CHAPTER 2: DEMAND, SUPPLY & MARKET EQUILIBRIUM

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CHAPTER 2: CHAPTER 2: DEMAND, SUPPLY & MARKET EQUILIBRIUMDEMAND, SUPPLY & MARKET EQUILIBRIUM

1.1 Introduction: Market Mechanism Principles 1.2 Demand 1.3 Supply

1.4 Market Equilibrium1.5 Change in SS & DD

1.6 SS/DD Analysis Example

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DD & SS Interaction

Output (Product) MarketOutput (Product) Market

Utility (excluded)Consumer surplusFactors effect DD

Elasticity

ProductionSupplier surplusFactors effect SS

ElasticityMarket structure

Changes in DD / SS:Equilibrium Price &

Quantity

Input (Factor) MarketInput (Factor) Market

Microeconomics scope for UBEA 1013 Economics

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1.1 Introduction: Market Mechanism Principles1.1 Introduction: Market Mechanism Principles

Demand & supply

interaction

Economics decision-making units

Market & the circulation flow

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1.2 Demand1.2 Demand

Definition: “Demand” can be defined as the purchase of product.

ONE household / individual

Market demand

ALL Household / Individual

Household / individual demand

Demand curve (graph) Demand function (equation)

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Demand curve (graph):

Quantity of X demanded, QdX = f (PX; PY, I, preference, and others)

Demand function (equation):

Factor effecting demandFactor effecting quantity demanded

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Quantity of X demanded, QdX = f (PX; PY, I, preference, and others)

Demand function (equation):

Law of Demand:– negative, or inverse relationship

between price & quantity– movement along demand curve– change in quantity demanded

(i) Relationship of products: – substitution or complement product: (PY) – normal, luxury or inferior products: (I)(ii) Shift of DD curve: (PY, I, preference, and others) – (later section) new equilibrium price & quantity

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Law of Demand:

Figure 2.3: Price & Quantity Demanded: The Law of Demand

Law of Demand:– negative, or inverse relationship– movement along demand curve– change in quantity demanded

Why?:Due to the income constraint and utility interaction.

Exception?: Giffin product.

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Shift of DD curve & Relationship of products:

PY change: Substitute

– Substitutes are products that can replace one another – Positive relationship between PY and demand for X

(the substitute product): When (PY) increases, demand for X increases.

– Examples: Coffee & tea; Coca-cola & Pepsi Cola

Law of demand Substitution product

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PY change: Complement

– Complement are products that are consumed together

– Negative relationship between PY and demand for Z (the complement product): When (PY) decreases, demand for Z increases.

– Examples: Car & petrol; coffee & sugar

Law of demand Complement product

Shift of DD curve & Relationship of products:

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Income change: Normal Product– Demand increase when income

increase – Examples: Cloth & movie

Normal product

Inferior product

Income change: Luxury Product– Same effect as normal product but

demand increase more when income increase

– Examples: luxury car.

Income change: Inferior Product– Low quality products (potato &

secondhand cloth) – Income increase, demand decrease

(able to buy better quality product).

I ↑

I ↑

Shift of DD curve & Relationship of products:

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Necessity Product? Insignificant product?

– Their consumption did not effect much by change in income. Their consumption is only a very small percentage of total income.

– The demand curve did not shift (or shift too little that we can ignore)

– Examples: salt

Shift of DD curve & Relationship of products:

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Other factors: Taste / preference

Other factors: Expected future price

Other factors: Increase of buyer

– Demand increase when taste / preference towards the product increase (DD curve shift to the left)

– Examples: low fat item & fashion

– Demand increase when Future price of product is expected to increase (DD curve shift to the left)

– Examples: If petrol price to increase from 12am tomorrow, demand for petrol increase immediately (today).

– Increase in number of buyer, increase demand (DD curve shift to the left)

Shift of DD curve & Relationship of products:

… continue

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1.3 Supply1.3 Supply

Definition: “Supply” can be defined as selling of product.

ONE firm

Market supply

ALL firms

Individual (firm) supply

Supply curve (graph) Supply function (equation)

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Supply curve (graph):

Quantity of X supplied, QSX = f (PX; K, L, technology, PY and others)

Supply function (equation):

Factor effecting supplyFactor effecting quantity supplied

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Quantity of X demanded, QSX = f (PX; K, L, technology, PY and others)

Supply function (equation):

Law of Supply:– positive relationship between price & quantity– movement along supply curve– change in quantity supplied

Shift of SS curve: (K, L, technology, PY and others) – (later section) new equilibrium price & quantity

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Law of Supply:

Figure 2.7: Price & Quantity Supplied: The Law of Supply

Law of Supply:– positive relationship– movement along supply curve– change in quantity supplied

Why?:Due to the higher revenue & profit (assuming every quantity supplied can be sold).

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Shift of SS curve:

Change in K, L, technology, PY:

– E.g. reduced in cost of capital, reduced in wages, technology improvement, price of other product decline, expected future price to decline >>> shift the SS curve to the right

Law of supply

Shift of SS curve

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DD & SS Interaction

Output (Product) MarketOutput (Product) Market

Utility (excluded)Consumer surplusFactors effect DD

Elasticity

ProductionSupplier surplusFactors effect SS

ElasticityMarket structure

Changes in DD / SS:Equilibrium Price &

Quantity

Input (Factor) MarketInput (Factor) Market

Microeconomics scope for UBEA 1013 Economics

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DD & SS Interaction

Output (Product) MarketOutput (Product) Market

1.4 Market Equilibrium1.4 Market Equilibrium

3 set of market condition:

(a) The quantity demanded equal the quantity supplied at the current price. This situation called “equilibrium”

(b) The quantity demanded exceeds the quantity supplied at the current price. This situation called “excess demand”

(c) The quantity supplied exceeds the quantity demanded at the current price. This situation called “excess supply”

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(a) Equilibrium

Quantity supplied = Quantity demanded

(No tendency for the market price to change )

Quantity supplied > Quantity demanded(Excess supply or surplus)

Equilibrium quantity

Equilibrium price

Equilibrium point

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(b) Excess demand (shortage)

Quantity demanded > Quantity supplied

Price tend to rise (as buyer willing to pay more)

Price increases >> quantity demanded fall (law of demand) while quantity supplied rise (law of supply).

Price increase to RM 20 (all excess demand wipe out by increased in quantity supplied and reduced in quantity demanded.

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(c) Excess supply (surplus)

Quantity supplied > Quantity demanded

Price tend to drop (as seller willing to sell at lower price)

Price drop >> quantity demanded rise (law of demand) while quantity supplied drop (law of supply). Price drop to RM 20 (all excess supply wipe out by decreased in quantity supplied and increased in quantity demanded.

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Figure 2.12: Changes in Equilibrium

(a) Increase in demand (b) Increase in supply

(c) Decrease in demand (d) Decrease in supply

1.5 Change in Supply and Demand1.5 Change in Supply and Demand

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Figure 2.13: Relative Magnitude Change: Supply Increase & Demand Decrease

(a) Supply change > demand change (b) Supply change < demand change

(a) Supply change > demand change (b) Supply change < demand change

Figure 2.14: Relative Magnitude Change: Supply & Demand Increase

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Relative Magnitude Change: Supply Decrease & Demand Increase

(a) Supply change > demand change (b) Supply change < demand change

(a) Supply change > demand change (b) Supply change < demand change

Relative Magnitude Change: Supply & Demand Decrease

D1D0

D1D0

S1S0

S1 S0

P0

P1

Q0Q1

P0

P1

Q0 Q10 0

Price

Quantity

Price

Quantity

↓ SS > ↑ DD ↓ SS < ↑ DD

D0D1D1

D0

S1S0

S1

P0

P1

Q0Q1

P1

P0

Q1 Q00 0

Price

Quantity

Price↓ SS > ↓ DD ↓ SS < ↓ DD

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DDSS

Decrease

Unchanged

Increase

Decrease Unchanged Increase

Unchanged

Q down[Note 1]

P downQ down

P upQ up

P up[Note 3]

Q up[Note 4]

P downQ up

P upQ down

P down[Note 2]

Note 1: P up if ∆ DD < ∆ SS

Note 2: Q up if ∆ DD < ∆ SS

Note 3: Q up if ∆ DD > ∆ SS

Note 4: P up if ∆ DD > ∆ SS

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Equilibrium: Special Case

SS

Quantity

D0

D1

P1

P0

Q0

Price (1) Vertical SS curve:

Example of vertical SS is supply of durian.

The equilibrium quantity is determined entirely by supply condition.

The equilibrium price is determined entirely by demand condition.

(2) Horizontal SS curve:

Horizontal SS exist when all suppliers fixed a price for any quantity.

The equilibrium quantity is determined entirely by supply condition.

The equilibrium price is determined entirely by demand condition.

SS

Quantity

D0

D1

Q1

P0

0

Price

Q0

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Equilibrium: Special Case

DD

Quantity

S0

P1

P0

Q0

Price (3) Vertical DD curve:

Example of vertical DD is demand for necessity products like salt.

The equilibrium quantity is determined entirely by demand condition.

The equilibrium price is determined entirely by supply condition.

(4) Horizontal DD curve:

Horizontal DD exist when there is only one market price consumers willing to pay.

The equilibrium quantity is determined entirely by supply condition.

The equilibrium price is determined entirely by demand condition.

DD

Quantity

S0

S1

Q1

P0

0

Price

Q0

S1

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1.6 Supply and Demand Analysis: An Example1.6 Supply and Demand Analysis: An Example

(a) Proton Berhad decreases the price of its car model, Proton Savvy from P0 to P1. Explain the law of demand

and based on it, explain what will happen to the quantity demanded for Proton Savvy car. Sketch a graph to illustrate your explanation.

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(b) What will be the effect of Proton Savvy car price drop to its competitor model, the Perodua MyVi? Sketch a graph to illustrate your explanation

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(c) Assume that Proton Savvy cars need a specific regular maintenance service to bring out the performance of the car. Based on situation in (a), what will happen to the demand of that specific regular maintenance service?

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(d) Assume Proton Savvy car has an inelastic price elasticity of demand. If Proton Berhad drops the price of its Proton Savvy car to increase its revenue from its Proton Savvy sales, do you think it is a wise strategy?

Not a wise strategy.Percentage of quantity demanded increase is less than percentage of price drop.Increase in revenue due to quantity demanded increase is less than decrease in revenue due to price drop. Therefore, the net effect is that revenue will drop, not increase.

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