Demand and Supply: How Prices are determined in a Market EconomyREVIEW: For review exercises click HERE Show
Introduction Structural Adjustment Policies In our introductory lecture on Structural Adjustment we discussed various policies that countries are adopting all around the word to promote economic growth (increasing output rather than increasing their ability) and achieve productive and allocative efficiency. It is hoped that as economies move away from command economies (Chapter 23) toward mzrket economies or capitalism (chapter 4). These policies are: 1. Privatization Even though the concepts of SUPPLY and DEMAND are microeconomic concepts, they are reviewed in this macroeconomics course because not all students have taken micro (ECO 211) and they are fundamental principles that all economic student should master. We will study supply and demand in this "Macroeconomics of the Gloabal Econaomy" course to better understand why there is a worldwide movement to remove price controls and let Supply and Demand determine prices. In a capitalist economy, prices are very important. They have two fundamental functions:
By doing this they help the economy maintain allocative efficiency and productive efficiency. In the 5Es lesson on allocative efficiency we discussed that it was good for the price of plywood to increase in Florida after a hurricane. When the price increased two things happened: (1) plywood was rationed to its most important uses (not doghouses or decks), and (2) the high prices were an incentive for more plywood to be guided to Florida so that they had more plywood. If the price of plywood was kept too low the result was allocative inefficiency (a shortage). Prices are also very important in maintaining productive efficiency. In the 5Es lecture on Productive efficiency we defined it as producing at a minimum cost. In order to minimize costs, producers must know the prices of the resources. If these resource prices are determined by demand and supply then they will reflect the relative scarcity of the resources and their relative importance (more scarce and important resources will have a higher price) and the economy can achieve productive efficiency. In a capitalist society prices are determined by the interaction of demand and supply. Since prices are so important, we need to better understand how they are determined. why is the price of gasoline $1.59 a gallon. Why does a candy bar cost $0.75? Why is the price of plywood normally $10 a sheet, but $30 a sheet after a hurricane? Demand If the price of a product increases what happens to demand for that product? For example, If the price of pizza increases, then the demand for pizza does what? - - - - - - - NOTHING! If the price of pizza increases, the demand for pizza does not change. This is because in economics we have a more precise definition of demand. Demand is NOT the quantity that people buy. DEFINITION: So what is demand? Demand is a schedule that shows the various quantities that consumers are willing and able to buy at various prices in a given time period, ceteris paribus. We should look more closely at this definition. Demand is a table of numbers. Look at the table below. The whole table might represent my demand for pizza. Demand Schedule and Curve As we learned in a previous lesson, any point on a graph represents two numbers, so we can plot our demand table as in the graph below. If we assume that there are quantities and prices in-between those in the table (for example if the price was $4.50 how many pizzas would I buy?) we can connect the points and we get the demand curve (graph). This is my demand for pizza. This demand curve does NOT tell us what the price will be. To know what the price will be we need both demand and supply. But we can see what happens to demand if the price of pizzas increases. If the price of pizza increases, say from $6 to $9, nothing on the table changes (demand does not change) because demand already includes various prices and various quantities. Demand (the table or the graph) does not change when the price changes because demand INCLUDES various prices and various quantities. Demand is NOT how much we buy. Note that our definition of demand includes the ceteris paribus assumption. When we develop a demand curve only the price and quantity demanded change. Everything else is assumed to remain constant. I don't get a large increase in my income. I don't win the lottery. There isn't a new study out that states pizzas cause cancer. All other factors remain the same - only the price and quantity demanded change. Law of Demand As we can see on the demand graph, there is an inverse relationship between price and quantity demanded. Economists call this the Law of Demand. If the price goes up, the quantity demanded goes down (but demand itself stays the same). If the price decreases, quantity demanded increases. This is the Law of Demand. On a graph, an inverse relationship is represented by a downward sloping line from left to right. Why? Why is the law of demand true? Why is the demand curve downward sloping from left to right? Why do people buy more at lower prices and less at higher prices? As social scientists, economists try to explain human behavior. It is common sense that people behave this way - but how can we explain it? Economists have three explanations:
Market Demand Definition: Market demand is the horizontal summation of the individual demand curves. Or, instead of just my individual demand for a product what if there were two people, or more, in the market. the result would be tat for each price, the quantities demanded would be greater since there are more people. The prices stay the same, but the quantities get larger, or the demand graph shifts horizontally (to the right). Graphically: Sample Problem: Given the following individuals' demand schedules for product X, and assuming these are the only three consumers of X, which set of prices and output levels below will be on the market demand curve for this product? ANSWER Determinants of Demand The price of the product Economists stress the importance of price in determining how much people will buy. That is why they put price on the demand graph, but there are other things that affect how much of a product we buy besides the price. When we developed my demand curve for pizza we employed the ceteris paribus assumption. I didn't get a large increase in my income. I didn't win the lottery. There wasn't a new study out that stated pizzas cause cancer. All other factors remained the same - only the price and quantity demanded changed. The non-price determinants of demand Let's not talk about pizzas anymore and use a new product in our examples. - - - How about vodka? We know that when the price of vodka goes up we buy less and when the price goes down we buy more (this is the law of demand). But what else might cause us to buy more vodka besides the price? In other words, IF THE PRICE OF VODKA STAYED THE SAME, what might cause us to buy more or less vodka? Two Kinds of Changes Involving Demand If the price of a product increases what happens to demand for that product? For example, If the price of pizza increases, then the demand for pizza does what?NOTHING, demand does not change when the price changes, but the quantity demanded does change. This section will help us to better understand the difference between a change in quantity demanded (Qd) and a change in demand itself (D). [The triangle, "", means "change".] Change in Quantity Demanded (Qd) A change in quantity demanded caused ONLY by a change in the PRICE of the product. On a graph it is represented by a movement ALONG a SINGLE demand curve. So if the price of pizza increase from $6 to $9 we will get an decrease in quantity demanded (Qd) from 5 pizzas to 3 pizzas. This does not change the demand schedule or the demand curve. Demand does not change. But it does result in a movement along the SAME demand curve. Change in Demand (D) When there is a change in demand itself we get a new demand schedule and curve. We have to change the numbers in the demand schedule and this will SHIFT the demand curve. If there is an increase in demand ( D) the demand curve moves to the RIGHT.When we say that the demand curves shift to the right, it means that we have to change the numbers on the demand schedule. For the same prices, the quantities increase. This shifts the curve to the RIGHT. A decrease in demand will then shift the demand curve to the LEFT. For each price on the demand schedule, the quantities decrease. Be sure to draw your arrows to the RIGHT and LEFT. Many students want to draw the arrows perpendicular to the demand curve. Don't do this. Always draw your arrows horizontally because this indicates the the prices are the same, and only the quantities change. A change in demand is caused by a CHANGE in the non-price determinants of demand: Non-price determinants of demand: Pe, Pog, I, Npot, TIf these change we get a new demand schedule and curve. To understand why prices are what they are, and why they change, we need to understand very well how these determinants move the demand curve. This is where it all begins. In our definition of demand we held these things constant (ceteris paribus), but in the real world these things do change, changing demand, and ultimately changing prices. So let's look at each determinant individually to understand how they each affect demand. Pe -- expected price Pe in the future D today Pog -- price of other goods The effect of a change in the price of other goods on demand depends on what type of other goods we are talking about. There are three types: I -- income 1) normal goodsFor most goods, called normal goods, if consumer incomes increase, demand will increase and vice versa. Income D for normal goods Npot -- number of POTENTIAL consumers An increase in the number of potential consumers will increase demand and vice versa. Npot D T -- tastes and preferences There are hundreds of factors that affect the quantity of vodka sold. We don't want to memorize hundreds of different determinants for each product, so economists group everything else into "tastes and preferences". Tastes and preferences really refers to "everything else". Anything that increases a consumer's preference for a product will increase demand for that product. This will include advertising and fads. Supply Introduction Supply is more difficult for students to understand than demand. We are all consumers (demanders), but few of us own a business (suppliers). So, remember to think of yourself as a business owner when we discuss supply. Definition Supply is a schedule which shows the various quantities businesses are willing and able to offer for sale at various prices in a given time period, ceteris paribus. Supply is NOT the quantity available for sale. This is the way the term is often used in the popular press. Supply is the whole schedule with many prices and many quantities. Just like with demand, there is a difference between a change in quantity supplied and a change in supply itself. So, if the price increases what happens to supply? The best WRONG answer would be "supply increases", but it doesn't. Price does not change supply, it changes quantity supplied, because supply means the whole schedule with various prices and various quantities. Supply Schedule and Curve Below is a hypothetical supply schedule for pizza. If we plot these points (remember any point on a graph simply represents two numbers) We get the graph below. If we assume there are quantities and prices in-between those on the schedule we get a supply curve. Law of Supply The law of supply states that there is a direct relationship between price and quantity supplied. In other words, when the price increases the quantity supplied also increases. This is represented by an upward sloping line from left to right. Why? Why is the law of supply true? Why is the supply curve upward sloping? Why will businesses supply more pizzas only id the price is higher? I think it is just common sense. If you want the pizza places to work harder and longer and produce more pizzas, you have to pay them more, per pizza. But economists, as social science, want to explain common sense. We know businesses behave this way, but why? There are two explanations for the law of supply and both have to do with increasing costs. Businesses require a higher price per pizza to produce more pizzas because they have higher costs per pizza. Why? First, there are increasing costs because of the law of increasing costs. In a previous lecture we explained that the production possibilities curve is concave to the origin because of the law of increasing costs. the law of increasing costs is true because not all resources are identical. Let's say a pizza place is just opening. The owner figures that they will need five employees. After putting an ad in the paper there are twenty applicants. Five have had experience working in a pizza place before. They came to the interview clean and on time. The other fifteen had no work experience. Many came late. A few were caught steeling pepperoni on the way out. One spilled flour all over the floor. Which applicants will be hired? Of course it will be the five with experience and the other fifteen will be rejected because they would be too costly to hire. NOW, if the pizza place wants to produce more pizzas they will need more workers. This means they will have to hire some of those who were rejected because they were more costly (less experienced, etc.). So, they will only hire the more costly employees if they can get a higher price to cover the higher costs. this is one explanation why the supply curve is upward sloping. Second, there are increasing costs because some resources are fixed. This should not make sense to you. Why would there be increasing costs if we use the same quantity of some resource? Well, let's say that the size of the kitchen and the number of ovens (capital resources) are fixed. This means that they don't change. Now, if we want to produce more pizzas you will have to cram more workers into the same size kitchen. As they bump into each other and wait for an oven to be free they still get paid, but the cost per pizza increases. Therefore they will not produce more pizza unless they can get a higher price to cover these higher per unit costs. So the supply curve should be upward sloping. Market Supply Market supply is the horizontal summation of the individual supply curves. Instead of looking at how many pizzas one pizza place is willing and able to produce at different prices (individual supply), we keep the prices the same and add the quantities of additional pizza places. Prices stay the same, but quantities increase because there are more pizza suppliers. So the market supply of pizzas is further to the right (horizontal) than the individual pizza place supply curves. determinants of Supply The price of the product (P) Economists stress the importance of price in determining how much will be produced. That is why they put price on the supply graph, but there are other things that affect how much of a product will be produced besides the price. When we developed the supply curve for pizza we employed the ceteris paribus assumption. we assumed all other things stayed constant. For example there were no new technological discoveries, the prices of resources stayed the same, or no change in taxes. All other factors remained the same - only the price and quantity supplied changed. The non-price determinants of Supply Economists classify the non-price determinants of supply into 6 groups:a. Pe -- expected price Two Kinds of Changes Involving Supply Change in Quantity Supplied (Qs) A change in Quantity supplied caused ONLY by a change in the PRICE of the product. It is represented by a movement ALONG a SINGLE supply curve. Change in Supply (S) A change in supply is a shifting the supply curve because there is a new supply schedule. The supply curve either moves left or right (horizontally) since the prices stay the same and only the quantities change and quantity is on the horizontal axis. Be sure to draw your arrows to the RIGHT and LEFT. Many students want to draw the arrows perpendicular to the supply curve. Don't do this. Always draw your arrows horizontally because this indicates the the prices are the same, and only the quantities change. Also, if you draw you arrows perpendicular to the supply curve and arrow pointing UP will indicate a DECREASE in supply. That could get confusing! A change in supply is caused by a change in the non-price determinants of supply. these are the factors that we assumed were constant when we used the ceteris paribus assumption to develop the supply curve. Increase in Supply If there is an increase in supply ( S) the supply curve moves to the RIGHT. At the same prices, the quantities supplied will be greaterDecrease in Supply If there is an decrease in supply ( S) the supply curve moves to the LEFT. At the same prices, the quantities supplied will be smaller. Changes in supply are caused by a CHANGE in the non-price determinants of supply Pe -- change in expected price Let's look at these determinants on at a time. We must know how they shift the supply curve if we are to use the supply and demand tool to understand how prices are determined in a market economy. Pe -- expected price If a business expects that they can get a higher price in the future, what will happen to supply today? They will be less willing to sell there products today because they will know that if they waited they could get a higher price so supply today would decrease, shift to the left. (Remember, supply is not the quantity available for sale.) Pog -- price of other goods ALSO PRODUCED BY THE FIRM First, think of a business that produces two products, like farmers who can either grow corn or soybeans. Then the price of one increases, what happens to the supply of the other one. The price of resources ( Pres ), improved technology (Tech), and taxes and subsidies (Tax) all affect supply because they change the costs of production costs S (shifts left) Pres -- price of resources If the price of a resource used to produce the product increases, this will increase the costs of production and the producer will no longer be willing to offer the same quantity at the same price. They will want a higher price to cover the higher costs. This shifts the supply curve to the left (S). Tech --technology Does improved technology increase or decrease the costs of producing a product? Tax --taxes and subsidies Here we will discuss excise taxes. Excise taxes are a "per-unit" tax imposed on the production or sale of a product. Examples include the gasoline tax (so much per gallon), the cigarette tax (so much per pack) and the liquor tax (so much per bottle). N -- number of producers/sellers An increase in the number of producers of a product will increase supply of that product. If the number of computer manufacturers increases, the supply of computers will increase (shift to the right). Nprod S Market Equilibrium -- Equilibrium Price and Quantity Now we are ready to discuss PRICES. At the top of this online lecture I said: "In a capitalist society prices are determined by the interaction of demand and supply. Since prices are so important, we need to better understand how they are determined. why is the price of gasoline $1.59 a gallon. Why does a candy bar cost $0.75? Why is the price of plywood normally $10 a sheet, but $30 a sheet after a hurricane?" Market Equilibrium Equilibrium means that there is no further tendency to change. When something is at equilibrium, it is at rest, not changing. Like a pendulum. when it is swinging, it is changing. We call this disequilibrium. Eventually, it will stop swinging and achieve equilibrium. Prices do something similar. They move toward an equilibrium where they come to rest and don't change. But just like you can push a pendulum and cause it to swing and then slow down and achieve equilibrium again, prices can be "pushed" and they will change to a new equilibrium. It is the non-price determinants of demand and supply that "push" prices to a new equilibrium. We call this "market equilibrium". The equilibrium price is the price where the quantity demanded equals the quantity supplied. Qd = QsSometimes I hear people say that equilibrium is where demand equals supply. It is impossible for the whole demand curve to be the same as the whole supply curve (NOT: D = S), but there is one price where the quantity demanded equals the quantity supplied.
Market Disequilibrium Why will the price of pizzas be $9? Well, let's take a look at what happens if the price is not at equilibrium. If the price is $12, the quantity demanded is 2000 (Qd = 2000) and the quantity that businesses are willing to supply is 4000 (Qs = 4000). The result will be a surplus of 2000 pizzas (4000 - 2000 = 2000). If there is a surplus (more available than consumers are willing to purchase) the price will change - decrease. Twelve dollars is not equilibrium - it will change. See graph. If the price is $6, the quantity demanded is 5000 (Qd = 5000) and the quantity that businesses are willing to supply is 2000 (Qs = 2000). The result will be a shortage of 3000 pizzas (5000 - 2000 = 3000). If there is a shortage (consumers are willing to purchase more than is available) the price will change - increase. Six dollars is not equilibrium - it will change. See graph. Changes in Demand AND Supply Now that we can find equilibrium AND we know what causes supply or demand to change, let's see what happens to the equilibrium price and quantity if supply and/or demand changes. After we do this, we will put it all together. It all begins with a change in one of the eleven non-price determinants: DEMAND: Pe, Pog, I, Npot, T so you must know how they affect the graphs. We discussed this above and will review it again soon. Here, let's just concentrate on what happens to price and quantity if demand and/or supply changes. Case 1: D changes and supply stays the same If demand increases (shifts to the right) what effect will this have on PRICE and QUANTITY. Be sure to DRAW THE GRAPHS. You can probably guess what will happen to price and quantity and get it correct quite often, but why guess when you can draw the graphs and get it right almost all the time? BE SURE TO DRAW THE GRAPHS! So, if demand increases and supply stays the same you get (see graph):
If demand decreases (shifts to the left) and supply stays the same you get (see graph):
This is quite easy, but the key to understanding this are the non-price determinants of supply and demand. We will review them soon. Case 2: S changes and demand stays the same If supply increases (shifts to the right) what effect will this have on PRICE and QUANTITY. Be sure to DRAW THE GRAPHS. You can probably guess what will happen to price and quantity and get it correct quite often, but why guess when you can draw the graphs and get it right almost all the time? BE SURE TO DRAW THE GRAPHS! So, if supply increases and demand stays the same you get (see graph):
If supply decreases (shifts to the left) and demand stays the same you get (see graph):
Case 3: D and S both change What if BOTH supply and demand change at the same time? This means what happens to price and quantity if a non-price determinant and supply AND a non-price determinant of demand change shifting the graphs at the same time? 1. S increases, D decreases DON'T LOOK!!! 2. S decreases, D increases What happens to price and quantity if supply decrease and demand increases? 3. S increases, D increases What happens to price and quantity if both supply and demand increase (shift to the right)? 4. S decreases, D decreases What happens to price and quantity if supply decrease and demand increases? Using Supply and Demand Now let's put it all together. We can use our supply and demand model to understand why prices change. It all begins with the non-price determinants of demand (Pe, Pog, I, Npot, T) and the non-price determinants of supply ( Pe, Pog, Pres, Tech, Tax, Nprod ). These are the factors in the real world that cause prices to change. We will use supply and demand curves to illustrate how changes in these non-price determinants will affect the price and quantity of a product, ceteris paribus. Before you guess, answer the following questions: (1) Which determinant has changed? EXAMPLE 1 Our goal is to understand what happens to PRICE and QUANTITY, but don't just guess. If you do just think about it and try to figure it out in your head, you'll probably get it right a lot of the time. But wouldn't you rather get it right most, or all, of the time? We now have a tool (supply and demand) that we can use to better understand changes in price and quantity. So use the tool. Once you get used to it you'll see its benefits. Answer the four questions and the graph (tool) will give you the answer. (1) Which determinant has changed?Sometimes this is obvious. In this example it is income. Answer: So if consumer incomes increase, ceteris paribus, the price of computers will increase and consumers will buy more. EXAMPLE 2 (1) Which determinant has changed?TECHNOLOGY EXAMPLE 3 If the graph above is for Nintendo 64 Video Game Systems, what will happen to the price and quantity if there is a decrease in the price of personal computers? (1) Which determinant has changed?Pog - the product on the graph is Nintendo Video Game Systems and the price of another product, computers, has changed MORE EXAMPLES: For REVIEW exercises click HERE "Real World" Examples In the "real world" the determinants are not as easy to pick out. The tool still works, but it takes a little more practice. If you read a newspaper or Internet news article about a product whose price and/or quantity has changed, you can use supply and demand to analyze WHY the price and/or quantity has changed. We know that changes in the non-price determinants of demand and supply cause prices and quantities to change. So, to understand why, we have to look for the non-price determinants in the article. REAL-WORLD EXAMPLE 1 Below is a portion of an article from CNNFN.COM Read the article looking for the cause of the price change and then use our supply and demand graph to ILLUSTRATE what has happened. This will be similar to the extra credit question that you will have on exam 1. Remember to use our tool correctly: (1) Which determinants have changed? REAL-WORLD EXAMPLE 2 Below is a portion of an article from CNNFN.COM Read the article looking for the cause of the price change and then use our supply and demand graph to ILLUSTRATE what has happened. This will be similar to the extra credit question that you will have on exam 1. Remember to use our tool correctly: (1) Which determinants have changed? ANSWER: I have highlighted in red the important parts of this article. Let's analyze each one. "With oil prices hitting a post-Gulf War high Friday, three more carriers - US Airways, America West and Trans World Airlines - announced surcharges, charging customers $20 per round-trip ticket on virtually all domestic flights." (1) Which determinant has changed?PRICE OF RESOURCES. Oil (fuel) is a resources used by the airline industry The article also says: " The surcharge is unique in its acceptance by the typically cutthroat airline industry, and is a sign that demand for air travel remains strong." AND "Now the economy is moving ahead". (1) Which determinant has changed?INCOME ("The economy is moving ahead" means incomes are rising.) NOW LET'S PUT BOTH CHANGES ON THE SAME GRAPH. You must do this to show the overall effect of all changes. We have a decrease in supply caused by higher resource prices and an increase in demand caused by higher incomes, The result is higher prices (see graph) and the quantity stays about the same as the article states (therefore I shifted the curves the same amount). Other articles that you can analyze yourself:
ANSWERS Market Supply: correct answer "B" [RETURN] When an increase in the price of one good causes the demand for another good to fall then both goods are substitute for each other is this statement true or false explain?Answer and Explanation: The given statement is false. Reason: It is because if an increase in the price of one good hampers the demand for the other, then the goods cannot be treated as substitutes but rather to be treated as complementary goods.
When the increase in the price of one good cause the demand for another good to decrease the goods are?Two goods are complements if an increase in the price of one causes a decrease in the demand for the other.
When the increase in the price of one good causes the demand for another good to decrease the goods are quizlet?If an increase in the price of Good X causes a decrease in the demand for Good Y, we can conclude that: the two goods are complements to each other.
What happens when price of good increases?Other things remaining the same, • If the price of good rises, the quantity demanded of that good decreases. If the price of a good falls, the quantity demanded of that good increases. The relationship between the quantity demanded and the price of a good when all other influences on buying plans remain the same.
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