2 Demand Supply and Equilibrium

7/30/2019 2 Demand Supply and Equilibrium

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Demand, Supply,

and Equilibrium


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T.J. Joseph 230 April 2013

How does a market work?

Markets are dynamic (like weather)

They are constantly evolving

A careful study of markets reveal certain forces

underlying the movements in a market

Need a model - demand & supply model to forecast

the prices and outputs in individual markets

In a competitive market SS and DD determine the

quantity of each good produced and the price at which

it is sold


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DEMAND


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Demand Schedule

Quantity demandedof any good/service by anindividual is the amount of the good/service that the

individual is willing and able to purchase at

alternative prices during a given period of time, and

other things held constant

A demand scheduleor demand curveshows the

relationship between the market price of a

good/service and the quantity demanded of thatgood/service, other things held constant


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Demand Schedule

Price per unit Quantity per week

10 20012 170

14 140

16 11018 80

It shows how demand varies with price, ceteris paribus


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Demand Curve

0

2

4

6

8

10

12

14

16

18

20

80 110 140 170 200

Qty demanded

Price

per

unit

D


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Demand Schedule

The demand curve slopes downward(a negatively

slopeddemand curve)

Indicates an inverse relationshipbetween price andquantity demanded


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Law of Demand

A decrease in the price of a good, all other things

held constant (ceteris paribus), will cause an increase

in the quantity demanded of the good.

An increase in the price of a good, all other things

held constant (ceteris paribus), will cause a decrease

in the quantity demanded of the good.


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Change in Quantity Demanded

Quantity

Price

P0

Q0

P1

Q1

An increase in price

causes a decrease in

quantity demanded.


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Change in Quantity Demanded

Quantity

Price

P0

Q0

P1

Q1

A decrease in price

causes an increase in

quantity demanded.


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Market Demand

A market demand schedule specifies the units of

good or service all individuals in the market are

willing and able to purchase at alternative prices

Qd = f(P)

In other words, market demand is the sum of all the

individual demands for a particular good or service


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Why an inverse relationship?

Quantity demanded tends to fall as price rises fortwo reasons:

(1) Substitution effect: When price of a commodity

falls an individual buy more of it to substitute forother similar goods whose price has not changed

(2) Income effect: When price falls, the purchasing

power of an individual with a given income

increases, allowing him to buy more of it


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Factors Behind the Demand Curve

The market demand for a commodity is influenced

not only by the commoditys price

A whole array of factors influences how much will be

demanded at a given price:

Average disposable income of the consumers

Prices of other related commodities

Wealth of the consumers

Tastes and preferences

Size of the market (population)

Special Influences (govt. policies, seasons, etc.)

Expectations


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Classification of Goods

Inferior Good:

An inferior good is a good that decreases in demand

when consumer income rises

Inferiority, in this sense, relate to affordability ratherthan about the quality of the good

Example: People moving from public transport to

taxies



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Classification of GoodsGiffen Good:

A Giffen Good is a good that experiences increased

demand for when theprice rises and decreased

demand for when theprice falls

Absence of any close substitutes

Mainly a theoretical concept


A rise in the price of bread makes so large a drain on the resources of the

poorer labouring families, that they are forced to cut their consumption ofmeat and the more expensive foods: and, bread being still the cheapest food

which they can get and will take, they consume more, and not less of it.

- Sir Robert Giffen


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T.J. Joseph16

30 April 2013

Prices of Related GoodsSubstitutes

A substitute good is a good that can

be used in place of some other

good.

Assume Pepsi and Coca cola aresubstitutes

We want to study market demand

for Pepsi

Assume price of Pepsi and Coca Cola

is Rs.10


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Complementary goods

Any relation between demand

for CDs and CD Players?

If a good is jointly consumed

with another good, then it is

called complementary good


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Change in Demand

Quantity

Price

P0

Q0 Q1

An increase in demand

refers to a rightward shift in

the market demand curve.


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Change in Demand

Quantity

Price

P0

Q1 Q0

A decrease in demand

refers to a leftward shift in

the market demand curve.


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IMPORTANT !

Demand Vs. Quantity Demanded

Movement along curves versus shifts of curves

i.e., change in quantity demanded and change indemand are different


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SUPPLY


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Supply Schedule

Supply schedule (or supply curve) for a commodity

shows the relationship between its market price and

the quantity of that commodity that producers are

willing to produce and sell, other things heldconstant

Qs = f(P)


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Supply Schedule

Price per unit Quantity suppliedper week

10 50

12 70

14 90

16 110

18 130


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Law of Supply

A decrease in the price of a good, all other thingsheld constant (ceteris paribus), will cause a decreasein the quantity supplied of the good.

An increase in the price of a good, all other thingsheld constant (ceteris paribus), will cause an increasein the quantity supplied of the good.


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Change in Quantity Supplied

Quantity

Price

P1

Q1

P0

Q0

A decrease in price

causes a decrease in

quantity supplied.


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Change in Quantity Supplied

Quantity

Price

P0

Q0

P1

Q1

An increase in price

causes an increase

in quantity

supplied.


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Shifts in Supply Curve

Change in Production Technology

Change in Input (factors & materials) Prices

Change in the Number of Sellers/Producers

Change in Government policies

Change in Prices of Related Goods

Expectations

Special Influences (seasons, natural impacts, etc.)


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Change in Supply

Quantity

Price

P0

Q1Q0

An increase in supply

refers to a rightward

shift in the market

supply curve.


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Change in Supply

Quantity

Price

P0

Q1 Q0

A decrease in supplyrefers to a leftward shift in

the market supply curve.


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MARKETEQUILIBRIUM


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Market Equilibrium

Market equilibrium is determined at the intersection

of the market demand curve and the market supply

curve.

The equilibrium price causes quantity demanded to

be equal to quantity supplied.


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Market Equilibrium

Equilibrium is a position of balance

No incentive for anyone to change their behaviour

Market equilibrium exists when demand equalssupply

The equilibrium price clears the market


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Market Equilibrium

Price per unit Quantitydemanded perweek

Quantity suppliedper week

10 200 50

12 170 70

14 140 90

16 110 110

18 80 130

Equilibrium


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Market Equilibrium

Quantity

Price

P=16

Q=110

D S


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Market Equilibrium

Quantity

Price

P0

Q0

D0S0

Q1

P1

D1

An increase in demand willcause the market equilibriumprice and quantity to increase


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Market Equilibrium

Quantity

Price

P1

Q1

S0

Q0

P0

D0D1

A decrease in demand will

cause the market equilibriumprice and quantity to decrease


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Market Equilibrium

Quantity

Price

P0

Q0

D0 S0

Q1

P1

An increase in supplywill cause the marketequilibrium price todecrease and quantityto increase.

S1


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Market Equilibrium

Quantity

Price

P1

Q1

D0

Q0

P0

A decrease in supplywill cause the marketequilibrium price toincrease and quantity

to decrease.

S1 S0


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A Rise in Input Prices

An increase in wages, for example, will increase

firms costs

The supply curve will therefore shift upwards to the

left, as firms now require a higher price for theiroutput

The equilibrium price will rise and the quantity will

fall


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Application of Supply and Demand Analysis

To analyse the impact of a taxon transactions

Suppose there is a fixed excise tax, say Rs.Tper unit,

on the sellers for a particular good sold

What happens to the supply curve?

S0shifts leftwards S1and the vertical distance

between the two curve is Rs.T


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Quantity

Price

P1

Q

D0

Q0

P0

The outcome in terms ofprice and quantity wouldbe identical whether a tax

on transaction is leviedon the buyer or the seller

S1

S0

T

P


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Interpretation

Before tax, at price P0, the suppliers were willing to sell Q0

quantity (shown by S0curve)

And at price P, the suppliers were willing to supply Q

quantity (in the same S0curve)

Now, after the tax, the suppliers have to sell the same

quantity Qat P1=(P+T) price

The new equilibrium price P1is higher than the pre-taxprice P0

And the net of tax price Pis lower than this pre-tax price

P0


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That is, now; The sellers are getting a much lower price

And the buyers are paying a much higher price

The burden of the tax is borne by both the sellers andthe buyers

Note: The outcome in terms of price and quantity would be

identical whether a tax on transaction is levied on the buyeror the seller


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The Economics of

Price Controls


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Price ceilingis a legally established maximum pricethat sellers may charge.

Example: rent control

The direct effect of a price ceiling below the

equilibrium price is a shortage: quantity demanded

exceeds quantity supplied.

Price Ceilings


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Consider the rental housingmarket

where the price (rent) P0wouldbring the quantity of rental unitsdemanded into balance with thequantity supplied.

A price ceiling like P1 imposes a

price below market equilibrium causing quantity demanded QD

Because prices are not allowed todirect the market to equilibrium,non-price elementswill becomemore important in determiningwhere the scarce goods go.

to exceed quantity supplied QSresulting in a shortage.

The Impact of a Price ControlPrice(rent)

Quantity ofhousing units

Priceceiling

D

QS QD

P0

S

P1

Shortage

Rentalhousingmarket


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Price flooris a legally established minimum pricethat buyers must pay.

Example: minimum wage, agricultural price support

The direct effect of a price floor above the equilibrium

price is a surplus: quantity supplied exceeds quantity

demanded.

Price Floor

Th I t f P i Fl


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A price floor like P1 imposes aprice above market equilibriumcausing quantity supplied QS

Because prices are not allowed todirect the market to equilibrium,non-price elements of exchangewill become more important in

determining where scarce goods go

to exceed quantity demanded QDresulting in a surplus.

The Impact of a Price FloorPrice

Quantity

Pricefloor

D

QD QS

P0

S

P1

Surplus


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Direct effect:

Reduces employment of low-skilled labor.

Indirect effects:

Reduction in non-wage component of compensation.

Less on-the-job training.

Minimum Wage Effects

A higher minimum wage does little to help the poor.


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Employment and the Minimum WagePrice(wage)

Quantity(employment)

Minimumwage level

D

E1 E0

S

$ 5.15

Excesssupply

$ 4.00

Consider the market forlabor

where a price (wage) of $4.00couldbring the quantity of labordemanded into balance with thequantity supplied.

A minimum wage(price floor) of$5.15 would increase the earningsof those who were able to maintainemployment (E1), but wouldreduce the employment of others.

Those who lose their job (E0 to E1)

would be pushed into either theunemployment rolls or some otherless preferred form of employment.


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Questions for Thought:

1. Which of the following can be expected toresult from a price ceiling that keeps the priceof a product below market equilibrium level?

a. A surplus of the product will result.

b. A shortage of the product will result.

c. Changes in non-price factors that will be favorable tobuyers and unfavorable to sellers will occur.

d. Changes in non-price factors that will be favorable tosellers and unfavorable to buyers will occur.


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Exercise 2

Illustrate each of the following events using ademand and supply diagram for apples.

a) There is a report that imported apples are infectedwith a deadly virus

b) There is a drop in the consumers income

c) The prices of apples goes up

d) The prices of oranges falls due to very good harvest

e) Consumers expect that the pries of apples todecrease in the near future

f) The government has increased the excise duty ofapples from 5% to 15%


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References

1. Chapter 2 in Dominic Salvatore (2009),Principles of Microeconomics, 5th edition,Oxford publications.

2. Chapters 3 in William Boyes and MichaelMelvin (2009), Textbook of Economics, 6thedition, Biztantra publications.

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2 Demand Supply and Equilibrium