Lectures in Economics 4

Lectures following Rüdiger Dornbusch’ works (4)
FIGURE 3-1 DEVELOPING THE DEMAND CURVE.

(Figures will be presented on special pages.)

The diagram shows how the prices and quantities demanded specified in Table 3-1 can be translated into a demand curve. The vertical axis measures price and the horizontal axis quantity demanded. We can pick a price in the table, say, \$1, and observe the corresponding quantity demanded, 40 million pounds. Point A represents the price-quantity combination. Similarly, point B represents a price of \$4 and the corresponding quantity demanded of 10 million pounds. Plotting all the data in the table and connecting the resulting points yields the demand curve, shown as the negatively sloping schedule.

We are going to reexamine the discussion of excess supply, excess demand, and equilibrium. This is done in Figure 3-3. Now we have labeled the demand schedule as DD and the supply curve as SS. When the quantity demanded exceeds the quantity supplied at a given price, the horizontal distance between the demand and supply curves is the excess demand. At a price of \$2, for example, the quantity supplied is only 10, and the quantity demanded is 30. There is an excess demand of 20, shown by the distance AB in Figure 3-3. When the quantity supplied exceeds the quantity demanded at a given price, there is an excess supply.

FIGURE 3-2 THE SUPPLY CURVE. The data in Table 3-1 include for each price the corresponding quantity supplied by sellers. The price-quantity curve can be plotted to yield the supply schedule, SS. The supply schedule is upward-sloping, showing that price increases, so does the quantity supplied.

At a price of \$4, the quantity supplied and quantity demanded are 30 and 10, respec tively. There is an excess supply of shown by the distance CF.
When there is an excess supply, we say that there is a surplus. Suppliers wan sell more than buyers want to buy. The suppliers will be out looking for customers, but the customers can’t take all thet at the going price, and they do not want to buy as much as sellers would like to sell. When there is an excess demand, we say there is a shortage. Buyers look for sellers hoping to find someone who has the needed goods. But the total quantity demanded exceeds the quantity supplied, and buyers cannot buy as much as they would like.

Price Determination
Now we will discuss price determination.

(CHAPTER 3
DEMAND, SUPPLY, AND THE MARKET. CONTINUED)

FIGURE 3-3 EXCESS DEMAND AND SUPPLY.
At point E the market price is such that the quantity demanded by buyers is equal to the quantity supplied by sellers. The market is in equilibrium. At a higher price there is an excess supply or a surplus of the quantity sellers want to sell over the quantity demanded. At a lower price there is a shortage or an excess demand, as the quantity demanded exceeds the quantity supplied.

Sellers find themselves running out of fish before all the customers who want to buy at that price can obtain the quantities they want. The price therefore rises. At any price above \$3 there is an excess supply. Sellers find that they cannot sell as much as they want at that price and are left with unsold fish. They therefore reduce the price. Only at point E in Figure 3-3 is there neither excess demand nor excess supply. At point E the quantity demanded at the \$3 price is equal to the quantity supplied, the market clears, and there is no reason for the price to change. Thus \$3 is the equilibrium price, and 20 (million pounds per week) is the equilibrium quantity.

4 BEHIND THE DEMAND CURVE

To get a firmer idea of the determinants of the equilibrium price and quantity, we ask what is behind the data in Table 3-1 and in the diagrams. In concentrating on the relationship between the quantity demanded and the price, we are implicitly assuming that other things are constant. What are those other things? Similarly, in saying that the quantity supplied increases with the price, we are assuming that other things are given, or ceteris paribus. What are the relevant factors that are taken as given?
Three factors are important on the demand side: the prices of related goods, consumer income, and consumer tastes. We now look at each of these factors.

Prices of Related Goods
Changes in the prices of related goods will affect the demand for a good. Let us think about the demand for automobiles and ask what are the other relevant prices that affect the demand for automobiles. One price that matters is the price of public transportation, which is an alternative form of transportation. Another price that is relevant is the price of gasoline, for it affects the cost of using an automobile and therefore the desirability of owning an automobile. How could a change in either of these prices affect the dcmand for automobiles? A rise in the price of public transportation would shift people from using buses and subways to owning and using automobiles. The demand for automobiles increases when the price of public transportation rises. That is, at each given price buyers stand ready to buy more than they did at the same price before. Next consider a rise in the price of gasoline. The increased cost of using an automobile (given other things, including the price of public transportation) would shift people from owning and using cars to using public transportation, bikes, or their own two feet.

In everyday language we think of public transportation as a substitute for automobiles. When people switch away from public transportation, they use instead (or substitute) cars. We can say that using public transportation is a substitute for automobile use because an increase in the price of public transportation leads people to use cars more. Economists use a more exact definition of substitutes, which is introduced in Chapter 5 of the companion volume.2

But the everyday languge certainly gives the right idea of what a substitute is. We can also use everyday language to say that gasoline and cars are complements, for when the price of gasoline rises, people reduce the use of cars. Again, the economist’s definition is slightly different, but the everyday language gives the right idea.
How do these ideas about substitutes and complements relate to the demand for fish? Clearly, other foods (meat, poultry, etc.) are substitutes, and a rise in their prices will shift people toward fish consumption, raising fish demand. It is harder to think of fish complements-commodities whose rising prices would reduce the demand for fish. In some countries where fishand-chips (fried fish and french fries) is a typical dish, one might expect potatoes to
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2 In that text we say that using public transportation is a substitute for using cars because an increase in the price of public transportation leads people to use cars more. But does an increase in the price of cars lead people to use public transportation more? Sometimes these questions have different answers. For instance think of sugar and coffee. An increase in the price of sugar leads people to drink less coffee (suggesting that sugar and coffee are complements). But an increase in the price of coffee could increase the consumption of sugar (suggesting that coffee and sugar are substitutes). How could this happen? Suppose that people use more sugar in tea than in coffee. Then when the price of cof fee goes up, they switch to tea and use more sugar. We wouldn’t want to have a definition that says coffee and sugar are substitutes in one sense and complements in another. They should be either substitutes or conlplements. The economist’s definition avoids this difficulty (see companion volume).
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be a complement for fish. The difficulty thinking of a complement for fish suggests that goods are typically substitutes and that complementarity, while present many instances, is a more special feature (hats and feathers, coffee and nondairy cream, hammers and nails, screws and screwdrivers).

Income
The second important factor underlying 1 demand curve, in addition to the prices of other goods, is income. When income goes up, the demand for most goods will increase. But there are exceptions.
A normal good is a good for which deman increases when income rises, inferior good is a good for which demand falls when income rises. Inferior goods are typically goods for which there are alternatives of higher quality or greater convenience. For instance, bus riding is an inferior good. As income rises people reduce their use of buses and switch to taxis or their own cars. Margarine is another inferior good.3 As incomes rise, households buy more butter and less margarine.

Tastes
The third determinant of demand we take as given is tastes. Consumer tastes are shaped in part by convenience, social milieu and habits. The demand for haircuts is determined in part by social conventions about how long hair should be worn. Demand for textiles to produce skirts depends on fashions and the length of skirts. The health and fitness consciousnes today has expanded the demands for gimn equipment, health centers, natural foods, and tennis facilities while redu-
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3 Studies of the demand for margarine show that margarine is inferior. It might be that the concern over amount of cholesterol in the diet has transformed margarine from an inferior good to a normal good. There are not yet enough years of data to show this versatility.

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cing the demands for creamy cakes and other rich foods.
Conventions, habits, and tastes are quite stable. They usually change gradually over time (except perhaps for clothing fashions). But when they change, demand behavior also changes.
Along with tastes and habits, new products also affect demand. The invention of new products, such as hand-held calculators, automobiles, personal computers, or light beer, affects demand behavior in markets for related goods-just as changes in the prices of goods do. Indeed, one way of thinking of the introduction of a new good is to say that its price has just fallen from infinity (making it effectively impossible to buy) to an affordable range.

5 SHIFTS OF THE DEMAND CURVE
The demand curve is drawn for given tastes, the prices of related goods, and consumer income. What happens to the demand curve when there is a change in one of these factors2 Specifically, looking again at the fish market, suppose there is an increase in the price of beef. Consumners will then shift their purchases of food away from beef and toward fish. At each price of fish, there will be an increase in the quantity of fish demanded. Table 3-2 shows how the demand for fish increases as a result of the beef price
increase. Figure 3-4 shows the same thing with a shift in the demand curve from DD to DD’. At every price iţor fish there is an increase in the quantity demanded, as shown by the rightward shift of the entire demand schedule.

A change in demand conditions changes the equilibrium price and quantity. In Figure 3-5 the demand schedule shifts from DD to DD’. At point E, the initial equilibrium, the price was \$3 and the quantity was 20 million pounds. The increase in the price of beef has shifted the demand curve to the right. At the initial equilibrium price of \$3, the quantity demanded is now 40 million pounds, shown at point F. There is an excess demand of 20 million pounds at the price of \$3. The excess demand leads to an increase in the equilibrium price from point E to E ‘. The price rises to \$4, and the equilibrium quantity offish produced and sold is 30 million pounds.

What explains the shift from E to E ‘ P When the price of beef rises, consumers decide to buy more fish. The sellers of fish find themselves unable to meet the new higher quantity demanded, and so they raise the price of fish and at the same time try to obtain more fish to sell. Because the price is higher, it makes sense to work longer hours to bring more fish to market, to import fish from other areas, and for more people to go into the fishing business.
FIGURE 3-4 AN INCREASE IN THE PRICE OF BEEF SHIFTS THE DEMAND CURVE FOR FISH. A rise in the price of beef increases the quantity of fish dernanded at each price. Thus the entire demand schedule for fish shifts to the right. At the \$3 price, for example, the de#mand was 20 million pounds originally and is now 40 million. The new demand curve, corre#sponding to the higher price of beef, is DD ‘.

FIGURE 3-5 AN INCREASE IN THE PRICE OF BEEF SHIFTS THE DEMAND SCHEDULE FOR FISH AND RAISES THE EQUILIBRIUM PRICE OF FISH. The increase in the price of beef shifts the demand for fish from DD to DD ‘. At each price the quantity of fish demanded in#creases. At the initial equilibrium price of \$3 there is now an excess demand of 20, equal to the distance EF. The equilibrium price there#fore rises, and the equilibrium quantity of fish supplied increases. The new equilibrium is at point E’, with the price equal to \$4 and the quantity equal to 30 million pounds per week.