 Okay. Having talked about basic concepts in the first lectures, we're going to go now in these next three to the wonderful apparatus of supply and demand and how they can be used to think about and understand price determination, the way prices change, the way market quantities change. So now we're on to supply and demand. Let me, for those who aren't used to it yet, I want to just sketch the whole picture quickly. And then we're, so I'll quickly put supply and demand together and show you the axes. And then we're going to go slowly and think much more carefully about what demand means. What does it mean for demand to increase or decrease? We'll talk about the difference between demand and quantity demanded, which that's an important distinction. We'll talk about what changes in demand mean, and then we'll talk about on this section on demand. We'll talk about the factors, the main factors that can change demand. But first of all, sort of as an introduction to supply and demand overall, let me just quickly sketch the supply and demand graph for you. By convention, we put price on the vertical axis, and we put quantity on the horizontal axis. Okay? So we're looking at the relationship between price and quantity. The demand curve is downward sloping, D for downward sloping, the demand curve is downward sloping because logically at higher prices, other things being equal, people will want to buy a smaller quantity. Higher quantities are wanted for purchase when the price is lower. So that's why the demand curve slopes downward. The supply curve goes in the other direction, and logically, according to what we'll talk about as the law of supply, if sellers, the suppliers can only get low prices for their product, they wouldn't be so excited about selling so much, so they'll have smaller quantities at lower prices. But if prices that people will pay is high, sellers will be excited about that, and they'll be willing to offer a larger quantity for sale. So we start with that, and then here is the magic point. This intersection is what the graph represents as the market equilibrium, and there's a very strong tendency for the price that prevails in the market to be at that level. Very strong tendency. If markets are free, there's a very powerful push and pull toward that price level. And similarly, the equilibrium quantity down here, this will be the quantity that changes hands in the market. And all of this is in a period of time. Anytime you see a graph like this, unless otherwise specified, it means in a period of time. So that's the quantity that's bought by some people, sold by others in a week or in a month or whatever the period might be. So this is sort of the punchline. This is where we're going to get just as an overview for those who haven't had the supply and demand analysis yet. Now let's focus in on demand and what we mean by demand. The basic insight is absolutely familiar to almost all of us. If a store wants to get rid of its summer clothing to put on the shelves its fall clothing, what are they going to do? How can a store get rid of the clothing it has on the racks now? Lower their prices. There's the law of demand. The point I want to make here is that everyone is familiar with it, even if they never have heard that term before. The law of demand holds that other things being equal. At higher prices people don't want to buy as much. At lower prices they want to buy more. Now demand refers to actual and potential buyers and the prices they're willing to pay. So it's the buyers and the prices they're willing to pay. It's a representation of people who might be willing to buy this good whatever it might be. Now as we've said different people have different values, right? Different people will pay different amounts for things. They have different intensity of desire. One of you earlier pointed out the case of an auction. At an auction we discover how much different people are willing to pay for something. It's the identical good, but different people are willing to pay different amounts for us. Well with a demand curve we try to represent that. In the absence of a graphical or conceptual representation like demand, we're faced with the fact that there are all these people who are interested in buying whatever good it is. And they're in different places, well how do we organize it in our mind so we can think about it well? What we do is create a demand curve or a demand schedule. So a demand curve or a demand schedule is a way of organizing in our minds this great diversity of the buyers. And what we do is we say okay let's suppose we could line them up. We'll put whoever's most willing to pay first and then who's willing to pay the next amount and then the next and the next and the next and so on. And we'll line them up mentally. That's what a demand curve is. It's not something that's inherent in the nature of things. A demand curve is a human artifact. It's a really cool piece of let's think about it this way. Now if you will take a look please at the graph that I gave you on the table here with that imagines a very, very simple market for bottles of water and five different people whose names just by funny accident start with A, B, C, D and E. And I've made up for them just arbitrarily different willingness to pay for additional bottles of water. So you see this represented in the page in front of you or on the screen. We'll imagine Arthur's willing to pay $3 for a first bottle. Once he has one he's willing to pay only a dollar for a second and he doesn't even want a third. And similarly for the other imaginary characters in this market okay. Well how do we make sense of this complex reality, these different people with their different wishes? As I said we line them up in our imaginations and we get this demand curve where Charlie who's willing to pay the most is over there and he's willing to pay $10 so he's the first one there and he's in that position. The person willing to pay the next most is Ellie so she is in the second position willing to pay $9 and we arrange the various buyers in this market according to their willingness to pay in the manner that's shown. You're with me? That's what we do. In principle guys all demand curves are that way. Now most of the time we'll have something simple, we won't have names on them, we'll just have the smooth curve drawn in a downward fashion but when you see a demand curve like that I recommend that you think of it not as a line on a whiteboard or on a page but think of it as representing different people. Every point on that curve is somebody who's willing to pay that amount for one more of whatever the good is. That's what a demand curve represents, it represents people's different willingness to pay for things okay. Alright by convention we put all values on the vertical axis so we put price on the vertical axis in the case of a demand curve which really represents the value of each marginal good to each next buyer. On the vertical axis we could label that willingness to pay or value to buyer. The downward slope that you'll notice represents the law of demand we've talked about, other things being equal at lower prices people are willing to buy more. Again think of a demand curve as representing human psychology, representing human behavior. Don't think of supply and demand graphs as exercises in geometry. Alright now there are two kinds of information represented by the curve. One is information about quantity for every price. A demand curve will give you a quantity that people are willing to buy at every different price. So that's one kind of information that a demand curve gives you. At any price you might be interested in it will tell you the quantity demanded. I'll repeat that because that's sort of fundamental. At any price a demand curve shows you the quantity demanded at that price. But now let's turn it around. You can take it the other way. What does a demand curve tell us about any quantity, any marginal quantity that might be purchased by the people in this market? Take for example the seventh bottle of water. What does the demand curve tell us about that seventh bottle of water? It'll be valued at $3 and go to Betsy. It's valued at $3 to the buyer or it's worth $3 to the buyer. Good. So for any marginal, any additional unit that might be purchased the demand curve tells you the value to the purchaser. All right? And those are the two kinds of information that a demand curve gives us. Take a look at my description of Arthur, Betsy, Charlie, Donna and Ellie. What do you notice under willingness to pay about what happens to their willingness to pay for each additional or marginal bottle? Are they willing to pay more or less? Less. Less. Less. That makes sense. Take a moment and think. This is a standard principle in economics we call the principle of diminishing marginal utility, meaning that with each additional or marginal unit of something we have, the utility or usefulness or value to us goes down. Why would the value or the utility of each additional unit of something decrease for us? Well, once you've already satisfied your thirst on the first bottle, each subsequent bottle is less valuable. Sure. In this case, when we're thinking about water for satisfying our thirst, if you're thirsty, that first bottle really matters, right? Once you've had the first one, is the second one as attractive? No, you may still want a second bottle, but not as badly as you wanted the first one. Okay? That's the principle of diminishing marginal utility. Remember now, if we're talking about identical units, each additional identical unit of something will be of less value to someone because with the first unit, he or she has satisfied the most urgent want for it. That's the principle of diminishing marginal utility. Now, quantity demanded, as we've just seen, is meaningful at any price. At any price, we can see the different quantity demanded in a market from a demand curve. Demand is that whole curve. It's that whole line, that whole jagged line. The demand is the entire set of relationships, okay? So you could answer it this way. You could say, what is demand here? It says, well, it's one bottle at $10, two bottles at $9, three bottles at $7, and you could go right down and say it that way. That would be demand. With reference to the graph, the demand is that entire curve, not a position on the curve, but the whole curve. So to repeat, quantity demanded is a point that makes sense at some price. So quantity demanded is that point at the price. But demand is the whole curve, okay? Let's think now about the kinds of things that can increase the demand overall. If you look at the next piece of paper that I've given you to look at, the next graph, I imagine that two new guys come into the market. One is named Frank, one's named Gary, and each of them has a different individual demand or desire for water. Frank will pay $11 for a first bottle and $6 for a second. Gary is willing to pay $7 for a first bottle, $5 for a second, and $1 for a third. So if we add the demand of those two guys to the demand we already had in the market, we go from that curve on the left to the one on the right, and we actually, I've plotted in there for you, the willingness of each of those two men to buy water. So here the demand overall has increased. The whole curve has shifted out to the right. The whole set of relationships has changed. You're with me? What has happened to quantity demanded at every price? What has happened to quantity demanded at every price? It has increased, increased, increased, okay? And that's one meaning of an increase in demand. Thinking right and left about starting with prices. An increase in demand means at any price, quantity demanded is larger now. That's thinking of it as a rightward shift. But we can also think of it as an upward shift, okay? That's how to make sense of a demand curve. Now let's think about the kinds of factors that can change demand. I'll give you a product and a factor that can cause a change in demand, and you tell me does demand increase or decrease, okay? So let's take the market for assisted living facilities. This is actually something that being a baby boomer is a little unpleasant for me to think about, but it makes for a good example. As the baby boomers retire, what probably will happen to the demand for assisted living facilities? Increase. Will increase. God help us all. How about, so to give you the category, demographic changes can change demand. Immigration, aging of a population. So I'm giving you now factors that typically will change demand. One of them is a change, is a demographic change, a change in population patterns, okay? Next one is tastes. What has happened in the United States to the demand for cigarettes over the last four or five decades? Has it increased? What has happened to the demand for cigarettes? It's decreased because people aren't interested in smoking so much, mostly for health reasons. So different tastes will affect demand. What has happened to, the category here is substitute prices. Let's think about Pepsi Cola and Coca-Cola. What will happen to the demand for Coca-Cola? What will happen to the demand for Coca-Cola if Pepsi gets more expensive? If Pepsi gets more expensive, will the demand for Coca-Cola increase or decrease? Increase. It'll increase because people will turn away from, we call these substitutes, Coke and Pepsi are substitutes. So if the price of one substitute gets higher, people will go to the other and increase the demand therefore for that. How about compliment prices? Peanut butter and jelly are compliments. We like to eat them together on our sandwiches. If the price of jelly goes up, other things equal, what do you suppose will happen to the demand for peanut butter? Don't say anything while I think it through. If jelly gets more expensive, what's the reason? What will happen to the demand for peanut butter? Decrease. It'll decrease. Why? Demand for jelly will be decreased. Careful. The quantity demanded for jelly will decrease. If the price of jelly rises, the quantity demanded will decrease. If people are buying less jelly, they have less demand for peanut butter to go with it. Prices of substitutes will affect demand of its substitutes. Prices of compliments will affect demand. Expectations. Suppose people in the United States for some reason come to expect gasoline prices to be much higher next week. What will happen to demand today? Increase. Increase. High rocket will increase because people will want to fill up their tanks before prices go up. It's really quite a wonderful thing. That sort of thing is an illustration of how wonderfully rapidly markets will work. The minute people expect prices to be higher next week, they're higher today because demand increases. And finally, what we call derived demand, where the demand for an input product, a resource, is derived from the demand for what that resource is used to produce. So let's take housing. Suppose that housing is booming. As housing booms, what will happen to the demand for 2x4s with which to build houses? If housing booms, demand for 2x4s will increase. So those are some of the kinds of things that affect demand and can change demand. Let's shift the whole curve.