Supply and Demand - How Markets Work

1. Supply and Demand
How Markets Work

2. Marginal Values
The DIAMOND-WATER PARADOX:
• Why are diamonds so much more expensive than water?
• Even though water is obviously important to human
activity (life cannot exist without water), the price of
water is relatively low. Alternatively, diamonds are much
less important to human existence, but the price of
diamonds is substantially higher.
• Clarification of the diamond-water paradox results by
differentiating between total utility and marginal utility.

3. Marginal Values
• Marginal Utility: This is the extra satisfaction of wants
and needs obtained from consuming one additional unit
of good. That is, marginal utility is the incremental
satisfaction generated by, and the value of, a single unit
of a good.
• Values (and our choices) depend on the situation we
face.
• Just about anything could be more valuable than
anything else under appropriate circumstances: The
exact same diamond or glass of water may be valued
differently by different people, and even valued
differently at different times by the same person.
• Economists use the term “Margin”
(Decisions are made “at the Margin”)

4. Diminishing Marginal Utility
• The key to the marginal utility difference
between water and diamonds is the law of
diminishing marginal utility:
• as more of a good is consumed, eventually each
additional unit of the good provides less
additional utility - that is, marginal utility
decreases. Each subsequent unit of a good is
valued less than the previous one.
• Because diamonds are substantially less
plentiful, marginal utility is much higher. The law
of diminishing marginal utility is not active to the
same degree for diamonds as it is for water.

5. Everyday Choices Are Marginal Choices
Example: Study vs. Spending Time with Girlfriend?
The ‘economic way of thinking’ favors attention to
• marginal benefits
• marginal costs
There are no “all-or-nothing” decisions
Economic theory is sometimes referred to as
marginalism or marginal analysis because it
emphasizes the effects of additional benefits and
additional costs.

6. Law of Demand
• Law of Demand:
the inverse relationship between the price of a
good and the quantity consumers are willing to
purchase.
• As the price of a good rises, consumers buy
less.
• The availability of substitutes (goods that
perform similar functions) explains this
negative relationship.

7. Market Demand Schedule
• A market demand schedule is a table that
shows the quantity of a good people will demand
at varying prices.
• Consider the market for cellular phone service.
A market demand schedule lays out the quantity
of cell phone service demanded in the market at
various prices.
• We can graph these points (the different prices
and respective quantities demanded) to make a
demand curve for cell phone service.

8. Market Demand Schedule
Cellular phone
service price
(avg. monthly
bill)
Cellular
phone
subscribers
(millions)
$ 92 7.6
$ 73 16.0
$ 58 33.7
$ 46 55.3
$ 143 2.1
$ 41 69.2
120
100
80
40
0 20 30 40 50
Price
(monthly bill)
Quantity
(million
subscribers)
60
60 7010
140
Demand

9. Market Demand Schedule
• Notice how the law of demand
is reflected by the shape of the
demand curve.
• As the price of a good rises …
consumers buy less.
• NOTE: “Demand” is not a specific
number, but rather a relationship
among many numbers
(= a schedule or curve).
120
100
80
40
0 20 30 40 50
Price
(monthly bill)
Quantity
(million
subscribers)
60
60 7010
140
Demand

10. Normal Goods vs. Inferior Goods
• Goods and services can be categorized according to the
effect of the changes in income on demand.
• If an increase in income leads to an increase in demand,
then the product is a NORMAL GOOD (luxury cars,
steakhouse dinner…)
• Occasionally however, an increase in income may result
in a DECREASE for demand of a particular good. If this
happens, we are dealing with an INFERIOR GOOD.
Typically, inferior goods are low-budget items, where if
you had more money you would buy something else,
something nicer instead (subway tickets, cheap noodles,
generic brands...)

11. Normal Goods vs. Inferior Goods
The distinction between normal and inferior
products is important for business
decisions. When the economy is growing
and incomes are rising, the demand for
normal products will rise, while the demand
for inferior products will fall. By contrast,
when the economy is in recession and
incomes are falling, the demand for normal
products will fall, while the demand for
inferior products will rise.

12. Misperceptions caused by Inflation
• If we want to examine the effect of a particular
price increase, we must first abstract from the
effects of a general increase in prices.
• Example:
If the price of gasoline rose 50% during a period
in which the general price level rose 100%,
economic theory would predict an increase in
the quantity of gasoline demanded (gasoline
gets cheaper “in real terms”).

13. Changes in Demand and Quantity Demanded
• Change in Demand
– a shift in the entire demand curve.
• Change in Quantity Demanded
– a movement along the same demand curve in
response to a change in its price.

14. Demand Curve Shifters
• Change in the number of consumers
• Demographic changes
• Change in tastes and preferences
• Change in income (normal vs. inferior goods)
• Change in the price of substitutes
• Change in the price of a complementary good
• Change in the expected price of a good

15. Price Elasticity of Demand
Elasticity (= Responsiveness) to price changes is influenced by several factors:
•TIME
It takes time to find out and begin to use substitutes
•AVAILABILITY AND CLOSENESS OF SUBSTITUTES
Cup of coffee, Tacos…can be substituted with Tea, Burgers…Demand for such
goods is relatively elastic.
Gasoline, Electricity… have few close substitutes. Demand for such goods is
relatively inelastic.
•PROPORTION OF ONE’S BUDGET SPENT ON A GOOD
Salt, Toothpicks, Matches…relatively inelastic. (Low benefits of economizing – ‘low
involvement’)
Furniture…relatively elastic
•BUYER’S PRIOR COMMITMENTS
Cars (spare parts), Software (Upgrades) – whenever there is such a ‘lock-in’, demand
is less elastic.
The elasticity of demand helps a company decide how raising or lowering prices will
affect total revenue.

16. Producer Choice and the Law of Supply
Refresher on Opportunity Cost:
• The cost of an action is the value of the next-best alternative
opportunity sacrificed
• A decision for something is always a decision against something
else
• “De-cidere” = to cut off

17. Question for Thought
• Why do poor people travel between
cities by bus, while wealthy people
are more likely to travel by air?
• Answer: The higher one’s income, the
higher the opportunity cost of time

18. Costs are tied to Actions, not to Things
• Confusion between price and costs (Common
sense tells us that things have “real costs”)
• Costs are always tied to actions, decisions and
choices – COSTS TO WHOM?
• To see the true cost of things, recognize that
only actions have cost, and that actions can
entail different costs for different people
• Things cannot have a cost, only actions have a
cost, and these are the cost to the actor

20. Opportunity Costs of Production
• Producers purchase resources and use them to produce
output.
• Producers will incur costs as they bid resources away
from their alternative uses.
• Opportunity cost of production:
The sum of the producer’s costs of employing each
resource required to produce the good.
• Firms will not stay in business for long unless they are
able to cover the cost of all resources employed,
including the opportunity cost of the resources owned
by the firm.

21. Opportunity Costs of Production
• The resource that most clearly illustrates the opportunity
cost concept is land:
– Land can be used for residential, commercial, or
industrial purposes
– The cost you pay for land will be determined by the
alternative opportunities that people perceive for its
use
Question for Thought:
Why is there no potato field in the center of Prague?

22. Law of Supply
• Law of Supply:
there is a positive relationship between the price
of a product and the amount of it that will be
supplied.
• As the price of a product rises, producers will
be willing to supply a larger quantity.

23. Cellular phone
service price
(avg. monthly
bill)
Cellular
phone
subscribers
(millions) 120
100
80
40
0 20 30 40 50
60
60 7010
140
Supply
$ 60 5.0
$ 73 11.0
$ 80 15.1
$ 91 18.2
$ 107 21.0
$ 120 22.5
Market Supply Schedule
Price
(monthly bill)
Quantity
(million
subscribers
)

24. 120
100
80
40
0 20 30 40 50
60
60 7010
140
Supply
Price
(monthly bill)
Market Supply Schedule
• Notice how the law of supply
is reflected by the shape of
the supply curve.
• As the price of a good rises …
producers supply more.
Quantity
(million
subscribers)

25. The Irrelevance of Sunk Costs
• When making cost calculations do not look at the past, for the past
is filled with sunk cost (irretrievable cost)
• Sunk costs are irrelevant to economic decisions because the
represent no opportunity for choice
• The proper stance is to look forward to opportunity cost, which
always lie in the future
• Most people have difficulty putting this idea into practice. The
SUNK COST FALLACY is manifested when we have a greater
tendency to continue an endeavor once an investment in money,
effort or time has been made. (“Bounded Rationality”)

26. The Irrelevance of Sunk Costs
Examples:
A common mistake made by investors is reluctance to sell
securities at a loss. It does not matter what you paid for shares, if
the market price has fallen you have already made that loss. It is a
sunk cost and should be forgotten about. What matters is whether
the shares are worth holding or not at the current market price. A
key question is whether the shares would still be worth buying at
current prices. If not, they are probably not worth holding.
Colloquially, this is known as "throwing good money after bad".

27. The Irrelevance of Sunk Costs
If you have purchased a nonrefundable ticket to a concert, and you are feeling ill, you might attend the concert
anyway because you do not want the ticket to go to waste. However, the money spent to buy the ticket is sunk,
and the cost of the ticket is entirely irrelevant, whether it cost $5 or $100. The only relevant consideration is
whether you would derive more pleasure from attending the concert or staying home on the evening of the
concert.

28. The Irrelevance of Sunk Costs
• Sunk costs have a tendency to add up
• Example: Wrong career path? Cut your losses at time!

29. Changes in Supply and Quantity Supplied
• Change in Supply
– a shift in the entire supply curve.
• Change in Quantity Supplied
– movement along the same supply curve in
response to a change in its price.

30. Supply Curve Shifters
The following will cause a change in supply
(a shift in the entire curve):
• Technology changes
• Prices of substitutes
• Change in expected price (Hoarding)
• Change in overall number of suppliers
• Changes in taxes

31. Price Elasticity of Supply
• (1) Spare production capacity
• If there is plenty of spare capacity then a business should be
able to increase its output without a rise in costs and therefore
supply will be elastic in response to a change in demand. The
supply of goods and services is often most elastic in a recession,
when there is plenty of spare labor and capital resources
available to step up output as the economy recovers.
• (2) Stocks of finished products and components
• If stocks of raw materials and finished products are at a high
level then a firm is able to respond to a change in demand
quickly by supplying these stocks onto the market - supply will be
elastic. Conversely when stocks are low, dwindling supplies force
prices higher and unless stocks can be replenished, supply will
be inelastic in response to a change in demand.

32. Price Elasticity of Supply
• (3) The ease and cost of factor substitution
• If both capital and labor resources are occupationally
mobile then the elasticity of supply for a product is higher than if
capital and labor cannot easily and quickly be switched
• (4) Time period involved in the production process
• Supply is more price elastic the longer the time period that a
firm is allowed to adjust its production levels. In some agricultural
markets for example, the momentary supply is fixed and is
determined mainly by planting decisions made months before,
and also climatic conditions, which affect the overall production
yield.

33. Market Equilibrium
• This table & graph indicate demand & supply
conditions of the market for calculators.
• Equilibrium will occur where the quantity demanded
equals the quantity supplied. If the price in the market
differs from the equilibrium level, market forces will
guide it to equilibrium.
• A price of $12 in this market will result in a quantity
demanded of 450 … and a quantity supplied of 600 …
resulting in an excess supply.
With an excess supply present, there will be downward
pressure on price to clear the market.
7
8
9
10
11
12
13
Quantity demanded
= 450
Quantity supplied
= 600
Price ($)
450 500 550 600 650
D
S
Excess
supply Downwar
d
Price
(dollars)
Quantity
supplied
(per day)
Quantity
demanded
(per day)
12
10
8
Condition
in the
market
Direction
of pressure
on price
>600 450
550 550
500 650
Quantity

34. Excess
supply Downwar
d
Price
(dollars)
Quantity
supplied
(per day)
Quantity
demanded
(per day)
12
10
8
Condition
in the
market
Direction
of pressure
on price
>600 450
550 550
500 650
7
8
9
10
11
12
13
Price ($)
450 500 550 600 650
D
S
Market Equilibrium
• A price of $8 in this market will result in a
quantity supplied of 500 …and quantity
demanded of 650 … resulting in an excess
demand.
• With an excess demand present, there will be
upward pressure on price to clear the market.
Quantity supplied
= 500
Quantity demanded
= 650
Excess
demand Upwar
d
<
Quantity

35. Excess
supply Downwar
d
Price
(dollars)
Quantity
supplied
(per day)
Quantity
demanded
(per day)
12
10
8
Condition
in the
market
Direction
of pressure
on price
>600 450
550 550
500 650 Excess
demand Upwar
d
<
7
8
9
10
11
12
13
Price ($)
450 500 550 600 650
Quantity
D
S
Market Equilibrium
• A price of $10 in this market results in quantity
supplied of 550 …
• With market balance present, there will be an
equilibrium present and the market will clear.
and a quantity demanded of 550
…resulting in market balance.
Quantity demanded
= 550
Market
Balance Equilibriu
m
=
Quantity supplied
= 550

36. Excess
supply
Excess
demand
Equilibrium
price
7
8
9
10
11
12
13
Price ($)
450 500 550 600 650
Quantity
D
S
Excess
supply
Price
(dollars)
Quantity
supplied
(per day)
Quantity
demanded
(per day)
12
10
8
Condition
in the
market
Direction
of pressure
on price
>600 450
550 550
500 650 Excess
demand<
Market
Balance=
Market Equilibrium
• At every price above market equilibrium there is
excess supply and there will be downward
pressure on the price level.
• At every price below market equilibrium there is
excess demand and there will be upward
pressure on the price level.
• At the equilibrium price, quantity demanded
and quantity supplied are in balance.
Equilibriu
m
Upwar
d
Downwar
d

37. Outstanding Economist
Alfred Marshall (1842 – 1924)
• British economist Alfred Marshall was one of the most
influential economists of his era. Many concepts and tools
that form the core of modern microeconomics originated
with Marshall in his famous Principles of Economics, first
published in 1890. Marshall introduced the concepts of
supply and demand, equilibrium, elasticity, and the idea
of distinguishing between short-run and long-run
changes.

38. Recommended Reading
• Strategic Market Management
David A. Aaker, Damien McLoughlin; John Wiley & Sons, 2010

40. HISTORY OF POLITICAL AND ECONOMIC THOUGHT

41. FINANCIAL MARKETS: THE CITY OF LONDON

42. YOUR COUPON
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