Chapter 8

Demand, Supply and Prices

I. The Market System – As we know from previous chapters, in a market system, people act in their own self-interests and make decisions that guide the economy.

Ø Consumers make purchases in order to satisfy individual wants and needs, while

Ø Producers make products in order to make a profit.

The market system communicates information between consumers and producers.

The function of a market system is to bring together consumers and producers (in the chips game)

A Review of Demand –

Ø What is demand?

Ø What is the law of Demand?

A Review of Supply –

Ø What is supply

Ø What is the law of supply?

II. Equilibrium: Demand and Supply in Balance

When demand and supply balance one another we say that they are in equilibrium. In a market system, natural economic forces lead to an equilibrium or a balance between demand and supply.

Finding Equilibrium – see page 186 in textbook The schedule on page 187 shows the demand and supply schedules for a product. Notice that at $3.60 the quantity demanded and supplied are equal at 2,000 units.

Ø Equilibrium price – is the price at which the quantity demanded equals the quantity supplied ($3.60)

Ø Equilibrium quantity – is the quantity that is both demanded and supplied at the equilibrium price. (2,000 units)

Graphing Equilibrium

· From this graph, you can see that equilibrium occurs at the point where the demand curve crosses the supply curve.

· Any market is in equilibrium, or balance, when the quantity demanded equals the quantity supplied.

III. Price as a Rationing Device

Price is important in determining both the quantity demanded and the quantity supplied.

· Consumers look at prices as they decide how to spend their money

· Producers look at prices as they decide what goods and services to produce.

A shortage in the market – What is a shortage?

Shortage – a shortage exists when people are willing to buy more than producers have for sale at a given price. It is when the quantity demanded is greater than the quantity supplied at a certain price.

What is happening in this situation?

At $1.75 suppliers are willing to make units while consumers are willing to purchase $800 units. This situation causes an upward pressure on price.

How is a shortage eliminated?

Suppliers are likely to know when the quantity demanded is greater than the quantity supplied and that some people are willing to pay a higher price. In this situation, suppliers will raise their prices.

Once prices are raised, the amount demanded becomes less. As long as the quantity demanded is greater than the quantity supplied, the process continues. Only when there is not shortage is there no longer upward pressure on price.

A surplus in the market – What is a surplus?

Surplus – is the condition in which the quantity supplied is greater than the quantity demanded at a certain price. If the amount demanded is less than the amount supplied at any given price, there is a surplus.

What is happening in this situation?

At $3.50 suppliers are willing to make 800 units while consumers are only willing to buy 200 units. There is a surplus of products in this situation.

How is a surplus eliminated? Suppliers have more of the product than they can sell at this high price. They are likely to reduce the price to try to increase sales. When car companies produce too many cars, they frequently offer rebates to improve sales. Forces on both the demand and supply sides of the market react with downward pressure on price when there is a surplus. As price comes down, the amount demanded increases. As long as the quantity demanded is less than the quantity supplied, price continues to fall.

Changes in Demand

As you already have seen in Chapter 6, the demand curve shifts due to a number of factors. These factors are:

· Consumers’ incomes may change

· Consumers’ attitudes or expectations may change

· The prices of substitute products may change

· The price is complementary products may change

What happens to equilibrium if Demand Increases?

When the demand for a product goes up, the equilibrium price and quantity are affected. An increase in demand means that consumers are willing to buy more at each price than they would have before the rise in demand.

Now with the shift in demand consumers are willing to buy 600 units instead of 550 units. There will be a shortage of 50 units if the amount supplied does not change.

What happens when there is a shortage?

So, there are two important changes when there is an increase in demand. If demand goes up and the supply curve remains the same, the following occurs:

· Prices rise

· Quantity exchanged rises

What happens to equilibrium if demand decreases? With a lower level of demand, there is a surplus if the supply does not change.

Now, with the shift in the demand curve to the left, consumers are willing to purchase 400 units where as before they were willing to purchase 450 units. This situation creates a surplus which results in downward pressures on price.

Therefore, if demand falls while the supply curve stays the same, the following occurs:

· Price falls

· Quantity exchanged falls

What happens to equilibrium if Supply Increases?

An increase in supply means that producers are willing to supply more at each price.

The original supply curve showed that suppliers are willing to make 450 units at $2.50. Now with the shift to the right, suppliers are willing to make 600 units. This situation causes a surplus in the market if demand remains the same.

Therefore, if supply increases while the demand curve remains the same, the following results can be expected:

· Prices fall

· Quantity exchanged rises

What happens to equilibrium if supply decreases?

Supply shifts to the left when the cost of production goes up.

In this situation, the supply curve shifts to the left. Therefore, producers were once willing and able to make 500 units but now they can only make 350. This causes a shortage in the market. We know that when there is a shortage there is upward pressure on price. As the price rises, consumers reduce the quantity they demand.

If demand stays the same and supply decreases, we can expect the following results:

· Prices go up

· Quantity exchanged is less

IV. Governments may block the market system – there are many times when the government may act to block the market system thus preventing a balance between the quantity demanded and the quantity supplied.

There are two types of government actions that can prevent a balance in the market.

Price Floor – is a minimum price set by government that is above the market equilibrium price. This is usually done in order to protect suppliers from loosing profits. This usually done with agricultural products. In order to ensure that farmers have jobs, the government sets a price floor (the price is set $1.00 a bushel and cannot be lowered).

Since the price floor keeps price from falling below a certain level, it protects producers from losing profits. However, this government regulation causes the “market” to be out of balance.

The quantity supplied is greater than the quantity demanded at the government’s price. Producers produce more than consumers buy. What happens to the extra production? The government must either buy up the surplus or keep producers from producing so much.

The second situation is a price ceiling. A price ceiling is a maximum price set by government that is below the market equilibrium price.

A price ceiling keeps price down to the level the government thinks is right. To be effective, a price ceiling must be below the equilibrium price. In this situation, the government is trying to protect the consumer. It creates a shortage when there is increased demand and not enough supply, therefore the government needs to produce enough of the product to make up for the shortage. This can lead to non-market or illegal transactions to take place.