the price of heating oil rose, gasoline producers would have seen that they could have increased their profits if they switched production away from gasoline and onto heating oil. The supply of gasoline would have been reduced

S'

E'

Price

S'

S Quantity

(See 5.d. for a fuller explanation of a decrease in supply) and this would have raised its price and lowered the quantity demanded. This helps to explain the spike in gasoline price in 1995-1996. e. A global economic recovery in 1999-2000 leads to a sharp upturn in oil prices. The global economic recovery would have increased average incomes. People would choose to take more holidays, buy more goods and services all of which would have increased the demand for gasoline

D'

E'

Price

S Quantity

D'

(See 5.a. for a fuller explanation of an increase in demand) which would have raised the price and raised the quantity demanded. This helps explain the rapidly rising gasoline price in the early 2000s. 8. Examine Figure 3-3 on page 49. Does the price-quantity relationship look more like a supply curve or a demand curve? Assuming that the demand curve was unchanged over this period, trace supply curves for 1972 and 2000 that would have generated the (P,Q) pairs for those years. Explain what forces might have led to the shift in the supply curve.

The above chart is downward-sloping so it looks more like a demand curve.

Assuming a constant demand curve, the supply curves that would have generated the (P,Q) pairs would look something like this:
D S
1000

100

S'

10

1 0.0001 0.001 0.01 0.1 1 10 100 1000 10000

S
0.1

S'

(N.B. The graph uses a logarithmic scale so curves look straight) The forces that might have led to the shift in the supply curve are: The technology available to make computers has improved drastically. The amount of transistors and other devices that can be placed on a given area of silicon has increased hugely (Moores Law states that transistor density has doubled every two years). The use of software to design products, and machinery to automate the production process has increased. The amount of output that can be produced from a given amount of inputs has increased hugely due to technological advancement (which the availability of computers has itself driven). This will have increased supply. Inputs prices will have reduced. Production will have been outsourced to areas where labour costs are much lower, such as China. Computer components will be cheaper, due to the same forces of technological advancement and reduced input prices. This will have increased supply. Prices of related goods, such as typewriters, will have fallen. This will have increased supply. Government policy, for instance in providing funding for research for advanced technology (often for military purposes) and for technical education, will have increased the technological advancement that has driven increased supply. Special influences, such as the spirit of innovation, and the appeal of icons such as Bill Gates, Steve Jobs and Silicon Valley, has helped increase the supply of talent into the computing industry. Expectations of future technological advancement, such as Moores Law, has had an important influence, as has expectations of future demand Bill Gates vision of A computer on every desk and in every home. These have helped increase supply.

9. From the following data, plot the supply and demand curves and determine the equilibrium price and quantity:
Supply and Demand for Pizzas Quantity Quantity demanded supplied (pizzas per semester) (pizzas per semester) 0 40 10 30 20 20 30 10 40 0 125 0

Price ($ per box) 10 8 6 4 2 0

What would happen if the demand for pizzas tripled at each price? What would occur if the price were initially set at $4 per pizza? Plotting the supply and demand schedule given above gives:

Supply and Demand for Pizzas

12
10

Price ($ per pizza)

E
6 4 2 0 0

S
20 40 60 80 100 120

D
140

Quantity (pizzas per semester)

We can see that the equilibrium price is $6 per pizza, while the equilibrium quantity is 20 pizzas per semester. Tripling the demand for pizzas at each price:
Supply and Demand for Pizzas Quantity Quantity demanded supplied (pizzas per semester) (pizzas per semester) 0 40 30 30 60 20 90 10 120 0 375 0

Price ($ per box) 10 8 6 4 2 0

Supply and Demand for Pizzas

12 10

D, D' S E' E

Price ($ per pizza)

8 6 4 2 0 0

S
50 100

D
150 200 250 300 350

D'
400

Quantity (pizzas per semester)

The new equilibrium price is $8 per pizza , and the new equilibrium quantity is 30 pizzas per semester. If the price was initially set at $4 per pizza (in either case), there will be a shortage of pizzas (the demand curves are further along the horizontal quantity axis than the supply curves at this price). There are more pizzas demanded than are being supplied. Queues will form for pizzas. Consumers will bid up their prices for pizzas in order to obtain the scarce goods. The increasing price will encourage production and discourage consumption of pizzas with increasing price, the quantity supplied increases while the quantity demanded decreases. There will be movement up and along the curves until the equilibrium price is reached.