Lecture 2 Part II Supply and Demand
Classicals: Classicals vs Keynesians Markets generally function smoothly, at least as long as governments don t interfere They lead to full employment and full production equilibrium This is possible since prices (and wages) freely adjust Keynesians: Markets are unstable, therefore, government must intervene Equilibrium can be reached but it takes too long due to «sticky» wages and prices «In the long-run we are all dead»
The market model of the Classicals 1. Perfectly competitive: many buyers and sellers, all goods are identical, free entry and exit, perfect information 2. Spot: Goods and services are immediately delivered 3. Double auction: Both buyers and sellers state prices at which they are willing to buy/sell the goods and services To what extent are real-world markets similar to this market model?
A Supply Schedule for Coffee A Supply Schedule for Coffee Price ($/cup) 0.70 0.80 0.90 1.00 1.10 1.20 1.30 1.40 1.50 1.60 Cups of Coffee 300 400 500 600 700 800 900 1,000 1,100 1,200 Supplied/week
Supply Supply curve: a curve indicating the quantities that sellers are willing to supply at various prices Change in supply versus change in quantity supplied!
Price of Coffee ($ per Cup) The Supply Curve for Cups of Coffee 1.80 1.60 1.40 1.20 1.00 0.80 0.60 0.40 0.20 0.00 0 200 400 600 800 1000 1200 1400 Cups of Coffee Supplied per Week
Price of Coffee ($ per Cup) 1.80 1.60 An Increase in Supply S 1 S 2 1.40 1.20 1.00 0.80 0.60 0.40 0.20 0.00 0 200 400 600 800 1000 1200 1400 1600 1800 Cups of Coffee Supplied per Week
Price of Coffee ($ per Cup) A Decrease in Supply 1.80 1.60 S 2 S 1 1.40 1.20 1.00 0.80 0.60 0.40 0.20 0.00 0 200 400 600 800 1000 1200 1400 Cups of Coffee Supplied per Week
Demand Demand curve: a curve indicating the quantities that buyers are willing to buy at various prices Change in demand versus change in quantity demanded! Substitute goods: a good that can be used in place of another Complementary goods: a good that is used together with another good
A Demand Schedule for Coffee A Demand Schedule for Coffee Price ($/cup) 0.20 0.50 0.80 1.10 1.40 1.70 2.00 2.30 Cups of Coffee Demanded/week 1,000 900 800 700 600 500 400 300
Price of Coffee ($ per Cup) The Demand Curve for Cups of Coffee 2.40 2.20 2.00 1.80 1.60 1.40 1.20 1.00 0.80 0.60 0.40 0.20 0.00 0 200 400 600 800 1000 1200 Cups of Coffee Demanded per Week
Price of Coffee ($ per Cup) An Increase in Demand 2.40 2.20 2.00 1.80 1.60 1.40 1.20 1.00 0.80 0.60 0.40 0.20 0.00 0 200 400 600 800 1000 1200 1400 Cups of Coffee Demanded per Week D 1 D 2
Price of Coffee ($ per Cup) An Decrease in Demand 2.40 2.20 2.00 1.80 1.60 1.40 1.20 1.00 0.80 0.60 0.40 0.20 0.00 D 2 D 1 0 200 400 600 800 1000 1200 Cups of Coffee Demanded per Week
Price of Coffee ($ per Cup) Surplus, Shortage, and Equilibrium Surplus Supply 1.40 1.10 (D=600) E (S=1000) 0.80 (S=400) (D=800) Shortage Demand 0 200 400 600 800 1000 1200 Cups of Coffee per Week
Price of Coffee ($ per Cup) Market Adjustment to an Increase in Supply 2.40 2.20 2.00 1.80 1.60 1.40 1.20 1.00 0.80 0.60 0.40 0.20 0.00 E 1 E 2 Demand Surplus 0 200 400 600 800 1000 1200 1400 1600 Cups of Coffee per Week S 1 S 2
Price of Coffee ($ per Cup) Market Adjustment to and Increase in Demand D 1 D 2 1.40 1.10 E 1 E 2 Supply Shortage 600 700 1000 1100 Cups of Coffee per Week
Effects of Changes in Supply and Demand Effect on Equilibrium Price Effect on Equilibrium Quantity Increase in Supply fall rise Decrease in Supply rise fall Increase in Demand rise rise Decrease in Demand fall fall
Elasticities Price elasticity of demand: a measure of responsiveness of quantity demanded to changes in price Price elasticity of supply: a measure of responsiveness of quantity supplied to changes in price
Price Price Elasticity of Demand: Relatively Price-Elastic Demand S 2 S 1 P 2 P 1 D Q 2 Q 1 Quantity
Price Price Elasticity of Demand: Relatively Price-Inelastic Demand S 2 S 1 P 2 P 1 D Q 2 Q 1 Quantity
Macroeconomics and the Dynamics of Real-World Markets Not every market is a perfectly competitive spot market with smoothly functioning double-auction mechanisms We may have: Market power Differentiated goods Imperfect information Long-term contracts Different types of price adjustment The speed of price adjustments is crucial
When price adjustments are slow The theory of supply and demand doesn t tell us how long it will take until the market clears If a chain of different markets is involved in the production of a good or service, a quick adjustment of prices is unlikely Then, producers may adjust production (raise or cut production if there is a shortage or surplus, respectively). Instead of prices, quantities will adjust
When prices change rapidly Buyers may be interested not in the good itself, but in the direction of the movement of the prices Speculation: buying and selling assets with the expectation of profiting from appreciation or depreciation in their value People s mutually reinforcing optimism may cause asset prices to rise «too much» than realistically can be justified in economic terms
Nasdaq Composite Stock Index «Dot-com» Bubble: The Stock Market Bubble of 1999-2000 5,000 4,500 4,000 3,500 3,000 2,500 2,000 1,500 1,000 500 0 Date 1990 3-Dec- 1991 2-Dec- 1992 1-Dec- 1993 1-Dec- 1994 1-Dec- 1995 1-Dec- 1996 2-Dec- 1997 1-Dec- 1998 1-Dec- 1999 1-Dec- 2000 1-Dec- 2001 3-Dec- 2002 90 91 92 93 94 95 96 97 98 99 00 01 Source: Yahoo! Finance, Monthly data.