Supply and Demand
4 c h a p t e r
DEFINING A MARKET
Although we usually think of a market as a place where some sort of exchange occurs, a market is not really a place at all. A market is the process of buyers and sellers exchanging goods and services.
This means that supermarkets, the New York Stock Exchange, drug stores, roadside stands, garage sales, Internet stores, and restaurants are all markets.
Every market is different. That is, the conditions under which the exchange between buyers and sellers takes place can vary. These differences make it difficult to precisely define a market. After all, an incredible variety of exchange arrangements exists in the real world—organized securities markets, wholesale auction markets, foreign exchange markets, real estate markets, labor markets, and so forth.
Goods being priced and traded in various ways at various locations by various kinds of buyers and sellers further compound the problem of defining a market. For some goods, such as housing, markets are numerous but limited to a geographic area.
Homes in Santa Barbara, California, for example (about 100 miles from downtown Los Angeles), do not compete directly with homes in Los Angeles.
Why? Because people who work in Los Angeles will generally look for homes within commuting distance.
Even within cities, there are separate markets for homes, differentiated by amenities such as more living space, newer construction, larger lot, and better schools.
In a similar manner, markets are numerous but geographically limited for a good such as cement.
Because transportation costs are so high relative to the selling price, the good is not shipped any substantial distance, and buyers are usually in contact only with local producers. Price and output are thus
Markets
s e c t i o n
4.1
_ What is a market?
_ Why is it so difficult to define a market?
64 CHAPTER FOUR | Supply and Demand
In the stock market, there are many buyers and sellers, and profit statements and stock prices are readily available. New information is quickly understood by buyers and sellers and is incorporated into the price of the stock. When people expect a company to do better in the future, they bid up the price of that stock; when people expect the company to do poorly in the future, the price of the stock falls.
Photo used with permission of the New York Stock Exchange
eBay is an Internet auction company that brings buyers and sellers of goods together. The Web site allows sellers to offer their good to millions of potential buyers at a minimum cost. According to USA Today, the biggest transaction ever for the Internet auctioneer eBay was the sale of a Gulfstream business jet in August 2001.
Late in 2003, Ticket Master plans to begin auctioning the best seats for concerts.
© eBay Inc. All Rights Reserved
THE LAW OF DEMAND
Sometimes observed behavior is so pervasive it is called a law—like the law of demand. According to the law of demand, the quantity of a good or service demanded varies inversely (negatively) with its price,
ceteris paribus. More directly, the law of demand says that, other things being equal, when the price (P) of a good or service falls, the quantity demanded (QD) increases, and conversely, if the price of a good or service rises, the quantity demanded decreases.
P c 1 QD T and P T 1 QD c
WHY IS THERE A NEGATIVE RELATIONSHIP BETWEEN PRICE AND THE QUANTITY DEMANDED?
The law of demand describes a negative (inverse) relationship between price and quantity demanded.
When price goes up, the quantity demanded goes down, and vice versa. Why? There are several reasons.
Observed behavior tells us that consumers will buy more goods and services at lower prices than at higher prices, ceteris paribus. Businesses would not put items on sale if they did not think they could sell even more at lower prices—that is, at a lower price, there is a greater quantity demanded.
Another reason for the negative relationship is what economists call diminishing marginal utility.
In a given time period, a buyer will receive less satisfaction from each successive unit consumed. For example, a second ice cream cone will yield less satisfaction than the first and a third less satisfaction than the second and so on. It follows from diminishing marginal utility that if people are deriving less satisfaction from successive units, consumers would buy added units only if the price were reduced.
determined in a number of small markets. In other markets, like those for gold or automobiles, markets are global. The important point is not what a market looks like, but what it does—it facilitates trade.
BUYERS AND SELLERS
The roles of buyers and sellers in markets are important.
Buyers, as a group, determine the demand side of the market. Buyers include the consumers who purchase the goods and services and the firms that buy inputs—labor, capital, and raw materials. Sellers, as a group, determine the supply side of the market. Seller include the firms that produce and sell goods and services and the resource owners who sell their inputs to firms—workers who “sell” their labor and resource owners who sell raw materials and capital. It is the interaction of buyers and sellers that determines market prices and output—through the forces of supply and demand.
In this chapter, we focus on how supply and demand work in a competitive market. A competitive market is one in which a number of buyers and sellers are offering similar products and no single buyer or seller can influence the market price. That is, buyers and sellers have very little market power. Because most markets contain a large degree of competitiveness, the lessons of supply and demand can be applied to many different types of problems.
Demand 65
Demand
4.2
¡ What is the law of demand?
¡ What is diminishing marginal utility?
¡ What is the substitution effect?
¡ What is the income effect?
¡ What is an individual demand curve?
¡ What is a market demand curve?
1. Markets consist of buyers and sellers exchanging goods and services with one another.
2. Markets can be regional, national, or global.
3. Buyers determine the demand side of the market and sellers determine the supply side of the market.
1. Why is it difficult to define a market precisely?
2. Why do you get your produce at a supermarket rather than directly from farmers?
3. Why do the prices people pay for similar items at garage sales vary more than for similar items in a department store?
s e c t i o n c h e c k
Finally, there is the substitution and income effect of a price change. For example, if the price of pizza increases the quantity demanded of pizza will fall because some consumers might switch out of pizza into hamburgers, tacos, burritos, submarine sandwiches or some other foods that substitute for pizza. This is called the substitution effect of a price change. In addition, a price increase in pizza will reduce the quantity demanded of pizza because it reduces a buyer’s purchasing power—the buyer cannot buy as many pieces of pizza at higher prices as she could at lower prices. This is called the income effect of a price change.
INDIVIDUAL DEMAND
An Individual Demand Schedule
The individual demand schedule shows the relationship between the price of the good and the quantity demanded. For example, suppose Elizabeth enjoys drinking coffee. How many pounds of coffee would Elizabeth be willing and able to buy at various prices during the year? At a price of $3 a pound, Elizabeth buys 15 pounds of coffee over the course of a year. If the price is higher, at $4 per pound, she might buy only 10 pounds; if it is lower, say $1 per pound, she might buy 25 pounds of coffee during the year. Elizabeth’s demand for coffee for the year is summarized in the demand schedule in Exhibit 1. Elizabeth might not be consciously aware of the amounts that she would purchase at prices other than the prevailing one, but that does not alter the fact that she has a schedule in the sense that she would have bought various other amounts had other prices prevailed. It must be emphasized that the schedule is a list of alternative possibilities.
At any one time, only one of the prices will prevail, and thus a certain quantity will be purchased.
An Individual Demand Curve
By plotting the different prices and corresponding quantities demanded in Elizabeth’s demand schedule in Exhibit 1 and then connecting them, we can create the individual demand curve for Elizabeth shown in Exhibit 2. From the curve, we can see that when the price is higher, the quantity demanded is lower, and when the price is lower, the quantity demanded is higher. The demand curve shows how the quantity demanded of the good changes as its price varies.
WHAT IS A MARKET DEMAND CURVE?
Although we introduced the concept of the demand curve in terms of the individual, economists usually speak of the demand curve in terms of large groups of people—a whole nation, a community, or a trading area. As you know, every individual has his or her demand curve for every product. The horizontal summing of the demand curves of many individuals is called the market demand curve.
66 CHAPTER FOUR | Supply and Demand
Quantity Demanded Price (per pound) (pounds per year)
$5 5 4 10 3 15 2 20 1 25
Elizabeth’s Demand Schedule for Coffee
SECTION 4.2
EXHIBIT 1
What if the price of water increases significantly? At the new higher price, consumers will still use almost as much water for essentials like drinking and cooking. But they might not wash their cars as often, water their lawns daily, hose off their sidewalks, run their dishwashers unless they’re completely full, take long showers, or flush their toilets after each use.
Suppose the consumer group is composed of Homer, Marge, and the rest of their small community, Springfield, and that the product is still coffee.
The effect of price on the quantity of coffee demanded by Marge, Homer, and the rest of Springfield is given in the demand schedule and demand curves shown in Exhibit 3. At $4 per pound, Homer would be willing and able to buy 20 pounds of cof-
Demand 67
Price of Coffee (per pound)
$5 4 3 2 1 5 10 15 20 25 30
Quantity of Coffee Demanded (pounds per year)
0 Elizabeth’s Demand Curve
Elizabeth’s Demand Curve for Coffee
EXHIBIT 2
The dots represent various quantities of coffee that Elizabeth would be willing and able to buy at different prices in a given period. The demand curve shows how the quantity demanded varies inversely with the price of the good when we hold everything else constant—ceteris paribus. Because of this inverse relationship between price and quantity demanded, the demand curve is downward sloping.
$5 4 3 2 1 5 10 15 20 25
Price of Coffee Quantity of Coffee Price of Coffee Quantity of Coffee Price of Coffee Quantity of Coffee Price of Coffee Quantity of Coffee
0 $5 4 3 2 1 5 10 15 20 25
Homer Marge
0
DHOMER
$5 4 3 2 1 2,970 4,960
Rest of Springfield
DS
$5 4 3 2 1 3,000 5,000
Market Demand
DM
1 1 5
DMARGE
a. Creating a Market Demand Schedule for Coffee Quantity Demanded (pounds per year) Price Rest of Market (per pound) Homer 1 Marge 1 Springfield 5 Demand
$4 20 1 10 1 2,970 5 3,000 $3 25 1 15 1 4,960 5 5,000
b. Creating a Market Demand Curve for Coffee
Creating a Market Demand Curve SECTION 4.2
EXHIBIT 3
Is this house really priced to sell? What if this house had been on the market for a year at the same price and not sold? While no one seems to want this house at the current asking price, a number of people might want it at a lower price—the law of demand.
© Index Stock Photography
68 CHAPTER FOUR | Supply and Demand
a. Market Demand Schedule for Coffee b. Market Demand Curve for Coffee Price Total Quantity Demanded (per pound) (pounds per year)
$5 1,000 4 3,000 3 5,000 2 8,000 1 12,000
$5 4 3 2 1 2 4 6 8 10 12
Quantity of Coffee Demanded (thousands of pounds per year)
0 Market Demand Curve
A Market Demand Curve SECTION 4.2
EXHIBIT 4
The market demand curve shows the amounts that all the buyers in the market would be willing and able to buy at various prices. We find the market demand curve by adding horizontally the individual demand curves. For example, when the price of coffee is $2 per pound, consumers in the market collectively would be willing and able to buy 8,000 pounds per year. At $1 per pound, the amount collectively demanded would be 12,000 pounds per year.
1. The law of demand states that when the price of a good falls (rises), the quantity demanded rises (falls), ceteris paribus.
2. An individual demand curve is a graphical representation of the relationaship between the price and the quantity demanded.
3. The market demand curve shows the amount of a good that all buyers in the market would be willing and able to buy at various prices.
1. What is an inverse relationship?
2. How do lower prices change buyers’ incentives?
3. How do higher prices change buyers’ incentives?
4. What is an individual demand schedule?
5. What difference is there between an individual demand curve and a market demand curve?
6. Why does the amount of dating on campus tend to decline just before and during final exams?
fee per year, Marge would be willing and able to buy 10 pounds, and the rest of Springfield would be willing and able to buy 2,970 pounds. At $3 per pound, Homer would be willing and able to buy 25 pounds of coffee per year, Marge would be willing and able to buy 15 pounds, and the rest of Springfield would be willing and able to buy 4,960 pounds. The market demand curve is simply the (horizontal) sum of the quantities Homer, Marge, and the rest of Springfield demand at each price. That is, at $4, the quantity demanded in the market would be 3,000 pounds of coffee (20 + 10 + 2,970 = 3,000), and at $3, the quantity demanded in the market would be 5,000 pounds of coffee (25 + 15 + 4,960 = 5,000).
In Exhibit 4, we offer a more complete set of prices and quantities from the market demand for coffee during the year. Remember, the market demand curve shows the amounts that all the buyers in the market would be willing and able to buy at various prices. For example, when the price of coffee is $2 per pound, consumers in the market collectively would be willing and able to buy 8,000 pounds per year. At $1 per pound, the amount collectively demanded would be 12,000 pounds per year.
A CHANGE IN DEMAND VERSUS A CHANGE IN QUANTITY DEMANDED
Consumers are influenced by the prices of goods when they make their purchasing decisions. At lower prices, people prefer to buy more of a good than they do at higher prices, holding other factors constant.
Why? Primarily, it is because many goods are substitutes for one another. For example, an increase in the price of coffee might tempt some buyers to switch from buying coffee to buying tea or soft drinks.
Understanding this relationship between price and quantity demanded is so important that economists make a clear distinction between it and the various other factors that can influence consumer behavior.
A change in a good’s price is said to lead to a
change in quantity demanded. That is, it “moves you along” a given demand curve. The demand curve is drawn under the assumption that all other things are held constant, except the price of the good. However, economists know that price is not the only thing that affects the quantity of a good that people buy. The other factors that influence the demand curve are called determinants of demand, and a change in these other factors shifts the entire demand curve. These determinants of demand are called demand shifters and they lead to changes in demand.
SHIFTS IN DEMAND
An increase in demand shifts the demand curve to the right; a decrease in demand shifts the demand curve to the left, as seen in Exhibit 1. Some of the possible demand shifters are the prices of related goods, income, number of buyers, tastes, and expectations. We will now look more closely at each of these variables.
THE PRICES OF RELATED GOODS
In deciding how much of a good or service to buy, consumers are influenced by the price of that good or service, a relationship summarized in the law of demand. However, consumers are also influenced by the prices of related goods and services—substitutes and complements.
Substitutes
Suppose you go into a store to buy a couple of six packs of Coca-Cola and you see that Pepsi is on sale for half its usual price. Is it possible that you might decide to buy Pepsi instead of Coca-Cola?
Economists argue that most people would be, and empirical tests have confirmed that consumers are responsive to both the price of the good in question and the prices of related goods. In this example, Pepsi and Coca-Cola are said to be substitutes. Two goods are substitutes if an increase (a decrease) in the price of one good causes an increase (a decrease) in the demand for another good—a direct (or positive) relationship.
PGOOD A c 1 c DGOOD B
PGOOD A T 1 T DGOOD B
Substitutes are generally goods for which one could be used in place of the other, such as butter and
Shifts in the Demand Curve 69
Shifts in the Demand Curve
4.3
_ What is the difference between a change in demand and a change in quantity demanded?
_ What are the determinants of demand?
_ What are substitutes and complements?
_ What are normal and inferior goods?
_ How does the number of buyers affect the demand curve?
_ How do changes in taste affect the demand curve?
_ How do changing expectations affect the demand curve?
Price Quantity
Decrease in Demand Increase in Demand
D3 D1 D2
Demand Shifts SECTION 4.3
An increase in demand shifts the demand curve to the right. A decrease in demand shifts the demand curve to the left.
margarine, movie tickets and video rentals, jackets and sweaters, and Nikes and Reeboks.
Complements
If an increase (a decrease) in the price of one good causes a decrease (an increase) in the demand of another good (an inverse or negative relationship), the two goods are called complements. Complements are goods that “go together,” often consumed and used simultaneously, such as skis and bindings, peanut butter and jelly, hot dogs and buns, DVDs and DVD players, printers and ink cartridges. For example, if the price of motorcycles rises, it causes the demand for motorcycle helmets to fall (shift to the left), because the two goods are complements. A decrease in the price of stereo equipment leads to an increase in the demand (a rightward shift) for compact discs, because stereos and CDs are complements.
PGOOD A c 1 T DGOOD B
PGOOD A T 1 c DGOOD B
70 CHAPTER FOUR | Supply and Demand
Can you describe the change we would expect to see in the demand curve for Pepsi if the relative price for Coca-Cola increased significantly?
If the price of one good increases and, as a result, an individual buys more of another good, the two related goods are substitutes. That is, buying more of one reduces purchases of the other. In Exhibit 2(a), we see that as the price of Coca-Cola increases—a movement up along the demand curve—the demand for Pepsi increases, resulting ...
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