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3.1 — The Supply and Demand Model

ECON 306 · Microeconomic Analysis · Fall 2020

Ryan Safner
Assistant Professor of Economics
safner@hood.edu
ryansafner/microF20
microF20.classes.ryansafner.com

Equilibrium

Recall: 2 Major Models of Economics as a “Science”

Optimization

  • Agents have objectives they value

  • Agents face constraints

  • Make tradeoffs to maximize objectives within constraints

Recall: 2 Major Models of Economics as a “Science”

Optimization

  • Agents have objectives they value

  • Agents face constraints

  • Make tradeoffs to maximize objectives within constraints

Equilibrium

  • Agents compete with others over scarce resources

  • Agents adjust behaviors based on prices

  • Stable outcomes when adjustments stop

Recall: Optimization and Equilibrium

  • If people can learn and change their behavior, they will always switch to a higher-valued option

  • If there are no alternatives that are better, people are at an optimum

  • If everyone is at an optimum, the system is in equilibrium

Equilibrium Analysis: Questions to Answer

  • Where do prices come from?

  • How do they change?

  • How consumers and producers to respond to changes?

Equilibrium Analysis

  • An equilibrium is an allocation of resources such that no individual has an incentive to alter their behavior

  • In markets: "market-clearing" prices where quantity supplied equals quantity demanded

Partial Equilibrium Analysis

  • We will only look at "partial equilibrium" in a single market

  • Changes in one market often affect other markets, affecting the "general equilibrium"

    • e.g. a change in the price of corn will affect the market for wheat, soybeans, flax, cereal, sugar, candy, ethanol, gasoline, automobiles, etc...
    • think of all of the complements, substitutes, upstream and downstream goods in production...
    • General equilibrium is too complicated for undergraduate courses...

Recall: Demand

Demand Function

  • Demand function relates quantity to price

Example: q=10−p

  • Not graphable (wrong axes)!

Inverse Demand Function

  • Inverse demand function relates price to quantity
    • Take demand function and solve for p

Example: p=10−q

  • Graphable (price on vertical axis)!

Inverse Demand Function

  • Inverse demand function relates price to quantity
    • Take demand function and solve for p

Example: p=10−q

  • Vertical intercept ("Choke price"): price where qD=0 ($10), just high enough to discourage any purchases

Inverse Demand Function

  • Read two ways:

  • Horizontally: at any given price, how many units person wants to buy

  • Vertically: at any given quantity, the maximum willingness to pay (WTP) for that quantity

    • This way will be very useful later

Recall: Supply

Supply Function

  • Supply function relates quantity to price

Example: q=2p−4

  • Not graphable (wrong axes)!

Inverse Supply Function

  • Inverse supply function relates price to quantity
    • Take supply function, solve for p

Example: p=2+0.5q

  • Graphable (price on vertical axis)!

Inverse Supply Function

  • Inverse supply function relates price to quantity
    • Take supply function, solve for p

Example: p=2+0.5q

  • Graphable (price on vertical axis)!

Inverse Supply Function

Example: p=2+0.5q

  • Slope: 0.5

  • Vertical intercept called the "Choke price": price where qS=0 ($2), just low enough to discourage any sales

Inverse Supply Function

  • Read two ways:

  • Horizontally: at any given price, how many units firm wants to sell

  • Vertically: at any given quantity, the minimum willingness to accept (WTA) for that quantity

Market Equilibrium

Market Equilibrium

  • Market-clearing (equilibrium) price (p∗): $6.00

  • Market-clearing (equilibrium) quantity exchanged (q∗): 4

Why Markets Tend to Equilibrate

Excess Demand I

Example: Consider any price below $6, such as $5:

  • Qd=5Qs=2

  • Qd>Qs: excess demand

  • A shortage of 3 units

Excess Demand II

Example: Consider any price below $6, such as $5:

  • Qd=5Qs=2

  • Qd>Qs: excess demand

  • A shortage of 3 units

  • Sellers will not supply more than 2 units

  • For 2 units, some buyers are willing to pay more than $5

Excess Demand III

Example: Consider any price below $6, such as $5:

  • Qd=5Qs=2

  • Qd>Qs: excess demand

  • A shortage of 3 units

  • Buyers will raise their bids against one another, raising the price

  • At higher prices, sellers willing to sell more!

  • Until equilibrium, no pressure for change, Qd=Qs

Excess Supply I

Example: Consider any price above $6, such as $7:

  • Qd=2Qs=8

  • Qd<Qs: excess supply

  • A surplus of 6 units

Excess Supply II

Example: Consider any price above $6, such as $7:

  • Qd=2Qs=8

  • Qd<Qs: excess supply

  • A surplus of 6 units

  • Buyers will not buy more than 2 units

  • For 2 units, some sellers willing to accept less than $8

Excess Supply III

Example: Consider any price above $6, such as $7:

  • Qd=2Qs=8

  • Qd<Qs: excess supply

  • A surplus of 6 units

  • Sellers will lower their asking prices against one another, lowering the price

  • At lower prices, buyers willing to buy more!

  • Until equilibrium, no pressure for change, Qd=Qs

Why Markets Tend to Equilibrate

Comparative Statics

Ceterus Paribus I

  • Supply function and demand function relate quantity (supplied or demanded) to price only

    • Describes how buyers/sellers respond to changes in market price

  • Certainly there are many other factors that influence how much a buyer or seller will purchase at a particular price!

    • income, preferences, prices of other goods, expectations, etc.

  • A supply or demand function (or graph) requires "ceterus paribus" (all else equal)

Recall (for example), Demand I

  • A consumer's demand (for good x) depends on current prices & income:

qDx=qDx(m,px,py)

  • How does demand for x change?
  1. Income effects (ΔqDxΔm): how qDx changes with changes in income
  2. Cross-price effects (ΔqDxΔpy): how qDx changes with changes in prices of other goods (e.g. y)
  3. (Own) Price effects (ΔqDxΔpx): how qDx changes with changes in price (of x)

See Class 1.7 for a reminder.

Recall (for example), Demand II

  • A change in one of the "determinants of demand" will shift demand curve!

    • Change in income m
    • Change in price of other goods py (substitutes or complements)
    • Change in preferences or expectations about good x
    • Change in number of buyers

  • Shows up in (inverse) demand function by a change in intercept (choke price)!

  • Again, see my Visualizing Demand Shifters

See Class 1.8 for a reminder.

Ceterus Paribus II

  • Consider our demand function: qD=10−p

  • If the market price (p) changes (perhaps because supply changes), that results in a change in quantity demanded (qD)

    • We move along the existing demand curve

  • Ceterus paribus has not been violated

Ceterus Paribus III

  • Consider our demand function: qD=10−p

  • If the something other than price changes (income, preferences, price of a complement, etc), that results in a change in demand

    • We need to draw a new demand curve (or demand function)

qD=12−p

  • Ceterus paribus has been violated

Ceterus Paribus IV

  • There is a big difference between a change in "quantity demanded" and a change in "demand"!

Ceterus Paribus IV

  • There is a big difference between a change in "quantity demanded" and a change in "demand"!

Increase in Demand

Increase in Demand

  • More individuals want to buy more of the good at every price

  • Entire demand curve shifts to the right

Increase in Demand

  • More individuals want to buy more of the good at every price

  • Entire demand curve shifts to the right

  • At the original market price, a shortage! (qD>qS)

Increase in Demand

  • More individuals want to buy more of the good at every price

  • Entire demand curve shifts to the right

  • At the original market price, a shortage! (qD>qS)

  • Some buyers willing to pay more at this quantity

Increase in Demand

  • More individuals want to buy more of the good at every price

  • Entire demand curve shifts to the right

  • At the original market price, a shortage! (qD>qS)

  • Some buyers willing to pay more at this quantity

  • Buyers raise bids, inducing sellers to sell more

  • Reach new equilibrium with:

    • higher market-clearing price
    • larger market-clearing quantity exchanged

Decrease in Demand

Decrease in Demand

  • Fewer individuals want to buy less of the good at every price

  • Entire demand curve shifts to the left

Decrease in Demand

  • Fewer individuals want to buy less of the good at every price

  • Entire demand curve shifts to the left

  • At the original market price, a surplus! (qD<qS)

Decrease in Demand

  • Fewer individuals want to buy less of the good at every price

  • Entire demand curve shifts to the left

  • At the original market price, a surplus! (qD<qS)

  • Some sellers willing to accept less at this quantity

Decrease in Demand

  • Fewer individuals want to buy less of the good at every price

  • Entire demand curve shifts to the left

  • At the original market price, a surplus! (qD<qS)

  • Some sellers willing to accept less at this quantity

  • Sellers lower asks, inducing buyers to buy more

  • Reach new equilibrium with:

    • lower market-clearing price
    • smaller market-clearing quantity exchanged

Increase in Supply

Increase in Supply

  • More individuals want to sell more of the good at every price

  • Entire supply curve shifts to the right

Increase in Supply

  • More individuals want to sell more of the good at every price

  • Entire supply curve shifts to the right

  • At the original market price, a surplus! (qD<qS)

Increase in Supply

  • More individuals want to sell more of the good at every price

  • Entire supply curve shifts to the right

  • At the original market price, a surplus! (qD<qS)

  • Some sellers willing to accept less at this quantity

Increase in Supply

  • More individuals want to sell more of the good at every price

  • Entire supply curve shifts to the right

  • At the original market price, a surplus! (qD<qS)

  • Some sellers willing to accept less at this quantity

  • Sellers lower asks, inducing buyers to buy more

  • Reach new equilibrium with:

    • lower market-clearing price
    • larger market-clearing quantity exchanged

Decrease in Supply

Decrease in Supply

  • Fewer individuals want to sell less of the good at every price

  • Entire supply curve shifts to the left

Decrease in Supply

  • Fewer individuals want to sell less of the good at every price

  • Entire supply curve shifts to the left

  • At the original market price, a shortage! (qD>qS)

Decrease in Supply

  • Fewer individuals want to sell less of the good at every price

  • Entire supply curve shifts to the left

  • At the original market price, a shortage! (qD>qS)

  • Some buyers willing to pay more at this quantity

Decrease in Supply

  • Fewer individuals want to sell less of the good at every price

  • Entire supply curve shifts to the left

  • At the original market price, a shortage! (qD>qS)

  • Some buyers willing to pay more at this quantity

  • Buyers raise bids, inducing sellers to sell more

  • Reach new equilibrium with:

    • higher market-clearing price
    • smaller market-clearing quantity exchanged

Equilibrium Tendencies

  • Equilibrium is a tendency we can predict with our models

  • Buyers and sellers raise and lower their bids and asks to adjust to competition from other buyers and sellers, moving the market price

  • Ceterus paribus, market prices will settle on an equilibrium given existing conditions

  • But conditions are always changing (and so are prices)!

Equilibrium

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