Fall 97 Principles of Microeconomics slide 1

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R. Larry Reynolds
Fall 97 Principles of Microeconomics slide 2
Demand and Supply
Markets as allocative mechanism require:
nonattenuated property rights
[exclusive, enforceable, transferable]
voluntary transactions
Markets include all potential buyers and
sellers
behavior of buyers is represented by demand
[benefits side of model]
behavior of sellers is represented by supply
[cost side of model]
Fall 97 Principles of Microeconomics slide 3
Markets, Supply and Demand
markets include all potential buyers
and sellers
geographic boundaries of market
markets defined by nature of product
and characteristics of buyers
conditions of entry into market
markets, competition and substitutes
Fall 97 Principles of Microeconomics slide 4
Demand
Definition: A schedule of the quantities
of a good that buyers are willing and able
to purchase at each possible price during a
period of time, ceteris paribus. [all other
things held constant]
Demand can also be perceived as a schedule
of the maximum prices buyers are willing
and able to pay for each unit of a good.
Fall 97 Principles of Microeconomics slide 5
Demand Function
Is the functional relationship between the
price of the good and the quantity of that
good purchased in a given time period [UT],
income, other prices and preferences being
held constant.
A change in income, prices of other goods
or preferences will alter [shift] the
demand function.
Fall 97 Principles of Microeconomics slide 6
Quantity demanded
A change in the price of the good under
consideration will change the quantity demanded.
Q = f (P, holding M, Pr , preferences constant);
where: M = income
Pr = prices of related goods
DP causes a change in X [DQ], this is a change in
quantity demanded
Fall 97 Principles of Microeconomics slide 7
Change in demand
If M, Pr, or preferences change, the demand
function [relationship between P and Q] will
change.
These are sometimes called demand shifters
Be sure to understand difference between a
change in demand and a change in quantity
demanded
change in demand --- shift of the function
change in quantity demanded --- move on the function
Fall 97 Principles of Microeconomics slide 8
Law of Demand
Theory and empirical evidence
suggest that the relationship between
Price and Quantity is an inverse or
negative relationship
At higher prices, quantity purchased
is smaller, or at lower prices the
quantity purchased is greater.
Fall 97 Principles of Microeconomics slide 9
An example of hot chocolate:
There is a coffee cart in the building that primarily serves the
individuals who work in the building. The market is defined to some
extent by the geography of the building. Individuals who buy the
hot chocolate rarely come from other buildings to purchase a cup.
During the time period [UT]under consideration [8:00-9:00am on
a week day ] the incomes and preferences of buyers are unlikely to
change. The prices of coffee, lattes, etc. can be controlled by the
vendor and the price of soft drinks from the machines remains
constant. The number of workers in the building remain at a
constant level.

Under these circumstances, we observe the number of cups of hot
chocolate [H] sold each morning as the price [P] is changed.
From these observations the demand relationship is estimated.
Fall 97 Principles of Microeconomics slide 10
Cups of Hot Chocolate [H] purchased
eachday between8-9am
price
per cup
cups
purchased
A 0 20 .
B $ . 50 15 .
C $ . 75 12 . 5
D $ 1. 00 10 .
E $ 1. 25 7 . 5
F $ 1. 50 5 .
G $ 1. 75 2 . 5
H $ 2 . 00 0
The demand relationship
can be demonstrated as a
table:
Demand is a schedule of
quantities that will be
purchased at a schedule
of prices during a given
time period, cet. par.
As the price is increased,
the quantity purchased
decreases.
DQ < 0
[-7.5]
DP > 0
[+.75]
This demand relationship can be expressed as an equation:
P = 2 - .1Q or Q = 20 - 10P: [Q = f (P, . . .) but we graph P on
the Y axis and Q on the X axis.]
Fall 97 Principles of Microeconomics slide 11
The demand relationship can be expressed as a table
(previous slide) or an equation [either P = 2 - .1Q or Q = 20 - 10P]
The data from the table or equation can be graphed:
QUANTITY
{CUPS/UT}
P
R
I
C
E

2 4 6 8 10 12 14 16 18 20 22 24
.25
.50
.75
1.00
1.25
1.50
1.75
2.00
2.25
$
.
.
.
.
.
.
Demand
P = $2, Then Q = 0
P = $1.75, then Q = 2.5
P = $1.50, then Q = 5
P = $1.25, Q = 7.5
P = $1, then Q = 10
P = 0, then Q = 20
The demand function can be represented as a table,
an equation or a graph.
Fall 97 Principles of Microeconomics slide 12
QUANTITY

{CUPS/ UT}
P
R
I
C
E

2 4 6 8 10 12 14 16 18 20 22 24
.25
.50
.75
1.00
1.25
1.50
1.75
2.00
2.25
The demand equation P = 2 - .1Q was graphed
Demand [P = 2 - .1Q]
A change in quantity demanded is a movement on the demand
function caused by a change in the independent variable [ price].
DP from $1.50 to $1 causes DQ from 5 to 10 units
5
A
B
A change in quantity demanded is a move
from point A to B on the demand function
caused by a change in the price!
Fall 97 Principles of Microeconomics slide 13
QUANTITY
{CUPS/UT}
P
R
I
C
E

2 4 6 8 10 12 14 16 18 20 22 24
.25
.50
.75
1.00
1.25
1.50
1.75
2.00
2.25
The demand equation P = 2 - .1Q was graphed
Demand [P = 2 - .1Q]
A change in any of the parameters (income, price of related goods,
preferences, population of buyers, etc.) will cause a shift of the
demand function.
2.50
an increase in demand
D [ P = 2.5 - .1Q]
In this example, the intercepts have changed,
the slope has remained constant

D`` [P`` = 1.5 - .1Q]
Fall 97 Principles of Microeconomics slide 14
QUANTITY
{CUPS/UT}
P
R
I
C
E

2 4 6 8 10 12 14 16 18 20 22 24
.25
.50
.75
1.00
1.25
1.50
1.75
2.00
2.25
2.50
Demand [P = 2 - .1Q]
A change in the parameters [income, Pr, preferences, population,
etc.] might alter the relationship by changing the slope
an increase in
the slope
P = 2 - .25Q
buyers
are less
responsive
to DP
a decrease in the
slope
P` = 2- .048076923Q
buyers are more responsive to DP
A change in demand refers to a movement or shift of the entire
demand function
Fall 97 Principles of Microeconomics slide 15
Demand [P = 2 - .1Q]
An increase in demand
QUANTITY
{CUPS/UT}
P
R
I
C
E

2 4 6 8 10 12 14 16 18 20 22 24
.25
.50
.75
1.00
1.25
1.50
1.75
2.00
2.25
2.50
D2 [an increase in demand]
increase
results in a larger quantity being
purchased at each price
Q = 7.5
In this case, an increase in demand results
in an increase in the amount that will be purchased at a price of
$1.25. At this price the Quantity purchased increases from 7.5
to 18. An increase in demand!
Fall 97 Principles of Microeconomics slide 16
QUANTITY
[steak /UT]
P
R
I
C
E

2 4 6 8 10 12 14 16 18 20 22 24
.25
.50
.75
1.00
1.25
1.50
1.75
2.00
2.25
2.50
Demand [P = 2 - .1Q]
Effect of a change in the price of a
substitute
If the price of a substitute, like chicken, increases
buyers will buy more steak at each price of steak
If the price of chicken decreases, the buyers will want less steak at
each possible price of steak; the demand for steak decreases!
D2
Fall 97 Principles of Microeconomics slide 17
Complementary goods
Two goods may be complimentary, i.e. the two goods are
used together. [tennis rackets and tennis balls or CDs
and CD Players]
An increase in the price of CDs will tend to reduce the
demand [shift the demand function to the left] for CD Players
CDs/UT
PCDs
Dcd
CD Players
per UT
Pplayers
Dplayer
P2
P1
Y1 Y
As the price of CDs increases
from P1 to P2, the quantity of
CDs decreases from Y1
to Y.
As people buy fewer
CDs, the demand for
CD players decreases.
Dplayer
At the same price,
Ppl , the demand
is reduced
from Dto D.
X1 X
Ppl
Fall 97 Principles of Microeconomics slide 18
Compliments and Substitutes
Substitutes:
if the price of a substitute increases, the
demand for the good increases.
if the price of a substitute decreases, the
demand for the good decreases.
Compliments:
if the price of a compliment increases, the
demand for the good decreases.
if the price of a compliment decreases, the
demand for the good increases.
Fall 97 Principles of Microeconomics slide 19
Demand Summary
Law of Demand holds that usually as the
price of a good increases, individuals will
buy less of it.
The nature of this relationship is
influenced by a variety of other variables;
income, preferences, prices of related
goods, and other circumstances
as these circumstances change, the
demand relationship changes or shifts.
Fall 97 Principles of Microeconomics slide 20
Demand Summary [cont. . . ]
A change in demand means the relationship
between price and quantity was altered by a
change in some other variable [a demand shifter]
The demand shifts.
A change in quantity demanded is a change in the
quantity bought that was caused by a change in
the price of the good. There is a movement on the
demand function.
Fall 97 Principles of Microeconomics slide 21
Supply
Supply is defined as a schedule of
quantities of a good that will be produced
and offered for sale at a schedule of
prices during a given time [UT], ceteris
paribus.
Generally, producers are willing to offer
greater quantities of a good for sale at
higher prices; a positive relationship
between price and quantity supplied.
Fall 97 Principles of Microeconomics slide 22
Supply Schedule
Observation Price Quantity
Supplied
A $1 6
B $2 10
C $3 14
D $4 18
E
F $5 22
Q
P
2 4 6 8 10 12 14
$1
$2
$3
$4
$5
A supply schedule can be
displayed as a table.
The information can be represented
on a graph by plotting each
price quantity combination.
.
.
.
.
Both the graph and the table
represent a supply
relationship: Q = 2 + 4P
Fall 97 Principles of Microeconomics slide 23
Change in Quantity Supplied
A change in the price of the good
causes a change in the quantity
supplied.
The change in the price of the good
causes a movement on the supply
function, not a change or shift of
the supply function.
Fall 97 Principles of Microeconomics slide 24
Supply Schedule
Observation Price Quantity
Supplied
A $1 6
B $2 10
C $3 14
D $4 18
E
F $5 22
Q
/ut
P
$1
$2
$3
$4
$5
2 4 6 8 10 12 14 16
A change in the price causes a
change in the quantity supplied.
This can be represented by a
movement on the supply
function in the graph
DP from $1 to
$3
DP causes the quantity supplied
to increase from 6 to 14.
DP
$1
$3
CAUSES
DQ
This is a change in quantity
supplied. Not to be
confused with a change in
supply!
Fall 97 Principles of Microeconomics slide 25
Change in Supply
A change in supply [like a change in demand]
refers to a change in the relationship
between the price and quantity supplied.
A change in supply is caused by a change
in any variable, other than price, that
influences supply
A change in supply can be represented by a
shift of the supply function on a graph
Fall 97 Principles of Microeconomics slide 26
Change in Supply [cont. . . ]
There are many factors that infuence the
willingness of producers to supply a good.
technology
prices of inputs
returns in alternative choices
taxes, expectations, weather, number of
sellers, . . .
Qs = fs (P, Pinputs, technology, . . .)
Fall 97 Principles of Microeconomics slide 27
Change in Supply [cont. . . ]
Qs = fs (P, Pinputs, technology, number of
sellers, taxes, . . .)
A change in the price [P] causes a change
in quantity supplied;
a change in any other variable causes a
change in supply
Fall 97 Principles of Microeconomics slide 28
Supply Schedule
Observation Price Quantity
Supplied
A $1 6
B $2 10
C $3 14
D $4 18
E
F $5 22
Q
P
$1
$2
$3
$4
$5
2 4 6 8 10 12 14 16
Given the supply schedule,
An increase in the prices
of inputs would make it
more expensive to produce
each unit of output,
therefore, the supply
decreases
4
8
12
16
20
The decreased quantity
at each price shifts the
supply curve to the left!
a shift to the left
is a decrease in supply
The development of a new
technology that reduces the
cost of production will shift
the supply function to the right
Fall 97 Principles of Microeconomics slide 29
Equilibrium
Equilibrium: 1. a state of rest or balance due to
the equal action of opposing forces. 2. equal
balance between any powers, influences, [Websters
Encyclopedic Unabridged Dictionary of the English Language]
In a market an equilibrium is said to exist when
the forces of supply [sellers] and demand [buyers] are
in balance: the actions of sellers and buyers are
coordinated. The quantity supplied equals the
quantity demanded!
Fall 97 Principles of Microeconomics slide 30
10 20 30 40 50 60 70 80 90 100 110 120 130
10
20
30
40
50
60
70
80
90
100
Qx/ UT
Given a demand
function [which
represents the
behavior or choices
of buyers,
and a supply function
that represents the
behavior of
sellers,
Where the quantity that people want to buy is equal to the quantity
that the producers want to sell, there is an equilibrium quantity.
60
The price that coordinates the preferences of the buyers and sellers
is the equilibrium price.
$70
At the equilibrium price of $70, the quantity supplied is equal to
the quantity demanded.
Fall 97 Principles of Microeconomics slide 31
10 20 30 40 50 60 70 80 90 100 110 120 130
10
20
30
40
50
60
70
80
90
100
Qx/ UT
When the price is greater than the equilibrium price, the
amount that sellers want to sell at that price [quantity supplied]
exceeds the amount that buyers are willing to purchase [quantity
demanded] at that price. The price is too high.
60
$70
equilibrium price
e
q
u
i
l
i
b
r
i
u
m

q
u
a
n
t
i
t
y

At a Price of $90 the quantity supplied is 80,
$90
80
the quantity demanded is 35
35
At $90 there is a surplus
of 45 units [80-35=45]
surplus = 45
Fall 97 Principles of Microeconomics slide 32
10 20 30 40 50 60 70 80 90 100 110 120 130
10
20
30
40
50
60
70
80
90
100
Qx/ UT
60
$70
$90
80 35
At a price of $90 a surplus
of 45 units exists
surplus = 45
Suppliers have more to sell than
buyers will purchase at a price of $90.
To get rid of these unsold
units [inventory], the
sellers lower
the price.
lower
price
As the price of the good is reduced, the quantity supplied decreases.
Quantity
supplied
decreases
The quantity demanded increases as the price falls.
Quantity
demanded
increases
As the price moves toward equilibrium, quantity supplied and
quantity demanded are brought into equilibrium.
.
.
Fall 97 Principles of Microeconomics slide 33
10 20 30 40 50 60 70 80 90 100 110 120 130
10
20
30
40
50
60
70
80
90
100
Qx/ UT
At a price below equilibrium the
the quantity demanded exceeds
the quantity supplied.
.
At a price of $30 the quantity
demanded is 110.
$30
110
The quantity
supplied is 15.
15
At a price of $30 the quantity demanded exceeds the quantity
supplied by 95 units [110 - 15 = 95]. This is a shortage.
shortage = 95
.
Since the buyers cannot obtain all they want at a price of $30, some buyers will
offer to pay more. Some buyers will not pay the higher price, they buy less so the
quantity demanded decreases.
price
rises
quantity
demanded
decreases
At the higher price the quantity supplied increases
quantity
supplied
increases
As a result of market forces
the market moves to
equilibrium
.
60
$70
Fall 97 Principles of Microeconomics slide 34
10 20 30 40 50 60 70 80 90 100 110 120 130
10
20
30
40
50
60
70
80
90
100
Qx/ UT
60
$70
The market for good X is
in equilibrium at Px = $70
An increase in the price of a
substitute [good Y] causes the
demand for good X to increase.
demand
increases
As a result of the increased demand,
market forces push Px up.
price
rises
$89
equilibrium
quantity
increases
80
The increase in the demand for
good X results in an increase in
both the equilibrium price and
quantity.
Identify other factors that could
increase demand!
Fall 97 Principles of Microeconomics slide 35
10 20 30 40 50 60 70 80 90 100 110 120 130
10
20
30
40
50
60
70
80
90
100
Qx/ UT
Given a demand function,
an equilibrium is defined.
6 0
$70
A decrease in demand,
$50.89
39.2
establishes a new equilibrium
at a lower price and
quantity.
Demand might be reduced by:
a decrease in the price of a substitute,
an increase in the price of a compliment,
a change in income,
a change in the number of buyers
or their preferences, or, . . .
.
A change in the
price of the good
does not change
demand! It changes
the quantity
demanded.
Fall 97 Principles of Microeconomics slide 36
10 20 30 40 50 60 70 80 90 100 110 120 130
10
20
30
40
50
60
70
80
90
100
Qx/ UT
60
$70
Given an equilibrium
condition in a market,
supply
increases
an increase in supply will
increase the equilibrium
quantity and decrease
equilibrium P.
S2
price falls
$50
Quantity
increases
86
Identify factors that increase supply:
1. fall in price of inputs
2. improved technology
3. increase in number of sellers
4. fall in return in alternative
uses of inputs
5. or, . . .
Fall 97 Principles of Microeconomics slide 37
10 20 30 40 50 60 70 80 90 100 110 120 130
10
20
30
40
50
60
70
80
90
100
Qx/ UT
6 0
$70
A decrease in supply
decrease in supply
S1
price rises
$90
quantity
decreases
35
causes the equilibrium price to increase
and equilibrium quantity to decrease. What forces might cause the
supply to decrease?
1. an increase in the prices
of inputs
2. increase in returns from
alternative actions
3. problems in technology
[regulations, . . . ]
4. decrease in number of
sellers or producers
Fall 97 Principles of Microeconomics slide 38
Qx/ UT
10 20 30 40 50 60 70 80 90 100 110 120 130
10
20
30
40
50
60
70
80
90
100
When demand and supply both shift, the resultant effect on either
equilibrium price or quantity will be indeterminate.
6 0
$70
demand
increases
D2
results in
a market
force to
increase Q
and
increase
price
supply
increases
S2
results in
a market
force to
increase Q
and decrease
price
Both the increase in demand and supply increase quantity;
increase
increase
100
equilibrium Q increases.
The increase in demand pushes price up.
+DP
The increase in supply pushes price down.
price might
go up or down
or stay the same
-DP
The change in price may be positive or negative, it depends on the magnitude
of the shifts in and slopes of demand and supply.
If both supply and
demand decrease,
the DP will be
indeterminate and
the equilibrium Q
will decrease.
Fall 97 Principles of Microeconomics slide 39
10 20 30 40 50 60 70 80 90 100 110 120
10
20
30
40
50
60
70
80
90
100
Qx/ UT
60
$70
Price
A decrease in supply
decrease in supply
S1
pushes
price up
reduces
quantity
35
tends to increase P and reduce Q.
An increase in demand
an increase in
demand tends D2
to push
price up
and
increase
Q
tends to increase both P and Q.
Result is that Price will rise, Quantity may increase, decrease or stay the same
depending on the magnitudes of the shifts and slopes of supply and demand.
In this example,
the price
increases to
$105.
$105
49
the quantity decreases to 49
When supply
increases and
demand
decreases,
the price will
fall but the
change in Q
will be
indeterminate!
Fall 97 Principles of Microeconomics slide 40
Supply and Demand Analysis
Supply and demand is a simplistic model that
provides insights into the effects of events that
are related to a specific market.
Whether an event will tend to cause the price of a
good to increase or decrease is of importance to
decision makers.
To estimate the magnitude of price and quantity
changes more sophisticated models are needed.