Introduction to microeconomics

Lecture 3
Supply and demand
 The marginal and cost-benefit
principles
• http://www.economist.com/multimedia?bclid
=1777382270001&bctid=1722339398001
• What cost benefit principle is being
discussed”?
• Express this in marginal terms
• How does opportunity cost relate to this
problem?
• What do you need to improve decisions?
 Core ideas
• What is an economic model?
• The nature of supply
– Price as the “prime independent” variable
– Shift in supply (the other independent variables)
• The nature of demand
– Price as the “prime independent” variable
– Shift in demand (the other independent variables)
• The market place model (scissors) – ceteris paribus again
• Key assumption - Consumer and producer sovereignty ( freedom to
transact)
• The concept of the “scissors” and equilibrium
• Key assumption – Many buyers and sellers
• Shifts in demand and supply change equilibrium price and quantity
• Key assumption – Information is costless
 The market
• A market is any exchange of goods and services
– Labour market (university teaching, hiring at Burger King, …)
– Services (information, sports, sec trade…)
– Goods (wheat, oil….)
• A market unites willing buyers and willing sellers
• Markets may be periodic (auction for art, labour market) or
continuous (world market for oil)
– Depends on the institutional arrangements
– Markets exist only when transactions occur
– Example: Once I accepted the job at U of M (in 1974), I did not
continuously re-negotiate my wage every day
Why not?
 Supply
• Each seller needs to cover the costs of creating the
goods/services for sale
• The higher the price the higher the net return (price –
costs)
• Each seller has a reservation price (a price too low to
cover costs)
• Different sellers will have different costs
• Therefore, as price rises (just how to be discussed), new and
higher cost sellers are attracted to the market (Why?)
• The total volume (quantity) of goods and services
supplied increases.
 Figure 3.1: the Supply Curve of Hamburgers

The supply curve is upward

sloping.

Price

A supply curve shows the

relationship between price
and quantity supplied
Quantity

Copyright © 2012 McGraw-

Ch3-6 LO2: Market Supply
Hill Ryerson Limited
 Key assumption of a supply curve
• Costs for each seller remain static (But different sellers probably
have different costs)
• The supply “curve” (we are using a straight line for simplicity) applies
at a point in time (comparative statics)
• The upward slope also reflects opportunity costs (lower
sellers that do not increase the volume of goods offered,
give up higher net returns.
• Therefore as price rises
– New higher cost sellers come into the market
– Existing sellers find ways to increase the volume of goods
offered to not incur the lost of higher net returns (i.e. avoid the
opportunity cost of giving up net revenue)
• Price is the main independent variable
 The Math of the Supply Curve
• The supply curve could also be written
algebraically
Qs = a + bPs
– The parameter a is the horizontal intercept
– The parameter b is the reciprocal of the slope of the
supply curve
– The plus sign indicates a direct, positive relationship
between quantity supplied and price
• Based on Figure 3.1, a = 0 and b =4
Qs = 4Ps
If price increases by one dollar, quantity supplied will increase by 4000 hamburgers
 The other independent variables for
supply
• What other factors affect supply?
– Technology
–
–
• Changes in these other independent variables shift the
supply relationship
– For any given price, supply increases/decreases because
• Technology has lowered/raised cost
• …
• …
• Qs = a + bPs + c(rain) … (droughts reduce supply of wheat)
 Increase in supply due to technical
change
S0 S1
Price

• Technology lowers costs

• Shift supply to right
P0 • Increases amount
supplier at every price.
• Allows new sellers to
enter
• Encourages existing
sellers to increase
amount offered

Q0 Q1 Quantity
 Demand
• Each consumer develops an assessment of value for every
good/service offered
• For most of us, we have a value of “0” for most goods (we are
completely uninterested)
– If ballet shoes were $0, I would not be tempted!
– My granddaughter would take hundreds (especially the pink ones)
• Consumers have a reservation price (a price to high to induce
purchase)
• Different consumers have different valuations of a good
• As the price falls, consumers with lower valuations enter and
register their demand
• As price falls, existing consumers register increased demand
(opportunity cost again)
– At $500 a single iPhone 5 is purchased
– At $50, why not get a back-up and one for the spouse?
 Figure 3.2: the Demand Curve of Hamburgers
A Demand curve shows the
relationship between price and
quantity demanded

The demand curve is downward

sloping

Price

Quantity

Copyright © 2012 McGraw-

LO3: Market Demand Ch3-12
Hill Ryerson Limited
 The math of the demand curve
• The demand curve could also be written
algebraically
Qd = c - dPd
– The parameter c is the horizontal intercept
– The parameter d is the reciprocal of the slope of the
demand curve
– The minus sign indicates a negative relationship
between quantity demanded and price
• Based on Figure 3.2, c = 24 and d =4
Qd = 24 - 4Pd
If price increases by one dollar, quantity demanded will decrease by 4000 hamburgers
 The other independent variables of
demand
• Demand is affected by
– Increases in income
–…
• … Changes in these other independent variables shift
the demand relationship
– For any given price, demand increases/decreases because
• Income has increases/decreases
• …
• …
• QD = a + bPD + c(income) … (income increases shift demand out
for every given price
 Increase in demand to income
increase • Income increases allow
consumers to raise
D0 D1 reservation price
• Demand shifts to right
Price

• Increases amount
demanded at every
price.
• Allows new consumers
P0 to enter
• Encourages existing
consumers increase
amount demanded

Q0 Q1 Quantity
 Figure 3.3: the Equilibrium of Hamburgers
Market equilibrium occurs when all buyers
and sellers are satisfied with their respective
quantities at the market price

Copyright © 2012 McGraw-

LO4: Market Equilibrium Ch3-16
Hill Ryerson Limited
 FIGURE 3.4: Excess Supply
Excess supply = 8000 hamburgers/day
Supply

Demand

Copyright © 2012 McGraw-

LO4: Market Equilibrium Ch3-17
Hill Ryerson Limited
 Excess Supply
• More sellers arrive with hamburgers
• They are willing to supply 16 at the current price ($4),
but consumers are willing to purchase only 8
• Sellers have a choice
– Allow 8 burgers to spoil, feed them to the dogs, or give to
Winnipeg Harvest (getting $0 for each burger donated)
– Dropping price (sellers with low costs will still make some money and
sellers with high costs will cover some of their outlays even though the cost of
a burger is higher than the price)
– High cost sellers will lead the way in lowering price, forcing
other low cost sellers to match the lower price (or risk losing
all their sales).
– Over time, high cost sellers may be forced out of business.
 FIGURE 3.5: Excess Demand
Supply

Excess demand = 8000 hamburgers/day

Demand

Copyright © 2012 McGraw-

LO4: Market Equilibrium Ch3-19
Hill Ryerson Limited
 Excess Demand
• More consumers register their demand than
sellers can satisfy
• At the price of $2 consumers demand 16
burgers, but suppliers are willing to offer
• An alert seller notices that burgers are “flying
off the grill” and raises the price (opportunity
cost)
 Box 3.3: Market Equilibrium
Supply equals Demand

• The supply curve Qs = a + bPs

• The demand curve Qd = c – dPd
• Qs = Qd a + bPs = c – dPd
P* 
c  a
• Therefore b  d 
• Substitute P* into the supply/demand equation

 ca 
It is common to denote Q*  c  d   
equilibrium points by * bd 

Copyright © 2012 McGraw-

LO4: Market Equilibrium Ch3-21
Hill Ryerson Limited
 Box 3.3: Market Equilibrium
Supply equals Demand (Example)

• The supply curve Qs = 0 + 4Ps

• The demand curve Qd = 24 – 4Pd
• Qs = Qd 0 + 4Ps = 24 – 4Pd
P* 
24  0
 $3
• Therefore 4  4
• Substitute P* into the supply equation

Q*  0  4  3  12

Copyright © 2012 McGraw-

LO4: Market Equilibrium Ch3-22
Hill Ryerson Limited
 Equilibrium price and quantity
• The intersection od
demand and supply
D0 shows the market
S0
equilibrium
Price

• Sellers who price above

P*will lose all their
customers
P* • Sellers that price below
P* are giving up revenue

Q* Quantity
 Sellers that undercut the market
• Seller A decides to sell at
PA.
D0 • Recall that this model
S0
assumes that there are
Price

many buyers and sellers

• Seller A is a very small
portion of the market
and will not influence P*
P* • Seller A gives up
a b rectangle abcd
• No other seller will
d c
follow since that can sell
everything at P*

Q* Quantity
 The Effect on the Market for New Houses of a Decline in the
Price of Lumber
S
S′

160
150
D

40 50

When input prices fall, supply shifts right, causing

equilibrium price to fall and equilibrium quantity to
rise.

© 2012 McGraw-Hill Ryerson Limited LO6: Shifts in Supply and Demand Ch3-25
 Effect of Technical Change on the Market for French Fries

When new technology reduces the cost of production, supply shifts

right, causing the equilibrium price to fall and the equilibrium
quantity to rise.

© 2012 McGraw-Hill Ryerson Limited LO6: Shifts in Supply and Demand Ch3-26
 Substitutes and complements
Substitute (Good A and B) Complement (Good A and B)
• Goods and services • Goods and services that must
consumers see as equivalent be consumed jointly (car and
(iPhone and Blackberry) gas)
• Perfect substitutes • A price increase/decrease in A
• Imperfect substitutes causes a decrease/increase in
demand for Good B
• Price increase/decrease in
Good A will create a
increase/decrease in
demand for Good B

The “coupling” between good A and good B is a measure of their

substitutability or complementarity
 FIGURE 3.9: The Effect on the Market for Tennis Balls of a Decline in
Court Rental Fees

S
1.40

1.00

D′
D

40 58

When the price of a good’s complement falls, demand

for the good shifts right, causing equilibrium price and
quantity to rise.

© 2012 McGraw-Hill Ryerson Limited LO6: Shifts in Supply and Demand Ch3-28
 FIGURE 3.10: Effect on the Market for Overnight Letter Delivery
of a Decline in the Price of Internet Access

When the price of a substitute for a

good falls, demand for the good shifts
P left, causing equilibrium price and
quantity to fall.
P′

D
D′

Q Q′

© 2012 McGraw-Hill Ryerson Limited LO6: Shifts in Supply and Demand Ch3-29
 FIGURE 3.12: Four Simple Rules
An increase in A decrease in
demand will lead to demand will lead to a
an increase in both decrease in both
the equilibrium price equilibrium price and
and quantity. quantity.

An increase in supply A decrease in supply

will lead to a will lead to an
decrease in the increase in the
equilibrium price and equilibrium price and
an increase in the a decrease in the
equilibrium quantity. equilibrium quantity.

© 2012 McGraw-Hill Ryerson Limited LO6: Shifts in Supply and Demand Ch3-30
 FIGURE 3.14: Seasonal Variation in the Air Travel and Corn Markets

SW

SS
S PW

PS PS

PW DS

DW D

QW QS QW QS

Prices are highest during the Prices are lowest during the period of
period of heaviest heaviest consumption when heavy
consumption and are the consumption is the result of high
result of high demand. supply.

© 2012 McGraw-Hill Ryerson Limited LO6: Shifts in Supply and Demand Ch3-31
 Model Assumptions
1. All participants small - that no single buyer or
seller can influence price.
2. Buyers or sellers cannot form combinations
(monopoly) that can influence price.
3. Suppliers provide an identical product;
4. Information on price and quality of the
good/service is freely available to all buyers and
sellers.
5. Transactions are easy - buyers and sellers meet
easily to conduct transactions.
• Write down a trade-off you made today. In
hindsight did you make the right choice?
• Why do some university courses have waiting
lists after the first day of registration, while
others never fill up? (The price is constant
across courses, while the demand for courses
and the number of seats available are
different.)
 Problem
In 2010, the March price of strawberries (US) was $1.25/lb.
compared to $3.49 in 2009. Some growers ploughed the fields
and started to grow melons; others froze their harvest and
sold their output to jam and juice processors.

a. Is this a rational strategy – why/why not (what are the

assumptions)
b. What would have happened if growers offered consumers
a “pick for free” option (hint: who would have
participated, what would have happened to the available
supply; what costs does a grower have?)
c. What is the impact on the costs facing jam/juice
producers?
 # 15 p 75
• Since both the demand and supply curves for tofu
have shifted to the right, the equilibrium quantity
of tofu sold is higher than before. The equilibrium
price may be either higher (left panel) or lower
(right panel).
•
Price Price
($/kg) ($/kg)
S S' S
S'
P' P
P P'
D' D'
D
D
Q Q' Millions of Q Q' Millions of
kg per month kg per month
 #17, p75
• It is not appropriate to use supply and demand in this case
because there is only one supplier and because price is
determined by a regulatory authority. Price is not
determined by an equilibrium of supply with demand.
 Problem
Price
a. What are the equilibrium price and
quantity in this market?
7 b. What is the state of the market when the
price is $3?
c. What is the state of the market when the
5 price is $7?
d. If price in this market is $7, explain the
3 adjustment process that will bring the
market back to equilibrium.

100 175 225 Quantity

Answers
a. Equilibrium P = $5 and equilibrium Q = 175
b. A shortage (excess demand) of 120
c. A surplus (excess supply) of 120
d. The surplus of 120 signals firms to lower the price, which reduces the
quantity supplied and increases the quantity demanded until the
equilibrium price of $5 is reached.
WINNIPEG CHICAGO CORN
CANOLA