Economics: Supply and Demand

Introductory Microeconomics

Dr. Lisa Mohanty

TUI University

Supply and Demand

• Forces that make market economies

function

• Determines the quantity of each good

produced

• Demand and Supply in a competitive

Markets: some assumptions

What determines demand?

• Price (law of demand P h QD i)

– This is a movement along the demand curve.

• Income: wages, interest, rent or wealth (accumulation of what

household owns)

– Depends on type of good

• Normal goods: Income h QD h (shifts demand right)

• Inferior goods: Income h QD i (shifts demand left)

• Tastes, preferences

– Examples: fad diets, trends,

• Expectations

– Examples: future prices

• Prices of Related Goods

– Substitutes: goods that can be used to replace

one another.

• If A and B are substitutes:

– PA h QD of good B h (shifts demand right)

– Examples: Pepsi and Coke, Butter and Margarine,

DVD and videos

– Complements: goods that are used together.

• If A and B are substitutes

– PA h QD of good Bi (shifts demand left)

– Examples: Cereal and Milk, Bagels and Cream

Cheese, Chips and Salsa

Demand Curve

• Negative relationship between price of the good and quantity demanded, all other variables are held constant (ceterus paribus)

• Quantity demanded: amount of product that household would buy at a given price (willingness to pay)

• Changes in price will affect Quantity Demand. Changes in other factors will affect Demand.

• Based on Law of Demand: as prices falls, quantity demanded increases and vice versa

• Demand schedule: table showing how much

a given product household will buy at

different prices

• Demand curve: illustration of schedule

• Example: See next slide

P Q

5 1

4 3

3 7

2 9

1 12

Quantity Demanded & Demand

• Changes in Quantity

Demanded

• Movement ALONG

the demand curve due

to a price change

• Changes in Demand

• Shift of the entire

demand curve due to a

change other than

price

Market Demand

• Horizontal summation of all quantities of

good or services demanded per period by all

households in the market

Shifts in Demand

• Examples: Market for Bottled Water

(normal good)

– Increase in income- demand increase, shifts

demand right

– Decrease in the price of Sports Drinks

(substitute) – demand falls, shifts demand left

– Drinking water clears acne – demand increases,

shifts demand right

What determines Supply?

• Prices: (law of supply P h Qs h)

– This is a movement along the supply curve.

– Firms are profit motivated.

– Profit = Total Revenue – Total Cost

– Firms want to maximize revenue and minimize costs (see next slide)

– Total Revenue (TR) = P * Q so as price increases, TR increases , profit increases

Other factors

• Costs of production

– Kinds of inputs: capital or labor

– Amount of Inputs

– Prices of Inputs

• Prices of Related Goods

– Beef and Leather. If price of beef increases, firms will supply more beef; consequently produce more leather.

• Technology

– Improves productivity of resources so will reduce firm’s cost

• Expectations about the future

Supply Curve

• Law of Supply: Positive relationship between price of the good and quantity supplied, all other variables are held constant (ceterus paribus)

– as prices rises, quantity supplied increases and vice versa

• Quantity supplied: amount of product that firm is willingness to sell at a particular price (ceterus paribus)

• Changes in price will affect Quantity Supplied. Changes in other factors will affect Supply.

• Supply curve: illustration of schedule of

how much a product a firm will supply at

different prices

• Example: See next slide

P Q

5 13

4 10

3 7

2 4

1 2

Supply and Quantity Supplied

• Changes in Quantity

Supplies

• Movement ALONG

the Supply curve due

to a price change

• Changes in Supply

• Shift of the entire

demand curve due to a

change other than

price

• Show increase and

decrease (increase is a

shift right)

Market Supply

• Horizontal summation of all quantities of good or

services supplied per period by all firms in the

market (sum of all that is supplied each period by

all producers of a single product)

Shifts in Supply

• Examples: Market for Bottled Water

– Increase in technology- supply increases, shifts

supply right

– Increase in wages of bottle factory workers-

supply decreases, shifts supply left

Market Equilibrium

• Bring Supply and Demand together

• Market equilibrium: the point at which supply and

demand curves intersect (e.g. P = 3, Q =7)

• QS = QD a no tendency for price to change

• Quantity of the good that buyers are willing and

able to buy balances the quantity that sellers are

willing and able to sellsum of all that is supplied

each period by all producers of a single product

What if market is not in

equilibrium?

• Excess Supply

(surplus): prices fall

– QS > QD

• Excess Demand

(shortage): prices rise

– QS < QD

Changes in Equilibrium

• Market for Beef

– McDonalds introduces new salad menu

(substitute)- demand falls so demand shifts left-

price falls, quantity falls

– New growth hormone is introduced-supply

increases-price falls, quantity increase

– Price of ground turkey falls (substitute) and

Mad Cow Disease-demand falls, supply falls-

price is indeterminate (depends on size of shift)

but quantity falls

Price System

• Automatic mechanism for distributing

scarce goods and services

– Price rationing

• Determines allocation of resources among

producers and final output

Market Mechanism

• Total supply is

rational to those

willing and able to pay

a higher price

• Example:

– Shortage of Lobsters

– Price will rise until QS

= QD

• Lobster Market

Price Rationing

• Allocated goods and services to consumers

when QS < QD

• Price adjustment: can be a price control

• Price Control: price imposed by government

Price Controls-governement imposes

legal minimum or maximum prices

• Price ceiling: maximum price a

seller may charge (creates QS <

QD) a shortage

• Set below equilibrium

• e.g Rent Market

• Price Floor: minimum price a

seller may charge (creates QS >

QD) a surplus

• Set above equilibrium

• e.g. Minimum wage

Other forms of Rationing

• Queing: non-price mechanism

• Favored customers: those receiving special

treatment (bribery)

• Ration Coupons: tickets, permits which

entitle purchase of certain amounts

• Import fees

• Black market: illegal trading

Elasticity

• What determines shape of demand curve?

• Why are some deamnd curves steep or some flat?

• Gasoline example-how many of you stop driving when gas

prices rise? The quantity demanded of gasoline falls less

than the corresponding increase in price (e.g. gas prices

may rise 50%, but only 10% of consumers will buy less

gas)

• Since demand curve shows the relationship between price

and quantity demanded, we will examine how quantity

demanded changes when the price of a good changes

Elasticity

• Elasticity: measure of responsiveness of quantity

demanded (or quantity supplies) when another variable

(price, income, prices of other goods) changes

• Depends on types of goods

– Necessities vs. luxuries

– Whether close substitutes exist

– Time horizon-the longer the time period, consumers

will start to find substitutes for high priced goods so the

goods become less inelastic

Price Elasticity of Demand

• How much the quantity demanded responds

to a change in price

e = %D in QD

%D in Price

Elasticity will be negative (recall law of demand),

we can take the absolute value

Elasticity

• Elastic: e > 1

• Inelastic: e < 1

• Perfectly Elastic: e = infinity

• Perfectly Inelastic: e = 0

• Unit Elastic e = 1

Elasticity of Demand Example

e.g: Price increases from $2 to $2.20 and QD

falls from 10 units to 8 units

P0 = 2 P1 = 2.20

Q0 = 10 Q1 = 8

%D in QD a 10 – 8 * 100 = 20%

10

%D in Pa 2 – 2.20 * 100 = 10%

2

%D in QD a 20 = 2

%D in Price 10

Elasticity Changes along the

Demand Curve

Other types of Elasticity

• Elasticity of Supply

Price elasticity of supply =

Percentage change in quantity supplied

Percentage change in price

Cross Price Elasticity of demand

Cross Price Elasticity of demand

• A measure of how much the quantity demanded of one

good responds to a change in the price of another good,

computed as the percentage change in quantity demanded

of the first good divided by the percentage change in the

price of the second good

• Substitutes-cross price elasticity is positive

• Complements-cross price elasticity is

negative

Income Elasticity of Demand

Income Elasticity of Demand

• Income Elasticity

– Types of Goods

• Normal Goods –income elasticity is positive

• Inferior Goods-income elasticity is negative

– Higher income raises the quantity demanded for

normal goods but lowers the quantity

demanded for inferior goods.