Supply and Demand Graphs T O B E U S E D W I T H T H E S U P P LY A N D DEMAND GUIDE Review of x and Y axis A graph consists of two axes called the x (horizontal/quantity) and y (vertical/price) axes. The point where the two axes intersect is called the origin. The origin is also identified as the point (0, 0). X axis Moving right from the origin of (0,0), the numbers ascend. Moving left from the origin, the numbers descend. Y axis Moving up from the origin of (0,0), the numbers ascend. Moving down from the origin, the numbers descend. In this course, we will mainly be using the upper right quadrant of the graphic area. In economics it is the norm to show the independent variable on the y-axis and the dependent variable on the xaxis. The Demand Curve Demand Curve - A downward sloping curve that measures the relationship between the price of a good and the quantity demanded by consumers. Demand - The amount that consumers are willing and able to purchase at various prices. Change in Demand - A shift in the position of the demand curve that occurs in response to a change in one or more of the determinants of demand (non-price induced change). Law of Demand - All other factors equal, the higher the price of the good or service, the lower the quantity demanded (price induced change). And the lower the price, the higher the quantity demanded. Price and Quantity Demanded vary inversely. Change in Quantity Demanded - A change in the quantity consumers are willing and able to purchase. It is a response to a change in the market price. Why does the demand curve shift? The Determinants of demand Shifts in the curve (change in demand) result from changes in one or more of the non-price determinants of demand: Number of Consumers in the market (Size of Market) Consumer Tastes and Preferences Consumer Income Prices of Related Goods (Substitute Goods and Complimentary Goods) Expectations about the Future The Demand Curve: Increases In Demand Increase in Demand Curve shifts to the right as a result of an increase in demand by the consumers (D1 to D2). This is caused by a change in one or more of the determinants of demand. This causes Price to increase (P1 to P2). This shows a willingness to pay a higher price for all possible quantities of the good. Suppliers respond to the higher price by increasing Quantity Supplied (q1 to q2) . This process results in a new Equilibrium at e2 with Equilibrium Price P2 and Equilibrium Quantity q2. The Demand Curve: Decreases In Demand Decrease in Demand Demand curve shifts to the left as a result of a decrease in demand by the consumers (D1 to D2). This is caused by a change in one or more of the determinants of demand. This causes Price to decrease (P1 to P2). This shows a decreased willingness to pay for all possible quantities of the good. Suppliers respond to the lower price by decreasing Quantity Supplied (q1 to q2) . This results in a new Equilibrium at e2 with Equilibrium Price P2 and Equilibrium Quantity q2. Supply Curve Supply Curve - A curve that normally slopes upward (to the right) representing the quantity of a product producers are willing and able to bring to market at various prices. Supply - The amount that producers are willing and able to bring to market at various prices. Change in Supply - A shift in the position of the supply curve in response to a change in one or more of the determinants of supply (non-price induced change). Law of Supply - All other factors equal, the higher the price of a good or service, the greater the quantity supplied to the market (price induced change). And the lower the price, the lower the quantity supplied. Price and Quantity Supplied vary directly. Change in Quantity Supplied - A change in the quantity producers are willing and able to bring to market. It is a response to a change in the market price. Why does the supply curve shift? The determinants of supply Shifts in the curve can be attributed to changes in one or more of the non-price determinants of supply: Costs of Production: Input prices (prices of the Factors of Production - resources) Taxes Regulatory compliance costs Legal Expenses Transactions Costs Number of Firms in the Industry (productive capacity) Relative Prices of Alternative Outputs Technology (sometimes this is grouped with costs of production as technology determines the methods of production available to the firm) Expectations about the Future The Supply Curve: Increases In Supply Increase in Supply Supply curve shifts to the right as a result of increased supply in the market. (S1 to S2). This is caused by a change in one or more of the determinants of supply. This causes Equilibrium Price to decrease (P1 to P2). In response to the lower price, Quantity Demanded increases (q1 to q2). This produces a new Equilibrium e2 at Equilibrium Price P2 and Equilibrium Quantity q2. The Supply Curve: Decreases In Supply Decrease in Supply Supply curve shifts to the left as a result of decreased supply in the market. (S1 to S2). This is caused by a change in one or more of the determinants of supply. This causes Equilibrium Price to increase (P1 to P2). In response to the higher price, Quantity Demanded decreases (q1 to q2). This produces a new Equilibrium at e2 and Equilibrium Price P2 and Equilibrium Quantity q2. Steps to solve supply and demand problems Use the following steps - in the order provided - to solve supply and demand problems. Remember that changes occur for a reason and it is important to follow that chain of causation in all economic analysis. The Steps: Identify the determinant change indicated in the problem; Shift the curve whose determinant has changed; Shift it in the direction indicated by the determinant change; Change the market price in line with the curve shift; Move along the other curve in response to the price change (change in quantity demanded or quantity supplied as appropriate); Find the new market equilibrium price and quantity. An example: The Fresh Fruit Market Start with the Fresh Fruit market in equilibrium as shown in the graph. At equilibrium point e, the amount that consumers wish to buy at price P is exactly equal to the amount that producers wish to sell at price P. The quantity demanded is equal to the quantity supplied at the market price of P (quantity demanded = quantity supplied). The market clears - there is no shortage and no surplus. Then consumers decide to eat healthier foods, including more fresh fruit. The determinant that changes is Consumer Tastes and Preferences. An example: The Fresh Fruit Market - Step 2 Since consumers have now decided to consumer (buy) more fresh fruit, the demand curve shifts to the right. This shift graphically shows that consumers want more fresh fruit. AND that they are willing and able to pay more for all quantities of fresh fruit. This change is shown in the graph as the shift of the demand curve from D1 to D2. An example: The Fresh Fruit Market - Step 3 In response to the higher demand, the market price increases (P1 to P2). This, again, shows that consumers are willing and able to pay more of the larger quantities of fresh fruit that they now want to buy. The new price is shown as P2 in the graph of the Fresh Fruit Market. An example: The Fresh Fruit Market - Step 4 In response to the new higher price, producers will move along their supply curve from P1 at e1 to P2 at e2 and bring a higher quantity of fresh fruit to the market. This is an increase in Quantity Supplied. This is a reaction to the higher price in the market. The higher price is necessary to induce the greater quantity supply as expanding output involves increased costs of production as more resources must be hired. This process results in the new equilibrium point, e2, at the new equilibrium price of P2 and new equilibrium quantity of q2. Conclusion Follow this process as outlined in the Supply and Demand Guide and as discussed and illustrated in the previous slides. These steps work for any determinant change for either supply or demand. Should a problem involve a change in a determinant of demand and a determinant of supply, these steps still work and will lead you to the correct solution. In such a case, work through each determinant change individually, then combine the two changes to produce the total change in the market and the new market equilibrium. Supply and Demand Guide To solve the homework problems do the following: 1. 2. 3. 4. Identify the determinant change Shift the appropriate curve in the correct direction Change price appropriately Move along the other curve (the one that did not shift) in response to the price change. The following information will tell you the determinants and how the change, as well as definitions of the key terms. Demand Demand: The amount that consumers are willing and able to purchase at various prices. Law of Demand: Price and Quantity Demanded vary inversely. Quantity Demanded: The amount that consumers are willing and able to buy at a particular price. Change in Quantity Demanded: Changes in price change the quantity demanded. This is a Movement Along a Demand Curve in Response to a Price Change. Change in Demand: This is a shift in the position of the demand curve, either upward or downward. If the curve shifts upward, consumers are saying they will pay more for all quantities of the good or service. If it shifts downward, consumers are saying they will pay less for all quantities of the good or service. Determinants of Demand: The Demand Curve will shift only when one (or more) of the Determinants of Demand changes. These determinants are: 1. Size of Market: the number of consumers in the market for the good or service. If this factor increases, the curve shifts upward (increase in demand). If this decreases, the curve shifts downward (decrease in demand). 2. Consumer Tastes and Preferences: if these shift in favor of a product, the demand curve shifts upward (demand increases); if these shift against a product, the demand curve shifts downward (demand decreases). 3. Consumer Income: as the income of consumers increase, consumers purchase more of all normal goods (assume all the goods in the homework are normal goods), this shifts the demand curve upward (demand increases); if income decreases, then consumers buy less of all normal goods, this shifts the demand curve downward (demand decreases). 4. Prices of Related Goods: a. Complimentary Goods: These are goods that are used to together like peanut butter and jelly. If the price of peanut butter goes up, the Quantity Demanded of peanut butter will decrease (a movement along a demand curve in response to a price change). However, the Demand for jelly will decline (decrease in demand) as fewer people buy it to go with the peanut butter, since they are buying less peanut butter. b. Substitute Goods: These are goods that are used in place of each other. If the price of Coke Cola goes up, the Quantity Demanded of Coke does down (a movement along the demand curve). But the Demand for Pepsi - the substitute good - goes up as people substitute the lower priced Pepsi for the higher priced Coke (the Pepsi demand curve shifts upward). 5. Expectations about the Future: If people have a positive view of the future they will consumer more and save less. This shifts the demand curve for all normal goods upward. If people have a negative view of the future, they will consume less and save more, this shifts the demand curve for all normal goods downward. Supply Supply: The amount that producers are willing and able to bring to market at various prices. Law of Supply: Price and Quantity Supplied vary directly. Quantity Supplied: The amount that producers are willing and able to bring to market at a particular price. Change in Quantity Supply: Changes in price change the quantity supplied. This is a Movement Along a Supply Curve in Response to a Price Change. Change in Supply: This is a shift in the position of the supply curve, either upward (inward) or downward (outward). If the curve shifts upward, producers are saying they will bring less to market at all prices. If it shifts downward, producers are saying they will bring more to market at all prices. Determinants of Supply: The Supply Curve will shift only when one (or more) of the Determinants of Supply changes. These determinants are: 1. Number of Firms in the Industry: If the number of firms in an industry increases, the more the industry can produce - this shifts the supply curve downward (outward) - this is an increase in supply. If the number of firms in an industry decreases, the industry can produce less output - this shifts the supply curve upward (inward) - this is a reduction in supply. 2. Relative Price of Alternative Outputs: If a firm can produce Product A or Product B with the same resources (inputs), it will produce the product with the higher price. If the price of Product A increases relative to Product B, then the firm will produce more of A and less of B. This causes the Supply Curve for A to shift outward (increase in supply) and the Supply Curve for B to shift upward (decrease in supply). 3. Costs of Production*: The costs of production is the primary determinant of supply. If the costs of production increase, then supply decreases - the Supply Curve shifts inward (a decrease in supply). If the costs of production decrease, then supply increases - the Supply Curve shifts outward (an increase in supply). 4. Expectations About the Future: If firms have a positive view of the future, they will increase production which is an increase in supply - the curve shifts outward. If firms have a negative view about the future, they will decrease production and the supply curve will shift upward - a decrease in supply. * The Costs of Production include: Prices of inputs - the Factors of Production Business Taxes Complying with regulations Less any Subsidies the firm may receive In equilibrium, the quantity supplied equals the quantity demanded. P S P* D Q* Q Graph A When one or more of the determinants of demand (see above) change such that the demand for a good increases, that shows that consumers are willing to pay more for all possible quantities of the good. The upward shift in the demand curve causes an increase in price. Suppliers respond to the higher market price by bringing a greater quantity supplied to market - recall the Law of Supply. P S P* D Q* D' Q Graph B When one or more of the determinants of demand (see above) change such that the demand for that good decreases. The demand curve reflects this by shifting downward, showing the consumers are willing to pay less for all possible quantities of the good. This causes a decrease in price. Suppliers respond to the price change by bringing a lesser quantity supplied to market - recall the Law of Supply. P S P* D' Q* D Q Graph C When one or more of the determinants of supply (see above) change such that the supply for that good increases, the supply curve shifts outward showing that suppliers can bring more product to market at lower prices for all possible quantities. This causes a decrease in price. Demanders will respond to the price change with a greater quantity demanded - recall the Law of Demand. P S S' P* D Q* Q Graph D When one or more of the determinants of supply (see above) change such that the supply for that good decreases, the supply curve shifts inward showing the suppliers can bring fewer products to market at higher prices for all possible quantities. This causes an increase in price, and demanders are willing to buy a lesser quantity demanded - recall the Law of Demand. P S' S P* D Q*