Demand & Supply

• Chapter 7 discusses the laws of supply and demand and the ways in which a voluntary market supports them.

• E.2.1 Define supply and demand and explain the causes of the Law of Supply and the Law of Demand.

• E.2.2 Recognize that consumers ultimately determine what is produced in a market economy.

• E.2.3 Illustrate how supply and demand determine equilibrium price and quantity.

• E.2.4 Identify factors that cause changes in market supply and demand and how these changes affect price and quantity in a competitive market.

• E.2.5 Describe how elasticity (price) sends signals to buyers and sellers.

Demand

o The word demand has a special meaning in economics. To economists demand includes only those people who are willing and able to pay for a product or service.

I. The “Marketplace” A. All consumers individually and collectively have a great

influence on the price of all goods and services.

B. Demand is how people decide what to buy and at what price. It represents a consumer’s willingness and ability to pay.

C. Supply is how sellers decide how much to sell and at what price.

D. A market represents the freely chosen actions between buyers and sellers of goods and services.

1. A market is any meeting place or mechanism that allows buyers and sellers of an economic product to come together – may be local, national, international, or a combination of these. Ex = yard sale, flea market, ad in a newspaper, internet, etc.

2. In a market economy, individuals – whether as buyers or sellers – decide for themselves the answers to the What? How? And For Whom? Economic questions

II. Voluntary exchanges A. Buyers and sellers exercise their economic freedom

by working towards a satisfactory term of an exchange 1. The seller sets the price 2. The buyer agrees to the product and price

through the act of purchasing the product 3. In order to make the exchange, both the buyer

and the seller must believe that they will be better off – richer or happier – after the exchange than before.

B. The supplier’s problem of what to charge and the buyer’s problem of how much to pay is solved voluntarily in the market exchange

C. Supply and demand analysis is a model of how buyers and sellers behave in the market place – it’s a way of explaining cause and effect in relation to price.

• III. The Law of Demand A. Demand is created when the customer(buyer) is

both willing and able to buy a product.

B. Law of Demand explains how people react to changing prices in terms of the quantities demanded of a good or service.

C. Law of Demand states:

1. As price goes up, quantity demanded goes down.

2. As price goes down, quantity demanded goes up.

3. Key pt = there is an inverse, or opposite, relationship between quantity demanded and price

D. Several factors explain the inverse relationship between price and quantity demanded:

1. Real income effect a. People are limited by their income as to what they can buy b. A person can’t keep buying the same quantity of a product if

the price goes up but their income stays the same (fixed income) c. In order to keep buying the same amount of a product, you

will need to cut back on buying other things. The real income effect forces you to make trade-offs.

d. If the price goes down, your real income increases. You will have more purchasing power and will probably increase spending.

2. Substitute effect a. People can replace one product with another if it satisfies the

same need. Ex= Pepsi vs Coke, McDonalds vs Burger King, Verizon vs At&T

If the price of both products goes up, you may decide to purchase other substitutes.

As price goes up; demand

A. Goes up

B. Goes down

C. Stays the same

Which is not an example of a market

A. Grocery store

B. Internet

C. Yard sale

D. All of the above are markets

Demand only applies to those who are willing and have money

A. True

B. False

3. Diminishing Marginal Utility a. Utility is the ability of any good or service to

satisfy consumer wants

b. In deciding to make a purchase, people decide the amount of satisfaction, or use, they think they will get from a good or service.

c. People will purchase additional items until the satisfaction from the last unit is equal to the price.

d. Law of Diminishing Marginal Utility states – the additional satisfaction a consumer gets from purchasing 1 more unit of a product will lessen with each additional unit purchased

The demand curve and elasticity of demand

I. Graphing the Demand Curve

A. The Law of Demand can be graphed

1. Demand schedule – is a table of prices and the quantity demanded at each price. It is a list of quantity demanded at different prices

2. Demand Curve – you take the information from the demand schedule and put it on a graph. It is the same information shown in graph form. a. Demand curve always slope downward (fall from left to right and

show in graph form the quantities demanded at each possible price)

b. Demand curves show that as the price falls, the quantity demanded increases.

Demand Curve

II. Quantity Demanded vs. Demand

A. A change in quantity demanded is caused by a change in the price of a good and is shown as movement along the demand curve

B. If something other than price causes demand to increase or decrease, this is known as a change in demand and shifts the entire curve to the right (increase in demand) or left (decrease in demand)

When additional units provide less satisfaction this is an example of

A. Law of demand

B. Law of diminishing marginal utility

C. Demand curve

D. Demand schedule

III. Determinants of Demand A. Many factors besides price can affect demand for a specific product 1. Changes in population a. When population increases, opportunities to buy and sell increases & usually demand for most products increases (the entire demand curve shifts to the right) 2. Changes in income a. Demand for most goods & services depend on income. If your income decreases, your ability to purchase goods and services also decreases (the entire demand curve shifts to the left) If your income increases, you tend to buy more (the entire demand curve shifts to the right)

3. Changes in tastes and preference a. One of the key factors that determine demand is people’s tastes and preferences (it means what people like & prefer to choose) 4. Substitutes a. When a new competitor is added or an old competitor leaves the market. Ex = Butter and margarine are substitutes. Price of butter goes up, demand for margarine goes up. Price of butter goes down, demand for margarine goes down 5. Complementary goods a. There are products that rely upon one another, demand for one affects demand for the other. Ex = Cameras and film. If the price of cameras goes down, demand for cameras goes up and so does demand for film.

IV. The Price Elasticity of Demand A. How much consumers respond to a given change in price (increase or decrease) is elasticity. 1. Elastic Demand (flexibility) – occurs when the demand for some goods is greatly affected by the price a. If a small change in price (increase or decrease) causes a large change in quantity demanded, the demand for that good is elastic (consumers can be flexible when buying or not buying an item) Ex = price for product goes up – consumers buy less; price for something goes down – consumers buy more 2. Inelastic Demand (less flexibility) – occurs when the demand for some goods is less affected by the price b. If a large change in price (increase or decrease) causes only a small change in the quantity demanded, the demand for that product is inelastic. Ex = Salt – a higher or lower price for salt won’t bring about much change in the quantity demanded because people can consume only so much salt

B. Specific vs General market

1. When considering the elasticity of a product, it’s necessary to define the market being studied. Ex = demand for gas at a particular gas station is very elastic – raise or lower the price of gas and this will cause big changes in demand. Demand for gas in general is likely to be inelastic – raise the price of gas at all gas stations and consumers either pay the higher price or drive less.

C. What determines Price Elasticity of Demand 1. A person can determine the elasticity of demand for a product by considering 3 things a. Can the Purchase be delayed? (Time) i. If the purchase can be delayed, the demand tends to be elastic. ii. If it can’t, it tends to be inelastic b. Are there adequate substitutes available? i. If there are adequate substitutes, the demand tends to be elastic ii. The fewer the substitutes for a product, the more inelastic the demand c. Does the purchase use a large portion of income? (% of a person’s budget) i. If products require a large portion of income, the demand tends to be elastic ii. If they require a small portion of income, the demand tends to be inelastic

I. The Law of Supply and the Supply curve

A. The Law of Supply

1. Supply is the willingness and ability of producers to provide goods to consumers

2. Law of supply states: a. As prices rise, the quantity supplied generally rises

b. As prices fall, the quantity supplied falls

c. Key pt = a direct relationship exists between price and quantity supplied. Price goes up, quantity supplied goes up. Price goes down, quantity supplied goes down

B. The Incentive of greater profits

1. The higher the price of a good, the greater the incentive is for a producer to produce more a. The higher price not only returns higher profits, but it also must cover additional costs of producing more.

2. Higher prices encourage more competitors to join the market (competitors see there is more money to be made then before and the gain seems more worth the risk than it did before)

3. Higher prices turn potential suppliers into actual suppliers, adding to total output

C. The supply curve 1. The Law of Supply can be graphed: a. Supply Schedule = shows the quantity supplied at each given price (in the form of a table) b. Supply Curve = you take the information from the supply schedule & put it on a graph. It’s the same information shown in graph form. i. Supply curves always slope upward from left to right ii. The relationship between price and quantity supplied is direct – or moving in the same direction D. Quantity supplied vs. Supply 1. A change in quantity supplied is caused by a change in price and is shown as movement along the supply curve 2. If something other than price causes supply to increase or decrease, this is known as a change in supply and shifts the entire supply curve to the right (increase in supply) or left (decrease in supply)

Supply curve

E. The Determinants of Supply 1. Price of inputs or the Cost of Production – raw materials, wages, insurance, utilities, etc. can cause an increase or decrease in supply. Ex = leather shoes, Cattle prices fall, cost of shoe leather falls – producers can make more shoes at each and every price 2. Number of firms in the industry (competition) – when more firms enter the industry – increase in supply. When firms leave the industry – decrease in supply 3. Taxes – tend to increase production costs which decreases supply 4. Technology – an improvement in technology or the science used to develop new products or methods of production and distribution almost always increases supply (new technology usually reduces the costs of production)

F. The Law of Diminishing Returns

1. Adding units of one factor of production (such as labor) to all the other factors of production increases total output for a limited time period.

2. The extra output for each additional unit will eventually decrease

3. Businesses will continue to add units of a factor of production until doing so no longer increases revenue.

I. Putting supply and demand together A. Equilibrium price

1. In the real world, demand and supply work together.

2. The price at which the supply meets demand – where the two curves (supply and demand) intersect – is the equilibrium price

B. Shifts in equilibrium price

1. If the demand curve shifts due to something other than price, the equilibrium price will change

2. If the supply curve shifts due to something other than price, the equilibrium price will change

C. Prices serve as signals 1. In free enterprise systems, prices serve as signals to producers and consumers a. rising prices signal producers to make more and consumers to purchase less b. Falling prices signal producers to make less and consumers to purchase more 2. Shortages = a situation in which the quantity demanded is greater than the quantity supplied at a given price. 3. Surpluses = a situation in which the quantity supplied is greater than the quantity demanded at a given price. 4. Key pt. Market forces = one of the benefits of the market economy is that when it operates without restriction, it eliminates shortages and surpluses (prices will rise or fall to correct shortages and surpluses, forcing the market to seek equilibrium)

D. Price controls – Sometimes the government will set prices because it believes the market forces of supply and demand are unfair, and the government is trying to protect consumers and suppliers. Another reason is that special interest groups use pressure on elected officials to protect certain industries

1. Price ceilings a. A maximum price set by the government to prevent

prices from going above a certain level (it’s the maximum legal price that can be charged)

b. A price ceiling, like any other price, affects the allocation of products, but not always in the way intended.

i. When a price ceiling is set below the equilibrium price, a shortage occurs. Ex = rent control – when rents are capped at artificially low rates, “housing shortages” usually result

ii. Effective price ceilings – and resulting shortages – often lead to nonmarket ways of distributing goods and services

iii. Items in short supply might be rationed iv. Shortages can lead to a black market – or illegal places to

purchase such products at illegally high prices

Which is not a determinant of demand

A. Change in population

B. Change in income

C. shortages

Which is a determinant of supply

A. taxes

B. technology

C. competition

D. All of the above

In the real world supply and demand work together

A. True

B. False

2. Price floors a. A minimum price set by the government to prevent prices from going below a certain level (lowest legal price that can be paid for a good or service) b. Price floors set minimum wage levels and support agricultural prices, but sometimes this leads to a surplus. Ex = minimum wage – many economists argue that the minimum wage actually increases the number of people out of work because employers hire fewer workers at higher rates Key pt – there are situations in which it is important that the government prevent market forces from dealing with shortages and surpluses. Ex = natural disasters – floods, tornadoes, hurricanes, etc. People need food and water and there may be a shortage of clean water for drinking. If the government didn’t step in, market forces would cause the prices of water (needed for basic human survival) to increase to a point that many people couldn’t afford it, and they could become ill or die.