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We begin with demand because demand is usually easier to understand from our personal
experiences. We are all consumers and we all demand goods and services. Demand is
derived from consumers' tastes and preferences, and it is bound by income. In other
words, given a limited income (whether it be $30,000 or $5 million), the consumer must
decide what goods and services to purchase. Within his budget, the consumer will
purchase those goods and services that he likes best. Each consumer will purchase
different things because individual preferences and
incomes differ.
The law of demand holds that other things equal,
as the price of a good or service rises, its quantity
demanded falls. The reverse is also true: as the
price of a good or service falls, its quantity
demanded increases. This law is a simple,
common sense principle. Think of your trips to the
grocery store. When the price of orange juice rises,
for example, you buy less of it. When that item is
on sale, you purchase more of it. This is all that we
mean by the law of demand.
Table 1 lists the monthly quantity of rental videos demanded by an individual given
several different prices. If the rental price is $5, the consumer rents 10 videos per month.
If the price falls to $4, the quantity demanded increases to 20 videos, and so on. The
figure titled "Demand Curve" plots the inverse relationship between price and quantity
demanded.
TABLE 1
Demand for Videos
Price Quantity Demanded A demand curve is a graphical depiction of the law of
demand. We plot price on the vertical axis and quantity
$5
10
demanded on the horizontal axis. As the figure illustrates,
$4
20
the demand curve has a negative slope, consistent with the
$3
30
law of demand.
$2
40
$1
50
the producer can raise the price and sell the same
number of goods while holding costs constant,
then profits increase.
The law of supply holds that other things equal, as
the price of a good rises, its quantity supplied will
rise, and vice versa. Table 2 lists the quantity
supplied of rental videos for various prices. At $5,
the producer has an incentive to supply 50 videos.
If the price falls to $4 quantity supplied falls to
40, and so on. The figure titled "Supply Curve"
plots this positive relationship between price and
quantity supplied.
TABLE 2
Supply of Videos
30
$2
20
$1
10
At the market equilibrium, every consumer who wishes to purchase the product at the
market price is able to do so, and the supplier is not left with any unwanted inventory. As
Table 3 and the figure titled "Equilibrium" demonstrate, equilibrium in the video example
occurs at a price of $3 and a quantity of 30 videos.
TABLE 3
Video Market Equilibrium
Quantity
Demanded
Quantity
Supplied
$5
10
50
$4
20
40
$3
30
30
Price
40
20
Perhaps more often than not, markets are not exactly in equilibrium. Minor surpluses and
shortages are common in a market economy. A stroll through most malls at the end of the
clothing season reveals the excess clothing inventory that many stores carry. How do they
manage this situation? By lowering prices. Lower prices reduce the incentive for stores to
carry the clothes while simultaneously increasing the incentive for consumers to purchase
the clothes. The important point is that even though a market may not be in perfect
equilibrium, it tends to gravitate towards equilibrium over time. This fact makes markets
stable most of the time such that persistent surpluses and shortages are uncommon and
self-correcting.
Persistent and severe shortages and surpluses do occur in the U.S. economy every now
and then. At the end of 1998, for example, the supply of hogs in the U.S. markets was so
much greater than demand that the price of hogs fell from about $50 per hundredweight to
$13 per hundredweight. Many farmers were so badly hurt by that experience that they left
the hog market completely--a painful but self-correcting force. In the late 1970s the
relative shortage of gasoline resulted in long lines at the gas pumps. The shortages lasted
for a couple years until oil producers stepped up production and consumers learned to use
fuel more efficiently.
TABLE 4
Change in Demand for
Videos after Incomes Rise
We list and explain four factors that can shift a demand curve:
1. Change in consumer incomes: As the previous video rental example demonstrated,
an increase in income shifts the demand curve to the right. Because a consumer's
demand for goods and services is constrained by income, higher income levels
relax somewhat that constraint, allowing the consumer to purchase more products.
Correspondingly, a decrease in income shifts the demand curve to the left. When
the economy enters a recession and more people become unemployed, the demand
for many goods and services shifts to the left.
2. Population change: An increase in population shifts the demand curve to the right.
Imagine a college town bookstore in which most students return home for the
summer. Demand for books shifts to the left while the students are away. When
they return, however, demand for books increases even if the prices are
unchanged. As another example, many communities are experiencing "urban
sprawl" where the metropolitan boundaries are pushed ever wider by new housing
developments. Demand for gasoline in these new communities increases with
population. Alternatively, demand for gasoline falls in areas with declining
populations.
3. Consumer preferences: If the preference for a particular good increases, the
demand curve for that good shifts to the right. Fads provide excellent examples of
changing consumer preferences. Each Christmas season some new toy catches the
fancy of kids, and parents scramble to purchase the product before it is sold out. A
few years ago, "Tickle Me Elmo" dolls were the rage. In the year 2000 the toy of
choice was a scooter. For a given price of a scooter, the demand curve shifts to the
right as more consumers decide that they wish to purchase that product for their
children. Of course, demand curves can shift leftward just as quickly. When fads
end suppliers often find themselves with a glut of merchandise that they discount
heavily to sell.
4. Prices of related goods: If prices of related goods change, the demand curve for the
original good can change as well. Related goods can either be substitutes or
complements.
o Substitutes are goods that can be consumed in place of one another. If the
price of a substitute increases, the demand curve for the original good
shifts to the right. For example, if the price of Pepsi rises, the demand
curve for Coke shifts to the right. Conversely, if the price of a substitute
decreases, the demand curve for the original good shifts to the left. Given
that chicken and fish are substitutes, if the price of fish falls, the demand
curve for chicken shifts to the left.
o Complements are goods that are normally consumed together. Hamburgers
and french fries are complements. If the price of a complement increases,
the demand curve for the original good shifts to the left. For example, if
McDonalds raises the price of its Big Mac, the demand for french fries
shifts to the left because fewer people walk in the door to buy the Big Mac.
In contrast, If the price of a complement decreases, the demand curve for
the original good shifts to the right. If, for example, the price of computers
falls, then the demand curve for computer software shifts to the right.
TABLE 5
Change in Supply due to an
Increase in Video Costs
Paradoxes Resolved
We now have the tools necessary to explain more fully some of the paradoxes presented at
the beginning of the chapter. Why do school teachers earn $30,000 per year while some
star athletes earn $18 million per year? Although differences in demand are important, the
salary differentials are driven primarily by differences in the supply curves of the two
markets. The number of excellent school teachers in the U.S. is quite high. To teach at
most grade schools and high schools, one must attend college and typically earn a degree
and an education certificate. Thousands of students take such a track in life. In contrast,
star athletes are extremely rare. Home run hitters in baseball such as Babe Ruth, Mark
McGwire and Barry Bonds only come along so often. Likewise, talented basketball
players such as Michael Jordan and Moses Malone are rare. The incredibly small supply
of such superstars, coupled with a high demand for their services, allows them to
command enormous salaries. Is it fair that teachers are paid such dismal salaries relative
to the athletes? Many teachers may not think so, but again, fairness is a relative concept.
A couple that purchases diamond engagement rings for one another are undoubtedly
shocked by the high prices of diamonds. The same couple can stop at a water fountain and
take drinks of water for free. Married couples can survive without diamond rings--water is
essential. What accounts, then, for the high relative price for diamonds? Supply and
demand factors both play important roles in this example. In most parts of the world,
diamonds are in far shorter supply than drinking water. Consumers also value a diamond
more than a glass of water under normal circumstances. The relatively small supply and
the relatively high demand for diamonds drive their prices high relative to water.
Let's carry this paradox one step further. Suppose that the married couple somehow
becomes stranded in the desert with no water to be found. A man approaches carrying a
large jug of water. He offers to trade the water for the diamond rings. Does the couple
make the exchange. Why or why not?