chaPter

Demand, Supply, and Markets

Learning Outcomes
LO 1 LO 2 LO 3 LO 4 LO 5
explain how the law of demand affects market activity explain how the law of supply affects market activity Describe how the interaction between supply and demand creates markets Describe how markets reach equilibrium explain how markets react during periods of disequilibrium

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Why do roses cost more on Valentines Day than during the rest of the year?

Why do roses cost more on Valentines Day than during the rest of the year? Why do TV ads cost more airing them during a popular sport than during normal course of performance? Why do hotels in hill stations charge more in summers than in winters? Why do surgeons earn more than butchers? Why do cricket pros earn more than hockey pros? Answers to these and most economic questions boil down to the workings of demand and supplythe subject of this chapter. This chapter introduces demand and supply and shows how they Professional athletes should earn comparable salaries interact in competitive markets. regardless of the sport they play. Demand and supply are the most funStrongly Disagree Strongly Agree 1 2 3 4 5 6 7 damental and the most powerful of all economic toolsimportant enough to warrant a chapter. Indeed, some believe that if you program a computer to answer demand and supply to every economic question, you could put many economists out of work. An understanding of the two ideas will take you far in mastering the art and science of economic analysis. This chapter uses graphs, so you may need to review the Chapter 1 appendix as a refresher.

What do you think?

Topics discussed in Chapter 4 include:

Demand and quantity demanded Movement along a demand curve Shift of a demand curve Supply and quantity supplied Movement along a supply curve Shift of a supply curve Markets and equilibrium Disequilibrium

LO1 Demand
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How many Pepsi can will one buy each month at a price of `15? What if the price is `10? What if its `20? The answers
reveal the relationship between the price of Pepsi and the quantity demanded. Such a relationship is called the demand for Pepsi. Demand indicates the quantity consumers are both willing and able to buy at each possible price during a given time period, other things constant. Because demand pertains to a specific

demand

a relation between the price of a good and the quantity that consumers are willing and able to buy per period, other things constant

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perioda day, a week, a month is more demanded at a lower think of demand as the price? The explanation begins Sell for less, and the world will amounts purchased per period with unlimited wants conbeat a path to your door. at each possible price. Also, fronting scarce resources. notice the emphasis on willMany goods and services could ing and able. You may be able to buy satisfy particular wants. For exama new Harley-Davidson XL 883 Sportster for $6,999 ple, you can satisfy your hunger with pizza, burgbecause you can afford one, but you may not be willing ers, chicken, or hundreds of other foods. Similarly, to buy one if motorcycles dont interest you. Similarly, you can satisfy your desire for warmth in the winyou may be willing to buy a yacht but you may not be ter with warm clothing, a home-heating system, a able to buy it for lack of resources. Thus, in order for trip to Goa, or in many other ways. Clearly, some something to be demanded, the consumer must be alternatives have more appeal than others (a trip both willing and able to buy the commodity. to Goa is more fun than warm clothing). In a world without scarcity, everything would be free, so you would always choose the most attractive alternaThe Law of Demand tive. Scarcity, however, is a reality, and the degree of scarcity of one good relative to another helps deterIn 1962, Sam Walton opened his first store in Rogers, mine each goods relative price. Arkansas, with a sign that read Wal-Mart Discount Notice that the definition of demand includes City. We sell for less. Wal-Mart now sells more than the other-things-constant assumption. Among the any other retailer in the world because prices are other things assumed to remain constant are the among the lowest around. As a consumer, you underprices of other goods. For example, if the price of stand why people buy more at a lower price. Sell for pizza declines while other prices remain constant, less, and the world will beat a path to your door. Walpizza becomes relatively cheaper. Consumers are Mart, for example, sells on average over 20,000 pairs more willing to purchase pizza when its relative of shoes an hour. This relation between the price and price falls; they substitute pizza for other goods. the quantity demanded is an economic law. The law of This principle is called the substitution effect of a demand says that quantity demanded varies inversely price change. On the other hand, an increase in the with price, other things constant. Thus, the higher the price of pizza, other things constant, increases the price, the smaller the quantity demanded; the lower opportunity cost of pizza. This higher opportunity the price, the greater the quantity demanded. cost causes consumers to substitute other goods for the now higher-priced pizza, thus reducing their Demand, Wants, and quantity of pizza demanded. Remember that it is the Needs law of demand change in the relative pricethe price of one good relative the quantity of a good Consumer demand and wants that consumers are willto the prices of other goodsthat causes the substitution ing and able to buy per are not the same. As we effect. If all prices changed by the same percentage, period relates inversely, have seen, wants are unlimthere would be no change in relative prices and no or negatively, to the ited. You may want a new price, other things substitution effect. constant Mercedes SL600 Roadster the Income effect of a Price change convertible, but the $139,975 substitution effect of a price change price tag is likely beyond your A fall in the price increases the quantity demanded when the price of a budget (that is, the quantity good falls, that good for a second reason. Suppose you earn $30 a you demand at that price becomes cheaper comweek from a part-time job, so $30 is your money pared to other goods is zero). Nor is demand the income. Money income is simply the number of so consumers tend to same as need. You may need dollars received per period, in this case, $30 per substitute that good for a new muffler for your car, other goods week. Suppose you spend all that income on pizza, but a price of $300 is just too money income buying three a week at $10 each. What if the price high for you. If, however, the the number of dollars drops to $6? At the lower price you can now afford a person receives per price drops enoughsay, to five pizzas a week. Your money income remains period, such as $400 per $200then you become both week at $30 per week, but the decrease in the price has willing and able to buy one. increased your real incomethat is, your income real income income measured in measured in terms of what it can buy. The price the Substitution effect terms of the goods and reduction, other things constant, increases the services it can buy; real of a Price change purchasing power of your income, thereby increasincome changes when the price changes What explains the law of ing your ability to buy pizza. The quantity of pizza demand? Why, for example, you demand will likely increase because of this 74
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income effect of a price change. You may not increase your quantity demanded to five pizzas, but you could. If you decide to purchase four pizzas a week when the price drops to $6, you would still have $6 remaining to buy other goods. Thus, the income effect of a lower price increases your real income and thereby increases your ability to purchase all goods. Because of the income effect, consumers typically increase their quantity demanded when the price declines. Conversely, an increase in the price of a good, other things constant, reduces real income, thereby reducing the ability to purchase all goods. Because of the income effect, consumers typically reduce their quantity demanded when the price increases. Again, note that money income, not real income, is assumed to remain constant along a demand curve. A change in price changes your real income, so real income varies along a demand curve. The lower the price, the greater your real income.

If the price drops as low as $3, consumers demand 32 million per week. The demand schedule in Exhibit 1a appears as a demand curve in Exhibit 1b, with price measured on the vertical axis and the quantity demanded per week on the horizontal axis. Each price-quantity combination listed in the demand schedule in Exhibit 1a becomes a point in Exhibit 1b. Point a, for example, indicates that if the price is $15, consumers demand 8 million pizzas per week. These points connect to form the demand curve for pizza, labeled D. (By the way, some demand curves are straight lines, some are curved lines, and some are even jagged lines, but all are called demand curves.)

Exhibit 1b
The Demand Curve for(b) Demand Pizza

curve

Price per pizza

The Demand Schedule and Demand Curve

Demand can be expressed as a demand schedule or as a demand curve. Exhibit 1a shows a hypothetical demand schedule for pizza. In describing demand, we must specify the units measured and the period

$15 12 9 6 3 0

a b c d e D 8 14 20 26 32 Millions of pizzas per week

Exhibit 1a (a) Demand schedule

The Demand Schedule for Pizza

Price per Pizza a b c d e $15 12 9 6 04-084 SW EX04.01 3 ar1

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Quantity Demanded per Week (millions) 8 14 20 26 32

McEachern/Economics 7e 35p8 Wide x 16p8 Deep considered. In our example, the 4/C 06/11/04 DL unit is a 12-inch regular pizza and 06/23/04 JMAC period is a week. The schedthe
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ule lists possible prices, along with the quantity demanded at each price. At a price of $15, for example, consumers demand 8 million pizzas per week. As you can see, the lower the 04-084 SW EX04.01 ar1 price, other things constant, McEachern/Economicsthe greater the quantity 7e 35p8 Wide x 16p8 Deep demanded. Consumers sub4/C stitute pizza for other foods. 06/11/04 DL 06/23/04 JMAC And as the price falls, real income increases, causing consumers to increase the quantity of pizza they demand.
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A demand curve slopes downward, reflecting the law of demand: Price and quantity demanded are inversely related, other things constant. Besides money income, also assumed constant along the demand curve are the prices of other goods. Thus, along income effect of a the demand curve for pizza, price change the price of pizza changes a fall in the price of a good increases consumrelative to the prices of other ers real income, making goods. The demand curve consumers more able to shows the effect of a change purchase goods; for a normal good, the quanin the relative price of pizza tity demanded increases that is, relative to other demand curve prices, which do not change. a curve showing the Take care to distinguish relation between the price of a good and between demand and quanthe quantity consumers tity demanded. The demand are willing and able to for pizza is not a specific buy per period, other things constant amount, but rather the entire relationship between
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price and quantity demandedrepresented by the demand schedule or the demand curve. An individual point on the demand curve indicates the quantity demanded at a particular price. For example, at a price of $12, the quantity demanded is 14 million pizzas per week. If the price drops from $12 to, say, $9, this is shown in Exhibit 1b by a movement along the demand curvein this case from point b to point c. Any movement along a demand curve reflects a change in quantity demanded, not a change in demand. The law of demand applies to the millions of products sold in grocery stores, department stores, clothing stores, shoe stores, drugstores, music stores, bookstores, hardware stores, travel agencies, and restaurants, as well as through mail-order catalogs, the Yellow Pages, classified ads, online sites, stock markets, real estate markets, job markets, flea markets, and all other markets. The law of demand applies even to choices that seem more personal than economic, such as whether or not to own a pet. For example, after New York City passed an anti-dog-litter law, lawabiding owners had to follow their dogs around the city with scoopers, plastic bagswhatever would do the job. Because the law raised the personal cost of owning a dog, the quantity of dogs demanded decreased. Some owners simply abandoned their dogs, raising the number of strays in the city. The number of dogs left at aniquantity demanded mal shelters doubled. The law of demand predicts this the amount of a good consumers are willing inverse relation between and able to buy per pecost, or price, and quantity riod at a particular price, demanded. as reflected by a point on a demand curve It is useful to distinguish individual demand between individual demand, a relation between the which is the demand of an price of a good and the individual consumer, and quantity purchased by an individual consumer market demand, which is per period, other things the sum of the individual constant demands of all consumers in market demand the market. In most markets, the relation between the price of a good and there are many consumers, the quantity purchased sometimes millions. Unless by all consumers in the otherwise noted, when we market during a given period, other things talk about demand, we are constant; sum of the referring to market demand, individual demands in as shown in Exhibit 1. the market

Shifts of the Demand Curve

A demand curve isolates the relation between the price of a good and quantity demanded when other factors that could affect demand remain unchanged. What are those other factors, and how do changes in them affect demand? Variables that can affect market demand are (1) the money income of consumers, (2) prices of other goods, (3) consumer expectations, (4) the number or composition of consumers in the market, (5) consumer tastes, and (6) advertising outlay. How do changes in each affect demand?
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Changes in Consumer Income

Exhibit 2 shows the market demand curve D for pizza. This demand curve assumes a given level of money income. Suppose consumer income increases. Some consumers will then be willing and able to buy more pizza at each price, so market demand increases. The demand curve shifts to the right from D to D9. For example, at a price of $12, the amount of pizza demanded increases from 14 million to 20 million per week, as indicated by the movement from point b on demand curve D to point f on demand curve D9. In short, an increase in demandthat is, a rightward shift of the demand curvemeans that consumers are willing and able to buy more pizza at each price.

Exhibit 2
An Increase in the Market Demand for Pizza

$15 Price per pizza 12 9 6 D' 3 D 0 8 14 20 26 32 Millions of pizzas per week b f

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Goods are classified into two broad categories, depending on how demand responds to changes in money income. The demand for a normal good increases as money income increases. Because pizza is a normal good, its demand curve shifts rightward when money income increases. Most goods are normal. In contrast, demand for an inferior good actually decreases as money income increases, so the demand curve shifts leftward. Examples of inferior goods include low quality food grain, used furniture, and used clothing. As money income increases, consumers tend to switch from these inferior goods to normal goods (such as better quality food grain, new furniture, and new clothing).

Changes in the Prices of Other Goods

Again, the prices of other goods are assumed to remain constant along a given demand curve. Now lets bring these other prices into play. Consumers have various ways of trying to satisfy any particular want. Consumers choose among substitutes based on relative prices. For example, pizza and sandwiches are substitutes, though not perfect ones. An increase in the price of sandwiches, other things constant, reduces the quantity of sandwiches demanded along a given sandwiches demand curve. An increase in the price of sandwiches also increases the demand for pizza, shifting the demand curve for pizza to the right. Two goods are considered substitutes if an increase in the price of one shifts the demand for the other rightward and, conversely, if a decrease in the price of one shifts demand for the other leftward. Goods used in combination are called complements. Examples include Coke and pizza, milk and cookies, computer software and hardware, and airline tickets and rental cars. Two goods are considered complements if an increase in the price of one decreases the demand for the other, shifting that demand curve leftward. For example, an increase in the price of pizza shifts the demand curve for Coke leftward. But most pairs of goods selected at random are unrelatedfor example, pizza and housing, or milk and petrol. Still, an increase in the price of an unrelated good reduces the consumers real income and can reduce the demand for pizza and other goods. For example, a sharp increase in petrol prices reduces the amount of income people have to spend on other goods, such as pizza.

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Changes in Consumer Expectations

Another factor assumed constant along a given demand curve is consumer expectations about factors that influence demand, such as incomes or prices. A change in consumers income expectations can shift the demand curve. For example, a consumer who learns about a pay raise might increase demand well before the raise takes effect. A college senior who lands that first real job may buy a new car even before graduation. Likewise, a change in consumers price expectations can shift the demand curve. For example, if you expect the price of pizza to jump next week, you may buy an extra one today for the freezer, shifting this weeks demand for pizza rightward. Or if consumers come to believe that home prices will climb next month, some will increase their demand for housing now, shifting this months demand for housing rightward. On the other hand, if housing prices are expected to fall next month, some consumers will postpone purchases, thereby shifting this months housing demand leftward.

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Changes in the Number or Composition of Consumers

As mentioned earlier, the market demand curve is the sum of the individual demand curves of all consumers in the market. If the number of consumers changes, the demand curve will shift. For example, if the population grows, the demand curve for pizza normal good will shift rightward. Even a good, such as new if total population remains clothes, for which demand increases, or unchanged, demand could shifts rightward, as conshift with a change in the sumer income rises composition of the populainferior good tion. For example, a bulge a good, such as used in the teenage population clothes, for which demand decreases, or could shift pizza demand shifts leftward, as conrightward. A baby boom sumer income rises would shift rightward substitutes the demand for car seats goods, such as Coke and Pepsi, that relate and baby food. A growing in such a way that an student population would increase in the price of affect the demand for fast one shifts the demand for the other rightward foods. complements

Changes in Consumer Tastes

What kind of toppings do you like on your pizza?

goods, such as milk and cookies, that relate in such a way that an increase in the price of one shifts the demand for the other leftward

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Are you into tattoos and body piercings? Is music to your ears more likely to be rock, country, hip-hop, reggae, R&B, jazz, funk, Latin, gospel, new age, or classical? Choices in food, body art, music, clothing, books, movies, TVindeed, all consumer choices are influenced by consumer tastes. tastes are nothing more than your likes and dislikes as a consumer. What determines tastes? Your desires for food when hungry and drink when thirsty are largely biological. So too is your desire for comfort, rest, shelter, friendship, love, status, personal safety, and a pleasant environment. Your family background affects some of your tastesyour taste in food, for example, has been shaped by years of home cooking. Other influences include the surrounding culture, peer pressure, and religious convictions. So economists can say a little about the origin of tastes, but they claim no special expertise in understanding how tastes develop and change over time. Economists recognize, tastes however, that tastes have an consumer preferences; important impact on demand. likes and dislikes in conFor example, although pizza sumption; assumed to remain constant along a is popular, some people just given demand curve dont like it, and those who movement along a are lactose intolerant cant demand curve stomach the cheese topping. change in quantity demanded resulting from Thus, most people like pizza a change in the price of but some dont. the good, other things In our analysis of conconstant sumer demand, we will shift of a demand assume that tastes are given and curve movement of a demand are relatively stable. Tastes are curve right or left resultassumed to remain constant ing from a change in along a given demand curve. one of the determinants of demand other than A change in the tastes for a the price of the good particular good would shift supply that goods demand curve. a relation between the For example, a discovery that price of a good and the quantity that producers the tomato sauce and cheese are willing and able to combination on pizza prosell per period, other motes overall health could things constant change consumer tastes, law of supply shifting the demand curve for the amount of a good that producers are willpizza to the right. But because ing and able to sell per a change in tastes is so diffiperiod is usually directly cult to isolate from other ecorelated to its price, other things constant nomic changes, we should be supply curve reluctant to attribute a shift of a curve showing the the demand curve to a change relation between the in tastes. We try to rule out price of a good and the quantity producers other possible reasons for a are willing and able to shift of the demand curve sell per period other before accepting a change in things constant tastes as the explanation. 78
Part 1 Introduction to Economics

That wraps up our look at changes in demand. Before we turn to supply, you should remember the distinction between a movement along a given demand curve and a shift of a demand curve. A change in price, other things constant, causes a movement along a demand curve, changing the quantity demanded. A change in one of the determinants of demand other than price causes a shift of a demand curve, changing demand.

LO2 Supply
Just as demand is a relation between price and quantity demanded, supply is a relation between price and quantity supplied. Supply indicates
how much producers are willing and able to offer for sale per period at each possible price, other things constant. The law of supply states that the quantity supplied is usually directly related to its price, other things constant. Thus, the lower the price, the smaller the quantity supplied; the higher the price, the greater the quantity supplied.
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The Supply Schedule and Supply Curve

Exhibit 3 presents the market supply schedule and market supply curve S for pizza. Both show the quantities supplied per week at various possible prices by the thousands of pizza makers in the economy. As you can see, price and quantity supplied are directly, or positively, related. Producers offer more at a higher price than at a lower price, so the supply curve slopes upward.

Exhibit 3a
(a) Pizza The Supply Schedule for Supply schedule Price per Pizza $15 12 9 6 3 Quantity Supplied per Week (millions) 28 24 20 16 12

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>> Higher gasoline prices increase a companys ability to explore and drill in less accessible areas.
There are two reasons why producers offer more for sale when the price rises. First, as the price increases, other things constant, a producer becomes more willing to supply the good. Prices act as signals to existing and potential suppliers about the rewards for producing various goods. A higher pizza price attracts resources from lower-valued uses. A higher price makes producers more willing to increase quantity supplied. Higher prices also increase the producers ability to supply the good. The law of increasing opportunity cost, as noted in Chapter 2, states that the opportunity cost of producing more of a particular good rises as output increasesthat is, the marginal cost of production increases as output increases. Because producers face a higher marginal cost for additional output, they need to get a higher price for that output to be able to increase the quantity supplied. A higher price makes producers more able to increase quantity supplied. As a case in point, a higher price for gasoline increases oil companies ability to extract oil from tar sands, to drill deeper, and to explore in less accessible areas, such as the remote jungles of the Amazon, the stormy waters of the North Sea, and the frozen tundra above the Arctic Circle.

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Exhibit 3b
The Supply Curve for Pizza

(b) Supply curve S

$15 Price per pizza 12 9 6 3

0
12 16 20 24 28 Millions of pizzas per week

Thus, a higher price makes producers more willing and more able to increase quantity supplied. Producers are more willing because production becomes more profitable than other uses of the resources involved. Producers are more able because they can afford to cover the higher marginal cost that typically results from increasing output. As with demand, we distinguish between supply and quantity supplied. Supply is the entire relationship between prices and quantities supplied, quantity supplied the amount offered for as reflected by the supply sale per period at a parschedule or supply curve. ticular price, as reflected Quantity supplied refers to a by a point on a given supply curve particular amount offered individual supply for sale at a particular price, the relation between the as reflected by a point on a price of a good and the given supply curve. We also quantity an individual producer is willing and distinguish between indiable to sell per period, vidual supply, the supply other things constant of an individual producer, market supply and market supply, the sum the relation between the of individual supplies of all price of a good and the quantity all producers producers in the market. are willing and able to Unless otherwise noted, the sell per period, other term supply refers to market things constant supply.
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Shifts of the Supply Curve

The supply curve isolates the relation between the price of a good and the quantity supplied, other things constant. Assumed constant along a supply curve are the determinants of supply other than the price of the good, including (1) the state of technology, (2) the prices of relevant resources, (3) the prices of alternative goods, (4) producer expectations, and (5) the number of producers in the market. Lets see how a change in each affects the supply curve.

Exhibit 4
An Increase in the Supply of Pizza

S
$15 Price per pizza 12 9 6 3 0 12 16 20 24 28

S'

Changes in Technology
Recall from Chapter 2 that the state of technology represents the economys knowledge about how to combine resources efficiently. Along a given supply curve, technology is assumed to remain unchanged. If a better technology is discovered, production costs will fall, so suppliers will be more willing and able to supply the good at each price. Consequently, supply will increase, as reflected by a rightward shift of the supply curve. For example, suppose a new high-tech oven that costs the same as existing ovens bakes pizza in half the time. Such a breakthrough would shift the market supply curve rightward, as from S to S9 in Exhibit 4, where more is supplied at each possible price. For example, at a price of $12, the amount supplied increases from 24 million to 28 million pizzas, as shown in Exhibit 4 by the movement from point g to point h. In short, an increase in supplythat is, a rightward shift of the supply curvemeans that producers are willing and able to sell more pizza at each price.

Millions of pizzas per week

vant resource reduces supply, meaning a shift of the supply curve leftward. For example, a higher price of mozzarella increases the cost of making pizza. Higher production costs decrease supply, as reflected by a leftward shift of the supply curve.
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04-084 SW Changes in the Prices EX04.04 ar1 ofMcEachern/Economics 1e Goods Alternative 23p Wide x 17p10 Deep

Changes in the Prices of Relevant Resources

relevant resources are those employed in the production of the good in question. For example, suppose the price of mozzarella cheese falls. This price relevant resources decrease reduces the cost of resources used to making pizza, so producers produce the good in question are more willing and better alternative goods able to supply it. The supply other goods that use curve for pizza shifts rightsome or all of the same ward, as shown in Exhibit resources as the good in question 4. On the other hand, an increase in the price of a rele80
Part 1 Introduction to Economics

4/C Nearly all resources have alternative 06/11/04 DL uses. The labor, building, machinery, ingredients, and knowledge needed to run a pizza business could produce other baked goods. alternative goods are those that use some of the same resources employed to produce the good under consideration. For example, a decrease in the price of Italian bread reduces the opportunity cost of making pizza. As a result, some bread makers become pizza makers so the supply of pizza increases, shifting the supply curve of pizza rightward as in Exhibit 4. On the other hand, if the price of an alternative good, such as Italian bread, increases, supplying pizza becomes relatively less attractive compared to supplying Italian bread. As resources shift from pizza to bread, the supply of pizza decreases, or shifts to the left.

Changes in Producer Expectations

Changes in producer expectations can shift the supply curve. For example, a pizza maker expecting higher pizza prices in the future may expand his or her pizzeria now, thereby shifting the supply of pizza

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Changes in the Number of Producers

Because market supply sums the amounts supplied at each price by all producers, market supply depends on the number of producers in the market. If that number increases, supply will increase, shifting supply to the right. If the number of producers decreases, supply will decrease, shifting supply to the left. As an example of increased supply, the number of Caf coffee day shops has increased, shifting the supply curve of coffee to the right. Finally, note again the distinction between a movement along a supply curve and a shift of a supply curve. A change in price, other things constant, causes a movement along a supply curve, changing the quantity supplied. A change in one of the determinants of supply other than price causes a shift of a supply curve, changing supply. You are now ready to bring demand and supply together.

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rightward. When a good can be easily stored (crude oil, for example, can be left in the ground), expecting higher prices in the future might prompt some producers to reduce their current supply while awaiting the higher price. Thus, an expectation of higher prices in the future could either increase or decrease current supply, depending on the good. More generally, any change affecting future profitability, such as a change in business taxes, could shift the supply curve now.

LO3 Demand and Supply

Create a Market
Demanders and suppliers have different views of price. Demanders pay the price and suppliers
receive it. Thus, a higher price is bad news for consumers but good news for producers. As the price rises, consumers reduce their quantity demanded along the demand curve and producers increase their quantity supplied along the supply curve. How is this conflict between producers and consumers resolved?

required for exchange. For example, suppose you are looking for a summer job. One approach might be to go from employer to employer looking for openings. But this could have you running around for days or weeks. A more efficient strategy would be to pick up a copy of the local newspaper or go online and look for openings. Classified ads and Web sites, which are elements of the job market, reduce the transaction costs of bringing workers and employers together. The coordination that occurs through markets takes place not because of some central plan but because of Adam Smiths invisible hand. For example, the auto dealers in your community tend to locate together, usually on the outskirts of town, where land is cheaper. The dealers congregate not because they all took an economics course or because they like one anothers company but because together they become a more attractive destination for car buyers. A dealer who makes the mistake of locating away from the others misses out on a lot of business. Similarly, stores locate movement along a together so that more shopsupply curve pers will be drawn by the call change in quantity of the mall. From Orlando supplied resulting from a change in the price of theme parks to Broadway the good, other things theaters to Las Vegas casiconstant nos, suppliers congregate to shift of a supply attract demanders. curve

Markets
A market sorts out differences between demanders and suppliers. A market, as you know from Chapter 1, includes all the arrangements used to buy and sell a particular good or service. Markets reduce transaction coststhe costs of time and information

Market Equilibrium
To see how a market works, lets bring together market demand and supply. Exhibit 5 shows the market

movement of a supply curve left or right resulting from a change in one of the determinants of supply other than the price of the good

transaction costs
the costs of time and information required to carry out market exchange

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Alternatively, suppose the price initially is $6. You can see from Exhibit 5 Equilibrium in the Pizza Market that at that price, consumers demand 26 (a) Market schedules million pizzas but producers supply only 16 million, resulting in an excess quanMillions of Pizzas per Week tity demanded, or a shortage, of 10 million pizzas per week. Producers quickly Price per Quantity Quantity Surplus or Effect on notice that they have sold out and those Pizza Demanded Supplied Shortage Price customers still demanding pizzas are $15 8 28 Surplus of 20 Falls grumbling. Profit-maximizing producers 12 14 24 Surplus of 10 Falls Remains the same and frustrated consumers create mar9 20 20 Equilibrium ket pressure for a higher price, as shown 6 26 16 Shortage of 10 Rises by the arrow pointing up in the graph. 3 32 12 Shortage of 20 Rises As the price rises, producers increase their quantity supplied and consum(b) Market curves ers reduce their quantity demanded. The price continues to rise as long as quantity demanded exceeds quantity S supplied. Thus, a surplus creates downward $15 pressure on the price, and a shortage creSurplus ates upward pressure. As long as quan12 tity demanded differs from quantity supplied, this difference forces a price c 9 change. Note that a shortage or a surplus depends on the price. There is no 6 such thing as a general shortage or a Shortage general surplus, only a shortage or a 3 surplus at a particular price. D A market reaches equilibrium when 0 the quantity demanded equals quantity 14 16 20 24 26 supplied. In equilibrium, the indepenMillions of pizzas per week dent plans of both buyers and sellers exactly match, so market forces exert no pressure for for pizza, using schedules in panel (a) and curves in change. In Exhibit 5, the demand and supply curves panel (b). Suppose the price initially is $12. At that intersect at the equilibrium point, identified as point c. price, producers supply 24 million pizzas per week, The equilibrium price is $9 per pizza, and the equilibrium 04-084 SW but consumers demand only quantity is 20 million per week. At that price and quanEX04.05 ar1 surplus 14 million, resulting in an tity, the market clears. Because there is no shortage or McEachern/Economics 7e at a given price, the excess quantity supplied, or a 25p6 Wide xwhich Deep surplus, there is no pressure for the price to change. amount by 30p3 quansurplus, of 10 million pizzas 4/C supplied exceeds tity The demand and supply curves form an x at the 06/11/04 DL quantity demanded; a per week. Suppliers dont like intersection. The equilibrium point is found where x surplus usually forces getting stuck with unsold marks the spot. the price down pizzas. Their desire to elimiA market finds equilibrium through the indepenshortage nate the surplus puts downat a given price, the dent actions of thousands, or even millions, of buyward pressure on the price, amount by which quaners and sellers. In one sense, the market is personal tity demanded exceeds as shown by the arrow pointbecause each consumer and each producer makes a quantity supplied; a ing down in the graph. As the shortage usually forces personal decision about how much to buy or sell at price falls, producers reduce the price up a given price. In another sense, the market is impertheir quantity supplied and equilibrium sonal because it requires no conscious communicathe condition that exconsumers increase their tion or coordination among consumers or producers. ists in a market when quantity demanded. The the plans of buyers The price does all the talking. Impersonal market forces price continues to fall as long match those of sellers, synchronize the personal and independent decisions of so quantity demanded as quantity supplied exceeds many individual buyers and sellers to achieve equilibrium equals quantity supplied quantity demanded. and the market clears price and quantity. 82
Price per pizza
Part 1 Introduction to Economics

Exhibit 5

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LO4 Changes in equilibrium

Price and Quantity
equilibrium occurs when the intentions of demanders and suppliers exactly match. Once
a market reaches equilibrium, that price and quantity prevail until something happens to demand or supply. A change in any determinant of demand or supply usually changes equilibrium price and quantity in a predictable way, as youll see.

Exhibit 6
Effects of an Increase in Demand
S Price per pizza

$12 9 c

Shifts of the Demand Curve

In Exhibit 6, demand curve D and supply curve S intersect at point c to yield the initial equilibrium price of $9 and the initial equilibrium quantity of 20 million 12-inch regular pizzas per week. Now suppose that one of the determinants of demand changes in a way that increases demand, shifting the demand curve to the right from D to D9. Any of the following could shift the demand for pizza rightward: (1) an increase in the money income of consumers (because pizza is a normal good); (2) an increase in the price of a substitute, such as tacos, or a decrease in the price of a complement, such as Coke; (3) a change in consumer expectations that causes people to demand more pizzas now; (4) a growth in the number of pizza consumers; or (5) a change in consumer tastesbased, for example, on a discovery that the tomato sauce on pizza has antioxidant properties that improve overall health. After the demand curve shifts rightward to D9 in Exhibit 6, the amount demanded at the initial price of $9 is 30 million pizzas, which exceeds the amount supplied of 20 million by 10 million pizzas. This shortage puts upward pressure on the price. As the price increases, the quantity demanded decreases along the new demand curve D9, and the quantity supplied increases along the existing supply curve S until the two quantities are equal once again at equilibrium point g. The new equilibrium price is $12, and the new equilibrium quantity is 24 million pizzas per week. Thus, given an upward-sloping supply curve, an increase in demand increases both equilibrium price and quantity. A decrease in demand would lower both equilibrium price and quantity. These results can be summarized as follows: Given an upward-sloping sup-

0 20 24 30

D'

Millions of pizzas per week

ply curve, a rightward shift of the demand curve increases both equilibrium price and quantity and a leftward shift decreases both equilibrium price and quantity.

Shifts of the 04-084 SW Supply Curve

EX04.06 ar1 McEachern/Economics Lets consider shifts Wide xthe Deep7e of 16p2 supply curve. In 25p6 Exhibit 7, as before, 4/C begin with demand curve we 06/11/04 DL D and supply curve S intersecting at point c to yield an equilibrium price of $9 and an equilibrium quantity of 20 million pizzas per week. Suppose one of the determinants of supply changes, increasing supply from S to S9. Changes that could shift the supply curve rightward include (1) a technological breakthrough in pizza ovens; (2) a reduction in the price of a relevant resource, such as mozzarella cheese; (3) a decline in the price of an alternative good, such as Italian bread; (4) a change in expectations that encourages pizza makers to expand production now; or (5) an increase in the number of pizzerias. After the supply curve shifts rightward in Exhibit 7, the amount supplied at the initial price of $9 increases from 20 million to 30 million, so produc-

Exhibit 7
Effects of an Increase in Supply
S S'

eS rImaG

Price per pizza

$9 6

c d

GeS/J k Ima Stoc thINk

uPIte

0 20 26 30

Millions of pizzas per week

CHaPter 4 Demand, Supply, and Markets 83

04-084 SW EX04.07 ar3 McEachern/Economics 7e 25p6 Wide x 16p3 Deep 4/C 08/27/04GM 10/20/04 JMAC

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ers now supply 10 million more pizzas than consumers demand. This surplus forces the price down. As the price falls, the quantity supplied declines along the new supply curve but the quantity demanded increases along the existing demand curve until a new equilibrium point d is established. The new equilibrium price is $6, and the new equilibrium quantity is 26 million pizzas per week. In short, an increase in supply reduces the price and increases the quantity. On the other hand, a decrease in supply increases the price but decreases the quantity. Thus, given a downward-sloping demand curve, a rightward shift of the supply curve decreases price but increases quantity, and a leftward shift increases price but decreases quantity.

Exhibit 8
Indeterminate Effect of an Increase in Both Demand and Supply

(a) Shift of demand dominates S b a S'

Price

p' p

D' D

Simultaneous Shifts of Demand and Supply Curves

As long as only one curve shifts, we can say for sure how equilibrium price and quantity will change. If both curves shift, however, the outcome is less obvious. For example, suppose both demand and supply increase, or shift rightward, as in Exhibit 8. Note that in panel (a), demand shifts more than supply, and in panel (b), supply shifts more than demand. In both panels, equilibrium quantity increases. The change in equilibrium price, however, depends on which curve shifts more. If demand shifts more, as in panel (a), equilibrium price increases. For example, between 1995 and 2005, the demand for housing in the U.S. increased more than the supply, so both price and quantity increased. But if supply shifts more, as in panel (b), equilibrium price decreases. For example, in the last decade, the supply of personal computers has increased more than the demand, so price has decreased and quantity increased. Conversely, if both demand and supply decrease, or shift leftward, equilibrium quantity decreases. But, again, we cannot say what will happen to equilibrium price unless we examine relative shifts. (You can use Exhibit 8 to consider decreases in demand and supply by viewing D9 and S9 as the initial curves.) If demand shifts more, the price will fall. If supply shifts more, the price will rise. If demand and supply shift in opposite directions, we can say what will happen to
thINk Stoc k Ima GeS/J uPIte rImaG eS

0 Q Q ' Units per period

(b) Shift of supply dominates S S"

Price

p p"

0 Q Q"

D"

Units per period

equilibrium price. Equilibrium price will increase if demand increases and supply decreases. Equilibrium 04-084 SW price will decrease EX04.08 ar2 decreases and supply if demand increases. WithoutMcEachern/Economics 7e reference to particular shifts, 18p Wide x 30p6 however, we cannot say what willDeep happen to equilib4/C rium quantity. 06/11/04 DL These results are no doubt confusing, but Exhibit 06/23/04 JMAC 08/27/04GM 9 summarizes the four possible combinations of changes. Using Exhibit 9 as a reference, please take the time right now to work through some changes in demand and supply to develop a feel for the results.

LO5 Disequilibrium
a surplus exerts downward pressure on the price, and a shortage exerts upward pressure.
Markets, however, dont always reach equilibrium quickly. During the time required to adjust, the mar-

84

Part 1 Introduction to Economics

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Exhibit 9
Effects of Shifts of Both Demand and Supply
Change in demand Demand increases Equilibrium price change is indeterminate. Equilibrium quantity increases. Equilibrium price rises. Equilibrium quantity change is indeterminate. Demand decreases Equilibrium price falls. Equilibrium quantity change is indeterminate. Equilibrium price change is indeterminate. Equilibrium quantity decreases.

Change in supply

Supply increases

Supply decreases

Rare talent alone doesnt command high pay. Only the 300 or so top riders can earn a living. Only the top 50 or so make more than $100,000.

ket is said to be in disequilibrium. Disequilibrium is usually temporary as the market gropes for equi04-084 SW librium. But sometimes, often as a result of governEX04.09 ar1 ment intervention, disequilibrium can last a while, McEachern/Economics 7e 24p Wide x decades, perhaps17p6 Deep as we will see next.
4/C 06/11/04 DL

Price Floors
rubberball/JuPIterImaGeS

Sometimes public officials set prices above their equilibrium levels. For example, the state government regulates some agriculture prices in an attempt to ensure farmers a higher and more stable income than they would otherwise earn. To achieve higher prices, the state government sets a price floor, or a minimum selling price that is above the equilibrium price. Exhibit 10a shows the effect of a $2.50 per gallon price floor for milk. At that price, farmers supply

24 million gallons per week, but consumers demand only 14 million gallons, yielding a surplus of 10 million gallons. This surplus milk will pile up on store shelves, eventually souring. To take it off the market, the government usually disequilibrium agrees to buy the surplus the condition that exists in a market when the milk. The state government, plans of buyers do not in fact, spends billions buymatch those of sellers; a temporary mismatch being and storing surplus agritween quantity supplied cultural products. Note, to and quantity demanded have an impact, a price floor as the market seeks equilibrium must be set above the equiprice floor librium price. A price floor set at or below the equilibrium price would be nonbinding (how come?). Price floors distort markets and reduce economic welfare.
a minimum legal price below which a product cannot be sold; to have an impact, a price floor must be set above the equilibrium price

Why did Milk Prices Soar when Ganesha Started Drinking Milk?

The Hindu milk miracle was a phenomenon, considered by many Hindus as a miracle, which occurred on September 21, 1995. Before dawn, a Hindu worshipper at a temple in New Delhi made an offering of milk to a statue of Ganesha. When a spoonful of milk from the bowl was held up to the trunk of the statue, the liquid was seen to disappear, apparently taken in by the idol. Word of the event spread quickly, and by mid-morning it was found that statues of the entire Hindu pantheon in temples all over North India were taking in milk. By noon the news had spread beyond India, and Hindu temples in Britain, Canada, Dubai, and Nepal among other countries had successfully replicated the phenomenon, and the Vishva Hindu Parishad had announced that a miracle was occurring. On this day, many stores in areas with significant Hindu communities saw a massive jump in sales of milk. Overall milk sales in New Delhi jumped over 30 per cent. Since supplies could not adjust to the increased demand, instantaneously milk shortages were reported. The market adjusted with the price of milk soaring on this day. Several cafes (e.g., in Calcutta) stopped offering customers tea with milk. They instead preferred to sell milk for 10 times the normal price.

CHaPter 4 Demand, Supply, and Markets 85

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haNS-Peter merteN/maurItIuS DIe bIlDaGeNtur Gmbh/PhotolIbrary

aGeS

Price Ceilings
Sometimes public officials try to keep a price below the equilibrium level by setting a price ceiling, or a maximum selling price. Concern about the rising cost of rental housing in some cities has prompted city officials to impose rent ceilings. Exhibit 10b depicts the demand and supply of rental housing. The vertical axis shows monthly rent, and the horizontal axis shows the quantity of rental units. The equilibrium, or market-clearing, rent is $1,000 per month, and the equilibrium quantity is 50,000 housing units. Suppose city officials set a maximum rent of $600 per month. At that ceiling price, 60,000 rental units are demanded, but only 40,000 price ceiling supplied, resulting in a housa maximum legal price above which a product ing shortage of 20,000 units. cannot be sold; to have Because of the price ceilan impact, a price ceiling, the rental price no loning must be set below the equilibrium price ger rations housing to those who value it the most. Other

devices emerge to ration housing, such as long waiting lists, personal connections, and the willingness to make under-the-table payments, such as key fees, finders fees, high security deposits, and the like. To have an impact, a price ceiling must be set below the equilibrium price. A price ceiling set at or above the equilibrium level would be nonbinding. Price floors and ceilings distort markets and reduce economic welfare. Government intervention is not the only source of market disequilibrium. Sometimes, when new products are introduced or when demand suddenly changes, it takes a while to reach equilibrium. For example, popular toys, best-selling books, and chartbusting CDs sometimes sell out. On the other hand, some new products attract few customers and pile up unsold on store shelves, awaiting a clearance sale.

k ImaG kStoc thIN

eS/JuP

IterIm

Final Word
Demand and supply are the building blocks of a market economy. Although a market usually involves the interaction of many buyers and sellers, few markets are consciously designed. Just as the law of gravity works whether or not we understand Newtons principles, market forces operate whether or not participants understand demand and supply. These forces arise naturally, much the way car dealers cluster on the outskirts of town to attract more customers. Markets have their critics. Some observers may be troubled, for example, that an NBA star like Kevin Garnett earns a salary that could pay for 500 new schoolteachers, or that movie stars earn enough to pay for 1,000 new schoolteachers, or that U.S. con-

Exhibit 10a

Price floor for milk Price Floors for Milk (a) (a) Price floor for milk

Exhibit 10b

(b) Price ceiling for rent Price Ceilings for Rent(b) Price ceiling for rent S S Monthly rental price Monthly rental price

Price per gallon Price per gallon

S S Surplus Surplus 1.90 1.90

$1,000 $1,000

$2.50 $2.50

600 600 Shortage Shortage

D D 0 0 14 14 19 24 19 24 Millions of gallons month Millions of gallons perper month 86

Part 1 Introduction to Economics

D D 0 0 40 40 50 60 50 60 Thousands of rental units month Thousands of rental units perper month

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sumers spend over $40 billion on their pets. On your next trip to the supermarket, notice how much shelf space goes to pet productsoften an entire aisle. PetSmart, a chain store, sells over 12,000 pet items. Veterinarians offer cancer treatment, cataract removal, root canals, even acupuncture. Kidney dialysis for a pet can cost over $75,000 per year.

In a market economy, consumers are kings and queens. Consumer sovereignty rules, deciding what gets produced. Those who dont like the market outcome usually look to government for a solution through price ceilings and price floors, regulations, income redistribution, and public finance more generally.

CHaPter 4 Demand, Supply, and Markets 87

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Multiple ChoiCe Questions

1. The law of demand says that as the price of a good rises, a. buyers recognize that price may be even higher in the future, and so they buy now b. buyers purchase less in hopes that the price will fall in the future c. buyers purchase less, in part because their real income has fallen d. buyers purchase more, in part because the price of a substitute has risen e. buyers purchase more, in part because it has higher status at a higher price 2. Movements along a demand curve are called changes in a. Demand b. opportunity costs c. quantity demanded d. the substitution effect e. preferences 3. The substitution effect of a change in the price of bananas refers to the way in which a change in the a. price of a substitute affects the demand for bananas b. price of bananas affects the ability to buy them c. relative price of bananas changes demand for them d. relative price of bananas changes the quantity demanded of bananas e. price of a substitute affects the quantity demanded of bananas 4. If pretzels are a normal good, the income effect of a price change means that a. as income increases, the quantity demanded increases along the demand curve for pretzels b. as income increases, the demand curve for pretzels shifts rightward c. as income increases, the demand curve for pretzels shifts leftward d. as the price of pretzels increases, the real income of individuals who demand pretzels decreases, so the quantity demanded of pretzels decreases e. as the price of pretzels increases, income increases 5. Which of the following will not shift the demand curve for movie tickets? a. a change in the cost of babysitting services 88
Part 1 Introduction to Economics

b. a change in the price of movie tickets c. a change in the quality of television programs d. a change in the income of movie-goers e. a change in the number of consumers 6. The difference between normal and inferior goods is that a. normal goods are of better quality than inferior goods b. an increase in price will shift the demand curve for a normal good rightward and the demand curve for an inferior good leftward c. if the price of a normal good increases, individuals who buy it are poorer; for inferior goods, the opposite is true d. an inferior good is something that will not be demanded until quantities of the normal good have been exhausted e. an increase in income will shift the demand curve for a normal good rightward and the demand curve for an inferior good leftward 7. An increase in the demand for peanut butter could be caused by a(n) a. decrease in consumer income b. increase in the supply of peanut butter c. decrease in the price of bread d. drought in Georgia that destroyed 30 percent of the peanut crop e. decrease in the price of bologna 8. Supply curves generally slope upward because of all of the following reasons except one. Which is the exception? a. Producers are willing to offer more of a good at higher prices. b. A higher price attracts resources from lessvalued uses. c. Producers must be compensated for the rising opportunity cost of additional output. d. Producers have a greater incentive to sell more as the price increases. e. The price of a good usually must fall to induce an increase in quantity supplied. 9. Which of the following is the reason supply curves typically slope upward? a. Opportunity cost of production increases as quantity supplied increases. b. Supply increases as opportunity cost decreases.

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c. Price increases as supply decreases. d. Quantity supplied is unrelated to price. e. The income and substitution effects of a price change. 10. If the supply curves for the following goods were plotted, they all would slope upward except one. Which is the exception? a. red Corvettes b. yogurt c. diamond rings d. original copies of the Mona Lisa e. wine from Greece 11. An improvement in technology would shift a. the demand curve leftward b. the demand curve rightward c. the supply curve leftward d. neither the supply nor the demand curve; instead, there is movement along both of them e. the supply curve rightward 12. Which of the following will not shift the market supply curve for corn? a. a change in the price of corn b. a change in the price of soybeans c. a change in the price of herbicides and pesticides d. a change in storage technology e. a change in the number of acres planted in corn 13. Economists emphasize the importance of equilibrium in markets because a. trading in markets can only occur at the equilibrium price and quantity b. the behavior of buyers and sellers will automatically guide the market toward the equilibrium price and quantity c. all buyers and sellers are better off at the equilibrium point than any other price and quantity combination d. it represents a compromise between sellers hoping for low prices and buyers searching for high prices e. it is the only price-quantity combination that guarantees that the poorest members of society can purchase the good or service 14. Saccharin and aspartame are both low-calorie substitutes for sugar. If saccharin is found to cause cancer, a. the price of aspartame will increase b. the price of sugar will decrease c. the price of saccharin will increase d. the demand curves for aspartame and sugar will shift leftward

e. aspartame and sugar will be complements 15. Velcro is becoming more and more popular for a variety of uses, including as fasteners for shoes. What should happen to the equilibrium price and quantity for shoelaces as a result? a. Both price and quantity should increase. b. Both price and quantity should decrease. c. Price should increase and quantity decrease. d. Price should decrease and quantity increase. e. Nothing. 16. Attempts are being made to develop a biodegradable plastic using agricultural produce such as potatoes. If these attempts are successful, what will happen to the equilibrium price and quantity of potatoes? a. Price will increase and quantity decrease. b. Price will increase and quantity increase. c. Price will decrease and quantity increase. d. Price will decrease and quantity decrease. e. No change in equilibrium price and quantity will occur. 17. The market for chewing gum is competitive with a current price of 50 cents per pack and quantity of 100,000 packs. Which of the following events would lead to a new equilibrium price of 40 cents and quantity of 80,000 packs? a. an increase in the price of other kinds of candy b. an increase in the price of the ingredients used to make chewing gum c. a decrease in the number of young people in the population d. an agreement by workers in the chewing gum industry to work for lower wages e. an improvement in chewing gum production technology 18. A new hormone will increase the amount of milk each cow produces. If this hormone is adopted by many dairies, what will be the effect on the milk market? a. an increase in supply, higher equilibrium price, and lower equilibrium quantity b. a decrease in supply, lower equilibrium price, and lower equilibrium quantity c. an increase in supply, lower equilibrium price, and higher equilibrium quantity d. an increase in supply, higher equilibrium price, and higher equilibrium quantity e. a decrease in supply, lower equilibrium price, and higher equilibrium quantity

CHaPter 4 Demand, Supply, and Markets 89

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19. If demand increases and supply decreases, a. equilibrium price will fall and equilibrium quantity will rise b. equilibrium price and quantity will both rise c. equilibrium quantity will rise; equilibrium price will either rise or fall d. equilibrium price will fall; equilibrium quantity will either rise or fall e. equilibrium price will rise; equilibrium quantity will either rise, fall, or remain unchanged 16. b 17. c 18. c 19. e 20. e

20. Suppose a market is in equilibrium and then a price floor is established below the equilibrium price. Which of the following will happen? a. quantity demanded will increase b. a surplus will develop c. a shortage will develop d. the quantity sold will rise e. the market will remain in equilibrium

long Answer Questions

LO1 Explain how the law of demand affects market activity

1.1. (Shifting Demand) Using demand and supply curves, show the effect of each of the following on the market for cigarettes: a. A cure for lung cancer is found. b. The price of cigars increases. c. Wages increase substantially in states that grow tobacco. d. A fertilizer that increases the yield per acre of tobacco is discovered. e. There is a sharp increase in the price of matches, lighters, and lighter fluid. f. More states pass laws restricting smoking in restaurants and public places. 1.2. (Substitutes and Complements) For each of the following pair of goods, determine whether the goods are substitutes, complements, or unrelated: a. Peanut butter and jelly b. Private and public transportation c. Coke and Pepsi d. Alarm clocks and automobiles e. Golf clubs and golf balls 1.3 How will each of the following affect the position of the demand curve for DVD players? a. An increase in the price of film DVDs. b. A decrease in the price of DVD players. c. An increase in per capita income. d. A decrease in the price of cinema tickets. 1.4 What is meant by market demand curve? On what factors does the market demand function of a commodity depend? 1.5 Which of the following pairs of goods are substitutes and which are complements? Explain. a. Insulation and heating oil b. Hot dogs and mustard c. Television sets and videocassette recorders 90
Part 1 Introduction to Economics

Numericals 1.1 In a certain fish market, there are suppliers with different time perspectives. As such, three market supply functions are estimated: St = 10 ----------------Temporary period Ss = 4+0.5 P ------------------ Short period Sl = -20+ 2.5 P -----------------------Long period Suppose that the market demand for fish suddenly changes from D= 16 0.5 P to D = 24 0.5 P Estimate exactly the effect of this change on (i) market price, and (ii) market output of fish corresponding to different time perspectives. Show your results graphically also. 1.2 Assume the demand curve for gasoline is given by the following equation: P = 10 0.0005 Q, where P is the price per gallon and Q is the quantity of gasoline in gallons. Assume that the only supplier of gasoline in the region is General Gasoline Co. and that the marginal cost of production is constant at zero. a. If the company is currently charging $4 a gallon, is it maximizing profit? If so, prove it. If not, find out the price that maximizes its profit, and compare the profits at the two prices. b. Discuss the likely effect of the introduction of a fuel-efficient car in the region, i.e. what would happen to the equilibrium quantity. Show the changes on a graph that displays (you dont need to show actual numbers) General Gasolines pricing solution and explain. 1.3 In Country Dreamland, cigarettes are forbidden, so people trade cigarettes in a black market. The cigarette demand is QD = 12 P, and the cigarette supply is Qs = 2P. a. Find the equilibrium price and quantity in the black market. b. The government becomes aware of the black market and reinforces the police so that half of the cigarette supply would be seized and destroyed. Under this circumstance, what are

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Answers
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11. e 1. b

12. a 2. c

13. b 3. d

14. a 4. d

15. b 5. b

6. e

7. c

8. e

9. a

10. d

the demand and supply functions? What is the new equilibrium price and quantity? Show the change by using a supply and demand diagram c. How does the consumer surplus change between (a) and (b)? d. Suppose that the government changes the policy and legalizes cigarette trade. Now cigarettes are traded in an open market. However, for every unit of cigarette purchased, the buyer has to pay tax T to the government. T is equal to the pre-tax price P. What are the demand and supply functions under this circumstance? What are the equilibrium price and quantity? What is the after-tax price paid by buyers? e. Compare (b) and (d). Which policy do consumers prefer? Which policy does the government prefer and why? 1.4 Suppose you are a stock market analyst specializing in the stocks of theme parks, and you are examining Disneylands stock. The Wall Street Journal reports that tourism has slowed down in the United States. At Six flags Magic Mountain in Valencia, California, a new Viper roller coaster is now operating and another new ride, is expected to open this year. Using demand and supply analysis, predict the impact of these events on ticket prices and attendance at Disneyland. As reported in The Wall Street Journal, Disneyland slashed ticket prices and admitted that attendance was somewhat lower. Is this consistent with your prediction using demand and supply analysis? In light of the fact that both price and output were falling at Disneyland, is the law of demand being violated in the world of fantasy? 1.5 Evaluate the following statements using graphical analysis. Provide a brief narrative explanation of your graph to support your evaluation. Make sure the axes and curves in your graphs are properly labeled. a. When demand for home heating oil increases, a shortage of heating oil will occur. b. A decrease in the supply of random access memory (RAM) chips for personal computers causes a shortage of RAM chips.

a. The price of dairy cow fodder increases. b. The price of beef decreases. c. Concerns arise about the fat content of ice cream. Simultaneously, the price of sugar (used to produce ice cream) increases.

LO4 Describe how markets reach equilibrium

4.1. (Equilibrium) If a price is not an equilibrium price, there is a tendency for it to move to its equilibrium level. Regardless of whether the price is too high or too low to begin with, the adjustment process will increase the quantity of the good purchased. Explain, using a demand and supply diagram. 4.2. (Equilibrium) Assume the market for corn is depicted as in the table that appears below. a. Complete the table below. b. What market pressure occurs when quantity demanded exceeds quantity supplied? Explain. c. What market pressure occurs when quantity supplied exceeds quantity demanded? Explain. d. What is the equilibrium price? e. What could change the equilibrium price? f. At each price in the first column of the table below, how much is sold? Quantity Quantity Price Demanded Supplied per (millions (millions Surplus/ Will Price Bushel of bushels) of bushels) Shortage Rise or Fall? $1.80 320 200 ______ ______ 2.00 300 230 ______ ______ 2.20 270 270 ______ ______ 2.40 230 300 ______ ______ 2.60 200 330 ______ ______ 2.80 180 350 ______ ______ 4.3. (Market Equilibrium) Determine whether each of the following statements is true, false, or uncertain. Then briefly explain each answer. a. In equilibrium, all sellers can find buyers. b. In equilibrium, there is no pressure on the market to produce or consume more than is being sold. c. At prices above equilibrium, the quantity exchanged exceeds the quantity demanded. d. At prices below equilibrium, the quantity exchanged is equal to the quantity supplied 4.4. (Changes in Equilibrium) What are the effects on the equilibrium price and quantity of steel if the wages of steelworkers rise and, simultaneously, the price of aluminum rises?

LO2 Explain how the law of supply affects market activity

2.1. (Supply) What is the law of supply? Give an example of how you have observed the law of supply at work. What is the relationship between the law of supply and the supply curve?

LO3 Describe how the interaction between supply and

demand creates markets
3.1. (Demand and Supply) How do you think each of the following affected the world price of oil? (Use demand and supply analysis.) a. Tax credits were offered for expenditures on home insulation. b. The Alaskan oil pipeline was completed. c. The ceiling on the price of oil was removed. d. Oil was discovered in the North Sea. e. Sport utility vehicles and minivans became popular. f. The use of nuclear power declined. 3.2. (Demand and Supply) What happens to the equilibrium price and quantity of ice cream in response to each of the following? Explain your answers.

LO5 Explain how markets react during periods of

disequilibrium.
5.1. (Price Floor) There is considerable interest in whether the minimum wage rate contributes to teenage unemployment. Draw a demand and supply diagram for the unskilled labor market, and discuss the effects of a minimum wage. Who is helped and who is hurt by the minimum wage?
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DeMaND, SUPPLY, aND MarKetS

KeY terMS
demand
a relation between the price of a good and the quantity that consumers are willing and able to buy per period, other things constant

Chapter in review
LO1
Explain how the law of demand affects market activity.

LO2

Explain how the law of supply affects market activity.

law of demand

the quantity of a good that consumers are willing and able to buy per period relates inversely, or negatively, to the price, other things constant

substitution effect of a price change

when the price of a good falls, that good become cheaper compared to other goods so consumers tend to substitute that good for other goods

money income real income

Demand is a relationship between the price of a product and the quantity consumers are willing and able to buy per period, other things constant. According to the law of demand, quantity demanded varies negatively, or inversely, with the price. A demand curve slopes downward because a price decrease makes consumers (a) more willing to substitute this good for other goods and (b) more able to buy the good because the lower price increases real income.
The Demand Curve for Pizza The market demand curve D shows the quantity of pizza demanded, at various prices, by all consumers. Price and quantity demanded are inversely related. (b) Demand curve
a b c d e D 8 14 20 26 32 Millions of pizzas per week

the number of dollars a person receives per period, such as $400 per week income measured in terms of the goods and services it can buy; real income changes when the price changes

Supply is a relationship between the price of a good and the quantity producers are willing and able to sell per period, other things constant. According to the law of supply, price and quantity supplied are usually postitively, or directly, related, so the supply curve typically slopes upward. The supply curve slopes upward because higher prices make producers (a) more willing to supply this good rather than supply other goods that use the same resources and (b) more able to cover the higher marginal cost associated with greater output rates.
The Supply Curve for Pizza Market supply curve S shows the quantity of pizza supplied, at various prices, by all pizza makers. Price and quantity supplied are directly related. Supply curve (b)
S $15 Price per pizza 12 9 6 3

income effect of a price change

Price per pizza

a fall in the price of a good increases consumers real income, making consumers more able to purchase goods; for a normal good, the quantity demanded increases

$15 12 9 6 3 0

demand curve

a curve showing the relation between the price of a good and the quantity consumers are willing and able to buy per period, other things constant

quantity demanded

the amount of a good consumers are willing and able to buy per period at a particular price, as reflected by a point on a demand curve

individual demand

0
12 16 20 24 28 Millions of pizzas per week

a relation between the price of a good and the quantity purchased by an individual consumer per 04-084 SW period, other things constant EX04.01 ar1

market demandWide x 16p8 Deep 35p8

McEachern/Economics 7e

4/C the relation between the price of a good and the 06/11/04 DL quantity purchased by all consumers in the market 06/23/04 JMAC during a given period, other things constant; sum of the individual demands in the market

normal good

04-084 SW EX04.03 ar1 McEachern/Economics 7e 37p Wide x 17p Deep 4/C 06/11/04 DL 06/23/04 JMAC

LO3

Describe how the interaction between supply and demand creates markets. Demand and supply come together in the market for the good.

a good, such as new clothes, for which demand increases, or shifts rightward, as consumer income rises

A market provides information about the price, quantity, and quality of the good. In doing so, a market reduces the transaction costs of exchangethe costs of time and information required for buyers and sellers to make a deal. The interaction of demand and supply guides resources and products to their highest-valued use.

inferior good

a good, such as used clothes, for which demand decreases, or shifts leftward, as consumer income rises

substitutes

goods, such as Coke and Pepsi, that relate in such a way that an increase in the price of one shifts the demand for the other rightward

complements

goods, such as milk and cookies, that relate in such a way that an increase in the price of one shifts the demand for the other leftward

tastes

consumer preferences; likes and dislikes in consumption; assumed to remain constant along a given demand curve

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movement along a demand curve

Equilibrium in the Pizza Market Market equilibrium occurs at the price where quantity demanded equals quantity supplied. This is shown at point c. Price pressure occurs at all other points on the curves.
Price per Quantity Pizza Demanded $15 12 9 6 3 8 14 20 26 32

(a) Market schedules Millions of Pizzas per Week Quantity Supplied 28 24 20 16 12 Surplus or Shortage Surplus of 20 Surplus of 10 Equilibrium Shortage of 10 Shortage of 20 Effect on Price Falls Falls Remains the same Rises Rises

change in quantity demanded resulting from a change in the price of the good, other things constant

shift of a demand curve

movement of a demand curve right or left resulting from a change in one of the determinants of demand other than the price of the good

supply

a relation between the price of a good and the quantity that producers are willing and able to sell per period, other things constant

(b) Market curves

S $15 Price per pizza Surplus 12 9 6 3 0 14 16 20 24 26 Millions of pizzas per week D c

law of supply

the amount of a good that producers are willing and able to sell per period is usually directly related to its price, other things constant

supply curve

a curve showing the relation between price of a good and the quantity producers are willing and able to sell per period other things constant

Shortage

quantity supplied

the amount offered for sale per period at a particular price, as reflected by a point on a given supply curve

individual supply

LO4

the relation between the price of a good and the quantity an individual producer is willing and able to sell per period, other things constant

Describe how markets reach equilibrium. Impersonal market forces reconcile the personal and independent plans of buyers and sellers. Market equilibrium, 04-084 SW once established, will continue unless there is a change in a determinant that shapes EX04.05 ar1 McEachern/Economics 7e demand or supply. 25p6 Wide x 30p3 Deep
4/C 06/11/04 DL

market supply

Effects of an Increase in Demand An increase in demand is shown by a shift of the demand curve rightward from D to D. Both price and quantity are higher following the rightward shift of the demand curve.

S Price per pizza

the relation between the price of a good and the quantity all producers are willing and able to sell per period, other things constant

$12 9 c

relevant resources alternative goods

resources used to produce the good in question other goods that use some or all of the same resources as the good in question

movement along a supply curve

0 20 24 30

D'

change in quantity supplied resulting from a change in the price of the good, other things constant

Millions of pizzas per week

shift of a supply curve

Effects of an Increase in Supply An increase in supply is shown by a shift of the supply curve rightward, from S to S. At the new equilibrium, quantity is greater and the price is lower than before the increase in supply.

Price per pizza

movement of a supply curve left or right resulting from a change in one of the determinants of supply other than the price of the good

S'

transaction costs surplus

$9 6

the costs of time and information required to carry out market exchange at a given price, the amount by which quantity supplied exceeds quantity demanded; a surplus usually forces the price down

04-084 SW c EX04.06 ar1 McEachern/Economics 7e 25p6 Wide x 16p2 Deep d 4/C 06/11/04 DL

0 20 26 30

shortage

Millions of pizzas per week

at a given price, the amount by which quantity demanded exceeds quantity supplied; a shortage usually forces the price up

LO5

equilibrium

the condition that exists in a market when the plans of buyers match those of sellers, so quantity demanded equals quantity supplied and the market clears

Explain how markets react during periods of disequilibrium. Markets 04-084 SW EX04.07 disequilibrium occurs. cant always achieve equilibrium quickly. Until they do, a period ofar3 McEachern/Economics 7e 25p6 Wide 16p3 Deep Governments often impose price floors or price ceilings to managexthe uncomfortable 4/C 08/27/04GM market effects of disequilibrium, like falling income or product surplus. 10/20/04 JMAC
price floor price ceiling

disequilibrium

the condition that exists in a market when the plans of buyers do not match those of sellers; a temporary mismatch between quantity supplied and quantity demanded as the market seeks equilibrium

a minimum legal price below which a product cannot be sold; to have an impact, a price floor must be set above the equilibrium price

a maximum legal price above which a product cannot be sold; to have an impact, a price ceiling must be set below the equilibrium price

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