Supply and Demand

3 >> Supply and Demand Section 1: The Demand Curve How many people wanted to buy scalped tickets to see the New York Rangers and the Ottawa Senators play that April night? You might at first think the answer was: every hockey fan in Ontario who didn’t already have a ticket. But although every hockey fan wanted to see Wayne Gretzky play one last time, most fans weren’t willing to pay four or five times the normal ticket price. In general, the number of people who want to buy a hockey ticket, or any other good, depends on the price. The higher the price, the fewer people who want to buy the good; the lower the price, the more people who want to buy the good. So the answer to the question “How many people will want to buy a ticket to Gretzky’s last game?” depends on the price of a ticket. If you don’t yet know what the price will be, you can start by making a table of how many tickets people would want to buy at a number of different prices. Such a table is known as a demand schedule. This, in turn, can be used to draw a demand curve, which is one of the key elements of the supply and demand model. 2 CHAPTER 3 SECTION 1: THE DEMAND CURVE The Demand Schedule and the Demand Curve A demand schedule shows how much of a good or service consumers will want to buy at different prices. A demand curve is a graphical representation of the demand schedule. It shows how much of a good or service consumers want to buy at any given price. The quantity demanded is the actual amount consumers are willing to buy at some specific price. A demand schedule is a table showing how much of a good or service consumers will want to buy at different prices. At the right of Figure 3-1, we show a hypothetical demand schedule for tickets to a hockey game. According to the table, if scalped tickets are available at $100 each (roughly their face value), 20,000 people are willing to buy them; at $150, some fans will decide this price is too high, and only 15,000 are willing to buy. At $200, even fewer people want tickets, and so on. So the higher the price, the fewer the tickets people want to purchase. In other words, as the price rises, the quantity of tickets demanded falls. The graph in Figure 3-1 is a visual representation of the information in the table. The vertical axis shows the price of a ticket, and the horizontal axis shows the quantity of tickets. Each point on the graph corresponds to one of the entries in the table. The curve that connects these points is a demand curve. A demand curve is a graphical representation of the demand schedule, another way of showing how much of a good or service consumers want to buy at any given price. Suppose scalpers are charging $250 per ticket. We can see from Figure 3-1 that 8,000 fans are willing to pay that price; that is, 8,000 is the quantity demanded at a price of $250. Note that the demand curve shown in Figure 3-1 slopes downward. This reflects the general proposition that a higher price reduces the number of people willing to buy a good. In this case, many people who would lay out $100 to see the great Gretzky aren’t willing to pay $350. In the real world, demand curves almost always, with some very specific exceptions, do slope downward. The exceptions are goods called “Giffen goods,” but economists think these are so rare that for practical purposes we can ignore them. Generally, the proposition that a 3 CHAPTER 3 SECTION 1: THE DEMAND CURVE Figure 3-1 The Demand Schedule and the Demand Curve Demand Schedule for Tickets Price of ticket Price of ticket Quantity of tickets demanded $350 $350 5,000 300 300 6,000 250 250 8,000 200 200 11,000 150 15,000 100 20,000 150 100 As price rises, the quantity demanded falls. 50 0 5,000 Demand curve, D 10,000 15,000 20,000 Quantity of tickets The demand schedule for tickets is plotted to yield the corresponding demand curve, which shows how much of a good consumers want to buy at any given price. The demand curve and the demand schedule reflect the law of demand: As price rises, the quantity demanded falls. Similarly, a decrease in price raises the quantity demanded. As a result, the demand curve is downward sloping. 4 CHAPTER 3 SECTION 1: THE DEMAND CURVE The law of demand says that a higher price for a good, other things equal, leads people to demand a smaller quantity of the good. A shift of the demand curve is a change in the quantity demanded at any given price, represented by the change of the original demand curve to a new position, denoted by a new demand curve. higher price for a good, other things equal, leads people to demand a smaller quantity of that good is so reliable that economists are willing to call it a “law”—the law of demand. Shifts of the Demand Curve When Gretzky’s retirement was announced, the immediate effect was that more people were willing to buy tickets for that April 15 game at any given price. That is, at every price the quantity demanded rose as a consequence of the announcement. Figure 3-2 illustrates this phenomenon in terms of the demand schedule and the demand curve for scalped tickets. The table in Figure 3-2 shows two demand schedules. The second one shows the demand schedule after the announcement, the same one shown in Figure 31. But the first demand schedule shows the demand for scalped tickets before Gretzky announced his retirement. As you can see, after the announcement the number of people willing to pay $350 for a ticket increased, the number willing to pay $300 increased, and so on. So at each price, the second schedule—the schedule after the announcement—shows a larger quantity demanded. For example, at $200, the quantity of tickets fans were willing to buy increased from 5,500 to 11,000. The announcement of Gretzky’s retirement generated a new demand schedule, one in which the quantity demanded is greater at any given price than in the original demand schedule. The two curves in Figure 3-2 show the same information graphically. As you can see, the new demand schedule after the announcement corresponds to a new demand curve, D2, that is to the right of the demand curve before the announcement, D1. This shift of the demand curve shows the change in the quantity demanded at any given price, represented by the change in position of the original demand curve D1 to its new location at D2. 5 CHAPTER 3 SECTION 1: THE DEMAND CURVE Figure 3-2 An Increase in Demand Demand Schedules for Tickets Price of ticket Quantity of tickets demanded Price of ticket Before announcement After announcement $350 2,500 5,000 300 3,000 6,000 250 4,000 8,000 200 200 5,500 11,000 150 150 7,500 15,000 100 10,000 20,000 $350 300 Demand curve after announcement 250 100 50 0 Demand curve before announcement 5,000 D1 D2 10,000 15,000 20,000 Quantity of tickets Announcement of Gretzky’s retirement generates an increase in demand—a rise in the quantity demanded at any given price. This event is represented by the two demand schedules—one showing demand before the announcement, the other showing demand after the announcement—and their corresponding demand curves. The increase in demand shifts the demand curve to the right. 6 CHAPTER 3 SECTION 1: THE DEMAND CURVE A movement along the demand curve is a change in the quantity demanded of a good that is the result of a change in that good’s price. Figure It’s crucial to make the distinction between such shifts of the demand curve and movements along the demand curve, changes in the quantity demanded of a good that result from a change in that good’s price. Figure 3-3 illustrates the difference. The movement from point A to point B is a movement along the demand curve: the quantity demanded rises due to a fall in price as you move down D 1. Here, a fall in price from $350 to $215 generates a rise in the quantity 3-3 Movement Along the Demand Curve Versus Shift of the Demand Curve The rise in quantity demanded when going from point A to point B reflects a movement along the demand curve: it is the result of a fall in the price of the good. The rise in quantity demanded when going from point A to point C reflects a shift of the demand curve: it is the result of a rise in the quantity demanded at any given price. Price of ticket $350 A shift of the demand curve . . . A C . . . is not the same thing as a movement along the demand curve. B 215 D2 D1 0 2,500 5,000 Quantity of tickets 7 CHAPTER 3 SECTION 1: THE DEMAND CURVE demanded from 2,500 to 5,000 tickets. But the quantity demanded can also rise when the price is unchanged if there is an increase in demand—a rightward shift of the demand curve. This is illustrated in Figure 3-3 by the shift of the demand curve from D 1 to D 2. Holding price constant at $350, the quantity demanded rises from 2,500 tickets at point A on D 1 to 5,000 tickets at point C on D 2. When economists say “the demand for X increased” or “the demand for Y decreased,” they mean that the demand curve for X or Y shifted—not that the quantity demanded rose or fell because of a change in the price. Understanding Shifts of the Demand Curve Figure 3-4 illustrates the two basic ways in which demand curves can shift. When economists talk about an “increase in demand,” they mean a rightward shift of the demand curve: at any given price, consumers demand a larger quantity of the good than before. This is shown in Figure 3-4 by the rightward shift of the original demand curve D1 to D2. And when economists talk about a “decrease in demand,” they mean a leftward shift of the demand curve: at any given price, consumers demand a smaller quantity of the good than before. This is shown in Figure 3-4 by the leftward shift of the original demand curve D1 to D3. But what causes a demand curve to shift? In our example, the event that shifts the demand curve for tickets is the announcement of Gretzky’s imminent retirement. But if you think about it, you can come up with other things that would be likely to shift the demand curve for those tickets. For example, suppose there is a music concert the same evening as the hockey game, and the band announces that it will sell tickets at half-price. This is likely to cause a decrease in demand for hockey tickets: hockey fans who also like music will prefer to purchase half-price concert tickets rather than hockey game tickets. 8 CHAPTER 3 SECTION 1: THE DEMAND CURVE Figure 3-4 Shifts of the Demand Curve Price Any event that increases demand shifts the demand curve to the right, reflecting a rise in the quantity demanded at any given price. Any event that decreases demand shifts the demand curve to the left, reflecting a fall in the quantity demanded at any given price. Increase in demand Decrease in demand D3 D1 D2 Quantity Economists believe that there are four principal factors that shift the demand curve for a good: ■ Changes in the prices of related goods ■ Changes in income ■ Changes in tastes ■ Changes in expectations 9 CHAPTER 3 SECTION 1: THE DEMAND CURVE Although this is not an exhaustive list, it contains the four most important factors that can shift demand curves. When we said before that the quantity of a good demanded falls as its price rises other things equal, we were referring to the factors that shift demand as remaining unchanged. Two goods are substitutes if a fall in the price of one of the goods makes consumers less willing to buy the other good. Two goods are complements if a fall in the price of one good makes people more willing to buy the other good. Changes in the Prices of Related Goods If you want to have a good night out but aren’t too particular about what you do, a music concert is an alternative to the hockey game—it is what economists call a substitute for the hockey game. A pair of goods are substitutes if a fall in the price of one good (music concerts) makes consumers less willing to buy the other good (hockey games). Substitutes are usually goods that in some way serve a similar function: concerts and hockey games, muffins and doughnuts, trains and buses. A fall in the price of the alternative good induces some consumers to purchase it instead of the original good, shifting the demand for the original good to the left. But sometimes a fall in the price of one good makes consumers more willing to buy another good. Such pairs of goods are known as complements. Complements are usually goods that in some sense are consumed together: sports tickets and parking at the stadium garage, hamburgers and buns, cars and gasoline. If the garage next to the hockey arena offered free parking, more people would be willing to buy tickets to see the game at any given price because the cost of the “package”—game plus parking—would have fallen. When the price of a complement falls, the quantity of the original good demanded at any given price rises; so the demand curve shifts to the right. Changes in Income When individuals have more income, they are normally more likely to purchase a good at any given price. For example, if a family’s income rises, it is more likely to take that summer trip to Disney World—and therefore also more likely to buy plane tickets. So a rise in consumer incomes will cause the demand curves for most goods to shift to the right. 10 CHAPTER 3 SECTION 1: THE DEMAND CURVE When a rise in income increases the demand for a good—the normal case— we say that the good is a normal good. When a rise in income decreases the demand for a good, it is an inferior good. Why do we say “most goods,” not “all goods”? Most goods are normal goods— the demand for them increases when consumer income rises. However, the demand for some products falls when incomes rise—people with high incomes are less likely to take buses than people with lower incomes. Goods for which the demand decreases when income rises are known as inferior goods. When a good is inferior, a rise in income shifts the demand curve to the left. Changes in Tastes Why do people want what they want? Fortunately, we don’t need to answer that question—we just need to acknowledge that people have certain preferences, or tastes, that determine what they choose to consume and that these tastes can change. Economists usually lump together changes in demand due to fads, beliefs, cultural shifts, and so on under the heading of changes in tastes or preferences. For example, once upon a time men wore hats. Up until around World War II, a respectable man wasn’t fully dressed unless he wore a dignified hat along with his suit. But the returning GIs adopted a more informal style, perhaps due to the rigors of the war. And, President Eisenhower, who had been supreme commander of Allied Forces, often went hatless. The demand curve for hats had shifted leftward, reflecting a decline in the demand for hats. The main distinguishing feature of changes in tastes is that economists have little to say about them and usually take them as given. When tastes change in favor of a good, more people want to buy it at any given price, so the demand curve shifts to the right. When tastes change against a good, fewer people want to buy it at any given price, so the demand curve shifts to the left. Changes in Expectations You could say that the increase in demand for tickets to the April 15 hockey game was the result of a change in expectations: fans no longer expected to have future opportunities to see Gretzky in action, so they became more eager to see him while they could. 11 CHAPTER 3 SECTION 1: THE DEMAND CURVE Depending on the specifics of the case, changes in expectations can either decrease or increase the demand for a good. For example, savvy shoppers often wait for seasonal sales—say, buying holiday gifts during the post-holiday markdowns. In this case, expectations of a future drop in price lead to a decrease in demand today. Alternatively, expectations of a future rise in price are likely to cause an increase in demand today. Expected changes in future income can also lead to changes in demand: if you expect your income to rise in the future, you will typically borrow today and increase your demand for certain goods; and if you expect your income to fall in the future, you are likely to save today and reduce your demand for some goods. ■ 3 >> Supply and Demand Section 2: The Supply Curve The quantity supplied is the actual amount of a good or service people are willing to sell at some specific price. A supply schedule shows how much of a good or service would be supplied at different prices. Ticket scalpers have to acquire the tickets they sell, and many of them do so from ticket-holders who decide to sell. The decision of whether to sell your own ticket to a scalper depends in part on the price offered: the higher the price offered, the more likely that you will be willing to sell. So just as the quantity of tickets that people are willing to buy depends on the price they have to pay, the quantity that people are willing to sell—the quantity supplied— depends on the price they are offered. (Notice that this is the supply of tickets to the market in scalped tickets. The number of seats in the stadium is whatever it is, regardless of the price—but that’s not the quantity we’re concerned with here.) The Supply Schedule and the Supply Curve The table in Figure 3-5 shows how the quantity of tickets made available varies with the price—that is, it shows a hypothetical supply schedule for tickets to Gretzky’s last game. A supply schedule works the same way as the demand schedule shown in Figure 3-1 in “The Demand Curve”: in this case, the table shows the quantity of tickets season subscribers are willing to sell at different prices. At a price of $100, only 2 CHAPTER 3 S E C T I O N 2 : T H E S U P P LY C U R V E A supply curve shows graphically how much of a good or service people are willing to sell at any given price. 2,000 people are willing to part with their tickets. At $150, some more people decide that it is worth passing up the game in order to have more money for something else, increasing the quantity of tickets available to 5,000. At $200, the quantity of tickets available rises to 7,000, and so on. In the same way that a demand schedule can be represented graphically by a demand curve, a supply schedule can be represented by a supply curve, as shown in Figure 3-5. Each point on the curve represents an entry from the table. Figure 3-5 The Supply Schedule and the Supply Curve Price of ticket Supply Schedule for Tickets Price of ticket Quantity of tickets supplied $350 8,800 300 8,500 250 250 8,000 200 200 7,000 150 150 5,000 100 100 2,000 Supply curve, S $350 300 As price rises, the quantity supplied rises. 50 0 5,000 10,000 15,000 20,000 Quantity of tickets The supply schedule for tickets is plotted to yield the corresponding supply curve, which shows how much of a good people are willing to sell at any given price. The supply curve and the supply schedule reflect the fact that supply curves are usually upward sloping: the quantity supplied rises when the price rises. 3 CHAPTER 3 S E C T I O N 2 : T H E S U P P LY C U R V E Suppose that the price scalpers offer rises from $200 to $250; we can see from Figure 3-5 that the quantity of tickets sold to them rises from 7,000 to 8,000. This is the normal situation for a supply curve, reflecting the general proposition that a higher price leads to a higher quantity supplied. So just as demand curves normally slope downward, supply curves normally slope upward: the higher the price being offered, the more hockey tickets people will be willing to part with—the more of any good they will be willing to sell. Shifts of the Supply Curve A shift of the supply curve is a change in the quantity supplied of a good at any given price. It is represented by the change of the original supply curve to a new position, denoted by a new supply curve. A movement along the supply curve is a change in the quantity supplied of a good that is the result of a change in that good’s price. When Gretzky’s retirement was announced, the immediate effect was that people who already had tickets for the April 15 game became less willing to sell those tickets to scalpers at any given price. So the quantity of tickets supplied at any given price fell: the number of tickets people were willing to sell at $350 fell, the number they were willing to sell at $300 fell, and so on. Figure 3-6 shows us how to illustrate this event in terms of the supply schedule and the supply curve for tickets. The table in Figure 3-6 shows two supply schedules; the schedule after the announcement is the same one as in Figure 3-5. The first supply schedule shows the supply of scalped tickets before Gretzky announced his retirement. And just as a change in demand schedules leads to a shift of the demand curve, a change in supply schedules leads to a shift of the supply curve—a change in the quantity supplied at any given price. This is shown in Figure 3-6 by the shift of the supply curve before the announcement, S1, to its new position after the announcement, S2. Notice that S2 lies to the left of S1, a reflection of the fact that quantity supplied decreased at any given price in the aftermath of Gretzky’s announcement. As in the analysis of demand, it’s crucial to draw a distinction between such shifts of the supply curve and movements along the supply curve—changes in the quantity supplied that result from a change in price. We can see this difference in Figure 3-7. The movement from point A to point B is a movement along the supply curve: 4 CHAPTER 3 S E C T I O N 2 : T H E S U P P LY C U R V E Figure 3-6 A Decrease in Supply Price of ticket Supply Schedules for Tickets Quantity of tickets supplied S2 S1 $350 300 Supply curve after announcement Price of ticket Before announcement After announcement $350 9,800 8,800 300 9,500 8,500 250 9,000 8,000 200 8,000 7,000 150 6,000 5,000 100 3,000 2,000 250 200 Supply curve before announcement 150 100 50 0 5,000 10,000 15,000 20,000 Quantity of tickets Announcement of Gretzky’s retirement generates a decrease in supply—a decrease in the quantity supplied at any given price. This event is represented by the two supply schedules—one showing supply before the announcement—the other showing supply after the announcement, and their corresponding supply curves. The decrease in supply shifts the supply curve to the left. the quantity supplied falls along S1 due to a fall in price. Here, a fall in price from $250 to $200 leads to a fall in the quantity supplied from 9,000 to 8,000 tickets. But the quantity supplied can also fall when the price is unchanged if there is a 5 CHAPTER 3 S E C T I O N 2 : T H E S U P P LY C U R V E Figure 3-7 Movement Along the Supply Curve Versus Shift of the Supply Curve The fall in quantity supplied when going from point A to point B reflects a movement along the supply curve: it is the result of a fall in the price of the good. The fall in quantity supplied when going from point A to point C reflects a shift of the supply curve: it is the result of a fall in the quantity supplied at any given price. A shift of the supply curve . . . Price of ticket S2 C $250 200 0 . . . is not the same thing as a movement along the supply curve. S1 A B 8,000 9,000 Quantity of tickets decrease in supply—a leftward shift of the supply curve. This is shown in Figure 3-7 by the leftward shift of the supply curve from S1 to S2. Holding price constant at $250, the quantity supplied falls from 9,000 tickets at point A on S1 to 8,000 at point C on S2. 6 CHAPTER 3 S E C T I O N 2 : T H E S U P P LY C U R V E Understanding Shifts of the Supply Curve Figure 3-8 illustrates the two basic ways in which supply curves can shift. When economists talk about an “increase in supply,” they mean a rightward shift of the supply curve: at any given price, people will supply a larger quantity of the good than before. This is shown in Figure 3-8 by the shift to the right of the original supply curve S1 to S2. And when economists talk about a “decrease in supply,” they mean a leftward shift of the supply curve: at any given price, people supply a smaller quantity of the good than before. This is represented in Figure 3-8 by the leftward shift of S1 to S3. Economists believe that shifts of supply curves are mainly the result of three factors (though, as in the case of demand, there are other possible causes): ■ Changes in input prices Changes in technology ■ Changes in expectations ■ Changes in Input Prices An input is a good that is used to produce another good. To produce output, you need inputs—for example, to make vanilla ice cream, you need vanilla beans, cream, sugar, and so on. (Actually, you only need vanilla beans to make good vanilla ice cream.) An input is any good that is used to produce another good. Inputs, like output, have prices. And an increase in the price of an input makes the production of the final good more costly for those who produce and sell the good. So sellers are less willing to supply the good at any given price, and the supply curve shifts to the left. For example, newspaper publishers buy large quantities of newsprint (the paper on which newspapers are printed). When newsprint prices rose sharply in 1994–1995, the supply of newspapers fell: several newspapers went out of business and a number of new publishing ventures were canceled. Similarly, a fall in the price of an input makes the production of the final good less costly for sellers. They are more willing to supply the good at any given price, and the supply curve shifts to the right. 7 CHAPTER 3 S E C T I O N 2 : T H E S U P P LY C U R V E Figure 3-8 Shifts of the Supply Curve Price S3 Any event that increases supply shifts the supply curve to the right, reflecting a rise in the quantity supplied at any given price. Any event that decreases supply shifts the supply curve to the left, reflecting a fall in the quantity supplied at any given price. S1 S2 Increase in supply Decrease in supply Quantity Changes in Technology When economists talk about “technology,” they don’t necessarily mean high technology—they mean all the ways in which people can turn inputs into useful goods. The whole complex of activities that turns corn from an Iowa farm into cornflakes on your breakfast table is technology in this sense. And when a better technology becomes available, reducing the cost of production—that is, letting a producer spend less on inputs yet produce the same output—supply increases, and the supply curve shifts to the right. For example, an improved strain of corn that is more resistant to disease makes farmers willing to supply more corn at any given price. 8 CHAPTER 3 S E C T I O N 2 : T H E S U P P LY C U R V E Changes in Expectations Imagine that you had a ticket for the April 15 game but couldn’t go. You’d want to sell the ticket to a scalper. But if you heard a credible rumor about Gretzky’s imminent retirement, you would know that the ticket would soon skyrocket in value. So you’d hold off on selling the ticket until his decision to retire was made public. This illustrates how expectations can alter supply: an expectation that the price of a good will be higher in the future causes supply to decrease today, but an expectation that the price of a good will be lower in the future causes supply to increase today. ■ 3 >> Supply and Demand Section 3: Supply, Demand, and Equilibrium A competitive market is in equilibrium when price has moved to a level at which the quantity demanded of a good equals the quantity supplied of that good. The price at which this takes place is the equilibrium price, also referred to as the marketclearing price. The quantity of the good bought and sold at that price is the equilibrium quantity. We have now covered the first three key elements in the supply and demand model: the supply curve, the demand curve, and the set of factors that shift each curve. The next step is to put these elements together to show how they can be used to predict the actual price at which a good will be bought and sold. What determines the price at which a good is bought and sold? We have already learned the general principle that markets move toward equilibrium, a situation in which no individual would be better off taking a different action. In the case of a competitive market, we can be more specific: a competitive market is in equilibrium when the price has moved to a level at which the quantity demanded of a good equals the quantity supplied of that good. At that price, no individual seller could make herself better off by offering to sell either more or less of the good and no individual buyer could make himself better off by offering to buy more or less of the good. The price that matches the quantity supplied and the quantity demanded is the equilibrium price; the quantity bought and sold at that price is the equilibrium quantity. 2 CHAPTER 3 S E C T I O N 3 : S U P P LY, D E M A N D , A N D E Q U I L I B R I U M PITFALLS bought and sold? We have been talking about the price at which a good is bought and sold, as if the two were the same. But shouldn’t we make a distinction between the price received by sellers and that paid by buyers? In principle, yes; but it is helpful at this point to sacrifice a bit of realism in the interests of simplicity— by assuming away the difference between the prices received by sellers and those paid by buyers. In reality, people who sell hockey tickets to scalpers, although they sometimes receive high prices, generally receive less than those who eventually buy these tickets pay. No mystery there: that difference is how a scalper or any other “middleman”—someone who brings buyers and sellers together—makes a living. In many markets, however, the difference between the buying and selling price is quite small. It is therefore not a bad approximation to think of the price paid by buyers as being the same as the price received by sellers. And that is what we will assume in the remainder of this chapter. The equilibrium price is also known as the market-clearing price: it is the price that “clears the market” by ensuring that every buyer finds a seller, and vice versa. You may notice from this point on that we will no longer focus on middlemen such as scalpers but focus directly on the market price and quantity. Why? Because the function of a middleman is to bring buyers and sellers together to trade. But what makes buyers and sellers willing to trade is in reality not the middleman, but the price they agree upon—the equilibrium price. By going deeper and examining how price functions within a market, we can safely assume that the middlemen are doing their job and leave them in the background. So, how do we find the equilibrium price and quantity? Finding the Equilibrium Price and Quantity The easiest way to determine the equilibrium price and quantity in a market is by putting the supply curve and the demand curve on the same diagram. Since the supply curve shows the quantity supplied at any given price and the demand curve shows the quantity demanded at any given price, the price at which the two curves cross is the equilibrium price: the price at which quantity supplied equals quantity demanded. Figure 3-9 combines the demand curve from Figure 3-1 in “The Demand Curve” and the supply curve from Figure 3-5 in “The Supply Curve.” They intersect at point E, which is the equilibrium of this market; that is, $250 is the equilibrium price and 8,000 tickets is the equilibrium quantity. Let’s confirm that point E fits our definition of equilibrium. At a price of $250 per ticket, 8,000 ticket-holders are willing to resell their tickets and 8,000 people who do not have tickets are willing to buy. So at the price of $250 the quantity of tickets supplied equals the quantity demanded. Notice that at any other price the market would not clear: every willing buyer would not be able to find a willing seller, or vice versa. In other words, if the price were more than $250, the 3 CHAPTER 3 S E C T I O N 3 : S U P P LY, D E M A N D , A N D E Q U I L I B R I U M Figure 3-9 Market Equilibrium Market equilibrium occurs at point E, where the supply curve and the demand curve intersect. In equilibrium, the quantity demanded is equal to the quantity supplied. In this market, the equilibrium price is $250 and the equilibrium quantity is 8,000 tickets. Price of ticket $350 Supply 300 Equilibrium price 250 E Equilibrium 200 150 100 Demand 50 0 5,000 8,000 15,000 20,000 Quantity of tickets Equilibrium quantity quantity supplied would exceed the quantity demanded; if the price were less than $250, the quantity demanded would exceed the quantity supplied. The model of supply and demand, then, predicts that given the demand and supply curves shown in Figure 3-9, 8,000 tickets would change hands at a price of $250 each. 4 CHAPTER 3 S E C T I O N 3 : S U P P LY, D E M A N D , A N D E Q U I L I B R I U M But how can we be sure that the market will arrive at the equilibrium price? We begin by answering three simpler questions: 1. Why do all sales and purchases in a market take place at the same price? 2. Why does the market price fall if it is above the equilibrium price? 3. Why does the market price rise if it is below the equilibrium price? Why Do All Sales and Purchases in a Market Take Place at the Same Price? There are some markets where the same good can sell for many different prices, depending on who is selling or who is buying. For example, have you ever bought a souvenir in a “tourist trap” and then seen the same item on sale somewhere else (perhaps even in the next store) for a lower price? Because tourists don’t know which shops offer the best deals and don’t have time for comparison shopping, sellers in tourist areas can charge different prices for the same good. But in any market where the buyers and sellers have both been around for some time, sales and purchases tend to converge at a generally uniform price, so that we can safely talk about the market price. It’s easy to see why. Suppose a seller offered a potential buyer a price noticeably above what the buyer knew other people to be paying. The buyer would clearly be better off shopping elsewhere—unless the seller was prepared to offer a better deal. Conversely, a seller would not be willing to sell for significantly less than the amount he knew most buyers were paying; he would be better off waiting to get a more reasonable customer. So in any well-established, ongoing market, all sellers receive and all buyers pay approximately the same price. This is what we call the market price. 5 CHAPTER 3 S E C T I O N 3 : S U P P LY, D E M A N D , A N D E Q U I L I B R I U M Figure 3-10 Price Above Its Equilibrium Level Creates a Surplus The market price of $350 is above the equilibrium price of $250. This creates a surplus: at $350 per ticket, suppliers would like to sell 8,800 tickets but fans are willing to purchase only 5,000, so there is a surplus of 3,800 tickets. This surplus will push the price down until it reaches the equilibrium price of $250. Price of ticket Surplus Supply $350 300 E 250 200 150 100 Demand 50 0 5,000 8,800 8,000 Quantity demanded 15,000 20,000 Quantity of tickets Quantity supplied Why Does the Market Price Fall If It Is Above the Equilibrium Price? Suppose the supply and demand curves are as shown in Figure 3-9 but the market price is above the equilibrium level of $250—say, $350. This situation is illustrated in Figure 3-10. Why can’t the price stay there? As the figure shows, at a price of $350 there would be more tickets available than 6 CHAPTER 3 S E C T I O N 3 : S U P P LY, D E M A N D , A N D E Q U I L I B R I U M There is a surplus of a good when the quantity supplied exceeds the quantity demanded. Surpluses occur when the price is above its equilibrium level. hockey fans wanted to buy: 8,800 versus 5,000. The difference of 3,800 is the surplus— also known as the excess supply—of tickets at $350. This surplus means that some would-be sellers are being frustrated: they cannot find anyone to buy what they want to sell. So the surplus offers an incentive for those 3,800 would-be sellers to offer a lower price in order to poach business from other sellers. It also offers an incentive for would-be buyers to seek a bargain by offering a lower price. Sellers who reject the lower price will fail to find buyers, and the result of this price cutting will be to push the prevailing price down until it reaches the equilibrium price. So, the price of a good will fall whenever there is a surplus—that is, whenever the price is above its equilibrium level. Why Does the Market Price Rise If It Is Below the Equilibrium Price? There is a shortage of a good when the quantity demanded exceeds the quantity supplied. Shortages occur when the price is below its equilibrium level. Now suppose the price is below its equilibrium level—say, at $150 per ticket, as shown in Figure 3-11. In this case, the quantity demanded (15,000 tickets) exceeds the quantity supplied (5,000 tickets), implying that there are 10,000 would-be buyers who cannot find tickets: there is a shortage, also known as an excess demand, of 10,000 tickets. When there is a shortage, there are frustrated would-be buyers—people who want to purchase tickets but cannot find willing sellers at the current price. In this situation, either buyers will offer more than the prevailing price or sellers will realize that they can charge higher prices. Either way, the result is to drive up the prevailing price. This bidding up of prices happens whenever there are shortages—and there will be shortages whenever the price is below its equilibrium level. So the price will always rise if it is below the equilibrium level. 7 CHAPTER 3 S E C T I O N 3 : S U P P LY, D E M A N D , A N D E Q U I L I B R I U M Figure 3-11 Price Below Its Equilibrium Level Creates a Shortage The market price of $150 is below the equilibrium price of $250. This creates a shortage: fans want to buy 15,000 tickets but only 5,000 are offered for sale, so there is a shortage of 10,000 tickets. This shortage will push the price up until it reaches the equilibrium price of $250. Price of ticket Supply $350 300 E 250 200 150 Shortage 100 Demand 50 0 5,000 8,000 Quantity supplied 15,000 20,000 Quantity of tickets Quantity demanded Using Equilibrium to Describe Markets We have now seen that a market tends to have a single price; that the market price falls if it is above the equilibrium level but rises if it is below that level. So the market price always moves toward the equilibrium price, the price at which there is neither surplus nor shortage. ■ 3 >> Supply and Demand Section 4: Changes in Supply and Demand Wayne Gretzky’s announcement that he was retiring may have come as a surprise, but the subsequent rise in the price of scalped tickets for that April game was no surprise at all. Suddenly the number of people who wanted to buy tickets at any given price increased—that is, there was an increase in demand. And at the same time, because those who already had tickets wanted to see Gretzky’s last game, they became less willing to sell them—that is, there was a decrease in supply. In this case, there was an event that shifted both the supply and the demand curves. However, in many cases something happens that shifts only one of the curves. For example, a freeze in Florida reduces the supply of oranges but doesn’t change the demand. A medical report that eggs are bad for your health reduces the demand for eggs but does not affect the supply. That is, events often shift either the supply curve or the demand curve, but not both; it is therefore useful to ask what happens in each case. We have seen that when a curve shifts, the equilibrium price and quantity change. We will now concentrate on exactly how the shift of a curve alters the equilibrium price and quantity. 2 CHAPTER 3 S E C T I O N 4 : C H A N G E S I N S U P P LY A N D D E M A N D What Happens When the Demand Curve Shifts Coffee and tea are substitutes: if the price of tea rises, the demand for coffee will increase, and if the price of tea falls, the demand for coffee will decrease. But how does the price of tea affect the market for coffee? Figure 3-12 shows the effect of a rise in the price of tea on the market for coffee. The rise in the price of tea increases the demand for coffee. Point E1 shows the equilibrium corresponding to the original demand curve, with P1 the equilibrium price and Q1 the equilibrium quantity bought and sold. An increase in demand is indicated by a rightward shift of the demand curve from D1 to D2. At the original market price P1, this market is no longer in equilibrium: a shortage occurs because the quantity demanded exceeds the quantity supplied. So the price of coffee rises and generates an increase in the quantity supplied, an upward movement along the supply curve. A new equilibrium is established at point E2, with a higher equilibrium price P2 and higher equilibrium quantity Q2. This sequence of events reflects a general principle: When demand for a good increases, the equilibrium price and the equilibrium quantity of the good both rise. And what would happen in the reverse case, a fall in the price of tea? A fall in the price of tea decreases the demand for coffee, shifting the demand curve to the left. At the original price, a surplus occurs as quantity supplied exceeds quantity demanded. The price falls and leads to a decrease in the quantity supplied, with a lower equilibrium price and a lower equilibrium quantity. This illustrates another general principle: When demand for a good decreases, the equilibrium price of the good and the equilibrium quantity both fall. To summarize how a market responds to a change in demand: An increase in demand leads to a rise in both the equilibrium price and the equilibrium quantity. A decrease in demand leads to a fall in both the equilibrium price and the equilibrium quantity. 3 CHAPTER 3 S E C T I O N 4 : C H A N G E S I N S U P P LY A N D D E M A N D Figure 3-12 Equilibrium and Shifts of the Demand Curve The original equilibrium in the market for coffee is at E1 , at the intersection of the supply curve and the original demand curve D1. A rise in the price of tea, a substitute, shifts the demand curve rightward to D2. A shortage exists at the original price P1 , so both price and the quantity supplied rise, a movement along the supply curve. A new equilibrium is reached at E2 , with a higher equilibrium price P2 and a higher equilibrium quantity Q2. When demand for a good increases, the equilibrium price and the equilibrium quantity of the good both rise. Price of coffee An increase in demand . . . Supply . . . leads to a movement along the supply curve to a higher equilibrium price and higher equilibrium quantity. E2 P2 Price rises E1 P1 D2 D1 Q1 Q2 Quantity of coffee Quantity rises What Happens When the Supply Curve Shifts In the real world, it is a bit easier to predict changes in supply than changes in demand. Physical factors that affect supply, like the availability of inputs, are easier to get a handle on than the fickle tastes that affect demand. Still, with supply as with demand, what we really know are the effects of shifts of the supply curve. 4 CHAPTER 3 S E C T I O N 4 : C H A N G E S I N S U P P LY A N D D E M A N D A spectacular example of a change in technology increasing supply occurred in the manufacture of semiconductors—the silicon chips that are the core of computers, video games, and many other devices. In the early 1970s, engineers learned how to use a process known as photolithography to put microscopic electronic components onto a silicon chip; subsequent progress in the technique has allowed ever more components to be put on each chip. Figure 3-13 shows the effect of such an innovation on the market for silicon chips. The demand curve does not change. Figure 3-13 Equilibrium and Shifts of the Supply Curve The original equilibrium in the market for silicon chips is at E1, at the intersection of the demand curve and the original supply curve S1. After a technological change increases the supply of silicon chips, the supply curve shifts rightward to S2. A surplus exists at the original price P1, so price falls and the quantity demanded rises, a movement along the demand curve. A new equilibrium is reached at E2, with a lower equilibrium price P2 and a higher equilibrium quantity Q2. When supply of a good increases, the equilibrium price of the good falls and the equilibrium quantity rises. Price of chip S1 An increase in supply . . . S2 E1 Price falls P1 E2 P2 . . . leads to a movement along the demand curve to a lower equilibrium price and higher equilibrium quantity. Demand Q1 Q2 Quantity rises Quantity of chips 5 CHAPTER 3 S E C T I O N 4 : C H A N G E S I N S U P P LY A N D D E M A N D The original equilibrium is at E1, the point of intersection of the original supply curve S1 and the demand curve, with equilibrium price P1 and equilibrium quantity Q1. As a result of the technological change, supply increases and S1 shifts rightward to S2. At the original price P1, a surplus of chips now exists and the market is no longer in equilibrium. The surplus causes a fall in price and a rise in quantity demanded, a downward movement along the demand curve. The new equilibrium is at E2, with an equilibrium price P2 and an equilibrium quantity Q2. In the new equilibrium E2, the price is lower and the equilibrium quantity higher than before. This may be stated as a general principle: An increase in supply leads to a fall in the equilibrium price and a rise in the equilibrium quantity. What happens to the market when supply decreases? A decrease in supply leads to a leftward shift of the supply curve. At the original price, a shortage now exists; as a result, the equilibrium price rises and the quantity demanded falls. This describes the sequence of events in the newspaper market in 1994–1995, which we discussed earlier: a decrease in the supply of newsprint led to a rise in the price and the closure of many newspapers. We can formulate a general principle: A decrease in supply leads to a rise in the equilibrium price and a fall in the equilibrium quantity. To summarize how a market responds to a change in supply: An PITFALLS increase in supply leads to a fall in the equilibrium price and a rise in the which curve is it, anyway? equilibrium quantity. A decrease in supply leads to a rise in the equilibrium When the price of some good changes, in generprice and a fall in the equilibrium quantity. al we can say that this reflects a change in either supply or demand. But it is easy to get confused about which one. A helpful clue is the direction of change in the quantity. If the quantity sold changes in the same direction as the price—for example, if both the price and the quantity rise—this suggests that the demand curve has shifted. If the price and the quantity move in opposite directions, the likely cause is a shift in the supply curve. Simultaneous Shifts in Supply and Demand Finally, it sometimes happens that events shift both the demand and supply curves. In fact, this chapter began with an example of such a simultaneous shift. Wayne Gretzky’s announcement that he was retiring increased the demand for scalped tickets because more people wanted to see him play one last time; but it also decreased the supply because those who already had tickets became less willing to part with them. 6 CHAPTER 3 Figure S E C T I O N 4 : C H A N G E S I N S U P P LY A N D D E M A N D 3-14 Simultaneous Shifts of the Demand and Supply Curves (a) One Possible Outcome: Price Rises, Quantity Rises Price of ticket Small decrease in supply (b) Another Possible Outcome: Price Rises, Quantity Falls Price of ticket S2 S1 Large decrease in supply S2 S1 E2 E2 P2 P2 E1 E1 P1 P1 D2 D1 Q1 Small increase in demand Large increase in demand Q2 Quantity of tickets In panel (a) there is a simultaneous rightward shift of the demand curve and leftward shift of the supply curve. Here the increase in demand is relatively larger than the decrease in supply, so the equilibrium price and equilibrium quantity both rise. D1 Q2 Q1 D2 Quantity of tickets In panel (b) there is also a simultaneous rightward shift of the demand curve and leftward shift of the supply curve. Here the decrease in supply is relatively larger than the increase in demand, so the equilibrium price rises and the equilibrium quantity falls. 7 CHAPTER 3 S E C T I O N 4 : C H A N G E S I N S U P P LY A N D D E M A N D Figure 3-14 illustrates what happened. In both panels we show an increase in demand—that is, a rightward shift of the demand curve, from D1 to D2. Notice that the rightward shift in panel (a) is relatively larger than the one in panel (b). Both panels also show a decrease in supply—that is, a leftward shift of the supply curve, from S1 to S2. Notice that the leftward shift in panel (b) is relatively larger than the one in panel (a). In both cases, the equilibrium price rises, from P 1 to P 2 , as the equilibrium moves from E 1 to E 2 . But what happens to the equilibrium quantity, the quantity of scalped tickets bought and sold? In panel (a) the increase in demand is large relative to the decrease in supply, and the equilibrium quantity rises as a result. In panel (b) the decrease in supply is large relative to the increase in demand, and the equilibrium quantity falls as a result. That is, when demand increases and supply decreases, the actual quantity bought and sold can go either way, depending on how much the demand and supply curves have shifted. In general, when supply and demand shift in opposite directions, we can’t predict what the ultimate effect will be on the quantity bought and sold. What we can say is that a curve that shifts a disproportionately greater distance than the other curve will have a disproportionately greater effect on the quantity bought and sold. That said, we can make the following prediction about the outcome when the supply and demand curves shift in opposite directions: ■ When demand increases and supply decreases, the price rises but the change in the quantity is ambiguous. ■ When demand decreases and supply increases, the price falls but the change in the quantity is ambiguous. But suppose that the demand and supply curves shift in the same direction. Can we safely make any predictions about the changes in price and quantity? In 8 CHAPTER 3 S E C T I O N 4 : C H A N G E S I N S U P P LY A N D D E M A N D this situation, the change in quantity bought and sold can be predicted but the change in price is ambiguous. The two possible outcomes when the supply and demand curves shift in the same direction (which you should check for yourself) are as follows: ■ When both demand and supply increase, the quantity increases but the change in price is ambiguous. ■ When both demand and supply decrease, the quantity decreases but the change in price is ambiguous. ■