The Market Forces of
Supply and Demand
4
Economics
P R I N C I P L E S O F
N. Gregory Mankiw
Premium PowerPoint Slides by Ron Cronovich
In this chapter,
look for the answers to these questions:
What factors affect buyers’ demand for goods?
What factors affect sellers’ supply of goods?
How do supply and demand determine the price of a good and the quantity sold?
How do changes in the factors that affect demand or supply affect the market price and quantity of a good?
How do markets allocate resources?
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Markets and Competition
A market is a group of buyers and sellers of a particular product.
A competitive market is one with many buyers and sellers, each has a negligible effect on price.
In a perfectly competitive market:
All goods exactly the same
Buyers & sellers so numerous that no one can affect market price – each is a “price taker”
In this chapter, we assume markets are perfectly competitive.
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Demand
The quantity demanded of any good is the amount of the good that buyers are willing and able to purchase.
Law of demand: the claim that the quantity demanded of a good falls when the price of the good rises, other things equal
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The Demand Schedule
Demand schedule: a table that shows the relationship between the price of a good and the quantity demanded
Example: Helen’s demand for lattes.
Price of lattes
Quantity of lattes demanded
$
16
14
12
10
8
6
4
Notice that Helen’s preferences obey the Law of Demand.
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Price of Lattes
Quantity of Lattes
Helen’s Demand Schedule & Curve
Price of lattes
Quantity of lattes demanded
$
16
14
12
10
8
6
4
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Market Demand versus Individual Demand
The quantity demanded in the market is the sum of the quantities demanded by all buyers at each price.
Suppose Helen and Ken are the only two buyers in the Latte market. (Qd = quantity demanded)
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16
Helen’s Qd
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Ken’s Qd
+
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=
=
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=
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=
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24
Market Qd
$
Price
0
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P
Q
The Market Demand Curve for Lattes
P
Qd (Market)
$
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21
18
15
12
9
6
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Demand Curve Shifters
The demand curve shows how price affects quantity demanded, other things being equal.
These “other things” are non-price determinants of demand (., things that determine buyers’ demand for a good, other than the good’s price).
Changes in them shift the D curve…
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Demand Curve Shifters: # of Buyers
Increase in # of buyers increases quantity demanded at each price, shifts D curve to the right.
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Demand Curve Shifters: # of Buyers
P
Q
Suppose the number of buyers increases.
Then, at each P, Qd will increase (by 5 in this example).
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Demand for a normal good is positively related to income.
Increase in income causes increase in quantity demanded at each price, shifts D curve to the right.
(Demand for an inferior good is negatively related to income. An increase in income shifts D curves for inferior goods to the left.)
Demand Curve Shifters: Income
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Two goods are substitutes if an increase in the price of one causes an increase in demand for the other.
Example: pizza and hamburgers. An increase in the price of pizza increases demand for hamburgers, shifting hamburger demand curve to the right.
Other examples: Coke and Pepsi, laptops and desktop computers, CDs and music downloads
Demand Curve Shifters: Prices of Related Goods
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Two goods are complements if an increase in the price of one causes a fall in demand for the other.
Example: computers and software. If price of computers rises, people buy fewer computers, and therefore less software. Software demand curve shifts left.
Other examples: college tuition and textbooks, bagels and cream cheese, eggs and bacon
Demand Curve Shifters: Prices of Related Goods
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Anything that causes a shift in tastes toward a good will increase demand for that good and shift its D curve to the right.
Example: The Atkins diet became popular in the ’90s, caused an increase in demand for eggs, shifted the egg demand curve to the right.
Demand Curve Shifters: Tastes
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Expectations affect consumers’ buying decisions.
Examples:
If people expect their incomes to rise, their demand for meals at expensive restaurants may increase now.
If the economy sours and people worry about their future job security, demand for new autos may fall now.
Demand Curve Shifters: Expectations
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Summary: Variables That Influence Buyers
Variable A change in this variable…
Price …causes a movement along the D curve
# of buyers …shifts the D curve
Income …shifts the D curve
Price of related goods …shifts the D curve
Tastes …shifts the D curve
Expectations …shifts the D curve
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A C T I V E L E A R N I N G 1
Demand Curve
A. The price of iPods falls
B. The price of music downloads falls
C. The price of CDs falls
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Draw a demand curve for music downloads. What happens to it in each of the following scenarios? Why?
A C T I V E L E A R N I N G 1
A. Price of iPods falls
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Q2
Price of music down-loads
Quantity of music downloads
D1
D2
P1
Q1
Music downloads and iPods are complements.
A fall in price of iPods shifts the demand curve for music downloads to the right.
A C T I V E L E A R N I N G 1
B. Price of music downloads falls
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The D curve does not shift.
Move down along curve to a point with lower P, higher Q.
Price of music down-loads
Quantity of music downloads
D1
P1
Q1
Q2
P2
A C T I V E L E A R N I N G 1
C. Price of CDs falls
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P1
Q1
CDs and music downloads are substitutes.
A fall in price of CDs shifts demand for music downloads to the left.
Price of music down-loads
Quantity of music downloads
D1
D2
Q2
Supply
The quantity supplied of any good is the amount that sellers are willing and able to sell.
Law of supply: the claim that the quantity supplied of a good rises when the price of the good rises, other things equal
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The Supply Schedule
Supply schedule: A table that shows the relationship between the price of a good and the quantity supplied.
Example: Starbucks’ supply of lattes.
Notice that Starbucks’ supply schedule obeys the Law of Supply.
Price of lattes
Quantity of lattes supplied
$
0
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6
9
12
15
18
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Starbucks’ Supply Schedule & Curve
Price of lattes
Quantity of lattes supplied
$
0
3
6
9
12
15
18
P
Q
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Market Supply versus Individual Supply
The quantity supplied in the market is the sum of the quantities supplied by all sellers at each price.
Suppose Starbucks and Jitters are the only two sellers in this market. (Qs = quantity supplied)
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9
6
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Starbucks
12
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Jitters
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5
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Market Qs
$
Price
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P
Q
The Market Supply Curve
P
QS (Market)
$
0
5
10
15
20
25
30
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Supply Curve Shifters
The supply curve shows how price affects quantity supplied, other things being equal.
These “other things” are non-price determinants of supply.
Changes in them shift the S curve…
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Supply Curve Shifters: Input Prices
Examples of input prices: wages, prices of raw materials.
A fall in input prices makes production more profitable at each output price, so firms supply a larger quantity at each price, and the S curve shifts to the right.
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P
Q
Suppose the price of milk falls.
At each price, the quantity of Lattes supplied will increase (by 5 in this example).
Supply Curve Shifters: Input Prices
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Supply Curve Shifters: Technology
Technology determines how much inputs are required to produce a unit of output.
A cost-saving technological improvement has the same effect as a fall in input prices, shifts S curve to the right.
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Supply Curve Shifters: # of Sellers
An increase in the number of sellers increases the quantity supplied at each price,
shifts S curve to the right.
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Supply Curve Shifters: Expectations
Example:
Events in the Middle East lead to expectations of higher oil prices.
In response, owners of Texas oilfields reduce supply now, save some inventory to sell later at the higher price.
S curve shifts left.
In general, sellers may adjust supply* when their expectations of future prices change. (*If good not perishable)
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Summary: Variables that Influence Sellers
Variable A change in this variable…
Price …causes a movement along the S curve
Input Prices …shifts the S curve
Technology …shifts the S curve
# of Sellers …shifts the S curve
Expectations …shifts the S curve
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A C T I V E L E A R N I N G 2
Supply Curve
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Draw a supply curve for tax return preparation software. What happens to it in each of the following scenarios?
A. Retailers cut the price of the software.
B. A technological advance allows the software to be produced at lower cost.
C. Professional tax return preparers raise the price of the services they provide.
A C T I V E L E A R N I N G 2
A. Fall in price of tax return software
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S curve does not shift.
Move down along the curve to a lower P and lower Q.
Price of tax return software
Quantity of tax return software
S1
P1
Q1
Q2
P2
A C T I V E L E A R N I N G 2
B. Fall in cost of producing the software
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S curve shifts to the right:
at each price, Q increases.
Price of tax return software
Quantity of tax return software
S1
P1
Q1
S2
Q2
A C T I V E L E A R N I N G 3
C. Professional preparers raise their price
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This shifts the demand curve for tax preparation software, not the supply curve.
Price of tax return software
Quantity of tax return software
S1
P
Q
Supply and Demand Together
D
S
Equilibrium: P has reached the level where quantity supplied equals quantity demanded
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D
S
P
Q
Equilibrium price:
P
QD
QS
$0
24
0
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21
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2
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10
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15
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the price that equates quantity supplied with quantity demanded
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D
S
P
Q
Equilibrium quantity:
P
QD
QS
$0
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0
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21
5
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the quantity supplied and quantity demanded at the equilibrium price
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P
Q
D
S
Surplus (. excess supply):
when quantity supplied is greater than quantity demanded
Surplus
Example: If P = $5,
then QD = 9 lattes
and QS = 25 lattes
resulting in a surplus of 16 lattes
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P
Q
D
S
Surplus (. excess supply):
when quantity supplied is greater than quantity demanded
Facing a surplus, sellers try to increase sales by cutting price.
This causes QD to rise
Surplus
…which reduces the surplus.
and QS to fall…
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P
Q
D
S
Surplus (. excess supply):
when quantity supplied is greater than quantity demanded
Facing a surplus, sellers try to increase sales by cutting price.
This causes QD to rise and QS to fall.
Surplus
Prices continue to fall until market reaches equilibrium.
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P
Q
D
S
Shortage (. excess demand):
when quantity demanded is greater than quantity supplied
Example: If P = $1,
then QD = 21 lattes
and QS = 5 lattes
resulting in a shortage of 16 lattes
Shortage
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P
Q
D
S
Shortage (. excess demand):
when quantity demanded is greater than quantity supplied
Facing a shortage, sellers raise the price,
causing QD to fall
…which reduces the shortage.
and QS to rise,
Shortage
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P
Q
D
S
Shortage (. excess demand):
when quantity demanded is greater than quantity supplied
Facing a shortage, sellers raise the price,
causing QD to fall
and QS to rise.
Shortage
Prices continue to rise until market reaches equilibrium.
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Three Steps to Analyzing Changes in Eq’m
To determine the effects of any event,
1. Decide whether event shifts S curve, D curve, or both.
2. Decide in which direction curve shifts.
3. Use supply-demand diagram to see how the shift changes eq’m P and Q.
EXAMPLE: The Market for Hybrid Cars
P
Q
D1
S1
P1
Q1
price of hybrid cars
quantity of hybrid cars
STEP 1:
D curve shifts because price of gas affects demand for hybrids.
S curve does not shift, because price of gas does not affect cost of producing hybrids.
STEP 2:
D shifts right because high gas price makes hybrids more attractive relative to other cars.
EXAMPLE 1: A Shift in Demand
EVENT TO BE ANALYZED: Increase in price of gas.
P
Q
D1
S1
P1
Q1
D2
P2
Q2
STEP 3:
The shift causes an increase in price and quantity of hybrid cars.
EXAMPLE 1: A Shift in Demand
P
Q
D1
S1
P1
Q1
D2
P2
Q2
Notice: When P rises, producers supply a larger quantity of hybrids, even though the S curve has not shifted.
Always be careful to distinguish b/w a shift in a curve and a movement along the curve.
Terms for Shift vs. Movement Along Curve
Change in supply: a shift in the S curve
occurs when a non-price determinant of supply changes (like technology or costs)
Change in the quantity supplied: a movement along a fixed S curve
occurs when P changes
Change in demand: a shift in the D curve
occurs when a non-price determinant of demand changes (like income or # of buyers)
Change in the quantity demanded: a movement along a fixed D curve
occurs when P changes
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STEP 1:
S curve shifts because event affects cost of production.
D curve does not shift, because production technology is not one of the factors that affect demand.
STEP 2:
S shifts right because event reduces cost, makes production more profitable at any given price.
EXAMPLE 2: A Shift in Supply
P
Q
D1
S1
P1
Q1
S2
P2
Q2
EVENT: New technology reduces cost of producing hybrid cars.
STEP 3:
The shift causes price to fall and quantity to rise.
EXAMPLE 3: A Shift in Both Supply
and Demand
P
Q
D1
S1
P1
Q1
S2
D2
P2
Q2
EVENTS: price of gas rises AND new technology reduces production costs
STEP 1:
Both curves shift.
STEP 2:
Both shift to the right.
STEP 3:
Q rises, but effect on P is ambiguous:
If demand increases more than supply, P rises.
EXAMPLE 3: A Shift in Both Supply
and Demand
STEP 3, cont.
P
Q
D1
S1
P1
Q1
S2
D2
P2
Q2
EVENTS: price of gas rises AND new technology reduces production costs
But if supply increases more than demand, P falls.
A C T I V E L E A R N I N G 3
Shifts in supply and demand
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Use the three-step method to analyze the effects of each event on the equilibrium price and quantity of music downloads.
Event A: A fall in the price of CDs
Event B: Sellers of music downloads negotiate a reduction in the royalties they must pay for each song they sell.
Event C: Events A and B both occur.
A C T I V E L E A R N I N G 3
A. Fall in price of CDs
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2. D shifts left
P
Q
D1
S1
P1
Q1
D2
The market for music downloads
P2
Q2
1. D curve shifts
3. P and Q both fall.
STEPS
A C T I V E L E A R N I N G 3
B. Fall in cost of royalties
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P
Q
D1
S1
P1
Q1
S2
The market for music downloads
Q2
P2
1. S curve shifts
2. S shifts right
3. P falls, Q rises.
STEPS
(Royalties are part of sellers’ costs)
A C T I V E L E A R N I N G 3
C. Fall in price of CDs and
fall in cost of royalties
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STEPS
1. Both curves shift (see parts A & B).
2. D shifts left, S shifts right.
3. P unambiguously falls.
Effect on Q is ambiguous: The fall in demand reduces Q, the increase in supply increases Q.
CONCLUSION:
How Prices Allocate Resources
One of the Ten Principles from Chapter 1: Markets are usually a good way to organize economic activity.
In market economies, prices adjust to balance supply and demand. These equilibrium prices are the signals that guide economic decisions and thereby allocate scarce resources.
CHAPTER SUMMARY
A competitive market has many buyers and sellers, each of whom has little or no influence on the market price.
Economists use the supply and demand model to analyze competitive markets.
The downward-sloping demand curve reflects the Law of Demand, which states that the quantity buyers demand of a good depends negatively on the good’s price.
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CHAPTER SUMMARY
Besides price, demand depends on buyers’ incomes, tastes, expectations, the prices of substitutes and complements, and number of buyers. If one of these factors changes, the D curve shifts.
The upward-sloping supply curve reflects the Law of Supply, which states that the quantity sellers supply depends positively on the good’s price.
Other determinants of supply include input prices, technology, expectations, and the # of sellers. Changes in these factors shift the S curve.
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CHAPTER SUMMARY
The intersection of S and D curves determines the market equilibrium. At the equilibrium price, quantity supplied equals quantity demanded.
If the market price is above equilibrium, a surplus results, which causes the price to fall. If the market price is below equilibrium, a shortage results, causing the price to rise.
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CHAPTER SUMMARY
We can use the supply-demand diagram to analyze the effects of any event on a market: First, determine whether the event shifts one or both curves. Second, determine the direction of the shifts. Third, compare the new equilibrium to the initial one.
In market economies, prices are the signals that guide economic decisions and allocate scarce resources.
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This is perhaps the most important chapter in the textbook. It’s worth mentioning to your students that investing extra time to master this chapter will make it easier for them to learn much of the subsequent material in the book.
This is also one of the longest chapters in the textbook, and this PowerPoint file is one of the most graph-intensive. Many students taking economics for the first time have difficulty grasping the graphs, which are critically important in this and all subsequent chapters in the book. So an extra degree of hand-holding might be appropriate.
Accordingly, this PowerPoint has carefully detailed animations that build many of the graphs with great care. For example, we show a demand or supply schedule next to the axes, and highlight each coordinate pair in the table as the corresponding point appears on the graph.
Please be assured that the presentation of graphs is more streamlined in subsequent chapters. In this early chapter, though, we do not want to leave any students behind.
If your students are already very comfortable with scatter-type graphs, you may wish to simplify or turn off the animation on these slides, in order to get through them faster.
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In the real world, there are relatively few perfectly competitive markets. Most goods come in lots of different varieties – including ice cream, the example in the textbook. And there are many markets in which the number of firms is small enough that some of them have the ability to affect the market price.
For now, though, we look at supply and demand in perfectly competitive markets, for two reasons: First, it’s easier to learn. Understanding perfectly competitive markets makes it a lot easier to learn the more realistic but complicated analysis of imperfectly competitive markets. Second, despite the lack of realism, the perfectly competitive model can teach us a LOT about how the world works, as we will see many times in the chapters that follow.
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Demand comes from the behavior of buyers.
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This example violates the “many buyers” condition of perfect competition. Yet, we are merely trying to show here that, at each price, the quantity demanded in the market is the sum of the quantity demanded by each buyer in the market. This holds whether there are two buyers or two million buyers. But it would be harder to fit data for two million buyers on this slide, so we settle for two.
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Income is the first demand shifter discussed in this chapter of the textbook. I chose to start with a different one (number of buyers), for the following reason:
In discussing the impact of changes in income on the demand curve, the textbook also introduces the concept of normal goods and inferior goods. Students may find it easier to learn about curve shifts if the presentation focuses solely on a curve shift (at least initially) without simultaneously introducing other concepts.
If you wish to present the demand shifters in the same order as they appear in the book, simply reorder the slides in this presentation.
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Beginning economics students often have trouble understanding the difference between a movement along the curve and a shift in the curve. Here, the animation has been carefully designed to help students see that a shift in the curve results from an increase in quantity at each price.
(A more realistic scenario would involve a non-parallel shift, where the horizontal distance of the shift would be greater for lower prices than higher ones. However, to remain consistent with the textbook, and to keep things simple, this slide shows a parallel shift.)
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If you are willing to spend a couple extra minutes on substitutes and complements, and have a blackboard or whiteboard to draw on, here’s an idea:
Before (or instead of) showing this slide, draw the demand curve for hamburgers. Pick a price, say $5, and draw a horizontal line at that price, extending from the vertical axis through the D curve and continuing to the right. Suppose Q = 1000 when P = $5. Label this on the horizontal axis.
Now ask your students: If pizza becomes more expensive, but price of hamburgers does not change, what would happen to the quantity of hamburgers demanded? Would it remain at 1000, would it increase, or would it decrease? Explain.
Some and perhaps most students will see right away that people will want more hamburgers when the price of pizza rises. After establishing this, note that the increase in the price of pizza caused an increase in the quantity demanded of hamburgers. Then state the term “substitutes” and give the definition.
Before giving the other examples (listed in the 3rd bullet of this slide), do a similar exercise to develop the concept of complements. Finally, give the examples of substitutes and complements from the 3rd bullet point of this and the following slides, but mix up the order and ask students to identify whether each example is complements or substitutes.
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Students should notice that the only determinant of quantity demanded that causes a movement along the curve is price. Also notice: price is one of the variables measured along the axes of the graph.
Here’s a handy “rule of thumb” to help students remember whether the curve shifts: If the variable causing demand to change is measured on one of the axes, you move along the curve. If the variable that’s causing demand to change is NOT measured on either axis, then the curve shifts.
This rule of thumb works with all curves in economics that involve an X-Y relationship. (., it works for the supply curve, the marginal cost curve, the IS and LM curves, among many others, but it does not apply to curves drawn on time series graphs.)
In each case, there are only three possible answers:
- The curve shifts to the right
- The curve shifts to the left
- The curve does not shift (though there may be a movement along the curve)
Point out to your students that there are no numbers or units on either axis, and we are using “P1” and “Q1” to represent the initial price and quantity, rather than specific numerical values. Tell them that this is common, because in much economic analysis, the goal is only to see the direction of changes, not specific amounts. (Besides, if we put numbers on this graph, they’d just have been made up, so why bother?)
Also point out the following:
The price of music downloads is the same, but the quantity demanded is now higher. In fact, this is the nature of a shift in a curve: at any given price, the quantity is different than before.
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Supply comes from the behavior of sellers.
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Again, the assumption of only two sellers is a clear violation of perfect competition. However, it’s much easier for students to learn how the market supply curve relates to individual supplies in the two-seller case.
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“Non-price determinants of supply” simply means the things – other than the price of a good – that determine sellers’ supply of the good.
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In the second bullet point, “output price” just means the price of the good that firms are producing and selling. I have used “output price” here to distinguish it from “input prices.”
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Again, the animation here is carefully designed to help make clear that a shift in the supply curve means that there is a change in the quantity supplied at each possible price. If it seems tedious, you can turn it off.
In any case, be assured that, by the end of this chapter, the animation of curve shifts will be streamlined and simplified.
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“Tax return preparation software” means programs like TurboTax by Quicken and TaxCut by H&R Block.
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We now return to the latte example to illustrate the concepts of equilibrium, shortage and surplus.
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Step one requires knowing all of the things that can shift D and S – the non-price determinants of demand and of supply.
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“Supply” refers to the position of the supply curve, while “quantity supplied” refers to the specific amount that producers are willing and able to sell.
Similarly, “demand” refers to the position of the demand curve, while “quantity demanded” refers to the specific amount that consumers are willing and able to buy.
If you’d like to be a rebel, delete this slide and all references to the jargon it contains, and just use the terms “movement along a curve” and “shift in a curve.” Note, however, that this is not the official recommendation of Cengage/South-Western or Dr. Mankiw.
If you’d like to cover this slide but make it move more quickly, delete the text next to each second-level bullet (starting with “occurs when”). Instead, give the information to your students verbally or rely on them to read it in the textbook.
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Important note about Event B:
The royalties that sellers must pay the artists are part of sellers’ “costs of production.” Typically, this royalty is a fixed amount each time one of the artist’s songs is downloaded. Event B, therefore, describes a reduction in sellers’ “costs of production.”
This is an extension of Active Learning exercise 1C, where we saw that a fall in the price of compact discs would cause a fall in demand for music downloads, because the two goods are substitutes.
NOTE: Don’t worry that the text on this slide looks garbled in “Normal view” (., edit mode). It works fine in “Slide Show” (., presentation mode).
Event B: Sellers of music downloads negotiate a reduction in the royalties they must pay for each song they sell. This event causes a fall in “costs of production” for sellers of music downloads. Hence, the S curve shifts to the right.
It’s not necessary to draw a graph here. The answers to steps 1 and 2 should be clear from parts A and B. The answer to step 3 is a combination of the results from A and B.
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In the textbook, the conclusion of this chapter offers some very nice elaboration on the second bullet point. There is also an “In the News” box with a very nice article titled “In Praise of Price Gouging.”
