[MUSIC] Hi,Professor Navarro here. In the second lecture we will drill down into two keywords that you heard about often in your life, supply and demand. In particular I'll show you how the forces of supply and demand lead to an equilibrium in the market and thereby setting market prices. Perhaps most interestingly we will see that the market price reaches its competitive equilibrium at precisely the point that demand and supply curves cross. That's where the forces of demand and supply are just in balance. [MUSIC]. >> The British philosopher Thomas Carlyle once said teach a parrot the word supply and demand and you got an economist. Of course, economics is hardly that simple but Carlyle's raw observation does he hit on a basic truth of economics. Namely, that the concept of supply and demand rest at the core of any study of how the market system works. In this lecture, we're going to try and master some basic elements of supply and demand. Let's start then by looking carefully at this figure. It's a typical supply and demand diagram for a popular product in the consumer market, computers. Note that price will always be labeled on the vertical axis. And that quantity will always be labeled on the horizontal axis in these diagrams. Note also that the demand curve slopes downward and that the supply curve slopes upward. We will soon learn that where these two curves cross, we're likely to find the market equilibrium. Now let's construct each of the component parts of this diagram beginning with the consumer side of the equation, the demand curve. In order to build a demand curve, we've got to have some data on price and quantity. This we have in this table, which provides a demand schedule for corn flakes. Why don't you take out a pencil and paper now and try drawing a demand curve from this data? Did you label your axes correctly? Does your demand curve look like this? So, in this figure, the consumer will buy 20 boxes of cornflakes at point E, if the price is 1, but only 9 boxes at point A, if the price is 5. The implication of this downward sloping demand curve is that the lower the price, ceteris peribus, the more units the consumer will demand. And the higher the price, ceteris peribus, the less the consumer will demand. This is not just common sense, it's also a principle based on very careful scientific observation. It's called the Law of Demand. Why does quantity demanded tend to fall as price rises? For two reasons. First there is the substitution effect. When the price of a good rises, I will substitute other similar goods for it. For example, as the price of beef rises, I eat more chicken. Second reason why the quantity demanded falls as price rises is the income effect. This is because when, say, the price of beef rises, my purchasing power declines. And that portion of the increase of my purchases of chicken due to my reduction in purchasing power is the income effect. We'll talk more about the substitution and income effects in the next lecture. But in the mean time, what's this ceteris paribus stuff I just talked about? I kind of sneaked those words in on you, didn't I? But I did that on purpose because the concept of ceteris paribus is really critical to understanding economic analysis. The words ceteris paribus are Latin for other things constant. And economists usually use this ceteris paribus assumption to both draw their diagrams as well as isolate the effects of specific changes in a market. For example, in order to draw the demand curve in two-dimensional price and quantity space, we have to hold the other things constant. Which also affect the demand curve. Things like income and tastes and the prices of other products. These other factors are called shift factors because if one of these factors changes, the demand curve will shift inwards or outwards. For example, suppose the average income of consumers rises. With more money in their pockets consumers will tend to buy more of everything. Which way do you think the demand curve will shift in this case? That's right. It will shift outward just as a fallen income will shift the demand curve inwards. So how about a change in another shift factor, the prices of other goods? Think about it this way. Suppose you were analyzing the market for beef and the price of chicken rises. What do you think will happen to the beef demand curve? If you said the beef demand curve will shift out, you're right. This is because beef and chicken are substitutes for each other in the broader market for meat. So, if the price of one goes up, the demand for the other goes up or shifts. Other similar examples would include corn flakes and oatmeal, pens and pencils and oil versus natural gas. Still, a third shift factor has to do with consumer tastes. Suppose that tomorrow, the American Medical Association publishes a report that says. That people who eat prunes regularly live on average several years longer, while people who eat onion rings every day tend on average to live several fewer years. What do you think will happen to the demand for prunes and onion rings? But another way, which way will the demand curve shift? Now check this figure out to see if you got it right. This table summarizes the effect of the various shift factors on the demand curve in the automobile market. Note that besides income, prices of related goods and tastes, the table includes two other important shift factors, population and special influences.
