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Chapter 3-- Supply and Demand

How are prices of resources determined? Does some governing body decide the price we must pay for shoes, computers, pizza, and all else?

The answer to the latter is seldom. The prices we pay just kind of happen! It's magic-- really! It seems as though there are invisible forces that guide price levels to where they should be.

In 1776, Adam Smith, who some call the Father of Modern Economics (or maybe the Great Grandfather of Modern Economics if you believe Keynes to be the Father), published a book called The Wealth of Nations which described an "invisible hand" at work that guided buying and selling in the marketplace of goods and services.

While not advocating selfishness, Smith proposed that society would be better off if buyers and sellers acted in their own self-interests. That is, buyers would always try to get the most for the least money, and sellers would always try to get the most money for the least. This "tug-of-war" between buyers and sellers would force a compromise. There would have to be some "middle ground"-- some price where buyers and sellers would finally agree and both be happy; well, sort of.

  1. Demand
    1. Defined-- Demand is the quantity of goods that people will buy at a certain price.
      1. Obviously, at different prices, people will be willing to buy different amounts of a good or service.
        1. As you probably guessed it, the lower the price of something, the more of it people will buy.
        2. And the higher the price of a good, the less of it people will buy.


      2. This definition assumes that not only would people be willing to buy certain quantities of goods and certain prices, but also that they would be able to buy them (that there is a market).
        1. I would be willing to buy an hand-made Italian suit for $2,000, but I may not be able to spend that kind of dough on a suit. Therefore, I am not in the market for this good.


    2. See the Demand Schedule-- Table 1 on page 50.
      1. This table shows the daily demand for coach seats between Denver and Chicago (hypothetical).
      2. At $500 a ticket, how many seats could be sold?-- only 1,000.
      3. At $100 a ticket, how many seats would the public be willing to buy?-- 67,000!
      4. Notice that at all the points between, the lower the price, the more willing and able people are to buy the seats.


    3. Here come the graphs! (Did you think we wouldn't do them?)
    4. Figure 1 on page 50 takes that demand schedule in table 1 and plots each of the points on a graph labeled Price (on the Y axis) and Quantity (on the X axis).
    5. Playing "connect the dots" plotted from the demand schedule gives us a curve that moves downward and to the right.
      1. The demand curve shows that the relationship between Price and Quantity Demanded is inverse-- the higher the price, the lower the quantity demanded, and visa versa.
      2. So, here's a way to analyze the effects of price on buyer behavior.


  2. Supply
    1. Defined-- Supply is the quantity of a good that sellers would be willing to sell at different prices.
    2. Price and quantity sold have a direct relationship.
      1. The higher the prices people are willing to pay, the more of a good producers are willing to produce.
      2. Think about it; The more airlines could get for a seat between Denver and Chicago, the more they will make seats available.
        1. Airlines have to deal with scarcity, too. They have a limited number of planes, pilots, attendants, counter personnel, etc.
        2. They will allocate this scarcity to where it will make them the most money!
    3. Notice the supply schedule on page 51.
      1. At $500 a seat, how many seats could the airlines supply?-- 62,000!
      2. At $100 a seat, now how many seats would the airlines be willing to supply?-- only 2,000.
    4. Figure 2 is a supply curve that is drawn from the plotting of the supply schedule data.
      1. Notice that the supply curve moves upward and to the right.
        1. This movement and direction shows the direct relationship between price levels and quantity supplied.
        2. The higher the price, the more quantity producers can and will supply.


  3. Equilibrium
    1. One thing we notice when we hold the demand and supply schedules side by side: buyers and sellers have very different ideas about price!
    2. Can we find any price level in both schedules where buyers and sellers would be willing to make a deal?
      1. For $250 a seat, sellers are willing to make 30,000 seats available, and at that price, buyers would be willing to buy 30,000 seats as well.
      2. YOU GOT A DEAL! (They shake hands.)
    3. You've just witnessed the miracle of the free market economy-- people acting in their own self-interests, and the price level being moved by "the invisible hand."
    4. Gee, can this be shown on a graph?
      1. Yes it can, and thanks for asking.
    5. See Figure 3 on page 52.
    6. Notice that your author has kindly reproduced both the demand and supply curves, placing them on top of one another.
    7. Do you see the point where they intersect?
    8. Move your finger across to the left to see at what price demanders and suppliers agree, and down to the quantity at which they agree.
      1. What is it? They both agree that for $250, either would buy or sell a total of 30,000 seats.


  4. Surpluses and Shortages
    1. Is the equilibrium price the price we pay for goods and services, then?
      1. Not always. Just remember that market forces will always, at least, try to move prices toward equilibrium.
      2. Airlines and travelers will both be reluctant to move prices toward equilibrium. But, market forces will push prices toward the equilibrium price. Nevertheless, equilibrium might take a while.
    2. If prices are higher than the equilibrium price, a surplus results.
      1. Sellers are willing to sell more seats than buyers are willing to buy at $400 a seat.
      2. The natural tendency, then, is for sellers to lower prices to sell seats.
    3. If prices are lower that the equilibrium price, a shortage results.
      1. Using a different example, if the price of milk fell to $1 a gallon, consumers would want to buy substantially more milk than they now buy.
      2. But what would happen on the "supply side?"
      3. Milk producers would not consider it worthwhile to produce greater quantities.
        1. After all, it would require more cows, more machines, more employees, and various other capital requirements.
      4. Moreover, many milk producers that are now just barely getting by, would be forced to leave the industry due to decreased revenues.
      5. This move to $1 a gallon would create severe milk shortages.
      6. NOTE: Without government price supports and the legally imposed "price-floor" presently imposed, these shortages would come to pass. Milk prices, therefore, are kept artificially high in the marketplace.
      7. Without the price floor, the resulting shortage would eventually force consumers to accept higher prices and consume less. The shortage, itself, would then disappear.


  5. Shifts in Demand and Supply
    1. Let's clear something up at this point.
      1. Falling prices of a good or service cause an increase in the quantity demanded-- not the demand.
    2. Here's an example of an increase in demand:
      1. A study released that suggests that eating oatmeal helps lower cholesterol.
        1. Quaker Oats won't have to lower prices to get people to buy more!
      2. Therefore, the quantity demanded will be higher than before at any price!
      3. Yeah, but how does it look on a graph?
        1. This situation is similar to the graph on page 53-- figure 4.
    3. What other kinds of things increase demand?
      1. Higher incomes (as in times of prosperity)
        1. If people can afford more, they will buy more at a given price. This shifts the demand curve to the right.
      2. Higher prices for substitutes.
        1. Bus travel is an alternative to air travel.
        2. If Greyhound raises its ticket price from Denver to Chicago, you might see some increase in the demand for air travel between the cities.
      3. Changing preferences or tastes
        1. If a series of bus or train accidents are in the news, changes in attitudes about those modes of travel might prompt a shift in the demand curve for air travel.
          1. Conversely, if plane crashes are in the news, a shift to the left (decrease in demand) of the demand curve would temporarily occur.
    4. Decreases in demand occur when:
      1. Lower incomes force people to conserve (such as in a recession)
      2. Changing consumer preferences and substitutes are available.
        1. Demand for the Coke and Pepsi are flat (not growing significantly nor rapidly) because of changing consumer preferences for juices and other healthier beverages.


    5. Changes in Supply
      1. A rightward shift of the supply curve means that sellers are willing to sell more, overall, at any given price than they were before. (Figure 6-- page 55)
      2. Causes
        1. With technological improvements, producers will be able to produce more at the same cost. Increased productivity shifts the supply curve.
        2. Cheaper labor costs make companies more profitable. Therefore, they would be willing to produce more for less.
      3. A leftward shift in the supply curve means that sellers will now sell less for a given price than before.
      4. Causes
        1. Increased government regulation of an industry always increases the cost to produce. Therefore, producers respond by offering less for the same money.
        2. Wage increases
      5. In general, anything that makes businesses operate less profitably shifts the supply curve to the left, and visa versa.
  6. Here's another supply and demand example: heating oil prices-- summer and winter.
        1. Maybe you believe that oil companies simply gouge their customers by cruelly "jacking-up" prices in the dead of winter. Perhaps there is some shred of truth to it.
        2. But, imagine that you are the head of an oil company. In summer, how much demand is there for heating oil? Not too much, right?
        3. So, to stay in business (at least with heating oil) you would have to keep prices low so that people would be willing to buy some.
        4. Now, when cold weather begins, people demand a lot of heating oil.
        5. You, as president of the company, must find, drill, refine, and deliver more and more quantities of oil.(very expensive!)
        6. To do so, you need large capital investment in your business.
        7. Moreover, you will need to add to your staff, and they will work longer hours. (very expensive!)
        8. It costs you plenty to meet demand, and you pass these costs on to the consumer.