economics

Supply and Demand

How Markets Work?

Faculty of Business and Economics (FBE), The IIPM, New Delhi

Demand and Supply Analysis

“You cannot teach a parrot to be an economist simply by teaching it to say ‘supply’ and ‘demand’.”

---Anonymous


In this chapter you will…

Learn the nature of a ‘competitive Learn the nature of a ‘competitive market’.market’.Examine what determines the demand Examine what determines the demand for a good in a competitive market.for a good in a competitive market.Examine what determines the supply Examine what determines the supply of a good in a competitive market.of a good in a competitive market.See how supply and demand together See how supply and demand together set the price of a good and the set the price of a good and the quantity sold.quantity sold.Consider the key role of prices in Consider the key role of prices in allocating scarce resources. allocating scarce resources.


THE MARKET FORCES OF SUPPLY AND DEMAND

Supply and Demand are the Supply and Demand are the two words that economists use two words that economists use most often.most often. Supply and Demand are the Supply and Demand are the forces that make market forces that make market economies work!economies work! Modern microeconomics is Modern microeconomics is about supply, demand, and about supply, demand, and market equilibrium.market equilibrium.


MARKETS AND COMPETITION• The terms supply and demand The terms supply and demand refer to the behaviour of refer to the behaviour of people......as they interact people......as they interact with one another in markets.with one another in markets.• A market is a group of A market is a group of buyers and sellers of a buyers and sellers of a particular good or service.particular good or service.• Buyers determine demand...Buyers determine demand...• Sellers determine supply…Sellers determine supply…


Competitive Markets

A Competitive Market is a A Competitive Market is a market with many buyers and market with many buyers and sellers so that each has a sellers so that each has a negligible impact on the market negligible impact on the market price.price.


Competition: Perfect or Otherwise

Perfectly Competitive: Homogeneous Products Buyers and Sellers are Price Takers

Monopoly: One Seller, controls price

Oligopoly: Few Sellers, not aggressive competition

Monopolistic Competition: Many Sellers, differentiated products


DEMAND• Quantity Demanded refers to the amount (quantity) of a good that buyers are willing to purchase at alternative prices for a given period.


Determinants of Demand• What factors determine how much ice cream you will buy?

• What factors determine how much you will really purchase?

Product’s Own PriceConsumer IncomePrices of Related GoodsTastesExpectationsNumber of Consumers


Price

Law of Demand– The law of demand states that,

other things equal (ceteris paribus), the quantity demanded of a good falls when the price of the good rises.


Income– As income increases, the demand for a normal good will increase.

– As income increases, the demand for an inferior good will decrease.


Prices of Related Goods– Prices of Related Goods

– When a fall in the price of one good reduces the demand for another good, the two goods are called substitutes.

– When a fall in the price of one good increases the demand for another good, the two goods are called complements.


Others– Tastes & preferences– Expectations– Re-saleability– Advertising


The Demand Schedule and the Demand Curve

– The demand schedule is a table that shows the relationship between the price of the good and the quantity demanded.

– The demand curve is a graph of the relationship between the price of a good and the quantity demanded.

– Ceteris Paribus: “Other thing being equal”


Table 4-1: Catherine’s Demand Schedule

03.00

22.50

42.00

61.50

81.00

100.50

120.00

Quantity of cones Demanded

Price of Ice-cream Cone ($)


Figure 4-1: Catherine’s Demand CurvePrice of Ice-Cream Cone

Quantity of Ice-Cream Cones

2 4 6 8 10 120

$3.00

2.50

2.00

1.50

1.00

0.50


Market Demand Schedule

• Market demand is the sum of all individual demands at each possible price.

• Graphically, individual demand curves are summed horizontally to obtain the market demand curve.

• Assume the ice cream market has two buyers as follows…


03.00

100.50

120.00

CatherinePrice of Ice-cream Cone ($)

Table 4-2: Market demand as the Sum of Individual Demands

+

1

6

7

Nicholas

1

22.50

42.00

61.50

81.00

2

3

4

5

4

7

10

13

16

19

Market

=


Price of Ice-Cream Cone

Quantity of Ice-Cream Cones

D3

D1

D2

Decrease in demand

Increase in demand

Figure 4-3: Shifts in the Demand Curve


The Determinants of Quantity Demanded


Shifts in the Demand Curve versus Movements Along the

Demand Curve


Price of Cigarette

s, per Pack.

Number of Cigarettes Smoked

per Day

D2

A policy to discourage smoking shifts the demand curve to the left.

0 20

$2.00

D1

A

10

B

Figure 4-4 a): A Shifts in the Demand Curve


Price of Cigarette

s, per Pack.

Number of Cigarettes Smoked

per Day

0 20

$2.00

D1

A

A tax that raises the price of cigarettes results in a movements along the demand curve.

C

12

$4.00

Figure 4-4 b): A Movement Along the Demand Curve

Supply

• The quantity of goods or services that firms are ready and are willing to sell at a given price within a period of time , other factors being held constant .

• A product made available for sale by firms.

Law of Supply

• It states that if the price of a good or service goes up , the quantity supplied for such good or service will also go up ; if the price goes down , the quantity supplied also goes down , ceteris paribus .

Supply Schedule

• A schedule listing the various prices of a product and the specific quantities supplied at each of these prices .

• Can be used to construct a supply curve .

Supply Curve

• A graphical representation showing the relationship between the price of the product or factor of production and the quantity supplied per time period .

• Is consistent with the Law of Supply .

Supply Function

• A form of mathematical notation that links the dependent variable , quantity supplied (Qs), with various independent variables which determine quantity supplied .

• Among the factors that influence the quantity supplied are price of the product, number of sellers in the market , price of factor inputs , technology , business goals , importations , weather conditions , and government policies .

• Qs = f (own price , number of sellers , price of factor inputs , technology , etc .)

Change in Quantity supplied vs . Change in Supply

Change in Quantity Supplied

• A change in quantity supplied is brought about by an increase (decrease) in the product’s own price .The direction should be positive considering the Law of Supply .

Change in Supply

• When the entire demand supply curve shifts rightward or leftward .

• Caused by factors other than the price of the good itself such as change in technology , business goals , etc , resulting to the movement of the entire supply curve .

Optimization in the use of factors of production

What is Optimization?

- refers to the process of making

something as fully functional or effective as

possible.

Optimization in the use of Factors of Production

An optimization in the utilization of

resources will increase supply, while a

failure to achieve such will result to

decrease in supply.

Technological Change

Introduction of cost-reducing

innovations in production technology

increases supply on one hand. On the other

hand, this can also decrease supply by

means of freezing the production through

the problems that the new technology might

encounter, such as technical trouble.

Future Expectations

This factor impacts sellers as much as

buyers. If sellers anticipate a rise in prices,

they may choose to hold back the current

supply to take advantage of the future

increase in price. If sellers expect a decline

in price for their products, they will increase

present supply.

Number of Sellers

The number of sellers has a direct

impact on quantity supplied. Simply put, the

more sellers there are in the market the

greater supply of goods and services will be

available.

Weather Conditions

Bad weather, such as typhoons,

drought or other natural disasters, reduces

supply of agricultural commodities while

good weather has an opposite impact.

Government Policy

Removing quotas and tariffs on

imported products also affect supply. Lower

trade restrictions and lower quotas or tariffs

boost imports, thereby adding more supply

of goods in the market.

Quota – are limitation on the number of imported

goods which could enter a country.

Tariffs - tax imposed on imported goods and services.

Market Equilibrium

Market Equilibrium

Market Equilibrium

A situation in which the supply of an item is

exactly equal to its demand. Since there is neither

surplus nor shortage in the market, price tends to

remain stable in this situation.

This figure shows the equilibrium between quantity demanded and quantity supplied. (x-axis are the quantities and y-axis are the prices). As we can observe in the graph, market equilibrium is the point of intersection between the supply (S) and demand (D) curves, that is, at P=30 and Q = 150.

What happens when there is market

disequilibrium?

When there is market disequilibrium,

two conditions may happen: a surplus or a

shortage.

Surplus

Surplus is a condition where the

quantity supplied is more than quantity

demanded. Tendency is for sellers to lower

market prices. This means a downward

pressure to price in order to restore

equilibrium in the market.

As we can observe in the graph, surplus ia situation above the equilibrium point. This is because quantity supplied (say as P=40, Qs=200 units) is greater than quantity demanded (at P=40, Qd=100 units) resulting to 100 units more goods being supplied

Shortage

Shortage is a condition in the market in

which quantity demanded is higher than

supplied. When the market is experiencing

shortage, there is a possibility of consumers

being abused, while the producers are

enjoying imposing higher prices for their own

interest.

As we can observe in the graph, shortage happens when quantity demanded is greater than quantity supplied. For instance at price P20 quantity demanded is 200 units while quantity supplied is 100 units.

What happens if disequilibrium in the

market persists at longer period of time?

The government may intervene by

imposing price controls.

Price Control

Price Control is the specification by the

government of minimum or maximum prices

for goods and services. The price may be

fixed at a level below the market equilibrium

price or above it depending on the objective

in mind.

It is the legal minimum price imposed

by the government. This is undertaken if a

surplus in the economy persist. This move is

resorted to in order to prevent bigger losses

on the part of the producers

Floor Price

It is the legal maximum price imposed

by the government. Price ceiling is utilized

by the government if there is a persistent

shortage of goods. It is imposed to protect

consumers from abusive sellers who take

advantage of the situation.

Price Ceiling

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