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EC 1008Introduction to Microeconomics
Lecture 2: Analyzing markets: supply and demand
Sotiris GeorganasCity University London
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Learning outcomes
To understand the demand and supply function
To outline the laws of demand and supply
To analyse what causes movements and shifts
To understand the concepts of equilibrium and comparative statics
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Background
Understanding how markets work is a key part of a course in economics
In particular you need to understand the key role played by prices
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Markets
Differ in a number of important ways 1. Number of buyers and sellers2. Level of information ▪ Knowledge about the product and different
prices
3. How easy it is to set up in business ▪ Barriers to entry▪ Can service/product be easily copied?
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Perfect competition
One type of market structure A market is perfectly competitive if no
participant has market power Market power: the power to set the price of
the good
Key Assumptions
1. Numerous (many!) buyers and sellers 2. Perfect information3. Free entry and exit
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Demand, supply and (goods) markets
Market
Consumer
demand
Supply by firms
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Demand
Demand: the amount of a good or service that consumers are willing and able to purchase at each price
Can be different from the amount purchased
Reflects the degree of value/pleasure/utility consumers place on the good/service
Different people will value the same good/service differently
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Determinants of demand by consumers for goods and services
What?
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Determinants of demand by consumers for goods and services
Demand
Income
Preferences
Good’s price
Other goods’ prices
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Demand
Market demand function: relationship between quantity demanded of a particular product and all factors that influence demand
Qdx= f(Px, Py, I,....)
Quantity demanded is the ‘dependent’ (endogenous) variable Price, income etc are the independent
variables
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Demand curves
Isolate the impact of price Qdx = f(Px) ceteris paribus
(demand depends on price, holding all else equal) Complication – demand curves are drawn with
price (independent variable) on the vertical axis Why ?
Walras (1834 – 1910) developed the theory, with quantity the dependent variable
Marshall (1842 – 1924) developed graphical representation (probably following Cournot’s work 30 years earlier), with price as the dependent variable
Today we use Walrasian theory, but the Marshallian representation
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Since price is the vertical axis we use the inverse demand for graphs
Inverse demand : Px = g(Qdx) “Price as a function of quantity”
Direct demand : Qdx = f(Px) Where g=f-1
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Example: demand for potatoes
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Monthly market demand for potatoes
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Law of demand
Isolate the impact of price ↑ Px ⇒ ↓ Qdx (Ceteris paribus) ↓ Px ⇒ ↑ Qdx (Ceteris paribus)
Why? a. Substitution effect - as price rises
consumers have an incentive to switch to cheaper alternatives
b. Income effect - a rise in price reduces consumers’ `real’ income so they purchase less of a `normal’ good
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Movements along and shifts in the demand curve
We can use this model of demand to analyse the effect on demand of changes in price and other variables, such as income.
We distinguish between these by use of special terms:
– Movement along the demand curve, for price changes
– Shift in the demand curve, for changes in other variables
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Movement along the demand curve
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An increase in demand
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Types of goods
Substitutes: If price of X increases and demand for Y goes up, X and Y are substitutes.
Complements: If price of X increases and demand for Y goes down, X and Y are complements.
Normal Goods: If increase in income leads to increase in demand
Inferior goods: If increase in income leads to decrease in demand.
Examples?
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Examples
“normal”
“inferior”
substitutes
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Supply
Supply – the amount of a good or service producers are willing to offer for sale at each and every price
Market supply function – relationship between quantity supplied and all the factors that influence that supply
Supply curve isolates the impact of price Qsx = f(Px) ceteris paribus Inverse supply curve: Px=g(Qsx)
As before, g=f-1
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Determinants of supply
Supply
Technology
Good’s price
Other goods’ prices
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Supply
simple supply functionsQs =a+bP
more complex supply functionsQs =a+bP+dPi –ePj
a simple demand function Qd =a-bP
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Example: supply of potatoes
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Monthly market supply of potatoes
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Law of supply
↑ Px ⇒ ↑ Qsx (ceteris paribus)
Why? Higher price, ceteris paribus, the more
profitable the good. Acts as an incentive In the short run, existing suppliers switch
more resources into producing good X The existing producers increase supply
because it is profitable to produce more – has to do with the cost function.
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Shifts in the supply curve
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Market equilibrium
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Market equilibrium: undersupply
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Market equilibrium: oversupply
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Market equilibrium: all clear
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Effect of a shift in the demand curve on equilibrium
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Effect of a shift in the supply curve on equilibrium
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Example
Demand and supply curves are: Qd= a-bP (1) Qs= c+dP (2)
We need to solve for equilibrium price and quantity (P* , Q*)
Set quantity demanded and supplied equal, and solve for P.
(1)=(2) =>a-bP*=c+dP* => a-c= bP*+dP* => a-c= (b+d)P* =>
P*=(a-c)/(b+d) (3)
Insert result (3) into (1) => Q*=a-b( (a-c)/(b+d) )
So if, for example, a=30, b=1, c=0, d=2,we have P*=30/3 = 10 and Q*= 30-(10)=20 units
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Learning outcomes
To understand the demand and supply function
To outline the laws of demand and supply
To analyse what causes movements and shifts
To understand the concepts of equilibrium and comparative statics