Individual Markets:

Demand & Supply

3C H A P T E R

• What is a “market” ?

Buyers or Demanders Sellers or Suppliers

Good or Service

Price

Markets Defined

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

• A market may be local, national, or international in scope.

• Some markets are highly personal, face-to-face exchanges; others are impersonal and remote.

– A product market involves goods and services.

– A resource market involves factors of production

What is Demand?

• Assume the following:

Price of the good (KD) Quantity of the good (units)

5 10

3 20

4 35

2 55

1 80

PossiblePrices

Various amounts

In specified time period

Graphing DemandP Qd

5 10

4 20

3 35

2 55

1 80

P

Qd

5

3

2

1

4

10 704030 605020 80

Graphing DemandP Qd

5 10

4 20

3 35

2 55

1 80

P

Qd

5

3

2

1

4

10 704030 605020 80

Demand

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

• The schedule shows how much buyers are willing and able to purchase at five possible prices.

• To be meaningful, the demand schedule must have a period of time associated with it.

Law of demand

• Law of demand “other things being equal, as price increases, the corresponding quantity demanded falls”.

• Law of demand restated, “there is an inverse relationship between price and quantity demanded”.

• Note the “other-things-equal” assumption refers to consumer income and tastes, prices of related goods, and other things besides the price of the product being discussed.

The demand curve

1. Illustrates the inverse relationship between price and quantity.

2. The downward slope indicates lower quantity at higher price and higher quantity at lower price, reflecting the Law of Demand.

Individual versus market demand

1. Transition from an individual to a market demand schedule is accomplished by summing individual quantities at various price levels.

2. Market curve is horizontal sum of individual curves.

P PP

Qd1 Qd

MQd2

D1 D2DM

10KD

5 8 13

Consumer (1): at price (10) demands (5) units

Consumer (2): at price (10) demands (8) units

Market Demand: at price (10) the demand is (8) units

Changes in Demand

• Recall: as price changes, quantity demanded changes:

P

Qd

D10KD

5

As price falls from 10 to 7, Qd increases from (5) to (9) units

9

7KD

Change in prices of the good will always lead to changes in quantity demanded!

This is shown by a This is shown by a movement along the movement along the demand curvedemand curve

Recall: inverse Recall: inverse relationship between relationship between P and QP and Qdd

Determinants of demand

This is what we mean by “other things”:

a. Tastesfavorable change leads to an increase in demand; unfavorable change to a decrease.

b. Number of buyersmore buyers lead to an increase in demand; fewer buyers lead to a decrease.

c. Incomemore leads to an increase in demand; less leads to a decrease in demand for normal goods. (The rare case of goods whose demand varies inversely with income is called inferior goods).

d. Prices of related goodsi. Substitute goods (those that can be used in place of

each other): The price of the substitute good and demand for the other good are directly related. If the price of Coke rises (because of a supply decrease), demand for Pepsi should increase.

ii. Complementary goods (those that are used together like tennis balls and rackets): When goods are complements, there is an inverse relationship between the price of one and the demand for the other.

e. Expectationsconsumer views about future prices, product availability, and income can shift demand.

• Changes in determinants of demand will shift the demand curve!

Increase in demand

decrease in demand

P

QdNote that pricesNote that pricesare CONSTANTare CONSTANT

A summary of what can cause an increase in demand.

a. Favorable change in consumer tastes.

b.Increase in the number of buyers.

c. Rising income if product is a normal good.

d.Falling incomes if product is an inferior good.

e. Increase in the price of a substitute good.

f. Decrease in the price of a complementary good.

g.Consumer expectation of higher prices or incomes in the future.

A summary of what can cause a decrease in demand.

a. Unfavorable change in consumer tastes.b. Decrease in number of buyers.c. Falling income if product is a normal good.d. Rising income if product is an inferior good.e. Decrease in price of a substitute good.f. Increase in price of a complementary good.g. Consumers expectation of lower prices or incomes in

the future.G. Review the distinction between a change in quantity

demanded caused by price change and a change in demand caused by change in determinants.

Supply

• Supply is a schedule that shows amounts of a product a producer is willing and able to produce and sell at each specific price in a series of possible prices during a specified time period.

• A schedule shows what quantities will be offered at various prices or what price will be required to induce various quantities to be offered.

Law of supply.

• Law of supply “producers will produce and sell more of their product at a high price than at a low price”.

• Law of supply restated “There is a direct relationship between price and quantity supplied”.

Explanation: Given product costs, a higher price means greater profits and thus an incentive to increase the quantity supplied.

P Qs

5 60

4 50

3 35

2 20

1 5

Supply Schedule

Various quantities

At different prices

P Qs

5 60

4 50

3 35

2 20

1 5

Supply Schedule

P

QS

5

4

2

3

1

3010 20 5040 60

1

Changes in Qs

• Only changes in P will lead to changes in QS

• This is a movement along the S curve from one point to the other.

• Note that the S curve remains unchanged.

P

Qs

S

New as P increases

As P increasesQs increases

P

Qs

S

New as P decreases

As P increasesQs increases

Determinants of supply:

A change in any of the supply determinants causes a change in supply and a shift in the supply curve. An increase in supply involves a rightward shift, and a decrease in supply involves a leftward shift.

Six basic determinants of supply, other than price:

a. Resource prices: a rise in resource prices will cause a decrease in supply or leftward shift in supply curve; a decrease in resource prices will cause an increase in supply or rightward shift in the supply curve.

b. TechnologyA technological improvement means more efficient production and lower costs, so an increase in supply or rightward shift in the curve results.

c. Taxes and subsidiesA business tax is treated as a cost, so decreases supply; a subsidy lowers cost of production, so increases supply.

d. Prices of related goodsIf the price of substitute production good rises, producers might shift production toward the higher-priced good, causing a decrease in supply of the original good.

e. Expectations

Expectations about the future price of a product can cause producers to increase or decrease current supply.

f. Number of sellers

Generally, the larger the number of sellers the greater the supply.

SP

Qo

5

4

3

2

1

10 20 30 40 50 60 70 80

S’Increase

in

Supply

Changes in S determinants: Shifts in S

SP

Qo

5

4

3

2

1

10 20 30 40 50 60 70 80

Changes in S determinants: Shifts in S

decrease

in

Supply

S’

Market Equilibrium

• Market Equilibrium: where quantity supplied equals the quantity demanded.

• This is:

Qs=Qd

At PE

Recall from D and S tables:

P Qd Qs

5 10 60

4 20 50

3 35 35

2 50 20

1 80 5

If P=3, then Qs = Qdthere is no surplus (nor shortage) !

Recall from D and S tables:

P Qd Qs

5 10 60

4 20 50

3 35 35

2 50 20

1 80 5

This is the marketEquilibrium for our good

The rationing function of prices

is the ability of competitive forces of supply and demand to establish a price where buying and selling decisions are coordinated.

7

SP

Qo

5

4

3

2

1

2 4 6 8 10 12 14 16

D

Market Clearing Equilibrium

MARKET DEMAND & SUPPLY

4 7

SP

Qo

5

4

3

2

1

2 4 6 8 10 12 14 16

D

MARKET DEMAND & SUPPLY

SurplusAt a 4 price

more is being

supplied than

demanded

117

SP

Qo

5

4

3

2

1

2 4 6 8 10 12 14 16

D

At a 2 price

more is being

demanded than

supplied

Shortage

MARKET DEMAND & SUPPLY

117

SP

Qo

5

4

3

2

1

2 4 6 8 10 12 14 16

D

Quantity of Corn

Shortage

MARKET DEMAND & SUPPLY

Surplus

Application: Government-Set Prices (Ceilings and Floors)

Government-set prices prevent the market from reaching the equilibrium price and quantity.

A. Price ceilings. • The maximum legal price a seller may charge, typically

placed below equilibrium.

• Shortages result as quantity demanded exceeds quantity supplied.

• Examples: Rent controls and gasoline price controls

B. Price floors.

• The minimum legal price a seller may charge, typically placed below equilibrium.

• Surpluses result as quantity supplied exceeds quantity demanded.

• Examples: Minimum wage, farm price supports

Note: The federal minimum wage, for example, will be below equilibrium in some labor markets (large cities). In that case the price floor has no effect.