Introduction to Supply and Demand

S. Folland

The Law of Demand: When price falls, and if everything else stays the same, then the quantity demanded will increase.

In latin, “everything else stays the same” is stated as ceteris paribus.

Discussion questions: Why would families want more milk just because the price fell? Would all families buy more milk? Would some?

What happens to you if you break the law of demand?

Just for Perspective: A Note on Adam Smith

1. The concept of the demand curve was not developed fully until the 1880s by the “Austrian” economists.

2. The father of economics, Adam Smith, wrote his famous book The Wealth of Nations in 1776, long before the concept of demand was fully understood.

3. Smith thought the price of every good compared to other goods just depended on the amount of labor in each.

4. He said “if it takes two hours to catch one beaver, and just one hour to kill a deer, then one beaver will trade for two deer.” (This turned out to be not so good an idea).

5. Hundreds of Smith’s ideas did turn out to be good and are still used today.

Adam Smith, 1723-1790

Demand Shifters: 1. Personal income a. normal goods (demand increases with income) b. inferior goods (demand decreases with income) 2. Prices of related goods a. substitutes (demand for tea increases when the price of coffee increases) b. complements (demand for sugar decreases when the price of tea increases) 3. Tastes (Can mean ordinary tastes changing or can refer to something abstract, like age. 4. Expectations (e.g. if you believe housing prices will rise even further, you may buy now. 5. Population.

Discussion questions on demand shifts:

Which way would demand for ___ shift if?1. Apples, if the engine plant doubles salaries?2. Cigarettes, if the Surgeon General states they are hazardous to your health?3. Used clothing, if the engine plant doubles salaries?4. Mustard, if hot dogs double in price?5. Mercedes Benz’s if BMWs double in price?6. Exxon stocks, if an Exxon oil tanker runs aground in Alaska?7. Land suitable for residential housing, if an Interstate Highway is built to the property.

Study questions: 1. Would diary farmers offer every last drop of milk at say $1.00 so they could not possibly offer more than 45k at $1.50? 2. If not, where would the extra milk come from?

Supply Curve

Supply Shifters:

1. Technological change. E.g. robots improve productivity on the auto assembly line.

2. Number of Sellers. E.g. more firms start up; U.S. Loosens up the immigration laws.

3. Input price changes. E.g. price of chicken feed affects the supply of eggs.

4. Expectations

5. Weather. Applies mainly to agricultural products.

Study questions regarding equilibrium: a. What if the market price was above PE? b. Would there be pressures for the price to fall? c. During the time that the price is above equilibrium, which would be greater, quantity supplied or quantity demanded? d. What do we call the difference between those two quantities? What if the “good” were human labor, then what would we call the difference between these two quantities?

Comparative Static Analysis:

Compares two static equilibria.

(“Static” equilbrium: a snapshop of an equilbrium for a given time period.)

Examples: Suppose that Brazil, which grows a large share of the world’s coffee crop, suffers bad growing weather--a sudden deep freeze killing many plants, what will happen to the market for coffee in the Rochester area?

You Try It:

1. The effect on the market for rental apartments in Atlanta when the Summer Olympics came to town.2. The effect of the Black Plague on the labor market in a typical European city back in 1436.3. The OU faculty goes on strike and gets double their salarie, what effect on the market for student credit hours. 4. What happens to the market for Pentium III computer chips when the “Pentium IV” is invented. 5. The effect of an increase in the price of flour on the market for bread. 6. Marijuana is legalized, what happens to the market for marijuana. 7. The Russian ruble collapses in value, what effect on our domestic market for imported Russian furs. 8. When the price of CDs in general drops, what if anything happens to the market for CDs.

Market Intervention: When the government intervenes in the market.

1. Equilibrium can become unattainable.

2. Disequilibrium can cause unexpected and unwanted results.

3. There are two kinds of intervention:

a. Price floors: e.g. minimum wages, crop price supports.

b. Price ceilings: e.g. rent controls, the Irish potato famine story.

Points to notice: 1. AB is unemployment caused by the minimum wage, 2. LE- LD is the loss of jobs; 3. WE*LE is labor income before the MW; 4. MW*LE is labor income after the MW is in place (Whether the MW is good for labor or bad for them depends on whether labor income is larger before or after the minimum wage is put in place.

Average Weekly Full Time Equivalent Workers at Fast Food Restaurants Before and After An Increase in the Minimum Wage in New Jersey New Jersey Pennsylvania Before After Change Before After Change

BLS data

Feb-Nov 1992 37.2 37.6 0.41 42.5 42.4 -0.12

Card & Krueger data

Feb-Nov 1992 29.8 30.0 0.19 33.1 30.9 -2.23

Source: These data are from an article by Card and Krueger, published by the National Bureau of Economic Research, 1998, entitled, "A Reanalysis of the Effect of the New Jersey Increase in the Minimum Wage."

The Card-Krueger study shook up the standard model it seemed because apparently there was no real world drop in the average employment level.

A competing study by David Neumark from our sister university at MSU, disputed this result for some pretty good reasons. Also, we have a history of minimum wage studies, and a good majority of these agree with the standard theory. So, economists generally favor the standard theory.

However, this latest challenge turns out, we economists have been sternly reminded that the real world data rules, always.

Question: If there were a potato famine, and if the government were to rule that the price of potatoes must be frozen at the price of the previous, good year: Who would this favor? Who would this policy hurt?