3

Microeonomics
TAYLOR l WEERAPANA

Xia Tong
 Chapter 3
MICROECONOMICS
FINANCIAL CRISIS UPDATED EDITION
The Supply and
Demand Model

TAYLOR l WEERAPANA
 Introduction
•The supply and demand model can
explain the following:
• Why are ticket scalpers for Final Four seats
(or any sold out sporting event) able to sell
tickets for as much as $5,000?
• Why do gasoline prices go up or down so
easily?
• Why does the price of roses rise
significantly on Valentine’s Day?
 Demand
• Demand: a relationship between price
and the quantity demanded.
• Price: the amount of money or other
goods that one must pay to obtain a
particular good.
• Quantity Demanded: the quantity of a
good that people want to buy at a given
price during a specific time period.
 Demand
• Demand Schedule: a tabular
representation of demand showing the
price and quantity demanded for a
particular good, all else being equal.
 The Demand Curve
• Demand Curve: a graph of
demand showing the downward-
sloping relationship between price
and quantity demanded.
Figure 1: The Demand
Curve
 The Law of Demand
• The Law of Demand: the tendency
for the quantity demanded of a good
to decline as its price rises.

• Note: For a demand curve to be consistent with

the Law of Demand, the demand curve must be
downward sloping.
 The Law of Demand
According to the law
of demand, a lower
price will result in an
increase in the
quantity of the good
that consumers are
willing to buy, holding A lower price
all else constant.

Leads to a higher quantity demanded

 Law of Demand
• In 2008, General Motors (GM)
offered “employee pricing” deals
for its cars and trucks to increase
vehicle sales.
• Calculation by the Consumer
Reports estimated this to be a 13
percent decrease in the price of
the vehicle.
 Shifts in Demand
• Changes in the following can cause
the demand curve to shift to the left
or to the right:
• Consumers’ Preferences
• Consumers’ Information
• Consumers’ Income
• Number of Consumers in the Market
• Consumers’ Expectations of Future
Prices
• Prices of Closely Related Goods
a) Substitutes
b) Complements
Figure 2: A Shift in the
Demand Curve
 Consumers’ Preferences
• Changes in consumers’ preferences or
tastes for a product (relative to
another product) will change the
amount they purchase at a given
price.
• Example:
• After September 11, 2001, more consumers were
afraid to fly, resulting in a decrease in the
demand for air travel. The demand for gasoline
increased, as people chose to drive more to
different destinations.
 Consumers’ Information
•New information available to
consumers can result in a change in
the quantity that consumers buy of a
good, even though the price does not
change.
•Examples:
• Car owners bought less Firestone tires once
they learned of the mass recall of Firestone
tires.
• Demand for Krispy Kreme doughnuts declined
when people got information that eating less
carbohydrates can facilitate weight loss (a.k.a.,
the Atkins Diet).
 Consumers’ Incomes
• Normal Goods: goods for which
demand increases when the
consumers’ income rises and
decreases when consumers’
income falls.
• Examples:
• Jewelry
• Luxury cars
 Consumers’ Incomes
• Inferior Goods: goods for which
demand decreases when the
consumers’ income rises and
increases when consumers’
income falls.
• Examples:
• Instant noodles
• Bus tickets
Number of Consumers in the
Market
• More consumers in the market will
likely result in a larger demand for
the good or service, while fewer
consumers will likely result in a
smaller demand for the good or
service.
• Example:
• The demand for electricity in your city
increases as the population of the city
increases.
 Consumer’s Expectation of
Future Prices/incomes
• Expectations of higher future prices will
increase demand now. Expectations of
lower future prices will decrease demand
now.
• Example:
• Expectations of higher prices of gasoline
in the future tends to make individuals
fill up now.
 Prices of Closely Related
Goods
• Substitute: a good that has many of
the same characteristics as and can be
used in place of another good.
• Examples:
• Coke is a substitute for Pepsi.
• Riding a car is a substitute for taking the
bus.
• Downloaded music is a substitute for
music CDs.
 Prices of Closely
Related Goods
• Complement: a good that is
consumed or used together with
another good.
• Examples:
• Gasoline is a complement to SUVs.
• Cream is a complement to coffee.
 Prices of Closely Related
Goods
• If two goods are complements, then an
increase in the price of one good will result
in a decrease in the demand for the other
good.
• If two goods are substitutes, then an
increase in the price of one good will result
in an increase in the demand for the other
good.
 Figure 3: Shifts of versus
Movements Along the Demand
Curve P59
Draw a demand curve for music downloads.
What happens to it in each of
the following scenarios? Why?

A. The price of iPods

falls
B. The price of music
downloads falls
C. The price of CDs falls

24
A. Price of iPods falls
Music
Music downloads
downloads
Price of
and
and iPods
iPods are are
music
down- complements.
complements.
loads AA fall
fall in
in price
price of
of
iPods
iPods shifts
shifts the
the
P1
demand
demand curve curve for
for
music
music downloads
downloads
to
to the
the right.
right.
D1 D2

Q1 Q2 Quantity of
music downloads
25
 B. Price of music downloads
falls
Price of
music The
The D
D curve
curve
down- does
does not
not shift.
shift.
loads
Move
Move down
down along
along
P1 curve
curve to
to aa point
point with
with
lower
lower P,
P, higher
higher Q.
Q.
P2

D1

Q1 Q2 Quantity of
music downloads
26
 C. Price of CDs falls
Price of CDs
CDs andand
music music
music downloads
downloads
down-
are
are substitutes.
substitutes.
loads
AA fall
fall in
in price
price of
of CDs
CDs
P1 shifts
shifts demand
demand forfor
music
music downloads
downloads
to
to the
the left.
left.

D2 D1

Q2 Q1 Quantity of
music downloads
27
 Supply
• Supply: a relationship between
price and the quantity supplied, all
other things equal.
• Quantity Supplied: the quantity
of a good that sellers are willing to
sell at a given price during a
specific time period.
 Supply
• Supply Schedule: a tabular
representation of the supply curve.
 The Supply Curve
• Supply Curve: the graph of
supply showing the upward
relationship between price and
quantity supplied.
Figure 4: The Supply
Curve
 The Law of Supply
•The Law of Supply: the tendency
for the quantity supplied of a good
in a market to increase as its price
rises.
 The Law of Supply
According to the law
of supply, a higher
price will result to an
increase in the
quantity of the good A higher price
that sellers are willing
to sell, holding all
else constant.
Leads to a higher quantity supplied
 Shifts in Supply
• Changes in the following can cause the
supply curve to shift to the left or to
the right:
• technology,
• weather conditions,
• prices of inputs used in production,
• number of firms in the market,
• expected future selling price,
• government taxes, subsidies, and
regulations.
Figure 5: A Shift in the
Supply
 Technology
• Anything that changes the amount
that a firm can produce with a given
amount of inputs can be considered as
a change in technology. Improvements
in technology will correspond to an
increase in supply.
• Example:
• Innovations that decrease the time it
takes to produce cars.
 Weather Conditions
• Droughts, earthquakes, and
hurricanes affect how much of
certain goods can be produced.
• Examples:
• Unusually cold winter in California in
2006 decreased citrus production.
• Hurricane Katrina and Rita decreased
oil production in Louisiana and Texas.
 The Price of Inputs
Used in Production
• More expensive inputs (raw
materials, land, and capital)
increases the cost of production of
goods and services and may force
the firm to sell less at a given price.
• Example:
• Higher steel prices in 2002 decreased
the production of household appliances.
 The Number of Firms in the
Market
• If the number of firms in the market
increases, the supply curve shifts to
the right. If the number of firms in
the market decreases, the supply
curve shifts to the left.
 Expectations of Future
Prices
• Expectations of lower selling
prices in the future will increase
the supply today as firms decide
to sell less in the future when
prices are lower. Similarly,
expectations of higher selling
prices in the future will decrease
the supply today as firms decide
to sell more in the future when
prices are higher.
 Government Taxes,
Subsidies, and Regulations
• An increases in taxes (payments
by firms to the government) or a
decrease in subsidies (payment by
the government to firms) will
decrease supply. A decrease in
taxes or an increase in the
subsidies will increase supply.
 Government Taxes,
Subsidies, and Regulations
• Regulations: government policies
or rules that control a firm’s
behavior. These regulations can
affect a firm’s cost of production and
thereby affect supply.
• Example:
• Government requirements that food
vendors pass sanitary inspection will
reduce the number of vendors and
decrease supply.
 Shifts vs. Movement
• Movement along the supply
curve: occurs when a change in
the quantity supplied of a good is
brought along by a change in its
price.
• A shift in the supply curve:
occurs when a change is brought
along by any source other than
the price.
 Figure 6: Shifts of versus
Movements
Along the Supply Curve p64
Supply Curve
Draw a supply curve for tax
return preparation software.
What happens to it in each
of the following scenarios?
A. Retailers cut the price of
the software.
B. A technological advance
allows the software to be
produced at lower cost.
C. Professional tax return preparers raise the
price of the services they provide.
46
 A. Fall in price of tax return
software
Price of
tax return SS curve
curve does
does
S1
software
not
not shift.
shift.
P1 Move
Move downdown
along
along thethe curve
curve
P2 to
to aa lower
lower PP
and
and lower
lower Q.
Q.

Q2 Q1 Quantity of tax
return software
47
 B. Fall in cost of producing the
software
Price of
tax return
S1
SS curve
curve shifts
shifts
software S2
to
to the
the right:
right:
at
at each
each price,
price,
P1
QQ increases.
increases.

Q1 Q2 Quantity of tax
return software
48
 C. Professional preparers raise
their price
Price of
tax return
S1 This
This shifts
shifts the
the
software
demand
demand curve
curve for
for
tax
tax preparation
preparation
software,
software, not
not the
the
supply
supply curve.
curve.

Quantity of tax
return software
49
Figure 7: Overview of Supply and
Demand p66
 Market Equilibrium
• Shortage (excess demand): a situation
in which the quantity demanded is greater
than the quantity supplied. This occurs
when the price in the market is below the
equilibrium price.
• Surplus (excess supply): a situation in
which the quantity supplied is greater than
the quantity demanded. This occurs when
the current price in the market is above
the equilibrium price.
 Market Equilibrium
• Equilibrium price: the price at
which the quantity that sellers are
willing to sell equals the quantity
that consumers are willing to
purchase.
• Equilibrium quantity: the
quantity traded at the equilibrium
price.
 Market Equilibrium
• Market equilibrium: the
situation where the price equals
the equilibrium price and the
quantity traded equals the
equilibrium quantity.
Finding the Equilibrium with a
Supply and Demand Diagram
• If the price is below the
equilibrium, a shortage occurs,
causing the price to increase until
the price reaches equilibrium.
• If the price is above the
equilibrium, a surplus occurs,
causing the price to decrease until
the price reaches equilibrium.
Figure 8: Equilibrium Price and
Quantity p70
 Market Outcomes When
Supply or Demand Changes
• An increase in demand will shift
the demand curve to the right,
resulting in a higher equilibrium
price and quantity. This is
illustrated in Figure 9(a).
Figure 9(a): Effects of
an Increase in Demand
 Market Outcomes When
Supply or Demand Changes
• A decrease in demand will shift the
demand curve to the left, resulting
in a lower equilibrium price and
quantity. This is illustrated in
Figure 9(b).
Figure 9(b): Effects of a
Decrease in Demand
 Market Outcomes When
Supply or Demand Changes
• An increase in supply will shift the
supply curve to the right, resulting
in a lower equilibrium price and a
higher equilibrium quantity. This is
illustrated in Figure 10(a).
Figure 10(a): Effects of
an Increase in Supply
Market Outcomes When Supply
or Demand Changes
• A decrease in supply will shift the supply
curve to the left, resulting in a higher
equilibrium price and a lower equilibrium
quantity. This is illustrated in Figure 10(b).
Figure 10(b): Effects of
a Decrease in Supply
Using Supply and Demand
to Analyze
Real World Issues
 Economics in Action
• Between January and October 2005, the price of
gasoline increased by over 60 percent. Why?
• Two reasons:
– There was an increase in demand for
gasoline due to the use of more fuel-
hungry vehicles and more people driving
more miles.
• There was a decrease in supply of
gasoline because Hurricane Katrina
damaged refineries and oil rigs, shutting
down supply.
• The effects of these events are illustrated in
Figure 11.
Figure 11: Combined Effects of
a Simultaneous Increase in
Demand and Decrease in Supply
of Gasoline
 Economics in Action
• What could policymakers do to help lower
the price?
• Two possible solutions:
• Implement policies that would encourage
conservation of energy.
• Implement policies that would encourage
the development of new sources of energy,
or increase oil production.
• The effects of these solutions are illustrated
in Figure 12.
Figure 12: Predicted Effects of
Energy Policy P76
ACTIVE LEARNING Shifts in
supply and demand
Use the three-step method to analyze the effects of
each event on the equilibrium price and quantity of
music downloads.
Event A: A fall in the price of CDs
Event B: Sellers of music downloads negotiate a
reduction in the royalties they must pay
for each song they sell.
Event C: Events A and B both occur.

71
ACTIVE LEARNING 3
A. Fall in price of CDs
The market for
STEPS
P music downloads
1. D curve shifts S1
2. D shifts left
P1
3. P and Q both
P2
fall.

D2 D1
Q
Q2 Q1
72
ACTIVE LEARNING
B. Fall in cost of royalties
STEPS The market for
P music downloads
1. S curve shifts
(Royalties are part S1 S2
of sellers’ costs)
P1

2. S shifts right P2

3. P falls,
Q rises.
D1
Q
Q1 Q2
73
ACTIVE LEARNING
C. Fall in price of CDs and
fall in cost of royalties
STEPS
STEPS
1.
1. Both
Both curves
curves shift
shift (see
(see parts
parts AA && B).
B).
2.
2. D
D shifts
shifts left,
left, SS shifts
shifts right.
right.
3.
3. PP unambiguously
unambiguously falls. falls.
Effect
Effect on
on Q Q is
is ambiguous:
ambiguous:
The
The fall
fall in
in demand
demand reduces
reduces Q,Q,
the
the increase
increase in in supply
supply increases
increases Q.
Q.

74
 P
S1

P1

D2 D1
Q
Q1
demand supply
price quantity supplied
quantity demanded supply schedule
demand schedule law of supply
law of demand supply curve
demand curve shortage (excess demand)
normal good surplus (excess supply)
inferior good equilibrium price
substitute equilibrium quantity
complement market equilibrium