PRICE INDICES
Principles of Microeconomics: Demand and Supply DEMAND AND SUPPLY This lecture examines the basic Demand/Supply model that is central to microeconomics. We do so by defining the relationship between Price and Quantity in Demand and Supply without analyzing the cause of those relationships. We analyze the cause of the relationships later in the course. We begin with a definition of Microeconomics and Partial Equilibrium Analysis before explaining the importance of Demand/Supply for markets. Definition: Microeconomics is the study of individual units in an economy (households, firms, markets, etc.) and their relationships. This entails the study of the allocation of resources and the distribution of income. Methodology Modern economics relies heavily on two methodological tools: partial equilibrium analysis and atomism. Definition: Equilibrium is a state of rest with no tendency to change given existing forces (variables) Definition: Partial Equilibrium Analysis is the analysis of the relationship between two variables while holding other relevant variables constant (ceteris paribus = other things equal), then examining the effect of the other variables by systematically examining their variation. Example At what temperature does water boil? Most people would answer 1000 C but in fact this is only true holding at least two other variables constant: atmospheric pressure (sea level) and purity of the water (not salty, for example). Scientists use partial equilibrium analysis all the time to isolate relationships before they analyze the variations caused by changes in other variables.
-1-
Principles of Microeconomics: Demand and Supply Definition: General Equilibrium Analysis is the analysis of the relationship between all variables simultaneously. (We won’t use this approach in this class) General Equilibrium analysis is highly prized because it analyzes all the variables at once but this is a disadvantage because it requires more sophisticated mathematics and it doesn’t tell us about the cause-effect relationships between specific variables. We can approximate general equilibrium analysis by relaxing successively relaxing the ceteris paribus assumptions of partial equilibrium analysis. Definition: Atomism is the perspective that society (whole) is the sum of its parts (households and firms). Modern economics builds theory by analyzing the behaviour of the basic components of consumption (households) and production (firms). Demand is the aggregation of the behaviour of the individual consumers (households) and Supply is the aggregation of the behaviour of the individual producers (firms). Late in the course we will examine some of the issues that arise theoretically because of this methodological approach. Types of Economic Systems: There have been various types of economic systems historically, such as patriarchal, slave, feudal, socialist, and communistic. This course concentrates on the market system. Definition: Purchase and sale transactions between economic actors (households and firms) determine the allocation of resources in a market. => Price mechanism determines the allocation of resources in a market. Governments affect the allocation of resources in market economies in 5 ways. 1.
Government Spending (roads, education, transfer payments, and wars, for example)
2.
Taxation (income, sales, and property taxes, for example
-2-
Principles of Microeconomics: Demand and Supply 3.
Public Enterprises (e.g., Ontario Hydro, LCBO, TTC, etc.)
4.
Regulation (e.g., environmental, building, etc.)
5.
Monetary Policy (control of money supply effects prices, interest rates, and exchange rates)
Competitive Markets Definition: Competition is Price Taking Analysis of competition dates from at least Aristotle. Adam Smith described competition as ‘many buyers and sellers’ in his revolutionary discussion of the benefits of competitive markets in his 1876 The Wealth of Nations, but it was only at the end of the nineteenth century that economists formulated the modern analytic definition. The modern definition captures Smith’s meaning that buyers or sellers cannot influence price in a competitive market. It also simplifies the analysis of competitive behaviour since households and firms respond to a given price with no ability to change that price. Imperfect competition occurs when a buyer or seller can influence price. The most extreme examples are monopoly (single seller), which we shall discuss later in the course, and monopsony (single buyer). We shall see that Demand and Supply determine price in a competitive market. DEMAND (function, curve, schedule) Definition: Demand is the quantities of goods and services demanded by consumers (households)1 at each market price ceteris paribus. Demand is the relationship between 2 variables, price (P) and quantity demanded (q for the household and Q for the market), holding all other variables constant. The most important of the
1
Economists analyse households as the smallest unit of consumption rather than ‘consumers’ because there are consumers such as babies that do not make economic decisions.
-3-
Principles of Microeconomics: Demand and Supply other variables are prices of other goods (Pi where ‘i’ represents one of n commodities), income (Y), and preferences (tastes). We can express the Demand for the X commodity as D(qX or QX): qX or QX = f(PX | Y, Pi, Preferences) (everything after | is fixed) NOTE: We analyze Demand as a quantity response to price [Q = f(P)] not as a price response to quantity [P = f(Q]. (Alfred Marshall, the first economist to depict the Demand/Supply diagram, derived demand as a quantity response to price. Since price was the dependent variable and quantity was the independent variable, Marshall put quantity on the horizontal axis and price on the vertical axis following the mathematical convention of Y = f(X)). This concept of Demand satisfies our competitive definition that buyers are price takers. Example. The following table shows the number of kilograms of ground beef demanded by an individual during a year at given prices of ground beef, ceteris paribus. Price Quantity
$5 10
$4 15
$3 25
$2 40
$1 60
We graph this relation with Price on the vertical axis and quantity on the horizontal axis. Price ($s) 5 4 3 2 Demand
1 10
30
60 Quantity (kilos)
Law of Demand: ((∆Qx/∆Px < 0 or dQx/dPx < 0 for Qx = quantity of x and Px = price of x)
-4-
Principles of Microeconomics: Demand and Supply The Law of Demand says that an increase in price causes a decrease in quantity demanded and a decrease in price causes an increase in quantity demanded. (The change in Qx in response to the change in Px is less than zero) => A Demand curve is negatively sloped. The negative slope can be linear, concave, or convex. I will usually draw convex demand functions but use linear demand functions for calculations. Positive sloped demand functions can exist but are rare. Some positively sloped demand functions are called Giffen goods. NOTE.Do not confuse Demand and Quantity Demanded. Quantity demanded is the quantity response to one price whereas Demand is the set of all the prices and quantities. Perhaps the most common mistake in economics is the statement that the Demand for a commodity (e.g., gas) falls because of a rise in the price of the commodity. A fall in the price of a commodity causes a rise in the quantity demanded of the commodity (movement along the demand curve) but the demand curve itself does not change. A change in one of the ceteris paribus conditions, however, does change Demand. CHANGES IN DEMAND (shifts in the Demand Curve) Factors other than the price of a commodity affected the quantity demanded of a commodity. Changes in these variables change the Demand function, not merely the quantity demanded, since the price of the commodity need not change. We now look at the most common variables affecting Demand. 1.
Income a) Normal Good: Demand is positively related to Income (∆Qd/∆Y > 0 or dQd/dY > 0)
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Principles of Microeconomics: Demand and Supply An increase/decrease in the consumer’s income normally results in an increase in quantity demanded at every given price of a commodity. Suppose that the consumer’s income was $2,000/month in our ground beef example above. The table and graph below show the effect on Demand of an increase in income to $3,000 month. Price Quantity (Income = $2,000/month) Quantity (Income = $3,000/month)
$5 10 15
$4 15 21
$3 25 32
$2 40 48
$1 60 69
Price ($s) 5 4 3 2
D1
1
Do 10
20
30
40
50
60 Quantity (kilos)
a) Inferior Good: Demand is inversely related to Income (∆Qd/∆Y < 0 or dQd/dY < 0) Some goods are called ‘inferior’ because an increase (decrease) in income causes a decrease (increases) in Demand, i.e., a decrease (increase) in quantity demanded at every price. An inferior good is a poorer quality good purchased by a consumer with relatively low income because it is affordable. An increase in income causes the consumer to buy more preferred normal goods and less inferior goods. Students, for example, go to pizza joints rather than better restaurants or use the TTC rather than a car. Example: Suppose that margarine is an inferior good (relative to butter) for a consumer. An increase in income causes the consumer to buy more butter and less margarine at any price of margarine.
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Principles of Microeconomics: Demand and Supply
Price ($s)
Inferior Good: Increase in Income
Po
Do D1 Q1 Qo
2.
Quantity
Changes in Prices of related Consumption Goods and Services a) Substitutes in Consumption: Demand is positively related to the price of a Substitute (∆Qd/∆PSubC > 0 or dQd/∆PSubC > 0) Substitute goods are goods that are used in place of each other. Honey, saccharine, and
Splendida are common substitutes of refined sugar. Bicycles, walking, or public transportation are substitutes for travel by car. An increase in the price of a substitute (PSub) for good X causes the consumer to buy less of the substitute and more of good X. An increase in the price of cars, for example, would cause an increase in the Demand for public transportation (i.e., an increase in quantity demanded of public transportation at any given price of transportation). The diagram below shows an increase in demand for public transportation due to an increase in the prices of cars (perhaps because a fall in the supply of cars caused a fall in the quantity demanded of cars).
Price ($s)
Increase in the Price of Subsitute for Public Transportation Public Transportation Price ($s) Cars S1 So Po
P1 Po D1
Do
Q1 Qo
Do
Qo
Quantity
-7-
Q1
Quantity
Principles of Microeconomics: Demand and Supply b) Complements in Consumption: Demand is inversely related to price of a complement (∆Qx/∆PCompC < 0 or dQx/d PCompC < 0) A complement in consumption is consumed with a good. Examples include gas with cars, DVDs with DVD players, cream with coffee, etc. An increase (decrease) in the price of a complement of X decreases the demand for X. For example, an increase (decrease) in the price of gas decreases (increases) the demand for cars.
Price ($s)
Increase in the Price of Gas decreases Demand for Cars Cars Gas Price ($s) S1 So Po
P1 Po Do Do
Q1 Qo
3.
D1
Q1
Quantity
Qo
Quantity
A change in Taste or Preference A change in Taste of Preference will change the Demand for a commodity. For example, an
increase in environmental consciousness will decrease the Demand for cars and increase the demand for public transportation, walking, or bicycles. 4.
A change in the number of Consumers An increase in the number of consumers (immigration, population growth) will increase the
market demand for a commodity if the individual demand for the commodity remains the same.
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Principles of Microeconomics: Demand and Supply SUPPLY: Definition: Supply is the quantities of goods and services supplied by firms at every price ceteris paribus Supply is the relationship between 2 variables, price (P) and quantity supplied (q for the firm and Q for the industry, the sum of the firms), holding all other variables constant. The most important of the ceteris paribus conditions are the length of the supply period, the costs of inputs into production, the prices of other goods (Pi where ‘i’ represents one of n commodities), and technology. We can express the Supply for the x commodity as S(qX or QX): qX or QX = f(PX | Inputs Costs, Pi, Time Period, Technology) Note: Supply is defined for quantity supplied in response to price not vice versa. Supply is therefore a competitive concept so that monopolies, for example, do not have supply functions. Law of Supply: Quantity Supplied is positively related to Price Constant input costs imply that an increase in price will increase profit and thus quantity supplied. The quantity supplied only increases to the point where price equals opportunity cost. Analyzing the supply function is a key part of this course but we will leave it until later. Example: The following table shows the number of kilograms of ground beef supplied by a firm during a year to given prices of ground beef, ceteris paribus. Price Quantity
$5 40
$4 15
$3 25
-9-
$2 10
$1 0
Principles of Microeconomics: Demand and Supply We graph this relation with Price on the vertical axis and quantity on the horizontal axis. Price ($s) So 5 4 3 2 1 10
20
30
60 40 50 Quantity (kilos)
Note: A change in the price of the commodity implies a change in quantity supplied but not a change in supply. A change in a ceteris paribus condition implies a change in supply. Changes (shifts) in Supply: 1.
A change in Per Unit Costs Supply gives us the amount that a firm would produce at a given price so Supply is
essentially determined by the firm’s costs. A change in per unit costs changes the cost of producing a unit of output and thus changes the amount that a firm will produce. An increase in costs per unit of output means that the firm has to charge more to cover costs; supply therefore shifts up by the amount of the increase in per unit costs. We say that supply decreases in this case because the firm decreases quantity supplied at any given price. Example. The graph below shows the fall in supply due to an increase in costs of $1 per unit.
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Principles of Microeconomics: Demand and Supply Supply: Increase in Cost of $1/unit S1 Price ($s) So 5 4 3 2 1 10
20
30
60 40 50 Quantity (kilos)
2. Changes in Technology . An improvement in technology implies an increase in output for given resources. Supply increases because quantity supplied increases at every price. You could also see this as a decrease in the cost of production of every unit of output. Increase in Supply: Technological Improvement Price ($s) So
S1
5 4 3 2 1 10
3.
20
30
60 40 50 Quantity (kilos)
Changes in the Price of related Output We now discuss the effect on supply of changes in the price of substitutes and complements
in production. It is very important to remember that we refer to output and not input prices.
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Principles of Microeconomics: Demand and Supply a) Substitutes in Production (Alternative Products) (∆Qx/∆PSubP < 0 or dQx/d PSubP < 0) A firm usually has the possibility of producing more than one product with the same resources. An increase (decrease) in the price of a substitute product causes a decrease (increase) in the supply of the original product because the firm switches resources from the original product to the other product. Example: Suppose that the price of wheat and the price of oats are both $1/bushel in equilibrium and that a farmer cultivates 50 hectares of wheat and 50 hectares of oats as a result. An increase in the price of oats to $1.50 (perhaps due to an increase in demand) increases the quantity supplied of oats because the farmer now cultivates 70 hectares of oats. This means that the farmer is cultivating only 30 hectares of wheat at $1/wheat. The supply of wheat has therefore fallen. Decrease in Supply (Wheat) in response to Increase in Price of Substitute Product (Oats) Price ($s)
Oats
Wheat S1
Price ($s)
So
So
Po
P1 Po
D1 Do
Qo Q1
Q1
Quantity
Qo
Quantity
b) Complements in Production (∆Qd/∆PCompP > 0 or dQd/∆PCompP > 0) Complements in production are different outputs produced by the same production process. Examples include beef and hides from the raising of cattle, furniture and firewood from the production of furniture, or gasoline and tar from refining oil. An increase in the price of a - 12 -
Principles of Microeconomics: Demand and Supply complement in production for X increases the supply of X by reducing the cost of X through generation of more revenue from production. Example: Suppose that the price of beef is $2/kilo and the price of a hide is $50. The following graphs show that an increase in the price of hides (due to demand in this case) of $50 causes an increase in the supply of beef (since the cost of raising an animal is now $50 less). Increase in Supply (Beef) in response to Increase in Price of Complement Product (Hides) Hides
Price ($s)
Price ($s)
So
Beef So
S1
Po
P1 D1
Po
Do
Qo
Q1
Qo Q1
Quantity
Quantity
4. Changes in the Number of Firms An increase (decrease) in the number of firms in an industry increases (decreases) market supply. MARKET EQUILIBRIUM: QS = QD => PS = PD Market Demand is simply the sum of all the individual (household) demand functions and Market Supply is the sum of all the individual (firm) supply functions. Market Equilibrium is the state of rest with no tendency to change for given economic variables. Market Equilibrium occurs when the quantity demanded by consumers equals the quantity supplied by firms. This occurs when the price paid by consumers equals the price paid by firms for the same quantity. Markets move to equilibrium through price adjustment. Po > P* where QS = QD => Surplus production and a fall in price
- 13 -
Principles of Microeconomics: Demand and Supply Suppose that the price in the market place (Po) is greater than the price where the quantity demanded equals the quantity supplied (P*), as in the diagram below. This will mean that quantity supplied is greater than quantity demanded, which will leave a surplus of unsold goods in the market at that price as shown in the diagram below. Remember that Demand and Supply show the relationship between prices and quantities so that to we simply determine quantity demanded and quantity supplied from demand and supply respectively at the given price. This surplus will cause a fall in the price of the commodity. Price ($s) Supply
Po P* Demand Qd
Q* Qs
Quantity
Surplus
Po < P* where QS = QD => A shortage of production and a rise in price Suppose that the price in the market place (Po) is less than the price where the quantity demanded equals the quantity supplied (P*), as in the diagram below. This will mean that quantity supplied is less than quantity demanded at Po, which will results in a shortage of goods in the market. This shortage will cause unsatisfied buyers to bid up the price of the commodity.
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Principles of Microeconomics: Demand and Supply Price ($s) Supply
P* Po Demand Qs Q* Qd
Quantity
Shortage
Po = P* where quantity demanded = quantity supplied A price in the market equal to the price where quantity demanded equals quantity supplied means that there is neither a shortage nor a surplus. This gives the equilibrium price and quantity since there is no tendency for this price or quantity to change. Prices different than this equilibrium price will cause price changes in the market that will bring the price to the equilibrium price. A price greater than the equilibrium price will cause market price to fall and a price less than the equilibrium price will cause the market price to rise. We cannot determine the exact path from higher or lower prices to the equilibrium price but we can say that market forces will eventually move the price to the equilibrium price where it will stay until there is a change in economic conditions (i.e., variables).
- 15 -
-1-
Principles of Microeconomics: Demand and Supply Definition: General Equilibrium Analysis is the analysis of the relationship between all variables simultaneously. (We won’t use this approach in this class) General Equilibrium analysis is highly prized because it analyzes all the variables at once but this is a disadvantage because it requires more sophisticated mathematics and it doesn’t tell us about the cause-effect relationships between specific variables. We can approximate general equilibrium analysis by relaxing successively relaxing the ceteris paribus assumptions of partial equilibrium analysis. Definition: Atomism is the perspective that society (whole) is the sum of its parts (households and firms). Modern economics builds theory by analyzing the behaviour of the basic components of consumption (households) and production (firms). Demand is the aggregation of the behaviour of the individual consumers (households) and Supply is the aggregation of the behaviour of the individual producers (firms). Late in the course we will examine some of the issues that arise theoretically because of this methodological approach. Types of Economic Systems: There have been various types of economic systems historically, such as patriarchal, slave, feudal, socialist, and communistic. This course concentrates on the market system. Definition: Purchase and sale transactions between economic actors (households and firms) determine the allocation of resources in a market. => Price mechanism determines the allocation of resources in a market. Governments affect the allocation of resources in market economies in 5 ways. 1.
Government Spending (roads, education, transfer payments, and wars, for example)
2.
Taxation (income, sales, and property taxes, for example
-2-
Principles of Microeconomics: Demand and Supply 3.
Public Enterprises (e.g., Ontario Hydro, LCBO, TTC, etc.)
4.
Regulation (e.g., environmental, building, etc.)
5.
Monetary Policy (control of money supply effects prices, interest rates, and exchange rates)
Competitive Markets Definition: Competition is Price Taking Analysis of competition dates from at least Aristotle. Adam Smith described competition as ‘many buyers and sellers’ in his revolutionary discussion of the benefits of competitive markets in his 1876 The Wealth of Nations, but it was only at the end of the nineteenth century that economists formulated the modern analytic definition. The modern definition captures Smith’s meaning that buyers or sellers cannot influence price in a competitive market. It also simplifies the analysis of competitive behaviour since households and firms respond to a given price with no ability to change that price. Imperfect competition occurs when a buyer or seller can influence price. The most extreme examples are monopoly (single seller), which we shall discuss later in the course, and monopsony (single buyer). We shall see that Demand and Supply determine price in a competitive market. DEMAND (function, curve, schedule) Definition: Demand is the quantities of goods and services demanded by consumers (households)1 at each market price ceteris paribus. Demand is the relationship between 2 variables, price (P) and quantity demanded (q for the household and Q for the market), holding all other variables constant. The most important of the
1
Economists analyse households as the smallest unit of consumption rather than ‘consumers’ because there are consumers such as babies that do not make economic decisions.
-3-
Principles of Microeconomics: Demand and Supply other variables are prices of other goods (Pi where ‘i’ represents one of n commodities), income (Y), and preferences (tastes). We can express the Demand for the X commodity as D(qX or QX): qX or QX = f(PX | Y, Pi, Preferences) (everything after | is fixed) NOTE: We analyze Demand as a quantity response to price [Q = f(P)] not as a price response to quantity [P = f(Q]. (Alfred Marshall, the first economist to depict the Demand/Supply diagram, derived demand as a quantity response to price. Since price was the dependent variable and quantity was the independent variable, Marshall put quantity on the horizontal axis and price on the vertical axis following the mathematical convention of Y = f(X)). This concept of Demand satisfies our competitive definition that buyers are price takers. Example. The following table shows the number of kilograms of ground beef demanded by an individual during a year at given prices of ground beef, ceteris paribus. Price Quantity
$5 10
$4 15
$3 25
$2 40
$1 60
We graph this relation with Price on the vertical axis and quantity on the horizontal axis. Price ($s) 5 4 3 2 Demand
1 10
30
60 Quantity (kilos)
Law of Demand: ((∆Qx/∆Px < 0 or dQx/dPx < 0 for Qx = quantity of x and Px = price of x)
-4-
Principles of Microeconomics: Demand and Supply The Law of Demand says that an increase in price causes a decrease in quantity demanded and a decrease in price causes an increase in quantity demanded. (The change in Qx in response to the change in Px is less than zero) => A Demand curve is negatively sloped. The negative slope can be linear, concave, or convex. I will usually draw convex demand functions but use linear demand functions for calculations. Positive sloped demand functions can exist but are rare. Some positively sloped demand functions are called Giffen goods. NOTE.Do not confuse Demand and Quantity Demanded. Quantity demanded is the quantity response to one price whereas Demand is the set of all the prices and quantities. Perhaps the most common mistake in economics is the statement that the Demand for a commodity (e.g., gas) falls because of a rise in the price of the commodity. A fall in the price of a commodity causes a rise in the quantity demanded of the commodity (movement along the demand curve) but the demand curve itself does not change. A change in one of the ceteris paribus conditions, however, does change Demand. CHANGES IN DEMAND (shifts in the Demand Curve) Factors other than the price of a commodity affected the quantity demanded of a commodity. Changes in these variables change the Demand function, not merely the quantity demanded, since the price of the commodity need not change. We now look at the most common variables affecting Demand. 1.
Income a) Normal Good: Demand is positively related to Income (∆Qd/∆Y > 0 or dQd/dY > 0)
-5-
Principles of Microeconomics: Demand and Supply An increase/decrease in the consumer’s income normally results in an increase in quantity demanded at every given price of a commodity. Suppose that the consumer’s income was $2,000/month in our ground beef example above. The table and graph below show the effect on Demand of an increase in income to $3,000 month. Price Quantity (Income = $2,000/month) Quantity (Income = $3,000/month)
$5 10 15
$4 15 21
$3 25 32
$2 40 48
$1 60 69
Price ($s) 5 4 3 2
D1
1
Do 10
20
30
40
50
60 Quantity (kilos)
a) Inferior Good: Demand is inversely related to Income (∆Qd/∆Y < 0 or dQd/dY < 0) Some goods are called ‘inferior’ because an increase (decrease) in income causes a decrease (increases) in Demand, i.e., a decrease (increase) in quantity demanded at every price. An inferior good is a poorer quality good purchased by a consumer with relatively low income because it is affordable. An increase in income causes the consumer to buy more preferred normal goods and less inferior goods. Students, for example, go to pizza joints rather than better restaurants or use the TTC rather than a car. Example: Suppose that margarine is an inferior good (relative to butter) for a consumer. An increase in income causes the consumer to buy more butter and less margarine at any price of margarine.
-6-
Principles of Microeconomics: Demand and Supply
Price ($s)
Inferior Good: Increase in Income
Po
Do D1 Q1 Qo
2.
Quantity
Changes in Prices of related Consumption Goods and Services a) Substitutes in Consumption: Demand is positively related to the price of a Substitute (∆Qd/∆PSubC > 0 or dQd/∆PSubC > 0) Substitute goods are goods that are used in place of each other. Honey, saccharine, and
Splendida are common substitutes of refined sugar. Bicycles, walking, or public transportation are substitutes for travel by car. An increase in the price of a substitute (PSub) for good X causes the consumer to buy less of the substitute and more of good X. An increase in the price of cars, for example, would cause an increase in the Demand for public transportation (i.e., an increase in quantity demanded of public transportation at any given price of transportation). The diagram below shows an increase in demand for public transportation due to an increase in the prices of cars (perhaps because a fall in the supply of cars caused a fall in the quantity demanded of cars).
Price ($s)
Increase in the Price of Subsitute for Public Transportation Public Transportation Price ($s) Cars S1 So Po
P1 Po D1
Do
Q1 Qo
Do
Qo
Quantity
-7-
Q1
Quantity
Principles of Microeconomics: Demand and Supply b) Complements in Consumption: Demand is inversely related to price of a complement (∆Qx/∆PCompC < 0 or dQx/d PCompC < 0) A complement in consumption is consumed with a good. Examples include gas with cars, DVDs with DVD players, cream with coffee, etc. An increase (decrease) in the price of a complement of X decreases the demand for X. For example, an increase (decrease) in the price of gas decreases (increases) the demand for cars.
Price ($s)
Increase in the Price of Gas decreases Demand for Cars Cars Gas Price ($s) S1 So Po
P1 Po Do Do
Q1 Qo
3.
D1
Q1
Quantity
Qo
Quantity
A change in Taste or Preference A change in Taste of Preference will change the Demand for a commodity. For example, an
increase in environmental consciousness will decrease the Demand for cars and increase the demand for public transportation, walking, or bicycles. 4.
A change in the number of Consumers An increase in the number of consumers (immigration, population growth) will increase the
market demand for a commodity if the individual demand for the commodity remains the same.
-8-
Principles of Microeconomics: Demand and Supply SUPPLY: Definition: Supply is the quantities of goods and services supplied by firms at every price ceteris paribus Supply is the relationship between 2 variables, price (P) and quantity supplied (q for the firm and Q for the industry, the sum of the firms), holding all other variables constant. The most important of the ceteris paribus conditions are the length of the supply period, the costs of inputs into production, the prices of other goods (Pi where ‘i’ represents one of n commodities), and technology. We can express the Supply for the x commodity as S(qX or QX): qX or QX = f(PX | Inputs Costs, Pi, Time Period, Technology) Note: Supply is defined for quantity supplied in response to price not vice versa. Supply is therefore a competitive concept so that monopolies, for example, do not have supply functions. Law of Supply: Quantity Supplied is positively related to Price Constant input costs imply that an increase in price will increase profit and thus quantity supplied. The quantity supplied only increases to the point where price equals opportunity cost. Analyzing the supply function is a key part of this course but we will leave it until later. Example: The following table shows the number of kilograms of ground beef supplied by a firm during a year to given prices of ground beef, ceteris paribus. Price Quantity
$5 40
$4 15
$3 25
-9-
$2 10
$1 0
Principles of Microeconomics: Demand and Supply We graph this relation with Price on the vertical axis and quantity on the horizontal axis. Price ($s) So 5 4 3 2 1 10
20
30
60 40 50 Quantity (kilos)
Note: A change in the price of the commodity implies a change in quantity supplied but not a change in supply. A change in a ceteris paribus condition implies a change in supply. Changes (shifts) in Supply: 1.
A change in Per Unit Costs Supply gives us the amount that a firm would produce at a given price so Supply is
essentially determined by the firm’s costs. A change in per unit costs changes the cost of producing a unit of output and thus changes the amount that a firm will produce. An increase in costs per unit of output means that the firm has to charge more to cover costs; supply therefore shifts up by the amount of the increase in per unit costs. We say that supply decreases in this case because the firm decreases quantity supplied at any given price. Example. The graph below shows the fall in supply due to an increase in costs of $1 per unit.
- 10 -
Principles of Microeconomics: Demand and Supply Supply: Increase in Cost of $1/unit S1 Price ($s) So 5 4 3 2 1 10
20
30
60 40 50 Quantity (kilos)
2. Changes in Technology . An improvement in technology implies an increase in output for given resources. Supply increases because quantity supplied increases at every price. You could also see this as a decrease in the cost of production of every unit of output. Increase in Supply: Technological Improvement Price ($s) So
S1
5 4 3 2 1 10
3.
20
30
60 40 50 Quantity (kilos)
Changes in the Price of related Output We now discuss the effect on supply of changes in the price of substitutes and complements
in production. It is very important to remember that we refer to output and not input prices.
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Principles of Microeconomics: Demand and Supply a) Substitutes in Production (Alternative Products) (∆Qx/∆PSubP < 0 or dQx/d PSubP < 0) A firm usually has the possibility of producing more than one product with the same resources. An increase (decrease) in the price of a substitute product causes a decrease (increase) in the supply of the original product because the firm switches resources from the original product to the other product. Example: Suppose that the price of wheat and the price of oats are both $1/bushel in equilibrium and that a farmer cultivates 50 hectares of wheat and 50 hectares of oats as a result. An increase in the price of oats to $1.50 (perhaps due to an increase in demand) increases the quantity supplied of oats because the farmer now cultivates 70 hectares of oats. This means that the farmer is cultivating only 30 hectares of wheat at $1/wheat. The supply of wheat has therefore fallen. Decrease in Supply (Wheat) in response to Increase in Price of Substitute Product (Oats) Price ($s)
Oats
Wheat S1
Price ($s)
So
So
Po
P1 Po
D1 Do
Qo Q1
Q1
Quantity
Qo
Quantity
b) Complements in Production (∆Qd/∆PCompP > 0 or dQd/∆PCompP > 0) Complements in production are different outputs produced by the same production process. Examples include beef and hides from the raising of cattle, furniture and firewood from the production of furniture, or gasoline and tar from refining oil. An increase in the price of a - 12 -
Principles of Microeconomics: Demand and Supply complement in production for X increases the supply of X by reducing the cost of X through generation of more revenue from production. Example: Suppose that the price of beef is $2/kilo and the price of a hide is $50. The following graphs show that an increase in the price of hides (due to demand in this case) of $50 causes an increase in the supply of beef (since the cost of raising an animal is now $50 less). Increase in Supply (Beef) in response to Increase in Price of Complement Product (Hides) Hides
Price ($s)
Price ($s)
So
Beef So
S1
Po
P1 D1
Po
Do
Qo
Q1
Qo Q1
Quantity
Quantity
4. Changes in the Number of Firms An increase (decrease) in the number of firms in an industry increases (decreases) market supply. MARKET EQUILIBRIUM: QS = QD => PS = PD Market Demand is simply the sum of all the individual (household) demand functions and Market Supply is the sum of all the individual (firm) supply functions. Market Equilibrium is the state of rest with no tendency to change for given economic variables. Market Equilibrium occurs when the quantity demanded by consumers equals the quantity supplied by firms. This occurs when the price paid by consumers equals the price paid by firms for the same quantity. Markets move to equilibrium through price adjustment. Po > P* where QS = QD => Surplus production and a fall in price
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Principles of Microeconomics: Demand and Supply Suppose that the price in the market place (Po) is greater than the price where the quantity demanded equals the quantity supplied (P*), as in the diagram below. This will mean that quantity supplied is greater than quantity demanded, which will leave a surplus of unsold goods in the market at that price as shown in the diagram below. Remember that Demand and Supply show the relationship between prices and quantities so that to we simply determine quantity demanded and quantity supplied from demand and supply respectively at the given price. This surplus will cause a fall in the price of the commodity. Price ($s) Supply
Po P* Demand Qd
Q* Qs
Quantity
Surplus
Po < P* where QS = QD => A shortage of production and a rise in price Suppose that the price in the market place (Po) is less than the price where the quantity demanded equals the quantity supplied (P*), as in the diagram below. This will mean that quantity supplied is less than quantity demanded at Po, which will results in a shortage of goods in the market. This shortage will cause unsatisfied buyers to bid up the price of the commodity.
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Principles of Microeconomics: Demand and Supply Price ($s) Supply
P* Po Demand Qs Q* Qd
Quantity
Shortage
Po = P* where quantity demanded = quantity supplied A price in the market equal to the price where quantity demanded equals quantity supplied means that there is neither a shortage nor a surplus. This gives the equilibrium price and quantity since there is no tendency for this price or quantity to change. Prices different than this equilibrium price will cause price changes in the market that will bring the price to the equilibrium price. A price greater than the equilibrium price will cause market price to fall and a price less than the equilibrium price will cause the market price to rise. We cannot determine the exact path from higher or lower prices to the equilibrium price but we can say that market forces will eventually move the price to the equilibrium price where it will stay until there is a change in economic conditions (i.e., variables).
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