Demand and Supply: How Markets Work

1
Demand and Supply How Markets Work

• Lecture 1 academic year 2014/15
• Introduction to Economics
• Fabio Landini

2
Todays Plan

• The market what is it?
• Demand what changes the quantities demanded?
• Supply what changes the quantities supplied?
• How do we explain changes in prices as a result
  of shifts in demand and supply?

3
Market

• Definition A market consists of a group of
  buyers and sellers of a given good or service
• Buyers determine the demand.
• Sellers determine the supply.

During the first part of the course we will focus
mainly on markets for goods. However, the same
reasoning hold also for factors of production
(e.g. labour, capital).
4
Typologies of Markets

• Perfect competition
• Many sellers and many buyers, each of them with
  no influence on market prices
• Goods are perfect substitute

Fruits market in Panajii - India
5
Typologies of Markets

• Monopoly
• Only one seller that fix the price

6
Typologies of Markets

• Oligopoly
• Few sellers, not always in competition with each
  other (cartels)

7
Typologies of Markets

• Monopolistic competition
• Many sellers, tough competition, and product
  differentiation

8
The Demand

• The quantity demanded is the quantity that buyers
  want and can buy

9
Demand Table and Curve

• The demand table contains information on the
  relationship between the price of a good and the
  quantity demanded.
• The demand curve is a graph that shows the
  relationship between the price of a good and the
  quantity demanded.

10
Example Demand of Ice-cream
11
Example Demand of Ice-cream
12
Example Demand of Ice-cream
13
Law of the Demand

• Law of the Demand
• There exist an inverse relationship between price
  and quantity demanded

14
The Determinants of Demand

• What determines the quantity of ice-cream that is
  demanded ?
• Market price.
• Consumers income.
• Price of other goods.
• Consumers preferences.
• Consumers expectations.

15
Why does the quantity demanded vary?

• The quantity demanded can vary for two reasons
• Movements along the demand curve caused by a ?
  in market prices
• Shifts of the demand curve caused by a ? of the
  other determinants of demand (income, price of
  other goods, preferences, expectations).

16
Why does the quantity demanded vary?
17
Changes of the quantity demanded
18
Changes of the quantity demanded
Price of cigarettes (a packet in euro)
4.00
2.00
D1
0
12
20
Number of cigarettes smoked in a day
19
Changes of the quantity demanded
A tax on the production of tobacco increases the
price of cigarettes. Therefore, it induces a
movement along the demand curve.
Price of cigarettes (a packet in euro)
4.00
2.00
D1
0
12
20
Number of cigarettes smoked in a day
20
Changes of the quantity demanded
A tax on the production of tobacco increases the
price of cigarettes. Therefore, it induces a
movement along the demand curve.
Price of cigarettes (a packet in euro)
C
4.00
A
2.00
D1
0
12
20
Number of cigarettes smoked in a day
21
Changes of the quantity demanded
A tax on the production of tobacco increases the
price of cigarettes. Therefore, it induces a
movement along the demand curve.
Price of cigarettes (a packet in euro)
C
4.00
A
2.00
D1
0
12
20
Number of cigarettes smoked in a day
22
Shift of the Demand Curve
23
Shift of the Demand Curve
Price of cigarettes (a packet in euro)
4.00
2.00
D1
0
10
20
Number of cigarettes smoked in a day
24
Shift of the Demand Curve
Price of cigarettes (a packet in euro)
A public provision aimed at discouraging smoking
induces a leftward shift in the demand curve.
4.00
2.00
D1
0
10
20
Number of cigarettes smoked in a day
25
Shift of the Demand Curve
Price of cigarettes (a packet in euro)
A public provision aimed at discouraging smoking
induces a leftward shift in the demand curve.
4.00
2.00
D1
D 2
0
10
20
Number of cigarettes smoked in a day
26
Shift of the Demand Curve
Price of cigarettes (a packet in euro)
A public provision aimed at discouraging smoking
induces a leftward shift in the demand curve.
4.00
B
A
2.00
D1
D 2
0
10
20
Number of cigarettes smoked in a day
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What about a change in income?
Price of cigarettes (a packet in euro)
4.00
2.00
D1
30
0
10
20
Number of cigarettes smoked in a day
28
What about a change in income?
Price of cigarettes (a packet in euro)
4.00
2.00
D 2
D1
30
0
10
20
Number of cigarettes smoked in a day
29
What about a change in income?
Price of cigarettes (a packet in euro)
4.00
2.00
D 2
D1
30
0
10
20
Number of cigarettes smoked in a day
30
What about a change in income?
Price of Ice-ream (a cone in euro)
4.00
2.00
D 2
D1
3
0
1
2
Number of cigarettes smoked in a day
31
What about a change in income?
Price of Ice-ream (a cone in euro)
For a normal good, an increase in income
increases the quantity demanded
4.00
2.00
D 2
D1
3
0
1
2
Number of cigarettes smoked in a day
32
Price of other goods

• When a decrease in the price of one good causes a
  decrease in the quantity demanded of another
  good, the two goods are called substitute (e.g.
  tea and coffee).

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Price of other goods

• When a decrease in the price of one good causes
  an increase in the quantity demanded of another
  good, the two goods are called complementary(e.g.
  PCs and High-speed Internet access).

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Example what shifts the demand of a Toshiba PC?

• How does the demand of a Toshiba personal
  computer (PC) shift if
• Consumers income decrease
• The price of a Compaq PC decreases
• The price of high-speed Internet connection
  reduces
• The use of Internet across households increases

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From Individual Demand
Caterinas demand
Nicolas Demand
Price of
Price of
ice-cream
ice-cream
3.00
3.00
2.50
2.50
2.00
2.00
1.50
1.50
1.00
1.00
0.50
0.50
Quantity of
0
1
2
3
4
5
6
7
8
9
10
11
12
0
1
2
3
4
5
6
7
8
9
10
11
12
Quantity of
Ice-cream
Ice-cream
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. To Market Demand
Price of
ice-cream
Quantity of
Ice-cream
37
Supply
The quantity supplied is the quantity that
sellers want and can sell
38
The Determinants of Supply

• Market prices
• Cost of factors of production
• Technology
• Expectations

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Law of the Supply

• Law of the Supply the quantity supplied of a
  given good increases with the price.
• Why? Because, for given costs of production and
  commercialization, an increase in price generates
  greater revenues (all costs being equal) and thus
  it induces sellers to increase production.

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Supply Table and Curve

• The supply table is a table that contains
  information on the relationship between the price
  of a good and the quantity supplied
• The supply curve is a graph that shows the
  relationship between the price of a good and the
  quantity supplied

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Supply Curve
Price of
ice-cream
Quantity
of ice-cream
42
Supply Curve
Price of
ice-cream
Quantity
of ice-cream
43
Supply Curve
Price of
ice-cream
Quantity
of ice-cream
44
Why does the quantity supplied vary?

• The quantity supplied can vary for two reasons
• Movements along the supply curve, caused by a ?
  in market prices
• Shifts of the supply curve, caused by a ? of the
  other determinants of supply (technology, cost of
  factors of production, expectations)

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Why does the quantity supplied vary?
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Increase of Supply
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Increase of Supply
Price of
ice-cream
S1
0
Quantity
of ice-cream
48
Increase of Supply
Price of
ice-cream
S1
S2
Increase of supply
0
Quantity
of ice-cream
49
Increase of Supply
Price of
ice-cream
S1
0
Quantity
of ice-cream
50
Increase of Supply
Price of
S3
ice-cream
S1
Decrease of supply
0
Quantity
of ice-cream
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Example what shifts the supply of a Toshiba PC

• How does the supply of a Toshiba personal
  computer (PC) shift if
• The price of semi-conductors increases
• Toshiba re-organize her production lines to
  improve efficiency
• Toshibas managers expects a decrease in the
  price of semi-conductors in the future

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Summary Until Now

• Every market has two sides demand and supply
• The main determinants of demand are the price of
  the good, consumers income, the price of other
  goods, consumers preferences and expectations
• The main determinants of supply are the price of
  the good, costs of production, technology and
  expectations

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Equilibrium of Demand and Supply

• Equilibrium Price
• Is the price for which demand equals supply.
• Graphically, it is the price for which the demand
  curve and the supply curve intersect.

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Equilibrium of Demand and Supply

• Equilibrium Quantity
• Is the quantity for which demand equals supply.
• Graphically, it is the quantity for which the
  demand curve and the supply curve intersect.

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Equilibrium of Demand and Supply
Price of
ice-cream
Supply
2.00
Demand
Quantity of
0
1
2
3
4
5
6
7
8
9
10
11
12
13
Ice-cream
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Equilibrium of Demand and Supply
Price of
ice-cream
Supply
Equilibrium
2.00
Demand
Quantity of
0
1
2
3
4
5
6
7
8
9
10
11
12
13
Ice-cream
57
Equilibrium of Demand and Supply
Price of
ice-cream
Supply
Equilibrium
Equilibrium price
2.00
Demand
Equilibrium quantity
Quantity of
0
1
2
3
4
5
6
7
8
9
10
11
12
13
Ice-cream
58
Market out of equilibrium

• Excess supply
• Price is greater then its equilibrium level
• Sellers cannot sell the quantity they want at
  that price

• Excess demand
• Price is lower then its equilibrium level
• Buyers cannot buy the quantity they want at that
  price

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Excess Supply
Price of
ice-cream
Excess Supply
Supply
2.50
2.00
Demand
0
4
7
10
Quantity of
Ice-cream
Quantity demanded
Quantity supplied
60
Excess Supply
Price of
ice-cream
Supply
2.00
1.50
Excess Demand
Demand
0
4
7
10
Quantity of
Ice-cream
Quantity supplied
Quantity demanded
61
What happens if

• External events alter the market equilibrium.
• How do we study the determination of the new
  equilibrium?
• We have three things to do
• To understand if the external event causes shifts
  in the demand curve and/or the supply curve
• To understand in which direction the demand
  shift.
• To understand if the shift affects the
  equilibrium prices and quantities, and how the
  new equilibrium is achieved.

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Equilibrium effects of an increase in demand
Price of
ice-cream
S1
2.00
Initial Equilibrium
D1
0
7
Quantity of
Ice-cream
63
Equilibrium effects of an increase in demand
Price of
1. Nice weather causes an increase in the demand
of ice-cream
ice-cream
S1
2.00
Initial Equilibrium
D1
0
7
Quantity of
Ice-cream
64
Equilibrium effects of an increase in demand
Price of
1. Nice weather causes an increase in the demand
of ice-cream
ice-cream
S1
New Equilibrium
2.50
2.00
Initial Equilibrium
D2
D1
0
7
10
Quantity of
Ice-cream
65
Equilibrium effects of an increase in demand
Price of
1. Nice weather causes an increase in the demand
of ice-cream
ice-cream
S1
New Equilibrium
2.50
2.00
Initial Equilibrium
2.that causes an increase in prices
D2
D1
0
7
10
Quantity of
Ice-cream
3.and an increase in the quantity that is sold
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How do we move from the old to the new
equilibrium?

• We saw that nice weather causes a shift in the
  equilibrium. We havent yet explained how this
  happens.
• To do so, we use the concept of excess demand.
• If the demand increases, the quantity demanded is
  greater than the quantity supplied at the initial
  price.
• Market prices will tend to increase.

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How do we move from the old to the new
equilibrium?

• When the price increases, two things happen
• The quantity supplied increases (Law of the
  Supply)
• The quantity demanded reduces (Law of Demand)
• Results the initial excess demand reduces
  gradually, until in the new equilibrium it is
  equal zero.

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Conclusion

• The combination of demand and supply determines
  the price of the goods (and services) available
  in the market.
• Prices are the signals (information) that address
  the allocation of (scarce) resources and ensure
  the achievement of the market equilibrium.

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Next week

• We will start to look at some properties of
  demand and supply. In particular, elasticity