Chapter 3 Power Point Notes

Chapter 3 Power Point Notes - Chapter 3: Demand, Supply,...

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Unformatted text preview: Chapter 3: Demand, Supply, and Market Equilibrium Slides 1-2 (This slide correlates with no learning objective). Demand, supply, and market equilibrium constitute the foundation of conceptual building blocks in economics. Economics We are somewhat familiar with the dynamics of supply, demand, and equilibrium as a result of reasoning in economic ways of thinking in everyday life. 17th Edition Campbell McConnell and Stan Brue Chapter #3 Demand, Supply, and Market Equilibrium Chapter 3 Slide 2 However, there are dimensions of the interaction effects of these three variables that run somewhat counterintuitive to logic. 1 (This slide correlates with no learning objective). Demand, supply, and market equilibrium constitute the foundation of conceptual building blocks in economics. We are somewhat familiar with the dynamics of supply, demand, and equilibrium as a result of reasoning in economic ways of thinking in everyday life. However, there are dimensions of the interaction effects of these three variables that run somewhat counterintuitive to logic. Chapter Learning Objectives In this chapter you will learn: 1. What demand is and what affects it. 2. What supply is and what affects it. 3. How supply and demand together determine market equilibrium. 4. How changes in supply and demand affect equilibrium prices and quantities. In this chapter you will learn: 1. What demand is and what affects it. 2. What supply is and what affects it. 3. How supply and demand together determine market equilibrium. 4. How changes in supply and demand affect equilibrium prices and quantities. 5. What government-set prices are and how they can cause product surpluses and shortages. 5. What government-set prices are and how they can cause product surpluses and shortages. Chapter 3 Slide 3 2 Demand is a desire that exists among people and manifests itself as a willingness to sacrifice something of value, such as money, for something else of value, which here happen to be goods and services. The willingness of consumers to own them is reflected as demand and those goods and services they seek to purchase are provided by producers who are seeking a profit. We refer to these goods and services as supply. When these two variables, demand and supply, interact in ways that create an agreement among those who want the goods and those who have them, we say we have reached market equilibrium. Markets Markets bring buyers (those who demand) and sellers (suppliers) together and enable exchanges of goods and services at competitive prices. We observe the market function each time we buy a good or service and take the process quite for granted, however beneath the surface many interactions are automatically taking place. These interactions constitute the dynamic interplay of demand and supply. Chapter 3 3 Learning Objective 3-1 1 Chapter 3: Demand, Supply, and Market Equilibrium We begin our journey toward understanding each facet with a description of what constitutes a market. A very simple definition of a market is found in the situation in which a buyer who is eager to own a good, comes to terms with another person who has the very thing the buyer desires to own (a seller or supplier as we eventually come to call them) and they agree on the terms of trade for an exchange. Our contemporary perception of a market is a much more organized place in which people come to buy goods and services. However, even though we have grown to perceive a market as more of a physical place than a process, the same principle applies. Willing sellers and willing buyers are coming to agree on the terms of trade. Each will find ways to renegotiate the terms of trade in the event they are not content with the deal offered in the market. In summary, a market is both a place and process for those who want goods and services (demand) and those who have goods and services to sell (suppliers) to arrange for the terms of an exchange. This process is the most basic and incidentally the most critical function in market-based economics. Without the opportunity for exchange, all else would be irrelevant. Slide 4 Demand We define demand as a schedule or curve reflecting the various amounts of a product (or service) consumers are willing and able to purchase at each of a series of possible prices during a specified time period, assuming other things equal. The “able” dimension of the definition of demand is important in that many of us as consumers have the desire to buy certain goods and services, but lack the ability to afford them. Chapter 3 Learning Objective 3-1 4 Demand represents the desire to own a good or purchase the benefits provided by a service. Although we will move to a much more formal definition of demand momentarily, please take a moment to realize that market interactions are much easier understood if you recognize the unbreakable link between demand and desire. In addition, changes in desire (or lack thereof) result in shifts in the demand curve. The more formal definition of demand is a schedule or curve that shows the various amounts of a product that consumers are willing and able to purchase at each of a series of possible prices during a specified time period. Two facets of this definition are critical to the extent that each is worthy of additional clarification. The first involves the term “able.” Although many people may desire to own goods or services, their desire does not culminate in a change unless they are able (capable of affording) to make these choices. Although a change in desire can result in a changing demand curve, the change in desire must be coupled with the ability to make the choice. Secondarily, our definition of demand is limited to a specific time period. Doing so does not mean demand does not exist beyond our time limit, it merely means we choose a time frame that will be meaningful for us to observe and limit our consideration to that period. 2 Chapter 3: Demand, Supply, and Market Equilibrium Slide 5 Please recall from an earlier discussion a reference we made to the scientific approach to inquiry. Recall that when we continually tested the predictability of a notion and it never failed, it became a law. We now encounter our first law of economic study: The Law of Demand. The Law of Demand All else equal, as price falls, the quantity demanded rises, and as price rises, the quantity demanded falls. The “all else equal” assumption is very critical when considering the law of demand in that numerous other changes can also account for changes in demand. One such occurrence would be a change in expendable budgets. Chapter 3 5 Learning Objective 3-1 Simply stated, the law of demand maintains that “all else equal, as price falls, the quantity demanded rises, and as price rises, the quantity demanded falls.” The “all else equal” assumption associated with the demand curve is also familiar to us. We earlier identified it by the Latin name of ceteris paribus and it represents the assumption that we hold all other things equal so we may study the single variable (or very limited number of variables) of interest to us in that moment. I encourage you to test the law of demand within your own range of understanding in the market. Please consider goods you have a strong desire to own. How would substantial price increases on the one hand, and substantial price decreases, on the other hand impact your desire to own (demand) more, or less of the good? A number of different explanations exist for the behavior predicted in the market by the law of demand and the inverse relationship between price and quantity demanded. The first causal explanation we examine is common sense among consumers. Slide 6 What causes the inverse relationship between price and quantity demanded predicted by the law of demand? It stands to reason that each of us face budget constraints in the short-term time horizon. We are seeking to constantly choose from among a vast array of goods and services. Given our preferred mix of these goods and services we seek to maximize our satisfaction at that time. 1. Common sense among consumers. 2. Diminishing marginal utility. 3. The income effect (or lack thereof). 4. The substitution effect. Chapter 3 Learning Objective 3-1 6 When we are faced with changing prices, our common sense suggests we need to re-evaluate our decision process regarding our range of choices. We must then adjust accordingly. Therefore, we identify common sense among consumers as one of the determinants of the law of demand. We also recognize that as prices change for a good or service, so will our desires to own the goods and services from a common sense perspective. Secondarily, a process we refer to as diminishing marginal utility explains some of our behavior with regard to the law of demand as well. Succinctly stated, diminishing marginal utility asserts that as we consume more consecutive units of a good, we will eventually arrive at a point at which the additional satisfaction we derive from consuming consecutive units diminishes. Stated more simply, the more we consume of something, the less we enjoy the next unit of the good consumed. In order for us to continue to consume additional consecutive units of a good, something must change in ways that prompt us to continue consumption. Therefore, more units of a good or service will be consumed in consecutive consumption only in the event in which market price continues to decline. Another concept referred to as the “income effect” helps explain the inverse relationship between price and quantity demanded predicted by the law of demand. The income effect indicates that a lower price for a good will increase the purchasing power of a buyer’s money income and will enable the buyer to purchase more of the good than they did before the change in price. The counterpart of the income effect is referred to as the “substitution effect”. The substitution effect suggests that as prices increase for a good, the price change will induce buyers to migrate from buying the good to choosing a substitute good with a lower “relative” price. 3 Chapter 3: Demand, Supply, and Market Equilibrium Slide 7 Each of us has an individual demand scheme of the differing quantities of goods and services we demand at different price levels. In the event we were to list these quantities and prices for a good in a simple tabular form, we would have created a demand schedule for ourselves. The Demand Schedule The various quantities of a good or service an individual would consume at various quantities can be meaningfully arranged and presented as a demand schedule. Table 3.1 depicts one such demand schedule. In this demand schedule, different quantities and prices of corn are listed. You can easily assemble a demand schedule of your own by listing the quantities you would demand of a favored good (or service) at different price levels. Chapter 3 7 Learning Objective 3-1 Slide 8 Once a demand schedule is derived, we can create a demand curve for that individual by transferring the content from the schedule to a graph and allowing the y axis to represent price and the x axis to represent quantity demanded. Demand Graphed Demand for an individual is graphed merely by transferring the information from the demand schedule to a graph and then labeling the appropriate points. Chapter 3 8 Learning Objective 3-1 Slide 9 The transition from the demand schedule and curve for an individual to that of all individuals is merely a matter of representation of the accumulated data. In the event we were able to accumulate the demand schedules for all individuals and summarize them into one schedule, we would have captured a demand schedule for market demand. Market Demand In the event we could build demand schedules of all individuals and then combine all the data, we would have built a total or aggregate market demand schedule for a good or service. In reality, we don’t build millions of individual demand schedules and then combine them. We actually observe market demand after the fact and then draw conclusions from the market behaviors. Chapter 3 Slide 3-8 illustrates this process in that the information from Table 3.1 has been transferred to the accompanying graph. We gain one substantial benefit when transferring prices and respective quantities demanded to graphical format. We gain a linear representation, or picture of the trade-off between different price levels and the quantities demanded at each different price level. The image enables us to view the law of demand for this individual at work in a single glance. 9 In addition, we could then transfer that data to a similar graph and we would have an image of market demand. In reality, we don’t accumulate and represent market demand in this manner. We observe aggregate data after the fact (we derive our information from sales and consumption data from other sources) and then portray that data in graphical format. However, for our practical example at this level of study the concept is best understood by making the step from accumulating the demand data from one, to accumulating the same data from many and assembling them together. In addition, in the event we did so, the summarized approach would yield the same data included in the after-the-fact approach. 4 Chapter 3: Demand, Supply, and Market Equilibrium Slide 10 Table 3-2 represents our summarized data from three separate buyers aggregated together and illustrated in one table. This table is referred to as a market demand schedule. A Market Demand Schedule Our simplified demand schedule example is comprised of the total of three individual schedules combined. Learning Objective 3-1 Chapter 3 Slide 11 10 Market Demand Graphed Our graphed example of market demand below involves summing the plotted graphs of individual demand schedules and combining them into one illustration. Chapter 3 A natural extension of the concept of summarizing individual demand schedules in order to represent a market demand schedule also applies to the derivation of a market demand curve. We also summarize all individual demand schedules and represent the aggregate values as market demand. 11 Learning Objective 3-1 Slide 12 Changes in Demand Changes in demand require a shift in the demand curve. • An outward shift represents an increase in demand and more is desired at every price in the market. • An inward shift represents a decrease in demand and less is desired at every price. Chapter 3 Learning Objective 3-1 12 Now that we have identified how we arrive at and portray market demand, we must now address how we represent changes in market demand over time. It is quite obvious that we experience changes in market demand for many goods and services with the passage of time. Such changes in demand for goods are perhaps experienced more frequently in clothing markets in the United States than in any other market. Clothing manufacturers are constantly analyzing consumer preference changes in hopes of recognizing a change in demand as it occurs as opposed to observing it after the fact. The cost of failing to recognize changes in demand in a timely manner can be very costly to fashion manufacturers and merchandisers alike. Let’s observe exactly what is happening graphically when demand changes. First of all, we must clarify exactly what is meant by a change in demand. A change in demand occurs when either more or less of a good or service is demanded at any given price level. In the instance that more of a good or service is demanded at every given price level, we identify the change as an increase in demand. Alternatively, in the instance that less of a good or service is demanded at every given price level, we 5 Chapter 3: Demand, Supply, and Market Equilibrium identify this change as a decrease in demand. In summary, please recall that changes in demand constitute changes in desire to own the good or service. Slide 13 Slide 3-13 illustrates an increase in demand. Please note the demand curve has shifted rightward. At any given point along the new demand curve we would find not only a higher corresponding price when compared to the previous curve, but also a higher corresponding quantity demanded. An Increase in Demand The Demand Curve Shifts Outward from D1 to D2 . Price This illustration therefore constitutes an increase in desire to own the good or service at any price level. D2 D1 Quantity Chapter 3 13 Learning Objective 3-1 Slide 14 Alternatively, slide 3-14 depicts exactly the opposite of an increase in demand. The inward shift of the demand curve represents a decrease in demand. In the instance of a decrease in demand, less will be demanded at every price along the curve. A Decrease in Demand The demand curve shifts inward from D1 to D2 . Price D1 D2 Quantity Chapter 3 14 Learning Objective 3-1 Slide 15 What causes changes in demand? A change in any number of variables can result in a change in demand. The name for this category of variables is the determinants of demand. We will review these in the next few slides, but for now it is most critical for you to understand that anything leading to a change in desire to own the good will cause a change in demand. A change in any demand determinant has a high probability of also leading to a change in demand for the good or service. For instance, imagine how much demand would increase for a particular brand of bottled water if we discovered it had properties that preserved youth. Chapter 3 Now that we know what an increase and a decrease in demand looks like from a graphical perspective and also what it equates to in terms of consumer desire (or lack thereof) for any particular good or service, we must now seek to comprehend what sorts of situations can lead to changes in demand. We refer to these situations leading to changes in demand as demand determinants. 15 Learning Objective 3-1 6 Chapter 3: Demand, Supply, and Market Equilibrium Slide 16 The first determinant of demand is a change in consumer preference. We can easily identify with this determinant when considering changes in fashion trends. Determinants of Demand 1. Changes in consumer preferences (tastes). 2. Changes in the number of consumers in the market. 3. Changes in consumers’ incomes. 4. Changes in the prices of related goods. 5. Changes in consumer expectations about future prices and incomes. Chapter 3 Learning Objective 3-1 16 Most fashion trends are established by young people, quite often while they are in high school. This age group represents a cross section of the population with open minds and an impressionable mindset. In addition, as a whole they tend to be experimental and most often possess a deep-seated desire to distinguish themselves from their peers. In other instances, they have a desperate need to be like certain preferred peers. Those who lead the trend changes most often are the first to experiment with alternative modes of attire. In the event their choice of attire is perceived as “cool” many others will quickly seek to emulate their efforts. A fashion trend is born. This is precisely the sort of change in consumer preference leading to a change in demand. Alternatively, also please recognize that fashion trends can terminate almost as quickly as they emanate. The sword cuts both directions. A secondary determinant of demand can evolve as a result of a change in the number of consumers in the market. One such group affecting the demand for any number of goods over the past five decades is the baby boom generation. This group of people born in the years following World War II is so large that even small changes in preference among them will most likely become manifest as a change in demand. For instance, a substantial increase in demand for health care has evolved in the past twenty years. This increase was precipitated by the aging of the baby boomers. Obviously another possible future increase in demand relative to this group may be that of assisted living centers. In summary, a change in the number of consumers in a market will ultimately result in a change in demand, too. Changes in consumers’ incomes can also be a determinant of demand. Each year our national universities churn out a new crop of graduates. Many of these diploma-bearing individuals quickly obtain jobs and experience a sudden increase in disposable income. They may have an impact on a number of different goods and services markets as they vote with their new found dollars for goods they desire to own. The increase in desire among these new graduates to own these goods constitutes an increase in demand. Changes in the prices of related goods may be a determinant of demand as well. We refer to these related goods as substitute and complement goods. Changes in the prices of beef will result in changes in demand for chicken. Changes in the cost of producing electricity via petroleum-based generators results in an increase in demand for electricity generated by winddriven devices. Each of these examples involves substitute goods. Alternatively, demand changes between two or more complementary goods exhibit a positive relationship with one another. An increase in the demand for one good, such as ink jet printers, will lead to an increase in demand for related goods or complements such as ink jet cartridges. Finally, change in expectations about future price and income represents our last determinant of demand. In the instance one expects future prices for a good to increase, one may become motivated to make a purchase today, thus increasing current demand. Alternatively, in the instance one expects future prices to decrease, one may convince themselves to wait to make a purchase even though they strongly preferred completing the purchase today. The net result of this development is a decrease in current demand. The same can be said of incomes. I may convince myself to make a purchase at an earlier date in the instance I anticipate my future income may fall. Alternatively I may wait to make a purchase I wanted to make today because I am anticipating an greater income in the future. Both of these instances will also impact current demand. 7 Chapter 3: Demand, Supply, and Market Equilibrium Slide 17 Changes in demand for goods as compared to changes in income determine how we classify goods in economics. There are two broad classifications of these goods; normal goods and inferior goods. Normal and Inferior Goods Changes in income obviously results in more or less demand for most goods. Logic suggests that more of a good will be demanded as incomes rise. We refer to such goods as normal goods. Alternatively, demand actually diminishes for a certain range of goods as income levels rise. These goods are referred to as inferior goods. Chapter 3 17 Learning Objective 3-1 Slide 18 Examples of Normal and Inferior Goods Normal goods -most goods are normal goods. Examples include: luxury automobiles, designer clothing, fine jewelry, and computers. Examples of inferior goods are not nearly as easily identified. In most instances, generic store branded versions of supermarket goods qualify as inferior goods. • You can personally identify goods you would consider inferior when you think of the goods you would no longer desire to consume once you received a very large boost in income. • Many college students indicate macaroni made with dehydrated cheese is an inferior good because they consume so much of it due to budget constraints. Chapter 3 Learning Objective 3-1 18 The demand for normal goods will increase as income levels in general increase. Most goods are classified as normal goods. Included within this category are sports cars, luxury items, designer clothing, and a vast array of other goods far too numerous to list. Alternatively, a group of goods (and services for that matter) exists for which the demand will decrease as income levels in general increase. We refer to this classification of goods as inferior goods. Please realize that the classification title “inferior” has nothing to do with the relative quality of the good, merely how it is perceived by consumers. Consider a good you would no longer consume in the event you received an increase in compensation exceeding $20,000 per year. You have just identified a good you will consider to be inferior. Most generic goods in supermarkets are considered inferior in that the demand for these goods will diminish as affluence among the people who shop in these markets increases. We must also consider the other side of this situation. The demand for these goods increases as income levels decrease. When you become a poor college student your demand for certain goods such as many inexpensive microwaveable meals increases considerably. 8 Chapter 3: Demand, Supply, and Market Equilibrium Slide 19 Substitutes, Complements, and Independent Goods The way in which goods relate to other goods may impact demand as well. Substitute goods can be substituted for one another. An increase in the price of one will result in an increase in demand for the other. Complementary goods (or complements) are used together in consumption and are demanded jointly. Computers and software represent complements. As price for one rises, demand for the other will fall. In addition to substitutes and complements, we also recognize goods having no particular relational affiliation with other goods. In other words, the demand for these goods functions independently of other goods with which we compare them. We refer to this classification of goods and services as independents. Examples of independent goods includes: golf balls and butter, potatoes and automobiles, and bananas and wristwatches. Independent goods are not related in consumption and the price of one will have little or no effect on demand or price of the other. Chapter 3 19 Learning Objective 3-1 Slide 20 Change in Demand versus Change in Quantity Demanded Changes in demand always involve the demand curve shifting either inward or outward as depicted in slides 313 and 3-14. Alternatively, changes in quantity demanded do not involve any shift in a demand curve, merely a changing equilibrium along the same demand curve resulting from a shifting supply curve. We will visit this concept again and enable you to view the difference once we have integrated supply and equilibrium into our knowledge base. Chapter 3 We must now distinguish between a change in demand and a change in quantity demanded. Please recall when we indicated that a change in demand involved an inward or outward shift in the demand curve. Alternatively, a change in quantity demanded does not involve a shift in the demand curve, but a shift in a supply curve along a stable demand curve. In summary, a change in demand involves a shift in a demand curve, and a change in quantity demanded involves a shift in a supply curve, but no change in the demand curve. 20 Learning Objective 3-1 Slide 21 Supply and The Law of Supply Supply is a schedule or curve showing the amounts of a product that producers are willing and able to make available for sale at each of a series of possible prices during a specific period. The Law of Supply states that as price rises, the quantity supplied rises; and as price falls, the quantity supplied falls. • Note that the relationship between price and quantity is positive with supply whereas with demand the relationship is negative or indirect. You may have noticed that we mentioned something we had yet to introduce and explain in the previous slide; the concept of supply and the supply curve. Supply represents the counterpart to demand and together they bring a certain magic of sorts to market-based economic systems. Supply is defined as a schedule or curve showing the amounts of a product that producers are willing and able to make available for sale at each of a series of possible prices during a specific period. Supply has a supporting law as well. The Law of Supply states that as price rises, the quantity Chapter 3 21 supplied rises; and as prices falls, the quantity supplied falls. It is critical to note that the relationship Learning Objective 3-2 between price and quantity is a direct relationship. As price moves, quantity supplied moves in the same direction. Contrast this movement with the law of demand which depicts price and quantity moving adversely, or indirectly with one another. Therefore we say the relationship between price and quantity when studying supply is direct, or positive, and the 9 Chapter 3: Demand, Supply, and Market Equilibrium relationship between price and quantity when studying demand is indirect or negatively related. Supply curves also generally portray a positive slope, whereas demand curves normally possess a negative slope. A review of the appendix section involving graphs will both confirm and reinforce these conceptual relationships. Slide 22 Table 3.5 confirms the positive supply-based relationship between price and quantity. In precisely the same manner we observed with demand, information from the supply schedule for an individual producer is plotted on a graph and represents a supply curve. Supply Schedules and Supply Graphed An individual producer’s supply schedule (Table 3.5) represents the amounts he is willing and able to supply at the different price levels. Once plotted on a graph, this information becomes a supply curve for this single producer. Price per Bushel The slope of the normal supply curve is positive and gains elevation as we move along the base axis. S1 $5 $4 $3 $2 $1 5 Chapter 3 20 35 50 60 Quantity Supplied per Week 22 Learning Objective 3-2 Slide 23 Market Supply Table 3.6 represents the accumulated data of 200 producers and constitutes a limited market supply schedule. In a similar approach to determining market supply, we can observe producer responses in retrospect and derive an actual market supply curve. Table 3.6 represents a supply schedule of an entire market comprised of 200 individual producers. Derivation of a market supply curve is desirable because doing so enables us to study the current market and also speculate with regard to future possible changes in market supply and market demand. Market supply curves are derived just as market demand curves in that the market supply schedule data are plotted on a graph. Chapter 3 Slide 24 23 Learning Objective 3-2 Market Supply and Changes in Market Supply Supply curves and demand curves have a common denominator. Supply curves can shift either inward or The data plotted from the supply schedule on the previous slide (3-23) outward just as we observed with market demand curves. constitutes market supply and is represented by S1 . Alternatively S2 represents an increase in market supply (an outward shift) and S3 represents a decrease in market supply (an inward shift). Chapter 3 An outward shift from S1 to S2 represents an increase in supply. Alternatively, an inward shift from S1 to S3 represents a decrease in supply. 24 Learning Objective 3-2 10 Chapter 3: Demand, Supply, and Market Equilibrium Slide 25 An increase in supply from S1 to S2 represents an increase in supply. This increase may come about as a result of a number of different determinants, but most importantly the development equates to more of the good or service available at any price level in the current market. An Increase in Supply A shift in the supply curve from S1 to S2 represents an increase in supply and more is available of the good or service at every price level. There are a number of causes that can lead to an increase in supply. Chapter 3 25 Learning Objective 3-2 Slide 26 The list of possible causes of market supply increases includes changes in resource prices, technology, changes in tax and subsidy rates, changes in the prices of other goods, changes in price expectations, and the a changes in the number of sellers in the market. Determinants of Supply 1. 2. 3. 4. Resource Prices. Technology. Taxes and Subsidies. Prices of other (substitute or complementary) goods. 5. Price expectations. 6. The number of sellers in the market. Chapter 3 Let’s examine each determinant a bit more closely in hopes of explaining their respective impact on the process. 26 Learning Objective 3-2 Slide 27 Possible Causes of a Market Supply Increase 1. A decrease in the prices of resources used to produce the goods or services in the market. 2. Improvements in technology enabling higher productivity. 3. Lower taxes and/or higher subsidies for producers. 4. Higher prices for substitute and/or lower prices for complementary goods. 5. Changes in the expectation of prices in the future. 6. Changes in the prices of resources used in production to produce goods and services in the market may lead to a larger supply of finished goods available for sale. Lower prices for resources most often results in more finished goods in the market. Producers perceive an opportunity to increase net profit margins with lower production costs and increase production accordingly. An increase in the number of suppliers in the market. Chapter 3 27 Secondarily, gains in technological advancement sometimes lead to gains in productivity. In these instances, we are likely to experience more finished goods in the market as a result of either cost savings or increased efficiency. This is enabled by the advance in technology and gain in productivity. Learning Objective 3-2 Tax and subsidy rates also play a role in supply. Lower tax rates may result in higher supply levels of finished goods. Subsidy payments to producers also impact supply. Subsidized producers will deliver more finished goods to the market than those who are not subsidized, assuming all else is equal. 11 Chapter 3: Demand, Supply, and Market Equilibrium Changes in the prices of related goods may also have a bearing on the supply of another good. A decrease in the price of a related good will most likely lead to an increase in the supply of the good produced. For instance, a decrease in the price of ink jet printers will most likely lead to an increase in the supply of ink jet cartridges because the demand is likely to increase for replacement cartridges in the near future. Alternatively, a change in the price of a substitute good may impact supply a bit differently. If you are a cattle farmer, you may opt to increase production when an increase in the price of chicken occurs because you anticipate a forthcoming increase in the demand for beef. Changes in future price expectations may have a direct bearing on current supply as well. In the event we expect prices to fall in the future, we may seek to maximize current production and profits in the short-term time horizon through maximizing production. A final and most obvious determinant of supply involves changes in the number of suppliers in the market. It stands to reason that an increase in suppliers will lead to an increase in supply and a decrease in suppliers will most likely lead to a decrease in supply. Slide 28 A decrease in supply is signaled by an inward shift in the supply curve from S1 to S3. A number of different causes exist for a decrease in supply. A Decrease in Supply A shift in the market supply curve from S1 to S3 represents an decrease in supply. Although a few changes in supply can be identified as producer-induced since they represent a decrease in desire to produce, most are exogenous or external to producers and emanate from other causes. Less is available in the market at every price. There are also a number of causes that can lead to a decrease in supply. Chapter 3 28 Learning Objective 3-2 Slide 29 Possible Market Supply Decrease Causes 1. An increase in the price of resources used to produce the goods or services. 2. Increases in taxes or decreases in subsidy payments for producers. 3. Decreases in the prices of substitute goods or increases in the prices of complementary goods. 4. Changes in the price expectations for the future. 5. A decrease in the number of producers. Chapter 3 Learning Objective 3-2 29 Increases in the price or prices of resources will most likely lead to lower supply in the market. In these instances the least efficient producers are sometimes forced out of business in the short-term time horizon. Increases in taxes or decreases in subsidy payments usually lead to reductions in supply as well. An increase in taxes either partially or wholly borne by producers will result in lower supply. In addition, a reduction in subsidy payments to producers has the same net effect of raising production costs and will result in lower production rates too. Decreases in the prices of substitute goods will usually result in lower supply provided by current producers as well. A price reduction for a substitute good has the same net effect on producers as an increase in the cost of production of their own good. 12 Chapter 3: Demand, Supply, and Market Equilibrium In addition, an increase in the price of a complementary good will most likely dampen demand for that good and our good, too. For example, an increase in the price of ink jet printers will likely result in less demand for ink jet replacement cartridges. A higher expected price for the product we produce in the future will most likely result in lower supply today. This stands to reason in that producers will postpone production in hopes of earning higher profits in the future. In conclusion, a decrease in the number of producers will usually lead to a lower supply. Although existing producers may eventually absorb the production capacity of former competitors who went out of business eventually, in the short-term time horizon existing producers normally choose to maintain their current production plans. Slide 30 A Change in Supply versus A Change in Quantity Supplied Another essential step in developing our reasoning tools for supply and demand in the market includes learning to distinguish between a change in supply and a change in quantity supplied. A change in supply involves a shift inward (decrease) or outward (increase) of the supply curve. Alternatively, a change in quantity supplied does not involve a shift in the supply curve, merely movement along an existing supply curve (a shift in the demand curve). Chapter 3 A change in supply involves a shift, inward or outward, of the existing supply curve. A change in quantity supplied, on the other hand, involves a shift in a demand curve along the same supply curve. 30 Learning Objective 3-2 Slide 31 Market Equilibrium The point at which the market demand curve and market supply curves intersect is referred to as equilibrium. • The corresponding market price and quantity are also referred to as market equilibrium price and market equilibrium quantity. The market clears at this price as producers deliver this quantity and consumers purchase this quantity. • Please bear in mind neither are entirely satisfied in that producers would prefer to sell more at a higher price and consumers would prefer to consumer more at a lower price, but most importantly each accepts the terms of equilibrium and the market process continues to function efficiently. Chapter 3 31 Learning Objective 3-3 Now we are ready to combine supply and demand curves. Once we do so, the intersection point comprises market equilibrium for whatever good or service we are studying. Equilibrium means “at rest,” but in reality at rest has little to do with satisfaction. The truth of the matter is that consumers are not completely satisfied at equilibrium. They would prefer to consume more of the good at a lower price. Alternatively, producers are not entirely content at equilibrium, either. They would prefer to produce and sell more of the good at a higher price. In reality the market quantity clears and does so efficiently at equilibrium market price. A tendency exists for the market to resist moving away from equilibrium. A departure from equilibrium will only occur through a shift in the demand curve, the supply curve, or both simultaneously. Upon the occurrence of one of the three possibilities, a new equilibrium is established and the process begins anew. 13 Chapter 3: Demand, Supply, and Market Equilibrium Slide 32: Combining supply and demand curves for a single good or service also allows us to build a market schedule such as the one depicted in Table 3.8. A Market Supply and Demand Schedule Our corresponding table represents a market supply and demand schedule. Please note there is only one price level at which there is no surplus or shortage of quantity and this corresponds with equilibrium. We can determine equilibrium at a precursory glance in that supply and demand are equal at that level. Equilibrium price is $3 and equilibrium quantity is 7,000. All other price levels would result in either a surplus or shortage of the good available in this market. Prices higher than $3 will result in surplus quantities supplied and prices less than $3 will result in shortages of corn. Chapter 3 Slide 33 32 The illustration of market equilibrium in this instance is once again, merely data transferred from the market schedule to graphical format. Once the transfer process is complete, it becomes apparent what is meant regarding shortages and surpluses that occur outside equilibrium. Market Supply and Demand Graphed Plotting data from our market supply and demand schedule to a graph provides a visual illustration of not only equilibrium, but also the disparity created by higher and lower prices in the market which results in production shortages and surpluses. Chapter 3 33 A market forced to function outside natural equilibrium is said to be in disequilibrium. It is critical to distinguish between disequilibrium, when market prices are controlled, and natural changes in equilibrium occurring when it migrates to higher or lower points as a result of changes in demand and supply. Learning Objective 3-3 Slide 34 A Change in Equilibrium due to an Increase in Demand The graphical illustration on slide 3-34 represents a shift to a higher equilibrium caused by an increase in market demand. Note the increase in market demand is represented by the upward and outward shift of the demand curve from D1 to D2. Increase in Demand A shift in either a demand curve or supply curve represents a change in equilibrium. The higher equilibrium corresponds with a move to a higher price level, from P1 to P2, a larger quantity supplied from Q1 to Q2, but no change or shift in our supply curve. Please review this illustration and commit it to your memory as an increase in market demand. The increase in demand in the adjacent graph results in a higher equilibrium quantity supplied (from Q1 to Q2 ) and a higher equilibrium price (from P1 to P2 ). Chapter 3 34 Learning Objective 3-4 14 Chapter 3: Demand, Supply, and Market Equilibrium Slide 35 A Change in Equilibrium due to a Decrease in Demand Market demand curves also shift inward at times and move the market to a new lower equilibrium level. The illustration on slide 3-35 depicts this inward shift in the market demand curve from D1 to D2 . Demand decreases from D1 to D2 and results in a lower equilibrium quantity supplied (from Q1 to Q2 ) and lower equilibrium price (from P1 to P2 ). This reduction in market demand moves the market to a lower price level, P1 to P2 , and a lower quantity supplied, Q1 to Q2 . Please commit this example to your memory as a decrease in market supply. Chapter 3 Learning Objective 3-4 Slide 36 A Change in Equilibrium due to a Decrease in Supply Market equilibrium also responds to changes in supply as well. The illustration on slide 3-36 represents a decrease in market supply in that the supply curve shifts inward from S1 to S2 . A decrease in supply results in an inward shift of the supply curve from S1 to S2 . The new equilibrium results in market price shifting upward from P1 to P2 and market quantity demanded decreasing from S1 to S2. Please commit this scenario to your memory as a decrease in market supply. Consequently equilibrium price rises (P1 to P2 ) and equilibrium quantity demanded falls (Q1 to Q2 ). Chapter 3 36 Learning Objective 3-4 Slide 37 A Change in Equilibrium due to an Increase in Supply Our final illustration of a change in market equilibrium is illustrated on slide 3-37 and represents an increase in market supply. An increase in supply results in an outward shift of the supply curve from S1 to S2 and as a result equilibrium price decreases (P1 to P2 ) and equilibrium quantity demanded increases as well (Q1 to Q2 ). The supply curve shifts outward from S1 to S2 moving the market to a lower equilibrium level, lower price level as price moves from P1 to P2 , and a lower quantity demanded as it moves from Q1 to Q2 . Please commit this scenario to your memory as an increase in supply. Chapter 3 37 Learning Objective 3-4 15 Chapter 3: Demand, Supply, and Market Equilibrium Slide 38 Can Supply and Demand Curves Both Shift? Logic suggests this is so. Consider the example of a weather-induced supply shock. Hurricanes sweep ashore several times each year in our nation. The resulting damage they leave in their wake often results in an increase in demand for building materials needed to repair damage. In addition, when they strike areas that manufacture building materials, such as Georgia, we may also experience a simultaneous decrease in supply. Chapter 3 38 Learning Objective 3-4 Until now we have only observed instances in which one curve, supply or demand, shifts. We have reviewed the associated changes accompanying the change in either supply or demand. A question commonly emerges at this juncture. Is it possible for both market supply and market demand curves to either shift simultaneously, or within a very short time of one another? The answer to this question is a resounding “yes”. However this does not commonly occur. One instance of this phenomenon is found when observing the impact of hurricanes in limited geographical regions. The material damage inflicted by these storms often results in an immediate increase in regional market demand for most building materials. In addition, in those areas most impacted by the storm, supplies in inventory are often damaged and the result is not only a regional increase in market demand, but also a decrease in available market supply for building materials. Slide 39: Slide 3-39 represents a graphical illustration of the simultaneous shifts in market demand and market supply curves. Please note, in this instance we have portrayed market demand as having shifted momentarily ahead of market supply from D1 to D2. As a matter of order, we must portray one or the other as having moved first for the sake of practicality. The increase in demand results in a higher price and we observe market price increasing first from P1 to P2. Secondarily we observe market price advancing from P2 to P3 as a result of the shift in the supply curve. Market quantity demanded moves from Q1 to Q3 as a result of the outward shift in the market demand curve, and then from Q3 to Q2 as a result of the shift in the market supply curve. (NOTE: The narrator says Q1 to Q2 and Q2 to Q3, but this is incorrect. The end point is Q2, not Q3.) Please bear in mind, however that we merely portrayed demand as having shifted slightly ahead of market supply for the sake of practicality. Realistically, the storm resulted in a simultaneous increase in market demand as a result of the damage inflicted and a decrease in market supply as a result of damaged merchandise inventory in the retail sector of this area. Learning Objective 3-4 Hurricane Impact on Supply and Demand Illustrated The initial market response to a hurricane is an increase in demand for building materials (D1 to D2 ). Subsequently, supply may decrease (shift inward from S1 to S2 ) as a result of lost production capacity. Price S2 S1 P3 P2 P1 D2 D1 Please note the rise in price from P1 to P2 as a result of the increase in demand and the increase from P2 to P3 as a result of the decrease in supply. Chapter 3 Q1 Q2 Q3 Quantity 39 16 Chapter 3: Demand, Supply, and Market Equilibrium Slide 40 Changes in Supply and Demand Curves Simultaneously Chapter 3 Learning Objective 3-4 Slide 41 40 Table 3-9 provides a brief overview of the impacts of simultaneous shifts in curves and delineates what one can expect and could only be determined from analysis. For instance, an increase in supply and a decrease in demand will absolutely result in a lower price level, but the associated change in quantity will depend on how much each curve shifts. There may be an increase in quantity, a decrease in quantity, or it may remain the same, it all depends on how much each curve shifts. The table goes on to identify what may be observed with the other three possible scenarios as well. A decrease in supply and an increase in demand will result in an increase in price, but quantity effects will depend on the degree of shift in each curve. Please note that a great deal of geometric balance is inherent in economic reasoning in that the roles reverse as the shifts in the curves change. I encourage you to draw each instance out and observe the predictions. Becoming comfortable developing simple graphical illustrations is a great strategy for enhancing test performance in economics because doing so shifts us from verbal to controllable visual perspectives. We briefly referred to disequilibrium a bit earlier in this section. We will now revisit the concept and analyze what is meant by disequilibrium on a deeper On occasion government bodies become politically level. By this time you should be catching on to the sensitive to pressures from the public with regard to fact that our market system functions best with no prices in the market that are perceived to be exorbitant. outside intervention. Automated systems usually In response, government will impose price ceilings at don’t respond favorably to external manipulation and that is the situation in our own market economy, too. times which results in market disequilibrium. Disequilibrium due to Government Imposed Price Ceilings We can observe the impact of such price controls by studying rent controls in major cities. Rent controls distort price signals in the market and result in rental property shortages. Chapter 3 Learning Objective 3-5 In contrast, there are times when our market system is manipulated by government and doing so creates disequilibrium and introduces inefficiency into the process. There are two instances in which this occurs. The first occurs when government imposes a 41 price ceiling. One such example is found when rental rates in metropolitan markets are capped through legislation or ordinances. The resulting response in the market is often very inefficient. One can deduce quickly that the wrong signals are sent to the market because consumers would be inclined to demand more housing at the lower ceiling rental rate than the market will provide. This is precisely what we observe when viewing the impact of price ceilings from a graphical perspective as well. 17 Chapter 3: Demand, Supply, and Market Equilibrium Slide 42: The illustration on slide 3-42 depicts normal equilibrium, or the market equilibrium that would exist without a price ceiling as Po and Qo , and a price level of $2.50. Observe what happens when a price ceiling is imposed at the $2.00 per unit rate. Producers are prompted to naturally supply the quantity directly beneath the point at which the price ceiling line intersects the supply curve, Qs . Alternatively, consumers are prompted to demand and consume the quantity directly beneath the point at which the price ceiling line intersects the demand curve, Qd . Therefore the difference between Qs and Qd represents the shortage that will exist in the market. It can be easily measured quantitatively by observing this quantitative difference on the graph. In summary, price ceilings create perennial shortages. Price Ceilings and Shortages Graphed Po and Qo represent normal equilibrium. Pc is the price at which the price ceiling is imposed. Note the price ceiling price sends the signal for suppliers to produce Qs and signals consumers to demand Qd , resulting in the quantitative shortage measured from Qs to Qd. Learning Objective 3-5 Price ceilings result in persistent shortages! Chapter 3 Slide 43 42 Disequilibrium due to Government Imposed Price Floors Our other example of market disequilibrium occurs when governmental price floors are imposed in markets. Much of American agriculture has experienced the impact of this policy over the past several decades. Legislation is passed favoring payments to producers which equates to an arbitrary price floor. Some American agricultural producers receive subsidy payments for their production. In a very real sense, these payments constitute a price floor at a level above market equilibrium price and as such producers are prompted to produce an amount exceeding equilibrium quantity. Chapter 3 43 Producers receive actual market price for their product when selling in the open market, then the government programs provide additional payments on a per unit of production basis. The profitmaximizing perspective of this system provides the incentive for producers to maximize production, and thus also maximize subsidy payments too. Learning Objective 3-5 This extra compensation serves the same function as imposing a price floor in the market and disequilibrium is the result. 18 Chapter 3: Demand, Supply, and Market Equilibrium Slide 44 The graphical illustration depicted on slide 3-44 provides a visual perspective of the impact of a price floor in the market. Consumers are prompted to consume the quantity lying directly beneath the point at which the price floor line intersects the demand curve, Qd. Producers are prompted to supply the quantity directly beneath the point at which the price floor line intersects the supply curve, Qs . The natural market equilibrium which would occur without the existence of a price floor is Po and Qo . Please note that the quantitative difference between Qd and Qs represents the measurable quantity of surplus production the market will provide. This prediction is consistent with our observed reality in the farm example. We have experienced a number of years in which production has exceeded consumption. This results in inventory stocks of feed grains having to be carried forward at the expense of the taxpayer. In summary, price floors create surplus production. Price Floors and Surplus Production Graphed Learning Objective 3-5 Once again, Po and Qo represent normal equilibrium. A government imposed price floor at $3 sends the signals for consumers to demand Qd and producers to supply Qs. The quantity as measured from Qd to Qs represents the persistent surplus production of this commodity. Slide 45 Chapter 3 44 It would seem price ceilings represent the best interest of the public. Is this so? No. Price ceilings do allow a certain group of people the luxury of lower prices for housing. • Unfortunately, price ceilings also result in property developers seeking other areas to build housing and current landlords deferring maintenance and renovation for existing property in rent controlled areas resulting in an area shortage that does not benefit the general public. In addition, there are no market incentives to build more property in rent-controlled zones. Over time shortages appear and even those initial consumers who were benefiting from the lower rental rate eventually lose their benefit. • The natural market process (equilibrium without interference) will work these issues out much more efficiently over time. Chapter 3 One might be tempted to perceive price ceilings to be favorable for consumers and in fact, a rent freeze does tend to benefit the few consumers who receive favorable rental rates. However over time, landlords tend to neglect maintenance on rent-controlled properties as a means of offsetting some of the losses incurred with the imposition of the ceiling. 45 Learning Objective 3-5 19 Chapter 3: Demand, Supply, and Market Equilibrium Slide 46 It seems that price floors keep more producers in business and simultaneously result in lower market prices for consumers. Is this so? In addition, one might be tempted to perceive that price floors assure that we have adequate food stocks in the feed grain sector even in lean years and doing so is in the best interest of the public. This might be the case on very rare occasions, but in most years surplus production has resulted in the problematic process of dealing with excess inventory. Price floors do keep more producers in business and also keep market prices lower for these commodities as well. • However, the true cost of price floors is not revealed until we consider the increase in tax burden created by subsidy payments to producers. • Consumers gain nothing (and most likely experience a net loss) because we pay in the market and we pay through taxes that are redistributed to producers. • Equilibrium in the market would be much more efficient and even though some less efficient producers would fail, the net cost to consumers would be less without price floors. Chapter 3 46 Learning Objective 3-5 Although it is true that consumers would most likely pay more for major feed grains in the event price floors were eliminated, alternatively there would be no tax redistribution to farmers either and the system would become inherently more efficient again. The question for consumers is more a matter of whether to pay in the market with a market system, or pay in the market and in taxes for the subsidized system. The most critical point is that the true cost is not captured by the price paid in consumption. In conclusion of this topic, price floors and price ceilings are inefficient processes. Slide 47 The Common Denominator of Price Ceilings and Price Floors Price ceilings and price floors share a common denominator. • Each blocks the function of price in the market and interjects substantial inefficiency in the exchange process. • The eventual result, as you have already observed, is loss of equilibrium and confusion with regard to how much of the good or service consumers will demand and suppliers will provide. • Viewing the inefficiencies of price floors and ceilings enables us to reciprocally acknowledge the degree of efficiency that natural market equilibrium provides. Chapter 3 Learning Objective 3-5 We must reemphasize one very critical point as we complete this section on supply and demand in the market. Market-based economic systems rely on supply and demand to send signals to both producers and consumers automatically in order to remain efficient. At any point this signal-sending process becomes diverted, the system reverts to inefficiencies. This observation is consistent with our review of price ceilings and price floors. Once these manipulative schemes are in place, the signals sent by price in the market no longer perform their intended function and market failure is the result. In summary, price ceilings and price floors lead to market failure due to the loss of information conveying capacity in the market. 20 ...
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