Prof. Bryan Caplan

bcaplan@gmu.edu

http://www.gmu.edu/departments/economics/bcaplan

Econ 103

Spring, 2000

 

Weeks 4-5: Supply and Demand

I.                     Markets and Trade

A.                 The simplest examples of trade involve just two parties. 

1.                  Ex: I want to exchange bread for dollars, you want to exchange dollars for bread.

B.                 But it is not too hard to imagine there being a lot of would-be bread-buyers and bread-sellers.

C.                There are physical places where would-be buyers and sellers gather to trade.  These are often called "marketplaces" or just "markets."  Ex:

1.                  Farmers' market

2.                  Stock market

D.                From these observed markets, it is not too hard to make a leap to conceptualized markets.

1.                  Ex: The Internet.  No one is physically meeting, but it is easy to analogous it to a simple farmers' market.

E.                 Conceptualizing diverse activities as "markets" is probably the most important intellectual leap in economics.  Economics has "pre-packaged" set of intellectual tools for dealing with all such "markets," known as "supply-and-demand."

II.                   Supply and Demand, I: Setting Up the Problem

A.                 Mentally separate (or "partition") sellers and buyers.

1.                  Sellers are "the supply."

2.                  Buyers are "the demand."

B.                 Label axes.  Put quantity exchange on the x-axis, and the market price on the y-axis.

C.                What does a demand curve look like?  The higher the price, the fewer items (smaller quantity) demanders will want to buy.

D.                Why? 

1.                  Try introspecting. 

2.                  Think in terms of diminishing marginal utility.

E.                 What does a supply curve look like?  The higher the price, the more items (larger quantity) suppliers will want to sell.

F.                 Why?

1.                  Trying introspecting.

2.                  Think in terms of increasing marginal distutility.

III.                  Supply and Demand, II: Putting It Together

A.                 Now just put the S and D curve together on the same graph. 

B.                 What can be learned?  Market tends to be at the intersection of S and D!  Economists call this intersection the "equilibrium price."

C.                Why? 

D.                Suppose the market price exceeds the equilibrium price.  Then people want to sell MORE than people want to buy.  So what should a seller do, in his own interest?  Slightly cut the price to sell a much larger quantity!

E.                 Suppose the equilibrium price exceeds the market price.  Then people want to buy MORE than people want to sell.  So what should a buyer do, in his own interest?  Offer a slightly higher price, to be able to buy all that he desires!

F.                 What if there were a whole bunch of different prices?  Then buyers paying more than average could just switch sellers, and sellers getting less than average could just switch buyers.

G.                Thus, the amazing result that only the intersection of S and D is stable.  That is why we call it the equilibrium price - it is the only price that markets don't tend to move away from.

H.                 Additional amazing result: At the market equilibrium, all gains to trade - the difference between the D and the S curve - are realized.  (Consider analogy to one-on-one trade).

1.                  Area between the D curve and the price is called "consumers' surplus."  It shows the difference between consumers' maximum willingness to pay, and the amount they actually paid.

2.                  Area between S curve and the price is called "producers' surplus" (or "economic profits").  It shows the difference between the minimum producers were willing to accept, and the amount they actually got.

IV.               Supply and Demand, III: Shifts

A.                 There are four kinds of shifts that can happen.

B.                 Shift #1: Demand Increases.  Ex: A fad for kiwis.

C.                Shift #2: Demand Decreases.  Ex: People find out kiwis cause bad breath.

D.                Shift #3: Supply Increases.  Ex: Innovations in kiwi fertilizer.

E.                 Shift #4: Supply Decreases.  Ex: The price of gas rises, making transportation of kiwis more expensive.

F.                 Shifts versus movements along a curve.  Students often have trouble translating changes correctly.  They will say "demand increases" when what actually happens is that demand stays the same, supply increases, and thus the quantity demandED increases.

G.                Simple point: A shift in one curve necessary implies movement along the other.

H.                 How to tell the difference.  Think about whether the posited change makes people WANT a good more or less.  If so, it's a D change.  On the other hand, it is makes people less willing to PRODUCE a good, it's a S change.

I.                     Canonical table, plus some examples.

Shift

Price

Quantity

D increases

+

+

D decreases

-

-

S increases

-

+

S decreases

+

-

J.                  What about combined shifts?

 

 


Demand

Supply

Price

Quantity

+

+

?

+

+

0

+

+

+

-

+

?

0

+

-

+

0

0

0

0

0

-

+

-

-

+

-

?

-

0

-

-

-

-

?

-

K.                 The interrelatedness of markets: A shift in one market sets off additional shifts in other markets.

1.                  Ex: The supply of DVD players increases.  How do the effects in the DVD market "ripple out" to other markets?  Which others?  How much?

V.                 Elasticity

A.                 Economic theory by itself only tells us the sign of the slopes of D and S, not their shape.

B.                 But: We have an intuitive sense that the shape varies a lot from market to market.

C.                Economists formalize this notion of shape with the concept of "elasticity."  If a curve is vertical, we call it "perfectly inelastic," if it is horizontal we call it "perfectly elastic."  The flatter is gets, the "more elastic" it is; the steeper is gets, the "more inelastic" is it.

D.                Consider some polar cases:

1.                  Perfectly elastic demand curve.

2.                  Perfectly inelastic demand curve.

3.                  Perfectly elastic supply curve.

4.                  Perfectly inelastic supply curve.

E.                 Elasticity determines how much a shift changes quantity versus price.

1.                  If D increases and S is perfectly inelastic, then price rises and quantity doesn't change.

2.                  If S increases and D is perfectly inelastic, then price falls and quantity doesn't change.

3.                  If D increases and S is perfectly elastic, then price stays the same and quantity rises.

4.                  If S increases and D is perfectly elastic, then price stays the same and quantity rises.

F.                 What goods have...

1.                  ...very elastic demand?

2.                  ...very inelastic demand?

3.                  ...very elastic supply?

4.                  ...very inelastic supply?

VI.               Price Controls

A.                 Governments are often unhappy about what the equilibrium price in a given market is.  Oftentimes, they respond by imposing "price controls."

B.                 If they want the market price to be lower, they impose a price ceiling (or price maximum).

1.                  Ex: During WWII, and again during the '70's, there were economy-wide price ceilings imposed.

2.                  Ex:  During the '70's, the price of gas and oil was capped.

C.                What does S and D analysis predict will happen?  With the price fixed below the equilibrium level, D exceeds S - a condition known as a SHORTAGE.

D.                This leads to some form of rationing of buyers.

1.                  Simplest form: Suppliers decide.

2.                  Alternate: Standing in line ("queuing").

3.                  Alternate: Government ration tickets.

E.                 What other effects would S and D analysis predict?

1.                  Corruption.

2.                  Increased search effort by demanders.

3.                  Quality reductions by suppliers.

F.                 How well does the S and D model work in explaining the effects of price ceilings?  Very well indeed. 

1.                  Ex: Gasoline price controls.

2.                  The case of Berkeley.

G.                If governments want market prices to be higher, they impose a price floor (or price minimum).

1.                  Ex: In agriculture since the '30's.

2.                  Ex:  The minimum wage.

H.                 What does S and D analysis predict will happen?  With the price fixed above the equilibrium level, S exceeds D  - a condition known as a SURPLUS.

I.                     This leads to rationing of sellers.

1.                  Simplest form: Demanders decide.

2.                  Alternate: Government licensing.

3.                  Alternate: Government buys surplus.

J.                  What other effects would S and D analysis predict?

1.                  Corruption.

2.                  Increased search effort by suppliers.

3.                  Quality increases by suppliers.

K.                 How well does the S and D model work in explaining the effects of price floors?  Again, quite well.

1.                  Ex: Airline regulation.

2.                  Ex: Minimum wage in the U.S.

3.                  Ex: European unemployment.

L.                  Why are price controls so popular?  There are always some beneficiaries, but the widespread public sympathy is hard to explain as anything other than a product of lack of economic understanding.

VII.              Entry and Exit

A.                 A further effect of price controls is to induce entry and exit of firms into the market.

1.                  Price ceilings induce...?

2.                  Price floors induce...?

B.                 This is just part of a more general pattern:

1.                  When firms in an industry are earning economic profits, this attracts new entrants.

2.                  When firms in an industry are earning economic losses, this induces exit (sometimes in the form of bankruptcy).

C.                This is how markets move resources from industry to industry.  When demand increases, this temporarily leads to economic profits, but at the same time induces new entry.

D.                When demand decreases, this temporarily leads to economic losses, but at the same time induces exit.

E.                 People often lament exit and bankruptcy, but what is the alternative?   A world where production fails to respond to desires.

1.                  Ex: Cowen and the German art community

F.                 How should this be diagramed?  Distinguish between "long-run" and "short-run" demand and supply elasticity.  Elasticity is normally greater in the long-run because people find substitutes and otherwise rearrange their affairs to take advantage of changes in their budget set.

G.                Ex: Video stores.

VIII.            Exercise: Name an Industry

A.                 Name an industry.  Let's try to analyze it in S and D terms.