Topic 1 and 2

Supply and Demand(Chapter 2)

Ratna K. Shrestha

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The Market Forces of Supply and Demand

Supply and Demand are the forces that make market economies work!

This model allows managers to predict changes in market outcomes caused by changes in economic situations such as new taxes, prices of inputs, and income.

For example, it can predict what happens to the demand for online music when the price of iPod goes down?

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2.1 The Demand Curve

D

The Effect of Price:The demand curve slopesdownward demonstrating that consumers are willing

to buy more at a lower price, given that other factors such as income doesn’t change.

Quantity

Price($ per unit)

P2

Q1

P1

Q2

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The Demand CurveVariables (Other than Price) Affecting Demand

Income: Increases in income allow consumers to purchase more at all prices, shifting the demand curve to the right.

Consumer Tastes: Advertisement can affect people’s taste.

Price of Related GoodsSubstitutes and Complements

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The Demand Curve

When the fall in price of one good reduces the demand for another good (shift of demand curve to the left), the two goods are substitutes. Examples: Pepsi and Coke, butter and margarine, etc..

When the fall in the price of one good increases (shifts right) the demand for another good, the two goods are complements. e.g., computer and software.

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The Demand CurvePopulationConsumer Expectations: If the consumers

expect the price of autos to be higher next year, its demand today will increase (shifting the curve to the right).

Govt. rules and regulations: If the city bans the use of skateboards on its street, the demand for skateboards falls (shift left). Sales taxes can decrease the demand for goods (shift left).

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DP

Q

D’

Q1

P2

Q0

P1

Q2

Change (Shift) in Demand

With an increase in income, demand increases from Q1 to Q2 at P1 and as a result demand curve shifts right.

This good is a Normal good.

Examples

Melbourne newspaper reports that local book retailers are faring better this Christmas (2008) than last. So the income elasticity seems to be helping out here. Possibly books are inferior goods.

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The Demand Curve

Changes in quantity demandedMovements along the demand curve

caused by a change in the price of the good itself.

Changes in demand (shift)A shift of the entire demand curve caused

by something other than price, such as income, preference, expectation etc...

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The Demand FunctionEstimated demand function for pork in Canada

QD = 171-20P+20Pb +3PC +2Y,

where Pb= Price of beef; PC = Price of chicken and Y = income.

For given Pb= $4, PC = $3.33 and Y = 12.5, QD = 286 – 20P.

In this case, QD/ P = - 20. A 1$ increase in P decreases QD by 20 units (Law of demand).

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The Demand Function

We can also analyze the effects of other factors: QD = 171 - 20P + 20Pb + 3PC + 2Y.

QD /Pb = 20. A 1$ increase in Pb increases pork demand by 20 units, implying that pork and beef are substitute goods.

QD/ Y = 2 >0. When incomes increases, pork demand also increases, implying that pork is a normal good.

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Market Or Industry Demand

Market Demand CurveThe sum of all the individual demand

curves in the market.It is the horizontal summation of all the

individual demand curves.For example, at P = $3, if DA = 2 and DB =6,

the total demand = 8 as given by the market demand curve in the next slide.

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Summing to Obtain aMarket Demand Curve

Quantity

1

2

3

4

Price

0

5

5 10 15 20 25 30

DB

Market DemandDA

If QA = 8 - 2P and QB = 12 – 2P, then market Q = QA + QB = 20 – 4P.

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2.2 The Supply Curve

S

Effect of PriceThe supply curve slopes

upward demonstrating thatat higher prices firms are

willing to supply more.

Mathematically: dQs/dP > 0.

Quantity

Price($ per unit)

P1

Q1

P2

Q2

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The Supply CurveOther Variables (except Price) Affecting

SupplyCosts of Production: Labor, Capital, Raw

Materials: Lower costs of production allow a firm to

produce more at each price level (and vice versa) and shift the supply curve to the right. Thus the decrease in the prices of factors of production shift supply curve to the right.

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The Supply CurveWeather pattern especially in the case of agricultural products

TechnologyGovernment regulation (taxes): excise tax on production (tax on per unit production) make it more expensive to produce and shifts supply curve to the left.

Expectations about future pricesNumber of producers

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Change (or Shift) in Supply

Initially, produced Q1 at P1

After the cost of raw materials falls, produce Q2 at P1.

Supply curve shifts right to S’

P S

Q

P1

Q1

S’

Q2

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The Supply Curve

Change in Quantity SuppliedMovement along the curve caused by a

change in price of the good itself.Change in Supply (shift)

Shift of the curve caused by a change in something other than price of the good itself such as changes in costs of production.

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Supply Function

Pork supply function:

QS = 178 + 40P - 60Ph.

where Ph= Price of hog.

For given Ph= $1.5, supply QS = 88 + 40P.

In this case, QS/ P = 40. QS increase as its market P increases (the law of supply).

QS/ Ph = - 60, implying that when the price of hog goes up, supply decreases (shifts left).

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2.3 The Market Equilibrium

D

SThe market equilibrium is determined by the interactions of S and D. At the market-clearing price P0, QD = QS.

P0

Q0 Quantity

Price($ per unit)

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The Market Equilibrium

D

S

P0

Q0

1. If price is above the market clearing price,

QS > QD

2. Price falls to the market-clearing price

3. Market adjusts to equilibrium

P1

Surplus

Quantity

Price($ per unit)

QSQD

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The Market Equilibrium

D

S

QS QD

P2

Quantity

Price($ per unit) 1. If price is below

the market clearing price,

QD > QS

2. Price rises to the market-clearing price

3. Market adjusts to equilibrium.

Q3

P3

Shortage

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Finding Market Equilibrium

Pork supply and demand functions:QS = 88 + 40p

QD = 286 – 20pAt equilibrium, QD = QS

286 – 20p = 88 + 40pSolving for p, p = $ 3.3. Substituting p = 3.3

in either equation, Q = 220.

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2.4 Shocks to EquilibriumWhat happens to the price of Pork when the

price of hog (input) goes up?QS = 178+ 40p – 60ph

QD = 286 – 20pAt equilibrium, QD = QS

286 – 20p = 178 + 40p – 60ph.

Or, p = 1.8 + ph

Differentiating, p/ ph = 1, when ph goes up by $1, p increases by $1 as well.

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S’

Shocks to Equilibrium

When the price of hog goes up (shifting S curve to the left), the price of pork goes up as well.

P

Q

SD

P1

Q1Q2

P2

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D’S

D

Q3

P3

Changes In Market Equilibrium

When income IncreasesDemand shifts to D’Shortage at P1 of Q2

– Q1

Shortage drives P upEquilibrium at P3 , Q3

P

QQ1

P1

Q2

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Application: Market for a College Education

Q (millions enrolled)

P

D1970

S1970

S2010

D2010

$6,000

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$2,600

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Application: BC Cranberry

After the discovery of beneficial health effect of Cranberry in 1996 (Harvard Study), BC cranberry farmers expected its demand and hence price to go up. But to their dismay, the price fell instead.

Analyze what might have caused this unexpected result??