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BS1163 Introductionto Microeconomics:
Lecture 2The Theory of
Demand, Supply, andMarket Equilibrium
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1.2
Economic Systems - The Process ofAllocation Can Be Handled Differently
Command economy - decisions aretaken by government and its agencies
Free market - changes in prices act assignals to consumers and firms and directresources to their allocations
Mixed economy - such as the UK,combines elements of both
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Commandeconomy
free-marketeconomy
N. Korea
Cuba Poland France
UK
USA
Early 1980s
Classifying economic systems
China Hong
Kong
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Commandeconomy
free-marketeconomy
N. Korea
N. Korea
Cuba
China
Poland
Poland France
France
UK
UKUSA
USA
Early 1980s
Early 2000s
Classifying economic systems
China Hong
Kong
CubaChina
(HongKong)
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Advantages of Markets
Prices transmit information betweenbuyers and sellers
no need for costly bureaucracy
incentives to be efficient - because of
profit and utility maximisation competitive markets are responsive to
consumers
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Disadvantages of Markets
competition may be limited: problem ofmarket power
inequality -prices distribute income the environment and other social goals
may be ignored
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Reality - A Mixed Economy
A mixed economy such as in the UKresults when society employs markets
where they workBut uses regulation and government
provision where markets dont work
Important Lesson - An economy thatallocated resources purely with themarket mechanism would beinefficient.
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Demand and Supply:
A Model of How MarketsDetermine the Prices and
Quantities of Goods Sold
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1.9
Price and Opportunity Cost
Price is the number of dollars that mustbe given up in exchange for an item this is referred to as the money price.
The ratio of one price to another isreferred to as the relative price.
Relative prices are opportunity costs.
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1.10
Price and Opportunity Cost
Relative Prices
price index
Supply and demand determines relative prices.
Price falling means the price falls relative to theaverage price of other goods and services.
Computers and Air Travel are both examples ofgoods with prices that have declined in relative termsover the past 30 years.
E.g their prices in nominal terms have risen less fastthan general price inflation, or may even have fallen
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1.11
Moores Law and the Cost/Price of
Computers In 1970 Gordon Moore predicted that the number of
transistors on a chip would double every two years.
This also means that the average cost of producing chipshas declined over time. As this cost reducing effect hasoutstripped the increase in demand for computers, prices
in both nominal and real terms for computers have fallen .e.g opportunity costs have declined. Source:
http://www.intel.com/technology/mooreslaw/index.htm
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1.12
Historically Commodity Prices have been falling given bettertechnology and new sources, but in past few years this trend hasbeen reversed as demand (fueled by Chinese and other growth)has outstripped supply: Example Canadian Commodity Prices.
Source: http://www.bankofcanada.ca/bcpi/web_annual.pdf
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1.13
This has a follow on effect in the currency markets, as The Economist ArticleThe Looney Takes Wing Sept 27th 2007, discusseshttp://www.economist.com/world/la/displaystory.cfm?story_id=9867397
This shows interrelationshipbetween markets with conditionsin one market (e.g demand andsupply of commodities, influenci
market outcomes in the currencymarkets
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The Theory of
DEMAND
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1.15
What Determines Buyingplans?
The Most Important Factor
The price of a good
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1.16
Demand Schedule - lists the quantitiesdemanded at each possible price (ceterisparibus).
a 1 9b 2 6
c 3 4
d 4 3
e 5 2
Price Quantity(dollars per Video) (millions of videos per week)
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1.17
Demand Curve - shows the relationshipbetween the quantity demanded of a good andits price (ceteris paribus).
0 2 4 6 8 10
1
2
3
4
5
6
e
d
c
b
a
Quantity (millions of videos per week)
Price(dollarpervideo)
Demand for videos
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Quantity Demanded Is the specific quantity of a good that
buyers wish to purchase at a particular
price. A specific point on the demand curve
Demand the quantity of a good buyers wish to
purchase at each conceivable price
The entire demand curve
Demand vs. Quantity Demanded
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1.19
When Prices Change, this causes achange in the Quantity Demanded
If the price of a product changes, this
causes movement along a demandcurve, and shows a change in thequantity demanded.
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The Law of Demand
D
Quantity
Price
ceteris paribus, as price
increases, the quantity
demanded of a product
decreases.
Demand Curves are
Downward Sloping
A negative relationship
between P and QD
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1.21
What Else Determines Buyingplans?
The Determinants of Demand
Prices of related goods
consumer income consumer preferences
Expected future prices
Number of Buyers
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1.22
Prices of Related Goods
Substitutes - goods used in the place ofanother good Demand increases asthe price of substitutes increases
Complements - goods used in conjunctionwith another good Demand decreasesas the price of complements increase
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1.23
Income
Normal Goods demand increases asincome increases
Inferior Goods demand decreases asincome increases
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1.24
Expected Future Prices
If the price of a good is expected to rise inthe future, people buy more of the goodnow. This increases demand today
If the price of a good is expected to fall inthe future, people buy less of the goodnow. This decreases demand today
O
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1.25
Two Other Determinants ofDemand
Number of Buyers
Size and age structure of population
Preferences
Attitudes toward goods and services
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1.26
A Change in the Quantity DemandedVersus a Change in Demand
A movement along a demand curve,
which results from a change in price,shows a change in the quantitydemanded.
If some other influence on buyers planschanges, holding price constant, thereis a change in demand.
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1.27
The Demand Function and ceteris paribus
P=- bQD+a+bIncome-cPComplements +dPSubstitutes+
ePFuture+ gBuyers+ fPreferences
When we assume that all things are equal except for price, allthe determinants of demand are constant and we can write
P = abQDWhich is the simple relationship between demand and price
shown in a demand curve
Changes in the determinants of demand therefore cause theintercept of the demand curve to change and will cause the
entire curve to move up or down.
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1.28
a
Demand
Quantity demanded (QD)
Price(P)
Intercept on
y axis is a
Slope is - b
P = a - bQD
Demand Curve
0
Any change in a
determinant of demandcauses a change in theintercept a, and movesthe Demand curve upor down
Any change in pricecauses movementalong the curve
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1.29
Example: Impact of reduction in VideoRecorders on the demand for videos
Original demand schedule New demand schedule
VCR $200 VCR $50
Price Quantity Quantity(dollars
per video)(millions of videos
per week)
a 1 9
Price(dollars
per video)
(millions of videos
per week)
b 2 6
c 3 4
d 4 3
e 5 2
a' 1 13
b' 2
c' 3
d' 4
e' 5
10
8
7
6
Increase in Demand with Lower VCR Price: The
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1.30
Increase in Demand with Lower VCR Price: TheQuantity Demanded is higher at every price sothis is an increase in demand
0 2 4 6 8 10 12 14
1
2
34
5
6
Quantity (millions of videos per week)
Price(dollarp
erVideo)
e
d
c
b
aDemand for videos(VCR $200)
e'
d'
c'
b'
a'
Demand for vidoes
(VCR $50)
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The Theory of
Supply
Wh t D t i S lli
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1.32
What Determines Sellingplans?
The Most Important Factor
The price of a good
Supply Schedule list the quantities
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1.33
Supply Schedule list the quantitiessupplied at each different price (ceterisparibus).
a 1 0
b 2 3
c 3 4
d 4 5
e 5 6
Price Quantity(dollars per video) (millions of vidoes per week)
Supply curve shows the relationship
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1.34
Supply curve shows the relationshipbetween the quantity supplied of a goodand its price (ceteris paribus).
0 2 4 6 8 10
1
2
34
5
6
Quantity(millions of vidoes per week)
Price(dollarp
ertape)
Supply of Videos
a
b
c
d
e
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1.35
Supply vs. Quantity Supplied
Supply the quantity of a good suppliers wish to sell
at each conceivable price
The entire supply curve
Quantity Supplied Is the specific quantity of a good that
sellers wish to sell at a particular price.
A specific point on the supply curve
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The Law of Supply
Quantity
Price
S
ceteris paribus, as
price increases, the
quantity supplied of a
product increases.
Supply Curves are
Upward Sloping
A positive relationshipbetween P and QS
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1.37
The Determinants of Supply
Prices of Inputs
The Number of Suppliers
Technology
Government Regulation
Expected Future Prices
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1.39
Example: Impact of Cost ReducingTechnology on the supply of videos
Original supply schedule New supply schedule
Old technology New technology
Price Quantity Quantity(dollars
per video)(millions of videos
per week)
a 1 0
Price(dollars
per video)
(millions of videos
per week)
b 2 3
c 3 4
d 4 5
e5 6
a' 1 3
b' 2
c' 3
d' 4
e'5
6
8
10
12
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1.40
Increase in Supply
Quantity (millions of videos per week)
Pri
ce(dollarperta
pe)
0 2 4 6 8 10 12 14
1
2
34
5
6
a
e
d
c
bSupply of videos
(new technology)
a'
b'
c'
d'
e'
Supply of videos(old technology)
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1.41
A Change in the Quantity SuppliedVersus a Change in Supply
Quantity
Price S0S0 S1
S2
Increase in
supplysupply
Decrease in
Increase in
quantity
supplied
Decrease in
quantity
supplied
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1.42
A Change in the Quantity SuppliedVersus a Change in Supply
A movement along a supply curve,which results from a change in price,shows a change in the quantitysupplied.
If some other influence on sellers plans
changes, holding price constant, thereis a change in supply.
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Market Equilibrium
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1.45
Market Equilibrium
Quantity Quantity Excess Demand()Price demanded supplied Excess Supply(+)(dollars
per video) (millions of videos per week)
1 9 0 -9
2 6 3 -3
3 4 4 04 3 5 +2
5 2 6 +4
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1.46
Market Equilibrium
0 2 4 6 8 10
1
2
34
5
6
Quantity (millions of videos per week)
Price(dollarpertape)
Supply of videos
Demand for videos
Equilibrium
ExcessDemand of 3
million at $2
a video
Excess Supply
of 2 million at$4 a video
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E S l P i Ab
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Excess Supply-Price AboveEquilibrium Price
If price were above P0 therewould be excess supply ofEB - EA
producers wish to supplymore than consumers
wish to demand In response, prices would
fall, causing Qsupplied todecreaseQdemand toincrease, moving themarket back to
equilibriumD0
D0S
S
Q0
P0 E0
Quantity
P1EA EB
E D d P i B l
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Excess Demand-Price BelowEquilibrium Price
If price were below P0 therewould be excess demand ofEB - EA
consumers wish todemand more thanproducers wish to supply
Prices would go up,causing Qsupplied toincreaseQdemand todecrease, moving themarket back toequilibrium
D0
D0S
S
Q0
P0 E0
Quantity
P1E
A E
B
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Market equilibrium
Market equilibrium is at
E0 where quantitydemanded equalsquantity supplied
with price P0 and
quantity Q0D0
D0S
S
Q0
P0 E0
Quantity
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1.51
Market Equilibrium
Price Adjustments
Excess Demand results in a shortage and
forces the price up to the equilibrium price Excess Supply results in a surplus and
forces the price down to the equilibriumprice.
I t f P i C ili A
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Impact of Price Ceilings: AMarket in Disequilibrium
Suppose a disastrousharvest moves the supplycurve to SS
government may try toprotect the poor, setting aprice ceilingat P1
which is below P0, thenew equilibrium price
RATIONINGis needed to
cope with the resultingexcess demand
Moreover, Q0-Q1 will notbe supplied because ofthe price ceiling
Quantity
P0
Q0Q1
D
S
S
P1
E
A B
P2
Minimum price: price floor
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Minimum price: price floorP
QO
Pe
minimumprice
Qd Qs
S
D
surplus
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What, How and For Whom
The market:
decides how muchof a good should be produced
by finding the price at which the quantity demanded
equals the quantity supplied
tells us for whomthe goods are produced
those consumers willing to pay the equilibrium price
determines whatgoods are being produced
there may be goods for which no consumer is prepared
to pay a price at which firms would be willing to supply
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1.57
For Review
Changes In DemandThe demand for tapes
Decreases if:
The price of a substitute falls.The price of a complement rises.
Income falls (a tape is a normal good).
The population decreases.The price of a tape is expected to fall in
the future.
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1.58
For ReviewChanges In Demand
The demand for tapes
Increases if:
The price of a substitute rises.
The price of a complement falls.
Income rises (a tape is a normal good).
The population increases.
The price of a tape is expected to rise inthe future.
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1.59
FOR REVIEW: A Change in the QuantityDemanded Versus a Change in Demand
Quantity
Price
D1
D2
Decrease in
quantity
demanded
Increase in
quantity
demanded
D0
Increase in
demand
Decrease in
demand
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1.60
Two ways in which demand may increase -(1) Change in Quantity Demanded
(1) A movementalongthe demandcurve from A to B
represents consumerreaction to a pricechange
This occurs inresponse to a
CHANGE INSUPPLY which hascaused the supplycurve to shift
A
B
P0
P1
Q0Q1 Quantity
D
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1.61
Two ways in which demand may increase(2) A Change in Demand
(2) A movementofthedemand curve from D0to D1
Caused by a change in
a Determinant ofDemand causingdemand to change atevery price
e.g. at P0
demandincreases from Q0to Q1
Causes a Change in QSupplied
A
B
P0
Q0 Q1
C
D0D1
Quantity
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1.62
For Review:
The Law of Supply
The quantity of tapes supplied
Decreases if:The price of a tape falls.
Increases if:
The price of a tape rises.
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1.63
For Review:
Changes In Supply
The supply of tapes
Decreases if:
The price of inputs used to produce tapes rises. The number of tape producers decreases.
The price of a tape is expected to rise in thefuture
Government regulation increases costs
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1.64
For Review:
Changes In Supply
The supply of tapesIncreases if:
The price of a inputs used to produce tapes falls. The number of tape producers increases
More efficient technologies for producing tapes arediscovered.
The price of a tape is expected to fall in the future.
Changes in government regulations reduce costs
M h i l NAny change in a
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Mathematical Note
c
Supply
Quantity supplied (Q )
Price(P
)
Slope is d
P = c + dQSSupply Curve
Intercept ony axis is c
0
Any change in adeterminant of supplycauses a change in theintercept c, and moves
the supply curve up ordownAny change in pricecauses movementalong the curve