Demand, Supply and Market Equilibrium MB Chp: 3

1. Demand, Supply and Market EquilibriumMB Chp: 3 Lecture: 3

2. Chapter Objectives • Demand and its determinants • Supply and its determinants • Supply, demand, & market equilibrium • Changes in supply and demand • Government-set prices

3. 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

4. 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

5. 6 5 4 3 2 1 0 Price (per bushel) 10 20 30 40 50 60 70 80 Quantity Demanded (bushels per week) Individual Demand P Individual Demand P Qd $5 4 3 2 1 10 20 35 55 80 D Q 3-5

6. 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

7. 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

8. 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

9. 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)

10. 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)

11. 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

12. 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

13. 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

14. 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)

15. 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

16. 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

17. 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

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

19. 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

20. 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

21. Market Equilibrium • Change in demand • Shift of the demand curve • Change in supply • Shift of the supply curve • Change in equilibrium price and quantity

22. Complex cases Quantity Price • Supply increase; Demand decrease • Supply decrease; Demand increase • Supply increase; Demand increase • Supply decrease; Demand decrease ? ? ? ?

23. 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

24. 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

25. 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

26. 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)