Supply and Demand

Question 1

What is demand?

Answer 1

Demand means how much of something you’re willing and able to pay for.

i.e. you want a bajillion scoops of icecream - this desire isn’t a demand in an economic sense.

Your demand is in fact 3 scoops because you’re willing and able to buy three scoops at the current price.

Question 2

What is the difference between quantity demanded and demand?

Answer 2

• Quantity demanded,* refers to how much you demand at a specific price given your income and preferences.
• Demand,* means the whole range of quantities that a person with a given income and preferences demands at various possible prices.

To better understand the difference between these two concepts, remember that economists divide everthing that can possibly affect the quantity demanded into two groups: the price and everything else.

*Remember the higher the pirce, the less people demand (if all the other things that may possibly affect the quantity demanded are held constant aka cetirus paribus).

Question 3

Give a real world example of quantity demanded and demand.

Answer 3

Other things that we may hold constant include such important factors as tastes, preferences and incomes.

No matter how low the price, Spurs fans aren’t going to buy a single seat at Arsenal because they don’t value having a seat.

No matter how expensive a seat at Arsenal costs, the people who love the team have a higher quantity demanded than Spurs fans.

Because this remains true for every possible price, we say that Arsenal fans have a higher demand for this particular product than Spurs fans.

Question 4

Describe the difference between normal goods and inferior goods.

Answer 4

Another important factor is income.

As you get richer, you increase your purchases of certain goods that you’ve always liked and can now afford to buy in larger quantities = normal goods.

On the other hand, you decrease your purchases of things that you were buying only because you were too poor to get what you really wanted = inferior goods.

Ex. new cars are normal goods, whereas really old poorly running used cars are inferior goods.

Ex 2. freshly made organic salads are normal goods, whereas three-day old discounted bread is an inferior good.

Question 5

How do we get the demand curve?

Answer 5

By adding up the demands for different consumers in a market.

Question 6

What happens when there’s an increase or decrease in price?

Answer 6

When you consider the r’ship between the price and the quantity demanded at each price, you need to understand that increases or decreases in price simply move you along the demand curve, so that you just read off the price and quantity at a new point on the same curve.

Question 7

What determines the location and shape of the demand curve?

Answer 7

Non-price factors.

Any changes in these factors causes the demand curve to shift its location.

Question 8

Give an example of demand increasing, at any given price.

Answer 8

Suppose that a gov health study comes out saying that cabbages make people irresistable to other people. Naturally the demand for cabbages increases, at any given price.

Compare point A with A’. Both share the same price of £2 per cabbage but now thanks to the gov paper people demand 15 cabbages at that price rather than 5.

Because the price is the same for the two points, you know that the change in quantity demanded was caused by something other than price.

Question 9

What other factors may influence people’s demand?

Answer 9

Changes in income or wealth and changes in tastes and preferences.

Question 10

In terms of demand curves, how do different reactions to price changes lead to different slopes?

Answer 10

The person who buys a lot more when the price falls has a flat demand curve, whereas the person whose purchases barely budge when the price falls has a steep demand curve.

Compare points A and B below.

Question 11

What does price elasticity of demand mean?

Answer 11

How much the quantity demanded changes when the price changes.

In the previous graph, the inelastic demand curve (A) has a lot less demand elasticity than the elastic demand curve (B) because the same change in price causes the quantity demanded in A to fall much less than in B.

Question 12

Give an example of a perfectly inelastic demand curve.

Answer 12

The vertical demand curve, D, is said to be perfectly inelastic, because exactly Q units are demanded, no matter what the price.

What sort of goos has such a demand curve?

Any life saving drug

Ransoms in kipnappings

In fact, any good has an inelastic demand curve when your valuation of the good is so extreme that you’re willing to pay anything for it.

Question 13

What is the best way of understanding perfectly elastic demand?

Answer 13

Try to imagine a very gradually sloping demand curve that’s almost - but not quite - horizontal. On such a shallowly sloped demand curve, even a small change in price causes a big change in the quantity demanded.

Indeed, the flatter a demand curve becomes, the greater is the change in the quantity demanded for any given price.

Question 14

What is the definition of perfectly elastic demand?

Answer 14

Even the tiniest change in price brings forth an infinite change in quanitity demanded. That is, when prices are above P’ you buy nothing, whereas when prices are at P’ or just a penny less, you buy an infinite amount.

Question 15

Give a real world example of perfect demand elasticity.

Answer 15

Suppose you work in a restaurant and have to buy tons of ketchup. Your options are brand X and brandY, but becasue they taste the exact same, the only thing that matters is the price.

Consequently, when the price of brand X is even the slightest bit lower than brand Y, you buy tons of X and none of Y and vice versa.

In other words, when brand X is easily substitued with Y, the demand for brand X tends towards being perfectly elastic.

Question 16

What is the key underlying concept of supply and what direction does the supply curve slope?

Answer 16

The key underlying concept is that supplying things is costly.

Because production costs rise as you produce more output, when you want producers to make more and more, you have to pay them more and more. This fact implies that supply curves slope upwards.

Question 17

What does each amount in pounds on a supply curve represent?

Answer 17

Each amount on the supply curve doesn’t represent the prices that the producer wants to receive for any given amount of his product - obviously, he wants to receive as much as he can get for each one.

Instead, each amount in pounds on a supply curve represents the minimum that you can pay him and still get him to produce the desired amount.

If you pay beloew his minimum he refuses. Why? because he has costs - and he can cover them when he gets the minimum but nothing below.

Question 18

How do economists split all the things that can affect the quantity supplied?

Answer 18

Into two groups: the price and everything else. The things that go into everthing else relate to the costs of supplying the good in question.

Question 19

Why do prices move you along the supply curves?

Answer 19

Regardless of exactly how the curved is sloped or its position, the fact that costs increase as output increases means that you need to offer a higher and higher price to the supplier when you want to obtain more units.

Question 20

Give an example of a leftward shift in the supply curve.

Answer 20

Mr. Babbage’s costs increase because the gov imposes a new organic farming law under which he’s required to grow cabbages without using pesticides. In response, he has to hire more workers to kill pests with tweezers instead of simply spraying them with cheap chemicals.

Because his costs of production have increased, the minimum you have to pay him to produce any given level of output also goes up. So his supply curve shifts vertically from, S₀ to S₁.

COMPARE POINTS A AND A’.

Question 21

Wht are the two ways in which a supply curve can shift and how might you interpret these?

Answer 21

When costs increase - supply curve shifts to the left.

When costs decrease - supply curve shifts to the right.

Question 22

Define perfectly inelastic supply.

Answer 22

Perfectly inelastic supply is the situation in which the price has no effect on the quantity supplied. No matter how high or low the price, the same quantity is supplied.

In other words, the quantity supplied is perfectly unresponsive to the price.

Question 23

Give examples of things with perfectly inelastic supply curves.

Answer 23

1. The hope diamond. Because only one can exist, no matter how much anyone wanted to pay, its supply curve is vertical.
2. Land. As the comedian Will Rogers said back in the early 20th century, ‘Buy land. They ain’t maing more of it’.
3. The electromagnetic spectrum. Only one set of radio frequencies exists, and we all have to share because making more frequencies is impossible.

Question 24

Define perfectly elastic supply.

Answer 24

Perfectly elastic supply is where the supplier is producing something with non-increasing costs. No matter how many units you want, the supplier’s cost remains only P’ pounds to make a unit.

Consequently, whether you want one unit produced or one jillion units produced, you pay only P’ pounds per unit.

Question 25

Give a real world example of perfectly elastic supply curves.

Answer 25

In the real world, perfectly elastic supply curves are rare to the point of non-existance because production costs typically rise with output levels.

They are however, very common in the virtual world. Ex. it costs gGoogle a negliglible amount to supply an extra search. One problem associated with that is that it proves to be very difficult to charge direct users for their searches.

Question 26

What are the three things you need to remember about the supply and demand model?

Answer 26

1. The equilibrium of the supply and demand model is where the supply and demand curves cross (rememeber: x marks the spot).
2. The price and the quantity where the curves cross are, respectively, how much the good or service in question costs and how much of it gets sold. This price and this quantity are known as the market price and the market quantity.
3. The market price and market quantity represent a stable equilibrium such that the market forces always push the price and quantity back to these values. Consequently, the market price and market quantity are also called the equilibrium price and the equilibrium quantity.

Question 27

What is special about the price P*?

Answer 27

We label the market price and quantity as P* and Q*, what makes this price and quantity special is that at price P*, the q that buyers demand is equal to the q that producers want to supply.

Question 28

Why is the market equilibrium called a stable equilibrium?

Answer 28

The market equilibrium called a stable equilibrium because no matter where the demand and supply model starts off, it always gravitates back to the market equilibrium - just as long as we don’t intorduce any outside forces.

Question 29

What is so great about inherent market stablity?

Answer 29

This inherent stability is great because it means that markets are self-correcting, and when you know where the d and s curves are, you know where prices and quatities are going to end up.

Also the actions of buyers and sellers move the makret towards equilibrium without the need for any outside intervention, such as government regulations.

Question 30

Explain excess supply.

Answer 30

This occurs when you have a price P^H that starts out higher than the market equilibrium price, P*.

At price P^H the quantity demanded by buyers, Q^D, is less than the quantity supplied by sellers, Q^S.

Economists refer to such a situation as excess supply, and it can’t be an equilibrium because sellers aren’t able to sell everything they want to sell at price P^H .

Question 31

What is the calculation to see what remains unsold?

Answer 31

Of the total amount that sellers want to sell, Q^S, only the amount QD is sold, meaning that the remaining amount, Q^S - Q^D remains unsold unless something is done.

Usually the firm puts on a sale to get rid of the excess items.

Question 32

When do prices stop decreasing?

Answer 32

Sellers lower the price and keep lowering unitl supply no longer exceeds demand. This means sellers keep lowering the price until it falls all the way down to P* (where the quantity demanded by buyers = the quantity that sellers want to supply).

Question 33

Explain Excess Demand.

Answer 33

Excess demand occurs at price P^L, as the amount that buyers want to buy, Q^D, exceeds the amount that suppliers want to sell, Q^S.

In other words, a shortage exists that equals Q^D - Q^S units. As a result, buyers start bidding the price up, competing against eachother for the insufficient amount of the good.

Question 34

Describe how a rightward shift of the demand curve re-establishes the market equilibrium.

Answer 34

Before the demand curve shifts from D₀ to D₁ , the market equilibrium is P^*₀ , and the market equilibrium quantity is Q^*₀.

When the d curve shifts to the right to D₁ , the price momentarily stays the same at P^*₀ . But this price can’t last because with the new d curve, an excess demand now exists: that is, at price P^*₀ the quantity demanded, Q^D₁, exceeds the quantity supplied, Q^*₀.

Question 35

Why does the equilibrium move from Q^*₀ to Q^*₁?

Answer 35

Because if demand increases and buyers are willing to pay more for something, you expect more of it to be supplied.

Also, thee price goes up from one equilibrium to the other because to get suppliers to supply more in a world of rising costs, you have to pay them more.

Question 36

How does the slope of the supply cureve interact with the demand curve?

Answer 36

Very subtly, the slope of the supply curve interacts with the demand curve to determine the size of the changes in price and qunatity.

Thinking through our previous extreme cases (horizontal and vertical supply curves) hammers home that in a situation like the one below, netiehr demand nor supply is in complete control.Their interaction jointly determines equilibrium prices and quantities and how they change if the demand curve or supply curve shifts.

Question 37

What is the cause of a leftward shift in the supply curve.

Answer 37

The supply curve may shift to the left due to an increase in production costs. The shift causes the maket equilibrium to adjust.

Question 38

What are the effects of a leftward shift of the supply curve?

Answer 38

For a moment, the price remains at P^*₀ . But this price can’t continue because the quantity demanded at this price, Q^*₀, exceeds the quantity supplied Q^s₁.

This situation of excess demand causes the price to be bid up until reaching the new equilibrium price of P^*₁, at which price the quantity demanded = the quantity supplied.

Question 39

What gov policy/intervention in a market might ensure that the price stays below the market equilibrium price, P^*?

Answer 39

Remember that prices below the market equilibrium normally rise, and therefore these policies are called price ceilings, because they prevent the price from rising as high as it may have gone if left alone. Prices hit the celing and then go no higher.

Question 40

How might one indicate a price ceiling?

Answer 40

To make clear that we have a price ceiling above which the price can’t rise, we draw a solid horizontal line.

Question 41

What is the problem with price ceilings?

Answer 41

The problem is, at the ceiling price, the quantity demanded Q^d, far exceeds the quantity supplied, Q^s.

Now you have to figure out a way to allocate the insufficient supply among all the people who want it. The result is that people end up queuing to get the limited supply.

Question 42

Give a real life example of a price ceiling.

Answer 42

The private housing market in Britain used to include price ceilings for how much a landlord could charge - rent controls.

It has largely disappeared, and many feel rent is too high (students). In spite of the initial anger, in many ways the change was an improvement.

In the 70’s, rent controls inhibited individuals from getting a house because many lanlords were reluctant to put their propertys on the market at the prevailing regulated prices.

Therefore, excess demand for housing existed at that price. After the rent controls were abolished, more properties came onto the rental market, albeit at a higher price.

After the impediment to supply and demand adgusting changed, the excess demand was cleared from the market to some degree.

Question 43

What gov policy/intervention might keep the price above the market equilibrium?

Answer 43

Price floor

This is when the floor price is greater than the market equilibrium price.

Question 44

What is the issue with price floors?

Answer 44

The problem is that at the floor price, the quantity supplid, is much bigger than the quantity demanded.

The normal response to such a situation of excess supply is for the price to fall.

To prevent the price from falling the gov steps in and buys up the excess supply to prop the price up.

Question 45

What is meant by price supports?

Answer 45

Of the total amount supplied at the price floor, regular consumers demand and purchase Q^d. The remainder, Q^s - Q^d must be purchased by the gov.

This situation doesn’t sound too bad until you read about price floors in agriculture, which proponents usually refer to euphemistically as price supports (i.e. you poor thing, all you need is a little support).

Question 46

What is the issue with price supports?

Answer 46

Price supports generate huge piles of crops that nobody wants to buy. Ex. the european Union’s CAP in effect acts as a price floor.

Thanks to the policy of supporting European farmers, Europe produces mountains of unwanted butter, and lakes of undrinkable wine.

Question 47

Regarding the mischief caused by price ceilings and floors, how then, should a gov intervene in a market?

Answer 47

Gov’s should not never intervene in the operation of a market, instead they should be smart enough not to intervene in ways that they know are going to lead to perverse results.