Market Forces: Demand and Supply
Chapter 2
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Learning Objectives
Explain the laws of demand and supply, and identify factors that cause demand and supply to shift.
Calculate consumer surplus and producer surplus, and describe what they mean.
Explain price determination in a competitive market, and show how equilibrium changes in response to changes in determinates of demand and supply.
Explain and illustrate how excise taxes, ad valorem taxes, price floors, and price ceilings impact the functioning of a market.
Apply supply and demand analysis as a qualitative forecasting tool to see the “big picture” in competitive markets.
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2
Market demand curve
Illustrates the relationship between the total quantity and price per unit of a good all consumers are willing and able to purchase, holding other variables constant.
Law of demand
The quantity of a good consumers are willing and able to purchase increases (decreases) as the price falls (rises).
Price and quantity demanded are inversely related.
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Demand
Demand
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3
Market Demand Curve
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2-4
Quantity
(thousands per year)
Price ($)
Demand
$40
0
$30
$20
20
40
$10
60
80
Demand
Changing only price leads to changes in quantity demanded.
This type of change is graphically represented by a movement along a given demand curve, holding other factors that impact demand constant.
Changing factors other than price lead to changes in demand.
These types of changes are graphically represented by a shift of the entire demand curve.
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Demand
Shift in Quantity Demanded versus a Shift in Demand
Changes in Demand
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Quantity
0
Price
D1
Increase
in
demand
Demand
A
B
D0
D2
Decrease
in
demand
Demand Shifters
Income
Normal good
Inferior good
Prices of related goods
Substitute goods
Complement goods
Advertising and consumer tastes
Informative advertising
Persuasive advertising
Population
Consumer expectations
Other factors
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Demand
Advertising and the Demand for Clothing
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Quantity of
high-style
clothing
0
$50
$40
50,000
Price of
high-style
clothing
D2
60,000
Due to an
increase in
advertising
Demand
D1
The Demand Function
The demand function for good X is a mathematical representation describing how many units will be purchased at different prices for X, the price of a related good Y, income and other factors that affect the demand for good X.
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Demand
The Linear Demand Function
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Demand
Understanding the Linear Demand Function
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Demand
The Linear Demand Function in Action
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Demand
Inverse Demand Function
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Demand
Graphing the Inverse Demand Function in Action
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Quantity
Price
$2,020
0
6,060
Demand
Marketing strategies – like value pricing and price discrimination – rely on understanding consumer value for products.
Total consumer value is the sum of the maximum amount a consumer is willing to pay at different quantities.
Total expenditure is the per-unit market price times the number of units consumed.
Consumer surplus is the extra value that consumers derive from a good but do not pay extra for.
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Consumer Surplus
Demand
Quantity
in liters
Price per
liter
Demand
$5
0
$3
$2
1
2
$1
4
5
Market Demand and Consumer Surplus in Action
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Total Consumer Value:
0.5($5 – $3)x2+(3-0)(2-0) = $8
Expenditures:
$(3-0) x (2-0) = $6
Consumer Surplus:
0.5($5 – $3)x(2-0) = $2
Demand
$4
3
Consumer Surplus
16
Market supply curve
A curve indicating the total quantity of a good that all producers in a competitive market would produce at each price, holding input prices, technology, and other variables affecting supply constant.
Law of supply
As the price of a good rises (falls), the quantity supplied of the good rises (falls), holding other factors affecting supply constant.
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2-17
Supply
Supply
Changes in Quantity Supplied versus Changes in Supply
Changing only price leads to changes in quantity supplied.
This type of change is graphically represented by a movement along a given supply curve, holding other factors that impact supply constant.
Changing factors other than price lead to changes in supply.
These types of changes are graphically represented by a shift of the entire supply curve.
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Supply
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Changes in Supply
Quantity
Price
S2
0
Decrease
in supply
Supply
A
B
S0
S1
Increase
in supply
Input prices
Technology or government regulation
Number of firms
Entry
Exit
Substitutes in production
Taxes
Excise tax: a tax on each unit of output sold, where tax revenue is collected from the supplier
Ad valorem tax: percentage tax
Producer expectations
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Supply
Supply Shifters
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A Per Unit (Excise) Tax
Quantity of
gasoline per
week
Price
of
gasoline
0
t = per unit tax of 20¢
Supply
S0
S0+t
t = 20¢
$1.20
$1.00
t
Excise tax
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2-22
An Ad Valorem Tax
Quantity of
backpacks per
week
Price
of
backpacks
0
Supply
S0
S1 = 1.20 x S0
$24
$10
Ad valorem tax
$12
1,100
$20
2,450
The Supply Function
The supply function for good X is a mathematical representation describing how many units will be produced at alternative prices for X, alternative input prices W, and alternative values of other variables that affect the supply for good X.
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Supply
The Linear Supply Function
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Supply
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2-25
Supply
Understanding the Linear Supply Function
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Supply
The Linear Supply Function in Action
Inverse Supply Function
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Supply
Producer surplus: the amount producers receive in excess of the amount necessary to induce them to produce the good.
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Supply
Producer Surplus
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Producer Surplus in Action
Quantity
Price
Supply
$400
0
800
Supply
Producer surplus
29
Competitive Market Equilibrium
Determined by the intersection of the market demand and market supply curves.
A price and quantity such that there is no shortage or surplus in the market.
Forces that drive market demand and market supply are balanced, and there is no pressure on prices or quantities to change.
The equilibrium price is the price that equates quantity demanded with quantity supplied
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Market Equilibrium
Market Equilibrium
Market Equilibrium
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Quantity
Price
Supply
0
280
Demand
Surplus
Shortage
Market Equilibrium
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Market Equilibrium in Action
Market Equilibrium
Price Restrictions and Market Equilibrium
In a competitive market equilibrium, price and quantity freely adjust to the forces of demand and supply.
Sometime government restricts how much prices are permitted to rise or fall.
Price ceiling
Price floor
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Price Restrictions and Market Equilibrium
A Price Ceiling
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Quantity
Price
Supply
0
280
Demand
Shortage
Priceceiling
Nonpecuniary price
Lost social welfare
Price Restrictions and Market Equilibrium
Price Ceiling in Action
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Price Restrictions and Market Equilibrium
A Price Floor
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Quantity
Price
Supply
0
280
Demand
Surplus
Pricefloor
Price Restrictions and Market Equilibrium
Cost of
purchasing
excess supply
Price Floor in Action
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Price Restrictions and Market Equilibrium
Comparative static analysis
The study of the movement from one equilibrium to another.
Competitive markets, operating free of price restraints, will be analyzed when:
Demand changes
Supply changes
Demand and supply simultaneously change
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Comparative Statics
Comparative Statics
Increase in demand only
Increase equilibrium price
Increase equilibrium quantity
Decrease in demand only
Decrease equilibrium price
Decrease equilibrium quantity
Example of change in demand
Suppose that consumer incomes are projected to increase 2.5% and the number of individuals over 25 years of age will reach an all time high by the end of next year. What is the impact on the rental car market?
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Changes in Demand
Comparative Statics
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Effect of a Change in Demand for Rental Cars
Quantity
(thousands
rented per day)
Price
Supply
0
$45
104
Demand1
$49
Demand0
100
Comparative Statics
108
Increase in supply only
Decrease equilibrium price
Increase equilibrium quantity
Decrease in supply only
Increase equilibrium price
Decrease equilibrium quantity
Example of change in supply
Suppose that a bill before Congress would require all employers to provide health care to their workers. What is the impact on retail markets?
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Changes in Supply
Comparative Statics
Effect of a Change in Supply
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Quantity
Price
Supply0
0
Demand
Supply1
Comparative Statics
Simultaneous Shifts in Supply and Demand
Suppose that simultaneously the following events occur:
An earthquake hit Kobe, Japan and decreased the supply of fermented rice used to make sake wine.
The stress caused by the earthquake led many to increase their demand for sake, and other alcoholic beverages.
What is the combined impact on Japan’s sake market?
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Comparative Statics
Simultaneous Shifts in Supply and Demand in Action
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Quantity
Price
Supply0
0
Demand1
Supply1
Demand0
Comparative Statics
Japan’s Sake Market
Supply2
A
B
C