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MC MB Supply and Demand: An Introduction Supply and Demand: An Introduction How do consumers get the goods and services they want in the right quantities and qualities? Some goods and services are allocated by the market forces of supply and demand MB MC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 3 - Supply and Demand: An Introduction Slide 2 MB MC Supply and Demand: An Introduction MB MC What, How, and for Whom? Central Planning Versus the Market Why do some goods and services have shortages or surpluses and others do not? Some good and supplies services are regulated by government Three Problems All Economic Systems Must Address What should be produced? How should it be produced? For whom will it be produced? Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 3 - Supply and Demand: An Introduction Slide 3 Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 3 - Supply and Demand: An Introduction Slide 4 MB MC What, How, and for Whom? Central Planning Versus the Market MB MC What, How, and for Whom? Central Planning Versus the Market Centralized Economic Organizations Agrarian society Former Soviet Union Cuba, North Korea China Bureaucracy A small number of individuals address What Establish production targets for factories and farms How Plan how to achieve the goals For Whom Distribute the goods and services produced Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 3 - Supply and Demand: An Introduction Slide 5 Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 3 - Supply and Demand: An Introduction Slide 6 1 MB MC What, How, and for Whom? Central Planning Versus the Market MB MC Buyers and Sellers in Markets A Market Consists of all buyers and sellers of a good or service Free-Market or Capitalist Economic Systems Individual choices determine Which careers to pursue Which products to produce or buy When to start and shut-down a business Who gets what, which is decided by individual preferences and purchasing power What do you think? What determines the price of pizza, gasoline, a car wash, or other goods and services? Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 3 - Supply and Demand: An Introduction Slide 7 Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 3 - Supply and Demand: An Introduction Slide 8 MB MC MB MC Buyers and Sellers in Markets The Demand Curve A schedule or graph that tells us the quantity of a good that buyers wish to buy at each price Buyers and Sellers in Markets A Property of Demand As price of a good or service goes down the quantity consumers wish to buy will increase Therefore, the demand curve is downwardsloping Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 3 - Supply and Demand: An Introduction Slide 9 Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 3 - Supply and Demand: An Introduction Slide 10 MB MC The Daily Demand Curve for Pizza in Chicago Price ($ per slice) MB MC Buyers and i Markets The Demand Curve Why do buyers purchase a greater quantity at lower prices and vice-versa? The substitution effect The income effect 4 3 2 Demand 8 12 16 Quantity (1000s of slices per day) Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 3 - Supply and Demand: An Introduction Slide 11 Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 3 - Supply and Demand: An Introduction Slide 12 2 MB MC MB MC Buyers and Sellers in Markets The Substitution Effect The change in the quantity demanded of a good that results because buyers switch to substitutes when the price of the good changes Buyers and Sellers in Markets The Income Effect The change in the quantity demanded of a good that results because a change in the price of a good changes the buyer s purchasing power Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 3 - Supply and Demand: An Introduction Slide 13 Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 3 - Supply and Demand: An Introduction Slide 14 MB MC MB MC Buyers and Sellers in Markets The Cost-Benefit Principle The reservation price is the benefit the buyer receives from the good The cost of the good is its market price If the reservation price (benefit) exceeds the market price (cost) the consumer will purchase the good At higher prices, benefit will exceed cost for a smaller quantity than at lower prices Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Buyers and Sellers in Markets Price ($ per slice) The buyers reservation price: 4 The largest dollar amount the buyer would be willing to pay for a good 3 2 Demand 8 12 16 Quantity (1000s of slices per day) Chapter 3 - Supply and Demand: An Introduction Slide 15 Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 3 - Supply and Demand: An Introduction Slide 16 MB MC MB MC Buyers and Sellers in Markets Horizontal Interpretation Price ($ per slice) Buyers and Sellers in Markets Vertical Interpretation Price ($ per slice) 4 Price determines quantity demanded 4 3 3 Quantity measures the marginal buyer s reservation price 2 2 Demand Demand 8 12 16 8 12 16 Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 3 - Supply and Demand: An Introduction Slide 17 Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 3 - Supply and Demand: An Introduction Slide 18 3 MB MC MB MC Buyers and Sellers in Markets The Supply Curve A curve or schedule showing the quantity of a good that sellers wish to sell at each price Buyers and Sellers in Markets Question Will the opportunity cost of producing additional units of pizza increase or decrease? Hint: Low-hanging-fruit principle Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 3 - Supply and Demand: An Introduction Slide 19 Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 3 - Supply and Demand: An Introduction Slide 20 MB MC MB MC Buyers and Sellers in Markets The Supply Curve Sellers must receive a higher price to produce additional units of a product to cover the higher opportunity costs of each additional unit The Daily Supply Curve for Pizza in Chicago Price ($ per slice) Supply 4 3 2 8 12 16 Quantity (1000s of slices per day) Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 3 - Supply and Demand: An Introduction Slide 21 Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 3 - Supply and Demand: An Introduction Slide 22 MB MC The Daily Supply Curve for Pizza in Chicago Horizontal Interpretation Price ($ per slice) MB MC The Daily Supply Curve for Pizza in Chicago Vertical Interpretation Price ($ per slice) Supply Supply 4 Shows the quantity produced for each price 4 Shows the marginal cost (reservation price) for producing each additional unit 3 3 2 2 8 12 16 Quantity (1000s of slices per day) 8 12 16 Quantity (1000s of slices per day) Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 3 - Supply and Demand: An Introduction Slide 23 Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 3 - Supply and Demand: An Introduction Slide 24 4 MB MC MB MC Market Equilibrium Seller s Reservation Price The smallest dollar amount for which a seller would be willing to sell an additional unit, generally equal to marginal cost Market Equilibrium Equilibrium A system is in equilibrium when there is no tendency for it to change Market Equilibrium Occurs in a market when all buyers and sellers are satisfied with their respective quantities at the market price Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 3 - Supply and Demand: An Introduction Slide 25 Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 3 - Supply and Demand: An Introduction Slide 26 MB MC The Equilibrium Price and Quantity of Pizza in Chicago Price ($ per slice) MB MC Market Equilibrium Equilibrium Price and Equilibrium Quantity The values of price and quantity for which quantity supplied and quantity demanded are equal Supply 4 3 Equilibrium at $3 Quantity Demanded = Quantity Supplied 2 Demand Quantity (1000s of slices per day) 8 12 16 Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 3 - Supply and Demand: An Introduction Slide 27 Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 3 - Supply and Demand: An Introduction Slide 28 MB MC MB MC Market Equilibrium What Do You Think? Would buyers prefer a lower price than the equilibrium price? Would sellers prefer a higher price than the equilibrium price? Excess Supply Excess supply = 8,000 slices per day Price ($ per slice) Supply 4 3 2 Demand Quantity (1000s of slices per day) 8 12 16 Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 3 - Supply and Demand: An Introduction Slide 29 Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 3 - Supply and Demand: An Introduction Slide 30 5 MB MC MB MC Excess Demand Price ($ per slice) Points Along the Demand and Supply Curves of a Pizza Market Demand for pizza Supply of pizza Price ($/slice) Quantity supplied (1000s of slices/day) Supply 4 Excess demand = 8,000 slices per day Price ($/slice) Quantity demanded (1000s of slices/day) 3 1 2 8 6 4 2 1 2 3 4 2 4 6 8 2 Demand Quantity (1000s of slices per day) 3 4 8 16 Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 3 - Supply and Demand: An Introduction Slide 31 Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 3 - Supply and Demand: An Introduction Slide 32 MB MC Graphing Supply and Demand and Finding the Equilibrium Price and Quantity MB MC Market Equilibrium What Do You Think? Is the market equilibrium always an ideal outcome for all market participants? Price ($per slice) 5 4 3 2.50 2 1 Supply The Equilibrium Price = $2.50 The Equilibrium Quantity = 5 Demand 2 4 5 6 8 10 Quantity (1000s of slices per day) 0 Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 3 - Supply and Demand: An Introduction Slide 33 Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 3 - Supply and Demand: An Introduction Slide 34 MB MC MB MC An Unregulated Housing Market Rent Controls Monthly Rent ($/apartment) Monthly Rent ($/apartment) Supply Supply 2400 What Do You Think? Is $1600 more than some people can afford? 1600 1600 Excess demand = 2 million apartments per month Demand Controlled = 800 Demand Quantity (Millions of apartments/day) Quantity (Millions of apartments/day) 2 0 1 2 3 Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 3 - Supply and Demand: An Introduction Slide 35 Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 3 - Supply and Demand: An Introduction Slide 36 6 MB MC MB MC Market Equilibrium Rent Controls Reconsidered Other consequences of rent controls Maintenance will decline and housing quality will fall Illegal payments Creation of co-ops and conversion to condominiums Reduction in household mobility Discrimination Market Equilibrium What do you think? How can we make housing affordable for poor people without using rent ceilings? Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 3 - Supply and Demand: An Introduction Slide 37 Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 3 - Supply and Demand: An Introduction Slide 38 MB MC MB MC Rent Controls Monthly Rent ($/apartment) Price Controls in the Pizza Market Price ($ per slice) Supply Supply 1200 4 What is the impact of a rent control set at $1,200/month? Excess demand = 8,000 slices per day 800 3 Price ceiling = 2 Demand Quantity (Millions of apartments/day) Demand Quantity (1000s of slices per day) 0 1 2 3 8 12 16 Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 3 - Supply and Demand: An Introduction Slide 39 Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 3 - Supply and Demand: An Introduction Slide 40 MB MC MB MC Market Equilibrium Pizza Price Controls? Market responses to a pizza price ceiling Long lines Preferential treatment to selected customers Alternative pricing strategies Poorer quality ingredients Black-market pizzas Predicting and Explaining Changes in Prices and Quantities Distinguishing Between A change in the quantity demanded A movement along the demand curve that occurs in response to a change in price A change in demand A shift of the entire demand curve Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 3 - Supply and Demand: An Introduction Slide 41 Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 3 - Supply and Demand: An Introduction Slide 42 7 MB MC An Increase in Quantity Demanded vs. an Increase in Demand Price ($/can) MB MC An Increase in Quantity Demanded vs. an Increase in Demand Price ($/can) D 6 5 4 3 2 1 D Increase in quantity demanded 6 5 4 D Increase in demand 3 2 D D 2 4 12 Quantity (1000s of cans/day) 1 D 12 Quantity (1000s of cans/day) 0 0 Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 3 - Supply and Demand: An Introduction Slide 43 Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 3 - Supply and Demand: An Introduction Slide 44 MB MC Predicting and Explaining Changes in Prices and Quantities MB MC An Increase in Quantity Supplied vs. an Increase in Supply Price ($/can) Change in the quantity supplied A movement along the supply curve that occurs in response to a change in price 6 5 4 3 2 S Increase in quantity supplied Change in supply A shift of the entire supply curve S 1 Quantity (1000s of cans/day) 0 2 4 6 8 10 Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 3 - Supply and Demand: An Introduction Slide 45 Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 3 - Supply and Demand: An Introduction Slide 46 MB MC An Increase in Quantity Supplied vs. an Increase in Supply Price ($/can) MB MC The Effect on the Market for Tennis Balls of a Decline in Court Rental Fees Price ($/ball) S 6 5 4 3 2 1 S S 1.40 Increase in supply 1.00 D S 0 2 4 S 6 8 10 Quantity (1000s of cans/day) D 40 58 Quantity (letters/month) Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 3 - Supply and Demand: An Introduction Slide 47 Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 3 - Supply and Demand: An Introduction Slide 48 8 MB MC Effect on the Market for Overnight Letter Delivery of a Decline in the Price of Internet Access MB MC Predicting and Explaining Changes in Prices and Quantities Price ($/letter) Economic Naturalist S P P D D Q Q Quantity (letters/month) When the Federal Government implements a large pay increase for its employees, why do rents for apartments near Washington Metro stations go up relative to rents for apartments located far away from Metro stations? Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 3 - Supply and Demand: An Introduction Slide 49 Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 3 - Supply and Demand: An Introduction Slide 50 MB MC Predicting and Explaining Changes in Prices and Quantities MC MB Predicting and Explaining Changes in Prices and Quantities Shifts in Demand Complements Two goods are complements in consumption if an increase (decrease) in the price of one cause a decrease (increase) in the demand for the other Shifts in Demand Substitutes Two goods are substitutes in consumption if an increase (decrease) in the price of one causes an increase (decrease) in the demand for the other Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 3 - Supply and Demand: An Introduction Slide 51 Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 3 - Supply and Demand: An Introduction Slide 52 MB MC Predicting and Explaining Changes in Prices and Quantities MB MC Predicting and Explaining Changes in Prices and Quantities Shifts in Demand Changes In Demand An increase (decrease) in the demand for a good will shift the demand curve to the right (left) What do you think? How will a decline in airfares affect intercity bus fares and the price of hotel rooms in resort communities? Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 3 - Supply and Demand: An Introduction Slide 53 Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 3 - Supply and Demand: An Introduction Slide 54 9 MB MC The Effect of a Federal Pay Raise on the Rent for Conveniently Located Apartments in Washington D.C. MB MC Predicting and Explaining Changes in Prices and Quantities Rent (dollars per month) A Change In Income S Normal Good One whose demand increases (decreases) when the incomes of buyers increase (decrease) P P D Conveniently located apartments (units per month) D Q Q Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 3 - Supply and Demand: An Introduction Slide 55 Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 3 - Supply and Demand: An Introduction Slide 56 MB MC Predicting and Explaining Changes in Prices and Quantities MB MC The Effect of the Release of Jurassic Park on the Market for Toy Dinosaurs D = demand after release of movie A Change In Income Inferior Good One whose demand decreases (increases) when the incomes of buyers increase (decrease) Price S P P D D Q Q Toy Dinosaurs (units per month) Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 3 - Supply and Demand: An Introduction Slide 57 Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 3 - Supply and Demand: An Introduction Slide 58 MB MC The Effect of a Credible Rumor on the Market for Apple Macintosh Computers D = demand after rumor of cheaper model soon to be released Price MB MC The Effect of the Increase in the Population of Potential Buyers D = demand after increase in population Price S S P P D Apple Computers (units per month) P P D Housing NY City (units per month) D Q Q D Q Q Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 3 - Supply and Demand: An Introduction Slide 59 Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 3 - Supply and Demand: An Introduction Slide 60 10 MB MC The Effect on the Skateboard Market of an Increase in the Price of Fiberglass MB MC Predicting and Explaining Changes in Prices and Quantities Price ($/skateboard) What Do You Think? S S Does the increase in the cost of fiberglass have any effect on the demand curve for skateboards? 80 60 D 800 1000 Quantity (skateboards/month) Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 3 - Supply and Demand: An Introduction Slide 61 Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 3 - Supply and Demand: An Introduction Slide 62 MB MC The Effect on the Market for New Houses of a Decline in Carpenters Wage Rates MB MC The Effect of Technical Change on the Market for the Term Paper Revisions Price ($1000/house) Price ($/revision) S S 55 120 90 S S D 40 50 Quantity (houses/month) 7.50 12 36 D Quantity (millions of revisions per year) Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 3 - Supply and Demand: An Introduction Slide 63 Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 3 - Supply and Demand: An Introduction Slide 64 MB MC Predicting and Explaining Changes in Prices and Quantities MB MC Four Rules Governing the Effects of Supply and Demand Shifts: I An increase in demand will lead to an increase in both the equilibrium price and quantity Price Other determinants of supply Weather Expectations Number of sellers S P P D Q Q D Quantity Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 3 - Supply and Demand: An Introduction Slide 65 Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 3 - Supply and Demand: An Introduction Slide 66 11 MB MC Four Rules Governing the Effects of Supply and Demand Shifts: II A decrease in demand will lead to a decrease in both the equilibrium price and quantity Price MB MC Four Rules Governing the Effects of Supply and Demand Shifts: III An increase in supply will lead to a decrease in the equilibrium price and an increase in the equilibrium quantity Price S S S P P P P D Q Q D Quantity D Quantity Q Q Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 3 - Supply and Demand: An Introduction Slide 67 Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 3 - Supply and Demand: An Introduction Slide 68 MB MC Four Rules Governing the Effects of Supply and Demand Shifts: IV An decrease in supply will lead to an increase in the equilibrium price and a decrease in the equilibrium quantity Price MB MC Predicting and Explaining Changes in Prices and Demand Factors That Cause an Increase (rightward or upward shift) in Demand S S P P D Quantity 1. A decrease in the price of complements to the good or service 2. An increase in the price of substitutes for the good or service 3. An increase in income (for a normal good) Q Q Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 3 - Supply and Demand: An Introduction Slide 69 Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 3 - Supply and Demand: An Introduction Slide 70 MB MC Predicting and Explaining Changes in Prices and Demand Factors That Cause an Increase (rightward or upward shift) in Demand MB MC Predicting and Explaining Changes in Prices and Demand Factors That Cause an Increase (rightward or upward shift) in Supply 4. An increased preference by demanders for the good or service 5. An increase in the population of potential buyers 6. An expectation of higher prices in the future 1. A decrease in the cost of materials, labor, or other inputs used in the production of the good or service 2. An improvement in technology that reduces the cost of producing the good or service Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 3 - Supply and Demand: An Introduction Slide 71 Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 3 - Supply and Demand: An Introduction Slide 72 12 MB MC Predicting and Explaining Changes in Prices and Demand Factors That Cause an Increase (rightward or upward shift) in Supply MB MC The Effects of Simultaneous Shifts in Supply and Demand The Market for Corn Tortilla Chips Price ($/bag) S P P S 3. An improvement in the weather, especially for agricultural products 4. An increase in the number of suppliers 5. An expectation of lower prices in the future S after reduction in price of corn harvesting equipment D after discovery that oils are harmful to people s health D D Q Q Millions of bags per month Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 3 - Supply and Demand: An Introduction Slide 73 Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 3 - Supply and Demand: An Introduction Slide 74 MB MC The Effects of Simultaneous Shifts in Supply and Demand The Market for Corn Tortilla Chips Price ($/bag) MB MC Predicting and Explaining Changes in Prices and Demand Assume S S S after reduction in price of corn harvesting equipment D after discovery that oils are harmful to people s health P P D D A vitamin found in corn chips helps protect against cancer and heart disease A swarm of locusts destroys part of the corn crop What Do You Think? Millions of bags per month What will happen to the equilibrium price and quantity of corn chips? Q Q Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 3 - Supply and Demand: An Introduction Slide 75 Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 3 - Supply and Demand: An Introduction Slide 76 MB MC Predicting and Explaining Changes in Prices and Demand MB MC Seasonal Variation in Air Travel and Corn Markets High Consumption due to High Demand Price ($/ticket) Economic Naturalist Why do the prices of some goods, like airline tickets to Europe, go up during the months of heaviest consumption, while others, like sweet corn, go down? S PS PW DW QW QS 1000s of tickets DS Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 3 - Supply and Demand: An Introduction Slide 77 Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 3 - Supply and Demand: An Introduction Slide 78 13 MB MC Seasonal Variation in Air Travel and Corn Markets Price ($/bushel) MB MC Markets and Social Welfare What Do You Think? High Consumption due to High Supply SW SS PS PW When are the prices and quantities determined in market equilibrium socially optimal, in the sense of maximizing total economic surplus? D QW QS Millions of bushels Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 3 - Supply and Demand: An Introduction Slide 79 Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 3 - Supply and Demand: An Introduction Slide 80 MB MC MB MC Markets and Social Welfare Cash On The Table Assume All exchange is purely voluntary Markets and Social Welfare Cash On The Table Buyer s surplus The difference between the buyer s reservation price and the price he or she actually pays If so The buyer s reservation price exceeds the seller s reservation price and both the buyer and seller receive an economic surplus Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 3 - Supply and Demand: An Introduction Slide 81 Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 3 - Supply and Demand: An Introduction Slide 82 MB MC MB MC Markets and Social Welfare Cash On The Table Seller s surplus The difference between the price received by the seller and his or her reservation price Markets and Social Welfare Cash On The Table Total surplus The difference between the buyer s reservation price and the seller s reservation price Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 3 - Supply and Demand: An Introduction Slide 83 Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 3 - Supply and Demand: An Introduction Slide 84 14 MB MC MB MC Price Controls in the Pizza Market Assume Buyer s reservation P = $4 Sellers reservation P = $2 Pizza sells for $3 Price Controls in the Pizza Market Excess demand = $8,000 slices/day Assume price controls = $2 Quantity supplied falls to 8,000 Buyer s reservation price ($4) is greater than seller s ($2) Both would benefit from additional production There is CASH ON THE TABLE Price ($ per slice) S Price ($ per slice) 4 Buyer s surplus: $4 - $3 = $1 Seller s surplus: $3 - $2 = $1 Total surplus: $4 - $2 = $2 4 3 3 2 2 D Quantity (1000s of slices per day) S D Quantity (1000s of slices per day) 8 12 16 8 12 16 Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 3 - Supply and Demand: An Introduction Slide 85 Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 3 - Supply and Demand: An Introduction Slide 86 MB MC MB MC Markets and Social Welfare Cash On The Table Economic metaphor for unexploited gains from exchange Markets and Social Welfare Smart For One, Dumb For All Socially optimal quantity The quantity of a good that results in the maximum possible economic surplus from producing and consuming the good The socially optimal quantity occurs when MC = MB Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 3 - Supply and Demand: An Introduction Slide 87 Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 3 - Supply and Demand: An Introduction Slide 88 MB MC MB MC Markets and Social Welfare Smart For One, Dumb For All Economic efficiency occurs when all goods and services are produced and consumed at their respective socially optimal levels Markets and Social Welfare Smart For One, Dumb For All Achieving economic efficiency Maximizes the economic surplus Increases the economic pie Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 3 - Supply and Demand: An Introduction Slide 89 Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 3 - Supply and Demand: An Introduction Slide 90 15 MB MC MB MC Markets and Social Welfare Smart For One, Dumb For All When is the market equilibrium efficient? When all costs of producing the good or service are borne directly by the seller When all benefits from the good or service accrue directly to buyers Markets and Social Welfare Smart For One, Dumb For All Inefficient market equilibrium When some costs of production fall on people other than those who sell the good or service Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 3 - Supply and Demand: An Introduction Slide 91 Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 3 - Supply and Demand: An Introduction Slide 92 MB MC MB MC Markets and Social Welfare Example: Pollution The market is in equilibrium: MC = MB MC however underestimates the cost to society of producing the good Therefore, the market produces more than the efficient amount and there is no incentive for producers and consumers to alter their behavior Markets and Social Welfare Smart For One, Dumb For All Inefficient market equilibrium When some benefits from the good or service accrue to people who did not buy the good or service Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 3 - Supply and Demand: An Introduction Slide 93 Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 3 - Supply and Demand: An Introduction Slide 94 MB MC MB MC Markets and Social Welfare Example: Vaccinations The market is in equilibrium: MC = MB MB underestimates the benefits to society of consuming the vaccinations The market produces less than the efficient amount of vaccinations and there is no incentive for producers and consumers to alter their behavior Markets and Social Welfare Smart For One, Dumb For All In these markets Buyers and sellers are behaving rationally Market equilibrium exists There are no unexploited opportunities for individuals Economic surplus is not maximized Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 3 - Supply and Demand: An Introduction Slide 95 Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 3 - Supply and Demand: An Introduction Slide 96 16 End of Chapter MB MC 17

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