1SUPPLY, DEMAND, MARKETS AND APPLICATIONSUnderstanding How Markets Work1Markets I: Supply and Demand BasicsMarkets II: We Love Free Markets!Markets III: Sometimes We Don’t!Markets IV: Applications of MarketsMARKETS IDEMAND AND SUPPLY:THE BASICS!Where do prices come from?2“Gas prices seen spiking again in spring”;Associated Press, Jan 31, 2008Talk is cheap because supply exceeds demand!“Oil hovers around $72 amid demand concerns”; Associated Press, August 26, 2009OVERVIEW / Questions of the DayWhere do prices come from? How are they determined?How do we know we will have enough food? Homes? Teachers?Economists construct a model to answer• Constructing an economic model – Supply and Demand• How do we capture the behavior of potential buyers?• How do we capture the behavior of potential sellers?32Creating ‘The Market’••The Market (more or less) sets the price for all items• As consumers, we choose • As businesses, we choose•How does this work?•Economists try to capture this with the model of Supply and Demand4Creating ‘The Market’•Economists create the model of supply and demand by representing two sides of the market•On one side –• They value to item/product and would like to buy/use it•On the other side –• They would like to •We try to • What makes buyers behave the way they do?• What makes sellers behave the way they do?5DEMANDAll those willing and able to buy the good/service make up the demand side of the marketAll those interested or even potentially interested, whether households, firms or governmentBack to our basic question:• What to produce? How much of a good to produce?63How much do buyers want?Part of the answer lies with buyers – how much do they really want?•What affects buyer behavior?• What could change in your life to induce you to buy more or less of a good/service than you do right now?•How many times a year do you go to the movies?•What could change that would induce you to go more or less often?7How much do buyers want?• There are MANY factors that influence your decision to buy or not buy something• Some of the factors considered more important: 8Price of the Good/Service ItselfQuantity Demanded (QD):The amount of a good or service that people • Ceteris Paribus means holding all factors (2 - 6) constant• Very simply, ••Law of Demand: Price and quantity demanded are• As price rises, • people wish to buy less of the good as it becomes more expensive• As price falls, • people wish to buy more of the good as it becomes cheaper94Price and Quantity DemandedThere are 3 ways to show the negative relationship between price (P) and quantity demanded (QD)1. Demand Function: a 2. Demand Schedule: a table showing the relationship between P and QD3. Demand Curve: a graphical representation of the relationship between P and QD10Demand Function: ExampleDemand Function: A mathematical formula that shows the relationship between the price of the good/service (P) and the amount demanded (QD)Suppose fictional person named K demands “do-dads”• We can write K’s demand for do-dads as a function• This shows the relationship between the price of do-dads (P) and the amount he wishes to buy per month (QD):11Demand Schedule: Example12Demand Schedule: A table that shows the relationship between the price of the good and the amount demanded Example – K’s demand for do-dadsPrice(do-dads)K’s Quantity Demanded (per month) We can fill in the schedule by plugging numbers into the functionP = $18 – 3QD5Demand Curve: Example13Plot the schedule to get the demand curvePrice(do-dads)K’s Quantity Demanded(per month)Other FactorsRemember: These points and this curve are ceteris paribus!!14ALL OTHER FACTORS THAT WHEN THEY CHANGE, THEY Demand Shifters: IncomeNormal Goods: have a • As your income ↑, •As K’s income increases, K purchases more do-dads per month, even if the price stays the same, •Graphically, this • Opposite also true – as income ↓, so does the amount of the good buyers demand, shifting each point to the left• Inferior Goods: the exception to the rule; as income ↑, people demand less of the good• Examples?156Demand Shifters: Income16P181593 4Q (do-dads/month)16D212If K’s income rises…Price(do-dads)K’s Old Qd(per month)K’s New Qd(per month)$18 0$15 1$12 2$9 3$6 4Demand Shifters: Prices of Related GoodsWhen goods A & B are • Examples?• How are they related?What happens to the amount of Good A purchased when the price of Good B rises?• Amount• Demand When goods A & B are • Examples?• How are they related?What happens to the amount of Good A purchased when the price of Good B rises?• Amount • Demand 17Complement Goods Substitute GoodsWhen 2 goods are related, it means that when the price of Good A changes, consumers respond by changing the amount they buy of Good BComplements and SubstitutesComplement Goods• ExamplesSubstitute Goods• Examples18A change in the price of one of these will graphically7Demand Shifters: Tastes/Preferences•Preferences/tastes change over time•Some goods become more popular, some become less popular•When there is a change in the general preference for a product, we show that graphically as a shift in its demand curve• More popular –• Less popular –19Demand Shifters: Price ExpectationsBuyers sometimes expect the price of the good to change in the future;This may affect how much of the good they want to buy nowQ. If buyers think the price of the good will rise in the near future, will they want to buy more or less today?A. More: they will want to buy it now before the price increase• Graphically, this causes a rightward shift in demand•Opposite also true20Demand Shifters: Any OthersAnything, other than a change in the price of the good itself, that makes buyers wish to buy more or less of the good will shift the demand curve•An increase •A decrease 21PQD8Individual and Market DemandMarket Demand: the summation of each individual’s quantity demanded at every price•As an example, simplify our world to 3 people who demand do-dads – K, L, and M:22K’s DemandP Q18 015 112 29 36 43 5L’s DemandP Q18 015 012 29 46 63 8M’s DemandP Q18 015 012 09 16 23 3Market DemandP Q18151296323Market Demand128 164Q (do-dads/month)181512936P1PriceMarketDemand(per month)$18 0$15 1$12 4$9 8$6 12$3 16Summary: Market Demand ShiftersIncrease in Market Demand• Increase in consumer incomes• Decrease in