Demand, Supply and Market Equilibrium MB Chp: 3

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Demand, Supply and Market EquilibriumMB Chp 3

• Lecture 3

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Chapter Objectives

• Demand and its determinants
• Supply and its determinants
• Supply, demand, market equilibrium
• Changes in supply and demand
• Government-set prices

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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

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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

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Individual Demand
P
Individual Demand
P
Qd
5 4 3 2 1
10 20 35 55 80
D
Q
3-5
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Law of Demand

• Law of Demand is a fundamental characteristic of
  demand behavior
• All 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

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Explanation behind the Law of Demand

• 1. 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),
  gives the incentive to substitute (or buy more of
  good X) the lower- priced good for now relatively
  higher-priced goods

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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

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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)

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Determinants of Demand

• 1. Tastes
• Favorable 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. Income
• As income increases, demand for normal (or
  superior) goods varies directly. However, demand
  for inferior goods decreases as income increases
  (used cars, clothing etc)

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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 Expectations
• Consumers views about future prices, product
  availability and income can shift demand

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• 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

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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

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Individual 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

P
6 5 4 3 2 1 0
Individual Supply
S1
P
Qs
5 4 3 2 1
60 50 35 20 5
Price (per bushel)
Q
10 20 30 40 50
60 70
Quantity Supplied (bushels per week)
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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

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Determinants of Supply

• Changes in any of the determinants cause shifts
  in the supply curve
• 1. Resource prices
• A rise in resource prices will cause a decrease
  in supply or leftward shift
• 2. Technology
• Technological improvements leading to efficient
  production and lower costs can increase supply
• 3. Taxes and Subsidies
• Tax is treated as cost, subsidy lowers cost and
  increases supply

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Determinants of Supply

• 4. Price of related goods
• If 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

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Market Equilibrium

• Equilibrium price and quantity
• Where qty demanded and supplied equals
• Can any other price exist?
• Surplus and shortage

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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

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Efficient allocation

• Competitive 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

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Market Equilibrium

• Change in demand
• Shift of the demand curve
• Change in supply
• Shift of the supply curve
• Change in equilibrium price and quantity

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Complex cases
Quantity
Price
?

• Supply increase Demand decrease
• Supply decrease Demand increase
• Supply increase Demand increase
• Supply decrease Demand decrease

?
?
?
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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

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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

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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

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Market Equilibrium
200 Buyers 200 Sellers
Market Supply 200 Sellers
Market Demand 200 Buyers
6 5 4 3 2 1 0
6,000 Bushel Surplus
S
P
Qd
P
Qs
4 Price Floor
5 4 3 2 1
2,000 4,000 7,000 11,000 16,000
5 4 3 2 1
12,000 10,000 7,000 4,000 1,000
Price (per bushel)
3
2 Price Ceiling
7,000 Bushel Shortage
D
7
2 4 6 8 10 12 14
16 18
Bushels of Corn (thousands per week)