Demand, Supply and Market Equilibrium

MB Chp: 3

Lecture: 3

Chapter Objectives

Demand and its determinants

Supply and its determinants

Supply, demand, & market equilibrium

Changes in supply and demand

Government-set prices

Markets

A market is an institution or mechanism that brings together buyers (demanders) and sellers (suppliers) of particular goods and services

This chapter concerns purely competitive markets with a large number of independent buyers and sellers

Demand

Demand is a schedule or a curve that shows the various amounts of a product consumers are willing and able to buy at each specific price in a series of possible prices during a specified time period

Demand is simply a statement of a buyers' plans, or intentions

Price will be determined by interaction of demand and supply

Individual Demand

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0 10 20 30 40 50 60 70 80 Quantity Demanded (bushels per week)

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ce (

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P Qd

$5

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10

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35

55

80

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Law of Demand Law of Demand is a fundamental

characteristic of demand behavior

All else equalAll else equal, as price falls, the quantity demanded rises, and as price rises, the quantity demanded falls – there is an inverse (or negative) relationship between price and quantity demanded

“All else equal” implies that tastes, income, price of substitutes etc are constant

This inverse r/s is the law of demand

Explanation behind the Law of Demand1. Diminishing marginal utility – the decrease in added

satisfaction that results as one consumers additional units of a good or services i.e the second Big Mac yields less satisfaction (or utility) than the first. Thus you will only buy additional units if price is reduced

2. Income effect : A lower price increases the purchasing power of money income enabling the consumer to buy more of the product than before (or less at a higher price)

3.Substitution effect: A lower price (of good X),(of good X), gives the incentive to substitute (or buy more of good X)(or buy more of good X) the lower- priced good for now relatively higher-priced goods

Market Demand Curve

By adding the quantities demanded by all consumers at each of the various possible prices, we can get a market demand schedule from individual demands

It is the horizontal sum of individual curves

Change in Demand There are several determinants of demand or

the “other things” besides price , which affect demand

Changes in these determinants cause the demand schedule to shift graphically

This is called a change in demand

A change in quantity demanded comes from price changes and it is a movement ALONG demand schedule (with no shifts involved)

Determinants of Demand

1. TastesFavorable change leads to increase in demand , unfavorable change to decrease

2. Number of buyers An increase in the number of buyers in a market will result in increase in product demand

3. IncomeAs income increases, demand for normal (or superior) goods varies directly. However, demand for inferior goods decreases as income increases (used cars, clothing etc)

Determinants of Demand

4. Price of related goods:

Substitute good is one that can be used in place of another good. An increase in price of a substitute will increase the demand for actual good (direct R/s)

Complementary good is one that is used together with another good. The goods have a joint demand An increase in price of comp. good will decrease the demand for the other good (inverse R/s)

5.Consumer ExpectationsConsumers views about future prices, product availability and income can shift demand

A change in demand must not be confused with a change in quantity demanded

A change is demand is a shift of the demand curve Occurs due to one or more of the determinants of

demand altering

A change in quantity demanded is a movement from one point to another point Cause of such a change is the increase or

decrease in price

Supply

Supply is a schedule or curve showing the various amounts of a product that producers are willing and able to make available for a sale at each of a series of possible prices during a specific period

Individual Supply

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Quantity Supplied (bushels per week)

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$5

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Supply is a schedule or curve showing the various amounts of a product that producers are willing and able to make available for a sale at each of a series of possible prices during a specific period

Law of Supply Law of Supply:

As price increases, quantity supplied will also increase. There is a direct relationship between price and supplied qty.

Explanations:

1. Revenue implications

Given product costs, a higher price means greater profits and thus an incentive to increase the qty supplied

2. Marginal cost

Beyond some production level, producers usually encounter increasing costs per added unit of output

Market supply is derived by horizontally adding the supply curves of individual producers

Determinants of Supply Changes in any of the determinants cause shifts in the

supply curve

1. Resource pricesA rise in resource prices will cause a decrease in supply or leftward shift

2. TechnologyTechnological improvements leading to efficient production and lower costs can increase supply

3. Taxes and SubsidiesTax is treated as cost, subsidy lowers cost and increases supply

Determinants of Supply

4. Price of related goodsIf price of substitute good increases, prod. might shift production to that good

5.Expectations about future price of product Can lead to increases or decreases in supply

6. Number of sellers Larger number of sellers lead to greater supply

Market Equilibrium

Equilibrium price and quantityWhere qty demanded and supplied equals

Can any other price exist?Surplus and shortage

Rationing function of price

Ability of competitive forces of supply and demand to establish a price at which selling and buying decisions are consistent

At equilibrium price, no surplus or shortage remains – market clearing price

Efficient allocationCompetitive markets ensure: Productive efficiency

Production of any particular good in the least costly way

Allocative efficiency The particular mix of goods and services most

highly valued by society

At the intersection of D and S therefore, MB =MC and there is neither an underallocation of an overallocation of resources to a particular product

Market Equilibrium

Change in demandShift of the demand curve

Change in supplyShift of the supply curve

Change in equilibrium price and quantity

Complex cases

Supply increase; Demand decrease

Supply decrease; Demand increase

Supply increase; Demand increase

Supply decrease; Demand decrease

Price Quantity

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Price Floors A price floor is a minimum price fixed by the

government. A price at or above the price floor is legal, a price below is not.

Support prices for wheat, minimum wages for labor are good examples

Price floors result in excess supply

Price Floors contd. Govt. has to either restrict supply by giving permits

to certain farmers to produce OR

Increase demand by finding new uses for the product

Govt. has to buy the excess output (store or destroy it)

PF lead to distorted allocation of scarce resources – allocative inefficiency

Consumers pay higher prices;

Tax money wasted on purchasing excess output

Price Ceilings A price ceiling sets the maximum legal price a seller

can charge for a product or service. A price at or below the ceiling is legal, a price above it not.

Price Ceiling results in excess demand which will cause problems:

1. Rationing Problem: How will the available amount be apportioned among

consumers who demand a higher amount? coupons

2. Black Market Many buyers are willing to pay a higher price and it

therefore profitable for producers to sell to these customers

A black market will flourish where the product is bought and sold at a higher price

Market Equilibrium

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0 2 4 6 8 10 12 14 16 18Bushels of Corn (thousands per week)

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$5

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2,000

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11,000

16,000

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12,000

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7,000

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$4 Price Floor

6,000 BushelSurplus

$2 Price Ceiling

7,000 BushelShortage