Top Posters
Since Sunday
5
o
5
4
m
4
b
4
x
4
a
4
l
4
t
4
S
4
m
3
s
3
A free membership is required to access uploaded content. Login or Register.

Chapter 4 - Demand, Supply, and Equilibrium

Boston College : BC
Uploaded: 6 years ago
Contributor: nithepanthiel
Category: Finance
Type: Outline
Rating: N/A
Helpful
Unhelpful
Filename:   ALL_1e_IM_Ch04_fmt.docx (311.13 kB)
Page Count: 18
Credit Cost: 1
Views: 191
Last Download: N/A
Transcript
CHAPTER 4 Demand, Supply, and Equilibrium I. Key Ideas In a perfectly competitive market, (1) sellers all sell an identical good or service, and (2) any individual buyer or any individual seller isn’t powerful enough on his or her own to affect the market price of that good or service. The demand curve plots the relationship between the market price and the quantity of a good demanded by buyers. The supply curve plots the relationship between the market price and the quantity of a good supplied by sellers. The competitive equilibrium price equates the quantity demanded and the quantity supplied. When prices are not free to fluctuate, markets fail to equate quantity demanded and quantity supplied. II. Getting Started The Big Picture In this chapter, our goal is to understand the properties of markets that have flexible prices and are perfectly competitive (identical goods and market participants who can’t influence the market price). Along the way, we’ll ask three questions: How do buyers behave? How do sellers behave? How does the behavior of buyers and sellers jointly determine the market price and quantity of goods transacted? The workhorse model of microeconomics is supply and demand (S&D). ALL introduces it early, and then goes back and addresses details about the origins of demand in Chapter 5 and the origins of supply in Chapter 6. S&D pulls together optimizing buyers and sellers. We characterize the equilibrium and run comparative statics to analyze various shocks and government policies. One could do some empirical work by gathering data on consumption and prices (e.g., how many loaves of bread a grocery store sells as a function of price, which depends on sales, coupons, etc.). Where We’ve Been Chapter 1 introduced the three underlying principles (optimization, equilibrium, and empiricism) and focused on the true cost of spending an hour per day on Facebook. Even though it is “free” to join Facebook, one must give up valuable time and the other goods one could have purchased instead; thus, the demand for Facebook services and the demand for other goods are linked. Chapter 2 focuses mostly on empirical methods and a model of the returns to education. This naturally makes the reader think about the demand for education services and whether buying them will pay off in the long run. Chapter 3 presents two related ways to optimize in the context of choosing where to live. We learn that the price of a typical apartment (with a standard set of common amenities) is a function of its location, and in cities with beltways, we would expect apartments near the beltway to have similar rent. Rent is determined by forces of supply (potential landlords) and demand (potential tenants) in the market. In short, by the time they get to Chapter 4, readers should have had a chance to ponder the demands for Facebook services, education services, and apartments. They should have a basic understanding of opportunity costs, scarcity, models, and marginal thinking. Where We’re Going Chapters 2 and 3 are unique (i.e., not often found in principles-level textbooks) but can add a rich layer of understanding to the empirical parts of the presentation as well as prepare students to envision a world consisting of optimizing economic agents, whether they are utility-maximizing households, profit-maximizing firms, or social welfare-maximizing governments. Chapter 4 is pretty standard and prepares the reader for subsequent applications of supply and demand in later chapters. Here’s a quick guide to some of the applications of S&D that you’ll find in the remainder of the microeconomic chapters: Chapter 5 Consumers and Incentives: Using marginal benefit per dollar spent, your consumption (shopping) decisions generate demand curves for sweaters and jeans. Chapter 6 Sellers and Incentives: Given its technology, labor input costs, and output price, Cheeseman decides how many cheese boxes to supply. Chapter 7 Perfect Competition and the Invisible Hand: We examine buyer and seller decisions in markets for iPods, paper delivery, corn hauling, and bottled water. Chapter 8 Trade: Danish cobblers (shoemakers) are affected by import tariffs and other trade policies in the global market for tennis shoes. Chapter 9 Externalities and Public Goods: From society’s perspective, power plants produce too much electricity and pollution, a negative externality. Meanwhile, a government sums individual demands to construct a market demand, and then decides how much of a public good (such as space missions) to provide. Chapter10 The Government in the Economy: Taxation and Regulation: To finance park construction, the City of New Orleans levies a hypothetical $2 tax on jambalaya plates and ponders how the tax will be split across buyers and sellers. Chapter 11 Markets for Factors of Production: Alice and Tom make labor supply decisions, while Cheeseman uses its labor demand curve and the wage to make hiring decisions; we consider events that would shift labor supply and/or demand. Chapter 12 Monopoly: Schering-Plough exploits its patent-based monopoly power to determine its profit-maximizing output and price, given the market demand for Claritin. Chapter 13 Game Theory and Strategic Play: Rival surf shops Hang Ten and La Jolla make advertising decisions that affect each firm’s residual demand. Chapter 14 Oligopoly and Monopolistic Competition: Facing a market demand for their perfectly substitutable landscaping services, firms Dogwood and Rose Petal competitively set prices; Dairy Queen’s residual demand depends on entry by other monopolistically competitive rivals. Chapter 15 Trade-offs Involving Time and Risk: Banks serve as financial intermediaries, bringing together borrowers and lenders, who are effectively buyers and sellers in the market for loanable funds; we also consider the demand for extended warranties on consumer electronic goods, such as a $300 television from Best Buy. Chapter 16 The Economics of Information: The demand for used cars is complicated by an adverse selection problem: a buyer doesn’t know whether a particular used car is a lemon (low quality) or a gem (high quality). Chapter 17 Auctions and Bargaining: The demand for Oakland Raiders tickets depends on fans’ willingness to pay; if Caribou Coffee is a large buyer of labor services and there are many individual sellers, then we’d expect a relatively low equilibrium wage. Chapter 18 Social Economics: If the act of giving is viewed as an economic good, then when tax rates drop, the price of charitable giving rises, and individuals in the highest tax brackets reduce their contributions, consistent with the Law of Demand. Number of Lectures Given the importance of this material and the subsequent presentations of demand in Chapter 5 and Chapter 6, an instructor would probably choose to spend two 50-minute lectures on this material. Here are the essential elements and suggested time allocations: Lecture 1: How to draw demand; demand curve intuition; aggregating individual buyers [15 mins.] Moving along a given demand curve; demand curve shifters [15 mins.] How to draw supply; supply curve intuition; aggregating individual sellers [10 mins.; once you’ve done this in detail for demand, it is faster to present supply.] Moving along a given supply curve; supply curve shifters [10 mins.] Lecture 2: A quick overview of S&D (e.g., show the complete lists of S&D shifters), equilibrium [10 mins.] How market forces eliminate surpluses and shortages, showing how both S&D are responsible for surpluses and shortages at a non-equilibrium price [15 mins.] How to analyze a single market event, with plenty of exercises [15 mins.] How to analyze pairs of market events [10 mins.] Opening Question and Evidence-Based Economics “How much more gasoline would people buy if its price were lower?” This is a good question to ask because it is relevant (many will consider buying vehicles soon after graduation and some own vehicles now or have friends who do) and timely (transportation of physical goods is so important in the economy that gas price is a regular topic of conversation and growing U.S. production of natural gas has led some firms to consider replacing gasoline engines with natural gas engines). Elsewhere in the chapter, when we discuss the price of substitute goods, we could bring up the changing relative prices of natural gas and gasoline and the impact of this on the market for trucking. III. Chapter Outline 4.1 Markets In a well-functioning market, an amazing amount of information is boiled down into the market price, which is the key piece of information that participants need to know. Adding on to the book’s discussion of gas stations, one might ask students why gas stations rarely run out of gas. In general, it is because profit-seeking gas station managers arrange for tanker trucks to fill the giant tanks under the station in the wee hours of the morning in anticipation of the appearance of drivers who want to fill up their tanks. Occasionally, gasoline shortages are caused by natural disasters (e.g., hurricanes) or price-gouging laws. Great quote from the text: “Prices act as a selection device that encourages trade between the sellers who can produce goods at low cost and the buyers who place a high value on the goods.” One might ask students whether it is fair that only the lowest cost producers get to sell and only the buyers willing, able, and ready to pay the most get to buy. After introducing the supply and demand curves and the equilibrium price, one should remind the reader that the equilibrium price effectively chops off the top right end of an upward sloping supply curve and the bottom right end of a downward sloping demand curve. Alternative Teaching Examples: Other markets include flea markets and farmers’ markets, as well as buyers and sellers brought together at roadside stands or yard sales. There may be underground markets for babysitting or economics tutoring, as well as for controversial goods and services such as moonshine, ecstasy, pirated movies, and kidneys. Competitive Markets—In a perfectly competitive market characterized by (i) many insignificant individual buyers and sellers, and (ii) homogeneous products, we expect price taking behavior and transactions to occur in a “take it or leave it” style at the single market price. Textbooks vary on how many conditions to attach to the definition of perfect competition, so an instructor should weigh the costs and benefits of expanding the definition. For instance, “free entry and exit” is included as a third condition in the perfectly competitive market definition in Section 6.1, but because entry isn’t discussed until then, it may make sense to postpone mention of entry until one covers Chapter 6. Likewise, one might delay mention of no externalities, no public goods, no transactions costs, and perfect information until later in the course. Alternatively, one can identify these conditions now, but say that they will be addressed with more detail later in the course. Teaching Ideas: It’s hard to find good real-world examples of perfectly competitive (hereafter, P.C.) markets, but it’s fun to ask students to try to identify some because this inevitably leads to class discussion about market failures (violations of one or more of the perfectly competitive market conditions). Markets for agricultural products such as wheat were classic textbook examples of P.C. markets, though this was more compelling in the days of family farms than in the modern day of massive agricultural conglomerates. Markets for “used” shares of large, publicly traded firms such as Facebook are pretty competitive. And as a search of Apple’s App Store or Google Play for “Sudoku” will reveal, the market for smartphone apps is rather competitive. Students will better appreciate how microeconomics fits together if one explains why we typically go through the P.C. model first, and then address some of the most important market failures. Once students understand the causes of market failures, their symptoms, and potential market- and government-based remedies, they will have a better perspective on the proper role of government in an economy. It may be helpful to emphasize the point from Chapter 2 that models are just approximations of reality. One might introduce J.M. Clark’s (1940) notion of workable competition: A workably competitive market comes close to satisfying the perfectly competitive market conditions, so any market failures are minor. This way, students understand that there is a difference between a strict textbook definition of perfect competition and the casual way economists use the term. Similarly, when discussing monopoly in Chapter 12, we might distinguish between a textbook model of monopoly, in which there is a single seller with 100 percent market share, and a real-world sort of monopoly, such as Microsoft’s Windows operating system, which for many years has had a more than a 90 percent market share for PC-based desktop computers. This is also a good time to talk about benchmarks. Why would economists analyze a model that doesn’t seem to apply very well to most real-world markets? Because it shows us how things would work in an ideal case, and then we have some results against which to compare the results we observe in messier real-world markets. One might say that we will first investigate the polar extreme cases of perfect competition and monopoly, and then fill in the middle with the more commonly encountered market structures of oligopoly and monopolistic competition. Teaching Ideas: One might not be successful in trying to haggle with a gas station for a better gas price, but there are situations when haggling can work and may even be expected. Ask students to describe situations in which they have observed a buyer successfully negotiating a better price (instead of take-it-or-leave-it prices). You can then talk about how the ability to walk away from a deal (perhaps to a fallback option) may generate bargaining power and a better final price. 4.2 How Do Buyers Behave? Our goal is to understand market demand curves, which illustrate quantity demanded over the range of possible prices. These are just a graphical representation of consumer behaviors or tendencies: holding a number of other demand-affecting variables fixed, what is the relationship between price and the number of units consumers collectively are willing, ready, and able to buy? It may help to write down a demand function in this conceptual way: Quantity demanded of gas = f[Price of gas, Number of gas buyers, Price of gas substitutes (diesel, natural gas, electricity), Price of gas complements (cars, lawn mowers, gas cans), Income, Perception of fossil fuels and their relationship with global warming, Expectations about future gas prices, etc.] Then introducing the Latin phrase ceteris paribus (interpreted as “holding all else equal or constant”) helps students understand that we will analyze how the quantity demanded of gas changes when there is a change in the number of gas buyers but everything else on the right hand side remains unchanged. If we underline those things held constant, then we have Quantity demanded of gas = f[Price of gas, Number of gas buyers, Price of gas substitutes (diesel, natural gas, electricity), Price of gas complements (cars, lawn mowers, gas cans), Income, Perception of fossil fuels and their relationship with global warming, Expectations about future gas prices, etc.] and it is clear which particular relationship we are highlighting. Teaching Ideas: Exhibit 4.1 illustrates a typical, downward-sloping demand curve for an individual. Subsequent demand analysis critically depends on having a good understanding of this diagram, so it is important to explain it in detail. To give names to the two endpoints of the demand curve, one might choose to introduce the terms choke price (the price-intercept, which is the lowest price at which the quantity demanded remains zero) and giveaway quantity (the quantity-intercept, which is the quantity demanded when the good is free). Demand Curves—Typical demand curves are downward sloping, which means that as the price rises (falls), the quantity demanded falls (rises). This negative relationship between price and quantity demanded is so common that we refer to it as the Law of Demand. We often draw linear, downward-sloping demand curves because they are aesthetically pleasing, easy to draw, easy to express algebraically, and easy to use (e.g., the area beneath it takes the form of a triangle). That said, real-world demand curves are probably not linear; they are probably discrete step functions, so we have another case of economists making an assumption to generate a tidy model. Realistic non-linear demand curves don’t provide much additional insight and are much harder to work with. Being upfront about these things with students may help them buy into the economist’s perspective on the world. For typical demand curves, price and quantity demanded are negatively related. One might refer students to the text around Exhibits 2A.5 and 2A.6 in the Chapter 2 Appendix, where the authors show how to find the slope of a curve. Willingness to Pay—The height of a demand curve reflects willingness to pay. We can read a demand curve in two ways: quantity demanded as a function of price, Qd[P], and price as a function of quantity demanded, P[Qd]. (Technically, the former is a demand function, whereas the latter is an inverse demand function.) Intuitively, for a given price, we can determine the number of units that the buyer(s) will want to buy, and for a given number of units for sale, we can determine the price that would ensure that no units are left unsold. Later, when we get to Chapter 12 and we study the output decision of a monopoly, we will see that once the firm decides how much to produce, it will charge the highest price that will allow it to sell all of its output. Beyond the scope of a principles of economics course is the technical issue of how to properly define willingness to pay without opening the old “derivatives or deltas” can of worms: it’s hard to mix a continuous, differentiable demand function such as Qd = 350 – 50P with a discrete concept such as the willingness to pay for one additional (discrete, indivisible) unit. (The controversy involves the italicized parts of this definition: Willingness to pay [WTP] is the highest price that a buyer is willing to pay for an extra unit of a good, given a certain amount of that good already at her disposal.) To keep things simple, the authors chose the standard approach, which is to use the height of the demand curve as the WTP for that unit; e.g., in Exhibit 4.1, Chloe is willing to pay $4 for the 150th unit. Pedants may choose to use larger numbers for quantity demanded (so the difference between the WTP for the, say, 150,000th and 150,001st units is negligible) or argue that gallons of gasoline are divisible, and that we’re really thinking about the per-gallon price of a tiny increment of gasoline, not necessarily an entire extra gallon. The concept of diminishing marginal benefits appears frequently in economics. That is, we observe diminishing marginal utility when a child keeps eating Halloween candy and diminishing marginal product (of labor) when a sub sandwich shop manager hires another worker and puts him to work in an already congested space. From Individual Demand Curves to Aggregated Demand Curves—A total demand curve is found by horizontally adding individual demand curves. Intuitively, the total quantity demanded in the market at a price of P0 is equal to Person 1’s quantity demanded at P0, plus Person 2’s quantity demanded at P0, and so on. It’s useful to explain horizontal summation both using words (“The city’s demand for hamburgers is equal to the sum of all of the city’s citizens’ individual demands for hamburgers”) and a graph like Exhibit 4.2 (which shows qd1 + qd2 = Qd). This diagram nicely emphasizes the “right and left” way we think about demand curves: at a given price, we horizontally sum Sue’s Qd and Carlos’ Qd to get the total quantity demanded. Building the Market Demand Curve—The market demand curve is found by horizontally summing the individual demand curves for all of the potential buyers. If students don’t fully understand horizontal summation of individual demand curves, they may have another chance to think about it in Chapter 9 (Externalities and Public Goods), since many instructors like to introduce vertical summation of the individual demand curves for a public good by contrasting that process with the horizontal summation of individual demand curves for a private good. Alternative Teaching Examples: Students interested in marketing might find it interesting to think about segmenting markets in a wide variety of other ways, including climate, age, gender, socio-economic class, occupation, education, religion, personality, type of smartphone, etc. One might ask a student to think of how many distinct ways s/he could be classified. Shifting the Demand Curve—A change in the price of a good causes movement along the demand curve, whereas a change in one of five major demand determinants causes the entire demand curve to shift. Again, it’s helpful for some students when one writes Quantity Demanded = f[Own Price, Tastes and Preferences, Income and Wealth, Availability and Prices of Substitutes or Complements, Number and Scale of Buyers, Buyers’ Beliefs About the Future] and explains that we’ll examine the impact of changing any ONE right hand side variable, while holding the others constant. Remember to shift the demand curve right (“east”) or left (“west”), as opposed to up (“north”) or down (“south”). So, think in terms of demand function Qd[P], not inverse demand function P[Qd]. Throughout the book, the authors use “right/rightward” and “left/leftward” terminology. Exhibit 4.4 on left and right shifts of the demand curve contrasted with movements along the demand curve is very important and should be shown in multiple courses because even senior economics majors have trouble with it. If one wants to go into more detail with the impact of changing income, one could distinguish between inferior goods (when income rises, the quantity demanded falls), unaffected goods (e.g., one probably buys the same amount of toothpaste even after winning the lottery), normal “necessity goods” (when income rises, the quantity demanded rises), and normal “luxury goods” (when income rises by 10 percent, the quantity demanded rises by more than 10 percent; e.g., yachts and butlers are not necessary but improve the quality of life). A fun example is upgrading from (inferior) Kraft Mac ‘n’ Cheese to (normal) fettuccine alfredo—a grown-up version of pasta and cheese—after starting a big job after graduation. One can return to these topics if one discusses income-elasticity of demand in Chapter 5. This chapter is especially useful in generating exam questions. Given a particular market and a specific event, the student can identify which curve shifts (S or D), the direction in which the curve shifts (left or right), the impact on equilibrium price (up or down), and the impact on equilibrium quantity (in or out). A more advanced exam question presents a pair of events and simply asks whether we would expect equilibrium price to rise or fall and equilibrium quantity to rise or fall after both shocks hit the market. Teaching Ideas: Ask the students to form small groups and come up with real-world examples of each of the major demand curve shifters for the smartphone market. They may come up things like the following: Tastes and Preferences: Consumers prefer “phablets” with larger screens to traditional smartphones. Income and Wealth: As average household income rises in China, the Chinese demand more smartphones. Availability and Prices of Related Goods (Complements and Substitutes): The rapid growth of the market for affordable, useful smartphone apps drives smartphone sales. It is increasingly hard to find “dumb phones” and pay phones. Number and Scale of Buyers: In addition to adults, teens, tweens, and even young children now use smartphones. Buyers’ Beliefs About the Future: Anticipating the continued demise of the stand-alone camera market, would-be photographers buy smartphones with built-in cameras. Evidence-Based Economics: How much more gasoline would people buy if its price were lower?—This EBE case presents empirical evidence of the Law of Demand, which predicts that demand curves slope downwards (i.e., that at lower prices one expects to find a higher quantity demanded, ceteris paribus). Indeed, Brazil and Venezuela are countries with much in common, but due to relatively high Brazilian taxes and relatively large Venezuelan subsidies, their gasoline prices are very different, and as a result, Venezuelans purchase about five times as much gasoline as their Brazilian neighbors. The essential point is that the demand for gasoline slopes downward, so we would expect lower consumption when prices are higher, and higher consumption when prices are lower. Later in the chapter we learn that Brazil imposes higher taxes on gasoline purchases, Venezuela uses a subsidy large enough to make gasoline nearly free, and Mexico provides a more typical market, and as we might expect, Venezuelans load up on cheap gas, Brazilians consume substantially less, and Mexicans are somewhere in between. 4.3 How Do Sellers Behave? The other half of the supply and demand diagram is the supply curve, which is based on profit-maximizing decisions by potential suppliers, who determine how many units to supply at any given price. The authors make a good point about the supply of oil: “The higher the price of oil goes, the more drilling locations become profitable for ExxonMobil. Many observers talk about oil and warn that we are running out of it. In fact, companies like ExxonMobil are only running out of cheap oil. There is more oil under the surface of the earth than we are ever going to use. The problem is that much of that oil is very expensive to extract and deliver to the market.” This is one of those great insights that economics offers the world, so it’s worth addressing in class. To take it a step further, if oil ever becomes very expensive, it will become more and more lucrative to develop alternative energy sources. Supply Curves—An individual producer’s supply curve shows the quantity supplied at different prices. In the vast majority of cases, the supply curve slopes upward, reflecting the positive relationship between the two variables known as the Law of Supply: at higher prices, more projects become profitable, and the firm supplies a higher quantity. It’s intuitively appealing to draw supply curves that start on the price axis at some positive price, rather than starting at the origin, because realistically, most sellers will not be willing to supply the good at zero price; furthermore, because the supply curve tracks the firm’s marginal cost, we would prefer a model in which marginal costs are positive. For example, in Exhibit 4.6 ExxonMobil’s supply curve starts above the origin; at a price of $10 per barrel, the profit-maximizing firm is unwilling to produce any barrels of oil. As we will see in Chapter 6, the firm’s supply curve follows its (rising) marginal cost curve for prices above the shutdown price. Much as we constructed the total demand curve in Exhibit 4.2, we horizontally sum individual supply curves to get a total supply curve. The total supply curve begins at the most efficient firm’s shutdown price. Willingness to Accept—Equivalent to marginal cost, willingness to accept (WTA) is the lowest price at which a seller will produce and sell an additional unit. Exhibit 4.7 illustrates how to sum two individual firm supply curves horizontally to get a total supply curve. As with summing individual demand curves (shown in Exhibit 4.2), it is very helpful to show this to students and talk through it: If Chevron supplies 1.0 billion barrels at a price of $100/barrel, and ExxonMobil supplies 1.5 billion barrels at the same price, then the total quantity supplied by the two firms is 2.5 billion barrels at a price of $100/barrel. Just as willingness to pay is the height of the demand curve, willingness to accept is the height of the supply curve. Also, just as a buyer will compare her WTP to the price she would pay to buy a good, a seller will compare her WTA to the price she would receive by selling a good. From the Individual Supply Curve to the Market Supply Curve—The market supply curve is found by horizontally summing all of the individual supply curves. To expand on the discussion on building the total market for oil, we might think about horizontally summing the output of all of the nations that produce oil. According to the International Energy Agency (www.iea.org), the top 10 producers in 2012 were (in order) Russia, Saudi Arabia, United States, Iran, China, Canada, Iraq, United Arab Emirates, Venezuela, and Mexico. Shifting the Supply Curve—When the price changes, we move along the market supply curve; in contrast, the entire supply curve shifts when there is a change in one of these four variables: prices of inputs used to produce the good technology used to produce the good number and scale of sellers sellers’ beliefs about the future Instructors with highly motivated students may wish to include a fifth set of shifters: prices of related outputs. If 1 cow = 1 meat and 1 hide, then as meat prices rise, more cows will be converted to meat, which has the effect of shifting out the supply of the productive complement, hides. If 1 dairy cow = 1 meat or 1 milk stream, then as meat prices rise, more dairy cows will be converted to meat, which has the effect of shifting in the supply of the productive substitute, milk. In the context of oil, an oil well produces both crude oil and some natural gas (productive complements). Also, if crude oil could be refined or simply used in its current form (e.g., heated and dumped on invaders trying to attack one’s castle), then we’d have productive complements because it could be sent to two different product markets. As with the demand shifters (or determinants), one approach is to provide a list of events and have students classify each event (as affecting either input prices, technology, number of sellers, or sellers’ beliefs). For example, in the market for beef, we could analyze the following events: The United States bans the use of growth hormones with beef cattle, decreasing the beef obtained from each cow. (Supply shifts left due to a technological downgrade.) Suppose one cow yields both 1 unit of beef and 1 unit of leather. Suppose further that leather jackets become very popular among the millions of retiring Baby Boomers. (Supply shifts right due to productive complements; to meet the increased demand for jacket inputs, farmers produce more leather, and automatically produce more beef.) A different approach is to provide the list of shifters and ask students to come up with plausible examples of each. In the market for tortilla chips, supply shifts right (and sellers increase the quantity supplied) if input prices fall (e.g., favorable growing conditions result in a bumper crop of corn), regulatory costs decrease (e.g., the appointment of a business-friendly commissioner to the Food and Drug Administration results in the relaxation of some costly food safety measures), there are more sellers (e.g., the Latino population of Chicago increases and new tortilla chip-makers enter the market), new technology is introduced (e.g., factories that once made chips by hand now automate, allowing a sizable expansion of output), etc. 4.4 Supply and Demand in Equilibrium Putting together the two curves gives us the familiar S&D diagram, which features a competitive equilibrium characterized by a competitive equilibrium price (CEP) and a competitive equilibrium quantity (CEQ). At prices above the CEP, we expect an excess supply and market forces acting to reduce the price. At prices below the CEP, we expect an excess demand and market forces acting to increase the price. A student-friendly approach is to assume explicitly that the supply curve consists of many “little red people,” each of whom could sell one unit of the good, and assume that the demand curve consists of many “little blue people,” each of whom could buy one unit of the good. This has the effect of translating units of the good into numbers of red sellers and blue buyers. Draw a bunch of them in two lines under the quantity axis. Explain the competitive equilibrium price as the price that makes the two lines exactly the same length, so each red seller can pair up with one blue buyer to trade. Next, at a price above the competitive equilibrium price, the line of red sellers will be longer than the line of blue sellers, so when they try to pair up, there are a bunch of extra, partner-less red sellers; they don’t want to be left out in the cold, alone, so they approach some of the already-partnered blue buyers and offer to sell at a lower price (as if they were putting their goods on sale), and this continues until the price falls to its equilibrium level. Conversely, at low prices, there will be extra blue buyers, who will offer to pay just a little more in order to find a willing red seller. The typical market force stories to tell to justify the adjustment to the CEP involve using sales to address surpluses, or buyers bidding up the price when there is a shortage. It is important to communicate to students that with nice supply and demand curves, a shortage could be blamed on both buyers and sellers. At a price below the CEP, there will be extra potential buyers, attracted by the great deal, and the market will witness the exodus of some sellers, who no longer find it profitable to produce at the lower price. A useful graphical exercise is to use the supply and demand curves to show that a given shortage can be divided into two parts. For instance, in Exhibit 4.10, we see that CEP = $100 and CEQ = 35, and in Exhibit 4.12, see that that at a market price of $60, there is a shortage of 44 – 30 = 14. This 14-unit shortage might occur because the quantity demanded rose 44 – 35 = 9 units while the quantity supplied fell 35 – 30 = 5 units; intuitively, this says that to eliminate the surplus, the market needs to scare off 9 buyers and attract 5 sellers (assuming each party buys or sells one unit), and raising the price from $60 up to $100 will do this. To show this, simply draw a horizontal line at the new price, note where it intersects the supply and demand curves, and compare the new quantity supplied and the new quantity demanded to the competitive equilibrium quantity. A similar exercise can be done to decompose a surplus into the portion caused by buyers and the portion caused by sellers. All of the diagrams (Exhibits 4.10–4.13) in this section are useful to go through with students. Exhibit 4.11 helps us understand why winter clothing goes on sale in February. Exhibit 4.12 helps us understand why buyers competing for scarce goods bid up prices until the market clears. Both Exhibits 4.11 and 4.12 are important for understanding how competitive markets adjust to various market shocks and return to a state of equilibrium. Curve Shifting in Competitive Equilibrium—Economists use the S&D diagram to analyze events that shock either supply or demand. Once we know how to analyze one shock, we can analyze a pair of shocks by analyzing one and then the other. In Exhibit 4.13, after a left shift of the supply curve, there would be a shortage at the original CEP, so market forces drive up the price. In Exhibit 4.14, after a left shift of the demand curve, there would be a surplus at the original CEP, so market forces drive down the price. There are two curves (supply and demand) and two shift directions (left and right), so if one curve shifts in one direction, then there are four possible combinations (S left, S right, D left, D right). Each combination leads to a particular set of changes in P and Q. It’s helpful to think of the competitive equilibrium as shifting in one of the diagonal compass directions, as shown in the graphic below (note that the colors are consistent with ALL’s preferences for red demand and blue supply). If we start with nice, regular S&D curves, then a single shift of the red demand curve will move the equilibrium either northeast or southwest, and a single shift of the blue supply curve will move it either northwest or southeast. (After introducing elasticity, we could expand this approach to handle perfectly price-elastic (horizontal) and perfectly price-inelastic (vertical) curves; then the pure north, south, east, and west movements may be possible.) If a curve shifts and drives price down, then there will be a surplus at the original price P0 until the price adjusts to clear the market. Likewise, a shift that drives price up causes a temporary shortage. It’s useful to think in an if and only if () way: A rightward demand shift causes P and Q, and if we observe P and Q, we can deduce that the demand curve must have shifted to the right. Common Mistakes or Misunderstandings: A common pitfall with S&D shifts is the confusion caused when one uses the terms up and down rather than left and right, especially when referring to supply curve shifts. Throughout the book, the authors use “right/rightward” and “left/leftward” terminology. Exhibit 4.15’s set of three graphs shows that when the market is hit with leftward supply and demand shifts, the CEQ will fall, but the CEP could rise, fall, or stay the same. Teaching Ideas: Once students understand how to analyze a single event (i.e., one curve shifts in one direction), then it is not hard to make the leap to multiple events (i.e., either the same curve shifts twice— either in the same direction or in different directions— or each curve shifts once). The principal challenge is to remember that one of the shifts could be tiny and the other could be much larger, so we have to be careful in making qualitative predictions; e.g., if a rightward supply shift drives down price and a rightward demand shift drives up price, then we need more information to conclude whether the price ultimately ends up higher, lower, or at its original level. A practical way to tackle this challenge is to draw an original S&D diagram, draw a moderate shift for the first event, resulting in a new equilibrium, and then use little arrows near the axes to show what happens to equilibrium price and quantity. Next, on the same diagram, starting from the new equilibrium (resulting from the first event), draw two exaggerated shifts for the second event—one shift that is very small and one shift that is very large—and then the two possible equilibria that would result from those shifts. This should provide enough information for one to conclude what the net effect would be on both price and quantity. If the same curve shifts twice in the same direction, the second shift will reinforce the first shift. If the same curve shifts twice in opposite directions, either the larger shift will swamp the smaller shift, or the two shifts will exactly cancel each other. If both S&D curves shift, and both are nicely shaped (i.e., upward-sloping supply and downward-sloping demand), then one should be able to predict either the change in price or the change in quantity, but not both; one change will remain ambiguous. If either supply or demand is horizontal or vertical, things get more interesting. It is a good idea to revisit the concept of S&D shifters after introducing elasticity and the possibility of horizontal or vertical curves in Chapters 5 and 6. 4.5 What Would Happen If the Government Tried to Dictate the Price of Gasoline? This introduces the idea of a price ceiling but postpones discussion of the matter until Chapter 10. One might choose to tackle (binding) price ceilings here because the necessary tools are in place to at least comment on the shortage problem and who is to blame (both potential buyers and potential sellers on a nice S&D diagram), even if we haven’t covered elasticity or welfare analysis. Choice & Consequence: The Unintended Consequences of Fixing Market Prices—When the price of used Apple laptops was fixed at $50, which was below the competitive equilibrium price, there was an excess demand (shortage) of 4,000 laptops, and free market forces were prevented from operating to clear the market. The S&D diagram gives us useful insights even if we don’t technically have many identical, weak sellers or an upward-sloping supply curve. The supply curve in this diagram looks unusual: rather than the regular, upward-sloping version, we have a vertical supply curve, representing the fixed number of laptops that will be supplied at any price. We could envision this supply curve as starting at the origin, hugging the Quantity axis from Q = 0 out to Q = 1,000, and then going vertical. This right-angled, backwards-“L”-shaped supply curve is a limiting case of upward sloping. IV. Active Learning Exercises 1. (Shifting the Demand Curve; Shifting the Supply Curve; Supply and Demand in Equilibrium; Curve Shifting in Competitive Equilibrium) Consider the market for airlines and assume that it is a perfectly competitive market. Assume the U.S. domestic market is currently at equilibrium with a total of 642 million ticketed passengers per year at a price of $375 per ticket. (You can find these statistics on the website of the United States Department of Transportation’s Bureau of Transportation Statistics). Suppose a study is released that documents large negative health effects of increased exposure to radiation from flying. In addition, suppose there is a sudden increase in the price of jet fuel. If you were asked by a newspaper to comment on these developments, would you predict that the average price per ticket would increase or decrease or that we would be unable to be certain? Would you predict that the number of ticketed passengers would increase or decrease or that we would need additional information? Solution: See graph below. The study on the negative health effects would reduce demand (shown in the graph as the shift from D1 to D2). The increase in jet fuel would reduce supply (shown in the graph as the shift from S1 to S2). The shifts in the demand and the supply curve are both pushing the equilibrium quantity down, and therefore we know the equilibrium quantity will decrease. However, the shift in the demand curve is pushing the equilibrium price down, and the shift in the supply curve is pushing the equilibrium price up. We would need addition information to predict the direction of the change in the equilibrium price. 2. (Shifting the Demand Curve; Shifting the Supply Curve; Supply and Demand in Equilibrium; Curve Shifting in Competitive Equilibrium) The Super Bowl in 2014 was held outdoors in New Jersey in the winter. Assume the market for tickets to the event was in equilibrium one week prior to the Super Bowl. A weather report forecasted cold weather for the event, and the price for outdoor seats fell. On one website the prices fell from $2,233 to $1,395 per ticket. The price for club seats that included access to a heated area did not change during the week before the event. Show the effect of the weather report in a graph. Solution: See graph below. The weather report likely reduced the attractiveness of sitting outside and watching the game; therefore, the demand curve shifted to the left. The equilibrium price for the tickets fell. 3. (Supply and Demand in Equilibrium; Government Interference in Markets) Suppose the following information is gathered for the market for T-shirts in the town where you go to school: Price Quantity Demanded Quantity Supplied $2.00 5,000 0 $4.00 4,500 2,000 $6.00 3,800 2,500 $8.00 3,000 3,000 $10.00 2,000 3,250 $12.00 1,000 3,500 $14.00 0 3,700 A. What is the current equilibrium price and equilibrium quantity? B. Suppose college students rallied and convinced the local government to make it a law that the highest legal price for T-shirts should be $4.00. Would the market be in equilibrium? Solution: Part A: The equilibrium price and equilibrium quantity occur at the price where the quantity demanded is equal to the quantity supplied. The equilibrium price is $8.00, and the equilibrium quantity is 3,000 T-shirts. Part B: The market would not be in equilibrium if the price is not allowed to rise above $4.00. Buyers would want to purchase 4,500 T-shirts, but the stores would only be willing to supply 2,000 T-shirts. 4. (Shifting the Demand Curve; Shifting the Supply Curve; Supply and Demand in Equilibrium; Curve Shifting in Competitive Equilibrium) An article in the Financial Times on January 28, 2011, discussed the price of oil. One issue cited was the political tension in Egypt surrounding the protests that eventually led to the removal of President Hosni Mubarak from power. Due to potential problems in the Suez Canal, some oil was shipped around the southern tip of Africa instead, a much longer (and costlier) trip for the oil tankers. Use a demand and supply graph to show the effect of the political tension on the market for oil. What has happened to the equilibrium price? What has happened to the equilibrium quantity? Solution: See graph below. The longer trip for the oil tankers increases the transportation costs of the oil, an input into the production of the product. Therefore, the supply curve shifts to the left. The equilibrium price increases, and the equilibrium quantity decreases. 5. (Shifting the Demand Curve; Shifting the Supply Curve; Supply and Demand in Equilibrium; Curve Shifting in Competitive Equilibrium) In February of 2014 a large study was published by The British Medical Journal that questioned the value of mammograms for women. The study found that women who only had clinical breast exams had similar death rates from breast cancer as women who had both regular mammograms and clinical breast exams. What is the likely effect of the publicity of this study on the demand for mammograms? Show your answer in a graph. Solution: See graph below. The study will likely alter the tastes and preferences of some women. As a result, demand for mammograms will decrease, and the demand curve will shift to the left. The equilibrium price will decrease, and the equilibrium quantity will decrease. s

Related Downloads
Explore
Post your homework questions and get free online help from our incredible volunteers
  1101 People Browsing
Your Opinion
Who's your favorite biologist?
Votes: 585