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MicroeconomicsSultan Qaboos University

Lecture 4

Learning ObjectivesDiscuss the essential features of the price systemEvaluate the effects of changes in demand and supply on the market price and equilibrium quantityDiscuss the Policy of Government-Imposed Price ControlsExplain the effects of price ceilingsExplain the effects of price floors

2ReviewThe law of demand says that prices and quantity demanded are inversely related:

At a higher price people buy less, at a lower price people buy more3Review(cont'd)A change in quantity demanded versus a change in demandA change in quantity demanded is a movement along the same demand curveA change in demand is a shift of the whole demand curve4Review(cont'd)The law of supply states that price and quantity supplied are directly related

Firms offer more at a higher price; firms offer less at a lower price

5Review(cont'd)A change in quantity supplied versus a change in supply

A change in quantity supplied is a movement along the same supply curveA change in supply is a shift of the whole supply curve6Putting a Market TogetherThe interaction of buyers and sellers makes a market. Equilibrium: only one price and quantity combination is compatible with the intentions of both buyers and sellers. Equilibrium is located where the demand curve and supply curve intersect.All the points on the graph except the equilibrium point represent situations where the buyers and sellers disagree.

DSPQPeQeEquilibriumNo shortage exists.No surplus exists.Qd = Qs = Qe.The price will not change until there is a shift in demand or in supply.

DSPQPeQeEquilibriumMarkets reach equilibrium because buyers have a demand behavior (raise price, buy less, and vice versa) and sellers have a supply behavior (raise price, supply more, and vice versa).The market mechanism (Adam Smiths invisible hand) leads the market to equilibrium.At equilibrium, quantity demanded (Qd) equals quantity supplied (Qs) at the equilibrium price (Pe).We say that the market mechanism signals the desired outcome at Pe.The Invisible Hand TheoryAccording to Adam SmithPeople are motivated by self-interest.

The goal of profit maximization will serve societys collective interest.

In other words, the theory for the Invisible Hand states that if each consumer is allowed to choose freely what to buy and each producer is allowed to choose freely what to sell, the market will settle on a product distribution and prices that are efficient.

Putting Demand and Supply Together, Panel (a)

11Resolving a Market SurplusMarket surplus: the amount by which quantity supplied (Qs) exceeds quantity demanded (Qd) at a given price; excess supply.Price is too high.Qs > Qd, a surplus.Buyer and seller behaviors kick in.Price will fall to equilibrium price, Pe.

DSPQPeQePhighSurplusQdQsResolving a Market ShortageMarket shortage: The amount by which quantity demanded (Qd) exceeds quantity supplied (Qs) at a given price; excess demand.Price is too low.Qs < Qd, a shortage.Buyer and seller behaviors kick in.Price will rise to equilibrium price, Pe.

DSPQPeQePlowShortageQsQdWhat Causes the Price to Change?Price changes when equilibrium is upset. due to a shift in demand (a change in buyers behavior), or due to a shift in supply (a change in sellers behavior).After the shift, a surplus or a shortage is created, and the market mechanism goes into effect to find the new equilibrium.Demand IncreasesBuyers behavior changes.Demand shifts right.Old equilibrium is upset.Creates a shortage.Price rises.A new equilibrium is established.Price rises from P1 to P2.Quantity rises from Q1 to Q2.

D1SPQP1Q1D2ShortageP2Q2Demand DecreasesBuyers behavior changes.Demand shifts left.Old equilibrium is upset.Creates a surplus.Price falls.A new equilibrium is established.Price falls from P1 to P2.Quantity falls from Q1 to Q2D1SPQP1Q1D2SurplusP2Q2Supply IncreasesSellers behavior changes.Supply shifts right.Old equilibrium is upsetCreates a surplus.Price falls.A new equilibrium is established.Price falls from P1to P2.Quantity rises from Q1 to Q2.

DS1PQP1Q1S2SurplusP2Q2Supply DecreasesSellers behavior changes.Supply shifts left.Old equilibrium is upsetCreates a shortage.Price rises.A new equilibrium is established.Price rises from P1to P2.Quantity falls from Q1 to Q2.DS1PQP1Q1S2ShortageP2Q2Summary: When Do Prices Change?Only when a market is in disequilibrium.Shortage? Price rises.Surplus? Price falls.A shift in either demand or supply causes the price to change, BUT.A price change does NOT cause the demand curve to shift or the supply curve to shift.19ExerciseIf income increases, demand shifts and the price willIf tastes decrease, demand shifts and the price willIf cost of inputs rise, supply shifts and the price will If the number of sellers increase, supply shifts and the price will rightfallleftriserightfallriseleft20Changes in Demand and Supply (cont'd)SummaryIncreases in demand increase equilibrium price and quantityDecreases in demand decrease equilibrium price and quantity21Changes in Demand and Supply (cont'd)SummaryIncreases in supply decrease equilibrium price and increase equilibrium quantityDecreases in supply increase equilibrium price and decrease equilibrium quantity22Changes in Demand and Supply (cont'd) ExampleIncomes increase. In a graph of the market for iPod we would expect:a. The demand curve to shift to the leftb. The demand curve to shift to the right.c. The supply curve to shift upwards.d. The supply curve to shift downwards.e. Neither the supply nor the demand curve shifts.

23Changes in Demand and Supply (cont'd) ExampleIncome rises. We should expect to see that price will and quantity will in the new equilibrium in the market for iPod.a. increase increase e. increase be uncertainb. increase decrease f. be uncertain - increasec. decrease increase g. decrease be uncertaind. decrease decrease h. be uncertain decrease24Changes in Demand and Supply (cont'd) ExampleThe price of computer memory chips increases. In the market for computers, we would expect to see:a. The demand curve to shift to the leftb. The demand curve to shift to the right.c. The supply curve to shift upwards.d. The supply curve to shift downwards.e. Neither the supply nor the demand curve shifts.25Changes in Demand and Supply (cont'd) ExampleThe price of computer memory chips increases. In the market for computers, we would expect price will and quantity will in the new equilibrium.a. increase increase e. increase be uncertainb. increase decrease f. be uncertain - increasec. decrease increase g. decrease be uncertaind. decrease decrease h. be uncertain decrease26Changes in Demand and Supply (cont'd)Changes in Demand and Supply Example

What happens to the equilibrium price and quantity of an iPod when simultaneously: Buyers incomes rise, and Technology to make the iPods improves?

0 / 30What happens to the price and quantity bought/sold of iPods if incomes rise and technology advances?Price down; quantity upPrice same; quantity upPrice up; quantity upPrice down; quantity downNone of the aboveChanges in Demand and Supply (cont'd)Changes in Demand and Supply Example Answer

An increase in incomes will increase demand (price and quantity increase).

An advance in technology will increase supply (price decreases and quantity increases).

The combined effect is that price change is indeterminate and equilibrium quantity increases. Changes in Demand and Supply (cont'd)Changes in Demand and Supply Example

What happens to the equilibrium price and quantity of cars when simultaneously:

Buyers incomes rise, and Sellers cost increases?Example: The Effects of a Decrease in the Supply of Cars in Conjunction With an Increase in the Demand

Changes in Demand and Supply (cont'd)When both demand and supply change

If both the supply and demand curves shift simultaneously, the outcome is indeterminate for either equilibrium price or equilibrium quantity

The resulting effect depends upon how much each curve shifts32QuantityPriceSupply00Demand1Supply1Demand0Simultaneous Shifts in Supply and DemandSupply2ABCChanges in Demand and Supply (cont'd)When both demand & supply increaseChange in equilibrium price is indeterminateEquilibrium quantity increases unambiguouslyWhen both demand & supply decreaseChange in equilibrium price is indeterminateEquilibrium quantity decreases unambiguously34Changes in Demand and Supply (cont'd)When supply decreases & demand increasesEquilibrium price increasesThe change in the equilibrium quantity is uncertain without more information

When supply increases & demand decreasesEquilibrium price decreasesThe change in the equilibrium quantity is uncertain without more information

35Price ControlsGovernments may impose an arbitrary maximum price (price ceiling) or a minimum price (price floor) on a market.The result is that the market cannot reach equilibrium. Price CeilingGovernment imposes a maximum price less than Pe.This generates a shortage (Qd > Qs).The market mechanism cannot clear the market.A permanent shortage exists.Examples:rent controlsprice controls during wartime

DSPQPeQePriceceilingQsQdShortagePrice FloorGovernment imposes a minimum price greater than Pe.This generates a surplus (Qs > Qd).The market mechanism cannot clear the market.A permanent surplus exists.Examples:agricultural price supportsminimum wage laws

DSPQPeQePricefloorQdQsSurplusSummary Discussion Determining market price and equilibrium quantityThe demand and supply curves intersect at the market clearing, or equilibrium pointSurpluses exist if the price of the good is greater than the market priceShortages exist when the price of a good is below the market price39Summary Discussion (cont'd)How changes in demand and supply affect market price and equilibrium quantityIf supply does not change, increases in demand increase equilibrium price and quantity; decreases in demand decrease equilibrium price and quantityIf demand does not change, increases in supply decrease market price and increase equilibrium quantity; decreases in supply increase market price and decrease equilibrium quantity40Summary Discussion (cont'd)How changes in demand and supply affect equilibrium price and equilibrium quantityWhen both demand and supply shift at the same time, the outcome is indeterminate for either equilibrium price or equilibrium quantity41Summary Discussion (cont'd)How government price controls affect market outcomes.The effects of price ceilingsA price ceiling set below the market clearing price results in a shortageThe resulting shortage can lead to black markets (A marketin which goods or services are traded illegally)42Summary Discussion (cont'd)The effects of price floorsIf the price floor is set above the market clearing price, a surplus resultsA price floor can take the form of a government-imposed price support or minimum wage43