Demand, Supply and Market Equilibrium

1. Demand, Supply and Market Equilibrium Lecture 3

2. 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

3. 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 • Table 3.1, pg 45 (Brue) • The Downward shape indicates lower quantity demanded at higher price and vice versa

4. Demand • The table reveals the r/s between the price of corn and the quantity demanded at each price level • Willingness to buy in itself is not sufficient, so we say ‘consumer is willing and able to buy’ • The table does not tell us which price actually prevails in the market, that depends on the ‘demand and supply’ together • Price is an obstacle that deters consumers from buying

5. 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 • This inverse r/s is the law of demand • (“All else equal” implies that tastes, income, price of substitutes etc are constant)

6. Law of Demand • Example of ceteris paribus: quantity of Nikes purchased will also depend on the prices of substitute brands. • Fewer Nikes will be bought if price of Nikes goes up and its substitutes maintain constant prices. • Relative price of Nike goes up

7. Explanation behind the Law of Demand • Diminishing marginal utility – the decrease in added satisfaction that results as you consume additional units of a good or services i.e the second Big Mac yields less satisfaction (or utility) than the first… • Since each successive unit yields less MU, consumers will be willing to buy additional units only if the price of those units is progressively reduced

8. Explanation behind the Law of Demand • 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) • 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

9. 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 • See figure 3.2 & Table 3.1

10. 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)

11. Determinants of Demand • Tastes- favorable change leads to increase in demand , unfavorable change to decrease • Number of buyers – an increase in the number of buyers in a market will increase in product demand • 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) • 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) • Consumer Expectations- consumer views about future prices, product availability and income can shift demand

12. 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 • Law of Supply-As price increases, quantity supplied will also increase. There is a direct relationship between price and supplied qty. • Given product costs, a higher price means greater profits and thus an incentive to increase the qty supplied • Beyond some production level, producers usually encounter increasing costs per added unit of output • Supply graph : pg 51 • Market supply is derived by horizontally adding the supply curves of individual producers

13. Determinants of Supply Changes in any of the determinants cause shifts in the supply curve • Resource prices- a rise in resource prices will cause a decrease in supply or leftward shift • Technology-tech improvement leading to efficient production and lower costs can increase supply • More units produced with fewer resources • Taxes and Subsidies- tax is treated as cost and decreases supply • a subsidy lowers cost and increases supply

14. Determinants of Supply • Price of related goods – if price of substitute good increases, prod. might shift production to that good • Expectations- about future price of product can lead to increases or decreases in supply • Withhold supply in anticipation of increased prices • Hire more workers to increase supply in anticipation of future price hikes • Number of sellers – larger number of sellers lead to greater supply

15. Supply • Change in quantity supplied is a movement along the supply curve from one point to another on a fixed supply curve. • Change in supply means a shift of the supply curve- it is caused by changes in one or more of the determinants of supply.

16. Market Equilibrium • Figure 3.6 • Productive Efficiency: the production of any particular good in the least costly way (due to competitive markets) • Allocative Efficiency: the particular mix of goods and services most highly valued by society (minimum cost production assumed)

17. Changes in Supply, Demand & Equilibrium • Figure 3.7 – explaining changes in Demand and Supply • Changes in Demand/Supply • Complex cases • Supply increase/Demand decrease • Supply decrease/Demand increase • Supply increase/Demand increase • Supply decrease/Demand decrease

18. 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. • Graph – 3.8, pg 58 • Price Ceiling results in excess demand • Rationing Problem : coupons • Black Markets

19. 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 • Graph – 3.9, pg 60 • Price floors result in excess supply

20. 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