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Basic Economic Concepts Demand, Supply, and Equilibrium 1 a Market Basic Economic Concepts Demand, Supply, and Equilibrium A market is an institution or mechanism that brings together buyers (demanders) and sellers (suppliers) of particular goods and services. A market may be local (particularly in microeconomics), national, or international in scope. On the macroeconomic end only, we’re concerned with competitive markets with a large number of independent buyers and sellers. Individually, each of these buyers and sellers are so small that they cannot affect the price of the product. Together, they can destroy it. Demand. The law of demand states, all other things equal, that for all goods and services, when the price increases, quantity demanded will decrease. When the price decreases, quantity demanded will increase. Mathematically, this is represented by an inverse relationship in a demand curve or demand schedule. Movement along the demand curve. All other things equal, a change in price will cause a corresponding change in quantity demanded. If it’s a change in ANYTHING ELSE OTHER THAN PRICE, it’s not a movement along the curve, but a shift of the entire curve. 1 Basic Economic Concepts Demand, Supply, and Equilibrium Shifts of the demand curve. Certain events can cause a shift of the entire demand curve. If demand increases, the demand curve shifts to the right. At any price, consumers wish to buy more. If demand decreases, the demand curve shifts to the left. At any price, consumers wish to buy less. Causes of shifts of the demand curve: MERIT 1. Market size (Population). More buyers lead to an increase in demand; fewer buyers lead to decrease. Demand for prescription drugs has increased, as the population has grown older. Demand for infant formula would decrease if families had fewer babies. 2. Expectations. Consumers have expectations about future prices, product availability, and income, and these expectations can shift demand. If I expect the price of gas to decrease next week, my demand for gas will decrease this week. I will wait for the price to fall. If I take a new job and expect my salary to rise next month, I may increase my demand for a new suit today. 2 Basic Economic Concepts Demand, Supply, and Equilibrium 3. Related goods Substitute goods—a rise in the price of one good leads to an increase in demand for other good, and vice versa. If the price of Nike rises, demand for New Balance shifts to the right. If the price of Nike decreases, demand for New Balance would shift to the left. Complementary goods—a rise in the price of one good leads to a decrease in the demand for other good, and vice versa. If the price of shoes rises, demand for socks will shift to left. If the price of shoes decreases, demand for socks will shift to the right. 4. Income Normal goods Income increases: Demand for normal goods increases. Example: a rise in income increases demand for a normal good: steak, iPods. Income decreases: Demand for normal goods decreases. Inferior goods Income increases: Demand for inferior goods decreases. Example: a rise in income decreases demand for an inferior good: second-hand goods, generics Income decreases: Demand for inferior goods increases. 5. Tastes. Favorable change in tastes leads to an increase in demand; unfavorable change to a decrease. 3 Basic Economic Concepts Demand, Supply, and Equilibrium 4 Basic Economic Concepts Demand, Supply, and Equilibrium Supply. The law of supply says that, other things being equal, when the price increases, the quantity supplied will increase. When the price decreases, quantity supplied will decrease. Mathematically, this is represented by a direct relationship in the supply curve or supply schedule. Movement along the supply curve. All other things equal, a change in price will cause a corresponding change in quantity supplied. If it’s a change in ANYTHING ELSE OTHER THAN PRICE, it’s not a movement along the curve, but a shift of the entire curve. 5 Basic Economic Concepts Demand, Supply, and Equilibrium Shifts of the Supply Curve. Certain events can cause a shift of the entire supply curve. If supply has increased, it has shifted right. At any price, firms want to produce more. If supply has decreased, it has shifted left. At any price, firms want to produce less. Causes of shifts of the supply curve (RECITe) 1. Related goods or services. If the price of a substitute production good rises, producers might shift production toward the higher priced good causing a decrease in supply of the original good, and vice versa. If the price of a complementary production good rises, producers will decrease their use of the complement, causing a decrease in supply of the original good, and vice versa. a. An increase in the price of soybeans may cause a farmer to decrease the supply of corn. 2. Expectations. Expectations about the future price of a product can cause producers to increase or decrease current supply. a. Expectations of higher corn prices (next month) may cause farmers to decrease supply to the market today. 3. Competition (population). Generally, the larger the number of sellers the greater the supply, and vice versa. 4. Input (Resource) prices. A rise in an input price will cause a decrease in supply or leftward shift in supply curve; a decrease in an input price will cause an increase in supply or rightward shift in the supply curve. The issue is production cost. If the cost of production goes up, then producers will produce less. If the cost of production decreases, then producers will produce more. a. An increase in the price of fertilizer would cause a decrease in supply of corn. 5. Technology. A technological improvement means more efficient production and lower costs, so an increase in supply or rightward shift in the curve results. a. Genetically improved seeds will increase supply of corn. 6 Basic Economic Concepts Demand, Supply, and Equilibrium 7 Basic Economic Concepts Demand, Supply, and Equilibrium Equilibrium. An economy is in equilibrium when both demand and supply are met. An individual, either consumer or producer, would be no better off buying or producing at a different price. Equilibrium price occurs at the intersection of price and quantity demanded and supplied. Equilibrium quantity is the quantity of good bought and sold at equilibrium price. Surplus exists when the quantity supplied exceeds quantity demanded. Surpluses occur when the price is above its equilibrium level. At current price, there are no consumers who want to purchase. The surplus creates an incentive for sellers to lower price in order to attract business from other producers and get more consumers to buy. The result will be to push the price down until it reaches equilibrium. The price of a good will fall whenever there is a surplus—market price is above equilibrium. Surplus = QS - QD Shortage exists when quantity demanded exceeds quantity supplied. Shortages occur when price is below equilibrium level. At current price, there are no producers who want to produce. The shortage creates an incentive for consumers to offer more for the product and sellers will increase their price. The result is to drive up the price until it reaches equilibrium. The price of a good will rise whenever there is a shortage—market price is below equilibrium. Shortage = QD - QS 8 Basic Economic Concepts Demand, Supply, and Equilibrium Changes in Equilibrium For the AP Exam, you must be able to do the following: 1. What is causing the shift in the market? 2. What curve is shifting and in what direction? 3. What happens to equilibrium price and quantity? Shift of the demand curve Increase in demand. Initially, equilibrium is at the intersection of D1 and S. When there is an increase in demand, the demand curve will shift to the right from D1 to D2. After the initial increase, a shortage is created along P1 to D2. Shortage puts pressure on the price to move upward. As price increases to P2, Q will increase along S until P and Q are at equilibrium where D2 and S intersect (P2, Q2). P increases, Q increases. Decrease in demand. Initially, equilibrium is at the intersection of D1 and S. When there is a decrease in demand, the demand curve will shift to the left from D1 to D2. After the initial decrease, a surplus is created along P1. Surplus puts pressure on the price to move downward. As price decreases to P2, Q will decrease along S until P and Q are at equilibrium where D2 and S intersect (P2, Q2). P decreases, QD decreases. 9 Basic Economic Concepts Demand, Supply, and Equilibrium Shift of the Supply Curve Increase in Supply. Initially, equilibrium is at intersection of S1 and D. When there is an increase in supply, the supply curve will shift right from S1 to S2. After the initial increase, a surplus is created along P1. Surplus puts pressure on the price to move downward. As price decreases to P2, Q will decrease along D until P and Q are at equilibrium where S2 and D intersect. Price decreases, Q increases. Decrease in Supply. Initially, equilibrium is at S1 and D. When there is a decrease in supply, the supply curve will shift left from S1 to S2. After the initial decrease, a shortage is created along P1. Shortage puts pressure on the price to move upward. As price increases to P2, Q will increase along D until P and Q are at equilibrium where S2 and D intersect. Price increases, Q decreases. Summary Increase in Demand. P increases, Q increases. Decrease in Demand. P decreases, Q decreases. Increase in Supply. P decreases, Q increases.
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