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Demand, Supply and Price Theory
Week 2
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What is opportunity Cost? Why are incentives important to policy
makers? Why isn’t trade amongst countries a game
with winners and losers? Why is productivity important? What is the relationship between Marginal
Benefit and Marginal Cost
Recap
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Economics is a Science Economists devise theories, collect
data and analyze it Scientific economists make positive
statements
The Scientific Method
Identify the problem
Develop a model based on simplified assumptions
Collect data and
test models
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The Circular Flow Diagram The production possibilities frontier Market equilibrium
Three Economic Mode
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“A visual model of the economy that shows
how money flows through markets amongst households and firms”
The Circular flow diagram
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A graph that shows the combinations of output that
the economy can possibly produce given the available factors of production and the available production technology.
Example Economy can produce 300 shirts or 100 cakes Producing at the PPF causes the market to be “efficient” It is easy to see trade offs and opportunity costs Opportunity Cost = the slope of the PPF Line
Slope = Change in Y/ Change in X 300-0/100/0 = 3
Production Possibilities Frontier
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What happens
To the price of petrol when war breaks out in Iran To the price of mangoes when farmers have an abundant
year To the number of tourists when the tsunami hit Sri-Lanka
All of the above show the workings of Supply and Demand
Supply and Demand are the forces that make market economies work. They determine the following
Quantity of Goods produced Price of which goods are sold
Markets and Competition
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A group of buyers and sellers of a particular good or
service. Characteristics of markets
Organized markets Less Organized markets.
A competitive market is a market which has many buyers and sellers so that each has a negligible impact on price.
For today’s class we will assume that markets are perfectly competitive. The goods offered for sale are exactly the same so that
no single buyer or seller has influence over price.
What is a Market?
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Quantity Demanded – the amount of a good that buyers
are willing and are able to pay.
Market Demand – the sum of all individual demand for a particular good or service
Demand
Law of DemandThe claim that other things equal the
quantity Demanded of a good falls when the price of
The good increases.
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Price Quantity
Demanded
0 6
50 5
100 4
150 3
200 2
250 1
300 0
Demand
Shifts in the demand curveDemand curves can shift• To the RIGHT (A)• To the LEFT (B)
Shifts to the right means demand hasincreasedShift to the left means demand has decreased
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Income Prices of Related goods Tastes Expectations Number of Buyers
Variables that cause Demand Curves to
shift
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Normal goods
A good for which other things equal an increase in income leads to an increase in demand
Inferior Good A good for which other things equal an increase
in income leads to a decrease in demand.
Income
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Substitutes
Two goods for which an increase in price of one leads to an increase in demand for the price of the other
Complements Two goods for which an increase in the price of
one leads to a decrease in demand for the other.
Price of Related Goods
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Quantity Supplied
The amount of a good that sellers are willing and able to sell.
Supply
Law of SupplyThe claim that other things equal the
quantity Supplied of a good increase when the price
of The good increases.
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Price of cone
Quantity Supplied
0 0
50 0
100 1
150 2
200 3
250 4
300 5
Supply
Shifts in the Supply Curve
• Shifts to the right increase supply• Shifts to the left decrease supply
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Input Prices
Costs of inputs. If they increase production decreases, if they decrease production will increase
Technology Machinery increases productivity
Expectation Number of Sellers
Variables that cause the supply curve to
shift
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Equilibrium – A situation which the market
price has reached the level at which quantity supplied equals the quantity demanded. Equilibrium price – the price that balances Qd
and Qs Equilibrium quantity – the quantity that
balances Pd and Ps
Market Equilibrium
Law of Supply and DemandThe claim that the price of any good adjusts to bring the Qd and the Qs for the good into
balance.
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Surplus – A situation where Qs is greater than
Qd Shortage – A situation where Qd is greater
than Qs
Surplus and Shortage
No change in Supply
An increase in supply
Decrease in supply
No change in demand
P.Q No change
P downQ up
P upQ down
Increase in Demand
P up Q down
P ambiguousQ up
P is upQ ambiguous
Decrease in demand
P downQ up
P downQ ambiguous
P ambiguousQ down
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We use absolute numbers even though Qd is negatively related to its price.
|Ped|= △Q/△P = 20/10 = 2
Elasticity of Supply and Demand
Price Elasticity
of Demand
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Perfectly Inelastic Demand Inelastic Demand Unitary Elastic Demand Elastic Demand Perfectly Elastic Demand
Different Types of Demand
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Sustainability Nature of the Product Proportion of Income Definition of Market The Possibility of new purchases Time Horizons Addiction Complementary goods Price expectations
Determinants of Price Elasticity
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A measure of how much the quantity
demanded for a good responds to a change in consumers income.
Income Elasticity of Demand
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Negative elasticity
Ey>0 – D decreases as I increases Zero Income Elasticity
Ey=0 – D does not change as I rises of falls Income Inelastic Demand
0<Ey<1 – D rises at a smaller proportion than I Unit Income Elasticity
Ey=1 – D rises exactly the same proportion as I Income elastic demand
1<Ey<∞ - D rises at a greater proportion than income
(Ey)
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The measure of how much the quantity
demanded of one good responds to a change in the price of another good.
The Cross Price Elasticity of Demand
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Es = △Q/Q = △Q x P △P/P △P Q
Price Elasticity of Supply
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Time Excess Supply or Unsold Stock Factor Mobility Natural Constraints Risk Taking
Determinants of Elasticity of Supply
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