Introduction to Demand

A market exists when buyers and sellers interact to exchange products. You might think that the easiest market to explore would be the interaction between one buyer and one seller. For example, suppose Crusoe has coconuts and would really like some fish, and Friday has fish and would really like some coconuts. There is the possibility for a mutually beneficial trade here, but we cannot predict what the price or quantity will be e en if we know their preferences because the outcome depends on their relati e bargaining skills. !ence, economic theory has little to tell us about this most simple of markets. "t is easier to analy#e a market in which there are many buyers and sellers, each small relati e to the o erall market. "t helps also if both buyers and sellers are well informed, and buyers and sellers form distinct and separate groups. To explain a market with these qualities, economists use supply and demand analysis. You should be aware that supply and demand analysis does not work in all markets, but only in those with the abo e characteristics. "f buyers are a group distinct from the sellers, we can analy#e how they act separately from how sellers act. $nly after we ha e looked at these two groups separately will we combine them and see how they interact. %e will begin by looking at the buyers. %hat determines the amount of a product that people are willing and ready to buy during some period of time& For example, what determines the amount of hamburger purchased in Chicago during a week& 'conomists answer such questions by examining the costs and benefits of buying the product. %hen any of the costs or benefits changes, the amount of the product that people will buy should also change. The benefits a person gets from a product depend on his goals. These goals are referred to in many ways in discussions of demand. The words "tastes," "wants," "needs," "preferences," and "usefulness" all refer to goals. %hen people(s goals change, the amount of benefit they get from the good changes, and this will cause them to change the amount of the good they want to buy. )oals *or preferences or tastes+ depend on many factors, such as the age of people and the amount of education they ha e. ,ocial custom is an important determinant of preferences and can account for many differences in demand among groups. $ne can explain the large differences in squid sales in -apan and the .nited ,tates, or the large differences in consumption of horse meat in 'urope and the .nited ,tates, almost entirely in terms of differences in preferences caused by differences in social custom.

Shortages and Surpluses

/iewing points on the demand cur e as points of buyer equilibrium and points on the supply cur e as points of seller equilibrium helps explain how an ad0ustment process takes place in the supply and demand model. "f price is originally P1 in the graph below, only Q1 will be sold e en though buyers would like to buy Q2. The difference Q2 - Q1 represents a shortage. The sellers are in equilibrium in this situation because they can sell e erything they want to sell at this price, but buyers are not. ,ome buyers who cannot obtain the product are willing to offer more, and sellers are always willing to accept a higher price. Therefore, the actions of the buyers, as they compete with each other to obtain the amount that is a ailable, dri e the price upward in this model toward market equilibrium.

"f price is originally at P1 in the picture below, only Q1 will be sold because this is all that buyers will purchase, e en though sellers are willing to sell more, Q2. The difference Q2 - Q1 is called a surplus. "n this situation the buyers are in equilibrium because they can buy all they want to buy at the going price. !owe er, the sellers are not in equilibrium and will compete among themsel es to get rid of the surplus. ,ome sellers will be willing to offer their product at a lower price. 1uyers are always willing to mo e down the demand cur e, so there is a tendency to mo e downward toward market equilibrium in the picture below.

"f left to itself, a supply2and2demand market tends to ad0ust to the point where the supply and demand cur es cross. The price at this intersection is called the market-clearing price. There is, howe er, the possibility that the existence of lags in the ad0ustment process may make the ad0ustment more complex than the pre ious discussion indicates. ,uppose that the price of cattle feed rises sharply. This e ent should affect the supply cur e of cattle by shifting it to the left. The profitability of cattle production is reduced at each possible price, and some producers will drop out of the industry while others will curtail production. 3ooking at the cur es, we see that price should rise and quantity should drop. !owe er, initially price might drop and quantity might rise, which is the exact opposite of the prediction from the supply and demand graph. The higher costs of feed will encourage farmers to raise fewer cattle, but as part of that cutback, they will temporarily send more cattle to the slaughterhouses. The prediction that supply2demand analysis gi es will ultimately be correct, but it will not be correct in the process of ad0ustment. 4ore complicated ad0ustment patterns are possible. ,uppose, for example, that higher beef prices shift the demand for pork to the right. ,upply and demand analysis says that this should increase pork prices, and at the higher prices, farmers should produce more hogs.

!owe er, hog production takes time, and will only happen if farmers expect the higher prices to continue for a long time. "f pork producers do expect the higher prices to last, they may decrease the number of pigs sent to slaughter, further increasing price. A sow can either produce pork or baby pigs, but not both. "f farmers expect high prices to last, they will keep their sows for piglet production. "n six months to a year, the baby pigs will ha e grown enough to go to market. "f enough farmers had expected the high prices to last, they may ha e produced so many pigs that pork prices will now plunge to a le el below that which is considered normal. The new, abnormally low price can then influence decisions that will not affect the price for many months. You should see that, once disturbed, a market with long time lags in production may bounce around for years before it finally finds its way back to equilibrium. "f such a market is disturbed often enough, its prices and quantities will ne er come to rest at equilibrium le els. 4icroeconomic discussion generally ignores ad0ustment problems, at least at the introductory le el. 4icroeconomics assumes that markets clear, that is, they are always in equilibrium. "ts analysis begins with the assumption that equilibrium has been reached and then asks questions about that equilibrium. !owe er, ad0ustment problems are ery important in macroeconomics. 4acroeconomics cannot assume there are no ad0ustment problems or else it assumes away one of the problems it wants to explain, unemployment. "n fact, much of macroeconomics is about the forces that bump an economy away from equilibrium, and why, once it is away, it has problems reaching a new equilibrium.

he !odel of Suppl" and Demand

To this point, we ha e de eloped two beha ioral statements, or assertions, about how people will act. The first says that the amount buyers are willing and ready to buy depends on price and other factors that are assumed constant. The second says that the amount sellers are willing and ready to sell depends on price and other factors that are assumed constant. "n mathematical terms our model is 5d 6 f*price, constants+ 5s 6 g*price, constants+ This is not a complete model. 4athematically, the problem is that we ha e three ariables *5d, 5s, price+ and only two equations, and this system will not ha e a solution. To complete the system, we add a simple equation containing the equilibrium condition7 5d 6 5s. "n words, equilibrium exists if the amount sellers are willing to sell is equal to the amount buyers are willing to buy. "f we combine the supply and demand tables in earlier sections, we get the table below. "t should be ob ious that the price of 89.:: is the equilibrium price and the quantity of ;: is the equilibrium quantity. At any other price, sellers would want to sell a different amount than buyers want to buy.

Suppl" and Demand ogether at #ast

<rice of %idgets 8>.:: 8?.:: =umber of %idgets =umber of %idgets <eople %ant to 1uy ,ellers %ant to ,ell >:: @: >: A:

89.:: 8A.::

;: A:

;: >A:

The same information can be shown with a graph. $n the graph, the equilibrium price and quantity are indicated by the intersection of the supply and demand cur es.

"f one of the many factors that is being held constant changes, then equilibrium price and quantity will change. Further, if we know which factor changes, we can often predict the direction of changes, though rarely the exact magnitude. For example, the market for wheat fits the requirements of the supply and demand model quite well. ,uppose there is a drought in the main wheat2producing areas of the .nited ,tates. !ow will we show this on a supply and demand graph& ,hould we mo e the demand cur e, the supply cur e, or both& %hat will happen to equilibrium price and quantity& A dangerous way to answer these questions is to first try to decide what will happen to price and quantity and then decide what will happen to the supply and demand cur es. This is a route to disaster. Bather, one must first decide how the cur es will shift, and then from the shifts in the cur es decide how price and quantity would change. %hat should happen as the result of the drought& $ne begins by asking whether buyers would change the amount they purchased if price did not change and whether sellers would change the amount sold if price did not change. $n reflection, one reali#es that this e ent will change seller beha ior at the gi en price, but is highly unlikely to change buyer beha ior *unless one assumes that more than the drought occurs, such as a change in expectations caused by the drought+. Further, at any price, the drought will reduce the amount sellers will sell. Thus, the supply cur e will shift to the left and the demand cur e will not change. There will be a change in supply and a change in quantity demanded. The new equilibrium will ha e a higher price and a lower quantity. These changes are shown below.

%hat should one predict if a new diet calling for the consumption of two loa es of whole wheat bread sweeps through the ..,.& Again one must ask whether the beha ior of buyers or sellers will change if price does not change. Beflection should tell you that it will be the beha ior of buyers that will change. 1uyers would want more wheat at each possible price. The demand cur e shifts to the right, which results in higher equilibrium price and quantity. ,ellers would also change their beha ior, but only because price changed. ,ellers would mo e along the supply cur e.