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Theory of Supply and Demand

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  1. Theory of Supply and Demand • How supply and demand determine the price of a good and the quantity sold in the market? • Role of prices in allocating resources in the market economy

  2. Types of markets • Market is a group of buyers and sellers of a particular good or service • Buyers determine the demand for a product and sellers determine the supply of the product • Competitive market is a market in which there are many buyers and many sellers in the market so that each has a negligible impact on the market price • We assume perfectly competitive markets when we study the theory of demand and supply

  3. Types of Markets • Perfectly competitive markets have the following two characteristics: • Goods being sold are all the same • Both Buyers and sellers are price takers • Monopoly is characterized by: • One seller and many buyers • Seller sets the price • Oligopoly is characterized by • Few sellers without rigorous competition • The sellers get together to set a price • Monopolistic competition is characterized by • Many sellers, each selling a differentiated product • Sellers have some ability to set the price for their own product

  4. Law of Demand • Other things equal, the quantity demanded of a good falls when the price of the good rises. • Price and quantity demanded are negatively related • Quantity demanded is the amount of the good that buyers are willing to purchase

  5. Determinants of Demand • Determinants of quantity demanded: • Income (normal, inferior) • Prices of related goods (substitutes, complements) • Tastes • Expectations • Number of buyers (Market demand curve) • Demand schedule and Demand curve • Demand schedule is a table that shows the relationship between the price of a good and the quantity demanded • Demand curve graphs the demand schedule. The demand curve slopes downward

  6. Market Versus Individual Demand • Market demand is the horizontal sum of all individual demands for a particular good or service • Market demand is derived from individual demands and thus depends on all those factors that determine individual demand (income, expectations, etc) • In our case, market demand curve shows the variations in the quantity demanded of a good as price changes

  7. Shifts Versus Movements Along the Demand Curve • Any change that varies the quantity that buyers wish to buy at a given price shifts the demand curve • Changes in price that varies the quantity that buyers wish to buy is represented as a movement along the demand curve • To summarize: Demand curve shows what happens to the quantity demanded of a good when its price varies, holding constant all other determinants of quantity demanded. When one of these determinants changes, the demand curve shifts.

  8. Application of law of Demand: Policy to Reduce Smoking • Option #1: Raise prices of cigarettes by levying a tax • Option #2: Introduce a public awareness program regarding ill effects of smoking • Policy impact on substitutes • Policy impact on complements

  9. SUPPLY • Quantity supplied of any good is the amount that sellers are willing to sell in the market • Determinants of supply: • Price • Input prices • Technology • Expectations • Number of sellers (Market supply curve)

  10. Law of Supply • Other things equal, the quantity supplied of a good rises when the price of the good rises. • Quantity supplied is positively related to the price of the good • Supply schedule is a table that shows the relationship between the price of a good and the quantity supplied • Supply curve graphs the supply schedule. It is upward sloping

  11. Market Versus Individual Supply • Market supply is derived by horizontally summing the individual supply curves • Market supply curve shows how the quantity supplied varies as the price of the good varies • Any change that varies the quantity supplied at a given price shifts the supply curve • Changes in price that varies the quantity supplied in the market is represented as a movement along the supply curve

  12. SUPPLY AND DEMAND • How do supply and demand combined together determine the quantity and price of a good sold in the market? • Supply and demand curves intersect. At this equilibrium price quantity supplied equals quantity demanded • Equilibrium is a situation in which supply equals demand • Equilibrium price is also called as the market clearing price as quantity supplied equals quantity demanded

  13. SUPPLY AND DEMAND • What happens when market price is not equal to the equilibrium price? • Excess supply- surplus in the market • Excess demand- shortage in the market • Free markets reach equilibrium through the interaction of buyers and sellers and price is the tool through which the market is cleared

  14. LAW OF SUPPLY AND DEMAND • Other things remaining same, the price of any good adjusts to bring the supply and demand for that good into balance. • Shifts versus movements along curves • Change in quantity supplied and change in quantity demanded is represented as a movement along the fixed supply and demand curves respectively • Change in supply and change in demand is represented as shifts in supply and demand curves respectively

  15. Analyzing Changes in Equilibrium: Application • Change in demand- shifts in the demand curve • Change in supply- shifts in the supply curve • Changes in both supply and demand- Change in equilibrium quantity and price A simple application

  16. Analyzing Changes in Equilibrium: Summary

  17. How Prices allocate Resources • Prices act as signals that guide the allocation of scarce resources in a market economy • Prices in turn are determined by forces of supply and demand